AUDITING PROFESSIONAL 1 EXAMINATION - APRIL 2014

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1 AUDITING PROFESSIONAL 1 EXAMINATION - APRIL 2014 NOTES: Section A - You are required to answer Questions 1, 2 and 3. Section B - You are required to answer any two out of Questions 4, 5, 6 and 7. (If you provide answers to more than two questions in this section, you must draw a clearly distinguishable line through the answer(s) not to be marked. Otherwise, only the first two answers to hand for these four questions will be marked.) TIME ALLOWED: 3 hours, plus 10 minutes to read the paper. INSTRUCTIONS: During the reading time you may write notes on the examination paper but you may not commence writing in your answer book. Marks for each question are shown. The pass mark required is 50% in total over the whole paper. Start your answer to each question on a new page. You are reminded to pay particular attention to your communication skills, and care must be taken regarding the format and literacy of your solutions. The marking system will take into account the content of your answers and the extent to which answers are supported with relevant legislation, case law or examples, where appropriate. List on the cover of each answer booklet, in the space provided, the number of each question attempted. The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.

2 THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND AUDITING PROFESSIONAL 1 EXAMINATION - APRIL 2014 Time Allowed: 3 hours, plus 10 minutes to read the paper. Section A - You are required to answer Questions 1, 2 and 3. Section B - You are required to answer any two out of Questions 4, 5, 6 and 7. (If you provide answers to more than two questions in this section, you must draw a clearly distinguishable line through the answer(s) not to be marked. Otherwise, only the first two answers to hand for these four questions will be marked.) SECTION A - Questions 1, 2 and 3 are compulsory. 1. You are a trainee auditor with Williams and Company and have been assigned audit responsibility of the property, plant and equipment of Nemo, a company engaged in the manufacture and supply of bottled flavoured water to the retail, catering and leisure industries. You have been provided with the following schedule summarising the movements in tangible non-current assets during the year ended 31 October Land & Buildings Plant and equipment Total Cost 1 Nov ,867 3,641 5,508 Additions 1, ,918 Disposals 0 (72) (72) At 31 Oct ,079 4,275 7,354 Depreciation At 1 Nov ,645 2,155 Charge for the year Disposal 0 (51) (51) At 31 Oct ,029 2,578 Net Book Value At 1 Nov ,357 1,996 3,353 At 31 Oct ,530 2,246 4,776 In recent discussions with the finance director, you ascertain that a capital expenditure budget is prepared annually. Departmental managers may authorise capital expenditure up to 5,000, as long as it is within their budget. Board approval is required for amounts above the 5,000 threshold. However, the managing director, who is also the major shareholder in the company, does not always adhere to this policy. He often commits the company to acquiring assets without considering how they are to be financed, leaving the finance director to arrange the borrowings. Capital expenditure proposal forms are required to be completed but this is not always done, particularly when items are required in an emergency, and there is no formal policy in respect of obtaining quotes for major items of expenditure. There is a property, plant and equipment register which is reconciled to the nominal ledger on a monthly basis. No other checking procedures involving the non-current asset register are undertaken. Page 1

3 REQUIREMENT: (a) (b) Discuss the significant deficiencies in Nemo s tangible non-current asset control system. Your discussion should incude the possible implication of each deficiency and the recommendation to address each one. (10 marks) Describe FIVE substantive audit procedures that an auditor would normally carry out on the tangible noncurrent assets of Nemo, and explain the purpose of each procedure. (10 marks) [Total: 20 Marks] 2. (a) The training partner in your firm has just given you a list of the following typical questions about stocktakes which recur regularly among the firm s trainee auditors. REQUIREMENT: Prepare brief notes on each of the following: (i) The client did not provide any stocktaking guidelines. Is that a problem? (3 marks) (ii) (iii) What kind of details would you expect to find on properly completed stocktake sheets and what should be done if these details are missing? (3 marks) What does the term cut-off details mean and what are the implications for the auditor and the client? (3 marks) (iv) What is the auditor s responsibility concerning obsolete stock? (3 marks) (b) You are auditing the stock system of Augustus Ltd and you are placing reliance upon the client s stock system for the details of the year end closing stock. The following is an example of one of the computerised reports available for the firm s stock items: Stock Movements; December 2013; Item; Widgets Date Document Reference Units In Units Out Balance in units 01 December Opening Balance December Despatch Note December Good Received Note No December Despatch Note December Good Received Note No December Despatch Note REQUIREMENT: (i) Discuss the reliability of this stock movement report as a source of audit evidence. (3 marks) (ii) Describe the audit tests which should be carried out on this stock movement report to establish that the opening balance, dispatches and goods received entries recorded are authorised, accurate and complete. (5 marks) [Total: 20 Marks] Page 2

