ANALTTICAL PROCEDURES Analytical procedures refers to the analysis of significant ratios and trends including the resulting investigation

of fluctuations and relationships that are inconsistent with other relevant information or which deviate from predicted amounts. Nature of analytical procedures These may be achieved through the consideration of comparisons of the entitys financial information with, for example: Comparable information for prior periods The entitys anticipated results Similar industry information. When performing analytical procedures, the auditors examine both financial data and nonfinancial data, such as the number of employees. Before starting their analytical procedures, auditors estimate the expected value (of the ratio/ trend/ account balance/ transaction, etc.) before calculating the actual value so as to avoid the actual value being biased for the auditors estimate of the expected value. The expected results are estimated based on preliminary discussions with the clients. After having performed their analytical procedures, the auditors then compare the actual results with those expected and look for reasons for any significant variations. Unexplained variations may indicate a misstatement in the figures in that area, which would lead the auditors to plan their audit work to devote more time and resources to those areas. When the application of analytical procedures does not identify any unusual or unexpected differences, the results provide evidence in support of managements assertions. Timing and purpose of analytical procedures Analytical procedures may be performed at any of all three stages in the audit process: the planning phase, the testing phase and the completion phase. During the planning phase, analytical procedures can be used as risk assessment procedures. They help auditors identify significant matter s requiring special consideration later in the audit engagement, such as to: understand the clients industry and business indicate possible misstatements reduce detailed tests. During the testing phase, analytical procedures can be used as substantive procedures in collecting appropriate audit evidence. They can be performed together with other substantive procedures (substantive tests of transactions and tests of details of balances) and they help to: indicate possible misstatements reduce detailed tests. During the completion phase, analytical procedures can be used as part of an overall review of the financial statements for the auditors to reach conclusions about the fair presentation of the financial statements. The analytical procedures help the auditors to take a final review of the audited financial statements objectively and help to: assess going concern indicate possible misstatements. Limitation of analytical procedures as substantive procedures Analytical procedures only provide conclusions on reasonableness of data rather than precision and cannot easily be linked to specific assertions (i.e. the nature or cause of a difference); therefore analytical procedures are less persuasive [Type the company address] Page 1

than tests of details of balances. The substantive evidence gathered using analytical procedures is thus generally used to corroborate other substantive evidence gathered, rather than being used as a sole source of evidence. Cost-benefit of analytical procedures Analytical procedures cost the least because of the relative ease of making calculations and comparisons. It is quite often easier for auditors to obtain considerable information about potential misstatements by simply comparing two or three numbers. Advice on the use of analytical procedure Analytical procedure is a powerful tool that has the potential to increase the efficiency of audits since it is a relatively low-cost procedure that seems to have considerable power in identifying errors or irregularities and in guiding audits. Although the calculation of ratios and comparison of trends are relatively easy tasks, the analysis of ratios and trends requires a good understanding of the clients business and industry. Hence analytical procedures are preferably handled by a more senior auditor within the audit team. Types of Analytical Procedures 1. Ratios 2. Trend Analysis 3. Predictive Tests 4. Data Analysis AUDIT METHODOLOGIES The audit strategy document describes the audit methodology to be used in gathering evidence. Following are the main methodologies currently used by the auditors: 1. 2. 3. 4. 5. Risk Based Audit. Top down approach. System audit. Balance sheet approach. Directional testing

Risk based audit: Consider for example you are auditing a small manufacturing company. The company owns the land and building in its statements of financial position which it depreciates over 50 years and has always been valued at cost. The other major item is inventory. Now considering the nature of business, inventory is likely to be far more complex. The chance of audit engagement partner drawing an inappropriate conclusion about inventory is higher than the risk in connection with land and building. Under risk based auditing the auditor will do less work on land and building and will apply more audit procedures on inventory. Top down approach: With a top down approach also known as business risk approach, controls testing is aimed at high level controls and substantive testing is reduced. Following such approach the auditor: 1. Pays greater attention to high level controls such as control environment and corporate governance rather than [Type the company address] Page 2

the detailed procedural controls testing under traditional approaches 2. Apply analytical procedures more heavily to understand the entitys business rather than to prove financial statement figures. 3. Reduce its substantive testing. Advantages: 1. Added value to the clients as the approach focuses on the business as a whole. 2. Increase efficiency and reduce cost as substantive testing is reduced. 3. Responds to the importance that regulators and government have placed on corporate governance in recent years. 4. Lower engagement risk through broader understanding of the clients business and practices. Systems audit: Also known as traditional approach to auditing in which auditor assesses the system of controls (such as for sales, purchases, payroll, receipts and disbursements) put in place by the management and ascertain whether they are effective enough for the auditors to reduce their substantive procedures. Balance sheet approach: Under this approach the auditor seek to concentrate efforts on substantiating the closing position in the year, shown in the statement of financial position, having determined that the closing position from the previous year has been correctly transferred to be the opening balance in the current year. Such an approach can be undertaken with reduced element of substantive testing under business risk approach. Such approach is effective for small companies whose financial statement contains very few material items and there are no sophisticated controls in such a company. But it can be costly as substantive procedure usually takes time to be performed. Directional testing: It is a method of undertaking detailed substantive testing. Substantive testing seeks to discover errors and omissions and the discovery of these will depend on the direction of the test. Broadly speaking, substantive procedures can be said to fall in to two categories: 1. Test to discover errors (resulting in over or understatement) 2. Test to discover omissions (resulting in understatements) Test to discover errors: Such test starts with accounting records in which transactions are recorded and then trace to supporting documents. Example if the test is to check sales are priced correctly, the test would begin with a sales invoice selected from the sales ledger. Prices would then be checked to the official price list.

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These test start outside the accounting record and then check back to those records. Example if the test is designed to discover whether all raw material purchases have been properly processed, the test would start say with goods received notes, to be checked to the inventory records or purchase ledger. Directional testing is particularly useful when there is high level of detailed testing to be carried out for example when the auditors have assessed the companys controls and accounting systems as ineffective. AUDIT OPINION S.NO 1. 2. 3. 4. REASON Material misstatements Material and pervasive misstatements Material inability to obtain sufficient and appropriate audit evidence Material and pervasive inability to obtain sufficient and appropriate audit evidence OPINION Qualified (except for) Refer Illustration 1 Adverse Refer Illustration 2 Qualified (except for) Refer Illustration 3 Disclaimer of opinion Refer Illustration 4

Emphasis of Matter Paragraph A paragraph included in the auditors report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditors judgment, is of such importance that is fundamental to users understanding of the financial statements. Example of situations where Emphasis of Matter Paragraph is used: 1. Uncertain outcome of material litigation. 2. Early application of accounting standard that has a pervasive effect on the financial statements in advance of its effective date. 3. A major catastrophe that has had, or continues to have, a devastating effect on the entitys financial position. 4. The financial reporting framework is unacceptable but for the fact that it is prescribed by law or regulation. 5. There is a material uncertainty relating to events or condition that may cast significant doubt on the entitys ability to continue as a going concern. The emphasis of matter paragraph should be included immediately after the opinion paragraph in the auditors report and should be clearly identified as an Emphasis of Matter. Example We draw attention to note 22(a) to the financial statements which describes the uncertainties related to the outcome of the law suits filed against the Company. Our opinion is not qualified in respect of this matter. Other Matter Paragraph A paragraph included in the auditors report that refers to a matter other than those presented or disclosed in the financial statements that, in the auditors judgment, is relevant to users understanding of the audit, the auditors responsibilities or the auditors report.

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Example of situation where Other Matter Paragraph is used: 1. Where prior period financial statements were unaudited. 2. Where prior period financial statements were audited by a predecessor auditor. 3. When reporting on prior period financial statements in connection with the current periods audit, if the auditors opinion on such prior period financial statements differs from the opinion the auditor previously expressed. 4. If the revision of other information is necessary and management refuse to make the revision. 5. The auditor is unable to withdraw from the engagement and yet is unable to obtain sufficient appropriate audit evidence, when the auditor has been requested to report on other matters or to provide more clarifications in line with legal jurisdiction of the country. The other matter paragraph is included immediately after the opinion paragraph and any emphasis of matter paragraph. Example The financial statements of the Company for the year ended 30 June 2009 were audited by another firm of chartered accountants whose report dated 11 September 2009 expressed an unqualified opinion on those financial statements. However, the said auditors report included an emphasis of matter paragraph regarding short provision of taxation in respect of prior years. ILLUSTRATIONS

Illustration 1: An auditor's report containing a qualified opinion due to a material misstatement of the financial statements. Illustration 2: An auditor's report containing an adverse opinion due to a material misstatement of the financial statements. Illustration 3: An auditor's report containing a qualified opinion due to the auditor's inability to obtain sufficient appropriate audit evidence. Illustration 4: An auditor's report containing a disclaimer of opinion due to the auditor's inability to obtain sufficient appropriate audit evidence about a single element of the financial statements. Illustration 5: An auditor's report containing a disclaimer of opinion due to the auditor's inability to obtain sufficient appropriate audit evidence about multiple elements of the financial statements. Illustration 1: Basis for Qualified Opinion The company's inventories are carried in the balance sheet at xxx. Management has not stated the inventories at the lower of cost and net realizable value but has stated them solely at cost, which constitutes a departure from International Financial Reporting Standards. The company's records indicate that had management stated the inventories at the lower of cost and net realizable value, an amount of xxx would have been required to write the inventories down to their net realizable value. Accordingly, cost of sales would have been increased by xxx, and income tax, net income and shareholders' equity would have been reduced by xxx, xxx and xxx, respectively. [Type the company address] Page 5

Qualified Opinion In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. Illustration 2: Basis for Adverse Opinion As explained in Note X, the company has not consolidated the financial statements of subsidiary XYZ Company it acquired during 20X1 because it has not yet been able to ascertain the fair values of certain of the subsidiary's material assets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis. Under International Financial Reporting Standards, the subsidiary should have been consolidated because it is controlled by the company. Had XYZ been consolidated, many elements in the accompanying financial statements would have been materially affected. The effects on the consolidated financial statements of the failure to consolidate have not been determined. Adverse Opinion In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, the consolidated financial statements do not present fairly (or do not give a true and fair view of) the financial position of ABC Company and its subsidiaries as at December 31, 20X1, and (of) their financial performance and their cash flows for the year then ended in accordance with International Financial Reporting Standards. Illustration 3: Basis for Qualified Opinion ABC Company's investment in XYZ Company, a foreign associate acquired during the year and accounted for by the equity method, is carried at xxx on the balance sheet as at December 31, 20X1, and ABC's share of XYZ's net income of xxx is included in ABC's income for the year then ended. We were unable to obtain sufficient appropriate audit evidence about the carrying amount of ABC's investment in XYZ as at December 31, 20X1 and ABC's share of XYZ's net income for the year because we were denied access to the financial information, management, and the auditors of XYZ. Consequently, we were unable to determine whether any adjustments to these amounts were necessary. Qualified Opinion In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of ABC Company as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. Illustration 4: Basis for Disclaimer of Opinion We were not appointed as auditors of the company until after December 31, 20X1 and thus did not observe the counting of physical inventories at the beginning and end of the year. We were unable to satisfy ourselves by alternative [Type the company address] Page 6

means concerning the inventory quantities held at December 31, 20X0 and 20X1 which are stated in the balance sheet at xxx and xxx, respectively. In addition, the introduction of a new computerized accounts receivable system in September 20X1 resulted in numerous errors in accounts receivable. As of the date of our audit report, management was still in the process of rectifying the system deficiencies and correcting the errors. We were unable to confirm or verify by alternative means accounts receivable included in the balance sheet at a total amount of xxx as at December 31, 20X1. As a result of these matters, we were unable to determine whether any adjustments might have been found necessary in respect of recorded or unrecorded inventories and accounts receivable, and the elements making up the income statement, statement of changes in equity and cash flow statement. Disclaimer of Opinion Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we have not been able to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do not express an opinion on the financial statements.

AUDIT OPINION QUESTIONS December 2007 Question 5 You are the audit manager for two clients of Bertie & Co, a firm of Chartered Certified Accountants. The financial year end for each client is 30 September 2007. You are reviewing the audit seniors proposed audit reports for two clients, Alpha Co and Deema Co. Alpha Co, a listed company, permanently closed several factories in May 2007, with all costs of closure finalized and paid in August 2007. The factories all produced the same item, which contributed 10% of Alpha Cos total revenue for the year ended 30 September 2007 (2006 23%). The closure has been discussed accurately and fully in the chairmans statement and Directors Report. However, the closure is not mentioned in the notes to the financial statements, nor separately disclosed on the financial statements. The audit senior has proposed an unmodified audit opinion for Alpha Co as the matter has been fully addressed in the chairmans statement and Directors Report. In October 2007 a legal claim was filed against Deema Co, a retailer of toys. The claim is from a customer who slipped on a greasy step outside one of the retail outlets. The matter has been fully disclosed as a material contingent liability in the notes to the financial statements, and audit working papers provide sufficient evidence that no provision is necessary as Deema Cos lawyers have stated in writing that the likelihood of the claim succeeding is only possible. The amount of the claim is fixed and is adequately covered by cash resources. The audit senior proposes that the audit opinion for Deema Co should not be qualified, but that an emphasis of matter paragraph should be included after the audit opinion to highlight the situation.

Required: Evaluate whether the audit seniors proposed audit report is appropriate, and where you disagree with the proposed report, recommend the amendment necessary to the audit report of:

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(i) Alpha Co; (6 marks) (ii) Deema Co. (4 marks)

Answer Alpha Co The factory closures constitute a discontinued operation per IFRS 5 Non-Current Assets Held for Sale and Discontinued Operations, due to the discontinuance of a separate major component of the business. It is a major component due to the 10% contribution to revenue in the year to 30 September 2007 and 23% contribution in 2006. It is a separate business component of the company due to the factories having made only one item, indicating a separate income generating unit. Under IFRS 5 there must be separate disclosure on the face of the income statement of the post tax results of the discontinued operation, and of any profit or loss resulting from the closures. The revenue and costs of the discontinued operation should be separately disclosed either on the face of the income statement or in the notes to the financial statements. Cash flows relating to the discontinued operation should also be separately disclosed per IAS 7 Cash Flow Statements. In addition, as Alpha Co is a listed company, IFRS 8 Operating Segments requires separate segmental disclosure of discontinued operations. Failure to disclose the above information in the financial statements is a material breach of International Accounting Standards. The audit opinion should therefore be qualified on the grounds of disagreement on disclosure (IFRS 5, IAS 7 and IFRS 8). The matter is material, but not pervasive, and therefore an except for opinion should be issued. The Basis for Qualified Opinion paragraph should clearly state the reason for the disagreement, and an indication of the financial significance of the matter. The audit opinion relates only to the financial statements which have been audited, and the contents of the other information (chairmans statement and Directors Report) are irrelevant when deciding if the financial statements show a true and fair view, or are fairly presented. Deema Co The claim is an event after the balance sheet date. If the accident occurred prior to the year end of 30 September 2007, the claim gives additional evidence of a year end condition, and thus meets the definition of an adjusting post balance sheet event. In this case the matter appears to have been properly disclosed in the notes to the financial statements per IAS 10 Events After the Balance Sheet Date and IAS 37 Provisions, Contingent Liabilities and Contingent Assets. A provision would only be necessary if the claim was probable to succeed and there is sufficient appropriate evidence that this is not the case. There is therefore no disagreement, and no limitation on scope. Therefore the senior is correct to propose an unqualified opinion. However, it is not necessary for the audit report to contain an emphasis of matter paragraph. ISA 701 Modifications to the Independent Auditors Report states that an emphasis of matter paragraph should be used to highlight a matter where there is significant uncertainty. Uncertainties are normally only regarded as significant if they involve a level of concern about the going concern status of the company or would have an unusually great effect on the financial statements. This is not the case here as there is enough cash to pay the damages in the unlikely event that the claim goes against Deema Co. This appears to be a one[Type the company address] Page 8

off situation with a low risk of the estimate being subject to change and thus there is no significant uncertainty. June 2009 Question 5 You are the partner responsible for performing an engagement quality control review on the audit of Pluto Co, a listed company. You are currently reviewing the engagement partners proposed audit report on the financial statements of Pluto Co for the year ended 31 March 2009. During the year the company has undergone significant reorganization, involving the discontinuance of two major business segments. Extracts of the proposed audit report are shown below: Adverse opinion arising from disagreement about application of IAS 37 The directors have not recognized a provision in relation to redundancy costs associated with the reorganization during the year. The reason is that they do not feel that a reliable estimate of the amount can be made, and so the recognition criteria of IAS 37 have not been met. We disagree with the directors as we feel that an estimate can be made. This matter is more fully explained in a note to the financial statements. We feel that this is a material misstatement as the profit for the year is overstated. In our opinion, the financial statements do not show a true and fair view of the financial position of the company as of 31 March 2009, and of its financial performance and its cash flows for the year then ended in accordance with International Financial Reporting Standards. Emphasis of matter paragraph The directors have decided not to disclose the Earnings per Share for 2009, as they feel that the figure is materially distorted by significant discontinued operations in the year. Our opinion is not qualified in respect of this matter. Required: Critically appraise the proposed audit report of Pluto Co for the year ended 31 March 2009. Note: you are NOT required to re-draft the extracts from the audit report. (9 marks) Answer Adverse opinion paragraph The title of the opinion paragraph clearly states that it is an adverse opinion. For the sake of clarity it may be better just to state that the opinion is adverse rather than go into the reason for the opinion in the title, i.e. remove wording arising from disagreement about application of IAS 37. Normally the reason for any modification to the audit report affecting the opinion is explained in a separate paragraph immediately preceding the opinion paragraph. Here the reason for the modification is explained within the opinion paragraph which could be confusing for the readers. ISA 701 Modifications to the Independent Auditors Report states that a clear description of all of the substantive reasons for any modification to the opinion should be included in the report, including, where practicable, an estimate of the financial effect. The proposed audit report partially explains the disagreement but does not go into sufficient detail. Specifically no estimate of the financial effect has been provided. Quantification of the amount of the omitted provision must be available, as this is the basis of the disagreement with management. Other detail of the provision should also be provided, such as the timing of the probable cash outflow. To aid the readers understanding of the breach of financial reporting standards that has occurred, it would be useful to fully state the title of IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The paragraph refers to a note to the financial statements where the matter is more fully explained. This is ambiguous. [Type the company address] Page 9

Does the note explain the reason why the directors feel unable to quantify the value of the provision? Does the note describe the situation in terms of a contingent liability (which appears to be how the directors are treating the item)? The paragraph should be more precise in referring to what the note actually contains. A page reference should also be given to help the readers to find the note. The paragraph ends with an observation that profits are overstated as a result of the non-recognition of the provision. There should also be a comment on the impact on the statement of financial position, in which liabilities are understated. The effect should be quantified, as discussed above. Finally, and most importantly, whether this issue should give rise to an adverse opinion is debatable. An adverse opinion should be given when the effect of a disagreement is so material and pervasive that the financial statements are rendered meaningless. Without any figures being provided it is not possible to comment on materiality, however, the provision would have to be extremely significant for its omission to make the financial statements meaningless. The report itself could appear to be contradictory, as it states that the omission has caused a material misstatement, implying a material but not a pervasive impact on the financial statements. It is likely in this case that an except for qualification would be sufficient. Emphasis of matter paragraph The paragraph appears to be describing a breach of financial reporting standards. IAS 33 Earnings per Share requires that listed companies must disclose basic and diluted earnings per share figures, including comparatives, on the face of the financial statements. The fact that the directors have decided not to disclose is a clear misapplication of the standard. Earnings per share is material by nature, so its omission represents a material misstatement in the financial statements. The audit opinion should be qualified in respect of this, with an except for disagreement appearing the most appropriate opinion. Therefore a paragraph discussing the disagreement should be inserted above the opinion paragraph, including an estimate of the financial effect, and a reference to a note to the financial statements if this has been provided. The emphasis of matter paragraph does not state whether the prior years earnings per share figure has been disclosed or not. A comparative is required by IAS 33. The emphasis of matter paragraph should not be used to highlight situations where the directors have decided not to include a matter in the financial statements. The paragraph is reserved for use to explain significant uncertainties or going concern issues and its use in this situation is entirely inappropriate.

AUDIT PLANNING Why planning is necessary? The auditor should plan the audit so that the engagement will be performed in an effective and efficient manner. What planning is all about? Planning involves establishing the overall audit strategy for the engagement and developing an audit plan to reduce audit risk to an acceptably low level. What is overall Audit Strategy? The overall audit strategy sets the scope, timing and direction of the audit and guides the development of [Type the company address] Page 10

audit plan. Scope refers to: 1. 2. 3. 4. 5. 6. 7. 8. The financial reporting framework. Industry specific reporting requirement. Expected audit coverage. Extent of usage of work of another auditor Reporting currency. Extent of usage of work of internal auditor. The effect of information technology. Extent of usage of prior year working papers.

Timing refers to: 1. Tentative deadlines for audit deliverables such as audit report. 2. Timing of communication of significant matters with management and those charged with governance. Direction refers to: 1. 2. 3. 4. 5. 6. 7. 8. Setting of materiality. Indentifying areas where there is high risk of material misstatement. Selection of engagement team. Assignment of audit work to team members. Engagement budgeting. Assessment of internal controls at entity. Assessment of significant business development. Changes in accounting policy.

What is audit plan? The audit plan includes the nature, timing and extent of audit procedures to be performed in response to the conclusion drawn at the time of developing the audit strategy. Who are involved in a planning process? Planning involves the engagement partner and other key members of the engagement team. What factors influence the nature and extent of planning? 1. Size and complexity of the entity. 2. Previous experience with the entity. 3. Changes in circumstances that occur during the period under the audit. What is the appropriate time for planning? Planning is a continual process that begins shortly after the completion of the previous audit and continues until the completion of the current audit engagement. What are preliminary mandatory engagement activities? 1. Performance of procedures regarding the continuance of client relationship. 2. Evaluation of compliance with ethical requirement including independence. [Type the company address] Page 11

3. Establish an understanding of the terms of the engagement. What are additional considerations in Initial Audit Engagements? 1. Perform procedures regarding the acceptance of the client. 2. Communicate with the previous auditor. What are the advantages of planning? 1. 2. 3. 4. Appropriate attention is devoted to important areas of the audit. Potential problems are identified and resolved on a timely basis. Adequate planning also assists in the proper assignment of work to team members. Facilitates the direction and supervision of engagement team members and the review of their work.

RISK ASSESSMENT QUESTIONS

December 2007 Question 1 Your client, Island Co, is a manufacturer of machinery used in the coal extraction industry. You are currently planning the audit of the financial statements for the year ended 30 November 2007. The draft financial statements show revenue of $125 million (2006 $103 million), profit before tax of $56 million (2006 $51 million) and total assets of $95 million (2006 $90 million). Your firm was appointed as auditor to Island Co for the first time in June 2007. Island Co designs, constructs and installs machinery for five key customers. Payment is due in three installments: 50% is due when the order is confirmed (stage one), 25% on delivery of the machinery (stage two), and 25% on successful installation in the customers coal mine (stage three). Generally it takes six months from the order being finalised until the final installation. At 30 November, there is an amount outstanding of $285 million from Jacks Mine Co. The amount is a disputed stage three payment. Jacks Mine Co is refusing to pay until the machinery, which was installed in August 2007, is running at 100% efficiency. One customer, Sawyer Co, communicated in November 2007, via its lawyers with Island Co, claiming damages for injuries suffered by a drilling machine operator whose arm was severely injured when a machine malfunctioned. Kate Shannon, the chief executive officer of Island Co, has told you that the claim is being ignored as it is generally known that Sawyer Co has a poor health and safety record, and thus the accident was their fault. Two orders which were placed by Sawyer Co in October 2007 have been cancelled. Work in progress is valued at $85 million at 30 November 2007. A physical inventory count was held on 17 November 2007. The chief engineer estimated the stage of completion of each machine at that date. One of the major components included in the coal extracting machinery is now being sourced from overseas. The new supplier, Locke Co, is located in Spain and invoices Island Co in Euros. There is a trade payable of $15 million owing to Locke Co recorded within current liabilities. All machines are supplied carrying a one year warranty. A warranty provision is recognised on the balance sheet at $25 million (2006 $24 million). Kate Shannon estimates the cost of repairing defective machinery reported by customers, and this estimate forms the basis of the provision.

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Kate Shannon owns 60% of the shares in Island Co. She also owns 55% of Pacific Co, which leases a head office to Island Co. Kate is considering selling some of her shares in Island Co in late January 2008, and would like the audit to be finished by that time. Required: Using the information provided, identify and explain the principal audit risks, and any other matters to be considered when planning the final audit for Island Co for the year ended 30 November 2007.

Answer ISLAND CO Briefing Notes Subject: Principal Audit Risks Island Co Revenue Recognition timing Island Co raises sales invoices in three stages. There is potential for breach of IAS 18 Revenue, which states that revenue should only be recognised once the seller has the right to receive it, in other words the seller has performed its contractual obligations. This right does not necessarily correspond to amounts falling due for payment in accordance with an invoice schedule agreed with a customer as part of a contract. Island Co appears to receive payment from its customers in advance of performing any obligation, as the stage one invoice is raised when an order is confirmed i.e. before any work has actually taken place. This creates the potential for revenue to be recognised too early, in advance of any performance of contractual obligation. When a payment is received in advance of performance, a liability should be recognised equal to the amount received, representing the obligation under the contract. Therefore a significant risk is that revenue is overstated and liabilities understated. Tutorial note: Equivalent guidance is also provided in IAS 11 Construction Contracts and credit will be awarded where candidates discuss revenue recognition under IAS 11 as Island Co is providing a single substantial asset for a customer under the terms of a contract. Disputed receivable The amount owed from Jacks Mine Co is highly material as it represents 509% of profit before tax, 23% of revenue, and 3% of total assets. The risk is that the receivable is overstated if no impairment of the disputed receivable is recognised.

Legal claim The claim should be investigated seriously by Island Co. The chief executive officers (CEO) opinion that the claim will not result in any financial consequence for Island Co is nave and flippant. Damages could be awarded against Island Co if it is found that the machinery is faulty. The recurring high level of warranty provision implies that machinery faults are fairly common and therefore the accident could be the result of a defective machine being supplied to Sawyer Co. The risk is that no provision is created for the potential damages under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, if the likelihood of paying damages is considered probable. Alternatively, if the likelihood of damages being paid to Sawyer Co is considered a possibility then a disclosure note should be made in the financial statements describing the nature and possible financial effect of the contingent liability. As discussed below, the CEO, Kate Shannon, has an incentive not to make a provision or disclose a contingent liability due to the planned share sale post year end. A further risk is that any legal fees associated with the claim have not been accrued within the financial statements. As the claim has arisen during the year, the expense must be included in this years income statement, even if the claim is [Type the company address] Page 13

still ongoing at the year end. The fact that the legal claim is effectively being ignored may cast doubts on the overall integrity of senior management, and on the integrity of the financial statements. Management representations should be approached with a degree of professional scepticism during the audit. Sawyer Co has cancelled two orders. If the amounts are still outstanding at the year end then it is highly likely that Sawyer Co will not pay the invoiced amounts, and thus receivables are overstated. If the stage one payments have already been made, then Sawyer Co may claim a refund, in which case a provision should be made to repay the amount, or a contingent liability disclosed in a note to the financial statements. Sawyer Co is one of only five major customers, and losing this customer could have future going concern implications for Island Co if a new source of revenue cannot be found to replace the lost income stream from Sawyer Co. If the legal claim becomes public knowledge, and if Island Co is found to have supplied faulty machinery, then it will be difficult to attract new customers. A case of this nature could bring bad publicity to Island Co, a potential going concern issue if it results in any of the five key customers terminating orders with Island Co. The auditors should plan to extend the going concern work programme to incorporate the issues noted above. Inventories Work in progress is material to the financial statements, representing 89% of total assets. The inventory count was held two weeks prior to the year end. There is an inherent risk that the valuation has not been correctly rolled forward to a year end position. The key risk is the estimation of the stage of completion of work in progress. This is subjective, and knowledge appears to be confined to the chief engineer. Inventory could be overvalued if the machines are assessed to be more complete than they actually are at the year end. Absorption of labour costs and overheads into each machine is a complex calculation and must be done consistently with previous years. It will also be important that consumable inventories not yet utilised on a machine, e.g. screws, nuts and bolts, are correctly valued and included as inventories of raw materials within current assets. Overseas supplier As the supplier is new, controls may not yet have been established over the recording of foreign currency transactions. Inherent risk is high as the trade payable should be retranslated using the year end exchange rate per IAS 21 The Effects of Changes in Foreign Exchange Rates. If the retranslation is not performed at the year end, the trade payable could be significantly over or under valued, depending on the movement of the dollar to euro exchange rate between the purchase date and the year end. The components should remain at historic cost within inventory valuation and should not be retranslated at the year end. Warranty provision The warranty provision is material at 26% of total assets (2006 27%). The provision has increased by only $100,000, an increase of 42%, compared to a revenue increase of 214%. This could indicate an under provision as the percentage change in revenue would be expected to be in line with the percentage change in the warranty provision, unless significant improvements had been made to the quality of machines installed for customers during the year. This appears unlikely given the legal claim by Sawyer Co, and the machines installed at Jacks Mine Co operating inefficiently. The basis of the estimate could be understated to avoid charging the increase in the provision as an expense through the income statement. This is of Special concern given that it is the CEO and majority shareholder who estimates the warranty provision.

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Majority shareholder Kate Shannon exerts control over Island Co via a majority shareholding, and by holding the position of CEO. This greatly increases the inherent risk that the financial statements could be deliberately misstated, i.e. overvaluation of assets, undervaluation of liabilities, and thus overstatement of profits. The risk is severe at this year end as Kate Shannon is hoping to sell some Island Co shares post year end. As the price that she receives for these shares will be to a large extent influenced by the balance sheet position of the company at 30 November 2007, she has a definite interest in manipulating the financial statements for her own personal benefit. For example: Not recognising a provision or contingent liability for the legal claim from Sawyer Co Not providing for the potentially irrecoverable receivable from Jacks Mines Co Not increasing the warranty provision Recognising revenue earlier than permitted by IAS 18 Revenue. Related party transactions Kate Shannon controls Island Co and also controls Pacific Co. Transactions between the two companies should be disclosed per IAS 24 Related Party Disclosures. There is risk that not all transactions have been disclosed, or that a transaction has been disclosed at an inappropriate value. Details of the lease contract between the two companies should be disclosed within a note to the financial statements, in particular, any amounts owed from Island Co to Pacific Co at 30 November 2007 should be disclosed. Other issues Kate Shannon wants the audit to be completed as soon as possible, which brings forward the deadline for completion of the audit. The audit team may not have time to complete all necessary procedures, or there may not be time for adequate reviews to be carried out on the work performed. This is especially important given that this is the first year audit and therefore the audit team will be working with a steep learning curve. Audit procedures may take longer than originally planned, yet there is little time to extend procedures where necessary. Kate Shannon may also exert considerable influence on the members of the audit team to ensure that the financial statements show the best possible position of Island Co in view of her share sale. It is crucial that the audit team members adhere strictly to ethical guidelines and that independence is beyond question. Due to the seriousness of the matters noted above, a final matter to be considered at the planning stage is that a second partner review (Engagement Quality Control Review) should be considered for the audit this year end. A suitable independent reviewer should be identified, and time planned and budgeted for at the end of the assignment. Conclusion From the range of issues discussed in these briefing notes, it can be seen that the audit of Island Co will be a relatively high risk engagement.

June 2008 Question You are a senior audit manager in Mitchell & Co, a firm of Chartered Certified Accountants. You are reviewing some information regarding a potential new audit client, Medix Co, a supplier of medical instruments. Extracts from notes taken at a meeting that you recently held with the finance director of Medix Co, Ricardo Feller, are shown below: [Type the company address] Page 15

Meeting notes meeting held 1 June 2008 with Ricardo Feller Medix Co is a provider of specialised surgical instruments used in medical procedures. The company is owner managed, has a financial year ending 30 June 2008, and has invited our firm to be appointed as auditor for the forthcoming year end. The audit is not going out to tender. Ricardo Feller has been with the company since January 2008, following the departure of the previous finance director, who is currently taking legal action against Medix Co for unfair dismissal. Company background Medix Co manufactures surgical instruments which are sold to hospitals and clinics. Due to the increased use of laser surgery in the last four years, demand for traditional metal surgical instruments, which provided 75% of revenue in the year ended 30 June 2007, has declined rapidly. Medix Co is expanding into the provision of laser surgery equipment, but research and development is at an early stage. The directors feel confident that the laser instruments currently being designed will eventually receive the necessary licence for commercial production, and that the laser product will replace surgical instruments as a leading source of revenue. There is currently one scientist working on the laser equipment, subcontracted by Medix Co on a freelance basis. The building in which the research is being carried out has recently been significantly extended by the construction of a large laboratory.

A considerable revenue stream is derived from agents who are not employed by Medix Co. The agents earn a commission based on the value of sales they have secured for Medix Co during the year. There are many suppliers into the market and agents are used by all manufacturers as a means of marketing and distributing their products. The companys manufacturing facility is located in another country, where operating costs are significantly lower. The facility is under the control of a local manager who visits the head office of Medix Co annually for a meeting with senior management. Products are imported via aeroplane. The overseas plant and equipment is owned by the company and was constructed 12 years ago specifically for the manufacture of metal surgical instruments. The company has a bank overdraft facility and makes use of the facility most months. A significant bank loan, which will carry a variable interest rate, is currently being negotiated. The terms of the loan will be finalised once the audited financial statements have been viewed by the bank. After receiving permission from Medix Co, you held a discussion with the current audit partner of Medix Co, Mick Evans, who runs a small accounting and audit practice of which he is one of two partners. Mick told you the following: Medix Co has been an audit client for three years. We took over from the previous auditors following a disagreement between them and the directors of Medix Co over fees. As we are a small practice with low overheads we could offer lower fees than our predecessors. We could also do the audit very quickly, which pleased the client, as they like to keep costs as low as possible. During our audits we have found the internal systems and controls to be quite weak. Despite our recommendations, there always seemed to be a lack of interest in making improvements to the accounting systems, as this was seen to be a waste of money. There have been two investigations by the tax authorities, which we did not deal with, as we are not tax experts. In the end the directors sorted it all out, and I believe that the tax matter is now resolved. We never had a problem getting access to accounting books and records. However, the managing director, Jon Tate, once gave us what he described as the wrong cash book by mistake, and replaced it with the proper version later in the day. We never found out why he was keeping two cash books, but cash was an immaterial asset so we didnt worry about it too much. We are resigning as auditors because the work load is too much for our small practice, and as Medix Co is our only audit [Type the company address] Page 16

client we have decided to focus on providing non-audit services in the future. You have also found a recent press cutting regarding Medix Co: Extract from local newspaper business section, 2 June 2008 It appears that local company Medix Co has breached local planning regulations by building an extension to its research and development building for which no local authority approval has been given. The land on which the premises is situated has protected status as a greenfield site which means approval by the local authority is necessary for any modification to commercial buildings. A representative of the local planning office stated today: We feel that this is a serious breach of regulations and it is not the first time that Medix Co has deliberately ignored planning rules. The company was successfully sued in 2003 for constructing an access road without receiving planning permission, and we are considering taking legal action in respect of this further breach of planning regulations. We are taking steps to ensure that these premises should be shut down within a month. A similar breach of regulations by a different company last year resulted in the demolition of the building. Required: Using the information provided, identify and explain the principal business risks facing Medix Co. (12 marks) Answer Business risks include the following: Product life cycle Demand is declining for the main revenue generating product. The market is moving such that demand for laser surgical instruments is increasing, while demand for traditional metal instruments is declining. The continued loss of a main revenue stream will have significant detrimental profit and cash flow implications. Demand has been declining for four years, yet it seems that research has only recently commenced into a new source of revenue. The management appears not to be focused on the long term strategy needed for survival in this competitive market. Research is at an early stage. It may take many years for the development stage to be reached. Research and development necessitates a significant cash outflow, and this is happening at the same time as loss of cash inflows from the main revenue stream. As the company is already short of liquid funds, as evidenced by the on-going use of an overdraft facility, it could be that there will be insufficient funds to continue to develop the new product. The research is being conducted by only one scientist, who is not employed by the company. The scientist is critical for the successful development of a replacement revenue stream. If the scientist were to leave, Medix Co would lose the knowledge base of the new technology, hindering progress into the new market. Given that this is a very specialist role, it may be a difficult and lengthy process to find a new scientist to work on the project. It is a significant risk to rely so heavily on a person not employed by the company for such a crucial role in the future success of the business. There may also be confidentiality issues if the scientist is freelancing for any competitor of Medix Co, the new laser equipment designs could be copied and used unless Medix Co secures protection of the design e.g. by taking out a patent. Finally, the industry is highly regulated, and licences are necessary in order to take medical instruments to market. If the licence is not granted, the research and development funds will have been wasted and the continuation of the business as a going concern could be jeopardised.

