Audit and Assurance (AA)

Short conceptual Notes on auditing and assurance

Paper F-8 (INT) & P7 (INT) ACCA (UK)

Audit and Assurance (CAF 9) CA (PAK)
Audit and Assurance ACMAP (PAK)

Compiled by: Kanwar Abid Ali (ACA& LLB)

Principal-CCA Multan

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Why need Audit:
Increase confidence of the stakeholders especially shareholders.
Reduce risk of misstatement, as someone independent, qualified audit and gives
an opinion on the truth and fairness in all material aspects of the financial
statements.
 Enhance the creditability of financial statement.
HOWEVER, audit does not assure
 Future viability of the entity
 Nor efficiency or effectiveness with which management has conducted the
conducted the affairs of entity.

Development of audit and other assurance engagements :

Students Notes (if any):

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Stewardship: is the responsibility to take good care of resources. A steward is a person
entrusted with management of another person’s property.
Fiduciary Relationship: where one person has a duty of care towards someone else
is known as a fiduciary relationship.
Accountability: means that people in positions of power can be held to account for
their actions. (e.g. directors are accountable to shareholders and to society at large for
making decision on behalf of company’s owners)
Concept of Agency: where one person (Principal) employs another party (Agent).

Students Notes (if any):

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Audit: is independent examination of financial information of an entity to enable
an auditor to express an opinion as to whether financial statement give true
and fair view/present fairly in all material aspect in accordance with the identified
financial reporting frameworks.

Important points in the definition are as follows:

1. Independent
Means independence from management or has no interest in the
company. Auditor should be independent legally and ethically.
Auditor needs to be independent because it is appointed by the
shareholders on their behalf to examine the work performed by the
management and report to the shareholders.
 Actual Independence (Independence of mind)
 Perceived Independence (Independence in
appearance)

2. Examination
Audit procedures i.e. Test of controls and substantive
procedures (Analytical and Test of details of transactions and
balances)
Audit procedures are:
1. Inspection of records and documents
2. Inspection of tangible assets
3. Observation
4. Enquiry including management representations
5. Confirmation
6. Recalculation
7. Reperformance
8. Analytical procedures (used at a planning, substantive and
overall review stage)
3. Financial information
Includes financial statements and all other supporting documents
(e.g. ledgers, vouchers, invoices, cheques, trial balance etc)
4. Entity
5. Auditor (Statutory auditor)
6. Opinion (Audit report)
7. Financial statements
8. True and fair means financial statements are not misleading. (i.e. not misstated
due to fraud and errors
9. Material aspects (not all aspects because of inherent limitations of audit)
10. Identified financial reporting frameworks (Acceptable financial reporting
frameworks)

Students Notes (if any):

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Fundamental/Ethical principles:
 Objectivity: not biased, no conflict of interest or undue influence of others to
override judgments.
 Integrity: should be honest and straightforward in all professional and business
relationship .
 Professional behavior: compliance with law and regulation and avoid action that
discredit the profession.
 Professional competence and due care: Professional knowledge and skills and act
diligently.
 Confidentiality: not disclose any information relating to entity to third parties Breach
but there are certain exceptions (obligatory and voluntary). confidentiality in
certain cases.
-When auditor is
Threats to fundamental principles: required by law.
 Self-interest threat: auditor or their family member has any kind of financial or -Required by
other interest in the audit client. e.g. court
o Owns the shares of audit client -when client has
o Overdue fees given permission.
-when auditor
o Significant proportion of total fee come from particular client have to defend
o Gifts and other hospitality himself.
o Family relationship -when it is in a
 Self-review threat: occurs where the auditor has to reevaluate work performed by public interest.
him.
o Prepare financial statement
o Develop internal control system
 Advocacy threat: auditor is asked to promote client position or to represent the
client in some way
o Promote the shares of client for stock exchange listing
o If client asked the auditor to represent them in court
 Familiarity threat: occurs when auditor is too sympathetic or trusting of the client
because of a close relationship with them.
o Close family relationship
o Close friendship
o Long term association with client
 Intimidation threat: client may harass or bully the auditor to give unqualified
opinion when qualified opinion is appropriate.
o Overdue fees
o Significant proportion of total fee come from particular client