4 3. You are planning the audit of Derry Ltd (Derry) for the year ended 31 December The company manufactures and sells products made from imported timber. In recent years, the company has expanded into the manufacture of quality childrens garden swings and slides which are sold with a 10-year guarantee. Most sales are to domestic customers, but the company also has a small export market which has grown steadily over the last few years. At a planning meeting with the finance director, the following matters were discussed: Operating Activities During the year, the company s revenue increased by 20% and the gross and operating margins increased by 5% and 2% respectively. Inventory and trade receivable balances are significantly higher than the previous year as a result of this increased activity. Online ordering on the company s website commenced in January Internet orders have grown steadily but only still represent a small percentage of the total of company sales. However, the company continues to invest in the website to maintain its speed and ease of use for customers. Payroll Following the successful implementation of a new computer system two years ago, payroll processing, which had been outsourced for many years, was brought back in house from 1 March Management was unhappy with the service provided by the external payroll company and cancelled the contract. Additional staff have been recruited to process the payroll. Managing Director (MD) The MD has announced his intention to sell his 100% shareholding in Derry in order to concentrate on his other business interests. Negotiations are underway with a potential buyer for his shares. REQUIREMENT: (a) (b) (c) Using the information provided, discuss the key audit risks and recommend an appropriate auditor s response to each risk in planning the audit of Derry. (10 marks) Explain the substantive procedures which the auditor should perform to confirm the accuracy and completeness of Derry s payroll charge. (6 marks) Discuss briefly what is meant by audit rotation and outline its supposed benefits and drawbacks. (4 marks) [Total: 20 Marks] Page 3

5 SECTION B Answer only 2 questions from this section. 4. You are a recently qualified Certified Public Accountant in charge of the internal audit department of IC ltd (IC), a rapidly expanding company. Turnover at IC has increased by about 20% per annum for the last five years, to the current level of 10 million. Net profits are also high, with an acceptable return being provided for the four shareholders. The internal audit department was established last year to assist the board of directors in their control of the company and to prepare for a possible listing on the stock exchange. The external auditors may seek to rely on work carried out by the internal audit department of their clients in the interest of audit efficiency. The Managing Director is keen to follow the principles of good corporate governance with respect to internal audit. However, he is also aware that the other board members do not have complete knowledge of corporate governance or detailed knowledge of International Standards of Auditing. REQUIREMENT: (a) Write a memo to the board of IC that: (i) Explains how the internal audit department can assist the board of directors in fulfilling their obligations under the principles of good corporate governance. (8 marks) (ii) Explains two advantages and disadvantages of an audit committee to IC. (4 marks) (b) Discuss the matters which the external auditor should consider at the planning stage to assess the effectiveness of a company s internal audit department. (8 marks) [Total: 20 Marks] Page 4

6 5. You are an audit supervisor in Island & Co and are currently reviewing documentation of Lisa and Co s (Lisa) purchases system in preparation for the interim audit. Lisa is a manufacturer of electrical goods. It has factories across the country and its customer base is medium and large retailers. The company s year-end is 31 March On receipt of an invoice by the head office accounts team, it is matched to and filed with the relevant goods receipt note (GRN), using the purchase order number marked on the invoice. If there is no purchase order number marked on the invoice, this must be obtained from the supplier. The invoice number is also noted on the GRN. The invoice is also checked to the original purchase order to ensure the agreed prices and discounts have been honoured. The purchases ledger clerk enters invoices onto the purchases system in batches. A batch control sheet is used, which details the number of invoices and the total value to be entered. These details are checked to the system batch report before confirming the data for processing by the system. Each invoice is stamped as "recorded" once the details have been entered onto the system. The purchase ledger manager inspects the file of invoices on a monthly basis to ensure that all invoices have been recorded. Suppliers are required to submit monthly supplier statements, which are reconciled to the relevant supplier s ledger account by the purchases ledger manager. The purchase ledger is reconciled to the purchase ledger control account on a monthly basis by the purchase ledger manager, and reviewed by the company accountant. The list of payments is sent to the company accountant by the purchase ledger manager. The company accountant agrees the details of each payment to the relevant invoice and signs each invoice to authorise payment and evidence that the check has been made. The list of payments is signed by the company accountant once all invoices have been checked, and sent to the cashier's office for payment. If any individual payment is for more than 25,000 or total payments are for more than 250,000 a second signatory is required. These payments must also be checked and signed by either the financial controller, or finance director. Payments are made by the cashier's office via bank transfer on a weekly basis. Invoices are stamped as "paid", and returned to the purchases ledger team who record the payment and file the invoices (separately from invoices not yet paid). The purchase ledger manager checks GRNs on a monthly basis to ensure that invoices have been received and paid on a timely basis. REQUIREMENT: (a) In respect of the internal controls within the purchase system of Lisa Co: (i) (ii) Discuss six effective controls in Lisa Co s purchasing system. Describe a test of control Island & Co would perform to assess if each of these controls is operating effectively. (12 marks) (b) Describe substantive procedures that should be performed at the year end to confirm the value of purchases included in the income statement of Lisa Co. (6 marks) (c) List four examples of external confirmations. (2 marks) [Total: 20 Marks] Page 5

