Question Bank - Kaplan Audit Qns 2008

ACCA EXAMINATION KIT
Audit and Assurance (INT) (F8)
June 2008
KAPLAN PUBLISHING
ACCA Examination kit- Audit and Assurance (INT) (F8)
© FTC Kaplan Limited, August 2007
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without the prior written permission of Kaplan Publishing Foulks Lynch.
KAPLAN PUBLISHING
Contents
Page
Syllabus v
Question Answer
Questions and Answers

The nature, purpose and scope of audit review
1 Directors’ responsibilities 7 61
Statutory audits
2 Decathalon & Co 7 64
3 Bentfasteners 9 66
Professional ethics and professional codes of conduct
4 Ethics 10 68
5 Ethics and independence 10 69
6 Soul 11 70
Preliminary planning procedures
7 Melton Manufacturing 12 72
8 Bondi (ACCA 6/99) 12 74
9 Radford Retail (ACCA 12/94) 14 77
10 Growing 14 79
11 Gnome Publications 15 80
The work plan, the work programme and documentation
12 Bestwood Engineering (ACCA 12/98) 16 82
13 Working papers 17 84
14 Risk 17 87
The work of others
15 Newthorpe Manufacturing (ACCA 6/97) 19 89
Internal control – sales and purchases
16 Southwell Engineering 20 92
17 Lidcombe (ACCA 6/99) 21 93
18 Ilkeston Products 21 95
19 Marshalls 23 97
20 Dean 25 98
Payroll
21 Bingham Manufacturing (ACCA 12/94) 26 101
22 Eastwood Engineering (ACCA 6/98) 26 103
23 Wormwood 27 105
Inventory
KAPLAN PUBLISHING
24 Lenton Electrical (ACCA 6/97) 29 107

25 Sheffield Homestores 30 109
26 Basford 32 112
Bank and cash
27 Lenton Textiles 33 114
28 Betterhome 34 117
KAPLAN PUBLISHING
Other audit and review evidence

29 Audit evidence 35 120
30 Sources of audit evidence 36 122
31 Daybrook Insurance Brokers (ACCA 6/95) 37 124
32 Simons Engineering 37 127
33 Newpiece Textiles (ACCA 12/97) 38 128
34 Pyrmont (ACCA 6/99) 40 131
35 Cambridge 42 133
36 Coogee (ACCA 6/99) 42 134
37 Tollerton (ACCA 6/96) 43 137
38 Galaxy 45 139
Going concern reviews
39 Mowbray Computers 46 143
40 Hyson Computers Take Two (ACCA 12/96) 46 144
Audit finalisation
41 Newbridge Trading 49 147
The final review
42 Wotsbrite 50 149
43 Technical department 51 151
44 Quality control 52 151
45 Webster 52 155
46 Melton Builders 53 157
Reporting
47 Gamston and Keyworth 53 159
48 Wulf, Sisters, Mog 54 162
49 Cremorne (ACCA 6/99) 55 168
Internal audit
50 Professional Promotions 58 171
51 Sighthill Supermarkets (ACCA 6/98) 59 175
52 Eastfield Distributors (ACCA 12/98) 60 179
Pilot paper
53 Billington Travel (Question 1 of Pilot Paper) 48 166
54 EWheels (Question 2 of Pilot Paper) 49 168
55 Roxy Hotels (Question 3 of Pilot Paper) 50 170
56 Springfield Nurseries (Question 4 of Pilot Paper) 51 172
57 Internal Control Systems (Question 5 of Pilot Paper) 52 174
58 Chingford Potteries (Question 6 of Pilot Paper) 52 176
December 2001
59 Internal and external auditors 55 179
60 Nepco 55 181
61 Cosmo 56 183
5
KAPLAN PUBLISHING
62 Goodfoot 57 185
63 ABC and XYZ 58 187
64 Auditing standards 59 189
KAPLAN PUBLISHING
Questions
Question 1 (Answer on page 61)
Directors’ responsibilities
ISA 200 Objective and General Principles Governing an Audit of Financial Statements deals
with responsibility for the financial statements and the concept of reasonable assurance.
Paragraph 8 of the statement states that:
‘An audit in accordance with ISAs is designed to provide reasonable assurance that the financial
statements taken as a whole are free from material misstatement. Reasonable assurance is a
concept relating to the accumulation of the audit evidence necessary for the auditor to conclude
that there are no material misstatements in the financial statements taken as a whole.
Reasonable assurance relates to the whole audit process.’
and paragraph 9:
‘.... there are inherent limitations in an audit that affect the auditor’s ability to detect material
misstatements ....’
The effect on the audit is explained in paragraph 10:
‘.... the work undertaken by the auditor to form an opinion is permeated by judgement…’
Required
(a) Briefly discuss the respective responsibilities of the directors and the external auditor in
the preparation of the financial statements. (6 marks)
(b) Describe the types of judgements made by auditors in the following areas.
(i) Gathering evidence (4 marks)

(ii) Forming an opinion on the financial statements (4 marks)
(c) What inherent limitations face the auditor when he attempts to undertake his work to the
required standard? (6 marks)
(Total: 20 marks)
Question 2
Decathalon & Co (Answer on page 64)
You have recently accepted the appointment as Personal Assistant to the Senior Partner of the
firm of Certified Accountants, Decathalon & Co. You are approached by Mr Hurl, the managing
7
KAPLAN PUBLISHING
director of Javelin Enterprises, who asks if your firm will be auditors of his company. He
explains that he would expect your firm to undertake the audit at a fee lower than that charged
by the existing firm of accountants, Pole Vault and Co. The existing firm of Pole Vault and Co
has not resigned but Mr Hurl informs you that they will not be reappointed as the company’s
auditors in future.
KAPLAN PUBLISHING
Required
Describe the action which you would expect your firm to take in response to the approach made
by Mr Hurl. In particular you should outline:
(a) the matters you would expect your firm to discuss with the existing auditors, Pole Vault &
Co and with the company, Javelin Enterprises, before deciding whether or not to accept
the appointment. (7 marks)
(b) what action your firm, Decathalon & Co should take in response to the request made by
Mr Hurl to reduce the audit fee. (7 marks)
(c) typical statutory procedures which must be observed by a company to remove its
auditors and to appoint another firm of auditors in their place. (6 marks)
(Total: 20 marks)
Question 3
Bentfasteners (Answer on page 66)
Your firm has recently completed the audit of Bentfasteners, an unlisted company, and after
extensive discussions with the directors of the company the audit report has been qualified in
respect of the auditor’s inability to agree with the directors on the appropriateness of an
allowance against obsolete inventory. The directors have informed you that they intend to
dismiss your firm as auditors and replace you with a small local firm of accountants. The
directors have informed you verbally that the reason for your dismissal is the disagreement over
the allowance for inventory obsolescence, and further they intend to appoint the new auditors
because they are more likely to accept the accounting policies of the directors. You have
recently received a letter from the nominee auditors asking if there are any professional reasons
why they should not accept appointment as auditors of Bentfasteners.
Required
(a) Describe the rights which typical legislation in most countries gives to the auditor when a
company proposes to dismiss him and has dismissed him. (7 marks)
(b) Draft a suitable letter in reply to the request from the nominee firm of auditors, asking if
there are any professional reasons why they should not accept appointment as auditors.
(Marks will be given for the style and content of the letter.) (4 marks)
(c) In view of the attitude of the directors towards the present auditors, discuss the factors
which the nominee auditors need to consider before accepting appointment.(5 marks)
(d) Describe the ethical implications for the nominee auditor, if he decides to accept the
appointment as auditor. (4 marks)
9
KAPLAN PUBLISHING
(Total: 20 marks)
Question 4
Ethics (Answer on page 68)
It is important that an auditor’s independence is beyond question and that he should behave
with integrity and objectivity in all professional and business situations. The following are a
series of questions which were asked by auditors at a recent update seminar on professional
ethics.
(a) Can I audit a company owned by my brother? (4 marks)
(b) A B & Company, the previous auditors, will not give my firm professional clearance or
the usual handover information because they are still owed fees. Should I accept the
client’s offer of appointment? (5 marks)
(c) Can I prepare the financial statements of a public company and still remain as auditor?
(4 marks)
(d) My client has threatened to sue the firm for negligence. Can I still continue to act as
auditor? (5 marks)
(e) I am a student of the Association of Chartered Certified Accountants. Am I bound by the

ethical guidelines of the Association? (2 marks)
(Total: 20 marks)
Required
You are required to discuss the answers you would give to the above questions posed by the
auditors.
Question 5
Ethics and independence (Answer on page 69)
An auditor’s independence may be compromised by the provision of other non-audit services.
(a) Many audit firms provide additional services to their audit clients:
♦ Calculating the company’s income tax liability and the directors’ personal tax liability, and
negotiating with the tax authorities.
♦ Preparing the company’s financial statements for audit, from the accounting records.
♦ Advising on systems of internal control.
Required
10
KAPLAN PUBLISHING
Consider for each of the services listed above:
(i) the effect on the auditor’s independence of providing these services.
(ii) the benefits provision of these services may provide to the client.
(iii) the procedures the audit firm should instigate to minimise the risk of providing
them affecting their independence. (10 marks)
(b) ‘Research carried out in one developed country has shown that the fees charged to
listed companies by audit firms for non-audit work are, on average, about equal to the
audit fee. It is alleged that:
(i) audit firms are charging low audit fees in order to obtain lucrative non-audit work.
(ii) with large fees from non-audit work, auditors will be reluctant to qualify their audit
report because of the risk of losing both the audit and non-audit fees.
(iii) auditors’ reluctance to qualify their audit report compromises their independence.
If these allegations are correct, then auditors of listed companies should be prevented
from providing other services to client companies.
Required
You are required to discuss this statement, consider each of the matters raised, and
come to a conclusion on whether external auditors should be allowed to provide other
services to the listed companies they audit. (10 marks)
(Total: 20 marks)
Question 6
Soul (Answer on page 70)
You are the manager responsible for the annual review of your firm’s audit engagements to
identify situations where independence may be at risk and where the appropriate safeguards
should be applied.
From your review of your firm’s files relating to Soul Shop you ascertain the following.
The company is expanding rapidly following a number of acquisitions and is preparing to apply
for admission to the Stock Exchange and to offer a proportion of its shares to the public. As a
result of the special investigations undertaken, total fees from Soul Shop amount to 17 per cent
of your firm’s gross practice income for the current year.
11
KAPLAN PUBLISHING
The company is about to undertake a feasibility study, on a proposal to expand into Europe,
which is to be kept secret from employees. To keep the initial costs of the Soul Shop team’s
European travel expenses a secret, a partner (who is not the engagement partner) has offered
to have them put onto his credit card. They would then be billed as professional fees.
Required
(a) Explain the risks you would consider in deciding whether or not the appointment should
continue. (8 marks)
(b) Briefly describe the safeguards available. (7 marks)
(c) Come to a conclusion on whether you consider the appointment should continue.
(5 marks)
(Total: 20 marks)
Question 7
Melton Manufacturing (Answer on page 72)
The directors of Melton Manufacturing, a private limited liability company, have asked your firm to
act as their auditors for the year ended 30 September 20X8. They will be asking their existing
auditors to resign as they say they do not provide a cost effective service.
Required
(a) Describe the investigations you would carry out and the statutory and ethical matters you
would consider before you can:
(i) accept the appointment as the company’s auditor; and

(ii) be appointed the company’s auditor. (11 marks)
You may assume that the company operates in a country whose statutory rules are
those typically found across the world.
(b) (i) Explain why it is important that an auditor should send a letter of engagement to
the client prior to undertaking the audit.
(ii) Briefly describe the main contents of a letter of engagement which you would
send to the directors of Melton Manufacturing. (9 marks)
(Total: 20 marks)
Question 8
12
KAPLAN PUBLISHING
Bondi (Answer on page 74)
You are a partner with a firm of Chartered Certified Accountants that has been invited, by the
board of directors, to accept nomination as external auditors to Bondi, a publicly owned
incorporated business. Bondi operates a number of car dealerships and has grown rapidly over
the past two years through an aggressive takeover strategy.
You are aware that the company’s existing auditors, a much smaller firm, qualified their last
auditors’ report. Over lunch with a number of your firm’s partners, the company’s chief financial
officer maintained that their existing auditors could not cope with the audit of a company their
size and, in particular, were not equipped to audit the recently installed sophisticated computer
accounting program. He also suggests that they need a firm of your reputation in order to
reassure the market as they intend to seek a public listing within two years.
The existing auditors, in response to your enquiry, advise against accepting the audit on the
following grounds:
♦ Insufficient consideration has been devoted by management to developing the accounting system in
line with the expanding business. In particular there is a lack of concern as to control. They detected
a number of petty employee frauds as a result of control weaknesses. No action was taken against
the employees identified as engaged in fraud. The attitude seems to be to encourage risk taking
employees who, if they make money on the side whilst securing good deals for the company, that is
seen as a legitimate bonus.
♦ The newly installed computer accounting system is unreasonably complicated. Bondi claims this is
necessary because of the need to maintain records to justify the company’s claims for volume
rebates and bonuses under the complex incentive schemes by which car manufacturers reward
dealers.
♦ They have no evidence of deliberate misrepresentation by the directors but audit staff were hindered
in their audit work by a less than helpful attitude by senior management who adopted an aggressive
stance whenever a query was raised. The chief financial officer was constantly on the phone to the
partner claiming the audit staff were incompetent and accusing them of wasting his time asking
unnecessary questions.
At a partner’s meeting a majority of partners accepted the story that the existing auditors were
out of their depth and that their complaints were merely an attempt to cover up their own
shortcomings. Your firm accepted nomination and was duly appointed as auditors.
Required
(a) State factors the partners should have considered for and against accepting nomination.
(7 marks)
(b) Detail the matters to which you would pay particular attention in obtaining the required
knowledge of the business and in developing your audit plan. (7 marks)
During the first audit your firm discovers that the reason for the complexity of the computer
system is to falsify records in order to reduce the amount of tax payable to the government.
(c) Describe the action you would take on discovery of the fraud. (6 marks)
13
KAPLAN PUBLISHING
(Total: 20 marks)
Question 9
Radford Retail (Answer on page 77)
ISAs 300 to 320 provide guidance on planning an audit of financial statements to ensure that
the audit can be performed in an effective manner.
You are the manager responsible for the audit of Radford Retail which has a number of stores
selling household products to the general public, including furniture, electrical equipment,
cooking equipment and carpets.
The company has an annual sales revenue of about $20 million. In previous years’ audits there
have been problems with:
♦ misappropriation of inventory by employees and customers

♦ slow moving and damaged inventory which is worth less than cost
♦ incomplete recording of sales when the customer pays in cash (these represent 55 per cent of all
sales).
The company has a small internal audit department, the staff of which visit branches and
perform appropriate audit work at the head office.
Required
Describe the work you will carry out and the matters you will consider in planning the audit prior
to the commencement of the detailed work, including consideration of the timetable for the audit.
(Total: 20 marks)
Question 10
Growing (Answer on page 79)
You are the auditor of a company called Growing which commenced trading on 1 April 20X5 as
a distributor of microcomputers. You completed the audit for the year ended 31 March 20X6 in
July 20X6 and reported by August 20X6.
Basic systems of internal control were not in evidence in all areas until after the end of the first
year. You qualified your report in respect of the first year on the grounds of lack of evidence
concerning the completeness of recording.
The company commenced business selling new computers and spares only, with a total staff of
five, and during the course of the first year extended its activities into the sale of second-hand
14
KAPLAN PUBLISHING
computers and the servicing and hire of computers. The total staff at the end of the year was
20, including an accounts department of 3.
You have contacted the client with a view to planning the audit for the year to 31 March 20X7.
You have established, from information provided by the company’s accountant, who joined the
company in August 20X6, that the total number of staff is expected to increase to over 50 by
March 20X7 and that sales are broadly doubling every three months.
During the course of the year, as additional staff have been taken on, the basic systems of
internal control have developed and altered to meet the needs of the rapidly expanding
business.
Required
(a) Identify, from the situation outlined above, circumstances particular to Growing that
should be taken into account when planning the audit. Explain clearly why these matters
should be taken into account. (10 marks)
(b) State the audit procedures you would carry out in order to address the above matters.
(10 marks)
(Total: 20 marks)
Question 11
Gnome Publications (Answer on page 80)
You are the manager in charge of the audit of Gnome Publications, a publishing company
based in a provincial town, with a year end of 31 March.
It is your first year in charge of the audit, although the company has existed and your firm has
been its auditors for three years. From discussions with the engagement partner and the new
managing director, Miss Hughes, you have ascertained the following information.
The company’s main business is the writing, production, printing and marketing of technical
publications. The company sells these publications mainly to companies in the training field and
also to universities and colleges.
The company has grown rapidly with a sales revenue now of approximately $5 million.
However, the financial results have been poor with profits around $100,000.
Miss Hughes was appointed on 1 August 20X6. Her objective is to produce better results and
as part of her motivation she has a remuneration package that is partly profit-related.
The company has recently invested heavily in desk top publishing equipment and is in the
process of changeover from more traditional typesetting methods. There are some ‘teething
15
KAPLAN PUBLISHING
problems’ but Miss Hughes is convinced these can be sorted out shortly. Old equipment will be
scrapped.
Accounting transactions are recorded on a microcomputer (an IBM-clone, the NAFF) using a
well-known off the shelf package, Sagg. No management accounts are prepared other than the
monthly nominal ledger printout from the Sagg system.
The final financial statements are prepared by an accountant (based in the capital city) who
travels to the company for two days during April for this purpose.
Required
Prepare a file memorandum setting out the factors you would consider in assessing audit risk
for Gnome Publications, explaining why you would take them into account and summarising the
implications for your audit procedures.
(Total : 20 marks)
Question 12
Bestwood Engineering (Answer on page 82)
Your firm is the external auditor of Bestwood Engineering which manufactures components for
motor vehicles and sells them to motor vehicle manufacturers and wholesalers. It has a sales
revenue of $10 million and a profit before tax of $400,000.
The company has a new financial director who has asked your advice on controls in the
company’s purchases system.
Bestwood Engineering has separate accounts, purchasing and goods received departments.
Most purchases are required by the production department, but other departments are able to
raise requisitions for goods and services. The purchasing department is responsible for
obtaining goods and services for the company at the lowest price which is consistent with the
required delivery date and quality, and for ensuring their prompt delivery.
The accounts department is responsible for obtaining authorisation of purchase invoices before
they are input into the computer which posts them to the payables ledger and the nominal
ledger. The accounting records are kept on a microcomputer and the standard accounting
software was obtained from an independent supplier. The accounting software maintains the
payables ledger, receivables ledger, nominal ledger and payroll.
The company does not maintain inventory records, as it believes the costs of maintaining these
records outweigh the benefits.
The financial director has explained that services include gas, electricity, telephone, repairs and
short-term hire of equipment and vehicles.
16
KAPLAN PUBLISHING
Required
(a) Describe the procedures which should be in operation in the purchasing department to
control the purchase and receipt of goods. (8 marks)
(b) Describe the controls the accounts department should exercise over obtaining
authorisation of purchase invoices before posting them to the payables ledger.
(6 marks)
(c) Explain how controls over the purchase of services, from raising the purchase requisition
to posting the invoice to the payables ledger, might differ from the procedures for the
purchase of goods, as described in your answers to parts (a) and (b) above.(6 marks)
(Total: 20 marks)
Question 13
Working papers (Answer on page 84)
‘Audit working papers’, according to ISA 230 Documentation, typically contain a wide range of
information. Such information tends to be recorded in a number of different files connected with
an audit or an audit client.
Required
(a) As a newly appointed senior in charge of an audit of long standing, describe what audit
working papers might be of particular assistance to you:
(i) in familiarising yourself with the client company. (6 marks)

(ii) when you are planning the current year’s audit. (6 marks)
(b) List and explain the criteria which you would use to judge the quality of audit working
papers. (8 marks)
(Total: 20 marks)
Question 14
Risk (Answer on page 87)
One of the recent developments in auditing has been consideration of audit risk, which in turn
has influenced the way audits are carried out and the balance of work between the different
sections of an audit.
Required
17
KAPLAN PUBLISHING
(a) List and describe the factors you would consider in assessing the audit risk when you
are planning the audit of the financial statements of a manufacturing company, and the
situations when you consider there will be a high level of audit risk. Your answer should
consider the following items in the accounts.
(i) Property, plant and equipment

(ii) Inventory (see note below)
(iii) Trade receivables
(iv) Trade payables (10 marks)
(b) Discuss the reasons why consideration of audit risk has become an important factor for
auditors to consider when planning and carrying out an audit. (10 marks)
(Total: 20 marks)
Note. In part (a) (ii) you should not consider construction contract work in progress.
18
KAPLAN PUBLISHING
Question 15
Newthorpe Manufacturing (Answer on page 89)
Your firm is auditing the financial statements of Newthorpe Manufacturing for the year ended 31
March 20X7. You have been assigned to the audit of the company’s non-current assets, which
comprise the following.
♦ Freehold land and buildings

♦ Plant and machinery
♦ Fixtures and fittings
♦ Motor vehicles
The freehold land and buildings were purchased ten years ago for $2 million. At the date of
purchase a valuer estimated the value of the land at $1 million and $1 million for the buildings.
Since then, depreciation has been charged on the building at 2% per annum on cost. At
31 March 20X7 the accumulated depreciation is $200,000 before the revaluation.
A qualified valuer, who is not an employee of the company, has recently valued the land and
buildings at $5 million, comprising the following.
♦ Land at $2.9 million

♦ Buildings at $2.1 million
These values will be incorporated into the financial statements at 31 March 20X7.
The partner in charge of the audit is concerned at the large increase in the value of the land and
buildings since they were purchased, and has asked you to check the reliability and accuracy of
the valuation. He has suggested that ISA 620 Using the Work of an Expert could assist you in
carrying out this work.
In addition, you have been asked to verify the existence and completeness of plant and
machinery which is recorded in the company’s computerised asset register. The asset register
records the description of each non-current asset, the original cost, the depreciation charge and
the accumulated depreciation. The company’s accounting policy on non-currrent assets is only
to capitalise items over $500.
Required
(a) Describe the audit work you will carry out to check whether the valuer has provided an
accurate and independent valuation of the land and buildings. (9 marks)
(b) Describe the audit work you will carry out to check the existence and completeness of
plant and machinery, as recorded in the company’s asset register. (5 marks)
(c) Describe the audit work you will perform to verify that:
(i) only capital items are included in additions to non-current assets; and
(ii) material items of capital expenditure are not charged as an expense in the year.
19
KAPLAN PUBLISHING
(6 marks)
(Total: 20 marks)
Question 16
Southwell Engineering (Answer on page 92)
Your firm is the auditor of Southwell Engineering, and you have been asked by the senior in
charge to describe how you can use computer assisted audit techniques to audit the company’s
computerised sales and receivables ledger system. Southwell Engineering will allow you to use
your data on test files to check the correct operation of the accounting computer programs and
to use computer audit programs to interrogate the receivables ledger file. You have already
satisfied yourself that controls over access to the receivables ledger system are effective.
Key features of the computerised sales system include the following.
♦ Details of goods to be despatched are input into the computer, and after approval by the credit
controller, a despatch note is printed in the despatch department who send the goods to the
customer.
♦ The computer prepares the sales invoice using prices from the price file. It posts the invoice to the
receivables ledger and the sales and applicable sales tax to the nominal ledger. The invoice is sent
to the customer.
♦ Cash received and discount allowed is posted to the receivables ledger by the sales accounting
department.
♦ The system allows posting of credit notes, adjustments (to correct errors) and writing off of bad debts.
♦ At monthly intervals, statements are sent to customers.
♦ The computer can print out at any time:
- details of transactions on any account
- an aged analysis of receivables ledger accounts
- the total of the balances on the receivables ledger
- details of transactions posted in the month
- an analysis of sales income for the month.
The following information is required when inputting despatch note details.
♦ Customer account number.

♦ Date of despatch (if different from the current date).
♦ Part number and quantity of each item despatched.
♦ Any special discounts allowed to the customer.
Required
(a) Describe the test data you would enter into the computerised sales system to check the
correct processing of despatch notes and sales invoices. (8 marks)
20
KAPLAN PUBLISHING
(b) Explain how a computer audit program can assist you in carrying out a debtors’
circularisation, including selecting the accounts receivable to circularise.(5 marks)
(c) Explain how you would use a computer audit program to help in verifying the year end
accounts receivable on the receivables ledger. (7 marks)
(Total: 20 marks)
Question 17
Lidcombe (Answer on page 93)
Lidcombe, a listed company, manufactures office furniture. It employs 250 staff at its single
factory and its sales revenue, last year, was $40 million.
You are an audit manager with a firm of Chartered Certified Accountants which has held
appointment as external auditor to Lidcombe for a number of years. However, you have not
previously been involved with the audit of Lidcombe. You are currently reviewing the audit file
prior to planning the audit for the financial year ending 31 December 20X9. Last year there
were no major audit problems and inherent risk was assessed as relatively low and the control
environment considered satisfactory.
The description of the purchases system as updated in last year’s audit file reads as follows:
‘Requisitioning
Department heads have authority to issue requisitions for non-capital purchases up to $5,000.
Requisitions over $5,000 and capital items below $20,000 must be approved by the appropriate
director. Capital expenditure over $20,000 requires Board approval. Inventory requisitions are
automatically issued by the computer when pre-determined re-order levels are reached.
Ordering
All requisitions pass through the purchasing office which checks the authority of the
requisitioner, identifies suitable suppliers and obtains quotes where necessary. The purchasing
office then opens up an order against the supplier which is recorded in the supplier master file
on the computer. The computer assigns an order number. A copy of the order is printed out
and sent to the supplier.
Receiving
Deliveries are only accepted at the centralised receiving dock. The receiving clerk accesses the
order on the computer and checks that the goods are in agreement with the order and are in
good condition. The receiving clerk then amends the computer record of the order with
receiving information.
Recording
21
KAPLAN PUBLISHING
Purchase invoices are numbered on receipt. The accounts payable ledger clerk checks the
invoice arithmetically, and verifies it against the computer record of the order ensuring that the
records confirm receipt of the goods. These checks are evidenced on the invoice together with
the account coding specified on the order. Receipt of the invoice is also noted on the order
record to prevent accidental acceptance of a duplicate invoice. Invoices are batched daily by
the accounts payable ledger clerk for computer processing and a control sheet is prepared for
each batch listing the total payable.
The assistant accountant approves each invoice before passing the batch to the computer
operator.
Payment
At the end of each month the computer prints out cheques for the balance owing to each
supplier together with a remittance advice itemising the make-up of the balance. A copy of the
remittance advices is also printed out in the form of an accounts payable ledger.
The assistant accountant reconciles the total payable with the daily batch control information,
test checks payables with suppliers’ statements, approves the copy remittance advices for
payment, has the cheques mechanically signed and passes them directly to the mail room.’
You note that your predecessor completed an internal control evaluation questionnaire (ICEQ)
and used the results to justify assessing control risk as low for all purchase and payment
transaction assertions associated with accounts payable.’
Required
(a) Two of the financial statement assertions relating to transactions identified by ISA 500
Audit Evidence are those of ‘occurrence’ and ‘completeness’.
(i) Explain these in the context of purchase transactions. (4 marks)
(ii) Identify control procedures in Lidcombe’s purchasing system that relate to each
of these assertions. (8 marks)
(b) (i) Comment on the extent to which you can accept your predecessor’s assessment
of inherent risk and the continuing effectiveness of the control environment.
(3 marks)
(ii) Describe further work you would plan to undertake to assess inherent risk and
the control environment during the current year’s audit. (5 marks)
(Total: 20 marks)
Question 18
Ilkeston Products (Answer on page 95)
22
KAPLAN PUBLISHING
Your firm has been appointed auditor of Ilkeston Products, a company which manufactures food
packaging.
You are the senior in charge of the audit. At your planning meeting with the managing director
you ascertain the following background information about the sales system.
The company operates from a single site and has a computerised sales system. The company
is quite large and there is proper division of duties within the sales system.
There have been no significant changes in the accounting and internal control system during the
current year. Your enquiries about the system indicate that your preliminary assessment of
control risk is likely to be less than high.
Required
(a) Describe, with reasons, the audit work you would undertake to obtain and document an
understanding of the sales system. (6 marks)
(b) Explain and distinguish between the following forms of systems documentation:
(i) Internal control questionnaires (ICQs)

(ii) Internal control evaluations (ICEs)
and state their relative advantages and limitations. (8 marks)
(c) Describe the audit work you would undertake to support the preliminary assessment of
control risk for the sales system. (6 marks)
(Total: 20 marks)
Note - You are not required to consider the use of computer assisted audit techniques.
Question 19
Marshalls (Answer on page 97)
Your firm is the long standing auditors of Marshalls, a company operating a small one-off
department store situated in a busy market town. The business was established more than 80
years ago by Arthur Marshall who built up the store from a stall in the local market.
The company is still largely family run. Arthur’s son, George, is chairman. His grandson, Alec,
is managing director and Alec’s sister-in-law, Kate, is finance director. There are two other
directors who have no connection with the family.
Despite having a good reputation in the area, the last few years have not been easy for the
company. Three years ago a new out-of-town shopping centre opened about 20 miles away.
Not surprisingly, the effect that this centre has had on Marshall’s sales revenue and profits has
been dramatic. In the last year, however, the store has been fighting back. Alec, the prime
23
KAPLAN PUBLISHING
mover for change, has convinced his fellow directors to bring in some retail consultants to
advise on marketing and organisation. This process began almost six months ago and since
that time Marshall has entered into a dramatic programme of rationalisation, reorganisation and
‘image update’. The company had adopted some sweeping changes and in terms of
rationalisation the store has cut back from 11 departments to the core areas of ladieswear,
menswear, childrenswear, perfumes and household goods.
Early indications are that this exercise has been successful. Preliminary estimates for the
current year show that sales revenue will be up by more than 15% on last year.
As senior in charge you have just completed the interim audit. The manager in charge of the
job has reviewed your file and is particularly concerned about the changes that have been made
to the store’s purchasing procedures. From your work on this area you have discovered that the
purchasing system now operates in the following way.
Each department has two buyers, ie a senior buyer and an assistant. It is the buyer’s
responsibility to liaise with suppliers, decide on quantity and negotiate the best price for the
store. Once they have decided on a purchase, the buyers telephone through to the central
purchasing department for it to place the order.
In the central purchasing department the purchasing clerk, Mr Weston, fills out a standard
sequentially numbered three part order form. One copy is sent to the supplier, one copy is sent
to goods inwards (the receiving department) and the third is retained by Mr Weston, filed in
number order.
When the ordered goods are received into the store Mr North, who is in charge of goods in,
completes a two part goods inwards note (GIN). One copy he files with his copy of the
purchase order, the other he sends to Mr Weston.
Mr Weston matches the GIN with the purchase order in his possession and files the two
together awaiting the receipt of the supplier’s invoice. He chases up orders which are
outstanding for more than two weeks.
When the supplier’s invoice is received, Mr Weston checks the prices, additions and extensions
and enters the details from the invoice into the purchases day book and from there into the
accounts payable ledger. The invoice, together with the GIN and purchase order, is filed
alphabetically by supplier.
On a weekly basis Mr Weston prepares a list of cheque payments to be made which is passed
to the cashier, Mrs Easter, to raise the cheques. Mr Weston uses this list to write up the
accounts payable ledger. The cheques are signed by Mrs Southgate, who is Marshall’s chief
buyer and independent of any department.
Suppliers’ statements are received by Mr Weston, reconciled to the payables ledger and filed in
alphabetical order.
Required
24
KAPLAN PUBLISHING
Set out, in a manner suitable for inclusion in a management letter, the significant areas of
weakness in the purchases system. For each weakness you should include a description of the
specific weakness, the possible consequences of the weakness and a recommendation to
remedy the weakness.
(Total: 20 marks)
Question 20
Dean (Answer on page 98)
You are the senior in charge of the audit of Dean, a limited liability company. To assist you in
your audit planning, one of the audit team has provided the following description of the
purchasing system. No other controls exist apart from those described.
‘The company has no buying department so employees place orders in their own area of
responsibility. A three-part order form is used; copy 1 is retained by the originator, copy
2 is sent to the goods inward (receiving) department and copy 3 is sent to the supplier.
‘Goods are received, but not checked, by the goods inwards clerk. Once received the
advice note and purchase order for those goods are sent to the payables ledger clerk.
‘When the supplier’s invoice is received the payables ledger clerk checks the
calculations on it, initials it and staples the advice note and purchase order to it. She
enters the invoice onto the payables ledger.
‘The invoice is then sent to the manager responsible for the employee who ordered the
goods. The manager codes the invoice and returns it to the payables ledger clerk.
Purchase invoices are coded, entered on an analysis sheet and posted to the nominal
ledger monthly by journal entry.
‘The cashier pays suppliers monthly on instructions from the payables ledger clerk. The
payables ledger control account is reconciled monthly by the payables ledger clerk who
also reconciles suppliers’ statements.’
Required
For each internal control weakness in the purchasing system:
(a) identify the weakness and explain briefly its audit significance (if any), in terms of the
type of errors that could result from it, and
(b) describe the effect it would have on your normal audit procedures in terms of any
additional or extended procedures required. (20 marks)
25
KAPLAN PUBLISHING
Question 21
Bingham Manufacturing (Answer on page 101)
You have been asked by the senior in charge of the audit of Bingham Manufacturing to describe
certain aspects of the work you will carry out in auditing the company’s wages system.
Employees of Bingham Manufacturing are paid on the basis of hours worked and quantities
produced. The hours worked are recorded on clock cards and the quantities produced are
confirmed by the supervisor. Wages are paid in cash each Friday for the previous week’s work.
Appointment of employees is authorised by the managing director, and the personnel
department maintains employees’ records and their rates of pay. The cashier is separate from
the wages department.
Previous years’ audits have highlighted weaknesses in internal controls in the company’s wages
system. This has allowed an employee in the wages department to perpetrate a fraud by
creating fictitious employees on the payroll and misappropriating the wages. Some of your audit
tests have been designed to detect whether this fraud is still taking place.
A ‘starters and leavers’ test is carried out to ensure that employees are not paid before they
commence employment or after they have left.
Required
(a) State the principal controls you would expect to exist in a wages system and explain
their purpose. (5 marks)
(b) Assuming you decide not to attend the wages payout, suggest other techniques you can
use to check the existence of employees. (5 marks)
(c) Describe how you will carry out a starters and leavers test. (4 marks)
(d) Describe the analytical review techniques you can use in auditing the wages system.
This should include suggesting any ratios you would calculate. (6 marks)
(Total: 20 marks)
Question 22
Eastwood Engineering (Answer on page 103)
You are auditing the financial statements of Eastwood Engineering for the year ended 31 March
20X5, and the partner in charge of the audit has asked you to consider the audit work you would
carry out on closure costs and capital commitments.
You are aware that the company plans to close one of its factories and to make the employees
redundant, and you have been asked to consider how this closure should be disclosed in the
26
KAPLAN PUBLISHING
financial statements for the year ended 31 March 20X5. You should assume that the effect of
this closure is material.
The loss arising from the closure is intended to include:
♦ costs of making employees redundant.

