Audit Tutorial 8

Question 1

Briefly explain FOUR (4) matters that should be considered by external auditor before accepting a
new audit client.

1) Qualification to act as an auditor

 Determine if the auditors are independent of the client and able to provide the
desired service.
 Required to comply with Companies Act 2016.
 Example: Under Section 264, Companies Act 2016  Disqualification of company
auditor  In debted to the company in an amount exceeding RM 25,000.

2) Ethical matters
 Auditors should determine if they accept the client would violate any applicable
regulations and standards of face any ethical threats to the independence of the
auditor.
 Example: self-interest threats.

3) Risk assessment
 Auditors should consider if they accept the client and the risk associated to the
client would pose a significant danger to the auditor’s reputation. When auditors
assess the risk, they need to consider the following:-
i) The viability and stability of the client’s business.
ii) The character and involvement of management.
iii) The effectiveness of accounting system and internal control system.
iv) The application of accounting standards and policies.
v) Whether is there any unusual item or going concern problem faced by the
client.

4) Resources available
 Auditors should determine whether they have resources (e.g. audit staff, audit
techniques) to perform the audit work and compete the audit engagement within
the deadline.
 Consider availability of time, sufficient audit staff and technical expertise to
complete the audit work.

5) Technical competence
 Determine whether the auditors have the necessary expertise, technical skills and
knowledge of the industry to carry out an effective audit especially if the client
business is in a specialized industry.
 Example: Oil & Gas, Banking, Insurance etc…

6) Replacement of previous auditors

 If this is the first year audit, auditors should consider the reasons for resignation of
the previous auditor. Auditors should contact the previous auditor to find out is
there any serious disagreement with directors over accounting matters.
 Contact previous auditor and find out why  professional clearance
 o “Statement of circumstances” or “Statement of no-circumstances”.
o Any serious disagreement with directors over accounting matters.

7) Procedures for obtaining information

 When considering accepting appointment, auditors should obtain and review the
available financial information (e.g. annual reports, intern management reports etc.)
and inquire third parties (e.g. banks, solicitors) about any information.

Question 2

[Refer case study of the tutorial]

Required:

a) Identify to whom in a company an audit engagement letter should be addressed, and explain
how the acceptance of the terms of engagement should be conveyed to the auditor.
 An audit engagement letter should be addressed to the directors of the company. If
the client requires other services, the scope of these services should be set out
clearly.
 An engagement letter defines the legal relationship between audit firm and its
client.
 Auditor should perform the following steps to ensure acceptance of engagement
letter.
1) Discuss with the directors on the terms of engagement on or before
acceptance of a new client.
2) Draft and sign the letter before commencing any part of the assignment.
3) Receive the client’s written resolution on acceptance to confirm to engage
the auditor.
4) Review the engagement letter every year to make any change.

b) Explain the purposes of an audit engagement letter, state when such a letter should be
issued to an audit client.
 An engagement letter defines the legal relationship between audit firm and its
clients, i.e. served as a contract, i.e. clearly outline the terms and conditions
between auditor and audit client.
 The purposed of engagement letter are:
1) To clearly define the objective, scope of audit and the form of report.
2) To clearly define the extent of the auditor’s responsibilities.
3) To minimize the risk of misunderstandings between auditor and client.
4) To confirm acceptance by the auditor of his engagement.
5) To confirm acceptance by the client of his engagement.
6) To inform and educate the client on the limitation of the engagement.

When to issue?

 Every auditor should send his client an engagement letter before commencement of
audit work.
c) Explain with reasons three examples of knowledge you would wish to obtain prior to 31 July
2019 in order to assist in the planning of the audit.
1) Consideration of materiality and risks
 Auditor uses his knowledge about the entity and its environment as a basis
for identifying and assessing the risk of material misstatements in the
financial statements.
 The viability and stability of the client’s business in order to assess the audit
risk.
 The character and involvement of management to determine the integrity of
management  Inherent risk.
 The effectiveness of accounting system and internal control system to assess
the control risk.

2) Understand the applicable laws and regulations

 Auditor should obtain a general understanding of the legal and regulatory
framework applicable to the client entity.
 The effectiveness of accounting system and internal control system to assess
the control risk.
 The application of accounting standards and policies to determine the
consistency of application of standards and policies.

