Copyright Reserved No. of Pages No. of Questions = 07 = 05 THE INSTITUTE OF CHARTERED ACCOUNTANTS OF SRI LANKA FINAL II EXAMINATION - DECEMBER 2009 ADVANCED AUDIT AND ASSURANCE Time allowed : 3 hours Marks : 100 marks Instructions to candidates: (1) (2) (3) Answer All questions. Begin each answer on a separate page. Submit all workings All answers should be in the English language, in the answer booklets provided. Question No. 01 EXCEL Furniture PLC ("Company", EXCEL Furniture ), a publicly traded company, manufactures and sells furniture. EXCEL Furniture specialises in office, factory and home furniture. The Company was founded in 1983 and is currently number 3 in the sale of furniture in terms of market share in Sri Lanka ( the market"). The company s head office is in Kandy and manufacturing operations are located in Kandy. EXCEL Furniture targets, which were approved by shareholders, are to increase: Sales by 10% per year for the next five years; and Increase Profit before Tax ("PBT") by 4% in 2008. EXCEL Furniture ambition and vision is to be the premier brand for furniture and to become number one in the market in the next five years. EXCEL Furniture long-term strategy includes strengthening the brand momentum by continuing to research and develop features for their most popular products. EXCEL Furniture would like to increase brand share by 1% per annum for the next five years and obtain 20% of the furniture market which is aligned to the goal of increasing sales by 10% per year for the next five years. EXCEL Furniture has been an audit client of your firm since 1989 and they have a 31 December year end. The company is considered an important audit and tax client of the audit firm. EXCEL Furniture product range includes all types of office furniture and home furniture. EXCEL Furniture continues to be one of several leading manufacturers of furniture. However, competition in the industry is intense and is based primarily on design, price, quality, and durability. In the last year, several new competitors including two listed entities have emerged. The key competitors include Furniture Trading Company (current market leader) and Furniture R Us (number two in the market.)
Both competitors sell their furniture through distribution chains and traditional store fronts as well as on-line. EXCEL Furniture does not sell its products on-line. The economy is currently in a phase of stagnation. The total furniture market volume is not expected to grow significantly in the next several years. Despite the impact to the industry, EXCEL Furniture as well as its competitors, still aim to increase sales volumes and are active in finding different ways to achieve this objective. In anticipation of the seasonality of furniture sales around the traditional holiday season, EXCEL Furniture increases its production in advance of the peak selling period, resulting in a corresponding build-up of inventory levels in the first three quarters of the year. Christmas sales represent a significant portion of total annual sales and usually start about 3 months before Christmas. Such sales end around 10th January. Seasonal shipping patterns result in significant peaks in accounts receivables in the third and fourth quarters of the year. Advertising and other marketing is done through traditional channels and is focused on different segments of the market. Related marketing costs follow the seasonality of sales with a peak in the last three months of the year. This year, EXCEL Furniture signed an exclusive licensing agreement with a popular reality TV show for a series of commercials, as part of the effort to increase brand recognition and ultimately sales. EXCEL Furniture source raw material and components for its furniture production are from domestic and overseas suppliers. Most of the overseas suppliers are from the Far East. There are valid signed contracts with all key suppliers to ensure reliable and timely supplies. Invoices are received in local and foreign currencies. EXCEL Furniture customer base consists primarily of large distribution companies that sell EXCEL Furniture products domestically and internationally. Many distributors have longstanding relationships with EXCEL Furniture. Sales to the distribution companies account for approximately 80% of EXCEL Furniture annual sales. EXCEL Furniture also sells to small independent furniture stores, which account for approximately 20% of sales. Most of these stores are small scale family owned entities and are located island-wide. EXCEL Furniture sells their products to a wide network of distribution companies ("Distributors") based in Sri Lanka. The number of Distributors varies between 25 and 30 companies. Distributors sell EXCEL Furniture products both in Sri Lanka and Maldives. Most sales in Maldives are to entities in the hospitality & leisure sector. Distributors can significantly impact sales volumes and customer satisfaction by getting the right product to the right place at the right time, at a lower cost. To meet the company s revenue goals for next five years, management has offered new contractual arrangements to the Distributors. This year, Distribution Service Contracts ("contracts") with majority of the Distributors have been amended to include non-standard conditions, specific to each distributor. Contract terms now include rebates based on the volume ordered and more flexible product return terms. Distributors are felicitated every year. Accounting for these transactions is more complicated than in prior years. EXCEL Furniture has updated its Accounting Manual in the first quarter of 2008 to reflect these new accounting procedures. (2)