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New research premises An extremely important problem is shown in the press cutting. If the local authority is successful in shutting down the newly constructed research laboratory, the company will have to find new premises, which could be expensive and take time. Any delay in the development of the new products will compound the cash flow pressures the company is already suffering. There is also the possibility that fines or penalties could be imposed on the company, and that the extension, or even the whole building may have to be demolished, which Medix Co may have to pay for, putting the company into further financial distress. The potential impairment of the building at the year end would have a detrimental impact on the companys net asset position at the year end, in turn affecting the ability to raise finance and causing potential going concern problems. Further bad publicity could follow, and demand for Medix Cos products may suffer as a result. Tutorial note: Planning regulations have already been breached. Candidates should not focus their answer on the breach itself, which has already occurred, but on the possible consequences of the breach i.e. financial risk of fines having to be paid, the need to find new premises, and operational risk of further decline in demand for products.

Use of agents for marketing and distribution Medix Co appears to rely heavily on agents to secure sales to hospitals and clinics. If the agents are unsuccessful, or decide to reduce the effort they put into promoting Medix Cos products in preference for products from an alternative supplier, then the company will face a substantial reduction in revenue and cash inflows. A second risk associated with the use of agents is that there is a scope for fraud the agents could deliberately overstate the value of sales in order to maximise the commission they receive. When this point is linked to the poor internal systems and controls as indicated by Mick Evans, it is likely that such frauds would not be detected. Overseas location of manufacturing facility The fact that products are manufactured abroad could lead to problems in controlling and monitoring production. Decisions made locally may not be compatible with the overall operating strategy of the company. Also, if communication channels are not operating efficiently then decisions made at the head office may take time to be relayed to the foreign manager. This could lead to production inefficiencies, e.g. if an agent secures a contract to supply a particular product, it may take time for this to be communicated to the manufacturing facility, and delays in fulfilling the order will then be inevitable, leading to loss of agent and customer goodwill. Having the production facility operating abroad could also lead to problems with monitoring the quality of output. This is a highly regulated industry, where suppliers of faulty equipment could face fines and bad publicity in the event of supplying a poor quality item. Agents would withdraw their support for the products immediately in preference to those of competitors. Importing goods using aeroplanes exposes the company to fluctuating overhead costs as fuel prices and freight costs are notoriously difficult to predict. Higher levels of tax could also be imposed on imported goods. Finally, as the company manufactures abroad, it is inevitable that it will make payments in foreign currency and will therefore be exposed to exchange rate risk. Capital expenditure and financial management

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Plant and equipment appears to be fairly old, constructed twelve years ago. In the future, if the research and development into new laser equipment is successful, then capital expenditure will be needed to create the capacity to manufacture the new products. The risk is that finance may not be available to invest in new plant.

The company appears to have a problem managing liquidity. Continually operating using an overdraft is expensive in terms of finance costs. A bank loan carrying a variable interest rate exposes the company to the economic risk of fluctuations in the interest rate, making planning and budgeting cash flows difficult. Internal systems and controls The comments made by Mick Evans show that the company has a weak control environment and poor systems. Frauds are more likely to occur in the absence of controls and the quality of financial information used by the directors for planning and reviewing business performance could be inadequate. Medix Co is an owner-managed business, and it appears that Jon Tate, the managing director, has a dominant style leading to frequent disagreements (with previous auditors and finance director) and flouting of rules (tax and local authority investigations). This increases the likelihood of management disregard for, and override of, controls. Tax investigations Recent tax investigations could indicate that the company is not complying with relevant tax regulations, which in turn leads to the risk of fines and penalties, which could be severe if this is a recurring breach of regulations which has not been resolved.

December 2009 Question

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You are the manager responsible for the audit of Papaya Co, a listed company, which operates a chain of supermarkets, with a year ending 31 December 2009. There are three business segments operated by the company two segments are supermarket chains which operate under internally generated brand names, and the third segment is a new financial services division. The first business segment comprises stores branded as Papaya Mart. This segment makes up three-quarters of the supermarkets of the company, and are large out of town stores, located on retail parks on the edge of towns and cities. These stores sell a wide variety of items, including food and drink, clothing, household goods, and electrical appliances. In September 2009, the first overseas Papaya Mart opened in Farland. This expansion was a huge drain on cash resources, as it involved significant capital expenditure, as well as an expensive advertising campaign to introduce the Papaya Mart brand in Farland. The second business segment comprises the rest of the supermarkets, which are much smaller stores, located in city centres, and branded as Papaya Express. The Express stores offer a reduced range of products, focussing on food and drink, especially ready meals and other convenience items. The company also established a financial services division on 1 January 2009, which offers loans, insurance services and credit cards to customers. The following information was provided during a recent meeting held with the finance director of Papaya Co. All of the matters outlined in the notes below are potentially material to the financial statements.

Notes from meeting held 29 November 2009 On 31 August 2009, Papaya Co received notice from a government body that it is under investigation, along with three other companies operating supermarket chains, for alleged collusion and price fixing activities. If it is found guilty, significant financial penalties will be imposed on Papaya Co. The company is vigorously defending its case. To help cash flows in a year of expansion, the company raised finance by issuing debentures which are potentially convertible into equity on maturity in 2015. To manage the risk associated with overseas expansion, in October 2009, the company entered for the first time into several forward exchange contracts which end in February 2010. The contracts were acquired at no cost to Papaya Co and are categorised as fair value through profit or loss financial instruments. The property market has slumped this year, and significant losses were made on the sale of some plots of land which were originally acquired for development potential. The decision to sell the land was made as it is becoming increasingly difficult for the company to receive planning permission to build supermarkets on the land. Land is recognised at cost in the statement of financial position. [Type the company address] Page 20

Papaya Co has 35 warehouses which store non-perishable items of inventory. Due to new regulation, each warehouse is required to undergo a major health and safety inspection every three years. All warehouses were inspected in January 2009, at a cost of $25,000 for each inspection. Required Using the specific information provided in respect of Papaya Co: Assess the financial statements risks to be addressed when planning the final audit for the year ending 31 December 2009, producing your answer in the form of briefing notes to be used at the audit planning meeting. (16 marks)

Answer Briefing notes to be used at audit planning meeting Subject: Financial statement risks identified at planning meeting Introduction At a recent planning meeting held with the finance director of Papaya Co, several issues were discussed which could lead to financial statement risks. All of these issues relate to matters which are potentially material to the financial statements. Alleged collusion and price fixing It appears that several companies are under investigation for breaching regulations, and Papaya Co could face potentially material financial penalties if found guilty. The situation needs to be assessed by reference to IAS 37 Provisions, Contingent Liabilities and Contingent Assets. The risk is that the financial statements do not reflect the situation as either a provision or a contingent liability, depending on the evaluation of the potential outcome of the case. If it is considered that the company faces a probable cash outflow, then a provision and associated expense should be recognised. If the outflow is considered possible, then a note to the financial statements should describe the contingent liability and show an estimate of the potential financial effect. Therefore the financial statement risk is both understated liabilities and overstated profit, if the cash outflow is considered probable but no provision is made. Alternatively, the risk is incomplete disclosure if the outflow is considered possible and no note is provided. Convertible debentures According to IAS 32 Financial Instruments: Presentation, convertible debt instruments should be presented in the statement of financial position split into two separate components. This is because the company does not know if it has an obligation to pay cash on the redemption of the debt in 2015, or whether the debt will be settled by an equity distribution. Therefore, on the receipt of cash proceeds, the credit entry is split between debt and equity. The debt is valued by discounting the potential cash outflows to present value, with the credit entry to equity a residual balancing [Type the company address] Page 21

figure. The financial statement risk is firstly that split accounting has not been applied, so the whole of the credit has been recognised as either debt or equity, and therefore incorrectly recognised in the statement of financial position. This would then have a further consequence for the statement of comprehensive income, as any finance charge calculated on the basis of an incorrect debt component would then also be incorrectly measured.

Forward exchange contracts These contracts are derivative financial instruments. As such, they must be recognised in the statement of financial position at the year end, as a financial asset or a financial liability, depending on whether the terms of the derivative contract are favourable or unfavourable at the reporting date. The financial statement risk is that the derivatives have not been recognised at all, particularly because the contracts were acquired at no cost, so there is no accounting entry when the contract is taken out. A second risk relates to the valuation of the derivative asset or liability. This could be complex to calculate, and if not performed by an experienced specialist, could cause the over or understatement of the financial instrument recognised, and an associated incorrect entry recognised in profit. Finally, IFRS 7 Financial Instruments: Disclosures imposes potentially onerous disclosure requirements in relation to derivative instruments. The risk is that disclosures made in the notes to the financial statements are incomplete. Land held for development potential There are indicators that the land could be impaired at the year end. Some land was sold at a loss during the year, and it seems that planning permission for the development of the sites is becoming harder to obtain, meaning that the value of the land has fallen. Following IAS 36 Impairment of Assets, an impairment review must be carried out if there are indicators of impairment to an asset. It is likely that land will be overstated in the statement of financial position, and expenses understated, unless an impairment review is conducted and any resulting loss fully recognised. In addition, the losses made on the disposal of land during the year should be separately disclosed in the statement of comprehensive income or a note to the financial statements per IAS 1 (Revised) Presentation of Financial Statements, so there is a risk of inadequate disclosure if this is not done. Inspection of warehouses A new regulatory requirement has resulted in an inspection of all of the warehouses operated by Papaya Co. Under IAS 16 Property, Plant and Equipment, costs of a major inspection should be capitalised and then depreciated over the period to the next inspection. The risk is that the cost has been expensed, in other words, treated as an operating expense. This would result in understated profit and understated non-current assets. Other financial statement risks (not arising from notes made at the planning meeting) include the following:

Disclosure of operating segments IFRS 8 Operating Segments requires listed companies to disclose in a note to the financial statements information about the performance of the various different operating segments of the business. Papaya Co has two potential new disclosures this year end. The first is the new financial services division, which is likely to be a separate reportable segment under IFRS 8. The second new disclosure relates to the overseas expansion of the company, as IFRS 8 requires disclosure of limited [Type the company address] Page 22

geographical analysis of revenue and non-current assets. The financial statement risk is the non-disclosure of information relating to these new operating and geographical segments. Internally generated brand names Papaya Mart and Papaya Express are internally generated brand names. IAS 38 Intangible Assets prohibits the recognition of internally generated brands. The risk arises from significant expenditure on the launch of the brand in Farland. If any of the associated expense has been capitalised as a brand name, this would mean that non-current assets are overstated, and profit for the year would be overstated. Conclusion There are several financial statement risks identified at the planning meeting, resulting from the company operating in a regulated industry, changed market conditions, and new business activities for the company. Now that the risks have been identified, an appropriate audit strategy will be devised to minimise the risk of material misstatement in relation to these matters. Tutorial note: Credit will be awarded for other financial statement risks identified from the question scenario, such as potential over-valuation of inventories, classification of land as held for sale, incorrect timing of recognition of revenue from financial services products, and potential impairment of loans made to financial services customers.

June 2010 Question You are a senior audit manager in Vegas & Co, responsible for the audit of the Grissom Group, which has been an audit client for several years. The group companies all have a financial year ending 30 June 2010, and you are currently planning the final audit of the consolidated financial statements. The groups operations focus on the manufacture and marketing of confectionery and savoury snacks. Information about several matters relevant to the group audit is given below. These matters are all potentially material to the consolidated financial statements. None of the companies in the group are listed. Grissom Co This is a non-trading parent company, which wholly owns three subsidiaries Willows Co, Hodges Co and Brass Co, all of which are involved with the core manufacturing and marketing operations of the group. This year, the directors decided to diversify the groups activities in order to reduce risk exposure. Non-controlling interests representing long-term investments have been made in two companies an internet-based travel agent, and a chain of pet shops. In the consolidated statement of financial position, these investments are accounted for as associates, as Grissom Co is [Type the company address] Page 23

able to exert significant influence over the companies. As part of their remuneration, the directors of Grissom Co receive a bonus based on the profit before tax of the group. In April 2010, the group finance director resigned from office after a disagreement with the chief executive officer over changes to accounting estimates. A new group finance director is yet to be appointed. Willows Co This company manufactures and distributes chocolate bars and cakes. In July 2009, production was relocated to a new, very large factory. One of the conditions of the planning permission for the new factory is that Willows Co must, at the end of the useful life of the factory, dismantle the premises and repair any environmental damage caused to the land on which it is situated. Hodges Co This companys operations involve the manufacture and distribution of packaged nuts and dried fruit. The government paid a grant in November 2009 to Hodges Co, to assist with costs associated with installing new, environmentally friendly, packing lines in its factories. The packing lines must reduce energy use by 25% as part of the conditions of the grant, and they began operating in February 2010.

Brass Co This company is a new and significant acquisition, purchased in January 2010. It is located overseas, in Chocland, a developing country, and has been purchased to supply cocoa beans, a major ingredient for the goods produced by Willows Co. It is now supplying approximately half of the ingredients used in Willow Cos manufacturing. Chocland has not adopted International Financial Reporting Standards, meaning that Brass Cos financial statements are prepared using local accounting rules. The company uses local currency to measure and present its financial statements. Further information Your firm audits all components of the group with the exception of Brass Co, which is audited by a small local firm, Sidle & Co, based in Chocland. Audit regulations in Chocland are not based on International Standards on Auditing. Required: Using the information provided, prepare briefing notes to be used in a discussion with your audit team, in which you evaluate the principal audit risks to be considered in your planning of the final audit of the consolidated financial statements for the year ending 30 June 2010. Note: Ignore those risks that relate to reliance on another auditor. (18 marks)

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Answer Briefing notes To: Audit team Regarding: Principal audit risks relating to the consolidated financial statements of Grissom Co, for the year ending 30 June 2010. Introduction These briefing notes summarise the principal audit issues for the consolidated financial statements of the group. There are three subsidiaries in the group and several other investments. The notes consider the audit issues company by company, and other issues which are relevant to the whole group. Grissom Co Non-controlling interests The first risk is an inherent risk that the investments have been inappropriately classified as associates. According to IAS 28 Investments in Associates, an investment should only be classified and accounted for as an associate if there is power to participate in financial and operating policy decisions, in which case equity accounting should be used to measure the investments in the group statement of financial position. The risk is that the investments have been classified and accounted for incorrectly. If Grissom Co cannot demonstrate the ability to exercise significant influence, then the investments should betreated as trade investments, and would not be consolidated. Alternatively, the substance of the interest in these companies could be a joint venture, if control is shared between Grissom Co and the other investors. A second issue raised by the diversification away from the groups normal activities is that the groups finance team may not have sufficient experience in these two new areas, for example, there may be a risk that they have insufficient knowledge to know how to correctly recognise and defer the revenue for a travel agent. In addition, a detection risk arises from the activities of the non-controlling interests. They represent a departure from the other activities of the group, and our firm may have little experience or knowledge of travel agencies and pet shops. This means that we may fail to identify risks of material misstatement relating to the amounts included from these investments in the consolidated financial statements.

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Bonus and changes to accounting estimates The directors receive a bonus based on group profit before tax. This leads to inherent risks of overstatement of income and/or understatement of expenses. The directors will want to maximise profits due to their financial interest in the groups results, which could lead to the manipulation of profits to achieve a desired bonus. The fact that the finance director left following a disagreement could indicate that the changes to accounting estimates were inappropriate. The estimates could have been changed as part of an earnings management strategy. Changes to accounting estimates can represent a high risk of material misstatement. IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors requires that changes to estimates are accounted for prospectively rather than retrospectively. There is a risk that management has confused changes to estimates with changes in policies, which require a retrospective accounting treatment. No group finance director The lack of a group finance director increases inherent risk and control risk. A group finance director should be in place, in order to ensure that group accounting policies are adhered to throughout the production of the consolidated financial statements. It is much more likely that a material misstatement could occur during the consolidation process if there is no one overseeing it. Errors are more likely to occur, and to remain undetected, as the group finance director should exercise a supervisory control over the whole consolidation process. Willows Co Dismantling costs According to IAS 16 Property, Plant and Equipment, the cost of an asset should include the estimated costs of dismantling and removing the asset (also known as decommissioning costs) if there is an obligation to incur the cost at the end of the life of the asset. A provision should also be recognised as a non-current liability. IAS 37 Provisions, Contingent Liabilities and Contingent Assets contains criteria that must be met in order to recognise a provision. The requirement contained in the planning permission creates an obligation leading to a probable outflow of economic benefit, and the construction of the factory is a past event. The risk is that the decommissioning cost has not been capitalised as part of the asset, in which case the asset is understated, and the other side of the entry will be missing, leading to incomplete provisions. In addition, the depreciation expense would be understated.

Even if the costs have been recognised, there are specific rules regarding the measurement of the amount recognised, which should be discounted to present value. There is risk that the calculation has not been carried out correctly, for example, using the incorrect discount factor. Furthermore, a finance charge should be recognised each year to reflect the unwinding of the discounted provision. The risk is that the charge has not been made, or has been measured incorrectly. Hodges Co Grant received [Type the company address] Page 26

IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that grants should be recognised as income over the periods necessary to match them with the related costs that they are intended to compensate. This means that the income should be deferred, and recognised as income over the estimated useful life of the packing lines, beginning in February 2010. The risk is that the income has been immediately recognised in full, overstating profit for the year, which would help the directors to maximise their bonus. Tutorial note: Under IAS 20, the grant should be presented on the statement of financial position either as deferred income, or by deducting the grant in arriving at the assets carrying value. Credit will be given for answers referring to either accounting treatment. Secondly, there is a condition attached to the grant. If Hodges Co fails to meet the environmental targets, the grant may have to be repaid, partly or in full. If this is the case, a provision should be recognised for the potential repayment (or a note should disclose a contingent liability in the case of a possible repayment). The risk is a potential understatement of provisions if the target has not been met. Identifying whether the company has defaulted from the conditions of the grant poses a risk in itself, as it may be difficult for the audit firm to obtain sufficient evidence on this matter, other than a written management representation or reliance on third party reports. Brass Co Mid-year acquisition Brass Co was acquired part way through the accounting period. Its results should be consolidated into the group statement of comprehensive income from the date that control passed to Grissom Co. The risk is that results have been consolidated from the wrong point in time. Given the directors incentive to maximise group profit, the results may have been consolidated from too early a point in time if Brass Co is profitable.

Goodwill on acquisition The goodwill on acquisition should be calculated according to IFRS 3 (Revised) Business Combinations. The calculation is inherently risky due to the need for significant judgements over the fair value of assets and liabilities acquired. There is also risk that not all acquired assets and liabilities have been separately identified, measured and disclosed. Risks are heightened due to the overseas location of the company, meaning that estimations of fair value may be more complex and subjective. Retranslation of Brass Cos financial statements The companys functional and presentational currency is local, and different to the rest of the group. Prior to consolidation, the financial statements must be retranslated, using the rules in IAS 21 The Effects of Changes in Foreign Exchange Rates. The assets and liabilities should be retranslated using the closing exchange rate, income and expenses at the average exchange rate, and exchange gains or losses on the retranslation should be recognised in group equity. This is a complex procedure, therefore inherently risky, and the determination of the average rate for the year can be subjective. The goodwill intangible asset must also be calculated using the closing exchange rate, which is effectively treated as a revaluation. The risk is that this retranslation has not occurred, and that goodwill remains at historic cost. Adjustments necessary to bring in line with group accounting policies [Type the company address] Page 27

Brass Co does not use the same financial reporting framework as the rest of the group. The companys financial statements must be adjusted to align them with group accounting policies. This will require considerable expertise and skill, and combined with the absence of a group finance director, the risk of errors is high. Intra-group transactions The trading transactions between Brass Co and Willows Co must be eliminated on consolidation. The risk is that the intra-group elimination is not performed, resulting in overstated revenue and operating expenses at group level (and receivables and payables if any amounts are outstanding at the yearend). In addition, for any items remaining in inventory which contain unrealized profit, a provision for unrealized profit must be made. If this adjustment is not carried out, inventory and group profi t will be overstated.

Conclusion Due to the many factors described in these notes the audit of several material components of the consolidated financial statements is relatively high risk. However, the consolidation of Grissom Co, Willows Co and Hodges Co is relatively low risk, as our firm has audited the consolidated financial statements for several years, and those companies all use the same reporting framework, report in the same currency, and have the same year end. How to Calculate Materiality Benchmarks in Exams In the P7 exam you need to calculate materiality in relation to specific item. You must only use the relevant comparator, for example, total asset if the matter relates to the statement of financial position, profit before tax if the matter impacts upon profit, and both if it relates to statement of financial position and impacts on profits, for example a provision. Now suppose you are auditing one of your clients namely ABC Company Limited. Following is the extract from the financial statements: Total Asset: Rs. 2,000,000 Profit: Rs. 350,000 Revenue: Rs. 1,000,000 Total Trade Debts: Rs. 200,000 Total Liabilities: Assumed Equal to Total Assets Closing stock: Rs. 250,000 Cost of Goods Sold: 500,000 Scenario 1: One of a customer of ABC Company Limited went bankrupt. The said customer owed Rs. 50,000 to the Company. ABC Limited is not willing to provide Rs. 50,000 in its financial statements. What will be your relevant benchmarks to assess [Type the company address] Page 28

your risk in this case? Scenario 2: ABC Company Limited is not accounting for goods in transit worth of Rs. 100,000 in its financial statements? What will be your relevant benchmarks to assess your risk in this case? Scenario 3: ABC Company Limited is accounting all its leases amounting to Rs. 100,000 as operating lease when in substance they are all finance leases? What will be your relevant benchmarks to assess your risk in this case? Scenario 4: ABC Company Limited inventory as at year consist of slow moving stock amounting to Rs. 50,000. ABC Company Limited is reluctant to account for resultant provision. What will be your relevant benchmarks to assess your risk in this case?

Test Your Self Auditors Confidence Level = 50% Planning Materiality = Rs. 950,000 Administration Expense Total = Rs. 1,000,000 Breakup of Administration Expense is as follows: Transaction 1: Rs. 200,000 Transaction 2: Rs. 50,000 Transaction 3: Rs. 10,000 Transaction 4: Rs. 10,000 Transaction 5: Rs. 100,000 Transaction 6: Rs. 75,000 Transaction 7: Rs. 150,000 Transaction 8: Rs. 150,000 Transaction 9: Rs. 50,000 Transaction 10: Rs. 100,000 Transaction 11: Rs. 52,500 Transaction 12: Rs. 52,500

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Required Determine performance materiality and transaction which needs to be verified by you. HOW TO TACKLE CASE STUDY IN YOUR EXAM

INTRODUCTION Each case study question will include several separate requirements taken from separate syllabus areas. This mirrors what happens in the real world when, for example, an audit manager planning an assignment needs to consider not only how to plan the work, but also assess the implications of any ethical, practice management, quality control, or current professional issues raised from information provided by the client. At least one of the requirements could be to provide a response to a specific enquiry raised by the client or potential client in the scenario. The first stage, when attempting a case study question, is to carefully read the requirements and understand exactly what is being asked for. PROFESSIONAL MARKS It is likely that Section A requirements containing professional marks will ask for the answer in a particular format, such as a report or briefing notes. The professional marks will be awarded for the following: structure and presentation clarity of explanation use of language appropriate to the addressee use of professional judgment discussion of both sides of a debate appreciation of relevant current professional issues.

CASE STUDY INFORMATION Having read the requirements and understood exactly what has been asked for, the next step is to carefully read through the information provided, all the time bearing in mind the specific instructions given in the requirements. The information provided in the scenario is likely to be both numeric and narrative, and could come from many different sources, such as: extracts from financial statements information from management systems details taken from working papers verbal representations from the client or members of the audit/assurance team statements from third parties.

The information in the question will need to be carefully read and it is important that sufficient time is spent digesting and understanding the information provided. When reading the case study scenario it is important, therefore, to identify the following: What is your role? For example, are you the manager responsible for the audit, or responsible for company-wide matters such as ethics or quality control? What is the time scale? Are you planning an assignment prior to the clients year end, or reviewing working papers at the conclusion of the audit? [Type the company address] Page 30

What does the company do? Is it involved in manufacturing, a service industry, or financial services? Does the company operate in a highly-regulated industry? What is the key relationship in the scenario? Is the company a long standing or potential client? Is this a one-off or a recurring engagement?

When reading through the scenario it is useful to highlight or underline important pieces of information. A lot of time can be wasted by continually re-reading the scenario, so thoroughly reading and annotating the question paper should improve time management. TIME ALLOCATION The case study questions will contain at least three discrete requirements. Time must be allocated between the requirements to ensure that each is addressed in sufficient depth. Failing to deal with a requirement obviously reduces the overall mark available for a question, but it also detracts from the quality of the answer as a whole. A general comment on time allocation: A common error is to spend too long on the first two questions, leaving very little time for the remaining questions. It is imperative that each question is properly attempted, and that sufficient time is left towards the end of the exam to attempt the final question. TAKE TIME TO THINK Failing to read the scenario carefully, or failing to think it through, could result in: making inappropriate suggestions, as a result of not thinking clearly and professionally about the relationship between the audit/assurance provider and the client. It is imperative that candidates appreciate that Paper P7 examines not just technical concepts, but also the ability to make commercial and professional comments and recommendations. This is one area where stopping and thinking about the relationships between individuals within the scenario is crucial. For example, if the candidate is given the role of an audit manager or partner, it is important not to defer to more junior members of the team. Equally, inappropriate comments to the client must be avoided. For example, the management of the client company should not be asked if they are corrupt or asked to prove their technical ability to prepare accounts. Clearly, such comments detract heavily from the quality of any answer, but can be avoided by thinking carefully about relationships and how they should be managed.

making wholly inappropriate practical suggestions. For example, asking, as part of audit evidence, to physically verify an asset that has been sold, or requesting sight of a purchase invoice for an item bought many years ago. Think carefully about requests or recommendations and ask whether the request could actually be carried out. seeing a word and assuming it means something, when really it means something entirely different this is a common mistake and results purely from not thinking before writing an answer. For example, if a scenario includes information about fines or penalties, it is important to think about whether the amount has been paid before the year end, and not to automatically assume, without taking time to think about the facts from the scenario, that a provision would be necessary. when performing calculations, it is crucial to think about the figures provided in the scenario and to use the correct figure in the right way. For example, when calculating materiality, make sure that the correct benchmark [Type the company address] Page 31

is used. If calculating the materiality of an asset, the materiality calculation should be based on the balance sheet, rather than on revenue as this is totally inappropriate.

PRESENTING THE ANSWER It should go without saying that answers should be clearly presented, as this makes marking much easier. In particular, the following points should be noted: Use headings and sub-headings to give the answer a logical flow. Bullet points are only appropriate when listing facts which require little explanation, which will be rare in Paper P7. Illegible handwriting is a major problem for markers. If handwriting is a particular area of concern, leave a blank line between each line of writing, and write more slowly. Start each answer on a new page of the answer booklet.

Remember that some requirements contain professional marks, as discussed earlier, and in these requirements the presentation and layout of the answer is particularly important.

COMPARATIVES Comparative information The amounts and disclosures included in the financial statements in respect of one or more prior periods in accordance with the applicable financial reporting framework. Corresponding figures Where amounts and disclosure in respect of prior periods are considered as an integral part of the current period figures and should be read in conjunction with current period figures. Comparative financial statements Where prior period figures are considered as separate financial statements and should be read in isolation. Difference in reporting requirements In case of corresponding figure audit report only refers to the current period only In case of comparative financial statements audit report refers to all the periods presented Exceptions to the reporting requirement Corresponding figure: In case of corresponding figure audit report only refers to current period only except when prior period audit report was modified and matter that given rise to that modification is unresolved. In such a case the auditor shall modify the auditors opinion on the current period financial statements and refers to prior period in basis for qualified opinion paragraph. For example: Management had changed the policy in respect of depreciation in prior year which is contrary to the requirement of applicable financial reporting framework and continues the same wrong policy this year. In this case we refer to both current and prior period in basis for modified opinion paragraph and will modify current period audit report. [Type the company address] Page 32

We were appointed as an auditor in prior year after the prior year end and did not perform the physical inventory count (assuming alternative procedures are impracticable). In this case we will refer to prior year in basis for qualified opinion paragraph and will explain that current year opinion in modified because of the effect of last year scope limitation as we know that in case of corresponding figures prior period figures are integral part of current period financial statements.

Comparative financial statements: In case of comparative financial statement auditors report refers to all the period presented in the financial statements except in case where prior period financial statements were audited by another auditor and the current auditor concludes that a material misstatement exists that affects the prior period financial statements on which the predecessor auditor had previously reported without modification. If the prior period financial statements are amended, and the predecessor auditor agrees to issue a new auditor's report on the amended financial statements of the prior period, the auditor shall report only on the current period. Prior Period Financial Statements Audited by a Predecessor Auditor If the financial statements of the prior period were audited by a predecessor auditor, the auditor shall state in an Other Matter paragraph: a. that the financial statements of the prior period were audited by a predecessor auditor; b. the type of opinion expressed by the predecessor auditor and, if the opinion was modified, the reasons therefore; and c. the date of that report. Prior period Financial Statements were Unaudited If the prior period financial statements were not audited, the auditor shall state in an Other Matter paragraph in the auditor's report that the corresponding figures are unaudited. Such a statement does not, however, relieve the auditor of the requirement to obtain sufficient appropriate audit evidence that the opening balances do not contain misstatements that materially affect the current period's financial statements. CONFLICT OF INTEREST Conflicts of interest can arise between: 1. Members and the clients interest 2. The interests of different clients. 3. Conflicts in the application of fundamental principles.

1. Conflicts between members and clients interest For example if member compete directly with a client or have joint venture or similar with a company that is in competition with a client. Member and firms should not accept or continue engagements in which there are significant conflicts of interest between members, firms and clients. 2. The interest of different clients Assurance firms are at liberty to have clients who are in competition with each other. However the firms should [Type the company address] Page 33

ensure that it is not the subject of a dispute between the clients. For example is case of takeover and we are the auditor of both predator and the target company, than we should not: 1. Be the principal advisors to either party. 2. Issue reports assessing the accounts of either party other than their audit report. Safeguards 1. 2. 3. 4. Both clients should be informed and ask to give consent Clearly mention this fact in the audit engagement letter Withdraw from one of the engagement if consent not received. In large audit firms, such clients can be put under two separate sections/ partner/branches with no communication to take place between the sections or partners (this is known as Chinese wall approach)

3. Conflicts in application of the fundamental principles For example in case of fraud is identified duty of confidentiality may be breached. The resolution process should include consideration of: 1. 2. 3. 4. Relevant facts. Fundamental principles related to the matter in question. Established internal control procedures. Alternative course of action.

Unresolved conflicts If the matter is unresolved, the member should consult with appropriate persons with in the firm. They may wish to obtain advice from ACCA or legal advisers. If after exhausting all relevant possibilities the ethical conflict remains unresolved, members should consider withdrawing from the engagement. For example in case of fraud is identified the duty of confidentiality can be breached in such a case we take legal advice whether there is a requirement to report a fraud or to withdraw from the engagement at all.

Public Interest Entities Public interest entities means entities, other than listed entities, which are of significant public interest because of their business, their size or their number of employees or their corporate status is such that they have a wide range of [Type the company address] Page 34

stakeholders. Examples of such entities might include credit institutions (for example banks), insurance companies, investment firms and pension firms; ENVIRONMENTAL AND SOCIAL AUDITING

Introduction As the companys primary objective is the maximization of shareholders wealth and in the accomplishment of its objective, company tends to focus on customers satisfaction. On the other hand customers not only expect desired quality and price of the companys product but also expect the welfare of the society and the environment in which they live. In this way environment and society are the indirect but important stakeholders of the company. Importance of Environment and the Society The following trends have contributed to the pressure on companies to operate in an economically, socially and environmentally sustainable way: Issues like environmental damage, improper treatment of workers, and faulty production that inconveniences or endangers customers are highlighted in the media. In some countries government regulation regarding environmental and social issues have increased. Some investors and investment fund managers have begun to take account of a corporations social and environmental policies in making investment decisions. Some consumers have become increasingly sensitive to the social and environmental performance of the companies from which they buy their goods and services. Implications for the Auditors Many companies now publish social and environmental reports. However, without independent audit and given public scepticism with regard to the aims of such reports they tend to lack credibility. In some cases the auditors are required whether under statutory requirements or otherwise for management purposes to verify and give opinion on managements Key Performance Indicators (KPIs) in respect of environmental and social regulations compliances. Examples of KPIs in respect of social compliances 1. To increases spending on staff training by 10% in the next 12 months. 2. To increase the monetary valuation of charitable donations by 10% in the next 12 months. Examples of KPIs in respect of environmental compliances 1. To reduce energy consumption by 10% over the next 2 years. 2. To increase the recycling of waste by 10% over the next 2 year. Matters to consider Are accountancy firms the right agent for such audit? It appears unlikely that an auditor would be able to measure [Type the company address] Page 35

carbon emissions or energy consumptions. There is a significant amount of subjectivity with regard to social and environmental reports, for example; the use of the term environmentally friendly. There are no formal agreed globally mandatory standards of reporting on such matters, which means directors can be selective in the reports they make. Other matters include: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. Who will the report be addressed to Who else will read it (and potentially rely on it) Can a liability disclaimer be included How detailed does the client want our work to be What evidence will be made available What format of report would they like How much assurance do they want us to provide Why is this assignment being done If we are to check something, against what criteria / standards are we to check Are there any professional guidance available for this type of assignment Who is responsible for the matter we are checking and reporting on

Contents of an assurance report on environmental issues There is no guidance in issue as to the contents of such report. The following items should be included as a minimum: 1. 2. 3. 4. 5. 6. Note of the objective of the review Opinions Basis on which those opinions have been reached Work performed Limitations to the work performed. Limitations to the opinion given

December 207 Question 2(d) Sci-Tech Co receives funding from governmental health departments, as well as several large charitable donations. This funding represents on average 25% of the companys research and development annual expenditure. The amount of funding received is dependent on three key performance indicator (KPI) targets being met annually. All three of the targets must be met in order to secure the government funding. [Type the company address] Page 36

Extracts from Sci-Tech Cos operating and financial review are as follows: KPI target Pharmaceutical products donated free of charge to health care charities: 1% revenue Donations to, and cost of involvement with, local community charities: 05% revenue Accidents in the work place: Less than 5 serious accidents per year Draft KPI 2007 Actual KPI 2006

08% revenue

12% revenue

06% revenue

08% revenue

4 serious accidents

2 serious accidents

In addition to performing the financial statement audit, your firm is engaged to provide an assurance opinion on the KPIs disclosed in the operating and financial review. Required (i) Discuss why it may not be possible to provide a high level of assurance over the stated key performance indicators; and (4 marks) Describe the procedures to verify the number of serious accidents in the year ended 30 November 2007. (4 marks)

(ii)

Answer (i) The main reason why it may not be possible to provide a high level of assurance is that the KPIs are not defined precisely: The value of donated pharmaceutical products is compared to revenue to provide a percentage. However, it will be difficult to accurately value the donated products are they valued at cost, or at sales price? Are delivery costs included in the valuation? The intrinsic value may be lower than sales value as Sci-Tech Co may decide to donate products which are not useful or relevant to the charities they are donated to. The value of cost of involvement with local charities is also not defined. If the donations are purely cash, then it should be easy to verify donations using normal audit procedures to verify cash payments. However, the involvement [Type the company address] Page 37

with local charities is not defined and will be difficult to quantify as a percentage of revenue. For example, involvement may include: Time spent by Sci-Tech Co employees at local charity events Education and training provided to members of the local community in health care matters

Number of serious accidents is also difficult to quantify as what constitutes a serious accident is subjective. For example, is an accident serious if it results in a hospitalization of the employee? Or serious if it results in more than five days absence from work while recovering? In addition, the sufficiency of evidence available is doubtful, as such matters will not form part of the accounting records and thus there may be limited and possibly only unreliable sources of evidence available. Donated goods may not be separately recorded in inventory movement records. It may not be possible to distinguish donated goods from sold or destroyed items. Unless time sheets are maintained, there is unlikely to be any detailed records of involvement in local charities. (ii) Procedures to verify the number of serious accidents during 2007 could include the following: Review the accident log book and count the total number of accidents during the year Discuss the definition of serious accident with the directors and clarify exactly what criteria need to be met to satisfy the definition For serious accidents identified: review HR records to determine the amount of time taken off work review payroll records to determine the financial amount of sick pay awarded to the employee review correspondence with the employee regarding the accident.

Review board minutes where the increase in the number of serious accidents has been discussed Review correspondence with Sci-Tech Cos legal advisors to ascertain any legal claims made against the company due to accidents at work Enquire as to whether any health and safety visits have been conducted during the year by regulatory bodies, and review any documentation or correspondence issued to Sci-Tech Co after such visits. Discuss the level of accidents with representatives of Sci-Tech Cos employees to reach an understanding as to whether accidents sometimes go unreported in the accident log book. Using the Work of an auditors expert ISA 620 Professionals audit staff are highly trained and educated, but their experience and training is limited to accountancy and auditing matters. In certain situations it will therefore be necessary to employ someone else with different expert knowledge to gain sufficient and appropriate audit evidence. Examples of situation where experts opinion is required: [Type the company address] Page 38

1. 2. 3. 4. 5.

Valuation of certain types of assets for example land and building, plant and machinery. Determination of quantities or physical conditions of assets. Determination of amounts using specialized techniques for example pensions accounting. The measurements of work completed and work in progress on contracts. Legal opinion.