3) Unusual item or going concern problem

 Whether is there any faced by the client to determine to risk of material
misstatement.

4) Review engagement letter

 As part of audit planning, the auditor may look for opportunities to
recommend additional value-added services such as risk assessment,
business performance assessment etc.

5) Replacement of previous auditors

 Auditors should contact the previous auditor to find out is there any serious
disagreement with directors over accounting matters.

6) Procedures for obtaining information

 Procedures for obtaining information e.g. annual reports, interim
management reports and inquire third parties such as banks, solicitors to
ensure that there is no limitation of scope.

d) Explain why good audit planning is essential for carrying out an effective audit.
1) Legal requirement of ISA 300 Audit Planning
 ISA 300 Planning on Audit of Financial Statements.
 Planning must be completed before the commencement of detailed audit
procedures.
2) Able to assist auditor to meet the deadline.
3) Able to delegate the audit work to various audit staff so to carry out the audit more
effective and efficient manner.
 4) Able to properly assess the risk of material misstatement.
5) Without planning, auditor may face high audit risk.

Question 3

a) Explain with TWO (2) reasons the importance of keeping complete audit working papers.
1) Working papers serve as evidence of work performed and conclusions drawn in
order to form opinion. This can be invaluable sources of evidence in the litigation
case where the Court orders the auditor to produce evidence.
2) Working papers can help in the supervision of the audit work. The engagement
partner needs to supervise the work delegated by him has been properly performed.
Hence, by asking audit staff to produce detailed working papers, he is able to
monitor the process of auditing.
3) Working papers will provide, for future reference details of audit problems
encountered.
4) Good working papers can help in planning and control the process of auditing.
5) The preparation of working papers encourages the auditors to adopt a high quality
of auditing.

b) Describe TWO (2) types of audit working papers files and explain TWO (2) reasons of
splitting the working papers files.
A) Permanent audit files are to:-
1) Document information which is of recurring value regarding items appearing in the
financial statements such as equity, number of issued shares etc.
2) Document information of a permanent nature regarding the client’s business.
Example: Trade licenses, Memorandum and Articles of Association.
3) Give audit staff who are new to the audit information regarding the client’s affairs
and the nature of audit.

B) Current audit files are:

 Audit files contain information relating primarily to the audit of a single (current)
period. The objectives of the current audit file are to:
1) Provide a record of the work planned.
2) Detail the work performed including audit procedures performed, information
obtained and conclusion reached.
3) Enable the audit partner to review the audit.

c) Briefly describe the following types of working papers and their function:
i) Audit plan
 An audit plan will set out the overall strategy to be followed by auditor in
conducting the audit.
 Also contain the overall framework of the audit, i.e. budgeted hours,
resources etc.

ii) Audit program

 An audit program consists of detailed instructions (detail audit procedures)
that instruct the auditor to collect the evidence.
  It includes audit work carried out, results of the test and conclusion drawn
from them.

Question 4

[Refer to case study of the tutorial]

Required:

You are the audit senior for the audit of AAA and you are about to commence planning the audit.

Identify the factors which should be considered when assessing the inherent risk of the company.
Include your overall conclusion as to whether you consider the inherent risk to be high, medium or
low.

AAA is a long established family limited company which manufactures cosmetics. These are sold
to customer who package and market them under their own trade names.

Risks:

1) Nature of the business  Family limited liability company  Manufacture cosmetics  Risk
of detect quality of products  sued by consumers  High IR  High AR.

The company has recently undergone some management changes following the death of its
managing director. George, formerly the sales director is new managing director. A new sales
director from outside the company has been appointed.
Risks:

2) Change in management  George, sales background  new MD  may not possess the
required experience and knowledge  increase the risk of deliberate or unintentional
misstatement  High IR  High AR.
3) New sales director  appointed from outside  new and guide by George  medium IR 
medium AR.

The finance director and company accountant, Mr. Tan is now 65 and has recently negotiated a
part-time contract of employment with the company. The company will appoint a full time
accountant to replace Mr. Tan after next financial year end.
Risks:

4) Finance director, Mr. Tan  negotiated a part time contract  proper handover of duties
from Mr. Tan to the new full time accountant  Proper succession planning  low IR  low
AR.