 Student must be able to give recommendation to

remove or minimize these threats
Student Notes (if any):

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 Misstatement: means fraud and errors.
Fraud: means intentional act involving the use of deception to obtain an unjust or
illegal advantage.
Errors: mean an unintentional mistake and could include accidental misapplication of
accounting policies, oversights or misinterpretation of the facts.
Fraud can be further split into two types:
1. Fraudulent Financial Reporting (Manipulation of accounts)
2. Misappropriation of assets

Sufficient and appropriate evidence:

1. Audit Procedures
1. Auditor applies audit procedures to obtain
evidences which support his opinion.

2. Sufficient mean well enough. It is matter of

2. Sufficient Appropriate audit evidence professional’s judgment. It is a quantitative
aspect. It depends on many factors (risk etc.)
Appropriate means which is relevant and
reliable (Qualitative aspect)
Relevant: depend on the nature of transaction
and assertion being tested.
Reliable:
More reliable Less reliable
Independent external Internally generated
evidence evidence
Internal evidence Internal evidence not
subject to effective subject to effective
controls controls
Evidence obtained Evidence obtained
directly by the auditor indirectly or by
interference.
Documentary Oral
Original documents Photocopies or
facsimiles

Evidence must be documented in soft or hard

copy and stored for required period. This
documentation is called Working Papers/Work
paper/Audit Documents.

3. On the basis evidence auditor will form an

3. Audit Reporting (Opinion) opinion.

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Opinion (Audit Reporting):
Basically there are two types of Audit Report.

1. Unqualified/Unmodified/Standard Means financial statement give true and

report fair/present fairly in all material aspect in
accordance identified financial reporting
framework.
2.Modified/Qualified report It is further divided into 3 categories (on
the basis of opinion)
3. Modified/Qualified report When there is material uncertainty about an
 Emphasis matter paragraph event or events or other matters or going
 Other matter paragraph concern uncertainty (by adding
 Going Concern Uncertainty paragraph additional paragraphs)

Auditor Judgment about the pervasiveness of the

effects or possible effects on the financial statements
Nature of the matter giving Material but not pervasive Material and pervasive
rise to the modification
Financial statements are Qualified Opinion Adverse Opinion
materially misstated (Except for)
(Disagreement with
management)
Inability to obtain sufficient Qualified Opinion Disclaimer of Opinion
appropriate evidence (Except for)
(Scope Limitation)

Students Notes (if any):

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Assurance and Non assurance engagements:
Elements of assurance engagements
1. Three party relationship
a. Professional Accountant
b. Responsible party
c. Intended Users
2. Subject matter
3. Suitable criteria
4. Sufficient and appropriate evidence
5. Report (opinion)
Types of Assurance Engagement

Reasonable Assurance Limited Assurance Absolute Assurance

High level of assurance Moderate level of assurance It is not possible to give
absolute level of assurance
due to the factors described
below:
Positive assurance Negative assurance

Not absolute Assurance (Inherent limitation of audit):

It is not possible for the auditor to give absolute level of assurance due to:
 Lack of precision often associated with the subject matter e.g. financial statements
are often subject to estimates and judgments (Nature of financial reporting)
 Nature, timing and extent of procedures (Nature of audit procedures)
 Evidence is usually persuasive rather than conclusive
 Use of testing or other means of examining populations for misstatements
 Completion problem
 Inherent Limitation of internal control.
o Collusion of employees
o Management override of controls
o Human errors
o Cost benefit consideration
o Happening of unusual event

Student Notes (if any):

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Differentiate between assurance (e.g. audit) Engagement
letter, Management letter (letter of weaknesses) and Written
Representation letter:

Assurance Management Written

Engagement Letter Letter/Letter of Representation Letter
(e.g. audit weakness
engagement letter)
What is Contains the terms Communicating any Written
and condition of weaknesses observed acknowledgement by
engagement agreed during the conduct of the management of
between client and the audit in the their responsibility
auditor. system of internal regarding financial
control. statements
By whom Auditor Auditor Client (i.e.
Management)
To who Appointing authority Management and Auditor
those charged with
governance
Time After receipt of Sent at the end of Before the signing of
appointment audit audit report.
information