Competence and objectivity of the auditors expert This involves considering: 1. The experts professional certification or licensing by or membership of an appropriate professional body. 2. The experts experience and reputation in the relevant field. The risk that the experts objectivity is impaired increases when the expert is: 1. Employed by the entity. 2. Related in some other manner to the entity, for example by being financially dependent upon or having an investment in the entity. The scope of work of the auditors expert The auditor shall agree in writing when appropriate on the nature, scope and objectives of that experts work. Such agreement/instruction should cover the following factors: 1. 2. 3. 4. 5. 6. The objective and scope of the experts work. A general outline as to the specific matters the experts report to cover. The intended use of the experts work. The extent of the experts access to appropriate records and files. Clarification of the experts relationship with the entity. Confidentiality of the entitys information.

Assessing the work of the auditors expert This requires the consideration of: 1. 2. 3. 4. 5. The source data used. The assumptions and methods used. When the expert carried out the work. The reasons for any change in assumptions and methods. The results of the experts work in the light of the auditors overall knowledge of the business and the results of other audit procedures.

Reference to an auditors expert in the audit report

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When unmodified report is issued: The auditor shall not refer the work in an auditors report unless required by law or regulation. The reason is that such a reference may be misunderstood and interpreted as a qualification of the audit opinion or division of responsibility neither of which are appropriate. When modified report is issued The auditor may refer to the work of an expert. In such a case auditor may need to obtain permission in advance from the expert. If such permission is not given then the auditors may have to seek legal advice. Important Engaging the expert is costly and should be involved if there is a real need to do so. When recommending audit procedure in the exam, only recommend using an expert if it is a relevant test. It is not a substitute for alternative test. Example Piles of copper and brass that can be distinguished with a simple acid test, have been mixed up. You are attending the inventory count. Required Explain whether it is necessary to use the work of an expert in this situation. If not what are the alternative procedures? Forensic Auditing Forensic Accounting This refers to use of accounting, auditing and investigative skills to conduct an examination into companys financial affairs. It involves the whole process of conducting an investigation, including acting as an expert witness. Forensic Investigations This refers to the practical steps that the forensic accountant takes in order to gather evidence relevant to the alleged fraudulent activity. Such investigations involve a planning phase, a phase of gathering evidence, a review phase and a report to the client. Forensic Audit This refers to the specific procedures adopted in order to produce evidence. From an accountancy perspective, this usually requires the adoption of traditional financial auditing skills and techniques. Application of Forensic Auditing Forensic auditing can be applied to a number of situations such as: 1. Fraud [Type the company address] Page 40

2. Negligence 3. Insurance claims 4. Other disputes such as: Shareholders disputes Partnership disputes Contract disputes Business sales and purchase disputes Matrimonial disputes Forensic accountants may be used as expert witness and as such they have the following duties: 1. Experts have an overriding duty to help the court on matters with in their expertise. 2. Expert should not act as mediators between the parties or require them to trespass on the role of the court in deciding facts. 3. Experts should provide opinions which are independent, regardless of the pressure of litigation. 4. Experts should not take it upon themselves to promote the point of view of the party engaging them. 5. Experts should indicate without delay where particular questions or issues fall outside their expertise. Experts Witness Reports The main contents are outlined below: 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. Index Summary of conclusion Instructions Issues Documentation Chronology Technical background Opinion References Declaration

Ethical Principals IFACs Code of Ethics for Professional Accountants applies to all ACCA members involved in professional assignments, including forensic investigations. There are specific considerations in the application of each of the principles in providing such a service. Integrity The forensic investigator is likely to deal frequently with individuals who lack integrity, are dishonest, and attempt to conceal the true facts from the investigator. It is imperative that the investigator recognizes this, and acts with impeccable integrity throughout the whole investigation.

Objectivity

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As in an audit engagement, the investigators objectivity must be beyond question. The report that is the outcome of the forensic investigation must be perceived as independent, as it forms part of the legal evidence presented at court. The investigator must adhere to the concept that the overriding objective of court proceedings is to deal with cases fairly and justly. Any real or perceived threats to objectivity could undermine the credibility of the evidence provided by the investigator. This issue poses a particular problem where an audit client requests its auditors to conduct a forensic investigation. In this situation, the audit firm would be exposed to threats to objectivity in terms of advocacy, management involvement and self review. The advocacy threat arises because the audit firm may feel pressured into promoting the interests and point of view of their client, which would breach the overriding issue of objectivity in court proceedings. Secondly, the investigators could be perceived to be involved in management decisions regarding the implications of the fraud, especially where the investigator acts as an expert witness. It is however the self-review threat that would be the most significant threat to objectivity. The self review threat arises because the investigation is likely to involve the estimation of an amount (i.e. the loss), which could be material to the financial statements. For the reasons outlined above, The Code states that the firm should evaluate threats and put appropriate safeguards in place, and if safeguards cannot reduce the threats to an acceptable level, then the firm cannot provide both the audit service and the forensic investigation. Professional competence and due care Forensic investigations will involve very specialist skills, which accountants are unlikely to possess without extensive training. Such skills would include: Detailed knowledge of the relevant legal framework surrounding fraud, An understanding of how to gather specialist evidence, Skills in the safe custody of evidence, including maintaining a clear chain of evidence, and Strong personal skills in, for example, interview techniques, presentation of material at court, and tactful dealing with difficult and stressful situations. It is therefore essential that forensic work is only ever undertaken by highly skilled individuals, under the direction and supervision of an experienced fraud investigator. Any doubt over the competence of the investigation team could severely undermine the credibility of the evidence presented at court.

Confidentiality Normally accountants should not disclose information without the explicit consent of their client. However, during legal proceedings arising from a fraud investigation, the court will require the investigator to reveal information discovered during the investigation. There is an overriding requirement for the investigator to disclose all of the information deemed necessary by the court. Outside of the court, the investigator must ensure faultless confidentiality, especially because much of the information they have access to will be highly sensitive. Professional behaviour Fraud investigations can become a matter of public interest, and much media attention is often focused on the work of the forensic investigator. A highly professional attitude must be displayed at all times, in order to avoid damage to the [Type the company address] Page 42

reputation of the firm, and of the profession. Any lapse in professional behaviour could also undermine the integrity of the forensic evidence, and of the credibility of the investigator, especially when acting in the capacity of expert witness. During legal proceedings, the forensic investigator may be involved in discussions with both sides in the court case, and here it is essential that a courteous and considerate attitude is presented to all parties.

Difference in approach than audit Materiality: In many investigations there will be no materiality Timing: Clearly less predictable than audit Documentation: Needs to be reviewed more critically than an audit Interviews: Challenging and requires high skills Computer aided techniques: More use than audit as transactions needs to be verified 100% in most cases.

Question You are a manager in the forensic investigation department of your audit firm. The directors of a local manufacturing company, Crocus Co, have contacted your department regarding a suspected fraud, which has recently been discovered operating in the company, and you have been asked to look into the matter further. You have held a preliminary discussion with Gita Thrales, the finance director of Crocus Co, the notes of this conversation are shown below: Notes of discussion with Gita Thrales Four months ago Crocus Co shut down one of its five factories, in response to deteriorating market conditions, with all staff employed at the factory made redundant on the date of closure. While monitoring the monthly management accounts, Gita performs analytical procedures on salary expenses. She found that the monthly total payroll expense had reduced by 3% in the months following the factory closure not as much as expected, given that 20% of the total staff of the company had been made redundant. Initial investigations performed last week by Gita revealed that many of the employees who had been made redundant had actually remained on the payroll records, and salary payments in respect of these individuals were still being made every month, with all payments going into the same bank account. As soon as she realised that there may be a fraud being conducted within the company, Gita stopped any further payments in respect of the redundant employees. She contacted our firm as she is unsure how to proceed, and would like our firms specialist department to conduct an investigation. Gita says that the senior accountant, Miles Rutland, has been absent from work since she conducted her initial investigation last week, and it has been impossible to contact him. Gita believes that he may have been involved with the suspected fraud. Gita has asked whether your department would be able to provide a forensic investigation, but is unsure what this would involve. Crocus Co is not an audit client of your firm. [Type the company address] Page 43

Required: Prepare a report to be sent to Gita Thrales (the finance director), in which you: (i) (ii) Describe the objectives of a forensic investigation; and Explain the steps involved in a forensic investigation into the payroll fraud, including examples of procedures that could be used to gather evidence. (14 marks) Assess how the fundamental ethical principles of IFACs Code of Ethics for Professional Accountants should be applied to the provision of a forensic investigation service. (6 marks)

(iii) Answer

Report to Gita Thrales Subject: Forensic investigation into alleged payroll fraud Introduction This report has been requested in order to outline and explain the operation of a forensic investigation into an alleged payroll fraud. The report will outline the steps taken in such an investigation and provide an explanation of the expected output of the work performed. Objectives of a forensic investigation The first objective is to decide if a deliberate fraud with the intention of stealing cash from the company has actually taken place. There is a possibility that the employees made redundant have remained on the payroll records by error rather than fraud. The investigation should uncover whether the situation has arisen through mistake or through deliberate criminal action. Secondly, the investigation will aim to discover the perpetrator(s) of the fraud, and ultimately to assist in their prosecution. The investigation will gather evidence, which may include an interview with the suspected fraudster, which can then be used in criminal procedures against the individual(s) concerned. In this case there is an individual suspected of involvement in the alleged fraud. It will be an important part of the investigation to discover if there were other people involved, as frauds often involve collusion between several individuals. Thirdly, the investigation should quantify the financial loss suffered by Crocus Co as a result of the fraud. The evidence gathered will determine the amount which has been stolen from the company as a result of the fraud. It is important for the loss to be quantified; as legally a crime has only been committed if a victim (i.e. Crocus Co) has suffered a financial loss. Steps in investigating a suspected fraud The first step will be to determine the type of fraud that has taken place. The fact that employees no longer employed by the company have not been removed from the payroll indicates a fraud known as a ghost employee scheme, whereby the fraudster diverts the payroll of the non-existent employees into their own possession. Then the investigator will need to consider how the fraud could have taken place. This would normally be due to the fraudster(s) circumventing internal controls and concealing their actions from their colleagues and supervisors. For example, there should be a control in place to ensure that any amendments made to payroll data (in this case an amendment appears to have been made to re-route the ex-employees pay into the bank account of the fraudster) must be approved by a senior manager, and should be flagged by an exception report. The investigator will also need to establish how long the fraud has been operating in this case it is likely that the [Type the company address] Page 44

fraud began at the same time as the factory closure, but this will need to be clarified. The next step would be to gather evidence this is a crucial part of the investigation as it should determine both the identity of the perpetrator(s) and the monetary value of the fraud. Gathering evidence could include an examination of accounting records and other documentation, the use of computer-assisted auditing techniques (CAATs), interviewing employees of the company, and discussions with management. A key issue here is to ensure that the evidence will be sufficient to prove three matters: That a fraud has taken place, The identity of the fraudster, and The amount of the loss to the company. This is essential because the legal framework will require clear evidence in order for a prosecution to be instigated against the perpetrator(s) of the fraud. Evidence must be sufficient and relevant to the accusations being made. For example, the legal framework is likely to require evidence of the following: The motive for the fraud, The ability of the alleged fraudster to conduct the fraud, and Any attempt made by the alleged to conceal the crime. Investigative procedures could include, for example: Review of authorisation of monthly payroll. Use of CAATs to determine any alteration of payroll details. Use of CAATs to determine: Any individual on the payroll who has no contact details. Any bank account receiving the pay of more than one individual. Employees who have not taken holiday or sick leave. Reconciliation of employees in the payroll database with employees in the human resources database. The purpose of the above is to establish how the controls that should have been operating in the payroll system were circumvented. It would seem that authorizations to alter payroll details, i.e. altering payments so that they all go into one bank account, have not taken place. The investigation should also involve an interview with the suspect(s), with the aim of extracting a confession. This would form a key part of the evidence to be ultimately presented at court. The investigator will produce a report for the attention of the management of Crocus Co, summarizing all findings and concluding on the identity of the fraudster(s) and the amount of financial loss suffered. This report is also likely to be presented as part of evidence during court proceedings. Though not strictly part of the investigation, which ends on the production of the report described above, it is worth mentioning that the investigator would be likely to be called as an expert witness during the legal process, whereby the evidence gathered and report produced as part of the investigation would be explained to those involved in the legal proceedings, and the investigator may be asked questions regarding the investigation performed. Finally, advice can be provided to management, as to how to prevent this kind of fraud from occurring again. Recommendations would be likely to focus on improvements in internal systems and controls in the specific part of the business where the fraud occurred. Conclusion [Type the company address] Page 45

This report has explained that the objective of a forensic investigation is to clarify whether a fraud has taken place, to discover the identity of the fraudster, and to quantify the financial loss suffered. The specialist skills of the investigation team will produce evidence which is sufficient and relevant enough to be used to assist legal proceedings against those involved with the fraud. Application of ethical principles to a fraud investigation IFACs Code of Ethics for Professional Accountants applies to all ACCA members involved in professional assignments, including forensic investigations. There are specific considerations in the application of each of the principles in providing such a service. Integrity The forensic investigator is likely to deal frequently with individuals who lack integrity, are dishonest, and attempt to conceal the true facts from the investigator. It is imperative that the investigator recognises this, and acts with impeccable integrity throughout the whole investigation. Objectivity As in an audit engagement, the investigators objectivity must be beyond question. The report that is the outcome of the forensic investigation must be perceived as independent, as it forms part of the legal evidence presented at court. The investigator must adhere to the concept that the overriding objective of court proceedings is to deal with cases fairly and justly. Any real or perceived threats to objectivity could undermine the credibility of the evidence provided by the investigator. This issue poses a particular problem where an audit client requests its auditors to conduct a forensic investigation. In this situation, the audit firm would be exposed to threats to objectivity in terms of advocacy, management involvement and self review. The advocacy threat arises because the audit firm may feel pressured into promoting the interests and point of view of their client, which would breach the overriding issue of objectivity in court proceedings. Secondly, the investigators could be perceived to be involved in management decisions regarding the implications of the fraud, especially where the investigator acts as an expert witness. It is however the self-review threat that would be the most significant threat to objectivity. The self review threat arises because the investigation is likely to involve the estimation of an amount (i.e. the loss), which could be material to the financial statements. For the reasons outlined above, The Code states that the firm should evaluate threats and put appropriate safeguards in place, and if safeguards cannot reduce the threats to an acceptable level, then the firm cannot provide both the audit service and the forensic investigation. Professional competence and due care Forensic investigations will involve very specialist skills, which accountants are unlikely to possess without extensive training. Such skills would include: Detailed knowledge of the relevant legal framework surrounding fraud, An understanding of how to gather specialist evidence, Skills in the safe custody of evidence, including maintaining a clear chain of evidence, and Strong personal skills in, for example, interview techniques, presentation of material at court, and tactful dealing with difficult and stressful situations.

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It is therefore essential that forensic work is only ever undertaken by highly skilled individuals, under the direction and supervision of an experienced fraud investigator. Any doubt over the competence of the investigation team could severely undermine the credibility of the evidence presented at court. Confidentiality Normally accountants should not disclose information without the explicit consent of their client. However, during legal proceedings arising from a fraud investigation, the court will require the investigator to reveal information discovered during the investigation. There is an overriding requirement for the investigator to disclose all of the information deemed necessary by the court. Outside of the court, the investigator must ensure faultless confidentiality, especially because much of the information they have access to will be highly sensitive. Professional behaviour Fraud investigations can become a matter of public interest, and much media attention is often focused on the work of the forensic investigator. A highly professional attitude must be displayed at all times, in order to avoid damage to the reputation of the firm, and of the profession. Any lapse in professional behaviour could also undermine the integrity of the forensic evidence, and of the credibility of the investigator, especially when acting in the capacity of expert witness. During legal proceedings, the forensic investigator may be involved in discussions with both sides in the court case, and here it is essential that a courteous and considerate attitude is presented to all parties.

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Question You are a manager in the forensic investigation department of your audit firm. The directors of a local manufacturing company, Crocus Co, have contacted your department regarding a suspected fraud, which has recently been discovered operating in the company, and you have been asked to look into the matter further. You have held a preliminary discussion with Gita Thrales, the finance director of Crocus Co, the notes of this conversation are shown below: Notes of discussion with Gita Thrales Four months ago Crocus Co shut down one of its five factories, in response to deteriorating market conditions, with all staff employed at the factory made redundant on the date of closure. While monitoring the monthly management accounts, Gita performs analytical procedures on salary expenses. She found that the monthly total payroll expense had reduced by 3% in the months following the factory closure not as much as expected, given that 20% of the total staff of the company had been made redundant. Initial investigations performed last week by Gita revealed that many of the employees who had been made redundant had actually remained on the payroll records, and salary payments in respect of these individuals were still being made every month, with all payments going into the same bank account. As soon as she realised that there may be a fraud being conducted within the company, Gita stopped any further payments in respect of the redundant employees. She contacted our firm as she is unsure how to proceed, and would like our firms specialist department to conduct an investigation. Gita says that the senior accountant, Miles Rutland, has been absent from work since she conducted her initial investigation last week, and it has been impossible to contact him. Gita believes that he may have been involved with the suspected fraud. Gita has asked whether your department would be able to provide a forensic investigation, but is unsure what this would involve. Crocus Co is not an audit client of your firm. Required: Prepare a report to be sent to Gita Thrales (the finance director), in which you: (i) (ii) Describe the objectives of a forensic investigation; and Explain the steps involved in a forensic investigation into the payroll fraud, including examples of procedures that could be used to gather evidence. (14 marks) Assess how the fundamental ethical principles of IFACs Code of Ethics for Professional Accountants should be applied to the provision of a forensic investigation service. (6 marks)

(iii) Answer

Report to Gita Thrales Subject: Forensic investigation into alleged payroll fraud Introduction This report has been requested in order to outline and explain the operation of a forensic investigation into an alleged payroll fraud. The report will outline the steps taken in such an investigation and provide an explanation of the expected output of the work performed. Objectives of a forensic investigation [Type the company address] Page 48

The first objective is to decide if a deliberate fraud with the intention of stealing cash from the company has actually taken place. There is a possibility that the employees made redundant have remained on the payroll records by error rather than fraud. The investigation should uncover whether the situation has arisen through mistake or through deliberate criminal action. Secondly, the investigation will aim to discover the perpetrator(s) of the fraud, and ultimately to assist in their prosecution. The investigation will gather evidence, which may include an interview with the suspected fraudster, which can then be used in criminal procedures against the individual(s) concerned. In this case there is an individual suspected of involvement in the alleged fraud. It will be an important part of the investigation to discover if there were other people involved, as frauds often involve collusion between several individuals. Thirdly, the investigation should quantify the financial loss suffered by Crocus Co as a result of the fraud. The evidence gathered will determine the amount which has been stolen from the company as a result of the fraud. It is important for the loss to be quantified; as legally a crime has only been committed if a victim (i.e. Crocus Co) has suffered a financial loss. Steps in investigating a suspected fraud The first step will be to determine the type of fraud that has taken place. The fact that employees no longer employed by the company have not been removed from the payroll indicates a fraud known as a ghost employee scheme, whereby the fraudster diverts the payroll of the non-existent employees into their own possession. Then the investigator will need to consider how the fraud could have taken place. This would normally be due to the fraudster(s) circumventing internal controls and concealing their actions from their colleagues and supervisors. For example, there should be a control in place to ensure that any amendments made to payroll data (in this case an amendment appears to have been made to re-route the ex-employees pay into the bank account of the fraudster) must be approved by a senior manager, and should be flagged by an exception report. The investigator will also need to establish how long the fraud has been operating in this case it is likely that the fraud began at the same time as the factory closure, but this will need to be clarified. The next step would be to gather evidence this is a crucial part of the investigation as it should determine both the identity of the perpetrator(s) and the monetary value of the fraud. Gathering evidence could include an examination of accounting records and other documentation, the use of computer-assisted auditing techniques (CAATs), interviewing employees of the company, and discussions with management. A key issue here is to ensure that the evidence will be sufficient to prove three matters: That a fraud has taken place, The identity of the fraudster, and The amount of the loss to the company. This is essential because the legal framework will require clear evidence in order for a prosecution to be instigated against the perpetrator(s) of the fraud. Evidence must be sufficient and relevant to the accusations being made. For example, the legal framework is likely to require evidence of the following: The motive for the fraud, The ability of the alleged fraudster to conduct the fraud, and Any attempt made by the alleged to conceal the crime. Investigative procedures could include, for example: [Type the company address] Page 49

 Review of authorisation of monthly payroll. Use of CAATs to determine any alteration of payroll details. Use of CAATs to determine: Any individual on the payroll who has no contact details. Any bank account receiving the pay of more than one individual. Employees who have not taken holiday or sick leave. Reconciliation of employees in the payroll database with employees in the human resources database. The purpose of the above is to establish how the controls that should have been operating in the payroll system were circumvented. It would seem that authorizations to alter payroll details, i.e. altering payments so that they all go into one bank account, have not taken place. The investigation should also involve an interview with the suspect(s), with the aim of extracting a confession. This would form a key part of the evidence to be ultimately presented at court. The investigator will produce a report for the attention of the management of Crocus Co, summarizing all findings and concluding on the identity of the fraudster(s) and the amount of financial loss suffered. This report is also likely to be presented as part of evidence during court proceedings. Though not strictly part of the investigation, which ends on the production of the report described above, it is worth mentioning that the investigator would be likely to be called as an expert witness during the legal process, whereby the evidence gathered and report produced as part of the investigation would be explained to those involved in the legal proceedings, and the investigator may be asked questions regarding the investigation performed. Finally, advice can be provided to management, as to how to prevent this kind of fraud from occurring again. Recommendations would be likely to focus on improvements in internal systems and controls in the specific part of the business where the fraud occurred. Conclusion This report has explained that the objective of a forensic investigation is to clarify whether a fraud has taken place, to discover the identity of the fraudster, and to quantify the financial loss suffered. The specialist skills of the investigation team will produce evidence which is sufficient and relevant enough to be used to assist legal proceedings against those involved with the fraud. Application of ethical principles to a fraud investigation IFACs Code of Ethics for Professional Accountants applies to all ACCA members involved in professional assignments, including forensic investigations. There are specific considerations in the application of each of the principles in providing such a service. Integrity The forensic investigator is likely to deal frequently with individuals who lack integrity, are dishonest, and attempt to conceal the true facts from the investigator. It is imperative that the investigator recognises this, and acts with impeccable integrity throughout the whole investigation. Objectivity As in an audit engagement, the investigators objectivity must be beyond question. The report that is the outcome of the forensic investigation must be perceived as independent, as it forms part of the legal evidence presented at court. The investigator must adhere to the concept that the overriding objective of court proceedings is to deal with cases fairly [Type the company address] Page 50

and justly. Any real or perceived threats to objectivity could undermine the credibility of the evidence provided by the investigator. This issue poses a particular problem where an audit client requests its auditors to conduct a forensic investigation. In this situation, the audit firm would be exposed to threats to objectivity in terms of advocacy, management involvement and self review. The advocacy threat arises because the audit firm may feel pressured into promoting the interests and point of view of their client, which would breach the overriding issue of objectivity in court proceedings. Secondly, the investigators could be perceived to be involved in management decisions regarding the implications of the fraud, especially where the investigator acts as an expert witness. It is however the self-review threat that would be the most significant threat to objectivity. The self review threat arises because the investigation is likely to involve the estimation of an amount (i.e. the loss), which could be material to the financial statements. For the reasons outlined above, The Code states that the firm should evaluate threats and put appropriate safeguards in place, and if safeguards cannot reduce the threats to an acceptable level, then the firm cannot provide both the audit service and the forensic investigation. Professional competence and due care Forensic investigations will involve very specialist skills, which accountants are unlikely to possess without extensive training. Such skills would include: Detailed knowledge of the relevant legal framework surrounding fraud, An understanding of how to gather specialist evidence, Skills in the safe custody of evidence, including maintaining a clear chain of evidence, and Strong personal skills in, for example, interview techniques, presentation of material at court, and tactful dealing with difficult and stressful situations. It is therefore essential that forensic work is only ever undertaken by highly skilled individuals, under the direction and supervision of an experienced fraud investigator. Any doubt over the competence of the investigation team could severely undermine the credibility of the evidence presented at court. Confidentiality Normally accountants should not disclose information without the explicit consent of their client. However, during legal proceedings arising from a fraud investigation, the court will require the investigator to reveal information discovered during the investigation. There is an overriding requirement for the investigator to disclose all of the information deemed necessary by the court. Outside of the court, the investigator must ensure faultless confidentiality, especially because much of the information they have access to will be highly sensitive. Professional behaviour Fraud investigations can become a matter of public interest, and much media attention is often focused on the work of the forensic investigator. A highly professional attitude must be displayed at all times, in order to avoid damage to the reputation of the firm, and of the profession. Any lapse in professional behaviour could also undermine the integrity of the forensic evidence, and of the credibility of the investigator, especially when acting in the capacity of expert witness. During legal proceedings, the forensic investigator may be involved in discussions with both sides in the court case, and here it is essential that a courteous and considerate attitude is presented to all parties.

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THE AUDITORS RESPONSIBILITIES RELATING TO FRAUD IN AN AUDIT OF FINANCIAL STATEMENTS ISA 240 What is error? Error is an unintentional act that results in the misstatement of the financial statement. What is fraud? Fraud is an intentional act by one or more individual amongst management, those charged with governance, employees or third parties involving the use of deception to obtain an unjust or illegal advantage. Fraud may be perpetrated by an individual or colluded in with people internal or external to the business. Auditor is only concerned with fraud that causes a material misstatement in financial statements. There are two types of financial statement s frauds: 1. Fraudulent financial reporting 2. Misappropriation of assets Fraudulent financial reporting: This may include: 1. Falsification or alteration of accounting records/supporting documents. 2. Omission of events, transactions or other significant information in the financial statements. 3. Intentional misapplication of accounting policies. Fraudulent financial reporting also involves management override of controls. Such fraud can be committed by management overriding controls using techniques such as: 1. 2. 3. 4. Recording fictitious journal entries. Inappropriately adjusting assumptions used to estimate account balance. Omitting, advancing or delaying recognition in the financial statements of events and transactions. Concealing or not disclosing facts that could affect the amounts recorded in the financial statements.

Fraud risk factor includes: Incentives/pressures Financial stability/profitability is threatened Opportunities Significant related party transactions Attitudes/rationalization Ineffective communication or enforcement of the entitys values or ethical standards by management Page 52

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Pressure on management to meet expectations of third parties Personal financial situation of management threatened by the entitys financial performance Excessive pressure on management or operating personnel to meet financial targets

Assets, liabilities, revenues or expenses based on significant estimates. Domination of management by a single person or small group

Known history of violation of laws and regulations A practice by management of committing to achieve aggressive or unrealistic forecast Low morale among senior management

Weak internal controls

Misappropriation of assets: Misappropriation of assets involves the theft of an entitys assets and is often perpetrated by employees in relatively small and immaterial amounts. However, it can also involve management who are usually more able to disguise or conceal misappropriations that are difficult to detect. Misappropriation of assets can be accomplished in a variety of ways including: 1. 2. 3. 4. Embezzling receipts e.g. (Diverting business receipts into personnel bank account). Stealing physical assets or intellectual property e.g. (stealing inventory for personal use or sale). Causing an entity to pay for goods and services not received e.g.( payments to fictitious vendors). Using an entitys assets for personnel use e.g. (using company car and computers).

Fraud risk factor includes: Incentive/pressures Personal financial obligations Adverse relationships between the management and employees with access to cash or other assets susceptible to theft Opportunities Large amount of cash on hand or processed. Inventory items that are small in size, of high value or in high demand Attitudes/rationalizations Overriding existing controls Failing to correct known internal control deficiencies

Easily convertible assets, such as diamonds or computer chips

Behavior indicating displeasure or dissatisfaction with the entity Page 53

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Inadequate internal controls over assets

Changes in behavior or life style

Responsibilities with regard to fraud Management and those charged with governance Management and those charged with governance in an entity are primarily responsible for preventing and detecting fraud. Auditor The auditors approach to the possibility of fraud: The auditor shall maintain professional skepticism throughout the audit, recognizing the possibility that a material misstatement due to fraud could exist, notwithstanding the auditors past experience of the honesty and integrity of the entitys management and those charged with governance. There should be discussion by members of the engagement team of the susceptibility of the entitys financial statements to material misstatement due to fraud, including how fraud might occur. The auditor should perform risk assessment procedure which includes: 1. 2. 3. 4. Inquiries of management and those charged with governance. Consideration of when fraud risk factors are present. Consideration of results of analytical procedures Consideration of any other relevant information.

The auditor must then come up with responses to assessed risk. Such a response should: 1. Consider the assignment and supervision of personnel. 2. Consider the accounting policies used by the entity. 3. Incorporate an element of unpredictability in the selection of the nature, timing and extent of audit procedures. The auditor must obtain written representation from the management that it acknowledges its responsibilities for the prevention and detection of fraud. Auditors reporting of identified fraud: a. Reporting to Management If the auditor has identified a fraud, or obtained evidence that indicates one may have occurred, the auditor should communicate this on a timely basis to an appropriate level of management. If the auditor suspects either management, employees with a significant role in internal controls or others where [Type the company address] Page 54

fraud results in a material misstatement, then the auditor should communicate the matter to those charged with governance. b. Reporting to Shareholder If the matter leads to a material misstatement or an inability to obtain sufficient appropriate evidence then the auditor must consider the impact upon the nature and wording of their audit report. If the matters are significant the auditor may choose to speak directly to shareholder at the AGM (Here obtaining legal advice is recommended). c. Reporting to Third Party Where the auditor believes that a suspected fraud should be reported to an appropriate authority in the public interest, they should notify directors in writing of their view and, if the entity does not voluntarily do so, should report it themselves. Where the suspected fraud casts doubt on the integrity of the directors, the auditor should make a report directly to the proper authority in the public interest without delay and without informing directors in advance (Here obtaining legal advice is recommended). Withdrawal from Engagements The auditor should consider the need to withdraw from the engagement if he uncovers exceptional circumstances with regard to fraud.

June 2009 Question 5 (a) Explain the term Fraudulent Financial Reporting, illustrating your explanation with examples. (4 marks) Answer Fraudulent financial reporting is a type of fraud that causes a material misstatement in the financial statements. The term is defined in ISA 240 The Auditors Responsibilities Relating to Fraud in an Audit of Financial Statements (Redrafted). Fraudulent financial reporting is a deliberate act, i.e. an intentional misstatement, and can include omissions. The aim of the activity is to deceive the users of the financial statements. Fraudulent financial reporting tends to fall into three categories, described below: 1. Manipulation, falsification (including forgery), or alteration of accounting records or supporting documentation from which the financial statements are prepared. An example would be where the management deliberately changes the trial balance which is then used as the basis of preparation of the financial statements. Fictitious journal entries could be used to window dress the yearend figures. 2. Misrepresentation in, or deliberate omission from, the financial statements of events, transactions or other significant information. An example would be where management knowingly fails to account for a transaction, so that the financial statements are incomplete. Revenue or costs could be omitted or delayed until the next accounting period. Failure to provide information about going concern problems is a deliberate omission of significant information. [Type the company address] Page 55

3. Intentional misapplication of accounting principles relating to amounts, classification, presentation or disclosure within the financial statements. An example would be the deliberate breach of a financial reporting standard. This could mean that balances are recognized inappropriately, necessary disclosures are not made, or the presentation is not correct. Such actions are often carried out to manage earnings in order to influence the perceptions of the companys performance. This is commonly referred to as earnings management and is prone to occur due to pressure on management to achieve a certain performance target. Alternatively, the statement of financial position of the company could be manipulated with the aim of securing finance.

June 2010 Question 2 (d) (i) Compare the responsibilities of the external auditor and of management in relation to the prevention and detection of fraud. (4 marks) Answer Responsibilities of external auditors and management in relation to the detection of fraud. The external auditor must comply with the requirements of ISA 240 The Auditors Responsibilities Relating to Fraud in an Audit of Financial Statements. ISA 240 also comments on the responsibilities of those charged with governance and of management. ISA 240 makes it clear that the primary responsibility for the prevention and detection of fraud rests with both those charged with governance and management of an entity. By establishing a sound system of operational and financial controls, management should reduce opportunities for fraud to take place, and establish a culture which should persuade individuals not to commit fraud due to the likelihood of detection and punishment. In some jurisdictions, codes of corporate governance require specific actions to be taken in respect of internal controls by management. The external auditor may provide recommendations and advice on the improvement of internal controls, but it is not their responsibility to put the recommendations into practice. The auditors responsibility is to consider the risk of material misstatement in the financial statements due to fraud. This means that the auditor is more focused on fraud that impacts on the accounts than on operational fraud which may not cause a material misstatement. A fraud with an immaterial impact may not be detected by audit procedures. Because the external auditor will use sampling techniques based on a level of materiality, not all balances and transactions will be subject to detailed testing, so small frauds are not likely to be detected. This is possibly why the fraud relating to supplier payments has remained undetected. A similarity is that both management and the external auditor should assess the strength of controls in place within the entity, and in doing so, evaluate the likelihood of a fraud occurring. The auditor will perform this evaluation while planning the audit. Corporate governance codes state that management should continually be monitoring the strength [Type the company address] Page 56

of the entitys control environment and systems.

Going Concern Under the going concern assumption, an entity is ordinarily viewed as continuing in business for the foreseeable future with neither the intention nor the necessary of liquidation, ceasing trading or seeking protection from creditors pursuant to laws and regulations. Accordingly assets and liabilities are recorded on the basis that the entity will be able to realize its assets and discharge its liability in the normal course of business. Management Responsibility Management has a responsibility to assess the entitys ability to continue as a going concern even if the financial reporting framework does not include an explicit requirement to do so. When there is a history of profitable operations and a ready access to financial resources, management may make its assessment without detailed analysis. Going Concern Indicators Financial 1. Net liability or net current liability position. 2. Fixed term borrowing approaching maturity without realistic prospects of renewal or payment or excessive reliance on short term borrowings to finance the long term assets. 3. Indication of withdrawal of financial support by debtors and creditors. 4. Negative operating cash flows indicated by historical or prospective financial statements. 5. Adverse key financial ratios. 6. Substantial operating losses. 7. Arrears or discontinuance of dividends. 8. Inability to pay creditors on due dates. 9. Inability to comply with the terms of loan agreements. 10. Change from credit to cash on delivery transaction with suppliers. 11. Inability to obtain finance for essential new product development or other essential investments. Operating 1. Loss of key management without replacement. 2. Loss of major market, licenses or principal suppliers. 3. Labor difficulties or shortage of important supplies.

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Other 1. Non compliance with statutory requirements. 2. Pending legal or regulatory proceedings against the entity that may, if successful, result in claims that are unlikely to be satisfied. 3. Change in legislation or government policy expected to adversely affect the entity. Mitigating Factors The significance of such events or conditions can often be mitigated by other factors. For examples, the effect of an entity unable to make its repayments may be counter balanced by managements plans to maintain adequate cash flows by alternative means, such as disposal of assets, rescheduling of loan repayments or by obtaining additional capital. Similarly, the loss of a principal supplier may be mitigated by the availability of a suitable source of supply Auditors Responsibility The auditors responsibility is to consider the appropriateness of managements use of the going concern assumption in the preparation of the financial statements, and consider whether there are material uncertainties about the entitys ability to continue as a going concern that need to be disclosed in the financial statements. The auditor considers the appropriateness of managements use of the going concern assumption even if the financial reporting framework used in the preparation of the financial statements does not include an explicit requirement for management to make a specific assessment of the entitys ability to continue as a going concern. The auditor cannot predict future events or conditions that may cause an entity to cease to continue as a going concern. Accordingly, the absence of any reference to going concern uncertainty in an auditors report cannot be viewed as a guarantee as to the entitys ability to continue as a going concern. The auditor should consider the same period as that used by management in making its assessment under the applicable financial reporting framework. If managements assessment of the entitys ability to continue as a going concern covers less than twelve months from the balance sheet date, the auditor should ask management to extend its assessment period to twelve months from the balance sheet date. If management is unwilling to make or extend its assessment when requested to do so by the auditor, the auditor should consider the need to modify the auditors report as a result of the limitation on the scope of the auditors work. The auditor should inquire of management as to its knowledge of events or conditions and related business risks beyond the period of assessment used by management that may cast significant doubt on the entitys ability to continue as a going concern.

When events or conditions have been identified which may cast significant doubt on the entitys ability to continue as a going concern, the auditor should: (a) (b) Review managements plans for future actions based on its going concern assessment; Gather sufficient appropriate audit evidence to confirm or dispel whether or not a material uncertainty exists [Type the company address] Page 58

through carrying out audit procedures considered necessary, including considering the effect of any plans of management and other mitigating factors; and (c) . Seek written representations from management regarding its plans for future action. Audit procedures that are relevant in this regard may include the following: Analyzing and discussing cash flow, profit and other relevant forecasts with management. Analyzing and discussing the entitys latest available interim financial statements. Reviewing the terms of debentures and loan agreements and determining whether any have breached. been

Reading minutes of the meetings of shareholders, those charged with governance and relevant committees for reference to financing difficulties. Inquiring of the entitys lawyer regarding the existence of litigation and claims and the reasonableness of managements assessments of their outcome and the estimate of their financial implications. Confirming the existence, legality and enforceability of arrangements to provide or maintain financial support with related and third parties and assessing the financial ability of such parties to provide additional funds. Reviewing events after period end to identify those that either mitigate or otherwise affect the entitys ability to continue as a going concern.

