SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 AUDIT & ASSURANCE [P2] PROFESSIONAL LEVEL

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1 Question No. 1 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 (a) Outsourcing of Internal Audit Function: 07 Outsourcing is where the company uses an external company to perform its internal audit service instead of employing its own staff. Following are the advantages and disadvantages of outsourcing the internal audit function: Advantages: (Any four) Greater focus on cost and efficiency of the internal audit function. Staff may be drawn from a broader range of expertise. Risk of staff turnover is passed to the outsourcing firm. Specialist skills may be more readily available. Costs of employing permanent staff are avoided. May improve independence. Access to new market place technologies, e.g. audit methodology software without associated costs. Reduced management time in administering an in-house department. Disadvantages: (Any four) Pressure on the independence of the outsourced function due to e.g. threat by management not to renew contract. Risk of lack of knowledge and understanding of the organization s objectives, culture or business. The decision may be based on cost with the effectiveness of the function being reduced. Flexibility and availability may not be as high as with an in-house function. Lack of control over standard of service. Risk of blurring of roles between internal and external audit, losing credibility of both. (b) Reporting System: 08 The Head of Internal Audit reports directly to the Chief Financial Officer (CFO) of the company. This limits the effectiveness of the internal audit reports as the CFO is also responsible for some of the financial systems that the internal auditor is reporting on. Similarly the Head of Internal Audit may soften or limit criticism in reports to avoid confrontation with the CFO. To ensure independence, the internal auditor should report to the Audit Committee. Scope of Works: The scope of work of internal audit is decided by the CFO in discussion with the Head of Internal Audit. This means that the CFO may try and influence the Head of Internal Audit regarding the areas that the internal audit department is auditing, possibly directing attention away from any contentious areas that the director does not want auditing. To ensure independence, the scope of work of the internal audit department should be decided by the Head of Internal Audit, perhaps with the assistance of an Audit Committee.

2 Audit Work: SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 The Head of Internal Audit appears to be auditing the controls which were proposed by that department. This limits independence as the auditor is effectively auditing his own work, and may not therefore identify any mistakes. To ensure independence, the Head of Internal Audit should not establish control systems in SLL. However, where controls have already been established, another member of the internal audit should carry out the audit of petty cash to provide some limited independence. Length of Service of Internal Audit Staff: All internal audit staff at SLL have been employed for at least five years. This may limit their effectiveness as they will be very familiar with the systems being reviewed and therefore may not be sufficiently objective to identify errors in those systems. To ensure independence, the existing staff should be rotated into different areas of internal audit work and the Head of Internal Audit independently review the work carried out. Appointment of Head of Internal Audit. The Head of Internal Audit is appointed by the Chief Executive Officer (CEO) of SLL. Given that the CEO is responsible for the running of the company, it is possible that there will be bias in the appointment someone who he knows will not criticise his work or the company. To ensure independence, the Head of Internal Audit should be appointed by an Audit Committee and appointment shall be approved by the Board of Directors. Question No. 2 Preconditions for an Audit: (a) (i) Preconditions for an Audit: 03 Auditors should only accept a new audit engagement, or continue an existing audit engagement if the preconditions for an audit required by ISA 210 Agreeing the Terms of Audit Engagements, are present. ISA 210 requires the auditor to: determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable. obtain the agreement of management that it acknowledges and understands its responsibilities for the following: preparing the financial statements in accordance with the applicable financial reporting framework. internal control necessary for the preparation of the financial statements to be free from material misstatement. providing the auditor with access to information relevant for the audit and access to staff within the entity to obtain audit evidence. (ii) If the preconditions for an audit are not present, the auditor should discuss the matter with management, and should not accept the engagement unless required to do so by law or regulation. 02