♦ the loss on disposal of non-current assets, which comprise freehold land and buildings, fixtures and
fittings, plant, computer equipment and motor vehicles.
♦ loss in the value of inventory, which will be surplus to requirements when the factory is closed.
Required
(a) Describe the audit work you would carry out to determine whether the closure of the
factory should be treated as an adjusting or a non-adjusting post balance sheet event.
(5 marks)
(b) Assuming you decide the closure is an adjusting post balance sheet event, describe the
audit work you would carry out to check the loss arising from the closure in the financial
statements. (10 marks)
(c) (i) State how capital commitments should be disclosed in the financial statements in
accordance with International Accounting Standards.
(ii) Describe the audit work you would carry out to verify the value of capital
commitments in the financial statements. (5 marks)
(Total: 20 marks)
Note – You should answer the question in accordance with International Accounting Standards,
particularly IAS 10 Events After the Balance Sheet Date, IAS 35 Discontinuing Operations and
IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Question 23
Wormwood (Answer on page 105)
Your firm is the external auditor of Wormwood Engineering which has a total sales revenue of
$100 million. The head office site includes the manufacturing unit, the accounting functions and
main administration. There are a number of sales offices in different parts of the country.
Wormwood Engineering does not have an internal audit department.
At the interim audit you have been assigned to the audit of the wages system. This will involve
obtaining an understanding of the wages system, testing the controls and performing
substantive procedures in order to verify wages transactions.
27
KAPLAN PUBLISHING
The wages records are maintained on a computer and all the wages information is processed at
the head office. Some of the employees in the manufacturing unit are paid in cash and all other
employees have their wages paid directly into their bank account.
Manufacturing employees are paid their wages a week in arrears. All other employees are paid
at the end of each week or month.
There is a personnel department which is independent of the wages department. The

personnel department maintain records of the employees, including their starting date, grade,
current wage rate and leaving date (if appropriate).
Previous years’ audits have revealed frauds by wages department staff which have been
facilitated by weaknesses in controls in the wages system. These frauds have included:
♦ paying employees after appointment but before they commenced work

♦ paying employees after they have left, and
♦ paying fictitious employees
A check of current controls in the wages system has revealed that the company has failed to
instigate controls to prevent these types of fraud recurring. So the audit programme requires
extensive substantive procedures to be carried out to ensure that recorded wages transactions
have not been misstated by similar frauds taking place in the current year.
The existence of employees at the head office site can be verified by physical inspection. From
a cost effectiveness point of view, only a small sample of sales offices will be visited. The audit
manager has asked you to consider the audit procedures you would carry out to obtain sufficient
appropriate evidence of the existence of employees at sales offices not visited by the audit staff.
The audit manager has explained that ‘unclaimed wages’ (in part (c) below) arise when
manufacturing employees are not present to collect their wages (when they are paid out in part
(b)). The unclaimed wage packets are given to the cashier who records their details in the
unclaimed wages book and is responsible for their custody. Any employee who has not
received his/her wage packet at the pay-out can obtain it from the cashier. You have
ascertained that there is no system of checking the operation of the unclaimed wages system by
a person independent of the cashier and the wages department.
Required
(a) Describe how you would verify that employees are not paid before they commenced
employment or after they have left (a ‘starters and leavers’ test). (5 marks)
(b) Describe the audit procedures you would carry out in connection with attending a pay-
out of wages in cash to manufacturing employees. (5 marks)
(c) Describe the substantive checks of transactions you would carry out on the unclaimed
wages system. (5 marks)
28
KAPLAN PUBLISHING
(d) Describe the evidence you would obtain to verify the existence of employees whose
wages are paid directly into their bank account, including those at sales offices.
(5 marks)
(Total: 20 marks)
Question 24
Lenton Electrical (Answer on page 107)
Your firm is the external auditor of Lenton Electrical, which is a retailer of electrical products
(televisions, video recorders, audio equipment and audio and video tapes). The company’s year
end is Wednesday 30 April 20X7.
The company has a computerised inventory control system which records inventory quantities
and is not integrated with the payables ledger. After investigating the inventory system and
related controls, the senior in charge of the audit has decided that the approach to auditing
inventory quantities at the year end should be as follows:
♦ Test the operating effectiveness of controls by attending one of the periodic inventory controls on 14
April to check that the inventory is counted accurately and the computerised inventory records are
updated correctly for differences found at the physical count.
♦ Substantively test the inventory quantities on the computer system at 30 April 20X7. These inventory
quantities will be used to value inventory at the year end.
Key features of the inventory control system are as follows.
♦ Each product has a unique bar code.

♦ When goods are received the goods received department scans the bar code and enters the quantity.
The computer adds the items to inventory. When the scanner cannot read the bar code, the bar code
number is input manually.
♦ The goods received department make out a pre–numbered goods received note (GRN). They retain a
copy of the GRN and attach the second copy of the GRN to the advice note and send it to the
purchases accounting department.
♦ The purchases accounting department receive the purchase invoice. They check it to the advice note,
GRN and purchase order. If these checks are satisfactory, the purchase invoice is approved by the
managing director. Then it is posted to the payables ledger and the purchases account in the nominal
ledger. The purchase invoices are filed in alphabetical order by supplier name.
♦ When goods are sold to customers, the bar code is scanned. The computer deducts the items from
inventory and the customer’s bill is produced using the prices of products on the computer’s standing
data file. All customers pay by cash, cheque or credit card (charge card).
♦ A full inventory count at the year end is not carried out. A physical count is carried out every two
weeks when about a quarter of the inventory is counted and the quantities are compared with the
quantities on the computer. All inventory is counted within an eight week period.
♦ Adjustments to computer inventory quantities for differences found at the inventory count are input
into the system and authorised by the managing director.
29
KAPLAN PUBLISHING
♦ The inventory control system can print out the quantity of any item of inventory and details of receipts
and sales of inventory, including the date and time the goods were received or sold.
You attended one of the periodic inventory counts, which was carried out on Monday 14 April
20X7 from 6 pm to 8 pm. About 25% by value of the total inventory was counted. The store was
closed during the count to avoid sales cut–off errors and minimise purchases cut–off errors.
Required
(a) At the inventory count on 14 April 20X7, describe the procedures the company should
instigate to ensure the computerised inventory records are only amended for differences
found at the count and that no adjustment is made to the inventory records when the
difference is due to a counting error. (6 marks)
(b) Describe the audit procedures to check purchases cut–off at 30 April 20X7.(6 marks)
(c) In verifying the accuracy of the computer inventory quantities at 30 April 20X7:
(i) describe the checks you will carry out to verify that all the inventory is counted
within eight weeks of the year end.
(ii) consider the size and frequency of the errors in computer inventory quantities
found at the periodic counts and the effect of these errors on the accuracy of the
computer inventory quantities at the year end. Your answer should also consider
cases when the computer system shows a negative inventory balance.
(8 marks)
(Total: 20 marks)
Note - You should consider only the verification of inventory quantities. You are not required to
describe the work you would carry out in verifying the price per unit of inventory and the total
inventory value.
Question 25
Sheffield Homestores (Answer on page 109)
You have recently been appointed auditor of Sheffield Homestores and are planning the
forthcoming interim audit. You have obtained the following background information about the
company.
The company operates from a large retail store which sells decorating and other products for
the repair and maintenance of houses. The product range includes paint, electrical goods,
doors, windows, ladders, cement, bricks, screws, nails and tools such as power drills.
A computer system records sales and keeps a record of inventory levels and inventory turnover.
30
KAPLAN PUBLISHING
All sales are recorded at the tills at the exits from the store and payments are accepted by either
cash, cheque, MasterCard or Visa. Each product has a unique product bar code which is input
into the computerised till, which obtains the price and description of the goods from a central
computer. Till receipts show details of the goods purchased which are deducted from the book
inventory records. At the end of each till operator’s shift, the computer prints out the total of
cash and charge card takings.
The inventory records are updated by staff in the goods inwards department from goods
received notes using a terminal connected to the computer.
The in-store customer information desk has a terminal to the computer which is used to find
whether particular items are available in inventory. Office terminals are used to:
1 input details of new inventory lines and their selling price

2 alter the selling price of existing products
3 record customers’ returns
4 ascertain inventory levels and amend them after physical counts.
Monthly printouts of sales, inventory levels and inventory movements are available, and
summaries can be obtained at any time.
All terminals are connected to the computer, which has a hard disk backing store. Copies of the
information on the store are made periodically using a tape streamer.
Required
(a) Describe the controls you would expect to see in operation over sales to customers.
(6 marks)
(b) Explain the audit procedures which should be performed to assess the reliability of the
controls in operation over access to the sales and associated inventory control systems.
(8 marks)
(c) List the controls which you would expect to see in operation to ensure the accuracy of
standing data and transaction data files. (6 marks)
(Total: 20 marks)
31
KAPLAN PUBLISHING
Question 26
Basford (Answer on page 112)
You have been asked by the manager in charge of the audit of Basford Manufacturing to find
inventory which may be worth less than cost and to check that the company has correctly
valued the inventory in accordance with IAS 2 Inventories.
Basford Manufacturing has a sales revenue of about $5 million and the value of inventory in the
draft accounts is about $800,000 at 31 March 20X2. The company manufactures trolleys,
including shopping trolleys used in supermarkets.
You have been supplied with the following information about the price per unit for products A to
E, and you have been asked to determine the price per unit which should be used in valuing the
company’s inventory at 31 March 20X2.
Product A B C D E
Category RM RM RM WIP WIP
$ $ $ $ $
Cost to date 15 22 34 52 25
Costs to completion 37 41 10 21 32
Selling and transport costs 3 3 3 3 3
(as either RM, WIP or FG)
Estimated selling price:
At 31 March 20X2 as RM 13 14 39
At 31 March 20X2 as WIP 12 5
As finished goods 48 62 48 80 55
Note. RM = raw materials, WIP = work in progress, FG = finished goods.

Costs to completion are the additional costs required to convert the raw materials or work in
progress to finished goods.
The company carried out an inventory count at 31 March 20X2 when all the inventory was
counted. You attended this count and have verified that inventory was counted accurately. The
company’s policy is to convert work in progress into finished goods, but they may sell slow
moving raw materials (rather than converting them into finished goods).
Required
(a) State the value at which each of the products A, B, C, D and E should be included in the financial
statements at 31 March 20X2. You should include appropriate workings to show how you have
determined the value of the inventory, and to explain the basis of valuation you have used.
(10 marks)
32
KAPLAN PUBLISHING
(b) Describe the work you will carry out to find inventory which may be worth less than cost.
(5 marks)
(c) Describe the checks you will perform to verify that net realisable value has been
determined correctly for:
(i) finished goods

(ii) work in progress
(iii) raw materials. (10 marks)
(Total: 25 marks)
Question 27
Lenton Textiles (Answer on page 114)
Your firm is the auditor of Lenton Textiles and you have been asked to suggest the audit work
which should be carried out on the sales system.
Lenton Textiles sells textile products to shops. Most of its sales are made on credit, but very
small customers who do not have a receivables ledger account can collect their purchases and
pay in cash. For these cash sales:
♦ the customer orders the items from the sales department, which raises a pre-numbered multi-copy
advice note
♦ the despatch department make up the order and give it to the customer with a copy of the advice note
♦ the customer gives the advice note to the cashier who prepares a handwritten sales invoice
♦ the customer pays the cashier for the goods by cheque or in cash
♦ the cashier records and banks the cash.
For credit sales, cheques and cash are received in the post. The post is opened by two people,
who record cash and cheques received. The cheques and cash are given to the cashier who
records them in the cash book and pays them into the bank. The cashier reports the cheques
and cash received to the sales accounting department which posts the items to the receivables
ledger.
Credit notes must be authorised before they are sent to customers and posted to the
receivables ledger.
Required
(a) (i) State the weaknesses in the cash sales system.
(ii) Describe the systems based tests you would carry out to check that there is no
material fraud or error in this system. (7 marks)
33
KAPLAN PUBLISHING
(b) (i) Briefly explain why two people should open the mail which contains cheques and
cash from customers.
(ii) Describe the audit work you would carry out when you attend the opening of the
mail and follow through the process to banking of the cheques.(6 marks)
(c) (i) List the reasons why credit notes may be issued.
(ii) Describe the audit work you would perform to check that all credit notes have
been authorised and issued for a valid reason. (7 marks)
(Total: 20 marks)
Question 28
Betterhome (Answer on page 117)
You are the auditor of Betterhome, a company which sells building and do-it-yourself products
from 10 large stores nationwide. Its business is roughly equally divided between credit sales to
the building trade and cash sales to retail customers.
The company has used microcomputers, linked to the sales tills, at each store to record and
control inventories, and two microcomputers at its head office to handle all the other financial
records. Traditionally the company’s systems of control have been good.
During the year ending 31 December 20X6, Betterhome has installed a small mainframe
computer at its head office, and new software has connected the microcomputers at each store
on-line to the new mainframe computer. All sales data are now input direct from the stores.
The new software is a fully integrated standard package, modified to Betterhome’s

requirements, purchased from a specialist software house. Parallel running of the two systems
took place during July and August 20X6, since when the old system has been discontinued.
The finance director, Mr Wright, has indicated that, since the new system is fully integrated, he
expects that you need to do less audit checking for the year ended 31 December 20X6, and
that, as a result, he will be looking for a reduction in the audit fee.
Required
Write a formal letter to Mr Wright explaining:
(a) what internal controls you expect to see in place in relation to the new computer system.
(8 marks)
(b) what impact the installation of the new computer system will have on the extent of your
audit testing for the year ending 31 December 20X6. (12 marks)
(Total: 20 marks)
34
KAPLAN PUBLISHING
Question 29
Audit evidence (Answer on page 120)
ISA 500 Audit Evidence requires that ‘The auditor should obtain sufficient appropriate audit
evidence to be able to draw reasonable conclusions on which to base the audit opinion’. The
explanatory material contained within ISA 500 identifies five procedures for obtaining audit
evidence. ISA 500 also offers guidance as to assessing the reliability of audit evidence.
Required
(a) Identify and describe the procedures for obtaining audit evidence. (5 marks)
(b) For each of these procedures describe an audit test using that procedure to obtain
evidence as to the balance of plant and machinery shown in the balance sheet including
the related balances of accumulated depreciation and depreciation charged in the
income statement. (5 marks)
(c) For each of the procedures, discuss considerations affecting your judgement as to the
reliability of the evidence with particular reference to the test described in your answer to
(b). (10 marks)
(Total: 20 marks)
Question 30
Sources of audit evidence (Answer on page 122)
‘The auditor should obtain sufficient appropriate audit evidence to be able to draw reasonable
conclusions on which to base the audit opinion.’
‘Sufficiency is the measure of the quantity of audit evidence; appropriateness is the measure of
the quality of audit evidence and its relevance to a particular assertion and its reliability.’
ISA 500 Audit Evidence
Required
Discuss the extent to which each of the following sources of audit evidence is relevant, reliable
and sufficient.
(i) Oral management representations in respect of the completeness of sales where the
majority of transactions are conducted on a cash basis.
(ii) Flowcharts of the accounting and control system prepared by a company’s internal audit
department.
35
KAPLAN PUBLISHING
(iii) Year end suppliers’ statements.

(iv) Physical inspection of a non-current asset by an auditor.
(v) Comparison of income statement items for the current period with corresponding
information for earlier periods.
(Total: 20 marks)
Question 31
Daybrook Insurance Brokers (Answer on page 124)
Your firm is the auditor of Daybrook Insurance Brokers which operates from a number of
branches and provides insurance for the general public and for businesses. The company
obtains insurance from large insurance companies, and takes a commission for its services.
You have been asked to audit certain aspects of the company’s non-current assets for the year
ended 31 March 20X5.
The company’s main non-current assets comprise:

♦ freehold land and buildings
♦ microcomputers, printers and related equipment which are used by staff
♦ cars which are provided to directors and salespeople who visit customers.
The company has been operating for a number of years, and it maintains details of its office
equipment and cars on a computerised asset register. The company uses the following
depreciation rates.
Buildings 2% per annum on cost

Office equipment (including computers) 10% per annum on cost
Motor vehicles (ie cars) 25% per annum on cost.
You are concerned that the depreciation rate for the computers may be inadequate.
36
KAPLAN PUBLISHING
On 1 April 20X4 Daybrook Insurance Brokers purchased a competitor’s trade for $500,000. This
comprised the competitor’s customers and trade name but it did not include any other assets or
liabilities. In the financial statements for the year ended 31 March 20X5 the goodwill has been
included in the balance sheet and it is being amortised over a period of ten years.
Required
(a) Describe how you would verify the ownership of
(i) freehold land and buildings

(ii) computers and cars (5 marks)
(b) (i) Describe the investigations you would carry out to determine whether the
depreciation rate of the computers is adequate.
(ii) Describe the factors you would consider when deciding whether to qualify your
audit report on the understatement of the depreciation of the computers.
Assuming you decide to qualify your audit report on the understatement of

depreciation on the office equipment, you should describe the form of qualified
audit report you would use. (8 marks)
(c) Describe the audit work you would carry out to determine whether the goodwill on
purchase of the competitor’s trade is worth $450,000 at 31 March 20X5 and that the
amortisation charge of $50,000 is reasonable. (7 marks)
(Total: 20 marks)
Question 32
Simons Engineering (Answer on page 127)
You have been asked to carry out the audit of the non-current assets of Simons Engineering for
the year ended 31 March 20X5. The draft accounts show the following movements on non-
current assets in the year.
Cost or valuation Freehold land Plant & Motor Total

& buildings machinery vehicles
$ $ $ $
At 1 April 20X4 353,000 406,000 173,000 932,000
Additions 292,000 86,000 65,000 443,000
Disposals – (29,000) (47,000) (76,000)
_______ _______ _______ ________
At 31 March 20X5 645,000 463,000 191,000 1,299,000
_______ _______ _______ ________
Depreciation
At 1 April 20X4 132,000 187,000 74,000 393,000
Charge for the year 12,900 43,000 42,000 97,900
37
KAPLAN PUBLISHING
On disposals – (25,000) (32,000) (57,000)

_______ _______ _______ ________
At 31 March 20X5 144,900 205,000 84,000 433,900
_______ _______ _______ ________
Net book value at 31 March 20X5 500,100 258,000 107,000 865,100
_______ _______ _______ ________
During the year ended 31 March 20X5 the company purchased some land and built a new
factory, which was completed during the year.
The company maintains an asset register for all non-current assets, and it depreciates its non-
current assets at the following annual rates.
Land and buildings 2% on cost

Plant and machinery 10% on cost
Motor vehicles 25% on cost
Required
(a) List and describe the audit tests you would perform to verify the amounts shown in non-
current assets in the company’s financial statements for the year ended 31 March 20X5.
(10 marks)
(b) If the company did not maintain an asset register, describe the problems you would
experience and how it would affect your audit work and opinion. (10 marks)
(Total: 20 marks)
Question 33
Newpiece Textiles (Answer on page 127)
Your firm is the auditor of Newpiece Textiles and you are auditing the financial statements for
the year ended 31 October 20X7. The company has a sales revenue of $2.5 million and a profit
before tax of $150,000.
The company has supplied you with the following bank reconciliation at the year end. You have
entered the ‘date cleared’ on the bank reconciliation, which is the date the cheques and
deposits appeared on November’s bank statement.
$ $
Balance per bank statement as at 31 October 20X7 (9,865)
Add: deposits not credited

CB date Cheque no Type Date cleared
31 Oct SL 3 Nov 11,364
24 Oct CS 3 Nov 653
27 Oct CS 4 Nov 235
28 Oct CS 5 Nov 315
29 Oct CS 6 Nov 426
38
KAPLAN PUBLISHING
30 Oct CS 7 Nov 714

31 Oct CS 10 Nov 362
______
14,069
Less uncleared cheques

30 Oct 2163 CP 3 Nov 1,216
31 Oct 2164 PL 18 Nov 10,312
31 Oct 2165 PL 19 Nov 11,264
31 Oct 2166 PL 18 Nov 9,732
31 Oct 2167 PL 20 Nov 15,311
31 Oct 2168 PL 21 Nov 8,671
31 Oct 2169 PL 19 Nov 12,869
31 Oct 2170 PL 21 Nov 9,342
31 Oct 2171 CP 3 Nov 964
______
(79,681)
______
Balance per cash book at 31 October 20X7 (75,477)
______
Notes
♦ ‘CB date’ is the date the transaction was entered in the cash book.
♦ Type of transaction: SL – sales ledger receipt; CS – receipt from cash sales; CP – cheque payment
(for other expenses); PL – purchase ledger payment.
♦ All cheques for purchase ledger payments are written out at the end of the month.
Required
(a) Describe:
(i) the matters which cause you concern from your scrutiny of the bank
reconciliation;
(ii) the investigations you will carry out on the items in the bank reconciliation which
cause you concern;
(iii) the adjustments you will probably require to be made to the financial statements
if your investigations confirm the problems you have highlighted in (i) above.
(10 marks)
(b) The manager in charge of the audit has asked you to consider the petty cash system
and recommend what audit work may be necessary. You have found that petty cash is
recorded in a hand written analysed petty cash book and it is not kept on an imprest
system. From the petty cash book you have recorded the petty cash expenditure for
each month as follows.
$
20X6
November 855
39
KAPLAN PUBLISHING
December 6,243
20X7
January 972
February 796
March 893
April 751
May 986
June 695
July 749
August 8,634
September 948
October 849
______
Total 23,371
______
Required
(i) Advise the audit manager as to the desirability of performing further substantive
procedures on petty cash. You should consider materiality and audit risk in relation to
the petty cash system. (4 marks)
(ii) Assuming the audit manager decides that further audit work is necessary, describe the
detailed substantive tests of transactions and balances you should carry out on the petty
cash system. (6 marks)
(Total : 20 marks)
Question 34
Pyrmont (Answer on page 127)
For several years Pyrmont, a listed company, has maintained perpetual inventory records at
each of its 10 shoe shops. Nevertheless, it has continued to determine closing inventory by
physical count at or near the year end. As the senior in charge of Pyrmont’s external audit for
the year ending 31 December 20X9, you are in the process of planning the audit. In
discussions with the company’s chief accountant she informs you that the company is intending
to dispense with the annual physical inventory count and to rely on the perpetual records in
determining closing inventory.
The company operates a centralised computer system networked to terminals and point of sale
registers in each shop. Last year’s audit file indicates that control risks over purchase and sale
transactions were assessed as low for occurrence, completeness and measurement assertions.
However, the control risk assessment did not extend to the recording of sale and purchase
transactions into the inventory records since inventory was determined by physical count. The
description of the accounting system shows inventory as being delivered directly to each shop.
The manufacturers attach a bar-coded tag to each pair of shoes. On delivery, shop personnel
physically check each pair of shoes with the description coded on the tag. They then scan the
40
KAPLAN PUBLISHING
tags. The networked computer verifies the goods against the order and records them on the
shop’s inventory records. At the point of sale the tag is again scanned which both records the
sale and removes the item from inventory records.
During the past year the company’s computing department has rewritten the inventory control
system to incorporate inventory costs as well as quantities. The computer system now records
cost at the point of delivery. On sale the computer determines cost of sale on a first in first out
(FIFO) basis and recalculates the cost of inventory on hand at each shop.
Required
(a) (i) Describe the control procedures you would need to identify in order to accept
book inventory as the basis for determining the quantity of inventory on hand at
the year end. (5 marks)
(ii) Describe how you would test those controls. (3 marks)
Assuming your assessment of control risk over recorded inventory is sufficiently low for you to
plan substantive procedures that do not require observation of the inventory count at or near the
year end:
(b) Describe the substantive procedures you would perform, both during the year and as at
the year end, in order to verify the completeness and existence of inventories.
(8 marks)
(c) State the systems development controls you would expect to find applied to the rewriting
of the inventory control system. (4 marks)
(Total: 20 marks)
41
KAPLAN PUBLISHING
Question 35
Cambridge (Answer on page 127)
Cambridge is a company that wholesales motor car spares to a large number of retail stores.
Details of accounts receivable at the year end were as follows.
Number % Value %
$
Nil balances 600 9.1 - -
Credit balances 50 0.8 (120,000) (1.0)
$1 to $1,000 5,120 77.8 3,072,000 22.2
$1,001 to $10,000 600 9.1 4,620,000 33.4
$10,001 to $20,000 120 1.8 1,810,000 13.1
$20,001 to $50,000 60 0.9 2,350,000 17.0
Over $50,000 35 0.5 2,120,000 15.3
_____ _____ _________ _____
6,585 100.0 13,852,000 100.0
_____ _____ _________ _____
Required
(a) Explain what you understand to be the objectives of a debtors circularisation highlighting
which objective is met by substantive procedures and which by tests of control.(5
marks)
(Note: An alternative term for a debtors circularisation is an external confirmation of

accounts receivable.)
(b) Explain the following terms:
(i) Positive circularisation
(ii) Negative circularisation (4 marks)
(c) State how you might select a sample for circularisation of:
(i) Balances over $50,000
(ii) Balances between $1 and $1,000 (6 marks)
(d) Set out what you understand by the term ‘statistical sampling’. State how this differs
from ‘judgmental sampling’. (5 marks)
(Total: 20 marks)
Question 36
Coogee (Answer on page 134)
Coogee is a medium sized, privately owned and incorporated engineering business with annual
sales of $23 million. Most of its sales are on credit. At its financial year end of 31 December
20X8 its accounts receivable ledger contained 2,000 accounts with balances ranging from $50
to $10,000 and totalling $2,300,000. As a staff member of Coogee’s external auditors you have
42
KAPLAN PUBLISHING
been assigned to the audit of the allowance for bad and doubtful debts which has been set at
$120,000. Your initial enquiries establish that $80,000 relates to the allowance against specific
bad and doubtful debts and $40,000 is a general allowance determined as a percentage of
overdue receivables with an increasing percentage being applied against the longest overdue
accounts.
You are aware that ISA 540 Audit of Accounting Estimates is likely to be relevant to your audit
of the allowance for bad and doubtful debts.
Required
(a) Explain the approaches adopted by auditors in obtaining sufficient appropriate audit
evidence regarding accounting estimates. (3 marks)
(b) Describe the procedures you would apply in verifying the general allowance for bad and
doubtful debts. (9 marks)
(c) Describe the procedures you would apply in verifying the specific allowance for bad and
doubtful debts. (8 marks)
(Total: 20 marks)
Question 37
Tollerton (Answer on page 137)
You are the senior in charge of the audit of a manufacturing company called Tollerton and you
are auditing the company’s trade accounts payables at 30 April 20X6.
A junior member of the audit team has been checking suppliers’ statements to the balances on
the payables ledger. He is unable to reconcile a material balance, relating to Carlton, and has
asked for your assistance, and your suggestions on the audit work which should be carried out
on the differences.
The balance of Carlton on Tollerton’s payables ledger is shown below.
Payables ledger
Supplier: Carlton
Date Type Ref Status Dr Cr Balance
10.2 Invoice 6004 Paid 1 2,130

18.2 Invoice 6042 Paid 1 1,525
23.2 Invoice 6057 Paid 1 2,634
4.3 Invoice 6080 Paid 2 3,572
15.3 Invoice 6107 Paid 2 1,632
26.3 Invoice 6154 Paid 2 924
43
KAPLAN PUBLISHING
31.3 Payment Cheque Alloc 1 6,163

Discount Alloc 1 126
14.4 Invoice 6285 2,156
21.4 Invoice 6328 3,824
30.4 Payment Cheque Alloc 2 6,005
Discount Alloc 2 123
30.4 Balance 5,980
Carlton’s supplier’s statement shows the following.
Customer: Tollerton
Date Type Ref Status Dr Cr Balance
7.2 Invoice 6004 2,130

16.2 Invoice 6042 1,525
22.2 Invoice 6057 2,634
2.3 Invoice 6080 3,752
13.3 Invoice 6107 1,632
22.3 Invoice 6154 924
10.4 Receipt Cheque 6,163
4.4 Invoice 6210 4,735
12.4 Invoice 6285 2,156
18.4 Invoice 6328 3,824
28.4 Invoice 6355 6,298
30.4 Balance 23,447
Carlton’s terms of trade with Tollerton allow a 2 per cent cash discount on invoices where
Carlton receives a cheque from the customer by the end of the month following the date of the
invoice (ie a 2 per cent discount will be given on March invoices paid by 30 April).
On Tollerton’s payables ledger, under ‘Status’ the cash and discount marked ‘Alloc 1’ pay
invoices marked ‘Paid 1’ (similarly for ‘Alloc 2’ and ‘Paid 2’).
Tollerton’s goods received department check the goods when they arrive and issue a goods
received note (GRN). A copy of the GRN and the supplier’s advice note is sent to the purchases
accounting department.
Required
(a) Prepare a statement reconciling the balance on Tollerton’s payables ledger to the
balance on Carlton’s supplier’s statement. (4 marks)
(b) Describe the audit work you will carry out on each of the reconciling items you have
determined in your answer in part (a) above, in order to determine the balance which
should be included in the financial statements. (10 marks)
44
KAPLAN PUBLISHING
(c) In relation to verifying trade accounts payable:
(i) consider the basis you will use for selecting suppliers’ statements to check the
balances on the payables ledger; and
(ii) describe what action you will take if you find there is no supplier’s statement for a
material balance on the payables ledger. (6 marks)
(Total: 20 marks)
Question 38
Galaxy (Answer on page 139)
You are the senior in charge of the audit of Galaxy, a long established company which
manufactures biscuits and confectionery.
The draft figures for ‘Current liabilities’ as at 30 September 20X6 are as follows.
20X6 20X5
$ $
Trade payables 261,521 177,625
Accruals 21,162 18,177
Provisions
Legal action 40,000 -
Factory repairs 72,000 62,000
_______ _______
394,683 257,802
_______ _______
You have obtained the following additional information.
(1) The provision for legal action relates to a competitor’s claim that their manufacturing
process has been illegally copied.
(2) The provision for factory repairs was first set up in 20X5 in respect of sums required to
be spent on urgent repairs to the factory foundations and structural steel work. $58,500
was spent during the year to 30 September 20X6.
The audit of trade payables, accruals and provisions as shown in the balance sheet at the year
end is to be performed under your supervision by a junior member of staff with no previous
experience in this area.
Required
(a) Explain why the audit of trade payables, accruals and provisions is a more difficult area
for the auditor than gross trade receivables and prepayments. (5 marks)
45
KAPLAN PUBLISHING
(b) State, with reasons, the procedures that should be undertaken by the junior member of
staff carrying out the audit of:
(i) trade payables

(ii) accruals
(iii) provisions (15 marks)
(Total: 20 marks)
Question 39
Mowbray Computers (Answer on page 143)
You are carrying out the audit of Mowbray Computers for the year ended 30 April 20X4. The
company assembles microcomputers from components purchased from the Far East and sells
them to retailers, and to individuals and businesses by mail order. In the current year, there has
been a recession and strong competition which has resulted in a fall in sales and the gross profit
margin. This has led to a trading loss and the company experiencing going concern problems.
Required
(a) Describe the factors which indicate that a company may not be a going concern. Your
list should include all factors, and not just those which apply to Mowbray Computers.
(14 marks)
(b) Consider the form of audit report (ie modified or unmodified) you would use on the
Mowbray Computers financial statements, if you conclude that the company is
experiencing serious going concern problems, in the following situations.
(i) You conclude that the financial statements give sufficient disclosure of the going
concern problems.
(ii) There is no disclosure of the going concern problems in the financial statements
and you believe there is a serious risk that the company will fail in the
foreseeable future. (6 marks)
In each case you should say how the audit report will differ from an unmodified audit
report (ie the example in paragraph 28 of ISA 700 The Auditor’s Report on Financial
Statements).
(Total: 20 marks)
Question 40
Hyson Computers Take Twov144
46
KAPLAN PUBLISHING
You are commencing the final audit of Hyson Computers which purchases computers and
associated equipment from North America and the Far East, and sells them to small computer
suppliers.
You have been presented with the summarised draft financial statements for the year ended
30 September 20X8 together with the audited figures for 20X7.
INCOME STATEMENT
20X8 20X7
$000 $000
Sales revenue 22,650 25,150
Cost of sales (17,650) (17,605)
______ ______
Gross profit 5,000 7,545
Overheads (3,950) (3,900)
Interest (700) (450)
______ ______
Profit before tax 350 3,195
Income tax expense (100) (1,000)
______ ______
Profit after tax 250 2,195
Dividends (500) (1,150)
______ _____
Retained (loss)/profit (250) 1,045
______ _____
BALANCE SHEET
20X8 20X7
$000 $000
Property, plant and equipment 10,400 8,100
______ ______
Current assets
Inventories 6,400 4,300
Trade receivables 4,500 6,300
______ ______
10,900 10,600
______ ______
Total assets 21,300 18,700
______ ______
Capital and reserves

Issued share capital 5,000 5,000
Accumulated profits 3,500 3,750
______ ______
8,500 8,750
______ ______
Non-current liabilities
Bank loans 6,000 4,000
______ ______
47
KAPLAN PUBLISHING
Current liabilities
Bank overdraft 4,130 3,800
Trade payables 2,650 875
Tax payable 20 625
Proposed dividend - 650
______ ______
6,800 5,950
______ ______
Total equity and liabilities 21,300 18,700

______ ______
The following ratios have been produced:
20X8 20X7
Gross profit margin 22.10% 30.00%
Net profit margin 1.55% 12.70%
Return on capital employed 4.12% 36.50%
Overheads (excluding interest) to sales 17.40% 15.50%
Dividend (% of shareholders’ funds) 5.88% 13.14%
Interest cover (times) 1.50 8.10
Dividend cover (times) 0.50 1.91
Current ratio 1.60 1.78
Acid test ratio (or quick ratio) 0.66 1.06
Gearing (bank overdraft included with loans) 1.19 0.53
Inventory age (months) 4.35 2.93
Receivables age (months) 2.38 3.01
Payables age (months) 1.80 2.59
The company’s Financial Director has explained these figures as follows.
Trading has been difficult in 20X8, as there has been severe competition. The company has had
to reduce its prices in an attempt to maintain sales.
The issued share capital is 5,000,000 ordinary shares of $1 each, and it has been the
company’s policy to pay an interim dividend of 10c a share on 1 May. The final dividend is
determined so that total dividends for the year are about 50% of the profit after tax. In view of
the low profits in 20X8, no final dividend will be paid.
There are long-term contracts for the purchase of computers and equipment from North
America and the Far East. The company must specify these purchases six months in advance,
and they must be paid for in the overseas currency two months after they are received by the
company. The discount given by suppliers on these purchases increases with an increase in
the quantity ordered. Currently, the company is planning to reduce purchases of this equipment
as inventories are high and sales are falling.
The company has had a number of bad debts owing to customers going out of business.
48
KAPLAN PUBLISHING
Required
(a) Comment on the company’s performance in 20X8, compared with 20X7, based on the
ratios and the information provided in the question. (6 marks)
(b) Describe the matters you will investigate in your audit, as a result of your review of the
company’s financial statements. (7 marks)
(c) Consider whether Hyson Computers is a going concern.
Your answer should:
(i) consider the information provided in the financial statements.
(ii) consider the effect on future profits and cash flows of the company’s prediction
that there will be a reduction in sales in the coming year.
(iii) describe the further investigations you will carry out and additional matters you
will consider to decide whether the company is a going concern.(7 marks)
Notes
You should assume that the ratios given in the question are calculated correctly.
Return on capital employed = profit before tax/shareholders’ funds × 100%
Gearing = (loans + bank overdraft)/shareholders’ funds
Receivables age is based on sales
Payables age and inventory age are based on cost of sales
(Total: 20 marks)
Question 41
Newbridge Trading (Answer on page 147)
ISA 560 Subsequent Events has been issued to provide guidance on the auditor’s responsibility
regarding events after the balance sheet date.
You are auditing the financial statements of Newbridge Trading for the year ended 31 October
20X7.
The senior partner of your audit firm has asked you to consider the auditor’s responsibilities for
identifying subsequent events. Also, he has asked you to describe the audit procedures which
examine subsequent events.
He has suggested that an example of one point in answer to part (b) below would be:
49
KAPLAN PUBLISHING
‘checking receivables ledger cash received after the year end to determine the realisability of
accounts receivable at the year end and highlight doubtful debts.’
The detailed audit work was completed on Friday 5 December 20X7. It is proposed that:
♦ the audit report is signed on Friday 19 December

♦ the financial statements are sent to shareholders on Monday 5 January 20X8
♦ the company’s annual general meeting will be held on Wednesday 28 January 20X8.
Required
(a) Consider the auditor’s responsibilities for detecting material subsequent events in the
periods:
(i) 31 October to 5 December 20X7
(ii) 5 December to 19 December 20X7
(iii) 19 December 20X7 to 5 January 20X8
(iv) 5 January 20X8 to 28 January 20X8
(v) after 28 January 20X8 (7 marks)
(b) List and briefly explain audit procedures which involve examination of subsequent
events. (10 marks)
(c) Describe the audit work you will carry out in period (a)(ii) above. (3 marks)
Note. an alternative term for ‘subsequent events’ is ‘post balance sheet events’.
(Total: 20 marks)
Question 42
Wotsbrite (Answer on page 149)
As auditor of Wotsbrite you have received the following letter from the finance director.
Dear Alex
I am currently preparing the 20X6 financial statements from our management
accounts for the 12 months to 31 December and I thought it would be advisable to
clear with you the following points.
(1) The net profit for the year is similar to last year but would have trebled had it
not been for two very large bad debts during the year totalling $80,000.
Although we have never had bad debts of this size in the past, I consider
them to be a normal business cost and therefore I propose not to disclose
them in the financial statements but to include them in the total for
administrative expenses.
(2) Try as she might, my assistant has been unable to reconcile the receivables
ledger and there is a difference of $740 on the control account which I
50
KAPLAN PUBLISHING
propose to write-off against the gross profit.