Audit Conclusion and Reporting 1. Going concern assumption appropriate but a material uncertainty exists:

a. If adequate disclosure is made than unqualified opinion plus emphasis of matter paragraph is required referring to a note to the financial statements describing material uncertainty regarding the entitys ability to continue as a going concern. In extreme cases, such as situations involving multiple material uncertainties that are significant to the financial statements, the auditor may consider it appropriate to express a disclaimer of opinion instead of adding an emphasis of matter paragraph.

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b. If adequate disclosure is not made, the auditor should express a qualified opinion or adverse opinion as appropriate. The report should include specific references to the fact that there is a material uncertainty that may cast significant doubt on the entitys ability to continue as a going concern.

2. Going concern Assumption inappropriate: Express adverse opinion if financial statements have been prepared on such basis even adequate disclosure is made in the financial statements. When the entitys management has concluded that the going concern assumption used in the preparation of the financial statements is not appropriate, the financial statements need to be prepared on an alternative authoritative basis. If on the basis of the additional audit procedures carried out and the information obtained the auditor determines the alternative basis is appropriate, the auditor can issue an unqualified opinion if there is adequate disclosure but may require an emphasis of matter in the auditors report to draw the users attention to that basis.

Negative working capital

We draw your attention to note 2 to the financial statements which states that the Companys financial statements show a negative working capital of Rs. 12.823 million (2009: Rs. 34.175 million) as at balance sheet date which is mainly due to current portion of long term finances, long term lease liability and short term running finance.

We have been informed that lenders are fully aware of the above situation and the management of the Company is in compliance with debt covenants, Prudential Regulations and State Bank directives and no penalty was levied on the Company during the year. We understand that in order to mitigate the above situation, the management is planning to take certain appropriate steps such as increased sales targets and restructuring of short term running finances to long term loans with commercial banks. Accordingly, the management believes that the outcome of its plan made in this respect will improve the situation. Our opinion is not qualified in respect of this matter.

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GROUP AUDIT QUESTIONS

June 2011 Question 5 (a) You are the manager responsible for the audit of the Nassau Group, which comprises a parent company and six subsidiaries. The audit of all individual companies financial statements is almost complete, and you are currently carrying out the audit of the consolidated financial statements. One of the subsidiaries, Exuma Co, is audited by another firm, Jalousie & Co. Your firm has fulfilled the necessary requirements of ISA 600 Special Considerations Audits of Group Financial Statements (Including the Work of Component Auditors) and is satisfied as to the competence and independence of Jalousie & Co. You have received from Jalousie & Co the draft audit report on Exuma Cos financial statements, an extract from which is shown below: Basis for Qualified Opinion (extract) The company is facing financial damages of $2 million in respect of an on-going court case, more fully explained in note 12 to the financial statements. Management has not recognised a provision but has disclosed the situation as a contingent liability. Under International Financial Reporting Standards, a provision should be made if there is an obligation as a result of a past event, a probable outflow of economic benefit, and a reliable estimate can be made. Audit evidence concludes that these criteria have been met, and it is our opinion that a provision of $2 million should be recognised. Accordingly, net profit and shareholders equity would have been reduced by $2 million if the provision had been recognised. Qualified Opinion (extract) In our opinion, except for effects of the matter described in the Basis for Qualified Opinion paragraph, the financial statements give a true and fair view of the financial position of Exuma Co as at 31 March 2011... An extract of Note 12 to Exuma Cos financial statements is shown below: Note 12 (extract) The company is the subject of a court case concerning an alleged breach of planning regulations. The plaintiff is claiming compensation of $2 million. The management of Exuma Co, after seeking legal advice, believe that there is only a 20% chance of a successful claim being made against the company. Figures extracted from the draft financial statements for the year ending 31 March 2011 are as follows: Nassau Group $ million 20 85 Exuma Co $ million 4 20

Profit before tax Total assets Required:

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Identify and explain the matters that should be considered, and actions that should be taken by the group audit engagement team, in forming an opinion on the consolidated financial statements of the Nassau Group. (10 marks) (b)A trainee accountant, Jo Castries, is assigned to your audit team. This is the first group audit that Jo has worked on. Jo made the following comment regarding the group audit: I understand that in a group audit engagement, one of the requirements is to design and perform audit procedures on the consolidation process. Please explain to me the principal audit procedures that are performed on the consolidation process. Required: Respond to the trainee accountants question. (8 marks)

Answer (a) Significant component A significant component is defined in ISA 600 Special Considerations Audits of Group Financial Statements (Including the Work of Component Auditors) as a component identified by the group audit engagement team that is of individual significance to the group. Exuma Co meets the definition of a significant component because it contributes 20% of group profit before tax, and 235% of group total assets. Exuma Co is therefore material to the group financial statements. Materiality of accounting issue The legal case against Exuma Co involves a claim against the company of $2 million. This is material to the individual financial statements of Exuma Co as it represents 50% of profit before tax, and 10% of total assets. The matter is also material to the group financial statements, representing 10% of group profit before tax, and 24% of group total assets.

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Qualified Opinion Exuma Co financial statements Jalousie & Co has expressed a qualified opinion due to a material misstatement regarding the accounting treatment of the court case. Management has treated the matter as a contingent liability, as they believe that it is possible, but not probable, that the court case will go against the company, but the auditors believe that it should have been recognised as a provision according to IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Given the materiality of the matter to the individual financial statements, this opinion seems appropriate (rather than an adverse opinion), as long as the audit evidence concludes that a provision is necessary. In other words, the audit evidence should indicate that it is probable that the legal claim will give rise to an outflow of cash. Review and discussion of audit work relating to the court case Due to the significance of this matter, the audit work performed by Jalousie & Co should be subject to review by the group audit engagement team. Specifically, the evidence leading to the conclusion that a probable outflow of cash will occur should be reviewed, and the matter should be discussed with the audit partner responsible for the opinion on Exuma Cos financial statements. Evidence should include copies of legal correspondence, a copy of the actual claim showing the $2 million claimed against the company, and a written representation from management detailing managements reason for believing that there is no probable cash outflow.

Further audit procedures According to ISA 600, when a risk of material misstatement has been identified in a component in which a component auditor has performed the audit work, the group engagement team shall evaluate the appropriateness of any further audit procedures being performed, and shall determine whether it is necessary to be involved in the further audit procedures. Given the subjective nature of this matter, the group engagement partner may consider engaging an external expert to provide an opinion as to the probability of the court case going against Exuma Co. Discussion with Nassau Group management The matter should be discussed with the Group management team, and the views of Group management as to whether a provision is necessary should be sought and documented in a written representation. There should also be discussion with management, and communication with those charged with governance regarding the potential impact of the matter on the group audit opinion. The impact depends on whether an adjustment is made in the individual accounts of Exuma Co, on consolidation, or not made at all, as explained below: Adjustment to Exuma Co financial statements Exuma Co is a subsidiary of Nassau, and by definition is under the control of the parent company. Therefore, management of Exuma Co can be asked to adjust the financial statements to recognise a provision. If this happens, Jalousie & Cos audit report can be redrafted as unqualified, and the group audit opinion will also be unqualified. Adjustment on consolidation Even if Exuma Cos financial statements are not amended, an adjustment could be made on consolidation of the group financial statements to include the provision. In this case, the opinion on Exuma Cos financial statements would remain qualified, but the group audit opinion would not be qualified as the matter causing the material misstatement has been rectified. No adjustment made [Type the company address] Page 63

If no adjustment is made, either to Exuma Cos individual financial statements, or as a consolidation adjustment in the group financial statements, and if the group engagement partner disagrees with this accounting treatment, then the group audit opinion should be qualified due to a material misstatement. In this case, a paragraph entitled Basis for Qualified Opinion should explain the reason for the qualification, i.e. non-compliance with IAS 37, and should also quantify the financial effect on the consolidated financial statements. Reference to the work performed by a component auditor should not be made. (b) ISA 600 firstly requires that the auditor shall obtain an understanding of the group-wide controls and the consolidation process. This includes an evaluation of instructions given by group management to components of the group. The operating effectiveness of controls over the consolidation process will be tested. The audit procedures will mainly focus on adjustments made on consolidation. For example, significant adjustments such as goodwill calculations and impairments are recalculated, underlying assumptions checked for validity, and the authorisation of the adjustment should be checked. Adjustments should be agreed to underlying documentation, and where relevant, to prior year audited financial statements or audit working papers. The elimination of inter-company transactions is usually a key feature of the consolidation process. Reconciliations of intercompany balances should be arithmetically checked, and unrealised profits should be recalculated for accuracy. Figures included in the consolidation schedules should be agreed back to audited financial statements of all components. Disclosures made in the notes to the group financial statements should also be agreed back to the individual components financial statements where relevant, for example disclosures on related parties. Audit procedures will be needed to verify that subsidiary balances have been included where relevant at fair value in the consolidated financial statements. For example, properties may be held at cost in the individual financial statements of the component, but should be consolidated at fair value. The auditor may consider the need to engage an expert to provide evidence on fair values, especially if the amounts involved are material. The audit of fair values is crucial as it forms the basis of the goodwill calculation. The accounting policies of all components of the group should be checked for consistency, as additional adjustments may be necessary to bring the components into line with group accounting policies. The deferred tax consequences of consolidation and fair value adjustments should be reviewed for completeness, and calculations re-performed for accuracy. Where the group has investments in non-controlling interests, additional procedures will be necessary to check the validity of treating the investments as associates and/or joint ventures, such as verification of the percentage shareholding by a review of purchase documentation or obtaining copies of the register of significant investors from the investee companies. The consolidation schedule should be arithmetically checked by casting and cross-casting. ISA 600 - SPECIAL CONSIDERATIONSAUDITS OF GROUP FINANCIAL STATEMENTS (INCLUDING THE WORK OF COMPONENT AUDITORS) Definitions

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For purposes of the ISAs, the following terms have the meanings attributed below: (a) Component An entity or business activity for which group or component management prepares financial information that should be included in the group financial statements. Component auditor An auditor who, at the request of the group engagement team, performs work on financial information related to a component for the group audit. Component materiality The materiality for a component determined by the group engagement team. Group All the components whose financial information is included in the group financial statements. A group always has more than one component. Group audit The audit of group financial statements. Significant component A component identified by the group engagement team (i) that is of individual financial significance to the group, or (ii) that, due to its specific nature or circumstances, is likely to include significant risks of material misstatement of the group financial statements.

(b)

(d) (e) (f) (g)

REQUIREMENTS Responsibility The group engagement partner is responsible for the direction, supervision and performance of the group audit engagement in compliance with professional standards and applicable legal and regulatory requirements, and whether the auditor's report that is issued is appropriate in the circumstances. As a result, the auditor's report on the group financial statements shall not refer to a component auditor, unless required by law or regulation to include such reference. If such reference is required by law or regulation, the auditor's report shall indicate that the reference does not diminish the group engagement partner's or the group engagement partner's firm's responsibility for the group audit opinion.

Acceptance and Continuance If the group engagement partner concludes that: (a) (b) it will not be possible for the group engagement team to obtain sufficient appropriate audit evidence due to restrictions imposed by group management; and the possible effect of this inability will result in a disclaimer of opinion on the group financial statements),

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the group engagement partner shall either: in the case of a new engagement, not accept the engagement, or, in the case of a continuing engagement, withdraw from the engagement, where withdrawal is possible under applicable law or regulation; or where law or regulation prohibits an auditor from declining an engagement, having performed the audit of the group financial statements to the extent possible, disclaim an opinion on the group financial statements.

Overall Audit Strategy and Audit Plan The group engagement team shall establish an overall group audit strategy and shall develop a group audit plan which is reviewed by the group engagement partner. Understanding the Component Auditor If the group engagement team plans to request a component auditor to perform work on the financial information of a component, the group engagement team shall obtain an understanding of the following: (a) (b) (c) Whether the component auditor understands and will comply with the ethical requirements that are relevant to the group audit and, in particular, is independent. The component auditor's professional competence. Whether the group engagement team will be able to be involved in the work of the component auditor to the extent necessary to obtain sufficient appropriate audit evidence. Whether the component auditor operates in a regulatory environment that actively oversees auditors.

(d)

Materiality The group engagement team shall determine the following: (a) (b) Materiality for the group financial statements as a whole when establishing the overall group audit strategy. Component materiality.

Significant Components For a component that is significant due to its individual financial significance to the group, the group engagement team, or a component auditor on its behalf, shall perform an audit of the financial information of the component using component materiality. [Type the company address] Page 66

For a component that is significant because it is likely to include significant risks of material misstatement of the group financial statements due to its specific nature or circumstances, the group engagement team, or a component auditor on its behalf, shall perform one or more of the following: (a) (b) An audit of the financial information of the component using component materiality. An audit of one or more account balances, classes of transactions or disclosures relating to the likely significant risks of material misstatement of the group financial statements.

Components that Are Not Significant Components For components that are not significant components, the group engagement team perform analytical procedures at group level. shall

Communication with the Component Auditor The group engagement team shall communicate its requirements to the component auditor on a timely basis. This communication shall set out the work to be performed, the use to be made of that work, and the form and content of the component auditor's communication with the group engagement team. It shall also include the following: (a) A request that the component auditor, knowing the context in which the group engagement team will use the work of the component auditor, confirms that the component auditor will cooperate with the group engagement team. The ethical requirements that is relevant to the group audit and, in particular, the independence requirements. Component materiality. Identified significant risks of material misstatement of the group financial statements, due to fraud or error, that are relevant to the work of the component auditor. A list of related parties prepared by group management, and any other related [Type the company address] Page 67

(b) (c) (d)

(e)

parties of which the group engagement team is aware. The group engagement team shall request the component auditor to communicate matters relevant to the group engagement team's conclusion with regard to the group audit. Such communication shall include: (a) (b) (c) (d) (e) (f) (g) (h) Whether the component auditor has complied with ethical requirements that are relevant to the group audit, including independence and professional competence; Whether the component auditor has complied with the group engagement team's requirements; Identification of the financial information of the component on which the component auditor is reporting; Information on instances of non-compliance with laws or regulations that could give rise to a material misstatement of the group financial statements; A list of uncorrected misstatements of the financial information of the component; Indicators of possible management bias; Description of any identified significant deficiencies in internal control at the component level; The component auditor's overall findings, conclusions or opinion.

Communication with Group Management and Those Charged with Governance of the Group Communication with Group Management The group engagement team shall determine which identified deficiencies in internal control to communicate to those charged with governance and group management. In making this determination, the group engagement team shall consider: (a) (c) Deficiencies in group-wide internal control that the group engagement team has identified; and Deficiencies in internal control that component auditors have brought to the attention of the group engagement team.

If fraud has been identified by the group engagement team or brought to its attention by a component auditor the group engagement team shall communicate this on a timely basis to the appropriate level of group management. A component auditor may be required by statute, regulation or for another reason, to express an audit opinion on the financial statements of a component. In that case, the group engagement team shall request group management to inform component management of any matter of which the group engagement team becomes aware that may be significant to the financial statements of the component, but of which component management may be unaware. If group management refuses to communicate the matter to component management, the group engagement team shall discuss the matter with [Type the company address] Page 68

those charged with governance of the group. If the matter remains unresolved, the group engagement team, subject to legal and professional confidentiality considerations, shall consider whether to advise the component auditor not to issue the auditor's report on the financial statements of the component until the matter is resolved. Communication with Those Charged with Governance of the Group The group engagement team shall communicate the following matters with those charged with governance of the group: (a) (b) An overview of the type of work to be performed on the financial information of the components. An overview of the nature of the group engagement team's planned involvement in the work to be performed by the component auditors on the financial information of significant components. Instances where the group engagement team's evaluation of the work of a component auditor gave rise to a concern about the quality of that auditor's work. Any limitations on the group audit, for example, where the group engagement team's access to information may have been restricted. Fraud or suspected fraud involving group management, component management, employees who have significant roles in group-wide controls or others where the fraud resulted in a material misstatement of the group financial statements.

(c) (d) (e)

Examples of Conditions or Events that May Indicate Risks of Material Misstatement of the Group Financial Statements The examples provided cover a broad range of conditions or events; however, not all conditions or events are relevant to every group audit engagement and the list of examples is not necessarily complete. A complex group structure, especially where there are frequent acquisitions, disposals or reorganizations. Poor corporate governance structures, including decision-making processes, that are not transparent. Non-existent or ineffective group-wide controls, including inadequate group management information on monitoring of components' operations and their results. Components operating in foreign jurisdictions that may be exposed to factors such as unusual government intervention in areas such as trade and fiscal policy, and restrictions on currency and dividend movements; and fluctuations in exchange rates. Business activities of components that involve high risk, such as long-term contracts or trading in innovative or complex financial instruments. Unusual related party relationships and transactions. Components' application of accounting policies that differ from those applied to the group financial statements. Components with different financial year-ends. Aggressive tax planning within the group. Frequent changes of auditors engaged to audit the financial statements of [Type the company address] Page 69

components.

Joint Audits In Joint Audits, more than one auditor is responsible for the audit opinion and it is made jointly. Reasons for Joint Audits 1. Takeovers 2. Locational problems 3. Local laws Transnational Audits Transnational audits are audits of financial statements which may be relied upon outside an entitys home jurisdiction. Example 1. Private company in US raising debt finance in Canada. 2. Pakistani company is listed in New York stock exchange. 3. Charitable organisation receiving donations from different countries. THREATS TO INDEPENDENCE The auditor should be impartial and independent of the audit client so that he can give objective opinion (unbiased and straightforward opinion) on the financial statements. There are several threats to independence for which safeguards should be adopted by the auditor. Threats fall in 5 categories: 1. 2. 3. 4. 5. Self interest Self review Advocacy Familiarity Intimidation [Type the company address] Page 70

Self Interest Threat Self interest threat arises because of: Financial Interest A financial interest exists where an assurance firm or the assurance team has financial interest in the clients affairs. Example includes: 1. Assurance firm/auditor owns shares in the client (Direct financial Interest). 2. Assurance firm/auditor is a trustee of a trust that holds shares in the client (Indirect financial interest). ACCA does not allow the following to own a direct financial interest or indirect material financial interest in a client: The assurance firm The member of the assurance team Immediate family member of a member of the assurance team (spouse or equivalent and dependent)

Safeguards: 1. 2. 3. 4. Disposal of financial interest Remove the individual from the assurance team Informing the audit committee Carrying out a quality review of the work by another independent partner

Close business relationship Close business relationship means that the assurance firm has a close relationship with client. Example include audit firm and client have entered in a separate joint venture to sell combined products or markets / distribute each other products. Unless the interest is clearly insignificant, an assurance provider should not participate in such venture with assurance client. Safeguards: 1. Terminate the business relationship 2. Remove the individual from the assurance team if the particular member of the team is involved. 3. Reduce the quantum of business relationship Important Purchasing of goods and services from assurance client on arms length basis does not constitute a threat to independence. If there is substantial number of such transactions, there may be threat to independence and safeguards may be necessary.

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Employment or employment relationships with client Example includes: 1. Ex-engagement partner has recently joined the client as a finance director. 2. Audit senior has given interview for a vacant position at the client. Safeguards 1. Engagement partner should not accept key management position with the client until 2 years have elapsed since the conclusion of the audit he was involved with. 2. Procedures should be established so that assurance team member should inform his audit firm if he is being interviewed for a vacant position. 3. Carrying out a quality review of the audit by another independent partner.

Family and personal relationships Family and personal relationships between assurance firm and client staff should seriously threaten independence. Factors to consider: 1. The individuals responsibility on the assurance engagement 2. The closeness of the relationship 3. The role of the other party at the assurance client. When an immediate family member of a member of the assurance team is a director, an office or an employee of the assurance client in a position to exert direct and significant influence over the subject matter information of the assurance engagement, the individual should be removed from the assurance team. Safeguards 1. Remove the individual from the assurance team. 2. Procedures should be established so that assurance team member should inform his firm of such relationships. 3. Carrying out a quality review of the audit by another independent partner. Audit partner /team is a director on clients board Safeguard include should resign from the board. It may be acceptable for a partner or an employee of an assurance firm to perform the role of company secretary for an assurance client, if the role is essentially administrative.

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Gifts and Hospitality Should be clearly insignificant in value, otherwise do not accept Loans and Guarantee If client is a bank, then the loan should be on arms length basis and not material. If client is not a bank, audit firm should not enter any loan / guarantee arrangement at all.

Audit fees Matters related to audit fees: 1. Previous audit fees not yet paid than it creates self interest threat. 2. Contingent fees (fees should not be based on the outcome of the audit). 3. If the client fee constitute a major portion of firms revenue than this may also create a threat to independence. Safeguards includes: Discussing the issues with the audit committee. Obtaining external/internal quality control reviews. Consulting third party such as ACCA. 4. Low fees quoting low fees in order to get the business may also create threat. Safeguards includes such as: Maintaining records such that the firm is able to demonstrate that appropriate staff and time are spent on the engagement. Complying with all applicable assurance standards, guidelines and quality control procedures. 5. A contingent fee for non assurance services that is expected to be material to the audit firm is prohibited.

Self Review Threat Self review threat arises because of: 1. 2. 3. 4. 5. 6. 7. Recent employment with client. General and other services. Providing accounting services. Valuation services. Taxation services. Internal audit services. Corporate finance services

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8. Providing other services such as IT services, temporary staff cover, litigation support and legal services.

Recent employment with client Individuals who have been a director or officer of the client, or an employee in a position to exert direct and significant influence over the subject matter information of the assurance engagement in the period under review or the previous two years should not be assigned to the assurance team. If an individual had been closely involved with the client prior to the time limits set out above, the assurance firm should consider the threat to independence arising and apply appropriate safeguards, such as: 1. Obtaining a quality control review of the individuals work on the assignment. 2. Discussing the issues with the audit committee. General and other services For assurance clients, accountants are not allowed to: 1. Authorize, execute or consummate a transaction. 2. Determine which recommendation of the company should be implemented. 3. Report in a management capacity to those charged with governance. Supervising client employees in the performance of their normal duties and preparing source documents on behalf of the client also pose significant self review threats which should be addressed by safeguards. These could be: 1. 2. 3. 4. Ensuring non- assurance team staff are used for these roles. Involving independent professional accountant to advise. Making appropriate disclosures to those charged with governance. Resigning from the assurance engagement.

Preparing accounting records and financial statements There is clearly a significant risk of self review threat if a firm prepares accounting records and financial statements and then audits them. Valuation services Audit firms should not carry out valuations on matters which will be material to the financial statements. If the valuation is for an immaterial amount then the following safeguards should be applied: 1. Second partner review 2. Confirming that the client understands the valuations and the assumptions used. [Type the company address] Page 74

3. Ensuring the client acknowledges responsibility for the valuation. 4. Using separate personnel for the valuation and the audit. Taxation services In principal any taxation services provided could create a threat to independence, emphasizing that tax planning work can cause a threat if it has a material effect on the financial statements being audited. Internal audit services Internal audit services must not be provided if they relate to: 1. Significant part of the financial statements. 2. Financial accounting systems generating information which is significant to the financial statements. 3. Amounts or disclosures which are material to the financial statements. Corporate finance services Certain aspects of corporate finance will create self review threats that cannot be reduced to an acceptable level by safeguards. Therefore assurance firms are not allowed to promote, deal in or underwrite an assurance clients shares. Other corporate finance services, such as assisting a client in defining corporate strategies, assisting in identifying possible sources of capital and providing structuring advice may be acceptable, providing that safeguards such as using different teams of staff, and ensuring no management decisions are taken on behalf of the client. Advocacy Threat Advocacy threat arises where the audit firm promotes a point of view to the extent that future objectivity is compromised, examples include: 1. Commenting publicly on future prospects of the company. 2. Promotes buying of shares of the company. Remember, the ultimate opinion is always to withdraw from an engagement if the risk to independence is too high

Familiarity Threat Familiarity threat occurs when, because of long association with the client, the concerned partner /staff becomes sympathetic or losses professional skepticism (i.e. start trusting client)

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Safeguards for the listed and public interest entities: 1. Rotate engagement partner after every 5 years and should not return to the engagement until a period of 5 years have elapsed. 2. Rotate other partners (e.g Senior partner or QCR partner) normally after 7 years and should not return the engagement until a period of 2 years have elapsed. 3. Appropriately rotating members of the audit team. When an entity becomes a listed entity, the concerned partners should only continue in those positions for another 2 years. Intimidation Threat Intimidation threats means any kind of threat by the client due to which you lose your objectivity, examples include: 1. Threat of non-appointment or litigation by the client 2. Physical threat to you or your family Safeguards 1. Change of audit engagement partner. 2. Inform audit committee. 3. Resignation from audit engagement.

December 2007 Question 4 (b) & (c) You are an audit manager in Nate & Co, a firm of Chartered Certified Accountants. You are reviewing the following situations, which were recently discussed at the monthly audit managers meeting: (1) Nate & Co provides the audit service to CF Co, a national financial services organization. Due to a number of errors in the recording of cash deposits from new customers that have been discovered by CF Cos internal audit team, the directors of CF Co have requested that your firm carry out a review of the financial information technology systems. It [Type the company address] Page 76

has come to your attention that while working on the audit planning of CF Co, Jin Sayed, one of the juniors on the audit team, who is a recent information technology graduate, spent three hours providing advice to the internal audit team about how to improve the system. As far as you know, this advice has not been used by the internal audit team. (3) LA Shots Co is a manufacturer of bottled drinks, and has been an audit client of Nate & Co for five years. Two audit juniors attended the annual inventory count last Monday. They reported that Brenda Mangle, the new production manager of LA Shots Co, wanted the inventory count and audit procedures performed as quickly as possible. As an incentive she offered the two juniors ten free bottles of Super Juice from the end of the production line. Brenda also invited them to join the LA Shots Co office party, which commenced at the end of the inventory count. The inventory count and audit procedures were completed within two hours (the previous years procedures lasted a full day), and the juniors then spent four hours at the office party. Required: (a)With reference to CF Co, explain the ethical and other professional issues raised. (9 marks) (b)Identify and discuss the ethical and professional matters raised at the inventory count of LA Shots Co. (6 marks)

Answer (a)There are several issues that must be addressed as a matter of urgency: Extra work must be planned to discover the extent of the breakdown in internal controls that occurred during the year. It is important to decide whether the errors were isolated, or continued through the accounting period and whether similar errors have occurred in other areas e.g. cash receipts from existing customers or cash payments. A review of the working papers of the internal audit team should be carried out as soon as possible. The materiality of the errors should be documented. Errors discovered in the accounting systems will have serious implications for the planned audit approach of new customer deposits. Nate & Co must plan to expand audit testing on this area as control risk is high. Cash deposits will represent a significant class of transaction in CF Co. A more detailed substantive approach than used in prior year audits may be needed in this material area if limited reliance can be placed on internal controls. A combination of the time spent investigating the reasons for the errors, their materiality, and a detailed substantive [Type the company address] Page 77

audit on this area means that the audit is likely to take longer than previously anticipated. This may have cost and recoverability implications. Extra staff may need to be assigned to the audit team, and the deadline for completion of audit procedures may need to be extended. This will need to be discussed with CF Co. Due to the increased audit risk, Nate & Co should consider increasing review procedures throughout the audit. In addition CF Co is likely to be a highly regulated company as it operates in financial services, increasing possible attention focused on the audit opinion. These two factors indicate that a second partner review would be recommended. A separate issue is that of Jin Sayed offering advice to the internal audit team. The first problem raised is that of quality control. A new and junior member of the audit team should be subject to close direction and supervision which does not appear to have been the case during this assignment. Secondly, Jin Sayed should not have offered advice to the internal audit team. On being made aware of the errors, he should have alerted a senior member of the audit team, who then would have decided the action to be taken. This implies that he does not understand the limited extent of his responsibilities as a junior member of the audit team. Nate & Co may wish to review the training provided to new members of staff, as it should be made clear when matters should be reported to a senior, and when matters can be dealt with by the individual. Thirdly, Jin Sayed must be questioned to discover what exactly he advised the internal audit team to do. Despite his academic qualification, he has little practical experience in the financial information systems of CF Co. He may have given inappropriate advice, and it will be crucial to confirm that no action has been taken by the internal audit team.

The audit partner should consider if Nate & Co are at risk because of the advice that has been provided by Jin Sayed. As he is a member of the audit team, his advice would be considered by the client as advice offered by Nate & Co, and the partner should ascertain by discussion with the client whether this advice has been acted upon. Finally Nate & Co should consider whether as a firm they could provide the review of the financial information technology system, as requested by CF Co. IFACs Code of Ethics, and ACCAs Code of Ethics and Conduct places restrictions on the provision of non-audit services. Nate & Co must be clear in what exactly the review will involve. Providing a summary of weaknesses in the system, with appropriate recommendations is considered part of normal audit procedures. However, given the errors that have arisen in the year, CF Co may require Nate & Co to design and implement changes to the system. This would constitute a self-review threat and should only be considered if significant safeguards are put in place, for example, using a separate team to provide the non-audit service and/or having a second partner review of the work.

(b) There are several ethical and professional issues raised in relation to the inventory count of LA Shots Co. Firstly, it was inappropriate of Brenda Mangle to offer the incentive to the audit juniors. As she is a new manager, it may be that she didnt realize how the incentive would be perceived. Brenda should be informed that her actions could have serious implications. The offer could be viewed as a bribe of the audit juniors, and could be perceived as a self-interest independence threat as there is a financial benefit offered to members of the audit team. The value of the ten bottles of Super Juice should be considered, as it is only appropriate for a member of the audit [Type the company address] Page 78

team to accept any goods or hospitality from the audit client if the value is clearly insignificant. Ultimately it would be the decision of the audit partner as to whether the value is clearly insignificant. It is likely that this does not constitute a significant threat to independence; however the offer should still be referred to the audit partner. Also, if the juniors took ten bottles of Super Juice, this could interfere with the physical count of goods and/or with cut off details obtained at the count. The juniors should therefore have declined the offer and informed a senior member of the audit team of the situation. There may be a need to adequately train new members of staff on ethical matters if the juniors were unsure of how to react to the offer. The work performed by the juniors at the inventory count must be reviewed. The audit procedures were performed very quickly compared to last year and therefore sufficient evidence may not have been gathered. In an extreme situation the whole inventory count may have to be re performed if it is found that the procedures performed cannot be relied upon. In addition, the juniors should not have attended the audit clients office party without the permission of the audit manager. The party appears to have taken place during work time, when the juniors should have been completing the inventory count procedures. The two juniors have not acted with due professional consideration, and could be considered to lack integrity. The actions of the juniors should be discussed with them, possibly with a view to disciplinary action. There may also be questions over whether the direction and supervision of the juniors was adequate. As the two juniors are both recent recruits, this is likely to be the first inventory count that they have attended. It appears that they may not have been adequately briefed as to the importance of the inventory count as a source of audit evidence, or that they have disregarded any such briefing that was provided to them. In either case possibly a more senior auditor should have accompanied them to the inventory count and supervised their actions.

June 2008 Question 4 You are an audit manager in Smith & Co, a firm of Chartered Certified Accountants. You have recently been made responsible for reviewing invoices raised to clients and for monitoring your firms credit control procedures. Several matters came to light during your most recent review of client invoice files: Norman Co, a large private company, has not paid an invoice from Smith & Co dated 5 June 2007 for work in respect of the financial statement audit for the year ended 28 February 2007. A file note dated 30 November 2007 states that Norman Co is suffering poor cash flows and is unable to pay the balance. This is the only piece of information in the file you are reviewing relating to the invoice. You are aware that the final audit work for the year ended 28 February 2008, which has not yet been invoiced, is nearly complete and the audit report is due to be issued imminently. Wallace Co, a private company whose business is the manufacture of industrial machinery, has paid all invoices relating to the recently completed audit planning for the year ended 31 May 2008. However, in the invoice file you notice an invoice received by your firm from Wallace Co. The invoice is addressed to Valerie Hobson, the manager responsible for the audit of Wallace Co. The invoice relates to the rental of an area in Wallace Cos empty warehouse, with the following comment handwritten on the invoice: rental space being used for storage of Ms Hobsons speedboat for six months [Type the company address] Page 79

she is our auditor, so only charge a nominal sum of $100. When asked about the invoice, Valerie Hobson said that the invoice should have been sent to her private address. You are aware that Wallace Co sometimes uses the empty warehouse for rental income, though this is not the main trading income of the company. In the miscellaneous invoices raised file, an invoice dated last week has been raised to Software Supply Co, not a client of your firm. The comment box on the invoice contains the note referral fee for recommending Software Supply Co to several audit clients regarding the supply of bespoke accounting software. Required: Identify and discuss the ethical and other professional issues raised by the invoice file review, and recommend what action, if any, Smith & Co should now take in respect of: (a) Norman Co; (8 marks) (b) Wallace Co; and (5 marks) (c) Software Supply Co. (4 marks) (17 marks)

Answer Smith & Co (a) Norman Co The invoice is 12 months old and it appears doubtful whether the amount outstanding is recoverable. The fact that such an old debt is unsettled indicates poor credit control by Smith & Co. Part of good practice management is to run profitable, cash generating audit function. The debt should not have been left outstanding for such a long period. It seems that little has been done to secure payment since the file note was attached to the invoice in November 2007. There is also a significant ethical issue raised. Overdue fees are a threat to objectivity and independence. Due to Norman Co not yet paying for the 2007 yearend audit, it could be perceived that the audit has been performed for free. Alternatively the amount outstanding could be perceived as a loan to the client, creating a self-interest threat to independence. The audit work for the year ended 28 February 2008 should not have been carried out without some investigation into the unpaid invoice relating to the prior year audit. This also represents a self-interest threat if fees are not collected before the audit report is issued, an unmodified report could be seen as enhancing the prospect of securing payment. It seems that a check has not been made to see if the prior year fee has been paid prior to the audit commencing. It is also concerning that the audit report for the 2008 year end is about to be issued, but no invoice has been raised relating to the work performed. To maximize cash inflow, the audit firm should invoice the client as soon as possible for work performed. Norman Co appears to be suffering financial distress. In this case there is a valid commercial reason why payment has not been made the client simply lacks cash. While this fact does not eliminate the problems noted above, it means that the auditors can continue so long as adequate ethical safeguards are put in place, and after the monetary significance of [Type the company address] Page 80

the amount outstanding has been evaluated. It should also be considered whether Norman Cos financial situation casts any doubt over the going concern of the company. Continued cash flow problems are certainly a financial indicator of going concern problems, and if the company does not resolve the cash flow problem then it may be unable to continue in operational existence. Action to be taken: Discuss with the audit committee (if any) or those charged with governance of Norman Co the ethical problems raised by the non-payment of invoices, and a payment programme to secure cash payment in stages if necessary, rather than demanding the total amount outstanding immediately. Notify the ethics partner of Smith & Co of the situation the ethics partner should evaluate the ethical threat posed by the situation and document the decision to continue to act for Norman Co. The documentation should include an evaluation of the monetary significance of the amount outstanding, as it will be more difficult to justify the continuance of the audit appointment if the amount is significant. The ethics partner should ensure that a firm-wide policy is communicated to all audit managers requiring them to check the payment of previous invoices before commencing new client work. This check should be documented. Consider an independent partner review of the working papers prepared for the 28 February 2008 audit. The audit working papers on going concern should be reviewed to ensure that sufficient evidence has been gathered to support the audit opinion. Further procedures may be found to be necessary given the continued cash flow problems. Smith & Co have already acted to improve credit control by making a manager responsible for reviewing invoices and monitoring subsequent cash collection. It is important that credit control procedures are quickly put into place to prevent similar situations arising.

(b) Wallace Co Being the audit manager, Valerie Hobson is clearly in a position to influence the outcome of the audit. She appears to have entered into a private commercial transaction with her client. IFACs Code of Ethics for Professional Accountants does not prohibit such commercial transactions so long as they are: In the normal course of business,

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 At arms length, and The value is not material to either party. In this case the transaction is in the normal course of business for the client. Rental of storage space is not the main business of Wallace Co, but it appears that this type of transaction is quite common for the company. However the note on the invoice indicates that a substantial discount has been offered and accepted, and so the transaction is not at arms length. The value is not material to Wallace Co, but could represent a significant discount to normal commercial terms to the audit manager. Goods and services can be received from an audit client, but only if the value is clearly insignificant. A self-interest threat is clearly established. Valerie Hobson is benefiting financially from her position as audit manager. She may compromise the audit approach which has recently been planned and furthermore she may compromise the audit opinion to keep the client happy. She may also have other audit clients where bias could have occurred. Action to be taken: The ethics partner will need to evaluate whether the value of the transaction and the discount received is clearly insignificant. Her benefiting from a discount on services provided by Wallace Co, which was not disclosed, could result in disciplinary action. Valerie should be removed from the audit immediately, and a new audit manager assigned to Wallace Co. The audit planning for year ended 31 May 2008 should be subject to independent review and amendments made where necessary. The transaction should be disclosed to the audit committee of Wallace Co, or to those charged with governance. The ethics partner may wish to consider Valeries relationships with other audit clients for any evidence of transactions or other indicators of potential bias.

(c) Software Supply Co Here it seems that Smith & Co has referred the provision of bespoke accounting software to an external provider Software Supply Co, and that a commission is being paid to Smith & Co for these referrals. It is common for audit firms to recommend other providers to their audit clients. This could be perceived as an objectivity and self-interest threat, as the audit firm is benefiting financially through recommending clients to a particular provider of goods and services. However, if appropriate safeguards are in place, the referrals and receipt of commissions can continue. Action to be taken: Verification from all personnel involved with the audit of clients to whom Software Supply Co has provided a service that they have no financial or personal interest in Software Supply Co.