7 6. Kildangan Co (Kildangan) is an established furniture retailer which has 500 stores in over 20 countries. Although still profitable the company has seen a significant decline in its sales over the last two years, mainly due to an economic downturn. Competition in the furniture retail sector has intensified with substantial price discounts now being offered to customers by most retailers. In addition to a 20m refurbishment programme for its retail stores, Kildangan has recently invested 1.5m in its online retailing platform. These investments have been funded by bank loans. This has enabled the company to be more competitive by reducing its prices for a number of its inventory lines. Its closest competitors have already established a successful online presence for a number of years. The company has recently been reprimanded by the advertising standards regulatory authority regarding claims it has made about some of its sustainable timber lines. As a result of this a senior product designer has left the company. Kildangan has no plans to close any of its stores at present and its rental charges for these stores continue to be one of the company s major costs. Two of Kildangan s major lenders have voiced concerns regarding the ability of the company to meet its borrowing costs and are considering withdrawing loans. The directors believe that the company has a bright long-term future due to its profitability and the promising sales figures from its online retailing arm. The auditors have been informed that the directors of Kildangan have arranged a meeting with a number of its lenders in order to discuss the possibility of restructuring its debt. This meeting is due to take place after the audit report is completed. REQUIREMENT: (a) Describe the responsibility of the auditor regarding the going concern assumption. (2 marks) (b) (c) (d) Assess any potential indicators that Kildangan is not a going concern and evaluate the possible impact on the ability of the company to continue trading. (8 marks) Recommend the audit procedures that the auditor of Kildangan should perform in assessing whether or not the company is a going concern. (6 marks) Describe the impact on the audit report if the auditors believe that a material uncertainty exists regarding the going concern status of Kildangan. (4 marks) [Total: 20 Marks] Page 6

8 7. Your firm has recently been appointed as the external auditor and tax advisor of CHC Hotels Co (CHC). CHC runs a chain of boutique hotels. James Hetrip the engagement partner, met with CHC s finance director Sue Moran, last week. During the meeting Sue offered James the role of financial controller once the current year audit is complete. Sue also suggested offering all the members of the audit team a free-night stay in a CHC hotel of their choice. Sue asked James to organise a meeting with his auditing firm s tax partner. Sue needs advice on whether to challenge the local tax authority in respect of its assessment of CHC s carried forward tax losses. Sue wants your firm to assist with any challenge to the local tax authority. REQUIREMENT: (a) Assess, with respect to the information provided above, the ethical threats which may affect the independence of your firm in respect of the audit of CHC Hotels Co. Advise how each threat might be appropriately managed. (10 marks) (b) According to ISA 530 Audit Sampling and Other Means of Testing the objective of the auditor, when using audit sampling, is to provide a reasonable basis to draw conclusions about the population from which the sample is selected. (i) Define audit sampling and describe four methods of sampling. (8 marks) (ii) Define sampling risk and explain how it affects sample size. (2 marks) [Total: 20 Marks] END OF PAPER Page 7