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Differentiate between External and Internal auditor:

External Auditor Internal Auditor

Required by Statue/Law Not required by law
Appointed by Shareholders Management
Report to Shareholders Management
Scope of work is Law Management
determined by
Independent Must be independent May not be so much
independent as external
audit
What to do To give opinion about truth To seek evidence about
and fairness of financial the compliance with the
statements on basis of system of internal control,
evidence collected by management policies, the
applying audit procedures. company rules and
regulations and identify
the weaknesses in the
internal control system
and given
recommendation to
control that weaknesses.
Responsibility to Not only to members but all Solely responsible to
to all relying on his report. management.

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Audit and review engagements:

Nature of engagement Audit Review

Amount of work done Auditor, as much as deems Reviewer, as much as
decided by whom necessary to give positive deems necessary to give
opinion (detailed procedures negative opinion
according to the
circumstances
Type of assurance Reasonable, (but not Limited assurance
engagement absolute) assurance
Level of assurance provided High Moderate
Type of report provided Positive assurance Negative assurance
Period Statutory reporting period Any (determined in
review engagement)
Financial Statement Statutory Financial Statement Could be management
(i.e. required by law) accounts etc
Criteria Determined by Law Whatever agreed?
Procedures  Test of controls Analytical procedures and
 Substantive enquires
procedures

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Stakeholder of company/Users of financial statements:
 Shareholders
 Management
 Other employees
 Those charged with governance
 Customers
 Suppliers
 Government
 Lenders of funds
 Community organization, especially in the local neighborhood.

Audit Risk:
“The risk of that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated.”
Typically, stating that financial statement are true and fair, when in fact they are not.

Audit risk is further divided in two categories or arises due to:

Audit Risk =

Risk of Material Misstatement

Inherent Risk * Control Risk * Detection Risk can be

 Sampling risk
 Non Sampling
risk

Inherent Risk: The risk of errors or misstatements due to the nature of the company and
its transactions.

Control Risk: The risk of errors or misstatement because of the company’s internal
control systems are not effective to prevent, detect and correct them.

Detection Risk: This is the risk that the auditor’s procedures do not pick up material
misstatements.

Student Notes (if any):

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Examples of audit risk
Inherent risk
 Account balances for complex, judgmental areas of accounting. E.g. provisions
 Company operates in high tech or fast moving industry
 Bank is relying on financial statements or directors are paid a bonus based on profits
 It is a cash based business
 The company trades oversee
 New computer systems
 A client in a specialized industry

Control risk
 Lack of physical control
 Lack of IT base control
 Lack of authorization control
 Lack of segregation of control
 Client is based in multiple locations
 Cash based business
 New computer systems
 Temporary staff used during the year

Detection risk
 Client is based in multiple locations
 New audit client
 Tight audit deadline imposed by client
 Sampling risk

Student Notes (if any):

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 Audit Stages:
1. Planning: Planning involves:
 Risk assessment: means determination of chances of material
misstatement in the financial statements, done through by
acquiring Knowledge of business (KOB) through enquiries,
inspection, observation and analytical procedures.
 Development of Overall audit strategy and audit plan at
assertion level.
 Audit team selection
 Assessing materiality
 Selecting appropriate audit procedures
KOB means: Knowledge of industry, competition, technology, laws
and regulations, stakeholders, acquisitions, financing, disposal, systems
and related controls (i.e. internal and external knowledge)
Sources of KOB:
 Information from the firm
 External sources
 Past experiences
 From audit client.
Overall Audit strategy means: Scope, timing and direction.
Individual Audit Plan/audit program: means detailed audit
procedures

2. Understanding and evaluation of accounting and internal control system:

(Test of controls)

3. Substantive procedures:

4. Review of working papers

5. Final review

6. Reporting (report issues)

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Sources of obtaining Knowledge of business
1. Information from your firm
a. Partner
b. Manager
c. Industry experts
d. Last year’s team
e. Last year’s audit
f. Working paper file
2. Information form you
a. Past experience
3. Information from external sources
a. Industry surveys
b. Companies house
c. The internet
d. Trade press
e. Credit reference agencies
4. Information from the client
a. Discussion
b. Observation
c. Website
d. Brochures