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 Smith & Co must ensure that: For each client where a referral is made, full disclosure has been made to the client regarding the arrangement Written acknowledgement that Smith & Co is to receive a referral fee should be obtained from the client. Procedures must be put into place to monitor the quality of goods and services provided by Software Supply Co to audit clients.

December 2008 Question 4 You are a senior manager in Becker & Co, a firm of Chartered Certified Accountants offering audit and assurance services mainly to large, privately owned companies. The firm has suffered from increased competition, due to two new firms of accountants setting up in the same town. Several audit clients have moved to the new firms, leading to loss of revenue, and an over staffed audit department. Bob McEnroe, one of the partners of Becker & Co, has asked you to consider how the firm could react to this situation. Several possibilities have been raised for your consideration: 1. Murray Co, a manufacturer of electronic equipment, is one of Becker & Cos audit clients. You are aware that the company has recently designed a new product, which market research indicates is likely to be very successful. The development of the product has been a huge drain on cash resources. The managing director of Murray Co has written to the audit engagement partner to see if Becker & Co would be interested in making an investment in the new product. It has been suggested that Becker & Co could provide finance for the completion of the development and the marketing of the product. The finance would be in the form of convertible debentures. Alternatively, a joint venture company in which control is shared between Murray Co and Becker & Co could be established to manufacture market and distribute the new product.

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2. Becker & Co is considering expanding the provision of non-audit services. Ingrid Sharapova, a senior manager in Becker & Co, has suggested that the firm could offer a recruitment advisory service to clients, specializing in the recruitment of finance professionals. Becker & Co would charge a fee for this service based on the salary of the employee recruited. Ingrid Sharapova worked as a recruitment consultant for a year before deciding to train as an accountant. 3. Several audit clients are experiencing staff shortages, and it has been suggested that temporary staff assignments could be offered. It is envisaged that a number of audit managers or seniors could be seconded to clients for periods not exceeding six months, after which time they would return to Becker & Co. Required: Identify and explain the ethical and practice management implications in respect of: (a)A business arrangement with Murray Co. (7 marks) (b)A recruitment service offered to clients. (7 marks) (c) Temporary staff assignments. (6 marks) (20 marks)

Answer Becker & Co (a)Joint business arrangement The business opportunity in respect of Murray Co could be lucrative if the market research is to be believed. However, IFACs Code of Ethics for Professional Accountants states that a mutual business arrangement is likely to give rise to self-interest and intimidation threats to independence and objectivity. The audit firm must be and be seen to be independent of the audit client, which clearly cannot be the case if the audit firm and the client are seen to be working together for a mutual financial gain. In the scenario, two options are available. Firstly, Becker & Co could provide the audit client with finance to complete the development and take the product to market. There is a general prohibition on audit firms providing finance to their audit clients. This would create a clear financial self-interest threat as the audit firm would be receiving a return on investment from their client. The Code states that if a firm makes a loan (or guarantees a loan) to a client, the selfinterest threat created would be so significant that no safeguard could reduce the threat to an acceptable level. The provision of finance using convertible debentures raises a further ethical problem, because if the debentures are ultimately converted to equity, the audit firm would then hold equity shares in their audit client. This is a severe financial self-interest, which safeguards are unlikely to be able to reduce to an acceptable level. The finance should not be advanced to Murray Co while the company remains an audit client of Becker & Co. The second option is for a joint venture company to be established. This would be perceived as a significant mutual business interest as Becker & Co and Murray Co would be investing together, sharing control and sharing a return on [Type the company address] Page 84

investment in the form of dividends. IFACs Code of Ethics states that unless the relationship between the two parties is clearly insignificant, the financial interest is immaterial, and the audit firm is unable to exercise significant influence, then no safeguards could reduce the threat to an acceptable level. In this case Becker & Co may not enter into the joint venture arrangement while Murray Co is still an audit client. The audit practice may consider that investing in the new electronic product is a commercial strategy that it wishes to pursue, either through loan finance or using a joint venture arrangement. In this case the firm should resign as auditor with immediate effect in order to eliminate any ethical problem with the business arrangement. The partners should carefully consider if the potential return on investment will more than compensate for the lost audit fee from Murray Co.

The partners should also reflect on whether they want to diversify to such an extent this investment is unlikely to be in an area where any of the audit partners have much knowledge or expertise. A thorough commercial evaluation and business risk analysis must be performed on the new product to ensure that it is a sound business decision for the firm to invest. The audit partners should also consider how much time they would need to spend on this business development, if they decided to resign as auditors and to go ahead with the investment. Such a new and important project could mean that they take their focus off the key business i.e. the audit practice. They should consider if it would be better to spend their time trying to compete effectively with the two new firms of accountants, trying to retain key clients, and to attract new accounting and audit clients rather than diversify into something completely different. (b) Recruitment service IFACs Code of Ethics for Professional Accountants does not prohibit firms from offering a recruitment service to client companies. However several ethical problems could arise if the service were offered. The severity of these problems would depend on the exact nature of the service provided, and the role of the person recruited into the clients organization. Specific ethical threats could include: Self-interest clearly the motive for Becker & Co to offer this service is to generate income from audit clients, thereby creating a financial self-interest threat. The amount received for the recruitment service depends on the magnitude of the salary of the person employed. The more senior the person recruited, the higher their salary is likely to be, and therefore the higher the fee to be paid to Becker & Co. In addition, the firm could be tempted to advise positively on the recruitment of an individual merely to receive the relevant recruitment fee, without properly considering the suitability of the person for the role. Familiarity when performing the audit, the auditors may be less likely to criticize or challenge the work performed by a person they helped to recruit, as any significant problems discovered may make the recruitment appear ill-advised. Management involvement there is also a threat that the audit firm could be perceived to be making management decisions by selecting employees. The firm could offer services such as reviewing the professional qualifications of a number of applicants, and providing advice on the applicants suitability for the post. In addition the firm could draw up a shortlist of candidates for interview, using criteria specified by the client. However in all cases, the final decision as to whom to hire must be made by the client, as the audit firm should not make, or be perceived to be making, [Type the company address] Page 85

management decisions. The threats discussed above would increase in significance if the recruitee took on a role in key management pertaining to the finance function, such as finance director or financial controller. The threats would be less severe if the audit firm advised on the recruitment of a junior member of the clients finance function. If these threats could not be reduced to a level less than clearly insignificant, then the recruitment service should not be offered. Commercial evaluation The firm should consider whether there is likely to be much demand for the potential service before developing such a resource. Some form of market research is essential. Offering this type of service represents a significant departure from normal audit services. The firm should consider whether there is sufficient knowledge and expertise to offer a recruitment service. Ingrid Sharapova seems to have some experience, but her skills may be out of date, and may not be specifically relevant to the recruitment of finance professionals. It may be that considerable training and possibly the attainment of a new professional qualification relevant to recruitment may be necessary for a credible service to be offered to clients. If the recruitment service proved successful, then Ingrid could be faced with too much work as she is the only person with relevant experience, and has no one to delegate to. If the firm decides to offer this service, then one other person should receive appropriate training, to cover for Ingrids holidays and any sick leave, and to provide someone for Ingrid to delegate to. The financial cost of such training should be considered. Finally, Becker & Co should consider the potential damage to the firms reputation if the service offered is not of a high quality. If the partners decide to pursue this business opportunity, they may wish to consider setting it up as a separate entity, so that if the business fails or its reputation is questioned, the damage to Becker & Co would be minimized. (c) Temporary staff assignments Lending staff on a temporary basis to an audit client will create the following ethical threats: Management involvement Assuming that the manager or senior is seconded to the finance function of the audit client, it is likely that the individual would be in some way involved in decision making in relation to the accounting systems, management accounts or financial statements. Self-review On returning to the audit firm, a seconded individual could be a member of the audit team for the client to which they seconded. This would create a self- review threat whereby they would be unlikely to be critical of their own work performed or decisions made. Even if the individual were not assigned to the client where they performed a temporary assignment, the audit team assigned may tend to over rely on areas worked on by a colleague during the period of their temporary assignment. Familiarity if the individual is working at the client at any time during the audit, there will be a familiarity threat, whereby audit team members will be unlikely to sufficiently challenge, and therefore not exercise enough professional skepticism when dealing with work performed by the seconded individual.

In addition, due to the over-staffing problem of Becker & Co, the seconded individuals may feel that if they were not on [Type the company address] Page 86

the secondment, they could be made redundant. This may cause them to act in such as way as not to jeopardize the secondment, even if the action were not in the best interests of the firm. The threats discussed above are increased where a senior person likely to make significant decisions is involved with the temporary assignment, as in this case where audit managers or seniors will be the subjects of the proposed secondment. In practice, assistance can be provided to clients, especially in emergency situations, but only on the understanding that the firms personnel will not be involved with: Making management decisions, Approving or signing agreements or similar documents, and Having the authority to enter into commitments on behalf of the company. In addition, the individual seconded to a client should not then be involved in any way with the audit of that client when they return to the audit firm. This may be a difficult area, as presumably the client would prefer to have an individual seconded to them who has knowledge and experience of their business, i.e. a member of the audit team, and most likely in this scenario to be the audit manager. If this were the case the manager would then have to be reassigned to a different client, causing internal problems for the audit firm. This problem is likely to outweigh any benefits, financial or otherwise, to Becker & Co. If the temporary staff assignment were to a non-finance department of the client then the threats would be reduced. If Becker & Co decides to go ahead with the secondment programme, the firm must ensure that the staff are suitably experienced and qualified to carry out the work given to them by the client. There could be a risk to the reputation of Becker & Co if the seconded staffs are not competent or do not perform as well as expected by the client. One advantage of a secondment is that the individual concerned can benefit from exposure to a different type of work and work environment. This will provide some valuable insights into accounting within a business and the individual may bring some new skills and ideas back into the audit firm. However, the staff seconded could be offered a permanent position at the client. This would lead to the loss of key members of staff, and be detrimental for Becker & Co in the long run. The other benefit for the audit firm is that a programme of secondments will ease the problem of an over-staffed audit department, and should have cash flow benefits.

December 2009 Question 4 (b) You are a manager in the audit department of Peaches & Co, a firm of Chartered Certified Accountants. One of your responsibilities is to act as a mentor to new recruits into the department. A new junior auditor, Glen Rambaran, has asked you to answer some questions which relate to issues encountered in his first few weeks working at Peaches & Co. The questions are shown below: When I was on my initial training course, there was a session on ethics in which the presenter talked about being [Type the company address] Page 87

intimidated by a client. I assume this does not mean physical intimidation, so what is an intimidation threat? (3 marks) Required: Provide a response to the audit junior, in which you identify and explain the ethical or professional issue raised.

Answer Auditors are required to identify and assess the circumstances which could adversely affect the auditors objectivity, including any perceived loss of independence. Intimidation is one of the categories of threats to objectivity and independence identified in IFACs Code of Ethics for Professional Accountants. Intimidation means a threat arising when the auditors conduct is influenced by fear or threats. This could happen when the auditor encounters an aggressive and domineering individual who could coerce or manipulate the actions of the auditor using threatening behavior. However, intimidation is more likely to arise in the following ways: Being threatened with dismissal or replacement, Being threatened with litigation, Being pressured to reduce inappropriately the extent of work performed, e.g. in order to reduce audit fees.

Intimidation is often linked to other types of threats to objectivity and independence. For example, an auditor may be more susceptible to intimidation if the other person is a close family member, as they may be able to exert significant influence over the actions of the auditor. This is therefore linked to the familiarity threat.

When threats are identified (unless the threats are assessed as insignificant), the auditor should establish safeguards to eliminate or to reduce the threats to an acceptable level. In some jurisdictions, the regulatory framework provides a specific safeguard in the case of being intimidated with dismissal, as usually it is only the shareholders and not the management of an entity that can remove the auditor from office.

June 2010 Question 4 You are a manager in the audit department of Carter & Co, and you are dealing with several ethical and professional matters raised at recent management meetings, all of which relate to audit clients of your firm. 1. Fernwood Co has a year ending 30 June 2010. During this year, the company established a pension plan for its employees, and this year end the company will be recognising for the first time a pension deficit on the statement of financial position, in accordance with IAS 19 Employee Benefits. The finance director of Fernwood Co has contacted the

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audit engagement partner, asking if your firm can provide a valuation service in respect of the amount recognised. 2. The finance director of Hall Co has requested that a certain audit senior, Kia Nelson, be assigned to the audit team. This senior has not previously been assigned to the audit of Hall Co. On further investigation it transpired that Kia Nelson is the sister of Hall Cos financial controller. 3. Collier Co has until recently kept important documents such as title deeds and insurance certificates in a safe at its head office. However, following a number of thefts from the head office the directors have asked if the documents could be held securely at Carter & Cos premises. The partners of Carter & Co are considering offering a custodial service to all clients, some of whom may want to deposit tangible assets such as paintings purchased as investments for safekeeping. The fee charged for this service would depend on the value of item deposited as well as the length of the safekeeping arrangement. 4. Several audit clients have requested that Carter & Co provide technical training on financial reporting and tax issues. This is not a service that the firm wishes to provide, and it has referred the audit clients to a training firm, Gates Co, which is paying a referral fee to Carter & Co for each audit client which is referred.

Required: Identify and evaluate the ethical and other professional issues raised, in respect of: (a) Fernwood Co; (6 marks) (b) Hall Co; (6 marks) (c) Collier Co; (5 marks) (d)Gates Co. (3 marks) (20 marks)

Answer (a) The provision of a valuation service is an example of providing a non-audit service. The key issue is that if an audit firm provides a valuation service for an item which will be included in the financial statements, a self-review threat arises. The self-review threat exists because the audit firm will be auditing a balance on which they have themselves placed a valuation. The significance of the risk depends on the level of materiality of the item in the financial statements. According to IFACs Code of Ethics for Professional Accountants, if the valuation service involves the valuation of matters material to the financial statements, and the valuation involves a significant degree of subjectivity, the self-review threat created could not be reduced to an acceptable level by the application of any safeguards. If this were the case, the audit firm should not provide the valuation service. Alternatively, if the valuation service were provided, the firm should resign [Type the company address] Page 89

from providing the audit service. Carter & Co must assess the degree of risk in valuing Fernwood Cos pension liability. If the amount is immaterial to the financial statements, or does not involve a significant degree of subjectivity, the valuation service can be provided, as long as safeguards are put in place, for example: Using separate personnel for the valuation service and the audit. Performing a second partner review. Confirming that the client understands the valuation method and the assumptions used. The valuation of the pension balance recognised is likely to involve many judgments and assumptions, and so is likely to be a subjective exercise. It is, therefore, most likely that Carter & Co will assess the situation as creating a significant selfreview threat which safeguards cannot reduce to an acceptable level, in which case the valuation service should not be provided as well as carrying out the audit. If Carter & Co were to provide the valuation service, either because the self-review threat is assessed as low, or if they were to resign as auditor, then the firm should carefully consider whether it possesses sufficient skills and expertise to perform the valuation. This is a specialist area, and the firm would have to ensure that it could perform the work competently. (b) Allocation of staff to an audit team should be the decision of the audit firm, and should not be influenced by the wishes of the client. This point should be made clear to the finance director of Hall Co. Staff should be allocated to an audit team based on the needs of the audit. The team should comprise staff with a mix of skills, experience and technical knowledge as appropriate to the size and complexity of the audit, as well as logistical issues such as location and deadlines. Introducing an audit senior with no previous experience of the client may lead to ineffective leadership of the team, and could jeopardise the quality of the audit. On the other hand, working on a new audit client will provide Kia with more experience and broaden her knowledge and expertise. A further issue is that Kia is a relative of the financial controller of Hall Co. A family or personal relationship between a member of the audit team, and an officer or employee of the audit client can create threats to objectivity. The threats that arise are as follows:

Familiarity Kia may fail to approach the audit with professional scepticism Intimidation the financial controller may be able to exert influence on Kia, for example, influence her conclusions on work performed Self-interest Kia may be unwilling to challenge the financial controller about accounting matters for fear of causing problems for her relative. The degree of threat depends on the level of seniority of the close family member. Where they are in a position to exert direct and significant influence over the financial statements then the threat is significant. In this case, Kias relative is the financial controller, so is clearly in an influential position. Kia herself is also in a position of some influence over the audit, as she would take the position of audit senior, therefore responsible for the day-to-day supervision and direction [Type the company address] Page 90

of the junior members of the audit team. The most appropriate course of action would be that Kia is not assigned to the audit of Hall Co, and the reasons for this should be explained to the client.

(c) Usually documents such as title deeds or insurance certificates are held by the audit client or their legal advisors, but sometimes the service is provided by the accountant. IFACs Code of Ethics states that before agreeing to provide custodial services the audit firm must ensure that there is no legal restriction on holding assets (documents or tangible assets). A self-interest threat could be created as the firm receives a financial benefit from the fee charged for the service. There could also be a perception of a close relationship between the audit firm and the client, if one is holding documents on behalf of the other. Appropriate safeguards to be used in the provision of a custodial service could include: Keeping the assets physically separate from the firms assets, Keep orderly documentation regarding the assets and be ready to account for them to the client when requested, Establishing strict controls over the physical access to the assets, and Comply with all relevant laws and regulations in respect of holding the assets. Confidentiality is also a key issue the firm must ensure that documentation is only ever given to the client who has entrusted it to the firm. The reasons for this should be explained to the client. In addition Carter & Co should be vigilant in respect of money laundering regulations. The tangible assets could be purchased using the proceeds of crime and as such the firm in custody of such assets would be deemed to be involved with money laundering. The firm would have to be careful to ascertain the true origin of the assets in its custody. A further issue is whether Carter & Co has sufficient security to offer such a service. Employment of extra security methods such as alarm systems, CCTV, security personnel could be costly, and might outweigh the revenue to be derived from offering the service. In order to maximise the revenue from this source of income, Carter & Co could be tempted to concentrate on holding high value assets, as these would attract the highest fees. This would compound the security issues discussed above, especially the cost of extra insurance. If there were ever a problem such as documents held in custody being lost or damaged, or assets being stolen, then Carter & Co would face major reputational risk. This risk, along with the extra costs discussed above, may outweigh the relatively small revenue stream that the custodial service would provide.

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(d) Referral fees are not prohibited by IFACs Code of Ethics. However, a self-interest threat can arise, as the audit firm gains a financial benefit for each audit client referred to Gates Co. The referrals and payments to Carter & Co can continue, provided that safeguards are put in place. Safeguards could include: Disclosing to the audit clients that a referral fee arrangement exists, and the details of the arrangement. Receiving confirmation from the audit clients that they are aware of the referral arrangement. Receiving confirmation from all employees of Carter & Co that they have no interest in Gates Co. Carter & Co may also wish to consider the quality of the training provided by Gates Co. Any problems with the training provided could cause damage to the reputation of Carter & Co.

December 2010 Question 4 (b) You have set up an internal discussion board, on which current issues are debated by employees and partners of Neeson & Co. One posting to the board concerned the compulsory rotation of audit firms, whereby it has been suggested in the press that after a pre-determined period, an audit firm must resign from office, to be replaced by a new audit provider. Required: (i) Explain the ethical threats created by a long association with an audit client. (3 marks) (ii) Evaluate the advantages and disadvantages of compulsory audit firm rotation. (4 marks)

Answer (i) It is not uncommon for firms to act as auditor for a client for a number of years. However, the Code argues that using the same senior personnel on an assurance engagement over a long period of time may create a familiarity and selfinterest threat. The significance of the threat will depend upon factors such as: The length of time that the individual has been a member of the assurance team; The role of the individual on the assurance team; The structure of the firm; The nature of the assurance engagement; Whether the clients management team has changed; and Whether the nature, complexity of the clients accounting and reporting issues have changed. The problem of long association is that a familiarity threat to objectivity is created. The senior personnel risk losing their professional skepticism, and may cease to challenge the client on significant matters. A close relationship will be built up between the senior audit personnel and senior members of the clients management team, so the auditors become too

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sympathetic to the interests of the client. The Code requires that for public interest clients, the key audit partner should be rotated after a pre-determined period of seven years, as a means to safeguard against the familiarity threat. After such time, the key audit partner shall not be a member of the engagement team or be a key audit partner for the client for two years. During that period, the individual shall not participate in the audit of the entity, provide quality control for the engagement, consult with the engagement team or the client regarding technical or industry-specific issues, transactions or events or otherwise directly influence the outcome of the engagement. (ii) The main argument in favor of compulsory rotation of audit firms is that it should work to eliminate the familiarity threat. By not only rotating the key partner, but the entire audit firm, it is argued that the auditors independence is not compromised, and that this adds credibility to auditors reports and to the profession as a whole. It can also be argued that clients would benefit from a fresh pair of eyes after a number of years. A new audit firm can offer different insights from a fresh point of view. However, there are significant disadvantages to compulsory rotation of the audit firm. Firstly, from the audit firms perspective, there will be a loss of fee income when forced to resign as auditor. Also, the firm may be unwilling to make investments that may increase the quality or efficiency of a particular audit (for example, investing in bespoke audit software for a client), as the rewards would only be in the short-term. Audit effectiveness depends upon the audit firms accumulated knowledge of, and long-term experience with, the clients operations and financial reporting issues. Compulsory rotation undermines this accumulation of knowledge and experience. Audit problems are more likely to occur when the audit firm lacks this base. In the first few years auditors will know less about the client company and its management, and will be in a weaker position in making judgments about reporting issues. This severely detracts from the quality of the audit, and creates higher levels of risk exposure for the firm. Compulsory rotation of audit firms increases audit costs and creates significant practical problems. With each rotation, a new audit team must be brought up to speed on the clients operations and reporting issues, involving significant management time. Systems will need to be documented and evaluated. The increase in costs is likely to be passed onto the client in the form of a higher audit fee.

Finally, from the clients perspective, as well as facing increased audit fees and a potential loss of audit quality, the periodic rotation of audit provider could be disruptive to the business. On balance, it would seem that the disadvantages to both the audit firm and the client would outweigh the perceived benefits of compulsory rotation. The best safeguard to reduce familiarity threat is partner rotation, which allows the audit firm to continue in office, but avoids close relationships being built up. CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL STATEMENTS ISA 250 Non compliance Non compliance refers to acts of omission or commission by the entity, either intentional or unintentional which are contrary to the prevailing laws or regulations.

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Companies are subject to many laws and regulations for example: Company law Employment law Income tax law Labor law Environmental Protection law etc.

Responsibilities of Management and Auditors Management: Management is responsible for the prevention, detection and correction of non compliance with laws and regulations. The following policies and procedures may be implemented by the management in order to prevent and detect non compliance with laws and regulations: 1. 2. 3. 4. Maintain a register of significant laws with which the entity has to comply. Engage legal advisors to assist in monitoring legal requirement. Institute and operate appropriate system of internal controls. Develop, publicize and follow a code of conduct.

Auditor As with fraud and error, the auditor is not, and cannot be held responsible for preventing non compliance. There is unavoidable risk that some material misstatements in the financial statements go undetected even though the audit is properly planned and performed.

Certain factors will increase the risk of material misstatements due to non compliance with laws and regulations not being detected by the auditor. a) There are many laws and regulations, relating principally to the operating aspects of an entity that typically do not affect the financial statements and are not captured by the entitys information systems relevant to financial reporting. For example environmental and labor law. b) Non compliance may involve conduct design to conceal it such as collusion. For example everyone in the entity is involved. c) Whether an act constitute non compliance is ultimately a matter for legal determination by a court of law. Audit Procedures to identify non compliance with laws and regulations: 1. The auditor should obtain general understanding of the laws and regulations affecting the entity, which includes procedures such as: Use the auditors existing understanding of the entitys industry, regulatory and other external factors. Enquire of management as to the laws and regulations that may be expected to have a material effect on [Type the company address] Page 94

the operations of the entity. Enquire of management concerning the entitys policies and procedures regarding compliance with laws and regulations. Enquire of management the policies or procedures adopted for identifying, evaluating and accounting for litigation claims.

2. The auditor should obtain sufficient appropriate audit evidence of compliance with other laws and regulations such as entitys license to operate (non compliance may doubt going concern) that may have a fundamental affect on operations of the entity. 3. The following procedures may indicate the instances of non compliance such as: Reading minutes Enquiring the in house and external legal advisors. Performing substantive tests of details of classes of transactions, accounts balances and disclosures. 4. The auditor should obtain written representation from management and those charge with governance that they have informed auditor about all known and suspected non compliance. Audit procedures when non compliance is identified: In such a case the auditor shall obtain: 1. An understanding of the nature of the act and the circumstances in which it has occurred. 2. Further information to evaluate the possible effect on the financial statements. When evaluating the possible effect on the financial statements the auditor should consider the following: 1. Potential financial consequence such as fines and penalties. 2. Whether potential financial consequence require disclosure 3. Impact on the auditors report. When non compliance is identified the auditor should: 1. Reassess the risk. 2. Reassess the validity of written representation. 3. Take independent legal advice. In exceptional cases the auditor may consider whether withdrawal from the engagement is necessary. Reporting of identified or suspected non compliance: The auditor should report the intentional and material non compliance to those charged with governance as soon as practicable. If management and those charged with governance are involved than the auditor should report the non compliance to next higher level of authority such as Board of Directors. Impact on the auditors report: When non compliance is material and not adequately disclosed the auditor should express qualified opinion or adverse [Type the company address] Page 95

opinion. When the auditors is precluded by the management and those charged with governance from obtaining sufficient appropriated audit evidence than the auditor should express a qualified opinion or disclaim an opinion on the basis of limitation of scope.

Report to regulatory authority: The auditors duty of confidentiality would ordinarily preclude reporting noncompliance to a third party. However, in certain circumstances, that duty of confidentiality is overridden by statute, law or by courts of law (for example, in some countries the auditor is required to report noncompliance by financial institutions to the supervisory authorities). The auditor may need to seek legal advice in such circumstances, giving due consideration to the auditors responsibility to the public interest. Withdrawal from the Engagement The auditor may conclude that withdrawal from the engagement is necessary when the entity does not take the remedial action that the auditor considers necessary in the circumstances, even when the noncompliance is not material to the financial statements. Factors that would affect the auditors conclusion include the implications of the involvement of the highest authority within the entity which may affect the reliability of management representations, and the effects on the auditor of continuing association with the entity. In reaching such a conclusion, the auditor would ordinarily seek legal advice. Important There is distinction between checking systems of compliance and checking actual compliance. Example would be emission from a chemical factory. The auditor can only check controls on compliance with environmental law or can correspond with environmental authority but the auditor should not be expected to check actual emissions. Examples of factors indicating non compliance with laws and regulations: 1. 2. 3. 4. 5. 6. Investigation by a regulatory authority or payment of fines and penalties. Payment for unspecified services to consultants, related parties or employees. Purchasing at prices significantly above or below market price. Unusual transactions with companies registered in tax heavens. Payments without exchange control documentation. Existence of an information system that fails, whether by design or by accident, to provide an adequate audit trail or sufficient evidence. 7. Unauthorized transactions or unsupported transactions. 8. Adverse media comments. 9. Sales commission or agents fees that appear excessive in relations to those normally paid by the entity or in its industry.

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June 2012 Question 4

You are a senior manager in the audit department of Raven & Co. You are reviewing asituation which have arisen in respect of audit client, which was recently discussed at the monthly audit managers meeting: Plover Co is a private hospital which provides elective medical services, such as laser eye surgery to improve eyesight. The audit of its financial statements for the year ended 31 March 2012 is currently taking place. The audit senior overheard one of the surgeons who performs laser surgery saying to his colleague that he is hoping to finish his medical qualification soon, and that he was glad that Plover Co did not check his references before employing him. While completing the subsequent events audit procedures, the audit senior found a letter from a patients solicitor claiming compensation from Plover Co in relation to alleged medical negligence resulting in injury to the patient. Required: Identify and discuss the ethical, commercial and other professional issues raised, and recommend any actions that should be taken in respect of Plover Co. (7 marks)

Answer It appears that a surgeon is carrying out medical procedures without the necessary qualifications. This could clearly lead to serious damage being caused to a patient while undergoing laser eye surgery, and indeed this seems to have already occurred. The medical profession is highly regulated, and it is important for the auditor to consider obligations in the event of any serious breach of laws and regulations relevant to Plover Co. It is managements responsibility that laws and regulations are followed, and auditors are not expected to prevent or [Type the company address] Page 97

detect non-compliance, especially non-compliances which have limited impact on the financial statements. ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements provides relevant guidance. It is required that if the auditor becomes aware of a suspected non-compliance, an understanding of the nature of the act and the circumstances in which it occurred should be obtained. Therefore the auditor should establish whether it is the case that the surgeon is not qualified, possibly through reviewing the personnel file of the surgeon or discussing with the person responsible for recruitment. The auditor should also discuss the matter with management and/or those charged with governance. It may be that they are unaware of the surgeons apparent lack of qualifications, or possibly there is an alternative explanation in that the surgeon is qualified to perform laser eye surgery but does not possess a full medical qualification. The potential impact of the apparent non-compliance should be evaluated. In this case, Plover Co could face further legal action from dissatisfied or injured patients, fines and penalties from the regulatory authorities and its going concern may be in jeopardy if that authority has the power to revoke its operating licence. If these potential effects are considered to be material to the financial statements, legal advice may need to be obtained. In the event that the surgeons work is in breach of relevant laws and regulations, management should be encouraged to report the non-compliance to the relevant authority. If management fails to make such a disclosure, the auditor should consider making the necessary disclosure. However, due to the professional duty to maintain the confidentiality of client information, it is generally not acceptable to disclose client-related matters to external parties.

ACCAs Code of Ethics and Conduct provides additional guidance, stating that a member may disclose information which would otherwise be confidential if disclosure can be justified in the public interest. There is no definition of public interest which places members in a difficult position as to whether or not disclosure is justified. Matters such as the gravity of the situation, whether members of the public may be affected, and the possibility and likelihood of repeated non-compliance should be considered. Determination of where the balance of public interest lies will require very careful consideration and it will often be appropriate to take legal advice before making a decision. The reasons underlying any decision whether or not to disclose should be fully documented. The fact that a legal claim has been filed against Plover Co means that the audit work on provisions and contingent liabilities should be extended. Further evidence should be obtained regarding the legal correspondence, in particular the amount of the compensation claim. The date of the claim and the date of the medical incident to which it relates should also be ascertained in order to determine whether a provision for the claim should be recognised in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, or whether a note to the financial statements regarding the non-adjusting event should be made. The audit firm may wish to consider the integrity of the audit client. If the management of Plover Co knowingly allowed an unqualified person to carry out medical procedures then its integrity is questionable, in which case Raven & Co may wish to resign from the audit appointment as soon as possible. This is especially important given the legal claim recently filed against the client, which could result in bad publicity for Plover Co, and possibly by association for Raven & Co. MATERIALITY IN PLANNING AND PERFORMING AN AUDIT ISA 320

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An item is material if its omission or misstatement could influence the economic decision of user of the financial statements. An item might be material due to: 1. Nature 2. Value 3. Impact. There is an inverse relationship between the risk and the materiality. The higher the risk the lower the materiality level and vice versa. When materiality level is set at lower level than the auditor will have to verify more transactions. Materiality is set at two levels: 1. Overall financial statements level. (Overall materiality) 2. For each account balance appearing in the financial statement (Performance materiality). Performance materiality is set much lower level than the overall materiality so that small misstatements in aggregate should not cross the overall materiality level. Following are the bench marks for the materiality: Profit Revenue Total assets 5% 1%-2% 2%-5%

The following factors may affect the identification of an appropriate benchmark: 1. Elements of financial statements (assets, liabilities, equity, revenue, expenses) 2. Whether there are items on which users tend to focus. 3. Relative volatility of benchmarks.

Important: 1. The above benchmarks are only useful to calculate the materiality on the planning level. In the P7 exam you will also be calculating materiality in relation to specific item. You must only use the relevant comparator, for example, total asset if the matter relates to the statement of financial position, profit before tax if the matter impacts upon profit, and both if it relates to statement of financial position and impacts on profits, for example [Type the company address] Page 99

a provision.

2. The level of materiality must be revised for the financial statements if the auditor becomes aware of information during the audit that would have caused the auditor to have determined a different amount during planning.

MONEY LAUNDERING What is money laundering? Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the proceeds of their criminal activity. Example : Mr. ABC is an illegal weapon supplier. He also runs a night club in Thailand. What he receives from his weapons sales he transfer it to his club bank account. From the club bank account he transfers the amount to his brothers bank account in Dubai. Factors indicating money laundering: 1. 2. 3. 4. 5. Transactions routed through several jurisdiction. Secrecy over transactions. Excessive use of wire transfers High value deposits or withdrawals not characteristics of the type of account A pattern that after a deposit, the same amount is wired to another financial institution.

Question to learn You are the audit manager of loft Co, a chain of night clubs across the north west of England. During the course of the audit Mr. Roy, an employee of the company, informed you that a substantial cash deposit was paid in to the companys bank account and a month later, the same amount was paid by direct transfer into a bank account in the name of EVISSA, a company based overseas. The employee also informed you that Mr. Fox, the managing director of Loft Co had instructed him not to record the transaction in the accounting records as it had nothing to do with Loft cos business. Required: Identify the factors indicating money laundering in the above question. General ways of Money laundering: Captive Business: Captive business is a business whose cash flow is difficult to monitor for example hair stylists and retail business such as small restaurants. In such a business there may be no evidence of sales except for cut hairs or chicken bones lying on the floor because we usually do not ask for receipts of the services received and payments made. Cashing up: Take an example of Grocery Shop. In such a business there is a need to deposit the days sales amount in the bank on the very next day. What they do is they deposit the illegal money with their clean sales money to avoid suspicions by [Type the company address] Page 100

slowly showing increase in daily sales. Structured Business: Here the criminal avoid suspicions by depositing their illegal money in to several bank accounts in small amounts. The three stages of the money laundering process are: Placement; Layering.; and Integration

Anti money laundering procedures: The firm must gather know your client information to assist in spotting suspicious transactions. This includes: 1. 2. 3. 4. 5. Who the client is Who controls it The nature of the client The clients sources of funds The clients business and economic purposes.

In the UK, the basic requirements are for accountants to keep records of clients identity and to report suspicions of money laundering to the Serious Organized Crime Agency (SOCA). Elements of basic money laundering program: 1. Appoint Money Laundering Reporting Officer (MLRO). 2. Train the individuals to ensure that they are aware of relevant legislation, know how to deal with potential money laundering, how to report suspicions to MLRO. 3. Establish internal procedures such as know your client and client acceptance procedures to prevent money laundering. 4. Verify the identity of new and existing clients and maintain evidence of identification. 5. Maintain records of identification, and any transactions undertaken for or with the client. 6. Report suspicions of money laundering to SOCA. Important 1. Concealing and tipping off (MLRO or any individual discloses something that might prejudice any investigation) is itself a criminal offence. 2. The obligation to report money laundering act does not depend on the amount involved or the seriousness of the offence.

The need for ethical guidance on money laundering This is needed because there is a clear conflict between:

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1. The accountants professional duty of confidentiality in relation to clients business, and 2. The duty to report suspicions of money laundering to the appropriate authorities as required by law. Professional accountants are not in breach of their professional duty of confidentiality if they report in good faith their knowledge or suspicions of money laundering to the appropriate authority. Disclosure without reasonable grounds would possibly lead to the accountants being sued for breach of confidence.

MONEY LAUNDERING EXAM QUESTIONS December 2007 Question 4 (a) You are an audit manager in Nate & Co, a firm of Chartered Certified Accountants. Nate & Co has recently been approached by a potential new audit client, Fisher Co. Your firm is keen to take the appointment and is currently carrying out client acceptance procedures. Fisher Co was recently incorporated by

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Marcellus Fisher, with its main trade being the retailing of wooden storage boxes. Define money laundering and state the procedures specific to money laundering that should be considered before, and on the acceptance of, the audit appointment of Fisher Co. (5 marks) Answer Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the proceeds of criminal activity, allowing them to maintain control over the proceeds, and ultimately providing a legitimate cover for their sources of income. The objective of money laundering is to break the connection between the money, and the crime that it resulted from. It is widely defined, to include possession of, or concealment of, the proceeds of any crime. Examples include proceeds of fraud, tax evasion and benefits of bribery and corruption. Client procedures should include the following: Client identification: Establish the identity of the entity and its business activity e.g. by obtaining a certificate of incorporation If the client is an individual, obtain official documentation including a name and address, e.g. by looking at photographic identification such as passports and driving licenses Consider whether the commercial activity makes business sense (i.e. it is not just a front for illegal activities) Obtain evidence of the companys registered address e.g. by obtaining headed letter paper Establish the current list of principal shareholders and directors.

Client understanding: Pre-engagement communication may be considered, to explain to Marcellus Fisher and the other directors the nature and reason for client acceptance procedures. Best practice recommends that the engagement letter should also include a paragraph outlining the auditors responsibilities in relation to money laundering.