(3) A professional valuation of our plant and machinery has been carried out at
the year end and shows a surplus of $28,000 over book values. This is not
yet reflected in the management accounts but I have decided to take credit
for this item in the income statement as it will improve our net asset position.
I shall, of course, disclose it as an exceptional item.
(4) I have mislaid my copy of the IAS 1 and I should be grateful if you could
refresh my memory on the disclosure requirements in respect of the number
of our employees during the year and the wages etc paid to them.
(5) We ordered a new wagon ($24,000) on the last day of the year, for delivery
in April 20X7. We have until the end of February to cancel the order but we
are unlikely to do so as we shall be unable to operate without it. I have,
therefore, included the item in both non-current assets and payables.
I should be grateful if you would let me have your comments on each of the above
items before I present you with the draft accounts for audit.
Yours sincerely
W Kirby
Required
Write a letter of reply to the finance director, giving your views on the proposed treatments.
Write as from a firm, using fictitious names and addresses. (20 marks)
Question 43
Technical department (Answer on page 151)

You have recently joined your firm’s technical department on secondment.
Whenever any contentious accounting problem arises on an audit your department is consulted
prior to reporting. The following matters are currently to be dealt with.
(1) Grot is a mail order company specialising in selling limited edition arts items. They
capitalise mailing lists as intangible non-current assets in their financial statements.
(2) United revalued all its freehold buildings last year. At the end of this year it has revalued
the freeholds again and taken the movement to revaluation reserve.
(3) Half the sales force of Viking was made redundant just after the year end and provision
has been made in the accounts under review for redundancy payments amounting to
$40,000.
(4) One of Xanta’s largest customers notified its intention to go into liquidation just after the
year end and full allowance for a bad debt of $26,000 has been made in the accounts.
51
KAPLAN PUBLISHING
(5) A writ has been issued against Zeus by a former sales director who is claiming $9,000
for breach of his service agreement following his dismissal during the year under review.
No provision has been made in the balance sheet in respect of this claim.
Required
State the matters you would consider and the further audit work you would perform, in order to
reach a conclusion on the accounting treatment and disclosure of the above items.(20 marks)
Question 44
Quality control (Answer on page 155)

You are responsible for quality control in your firm of Chartered Certified Accountants. The firm
has three offices and 15 partners. The partner in charge of your audit firm believes quality
control is important, and she has asked you to provide guidance on quality control under the
following headings.
♦ The importance of quality in audit work
♦ Training of staff
♦ Monitoring the performance of staff and providing additional training
♦ Reviews of audit work:
(i) by staff and the audit engagement partner before the audit report is signed
(ii) a ‘cold’ review of audit work some time after the audit report is signed.
The partner has explained that a ‘cold’ review is carried out periodically on a sample of audits
after the audit report is signed to check the quality of the firm’s audit work.
Required
Write a memorandum to the senior partner of your audit firm on quality control, which covers the
four topics listed above. (20 marks)
Question 45
Webster (Answer on page 159)
Your firm has acted as auditors of Webster Breweries for many years. The audit for the year
ended 31 March 20X6 is drawing to a close. Results to date have been satisfactory but in your
review of a draft set of accounts, the following points have come to your attention.
♦ Short-term bank loans and overdrafts in the balance sheet at the year end have decreased
significantly in comparison with the balance sheet at 31 March 20X5. Further investigation reveals
that these had been repaid on 25 March 20X6 with the aid of a long-term loan from a major supplier.
However, on 5 April 20X6 the supplier had been repaid with a consequent effect on the company’s
bank overdraft.
♦ The directors’ report states that the directors have recommended a final dividend of $4.55 per share.
The notes to the accounts contain the following information.
52
KAPLAN PUBLISHING
- Proposed final dividend of $4.75 per share, $266,000.

- There are 56,000 ordinary shares in issue and ranking for a dividend.
♦ The chairman’s statement refers to plans to open a chain of cocktail bars throughout the capital city
and other metropolitan areas and includes estimates of future revenues amounting to a considerable
figure. The most recent board minutes, however, indicate that this project has now been abandoned.
Required
(a) Describe the matters you would consider in your overall review undertaken towards the
conclusion of the audit. (8 marks)
(b) Comment on the audit implications of each of the matters outlined above and outline the
audit steps that should be taken. (12 marks)
(Total: 20 marks)
Question 46
Melton Builders (Answer on page 162)
You are carrying out the audit of Melton Builders and you have been asked to check that a legal
claim against the company has been correctly treated in the accounts.
Melton Builders constructed an office building and sold it to Bingham Properties two years ago.
Bingham Properties claims that there are major defects in the building which will cost $3 million
to rectify and that the company will lose rents of $1m during the rectification works.
Melton Builders has obtained the opinions of a surveyor and a lawyer. The directors are of the
opinion that there is no justification for the claim, so no provision has been included in the
balance sheet. However, a note has been included in the accounts about this claim and the
contingent liability of $4 million. You have determined that a claim of $4 million is material to the
Melton Builders’ financial statements.
You have informed the financial director that the claim by Bingham Properties will be one of the
matters included in the letter of representation. The financial director has stated that he will
refuse to sign any letter of representation, as he says it is your responsibility to carry out the
audit.
He questions why your firm is charging a fee for the audit, as the firm could ask the directors to
sign the letter of representation and perform no audit work.
Required
(a) Describe the matters you would consider and the investigations you would carry out to
decide whether a provision is required for the claim by Bingham Properties.
(8 marks)
53
KAPLAN PUBLISHING
(b) In response to the financial director’s criticism, describe:
(i) the reasons why it is necessary for your firm to ask the directors to sign a letter of
representation
(ii) the matters which should be included in a letter of representation, and those
which in principle should not be included. (8 marks)
(c) Discuss the reliability of letters of representation as audit evidence. (4 marks)
(Total: 20 marks)
Question 47
Gamston and Keyworth (Answer on page 184)
International Standard on Auditing 700 The Auditor’s Report on Financial Statements

standardises the contents of the audit report and the form of qualified reports.
Your firm is the auditor of the following two companies, and you have been asked to consider
the form of qualified or unqualified audit report which should be given.
(a) Gamston Burgers has a loss–making branch and it has included non-current assets
relating to the branch at $710,000 after deducting an allowance for impairment in value
of $250,000. The directors believe that if operating changes are made and economic
conditions improve, there is a reasonable probability of the branch trading satisfactorily,
which will result in the current value of tangible assets exceeding $710,000. However,
under the current circumstances, the directors consider the extent of any impairment in
value to be uncertain. You have obtained all the evidence you would have reasonably
expected to be available.
If trading conditions do not improve, your audit investigations have concluded that the
branch will have to close. If the branch closes, the tangible assets will be worthless, as
the property is leased and the cost of moving any tangible assets will be more than their
net realisable value. If the tangible assets are worthless, you have concluded that the
effect will be material, but it will not result in the financial statements being misleading.
(b) Keyworth Supermarket sells food to the general public and customers pay in cash or by
cheque. Your audit tests reveal that controls over cash takings and custody of the
inventory are weak, and you have not been able to obtain sufficient evidence to quantify
the effect of any misappropriation of inventory or cash takings. You have concluded as
follows.
(i) If the uncertainty relates to all the company’s sales, it could result in the financial
statements being misleading.
54
KAPLAN PUBLISHING
(ii) If the uncertainty relates to only the sale of fresh fruit and vegetables, which
comprise 10% of the company’s sales, it will have a material effect on the
financial statements but it will not result in them being misleading.
Required
(a) List and briefly describe the contents of an unqualified audit report. (8 marks)
(b) Consider and describe the form of an unqualified or qualified audit report you would give
in each of the following situations:
(i) On the financial statements of Gamston Burgers if you agree with the directors’
statements about the uncertainty relating to the value of the tangible assets of
the branch.
(ii) On the financial statements of Gamston Burgers if you have come to the
conclusion that trading conditions will not improve and the company will close the
branch. Thus, the tangible assets will be worthless.
(iii) On the financial statements of Keyworth Supermarket if the uncertainty about the
misappropriation of inventory and cash takings relates to all the company’s sales.
(iv) On the financial statements of Keyworth Supermarket if the uncertainty about the
misappropriation of inventory and cash takings relates only to the sale of fresh
fruit and vegetables which comprise 10% of the company’s sales.
(12 marks)
(Total: 20 marks)
Question 48
Wulf, Sisters, Mog (Answer on page 164)
Described below are situations that have arisen in three audits. The year end in each case is
30 September 20X6.
(1) Wulf commenced development of a new type of cleaning process on 1 November 20X5.
Expenditure on this project is expected to amount to $500,000 over five years. The
outcome of the development work will not be foreseeable until the end of the second
year of the project. The directors have capitalised development costs to date of
$100,000.
The pre-tax profits of Wulf for the year ended 30 September 20X6 were $500,000 and
net assets on 30 September 20X6 amounted to $5 million.
(2) Sisters operates in a country whose national legislation prohibits companies from
making loans to their directors. However, the company has four directors who have
each borrowed $10,000 from the company. These loans, which total $40,000, have
55
KAPLAN PUBLISHING
been included in the balance sheet as on 30 September 20X6 within the total of current
assets under the heading ‘Sundry receivables – due within one year’. No separate
disclosure about the loans has been made in the directors’ report or the financial
statements. The audit senior has investigated this further and concluded that, whilst the
loans are illegal, they are genuine collectible current assets of the company.
The pre-tax profits of Sisters for the year ended 30 September 20X6 were $278,000 and
net assets on 30 September 20X6 amounted to $3 million.
(3) Mog manufactures light fittings. Certain of its finished inventory lines are out of fashion
and have a net realisable value which is $35,000 lower than their original cost.
However, the directors have argued that, overall, the net realisable value of the entire
inventory exceeds original cost and that fashions may well change over the next few
years such that the company can ultimately sell these lines above their current net
realisable value.
The pre-tax profits of Mog for the year ended 30 September 20X6 were $900,000. Net
assets and inventory on 30 September 20X6 totalled $10 million and $4 million
respectively.
Required
(a) Explain what is meant by materiality, and list the factors that may be taken into account
when deciding whether an amount is material. (5 marks)
(b) Discuss each of the situations outlined above, referring to materiality considerations and,
where appropriate, International Accounting Standards. For each situation indicate, with
reasons, what kind of audit qualification (if any) would be appropriate.
(15 marks)
(Total: 20 marks)
Question 49
Cremorne (Answer on page 171)
Cremorne is a listed construction company with annual sales of $350 million and its draft
income statement shows profit from operations for the year ended 31 December 20X8 of
$40 million. This is the first audit by this audit firm. Enquiry of the previous auditor revealed no
reasons for concern. On completing audit work at the company’s premises, the audit senior
drafts a memo, extracts from which are reproduced below.
(a) Inventory valuation
Inventories include $7 million, at cost, of scrap rubber. This material is widely used as a
road surface in other countries. Contracts for road building with this country’s Highways
Agency, the state authority for road construction, do not currently permit the use of this
56
KAPLAN PUBLISHING
material. However, the matter was known to be under review and, on being offered a
special purchase of this material, Cremorne speculated on a favourable outcome of the
review and purchased the material. In February 20X9, shortly before the financial
statements were approved by the directors, the Highways Agency reported that it would
not, currently, accept the use of this material. If used on non Highways Agency
contracts the material’s net realisable value would not exceed $2 million. The chief
financial officer maintains that, as the Highways Agency report was issued after the
balance sheet date, the write down of the inventory should be reflected in the next
period’s financial statements. (6 marks)
(b) Depreciation
In 20X4 the company purchased two computer controlled earth movers at a cost of
$2,500,000 each and a further two at the same price in 20X5. Depreciation has been
provided at 10% straight line, the same basis as it previously depreciated conventional
earth movers. This year, 20X8, the company decided that improvements in technology
made it worthwhile scrapping their first two computer controlled movers and replacing
them with the latest model at a cost of $4,000,000 each. The company’s chief engineer
tells you that technology is developing so rapidly it appears likely they will continue to
replace these machines every five years. The chief financial officer claims that the
depreciation rate of 10% is in line with industry standard and reflects the physical life of
the machines. He argues that continued improvements in technology cannot be
foreseen and that there is no justification for increasing depreciation to 20% because of
the possibility of technological obsolescence. (7 marks)
(c) Contingent liability
The company is being sued for $50 million by the Highways Agency for defective work
on a recently completed road. The company maintains that it met the Highways
Agency’s specification and that it is the Agency’s engineers who are at fault in drawing
up the specification. Cremorne maintains that it has no case to answer, that the
possibility of loss is remote and that the claim need not be disclosed as a contingent
liability. An investigative journalist has recently published an article suggesting that
other roads constructed by the company exhibit similar faults. The chief executive
officer has admitted that the company’s road building techniques are under investigation
by the Highways Agency. If the company were to lose the case its future as a going
concern would be threatened. (7 marks)
Required
Explain the effect of each matter (i) on the financial statements and (ii) if the company were to
refuse to amend the financial statements, on the auditor’s report. Your answer should consider
materiality where appropriate.
(Total: 20 marks)
57
KAPLAN PUBLISHING
Question 50
Professional Promotions (Answer on page 171)
Professional Promotions (known as Double P) are a concert hall and events company, with their
own venue in a large town close to the capital city. They organise around three events a week in
their own venue during the main season (closing during the Summer months). They have a
restaurant and two bars, which are open to the general public as well as those attending events.
They also arrange events for other organisations, in particular conferences and outdoor
concerts. Double P have a web site and telephone booking systems for events, using a
computerised booking and seat allocation system, which automatically produces information on
seat availability and capacity for each event. A separate Finance system is in place for capturing
significant expenditure – the prime costs being the booking of ‘acts’.
Double P has a Finance department but no internal audit team. The Chief Executive is
concerned about the level of risk exposure of the company and in particular the deteriorating
financial position in a time when events have been their most successful ever. You have been
asked to conduct an internal review of Double P and in particular to provide guidance on risk
assessment and recommendations on effective management of risk.
Required
(a) Explain how you would approach the review of Double P, in particular the key steps
required. (5 marks)
(b) Provide guidance on risk assessment and describe examples of the types of key risks
facing Double P. (6 marks)
58
KAPLAN PUBLISHING
(c) Describe how Double P might manage their risks, with specific examples of appropriate
controls. (6 marks)
(d) List appropriate means of reviewing the performance of Double P to help identify why
there is a deteriorating position at the time of their best performance ever.(3 marks)
(Total : 20 marks)
Question 51
Sighthill Supermarket (Answer on page 175)
ISA 610 has been issued on ‘Considering the Work of Internal Auditing’.
Your firm is the external auditor of Sighthill Supermarkets, a publicly quoted company. The
company has a head office, central warehouse and a large number of supermarkets which sell
food to the general public. The company’s Financial Director has suggested the audit fee could
be reduced if your firm was prepared to place greater reliance on the work of the internal audit
department.
The Financial Director has explained that the duties of the internal audit department include:
(i) testing and reporting on the effectiveness of internal controls by maintaining up to date
descriptions of the company’s accounting systems and evaluating the effectiveness of
controls in those systems. Recommendations are made of improvements in controls,
and proposed changes in controls are assessed.
(ii) checking the operation and reliability of the computer systems. The department uses the
computer assisted audit techniques of test data and computer audit programs (audit
software). Particular attention is paid to controls over access to the computer, checking
payment of suppliers and wages, and receipt of cash at supermarkets.
(iii) Visiting the central warehouse to check operation of the systems and the effectiveness
of controls. Inventory counting procedures are checked at the periodic physical
inventory counts.
(iv) Visits to supermarkets. All supermarkets are visited at least once a year with more
frequent visits to larger supermarkets and those where serious weaknesses have been
detected. At the supermarkets, the internal auditors check the effectiveness of controls
and carry out cash counts and test counts of the inventory. Visits are made to
supermarkets to attend the periodic inventory counts and check procedures.
The Financial Director says the internal audit department would be willing to amend the timing
of its work, so as to fit in with the external auditor’s work. The results of the internal auditor’s
work can be reported directly to the external auditor.
59
KAPLAN PUBLISHING
In part (a) of the question, in considering the effectiveness of the internal audit department, you
should consider factors which indicate the independence and competence of the internal audit
staff, reporting arrangements and the extent to which their recommendations are implemented.
In part (b) of the question, you should consider the extent to which you can rely on the internal
auditor’s work and either reduce or eliminate certain aspects of the audit work carried out by
your firm. The reduction in audit work will result in a reduction in the cost of carrying out the
audit and thus allow a reduction in the audit fee.
Required
(a) Describe the matters you should consider at the planning stage to assess the
effectiveness of the internal audit department. (6 marks)
(b) Consider the Financial Director’s proposals, namely the extent to which you can rely on
the work of the internal auditors and thus reduce your audit work in:
(i) recording accounting systems and evaluating the effectiveness of internal

controls
(ii) performing tests of controls
(iii) carrying out substantive procedures to verify assets and liabilities in the balance
sheet
(iv) auditing the computer systems, including using computer assisted audit
techniques
(v) visiting supermarkets. (14 marks)
(Total : 20 marks)
Question 52
Eastfield Distributors (Answer on page 179)
Your firm is the external auditor of Eastfield Distributors, which has annual sales of $25 million
and a profit before tax of $1.7 million. The company operates from a head office at Eastfield and
has sales and inventory holding centres in different parts of the country. The directors have
decided the company has reached a size when it needs an internal audit department. As is
becoming increasingly common, the directors have asked your firm to provide this service to the
company as well as being the statutory auditor of the company’s annual financial statements.
In answering the question, you should consider:
(i) the effects of the Association of Chartered Certified Accountants’ Rules of Professional
Conduct in relation to providing an internal audit service to Eastfield Distributors.
60
KAPLAN PUBLISHING
(ii) the extent to which your firm can rely on the internal audit work when carrying out the
statutory audit of Eastfield Distributors.
(iii) the arrangements over control of the work and reporting of the internal audit staff:
- the extent to which the internal audit staff should be responsible to Eastfield
Distributors, and who should control their work
- the extent to which the internal audit staff should be responsible to a manager or
partner of the external audit firm, and whether the same manager and partner
should be responsible for both the internal audit staff of Eastfield Distributors and
the external audit.
Required
You are required, in relation to your firm becoming internal auditors of Eastfield Distributors, to:
(a) describe the matters you should consider and the action you will take to ensure your firm
remains independent as external auditor of the annual financial statements.
(8 marks)
(b) describe the advantages and disadvantages to Eastfield Distributors of your firm
providing an internal audit service. (7 marks)
(c) describe the advantages and disadvantages to your audit firm of providing an internal
audit service to Eastfield Distributors. (5 marks)
(Total : 20 marks)
61
KAPLAN PUBLISHING
Answers
Answer 1
Part (a)
The directors are responsible for the preparation of the financial statements and the
maintenance of the accounting records.
Also, they must design and implement a system of internal control which should enable them to:
♦ safeguard the assets of the company

♦ prevent and detect fraud and error.
Auditors’ responsibilities
This is a reporting duty. The auditors design their work in order to form an opinion as to how
well the directors are fulfilling their responsibilities. Specific reporting duties are to state whether
the financial statements give a true and fair view in accordance with the identified financial
reporting framework and have been prepared in accordance with relevant statutory
requirements.
Other reporting duties are only disclosed by exception ie if they are not being observed.
Typical statutory requirements are that the audit procedures should be designed to determine
whether or not:
♦ Returns from branches not visited have been received.
♦ The financial statements agree to these returns.
♦ Proper accounting records have been kept.
♦ All information and explanations have been received.
♦ The information in the directors’ report is consistent with the information in the rest of the
financial statements.
Tutorial note - As indicated by the bold type above, you can remember these points by means
of the mnemonic RAPID.
Part (b)
(i) Sufficiency
62
KAPLAN PUBLISHING
An auditor must gather enough evidence to enable him to reach a valid opinion. What
constitutes ‘enough’ is a matter of judgement and is for the auditor to decide, based
upon his professional skills and experience.
Relevance
More guidance is available here so there is less requirement for judgement. Audit
evidence should be appropriate, in other words it should provide specific assurance
relating directly to one of the assertions laid out in ISA 500.
All audit tests should be designed to fulfil one or more of the following objectives:
♦ Completeness
♦ Occurrence (with authorisation)
♦ Valuation
♦ Existence
♦ Rights and obligations (ownership)
♦ Measurement
♦ Presentation and disclosure
Reliability
Generally, the more reliable the source of evidence, the less volume of evidence is
required.
The following table is useful for assessing the reliability of audit evidence.
Third party evidence → More reliable than Internally generated

→ evidence
Auditor generated evidence More reliable than Client generated evidence

→ →
Written evidence → More reliable than Oral evidence

→
(ii) The opinion on the financial statements is based upon materiality.
An item is material if it has a significant impact upon the view given by the financial
statements.
Some items are material in nature so it is not merely a question of size. Materiality levels
are largely based upon perceived levels of risk, ie the higher the risk, the lower the
‘tolerated’ level of error.
Whilst an initial materiality level can be calculated as a percentage (eg 1% of sales

revenue, or 10% of profit before tax) it is altered (increased or decreased) by the
auditor’s judgement in determining the level of associated risk.
63
KAPLAN PUBLISHING
Part (c)
ISA 200 identifies certain inherent limitations in an audit:
♦ the use of testing (eg sampling rather than looking at all items);
♦ the inherent limitations of any accounting and internal control system (eg the possibility of collusion);
♦ the fact that most audit evidence is persuasive rather than conclusive;
♦ the necessary use of judgement by the auditor.
The work standard required of the auditor is that he must obtain reasonable assurance about
his opinion. Though his opinion is based upon professional skills and experience, it is only an
opinion and not a certification of accuracy.
The key phrase is the primary reporting duty: ‘true and fair’ view. Truth is factual accuracy. If the
financial statements are true then they are prepared in accordance with all the relevant
disclosures required by the financial reporting framework.
Fair means reasonable and reasonable implies a degree of judgement.
The auditor, by making a judgement in this way, will always be exposing himself to the risk of
being wrong. This is audit risk – the risk of arriving at an inappropriate audit opinion.
All the auditor can do is to try and manipulate the risk levels. Risk cannot be removed
altogether, therefore the main limitation facing the auditor is that there is always a chance that
he will be wrong.
Answer 2
Decathalon & Co
Part (a)
Matters to be discussed prior to accepting office
A partner in Decathalon & Co should write to Mr Hurl requesting permission from the company
to communicate with the existing auditors, Pole Vault & Co, as a matter of professional ethics.
This is done for the following reasons:
♦ To ensure Pole Vault & Co are fully aware of the situation.

♦ To establish whether there is any professional or other reason why nomination should not be
accepted.
♦ To afford a measure of protection to the auditors by ensuring they are being ‘properly’ removed, ie
given all their statutory rights.
On receipt of a satisfactory reply from Pole Vault & Co stating that there are no professional
reasons why the nomination should not proceed, Decathalon & Co should arrange a preliminary
meeting with the directors of Javelin Enterprises to:
64
KAPLAN PUBLISHING
♦ ensure that Decathalon & Co has the necessary expertise and sufficient resources in terms of trained
staff for the assignment.
♦ discuss the size and geographical location of Javelin Enterprises.
♦ discuss the complexity of the business operation.
♦ explain other non-audit services which the firm can provide.
♦ discuss the basis of the fee for the work to be undertaken if successfully appointed at the next AGM.
In addition general agreement should be obtained as to the terms of the letter of engagement.
This will specify the scope and nature of the work Decathalon & Co will undertake once
appointed as auditors by the members in general meeting.
If Pole Vault & Co do state professional reasons for not taking on the appointment,
Decathalon & Co must form their own opinion as to the propriety of taking on Javelin
Enterprises as a client.
Part (b)
Request for reduction in fees
Decathalon & Co would need to assess the work required for the Javelin Enterprises audit and
budget the costs (based on staffing hours and chargeout rates, including partner review time)
which will be incurred.
This assessment could include considerations of how the fee might be reduced by providing a
more efficient audit; such as by using a risk based audit model to avoid ‘over-auditing’ low risk
areas.
An appropriate fee would then be agreed based on these amounts. If the fee offered was
insufficient to meet these costs, acceptance would imply one of the following:
(i) That Decathalon & Co intended to recover the loss by provision of other (non-audit)
services.
(ii) That Decathalon & Co would ‘cut corners’ to reduce costs – a practice which must be at
least unprofessional (as well as dangerous in the current climate of claims for negligence
against auditors).
Ethical guidance requires auditors obtaining work by undercutting incumbent auditors to prove
that they have performed an adequate audit in the event of a complaint.
Part (c)
Legal considerations on removal of an auditor
The usual statutory rule in most countries is that a company may remove an auditor by ordinary
resolution before the expiry of his term of office, notwithstanding any previous agreement to the
65
KAPLAN PUBLISHING
contrary. Government authorities may have to be informed of any such resolution having been
passed.
Notice of the resolution must be given to the company and on receipt of the notice proposing a
change of auditor when the present auditor’s term of office expires, the company should forward
a copy of that notice to the auditor being replaced and the proposed auditor.
The auditor may make representations in writing to the company and, providing the
representations are not:
♦ received too late, or

♦ of a nature that is seeking needless publicity for defamatory matters
it is used for the company to be required to include the representations in any notice of the
resolution given to members of the company.
If the auditors are successfully removed, best practice is for them to have to deposit a statement
of circumstances at the company’s registered office. The company will send a copy of the
statement to the government authorities and, if there are relevant circumstances, a copy to all
those entitled to receive accounts.
The new auditors can be appointed by ordinary resolution.
Answer 3
Bentfasteners
Part (a)
In most countries the auditor is acting on behalf of the shareholders and reports to the
shareholders as a body. It is therefore up to the shareholders to decide whether to dismiss the
appointed auditor.
The only way that directors of a company may dismiss the auditors is if they are also majority
shareholders and they propose a change in auditor. The rights of an auditor upon removal are
typically as follows.
(i) The auditor has the right to receive a copy of the notice requesting that the existing
auditor be removed. This notice must be lodged with the company before the meeting at
which the removal of the auditor is to be discussed.
(ii) The auditor has the right to make written representations to the members on matters
concerning his removal, and the company must either:
♦ send these representations out with the notice of the meeting where the resolution is
proposed to remove the auditor;
♦ send these representations out separately; or
♦ have these representations read out at the meeting.
66
KAPLAN PUBLISHING
(iii) The auditor has the right to attend and speak at the meeting on matters that relate to his
removal or dismissal.
Part (b)
Klingon & Co
Certified Accountants
1701 Spock Road, Leicester
Scott & Co
17 Docklands Crescent
Market Harborough, Leicester
15 March 20X6
Dear Sirs
We refer to your letter regarding your proposed appointment as auditors of Bentfasteners. In

respect of this matter we would draw your attention to the following matters.
(i) We have received verbal information from the directors of the company that they wish to
remove us from office over a disagreement concerning the appropriateness of an
allowance against obsolete inventory. We issued a qualified audit report, which we
consider we were justified in doing, on this matter.
(ii) The directors also informed us that they would ask a local firm to accept appointment.
(iii) In view of the above comments, we have reservations concerning the integrity of the
directors of this company.
If you require any further information, please contact us again so that a meeting can be
arranged.
Yours faithfully
A Vulcan
Partner
Part (c)
The nominee auditors should be aware of the attempted manipulation on the part of the
directors. If the new auditors feel that they will not be able to act within the required guidelines
on objectivity, then they should not accept the appointment.
The auditors should ensure that the guidelines on fee income are observed. Bentfasteners
should not represent more than 15 per cent of the gross practice fee income.
Other ethical matters also need to be considered. It should be ensured that there are no
personal relationships between auditor and client that are restricted by the guidance on
independence.
67
KAPLAN PUBLISHING
Part (d)
The new auditor must be and be seen to be independent.
In this particular case, care should be taken that the directors do not attempt to influence the
audit opinion.
The outgoing auditors should issue a statement of circumstances to show any matters that they
feel should be brought to the attention of the new auditors before the appointment is accepted.
The new auditors should ensure that they can cope with a client the size of Bentfasteners and
that it is the sort of client that will ‘fit’ with their current portfolio.
Answer 4
Ethics
Part (a)
You should not audit a company owned by your brother. The ethical guidance on independence
states that close personal relationships threaten the independence of the auditor to such an
extent that it will be impossible to appear objective in forming an audit opinion.
Other relationships that fall into this category include spouses and cohabitees, children and their
spouses, brothers and sisters and their spouses and dependent relatives.
Part (b)
The original firm does not have the power to grant professional clearance. It is the decision of
the incoming auditor as to whether or not he should accept the appointment. Also, the guidance
covering changes in professional appointment recommends co-operation in a prompt and
reasonable manner in circumstances such as these.
Outstanding fees is not a reason for refusing to accept appointment as auditor. It is a matter of
professional judgement as to whether the new auditor should help to recover the old
outstanding fees.
Part (c)
An auditor should not help to prepare the financial statements for a public company apart from
very routine work of a clerical nature or in an emergency. Otherwise the independence of the
auditor will be threatened and the continuation of the relationship is jeopardised. Regular
reviews of the work actually carried out should be performed to ensure that this is not the case.
68
KAPLAN PUBLISHING
Part (d)
A firm’s objectivity could appear to be threatened by a legal dispute because the management
or directors of the company may attempt to conceal information from the auditors as a result.
Therefore it is not recommended that the appointment should continue.
Firms should be aware that, in circumstances where public opinion perceives litigation to be
having an adverse effect upon the audit relationship, the continuation of the audit relationship
should cease.
Part (e)
Students are bound by the Association’s rules and regulations in the same way as full members.
They are also bound upon graduation before they are admitted to full membership.
Answer 5
Ethics and independence
Part (a)
(i) Owing to specialisation within audit firms the provision of taxation services to a client
should have little effect upon auditor independence. Different staff will do different types
of work and perhaps costs will even be saved by the client because the preparation and
audit of financial statements would actually enable the tax computation to be prepared
more efficiently, ie using at least some of the same information.
It may be difficult to be sure that directors have disclosed all their benefits in kind which
could lead to disputes with both the client and the tax authorities.
Independence may be threatened if the auditor is tempted to ‘back down’ in these cases
in order not to lose the fee income.
(ii) Many small clients do not have the same kind of resources as those that are available to
an audit firm, so it makes economic and financial sense for specialisation as long as
there is some kind of segregation of duties in operation so that the audit firm’s
independence is not threatened.
(iii) The auditors will become aware of weaknesses in the internal control system as they
carry out their audit work.
It is part of the auditor’s responsibilities to advise upon ways to improve the internal
control system but they should not be responsible for designing the initial system. This is
the responsibility of the company management or directors.
Part (b)
69
KAPLAN PUBLISHING
(i) It is quite difficult to prove that auditors are charging artificially low fees for their audit
work, because identifying exactly what is an audit fee and what is a fee for other
services is often very difficult. If both audit and non-audit work from a particular client is
lost then it is likely that the greater financial loss to the auditor will result from losing the
more profitable non-audit work which implies that the audit fee may almost be set as a
‘loss leader’ in some cases.
(ii) For the above reason statement (ii) is reasonable although any threat to the auditor’s
independence such as this should be avoided, as a last resort, by either resigning as
auditor or reducing the volume of non-audit work.
(iii) The loss of the financial benefit of non-audit work could well tempt the auditor to
compromise his independence by ‘altering’ his audit report. The higher the profitability of
this other work, the greater the pressure will be.
In conclusion, external auditors should only be allowed to provide other services to their listed
clients if they can institute effective safeguards to ensure the independence of the audit (eg
different partners, different teams of employees, etc). If such safeguards are impossible, then
no non-audit services should be provided by the auditor.
Answer 6
Soul
Part (a)
Risks
♦ Public interest
Recent expansion and the proposal to offer shares to the public make this client a public
interest company. The indicative limit on gross practice income is therefore 10 per cent
(previously 15 per cent).
Inherent risk is likely to be increased as a result of increased reliance on the audited

financial statements by financial investors.
♦ Fee income
The recurring fees (ie for audit and other recurring work) may exceed 10 per cent because
the assignment has previously been reviewed against a 15 per cent threshold. Even if the
recurring element is less than 10 per cent, the total for the current year could detract from
objectivity (as 17 per cent could constitute undue dependence on an audit client).
Also, recurring fees may increase in future years if the company continues to expand (likely,
especially if European expansion gets underway).
70
KAPLAN PUBLISHING
♦ Provision of other services
Although there is no objection, in principle, to the firm providing professional services in

connection with acquisitions, care must be taken not to make management decisions. For
example, if the firm recommended a course of action resulting in the acquisition of a
business and, with the benefit of hindsight, the purchase price was too high, objectivity may
be impaired by the desire to overstate the acquired business results.
Also, as a number of acquisitions have occurred there is a danger that a special relationship
has arisen between the firm’s assignment staff and the client. This could detract from
objectivity in the conduct of the audit assignment (eg if the same staff are involved in
auditing financial information connected with the acquisitions).
♦ Loans
The partner’s offer of the use of his credit card constitutes a quasi-loan. (The partner is
agreeing to pay expenditure incurred by Soul Shop to be subsequently reimbursed.) The
amounts involved are likely to be regarded as significant and the public, if they knew, would
undoubtedly perceive that objectivity was impaired.
The fact that the partner is not the engagement partner is irrelevant as he is so closely
connected to the practice (which is prohibited from making a loan to the audit client). That it is
a quasi-loan (rather than a loan) is unlikely to mitigate the impairment, in much the same way
that quasi-loans are largely regarded (and treated) as loans for the relevant companies, under
companies legislation in most countries.
The partner’s financial interest (in having the expenditure reimbursed) could threaten the
independence of the partner(s) responsible for the audit and special assignments (eg to
recommend a course of action to secure repayment of the feasibility costs).
♦ Personal relationships
The partner’s offer of a quasi-loan may appear to be an attempt to circumvent the ethical
prohibition of a practice making a loan to an audit client. That steps should appear to be taken
to cover up an impairment to objectivity may:
- make the situation look even worse if it comes to light;
- suggest a personal relationship between the partner(s) and client.
Part (b)
Safeguards available
♦ The engagement partner(s), if possible, should have separate responsibilities for the audit and other
(non-audit) assignments. Rotation of the audit engagement partner is advisable to ensure objective
audit opinions.
71
KAPLAN PUBLISHING
♦ The audit team should include a manager (qualified employee) not involved in the acquisition
assignments.
♦ Senior members of the audit team should be rotated to ensure an objective approach to the conduct
of the audit.
♦ The client’s responsibility for other services provided by the auditor should be clearly acknowledged
in an engagement letter for each assignment. All communications to the client must make it clear that
the firm is not performing management functions or making management decisions.
♦ Appropriate audit tests should be conducted even in respect of financial information reviewed during
the course of investigations.
♦ The partner’s offer of financial assistance should be withdrawn immediately. The company must have
other means of securing short-term finance for the feasibility study without compromising audit
independence.
♦ The client should be reviewed annually by an independent partner.
Part (c)
Conclusion
Assuming that the recurring fees do not exceed 10 per cent of gross practice income the audit
appointment could continue. Unless appropriate safeguards are available (eg for the
segregation of audit and other services) it may be necessary to decline the special investigative
work.
Answer 7
Melton Manufacturing
Part (a)
Parts (i) and (ii) together.
Before accepting appointment as the company’s auditor, I would do the following.
♦ Verify that I am a member of the Association of Chartered Certified Accountants, I hold a practising
certificate and am a registered auditor. If this applies, I have the basic qualifications to be auditor of
Melton Manufacturing.
♦ Try to determine the reason for the change in auditor. The question says that the directors believe
they do not receive a cost effective service from the existing auditor. However, there may be any
number of other problems which need to be identified. I would ask the client if I can communicate with
the retiring auditor and ask if there are any matters he wants to bring to my attention which would
influence my decision on whether to accept appointment as auditor. There should be a statement of
circumstances showing any relevant matter or a statement saying that no such circumstances exist.
♦ Ensure adherence to statutory responsibilities. The company must give notice to hold a meeting at
which an ordinary resolution is proposed to appoint me as auditor. Only a 50 per cent majority is
required to pass this resolution. The company must send a notice of the meeting and a copy of the
72
KAPLAN PUBLISHING
resolution to the retiring auditor, who has a right to attend and speak at the meeting. This resolution
must be passed before any audit work commences.
♦ Consider the size of the audit fee in relation to my gross practice income. I must ensure that it does
not represent more than 15 per cent of the total and would not be considered a threat to my
independence.
♦ Evaluate the likelihood of threats to independence from other sources. I would ensure that:
- no personal relationships exist between audit staff and clients

- no audit staff hold shares in the client company
- no loans exist either to or from auditor and client.
♦ Ensure that no conflict of interest exists between Melton Manufacturing and other clients as well as
between my audit firm and the new client. If there is a conflict, then I would have to consider refusing
to accept the new appointment.
♦ Confirm that my firm had staff available with the necessary qualifications and experience to be able to
perform the audit to an acceptable standard. I would also ensure that these staff are aware of the
confidential nature of the client information.
♦ Draft a letter of engagement ensuring that all services provided (audit and any additional) are clearly
set out as this document explains the contractual agreement between auditor and client.
♦ Complete a draft budget for completion of the audit work on Melton Manufacturing to ensure
profitability and adequacy of completion of assignment.
♦ Confirm that this is not a public company, noting that for a public company the auditor should not
normally both prepare and audit the financial statements. For other companies, if the auditor both
prepares and audits the financial statements, it is desirable that these are carried out by different
staff.
♦ Obtain copies of previous years’ audited accounts. If the audit report is qualified, it indicates that the
audit has a higher than normal risk. From these accounts I would assess whether the company is
having going concern problems and if there could be weaknesses in the system of internal control.
With a manufacturing company there are likely to be more problems with the valuation of inventory,
but there would be less risk over sales and purchases as they are likely to be on credit. There could
be problems with obsolete plant and machinery.
Part (b)
(i) A letter of engagement to the client explains the duties of both the auditor and the client.
This should prevent any misunderstandings arising about the auditor’s duties.
The letter of engagement explains that the auditor’s duties are governed by the relevant
statute. It also explains that the auditor reports to the shareholders, ie to a third party, on
how well the directors are carrying out their responsibilities.
The directors are responsible for preparing the financial statements and for ensuring there
are proper systems of internal control to prevent or detect errors, irregularities and fraud.
73
KAPLAN PUBLISHING
The auditors are only responsible for giving an opinion on the financial statements. Their
audit procedures should have a reasonable expectation of detecting material errors and
fraud.
The letter of engagement also explains how the auditor arrives at his initial fee estimate.
It is important that the letter of engagement is reviewed regularly and that a revised letter
is sent when there are significant changes made.
(ii) The main matters in a letter of engagement include the following.
♦ The letter is correctly addressed, ie to the directors of Melton Manufacturing.
♦ It states the directors’ responsibilities for keeping proper accounting records and for preparing
♦ The auditor has a duty to report on whether the financial statements show a true and fair
view and that they are in accordance with the identified financial reporting framework.
♦ Normally, the auditor would report if the financial statements depart from accepted
accounting standards (eg IASs).
♦ The audit is conducted in accordance with auditing standards (eg ISAs).
♦ Oral or written representations may be sought from the directors concerning various matters
in the financial statements where sufficient evidence is difficult to obtain.
♦ The directors are responsible for preventing and detecting fraud and error. The audit
procedures should be designed so there is a reasonable expectation of detecting material
misstatements in the financial statements.
♦ As auditor, we may provide additional services, such as:
- the preparation of financial statements