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Audit report contents
According to ISA-700, following are the content of unmodified audit report
Sr. # Section Purpose
To clearly identify the report as an independent Auditor’s
1 Title
report.
2 Addressee To identify the intended user of the report
Provides the auditor’s conclusion as to whether the
3 Auditor’s Opinion
financial statements give a true and fair view.
Provides a description of the professional standards
4 Basis for Opinion applied During the audit to provide confidence to users
that the report can be relied upon.
To draw attention to any other significant matter of which
the users should be aware to aid their understanding of the
5 Key audit matters
entity.
(Note: This section is only compulsory for listed entities)
To Clarify that management are responsible for the other
information. The auditor’s report does not cover the other
6 Other information information and the auditor’s responsibility is only to read
the other information and repot in accordance with ISA
720.
To Clarify that management are responsible for preparing
Responsibilities of
7 the financial statements and for the internal controls.
Management
Included to Help minimize the expectations gap.
To clarify that the auditor is responsible for expressing
reasonable assurance as to whether the FS give a true and
Auditor’s
fair view and express that opinion in the audit report. The
Responsibilities for
8 section also describes the auditor’s responsibilities in
the audit of the
respect of risk assessment, internal controls, going
financial statements
concern and accounting policies. Included to help
minimize the expectations gap.
To highlight any additional reporting responsibilities, if
applicable. This may include responsibilities in some
Other reporting
9 jurisdictions to report on The adequacy of accounting
Responsibilities
records, internal controls over financial reporting, or other
information published with the financial statements.
Name of the To identify the person responsible for the audit opinion in
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Engagement partner case of any queries.
Shows the engagement partner or firm accountable for the
11 Signature
opinion.
To identify the specific office of the engagement partner
12 Auditor’s address
in case of any queries.
To identify the date up to which the audit work has been
performed. Any information that comes to light after this
13 Date
date will not have been considered by the auditor when
forming their opinion.

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ISA 701 Communicating key Audit Matters in the Independent Auditor’s
Report

ISA 701 requires auditors of listed companies to determine key audit matters and to
communicate those matters in the auditor’s report.

Auditor of non-listed entities may voluntarily, or at the request of management or those

charged with governance, include key audit matters in the audit report.

Key audit matters are those that in the auditor’s professional judgment were
communicated to those charged with governance.

The purpose of including these matters is to assist users in understanding the entity, and
to provide a basis for the users to engage with management and those charged with
governance about matters relating to the entity and the financial statements. Each key
audit matter should describe why the matter was considered to be significant and how it
was addressed in the audit.
Key audit matters include:
 Areas of higher assessed risk of material misstatement, or significant risks
identified in accordance with ISA 315.
 Significant auditor judgments relating to areas in the financial statements that
involved significant management judgment, including accounting estimates that
have been identified as having high estimation uncertainty.
 The effect on the audit of significant events or transactions that occurred during
the period.

Specific examples include:

 Significant fraud risk
 Goodwill
 Valuation of financial instruments
 Fair values
 Effects of new accounting standards
 Revenue recognition
 Material provisions such as a restructuring provision
 Implementation of a new IT system, or significant changes to an existing system.

Note that a matter giving rise to a qualified or adverse opinion, or a material uncertainty
regarding going concern are by their nature key audit matters, However, they would not
be described in this section of the report. Instead, a reference to the Basis for qualified or
adverse opinion or the going concern section would be included.
If there are no key audit matters to communicate, the auditor shall:
 Discuss this with the engagement quality control reviewer, if one has been
appointed.

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  Communicate this conclusion to those charged with governance.
 Explain in the key audit matters section of the audit report that there are no
matters to report.

Illustration 1: Key Audit Matter

Goodwill
Under IFRSs, the Group is required to annually test the amount of goodwill for
impairment. This annual impairment test was significant to our audit because the balance
of XX as of December 31, 20X1 is material to the financial statements. In addition,
management’s assessment process is complex and highly judgmental and is based on
assumptions, specifically [describe certain assumptions], which are affected by expected
future market or economic conditions, particularly those in [name of country or
geographic area].