December 2009 Question 2(c) There are specific regulatory obligations imposed on accountants and auditors in relation to detecting and reporting money laundering activities. You have been asked to provide a training session to the new audit juniors on auditors responsibilities in relation to money laundering. Required: Prepare briefing notes to be used at your training session in which you: (i) (ii) Explain the term money laundering. Illustrate your explanation with examples of money laundering offences, including those which could be committed by the accountant; and Explain the policies and procedures that a firm of Chartered Certified Accountants should establish in order [Type the company address] Page 103

to meet its responsibilities in relation to money laundering. (10 marks) Answer Briefing notes to be used at training session Subject: Money laundering policies and procedures (i)Introduction A firm of Chartered Certified Accountants must establish sound policies and procedures to ensure that the firm meets its responsibilities under the relevant regulation in which the firm is operating. It is important that everyone who is a member of an audit engagement team is aware of the regulations, the firms policies and procedures, and their own responsibilities regarding money laundering activities. Definition of money laundering Money laundering is a process by which criminals attempt to conceal the true origin and ownership of the proceeds of criminal activities. It is a way in which money earned from criminal activities (dirty money) is transferred and transformed so it appears to have come from a legitimate source (clean money). Money laundering includes a wide range of potential crimes including possessing, dealing with, or concealing the proceeds of crime.

Money laundering activities could include: Acquiring, using or possessing the proceeds of criminal activities such as drug trafficking and terrorist activities or retaining control over proceeds of tax evasion. Benefits obtained through bribery or corruption. Inciting, aiding or concealing such activities.

The three stages of the money laundering process are placement, layering and integration: Placement is putting money into financial products or instruments, including life policies, pension arrangements, unit trusts, travelers cheques, and bank deposits. Layering is creating a series of transactions so that the original source of funds is obscured and difficult to trace. Integration is converting the proceeds of money laundering into a legitimate form.

For accountants there are specific ways that they could commit offences relating to money laundering. These could include: Handling the proceeds of criminal activity, or advising on the use of such proceeds. Failure to report knowledge or suspicion of money laundering activities to the appropriate authority. [Type the company address] Page 104

Making a disclosure which is likely to prejudice an investigation into money laundering (known as tipping off). Failure to comply with the specific regulatory requirements in relation to money laundering in the jurisdiction in which the accountant is operating.

(ii) Policies and procedures Appointment of Money Laundering Reporting Officer (MLRO). The MLRO is a nominated officer who is responsible for receiving and evaluating reports of suspected money laundering from colleagues within the firm, and making a decision as to whether further enquiry is required and if necessary making reports to the appropriate external body. The MLRO should have an appropriate level of seniority and experience and would usually be a senior partner. Customer identification procedures. This is often referred to as customer due diligence, or know your client procedures. The point of these procedures is to ensure that the firm has verified the identity of clients (whether the client is an individual or an entity), and has obtained evidence of that identity. For an individual, typical evidence of identity would be a passport, driving license, and evidence of address such as a utility bill. For an entity evidence may include a certificate of incorporation. The identification process for an entity would also involve identification of key management personnel and those people in control of the entity, and an assessment as to whether any connected individuals are politically exposed people.

Enhanced record keeping. Records must be kept of clients identity, the firms business relationship with them, and details of transactions with the client. All records should be kept for five years after the end of the business relationship or completion of the transactions. Internal and external reports made in connection to money laundering should also be securely kept for five years. Communication and training. All relevant employees should receive training so that they are aware of the main provisions of money laundering regulations, and so that they know how to recognize and deal with activities which may be money laundering. The training programme should be offered to all members of the firm with an involvement in audit engagements. Training should also be provided on the firms internal policies and procedures with relation to money laundering. In particular all staff should be aware of appropriate lines of communication, and who they should report suspicions of money laundering activities to. Internal controls, risk assessment, management and monitoring. The firm should establish systems and controls to effectively manage the risk that the firm is exposed to in terms of money laundering activities. This could include: Client screening procedures to minimize the risk of taking on a new client with a high risk of money laundering activities Systems and controls to ensure that training is taken/attended and understood by all relevant employees Systems that allow periodic testing that the firms policies and procedures comply with legislative and regulatory requirements.

All of the above contribute to the acceptance and following of firm-wide practices by all relevant individuals and can be seen as quality control measures. Conclusion It can be seen that the firm needs to have in place appropriate measures to ensure that complex anti-money laundering regulation is adhered to. It is the responsibility of all relevant staff to be alert for suspicious activities and to understand [Type the company address] Page 105

their own responsibility to report the activity. Failing to do so places the individual and the firm at risk of a breach of regulation.

June 2012 Question 3 (a) You are a manager in Lark & Co, responsible for the audit of Heron Co, an owner-managed business which operates a chain of bars and restaurants. This is your firms first year auditing the client and the audit for the year ended 31 March 2012 is underway. The audit senior sends a note for your attention: When I was auditing revenue I noticed something strange. Heron Cos revenue, which is almost entirely cash-based, is recognised at $55 million in the draft financial statements. However, the accounting system shows that till receipts for cash paid by customers amount to only $35 million. This seemed odd, so I questioned Ava Gull, the financial controller about this. She said that Jack Heron, the companys owner, deals with cash receipts and posts through journals dealing with cash and revenue. Ava asked Jack the reason for these journals but he refused to give an explanation. While auditing cash, I noticed a payment of $2 million made by electronic transfer from the companys bank account to an overseas financial institution. The bank statement showed that the transfer was authorised by Jack Heron, but no other documentation regarding the transfer was available. Alarmed by the size of this transaction, and the lack of evidence to support it, I questioned Jack Heron, asking him about the source of cash receipts and the reason for electronic transfer. He would not give any answers and became quite aggressive. Required: (i) Discuss the implications of the circumstances described in the audit seniors note; and (6 marks) (ii) Explain the nature of any reporting that should take place by the audit senior. (3 marks)

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Answer 3 (a) (i) The circumstances described by the audit senior indicate that Jack Heron may be using his company to carry out money laundering. Money laundering is defined as the process by which criminals attempt to conceal the origin and ownership of the proceeds of their criminal activity, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate cover for the sources of their income. Money laundering activity may range from a single act, such as being in possession of the proceeds of ones own crime, to complex and sophisticated schemes involving multiple parties, and multiple methods of handling and transferring criminal property as well as concealing it and entering into arrangements to assist others to do so. Heron Cos business is cash-based, making it an ideal environment for cash acquired through illegal activities to be legitimised by adding it to the cash paid genuinely by customers and posting it through the accounts. It appears that $2 million additional cash has been added to the genuine cash receipts from customers. This introduction of cash acquired through illegal activities into the business is known as placement. The fact that the owner himself posts transactions relating to revenue and cash is strange and therefore raises suspicions as to the legitimacy of the transactions he is posting through the accounts. Suspicions are heightened due to Jack Herons refusal to explain the nature and reason for the journal entries he is making in the accounts. The $2 million paid by electronic transfer is the same amount as the additional cash posted through the accounts. This indicates that the cash is being laundered and the transfer is known as the layering stage, which is done to disguise the source and ownership of the funds by creating complex layers of transactions. Money launderers often move cash overseas as quickly as possible in order to distance the cash from its original source, and to make tracing the transaction more difficult. The integration stage of money laundering occurs when upon successful completion of the layering process, the laundered cash is reintroduced into the financial system, for example, as payment for services rendered. The secrecy over the reason for the cash transfer and lack of any supporting documentation is another indicator that this is a suspicious transaction. Jack Herons reaction to being questioned over the source of the cash and the electronic transfer point to the fact that he has something to hide. His behaviour is certainly lacking in integrity, and even if there is a genuine reason for the journals and electronic transfer his unhelpful and aggressive attitude may cast doubts as to whether the audit firm wish to continue to retain Heron Co as a client. The audit senior was correct to be alarmed by the situation. However, by questioning Jack Heron about it, the senior may have alerted him to the fact that the audit team is suspicious that money laundering is taking place. There is a potential risk that the senior has tipped off the client, which may prejudice any investigation into the situation.

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Tipping off is itself an offence, though this can be defended against if the person did not know or suspect that the disclosure was likely to prejudice any investigation that followed. The amount involved is clearly highly material to the financial statements and will therefore have an implication for the audit. The whole engagement should be approached as high risk and with a high degree of professional skepticism. The firm may wish to consider whether it is appropriate to withdraw from the engagement (if this is possible under applicable law and regulation). However, this could result in a tipping off offence being committed, as on withdrawal the reasons should be discussed with those charged with governance. If Lark & Co continue to act as auditor, the audit opinion must be considered very carefully and the whole audit subject to second partner review, as the firm faces increased liability exposure. Legal advice should be sought. 3 (a) (ii) The audit senior should report the situation in an internal report to Lark & Cos Money Laundering Reporting Officer (MLRO). The MLRO is a nominated officer who is responsible for receiving and evaluating reports of suspected money laundering from colleagues within the firm, and making a decision as to whether further enquiries are required and if necessary making reports to the appropriate external body. Lark & Co will probably have a standard form that should be used to report suspicions of money laundering to the MLRO. The typical content of an internal report on suspected money laundering may include the name of the suspect, the amounts potentially involved, and the reasons for the suspicions with supporting evidence if possible, and the whereabouts of the laundered cash. The report must be done as soon as possible, as failure to report suspicions of money laundering to the MLRO as soon as practicable can itself be an offence under the money laundering regulations. The audit senior may wish to discuss their concerns with the audit manager in more detail before making the report, especially if the senior is relatively inexperienced and wants to hear a more senior auditors view on the matter. However, the senior is responsible for reporting the suspicious circumstances at Heron Co to the MLRO. OBTAINING AND ACCEPTING PROFESSIONAL APPOINTMENTS Change in auditors The common reasons for change in auditors are: There could be ethical reasons such as independence There could be conflicts of interest The auditor might disagree with the client over accounting policies The auditor might not want to reduce audit fee There could be personality reasons There could be statutory rotation

Advertizing and fees Advertisements for services provided by the firms Every business requires some good advertisement and so does the audit firms. However, accountants are professional people and people rely on their work. It is important therefore that their advertisements do not project an image that is [Type the company address] Page 108

inconsistent with that fact. Factors to consider The medium of advertisement should not reflect adversely on the member, ACCA or the accountancy profession. Advertisements and promotional material should not discredit the services offered by others by claiming that we are the best. Advertisements should not be misleading. Fall short of any local regulatory or legislative requirements.

Advertising fees It is generally inappropriate to advertize fees. For example: Audit firm usually estimate their cost and profit on the basis of hours spend by their staff. It is impossible in the advertisement to describe how much each service will cost without estimating the time particular jobs would take. It is more appropriate to advertize that we the auditor will give free consultations to discuss fees. Use of the ACCA logo Members of the ACCA are entitled to call themselves Chartered Certified Accountants or just Certified Accountants, and may use letters ACCA (as members) or FCCA (if they are fellows). These descriptions may not be used in the registered names of companies. For example you may not set up a company called John Smith Certified Accountant Ltd. A firm may describe itself as a firm of Chartered Certified Accountants where: At least half of the partners are ACCA members; and Those partners hold at least 51% of voting rights under the partnership agreement.

A firm in which all the partners are Chartered Certified Accountants may use the description Members of the Association of Chartered Certified Accountants. A firm which holds a firms auditing certificates from ACCA may describe itself as Registered Auditors. In the case of mixed firm (e.g. some partners are ACCA members and others are members of other Chartered Accountancy Bodies), the firm should not use the description Certified Accountants and Chartered Accountants or similar, since this could be misleading. Instead they may use The partners of this firm are members of either the Association of Chartered Certified Accountants or (e.g.) the Institute of Chartered Accountants in England and Wales.

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Tendering The auditor has to consider both practical issues and fees before approaching a tender. Practical Issues: The auditor should consider: Does the proposed time table for the work fit with the current work plan? Does the firm have suitable personnel available? Where will the work be performed and is it accessible/cost effective? Are (non-accounting) specialist skills necessary? Will staff need further training to do the work? If so, what is the cost of that further training?

It is likely that audit staff would have to have a meeting with the prospective client to discuss the following issues: What the client requires from the audit firm, (for example. Audit, tax work) What the future plans of the entity are, for example: Is it planning to float its shares on stock exchange in the near future? Is growth or diversification anticipated? If the entity is changing its auditors, the reason behind this.

Fees:

Determining whether the job can be done for a reasonable price will involve a substantial number of estimates. It involves three stages: 1. Ascertain what the job will involve. 2. Ascertaining the involvement of staff required such as experts. 3. Once the estimates have been made of how long the work will take and what level of expertise is needed, the firms charge out rates can be applied to that information.

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Contents of an audit proposal Generally the audit proposal has the following contents: The fee and how it has been calculated An assessment of the needs of the prospective client An outline of how the firm intends to meet those needs The assumptions made to support that proposal The proposed approach to the engagement A brief outline of the firm An outline of the key staff involved

Evaluation of tender Every organization has its own criteria of evaluating the proposal. However, there are some general points to bear in mind when putting together a proposal: 1. Fee It is possible that a reader might look at the fee and decide not to continue reading the proposal. 2. Professionalism Auditor provides the professional services and this should be reflected in their proposal. 3. Proposed approach Propose audit methodology should not be disruptive to the client staff. 4. Personal service It is important to highlight key staff and to foster relationship with the management from the outset of a relationship, and this means during the tender process.

Acceptance There are many ethical procedures associated with accepting engagements: Procedures before accepting engagements: 1. 2. 3. 4. Ensure that there are no ethical barriers. Ensure that the existing resources are adequate in terms of staff, expertise and time. Obtain references for the directors if they are not known personally to the audit firm. Consult with the previous auditors to ensure that are there any professional reasons why we should not accept [Type the company address] Page 111

the appointment. Procedures after accepting the appointments: 1. Ensure that the outgoing auditors removal or resignation has been properly conducted in accordance with the law 2. Ensure that that new auditors appointment is valid. The new auditors should obtain a copy of the resolution passed at the general meeting appointing them as the companys auditors. 3. Set up and submit a letter of engagement to the directors of the company. ISQC 1 gives a list of matters that the auditor might consider in relation to the acceptance decisions: Integrity of client 1. The identity and business relationship of the clients principal owners, key management, related parties and those charged with governance. 2. Nature of the clients operations including its business practices. 3. Information concerning the attitude of clients management. 4. Whether the client is aggressively concerned with maintaining the firms fees as low as possible. 5. Indications of an inappropriate limitation in the scope of work. 6. Indications that the client might be involved in money laundering or other criminal activities. 7. The reasons for the proposed appointment of the firm and non reappointment of the previous firm. Competence of the firm 1. Do the personal have knowledge of relevant industries/subject matter? 2. Do the firm personnel have experience with relevant regulatory or reporting requirements or the ability to gain the necessary skills and knowledge effectively? 3. Are experts available if needed? 4. Are there appropriate quality control procedures available? 5. Whether the firm will able to complete the engagement with in the reporting deadline?

Questions

June 2009 Question 2 (a) Explain FOUR reasons why firm of auditors may decide NOT to seek re-election as auditor. (6 marks) Answer 2 (a) Reasons why a firm of auditors may decide not to seek re-election any FOUR of the following: Disagreement with the client [Type the company address] Page 112

The audit firm may have disagreed with the client for a number of reasons, for example, over accounting treatments used in the financial statements. A disagreement over a significant matter is likely to cause a breakdown in the professional relationship between auditor and client, meaning that the audit firm could lose faith in the competence of management. The auditor would be reluctant to seek re-election if the disagreement were not resolved. Lack of integrity of client The audit firm may feel that management is not acting with integrity, for example, the financial statements may be subject to creative accounting, or dubious business ethics decisions could be made by management, such as the exploitation of child labor. The auditor would be likely not to seek re-election (or to resign) in this case to avoid being associated with the clients poor decisions. Fee level The audit firm could be unable to demand a high enough audit fee from the client to cover the costs of the audit. In this situation the audit firm may choose not to offer itself for re-election, to avoid continuing with a loss making audit engagement, and consequently to use resources in a more commercially advantageous way. Fee payments The audit firm could have outstanding fees which may not be fully recovered due to a clients poor cash flow position. Or, the client could be slow paying, causing the audit firm to chase for payment and possibly affecting the relationship between the two businesses. In such cases the audit firm may make the commercial decision not to act for the client any longer.

Resources The audit firm may find that it lacks the resources to continue to provide the audit service to a client. This could happen if the client company grows rapidly, financially or operationally, mean that a larger audit team is necessary. The audit firm may simply lack the necessary skilled staff to expand the audit team. Competence The audit firm could feel that it is no longer competent to perform an audit service. This could happen for example if a client company diversified into a new and specialized business operation of which the audit firm had little or no experience. The audit firm would not be able to provide a high quality audit without building up or buying in the necessary knowledge and skills, and so may decide not to be considered for re-election. Overseas expansion A client could acquire one or several material overseas subsidiaries. If the audit firm does not have an associate office in the overseas location, the firm may feel that the risk and resources involved in relying on the work of other auditors is too great, and so decide not to act for the client any longer. Independence There are many ethical guidelines in relation to independence which must be adhered to by auditors, and in the event of a potential breach of the guidelines, the audit firm may decide not to seek re-election. For example, an audit firm may need to increase the audit fee if a client company grows in size. This could have the effect of increasing the fee received [Type the company address] Page 113

from the client above the allowed thresholds. As there would be no ethical safeguard strong enough to preserve the perception of independence, in this case the audit firm would not be able to continue to provide the audit service. Tutorial note: Other examples may be used to explain why the issue of independence could cause an audit firm not to seek re-election, e.g. audit firm takes on a financial interest in the client, close personal relationships develop between the firm and the client. Conflicts of interest An audit firm may become involved in a situation where a conflict of interest arises between an existing audit client and another client of the firm. For example, an audit firm could take on a new audit client which is a competitor of an existing audit client. Although with the use of appropriate safeguards this situation could be successfully managed, the audit firm may decide that stepping down as auditor of the existing client is the best course of action.

Question 2 (b) & (c) The Dragon Group is a large group of companies operating in the furniture retail trade. The group has expanded rapidly in the last three years, by acquiring several subsidiaries each year. The management of the parent company, Dragon Co, a listed company, has decided to put the audit of the group and all subsidiaries out to tender, as the current audit firm is not seeking re-election. The financial year end of the Dragon Group is 30 September 2009. You are a senior manager in Unicorn & Co, a global firm of Chartered Certified Accountants, with offices in over 150 countries across the world. Unicorn & Co has been invited to tender for the Dragon Group audit (including the audit of all subsidiaries). You manage a department within the firm which specializes in the audit of retail companies, and you have been assigned the task of drafting the tender document. You recently held a meeting with Edmund Jalousie, the group finance director, in which you discussed the current group structure, recent acquisitions, and the groups plans for future expansion. Meeting notes Dragon Group Group structure The parent company owns 20 subsidiaries, all of which are wholly owned. Half of the subsidiaries are located in the same country as the parent, and half overseas. Most of the foreign subsidiaries report under the same financial reporting framework as Dragon Co, but several prepare financial statements using local accounting rules. Acquisitions during the year Two companies were purchased in March 2009, both located in this country: (i) Mermaid Co, a company which operates 20 furniture retail outlets. The audit opinion expressed by the incumbent auditors on the financial statements for the year ended 30 September 2008 was qualified by a disagreement over the non-disclosure of a contingent liability. The contingent liability relates to a court case which is still on-going. (ii) Minotaur Co, a large company, whose operations are distribution and warehousing. This represents a diversification away from retail, and it is hoped that the Dragon Group will benefit from significant economies of scale as a result of the [Type the company address]

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acquisition. Other matters The acquisitive strategy of the group over the last few years has led to significant growth. Group revenue has increased by 25% in the last three years, and is predicted to increase by a further 35% in the next four years as the acquisition of more subsidiaries is planned. The Dragon Group has raised finance for the acquisitions in the past by becoming listed on the stock exchanges of three different countries. A new listing on a foreign stock exchange is planned for January 2010. For this reason, management would like the group audit completed by 31 December 2009.

Required: (b) Recommend and describe the principal matters to be included in your firms tender document to provide the audit service to the Dragon Group. (10 marks) (c)Using the specific information provided, evaluate the matters that should be considered before accepting the audit engagement, in the event of your firm being successful in the tender. (7 marks)

Answer (b) Matters to be included in tender document Brief outline of Unicorn & Co This should include a short history of the firm, a description of its organisational structure, the different services offered by the firm (such as audit, tax, corporate finance, etc), and the locations in which the firm operates. The document should also state whether it is a member of any international audit firm network. The geographical locations in which Unicorn & Co operates will be important given the multi-national structure of the Dragon Group. Specialism of the firm Unicorn & Co should describe the areas in which the firm has particular experience of relevance to the Dragon Group. It would be advantageous to stress that the firm has an audit department dedicated to the audit of clients in the retail industry, as this emphasizes the experience that the firm has relevant to the specific operations of the group. Identification of the needs of the Dragon Group The tender document should outline the requirements of the client, in this case, that each subsidiary is required to have an individual audit on its financial statements, and that the consolidated financial statements also need to be audited. Unicorn & Co may choose to include here a brief clarification of the purpose and legal requirements of an audit. The potential provision of non-audit services should be discussed, either here, or in a separate section of the tender document (see below). Outline of the proposed audit approach This is likely to be the most detailed part of the tender document. Here the firm will describe how the audit would be conducted, ensuring that the needs of the Dragon Group (as discussed above) have been met. Typically contained in this [Type the company address] Page 115

section would be a description of the audit methodology used by the firm, and an outline of the audit cycle including the key deliverables at each phase of work. For example:

How the firm would intend to gain business understanding at group and subsidiary level. Methods used to assess risk and to plan the audits. Procedures used to assess the control environment and accounting systems. Techniques used to gather evidence, e.g. the use of audit software. How the firm would structure the audit of the consolidation of the group financial statements and how they would liaise with subsidiary audit teams. The firm should clarify its adherence to International Standards on Auditing, ethical guidelines and any other relevant laws and regulations operating in the various jurisdictions relevant to the Dragon Group. The various financial reporting frameworks used within the group should be clarified. Quality control Unicorn & Co should emphasize the importance of quality control and therefore should explain the procedures that are used within the firm to monitor the quality of the audit services provided. This should include a description of firm-wide quality control policies, and the procedures applied to individual audits. The firm may wish to clarify its adherence to International Standards on Quality Control. Communication with management The firm should outline the various reports and other communication that will be made to management as part of the audit process. The purpose and main content of the reports, and the timing of them, should be outlined. Unicorn & Co may provide some added value bi-products of the audit process. For example, the business risks identified as part of the audit planning may be fed back to management in a written report. Timing Unicorn & Co should outline the timeframe that would be used. For example, the audits of the subsidiaries financial statements should be conducted before the audit of the consolidated financial statements. The firm may wish to include an approximate date by which the group audit opinion would be completed, which should fit in, if possible, with the requirements of the group. If Unicorn & Co feels that the deadline requested by the client is unrealistic, a more appropriate deadline should be suggested, with the reasons for this clearly explained. Key staff and resources The document should name the key members of staff to be assigned to the audit, in particular the proposed engagement partner. In addition, the firm should clarify the approximate number of staff to be used in the audit team and the relevant experience of the key members of the audit team. If the firm considers that external specialists could be needed, then this should be explained in this section of the document. Fees

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The proposed fee for the audit of the group should be stated, and the calculation of the fee should be explained, i.e. broken down by grade of staff and hourly/daily rates per grade. In addition, invoicing and payment terms should be described, e.g. if the audit fee is payable in installments, the stages when each installment will fall due. Extra services Unicorn & Co should ensure that any non-audit services that it may be able to offer to the Dragon Group are described. For example, subject to ethical safeguards, the firm may be able to offer corporate finance services in relation to the stock exchange listing that the group is seeking, although the provision of this non-audit service would need to be carefully considered in relation to independence issues.

(c) Evaluation of matters to be considered: Size and location of the group companies The Dragon Group is a large multi-national group of companies. It is extremely important that Unicorn & Co assesses the availability of resources that can be allocated to the audit team. The assignment would comprise the audit of the financial statements of all 20 current subsidiaries, the audit of the parent companys and the groups financial statements. This is a significant engagement which will demand a great deal of time. The location of half of the groups subsidiaries in other countries means that the overseas offices of Unicorn & Co would be called upon to perform some or all of the audit of those subsidiaries. In this case the resource base of the relevant overseas offices should be considered to ensure there is enough staff with appropriate skills and experience available to perform the necessary audit work. Unicorn & Co must consider if they have offices in all of the countries in which the Dragon Group has a subsidiary. Depending on the materiality of the overseas subsidiaries to the group financial statements, it is likely that some overseas visits would be required to evaluate the work of the overseas audit teams. Unicorn & Co should consider who will conduct the visits (presumably a senior member of the audit team), and whether that person has the necessary skills and experience in evaluating the work of overseas audit teams.

Planned expansion of the group In light of the comments above, Unicorn & Co should consider that the planned further significant expansion of the group will mean more audit staff will be needed in future years, and if any subsidiaries are acquired in other countries, the audit is likely to be performed by overseas offices. The firm should therefore consider not only its current resource base in the local and overseas offices, but whether additional staff will be available in the future if the groups expansion goes ahead as planned. Relevant skills and experience Unicorn & Co has an audit department specializing in the audit of retail companies, so it should not be a problem to find audit staff with relevant experience in this country. [Type the company address] Page 117

On consolidation, the financial statements of the subsidiaries will be restated in line with group accounting policies and financial reporting framework, and will also be retranslated into local presentational currency. All of this work will be performed by the management of the Dragon Group. Unicorn & Co must evaluate the availability of staff experienced in the audit of a consolidation including foreign subsidiaries. Timing It is important to consider the timeframe when conducting a group audit. The audit of each subsidiarys financial statements should be carried out prior to the audit of the consolidated financial statements. Unicorn & Co should consider the expectation of the Dragon Group in relation to the reporting deadline, and ensure that enough time is allowed for the completion of all audits. The deadline proposed by management of 31 December is only three months after the year end, which may be unrealistic given the size of the group and the multi-national location of the subsidiaries. The first year auditing a new client is likely to take longer, as the audit team will need to familiarize themselves with the business, the accounting systems and controls, etc. Mermaid Co prior year qualification If Unicorn & Co accepts the engagement, the firm will take on the audit of Mermaid Co, whose financial statements in the prior year were in breach of financial reporting standards. This adds an element of risk to the engagement. Unicorn & Co should gather as much information as possible about the contingent liability, and the reason why the management of Mermaid Co did not amend the financial statements last year end. This could hint at a lack of integrity on the part of the management of the company. The firm should also consider whether this matter could be significant to the consolidated financial statements, by assessing the materiality of the contingent liability at group level. Further discussions should be held with the management of the Dragon Group in order to understand their thoughts on the contingency and whether it should be disclosed in the individual financial statements of Mermaid Co, and at group level. Contacting the incumbent auditors (after seeking relevant permission from the Dragon Group) would also be an important procedure to gather information about the qualification. Minotaur Co different business activity The acquisition of Minotaur Co represents a new business activity for the group. The retail business audit department may not currently have much, if any, experience of auditing a distribution company. This should be easily overcome, either by bringing in staff from a different department more experienced in clients with distribution operations, or by ensuring adequate training for staff in the retail business audit department. Highly regulated/reliance on financial statements and audit report The Group is listed on several stock exchanges, and is therefore subject to a high degree of regulation. This adds an element of risk to the engagement, as the management will be under pressure to publish favorable results. This risk is increased by the fact that a new listing is being sought, meaning that the financial statements and audit report of the group will be subject to close scrutiny by the stock exchange regulators. There may be extra work required by the auditors due to the listings, for example, the group may have to prepare reconciliations of financial data, or additional narrative reports on which the auditors have to express an opinion under [Type the company address] Page 118

the rulings of the stock exchange. The firm must consider the availability of staff skilled in regulatory and reporting listing rules to perform such work. Previous auditors of Dragon Group Unicorn & Co should consider the reason why the previous audit firm is not seeking re-appointment, and whether the reason would impact on their acceptance decision. After seeking permission from the Dragon Group, contact should be made with the previous auditors to obtain confirmation of the reason for them vacating office (amongst other matters). In conclusion, this is a large scale, multi-national group, which carries a fairly high level of risk. Unicorn & Co must be extremely careful to only commit to the group audit if it has the necessary resources, can manage the clients expectation in relation to the reporting deadline, is convinced of the integrity of management, and is confident to take on a potentially high profile client. Tutorial note: Credit will be awarded in this requirement for discussion of ethical matters which would be considered prior to accepting the appointment as auditor of the Dragon Group. However as the scenario does not contain any reference to specific ethical matters, marks will be limited to a maximum of 2 for a general discussion of ethical matters on acceptance. OPENING BALANCES ISA 510 Opening balances are those account balances that exist at the beginning of the period. Opening balances are based upon the closing balance of the prior period and reflect the effects of transactions and events of prior periods and accounting policies applied in the prior period. This ISA caters the following situations: 1. When the prior period financial statements were not audited. 2. When the prior period financial statements were audited by another auditor. The sufficiency and appropriateness of the audit evidence the auditor will need to obtain regarding opening balance depends on such matters as the following: 1. The accounting policies followed by the entity. 2. Whether the prior periods financial statements were audited, and if so whether the auditors report was modified. 3. The nature of the account and the risk of material misstatement in the current periods financial statements. 4. The materiality of the opening balance relative to the current periods financial statements. Specific audit procedures regarding opening balance For current assets and liabilities some audit evidence may be obtained as a part of current period audit procedures. For example, the collection (payment) of opening accounts receivables (accounts payable) during the current period will provide some audit evidence of their existence, rights and obligations, completeness and valuation at the beginning of the period. In case of inventory the roll back procedures may be performed such: 1. Perform the physical stock count at the end of current period. 2. Verify purchases and issuance of stock with supporting documents occurred during the year. [Type the company address] Page 119

3. Finally match the opening balance with the closing balance of prior year. For noncurrent assets and liabilities some audit procedures may be performed by examining the accounting records and other information underlying the opening balances. In certain cases, the auditor may be able to obtain some evidence regarding opening balance through confirmation with third parties, for example, for long term debt and investments.

Prior period balances audited by a predecessor auditor In such a case the auditor should review the predecessor auditors working papers after considering the ethical requirement. The current auditor should also perform audit procedures regarding the professional competency of the predecessor auditor. If there was a modification in the predecessor auditors report the current auditor must evaluate the effect on the current years audit report. Audit conclusion and reporting If the auditor is unable to obtain sufficient appropriate audit evidence regarding the opening balances, the auditor shall express a qualified opinion or disclaim an opinion on the financial statements as appropriate. If the auditor concludes that the opening balances contain a misstatement that materially affects the current period financial statements, and the effect of the misstatement is not appropriately accounted for or not adequately presented or disclosed, the auditor shall express a qualified opinion or an adverse opinion as appropriate. Other Information in a Document Containing Audited Financial Statements ISA 720 What is other information? Other information is financial and non financial information other than the financial statements and the auditors report, which is included, either by law, regulation or customs, in a document containing audited financial statements and the auditors report thereon. Examples of other information 1. 2. 3. 4. 5. 6. 7. A report by management or the board of directors on operations. Financial summaries or highlights Employment data Planned capital expenditure Financial ratios Names of officers and directors Selected quarterly data.

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An inconsistency exists when other information contradicts information contained in the audited financial statements. A material inconsistency may raise doubt about the audit conclusions drawn from the audit evidence previously obtained and possibly, about the basis for the auditors opinion on the financial statements. Auditors responsibilities Auditors have no responsibility to report that other information is properly stated because an audit is only an expression of opinion on the truth and fairness of the financial statements. However, they may be engaged separately, or required by statute, to report on elements of other information. In any case, the auditors should give consideration to other information as inconsistencies with the audited financial statements may undermine their report. Access to other information Timely access to other information will be required. The auditor therefore must make arrangements with the client to obtain such information prior to the date of their report.

Auditors procedures when material inconsistencies arise (Other information obtained before the date of auditors report)? If on reading the other information, the auditor indentifies a material inconsistency, the auditor shall determine whether the audited financial statements or other information needs to be amended. If the amendment of the audited financial statements is necessary and management refuses to make the revision, the auditor shall modify the opinion. If the amendment of other information is necessary and management refuses to make the amendment, the auditor shall communicate this matter to those charged with governance and: 1. Include in the auditors report an Other Matter(s) paragraph describing the material inconsistency or, 2. Withhold the auditors report or, 3. Withdraw from the engagement where withdrawal is possible under applicable law or regulation. Auditors procedures when material misstatements of facts arise (Other information obtained before the date of auditors report)? A misstatement of facts in other information exists when such information, not related to matters appearing in the financial statements, is incorrectly stated. A material misstatement of fact may undermine the credibility of the document containing the audited financial statements. If the auditor becomes aware that other information contains material misstatement of fact than the auditor shall: 1. Discuss the matter with management. 2. When the matter is not resolved through discussion the auditor should request management to consult with a qualified third party, such as the entitys legal counsel and should consider the advice received. If the auditor concludes that there is material misstatement of fact in the other information which management refuses to correct, the auditor should discuss the matter with those charged with governance and obtain legal advice.

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Availability of other information after the date of the auditors report. If on reading the other information, the auditor identifies material inconsistencies or becomes aware of an apparent material misstatement of fact, the auditor would determine whether the audited financial statements or other information need revision. When revision of the audited financial statements is appropriate, the guidance in ISA 560 Subsequent Events would be followed. When the revision of other information is necessary and the entity agrees to make the revision, the auditor would carry out the audit procedures such as reviewing the steps taken by the management to ensure that the individuals in receipt of the previously issued financial statements, auditors report and the other information are informed of the revision. When the revision of the other information is necessary but management refuse to make the revision, the auditor should inform those charged with governance in writing of the auditors concern regarding other information and obtain legal advice. AUDIT RISK IN P2 STANDARDS CONSTRUCTION CONTRACTS IAS 11 From the auditors point of view, the % age of completion and the assessment of the overall profitability of the contract are particularly risky areas to audit, as they involves management exercising its judgment. The auditor will have to audit the calculation of attributable profit or loss and assess if it is reasonable. He will then have to verify all the movements on the statement of financial position to that calculation. The auditor should undertake the following procedures: 1. Obtain a copy of the calculation and check the additions and calculation. 2. Assess whether the basis of calculation is comparable with prior years. 3. He should then verify the figures in the calculation: o Revenue to certification of work completed to date o Total contract price to original contract o Cost of work completed to invoices also payroll/clock cards/wages o Payments on account to remittance advices 4. He should discuss with management if there is any chance of a loss arising on the contract. TANGIBLE NON CURRENT ASSETS IAS 16 Recognition The key risk in relation to initial recognition is of cost being incorrectly recognized as asset, when they should in fact have been expensed to the income statement. IAS 16 Property, plant and equipment lists the following as component of cost:

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1. Purchase price less any trade discount or rebate. 2. Import duties and non refundable purchase taxes. 3. Directly attributable costs of bring the asset to working condition for its intended use, e.g.: o The cost of site preparation o Initial delivery and handling cost o Installation cost o Testing o Professional fees (architects, engineers) 4. Initial estimate of the unavoidable cost of dismantling and removing the asset and restoring the site on which it is located.

However the following should not be included in the cost of the asset and should be recognised as an expense: o o Administration and other general overhead Initial operating losses before the asset reaches planned performance.

Valuation IAS 16 allows both cost model and fair value model of valuation of tangible non- current assets. Cost is straightforward to audit where as fair value may be straightforward to audit. Once company has revalued assets, it is required to continue revaluing them regularly so that the valuation is not materially different from the fair value at period end. Another audit risk is in respect of depreciation charged for the year. Depreciation can be verified by re performing the depreciation calculations such as through proof in total check. Depreciation rate also creates audit risk as it depends upon useful life of the asset. This is determined by management based on expectations of how long the asset is expected to be used in the business. The auditor will audit this by scrutinizing those expectations and verifying them where possible for example, to the minutes of the meeting where management decided to buy the asset, to capital replacement budget, to past practice in the business. Impairment An asset is impaired when its carrying amount (depreciated cost or depreciated value) exceeds its recoverable amount. The recoverable amount of an asset is the higher of its fair values less cost to sell and its value in use. Value in use is the present value of the future cash flows expected to be derived from an asset. Management is required to determine if there is any indication that the assets are impaired. The auditors will consider whether there are any indicators of impairment when carrying out risk assessment procedures. They will use the same impairment criteria laid out in IAS 36 as management do. If the auditors believe that impairment is indicated, they should request that management show them the impairment review that has been carried out. If no impairment review has been carried out, then the auditors should discuss the need for one with management, and if management refuses to carry out an impairment review, qualify their opinion on [Type the company address] Page 123

grounds of a material misstatement in respect of IAS 36 as a result of management not carrying out an impairment review. For auditors, the key risk is that recoverable amount requires estimation. It may not have been necessary for the management to estimate both fair value and value in use, because if one is higher than the carrying amount, then the asset is not impaired. If it is not possible to make a reliable estimate of net realizable value than it is necessary to calculate value in use. Net realizable value is only calculable if there is active market for the goods. Cost to sell such as taxes can be recalculated by applying the appropriate tax rate to the fair value itself. Delivery cost can be verified by comparing costs with published rates by delivery companies, for example, on the internet. If the management has calculated value in use then the auditor will have to audit that calculation. The following procedures will be relevant: Obtain managements calculation of value in use Re perform calculation to ensure that it is mathematically correct Compare the cash flow projection with recent budgets and projections approved by the board Calculate/obtain long term average growth rate and ensure that it is reasonable Refer to competitors published information Compare to previous calculations Ensure that the cost/income from disposal of the asset at the end of its life has been included Ensure that cash flows from financing activities and income tax have been excluded Compare discount rate used to published market rates to ensure that it correctly reflects the return expected by the market

If the assets in impaired and has been written down to recoverable amount, the auditors should review the financial statements to ensure that the writ down has been carried out correctly and the IAS 36 disclosures have been made correctly. Held for sale non-current assets IFRS 5 requires that non-current assets that are held for sale should be presented separately in the statement of financial position. A number of detailed criteria must be met: The asset must be available for immediate sale in its present condition The sale must be highly probable

For sale to be highly probable the following must apply: Management must be committed to a plan to sell the asset There must be active plan to locate a buyer The asset must be marketed at a price that is reasonable in relation to its current fair value The sale should be expected to take place within one year from the date of classification It is unlikely that significant changes to the plan will be made or that the plan will be withdrawn

A non-current asset held for sale should be measured at the lower of its carrying amount and fair value less cost to sell. [Type the company address] Page 124

An impairment loss should be recognized where fair value less cost to sell is lower than the carrying amount Non-current assets should not be depreciated even if they are still being used by the entity. The following audit procedures will therefore be relevant: Confirm the asset meets the definition of an asset held for sale: o Discuss with the management the availability of asset for sale o Assess management commitment, e.g. board minutes o Evaluate and assess practical steps being taken to sell the asset e.g. appropriate real estate agents appointed o Determine when the sale is expected to take place by assessing progress to date o Determine and assess the basis on which sale price has been set o Discuss with management any significant changes to plans Confirm that asset has been valued as held for sale in accordance with IFRS 5 and assess how fair value has been determined Check that asset has not been depreciated from the date of reclassification Confirm separate disclosure in accordance with IFRS 5.