3 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 (b) Procedures due to Increased Risk of Fraud: 05 The audit senior should consider undertaking the following procedures as a result of the increased risk of the payroll fraud. Discuss with management and those charged with governance as to whether they are aware of any other payroll frauds or potential frauds. Review Board minutes for evidence of management discussion of the materiality of the payroll fraud and to the existence of any additional frauds or suspected frauds. Discuss with the Payroll Manager the nature of the payroll fraud, how it occurred and the financial impact of amounts incorrectly paid into the Payroll Officer s bank account. Review the supporting documentation to confirm the total of the fraudulent payments made and assess the materiality of this misstatement. Review and test the internal controls surrounding setting up of and payments to new joiners to assess whether further frauds may have occurred. Consider whether other information obtained by the audit team indicates risks of additional material misstatements with regards to payroll fraud. Obtain a written representation from management acknowledging that they have disclosed to the auditors all knowledge of actual and suspected payroll frauds. Question No. 3 (a) Advantages of Audit Planning: 04 Planning an audit involves establishing the overall audit strategy for the engagement and developing an audit plan. ISA 300 Planning an Audit of Financial Statements, states that adequate planning benefits the audit of financial statements in several ways, including the following: Helping the auditor to devote appropriate attention to important areas of the audit. Helping the auditor to identify and resolve potential problems on a timely basis. Helping the auditor to properly organize and manage the audit engagement so that it is performed in an effective and efficient manner. Assisting in the selection of engagement team members with appropriate levels of capabilities and competence to respond to anticipated risks and the proper assignment of work to them. Facilitating the direction and supervision of engagement team members and the review of their work. Assisting, where applicable, in coordination of work done by auditors of components and experts.

4 (b) (i) & (ii) SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 Threat Potential Employment with an Audit Client: A self interest threat may arise where a member of the engagement team has reason to believe they may become an employee of the client. They will not wish to do anything to affect their potential future employment. Taxation Service to an Audit Client: Tax calculations for inclusion in the financial statements and tax planning advice create a self review threat. Completion of tax returns is not deemed to create a self review threat. Audit Staff Leave the Firm to Join the Client. A self interest familiarity or intimidation threat may arise where an employee of the firm becomes a director or employee of an assurance client (in a position to exert significant influence over the financial statements or subjects matter of another assurance engagement). The threat is significant if significant connection remains between the employee and the firm such as entitlement to benefits or payments from the firm, or participate in the firms business and professional activities. For public interest entities, independence would be deemed to be compromised unless, subsequent to the partner, the public interest entity had issued audited financial statements covering a period of not less than twelve months and the partner was not a member of the audit team with respect to the audit of those financial statements. Safeguard The policies and procedures of the firm should require such individuals to notify the firm of the possibility of employment with the client. Removal of the individual from the assurance engagement. Performing an independent review of any significant judgements made by that individual. A firm cannot prepare tax calculations for an audit client that is listed, except in an emergency. Where services are provided, separate teams must be used. Reviewing (and revising) the composition of the engagement team. Performing an independent partner/quality control review of the engagement

5 Question No. 4 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 (a) Internal Control Components: 05 ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment considers the components of an entity s internal control. It identifies the following components: Control Environment: The control environment includes the governance and management functions and the attitudes, awareness, and actions of those charged with governance and management concerning the entity s internal control and its importance in the entity. The control environment sets the tone of an organisation, influencing the control consciousness of its people. The control environment has many elements such as communication and enforcement of integrity and ethical values, commitment to competence, participation of those charged with governance, management s philosophy and operating style, organisational structure, assignment of authority and responsibility and human resource policies and practices. Entity s Risk Assessment Process: For financial reporting purposes, the entity s risk assessment process includes how management identifies business risks relevant to the preparation of financial statements in accordance with the entity s applicable financial reporting framework. It estimates their significance, assesses the likelihood of their occurrence, and decides upon actions to respond to and manage them and the results thereof. Information System, including the Related Business Processes, Relevant to Financial Reporting, and Communication: The information system relevant to financial reporting objectives, which includes the accounting system, consists of the procedures and records designed and established to initiate, record, process, and report entity transactions (as well as events and conditions) and to maintain accountability for the related assets, liabilities, and equity. Control Activities Relevant to the Audit Control activities are the policies and procedures which help ensure that management directives are carried out. Control activities, whether within information technology or manual systems, have various objectives and are applied at various organisational and functional levels. Monitoring of Controls Monitoring of controls is a process to assess the effectiveness of internal control performance over time. It involves assessing the effectiveness of controls on a timely basis and taking necessary remedial actions. Management accomplishes the monitoring of controls through ongoing activities, separate evaluations, or a combination of the two. Ongoing monitoring activities are often built into the normal recurring activities of an entity and include regular management and supervisory activities.