9 SUGGESTED SOLUTIONS THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND AUDITING PROFESSIONAL 1 EXAMINATION - APRIL 2014 SOLUTION 1: (a) Deficiency The MD overrides authorisation controls. This deficiency encourages breaches of the control system. Capital expenditure proposal forms are always not completed. Assets may be purchased that are not required or where alternatives may be more appropriate (such as hiring). The finance director is not consulted prior to purchasing assets. The pressure on the FD to finance the purchases could lead to unfavourable loan terms. There is no formal policy in respect of obtaining quotes for major items of expenditure. Assets may not be acquired on the most favourable terms or may be of poor quality No physical checks of the assets listed on the register take place. Assets that have been disposed but not removed from the asset register will not be identified. Assets which need to be written down due to physical impairment may not be identified. Increased risk of theft due a lack of deterrent Implication This increases the potential for fraud and inappropriate capital purchases. Asset purchases are a large expense. Any unnecessary expenditure may result in cash shortages, reduce profit (due to increased depreciation) and may result in Nemo being unable to pay debts as they fall due. High interest rates could significantly damage cash flow and profitability. Strict loan covenants could be breached, resulting in the loan being recalled and/or the asset repossessed. Nemo s profits will be advesly affected as it may incur additional and unnecessary costs in repairing or replacing poor quality assets. If it pays for an asset profits will also be reduced. Assets that are stolen will need to be replacing, incurring additional (and preventable) expense for Nemos. Assets and profit in the financial statements will be overstated. Recommendations A formal system of authorisation for all transactions (such as two directors formally authorising all capital purchases over 5,000) should be agreed by the board. Strict penalties should be agreed for any individual bypassing those controls. Capital expenditure forms should be completed at all times and formally agreed upon at board level. All decisions at meetings should be formally minuted. The FD should be given the opportunity to investigate financing options. The board should discuss the options and decide upon an appropriate course of action during board meetings. All decisions at meetings should be formally minuted. A minimum of three quotations should be obtained by the individual responsible for procurement. The options should be discussed and a course of action agreed upon at board meetings. All decisions at meetings should be formally minuted. A formal inspection of all assets should take place, at least annually, by a member of the accounts team who is not responsible for maintaining the tangible asset register. Items on the register should be inspected to prove existence and valuation. Page 8 (10 Marks)

10 (b) Procedure Select a sample of assets from the non-current asset register of Nemos and physically inspect them. Select a sample of physical assets in use at Nemo and inspect the non-current asset register to ensure they tested. Select a sample of non-current assets and reperform the calculation of depreciation for the year, using the rates disclosed in the financial statements. For a sample of non-current assets purchased in the year inspect the purchase invoices to confirm the cost that has been recorded in the asset ledger. Obtain a breakdown of the costs incurred in the construction of the new packing line. For a sample of costs recorded compare back to source documents, such as: timesheets (or other payroll records) for own and subcontract labour; raw materials invoices; and bills used for apportioning overheads. Recast the cost, depreciation and net book value totals in the non-current asset ledger. For a sample of assets (in particular those acquired on a leasing basis) inspect a copy of the invoice or other contractual deeds to confirm that legal title (or risks and rewards of ownership) have passed to Nemo. Inspect the property plant and equipment note. Agree opening balances to the prior year s accounts and closing balances to the closing trial balance. Recast total balances. Reason Inspection of tangibles proves that the non-current assets recorded exist and identifies any obvious damage that might require an impairment and a change in valuation. This provides evidence regarding the completeness of the non-current asset register. This helps to confirm the accuracy of the depreciation charges recorded in the statement of profit or loss and that appropriate valuation procedures have been followed for non-current assets recorded in the statement of financial position. This provides evidence with regards to the accuracy of non-current assets costs and the valuation of assets at the year-end. This provides evidence with regards to the accuracy of non-current assets costs and the valuation of noncurrent assets at the year-end. This provides evidence of the numerical accuracy of the ledger and hence the valuation of non-current assets This confirms that Nemo has legal rights of ownership for their non-current assets (or at least, in substance they have the risks and rewards of ownership) and verifies rights and obligations. This provides evidence that property, plant and equipment balances have been disclosed appropriately in the year-end accounts. (10 Marks) [Total : 20 Marks] Page 9

11 SOLUTION 2 (a) To: Training Partner From: Audit Senior Date: 30 April 2014 RE: Briefing note on typical questions from trainees regarding stocktakes. Below are the some typical questions from trainees and suggested responses regarding stocktakes. Q (i) Is it a problem that the client does not provide any stocktaking guidelines? A (i) In the absence of guidance on counting, movements, obsolescence problems can arise resulting in increased risk of an incorrect stocktake. (3 marks) Q (ii) What kind of details would you expect to find on properly completed stocktake sheets and what should be done if these details are missing? A (ii) Stocktake sheet details should be: Pre-numbered and controlled contain details of the stock taker, and a listing of the stock items that might be counted. In the absence of the above there is an increased risk of errors on a stocktake with incorrect details being recorded or where stock-sheets go missing. Where stock-sheets are pre-numbered there is reduced risk of them going missing. (3 marks) Q (iii) What does the term cut-off details mean? What are the implications for the auditor and the client? A (iii) Cut-off concerns ensuring the correct transactions are recorded in the correct accounting period. At the cut-off the client should stop, or pause stock movements, and record details of the last goods received or despatch note that are relevant to the period being audited. The auditor must check that these details are correct. (3 marks) Q (iv) What is the auditor s responsibility concerning obsolete stock? A (iv) The auditor should ensure that the client, in the stock- take guidelines, provides guidance on how to identify and record obsolete stock and the auditor should check that these procedures occur. (3 marks) (b) (i) (ii) A stock movement report, in itsel, is not reliable form of audit evidence. The auditor will have to test the system that produced the stock movement report to ensure that it can be relied upon. (3 marks) The audit tst that shoud be carried out on the stock movement report are described in the table below: Item Authorised Complete Accurate Op bal Is this an item that the client purchases? Does this balance continue from previous balances? Is this the correct balance carried forward from November? Despatch Notes Vouch these details to copy despatch notes that are authorised by the warehouse manager/ Take a sample of despatch notes in December and trace all relevant details to this stock card. Do the details on the stock card correspond to the despatch note details? Goods Received Notes Vouch these details to original goods received notes that are authorised by the ware house manager/ Take a sample of the goods received notes in December and trace all relevant details to this stock card. Do the details on the stock card correspond to the good received note details? (5 marks) Page 10 [Total : 20 Marks]