AUDIT RISK IN P2 STANDARDS INTANGIBLE NON-CURRENT ASSETS - IAS 38 The key audit risk is whether the item meets the criteria to be recognized as an intangible asset or not. An intangible asset is an identifiable non-monetary asset without physical substance. It may be held for using in the production and supply of goods or services or for rentals to others or for administrative purposes. The asset must be: Controlled by the entity as a result of events in the past, and Something from which the entity expects future economic benefits to flow.

Important Internally generated goodwill will not be recognized as an asset. IAS 38 forbids the capitalization of internally generated brands. The following procedures are necessary: Prepare analysis of movement on cost and amortization accounts Obtain confirmation of all patents and trademarks held by a patent agent Verify payment of annual renewal fees Review specialist valuation of intangibles such as o Qualification of valuer o Scope of work o Assumptions and method used Inspect purchase agreement Confirm purchases have been verified [Type the company address] Page 125

Review amortization for clerical accuracy Confirm amortization rates are reasonable

The following procedures are relevant specifically for goodwill: Agree consideration to sales agreement Confirm valuation of assets acquired Check purchased goodwill is calculated correctly Check goodwill does not include non purchased goodwill Review amortization calculation for accuracy Review amortization rate for reasonableness Review impairment review for reasonableness Review useful life for reasonableness

Research and Development cost Research: is original and planned investigation undertaken with the prospect of gaining new scientific or technical knowledge and understanding. Development: Is the application of research finding for the development of new or improved goods and services prior to the commercial production or use. Important: Expenditure on research should be expensed out and not capitalized. Expenditure on development may be capitalized subject to the fulfillment of following criteria. Completion of the asset is technically feasible. The business will be able to complete the asset and use or sell it. The business can demonstrate how future economic benefit will be generated. Adequate technical, financial and other resources will be available to complete the asset Expenditure attributable to the development of asset can be measured reliably

Following audit procedures are necessary: Check project is clearly defined Check related expenditures can be separately identified Examine market research reports, feasibility studies, budgets and forecasts Consult clients technical experts Review budgets revenues and costs by examining results to date, production forecasts, advance orders and discussion with directors Review calculations of future cash flows to ensure resources exists to complete the project Review previously deferred expenditures to ensure IAS 38 criteria still justified Check whether amortization commences with production and charged on systematic basis

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FINANCIAL INSTRUMENTS IFRS 7 and IFRS 9 Financial instruments, particularly complex ones, increases audit risk. Factors which increase audit risk include the following: Lack of management understanding of financial instruments and therefore inadequate management control Inappropriate classification of financial instruments. This will affect gearing and therefore the risk profile of the business. This is particularly an issue where hybrid or compound instruments have been issued with both debt and equity elements. The use of fair values involves the use of valuation techniques including market estimates. Recognition of the costs associated with the instrument is not necessarily straight forward. For example, the discount on discounted debenture should be treated as a part of the overall cost of the instrument and recognized over the life of the debenture

The following audit procedures will normally apply: Review the terms of the financial instrument and confirm that they have been classified in accordance with their substance. Enquire of management as to their intention i.e. to sell in the short term or hold to maturity. Corroborate any statement by a review of events after the reporting period, forecast and projection. For listed shared the auditor can check the company exists by reviewing stock exchange listing. Unlisted companies can be verified by simple enquiries from the company registry. Confirm that all financial assets and liabilities have been valued at fair value where this is required by IFRS 9. Agree fair value to transaction price. Where part of the consideration has been given for something other than financial instrument, assess valuation technique adopted, e.g. discounting of future cash flows. Where there is an active market agree fair value to quoted market price. Where there is no active market assess the valuation technique adopted by management and any assumptions made. Ownership of shares in another company should be checked to the share certificate. The share certificates may be kept in a bank or at a broker, in which case the auditor should confirm with these parties that the share certificate exists. Check disclosure complies with IFRS 7. This includes e.g. qualitative disclosures about exposure to risk and risk management, and quantitative disclosure of summary data about exposures.

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FOREIGN EXCHANGE RATES IAS 21 Individual Company The most immediate audit risk is that entity fails to comply with the accounting rquirements of IAS 21 The Effects of Changes in Foreign Exchange Rates. For an individual company conducting trade in foreign currencies there are two separate issues: conversion and translation. Conversion is relatively easy and relates to an entity conducting transactions in a foreign currency and which incurs exchange gain or loss in relation to these transactions. The rule is simple: the gain or loss on conversion is recognized directly in profit and loss in the period in which it occurs. The principal risk here is of wrong rate being used, resulting in misstatement of the gain or loss in the financial statements. Translation is more complex. Translation is required at the end of an accounting period when a company still holds assets or liabilities which were obtained or incurred in foreign currency. IAS 21 distinguishes between monetary items and non monetary items. The basic rule is that monetary items e.g. cash and receivables should be retranslated using the rate rule at the end of each accounting period. Non-monetary items are left at the amount recognized at the date of transaction. Audit procedures here would therefore include: Groups It is also possible that parent company may have overseas subsidiaries. It must translate the financial statements of those operations in to its own reporting currency before they can be consolidated in to group accounts. There are two methods of achieving this. The method depends on whether the foreign operation has the same functional currency as the parent. Same functional currency Income statement Non monetary items Monetary items Exchange difference Transaction or average rate (where there is no significant fluctuations) Historic rate Closing rate Report as part of profit or loss for the year Check that monetary items included in the statement of financial position at the yearend are translated at the closing rate of exchange. Check that non-monetary items are translated at the historical rate of exchange. Check that items are included in the statement of comprehensive income at the historical rate of exchange.

Different functional currency

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Assets and liabilities

Income statement Exchange differences

Translate at the closing rate (The balancing figure on the translated statement of financial position represents the reporting entitys net investment in foreign operation Transaction or average rate (where there is no significant fluctuations) Taken to equity

Other issues 1. 2. 3. 4. Hyper inflationary trends Subsidiary may have been audited by component auditors Different accounting frameworks Possible difficulty in the parent being able to exercise control e.g. due to political instability or laws and regulations 5. Currency restrictions limiting payment of profits to the parent

REVENUE IAS 18 Revenue is commonly audited by analytical review. This is because revenue should be predictable and there are good bases on which to base analytical review, such as: Plenty of information, for example, last years account, budget, monthly analyses Logical relationships with items such as inventory and receivables

Unless complex transactions arise where revenue is not as clear cut as a product being supplied and invoiced for, revenue recognition is generally not an issue. However in some companies, for example, those that deal primarily in construction contracts, revenue recognition can be a material issue. Example of industries where this might be true: Building industry Engineering industry

In such industries, auditing revenue recognition will be part of auditing construction contracts. The auditor should: Consider whether the basis for recognition is reasonable Agree revenue recognized to relevant documents (for example work certificates or contracts)

However, it should not be thought that revenue recognition is generally a low risk area to audit. Far from it: revenue recognition is one of the commonest areas of fraudulent financial reporting. Indeed, ISA 240 The Auditors responsibilities Relating to Fraud in An Audit of Financial Statements states that the auditor should presume that there is a risk of fraud in relation to revenue recognition and should obtain an understanding of the controls related to those risks.

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The following recognition criteria are important: Sale of Goods The entity should only recognize when: Significant risks/reward of ownership of goods are transferred It has no continuing managerial involvement over goods Revenue can be measured reliably Probable that economic benefits will flow to enterprise Cost incurred can be measured reliably

Rendering of Services An entity should recognize revenue depending on the stage of completion of the transaction. Outcome can only be reliably estimated when: Interest Time proportion basis Royalties Accrual basis, per agreement Dividends When shareholders gain right to receive payments Revenue can be measured reliably Probable economic benefits will flow to the entity Stage of completion at year end can be measured reliably Cost incurred can be measured reliably

GOVERNMENT GRANTS IAS 20 Government Assistance: Action by government designed to provide an economic benefit specific to an entity or range of entities qualifying under certain criteria. Government Grant: Assistance by government in the form of transfers of resources to an entity in return for past or future compliance with certain conditions relating to the operating activities of the entity. It excludes transactions with government which cannot be distinguished from the normal trading transactions of the entity. Grants related to assets: Government grant whose primary condition is that an entity qualifying for them should [Type the company address] Page 130

purchase, construct or otherwise acquire long term assets. Grants related to income: Government grant other than those related to assets. Revenue grants are relatively easy to audit as compared to capital grants. Following is the summary of accounting treatment in this regard: Recognize government grant and forgivable loans once conditions complied with and receipt/ waiver is assured. Grants for depreciable assets should be recognized as income on the same basis as the asset is depreciated. Grants for non-depreciable assets should be recognized as income over the periods in which the cost of meeting obligation is incurred. A grant may be split into parts and allocated on different bases where there are a series of conditions attached. Where related costs have already been incurred, the grant may be recognized as income in full immediately. A grant in the form of non-monetary asset shall be valued at fair value. Grants related to assets may be presented in the statement of financial position either as a separate credit or deducted in arriving at the carrying value of the asset. Grants related to income may be presented in the statement of comprehensive income either as a separate credit or deducted from the related expense. Repayment of government grants should be accounted for as a revision of an accounting estimate.

AUDIT RISKS IN P2 STANDARDS LEASES IAS 17 The main audit risk is in respect of classification of lease as either operating or finance. Accounting treatment IAS 17 Leases contains detailed guidance on the classification and recognition of leased assets. There are several matters to consider: Whether the leases are correctly categorised as finance leases or operating leases. This depends on whether the risk and reward of ownership have passed to the lessee from the lessor. The leases should only be recognised on the statement of financial position if lessee has the risk and reward of ownership. Indicators of risk and reward passing to Lessee would include: Lessee is responsible for repairs and maintenance of the assets A bargain purchase option exists The lease period is for most of the expected useful life of the assets The present value of the minimum lease payments is substantially all of the fair value of the asset. Whether the amounts capitalised are solely in respect of the buildings element of the leases. IAS 17 prohibits the recognition of leases of land as finance leases; all land leases must be classified and accounted for as operating leases. Leases of land and buildings should therefore be unbundled and the two elements accounted for separately. The impact of the leases on the income statement must be considered. A finance charge should be calculated and expensed each accounting period, using the actuarial method of calculation (or the sum of digits method as an approximation). In addition, leased assets should be depreciated over the shorter of the lease term and the economic [Type the company address] Page 131

useful life of the asset. Presentation and disclosure The finance lease payable should be split between current and non-current liabilities in the statement of financial position. IAS 17 requires extensive disclosure relating to leases in the notes to the financial statements, including an analysis showing the amounts outstanding under the lease, and the timing of the cash outflows.

Audit evidence A review of the lease contract (using a copy of the lease obtained from the lessor) including consideration of the major clauses of the lease which indicate whether risk and reward has passed to Lessee. A calculation of the present value of minimum lease payments and comparison with the fair value of the assets at the inception of the lease (the fair value should be obtained from the lease contract). A recalculation of the finance charge expensed during the accounting period, and agreement of the interest rate used in the lease contract. Agreement to the cash book of amounts paid to the lessor i.e. deposit and instalments paid before the year end. A recalculation of the depreciation charged, and agreement that the period used in the calculation is the shorter of the lease term and the useful life of the assets. Confirmation using the lease contract that the amounts capitalised relate only to the buildings element of the lease. For the land elements which should be treated as operating leases, a recalculation of the lease expense recognised in the income statement (this should be calculated on a straight-line basis over the lease term). A recalculation and confirmation of the split of the total finance lease payable between current and non-current liabilities. A confirmation of the adequacy of the disclosure made in the notes to the financial statements, and agreement of the future payments disclosed to the lease contract.

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PROVISIONS AND CONTINGENCIES IAS 37 A provision is accounted for as a liability where as contingencies should be disclosed, so the auditors must ensure they have been classified correctly according to IAS 37. From the auditors point of view following contracts are risky and difficult to audit: Provision for restructuring A restructuring is a programme that is planned and is controlled by management and materially changes either: The scope of the business undertaken by an entity The manner in which that business is conducted

The IAS gives the following example of events that would fall under this definition The sale or termination of a line of business The closure of business location in a country or region or the relocation of business activities from one country region to another Changes in management structure Fundamental reorganizations that have a material effect on the nature and focus of the entitys operation

In order to make a provision an obligation must exist at the period end. In this context, a constructive obligation exists only in the following circumstances: An entity must have a detailed formal pan for restructuring It must have raised a valid expectation in those affected that it will carry out the restructuring by starting to implement that plan or announcing its main features to those affected by its.

A management or board decision would not normally be sufficient Onerous contracts An onerous contract is a contract in which the unavoidable cost of meeting the obligation under the contract exceed the economic benefits expected to be received under it. An example might be a vacant leasehold property. If an entity has a contract that is onerous a provision must be made for the net loss. Decommissioning provisions A provision is only recognised from the date on which the obligating event occurs.

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For example when an oil company initially purchases an oil field it is put under a legal obligation to decommission the site at the end of its life. The obligation exists therefore on initial expenditure on the field and therefore the liability exists immediately. The IAS also takes into view that the decommissioning costs may be capitalised as an asset representing future access to oil reserves (i.e. an asset and a provision are recognised). Contingent assets Contingent assets are only very rarely recognised, as IAS 37 requires an entity to be virtually certain that it will receive an inflow of economic benefits. The recognition of contingent assets in financial statements therefore represents a risk for auditors, as it is only in rare circumstances that they should be recognized. Audit procedures The audit tests that should be carried out on provisions and contingent assets and liabilities are as follows: Obtain detail of all provisions which have been included in the accounts and all contingencies that have been disclosed Obtain a detailed analysis of all provisions showing opening balances, movements and closing balances. Determine for each material provision whether the company has a present obligation as a result of past events by: Reviewing of correspondence relating to them Discussion with directors, have they created a valid expectation in other parties that they will discharge the obligation? Determine for each material provision whether it is probable that a transfer of economic benefits will be required to settle the obligation by: Checking whether any payments have been made after the year end Reviewing correspondence with solicitors, banks, customers, the insurance company and suppliers both pre and post year end Sending a letter to the solicitor to obtain their views Discussing the position of similar past provisions with directors Considering the likelihood of reimbursement Compare the amount provided with any post year end payments and with any amount paid in past for similar items In the event that it is not possible to estimate the amount of provision, check that this contingent liability is disclosed in the accounts Consider the nature of the clients business. Would you expect to see any other provision, for example warranties? Consider whether disclosure of provisions, contingent liabilities and contingent assets are correct and sufficient Obtain written representation letter from the management regarding the completeness of information provided to auditors in respect of provisions and contingencies. EMPLOYEE BENEFITS IAS 19 Audit Risk Area Related Audit Procedure

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Scheme assets (including quoted and unquoted securities, debt instruments, properties) Scheme liabilities

Ask directors to reconcile the scheme assets valuation at the scheme year end date with the asset valuation at the reporting entitys date being used for IAS 19 purposes Obtain direct confirmation of the scheme assets from the investment custodian Consider requiring scheme auditors to perform procedures Auditors must follow the principles of ISA 620 using the work of an expert to assess whether it is appropriate to rely n the actuarys work Specific matters includes: The source data used The assumptions and method used The results of actuaries work in the light of auditors knowledge of the business and results of other audit procedures Actuarial source data is likely to include: Scheme member data Scheme asset information

Actuarial assumptions (for example mortality rates, termination rates, retirement age and changes in salary and benefits levels)

Items charged to operating profits (current service cost, past service cost, gains and losses on curtailment and settlements, interest) DEFERRED TAX IAS 12

Auditors will not have the same expertise as actuaries and are unlikely to challenge the appropriateness and reasonableness of the assumptions. Auditors can however through discussion with directors and actuaries: Obtain general understanding of the assumptions and review the process used to develop them Compare the assumptions with those which the directors have used in prior years Consider whether based on their knowledge of the reporting entity and the scheme and on the results of other audit procedures the assumptions appear to be reasonable and compatible with those used elsewhere in the preparation of the entitys financial statements Obtain written representations from directors confirming that the assumptions are consistent with their knowledge of the business Consider with directors and actuaries the factors affecting (for example, a scheme closed to new entrants may see an increase year on year as a percentage of pay with the average age of the work force increasing)

In practice it Is rare for a deferred tax asset to be recognized, as the asset only exists insofar as the entitys tax liability can be reduced in the future, which in turn depends on the entity being profitable enough to a have a tax liability and thus to be able to use any tax losses. From the auditors perspective deferred tax assets are risky because a significant degree of judgment must be [Type the company address] Page 135

exercised in determining whether tax losses will infact result in reduced tax liabilities in the future. This is an illustration of the importance of the auditor approaching the audit with professional skepticism. Important Deferred tax assets and liabilities cannot be discounted Deferred tax assets and liabilities are measured at the tax rates expected to apply to the period when the asset is realised or liability settled, based on the tax rates and tax laws that have been enacted or substantively enacted by the end of the reporting period. BORROWING COST IAS 23 Following are the important aspects for the auditor: o o o o o o Borrowing cost should be capitalized as part of the cost of the asset if they are directly attributable to acquisition/construction/production. Other borrowing costs must be expensed out. Borrowing costs eligible for capitalization are those that would have been avoided otherwise Amount of borrowing cost available for capitalization is actual borrowing costs incurred less any investment income from temporary investment of those borrowings For borrowing obtained generally, apply the capitalization rate to the expenditure on the asset (weighted average borrowing cost). Capitalization is suspended if active development is interrupted for extended periods.(Temporary delays/ or technical/administrative work will not cause suspension Capitalization ceases when physical construction of the asset is completed

The following should be disclosed as a minimum: Accounting policy noted Amount of borrowing cost capitalized during the period Capitalization rate

P2 QUESTIONS December 2007 Question You are the manager responsible for the audit of Sci-Tech Co, a pharmaceutical research company. You are planning the substantive audit procedures to be used in the forthcoming audit of intangible assets. Relevant extracts from the financial statements are as follows: 30 November 2007 (draft) $000 30 November 2006 $000

Balance Sheet Intangible assets: Development costs

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Cost Accumulated amortisation

Total assets Income Statement Revenue Operating expenses include: Research costs Amortisation of development costs Salary expenses Profit before tax

2,750 (1,450) 1,300 18,500

2,000 (850) 1,150 15,000

4,500

3,800

160 600 380 1,800

200 450 400 1,530

The following is an extract from the notes to the draft financial statements: Expenditure on product development is capitalised as an intangible asset from the point at which it is probable that future economic benefits will result from the product once completed. Any product development costs which do not meet the above criteria are expensed as incurred as research costs. Two products are currently in the development phase: Medex, an antiseptic cream; and Flortex, a medicine to reduce the symptoms of fever. Amortisation of development costs commences with commercial production, the amortisation period being the estimated life span of the product. Currently two products are being amortised over the following periods: 1. Plummet Cold Cure five years 2. Blingo Cough Cure three years.

Required (i) (ii) (ii) Explain the matters you should consider to determine whether capitalised development costs are appropriately recognised; and (5 marks) Describe the evidence you would seek to support the assertion that development costs are technically feasible. (3 marks) Describe the audit procedures you should perform to determine the validity of the amortisation rate of five years being applied to development costs in relation to Plummet. (5 marks)

Answer (i) Materiality The net book value of capitalised development costs represent 7% of total assets in 2007 (2006 77%), and is therefore material. The net book value has increased by 13%, a significant trend. The costs capitalised during the year amount to $750,000. If it was found that the development cost had been inappropriately capitalised, the cost should instead have been expensed. This would reduce profit before tax by $750,000, representing 42% of the years profit. This is highly material. It is therefore essential to gather sufficient evidence to support the assertion that development costs should be recognised as an asset. [Type the company address] Page 137

In 2007, $750,000 capitalised development costs have been incurred, when added to $160,000 research costs expensed, total research and development costs are $910,000 which represents 202% of total revenue, again indicating a high level of materiality for this class of transaction. Relevant accounting standard Development costs should only be capitalised as an intangible asset if the recognition criteria of IAS 38 Intangible Assets have been demonstrated in full: Intention to complete the intangible asset and use or sell it Technical feasibility and ability to use or sell Ability to generate future economic benefit Availability of technical, financial and other resources to complete Ability to measure the expenditure attributable to the intangible asset. Research costs must be expensed, as should development costs which do not comply with the above criteria. The auditors must consider how Sci-Tech Co differentiates between research and development costs.

(ii) Evidence supporting the assertion that development costs are technically feasible would include the following: Review the results of scientific tests performed on the products, for example, the results of animal or human testing of the products. Discuss any detrimental results of these tests, e.g. harmful side effects, with the scientists working on the project to determine what corrective action is being taken. Enquire whether any licences necessary for continued development and/or commercial production have been granted by the appropriate regulatory body. Compare expected to actual development costs incurred per product being developed. Where actual costs are in excess of expected costs investigate whether the extra costs have been incurred in order to make good any problems identified in the development process. Review board minutes for relevant discussion of the product development taking place during the year. (iii) Audit procedures to determine the validity of the amortisation rate of five years being applied to development costs in relation to the product Plummet would include the following: Obtain the papers documenting market research carried out on Plummet. Review and ascertain that the market research supports a product life span of five years. Review actual sales patterns since the launch of Plummet and compare to the predicted sales per the market research document. Read the assumptions underpinning the market research sales projections, and consider whether these assumptions agree with the auditors understanding of the business. Discuss sales trends with the sales/marketing directors and ascertain whether sales are in line with managements expectations. [Type the company address] Page 138

 Read correspondence with retail outlets to ensure there is continued support for selling Plummet. Obtain marketing/advertising budgets and ascertain enough expenditure is continuing on Plummet to support continued sales.

June 2009 Question 3 Robster Co is a company which manufactures tractors and other machinery to be used in the agricultural industry. You are the manager responsible for the audit of Robster Co, and you are reviewing the audit working papers for the year ended 28 February 2009. The draft financial statements show revenue of $105 million, profit before tax of $32 million, and total assets of $45 million. One matter has been brought to your attention by the audit senior which relate to asset recognised in the statement of financial position for the first time this year: Leases In July 2008, Robster Co entered into five new finance leases of land and buildings. The leases have been capitalised and the statement of financial position includes leased assets presented as non-current assets at a value of $36 million, and a total finance lease payable of $32 million presented as a non-current liability. Required: In your review of the audit working papers, comment on the matters you should consider, and state the audit evidence you should expect to find in respect of the leases (8 marks) Answer Leases Matters to consider Materiality The amounts recognised in the statement of financial position in relation to the leases are material to the financial statements. The amount recognised in non-current assets amounts to 8% of total assets, and the total finance lease payable recognised amounts to 71% of total assets. Accounting treatment [Type the company address] Page 139

IAS 17 Leases contains detailed guidance on the classification and recognition of leased assets. There are several matters to consider: Whether the leases are correctly categorised as finance leases or operating leases. This depends on whether the risk and reward of ownership have passed to Robster Co (the lessee) from the lessor. The leases should only be recognised on the statement of financial position if Robster Co has the risk and reward of ownership.

Indicators of risk and reward passing to Robster Co would include: Robster Co is responsible for repairs and maintenance of the assets A bargain purchase option exists The lease period is for most of the expected useful life of the assets The present value of the minimum lease payments is substantially all of the fair value of the asset. Whether the amounts capitalised are solely in respect of the buildings element of the leases. IAS 17 prohibits the recognition of leases of land as finance leases, all land leases must be classified and accounted for as operating leases. Leases of land and buildings should therefore be unbundled and the two elements accounted for separately. The impact of the leases on the income statement must be considered. A finance charge should be calculated and expensed each accounting period, using the actuarial method of calculation (or the sum of digits method as an approximation). In addition, leased assets should be depreciated over the shorter of the lease term and the economic useful life of the asset. Presentation and disclosure The finance lease payable recognised of $32 million should be split between current and non-current liabilities in the statement of financial position. IAS 17 requires extensive disclosure relating to leases in the notes to the financial statements, including an analysis showing the amounts outstanding under the lease, and the timing of the cash outflows. Audit evidence A review of the lease contract (using a copy of the lease obtained from the lessor) including consideration of the major clauses of the lease which indicate whether risk and reward has passed to Robster Co. A calculation of the present value of minimum lease payments and comparison with the fair value of the assets at the inception of the lease (the fair value should be obtained from the lease contract). A recalculation of the finance charge expensed during the accounting period, and agreement of the interest rate used in the lease contract. Agreement to the cash book of amounts paid to the lessor i.e. deposit and instalments paid before the year end. A recalculation of the depreciation charged, and agreement that the period used in the calculation is the shorter of the lease term and the useful life of the assets. Confirmation using the lease contract that the amounts capitalised relate only to the buildings element of the lease. For the land elements which should be treated as operating leases, a recalculation of the lease expense recognised in the income statement (this should be calculated on a straight-line basis over the lease term). A recalculation and confirmation of the split of the total finance lease payable between current and non-current liabilities. A confirmation of the adequacy of the disclosure made in the notes to the financial statements, and agreement of the future payments disclosed to the lease contract.

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PROFESSIONAL LIABILITY The auditor may have professional liability in case of: 1. Under statutory law 2. Negligence

1. Professional Liability under statutory law: For example: Under insolvency legislation the auditor may be charged with criminal and civil offences in connection with winding up of the company. In case of insider dealing the auditor may be charged with criminal offence since they are privy to inside information. The auditor may be charged with criminal offence when they knowingly hide money laundering.

2. Negligence Concept of negligence provides compensation to a person who has suffered a loss due to another persons wrongful neglect. To succeed in an action for negligence, an injured party must prove three things: 1. A duty of care enforceable by law exists. 2. This duty of care was breached. 3. The breach caused the injured party a loss. Who might bring an action for negligence against the auditor? The parties likely to bring action for negligence against the auditor include: 1. 2. 3. 4. The company. Shareholders. The bank. Other lenders etc.

Important: In case of audit client auditor owes a duty of care automatically under law as it has a direct contract with the audit client. In all other cases it has to be judged whether duty of care exists or not. For example:

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1. Banks usually insert in their contract for financing with the company that they will refer to the audited accounts. Merely insertion of such a clause may not establish that the duty of care exists unless it is specifically known to the auditor. However having known the fact that the bank will refer the audited accounts the auditor disclaims such a liability towards bank in any way such as by including paragraph in an audit report then it may also be said that duty of care do not exists. 2. Individual investor cannot bring action against the auditor if he has sold or purchased the audit clients share on the basis of wrong opinion given by the auditor. In such a case a duty of care do not established. If one says that in such a case a duty of care exists then there is no limit on the auditors liability. Hence: Audit Client Automatic Must be proved Must be proved Other Parties Must be proved Must be proved Must be proved

Duty of care exists? Breached? Loss arising?

Litigation avoidance procedures: Includes: 1. 2. 3. 4. Proper client acceptance procedures should be performed. Audit work should be performed in accordance with professional standards and best practices. The audit firm should have its own quality control procedures. There should be proper disclaimer of the facts which makes the auditor over committed.

Out of Court Settlements: Many liability claims are settled out of court. Advantages: 1. It saves time and cost. 2. Avoids damaging audit firms reputation. Disadvantage is may be unacceptable to the insurance company. Professional Indemnity Insurance: Professional indemnity insurance is insurance against civil claims made by clients and third parties arising from work undertaken by the firm. Fidelity Guarantee Insurance: Fidelity Guarantee Insurance is insurance against liability arising through any acts of fraud or dishonesty by any partner, director or employee in respect of money or goods held in trust by the firm. ACCA requires that audit firm should have professional indemnity insurance. If the firm has employees, it must also have fidelity guarantee insurance. The cover must continue to exist for six years after a member ceases to engage in public practice. [Type the company address] Page 142

Advantages of Insurance: 1. It provides funds for an innocent party to be compensated. 2. It provides some protection against bankruptcy in the event of successful litigation against the firm. Disadvantages of Insurance: 1. Partners may become more care free. 2. Regular cost of premium for the firm.

Example of Standard Disclaimer Paragraph Our report will be made solely to the Members of the Company as prescribed in the statute applicable to that Company. Our audit work will be undertaken so that we report on the Companys audited financial statements and for no other purpose. In those circumstances, to the fullest extent permitted by law, we will not accept or assume responsibility to anyone other than the Company for our audit, for the audit report, or for the opinions we form.

June 2008 Question 5 (c) In the context of a standard unmodified audit report, describe the content of a liability disclaimer paragraph, and discuss the main arguments for and against the use of a liability disclaimer paragraph. (5 marks) Answer It has become increasingly common for audit firms to include a disclaimer paragraph within the audit report. However, it is not a requirement of auditing standards and individual audit firms need to assess the advantages and disadvantages of the use of a disclaimer paragraph. The wording is used to state the fact that the auditors report is intended solely for the use of the companys members as a body, and that no responsibility is accepted or assumed to anyone other than the company and the companys members as a body. The main perceived advantage is that the disclaimer should help to reduce the exposure of the audit firm to liability claims from anyone other than the company or the companys body of shareholders. The disclaimer makes it clear that the audit firm reports only to those who appointed the firm, i.e. the members of the company, and this may make it

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more difficult for the audit firm to be sued by a third party. It is also argued that the use of a disclaimer could help to bridge the expectation gap by providing a clearer indication of the responsibility of the auditor. In this way the audit firm can manage its risk exposure in an increasingly litigious environment. However, it can be argued that a disclaimer does not necessarily work to protect an audit firm. Each legal case has individual circumstances, and while a disclaimer might protect the audit firm in one situation, equally it may not offer any protection where the facts of the case are different. In addition, it is often argued that if an audit firm conducts an audit using full due care and diligence, there is no need for a disclaimer, as a high quality audit would be very unlikely to lead to any claims against the audit firm. Consequently, it could be argued that the use of disclaimers as a means to limit liability could permit low quality audits to be performed, the auditors being confident that legal cases against them are restricted due to the presence of a disclaimer within the audit report.

June 2010 Question 5 (b) You are responsible for providing direction to more junior members of the audit department of your firm on technical matters. Several recent recruits have asked for guidance in the area of auditors liability. They are keen to understand how an audit firm can reduce its exposure to claims of negligence. They have also heard that in some countries, it is possible to restrict liability by making a liability limitation agreement with an audit client. Required: (i) Explain FOUR methods that may be used by an audit firm to reduce exposure to litigation claims; (4 marks) (ii) Assess the potential implications for the profession, of audit firms signing a liability limitation agreement with their audit clients. (6 marks)

Answer

(i) All audit firms want to avoid litigation, due to the bad publicity that is likely to follow, the financial consequences, and the potential collapse of the audit firm. There are several ways that an audit firm can reduce its exposure to claims. Client acceptance procedures Firms should carefully assess the risk associated with potential audit clients. Screening procedures should be used to identify matters that create potential exposure for the audit firm. For example, it would be unwise to take on a new client with significant going concern problems. The issue is that a client should only be accepted if the associated risk can be managed to an acceptably low level given the skills and resources of the audit firm.

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Proper use of engagement letters The engagement letter should be used to clearly state the responsibilities of the auditor, and of management. As it forms a contract between the audit firm and the client, it should be updated on an annual basis, with care being taken to ensure the client is fully aware of any changes in the scope of the audit, or the reporting responsibilities of the audit firm.

Performance and documentation of audit work Audit firms should ensure that professional standards are maintained, and that International Standards on Auditing (ISAs) are adhered to. It is crucial that full documentation is maintained for all aspects of the audit, including planning, evaluation of evidence, and consideration of ethical issues. A claim of negligence is unlikely to be successful if the audit firm has documentary evidence that ISAs have been followed. Quality control Firms must ensure they have implemented firm-wide quality control procedures, as well as procedures applicable to the individual audit engagement. Quality control acts as an internal control for the audit firm, helping to ensure that ISAs and internal audit methods have been followed at all times. External consultations Firms should make use of external specialists when the need arises, for example obtaining legal advice where appropriate, to ensure that the auditors actions are acceptable within the legal and regulatory framework. Disclaimers In recent years it has become common in some jurisdictions for audit firms to include a disclaimer paragraph in the audit report. This is an attempt to restrict the duty of care of the audit firm to the shareholders of the company, thereby attempting to restrict legal liability to that class of shareholders. Disclaimers, however, may not always be effective. Tutorial note: More than the required numbers of points have been covered in the answer. Credit would be awarded for discussions of other, relevant means of limiting exposure to liability, such as the need for adequate Professional Indemnity Insurance. (ii) A liability limitation agreement is a contractual limitation of the auditors liability to a company. There are several possible implications for the audit profession which are discussed below. Audit quality One of the main arguments against the use of such agreements is that audit quality could suffer as a result. The argument is that auditors could become less concerned with the quality of their work, in the knowledge that if there was a claim against them, the financial consequences are limited. Value of the audit opinion As a consequence of the point above, many argue that users of the financial statements will place less reliance on the audit opinion, resulting in less credible financial statements.

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Pressure on audit fees It is considered that firms may be under pressure from clients to reduce their audit fees. This is a response to the fact that if the audit firm has reduced its risk exposure, then the fee for providing the audit service should be reduced. Competition in the audit market The ability to set a cap on auditors liability could distort the audit market. Bigger audit firms may have the ability to set a high cap, which creates a disadvantage to smaller audit firms. However, it can be argued that the ability to set a cap actually helps the audit market, by protecting firms and making collapse less likely, and can promote competition between the larger firms.

ISAE 3400 - The Examination of Prospective Financial Information Prospective Financial Information Prospective financial information means financial information based on assumptions about events that may occur in the future and possible actions by an entity. It is highly subjective in nature and its preparation requires the exercise of considerable judgment. Prospective financial information can be in the form of a forecast, a projection or a combination of both, for example, a one year forecast plus a five year projection. Forecast Forecast means prospective financial information prepared on the basis of assumptions as to future events which management expects to take place and the actions management expects to take as of the date the information is prepared (best-estimate assumptions). Projection Projection means prospective financial information prepared on the basis of: (a) Hypothetical assumptions about future events and management actions which are not necessarily expected to take place, such as when some entities are in a start-up phase or are considering a major change in the nature of operations; or (b) A mixture of best-estimate and hypothetical assumptions.

Prospective financial information can include financial statements or one or more elements of financial statements and may be prepared: As an internal management tool, for example, to assist in evaluating a possible capital investment; or For distribution to third parties in, for example: A prospectus to provide potential investors with information about future expectations. An annual report to provide information to shareholders, regulatory bodies and other interested parties. A document for the information of lenders which may include, for example, cash flow forecasts.

Management Responsibilities Management is responsible for the preparation and presentation of the prospective financial information, including the [Type the company address] Page 146

identification and disclosure of the assumptions on which it is based. The auditor may be asked to examine and report on the prospective financial information to enhance its credibility whether it is intended for use by third parties or for internal purposes. Auditors Responsibilities In an engagement to examine prospective financial information, the auditor should obtain sufficient appropriate evidence as to whether: (a) Managements best-estimate assumptions on which the prospective financial information is based are not unreasonable and, in the case of hypothetical assumptions, such assumptions are consistent with the purpose of the information; (b) The prospective financial information is properly prepared on the basis of the assumptions;

(c) The prospective financial information is properly presented and all material assumptions are adequately disclosed, including a clear indication as to whether they are best-estimate assumptions or hypothetical assumptions; and (d) The prospective financial information is prepared on a consistent basis with historical financial statements, using appropriate accounting principles. Prospective financial information relates to events and actions that have not yet occurred and may not occur. While evidence may be available to support the assumptions on which the prospective financial information is based, such evidence is itself generally future oriented and, therefore, speculative in nature, as distinct from the evidence ordinarily available in the audit of historical financial information. The auditor is, therefore, not in a position to express an opinion as to whether the results shown in the prospective financial information will be achieved. Further, given the types of evidence available in assessing the assumptions on which the prospective financial information is based, it may be difficult for the auditor to obtain a level of satisfaction sufficient to provide a positive expression of opinion that the assumptions are free of material misstatement. Consequently, in this ISAE, when reporting on the reasonableness of managements assumptions the auditor provides only a moderate level of assurance. However, when in the auditors judgment an appropriate level of satisfaction has been obtained, the auditor is not precluded from expressing positive assurance regarding the assumptions. Acceptance of Engagement Before accepting an engagement to examine prospective financial information, the auditor would consider, amongst other things: The intended use of the information; Whether the information will be for general or limited distribution; The nature of the assumptions, that is, whether they are best-estimate or hypothetical assumptions; The elements to be included in the information; and The period covered by the information.