- specific investigation to identify fraud or other irregularities
- providing personal or corporate taxation services.
♦ Fees are based on the time spent by partners and staff and on the levels of skill and
responsibility involved.
The letter ends by saying that it remains effective until it is replaced.
Answer 8
Bondi
Part (a)
There are the following factors in favour of accepting nomination as external auditor to Bondi:
♦ Such a rapidly growing company should generate significant audit fees and the potential for non-audit
fees over the coming years.
74
KAPLAN PUBLISHING
♦ Since Bondi intends to seek a public listing within two years, the directors will be very keen to avoid
another qualified audit report. This means that they should be able to be convinced of any
adjustments that the auditors wish to make to the financial statements. The larger size of my audit
firm rather than the outgoing firm also helps in the balance of power between the auditor and the
client. My firm has a better chance of being able to convince the directors to run their company in an
ethical and reputable manner.
♦ There is the risk that, if my firm does not accept nomination, a less reputable firm might be appointed,
who would not argue so strongly that high standards of behaviour are essential. This would not be in
the shareholders’ best interests.
There are the following factors against accepting nomination:
♦ The policy of rapid aggressive growth increases the inherent risk of the appointment. There are likely
to be poor internal controls in place throughout the group, since the directors will have concentrated
on their next takeover target rather than the less exciting job of implementing controls in the
companies that they already own.
♦ The company’s policy of taking no action against employees engaging in fraud means that a culture
of rule-breaking will be fostered throughout the group. This suggests a weak control environment in
which day-to-day operations are carried on.
♦ A newly installed complicated computer accounting system is a very sure sign that this may be a high
risk audit. The engagement partner must be certain that the audit fee is large enough to pay for the
many hours of computer audit time that will be required to audit this new system. Auditors with
specialist computer skills are likely to be required on the audit.
♦ Unhelpful and aggressive senior management are another bad sign, suggestive of possible
management fraud. It should be made clear to the directors that the audit can only be accepted if
there is a policy of full disclosure between the company and the auditors.
♦ The intended public listing of the company greatly increases the audit risk. If the company fails soon
after listing, investors will look to sue the auditors for compensation.
Part (b)
I would pay particular attention to the following matters in my obtaining the required knowledge
of the business and developing my audit plan:
♦ Opening figures – since last year’s audit report was qualified, and my firm were not the reporting
auditors, the opening figures for this year are subject to uncertainty. I must plan audit procedures to
vouch the opening balance sheet figures for this year.
♦ Employee frauds – I need a full understanding of the nature and incidence of the frauds detected by
the previous auditors. The control weaknesses that led to the frauds should be tested to see whether
things have been tightened up. Are the dishonest employees still working for the company? If so,
what positions do they hold? It will be worrying if positions of authority are now held by employees
who have proved themselves to be unreliable.
♦ New computer system – since the new computer system is complicated, I will plan to have computer
audit specialists as part of the audit team. I must evaluate the general controls and application
controls in force in the system, as well as the overall control environment over the system. Since the
system is an important part of the overall accounting system, I must be prepared to carry out
sufficient tests of controls before I can rely on the output from the computer. Computer assisted audit
techniques (CAATs) are likely to feature heavily in this testing.
75
KAPLAN PUBLISHING
♦ Nature of the business – Bondi is a car dealership. This is a business area in which the sales team
are remunerated largely by bonuses arising from sales volumes, while the company itself will earn
bonuses from the car manufacturers for shifting volumes of cars. Therefore, there is pressure for
sales to be falsified, to benefit both the employees and the company. It would be useful if an industry
specialist could be included in the audit team who has experience of auditing car dealerships. He or
she would know the usual terms of contracts between sales reps and the company, and between the
company and the car manufacturers. Unusual terms of contracts could be identified for further
investigation.
Part (c)
On discovery of the fraud, I would act in accordance with ISA 240 which lays down the
appropriate course of action.
♦ I would first carry out detailed audit work to gain a full understanding of the nature of the situation.
Am I sure that the purpose of making the computer system complicated was so that the fraud could
be perpetrated? An alternative explanation could be that the accounting records are wrong as an
accidental result of the system being so complicated. I must probe the circumstances of the situation
until I am confident that I understand what has happened and why.
♦ My next responsibility is to report the situation to senior management and urge them to put the matter
right. In the present case, the company must make full disclosure to the tax authorities, pay the full
amount due together with any penalties, and correct the computer system so that in future the right
amounts of tax are paid in full and on time.
♦ If management agree to come clean, my responsibility is to give my opinion on the financial

statements as corrected for the previous fraudulent entries. No specific mention need be made of the
matter in my audit report.
76
KAPLAN PUBLISHING
♦ If management refuse, I would consult with legal advisers as to my next course of action. If material, I
would qualify my audit report on grounds of disagreement with the amount of taxes payable. The
matter is probably not of such serious public interest that I should report the matter directly to the tax
authorities, but on this I will be guided by the legal advice that I receive.
♦ My most likely course of action, if management refuse to rectify the fraud, is to resign as auditor. I
must be careful with the wording of any statement that I make after resigning, to avoid any chance of
my being sued for defamation if I accuse the directors of fraud. Again I will be guided by the legal
advice that I am given.
Answer 9
Radford Retail
The following matters need to be considered when planning the audit of Radford Retail.
The timetable for the audit. This will really be a case of establishing when the financial
statements are to be presented to shareholders and then working backwards to set:
♦ the date when the financial statements are signed by the directors and the partner signs the audit
report.
♦ the date when the detailed audit work is completed. There must be sufficient time between this date
and when the audit report is signed to allow for review of the audit work, carrying out additional work
(where audit tests provide insufficient evidence) and making final adjustments to the accounts.
♦ the period when the final audit takes place. The start of the final audit should be at a time when
valuable audit work can be carried out, but it may be before the full accounts have been prepared.
Ideally, there should be some slack in the time budget to allow for delays and resolving problems
experienced in the audit.
♦ the date of the interim audit visit and the work which should be carried out at this stage. An interim
audit will not always be considered necessary.
♦ the dates of the physical inventory counts and the extent to which the company’s internal audit
department will assist in this work. As there are a number of shops, I will have to consider which
shops the internal auditor and my staff should visit and which will not be visited for the year-end
inventory count.
I will consider whether or not the previous year’s problems have been resolved because this will
be a major factor in assessing the audit risk.
A planning meeting will be held to discuss any significant changes in:
♦ staff
♦ accounting systems
♦ the nature of the business.
These factors will affect the type of audit work carried out and the associated level of risk.
I will consider the effect on the audit of the introduction of new accounting and auditing
standards and other legislation since last year’s audit.
77
KAPLAN PUBLISHING
A fee will be agreed with the client, which may be increased if major problems are experienced
during the audit. This fee will be based on the staff time and seniorities intended to perform the
audit.
I will consider the level of experience required for the audit staff. I will check that the appropriate
staff are available. Ideally, the same staff should undertake the interim and final audit work and
there will be a saving of learning time if staff have been on the audit of Radford Retail in
previous years. I will prepare a budget of the time allocation for each aspect of the audit and the
sequence in which the work should be performed.
I will assess the overall level of the audit risk (the risk of getting the audit opinion wrong) by
assessing the individual components of audit risk.
Inherent risk – the risk of a material misstatement occurring due to the nature of the business.
This is likely to be high because of the errors found in previous years.
Control risk – the risk of a material misstatement occurring due to poor internal controls. With
Radford Retail, I would concentrate on control over custody of the inventory as this will be a
large figure in the financial statements.
Detection risk – the risk of me as auditor failing to detect a material misstatement. The level of
detection risk will depend upon the level of inherent and control risk.
Overall audit risk is set by manipulating detection risk. This can be done by altering the timing of
audit work, changing the nature of the testing or simply by doing more tests.
I will specify the materiality level for the audit, and the value when errors and uncertainties
should be recorded. Although no fixed figure for materiality can be specified with the limited
information provided in the question, a sales revenue of $20 million would suggest a profit
before tax of around $2 million (at a net profit margin of 10 per cent), and materiality of 10 per
cent of profit before tax would result in a materiality level of $200,000. Errors over $20,000
would be noted if it was decided that all errors over 10 per cent of the materiality level should be
recorded.
I will prepare an audit planning memorandum, which will include many of the matters discussed
above. The question says that there have been problems with cash, inventory loss and
inventory valuation in previous years, so these points will be included in the memorandum and
more time will be allocated in the budget to these areas.
I will discuss my findings from this work with the partner and ask him to make any amendments
to my audit planning memorandum and plans for the audit.
(Note
There is also a case for including reference to the legal and ethical framework, although time
allocation prevents us from including it in any detail.)
78
KAPLAN PUBLISHING
Answer 10
Growing
Part (a)
(a) Circumstances Why take into account (b) Procedures
♦ The company is new, has Overtrading may be a Review, in detail, budgets,

little trading record and problem. forecasts and cash flow
has expanded rapidly.
projections for feasibility.
The nature of the business
may be unstable as the Agree any funding with
company is working in an the intended source (eg
overcrowded market. obtain confirmation).
♦ Expansion has been rapid. Rapid expansion often Adopt a predominantly

leads to slippage in substantive approach.
controls generally.
Systems changes often
occur after breakdown and
sometimes lead to a loss
of data.
♦ Staff numbers have New staff who are A systems-based

increased four fold and the unfamiliar with systems approach may be possible
accountant joined the
company during the year.
add to this problem. for the latter part of the
year when controls were
in place with reduced
substantive procedures.
Report systems
weaknesses to
management to enable
future improvement.
♦ There was a previous This indicates a possible Consider the need to

qualification due to lack of qualification again. This qualify for a second year.
evidence concerning
completeness of recording
would be viewed seriously
(and also the lack of basic by the banks or other
internal controls for part of providers of finance.
the current year).
♦ Sales are doubling every The drive to increase sales Circularise year end
three months. revenue may have been receivable balances.
accompanied by a
weakening of credit Assess adequacy of
doubtful debt allowances,
79
KAPLAN PUBLISHING
controls. paying special attention to

any large, overdue
accounts.
(a) Circumstances Why take into account (b) Procedures
♦ The company’s business is Potentially entire ranges of Discuss with directors

the sale, service and hire equipment are obsolete how slow moving
of new and second-hand
computers.
given its specialised inventories are to be
nature, particularly second- identified at the year end
hand models. inventory count.
The policies adopted for Examine reports on the

accounting for the hire of age of inventories.
computers may not be
appropriate, depending on Examine lease
the characteristics of the agreements to determine
lease agreement. whether they appear to be
operating or financing in
nature.
Answer 11
Gnome Publications
FILE MEMORANDUM
Client Gnome Publications
Year end 31 March 20X7 Prepared by XYZ
Subject Preliminary audit risk assessment Date X-X-XX
Factors Why take into account Implications for audit

procedures
♦ The company has not This may increase the risk of Areas of the accounts
been producing the overstatement of profits (eg by where judgement is to be
results that might be
expected given its
over-generous inventory exercised will need to be
valuation or under-provision scrutinised and the
80
KAPLAN PUBLISHING
sales revenue. for liabilities). appropriate nature of

accounting policies
♦ Miss Hughes is under
pressure to produce assessed particularly any
better results. changes. The overall
review of financial
statements will also need
to be more thorough than
usual.
♦ Miss Hughes has a This may increase

profit-related Miss Hughes’ personal
remuneration package
and has recently motivation to windowdress the
joined the company. results.
♦ The company uses a The package used is well Given the small size of the
well known accounting known and therefore in the organisation a substantive
package.
short-term probably reliable. approach is likely.
This should reduce the risk of
systematic errors. Systems
documentation should be
relatively straightforward.
Factors Why take into account Implications for audit

procedures
However, fast growth of the Consider suitability of

company may render the package given increasing
package unsuitable in the number of transactions.
future.
♦ The accounts are It is likely that many figures Examine and test carefully
prepared quickly quite may be very approximate year end adjustments.
soon after the year
end.
estimates (eg inventory
valuations, accruals), hence
liable to misstatement.
♦ Management This indicates a lack of Perform analytical

accounts are not management control/ procedures using the
prepared despite the
fact that the
commitment. information available.
information is
available.
81
KAPLAN PUBLISHING
♦ Inventories will be This is due to the risks of Analytical procedures on

particularly liable to deliberate manipulation and inventory levels should
overstatement.
obsolete inventory. give a preliminary
indication of problems with
build-up.
♦ The publications are Technical publications which Evaluate inventory

technical ones. have a high unit cost must be counting instructions with
updated regularly. Out of date particular reference to
publications are virtually procedures for identifying
worthless, so inventories even obsolete items in order that
a few months old may need to corrective action may be
be written off. taken if necessary.
Attend the physical

inventory count to establish
the existence and condition
of inventory and the
adequacy of any write-
downs.
♦ The old equipment is There is a risk of Detailed audit work will be

being scrapped as misstatement of proceeds to needed in respect of non-
new technology is
introduced.
avoid large losses being current asset disposals. In
recorded in the income particular disposal
statement. proceeds will need to be
agreed to sale
There will be no back up documentation.
facilities available to ensure
production can continue since Establish the operational
old equipment is scrapped. effect of production
problems as even small
delays in production may
lead to a loss of goodwill.
♦ The new equipment If the new equipment turns out

has teething to be unsuitable, it will have a
problems.
relatively low realisable value
and there will be significant
write-offs.
Answer 12
Bestwood Engineering
82
KAPLAN PUBLISHING
Part (a)
All purchase orders should be accompanied by an authorised requisition, ie signed by a

responsible official.
Purchase orders should be sequentially numbered to ensure completeness.
Suppliers should be authorised and new suppliers should not be used without proper
authorisation and investigation.
All goods should be checked for quality (to ensure they are not damaged) and a goods received
note raised and matched to purchase orders. This ensures that all goods received have actually
been ordered.
Goods received notes should be sequentially numbered to ensure completeness.
As purchase invoices are received they should be matched to goods received notes and all
purchase invoices should be authorised and sequentially numbered.
Any short deliveries should be investigated and the necessary debit notes authorised.
If invoices are received for goods when no purchase orders exist, then this constitutes a
weakness in the system and should be rectified.
Part (b)
Controls over authorisation of purchase invoices
All purchase invoices should be recorded in a register as they are received and they should
have an internally generated sequence number attributed to them.
The purchase invoice should be matched to a goods received note and a purchase order to
ensure that the correct goods have been received.
All purchase invoices should be authorised by a responsible official.
The quality of the goods should be checked before the invoices are authorised to ensure
damaged goods are identified and returned.
All ‘problem’ invoices should be held and suppliers should be contacted to solve problems of
quality of goods, pricing errors etc.
A supplier’s statement reconciliation should be carried out regularly and any differences
(particularly material ones) should be investigated.
Part (c)
It is more difficult to authorise invoices and payments for services because there is a greater
chance that purchase orders and goods received notes do not exist. So it is harder to prove that
the service has been consumed.
Comparison of individual costs with budgets and with previous year’s figures should be carried
out.
83
KAPLAN PUBLISHING
Some services (water, gas and electricity) can be verified. It is possible to determine usage by
reading meters etc.
A requisition should still be raised along with a purchase order to enable services to be
controlled in the same way as goods.
Answer 13
Working papers
Part (a)
Useful audit working papers
(i) Familiarisation with the client company
♦ The company’s statutory founding documents, a copy of which should be kept in the
permanent file. These should set out the objects of the company and its capital structure as
well as detailing the internal constitution.
♦ The latest available financial information which may be last year’s published financial
statements or this year’s draft financial statements or management accounts and budgets for
the year to date. This information will help to clarify the current operating results and financial
conditions of the client.
♦ An organisation chart providing details of the corporate operating structure, geographical

spread and management reporting structure. This will give an idea of how the company is
run and will help to identify the personnel most likely to be key audit contacts.
♦ Industry data showing an analysis of the key financial and operating ratios typical of this type
of business and thereby permitting comparisons to be made. Such data can be obtained
from both government and industry sources or may be maintained internally within the
auditing firm.
♦ Last year’s current audit file with particular reference to the problems arising during the audit
and how they were resolved in reaching the conclusion in the auditors’ report.
(ii) Planning the current year’s audit
♦ Last year’s current audit file with particular reference to the final audit notes for any matters
which will have continuing relevance.
♦ Notes made last year which were to be carried forward as important for this year.
♦ Interim or management accounts to determine the current trading circumstances together
with any significant changes in the business.
♦ Documented analytical procedures to note any factors likely to have a material effect on the
financial statements and to establish expectations of the results.
♦ Systems notes and flowcharts of the client’s accounting system in order to assess its
adequacy as a basis for the preparation of the financial statements.
Part (b)
84
KAPLAN PUBLISHING
Criteria
(i) Evidence of procedures followed and the tests performed
Working papers must indicate the client’s name, accounting period, a file reference, the
areas of the audit being covered and details of who performed the work and when. As
an overall requirement, working papers should be neat, clear and concise with sufficient
details to enable someone, not involved in the audit, to understand what work has been
performed.
In the interests of clarity, detailed explanatory information should be provided on

supporting schedules which should be suitably referenced and cross-referenced.
(ii) Record of information received, problems encountered and conclusions reached
Documenting details of all findings during the audit encourages the auditor to adopt a
methodical approach and ensures that problems are not overlooked. The working
papers should always summarise any significant matters or problems, and highlight any
judgmental aspects together with the auditor’s conclusions thereon.
Where judgmental areas have been reviewed it is important to note all relevant
information received from the client together with management’s views, so that these
views can be compared with the auditor’s views.
(iii) Evidence of review
All working papers prepared by each member of the audit team must be reviewed by a
more senior member. Such a review must be evidenced on the working paper, detailing
who has performed it and when. This review is important as it ensures that sufficient
work has been performed and that the findings and results support the audit
conclusions.
(iv) Degree of assurance given to the reporting partner
The reporting partner will need to satisfy himself that work delegated by him has been
properly performed by his review of the working papers. To achieve this the reporting
partner would expect a summary of the significant points affecting the financial
statements and the audit report, with details of how each matter has been dealt with.
(v) Sufficient for the preparation of reports to management
The working papers must give sufficient background details and examples of any
weaknesses to enable the report to management to be written. In making such
comments, generalities and gratuitous observations should be avoided and all
comments should be adequately supported by facts.
(vi) Usefulness in future years
85
KAPLAN PUBLISHING
The working papers should provide sufficient detail to enable members of the audit team
to familiarise themselves with the assignment from year to year and to plan subsequent
audits.
(vii) Evidence of adherence to Auditing Standards
In the event of the auditor’s opinion being challenged, the working papers will provide
evidence that the auditor followed the basic principles prescribed by the relevant
Auditing Standards (eg ISAs). They will also illustrate that the auditor has been
competent in applying proper standards of skill and care in arriving at the audit opinion.
Tutorial note – Other points for (a) (i) could include:
♦ Press cuttings and Internet searches concerning the client would help to provide an awareness of any
current developments affecting the client.
♦ Copy board minutes to determine any current plans, developments or problems affecting the client.
♦ The tax file and relevant tax returns together with any correspondence with the tax authorities.
♦ Copies of brochures and marketing literature will help to give an idea of the product range and
customer base for this client.
♦ Reports to management concerning the client in order to determine the areas of weakness identified
in the past.
♦ Internal audit reports to establish the extent of the work performed by the department and its findings.
♦ The correspondence file for details of all issues arising during the year which might affect the audit.
♦ The permanent file will contain useful background information including details of bankers and
extracts from statutory books such as the register of charges, register of members, register of
directors’ interests and register of directors and secretaries.
Other points for (a) (ii) could include:
♦ Minutes of the audit planning meeting with the client which would cover the following issues:
- interim financial results

- major new products or services
- new contracts
- planned acquisitions or disposals
- changes in personnel, management or accounting systems
- timing of the audit, and
- new legislation or accounting and auditing requirements which may affect the client.
♦ The engagement letter to clarify the scope of our responsibilities and the form of our audit report.
♦ The time control, billing and budget details for the client.
♦ Working papers determining planning materiality and the assessment of risk to consider the
maximum amount of error which can be accepted and to focus the audit effort on the high risk areas.
86
KAPLAN PUBLISHING
The examiner commented that many candidates failed to differentiate between the working
papers that would be of particular assistance for familiarisation and those needed for audit
planning. There was a tendency for candidates merely to list the contents of the permanent file
in (a) (i) and the previous year’s audit file in (a) (ii).
Answer 14
Risk
Part (a)
Audit risk is the risk that the audit opinion will be wrong, ie qualified when it should be
unqualified or vice versa.
Audit risk comprises three component parts as follows.
♦ Inherent risk. The risk of material error due to the nature of circumstances.
♦ Control risk. The risk of material error due to a lack of an adequate system of internal controls.
♦ Detection risk. The risk that the auditor’s work will fail to identify a material error.
87
KAPLAN PUBLISHING
The levels of audit risk will vary depending upon a number of factors.
(i) Property, plant and equipment have a relatively low inherent risk because it is
reasonably easy to physically identify them.
Depreciation policy involves judgement and increases inherent risk to some extent. Also,
the risk of obsolescence, particularly with computers or machinery, increases inherent
risk.
A high volume of items in the plant register increases control risk and this is the main
reason why detection risk may need to be manipulated downwards by testing more
items or seeking more reliable forms of evidence.
(ii) Inventory. This is likely to be a high value item with a high level of associated audit risk.
Valuation problems with inventory imply a high inherent risk whilst problems of pilferage
and safe custody suggest a high control risk.
In manufacturing companies, inventory value will be more difficult to determine than in

retail companies, as it includes direct labour cost and production overheads.
It is likely that inventory is an area where a lot of audit work will be carried out, thus
reducing both detection risk and overall audit risk.
(iii) Trade receivables. In most manufacturing companies, receivables have a lower risk than
inventory and accounts payable. You are testing for overstatement so ‘testing what is
there’ will provide you with sufficient audit evidence.
The inherent risk is mainly related to the level of bad debts the company incurs. There
will be a lower risk where a company sells to large companies, rather than to a large
number of small businesses.
(iv) Trade payables. Payables are likely to be a higher risk than receivables, because of
possible omissions which have significant impact upon the objective of testing for
understatement. How do you test for something that isn’t there? This particularly affects
inherent risk levels.
Inherent risk is also increased if there is a high level of disputes with suppliers as this
throws into question the value of the payable as well as its existence.
Part (b)
Consideration of audit risk by auditors has become important for the following reasons.
Audit risk is concerned with highlighting areas where there is a high risk of the accounts being
incorrect.
88
KAPLAN PUBLISHING
Identification of high risk areas means that the auditor may concentrate his work on these items.
In order to maintain the profitability of the auditing services, firms have had to reduce the time
spent carrying out an audit, and identifying high audit risk areas should enable firms to do this.
There is an inverse relationship between the time spent on audit work and the associated risks
of not identifying a material misstatement.
So, as auditors’ efficiency increases, so must the quality of the audit work produced.
Efficiency may be increased by using risk and materiality to identify areas where errors are likely
to occur. This enables work to centre on high risk areas.
For example the value of inventory on the balance sheet is likely to be high, therefore any errors
found could well be material.
One method of improving audit efficiency is to cut down on transaction testing and spend more
time on review of the financial statements. This will identify areas where problems occur and
enable further work to be carried out where necessary.
Using audit risk and materiality to eliminate unnecessary audit work which will improve
efficiency should enable auditors to keep the risk of litigation to a minimum.
Answer 15
Newthorpe Manufacturing
Part (a)
Firstly, obtain a letter from the valuer stating the value of the property. This should be the
original letter. Check the existence of the valuing firm by checking its name to the telephone
directory.
Then consider the independence of the valuer.
♦ To confirm that the valuer is not an employee of the company the payroll should be examined.
♦ If the valuer has the same surname as a director or senior employee of Newthorpe Manufacturing,
determine whether the valuer is related to that employee. If they are related it could prejudice the
independence of the valuer. If the valuation has been done by a firm of valuers, check that none of
the surnames of the partners are the same as directors or senior employees of the company.
♦ Confirm with the directors that they are not related in any way to the valuer and include a
representation letter point to the same effect.
♦ The valuer should not own shares in Newthorpe. Check the register of shareholders to ensure that
the valuer is not a shareholder. If the number of shares is small then this would not be a particular
problem.
♦ Consider whether the fee for the valuation is a substantial proportion of the fees of the valuer as
undue reliance upon the income from one client may threaten the valuer’s independence.
89
KAPLAN PUBLISHING
♦ Check the valuer’s qualifications by looking on the letter heading or perhaps referring to a relevant
professional directory.
♦ The valuer needs experience in valuing the specific type of property owned by Newthorpe
Manufacturing to ensure that the evidence provided by the valuer is relevant.
♦ The appointment of the valuer should be confirmed by obtaining a copy of the initial letter of
engagement.
Concerning the valuation itself.
♦ The property should be valued in accordance with IAS 16 at its fair value (normally its market value).
♦ We are predominantly concerned with over valuation in this case and this should be borne in mind
when identifying the basis of valuation and assessing its reliability.
♦ The values of similar properties on the current market can be compared to ensure that Newthorpe
Manufacturing’s property is valued consistently.
♦ If I am still not satisfied that my audit evidence concerning the valuation is sufficient, relevant and
reliable, I would consider seeking a second opinion, ie find another valuer.
Part (b)
♦ Verify the opening balances by confirming that they agree to the closing balances in the previous
year’s financial statements. This will ensure accuracy of the figures.
♦ Select a sample of items from the asset register and physically verify them. Then perform the same
test the other way around. This will help to verify existence. It may also highlight assets held on behalf
of third parties (ie a test for ownership).
♦ The physical condition of the assets can also be checked which will help decide whether the net book
value of the assets is recoverable or not.
Part (c)
An asset should be capitalised if it fulfils the definition in the IASC Framework Document.
Assets are items held by the business in order to yield future economic benefit.
(i) Firstly, the non-current assets ledger account would be examined to ensure that no item
(eg a repair) has been capitalised in error. If a material error is found it should be
adjusted in the financial statements.
(ii) Items that have not been capitalised should be examined to see if anything material has
been omitted. A number of single item errors under $500 could add up to a material
misstatement.
Areas to concentrate upon would be as follows.
♦ Repairs and renewals

♦ Motor and travel
♦ Sundries
90
KAPLAN PUBLISHING
These are the most likely nominal ledger accounts to include non-current assets in error.
Firstly, compare the charges in each of these accounts to those of previous years. Any
significant fluctuations should be investigated as they may have resulted from initial
miscategorisation of costs/expenses. From these accounts, select a sample of items
over the minimum capitalisation value (ie over $500) and check to the purchase invoice
whether they are capital and should be included in non-current assets. Any items that
should be capitalised should be scheduled out in a list of unadjusted errors and
discussed with management.
If there is a material understatement of additions to non-current assets (which has a

material effect on the profit for the year), ask the directors to amend the financial
statements, and if they refuse consider qualifying the audit report.
91
KAPLAN PUBLISHING
Answer 16
Southwell Engineering
Part (a)
Test data includes examples of both valid and invalid data. Both are required because the test
data is used to determine whether or not the client’s system is processing transactions in the
correct way. Invalid data ought to be rejected by the system by way of an exception report.
Concerning the sales system, valid data would include an account number and the part
numbers of various items available for despatch to customers.
An example of invalid data would be an account number that we know is either false or outside
the normal range of numbers. It would be expected that the computer would reject such a
number.
An incorrect part number could also be used as invalid data. With a correct part number, details
would be displayed on the computer screen so they may be verified. An incorrect part number
may trigger an error report to be displayed instead. The validity of part numbers could also be
ensured by using check digits.
The system should be set up so that numerical characters are not recognised when an
alphabetic character is required and vice versa.
It is also possible to trigger an exception/error report if zero or negative quantities are input.
Part (b)
A computer audit program can assist in the completion of a debtors circularisation test in a
number of ways. A sample may be selected using a desired sampling technique; probably the
most appropriate would be the monetary unit method.
If balances total $2 million and 50 debtors are to be circularised then one debtor will be
circularised for every $40,000 of the population.
Normally all the accounts receivable balances will already be listed in order of account number.
A random number would be chosen as a starting point (say $18,199) and then the sample is
selected as follows.
Debtor name Amount Cumulative total Cumulative total Sample

receivable b/f c/f
$ $ $
1 ABC Limited 7,664 - 7,664 No

2 DEF Limited 15,128 7,664 22,792 Yes
3 GHI Limited 1,029 22,792 23,821 No
4 JKL Limited 21,680 23,821 45,501 No
5 MNO Limited 189 45,501 45,690 No
92
KAPLAN PUBLISHING
6 PQR Limited 18,271 45,690 63,961 Yes
Item 2 straddles the value $18,199 and item 6 straddles the value $58,199. The process is
continued until all 50 sample items are identified.
The age of the balances receivable at any point in time may also be checked by the computer
audit program and old balances or balances that have gone over their credit limit may be printed
out quickly and accurately.
The actual letters sent out to the debtors in the circularisation exercise may be formatted,
generated and printed by a computer program.
Part (c)
A computer audit program may also perform tests upon the receivables ledger transactions files
as follows.
♦ Test the additions within the individual ledger accounts.

♦ Check that the total on each account agrees to the total on the list of balances.
♦ Test the additions of the total list of balances.
♦ Print out old balances.
♦ Print out instances where the customer has exceeded their credit limit.
♦ Select the items for circularisation and help to analyse the results, highlighting any differences that
require further investigation.
Computer audit programs will perform bulk standard audit tests, such as additions or sample
selections, more quickly and accurately than the auditor would using manual techniques.
This leaves the auditor free to concentrate on areas that require more judgement that are not
particularly suited to computer assisted audit techniques such as an assessment of the
reasonableness of the doubtful debt allowance.
Answer 17
Lidcombe
Part (a)
(i) The meaning of occurrence is twofold. Firstly, it means that a transaction has occurred
and secondly that it is a legitimate business transaction.
For purchases this means that all purchases have an authorised invoice, goods received
note and order and that they are not in respect of private expenses, eg flowers for the
director’s spouse.
93
KAPLAN PUBLISHING
Completeness means that all transactions must be recorded. To ensure completeness

over purchase orders, goods received notes and invoices, they should be sequentially
numbered and any missing numbers should be investigated.
(ii) Control procedures
All orders should be accompanied by an authorised requisition.
The requisition and the order should be generated and authorised separately. These two
controls should prevent private goods from being ordered.
All purchase invoices should be checked against the relevant goods received notes and
purchase orders to ensure all costs are recorded but also that the same invoice is not
recorded twice.
To avoid duplication but also to ensure completeness of input onto the computerised
purchase ledger, a batch total should be used.
Suppliers statement reconciliations should be performed regularly and any difference

investigated to ensure that all accounts payable have been recorded.
Any orders that have not been matched to invoices should be investigated.
Any goods received notes not matched to invoices should also be investigated to ensure
that no legitimate costs have been omitted.
Part (b)
(i) Knowledge of the risk levels associated with a particular company can be, in part,
obtained from previous years’ files and assessments.
Some circumstances relating to a particular client do not change much. For example, a
client’s staff, accounting systems and the integrity of management once assessed do not
really alter unless there is a fundamental change in the nature of the business or the
market in which it operates.
A business takeover or a change in market conditions could require a total re-

assessment of both levels of inherent risk and the control environment.
(ii) Additional investigations would be carried out in the following areas.
The integrity of management and the likelihood that they will manipulate the company
results.
Changes in management could result in different risk levels as management integrity

can no longer be relied upon.
Tight deadlines and the employees/management being under pressure to complete or

achieve results may lead to corners being cut.
94
KAPLAN PUBLISHING
Companies operating in industries that are subject to major changes, eg technological

obsolescence.
Changes in economic conditions could alter margins/profitability and consequently affect

risk levels.
Answer 18
Ilkeston Products
Part (a)
Audit work
♦ Ask the finance director if the company has a detailed description of the sales system. If so, obtain a
copy for the permanent (or systems) audit file.
♦ Ask relevant sales and accounts staff about their roles in the sales accounting and internal control
system.
♦ Obtain sample documents (eg sales orders, despatch notes, sales invoices and customer
statements) for the permanent audit file.
♦ Produce a flowchart of the system (unless the client system description is in suitable flowchart form)
supported by narrative notes, eg:
- against each operation (eg ‘Order confirmation authorised by sales manager’).
- describing the action taken when problems are encountered (eg if the credit controller
refuses to authorise a despatch of goods to a customer exceeding their credit limit).
♦ Perform a ‘walk-through test’ of individual transactions to confirm that the system appears to operate
in the manner documented (eg by the auditor’s flowchart). (Modify the flowchart and notes as
necessary.)
Part (b)
Systems documentation
(i) ICQs
♦ Questions in an ICQ are of the form ‘Does a specific control exist to ensure that something
good happens/something bad does not happen?’.
♦ For example, ‘Does the credit controller check customers for creditworthiness before
authorising goods to be despatched to them?’.
♦ Questions are consistently phrased. For example, a ‘Yes’ answer means that a control
exists; a ‘No’ answer indicates a potential weakness.
♦ Consistent phraseology facilities evaluation. For example, the auditor can review the
answers and consider the impact of the ‘No’ answers.
95
KAPLAN PUBLISHING
(ii) ICEs
♦ An ICE asks ‘key’ control questions or objectives of a more general nature. For example,
‘Can goods be despatched to a bad credit risk?’ or ‘To ensure that goods cannot be
despatched to a bad credit risk’.
♦ Answers need to identify the ‘key’ controls to prevent or detect and correct errors and must
therefore be drafted by more senior staff.
(iii) Relative advantages
ICQs
♦ Standard questions for each major accounting system can be answered by relatively junior
audit staff. More senior audit staff only need to be involved with evaluating the impact of ‘No’
answers.
♦ As comprehensive lists of questions they should highlight most weaknesses in a system.
ICEs
♦ ‘Key’ control questions/objectives force the auditor to identify the ‘key’ controls to minimise
the risk of fraud and error.
♦ The ‘key’ controls identified in response to ‘key’ questions/objectives are those on which tests
of control must be performed (if reliance is sought to be placed on them in order to reduce
levels of substantive procedures).
(iv) Relative disadvantages
ICQs
A standard set of questions may not apply to the particular situation being audited.
Questions may be too detailed for small simple systems but inadequate for large
complex systems.
Part (c)
Audit work on sales system
♦ Perform tests of control. For example, check a sample of sequentially numbered despatch notes (say
th
every 50 item from a random start).
♦ Tests of control may include:
- observation of internal control function (eg the credit controller checking that customers
are not on a ‘stop list’ before authorising customer orders).
- inspection of documents supporting controls (eg authorisation signature of the credit
controller on customer orders).
96
KAPLAN PUBLISHING
- examination of minutes of management meeting at which an aged debt analysis is

discussed and action to be decided on (eg to improve credit control).
- reperformance of control procedures (eg reconciliation of the total of the list of balances
(extracted from the receivables ledger) to the balance per the receivables ledger control
account (in the nominal ledger)).
♦ When deviations are detected, specific enquiries must be made to ascertain their cause and nature
(eg isolated error by temporary staff or systematic error due to a program error).
♦ The preliminary assessment may be supported despite deviations. However, if the assessed level of
control risk needs to be revised, the nature, timing and extent of planned substantive procedures
must be modified.
Tutorial note – Markers have made the following comments.