6 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 (b) Importance of Reporting to those Charged with Governance: 03 In accordance with ISA 260 Communication with Those Charged with Governance, it is important for the auditors to report to those charged with governance as it helps in the following ways: (1) It assists the auditor and those charged with governance in understanding matters related to the audit, and in developing a constructive working relationship. This relationship is developed while maintaining the auditor s independence and objectivity. (2) It helps the auditor in obtaining, from those charged with governance, information relevant to the audit. For example, those charged with governance may assist the auditor in understanding the entity and its environment, in identifying appropriate sources of audit evidence and in providing information about specific transactions or events. (3) It helps those charged with governance in fulfilling their responsibility to oversee the financial reporting process, thereby reducing the risks of material misstatement of the financial statements. (c) (i) & (ii) Purchase and Payment System: Any four deficiency, potential effect and recommendation = Deficiency Potential Effect Recommendation When raising purchase orders, the Order Clerk choose the supplier on the basis of fast delivery. Purchase orders are not sequentially numbered. Purchase orders below Rs.10,000 are not authorised and are processed solely by an order clerk. This could result in GHC ordering goods at a much higher price or a lower quality than they would like, as the only factor considered was speed of delivery. It is important that goods are dispatched promptly, but this is just one of many criteria that should be used in deciding which supplier to use. Failing to sequentially number the orders means that GHC s ordering team are unable to monitor if all orders are being fulfilled in a timely manner; this could result in stock outs. If the orders are numbered, then a sequence check can be performed for any unfulfilled orders. This can result in goods being purchased which are not required by GHC. In addition, there is an increased fraud risk as an order clerk could place orders for personal goods up to the value of Rs. 10,000, which is significant. An approved supplier list should be compiled; this should take into account the price of goods, their quality and also the speed of delivery. Once the list has been produced, all orders should only be placed with suppliers on the approved list. All purchase orders should be sequentially numbered and on a regular basis a sequence check of unfulfilled orders should be performed. All purchase orders should be authorised by a responsible official. Authorised signatories should be established with varying levels of purchase order authorisation.

7 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 Purchase invoices are input daily by the Purchase Officer and due to his experience, he does not utilise any application controls. Deficiency Potential Effect Recommendation Without application controls there is a risk that invoices could be input into the system with inaccuracies or they may be missed out entirely. This could result in suppliers being paid incorrectly or not all, leading to a loss of supplier goodwill. The purchase day book automatically updates with the purchase ledger but this ledger is manually posted to the general ledger. GHC s saving (deposit) bank accounts are reconciled quarterly. GHC has a policy of delaying payments to their suppliers for as long as possible. The Director Finance authorises the bank transfer payment list for suppliers; however, he only views the total amount of payments to be made. Manually posting the amounts to the general ledger increases the risk of errors occurring. This could result in the payables balance in the financial statements being under or overstated. If these accounts are only reconciled periodically, there is the risk that errors will not be spotted promptly. Also, this increases the risk of employees committing fraud. If they are aware that these accounts are not regularly reviewed, then they could use these cash sums fraudulently. Whilst this maximises GHC s bank balance, there is the risk that GHC is missing out on early settlement discounts. Also, this can lead to a loss of supplier goodwill as well as the risk that suppliers may refuse to supply goods to GHC. Without looking at the detail of the payments list, as well as supporting documentation, there is a risk that suppliers could be being paid an incorrect amount, or that sums are being paid to fictitious suppliers. The Purchas Officer should input the invoices in batches and apply application controls, such as control totals, to ensure completeness and accuracy over the input of purchase invoices. The process should be updated so that on a regular basis the purchase ledger automatically updates the general ledger. A responsible official should then confirm through purchase ledger control account reconciliations that the update has occurred correctly. All bank accounts should be reconciled on a regular basis, and at least monthly, to identify any unusual or missing items. The reconciliations should be reviewed by a responsible official and they should evidence their review. GHC should undertake cash flow forecasting/budgeting to maximise bank balances. The policy of delaying payment should be reviewed, and suppliers should be paid in a systematic way, such that supplier goodwill is not lost. The Director Finance should review the whole payments list prior to authorising. As part of this, he should agree the amounts to be paid to supporting documentation, as well as reviewing the supplier names to identify any duplicates or any unfamiliar names. He should evidence his review by signing the bank transfer list.