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Materiality (in context with misstatement):

Information is material if its omission or misstatement individually or in aggregate could

influence the economic decisions of users taken on the basis of the financial statements.
 Qualitative materiality: (materiality by nature)
o Non-disclosure of related party transactions
o Non-disclosure of revenue recognition policy
o Non- disclosure of contingencies or commitments
 Quantitative materiality: (materiality by size)
o .
o .
o .
Common measures are:

 0.5% --- 1% of turnover

 5% ----- 10% of results
 1 %----- 2% of assets

But these are up to the judgment of auditor.

Concept of Performance Materiality

Students Notes (if any):

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Factors to be considered before accepting new audit engagement
1. Ethical issues:
a. Integrity
b. Objectivity
c. Professional l behavior
d. Professional competence and due care
e. confidentiality
2. Risk assessment:
a. Poor business performance
b. Complexity of transactions
c. Money laundering risks etc
3. Legal issues:
4. Resource availability: in terms of staff, timing etc
5. Integrity of management:

Students Notes (if any):

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Pre-condition of audit
 Determine whether financial reporting framework adopted by management or
where appropriate those charged with governance for preparation of financial
statement is acceptable.
 Obtain management agreement that it acknowledges and understands its
responsibilities for the following
o Preparing the financial statements in accordance with the applicable
financial reporting framework
o Internal control that is necessary to enable preparation of financial
statement which are free form material misstatements
o Providing auditor with access to all information of which management is
aware that is relevant to the preparation of the financial statements with
additional information that auditor may request.
o Unrestricted access to entity staff from whom auditor determine
necessary to obtain evidence.

Factors to consider for determination of preconditions of audit.

1. Nature of the entity
2. Purpose of the financial statements
3. Nature of financial statement and whether law or regulation prescribes the
financial applicable financial reporting framework.

If preconditions are not present, the auditor shall discuss the matter
with management. The auditor shall not accept the audit engagement if:
 The auditor has determined that the financial reporting framework to be applied
is not acceptable
 Management‘s agreement referred to above has not been obtained.

Responsibilities of auditor and management with respect to frauds and

errors
 Auditor is responsible to give reasonable assurance. So auditor is only
responsible for material misstatement (i.e. material misstatement).
 Prime responsibility for detection of all fraud and errors rest with management.

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Corporate Governance
Corporate Governance is the policies and procedures (rules and regulation) through
which companies are monitored and controlled.
Corporate Governance Aspects
1. Separation of roles between Chairman and Chief Executive.
2. Appointment of Non-Executive directors
3. Balance between executive and non-executive directors
4. Establishment of different committees
a. Audit committee (functions, advantages and disadvantages)
b. Nomination committee
c. Remuneration committee
d. Risk committee
5. Establishment of internal audit department
6. Appointment of independent external auditor
7. Risk management department
8. Internal control system

Internal Control System

Internal control systems are policies and procedures established/adopted by management
of an entity to achieve its objectives.
Objectives of Internal control system
1. Orderly and efficient conduct of business
2. Safeguarding of assets (Physical and logical)
3. Prevention and detection of frauds and errors
4. Timely preparation of accounting records
5. Accuracy and completeness of financial records
6. Compliance with law and regulation

Elements of internal control system

1. Control Environment
a. Commitment to competence
b. Participation by those charged with governance
c. Communication and enforcement of integrity and ethical values
d. Management philosophy and operating style
e. Organization structure
f. Assignment of authority and responsibility
g. Human resource policies and practices
2. Risk Assessment process for:
a. Identifying business risks relevant financial reporting framework
b. Estimating the significance of risk

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 c. Assessing the likelihood of their occurrence
d. Deciding upon actions to address those risks
3. Information and communication system
4. Control Activities
a. Segregation of duties
b. Supervision
c. Physical controls
d. Approval, authorization and control of documents
e. Application controls
f. Checking arithmetic accuracy of record
g. Maintaining and reviewing control accounts and trial balance
h. Reconciliations
5. Monitoring

Ways of documenting the system and related advantages and disadvantages:

 Decision trees
 Narrative notes
 Internal control questionnaire
 Internal control evaluation questionnaire

Internal Audit Department

Need for internal audit department

1. Scale, diversity and complexity of activities.
2. Number of employees
3. Cons/ benefit consideration and
4. Desire of senior management to have assurance and advice on risk and control.