12 SOLUTION 3 (a) Audit Risks The key audit risks with respect to the audit of Derry Ltd are set and discussed in th etable below along with recommended procedures in respose to each risk. Risk Purchase invoices from imports are likely to be in foreign currencies (unlikely but possible for export sales). This increases the risk of incorrect translation of foreign amounts into the home currency. There is a risk of misstatement of purchases and payables (and possibly of sales and receivables). All play equipment is sold with a 10-year warranty. Directors will need to estimate the potential repair costs for faulty goods sold within the last 10 years, which may be difficult to do accurately. There is a risk of misstatement of the provision for warranty costs. The increase in revenue coupled with gross profit margin may not on its own give rise to suspicion. However, the MD/100% shareholder selling his shares provides a significant reason to want to manipulate annual profits so that he can achieve the maximum possible gain from the share sale. There is a risk of misstatement of annual revenue/profit in Derry continues to invest in the website to improve its ease of use. Subsequent repair costs should by expensed. Only those costs that increase the benefit of the noncurrent assets may be capitalised There is a risk of misstatement of website maintenance costs. The new payroll system has only been operational for 9 months and the staff who administer it are also new. The system may be prone to teething problems due to a developing control environment. There is a risk of misstatement of payroll costs and related liabilities. Page 11 Recommend Procedures For a sample of purchases agree the exchange rate applied to an external source (such as the Irish Times) to confirm the accuracy of the retranslation. Confirm software capable of dealing with exchange rates by testing a sample of rates used in the system to externally gathered exchange rates. Enquire of directors how they (or the accounting system) identify the correct daily translation rate. For a sample of material payables balances re-translate the amount owed at 31 December 2013 with the translation rate on that day to ensure all outstanding amounts are translated to current amounts. Enquire of directors how they have estimated the provision and re-perform the calculation. Compare the provision to a mixture of forecasts and post yearend correspondence from claimants to assess whether the current provision is adequate to cover estimated returns. Compare previous years provisions to the level of actual returns received in the following years to identify the accuracy of previous estimates. Analytically review sales lines across the whole garden furniture line. Obtain appropriate explanations for significant rises in sales by product. Re-perform cut-off procedures for goods despatched just prior to and just after the year-end. Trace them to the sales ledger to confirm they are recorded in the correct period. Review a sample of credit notes raised shortly after the year-end to identify the completeness of any provisions against annual sales. Analytically review repairs and maintenance costs to identify any unusual changes in expenses trends. Inspect breakdown of additions to noncurrent assets to identify any amounts which should be expensed as repair costs. Inspect a sample of invoices relating to system costs to identify if they relate to system improvements or repair/maintenance costs. Document the payroll system,highlighting the controls that operate. Test the operation of the system and controls using walkthrough procedures. Test a sample of monthly payroll totals by comparing amounts entered into the system to original documents, such as salary contracts and timesheets. Confirm year-end wage/ salary and tax liabilities by comparing to the December 2013 payroll and cash book. (10 marks)