Profit has been declined in the last two years and the company is seeking to improve profitability
prior to a possible listing on its stock market. An incentive scheme has been recently implemented
with the aim of improving productivity within the company. Certain managers and all directors
will be paid a bonus based on the production achieved above a pre-determined level.
Risks:

5) Profit declined in the last 2 years  plan for listing on its stock market  Possible
overstated of sales or understated of expenses in order to maintain profits  High IR 
High AR.
 6) Profit declined in the last 2 years  plan for listing on its stock market  Increase sales 
Possible overtrading and over production  cash flow problem  going concern problem
 High IR  High AR.
7) Incentive scheme based on the production achieved above pre-determined level  possible
supply more than demand  Over-production  Risk of inventory obsolescence and having
slow moving inventory  High IR  High AR.
8) Incentive scheme based on the production achieved above pre-determined level  These
incentives or temptations might lead personnel to engage in dishonest, illegal or unethical
acts that might affect the truth and fairness of financial statements  High IR  High AR.

1) Nature of business
 AAA is a long established family limited liability company which manufactures cosmetics
which subject to high IR and AR due to risk of contaminated cosmetics and health-
related complaints.

2) Change in management
 There were changes in management during the period and new management team
might not possess the required management experience and knowledge. This will
increase the risk of deliberate or unintentional misstatement in the financial statements
 High IR  High AR.
 George, sales background become the new MD. He may not possess the required
experience and knowledge to be the MD. This will increase the risk of deliberate or
unintentional misstatement  High IR  High AR.

3) Part time accountant

 The appointment of a full time accountant while Mr. Tan is still a part-time company
accountant would enable a proper handover of duties to the new accountant. This
would ensure the new accountant who takes over the job is familiar with the company’s
accounting system and is therefore able to handle this job competently. Timely and
proper preparation of accounting records could therefore be enhanced  Low IR  Low
AR.

4) Excessive bonuses
 The significant portion of management’s compensation is represented by bonuses, the
value of which is contingent upon the equity achieving unduly aggressive targets for
production. These incentives or temptations might lead personnel to engage in
dishonest, illegal or unethical acts that might affect the truth and fairness of financial
statements  High IR  High AR.

5) Potential overstatement of profitability

 In order to target for a possible listing on its stock market, the company is planning an
expansion and employing strategies to improve on profitability. There is a risk of over-
trading, i.e. the business will exhaust its cash resources too soon as a result of rapid
growth. In such circumstances, there is a risk that creditors will go unpaid and that the
business will be forced into liquidation  High IR  High AR.
 In order to target for a possible listing on its stock market, the directors may overstated
of revenue or understated expenses in order to improve on profitability  affect true
and fairness of F/S  High IR  High AR.
6) Overproduction also increases the risk of inventory obsolescence and having slow moving
inventory  High IR  High AR.
Conclusion:
 Based on the factors identified above, the inherent risk of the company appears to be
high as a whole.

Question 5

a) Explain what is meant by the going concern concept, and describe the effect that this
concept has on the preparation of financial statements.
1) The financial statements of an entity should normally be prepared on the presumption
that the entity will continue in operational existence for the foreseeable future. This is
12 months from the statement of financial position date.
2) This is the essence of the going concern concept and means specifically that the financial
statements of an organisation are prepared on the assumption that there is no intention
or necessity to liquidate the organisation or to curtail significantly the scale of its
operation.
3) The major implications of this for the preparation of financial statements include the
following:
i) Assets are recorded and valued on the basis that the organisation expects to recover
the recorded amounts in the normal course of business; and
ii) Liabilities are recorded and valued on the basis that they will be paid in the normal
course of business.

b) State two situations when the going concern concept is not to be used in the preparation of
financial statements.
The going concern concept cannot be used:
1) When the company is in liquidation; or
2) When the directors see no choice other than to put the company into liquidation.

c) Explain how the auditor judgement about the going concern affects auditor’s planned audit
procedures.
 If the client’s going concern status is in doubt, the financial statements should be
prepared in the break up basis (Net realizable value).
 Auditor has to ensure full disclosure on going concern issues have be disclosed in the
explanatory note.