8 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 Question No. 5 (a) (i) The requirements to be complied with as per ISA 620 before engaging the expert would be as follows: 04 The Competence, Capabilities and Objectivity of the Auditor s Expert: The auditor shall evaluate whether the auditor s expert has the necessary competence, capabilities and objectivity for the auditor s purposes. In the case of an auditor s external expert, the evaluation of objectivity shall include inquiry regarding interests and relationships that may create a threat to that expert s objectivity. Obtaining an Understanding of the Field of Expertise of the Auditor s Expert: The auditor shall obtain a sufficient understanding of the field of expertise of the auditor s expert to enable the auditor to : (a) Determine the nature, scope and objectives of that expert s work for the auditor s purposes; and (b) Evaluate the adequacy of that work for the auditor s purposes. (ii) Evaluating the Adequacy of the Auditor s Expert s Work: The auditor shall evaluate the adequacy of the auditor s expert s work for the auditor s purposes, including: The relevance and reasonableness of that expert s findings or conclusions, and their consistency with other audit evidence; If that expert s work involves use of significant assumptions and methods, the relevance and reasonableness of those assumptions and methods in the circumstances; and If that expert s work involves the use of source data that is significant to that expert s work, the relevance, completeness, and accuracy of that source data. 03 (iii) Course of Actions Available to the Auditors, If They Determine that the Work of the Auditor Expert is not Adequate for the Audit Purpose: 02 If the auditor determines that the work of the auditor s expert is not adequate for the auditor s purposes, the auditor shall: Agree with that expert on the nature and extent of further work to be performed by that expert; or Perform additional audit procedures appropriate to the circumstances. (b) (i) Anomaly: A misstatement or deviation that is demonstrably not representative of misstatements or deviations in a population. (ii) Stratification: The process of dividing a population into sub-populations, each of which is a group of sampling units which have similar characteristics (often monetary value). (iii) Tolerable misstatement: A monetary amount set by the auditor in respect of which the auditor seeks to obtain an appropriate level of assurance that the monetary amount set by the auditor is not exceeded by the actual misstatement in the population

9 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 Question No. 6 Substantive Procedures for Receivables: (Any four) Review the aged receivable ledger to identify any slow moving or old receivable balances, discuss the status of these balances with the credit controller to assess whether they are likely to pay. Select a significant sample of receivables and review whether there are any after date cash receipts, ensure that a sample of slow moving/old receivable balances is also selected. Review customer correspondence to identify any balances which are in dispute or unlikely to be paid. Review board minutes to identify whether there are any significant concerns in relation to payments by customers. Calculate average receivable days and compare this to prior year, investigate any significant differences. Inspect post year-end sales returns/credit notes and consider whether an additional Select a sample of goods despatched notes (GDN) before and just after the year end and follow through to the sales ledger to ensure they are recorded in the correct accounting period. Select a sample of year-end receivable balances and agree back to valid supporting documentation of GDN and sales order to ensure existence. Substantive Procedures for Bank Loan: (Any four) Agree the opening balance of the bank loan to the prior year audit file and financial statements. For any loan payments made during the year, agree the cash outflow to the cash book and bank statements. Review bank correspondence to identify whether any late payment penalties have been levied and agree these have been charged to profit or loss account as a finance charge. Obtain direct confirmation at the year end from the loan provider of the outstanding balance and any security provided; agree confirmed amounts to the loan schedule and financial statements. Review the loan agreement for details of covenants and recalculate to identify any breaches in these. Agree closing balance of the loan to the trial balance and draft financial statements and that the disclosure is adequate, including any security provided, that the loan is disclosed as a current liability and disclosure is in accordance with accounting standards and local legislation. Substantive Procedures for Revaluation of Property, Plant and Equipment (PPE): (Any four) Obtain a schedule of all PPE revalued during the year and cast to confirm completeness and accuracy of the revaluation adjustment and agree to trial balance and financial statements. Consider the competence and capability of the valuer, Mr. Tariq, by assessing through enquiry his qualification, membership of a professional body and experience in valuing these types of assets. Consider whether the valuation undertaken provides sufficiently objective audit evidence. Discuss with management whether Mr. Tariq has any financial interest in CPM which along with the family relationship could have had an impact on his independence. Agree the revalued amounts to the valuation statement provided by the valuer. Review the valuation report and consider if all assets in the same category have been revalued in line with IAS 16 Property, Plant and Equipment. Agree the revalued amounts for these assets are included correctly in the non-current assets register. Recalculate the total revaluation adjustment and agree correctly recorded in the revaluation surplus. Recalculate the depreciation charge for the year to ensure that for the assets revalued during the year, the depreciation was based on the correct valuation and was for 12 months. Review the financial statements disclosures relating to the revaluation to ensure they comply with IAS