Internal Audit Functions/Assignments

1. Value for money assignments (3 E’s)
2. The audit of IT systems
3. Financial audit and
4. Operational audit

Objectives of Internal Audit department

I. To ensure orderly and efficient conduct of business
II. To ensure safeguarding of assets (Physical and logical)
III. To ensure prevention and detection of frauds and errors
IV. To ensure timely preparation of accounting records
V. To ensure accuracy and completeness of financial records
VI. To ensure compliance with law and regulation

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Outsourcing Internal Audit department
Advantages
1. Greater focus on cost and efficiency of internal audit function
2. Staff may be drawn from a broader range of expertise
3. Risk of staff turnover is passed to the outsourcing firm
4. Specialist skills may be more readily available
5. Cost of employing permanent staff are avoided
6. May improve independence’
7. Access to new market place technologies e.g. audit methodology
8. Reduced permanent time in administering an in house department

Disadvantages
1. Possible conflict of interest if provided by external auditor
2. Pressure on the independence of outsourced function due to (threat by
management not to renew contract
3. Risk of lack of knowledge and understanding of organization’s objective, culture
or business
4. Decision may be based on cost with effectiveness of the function being reduced
5. Flexibility and availability may not be as high as with an in house function
6. Lack of control over standard of service
7. Risk of blurring of roles between internal and external audit, losing credibility of
both

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 Some other Important Areas:
 Going concern
o Definition
o Indicators
o Audit procedures for verification of going concern assumption
o Effect on audit report
 Subsequent events
o Definition
o Accounting treatment
o Audit procedures for verification of subsequent events
o Effect on audit report
 CAATs (computer assisted auditing techniques)
o Definition and types
 Audit software
 Test data
o Advantages and disadvantages of CAATs.
 Sampling
o Definition and statistical & non statistical sampling
o Sampling and non-sampling risk
o Types of sampling method
 Random selection
 Systematic sampling
 Stratification
 Block selection
 Haphazard selection
 Monitory unit selection
 Value weighted average selection
 Regulatory authorities (IFAC etc.) and Auditor’s appointment etc.

Important Note
 Solution to below questions will be provided in class.
 Further practice will be done from exam kit, other study material and through
testing/class assignments to cover all areas.
 Further notes will be provided on audit procedures.

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Some important practice questions
1 Code of Ethics (June-10)

(a) State the FIVE threats contained within ACCA’s Code of Ethics and Conduct and for
each threat list ONE example of a circumstance that may create the threat. (5 marks)

(b)
You are the audit manager of Jones & Co and you are planning the audit of LV Fones Co, which
has been an audit client for four years and specializes in manufacturing luxury mobile phones.
During the planning stage of the audit you have obtained the following information. The
employees of LV Fones Co are entitled to purchase mobile phones at a discount of 10%. The
audit team has in previous years been offered the same level of staff discount.
During the year the financial controller of LV Fones was ill and hence unable to work. The
company had no spare staff able to fulfill the role and hence a qualified audit senior of Jones &
Co was seconded to the client for three months. The audit partner has recommended that the
audit senior work on the audit as he has good knowledge of the client. The fee income derived
from LV Fones was boosted by this engagement and along with the audit and tax fee, now
accounts for 16% of the firm’s total fees.

From a review of the correspondence files you note that the partner and the finance director have
known each other socially for many years and in fact went on holiday together last summer with
their families. As a result of this friendship the partner has not yet spoken to the client about the
fee for last year’s audit, 20% of which is still outstanding.

Required:

(i) Explain the ethical threats which may affect the independence of Jones & Co’s audit of
LV Fones Co; and (5 marks)

(ii) For each threat explain how it might be avoided. (5 marks)

(c) Describe the steps an audit firm should perform prior to accepting a new audit
engagement. (5 marks)

(20 marks)

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2 Planning and Audit risk
(a) In agreeing the terms of an audit engagement, the auditor is required to agree the basis on
which the audit is to be carried out. This involves establishing whether the preconditions for an
audit are present and confirming that there is a common understanding between the auditor and
management of the terms of the engagement.