Many answers to part (a) on obtaining and documenting an understanding of the sales system
were good, although some students (wrongly) restricted their answers to flowcharts and
narrative notes.
Answers to part (b) were not so good. Most students were unable to distinguish between ICQs
and ICEs or illustrate their form and content.
Answer 19
Marshalls
Weakness Possible consequences Recommendation
(a) Buyers placing orders with the central purchasing department
♦ Orders are placed with ♦ Unauthorised orders may ♦ Orders should only be
the purchasing be placed on the same made in writing and
department by telephone. order by the two different authorised by the senior
buyers in each buyer in each
department. department.
(b) Placing orders with suppliers
♦ After receiving ♦ Goods could be ordered ♦ Written orders from

instructions to buy goods, for the wrong price. buyers should detail the
purchase orders are agreed price and the
placed without reference chief buyer should
to the agreed price. countersign all orders
before they are sent to
suppliers.
(c) Purchase order documentation
♦ No copy of the purchase ♦ The requisitioning ♦ An extra copy of the

order which is sent to department may not be purchase order should be
suppliers is returned to aware that the goods it made and sent to the
97
KAPLAN PUBLISHING
the requisitioning has requested have been requisitioning department.

department. ordered.
(d) Receipt of goods
♦ Goods are not physically ♦ The incorrect quantity of ♦ All goods should be
checked for quality or goods may be received. checked by Mr North for
correct quantity on arrival Also goods may be both quantity and quality
at the store. received which do not on arrival at the store.
match the store’s Mr North should sign the
specifications or are sub- GIN as evidence that this
standard. has been done.
(e) Payment of purchase invoices
♦ Cheques are signed ♦ Cheques could be signed ♦ Suppliers’ invoices and

without the purchase other than for legitimate supporting documentation
invoice being made purchases. should be inspected by
available to show what cheque signatories who
the cheque is actually should stamp the invoice
paying. ‘paid’ and initial it so that
it cannot be paid twice.
(f) Suppliers’ statements
♦ Although suppliers’ ♦ The payables ledger ♦ Suppliers’ statement

statements are reconciled could incorrectly show old reconciliations should be
to individual ledger paid items or omit reviewed by the finance
accounts, there is no invoices that are a director on a regular
evidence that any genuine liability of the basis to confirm that all
differences found are company. discrepancies have been
investigated. investigated.
(g) Control account
♦ A payables ledger control ♦ Any errors occurring in ♦ A payables ledger control

account is not prepared. individual payables ledger account should be
accounts may go prepared and reconciled
undetected. monthly to total accounts
payable as per the
payables ledger.
(h) Management control
♦ The current level of ♦ Lack of management ♦ A director should be

management review in control could mean that assigned to monitor the
the purchasing errors or irregularities purchasing function on a
department is not may be undetected. regular basis.
sufficient.
Answer 20
98
KAPLAN PUBLISHING
Dean
Part (a)
Weakness Audit significance
Ordering and receipt of goods
1 Goods are ordered without specific Buying errors may arise through incorrect
authorisation. product coding/description (eg 5,000
staplers ordered instead of staples).
Write-downs may be required for slow
moving/excess inventories held as a
result.
2 Goods received may be accepted for Cut-off errors on inventory/purchases/

short deliveries, inferior quality etc. payables may arise if part-deliveries prior
to year end are invoiced as complete
consignments. Write-downs may be
required for faulty or damaged goods.
3 Pre-numbered goods received notes The audit trail may be lost as the
(GRNs) are not raised on receipt of completeness of recording goods
goods.
received is not established.
Purchases/payables may be understated
in the financial statements.
Invoicing and payment
4 Invoices may be processed (ie liabilities Any errors made by the payables ledger
raised) for goods not received (eg for clerk are unlikely to be detected by the
part-deliveries).
client’s system of internal control
5 Invoices sent to managers for coding Purchases/payables will be understated if

may be lost. the financial statements reflect the
nominal ledger account balances (rather
than the payables ledger balances).
6 Even if not lost, invoices sent to Purchases/payables may be understated

managers give rise to a ‘timing owing to cut-off errors.
difference’ between nominal ledger and
payables ledger balances.
7 There is a lack of segregation of duties Any errors made by the payables ledger
in the purchases system as the clerk are unlikely to be detected by the
payables ledger clerk:
99
KAPLAN PUBLISHING
Weakness Audit significance
♦ records purchases client’s system of internal control.

♦ authorises payments, and
♦ performs reconciliations.
8 Liabilities are raised (in the payables None.

ledger) before authorisation/approval.
9 Purchases may be misanalysed to The analysis of expenditure in the income

nominal ledger accounts. statement may not be comparable with
the prior year. Gross profit or expenses
separately disclosed may be misstated.
10 The cashier may be instructed to pay If overpayments to suppliers arise,

suppliers for short delivered or allowances may be required for their
incorrectly priced goods.
subsequent irrecoverability.
Part (b)
Effect on normal audit procedures
1 Reliance on internal controls
It will not be possible to place reliance on internal controls because of the following.
♦ Very few controls exist.
♦ The accounting control (of reconciliations) is not independently reviewed.
♦ There is little evidence of controls being implemented which can be tested directly
(evidencing the check of invoice calculations is of limited use when quantities and prices are
not agreed).
As control risk is high, detection risk must be rendered low by adopting a substantive
approach.
2 Additional procedures required (weaknesses 1, 2, 3, 4, 7)
♦ For a sample of purchase invoices from significant suppliers, agree quantities invoiced to
advice note and purchase order.
♦ If invoice quantity exceeds advice note quantity, ascertain by discussion with client whether
shortfall has been made good or credit note received.
♦ If invoice/advice note quantities exceed purchase order quantity, inspect quantity still in
inventory. Consider need for write-down of inventory value if excessive.
3 Extended procedures
100
KAPLAN PUBLISHING
Cut-off (weaknesses 2 to 7 inclusive)
♦ As at the year end date obtain/prepare a list of all ‘unmatched’ advice notes (ie pending
receipt of invoice) held by the payables ledger clerk. These represent goods received but not
invoiced and should therefore be accrued in year end purchases* and payables.
(* If purchases cover different nominal ledger codings, an analysis will also be required.)
♦ The payables ledger clerk should be required, in advance of the year end, to maintain a list of
invoices sent to managers and to record their subsequent return. As at the year end date, the
total of ‘invoices with managers’ should constitute the most significant reconciling item
between the payables ledger control account balance and the list of payables ledger
balances. These too should be accrued.
♦ Suppliers’ statement reconciliations should be re-performed for all significant accounts
payable and the accounting treatment of reconciling items followed through.
4 Analytical procedures (weaknesses 7 and 9)
Compare cumulative nominal ledger account balances with prior year. Investigate any
significant variances via analysis sheets back to purchase invoices to ensure no material
misanalysis.
Alternatively, for all significant nominal ledger account balances, scrutinise and compare
the monthly postings. Investigate any unusual amounts via analysis sheets back to
purchase invoices.
5 Tests on payables ledger balances (weaknesses 7 and 10)
Debit balances on payables ledger accounts may indicate that errors have arisen, eg
♦ suppliers have been overpaid

♦ invoices/payments have been posted to the wrong creditor’s account
If debit balances are significant it may be appropriate to reclassify them as current

assets. The subsequent recoverability should be assessed by reference to post year end
suppliers’ statements, etc.
Answer 21
Bingham Manufacturing
Part (a)
The principal controls in a wages system and their purpose would include the following.
♦ There should be a proper division of duties in the wages system. Employees who calculate wages
should not be responsible for making up the wage packets.
♦ There is proper control over custody of cash for wages and unclaimed wages.
101
KAPLAN PUBLISHING
♦ Wages are only paid to employees for work done, ie not in advance.
♦ Employees are paid at a rate authorised by management.
♦ There is appropriate authorisation over employee appointment and dismissal.
♦ Deductions are correctly calculated and paid promptly to the relevant authorities, ie the tax authorities
and pension companies.
♦ Payments are made to employees actually registered with the company.
♦ The transactions are correctly recorded in the books of account, including the allocation of the wages
expense between sales, manufacturing, administration, etc.
The aim of these controls is to ensure that employees are paid at authorised rates for work
done, that the transactions are recorded accurately in the accounting records, that the
employees and other authorities are paid the correct sums and that the risk of fraud and error is
minimised.
Part (b)
In checking the existence of employees the following techniques can be used.
♦ The signature of the employee signing for his or her wage can be checked to the record in the
personnel department. The signature of the employee in the personnel records should have been
obtained when the individual started employment in the company. (For the purposes of the exam
everyone can be assumed to have signed a contract.)
♦ The employee can be checked to the annual return made to the tax authorities and there may be
official correspondence that can be inspected between the authorities and the employer in respect of
this employee. If the employee has just joined the company (and had previously been employed by
another organisation), there should be a notification from the former employer of the individual’s gross
pay and tax paid to date.
♦ The employee should have a social security or national identity number which may also be used to
verify existence.
♦ Each department manager could acknowledge a list of individuals employed in his department. This
is difficult to obtain when a large number of staff are involved.
Part (c)
The purpose of a starters and leavers test is to ensure that employees are neither paid before
they start nor after they have left the company’s employment.
To carry out this procedure, I will select two payrolls, say three months apart, and compare the
names on the payroll. Where the name appears on both payrolls, the employee has been paid
for the full three month period. Where the name appears on the first payroll and not the second,
this is a ‘leaver’, and where the name appears on the second payroll and not on the first, this is
a ‘starter’. Starting and leaving dates should then be verified by examining the relevant
personnel records.
102
KAPLAN PUBLISHING
I can then ensure that they have been paid for the correct period by checking the dates on the
payroll and their actual dates of joining or leaving the company.
Part (d)
The analytical review techniques I can use in auditing the wages system will include the
following.
♦ The gross and net wages, tax and social security expense will be compared for each month and with
the previous year. Any unusual changes can be identified and investigated.
♦ The average wage per employee will be calculated and any significant changes will be investigated.
The ratio of income tax and social security expense to gross wages will be checked. This would be
expected to be fairly constant from period to period.
♦ A sample of payrolls will be scrutinised and any large amounts will be investigated.
♦ The returns to the tax authorities will be test checked to the payroll. This will include monthly tax and
social security payments, and test checks of annual returns for individual employees.
♦ The computations on the payroll will be test checked, including the calculation of the deductions and
the sum of each employee’s pay to the total. I will check that the total gross pay is equal to the total
net pay plus the deductions. These checks may be very limited where the wages system is
computerised and the wages programs have been shown to be reliable.
♦ The analysis of the wages expense (eg sales, production, administration wages) will be test checked
from the payroll to the nominal ledger and the total for the year will be compared with previous years.
Any significant changes will be investigated.
Answer 22
Eastwood Engineering
Part (a)
IAS 10 Events After the Balance Sheet Date explains that an adjusting event concerns
conditions that existed at the balance sheet date, while a non-adjusting event concerns
conditions that arose after the balance sheet date. The implication is that the closure of a
material segment of a company’s activities is an adjusting event unless it is reasonable to claim
that the closure could not be reasonably anticipated at the balance sheet date.
The matter should be discussed with management and directors to decide whether or not this is
the case.
The board minutes should be inspected because they may provide evidence of the date when
the decision was actually made.
If the decision was made and publicly announced before the year end, then it will definitely be
an adjusting event.
103
KAPLAN PUBLISHING
If the factory had been making a loss for a long time then it is probable that the decision to close
was made some time ago, so it is the date of the public announcement of the closure that
becomes relevant.
The financial status of the segment could be checked by reviewing the monthly financial
statements of Eastwood.
A relatively short time period between the year end and the audit would, at least, suggest
initially that the closure should be treated as an adjusting event.
Part (b)
Consider first the amounts of the three components that are intended to be included in the
provision for closure costs:
1 Redundancy costs
Employee existence may be verified by inclusion in the payroll or reference to the contracts of
employment.
The basis of the redundancy calculation should be checked. Normally it would be based upon
the number of years’ service.
The actual provision should be tested for accuracy, ie the additions and calculations should be
checked.
Employee contracts may contain specific clauses in respect of redundancy costs. It should be
ensured that these are observed.
2 Losses on non-current assets
(i) Land and buildings
If items are sold by the time the auditor is carrying out his work, then actual losses on
disposal can be verified.
If they have not been sold, then the estimated proceeds should be agreed as
reasonable, preferably by an independent valuer.
(ii) Other non-current assets
Again, any items actually sold can have their actual proceeds, profits and losses on
disposal vouched.
For unsold items, categories such as fixtures and computer equipment would be
expected to have a scrap value only.
104
KAPLAN PUBLISHING
Motor vehicles’ proceeds can be agreed to an independent trade journal value. Plant
and machinery estimated proceeds may require the use of an expert valuer unless they
are specialised in nature in which case the scrap value is likely to be negligible.
3 Losses on inventories
It is probable that at least some inventory sold as a result of the closure will have a net
realisable value lower than cost. Based on the most recent inventory sales, ie March/April 20X5,
the estimate of the disposal proceeds would be checked for reasonableness.
One should also ensure that, based upon this work, an adequate allowance for slow moving or
obsolete inventory is included.
Next we should consider whether these three components are properly included in the provision
for the loss on closure. IAS 37 requires that amounts should only be provided if there is an
actual obligation to pay the amounts at the balance sheet date. Thus the provision should
include only the direct costs of the closure. Each of the three components above would
probably qualify as direct costs, so they are all properly included within the provision for the loss
on closure.
Part (c)
(i) IAS 1 requires that capital expenditure commitments not provided for should be
disclosed in the notes to the financial statements.
(ii) The audit work to be carried out in verifying capital commitments will include the
following.
♦ Check the authorisations for capital expenditure in the board minutes before the year end to the
schedule, and note any items authorised in the board minutes which are not included in capital
commitments.
♦ Check purchase orders for capital equipment issued before the year end and check that they are
included in items contracted for and that they are included at the correct value. Purchase orders are a
reasonable alternative way to board minutes for verifying authorisation.
♦ Some items of capital expenditure may be in progress at the year end, so check that the amount
included in capital commitments is the total amount authorised less the amount included in non-
current assets at the year end.
♦ Compare this year’s capital commitments with last year and ensure that the change is reasonable,
and that the same basis was used. The value of capital commitments is likely to fluctuate, as it will be
affected by the general level of capital expenditure and any major projects.
Based on this work, you will need to decide whether capital commitments are fairly stated in the
Answer 23
105
KAPLAN PUBLISHING
Wormwood
Part (a)
Two payrolls should be selected from different periods in the year.
Employees not listed on the second payroll should have left during the year and employees not
listed on the first payroll should have started during the period.
This can then be verified by examining the permanent payroll information where there should be
a copy of each employee’s contract of employment. Also official documents sent to the tax
authorities should confirm departure and start dates. The main reason for carrying out this
exercise is to ensure that all employees are bona fide, ie payments are being made to
authorised employees.
Part (b)
Attendance at the wages payout
Before attendance I will review the payroll to ensure that a pay packet exists for all employees.
Each employee should sign for the pay packet when they collect it. After they sign, the auditor
should verify the signature to the contract of employment.
It should be ensured that no one employee collects more than one pay packet.
All unclaimed wages should be listed; the payroll date, name and amount noted.
The unclaimed wages should then be stored in the safe until collected.
Part (c)
All unclaimed wages should be recorded in an unclaimed wages book and it should be checked
that a wage packet physically exists for each entry in the book.
If someone has collected wages on behalf of somebody else then it should be ensured that a
letter of authorisation exists allowing the pay packet to be collected.
After a certain period, say a month, all unclaimed wages should be returned to the bank, so the
details for each pay packet should be agreed from the unclaimed wages book to the banking
slip.
Any significant delay in banking unclaimed wages should be noted and investigated.
106
KAPLAN PUBLISHING
Part (d)
Verification of direct bank payments
Carry out a physical verification of employees to ensure that they actually exist.
Check employee details to the personnel records from payroll information.
The finance director could be asked to sign a copy of the payroll to verify that all the employees
are bona fide.
Employees’ existence can be verified by confirmation of signatures on expense claims.
Also, correspondence with the tax authorities concerning employees can be reviewed.
Answer 24
Lenton Electrical
Part (a)
The purchase cut-off should be checked first.
A sample of goods received notes from before the year end would be selected and it is ensured
that these items were included in inventory and the purchases were included in the income
statement.
Another sample of goods received notes from after the year end would be selected and it is
ensured that these items were not in inventory and were not included as purchases in the
income statement.
Compare the physical and computer inventory quantities at 14 April.
♦ If the quantities are the same, no further work is required.
♦ If the value of the difference is small (ie immaterial) there is no need to change the inventory
quantities on the computer.
♦ If the difference is large in terms of quantity or value, further investigations will need to be carried out.
If there are very large differences the inventory may need to be recounted. There should be a
set procedure which must be observed when altering computer inventory quantities.
♦ This should be permitted only after authorisation by a senior manager. The computer system should
only allow these adjustments to be processed after authorisation using a password and a secret
code.
♦ There should be a written record of the procedures undertaken to verify that the difference is valid.
♦ There should be a printout of changes of the inventory quantities, which should be filed and reviewed.
The computer system should have the facility to print out details.
107
KAPLAN PUBLISHING
Part (b)
To check purchases cut-off at 30 April 20X7, I will select a sample of goods received before and
after the year end from the goods received notes (GRNs) in the goods received department.
For goods received before the year end the format is as follows.
♦ In the purchases accounting department find the advice note and purchase invoice which relate to the
GRN.
♦ Ensure that the inventory records before the year end reflect the transactions.
♦ Check that the purchase invoice has been posted correctly to the payables ledger.
For goods received after the year end, check that the items are included in neither the year end
inventory balance nor the year end payables figure.
Part (c)
(i) I will select a sample of inventory items from the computer inventory records at 30 April
20X7 (the year end) and go through the records of inventory counts carried out in March
and April 20X7 to determine what proportion of my selected lines had been counted in
the eight weeks prior to the year end.
I would discuss my findings with employees at the company who may be able to point
out instances of counting to me which I had not found in the records.
Then I would discuss any problems arising from this exercise with senior managers of
the company.
(ii) Small, infrequent errors will not be of particular concern.
A large number of errors or errors of a significant value suggest that there is a material
error that will need to be adjusted.
Errors adjusted on the computer system are the actual errors that were identified at the
inventory count.
Negative inventory quantities on the computer system need to be investigated. These

could arise because of human error, eg an incorrect part number being manually
entered.
Some kind of computer edit check, such as a check digit, could be used to help prevent
this from occurring. If an invalid code is entered then the system should reject it and
throw out an exception report.
It is necessary to check to see how the company has corrected negative inventory
quantities that have been identified.
108
KAPLAN PUBLISHING
Ideally, negative quantities should not be included in the inventory valuation, as they will
distort the value.
Answer 25
Sheffield Homestores
Part (a)
Controls in operation over sales to customers
(i) Access to tills
♦ Access to closed checkouts is physically restricted (eg by a ‘No entry’ barrier or chain).
♦ Access to tills is restricted to authorised key holders. Authorised till assistants and
supervisors have their own passwords which are changed periodically.
♦ The computer logs all access (and by whom) and all attempted access. The log is
independently reviewed by the store manager.
(ii) Input
♦ A laser scanner and/or light pen is used to read the bar codes.
♦ When the light pen is applied to a bar code the product name and price is displayed on a till
screen to be visually confirmed by the checkout assistant (and customer).
♦ All manual input via a keyboard (eg sale of ex-display items) is printed out for management
review (ie reported by exception).
♦ Unauthorised customer returns at the checkout are prohibited. All exchanges, refunds, etc
are dealt with at the information desk where specific authorisation for exchange, credit card
refund or cash refund (as appropriate) is obtained from the store manager or supervisors
(according to their authorisation limits).
(iii) Creditworthiness
♦ For cash receipts all $50 and $100 notes are examined for authenticity and $100 notes are
referred to the checkout supervisor before being accepted.
♦ For payments accepted by cheque, the amount of the cheque does not exceed the
customer’s current cheque card limit. (The cashier records the cheque card number on the
back of the cheque and agrees the signature with the cheque card.)
♦ Credit cards are put through a ‘card swipe’ (ie a badge reader) to validate the card as being
acceptable (ie it has not expired and does not have a card number which has been recorded
as lost or stolen). The customer’s signature on the computer-generated sales voucher is
agreed to that on the credit card.
♦ If the ‘floor limit’ set by a credit card company is exceeded, the cashier refers the amount of
the payment to the credit card company (by a telephone link) for an authorisation code which
is written onto the credit card voucher.
109
KAPLAN PUBLISHING
♦ If the cashier has any doubts about the identity of a cheque or credit card holder he should
ask for proof of identity/address.
(iv) Daily takings
♦ Tills are regularly (eg hourly) cleared of excess notes and all cheques by a supervisor, in the
presence of the till assistants, possibly with another employee in attendance (eg a security
guard).
♦ At the end of each till operator’s shift:
- the operator signs off on the till roll in the presence of a supervisor
- the till contents are replaced with a float for the incoming operator, and
- the till takings for the shift are reconciled to the computer printout for the shift.
♦ All cash counting is conducted in a secure location (eg office restricted to authorised
personnel) by two responsible members of staff.
♦ Daily takings are banked intact. Afternoon takings which cannot be banked until the next
working day are kept locked in a fire-proof safe (or lodged in an overnight bank deposit box).
A hired security service is used to transfer takings to the bank.
♦ Management review of reconciliations of computer-generated takings with subsequent

lodgements on the bank statements.
♦ There is adequate insurance cover for all staff handling cash (fidelity insurance) and the
maximum amount of cash held on the store premises overnight.
Part (b)
Audit procedures to assess reliability of controls in operation
(i) General – design of user identification (passwords)
♦ Review management’s system for implementing passwords to ensure segregation of duties

(eg between till operators and staff in the goods inwards department). Establish minimum
length of passwords (say 5 characters) and the frequency with which they are changed
(weekly/monthly).
(ii) Sales system via till
♦ Attempt to access a till without a key. Request supervisor to unlock till. Attempt to operate till
by guessing password (eg name of till operator, current month).
♦ Check that attempted access has been accurately recorded on a printout of the computer log.
♦ Review filed computer logs for evidence of manager review (eg signature and comment on
reason) and discuss with the store manager any apparent recurring problems.
(iii) Office and goods inward terminals
110
KAPLAN PUBLISHING
♦ Inspect locations of office terminals and assess ease with which they can be attained by an
unauthorised employee or customer. Consider whether a new member of the audit team was
challenged on his first appearance (eg for an inventory or cash count) in the store’s offices.
♦ Attempt to access terminals without an authorised password. Observe whether a terminal

which has been inactive for (say) 5 minutes, switches off automatically.
♦ Review computer log recording access outside normal working hours for evidence of
management review. If staff appear to be working overtime, confirm that this has been
authorised (eg by overtime payments being made).
(iv) Sales system via office terminals
♦ Use a package of test data to:
- alter the selling price of a product in inventory (computer may ask for a validation
code to accept change)
- confirm the accuracy of reported changes to standing data
- input returned inventories (include negative return quantities (equivalent to goods

outwards) and ensure rejected).
(v) Inventory control system via in-store customer information desk
♦ Observe staff dealing with customer queries at the in-store customer information desk. Make
own enquiries into inventory levels of a sample of product codes and confirm that the terminal
facilitates ‘Read-only’ access.
Part (c)
Controls to ensure accuracy
(i) Standing data
♦ Computer-generated printout of all amendments to standing data (eg new product code,
selling price, re-order level) for manual checking against authorised input form.
♦ Logging of computer usage and standing data amendments and evidence of independent
review.
♦ Periodic printout and manual checking of product prices to those authorised by management
and on display in the store.
♦ Exception reporting (eg of selling price less than cost).
(ii) Transaction data files
♦ Reconciliation of recorded transactions with physical quantities (eg of daily sales with
cash/credit takings and book inventory quantities with physical).
♦ Recording of management’s authorisation of all manual adjustments (eg to adjust book

inventory quantities to physical after periodic inventory counts) on an appropriate standard
input form.
111
KAPLAN PUBLISHING
♦ Exception reporting (eg of negative inventory quantities).
♦ Daily copying of transaction data.
Tutorial note – In (b) controls in operation over access to the sales system (eg via tills) may
have already been identified in (a). To the extent that controls have not yet been considered
(eg in respect of access to recorded inventory levels) these must be identified in (b) in order to
recognise relevant audit procedures.
The examiner commented that although this was not a technically difficult question, the majority
of students failed to produce an answer approaching a pass mark. This was due to insufficient
attention being given to what (and the scope of what) was required, namely:
(a) describe controls (over sales)

(b) explain audit procedures (over access controls)
(c) list controls (over standing and transaction data).
The lists of controls produced by some students were so unstructured that it was not apparent
which part of the question they were attempting to address. Students who scored particularly
poorly on this question should observe the examiners‘ Guidance to candidates – Note 4
‘Candidates should take care in planning the layout of their answers. They are advised to
READ, THINK and then WRITE’.
Answer 26
Basford
Tutorial note - There are perhaps too many numbers in this question to represent a current
exam question. However, it is good practice for basic knowledge.
Part (a)
Product A B C D E
$ $ $ $ $
Cost as raw materials/WIP 15 22 34 52 25
___ ___ ___ ___ ___
NRV as raw materials/WIP
Estimated selling price 13 14 39 12 5
___ ___ ___ ___ ___
NRV as raw materials/WIP 10 11 36 9 2
___ ___ ___ ___ ___
Product A B C D E
112
KAPLAN PUBLISHING
$ $ $ $ $
NRV as finished goods
Estimated selling price 48 62 48 80 55
___ ___ ___ ___ ___
NRV as finished goods 45 59 45 77 52
Less costs to completion 37 41 10 21 32
___ ___ ___ ___ ___
NRV at 31 March 20X2 (see note) 8 18 35 56 20
___ ___ ___ ___ ___
Note. This net realisable value assumes that the raw materials and work in progress will be
converted into finished goods.
Lower of cost
Product Cost NRV NRV valuation based on:
and NRV
$ $ $
A 15 10 10 RM valuation
B 22 18 18 Costs to completion
C 34 36 34 RM valuation
D 52 56 52 Costs to completion
E 25 20 20 Costs to completion
Part (b)
In order to identify the items to be included at net realisable value, you could do the following.
♦ Identify any obsolete or slow moving items as they are likely to require valuation at an amount less
than cost.
♦ Obtain representations from management concerning any valuation problems with various inventory
lines.
♦ Inspect board minutes for evidence of any slow moving/obsolete items.
♦ Examine the inventory records to determine whether any items are more than three months old. If so,
an allowance may be required to reduce the balance sheet valuation.
♦ Any large value inventory items held at the year end should be checked against after date sales
invoices to ensure that they are sold for more than the cost. This suggests that material items in
inventory are not subject to any valuation problems.
Part (c)
IAS 2 states that inventories should be valued at the lower of cost and net realisable value.
113
KAPLAN PUBLISHING
Cost includes all expenses incurred in bringing an item of inventory to its present condition and
location.
Net realisable value is the actual or estimated selling price less any costs to completion and less
selling, marketing and distribution costs.
To determine the net realisable value the actual selling price is obtained from after date sales
invoices. For unsold year end inventory, estimated selling price will have to be used.
(i) The net realisable value of finished goods is determined by deducting selling and
distribution costs from estimated selling price.
To check that the selling and distribution expenses are reasonable you should review
the income statement and consult the management of the company to establish how the
expenses are included in the NRV calculation.
(ii) For work in progress, the costs to completion include additional raw material. Labour and
overhead costs should be tested by referring to purchase invoices and employee clock
cards. Overheads are checked as in (i) above.
(iii) The net realisable value of raw materials is tested by a similar method to (ii) as it is
assumed that the raw materials will all be converted into finished goods. Otherwise, the
net realisable value of raw materials will be the cost of the materials, less any disposal
costs.
In most cases the method that should be used is the one that gives the highest net
realisable value or the lowest loss, but obviously if the company plans to dispose of raw
materials without converting them into finished goods then the intention should be
acknowledged and the second method used.
Answer 27
Lenton Textiles
Part (a)
(i) The weaknesses in the cash sales system include the following.
♦ Sales invoices are not sequentially numbered (if they are not pre-numbered, they should be,
to ensure completeness).
♦ There is no control to ensure payment for goods. Goods should be released upon receipt of
an invoice which has been verified by the cashier.
♦ As the cashier raises the sales invoice there is no control to correct any errors he makes.
Also, he may not use the correct prices when preparing the sales invoice.
♦ There is no control to ensure that the cashier banks the cash for each sales invoice. Another
member of staff should check that this is happening.
114
KAPLAN PUBLISHING
Tutorial note - Some of these weaknesses are taken straight from the question. Others
are implied weaknesses, eg the question does not tell you whether sales invoices are
pre-numbered or not so assume they are not. Always assume whatever gives you the
most to write about unless the question specifically states to the contrary.
(ii) Audit work on a cash sales system would include the following.
♦ Record the system and perform an initial test to confirm how the system should be operating.
♦ Evaluate the controls and identify the weaknesses (these have been described above).
♦ Test the system by starting from advice notes. These advice notes should be sequentially numbered.
Check a sample of advice notes and investigate any that are missing from the sequence. Then, for a
smaller sample of advice notes, check the following for each advice note.
- Establish that a copy of the advice note is in the despatch department, and that there is
evidence of the goods being despatched.
- Follow the system through to the cashier and check that he has raised a sales invoice
and that its value has been recorded in the cash book. Check that the sales invoice is
sequentially numbered (for completeness), that it refers to the advice note, that the
details agree with the advice note, that the prices per unit are correct and that the
calculations on the invoice are correct.
♦ For a large sample of advice notes, check that a sales invoice has been raised and the cash has
been entered in the cash book. Any cases where there is an advice note and no cash has been
banked should be investigated.
♦ Check the bank reconciliation to ensure that these cash sales are banked promptly.
Part (b)
(i) The reason why two people should open the mail is that this transaction involves both
custody of the asset and the recording of the transaction. If opening of the mail was
carried out by a single person, there would be no segregation of duties, so there would
be weakness in the system of internal control. By having two people open the mail, one
checks the work of the other which should prevent fraud and error taking place.
(ii) The audit work I would perform in checking from the opening of the mail to banking of
the cheques would include the following.
♦ Attend the opening of the mail to ensure that two people, independent of the cashier and
sales accounting department, should open the mail. The cheques received should be listed
and the total calculated. A copy of the list and the cheques should be handed to the cashier,
and the second copy of the list should be filed.
♦ Ensure that the cheques are entered in the cash book and subsequently promptly banked by
the cashier.
♦ There should be evidence that a responsible official periodically test checks the lists of
cheques received to the cash book, probably the finance director.
115
KAPLAN PUBLISHING
♦ The total of the cash received for the day as recorded in the cash book should be entered on
the paying-in slip, and the paying-in slip should be stamped by the bank on the same day or
the day after the cheques have been received.
♦ Check the bank statement to ensure that this sum has been credited to the bank statement
on either the same day as the cheques were paid in or shortly afterwards (ie within two
banking days).
Part (c)
(i) The reasons why credit notes are issued include the following.
♦ When not all the goods on the invoice are received by the customer. Credit is given for the
goods not delivered.
♦ When the invoice charges the goods at too high a price. Credit may be given for the
difference.
♦ Any other errors on the sales invoice (eg incorrect calculation or cross cast errors).
♦ Where the goods are faulty.
♦ Additional charges made on the invoice which should not have been made or are more than
agreed (eg an incorrect charge for carriage).
(ii) In checking the authorisation of credit notes and ensuring they are issued for valid
reasons, the auditor should ascertain and record the system. All credit notes should be
authorised. There should be sufficient controls in the system to prevent fraudulent or
unauthorised credit notes from being issued.
A sample of credit notes would be selected from a number of places in the system. The
credit notes should cover the company’s financial year and a greater proportion of large
value credit notes would be checked. The credit notes would be selected from:
♦ the receivables ledger

♦ a sample of credit notes which are filed in sequential number order
♦ a sample of credit notes listed in the sales day book.
For all these credit notes, I would check that they have been authorised by an
appropriate responsible officer. For most of the other items, I would check the
company’s records of correspondence with the customer. If there are only written notes
by the company’s staff, this is weaker evidence and it could be fraudulent (eg the
company could raise a credit note for a valid debt, and an employee misappropriate
cash received from the customer). This evidence would be more reliable if it comes from
more than one member of the company’s staff.
The evidence I would expect to see would comprise the following.
♦ Where there is a short delivery, there should be a letter from the customer and evidence that
not all the goods were received.
♦ Where the charge is at too high a price, I would check the correct price to the company’s
authorised price list.
116
KAPLAN PUBLISHING
♦ Where there is an error on the invoice, I would inspect it and consider whether it is
reasonable.
♦ Where the goods are faulty, there should be a letter from the customer to that effect.
♦ Where there are unauthorised charges on the invoice, I would check that they should not
have been made.
Based on this work I would assess the strengths of the system for issuing credit notes. I
would report any weaknesses to management.
Answer 28
Betterhome
Smith, Jones & Co

1 Hough Street
Cardiff
Wales
C21 6XZ
Mr J Wright
Finance Director
Betterhome
1 Valley Road
Swansea
Wales
S23 5BV 18 October 20X6
Dear Mr Wright
New computer network
Further to our telephone conversation yesterday I set out suggestions for internal controls and
the likely impact of the new system on our audit work.
(a) Internal controls
(i) IT (general) controls
These will be controls over the whole computer environment including in-store
micros and the head office mainframe. A general control is operative irrespective
of which particular program is being run. These tend to be manual, organisation
or physically-based controls and should include:
♦ supervision of staff operating the in-store micros and mainframe computer.
♦ restricted access to the computer room (ie limited to authorised personnel).