10 Question No. 7 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 (a) Purpose of Final Review: It is the responsibility of the engagement partner to perform a review of audit documentation (including a discussion with the engagement team) in order to satisfy themselves that sufficient appropriate evidence has been obtained to support any conclusions reached and, ultimately, the audit opinion. Considerations include, for example: (any five) Has work been performed in accordance with professional standards? 05 Have the significant risks identified during planning been addressed? Are there any critical areas of judgment relating to difficult or contentious matters? Have the objectives of the engagement procedures been achieved? Does the work documented support the conclusions made? Is there a need to revise the nature, timing and extent of procedures? Is the evidence sufficient to support an opinion? Reviews are also significant for a firm s appraisal system and development of staff. Additionally they are an important element of any monitoring system, implemented to identify and rectify deficiencies that could lead to poor quality work. Appropriate review procedures are an integral part of an audit and are a requirement of ISA 220 Quality Control for an Audit of Financial Statements. (b) Emphasis of Matter Paragraph: A paragraph included in the auditor s report that refers to a matter appropriately presented or disclosed in the financial statements that, in the auditor s judgment, is of such importance that it is fundamental to users understanding of the financial statements. Examples of circumstances where the auditor may consider it necessary to include an Emphasis of Matter paragraph are; An uncertainty relating to the future outcome of exceptional litigation or regulatory action. 05 Early application (where permitted) of a new accounting standard (for example, a new International Financial Reporting Standard) that has a pervasive effect on the financial statements in advance of its effective date. A major catastrophe that has had, or continues to have, a significant effect on the entity s financial position.

11 SUGGESTED SOLUTIONS/ ANSWERS EXTRA ATTEMPT EXAMINATIONS, MAY of 11 (c) Types of Audit Reports: 10 (i) (ii) The financial statements are materially misstated since this is a contingent liability in accordance with IAS 37 and so should be disclosed by note. The matter is material. A modified report with a qualified opinion will be issued (using the except for wording) due to a material omission. The financial statements are materially misstated as the event after the reporting date is an adjusting event in accordance with IAS 10 and therefore the debt should be written off. The debt of Rs.300,000 is material since it is 10% of profit and 23.08% of the total receivables. A report with a qualified opinion will be issued (using the except for wording) due to a material misstatement. (iii) An unmodified opinion would be issued since the auditors agree with the treatment and disclosure of the contingent liability. However. there is a fundamental uncertainty (the outcome of the court case will be determined in the future). The report would be modified with an emphasis of matter paragraph. (iv) There is a lack of sufficient appropriate audit evidence, specifically relating to the valuation of inventory. Inventory is a material amount since it is 8.75% of sales revenue and 20% of profit. A modified report with a qualified opinion will be issued (using the except for wording) due an inability to obtain sufficient appropriate audit evidence. (v) There is a lack of sufficient appropriate audit evidence if there is no method available to confirm cash sales. The matter would be material and pervasive since if cash sales cannot be confirmed, it may also not be possible to verify other figures in the financial statements. A modified report with a disclaimer of opinion will be issued. NOTE: Where a modified opinion is required, the audit report will also require a basis for paragraph to explain the reason for the modification. The basis for paragraph to explain the reason for the modification. The basis for paragraph is included above the opinion paragraph. THE END