Required:
Describe the process the auditor should undertake to assess whether the
PRECONDITIONS for an audit are present. (3 marks)

(b) List FOUR examples of matters the auditor may consider when obtaining an
understanding of the entity. (2 marks)
(c) You are the audit senior of White & Co and are planning the audit of Redsmith Co for the year
ended 30 September 2010. The company produces printers and has been a client of your firm for
two years; your audit manager has already had a planning meeting with the finance director. He
has provided you with the following notes of his meeting and financial statement extracts.

Redsmith’s management were disappointed with the 2009 results and so in 2010 undertook a
number of strategies to improve the trading results. This included the introduction of a generous
sales-related bonus scheme for their salesmen and a high profile advertising campaign. In
addition, as market conditions are difficult for their customers, they have extended the credit
period given to them.

The finance director of Redsmith has reviewed the inventory valuation policy and has included
additional overheads incurred this year as he considers them to be production related. He is
happy with the 2010 results and feels that they are a good reflection of the improved trading
levels.

Financial statement extracts for year ended 30 September

DRAFT ACTUAL
2010 2009
$m $m
Revenue 23·0 18·0
Cost of Sales (11·0) (10·0)
––––– –––––
Gross profit 12·0 8·0
Operating expenses (7·5) (4·0)
––––– –––––
Profit before interest and taxation 4·5 4·0
–––––––––– ––––––––––
Inventory 2·1 1·6
Receivables 4·5 3·0
Cash – 2·3
Trade payables 1·6 1·2
Overdraft 0·9 –

Required:

Using the information above:

(i) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning
the audit; and (5 marks)
(ii) From a review of the above information and the ratios calculated, explain the audit
risks that arise and describe the appropriate response to these risks. (10 marks)
(20 marks)

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3 Risk assessment (June-08)
(a) With reference to ISA 520 Analytical Procedures explain
(i) what is meant by the term ‘analytical procedures’; (2 marks)
(ii) the different types of analytical procedures available to the auditor; and
(3 marks)
(iii) the situations in the audit when analytical procedures can be used.
(3 marks)
Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with
income being in the form of cash and debit cards. All items purchased are delivered to the
customer using Zak’s own delivery vans; most sheds are too big for individuals to transport in
their own motor vehicles. The directors of Zak indicate that the company has had a difficult year,
but are pleased to present some acceptable results to the members.
The income statements for the last two financial years are shown below:
Income statement
31 March 2008 31 March 2007
$000 $000
Revenue 7,482 6,364
Cost of sales (3,520) (4,253)
–––––– ––––––
Gross profit 3,962 2,111
Operating expenses
Administration (1,235) (1,320)
Selling and distribution (981) (689)
Interest payable (101) (105)
Investment income 145 –
–––––– ––––––
Profit/(loss) before tax 1,790 (3)
–––––––––––– ––––––––––––
Financial statement extract
–––––– ––––––
Cash and bank 253 (950)
–––––––––––– ––––––––––––
Required:

(b) As part of your risk assessment procedures for Zak Co, identify and provide a possible
explanation for unusual changes in the income statement. (9 marks)

(c) Confirmation of the end of year bank balances is an important audit procedure.
Required:
Explain the procedures necessary to obtain a bank confirmation letter from Zak Co’s bank.
(3 marks)
(20 marks)

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Answer
2.
(a) ISA 210 Agreeing the Terms of Audit Engagements provides guidance to auditors on the steps they
should take in accepting a new audit or continuing on an existing audit engagement. It sets out a number of
processes that the auditor should perform including agreeing whether the preconditions are present,
agreement of audit terms in an engagement letter, recurring audits and changes in engagement terms.

To assess whether the preconditions for an audit are present the auditor must determine whether the
financial reporting framework to be applied in the preparation of the financial statements is acceptable. In
considering this the auditor should assess the nature of the entity, the nature and purpose of the financial
statements and whether law or regulations prescribes the applicable reporting framework.