117
KAPLAN PUBLISHING
♦ password protection of software to prevent unauthorised amendment.
♦ an operating log to record user’s password, date and time of use, files accessed and
updated.
♦ review of log by a senior manager for unauthorised access and processing.
♦ maintaining back-up copies of computer files in a separate, fire-proof location.
These controls are necessary to ensure the integrity of program and data files
and computer operation. Without good IT controls the effectiveness of
application controls will be diminished.
(ii) Application controls
These are over the input and processing of data and the amendment of master
files. These controls are operative only when a program or application is run.
There should be controls over input from the stores and also over head office
input via the key-to-disk system for head office expenses, payroll and central
purchases.
(1) Specific input controls
♦ Range and validity checks programmed into the in-store micros to ensure
that sales input relates to a valid store number and product code. Input
errors should be clearly identified at the point of sale so that remedial action
can be taken by the cashier or manager.
♦ Specific passwords developed for in-store and head office input. Each
cashier should be given an identification password which must be entered
correctly before the till can be operated.
♦ Restrictions on the ability to update store data other than through normal till
input (eg by senior head office staff upon receipt of written authorisation by
the branch manager).
♦ Batch reconciliations of overhead and purchase invoices by comparison of a

manually derived batch header total with a computer produced pre-total prior
to processing.
(2) Processing controls
♦ Comparison of output against expected amounts by reference to trends and

weekly budgets.
♦ Head office reconciliations of cash sales data transmitted from stores with
banking records.
The master files relating to credit customers, suppliers and employees must be
closely controlled as any unauthorised adjustments (eg to discounts, credit terms
or wages) could result in financial loss to the company. Controls should include
118
KAPLAN PUBLISHING
one-for-one checks of all master file amendments, password protection and

computer printout of changes made.
(b) Impact of new system on extent of audit testing
Our usual audit approach is systems-based (ie tests of controls over transactions during
the year and reduced substantive procedures at the year end). To retain this approach
this year, transactions for the first half of the financial year may be tested as for last year
(as the new system was not fully integrated until the second half of the financial year).
Controls over the new system must be ascertained, evaluated and tested. The level of
year-end checking may be reduced further or increased, depending on whether our
reliance on controls in the second half of the year is greater or less.
The accuracy of the data transfer must be verified. If inaccurate, a systems-based

approach would not be appropriate and wholly substantive procedures at the year end
would be performed.
As a preliminary, the changes made to the in-store and head office installations must be
documented. A copy of the systems and operations manuals provided by the software
house will assist in this respect. Walk-through checks will confirm the accuracy, or
otherwise, of our recording of the system.
To verify the accuracy of the data transfer, we will:
♦ review your documentation comparing outputs of the old and new systems during parallel
running.
♦ select a sample of documented differences and discuss their resolution with systems staff.
♦ check any necessary amendments to the software files relating to the new system.
To determine the reliance which can be placed on new controls, we will:
♦ include live test data with a number of days sales data input at selected stores during
December, to test the accuracy of data transmission and operation of relevant controls (eg
head office reconciliations), and
♦ at our final audit visit reperform tests of controls on which we may seek to rely (eg
programmed range and validity checks) to cover the period since the interim audit.
At the final audit we may use audit software to:
♦ identify stores and product lines with unusual margins (which may indicate potential errors in
sales recording) for detailed substantive work.
♦ calculate receivables days for major credit customers for inter-store comparison.
Because of the need to record the changes to the system and devote audit effort to assessing
controls, the accuracy of the changeover and the period of parallel running, it is extremely
unlikely that there will be any reduction in audit fee for the year ending 31 December 20X6.
119
KAPLAN PUBLISHING
If you have any further queries please contact me.
Yours sincerely
Ian Jones
Tutorial note – The examiner commented that the quality of letter writing was, on the whole,
good.
However, in part (a) many candidates gave general answers on computer controls not specific
to the circumstances given, including, for instance, batch processing.
In part (b) candidates tended to overlook the need to test the old system or the changeover.
Additional IT controls could include:
♦ software amendment should ideally only be carried out by the software supplier.
♦ different passwords for those entitled to read and those allowed to update.
♦ 24 hour maintenance contracts and an emergency power supply in the event of power failure.
♦ adequate insurance cover for all computer installations including consequential loss.
Answer 29
Audit evidence
Part (a)
Inspection
This could either be physical inspection (eg of tangible assets) or the inspection of documents,
such as purchase invoices.
Observation
This is most relevant for observing the adequacy and operational effectiveness of control
procedures, eg observation of the procedures for the counting of inventories.
Enquiry and confirmation
Enquiry comprises obtaining explanations from responsible officials within the organisation and
then the auditors should carry out their own investigations to confirm the reasonableness of the
explanations provided by the client.
Computation
This normally consists of the auditor performing some mathematical checks, perhaps by
checking the calculations on purchase invoices.
Analytical procedures
This is the comparison of past and present performance including the analysis of significant
ratios and trends. An analysis of overall trends can identify fluctuations that may require further
120
KAPLAN PUBLISHING
investigation. These areas will be the ones where detailed audit tests will be performed.
Analytical review can enable the auditor to increase audit efficiency by concentrating his/her
detailed audit work in areas of greatest risk.
Part (b)
Inspection
Carry out a physical inspection of tangible non-current assets and ensure that all assets are
recorded in the asset register.
Observation
Observe client staff checking the physical condition of assets and their frequency of use to
determine the useful life and replacement policy. This provides evidence of accuracy and
valuation.
Enquire as to the method of revaluation of assets when their market values change and confirm
with an external source (such as an expert opinion or trade journals) as to the reasonableness
of accuracy of this revaluation.
Computation
Test check the additions and calculations on the purchase invoices to ensure adequate and
accurate measurement in the financial records.
Test check the global depreciation charge (ie the total charge for plant and machinery) to
ensure that it is in accordance with the stated accounting policy. If there is a significant
discrepancy then the depreciation charge for a selection of individual assets may also be
checked.
Part (c)
Inspection
Physical inspection of assets by the auditor is auditor generated evidence and more reliable
than merely relying upon the client records.
The inspection of original documents is a more reliable source of evidence than if they were
photocopies or facsimiles.
Observation
Reliance upon evidence obtained by observing procedures is normally of limited value,

especially if the staff carrying out the procedures know that they are being observed.
121
KAPLAN PUBLISHING
Enquiry is client generated information and confirmation is auditor generated which is

considered more reliable. Confirmation by using a third party opinion as external evidence is
more reliable (assuming that the third party is independent) than internally generated evidence.
Computation
Re-performance of calculations by the auditor, perhaps by using any number of computer

assisted audit techniques, is a highly reliable source of evidence.
On its own, evidence obtained from analytical review is not sufficient owing to lack of detail,
despite the fact that it is auditor generated evidence.
Some detailed tests would be required. In the case of plant and machinery, perhaps the testing
of a sample of assets from the asset register to physical existence noting their physical
condition could provide more evidence as to the appropriateness of the depreciation policy.
Answer 30
Sources of audit evidence
(i) Oral management representations
These are clearly relevant to the completeness of sales. They are not relevant to the
occurrence, measurement or presentation of sales.
There is a high risk of management bias in this area which makes this evidence alone
unreliable. Internally-generated evidence is less reliable than external evidence. As oral
evidence is less reliable than written, the directors must confirm their representations in
a letter or board minute.
This evidence could never be sufficiently persuasive on its own to form an unqualified
opinion. Sales are material to the income statement. There is also the high risk of theft
of cash. The auditor must perform detailed additional tests on costs of sales and
margins, including analytical procedures.
(ii) Flowcharts
Flowcharts provide background information to be used at the planning stage. They are
relevant to obtaining an understanding of the accounting system and control
environment.
122
KAPLAN PUBLISHING
Their reliability depends on the competence of the internal audit staff, how long ago they
were updated and whether there have been subsequent changes. ‘Walk-through’ tests
of a few transactions should be carried out each year to assess their reliability.
These flowcharts provide no persuasive evidence as to the completeness and accuracy

of the accounting records or the effective operation of internal controls. The auditor
must perform tests of control and substantive procedures to provide that evidence.
(iii) Year end suppliers’ statements
These provide evidence as to the existence, obligations, completeness and valuation,

but not presentation of liabilities. They also provide evidence as to the recording of
inventory ‘cut-off’.
Although they are more reliable than documents from within the enterprise, they could
contain errors or discrepancies (eg year end cash in transit). They are more reliable
than verbal confirmation by telephone.
As trade payables are usually a material balance in the balance sheet and there is the
risk of understatement, this evidence alone is not sufficient. Further evidence should
include analytical procedures on margins and expenses and attendance at the physical
inventory count.
(iv) Inspection
This is relevant to the existence, but not the presentation of non-current assets. It
provides corroborative evidence as to the rights to benefits from an asset. The physical
condition of assets is relevant to their valuation.
Direct observation by the auditor is the most reliable evidence available as to the
existence and condition of non-current assets.
This is sufficient evidence as to the existence, condition and possibly valuation of a non-
current asset. In conjunction with documentary evidence (eg a purchase invoice) rights
to benefits may also be verified.
(v) Comparison of income statement items
This is relevant at the planning stage to identify matters requiring further investigation. It
also provides evidence as to the reasonableness of the amounts recorded.
Analytical procedures provide some of the most reliable evidence (being performed by
the auditor). The procedures must, however, be properly planned, conducted and
documented, and the reliability of underlying information assessed.
This procedure may provide sufficient evidence as to the completeness and accuracy of
trading results of low risk, immaterial, separately identifiable components of the
123
KAPLAN PUBLISHING
business. The persuasiveness of this evidence will depend upon the auditor’s previous
experience of the reliability of the accounting records and knowledge of the business.
Tutorial note – The examiner commented that this question was reasonably well answered by
the majority of candidates. Many candidates wasted time by reproducing paras 9 and 13 of ISA
500 Audit Evidence, instead of applying the principles of relevance, reliability and sufficiency to
the examples given in the question.
(i) Although the majority of candidates recognised that such representations would be
insufficient, only a minority stated that they would have to be corroborated with other
evidence such as a review of profit margins.
(ii) Candidates tended to write lengthy answers on the reliability of the internal auditor at the
expense of relevance and sufficiency of this source of evidence.
(iii) Few candidates recognised that suppliers’ statements may not be available for all
suppliers.
(iv) The majority of candidates recognised that physical inspection would provide evidence
of existence and physical condition of the asset but many failed to state that it does not
provide evidence of rights to benefits from and value of the asset.
(v) Few candidates recognised that such comparisons would be meaningful only if the
underlying data was reliable.
Answer 31
Daybrook Insurance Brokers
Part (a)
(i) The ownership of freehold land and buildings would be verified as follows.
♦ Checking the latest legal transfer document for the property, which should be in the name of
the company. This is third party external evidence and is considered by the auditor to be a
reliable source. However, it should be ensured that the report is prepared by an independent
and properly qualified property professional.
♦ Checking the land registry certificate (if available), which should give a plan of the plot and
building (ie the offices) and state that it is owned by the company.
♦ Contacting the land registry to confirm the ownership of the land (eg the company’s records
could be photocopies, and this check would confirm the ownership of the building and land).
(ii) Ownership of cars can be verified by checking the relevant details to the vehicle
registration documents. Also an auditor would verify details of additions and disposals to
purchase and sales invoices and orders.
124
KAPLAN PUBLISHING
Computers can also be verified by checking the purchase invoices and details such as
names, addresses and goods descriptions.
Enquiries would be made as to the existence of any assets held under a lease
agreement. Items held under finance leases would be considered to be owned by
Daybrook Insurance whilst assets subject to an operating lease are still owned by the
lessor.
Part (b)
(i) Depreciation is the using up or wearing out of an asset over its estimated useful life. The
depreciation rate of 10 per cent on cost seems very low for computers, as it indicates a
life of ten years. To assess the life of the computers, I would suggest the following.
♦ Ask management their policy for renewal and upgrading of computers. If they plan to replace
the computers in the near future, then a depreciation rate of 10 per cent per annum appears
to be too low. If they plan to defer purchase of new computers, I would consider whether this
is realistic.
♦ Look at disposals of computers (or scrapping), and check if there is a profit or loss on
disposal. If there is a loss on disposal the depreciation rate is too low, and if there is a profit
on disposal, the depreciation rate is too high (which seems unlikely). If there are a large
number of computers which are fully written off, it indicates that the depreciation rate is too
high which also seems unlikely.
♦ Look round the offices and check whether there are any unused computers. It is probable
that they are obsolete, and I would ask management’s views on whether they would be used
again. If these obsolete computers are not identifiable in this way, I would be able to find
them by selecting old computers from the asset register and checking their existence (they
may be kept in a store room). In order to confirm that they exist, management would have to
show them to me. These obsolete computers would probably have a very low value, and it
may be appropriate to assume they are worthless.
♦ Based on these investigations, I would decide the life of the computers and estimate the
understatement of the depreciation charge and the overstatement of the value of the
computers. I believe that a depreciation rate of 20–25 per cent on cost should be used for
computers, giving a life (to zero value) of four to five years.
(ii) As stated in part (b) (i) above, I would quantify the amount of the understatement of the
deprecation charge and the overstatement of the value of the computers and consider
whether this error is material.
If a material error is taken as 10 per cent of the profit before tax, then if the understated
depreciation charge affects the profit before tax by more than 10 per cent, its effect is
material and the audit report should be qualified. Also, if the effect of this error together
with other errors overstates profit before tax by more than 10 per cent, the audit report
should be qualified. However, it seems unlikely that the error in the depreciation charge
would affect the profit before tax by more than 10 per cent.
For the value of the computers in the balance sheet, it is more difficult to say how much
a material error would be. It could be taken as 10 per cent of the net book value of all
non-current assets (which may be considered to be too large an acceptable error), or it
125
KAPLAN PUBLISHING
may be 10 per cent of the value of plant and machinery (which may include motor
vehicles and fixtures and fittings).
Concerning qualification of the audit report:
♦ I have seen all the evidence I would have reasonably expected to be available.
♦ The financial statements are prepared in accordance with accounting standards.
♦ The understated depreciation is not a fundamental uncertainty.
♦ The financial statements do not give a true and fair view.
♦ The effect of the disagreements is not sufficient to make the financial statements misleading.
So, the form of qualified audit report is a qualified opinion ‘except for disagreement’.
Part (c)
Goodwill is the value of a business over and above the value of each of the individual separable
net assets. The audit work I would perform to determine whether the goodwill is worth at least
$450,000 at 31 March 20X5 would include the following.
♦ I would obtain the purchase agreement, and check that Daybrook Insurance Brokers has acquired the
trade, and has legal title to it. I would check to the cash book that payment has been made to the
business which has sold its trade.
♦ I would obtain details of the trade which has been purchased (this will comprise customers and may
include staff of the old business).
♦ I would check that the trade was worth $500,000. This would include checking the profitability of the
business before it was purchased and comparing the cost with the cost of purchasing similar
businesses.
♦ I would ask the company to provide a schedule of the trade and commission earned from this
business. I would check that the business on the schedule relates to what has been acquired (ie it
should be renewal of premiums from customers of the old business, and not customers of Daybrook
Insurance Brokers or new customers since the acquisition).
♦ I would ask the company to provide an estimate of the profitability of the business acquired. The
gross income would be the commission from the insurance premiums, and the costs would relate to
employees’ wages and overheads incurred in carrying out that business. It may be possible to identify
the employees, if they are in separate departments or buildings. Otherwise, it is probably acceptable
to apportion overheads on the basis of the premium income received in the purchased and existing
business. I would test check the income from premiums and the overheads, and the calculation of the
net profit of the business acquired.
♦ I would consider whether the profitability of the business acquired is consistent with the amount paid
for it. The return on the investment should be greater than the cost of borrowing money to finance the
investment. If the return is quite high, then the value of $450,000 for the goodwill is probably
acceptable.
The amortisation period of ten years seems long. If the business acquired is being operated as
a separate branch, it would be easier to check the value of the goodwill and its amortisation
period than if the new business has been incorporated into the existing business. One would
126
KAPLAN PUBLISHING
expect the goodwill to relate to the business’s customers when it was purchased on 1 April
20X4, and that it would not relate to any customers acquired after 1 April 20X4.
Based on these investigations, I would decide whether the value of the goodwill in the balance
sheet at 31 March 20X5 and the amortisation of $50,000 in the income statement are
reasonable.
Answer 32
Simons Engineering
Part (a)
The audit work to be performed on non-current assets in Simons Engineering would include the
following.
♦ Obtain a schedule from the client of movements in non-current assets for the year. Check the
additions on the schedule and agree the totals to the draft financial statements.
♦ Check the opening balances on the schedule to last year’s financial statements.
♦ For additions to non-current assets the following would apply.
- Check authorisation to the board minutes.
- Vouch additions to purchase invoices for material items.
- Check that the addition is correctly entered in the asset register and nominal ledger to
ensure accuracy.
♦ For disposals of non-current assets the following would apply.
- Check authorisation for the disposal. It should be by a responsible official.
- Check the sale to a sales invoice or the cash book.
- Check consistent treatment in the asset register.
- Check the correct treatment in the nominal ledger (ie transfer of cost, accumulated
depreciation and the sale proceeds to the asset disposal account and the correct
calculation of profit or loss on disposal).
♦ Test check a sample of assets in the asset register to verify the depreciation calculation.
♦ Physically inspect a sample of non-current assets. This should be done from asset register to factory
floor and vice versa. This tests for existence of assets as well as completeness of the accounting
records.
♦ The reasonableness of depreciation rates could be checked by reviewing profits and losses on
disposal of assets to see if they are unusually high. If they are, this suggests that the depreciation
rates are inappropriate.
127
KAPLAN PUBLISHING
♦ To verify ownership the title deeds of the property should be examined. These would normally be held
at the bank and provide reliable third party evidence.
♦ Ownership of vehicles is checked by examining vehicle registration documents.
♦ Various nominal ledger expense accounts, such as repairs and renewals or motor and travel
expenses, should be examined to ensure that any capital items have not been treated incorrectly.
♦ The letter of representation would include a paragraph covering the verification of non-current assets,
particularly anything involving judgement such as the appropriateness of depreciation rates.
Part (b)
Land and buildings
This would not be too difficult to control without an asset register as it is unlikely to involve a
large number of small value items. Even two or three separate sites should still be easy to
verify.
Motor vehicles
A register could be constructed using vehicle registration documents so again this is not a
particular control problem.
Plant and machinery
There is likely to be a large number of items that are difficult to identify and control.
Particularly difficult will be verifying the proceeds and profits or losses on disposal of items that
are sold.
An audit qualification may be required because of the following.
♦ The cost recorded in the financial statements cannot be accurately verified.
♦ The depreciation charge in the income statement may be materially misstated.
The above restrictions would suggest that a ‘limitation of scope’ audit report qualification is
applicable owing to all relevant information and explanations not being available.
Whether this limitation of scope is material or pervasive would depend upon the value of non-
current assets in relation to the rest of the figures in the financial statements.
Answer 33
Newpiece Textiles
Part (a)
128
KAPLAN PUBLISHING
(i) The matters which cause me concern in the bank reconciliation are as follows.
♦ The late banking of cash sales. The delay appears to be about a week. There could be a
teeming and lading fraud.
♦ The delay in clearing cheque payments to suppliers. The delay appears to be about two
weeks. It seems probable that the cheques were sent out after the year end, rather than
before the year end (as recorded in the cash book).
The delay in banking the sales ledger cash seems reasonable, as is the delay in clearing
sundry cheque payments.
(ii) I will carry out the following investigations on the delay in paying cash sales into the
bank.
♦ I will check the date stamped by the bank on the paying-in slip. If this is the same date as on
the bank statement (or the day before) then this is the actual date the cash was paid into the
bank.
♦ I will check that the amount banked agrees with the cash sales invoices for the date shown in
the cash book (ie cash sales for 27 October were $235).
♦ If there appears to be a delay in banking cash sales I would consider performing checks at
other times of the year.
♦ Then, I will ask if there is cash for sales which is unbanked. If there is no cash, then a fraud is
probably taking place (ie a teeming and lading fraud). Only if all the cash is present is no
fraud taking place. However, even if the cash exists, it should have been banked, so the
problem would be included in my management letter.
♦ If there is a fraud, it will be reported to senior management, who should carry out an
investigation and take action. As auditor, I will write to the company’s management informing
them of the fraud.
Concerning the uncleared year-end cheque payments, I will establish whether or not
these cheques were sent out before the year-end or not.
This could be done by enquiring of the relevant staff members or performing a supplier’s
statement reconciliation.
Finally, I would check that the sales ledger cash received on 31 October (per the cash
book) was actually received on that day. Evidence for the date of receipt could include
the date stamped by the company on the remittance from the customer, the pre-list of
sales ledger cash received in the day, and any details of post received in the day.
(iii) It appears that two adjustments are required to the bank balance at the year end as a
result of checking the bank reconciliation.
♦ If the cash sales receipts from 24 to 31 October are a teeming and lading fraud, then these
receipts should be excluded from the cash book (as the asset does not exist). Thus, cash
receipts should be reduced by $2,705 at the year end.
129
KAPLAN PUBLISHING
♦ It appears that the purchase ledger payments recorded on 31 October in the cash book were
really payments after the year end, as the date of the payment is the date the cheque was
sent to the supplier (and not the date on the cheque). Thus, cheque numbers 2164 to 2170
should not be included in the cash book before the year end, which would result in $77,501 of
purchase ledger payments being excluded from the cash book with a consequent effect on
the bank balance at the year end. The value of these payments should be added to the
purchase ledger balance at the year end (thus increasing accounts payable in current
liabilities by $77,501).
This would give an adjusted cash book balance as follows.
$
Initial balance (75,477)
Add cheque payments adjustment 77,501
Less receipts re fraud (2,705)
______
Final balance (681)
______
Part (b)
(i) By listing the monthly petty cash expenditure, some analytical procedures have been
carried out.
The company’s profit before tax is about $150,000. Thus, a material error of 5 per cent
of profit before tax would be $7,500 and 10 per cent of profit before tax is $15,000. The
total petty cash expenditure is $23,371, which is material in terms of profit before tax, so
petty cash should be audited. However, August and December’s petty cash payments
total $14,877, and the remaining ten months’ expenditure is only $8,494 (which is not
material).
In terms of audit risk, petty cash is a high risk area of the audit, as there is a high risk of
fraud. However, if petty cash expenditure is small (as in ten months of the year) it is
most unlikely that any fraud or error would be material.
The high petty cash expenditure in August and December should be investigated, as it is
unusually large compared with the other months.
As petty cash is not on an imprest system, this increases audit risk, so the auditor should
check both a sample of transfers from the cash book to petty cash and the total transfer
for the year.
It may be appropriate to test check additions in the petty cash book and posting of
transactions from the petty cash book to the nominal ledger.
130
KAPLAN PUBLISHING
(ii) Firstly, for August and December I will find the reasons for the unusually large petty cash
expenditure. This would be done by checking from the amounts in the petty cash book to
authorised vouchers and obtaining explanations where appropriate.
The amount of audit work I will carry out on the other petty cash expenditure will depend
on the results I have found from my investigations on August and December’s payments,
and the level of expenditure. Thus, except for August and December, I will carry out only
limited audit work on the petty cash system (ie I will check only a small sample of items).
My audit tests could include the following.
♦ Selecting payments from the petty cash book and checking there are supporting documents
for the payments. These should be authorised by a responsible official.
♦ Test checking additions in the petty cash book and posting to the nominal ledger.
♦ Test checking payments from the cash book to petty cash. As petty cash is not an imprest
system, this increases audit risk. With an imprest system the amount reimbursed equals the
value of petty cash payments in the period. Also, each reimbursement is of a different value,
so it is easier to check each payment from the cash book to petty cash. With a non-imprest
system, petty cash is likely to be reimbursed by the same amount each time, and it is difficult
to be certain that each payment from the cash book is entered in petty cash.
♦ Counting the petty cash at today’s date. The amount of petty cash should equal the amount
in the petty cash book. Allowance will be made for any petty cash payments which have not
been recorded in the petty cash book. However, the petty cash book should be kept
reasonably up-to-date.
Normally, petty cash should be counted without warning to ensure the correct procedure
is followed by staff responsible at all times, and not just during the audit.
Answer 34
Pyrmont
Part (a)
(i) The company wishes to use book inventory as the basis for determining the balance
sheet value of inventory held, rather than conducting a separate inventory count around
the year end. As auditor I would only be happy with this proposal if appropriate controls
exist in the inventory system and have operated satisfactorily throughout the year.
These controls will relate to transactions into and out of the inventory holding, as well as
more general controls comparing the physical inventories held with the book inventories.
Last year’s audit will have identified control procedures operating in respect of purchase
and sale transactions. I must ensure that these controls continued to be operated
satisfactorily this year. However, last year’s testing did not extend into the inventory
records, so the scope of my testing must be expanded. Since I am dealing with a
computerised system, the main thrust of my testing will involve computer assisted audit
techniques (CAATs) such as test data.
131
KAPLAN PUBLISHING
Even though a system of perpetual records is now being operated, the company will still
be expected to carry out physical inventory counts on a regular basis, to confirm that the
perpetual records are accurate. These counts do not have to cover all lines of inventory
at the same time, but all lines should be counted at least once during each year. The
usual procedure is for high-value items to be counted more regularly, say monthly, while
low-value items can be counted less regularly, say every six months. Written formal
control procedures should be in place to lay down who should do the counting, what
lines should be counted when, and how apparent discrepancies should be followed up.
(ii) The controls described in part (a) (i) referred to procedures in respect of movements in
and out of physical inventory, movements in and out of book inventories, and in respect
of the regular test counts to be carried out.
Movements in and out of physical inventories would have been covered by last year’s
audit procedures. I would test that the control environment over the shops’ inventory is
robust.
Movements in and out of book inventories would be covered by the new computerised
system. I would test a sample of purchase orders to bar-coded delivery tags to receipts
into the inventory system, and a sample of invoices to movements out of the inventory
system.
I would observe a test count of inventories being held at a number of shops, seeing
whether the count was carried out in accordance with the formal instructions. I would
follow up these counts by seeing how any discrepancies between book inventories and
physical inventories were dealt with. Any alterations to the book inventories must be
authorised by a senior member of staff.
Part (b)
I would carry out the following substantive procedures during the year:
♦ Make my own test counts of lines of inventory when attending the company’s inventory counts. I
would then check my numbers of physical items held against the book inventory number for those
lines. Any discrepancies should be brought to the client’s attention and an explanation requested.
♦ Vouch the corrections to the book inventory records arising from both my discrepancies identified and
the client’s own discovered discrepancies.
♦ Check the arithmetical accuracy of the inventory records. Since the records are now fully
computerised, this would be best achieved using computer audit software.
♦ Check that all lines of inventory seem to be being physically counted at least once during each year.
♦ Discuss with management their plans for the year end. If the test counts carried out during the year
provide many examples of discrepancies, I will recommend that the company decides to carry out a
full physical count at the balance sheet date as before, since the book records will be unreliable.
I would carry out the following substantive procedures at the year end:
132
KAPLAN PUBLISHING
♦ Make a limited test count of my own to and from the book records and the physical inventories.
♦ Ensure correct cut-off between the sales and purchases records and the inventory records.
♦ Ensure that the year end inventory figure from the book records agrees with the balance on the
inventory control account in the nominal ledger, and has been correctly carried into the balance sheet
showing appropriate classifications of inventory.
♦ Carry out appropriate analytical procedures to check that the inventory figure is reasonable, for
example calculating ratios such as the inventory turnover ratio and comparing this year’s figure with
last year’s figure and any budgeted figure.
Part (c)
I would expect the following systems development controls to have applied to the rewriting of
the inventory control system:
♦ A feasibility study had been carried out to lay down formally the requirements of the new system.
♦ The accounts system personnel, as the ultimate users, had participated in the planning of the new
system and had given their approval to the plan decided upon.
♦ Sufficient proper testing of the proposed new system.
♦ Careful file conversion procedures once the new system had been chosen. In particular the opening
FIFO inventory details are required for each line of inventory.
♦ Full documentation of the new system, including the recommended procedures to be carried out,
especially in respect of test counts of lines of inventory.
♦ Post-audit of the development some months after the new system has been up and running, to
ensure that the expected improvements have been realised as anticipated.
Answer 35
Cambridge
Part (a)
Objectives of a debtors’ circularisation
♦ To verify the completeness, accuracy, existence and ownership of the accounts receivable balances
at the year end. Thus, a debtors’ circularisation is a substantive procedure which can be carried out
to substantiate the receivables figure at the year end.
♦ To provide evidence of the adequacy of the system of internal controls over sales and receivables.
To check the accuracy of cut-off and help draw attention to irregularities (eg ‘teeming and lading’ and
window-dressing).
Part (b)
Methods of circularisation
133
KAPLAN PUBLISHING
(i) Positive
A letter is sent to customers asking them to reply saying that they either agree or
disagree with the balance stated (ie a reply is always sought and non-replies must be
followed up by the auditor).
(ii) Negative
A letter is sent to customers asking them to reply only if they do not agree with the
balance as stated. If no reply is received it is assumed that the customer agrees with
the balance.
Part (c)
Selecting a sample
(i) Balances over $50,000
There are 35 balances over $50,000 representing 15.3% in value of accounts

receivable. The number of these balances selected would depend on the materiality
level in the accounts as a whole. If balances of $50,000 and over are material to the
accounts, it is likely that 100% testing of these balances would be carried out.
(ii) Balances between $1 and $1,000
There are 5,120 balances between $1 and $1,000 representing 22.2% in value of
accounts receivable. Once a sample size has been calculated (ie the total number of
balances to be circularised) the selection from these balances should be on a
representative basis. For example, random selection (rarely used), interval or
systematic selection (every nth item), value-weighted selection (eg MUS, ie every nth $).
Part (d)
Statistical v judgmental sampling
Statistical sampling is a method of sample design, selection and evaluation which has a
mathematical base (probability theory) such that audit conclusions can be drawn with a specific
level of confidence (ie sampling risk is measured).
Judgmental sampling is non-statistical sampling. This includes, for example, choosing a sample
size which is more or less than determined statistically or selecting items with a deliberate bias.
Consequently, sampling risk cannot be quantified.
Answer 36
Coogee
Part (a)
134
KAPLAN PUBLISHING
ISA 540 suggests three possible approaches to the audit of accounting estimates:
♦ Review and test the process used by management to develop the estimate.
♦ Use an independent estimate for comparison with that prepared by management.
♦ Review subsequent events which confirm the estimate made.
Part (b)
I would carry out the following procedures in verifying the general allowance for bad and
doubtful debts:
♦ Determine the process used by the company to calculate the year end general allowance. The
question explains that the $40,000 year end allowance is established as a percentage of overdue
balances receivable, with an increasing percentage being applied to the longest overdue accounts. I
need to find out precisely what percentages are used for what categories of receivables, eg 10% of
balances one month overdue, 20% of balances two months overdue and 50% of balances three or
more months overdue.
♦ Obtain an aged analysis of trade receivables balances at the balance sheet date. I would test check
that the entries on the analysis were genuine receivables (by checking that sales invoices had been
raised) and that the ageing analysis had been carried out accurately (by checking the date of the
sales invoice). I would then check that the correct percentages had been applied to the correct totals
to derive the total general allowance. I would check that the total of the receivables balances in the
aged analysis agrees with the total trade receivables per the receivables control account and the
subsidiary receivables ledger.
♦ In calculating the general allowance, any receivable balances against which a specific allowance is to
be made should be excluded from the percentage calculations so I would confirm that this had indeed
been done.
♦ Determine whether the basis for calculating the general allowance this year is the same as was used
in previous years. Any changes in the percentages or the times overdue should be discussed with
management and justification sought.
♦ Compare the level of year end allowances for doubtful debts with the actual amounts of debts written
off as bad during the year. If very few debts are written off as bad, but a large allowance is
maintained, perhaps the allowance for doubtful debts is being used as a profit smoothing mechanism
rather than fulfilling its true role.
♦ Carry out analytical procedures on the general allowance. At the 31 December 20X8 year end, the
general allowance is:
$40 ,000
× 100% = 1.7% of year end receivables.
$ 2 .3 m
I would expect this percentage to be similar to previous years, so would calculate the
percentage for the immediately preceding years and investigate any large differences.
♦ Confirm that the directors have properly considered the level of the general allowance. If I am unable
to find evidence that the directors have considered and approved the amount of general allowance
this year, I will consider asking for this matter to be included in the letter of representation I will be
sent.
Part (c)
135
KAPLAN PUBLISHING
I would carry out the following procedures in verifying the specific allowance for bad and
doubtful debts:
♦ Determine the process used by the company to calculate the year end specific allowance, and vouch
the items allowed against, to any documentary evidence that exists. I must obtain a list of the
balances making up the specific allowance at 31 December 20X8. Perhaps there will be
correspondence between Coogee and the debtor concerning a balance in dispute. Perhaps the
debtor is in receivership and a letter has been sent by the receiver indicating how many cents in the
dollar will be paid of the balance due.
♦ Review the results of my debtors circularisation. Where a reply has been received from a debtor
included in the list of year end specific balances, the reply may provide further evidence on whether
the debtor is intending to pay. Equally important will be replies received concerning receivable
balances not currently allowed against. Any debtor that is refusing to pay (eg claiming that the goods
supplied were sub-standard) or unable to pay (eg the company is in liquidation) should be brought to
the attention of management and their comments sought.
♦ Review the year end aged analysis obtained in part (b). This would highlight specific invoices that
remain unpaid after a long period of time. Unless the management have good reasons to the
contrary, a specific allowance should be raised against these balances.
♦ Review subsequent events, ie after the 31 December 20X8 year end. If an amount has been
specifically allowed against, but the debt has been paid before the 20X8 financial statements are
approved by the directors, then the receipt of the cash is an adjusting post balance sheet event, and
the balance should not appear in the list of specific allowances at the year end. I would also monitor
correspondence between Coogee and its debtors during 20X9 in respect of amounts owing as at 31
December 20X8.
♦ Review credit notes raised during 20X9. These might give evidence of receivable balances at
31 December 20X8 which will never be recovered in cash, so that a specific allowance should be
established against them.
♦ Confirm that the directors have properly considered the level of the specific allowance. As with the
general allowance, if I cannot find sufficient evidence on this point, I may wish the matter to be
included in the letter of representation.
136
KAPLAN PUBLISHING
Answer 37
Tollerton
Part (a)
Reconciliation of payables ledger balance to balance on supplier’s statement
$ $
Balance per payables ledger 5,980
Differences:
(i) 31.3 Discount not allowed by supplier 126
(ii) 4.3 Transposition error invoice 6080 180
(iii) 4.4 Invoice 6210 not on payables ledger 4,735
(iv) 28.4 Invoice 6355 not on payables ledger 6,298
(v) 30.4 Cash in transit 6,005
(vi) Discount not allowed? 123
______
17,467
______
Balance per supplier’s statement 23,447
______
Part (b)
(i) As the difference due to the disallowed discount is very small, I may perform very little
work on this item, and record it as an unadjusted error. However, if detailed checks were
considered necessary, they would be as described below.
From the date of the cash received which pays the February invoices, it appears that
Carlton may not have received the cheque until after 31 March, so it would not be
entitled to the cash discount of 2 per cent. The date the cheque for $6,163 was received
by Carlton can be found by looking at Tollerton’s bank statement and checking the date
it was cleared by the bank.
It is worthwhile to ask the payables ledger clerk what normally happens with disallowed
discounts, because, if they are normally honoured, then no adjustment will be
necessary.
(ii) The apparent transposition error on invoice 6080 would be checked by inspecting the
invoice. If the invoice shows $3,752, then an additional amount payable of $180 should
be added at the year end to correct this error. No adjustment will be necessary if
Tollerton’s figure is correct.
(iii) It appears that invoice 6210 for $4,735 has not been included on Tollerton’s payables
ledger.
137
KAPLAN PUBLISHING
As the invoice is dated some time before the year end it is likely that it is in dispute. I
would check that the goods were received by referring to goods received notes and then
enquire as to the nature of any discrepancies.
(iv) For invoice 6355, the question is whether Tollerton received the goods before the year
end. I will check whether Tollerton received the goods before the year end by looking at
the date on the goods received note. If the date is before the year end, then Tollerton
should include a purchase accrual at the year end for this invoice. If Tollerton received
the goods after the year end, no purchase accrual is required.
(v) The cheque on 30 April appears to be cash in transit. I will check the date the cheque is
cleared by the bank after the year end. If this is within a week, and most other cheques
are cleared within a week, then this is validly cash in transit. If most cheques issued
immediately before the year end take more than a week to clear, it indicates they were
sent to suppliers after the year end, in which case they should be deducted from
payments before the year end and added to payables.
(vi) If, as appears likely, the cheque for $6,005 is not received by Carlton until some time
after the year end, then the discount of $123 will be disallowed by Carlton. If this
discount is disallowed, it should be added to payables at the year end
Part (c)
(i) The suppliers’ statements I will select for checking to the payables ledger balances will
concentrate on creditors with large balances, and creditors who are large suppliers to
the business (ie those who have a large volume of transactions with Tollerton).
A sample of smaller value accounts payable will be selected, to check that the payables
ledger is accurate for processing lower value payables and purchase invoices.
(ii) If there is no supplier’s statement for a large balance on the payables ledger, I will ask
the purchase accounting department if such a statement exists. If no statement exists at
30 April, I will ask if there is a statement at 31 May.
If there is a statement at 31 May, I will use it to check the balance on the payables
ledger at 30 April. If there is no statement on the client’s premises, I will contact the
supplier (with the client’s permission) and ask them either to send me a copy of the
statement, or confirm the balance on the client’s payables ledger.
If it is not possible to contact the client, I will consider whether the client’s system is
reliable at processing purchase invoices. I will look at the balance on the payables
ledger and consider whether it is reasonable (the value of April’s purchases).
Also I will look at correspondence with the supplier, and check if there are any invoices
on ‘hold’ which have not been posted to the payables ledger. I will see if any goods were
received immediately before the year end, and check that they have either been posted
138
KAPLAN PUBLISHING
to the payables ledger or included as a purchase accrual. Based on these investigations,

I will decide whether the payables ledger balance is correct.
Answer 38
Galaxy
Part (a)
Explanation of relative difficulty
Payables are tested primarily for understatement whereas receivables are tested primarily for
overstatement. It is more difficult to test the completeness of payables (ie for something which
isn’t there) than to verify a receivables balance.
Provisions are usually estimates based, for example, on management’s expectation of future
outcomes. Although prepayments are accounting estimates they are less subjective, being
calculated on a known amount (the amount paid).
Accruals and provisions do not arise through the processing of transactions but through period-
end adjustments (ie via journal entries). The need for an accrual/provision must therefore be
identified before it can be recorded.
Sufficient relevant and reliable audit evidence may not be easily available to form an unqualified
opinion on trade payables, accruals and provisions. For example, not all major suppliers may
provide statements, and payments to them do not confirm the completeness of the recorded
liability (unlike cash receipts from debtors).
The prudence concept creates a disparity between recognition and accounting treatment of
costs/payables and revenues/receivables. A probable loss should be provided for even though
the amounts involved may be uncertain (therefore less evidence). Revenue can only be
recognised when its ultimate cash realisation is reasonably certain (can therefore expect more
evidence).
If management is biased to overstating profit it may be easier for expenditure to be suppressed

than for revenue to be inflated. If management sent unsolicited goods/invoices to customers,
financial loss could result (through loss of goodwill/non-return).
Part (b)
Procedures Reasons
(i) Trade payables
♦ Check (on a sample basis) the ♦ Reperformance of the extraction verifies

client’s extraction of an accounts the completeness of the accounts payable
payable listing from the payables listing.
139
KAPLAN PUBLISHING
ledger.
♦ Compare the list of balances with ♦ Increase could signify:

the previous year and enquire into
the significant increase of almost - an increase in payable days due
50%. to cash flow difficulties.
- cut-off errors (eg between cash

and payables).
- business expansion.
♦ Check the cast of the accounts ♦ Any reconciling items identified (eg in
payable listing and agree the total respect of discounts received/receivables
to the balance per the payables ledger contras) will need to be accounted
ledger control account in the for.
nominal ledger.
♦ Select the most significant ♦ Potentially material balances could be

suppliers accounts identified by: misstated by their omission (since the
primary testing of payables is for
- balances on the accounts understatement).
payable listing.
- last year’s working papers.
- tests on purchase invoices.
Procedures Reasons
♦ Obtain year end suppliers ♦ Suppliers statements provide independent

statements (by circularisation third party evidence of amounts payable.
request if necessary) and agree
the client’s reconciliation of
amounts due to the accounts
payable listing balance.
♦ For (a sample of) purchase ♦ If omitted from inventory, the cut-off error
invoices received immediately gives rise to understatement of profit.
prior to the year end and included
in payables, confirm (eg by
reference to goods received notes
(GRN)) their inclusion in year end
physical inventory.
♦ List all debit balances over $X ♦ If material, amounts recoverable should

and obtain explanations. be reclassified to trade receivables/
140
KAPLAN PUBLISHING
prepayments.
(ii) Accruals
♦ Obtain/prepare a schedule of ♦ An apparent omission in current year may

accruals and compare with prior be included in current year trade
year. payables.
♦ Trace ‘Goods received not ♦ If these reconciling items are not accrued
invoiced’ on the suppliers the cut-off error will result in profit
statement reconciliations to the overstatement.
GRN accrual.
♦ Prepare or obtain a control ♦ To ensure that payroll deductions are

account for income tax and other promptly accounted for.
payroll deductions and agree the
amount paid after the year end.
♦ Check calculations to ensure that ♦ To test for omission or other under-

adequate accrual has been made statement resulting in the overstatement
for: of profit.
- periodic payments (rent,

property taxes, insurance,
etc).
- accrued salaries, wages

and employer’s social
security costs.
- payroll deductions.
- professional charges (eg

legal costs).
- sales taxes due.
Procedures Reasons
(iii) Provisions
Legal action
♦ Discuss with management the ♦ To ascertain whether (say) the provision

basis of their provision (eg legal relates to a publicly agreed admission of
costs and/or damages). IAS 27 guilt or for an agreed out-of-court
requires that provisions should settlement to prevent lengthy/costly legal
only be made if an obligation proceedings/adverse publicity.
existed at the balance sheet date.
♦ Review correspondence with ♦ To ascertain the nature and amount of the