The auditor should not accept, or should withdraw from, an engagement when the assumptions are clearly unrealistic

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or when the auditor believes that the prospective financial information will be inappropriate for its intended use. The auditor and the client should agree on the terms of the engagement. It is in the interests of both entity and auditor that the auditor sends an engagement letter to help in avoiding misunderstandings regarding the engagement. Knowledge of the Business The auditor should obtain a sufficient level of knowledge of the business to be able to evaluate whether all significant assumptions required for the preparation of the prospective financial information have been identified. The auditor would also need to become familiar with the entitys process for preparing prospective financial information, for example, by considering the following: The internal controls over the system used to prepare prospective financial information and the expertise and experience of those persons preparing the prospective financial information. The nature of the documentation prepared by the entity supporting managements assumption. The extent to which statistical, mathematical and computer-assisted techniques are used. The methods used to develop and apply assumptions. The accuracy of prospective financial information prepared in prior periods and the reasons for significant variances.

The auditor should consider the extent to which reliance on the entitys historical financial information is justified. The auditor requires knowledge of the entitys historical financial information to assess whether the prospective financial information has been prepared on a basis consistent with the historical financial information and to provide a historical yardstick for considering managements assumptions. The auditor will need to establish, for example, whether relevant historical information was audited or reviewed and whether acceptable accounting principles were used in its preparation. Period Covered The auditor should consider the period of time covered by the prospective financial information. Since assumptions become more speculative as the length of the period covered increases, as that period lengthen, the ability of management to make best-estimate assumptions decreases. The period would not extend beyond the time for which management has a reasonable basis for the assumptions. The following are some of the factors that are relevant to the auditors consideration of the period of time covered by the prospective financial information: Operating cycle, for example, in the case of a major construction project the time required to complete the project may dictate the period covered. The degree of reliability of assumptions, for example, if the entity is introducing a new product the prospective period covered could be short and broken into small segments, such as weeks or months. Alternatively, if the entitys sole business is owing a property under long-term lease, a relatively long prospective period might be reasonable. The needs of users, for example, prospective financial information may be prepared in connection with an application for a loan for the period of time required to generate sufficient funds for repayment.

Examination Procedures When determining the nature, timing and extent of examination procedures, the auditors considerations should [Type the company address] Page 148

include: The likelihood of material misstatement; The knowledge obtained during any previous engagements; Managements competence regarding the preparation of prospective financial information; The extent to which the prospective financial information is affected by the managements judgment; and The adequacy and reliability of the underlying data.

The auditor should obtain written representations from management regarding the intended use of the prospective financial information, the completeness of significant management assumptions and managements acceptance of its responsibility for the prospective financial information. Presentation and Disclosure When assessing the presentation and disclosure of the prospective financial information, in addition to the specific requirements of any relevant statutes, regulations or professional standards, the auditor will need to consider whether: The presentation of prospective financial information is informative and not misleading; The accounting policies are clearly disclosed in the notes to the prospective financial information; The assumptions are adequately disclosed in the notes to the prospective financial information. It needs to be clear whether assumptions represent managements best-estimates or are hypothetical and, when assumptions are made in areas that are material and are subject to a high degree of uncertainty, this uncertainty and the resulting sensitivity of results needs to be adequately disclosed; The date as of which the prospective financial information was prepared is disclosed. Management needs to confirm that the assumptions are appropriate as of this date, even though the underlying information may have been accumulated over a period of time; The basis of establishing points in a range is clearly indicated. Any change in accounting policy since the most recent historical financial statements is disclosed, along with the reason for the change and its effect on the prospective financial information.

Report on Examination of Prospective Financial Information The report by an auditor on an examination of prospective financial information should contain the following: Title; Addressee; Identification of the prospective financial information; A reference to the ISAE or relevant national standards or practices applicable to the examination of prospective financial information; A statement that management is responsible for the prospective financial information including the assumptions on which it is based; When applicable, a reference to the purpose and/or restricted distribution of the prospective financial information; A statement of negative assurance as to whether the assumptions provide a reasonable basis for the prospective financial information; An opinion as to whether the prospective financial information is properly prepared on the basis of the assumptions and is presented in accordance with the relevant financial reporting framework; [Type the company address] Page 149

Appropriate caveats concerning the achievability of the results indicated by the prospective financial information; Date of the report which should be the date procedures have been completed; Auditors address; and Signature.

When the auditor believes that the presentation and disclosure of the prospective financial information is not adequate, the auditor should express a qualified or adverse opinion in the report on the prospective financial information, or withdraw from the engagement as appropriate. An example would be where financial information fails to disclose adequately the consequences of any assumptions which are highly sensitive. When the auditor believes that one or more significant assumptions do not provide a reasonable basis for the prospective financial information prepared on the basis of best-estimate assumptions or that one or more significant assumptions do not provide a reasonable basis for the prospective financial information given the hypothetical assumptions, the auditor should either express an adverse opinion in the report on the prospective financial information, or withdraw from the engagement. When the examination is affected by conditions that preclude application of one or more procedures considered necessary in the circumstances, the auditor should either withdraw from the engagement or disclaim the opinion and describe the scope limitation in the report on the prospective financial information.

The following is an example of an extract from an unmodified report on a forecast: We have examined the forecast in accordance with the International Standard on Assurance Engagements applicable to the examination of prospective financial information. Management is responsible for the forecast including the assumptions set out in Note X on which it is based. Based on our examination of the evidence supporting the assumptions, nothing has come to our attention which causes us to believe that these assumptions do not provide a reasonable basis for the forecast. Further, in our opinion the forecast is properly prepared on the basis of the assumptions and is presented in accordance with .. Actual results are likely to be different from the forecast since anticipated events frequently do not occur as expected and the variation may be material. The following is an example of an extract from an unmodified report on a projection: We have examined the projection in accordance with the International Standard on Assurance Engagements applicable to the examination of prospective financial information. Management is responsible for the projection including the assumptions set out in Note X on which it is based. This projection has been prepared for (describe purpose). As the entity is in a start-up phase the projection has been prepared using a set of assumptions that include hypothetical assumptions about future events and managements actions that are not necessarily expected to occur. Consequently, readers are cautioned that this projection may not be appropriate for purposes other than that described above. Based on our examination of the evidence supporting the assumptions, nothing has come to our attention which causes [Type the company address] Page 150

us to believe that these assumptions do not provide a reasonable basis for the projection, assuming that (state or refer to the hypothetical assumptions). Further, in our opinion the projection is properly prepared on the basis of the assumptions and is presented in accordance with.......................................... Even if the events anticipated under the hypothetical assumptions described above occur, actual results are still likely to be different from the projection since other anticipated events frequently do not occur as expected and the variation may be material.

December 2009 Question 3

Your audit client, Apricot Co, is intending to purchase a new warehouse at a cost of $500,000. One of the directors of the company, Pik Choi, has agreed to make the necessary finance available through a directors loan to the company. This arrangement has been approved by the other directors, and the cash will be provided on 30 March 2010, one day before the purchase is due to be completed. Piks financial advisor has asked to see a cash flow projection of Apricot Co for the next three months. Your firm has been asked to provide an assurance report to Piks financial advisor on this prospective financial information. The cash flow forecast is shown below: January 2010 $000 Operating cash receipts: Cash sales Receipts from credit sales Operating cash payments: Purchases of inventory Salaries Overheads Other cash flows: Dividend payment Purchase of new licence Fixtures for new warehouse Loan receipt Payment for warehouse Cash flow for the month Opening cash February 2010 $000 March 2010 $000

125 580 (410) (100) (175)

135 600 (425) (100) (175) (80)

140 625 (425) (100) (175)

(35) (60) 500 (500) 5 40 Page 151

(15) 100

(45) 85

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Closing cash The following information is relevant:

85

40

45

1. Apricot Co is a wholesaler of catering equipment and frozen food. Its customers are mostly restaurant chains and fast food outlets. 2. Customers who pay in cash receive a 10% discount. Analysis has been provided showing that for sales made on credit, 20% of customers pay in the month of the sale, 60% pay after 45 days, 10% after 65 days, 5% after 90 days, and the remainders are bad debts. 3. Apricot Co pays for all purchases within 30 days in order to take advantage of a 12% discount from suppliers. 4. Overheads are mainly property rentals, utility bills, insurance premiums and general office expenses. 5. Apricot Co needs to have a health and safety licence as it sells food. Each licence is valid for one year and is issued once an inspection has taken place. 6. A profit forecast has also been prepared for the year ending 31 December 2010 to help with internal planning and budgeting. This is the first time that Apricot Co has requested an assurance report, and the directors are unsure about the contents of the report that your firm will issue. They understand that it is similar in format to an audit report, but that the specific contents are not the same. Required: (a) Recommend the procedures that should be performed on the cash flow forecast for the three months ending 31 March 2010 in order to provide an assurance report as requested by Apricot Co. (11 marks) (b) Explain the main contents of the report that will be issued on the prospective financial information. (5 marks)

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Answer (a) Recommended procedures to be performed on the cash flow forecast include:

Accuracy checks: Agree the opening cash position to cash book and bank statement/bank reconciliation. Cast the forecast. Cash receipts: Assess whether the assumption regarding the split of revenue between cash and credit sales is accurate by considering whether it is in line with knowledge of the business. Agree the forecast cash receipts from cash sales to the forecast revenue figures in the profit forecast for January, February and March 2010. Verify the 10% discount has been accounted for in calculating the cash sales by recalculation. Agree the 10% discount to a small sample of invoices raised. Recalculate the pattern of receipts from credit customers by applying the stated average credit terms to actual sales in October, November and December 2009, and the forecast sales for January, February and March 2010. Review the latest aged receivables analysis available for confirmation of the pattern of payment from credit customers. Purchases: Recalculate the pattern of cash flows relating to purchases by applying the stated credit terms to the forecast purchases figures in the profit forecast. Using the latest available information, calculate a suppliers payment ratio to compare with the stated usual credit terms applied to purchases of 30 days. Agree the 12% discount to invoices received, supplier statement reconciliations, or signed contracts with suppliers. Other operating cash outflows: Discuss with the management of Apricot Co the relationship between sales and operating cash outflows. It appears that outflows could be understated, as salaries and expenses are static, whereas cash receipts from sales are increasing over the period. Agree the monthly salary cash outflow to latest available payroll records, and to the profit forecast. Obtain a breakdown of the contents of the overheads cash outflow category. Review the schedule for any non-cash items which should not be included, e.g. depreciation and amortisation, bad debt expenses. Compare the components of the overhead cash outflow to a breakdown of operating expenses included in the profit forecast, looking for omissions. For each of the main components of the overheads cash outflow, review supporting documentation such as invoices, utility bills, and agree the amount paid each month.

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Non-recurring cash flows: Agree the cost of the licence to supporting documentation, e.g. any correspondence already received from the issuing body, and compare the cost of $35,000 to the cost of the previous years licence. Confirm that the 2009 licence expires in December and that the new licence will be required in January 2010 by reviewing the terms of the licence. Discuss the inspections required for the new licence to be granted, and ascertain if the inspections have yet taken place, and if so, the results of the inspection. Review the board minutes, and minutes of shareholder meetings for approval of the dividend payment in February 2010. Cash flows associated with the new premises: For the new fixtures, agree the estimated cost to supplier price lists, or to any quotations received. Discuss the timing of the cash outflow in relation to fixtures with management. Presumably the fixtures can only be put into place once the premises have been acquired, which is planned for the end of March. It seems likely that the fixtures will not be purchased until April, in which case the cash payment is recognised too early in the forecast. For the premises, agree the potential purchase price to correspondence with the vendor and solicitors. Obtain a breakdown of the potential cost of $500,000 and review to ensure the cost is complete, i.e. have legal fees, stamp duty and other associated costs been included. Review board minutes for approval of the purchase, and approval that the finance will be raised from Pik Choi. General enquiries: Enquire with the preparer of the forecast regarding the following: Enquire as to the competence and experience of the preparer of the forecast. No finance costs or tax payments appear to have been included have they been omitted or are there no finance or tax payments in the three-month period? Are there any other costs to be incurred in relation to the new premises in the three-month period? e.g. recruitment costs for new staff, any additional working capital requirements, installation of plant and fixtures to the new premises. Discuss the reason for the acquisition of the new premises. Enquire whether any payments in advance or deposits will need to be made; currently the full amount is forecasted to be paid on the date of acquisition. Enquire about any other potential sources of finance in case Pik Choi fails to provide the full amount required, or in case the new premises cost more than the estimated amount.

(b) Main contents of an assurance report: ISAE 3400 The Examination of Prospective Financial Information provides guidance on the content of an assurance report given when a professional accountant has examined forecasts or projections. Title and addressee. [Type the company address] Page 154

 Identification of the prospective financial information (PFI); this should be by reference to a page number, or to the titles of the statements which have been evaluated. There should also be a reference to the period that the PFI covers. A reference to ISAE 3400 or relevant national standards applicable to the examination of PFI; this adds credibility to the report because it has been prepared according to a recognised regulatory statement. A statement that management is responsible for the PFI including the assumptions on which it is based. There should be a page reference for the assumptions, as these are a key component of the PFI. Where applicable, a reference to the purpose and/or restricted distribution of the prospective financial information. The report should caution readers that because the PFI is based on hypothetical assumptions, the events and figures contained in the PFI may not necessarily occur as expected. There should also be a caution as to the potential use of the PFI. A statement of negative assurance as to whether the assumptions provide a reasonable basis for the PFI. This would be stated as follows: nothing has come to our attention which causes us to believe that the assumptions do not provide a reasonable basis for the projection. An opinion as to whether the PFI is properly prepared on the basis of the assumptions and is presented in accordance with the relevant financial reporting framework. Appropriate caveats concerning the achievability of the results indicated by the PFI. The date, name of the audit firm, and a signature. The following points are not specifically referred to in ISAE 3400, but would commonly be included by firms providing assurance reports on PFI: A reference to the engagement letter and to the specific procedures that were requested, and have been carried out. A statement that the procedures carried out were those specified by the company and the third party to whom the report is issued. Details of any errors and exceptions found. RELATED PARTIES ISA 550 The auditor must obtain an understanding of related parties and transactions with related parties regardless of whether this is required by the applicable accounting framework. Related party relationships and transactions may give rise to increased risk due to the following reasons: 1. Management may be unaware of the existence of all related party relationships and transactions. 2. Information systems may be ineffective. 3. Related party relationships provide a greater opportunity for collusion, concealment or manipulation by management. Auditors procedures: The engagement teams must discuss the susceptibility of the entitys financial statements to material misstatement due to fraud or error that may result from related party relationships and transactions. Such discussions should address the following matter: 1. 2. 3. 4. The importance of maintaining professional skepticism. The circumstances or conditions of the entity that may indicate the existence of the related party transactions. Records or documents that may indicate the existence of related party transactions and relationships. The importance that management and those charged with governance attach to the identification, appropriate accounting for and disclosure of related party relationship and transactions. 5. How transactions between entity and a known business partner of a key member of management could be arranged to facilitate misappropriation of the entitys assets.

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The auditor should consider the features of control environment such as the following: 1. Policies and procedures for the timely identification and disclosure of related party transactions and relationships. 2. Clear guidelines for the approval of related party transactions. 3. Periodic review by the internal auditors. 4. Proactive action taken by the management to resolve related party disclosure issues, such as by seeking advice from the auditor or external legal counsel.

The auditor should review the following documents and records for the identification of related parties: 1. 2. 3. 4. 5. 6. 7. 8. 9. Confirmations circularized to banks, legal advisors, debtors and creditors. Minutes of the meeting of shareholders and those charged with governance. Entitys income tax returns. Information supplied by the entity to regularity authority. Records of the entitys investments and those of its pension plans. Contracts and agreements with key management or those charged with governance. Significant contracts and agreements not in the ordinary course of business Life insurance policies acquired by the entity. Internal auditors report.

The auditor should enquire management of transactions which are outside the normal course of business of the entity. Examples of such transactions are: 1. Complex equity transactions. 2. Transactions with offshore entities in jurisdictions with weak corporate laws. 3. The leasing of premises or the rendering of management services by the entity to another party if no consideration is received. 4. Sales transactions with unusually large discounts or returns 5. Transactions under contracts whose terms are changed before expiry. The auditor should obtain written representation from management and those charged with governance regarding the completeness and appropriate disclosure of all related party relationships and transactions. Management Representations ISA 580 Main points to be covered in representation letter: 1. Management acknowledges its responsibilities for the preparation and fair presentation of the financial statements in accordance with the applicable financial reporting framework. 2. Material matters to the financial statements when other sufficient appropriate audit evidence cannot reasonably be expected to exists. 3. Acknowledgment by the management of its responsibility for the design and implementation of internal [Type the company address] Page 156

controls. 4. That the management has provided the auditor all relevant information. etc. Management representations cannot be substitute for the audit evidence that is expected to be available for example in case of debtors if the management insists not to circularize the confirmation and rely on its representation than it is a scope limitation on the auditors work. The auditor should evaluate the reasonableness and consistency of representations with other audit evidences obtained. A management representation letter would ordinarily be signed by the member of management who has primary responsibility for the entity and its financial aspects. In certain circumstances, the auditor may wish to obtain representation letters from other members of the management. For example representation regarding the completeness of minutes of the meeting of shareholders, board of directors and other committees from company secretary. If the management refuses to provide the representation that the auditor consider necessary, this constitute a scope limitation and the auditor should express a qualified opinion or disclaimer of opinion. A management letter would ordinarily be dated the same date as the auditors report.

RISK ASSESSMENT UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT Why do we need understanding of the entity and its environment? We need understanding: 1. To identify and assess the risks of material misstatements in the financial statements. 2. To enable the auditor to design and perform further audit procedures. 3. To set audit materiality What do we need to understand? We need to understand: 1. 2. 3. 4. 5. 6. Industry, regulatory and other external factors including applicable financial reporting framework. Nature of the entity, including operations, ownership and governance, investments, structure and financing. Accounting policies. Objectives and strategies and related business risk. Standards of measurement and review of entitys financial performances. Internal controls.

How do we gain understanding? We gain understanding through: 1. Inquiries of management. [Type the company address] Page 157

2. 3. 4. 5.

Analytical procedures. Observation and inspection. Prior period knowledge. Client acceptance and continuance procedures.

ASSESSING THE RISK OF MATERIAL MISSTATEMENTS There are two categories of risk: 1. Business risk 2. Audit risk

Business risk: Business risk covers the overall business and results from significant conditions, events and actions of management. Business risk has three major components: 1. Financial risk Complex financial transaction may increase risk such as increased gearing ratio. 2. Operational risk Customer dissatisfaction due to substandard products. 3. Compliance risk Penalties due to non compliance of laws and regulations. We can only identify business risk when we have sufficient understanding of the entity and its environment. Audit risk: Audit risk is the risk that an auditor gives and incorrect opinion on the financial statements. Hence audit risk only relates to financial statements where as business risk covers the entire business operations. There are three elements of Audit risk: 1. Inherent risk. 2. Control risk. 3. Detection risk. AUDIT RISK = INHERENT RISK X CONTROL RISK X DETECTION RISK Inherent Risk Inherent risk is the risk inherent in the nature of business. Examples: 1. 2. 3. 4. Highly regulated industries such as financial institutions. Technological problems. Assets at risk of being stolen or lost such as cash. Environmental issues in manufacturing industries. [Type the company address] Page 158

Control Risk Control risk is the risk that existing controls are not effective enough to detect misstatements. For example: 1. Lack of segregation of duties. The person prepares the cheques also approves the payments. 2. Domination by one individual which creates a risk of override of controls. 3. Lack of hard copy documentation in complex IT systems. Detection Risk Detection risk means an auditor fails to detect material misstatement in the financial statements. Detection risk depends on sampling and non sampling risk. Sampling risk: As the auditor performs audit procedures on sample of transactions and not on entire population it may be possible that the misstatement did not come under the sample selected. Hence the more the sample size the lower the sampling risk. Non Sampling risk: Includes all reasons other than sampling risk Example includes unqualified / inexperienced staff who were not able to detect the misstatement or lack of adequate planning. The overall objective of the auditor is to minimize the AUDIT RISK, so that the auditor does not give wrong opinion. The auditor cannot control / reduce the inherent risk and control risk however detection risk is in the hand of auditor. If inherent and control risks are high This means that the client is risky by nature and the internal controls are weak. In order to keep the audit risk low, the auditor will have to reduce the detection risk. In order to reduce the detection risk, the auditor will have to increase his substantive procedures.

If inherent and control risks are low [Type the company address] Page 159

This means that the chance of misstatements is less and even if a misstatement occurs, there are strong internal controls in place to prevent and detect misstatement. Then the auditor can place higher reliance on internal controls. Accordingly, auditor can reduce his substantive procedures.

Responding to the Risk assessment Overall response Overall response includes such as: 1. 2. 3. 4. Emphasizing to the audit staff the need to maintain professional skepticism. Assigning additional or more experienced staff to the audit team. Providing more supervision on the audit. Incorporating more unpredictability into the nature, timing and extent of audit procedures.

Response at the assertion level The auditor should design and perform further audit procedures whose nature, timing and extent are based on and are responsive to the assessed risks of material misstatement at the assertion level. Nature Nature refers to the purpose and type of test which includes: 1. Test of controls Audit procedures design to evaluate operating effectiveness of controls in preventing, detecting and correcting material misstatement. 2. Substantive procedures. Audit procedures design to detect material misstatement at the assertion level. They consist of tests of detail of classes of transaction, account balances and disclosures and substantive analytical procedures. Timing 1. In case of test of controls for example if a entity performs inventory count at year end controls over inventory count can only be tested at year end. 2. In case of substantive procedures for example the cut of date to mark subsequent position of trade receivables.

Extent For example in case the risk of material misstatement is low the auditor can reduce its sample size for test of controls and substantive procedures. If the auditor assess that the controls at the entity are effective than the auditor can perform test of controls and reduce the nature timing and extent of its substantive procedures.

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In case the entity uses the IT systems the auditor has to perform test of controls as the substantive procedures alone do not provide sufficient and appropriate audit evidence as in such a case there is lack of hard copy documentation. Business risk from current trends in IT Specific business risks include: 1. 2. 3. 4. 5. Loss of transaction integrity Pervasive e-commerce security risk Improper accounting policy for example capitalization of website development costs. Over reliance on e-commerce Systems and infrastructure failures.

Financial Statement Risk This is the risk that the financial statements are materially misstated. The material misstatement could involve: 1. Errors in the amounts recorded in the financial statements. 2. Errors in or omissions from the disclosure notes. Many, if not all, business risks will produce a financial statement risk. Following are the examples: Business Risk The business may lose sales due to sub standard products. Breaches of debt covenants of long term debts Financial Statement Risk Uncertainties over going concern may not be fully disclosed Financial consequences may not be fully disclosed.

ISA 402 - AUDIT CONSIDERATIONS RELATING TO AN ENTITY USING A SERVICE ORGANIZATION

Definitions For purposes of the ISAs, the following terms have the meanings attributed below: Service organization Means third-party organization that provides services to user entity. User entity An entity that uses a service organization and whose financial statements are being audited. User auditor An auditor who audits and reports on the financial statements of a user entity. Service auditor An auditor who, at the request of the service organization, provides an assurance report on the controls of a service [Type the company address] Page 161

organization. Report on the description and design of controls at a service organization (referred to in this ISA as a type 1 report) A report that comprises: I. II. A description, prepared by management of the service organization, of the service organization's system, control objectives and related controls that have been designed and implemented as at a specified date; and A report by the service auditor with the objective of conveying reasonable assurance that includes the service auditor's opinion on the description of the service organization's system, control objectives and related controls and the suitability of the design of the controls to achieve the specified control objectives.

Report on the description, design, and operating effectiveness of controls at a service organization (referred to in this ISA as a type 2 report) A report that comprises: I. A description, prepared by management of the service organization, of the service organization's system, control objectives and related controls, their design and implementation as at a specified date or throughout a specified period and, in some cases, their operating effectiveness throughout a specified period; and A report by the service auditor with the objective of conveying reasonable assurance that includes: a. The service auditor's opinion on the description of the service organization's system, control objectives and related controls, the suitability of the design of the controls to achieve the specified control objectives, and the operating effectiveness of the controls; and b. A description of the service auditor's tests of the controls and the results thereof.

II.

Requirements Obtaining an Understanding of the Services Provided by a Service Organization, Including Internal Control When obtaining an understanding of the user entity in accordance with ISA 315, the user auditor shall obtain an understanding of how a user entity uses the services of a service organization in the user entity's operations, including: a. The nature of the services provided by the service organization. b. The materiality of the transactions processed or accounts or financial reporting processes affected by the service organization; c. The degree of interaction between the activities of the service organization and those of the user entity; d. The nature of the relationship between the user entity and the service organization, including the relevant contractual terms for the activities undertaken by the service organization. If the user auditor is unable to obtain a sufficient understanding from the user entity, the user auditor shall obtain that understanding from one or more of the following procedures: a. Obtaining a type 1 or type 2 report, if available; b. Contacting the service organization, through the user entity, to obtain specific information; [Type the company address] Page 162

c. Visiting the service organization and performing procedures that will provide the necessary information about the relevant controls at the service organization; or d. Using another auditor to perform procedures that will provide the necessary information about the relevant controls at the service organization. Using a Type 1 or Type 2 Report to Support the User Auditors Understanding of the Service Organization In determining the sufficiency and appropriateness of the audit evidence provided by a type 1 or type 2 report, the user auditor shall be satisfied as to: a. The service auditor's professional competence and independence from the service organization; and b. The adequacy of the standards under which the type 1 or type 2 report was issued. Tests of Controls When the user auditor's risk assessment includes an expectation that controls at the service organization are operating effectively, the user auditor shall obtain audit evidence about the operating effectiveness of those controls from one or more of the following procedures: a. Obtaining a type 2 report, if available; b. Performing appropriate tests of controls at the service organization; or c. Using another auditor to perform tests of controls at the service organization on behalf of the user auditor. Reporting by the User Auditor The user auditor shall modify the opinion in the user auditor's report if the user auditor is unable to obtain sufficient appropriate audit evidence regarding the services provided by the service organization relevant to the audit of the user entity's financial statements. The user auditor shall not refer to the work of a service auditor in the user auditor's report containing an unmodified opinion unless required by law or regulation to do so. If such reference is required by law or regulation, the user auditor's report shall indicate that the reference does not diminish the user auditor's responsibility for the audit opinion. If reference to the work of a service auditor is relevant to an understanding of a modification to the user auditor's opinion, the user auditor's report shall indicate that such reference does not diminish the user auditor's responsibility for that opinion.

Question Mac Co is a large, private company, whose business activity is events management, involving the organisation of [Type the company address] Page 163

conferences, meetings and celebratory events for companies. Mac Co was founded 10 years ago by Danny Hudson and his sister, Stella, who still own the majority of the companys shares. The company has grown rapidly and now employs more than 150 staff in 20 offices. External auditors are Manhattan & Co another firm of Chartered Accountants. You are a manager in the business advisory department of Flack & Co. Your firm has just been engaged to provide the internal audit service to Mac Co. In your initial conversation with Danny and Stella, you discovered that currently there is a small internal audit team, under the supervision of Lindsay Montana, a recently qualified accountant. Before heading up the internal audit department, Lindsay was a junior finance manager of the company. The members of the internal audit team will be reassigned to roles in the finance department once your firm has commenced the provision of the internal audit service. Mac Co is not an existing client of your firm, and to gain further understanding of the company, you held a meeting with Lindsay Montana. Notes from this meeting are shown below. Notes of meeting held with Lindsay Montana on 1 June 2010 The internal audit team has three employees, including Lindsay, who reports to the finance director. The other two internal auditors are currently studying for their professional examinations. The team was set up two years ago, and initially focused on introducing financial controls across all of Mac Cos offices. Nine months ago the finance director instructed the team to focus their attention on introducing operational controls in order to achieve cost savings due to a cash flow problem being suffered by the company. The team does not have time to perform much testing of financial or operational controls. In the course of her work, Lindsay finds many instances of management policies not being adhered to, and the managers of each location are generally reluctant to introduce controls as they want to avoid bureaucracy and paperwork. As a result, Lindsays recommendations are often ignored. Three weeks ago, Lindsay discovered a fraud operating at one of the offices while reviewing the procedures relating to the approval of new suppliers and payments made to suppliers. The fraud involved an account manager authorizing the payment of invoices received from fictitious suppliers, with payment actually being made into the account managers personal bank account. Lindsay reported the account manager to the finance director, and the manager was immediately removed from office. This situation has highlighted to Danny and Stella that something needs to be done to improve controls within their organisation. Required: (a) Evaluate the benefits specific to Mac Co of outsourcing its internal audit function. (6 marks) (b) Explain the potential impacts on the external audit of Mac Co if the decision is taken to outsource its internal audit function. (4 marks)

Answer (a) Benefits specific to Mac Co of outsourcing the internal audit function Quality

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The service provider will have good quality staff with experience of financial reporting, auditing techniques and commercial and business awareness. This will enhance the credibility and efficiency of the work they are performing. Lindsay, being only recently qualified, may have limited experience, and the more junior members of her team who are studying for their professional examinations may not be technically competent in all of the areas that the internal audit team are responsible for. Authority/status Lindsay comments that many of her recommendations are ignored. This may be because she is seen to lack status and authority within the company, as she was a junior manager before heading the internal audit function, and because she is recently qualified. If the recommendations come from an independent source, which has authority and is supported by senior management, they are more likely to be followed. The current team lacks independence as they are employees who report to the finance director. The team may be reluctant to overly criticise the operations of the finance function. Resources It appears that Mac Cos internal audit function is currently under-resourced, as there are only three people to provide internal audit for a growing company, with multiple locations. Outsourcing the function will allow an immediate increase in the resource base, meaning that more work can be quickly performed e.g. the investigation into fraud can commence immediately. Focus/range of work From Lindsays comments, it seems that the team currently lacks a consistent focus. They are directed by the finance director, who has changed the focus from financial reporting controls to operational controls, and it seems the team is too small to do both. Outsourcing the function will provide as many staff as necessary (cost permitting) to cover a range of activities. Also, the team will be better focused and be able to prioritise objectives from an independent point of view. Reallocation of staff Lindsay and the rest of her team can be reallocated to other parts of the business. The finance team may benefit from extra resources if the company continues to grow. Internal controls are more likely to become embedded in the organisation as the finance function will have more knowledge and experience of developing and implementing controls.

(b) Impact of outsourcing on the external audit The external audit providers, Manhattan & Co should assess the impact of the outsourcing arrangement by reference to ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation. The ISAs require that the auditor determines the significance of the service organizations activities to the client, and the relevance to the audit. Manhattan & Co should consider the extent of reliance they may wish to place on the work of Flack & Co. It is likely that more reliance will be placed on internal audit than previously, which should increase the efficiency of the external audit. The fees charged by Manhattan & Co could be affected by this. As Mac Co is short of cash, the fee could be an important consideration for the company. [Type the company address] Page 165

The internal auditors may suggest changes to accounting systems and controls. When these changes occur, the external audit firm will need to document and evaluate the new procedures, which may be time consuming. (It could be argued that new systems and controls could reduce the reliance placed on them.) The control environment is likely to be improved over time. This means that Manhattan & Co should reassess their audit strategy, which will probably mean a reduction in the extent of substantive procedures that need to be carried out. Manhattan & Co will need to consider access to records and working papers held by Flack & Co, as information relevant to the external audit, especially in relation to the testing of controls, is likely to be held by the service provider.

Subsequent Events ISA 560 One limitation of the financial statements is that they are based on historical information up to the date of financial statements and they do not take into account any event after the reporting period, which could affects the figures in the financial statements. To overcome this limitation the auditor should review the subsequent events. Types of subsequent events 1. Those that provide evidence of conditions that existed at the end of the reporting period (Adjusting Events) for example: Outcome of litigation existed at the balance sheet date. The sale of inventory at a lower price than that shown in the financial statements. The discovery of fraud or errors that show that the financial statements are incorrect. Trade receivable going bad, due to the deteriorating financial conditions of the customer. 2. Those that are indicative of the conditions that arose after the reporting period (Non Adjusting Events) for example: Fire occurred after the balance sheet date. Significant decline in the market value of investments. Discontinuation of a product line. Purchase of a business. Procedures to identify subsequent events 1. Enquiries of management about the following: Whether new commitments, borrowings or guaranties have been entered into. Whether sales or acquisition of assets have occurred or are planned. Whether there is any issue of debenture or new shares. Whether there are any assets appropriated by the government. Whether any events have occurred that is relevant to the recoverability of assets. 2. Reading minutes of the meeting held after the date of financial statements and enquiring about the matters discussed at the meeting for which minutes are not yet available. 3. Reading latest available subsequent interim financial statements.

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Events occurring up to the date the auditors report Until the date of the audit report, the auditor has an active responsibility to identify and review all the subsequent events. Facts discovered after the date of auditors report but before the financial statements are issued Once the auditors report is issued the auditor is not responsible for conducting a review of the events that occur after the date of the audit report but before the financial statements are issued. However if they become aware of such facts they should: 1. 2. 3. 4. Discuss the matter with management and those charged with governance. Determine whether the financial statements need amendment and if so, Inquire how management intends to address the matter in the financial statements. If the financial statements are amended the auditor should perform the appropriate audit procedures and issue a new audit report on the amended financial statements. The date of this audit report should not be a date earlier than the date on which the amended financial statements are issued.

When management does not amend the financial statements and the auditor feels it is necessary to amend them and the report has not been issued to the entity, the auditor should express a qualified opinion or an adverse opinion in the audit report. However if the audit report has already been issued to the entity, the auditor should notify those charged with governance not to issue the financial statements and audit report to the third parties. If the financial statements are subsequently released, the auditor should take appropriate legal action to prevent reliance on the auditors report. He may also speak at the AGM to notify this fact to the shareholders. Facts discovered after the financial statements have been issued The auditor has no responsibility for inquiring into any events that occur after the issue of the financial statements. If the auditor becomes aware of a fact that existed at the date of the audit report and if known would have required the auditor to modify the audit report, the auditor should consider the need for revision of the financial statements. If the financial statements are revised the auditor should review steps taken by the management and issue a new audit report on the revised financial statements. The auditor should ensure that the revised financial statements and the new audit report should be made available to those to whom previous report was issued. The new audit report should include emphasis of matter paragraph referring to the note in the financial statements describing the reason for revision. When the management does not agree to the revision the auditor should notify those charged with governance that action will be taken by the auditor to prevent reliance on the auditors report. [Type the company address] Page 167

The auditor should also take legal advice in this case. COMPARATIVES Comparative information The amounts and disclosures included in the financial statements in respect of one or more prior periods in accordance with the applicable financial reporting framework. Corresponding figures Where amounts and disclosure in respect of prior periods are considered as an integral part of the current period figures and should be read in conjunction with current period figures. Comparative financial statements Where prior period figures are considered as separate financial statements and should be read in isolation. Difference in reporting requirements In case of corresponding figure audit report only refers to the current period only In case of comparative financial statements audit report refers to all the periods presented Exceptions to the reporting requirement Corresponding figure: In case of corresponding figure audit report only refers to current period only except when prior period audit report was modified and matter that given rise to that modification is unresolved. In such a case the auditor shall modify the auditors opinion on the current period financial statements and refers to prior period in basis for qualified opinion paragraph. For example: Management had changed the policy in respect of depreciation in prior year which is contrary to the requirement of applicable financial reporting framework and continues the same wrong policy this year. In this case we refer to both current and prior period in basis for modified opinion paragraph and will modify current period audit report. We were appointed as an auditor in prior year after the prior year end and did not perform the physical inventory count (assuming alternative procedures are impracticable). In this case we will refer to prior year in basis for qualified opinion paragraph and will explain that current year opinion in modified because of the effect of last year scope limitation as we know that in case of corresponding figures prior period figures are integral part of current period financial statements.

Comparative financial statements: In case of comparative financial statement auditors report refers to all the period presented in the financial statements except in case where prior period financial statements were audited by another auditor and the current auditor concludes that a material misstatement exists that affects the prior period financial statements on which the predecessor auditor had previously reported without modification. If the prior period financial statements are amended, and the predecessor auditor agrees to issue a new auditor's report on the amended financial statements of the prior period, the auditor shall report only on the current period. Prior Period Financial Statements Audited by a Predecessor Auditor If the financial statements of the prior period were audited by a predecessor auditor, the auditor shall state in an Other [Type the company address] Page 168

Matter paragraph: d. that the financial statements of the prior period were audited by a predecessor auditor; e. the type of opinion expressed by the predecessor auditor and, if the opinion was modified, the reasons therefore; and f. the date of that report. Prior period Financial Statements were Unaudited If the prior period financial statements were not audited, the auditor shall state in an Other Matter paragraph in the auditor's report that the corresponding figures are unaudited. Such a statement does not, however, relieve the auditor of the requirement to obtain sufficient appropriate audit evidence that the opening balances do not contain misstatements that materially affect the current period's financial statements.

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