In addition they must obtain the agreement of management that it acknowledges and understands its
responsibility for the following:

– Preparation of the financial statements in accordance with the applicable financial reporting framework,
including where relevant their fair presentation;
– For such internal control as management determines is necessary to enable the preparation of financial
statements that are free from material misstatement, whether due to fraud or error; and
– To provide the auditor with access to all relevant information for the preparation of the financial
statements, any additional information that the auditor may request from management and unrestricted
access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.

If the preconditions for an audit are not present, the auditor shall discuss the matter with management.
Unless required by law or regulation to do so, the auditor shall not accept the proposed audit engagement:

– If the auditor has determined that the financial reporting framework to be applied in the preparation of the
financial statements is unacceptable; or
– If management agreement of their responsibilities has not been obtained.

(b) Matters to consider in obtaining an understanding of the entity:

– The market and its competition
– Legislation and regulation
– Regulatory framework
– Ownership of the entity
– Nature of products/services and markets
– Location of production facilities and factories
– Key customers and suppliers
– Capital investment activities
– Accounting policies and industry specific guidance
– Financing structure
– Significant changes in the entity on prior years.

(c) (i) Ratios to assist the audit supervisor in planning the audit:

2010 2009

Gross margin 12/23 = 52·2% 8/18 = 44·4%

Operating margin 4·5/23 = 19·6% 4/18 = 22·2%
Inventory days 2·1/11 * 365 = 70 days 1·6/10 * 365 = 58 days
Receivable days 4·5/23 * 365 = 71 days 3·0/18 * 365 = 61 days
Payable days 1·6/11 * 365 = 53 days 1·2/10 * 365 = 44 days
Current ratio 6·6/2·5 = 2·6 6·9/1·2 = 5·8
Quick ratio (6·6 – 2·1)/2·5 = 1·8 (6·9 – 1·6)/1·2 = 4·4

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(ii)
Audit risk Response to risk

Management were disappointed with 2009 results Throughout the audit the team will need to be alert
and hence undertook strategies to improve the 2010 to this risk. They will need to carefully review
trading results. There is a risk that management judgmental decisions and compare treatment
might feel under pressure to manipulate the results against prior years
through the judgements taken or through the use of
provisions.

A generous sales-related bonus scheme has been Increased sales cut-off testing will be performed
introduced in the year, this may lead to sales cut-off along with a review of post year-end sales returns
errors with employees aiming to maximise their as they may indicate cut-off errors.
current year bonus

Revenue has grown by 28% in the year however, During the audit a detailed breakdown of sales will
cost of sales has only increased by 10%. This be obtained, discussed with management and
increase in sales may be due to the bonus scheme tested in order to understand the sales increase.
and the advertising however, this does not explain
the increase in gross margin. There is a risk that
sales may be overstated.

Gross margin has increased from 44·4% to 52·2%. The classification of costs between cost of sales and
Operating margin has decreased from 22·2% to operating expenses will be compared with the prior
19·6%. This movement in gross margin is significant year to ensure consistency.
and there is a risk that costs may have been omitted
or included in operating expenses rather than cost of
sales. There has been a significant increase in
operating expenses which may be due to the bonus
and the advertising campaign but could be related to
the misclassification of costs.

The finance director has made a change to the The change in the inventory policy will be discussed
inventory valuation in the year with additional with management and a review of the additional
overheads being included. In addition, inventory overheads included performed to ensure that these
days have increased from 58 to 70 days. There is a are of a production nature.
risk that inventory is overvalued.
Detailed cost and net realizable value testing to be
performed and the aged inventory report to be
reviewed
to assess whether inventory requires writing down

Receivable days have increased from 61 to 71 days Extended post year-end cash receipts testing and a
and management have extended the credit period review of the aged receivables ledger to be
given to customers. This leads to an increased risk performed to assess valuation.
of recoverability of receivables.

The current and quick ratios have decreased from Detailed going concern testing to be performed
5·8 to 2·6 and 4·4 to 1·8 respectively. In addition, the during the audit and discussed with management to
cash balances have decreased significantly over the ensure that the going concern basis is reasonable.
year. Although all ratios are above the minimum
levels, this is still a significant decrease and along
with the increase of sales could be evidence of
overtrading which could result in going concern
difficulties.

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