141
KAPLAN PUBLISHING
competitor/solicitors. claim (probably an injunction and/or

damages).
♦ Inspect the manufacturing ♦ A recent change in the manufacturing

process and capital expenditure process may substantiate the competitor’s
thereon. claim.
♦ Ask client to request confirmation ♦ To provide independent third party

from Galaxy’s legal advisers. evidence to appraise the likely outcome.
♦ Ask management for written ♦ To confirm that the information so far

assurance (representation) that provided is complete.
they are not aware of any other
matters referred to lawyers.
Factory repairs
♦ Obtain/prepare a schedule of the ♦ To assess the reasonableness/reliability

current year expenditure and of provisions previously made by
compare its make-up with the management.
prior year provision.
Again it is important that the

provision only includes amounts
that are obligations at the balance
sheet date (eg a contract with
builders has already been
signed).
♦ Obtain/prepare a schedule of the ♦ To assess whether the need for additional

current year end provision and repairs has come to light in the current
compare with surveyor’s estimate. year or whether the prior year provision
was underestimated.
♦ Vouch contractors’ invoices: ♦ Provides independent documentary

evidence.
- in year to current year
expenditure.
- post year end to the year

end provision.
142
KAPLAN PUBLISHING
Tutorial note – A substantive approach is suggested by a number of points in the question:
♦ the year end balance sheet amounts are being audited

♦ the size of the client/amounts involved do not suggest a system-based approach
♦ accruals and provisions are created by period-end adjustments.
Good answers would have made a clear distinction between the procedures appropriate to each
of trade payables, accruals and the provisions in a way which a junior member of staff could be
expected to understand.
Answer 39
Mowbray Computers
Part (a)
Going concern is one of the overall considerations required by IAS 1 in preparing financial
statements that give a true and fair view.
Going concern assumes that a company will continue to trade for the foreseeable future, which
is generally taken to mean at least one year from the balance sheet date.
If a company is not considered to be a going concern, then there is a very good chance that it
will fail.
Most businesses that fail do so because of liquidity problems. However, going concern
problems can be divided into profitability, liquidity and other problems. Frequently, these
problems are inter-related.
Profitability issues
♦ The company making losses or low profits. They are insufficient to fund the replacement of non-
current assets and the increase in working capital due to inflation or expansion.
♦ A fall in sales due to a recession, which either reduces profitability or creates a loss.
♦ In a recession or a competitive market companies reduce the prices of their products (to try to
maintain sales), and this results in a fall in the gross profit margin with a consequent effect on net
profit.
♦ Loss of a major customer, which results in a significant fall in sales. Normally it takes some time to
acquire new customers. If a customer fails and it results in a bad debt, this will create additional costs
in the income statement.
♦ The company’s products may become out of date compared with its competitors, so sales will
decline.
Liquidity issues
♦ There is a high risk that the bank overdraft limit will be exceeded.
♦ A gearing ratio of over one and increasing leads to high borrowing costs (ie interest) and lower profits.
143
KAPLAN PUBLISHING
♦ High inventory levels suggest that either too much inventory is being produced or that it may have to
be sold on at less than its cost in order to shift it. This is often linked to a fall in profitability. A
company experiencing falling profits is not behaving consistently if they are manufacturing large
quantities of inventory that may be difficult to sell.
♦ High levels of trade accounts receivable will increase the risk of bad debts occurring.
♦ Purchase of non-current assets for expansion when the market is depressed and profits are falling is
further evidence of a company with little regard for specific trading conditions.
Other factors include ineffective management or loss of key staff such as the finance director.
Part (b)
(i) A going concern problem should be disclosed in the audit report as a fundamental
uncertainty.
If it is disclosed in this way by adding a separate emphasis of matter paragraph at the
end of the audit report then no qualification is required.
(ii) If no disclosure is made in the financial statements, then an ‘except for’ audit report
qualification would normally be required on the grounds of inadequate disclosures.
An adverse audit report may be given when the going concern concept is inappropriate
and its use means that a true and fair view is not given.
There is no fixed time period over which the auditor should review in order to determine
whether or not a company is a going concern.
Answer 40
Hyson Computers Take Two
Part (a)
The Financial Director explains that competition has affected prices and that appears to be
substantiated by the fall in gross profit margin (30 per cent to 22.1 per cent) and the fall in net
profit margin (12.7 per cent to 1.55 per cent). The fall in net profit margin also suggests a
relaxing of control on overhead expenditure.
The company is proposing not to pay a final dividend in 20X8 (20X7 $650k was paid). This is
because of the net loss for 20X8 after the interim dividend of $250,000 (compared to a net profit
of $1,045,000 after all dividends in 20X7).
The payment of the previous year’s dividend appears to have put a strain on the cash resources
of the company in 20X8 as the bank overdraft has continued to increase ($3,800k in 20X7 to
$4,130k in 20X8).
As expected the short-term liquidity of the company is worsening with both the current ratio
(1.78 down to 1.6) and the acid ratio (1.06 down to 0.66) falling.
144
KAPLAN PUBLISHING
The long-term purchase contracts from North America and the Far East are subjecting Hyson
Computers to exchange rate risk as well as making it difficult to control costs in the short term,
as is proved by the decrease in profitability.
The company is performing poorly – lower profitability and falling liquidity – and yet Hyson
Computers appears to be behaving as if it is performing very well.
Additional debt finance has been obtained (bank loan of $2m and an increased bank overdraft)
and it is accumulating more inventory ($4,300k up to $6,400k in 20X8) and investing in capital
equipment ($8,100k to $10,400k in 20X8).
Part (b)
The particular matters to consider as a result of the review of financial statements, and other
matters raised in the question are as follows.
♦ The increase in non-current assets. I would verify additions to property, plant and equipment by
vouching them to purchase invoices. In view of the reduction in the non-current asset turnover, I
would consider whether the company requires all the non-current assets it has purchased, and
whether some of them are surplus to requirements or obsolete and will have to be sold at a loss.
♦ The increase in inventory. In view of the trading conditions, can all this inventory be sold for more
than cost, or will it have to be sold below cost? If it is sold for less than cost, it will have to be valued
at net realisable value.
♦ The company’s borrowings. With current gearing of 1.19 (ie over 1.0), is it possible to reduce
borrowing? What is the current bank overdraft limit, and is it being exceeded? If it is not exceeded,
how much additional finance from the bank is available?
♦ What are the future commitments for purchasing equipment from North America and the Far East? Is
this greater than planned sales after the year end? Will prices have to be reduced further to reduce
inventory levels, and will this result in further losses? Reducing the level of future purchases will
increase the price of items purchased (as quantity discounts will be smaller), thus further eroding the
future gross profit margin. Is there an exchange risk relating to currency movements between the
home country, North America and the Far East? Has this currency risk been hedged? What do other
similar businesses do about currency risk? We are more at risk if they hedge future exchange rates
and we do not.
♦ Receivables age and payables age seem reasonable, so the normal audit work would be performed.
However, I will have to check that the doubtful debt allowance is reasonable, as the Financial Director
has said there have been a lot of bad debts in the year (so there may be more after the year end).
♦ The bank overdraft and bank loans should be verified in the normal way (eg by obtaining a bank letter
and checking the bank reconciliation). I will have to find out how close the company is to its borrowing
limit. There will be a limit imposed by the bank to the overdraft and the company’s legal constitution
may also define a limit. If the company is close to or exceeding its borrowing limits, there is a risk the
company may not be a going concern.
♦ In view of the fall in sales, is the company planning to make some of its staff redundant? If so, a
provision for the redundancy costs should be made in the financial statements (assuming the
company had announced before the year end that it would make the employees redundant).
145
KAPLAN PUBLISHING
♦ With reference to the company’s borrowings above, it is probably not going to be possible to reduce
borrowings by the issue of additional share capital because
- it would dilute control of the company and upset existing shareholders
- interest in purchasing new shares would be difficult to generate given that no final
dividend has been proposed in 20X8, ie there is little or no return on equity investment.
Part (c)
The going concern concept assumes that Hyson Computers will continue to trade for the
foreseeable future. The foreseeable future generally means one year from the balance sheet
date.
There are a number of factors to suggest that Hyson Computers is not a going concern.
♦ Gearing of over 1.0 – the bank may refuse to provide further borrowings to the company.
♦ The low profitability in 20X8. If the decline in profitability has been progressive for the last year, it is
probable that the company is currently making losses.
♦ There is an exchange risk in purchasing parts for computers from the Far East and North America.
♦ Falling sales will probably mean that the company will have to reduce the selling price of its products
(to maintain sales) which will further reduce profitability.
♦ The combination of increasing costs of purchasing computers from suppliers, and falling sales and
selling prices will probably lead to the company making losses in 20X9. This is likely to have an
adverse effect on liquidity.
♦ The policy of investment in non-current assets and increased inventory holding places further strain
upon liquidity.
♦ The probable inability of the company to obtain any additional equity finance.
Additional matters to consider include the following.
♦ Review of Hyson Computers’ cash flow forecast and budgets for the year to 30 September 20X9.
♦ With the client’s permission, a discussion with the bank as to whether any further borrowings are
likely to be available.
♦ An analysis of an alternative purchasing strategy to increase the company’s flexibility over cost
control and to reduce exposure to exchange rate risk.
♦ An investigation into the sales forecasts for the following period in terms of both price and quantity.
Based on these investigations, I will decide whether there is a significant risk that Hyson
Computers will fail. If the forecast shows that Hyson Computers will make a loss, there is a
serious risk that the company may fail. If the forecast shows Hyson Computers will be profitable,
and this is realistic, then the risk of the company failing is low, and it should be possible to give
an unqualified audit report.
146
KAPLAN PUBLISHING
The above points appear to suggest that Hyson Computers is not a going concern but the final
few points detailing further investigations that are necessary mean that this may not be the
case.
Answer 41
Newbridge Trading
Part (a)
The auditor’s responsibilities in the periods listed in the question are given in ISA 560
Subsequent Events.
(i) In the period 31 October to 5 December 20X7, the auditor should carry out sufficient
appropriate audit work so that he has a reasonable expectation of identifying and
evaluating material subsequent events.
(ii) In the period 5 December 20X7 to 19 December 20X7 the auditor’s responsibilities are
the same as in period (a)(i) above.
(iii) In the period from 19 December 20X7 to 5 January 20X8 the auditor should reasonably
expect the directors to inform him of any material subsequent events detected in this
period which may affect the financial statements. During this period auditors do not have
any obligation to perform procedures or make enquiries regarding the financial
statements.
When the auditor becomes aware of material subsequent events in this period he has a
duty to determine the nature of their effect upon the financial statements.
If the directors amend the financial statements, the auditor should produce a new report
on the amended financial statements.
If the directors do not amend the financial statements, and the subsequent event is
material, the auditor should consider how the shareholders can be informed of the
subsequent event. This may include the auditors making a statement at the annual
general meeting at which the financial statements are approved by the shareholders.
The auditor may consider taking legal advice. Auditors do not usually have a statutory
right to communicate directly in writing to shareholders.
(iv) In the period from 5 January to 28 January 20X8, the auditors have no duty to seek out
whether any material subsequent events have occurred in this period. However, if the
auditor becomes aware of a material subsequent event in this period, he should consider
whether he should withdraw his audit report.
147
KAPLAN PUBLISHING
If the directors revise the financial statements, the auditor will have to audit these
revisions and come to a conclusion on whether the revised financial statements show a
true and fair view.
If the directors do not revise the financial statements, and do not make a statement at
the AGM, the auditor should take legal advice on the course of action he should take.
Normally, he should make a statement to shareholders at the AGM.
(v) ISA 560 does not provide guidance on the auditor’s responsibilities after the financial
statements have been approved by members at the annual general meeting. However, it
does appear that the auditor has no responsibility for detecting subsequent events in this
period.
Part (b)
The audit techniques which involve checking subsequent events include the following.
(i) Checking cash received from debtors after the year end to check recoverability of year-
end receivables ledger balances.
(ii) Checking sales after the year end to check recoverability of inventory at the year end. If,
for inventory held at the year end, the selling price after the year end is more than cost,
then the inventory can be valued at cost. However, if the selling price is less than cost
then the inventory value will need to be written down.
(iii) Checking any sales or disposals of non-current assets after the year end. This will
establish whether these assets have been sold for more or less than their balance sheet
value. If they are sold for less than their balance sheet value, they may have to be
written down to their realisable value at the year end.
(iv) Checking board minutes and management reports after the year end which relate to
events at or before the year end. Board minutes are likely to refer to any relevant
material events.
(v) Checking management accounts after the year end for any items which should have
been included at the year end (eg bad debts, inventory write-downs etc).
(vi) Checking cash book and petty cash transactions after the year end to see if there are
any unrecorded accruals and prepayments at the year end, and to confirm those items in
the financial statements.
(vii) Checking the bank reconciliation to check if payments were actually before the year end
and there is no teeming and lading fraud. If there is a long delay in clearing a significant
value of cheques issued before the year end, this indicates that the actual payment (ie
when the cheques were sent to the creditors) was made after the year end. A delay in
lodging cash received into the bank indicates a teeming and lading fraud.
148
KAPLAN PUBLISHING
These are standard audit procedures that are carried out during the normal course of an audit
that happen to impact upon subsequent events.
Part (c)
As no detailed audit work would have been carried out during this period there is a risk that
material subsequent events may have occurred. The auditor will have to obtain written
representations from the directors and senior management to decide if any material subsequent
events have occurred in this period or whether further evidence is available for uncertainties
existing at 5 December 20X7.
The auditor would also request to see the board minutes and look for any evidence of
subsequent events. The auditor may also ask to see management accounts and any other
relevant information, such as a notice of liquidation from a customer.
Answer 42
Wotsbrite
XYZ & Co
Capital House
999 The Strand
London
WC2 6XT
W Kirby
Finance Director
Wotsbrite
26 Market Street
Slough
SL4 5PQ 31 January 20X7
Dear Mr Kirby
Financial statements for the year ended 31 December 20X6
Thank you for your letter concerning the preparation of the financial statements. I shall, of
course, be able to discuss the points you raise in more detail when our final audit visit starts.
My initial comments on each of the matters you mentioned are given below.
(1) Bad debts - $80,000
I agree with your view that the bad debt expense written off represents a normal
business cost and should be included within administrative expenses. However IAS 8
requires that material items of this nature which arise in the normal course of business
149
KAPLAN PUBLISHING
should be separately disclosed in the financial statements so that the accounts present a
true and fair view.
(2) Difference on receivables ledger - $740
Although the difference between the receivables ledger and the receivables ledger
control account may appear trivial, it is important that they are properly reconciled. This
is because the difference may be hiding compensating errors, of material amounts,
which cancel out each other. We recommend your assistant continues to try to reconcile
the receivables ledger before our audit visit. We will look closely at this area during our
audit and hopefully by this stage any remaining differences will have been resolved.
(3) Revaluation of plant and machinery - $28,000
IAS 16 permits companies to revalue their non-current assets, furthermore the standard
specifies that this policy of revaluation must be applied to whole classes of assets.
However, any surpluses which result should not be credited to the income statement, but
transferred to a non-distributable revaluation reserve which will be shown as part of
equity in the balance sheet. The surplus cannot be treated as an exceptional profit
because it is unrealised.
Depreciation should be charged on the revalued amount of the asset and, in the year of
revaluation, the effect of the revaluation on the depreciation charge should be disclosed
in the notes to the accounts, together with the name or qualification of the valuer.
I am interested to note that the valuation of plant and machinery is in excess of book
value. During our audit we will review asset lives to ensure they are still appropriate.
(4) Disclosure requirements in respect of employees
All that IAS 1 requires is disclosure of the number of employees at the end of the period
or the average for the period. The staff costs for the period should also be disclosed on
the face of the income statement if you are presenting an income statement classifying
expenses by their nature. If you feel that these minimum disclosures are insufficient,
you can consider additionally disclosing by way of note to the financial statements the
following information in respect of the company’s employees.
♦ The average number of employees in the year analysed over category of persons employed
on a basis determined by the directors.
♦ Social security costs that the company has incurred on behalf of the employees (any
contributions to social security or pension schemes run by the state).
♦ Other pension costs incurred on behalf of the company’s employees.
These additional disclosures may be useful to readers of the financial statements in

giving the full picture of the staff costs that the company pays.
(5) Wagon ordered on 31 December

150
KAPLAN PUBLISHING
The new wagon will not be delivered until April, and so should not be included in non-
current assets at the balance sheet date. Neither should the liability be included in the
figure for payables, since you can always change your mind and avoid having to pay this
amount.
Since it is unlikely that the order will be cancelled in the permitted period, it is best
regarded as a capital commitment and disclosed as such in the financial statements, as
required by IAS 1.
If you have any further queries please do not hesitate to contact me again, otherwise I look
forward to seeing you in the near future when we begin our final audit.
Yours sincerely
A Moreton
XYZ & Co
Answer 43
Technical department
(1) Mailing lists
Matters to consider
♦ As the lists provide means to operate and hence generate revenues over many periods, they
may be regarded as non-current assets. IAS 38 allows such assets to be recognised in the
balance sheet as long as their cost can be measured reliably.
♦ If the lists were separately acquired, then their cost should be able to be measured reliably
without any particular problem, particularly when the purchase consideration is in cash.
♦ If the lists were acquired as part of a business combination, then they should only be
separately recognised if their cost (ie fair value at the date of acquisition) can be determined
with sufficient reliability. This is most likely if the lists are quoted on an active market.
♦ IAS 38 states specifically that internally generated customer lists should not be capitalised as
intangible assets in the balance sheet, since their cost cannot be distinguished from the cost
of developing the business as a whole.
♦ For the remainder of this answer, it is assumed that the lists have been properly recognised
as non-current assets, following the principles described above.
♦ The company should consider useful life on a prudent basis, bearing in mind the rate of
obsolescence, ie the rate at which the list becomes inaccurate through moves or exhausted
through over-use.
♦ If the lists at any time cease to have a recoverable value (either from sale or future use) in
excess of book value then a write-down should be made.
151
KAPLAN PUBLISHING
♦ The accounting policy for mailing lists should be disclosed together with the amounts
capitalised shown separately under intangible assets as well as the movements (including
amortisation) in the year.
Further audit work
♦ Ascertain whether the lists are purchased or acquired in a business combination.
♦ If purchased vouch to invoices and also review costs and regularity of updates to lists.
♦ If acquired in a business combination, consider the evidence available to support the fair
value at the acquisition date.
♦ Consider the useful life of the lists by evidence of re-orders from existing customers on lists
and by the rate of amendment required to lists.
♦ Consider whether lists’ book values are recoverable by sale of lists to other companies (have
any such sales been made?) or through internal use (consider forecast revenues from current
clients).
♦ Confirm detailed disclosure will be made in the financial statements as described above.
(2) Repeated revaluation
Matters to consider
♦ Property, plant and equipment may be revalued as a modification to the historic cost
convention and the surplus over book value should be taken to a revaluation reserve,
presumably done last year. IAS 16 requires that such revaluations, as here, are kept up to
date.
♦ However, in the situation described, it is important that the company has continued to charge
depreciation on the revalued amount.
♦ Depreciation should be based on spreading the total capitalised amount (ie the revaluation)
less residual value over the remaining useful life.
♦ In this year therefore the revalued amount should be compared to the book value after
depreciation for this year.
♦ The accounting policy for revaluation should be clearly stated and the properties
appropriately described as ‘at valuation’.
Further audit work
♦ Confirm the basis of valuation (eg open market value) and whether by a director or
independent valuer.
♦ Obtain details of the qualifications and experience of the valuer to consider the reliability of
the valuation.
♦ Consider the reasonableness of the valuation by reference to property values in the area, and
the rate of increase since the previous year.
♦ Review the actual valuation report to ensure that it has been correctly interpreted by the
directors and that it contains no qualifications.
152
KAPLAN PUBLISHING
♦ Confirm the directors’ treatment of depreciation and the disclosure as described above.
(3) Redundancy payments
Matters to consider
(a) Announced before balance sheet date
The liability should be reflected in the balance sheet. Further considerations

would be necessary in that:
♦ management may have budgeted for redundancies of, say, only a quarter of the
sales force at the balance sheet date (in which case only half of the total liability
should be provided for in the accounts under review), or
♦ management may have budgeted for the final redundancy figure of one half of the
sales force at the balance sheet date – a factor borne out by subsequent events (in
which case the whole of the liability should be provided for in the accounts under
review).
(b) Redundancy plans announced post balance sheet date
♦ This event would be of the non-adjusting category and should not be provided for in
the accounts for the year under review. The materiality of the event, however, might
be such that disclosure would be necessary in a note to the financial statements
giving details of the nature and causes of the event and its financial effect on future
trading and the abnormal changes to the liabilities as stated in the balance sheet.
♦ It would also be necessary to establish that the liability in question was stated in full,
net of recoveries receivable from the government.
Further audit work
♦ The detailed tests which the auditor should therefore conduct would include the examination
of:
- the cash book in the post balance sheet period to extract detailed information as
to the exact liability arising.
- correspondence with and subsequent receipts in the post balance sheet period
from the government as to amounts recoverable in respect of the enforced
redundancies.
- management accounts and budgets in the period under review to establish the
extent of management’s redundancy expectations.
- redundancy notices which were issued both in the period under review and in the
post balance sheet period to establish the extent to which provision in the
financial statements should be made.
- the payments made in respect of the redundancies by reference to notices and

returned cheques in the post balance sheet period.
153
KAPLAN PUBLISHING
♦ Full details of the financial effects would need to be obtained for inclusion in a note to the
accounts where the event proves to be of the non-adjusting category.
♦ If it is considered that the company’s status as a going concern is affected, then the event
becomes adjusting and should be dealt with as such.
(4) Bad debt
Matters to consider
♦ If the company adopts a policy of making a general allowance for doubtful debts (based,
perhaps, on a percentage of total book debts outstanding), thereby acknowledging the fact
that all debts have an element of doubt attaching as to their realisability, the debt in question
should be fully allowed for in the accounts under review.
♦ The remaining general allowance would require recomputation (the amount allowed for
would, of course, relate to the amount outstanding at the balance sheet date, and would not
include any sales made in the post balance sheet period).
Further audit work
♦ Review the receivables ledger, in particular the account of the debtor in question, for the
period under review and for the post balance sheet period to establish the exact amount in
doubt at the year end.
♦ Compare the above figure with the amount which the directors propose to allow to ensure
that the allowance, if found necessary, relates to transactions of the period under review.
♦ Review management reports concerning the receivables balances, in particular credit control
reports, to ascertain the extent of doubt, if any, attaching to the debt in question at the year
end.
♦ Consider the financial effect of the loss arising in the context of assessing the ability of the
company to continue as a going concern (the customer in question being one of the
company’s largest clients).
(5) Liability arising from a pending legal action
Matters to consider
♦ Where it is found that the claim is likely to succeed, the full amount of the liability should be
provided for in the financial statements.
♦ Where the liability, however, is in dispute, any part of the contingent loss which is not
provided for should be disclosed by way of note to the financial statements giving details of
the nature of the contingency together with an estimate of the amount of possible loss.
Further audit work
♦ Examine the service agreement of the former director together with the views expressed by
the company’s legal advisers in order to determine whether the claim has any validity and the
extent of the liability likely to arise.
♦ Examine the terms of the service agreement to establish the rights of both the company and
the director.
154
KAPLAN PUBLISHING
♦ Examine directors’ minutes to establish the causes of the dismissal and their relevance to the
action pending.
♦ Obtain a letter from the company’s legal advisers expressing their views as to the expected
outcome and amount involved.
♦ Where the event is of a material nature which could dramatically affect the results and
financial position for the period under review, obtain an independent legal opinion.
♦ Confirm the treatment eventually adopted by the directors in the letter of representation.
Answer 44
Quality control
MEMORANDUM
To: Senior Partner Date: 8 December 20X7
From: A Auditor
Re: Quality Control in the Audit Firm
(a) The importance of quality control
Quality control is important in audit work for a number of reasons.
Principally, if high quality audits are carried out, this reduces the risk of an unqualified
audit report being given and subsequently material errors or fraud are found in the
financial statements, or, less commonly, a qualified audit report is issued, but
subsequently no material errors or fraud are found in the financial statements. This can
result in the audit firm being sued for negligence. Also, it is likely to result in a
deterioration in the relationship with the client and possibly the loss of the audit. Adverse
publicity from a negligence claim can result in losing other clients and not gaining new
clients.
High quality audit work should increase the efficiency of the audit, and thus reduce
costs. Auditing is a balance between audit risk and the cost of carrying out an audit.
There has to be a balance between the time spent on the audit and the risk that material
errors and fraud are not detected. Nevertheless, if a ‘high quality audit’ means spending
more time on significant audit areas and spending little time on low risk areas, this
increased efficiency should reduce overall audit risk.
Finally, high quality work will give the client confidence in the standard of service
provided.
(b) Training of staff
155
KAPLAN PUBLISHING
Training of staff will ensure they have the highest level of competence in the work they
carry out.
If the staff are unqualified, they should be encouraged to undertake the exams of a
professional accounting body.
Staff may be given time off to study and take the professional examinations. Their
performance should be monitored and action should be taken where the employee’s
performance is unsatisfactory.
The firm should also train staff in the company’s auditing procedures. There should be
progressive courses for staff studying for the professional accounting exams. This will
start by explaining the firm’s basic audit procedures, then cover more advanced
procedures and finally include managing staff and the audit.
(c) Monitoring the performance of staff and providing additional training
The performance of each employee should be assessed. Ideally, it should be at the end
of each audit assignment. The senior in charge of the audit should assess each member
of his audit team and the manager should assess the senior in charge of the audit.
A number of factors should be included in the rating. These could include:
♦ technical ability
♦ organising ability
♦ initiative
♦ quality of working papers
♦ relations with the client.
(d) Reviews of audit work
The review type (i) in the question occurs before the audit report is signed by the audit
engagement partner. The type (ii) review is carried out on a sample of audits by staff not
involved in that audit some time after the audit report is signed. These reviews are
normally carried out annually.
The amount of review at each stage will depend on the competence of the staff at each
stage. It is probable that the manager will check all the detailed audit working papers,
and discuss the findings with the senior in charge. Where there are problems, they
should be overcome either by discussion or additional audit work. Any outstanding
problems should be listed in the audit working papers.
Problems encountered in the audit should be summarised. The audit engagement

partner can review this memorandum and discuss the audit with the manager and senior
in charge. Where problems are highlighted the partner will probably refer to the detailed
audit working papers. Staff should be informed when the review highlights weaknesses
in the audit approach or in the audit work.
156
KAPLAN PUBLISHING
The second type of review, after the audit report is signed, should be carried out on a
random sample of audits. The review will involve looking at the audit working papers and
interviewing the manager and partner in charge of the audit. A written report should be
prepared for each audit studied which assesses the quality of the audit and reports any
significant weaknesses. There should be a final report which notes the quality of the
audits of the office and reports common and significant weaknesses. These weaknesses
should be reported to staff, so they can be avoided in future audits.
Answer 45
Webster
Part (a)
Objectives of overall review
Technical compliance
Financial statements must state whether or not they have been prepared in accordance with
applicable accounting standards (IASs). Review of accounting policies confirms whether or not
accounting treatments are consistent with a true and fair view.
The auditors’ report must state whether or not the financial statements have been prepared in
accordance with the identified financial reporting framework. Failure to adhere to the prescribed
formats of IAS 1 should result in a qualified auditors’ report.
IASs require disclosures of certain particulars. Failure to disclose all appropriate matters can
impair truth and fairness, proper preparation, or both.
A ‘high level’ review of the balance sheet, income statement and cash flow statement for
compatibility with each other and with knowledge of the enterprise gained from audit contributes
to an assessment of the view given by the financial statements as a whole.
Audit evidence
The sufficiency of audit evidence must be assessed in order to:
♦ plan any further audit work necessary, and

♦ determine the form of the auditors’ report.
An unqualified auditors’ report and ‘except for’ (and adverse) opinions arise when there is
reasonable assurance as to the view given by the financial statements. Reasonable assurance
is obtained when there is sufficient evidence to support or discredit an amount, accounting
treatment or disclosure.
157
KAPLAN PUBLISHING
Where there is insufficient evidence, the auditors’ report is qualified for limitation on scope
(‘except for’ or disclaimer). Sufficiency is principally judged by reference to the risk(s) identified
(the higher the risk of misstatement, the more evidence is necessary to constitute sufficient
evidence).
Financial statements
Auditors are required to form an opinion on the balance sheet, income statement, cash flow
statement and related notes.
The process of forming these opinions culminates when the financial statements and audit
evidence are considered together.
Financial information issued with audited financial statements
Auditors are required to report if the directors’ report is inconsistent with the financial
statements. They have a professional responsibility under ISA 720 to consider if any other
financial information connected with the annual report may undermine the credibility of the
Consequently, prior to reporting, it is common practice to review:
♦ the directors’ report

♦ the chairman’s statement
♦ financial highlights
♦ any employee reports etc.
Part (b)
Audit implications and audit steps
Loan from supplier: audit implications
The classification of finance outstanding for just 11 days as a long–term loan is misleading and
distorts balance sheet statistics (eg the current ratio).
The purpose (to substitute long–term liabilities for current) and timing (receipt immediately
before year–end and repayment immediately after year–end) indicate that the substance of the
transaction was primarily to alter the appearance of the balance sheet. It is possible that such
‘window dressing’ transactions should be disclosed in the notes to the accounts in order to
explain the circumstances to the users of the accounts.
However, disclosure of repayment after the year–end may not be sufficient to achieve a true
and fair view. Therefore, it may be necessary to account for the substance of the transaction by
reclassifying the loan as a current liability at the year–end.
Loan from supplier: audit steps
♦ Review the terms of any loan agreement with the supplier to ascertain if a repayment date was set in
advance, and the interest terms (or details of any other reward for the provision of finance).
158
KAPLAN PUBLISHING
♦ Discuss with the directors their motives for raising the finance, their original repayment intentions, the
relationship with the supplier and reclassification of the loan as a current liability
Proposed dividend: audit implications
It appears that the directors’ report includes incorrect information concerning the rate of the final
dividend.
Note. The notes to the accounts are internally consistent (ie 56,000 × $4.75 = $266,000). It is
unlikely that the notes contain compensating errors, so the probability is that the directors’ report
is wrong.
As details of the dividend are also given in the financial statements, the directors’ report is
inconsistent with the financial statements.
Proposed dividend: audit steps
♦ Confirm the actual rate of final dividend by reference to subsequent payment or board minutes.
♦ Attempt to achieve elimination of the inconsistency by discussion with the directors and requesting
amendment in the directors’ report.
Chairman’s statement: audit implications
The reference in the chairman’s statement is misleading as the project has been abandoned.
ISA 720 imposes no duty (and confers no right) to refer to this in the auditor’s report. However, if
the reference remains and cancellation of the project is subsequently discovered by a reader,
the credibility of the financial statements may be questioned.
As future plans are usually subject to uncertainty, it is unlikely that the matter is so misleading
that a reader would consider the reliability of the financial statements undermined as a result.
Chairman’s statement: audit steps
♦ Request that the reference to the cocktail bars be removed from the chairman’s statement.
♦ If the directors or chairman decline, consider their reasons and the implications for the view drawn by
the readers of the annual report (eg if future prospects with this company are poor, the reader may be
significantly misled).
♦ If the reader may be significantly misled seek legal advice and consider attending the AGM to draw
the matter to the attention of shareholders.
Answer 46
Melton Builders
Part (a)
Matters to consider
159
KAPLAN PUBLISHING
IAS 37 requires that the legal claim should be accrued, if the loss is probable, or disclosed as a
contingent liability, if the loss is only possible.
Reliance may be placed on the expert opinions of the surveyor and lawyer depending on their
qualifications and experience and their degree of independence (eg the surveyor could be an
employee of Melton Builders).
The auditor should also consider the client’s previous claims experience including:
♦ the incidence of claims made against the company

♦ whether successful actions have been brought
♦ the expertise of the company’s defence, etc
Investigations
Review correspondence from Bingham Properties and their lawyers to ascertain:
♦ bases of estimates (of $3 million rectification costs and $1 million lost rents)
♦ whether any out of court settlement has been proposed.
Agree any references to contractual obligations, exclusions etc to the original contract.
Obtain a copy of the surveyor’s report/opinion. Consider the reasonableness of any

assumptions which vary significantly from those of Bingham Properties.
Obtain confirmation of the lawyer’s opinion, in writing, from the company’s legal advisers
(assuming client gives lawyer permission to communicate).
Consider whether the legal opinion as to the likelihood of an unsuccessful outcome is

remote/possible/probable/reasonably certain.
Part (b)
Response to criticism
Reasons
Management representations are a source of audit evidence, whether oral or documented.