13 (b) Substantive Procedures: To confirm the accuracy and completness of Derry s payroll charge the auditor should perform the following procedures: Agree the total wages and salaries expense per the payroll system to the detailed trial balance, investigate any differences. Cast a sample of payroll records to confirm completeness and accuracy of the payroll expense. For a sample of employees, recalculate the gross and net pay and agree to the payroll records to verify accuracy. Re-perform calculation of statutory deductions to confirm whether correct deductions for this year have been included within the payroll expense. Compare the total payroll expense to the prior year and investigate any significant differences. Review monthly payroll charges, compare this to the prior year and budgets and discuss with management any significant variances. Perform a proof in total of total wages and salaries, incorporating joiners and leavers and the pay increase. Compare this to the actual wages and salaries in the financial statements and investigate any significant differences. Select a sample of joiners and leavers, agree their start/leaving date to supporting documentation, recalculate that their first/last pay packet was accurately calculated and recorded. For salaries, agree the total net pay per the payroll records to the bank transfer listing of payments and to the cashbook. (6 marks) (c) Audit Rotation Rotation is the term given to limiting the number of years an individual or a firm is associated with the audit of a particular client. Professional ethics recommend that audit staff should not spend too many years associated with the same group of clients. The benefit of understanding of the clients business is outweighed by the possible loss of professional scepticism. At a further level it is argued that audit firms should only serve a fixed term of office. The benefits of securing non-audit work from clients are substantially reduced if the term of office as auditor is limited to say seven years. Similarly, efforts to maintain good relations with management possibly to the extent of condoning questionable financial statements would no longer serve a useful purpose. The argument against rotation of audit firms is that it imposes additional costs and risks. It is the first year as auditor that is most costly and also the year the auditor is at greatest risk of failing to detect misstatement through unfamiliarity with the client. Rotation of audit firms is statutorily required in some countries. (4 marks) [Total : 20 Marks] Page 12

14 SOLUTION 4 (a) (i) From: Chief Internal Auditor To: Board of IC Subject: Role of Audit Committee Date: May 20X4 Areas where the internal audit department can assist the directors with the implementation of good corporate governance in an organisation include: Board reports Reviewing reports to the board and reports produced by the board to ensure that they dopresent a balanced and understandable assessment of the company s position and prospects. The internal audit department will have good knowledge of the operations of the company as well as access to accounting information. The department can effectively audit board reports to ensure they are accurate and understandable. Internal controls The board need to maintain a sound system of internal control. The internal audit department will be able to review existing controls and recommend improvements to ensure this objective is met. Application of ISAs and IASs The board need to have a policy for applying appropriate International Standards on Auditing (ISA) and International Accounting Standards (IAS) to the organisation. Internal audit will certainly be aware of new auditing standards and will have the technical expertise (especially where internal auditors are professionally qualified) to identify changes required by accounting standards. Amendments to control systems for new auditing standards and financial accounting systems for new accounting standards can therefore be recommended. Communication with external auditors Under corporate governance regulations, communications with external auditors will normally be via the audit committee, although the board must maintain an appropriate relationship with the external auditors. However, internal and external auditors can also work together to ensure that the internal control system is sufficient; possibly by external audit delegating work to internal audit, and each auditor reviewing the work of the other auditor. The board will therefore receive reports from both sets of auditors which will be accurate because they have been properly checked. Communication to the board The internal auditor can also check that appropriate information is provided to the board from the external auditor. ISA 260 Communication of Audit Matters with those charged with Governance provides a list of matters which should be communicated to the board and the internal auditor can work with the external auditor to ensure that this information is provided. (8 marks) (ii) The advantages of an audit committee include: Public confidence Providing increased public confidence in the credibility and objectivity of published financial information. This will be particularly important for Icicle Ltd if listing arrangements go ahead. While an internal audit department is not normally necessary for incorporated companies, the provision of that department will provide additional confidence in the accuracy of the financial statements and hopefully make Icicle Ltd an attractive investment. Financial reporting Supports the directors in fulfilling their financial reporting obligations. The directors have to prepare financial statements for IC. The committee can assist by checking the financial statements to ensure that they comply with appropriate reporting requirements. This is especially important where the board do not have detailed knowledge of accounting requirements. Communication Enhancing the role of IC s external auditors by providing an appropriate channel of communication. Use of the audit committee will enable the external auditor to discuss issues with the financial statements with the internal auditor, prior to providing a final summary of key points to the board. Page 13