Carrying out an audit in accordance with ISA 200 Objective and General Principles Governing
an Audit of Financial Statements, and ISA 500 Audit Evidence requires that sufficient
appropriate evidence be obtained as a basis for forming the audit opinion on the financial
statements.
The possibility of misunderstandings between auditors and management is reduced when oral
representations are confirmed in writing.
Where a management representation contributes to sufficient evidence obtained in respect of a

material matter, its reliability is enhanced if it is formally acknowledged.
Matters for inclusion

160
KAPLAN PUBLISHING
The directors’ acknowledgement of their collective responsibility for the preparation of the
financial statements which they have approved.
Facts where knowledge is confined to management (eg completeness of disclosure of

transactions concerning directors). An auditor cannot be expected to vouch transactions with
the thoroughness that would be required to identify all disclosable transactions.
Matters of judgment and opinion where independent corroborative evidence could not
reasonably be available. For example, if a director were a surveyor or had a legal qualification
(or merely had more experience than the auditor in these matters), it would be unrealistic to
expect independent expert advice to be made available.
Matters for exclusion
Immaterial items do not require management representations because, in principle,

management’s failure to provide written representation on them cannot have any bearing on the
audit opinion. For example, if inventories for a client in a service industry are immaterial,
representation concerning completeness of the inventory count would not be required.
Oral representations, which can be corroborated by checking with other (sufficient) evidence, do
not require written confirmation. For example, if management asserts that a reduction in gross
profit is attributable to selling prices not having been increased although costs have increased,
this should be confirmed by reference to sales invoices and cost records.
Part (c)
Reliability
As a documentary source, letters of representation are more reliable than oral evidence from
management. As a formal acknowledgement, management will usually take more care in giving
written, rather than oral, assurances.
As an internal source, they are less reliable than an independent source. However,
management may possess considerable knowledge which is not capable of independent
confirmation. Where there are no doubts concerning management’s competence, integrity and
judgment, letters of representation may provide the only practicable source of evidence.
The reliability of representations is enhanced by its consistency with other sources of evidence
(ie the cumulative degree of assurance obtained is higher than that of individual sources). If
inconsistency exists, the reliability of both management’s representation and the other source
remains in doubt until the inconsistency is resolved.
The existence of conflicting evidence may render a representation letter totally unreliable. For
example, an undisclosed loan to a director might be discovered in the receivables ledger when
management has represented that no such transactions existed. This would cast doubts on
management’s representations in general not just the specific representation shown to be
untrue.
161
KAPLAN PUBLISHING
Answer 47
Gamston and Keyworth
Part (a)
An unqualified audit report includes the following.
♦ A title including the addressee, eg an auditor’s report to the members of XYZ Limited.
♦ An introductory paragraph identifying the actual financial statements that have been audited (eg
identifying them by page numbers) and explaining the respective responsibilities of management and
the auditor.
♦ A scope paragraph section including the following.
- Reference to relevant auditing standards (eg ISAs or relevant national standards or

practices).
- A description of the work that the auditor performed.
♦ An opinion paragraph containing:
- a reference to the financial reporting framework used to prepare the financial statements
(eg IASs or national standards).
- an expression of opinion on the financial statements.
♦ The report should be dated and signed by the auditor.
♦ The auditor should disclose the geographical address of the audit office responsible for the opinion.
Part (b)
(i) All evidence that you would expect to receive has been received. However there is a
fundamental uncertainty concerning the value of non-current assets.
As the disclosure of the uncertainty is adequate, an unqualified audit report with an

explanatory paragraph is sufficient.
(ii) All expected evidence has again been received and the financial statements are still
affected by the fundamental uncertainty over the value of non-current assets.
However, the tangible non-current assets are worthless so the financial statements do
not show a true and fair view and should be qualified in this respect. The form of
qualification should be an ‘except for’ opinion on the grounds of a material disagreement.
Apart from the value of non-current assets the identified financial reporting framework
(IASs) is being observed.
162
KAPLAN PUBLISHING
(iii) All expected evidence has not been received and we are therefore dealing with an audit
qualification on the grounds of a limitation of scope, ie insufficient evidence.
The effect of the misstatement is to render the whole of the financial statements
misleading. We therefore have to use a disclaimer of opinion (we are unable to form an
opinion) because of a pervasive limitation of scope.
We have not received all necessary information and explanations and we are also
unable to determine whether or not proper accounting records have been kept.
(iv) This is similar to (iii) in that we are dealing with a qualification that is required on the
grounds of a limitation of scope because insufficient evidence has been gathered.
In this case the misstatement is material but not pervasive and an ‘except for’
qualification on the grounds of a material limitation of scope is required.
Except for the inventory value, which is uncertain, there is no cause for concern.
The lack of adequate information and explanations and the query over whether proper
accounting records have been kept or not are confined this time to inventory.
Answer 48
Wulf, Sisters, Mog
Part (a)
Materiality
(i) Meaning
‘Materiality’ is defined in ISA 320 and the IASC Framework document. Information is
material if its omission or misstatement could influence the economic decisions of users
taken on the basis of the financial statements. Materiality is therefore an expression of
the relative significance of a particular matter in the context of the financial statements
as a whole. Materiality may also be considered in the context of any individual primary
statement within the financial statements or of individual items included in them.
Materiality is not capable of general mathematical definition as it has both qualitative and
quantitative aspects.
(ii) Factors
(1) Judgment
As there are no set criteria for measuring materiality given in International

Accounting Standards or Auditing Standards, the auditor must use his judgment
163
KAPLAN PUBLISHING
and expertise as well as his detailed knowledge of the client and its industry to
determine the materiality of an item.
(2) Measure against an effective yardstick
The auditor must ascertain the key measures of performance and financial
position that are affected by an item that might be material. Examples would be
sales revenue and profit before tax. It is important to note that the yardsticks
must be relevant to the user of the financial statements and not merely to the
preparer of the financial statements or the auditor himself. A relatively small
misstatement may have a significant influence on a reader of the financial
statements if it turns a profit into a loss, or perhaps net current assets to net
current liabilities.
(3) The size of the misstatement or omission
This is often an indication as to the materiality of an item, especially when its

relative size is measured against appropriate yardsticks, for example if the matter
were to result in a misstatement of sales revenue by 10%. An item may be
material by virtue of its smallness, when a much larger balance was expected.
(4) The nature of the misstatement or omission
The matter may simply affect one or two items in the financial statements, in
which case the impact on the financial statements may be material but also
readily identifiable. Alternatively the matter may affect a number of different
items within the income statement and balance sheet. If this is the case the
auditor will have to consider the overall impact of the matter very carefully and its
materiality in terms of all the areas affected.
A misclassification of amounts resulting from an error of commission, for instance

gas expense classified as electricity expense, is unlikely to be material even if
relatively large, unless separate disclosure of each of these types of expense is
felt necessary by the auditor for a true and fair view to be shown.
(5) Statutory requirements
Certain items such as directors’ loans and emoluments may be required by

statute to be disclosed in the financial statements at their actual amounts. The
auditor cannot merely be satisfied as to whether they are materially correct; if
wrong, they must be adjusted.
Part (b)
(1) Wulf
Accounting standards
164
KAPLAN PUBLISHING
IAS 38 Intangible Assets requires the capitalisation and deferral to future periods of
development expenditure in certain specific circumstances. If these circumstances are
not met, the expenditure must be written off in the year in which it is incurred.
One condition for capitalisation of development expenditure is that the outcome of the
project is reasonably certain as to its technical feasibility and commercial viability. As
the outcome of the project is not yet foreseeable it would contravene IAS 38 to carry the
expenditure forward, and it should therefore be written off. This is also in accordance
with the prudence concept which requires recognition of all known expenses as soon as
they are identified.
165
KAPLAN PUBLISHING
Materiality
The write-off of the capitalised expenditure will reduce profit by 20% and net assets by
2%. This is highly likely to be a material misstatement if the financial statements are not
adjusted to reflect the write-off, possibly as an exceptional item.
Audit qualification
In respect of the treatment of development expenditure, the auditor would disagree with
the contention that the financial statements give a true and fair view.
The auditor’s report would describe the circumstances leading to his qualification (ie
non-compliance with IAS 38) and quantify the extent of the disagreement.
Although the misstatement has a very large effect on profit and net assets, the user of
the financial statements could easily isolate the misstatement and take it into account,
while still drawing useful information from the financial statements. Thus, the financial
statements as a whole will not be misleading and the auditor’s disagreement will be
reflected in an ‘except for’ opinion.
(2) Sisters
Accounting standards/relevant statute
Statute prohibits any loans to directors. The company has made loans to four directors,
so the details should be disclosed in the financial statements so that readers can gain a
full understanding of what has happened.
Disclosure required:
♦ name of each director involved.

♦ principal and interest outstanding at the beginning and end of the year.
♦ maximum liability during the year.
♦ any interest due but not yet paid.
♦ the amount of any allowance against failure to repay the loan.
Materiality
Since statute prohibits all loans to directors, any misstatement or non-disclosure will be
material. The pre-tax profits and net assets are therefore not relevant to the auditor’s
consideration of these loans in the context of materiality.
The classification of the loans within current assets as sundry receivables is probably
acceptable, as long as the balances are genuinely collectible.
Audit qualification
Insofar as directors’ loans have not been disclosed in the accounts they must be
disclosed in the auditors’ report and the report would be qualified ‘except for’ on the
166
KAPLAN PUBLISHING
basis that the financial statements have not been properly prepared in accordance with
the statute in respect of this non-disclosure.
167
KAPLAN PUBLISHING
(3) Mog
Accounting standards
IAS 2 Inventories requires each item of inventory to be valued at the lower of cost and
net realisable value. Where this is impracticable the comparison may be carried out on
each category of inventory.
Failure to value inventory in this manner could result in the offsetting of foreseeable
losses against unrealised profits, which is clearly against the prudence concept.
Materiality
The write-down of inventory to its net realisable value would reduce profit by 4% and
reduce net assets and inventory by less than 1% each. It is therefore unlikely that the
misstatement would be considered material. The auditor might, however, be put on
guard to ensure that $35,000 is the maximum misstatement and that all other categories
of inventory are correctly valued. IAS 1 requires significant departures from accounting
standards to be disclosed in the financial statements. Because the impact on the
financial statements of this departure is limited, the auditor is unlikely to consider it to be
significant.
Audit qualification
ISA 700 The Auditor’s Report on Financial Statements only requires qualification on
matters that are material to the financial statements. Assuming that an adjustment of
$35,000 would not be material, no mention of the departure from IAS 2 would be made
and an unqualified opinion would be given.
Tutorial note:
The examiner commented that whilst most candidates could explain what was meant
by materiality, many failed to list a sufficient number of the factors to be taken into
account in deciding whether an amount is material. Part (b) of this question was
answered quite well.
Answer 49
Cremorne
Part (a)
Inventory valuation
The finance director’s belief that the issue of the Highways Agency report is a non-adjusting
post balance sheet event is irrelevant to the matter in hand, which is to decide on the best
168
KAPLAN PUBLISHING
estimate of the year end inventory valuation, decided in accordance with IAS 2 on the basis of
the lower of cost and net realisable value.
As at the balance sheet date, the cost of scrap rubber is $7m, while its net realisable value is
$2m. The report did not change the situation; at the balance sheet date the cost is still $7m and
the NRV still $2m. A write down of $5m is necessary against the operating profit for this year.
This write down is more than 10% of the draft operating profit in the draft income statement, so
is certainly material.
If the company were to refuse to amend the financial statements, the auditor’s report should be
qualified with an ‘except for disagreement’ qualification, since the disagreement is material but
not so material or pervasive that the accounts as a whole are misleading.
The auditor’s report would begin as normal with an unmodified report but after the opening
paragraph and the scope paragraph would be inserted a new paragraph explaining the details
of the disagreement and quantifying its effect on the figures in the accounts. The opinion
paragraph would then state that, except for the absence of this write down, the financial
statements do give a true and fair view.
Part (b)
Depreciation charge
IAS 16 requires that the useful life of a tangible non-current asset should be reviewed
periodically, and revised if expectations are significantly different from previous estimates. If a
useful life is revised, the carrying amount at the date of the revision should be depreciated over
the revised remaining useful life.
The finance director is claiming that technological obsolescence is not a justification for
increasing the depreciation charge; this is contrary to IAS 16’s discussion of depreciation, which
includes ‘technical obsolescence arising from changes or improvements in production’ as
reasons for amending the useful life of an asset.
It seems clear that a useful life of 5 years should be used for all computer controlled earth
movers, together with a nil residual value (since the two movers retired in 20X8 were scrapped
for zero proceeds).
We need to recalculate the 20X8 depreciation charge using the new basis of depreciation.
Assume that a full year’s depreciation has been charged in the 20X8 draft accounts on both the
two movers acquired in 20X5 and on the new movers just acquired, but no depreciation has
been charged on the movers sold in 20X8 (the usual assumption). The depreciation charged in
the draft accounts will be:
(2 × 10% × $2.5m) + (2 × 10% × $4m) = $1.3m
The depreciation that should have been charged in 20X8 is:
169
KAPLAN PUBLISHING
$2.5m - $0.75m
(2 × ) + (2 × 20% × $4m) = $3.35m
2 years remaining
(Tutorial note – Each mover acquired in 20X5 cost $2.5m and has had 3 years’ depreciation
charged up to 31 December 20X7, each year being 10% × $2.5m = $0.25m, so a total of
$0.75m will have been charged up to the beginning of 20X8. Under the new basis, each mover
is written off over 5 years, so each mover acquired in 20X5 has 2 years left from the start of
20X8.)
The required increase in the 20X8 depreciation charge is $3.35m - $1.3m = $2.05m, or just over
5% of the draft operating profit for the year. If this were the only error, I would not insist on
qualifying my audit report for this matter alone. Depreciation charges are always an imprecise
estimate, so an adjustment of 5% of profits is perhaps not material. However, if I have to qualify
my audit report due to the disagreement in part (a), I will also disclose my disagreement
concerning the depreciation charge on earth movers in my audit report, along the same basis as
described in part (a). This is another ‘except for disagreement’ qualification.
Part (c)
Contingent liability
The company is correct in saying that IAS 37 does not require contingent liabilities to be
disclosed if the possibility of a transfer of benefits is remote. However, one must think beyond
the strict requirements of accounting standards. The objective of financial statements is to
provide useful information, so one must ask whether the users of the financial statements would
be interested in this contingent liability. Since the $50m size of the liability is so large, more
than the draft operating profit for the whole year, and since the loss of the case would threaten
the company’s future as a going concern, I think that the users would be interested and that
omission of disclosure of the details would not enable a true and fair view of the financial
position to be given.
The details of the lawsuit should be disclosed in a note to the accounts. This note should
explain the particulars of the case, including the amounts involved and why the company has
decided not to make any provision.
If the company were to refuse to make this disclosure, I would qualify my audit report with an
‘except for disagreement’. I would include a new paragraph in my audit report after the opening
paragraph and the scope paragraph, explaining the details of the disagreement, while the
opinion paragraph would give my ‘except for’ qualified opinion.
A further point concerns the possible threat to the company’s going concern. If I believe that the
Highways Agency investigation introduces an inherent uncertainty fundamental to the future of
the company, I would consider adding an explanatory paragraph to my audit report highlighting
this matter, even if it is adequately accounted for and disclosed in the financial statements. It is
probably best if I take legal advice as to the likely outcomes from the investigation, so that I can
act appropriately in deciding on the wording of my audit report.
170
KAPLAN PUBLISHING
Answer 50
Professional Promotions
(a) Review of Double P
Key steps of the review
Planning
♦ Ascertain whether any risk assessment has previously been performed by the internal audit
department of Double P
♦ Discuss with Management and Finance the objectives of the internal review that you are being
requested to perform and their observations and comments on the deteriorating position
♦ Establish information held on similar businesses, including evaluation of common types of risks to
which these businesses are subject
♦ Establish any regulatory or specific requirements relevant to the circumstances of the review
Assessment of risk
♦ Look at the potential for a risk workshop with key individuals from Double P. This could have the
benefit of generating greater appreciation and understanding of risk across the organisation.
♦ Review likelihood and impact of risks identified
♦ Consider whether the management have given any prioritisation to the risks as regards the likeliness
of their occurrence, and the possible courses of action to manage the risks
171
KAPLAN PUBLISHING
Evaluation of controls
♦ Identify and record systems in place to manage risks
♦ Review appropriateness and adequacy of controls in place
♦ Assess the likely effectiveness of the controls in managing or controlling the risks
Testing
♦ Test controls in place to manage risks to provide factual evidence that the controls have been applied
as prescribed
Conclude and report
♦ Form opinion on the effectiveness of risk mitigation strategies and raise findings and
recommendations for improvement.
♦ Produce a report to management and ensure that it is acted upon by pursuing the action
management take in response to recommendations made.
(b) Risk assessment
We need to generate an understanding of risk and encourage management to consider ‘what

might go wrong’, ‘what could the effect be of something going wrong’ and ‘how likely is it that it
could go wrong’ ie ensure management are informed of the risks that exist, prioritising those
that are most likely to occur and have material impact, and identifying the recommended
strategy for tackling the risks.
A risk assessment workshop could be useful in Double P to encourage the focus on risk.
A structure for risk assessment would also help understand and identify risks.
Key risks facing Double P include:
Financial risks - financial loss could arise from a number of sources including:
♦ non-payment by those purchasing tickets or by suppliers ie payment made on stolen debit/credit

cards, or payment rejected by the credit card companies because the customer has already
exceeded their authorised credit limits
♦ fraudulent activity or misappropriation of assets by Double P’s own staff, or by the artists hired to
provide the events
♦ cancellation of events due to illness amongst performers
♦ large booking fees of acts, with costs not recovered
♦ excessive overheads or purchase of goods not required.
Financial risks seem to be a particular area of concern in view of the deteriorating trend in a
time of perceived success.
172
KAPLAN PUBLISHING
Damage to reputation - Double P are in the entertainment business and therefore their
reputation could easily be damaged by:
♦ poor quality of services and performances by the artists/acts

♦ poor service in the restaurants or bars
♦ association with cancelled and/or failed events, particularly those not in-house
Breach of regulatory requirements - could fail to meet in a number of key areas for example
♦ health and safety/crowd control at large public events
♦ data protection - confidential financial details may be recorded over the web or by telephone at the
time bookings are made
(c) Management of risks
♦ Controls over access to systems, particularly financial systems (e.g. password protection, regular
changes of passwords, access restricted to appropriate trained staff during normal operational hours
only.)
♦ Programme controls including evaluation of each act booked, recording the forecast of expected
versus actual returns and evaluation of potential financial impact in case of poor results. Risk
mitigation strategies for poor performance or cancellation of events. This may take the form of
insurance or other similar measures. Agreement on maximum level of exposure on events that the
management of Double P are prepared to entertain (i.e. risk appetite)
♦ Evaluation of risks associated with each outside event organised and clear understanding and
documentation of terms of such events. The external risks associated with outside events will be
much more difficult for Double P to predict, manage and control
♦ Purchasing controls to ensure value achieved for services and goods procured by Double P in
connection with the staging of events
♦ Nominated responsibility for health and safety and regular H&S reviews over staff within Double P’s
employment
♦ Nominated responsibility for data protection, with clearly understood guidelines on what is appropriate
information to be held, how long such data should be retained for, how such data should be treated
and how it should eventually be removed from Double P’s accounting systems.
♦ Training of staff to ensure appropriate quality of service. Approved lists of suppliers which should be
used for regular supply of goods and services when orders are placed by Double P’s purchasing
department
♦ Effective payment procedures, including authorisation of payments to ensure any discounts offered
by suppliers for prompt payment are evaluated and taken up if financially advantageous, and the
segregation of duties and reconciliations to ensure effective financial controls
(d) Reviewing the performance of Double P
Analytical review procedures would be beneficial for Double P, in particular to identify trends
and patterns, in case there are particular areas that give rise to the concern over the financial
position.
173
KAPLAN PUBLISHING
This could include trends in performance on events, costs incurred against expected, profit
against expected, level of bookings and income, overheads (for example any increases in
purchases of materials).
174
KAPLAN PUBLISHING
Answer 51
Sighthill Supermarkets
(a) IAS 610 Considering the Work of Internal Auditing para 13 lists four important criteria in
assessing the work of internal audit, which are listed in parts (i) to (iv) below.
(i) Organisational status. The internal audit department's status in the organisation
and the effect this has on its ability to be objective. Sighthill Supermarkets is a
public company, and it should have an audit committee. Ideally the internal audit
department should report to them (or be able to report to them). In practice, it is
probable that much of the work of the internal audit department may be
controlled by the Financial Director. However, there should be some input from
the Board and audit committee to ensure that all important aspects of the
company's operations are covered by the internal auditors. As stated earlier, the
internal audit department should have the right to report to the audit committee,
and the audit committee should review copies of reports by the internal auditors.
Also, the internal auditors should be free to communicate with the external
auditors. The independence of the internal audit department is important, and the
auditor will consider whether it has adequate independence both in terms of the
work it carries out and the reports it makes.
(ii) Scope of function. The external auditor will check what action is taken by the
company as a result of the internal auditors' work. Action should be taken by the
company when the internal auditors detect significant weaknesses in the
accounting systems or errors in processing transactions. The internal auditors
should re-test the systems to check that the problems have been corrected. The
internal auditors' working papers showing weaknesses and errors and
subsequent correction will provide me with evidence of whether action is taken
following adverse reports by the internal auditors.
(iii) Technical competence. The external auditor will check the qualifications and
experience of the internal auditors. If the internal auditors have appropriate
qualifications (e.g. a member of the ACCA/ICAEW/IIA) their work is likely to be
more reliable than if they are unqualified. Experience in auditing is important.
They could have qualified with a firm of professional accountants and have
performed audits of private and public companies, or they may have experience
of internal audit in other companies. They should attend courses to keep up to
date and learn about new developments. Unqualified staff should be studying for
the exams of a professional body. The external auditor will check these matters
by discussing them with the head of the internal audit department and obtaining
appropriate evidence.
(iv) Due professional care. The work of the internal auditors should be properly
planned, supervised, reviewed and documented. The external auditor will
scrutinise the working papers of the internal auditors. The external auditor will
175
KAPLAN PUBLISHING
check the work they have carried out is appropriate and that the conclusions they
reach are consistent with the results of the tests they have carried out. The
external auditor will assess the work programme of the internal audit department
and check it provides adequate coverage of the company's operations and that it
is carried out at an appropriate frequency. For instance, checks should be carried
out when new accounting systems are installed, and tests should be re-
performed at a later date when serious errors or weaknesses in controls are
found. There should be appropriate audit manuals for the internal audit staff.
(b) The existence of an internal audit department will improve controls in the company.
Firstly, this is because of the 'policing' effect, in that the existence of an internal audit
department will make employees aware there is an increased risk the internal auditors
will detect fraud or errors in their work. Thus employees will be more careful to minimise
and correct any errors and they will be deterred from perpetrating a fraud. In addition,
the internal auditors should improve the effectiveness and extent of controls as a result
of the tests they carry out and the recommendations they make. Thus, the existence of
an internal audit department reduces control risk. So, with an internal audit department,
the external auditor should be able to carry out fewer tests of controls and/or substantive
procedures in order to achieve the planned level of audit risk.
The extent to which the external auditor can rely on the internal auditors' work in relation
to the matters listed in the question and thus reduce their audit work are:
(i) For recording accounting systems, it is likely that the external auditor will rely
almost entirely on the internal auditors' work. Ideally, they should have the same
system and use the same symbols for recording accounting systems as the
external auditors’ firm. The external auditor will check the accounting systems
have been recorded correctly by performing walk through tests using a sample of
transactions. If the systems have been recorded accurately, the external auditor
can use the flowcharts in their audit working papers.
For evaluation of controls, the internal auditors' internal control evaluation

questionnaire (ICE) (or internal control questionnaire - ICQ) should be the same
or similar to the external auditors firm's. If they are the same or similar to my
firm's, the external auditor will check to the flowchart that the questions have
been answered correctly. If there are significant differences with the external
auditors firm's questionnaires, the external auditor will check that the internal
auditors' ICE or ICQ asks appropriate questions. The external auditor may fill in
their firm's ICE or ICQ rather than use the internal auditors' as this will make it
easier for the partner to review, and it would minimise the risk of missing
weaknesses in the internal auditors' ICE or ICQ. As the external auditors’ firm is
likely to be in office for a number of years, it is desirable that the internal auditors
should use the external auditors firm's ICE's or ICQ's rather than their own.
176
KAPLAN PUBLISHING
(ii) For tests of controls in accounting systems, the external auditor will review the
internal auditors' work and check they are testing appropriate controls. In this
area, the external auditor should not rely entirely on the internal auditors' work.
The external auditor will perform additional tests, either on the same items as
were checked by the internal auditor, or on a different sample of items. If they
find the results of their tests are similar to the internal auditors' (particularly in
terms of frequency and types of error found) then they will be able to place
reliance on the internal auditors' work and reduce the number of items they
check. If the external auditors’ checks detect either different types of error or at a
higher frequency than the internal auditors', the external auditors will have to
perform further work by increasing the number of items they test and they will
probably ask the internal auditors to perform more checks.
(iii) Internal auditors verify assets and liabilities by:

- checking the existence of property, plant and equipment
- attending physical inventory counts
177
KAPLAN PUBLISHING
- checking accounts receivable including carrying out debtors'

circularisations (in a supermarket, there are likely to be very few balances
receivable, so a debtors' circularisation may not be carried out)
- checking bank reconciliations
- counting cash in tills and petty cash
- checking payables ledger balances to suppliers' statements.
As stated in part (ii) above, external auditors should not rely entirely on the
internal auditors' work. The external auditor will check the internal auditors' work
by either re-performing their tests, or performing tests on a different sample of
items. Provided the external auditors test results are similar to the internal
auditors', the external auditors can reduce the number of items they check
(compared with what they would check if there was no internal auditor). Where
the internal auditors find weaknesses or errors, the external auditor will check the
internal auditors have re-checked the systems at a later date to ensure the
weakness has been corrected. The external auditor may perform more checks in
areas where the internal auditors have found weaknesses or an unacceptable
error rate.
(iv) The question says the internal auditors use computer assisted audit techniques.
The external auditors will look at the programme and results of their work. The
programme should ensure that new computerised accounting systems and
significant changes to existing systems are tested by the internal auditors. The
external auditor will check that any weaknesses or errors found as a result of
these tests are acted upon and re-tested by the internal auditors.
The external auditor will inspect the CAAT work carried out by the internal
auditors and consider whether it is appropriate and checks all the significant
aspects of the computerised accounting systems. If certain aspects have not
been covered, the external auditor will either ask the internal auditors to carry out
the work or they will perform the tests themselves.
Audit of the computer systems should not be limited to using CAATs. The
reliability of the computer system is vitally important, as any serious failure could
create major operational and financial problems. Thus, the internal auditors
should have carried out procedures to check the reliability of the system. For
instance, there should be no 'bugs' in the software which either result in the
system 'crashing' or data files being corrupted. As most large computer systems
contain some 'bugs', the system should be 'tolerant' so that it can continue to
operate when such problems occur. The internal auditors should have carried out
tests of controls over access to the computer. The system should be able to
detect errors in transmission of data (particularly over telephone lines to head
office) and ensure the data is re-transmitted. The external auditor will check the
178
KAPLAN PUBLISHING
internal auditors' work and consider whether it is sufficient for the purposes of my
audit. If the external auditors believe it is inadequate, they will either ask the
internal auditors to carry out the work or will carry it out themselves.
(v) The internal auditor is likely to carry out a substantial number of visits to
supermarkets. The question says visits to supermarkets are carried out more
frequently to large supermarkets and to those where problems have been found.
The external auditor will inspect their work and check the frequency of their visits
to supermarkets to confirm this is happening. The external auditor will check that
all supermarkets are visited at least once a year. It would not be possible for
external audit staff to visit all the supermarkets at every audit, so the external
auditor will visit the large supermarkets on every audit and smaller ones on a
rotational basis. The external auditors will compare the results of their tests with
those of the internal auditors. If the results of the tests are similar, they will be
able to place more reliance on the internal auditors' work than if there are
significant differences.
The audit procedures carried out at supermarkets will include checking balance
sheet items, such as inventory quantities and cut-off details. Also, they should
include checking controls such as receipt of goods, procedures at the cash
check-outs, custody and banking of cash and the existence of employees.
Checking procedures over employees is important, as the supermarkets are
likely to have a large number of full-time and part-time employees, who work
different hours. There should be evidence of their existence and the hours they
have worked. It is apparent there is a high risk of a fraud being committed by
creating fictitious employees, or, where the employees are paid in cash, of
inflating the employees' hours and the fraudster misappropriating the wage for
the overstated hours.
The internal audit department will be very helpful at the year end, as, with their
assistance, it will be possible to visit a greater proportion of the supermarkets at
the year end to attend the inventory count and obtain details of purchases cut-off
(sales cut-off should not be a problem with a supermarket). Provided the work of
the internal auditors is reliable, the external auditors may be able to reduce the
number of supermarkets they visit at the year end and at the interim and final
stages of the audit.
Answer 52
Eastfield Distributors
(a) The matters the external auditors will consider and the action they will take to ensure the
provision of an internal audit service does not conflict with their duties and the
independence requirements of their firm being external auditor to the company include:
179
KAPLAN PUBLISHING
(i) it appears that Eastfield Distributors is not a listed company, so the external
auditors fees from the external audit, the internal audit and other work they
perform for Eastfield Distributors should not exceed 15% of their practice income
(the limit is 10% for listed companies)
(ii) if Eastfield Distributors was a listed company, the audit firm should not prepare
the annual financial statements (except in emergency situations). This
requirement will apply to the firm's work as internal auditors. Even if Eastfield
Distributors is not a listed company, it is undesirable that the audit firm (as either
internal or external auditors) should prepare the annual financial statements
(iii) the Rules of Professional Conduct of the Association of Chartered Certified

Accountants (ACCA) do not specifically cover the independence of the internal
audit work from the external audit work when the external auditor carries out both
these functions. However, the situation seems to be similar to when the auditor
both prepares the annual financial statements and audits them. So, it appears to
be desirable that there should be some independence between the internal and
external audit functions within the audit firm. Thus, it is desirable that different
audit staff should carry out internal audit work from those who undertake the
statutory external audit. Internal audit staff should report to a different partner
from the engagement partner for the external audit. If the internal audit and
external audit staff report to the same engagement partner, the audit firm may be
criticised for a lack of independence
(iv) if the internal audit staff prepare the annual financial statements, then the audit
firm should make it clear that the directors must accept responsibility for these
financial statements
(v) the internal audit staff should be careful not to assume the role of management
when carrying out their work, as this would contravene the ACCA's Rules of
Professional Conduct. This may create problems, as the internal auditors may be
asked to design the company's accounting systems in order to provide adequate
controls. This problem may be reduced by requiring the company's directors to
confirm any recommendations by the internal auditors. The company's chief
financial officer (i.e. finance director or chief accountant) will be an important
person to be involved in this type of decision, as he/she will have the skills to
make a responsible decision
(vi) there may be problems about who the internal audit staff are responsible to. On a
day to day basis, they will probably report to the finance director, but they should
have the right to report to the audit committee or the full board of directors. For
the internal auditors to be truly independent of the external auditors, they should
not report to partners in the audit firm. However, this is impractical and
unrealistic. It is impractical, as the internal auditors will be employees of the audit
firm and their promotion will be determined by the audit firm. Thus, the audit firm
180
KAPLAN PUBLISHING
will have to be able to assess the quality of each employee's work. It is

unrealistic, as external auditors use the work of internal auditors in coming to
their audit opinion. Thus, the external audit staff will have to review the work of
the internal auditors, and the internal auditors may be asked to carry out certain
work to assist the external audit staff. There will need to be some agreement with
the client about the extent to which the company and the external audit firm
control the internal auditors' work. This should be included in the engagement
letter
(vii) there will have to be a decision about which members of the audit staff should
perform this internal audit service. The staff should have a range of skills and
range from junior to qualified staff. The external auditors will have to consider
whether the staff should always work for the audit client, or whether different staff
should be employed at different times. More staff may be provided for the internal
audit service when the external audit work-load is low, and fewer staff when the
external audit department is busy. It is important that the internal audit staff are
competent, as otherwise this could adversely affect Eastfield Distributors' opinion
of the audit firm. This will create the risk that Eastfield Distributors will want to
change the external auditor with the consequent risk to the external auditor's
independence
(viii) there will have to be an agreement about how much should be charged for the
internal audit service, and the services which will be provided. The charge will
probably be based on the number of hours worked by staff at Eastfield
Distributors and their level of experience; other considerations will be similar to
those for the audit firm being external auditor of Eastfield Distributors.
181
KAPLAN PUBLISHING
(ix) Issues arising concerning the independence of the internal audit staff will include:
- staff undertaking the internal audit work should not own shares in
Eastfield Distributors or have close family or other personal relationships
with the directors or senior employees of Eastfield Distributors
- there should be an agreement over payment of charges for the internal
audit work. If Eastfield Distributors is slow at paying these charges, it
could adversely affect the independence of the audit firm
- the internal audit staff will have to be careful in accepting goods, services
and hospitality from Eastfield Distributors. Any benefit from these items
should be modest. For instance, staff purchasing goods from the client
should receive them at no more favourable rates than employees of
Eastfield Distributors, and they should be only for personal use
- internal audit staff should not accept loans from Eastfield Distributors.
(x) an engagement letter should be agreed with Eastfield Distributors for the internal
audit work, which includes most of the matters listed above. It may be
appropriate to have a trial period after which Eastfield Distributors will decide
whether the service should continue.
Following this, both parties should agree a new engagement letter, which seeks
to overcome any problems and includes important matters which were omitted
from the original engagement letter.
(b) The advantages to Eastfield Distributors of having the external audit firm perform the
internal audit work will include:
(i) the new internal auditors should be skilled in carrying out audit work, so the
learning time for the staff should be short compared with setting up an internal
audit department within the company
(ii) the audit procedures and standard should be consistent with those of the
external auditor. Thus, the external audit staff should be able to use more of the
internal auditor's work in coming to their audit opinion. This should reduce the
cost of the external audit
(iii) the audit firm may be able to provide staff with a wider range of skills than
Eastfield Distributors may be able to recruit as employees. For instance, the audit
firm may be able to provide specialists in computer auditing, where it would not
be economical to have a computer audit specialist as an employee.
The disadvantages of the external audit firm performing the internal audit work will
include:
(i) there may be problems with who is in charge of the internal audit staff. The
internal audit staff will be employees of the external audit firm. The client
182
KAPLAN PUBLISHING
company will probably have less control over the internal audit staff, and this may
create problems over the work they do and the reports they make
(ii) because of the ACCA's Rules of Professional Conduct, the internal auditors may
be restricted in the work they do. For instance, they may be prevented from
preparing the financial statements and making management decisions. Thus,
they may not be able to decide the form and controls for a whole accounting
system
(iii) the internal audit staff will be skilled at performing work similar to the external
auditors, but they may have limited skills and experience of other work carried
out by internal auditors (eg advising on the purchase of a business)
(iv) using the external audit firm to perform internal audit work is likely to be more
expensive than the company employing its own internal audit staff, as the
external audit firm will want to cover its costs and make a profit on the work
(v) there may be problems with the internal audit staff changing from time to time.
The external audit firm will probably want to provide the maximum staff to
Eastfield Distributors when the audit firm are less busy and fewer staff when they
are busy. Having different staff at different times will require the new staff to learn
about Eastfield Distributors' business. This learning time is likely to be greater
than if Eastfield Distributors employed its own staff
(vi) the requirement of the external audit firm to have to perform external audits
(when it is busy) may mean that Eastfield Distributors does not have sufficient
internal audit staff during periods when it wants them (eg at the year end for
inventory counts and to help in preparation of the annual financial statements).
(c) The advantages to the external audit firm are frequently similar to the disadvantages to
the audit client. However, some advantages can apply to both the audit firm and the
client. The advantages can be summarised as:
(i) by having the internal auditors as part of the audit firm's staff, their audit
procedures should be the same and the confidence of the audit firm in their work
will probably be greater than if the internal auditors were employees of the client
company. Thus, the external auditor will probably be able to achieve a greater
reduction in the external audit work compared with if the internal audit work is
being carried out by employees of the client company
(ii) the service will provide additional income and profits to the audit firm. It may
provide a wider experience to the audit staff, but there may be problems with
obtaining the appropriate work experience for staff to become members of the
ACCA
(iii) it may be possible to use the internal audit work to fill in periods when there is
little external audit work. For instance, in the UK, there is little audit work from
183
KAPLAN PUBLISHING
July to early September, so more staff could be employed in internal audit work
during this period.
The disadvantages to the audit firm in providing an internal audit service include:
(i) the firm must be careful that the professional rules on independence are not
contravened. It may be difficult to ensure that none of the staff employed on
internal audit work are part of the external audit team. It may be very difficult to
ensure the rules of professional independence are complied with at all times, as
the internal auditors may be required to make executive decisions or be involved
in the preparation of the annual financial statements
(ii) if a dispute arises with the client over the internal audit work, this is likely to affect
the audit firm's relationship with the client. Because of this, there may be
implications on the external audit. For instance, if the audit firm is dismissed as
internal auditor of Eastfield Distributors, it may be dismissed as external auditor
as well.
184
KAPLAN PUBLISHING

Question Bank - Kaplan Audit Qns 2008

Uploaded by

Copyright:

Available Formats

Question Bank - Kaplan Audit Qns 2008

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Question Bank - Kaplan Audit Qns 2008

Uploaded by

Copyright:

Available Formats

ACCA EXAMINATION KIT

Audit and Assurance (INT) (F8)

© FTC Kaplan Limited, August 2007

Questions and Answers

24 Lenton Electrical (ACCA 6/97) 29 107

Other audit and review evidence

Paragraph 8 of the statement states that:

The effect on the audit is explained in paragraph 10:

(i) Gathering evidence (4 marks)

Decathalon & Co (Answer on page 64)

Bentfasteners (Answer on page 66)

Ethics (Answer on page 68)

(a) Can I audit a company owned by my brother? (4 marks)

(e) I am a student of the Association of Chartered Certified Accountants. Am I bound by the

Ethics and independence (Answer on page 69)

An auditor’s independence may be compromised by the provision of other non-audit services.

Consider for each of the services listed above:

(i) the effect on the auditor’s independence of providing these services.

Soul (Answer on page 70)

(b) Briefly describe the safeguards available. (7 marks)

Melton Manufacturing (Answer on page 72)

(i) accept the appointment as the company’s auditor; and

Bondi (Answer on page 74)

Radford Retail (Answer on page 77)

♦ misappropriation of inventory by employees and customers

Growing (Answer on page 79)

Gnome Publications (Answer on page 80)

Bestwood Engineering (Answer on page 82)

Working papers (Answer on page 84)

(i) in familiarising yourself with the client company. (6 marks)

Risk (Answer on page 87)

(i) Property, plant and equipment

Newthorpe Manufacturing (Answer on page 89)

♦ Freehold land and buildings

♦ Land at $2.9 million

Southwell Engineering (Answer on page 92)

Key features of the computerised sales system include the following.

The following information is required when inputting despatch note details.

♦ Customer account number.

Lidcombe (Answer on page 93)

(i) Explain these in the context of purchase transactions. (4 marks)

Ilkeston Products (Answer on page 95)

(i) Internal control questionnaires (ICQs)

and state their relative advantages and limitations. (8 marks)

Marshalls (Answer on page 97)

Dean (Answer on page 98)

For each internal control weakness in the purchasing system:

Bingham Manufacturing (Answer on page 101)

Eastwood Engineering (Answer on page 103)

The loss arising from the closure is intended to include:

♦ costs of making employees redundant.

Wormwood (Answer on page 105)

There is a personnel department which is independent of the wages department. The

♦ paying employees after appointment but before they commenced work

Lenton Electrical (Answer on page 107)

Key features of the inventory control system are as follows.

♦ Each product has a unique bar code.

Sheffield Homestores (Answer on page 109)

1 input details of new inventory lines and their selling price