15 Friend of the Board The audit committee may also act as a critical friend to the board by monitoring the work of the board and providing helpful guidance, where corporate governance requirements do not appear to be being met. The audit committee should have detailed knowledge of corporate governance as part of its monitoring function of the company and can share this with the board who may not have the time to obtain detailed information. The disadvantages of an audit committee include: Lack of understanding of function As the directors in IC do not have much knowledge of corporate governance, they may see the additional involvement of the audit committee as a threat to their authority or taking away some of their responsibilities. This memo has hopefully outlined the advantages of an audit committee in supporting the work of the directors, removing this as a problem. Role of non-executive directors As the audit committee will be made up mainly from non-executive directors, the board may see this as a means of decreasing their power and possibly letting other people run the company. Again, the audit committee must be seen as fulfilling a supporting role for the main board. It will utilise the special knowledge of accounts production and internal controls from the external auditor and business non-executives to provide appropriate review of information being given to the board. Cost The audit committee will increase the expenditure of the company as the non-executive directors will require some remuneration due to their additional responsibilities. While this cannot be avoided, the benefits of the committee in terms of providing assistance to the board and raising the profile of IC ready for possible listing must not be forgotten. (4 marks) (b) Four important criteria in assessing work of internal audit are generally recognised: (i) (ii) (iii) Organisational status. The internal audit department s status in the organisationand the effect this has on its ability to be objective. If the client is a listed company, it may have an audit committee. If it does, 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 will be controlled by the Financial Director. However, there should be some input from the Board (and audit committee, if it exists) 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 I will considerwhether it has adequate independence both in terms of the work it carries out and the reports it makes. 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 deficiencies 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 deficiencies and errors and subsequent correction will provide me with evidence of whether action is taken following adverse reports by the internal auditors. 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 CPA Ireland) 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 relevant courses to keep up to date and learn about new developments. If members of CPA Ireland they will be subject to the Institutes mandatory continuing professional development requirements. Unqualified staff should be studying for the exams of a relevant professional body. The external auditor will check these matters by discussing them with the head of the internal audit department and obtaining appropriate evidence. Page 14

16 (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 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 deficiencies in controls are found. There should be appropriate audit manuals for the internal audit staff. (8 marks) [Total : 20 Marks] Page 15

17 Solution 5 (a) Purchase System Lisa Co A number of effective internal controls in place in Lisa Co. are disussed in the table below. In the second column tests of control that Island & Co. should perform to assess if the controls discussed are operating. (i) Strength and explanation (ii) Test of control Batch controls are utilised in the data entry process. This enables data entry errors to be identified and corrected on a timely basis. Invoices are stamped as "recorded" and additional checks ensure all invoices are recorded. This ensures completeness of data processing and prevents invoices being processed twice, reducing the risk of under or over-statement of trade payables. Observe the invoice entry process to ensure batch control sheets are being completed and agreed the batch system report. With the client s permission, attempt to process a sample of invoices without confirming batch totals. The system should not process the invoices without confirmation of the data. Select a sample of invoices recorded on the system and inspect them to ensure they are marked as "recorded". Monthly supplier statement reconciliations are performed. This enables errors such as misrecorded purchases and payments to be identified and corrected on a timely basis. Regular control account reconciliations are performed. This ensures credits and payments recorded in individual supplier ledgers have also been recorded in the accounts (and vice versa). Segregation of duties monitors performance of controls and prevents fraud. The company accountant checks and authorises individual payments. Payments should be authorised by a senior member of the finance department to minimise the risk of error or fraud. Individual payments of more than 25,000 or total payments of more than 250,000 require a second authorisation. This reduces the risk of fraud or error on high value payments Payments are made by the cashier's office and recorded by the purchases ledger team. Segregation of duties prevents fraud and error. Invoices are stamped as "paid" and filed separately from invoices not yet paid. This prevents invoices being paid twice. GRNs are checked on a monthly basis. Ensures that suppliers are paid on a timely basis, which ensures that early settlement discounts available are obtained, and supplier goodwill is maintained. Page 16 For a sample of suppliers, inspect the monthly supplier statements received for evidence of reconciliation. Inspect the purchase ledger reconciliations for evidence of performance and review on a monthly basis. For a sample of payments made, inspect the payment list for evidence of the company accountant's review and authorisation. Select a sample of invoices of more than 25,000 and total payments of more than 250,000 and scrutinise purchase system documentation to ensure the financial controller or finance director s signature is present as evidence of authorisation. Observe the payment and recording system to ensure there is adequate segregation of duties. Inspect the file of paid invoices and ensure they are kept separate from invoices not yet paid. Inspect a sample of invoices for evidence of the payment stamp. Review evidence of the purchase ledger manager's monthly invoice review. (12 marks)

18 (b) Substantive procedures: purchases Select a sample of goods received notes before the year-end and follow through to inclusion in the statement of profit or loss: verifies cut-off of purchases. Recalculate a sample of accrued costs by reference to GRN notes and contracts and payment schedules: verifies accuracy of purchases. Review after date invoices to ensure no further items need to be expensed: verifies completeness of purchases. Review after date payments, if they relate to the current year then follow through to the statement of profit or loss: verifies completeness of purchases. Recalculate discounts and sales tax applied for a sample of large purchase invoices: verifies accuracy. Select a sample of purchase orders and agree these to the GRNs and purchase invoices through to inclusion in the statement of profit or loss: verifies completeness of purchases. Calculate gross profit margin for 2014 and compare to Investigate any significant fluctuations: verifies accuracy, completeness and occurrence of purchases. For a sample of suppliers, obtain supplier statements, reconcile these to the purchase ledger balances and investigate any reconciling items: verifies occurrence and completeness of purchases. (6 marks) (c) Four examples of external confirmations are: 1 Accounts receivable letter 2 Solicitor letter 3 Bank report letter 4 Inventory held by third parties (2 marks) [Total : 20 Marks] Page 17

19 SOLUTION 6 (a) Auditor s responsibility regarding Going Concern The auditor s responsibility is to obtain sufficient appropriate evidence about the appropriateness of management s use of the going concern assumption in the preparation of the financial statements. Specifically, the auditor must evaluate management s assessment of the entity s ability to continue as a going concern and conclude whether a material uncertainty exists that may cast significant doubt on the entity s ability to continue as a going concern that needs to be disclosed in the financial statements. If events or conditions are identified that may cast significant doubt on the entity s ability to continue as a going concern, the auditor must obtain sufficient appropriate evidence to determine whether or not a material uncertainty exists through performing additional audit procedures, including those specified by ISA570 Going Concern. (2 marks) (b) Going Concern Indicators Indicator Kildangan has seen a significant decline in its sales over the last two years. Competition has increased, characterised by substantial price discounting. Kildangan has invested in a recently launched e- commerce platform. Recent significant investments have been funded by new bank loans. Kildangan has been reprimanded following a breach of regulatory standards regarding advertising. A senior product designer has left the company. Rental charges, a fixed cost, form a significant part of Kildangan s expenditure. Two lenders are considering withdrawal of loan facilities. Page 18 Why could impact going concern Declining sales may mean that Kildangan will struggle to generate sufficient cash flows to cover its costs. Customers may switch to competitors due to the price discounting or Kildangan may reduce its prices too much so that it is unable to generate sufficient profits and cash flows. There is a risk that the new online retailing platform fails with customers experiencing problems or insufficient customers choosing Kildangan s website. The investment may fail to cover its costs which may increase financial pressure on the company. The higher finance costs associated with the loans increases the risk that Kildangan will be unable to generate sufficient cash flows in order to cover its interest payments. There is a risk that it will breach loan covenants resulting in lenders withdrawing funding. This may result in negative publicity and a lack of confidence and trust on the part of customers. Together these could result in a decline in sales and cash flows. In addition there may be significant fines which place further pressure on going concern. The loss of key personnel may mean that Kildangan may be unable to design and source the products that customers want. This could result in falling sales and cash flows leading to going concern problems The declining sales mean that Kildangan may find it difficult to cover its significant fixed costs. There is a greater risk that Kildangan will be unable to meet its commitments as they fall due, resulting in going concern difficulties Kildangan is unlikely to be able to continue to trade without the loans in place. The lenders may force the company into liquidation. (8 marks)

20 (c) The audit procedures that the auditor of Kildangen should perform in assessing whether or not the company is a going concern are listed below: Obtain and review the company s cash flow forecast and assess whether the impact of declining sales has been included. Assess the assumptions made, in particular regarding estimated sales from online retailing. Review the post year end management accounts for evidence of declining financial performance. This could include an examination of whether Kildangan is able to cover its finance costs. Review the post year end sales figures in respect of online retail sales to establish whether the director s confidence is justified. Discuss with management whether they have identified any alternative sources of finance should the major lenders withdraw their finance. Discuss with directors what their plans are for dealing with the current price discounting of competitors. Examine correspondence with lawyers and regulatory authorities to identify whether any further fines and or legal claims have been made against the company. Review board minutes to identify what the company plans to do to deal with the negative publicity associated with the product recall of one of its customers. Review correspondence with Banks/Lenders to determine whether Kildangan Co has breached any loan covenants which impact on the renewal of overdrafts and loan facilities. Discuss with directors what their plans are for dealing with the negative publicity caused by the breach of advertising standards. Discuss with directors whether they plan to replace the product designer and assess how far their recruitment plans have advanced. (6 marks) (d) The uncertainty regarding the renewal and restructuring of the company s loans is an matter of fundamental importance, which needs to be brought to the attention of the shareholders. An emphasis of matter paragraph would need to be included in the audit report. This paragraph should be inserted after the opinion paragraph and would explain clearly the uncertainty regarding going concern and include cross references to a note in the financial statements where more detailed information can be found. The audit opinion will not be affected and will remain unmodified. Should the directors fail to include a disclosure note then the audit opinion would be qualified with an except for audit opinion due to material misstatement. The financial statements would be materially misstated due to non disclosure of the uncertainty. (4 marks) [Total: 20 Marks] Page 19