In prior years, minor accounting issues relating to revenue recognition of sales to Distributors were identified by the external audit team, usually in the early stage of the audit. Management had accepted these audit recommendations and posted the necessary adjustments. EXCEL Furniture has 5 sales representatives. Each sales representative is responsible for managing relationship with their allocated Distributors account, which includes meeting their sales targets. To encourage the sales representatives to meet their sales targets, the Company introduced a new sales incentives scheme and bonuses. The proportion between the fixed and variable portion of their remuneration has changed. The total variable portion can reach as much as 100% of the fixed portion of their salary. EXCEL Furniture sells directly to about 30 furniture stores in Sri Lanka. These sales are initiated by the furniture stores through purchase orders. There are no sales representatives assigned to furniture stores. Customer orders are received and processed by the administrative staff in the sales department. No price or volume based rebates are offered to furniture stores. Payments are due 15 days after the invoice date. Accounting for such transactions is straightforward since there is no complex accounting requirements. The Accounting Manual includes accounting policy for sales to furniture stores. In prior years, there were no audit issues in relation to recognition of furniture stores sales. EXCEL Furniture aims to implement and maintain an effective Corporate Governance model, supported by appropriately qualified senior management. The organisational chart is regularly reviewed and formal job descriptions exist. We have been able to gain significant comfort from controls testing in prior years. The remuneration of the senior management is linked to the overall performance of the Company, i.e. reaching annual targets, as well as to individual performance. The Board of Directors ("the Board") has 4 members comprising CEO, Marketing Director, Company's lawyer and one representative of the majority shareholder. The Board is diligent and committed to producing financial statements compliant with Generally Accepted Accounting Principles. This sets a good "tone at the top" for the rest of the Company. The Code of Conduct brochure has been distributed to all staff and is available on the Company's intranet. It outlines the Company's values, moral and ethical standards which everyone in the Company is expected to comply. The CFO accompanied by the Financial Controller attends every other Board meeting and presents the Monthly Reporting Package ("the Package") to the Board. The Package provides a comprehensive analysis of monthly and year-to-date financial and non-financial results. The Board reviews these results and requests explanations for all variances from the budget. If necessary, the Board requests actions to be taken by the management in relation to the monthly results. The Audit Committee consists of 5 members; one of them is a financial expert. They review all transactions for any conflicts of interest. They also conduct employee "pulse" surveys designed to evaluate what messages the employees are hearing on a day-to-day basis. (3)
All members of the audit committee have the ability to ask probing questions about the financial risks. The audit committee is vigilant and diligent. The Company has an internal audit department which reports directly to the Audit Committee. Tissa Tissera, the Chief Executive Officer (CEO) of EXCEL Furniture, has been with EXCEL Furniture for the last 8 years. Tissa was appointed as CEO and to the Board in 2005. EXCEL Furniture is his first CEO appointment. He has limited background in finance so he often meets with the CFO to discuss various financial matters. He has recently introduced a whistle blower system. CEO remuneration is linked to the market capitalisation of the Company. Deshani De Silva, the Chief Financial Officer (CFO) of EXCEL Furniture, has been with the Company for two years. Even though she is not involved in day-to-day activities of the finance department and focuses more on dealing with banks and investors, she is active in monitoring the monthly financial results, budgeting, and communicating with the Board. The Financial Controller, Lakmali Bandusena, is a qualified chartered accountant, and has worked at EXCEL Furniture for many years. Lakmali was appointed as the Company's Financial Controller in 2006. Lakmali has four staff reporting directly to her in her department. Lakmali prepares the Monthly Financial Reporting Package after the month-end closing. She identifies the actual-to-budget variances and discusses them with Deshani. The Monthly Management Meeting is then organized on the 10th day of following month. Prior to providing the Package to the Board, it is sent to Tissa for his review and approval. The computer systems are centrally located at the headquarters in Kandy. The company has recently established a disaster recovery plan and a mechanism to store daily back-ups externally. Some of the IT systems have been modified internally. The company use authorised as well as pirated software. Some of the computers are branded. You are the audit senior assigned to carry out the statutory audit of EXCEL Furniture PLC for the year ended 31 December 2008. (i) (ii) Identify the business objectives, related business risks and the related key audit risks in relation to revenue. (8 marks) The following control activities have been identified relating to order processing. a) A valid customer number must exist in the order processing system to generate a sales order. Sales to fictitious customers are prevented. b) The system automatically assigns a sequentially numbered order number. Orders are recorded completely and accurately. c) The sales order will not be accepted into the system if there is incomplete or inaccurate information in any of the key fields. Orders are recorded completely and accurately. d) Standard prices are set up within the system and cannot be changed by the Sales Team. Price and amount of sale are correct. e) Orders identified in the system as 'Standby' cannot be processed until the Sales Manager verifies that the items are available. Procedures exist to approve sales orders. Which of the financial statement assertions are covered by the above control activities? (7 marks) (4)
(iii) Based on the work performed by the audit firm s IT auditors the following were noted in IT General Controls: Management relies upon the IT General Controls over interfaces between the order processing system and the General Ledger System as the key control to ensure all sales transactions are posted completely and accurately from the order processing to the General Ledger system. IT auditors tested the batch processing controls including the manual review of exception reports generated if the batch process fails. For the period, September 1, 2008 to October 15, 2008, it was noted that no manual review was performed of the exception reports generated as the responsible staff member was on vacation and no back-up person was identified to fulfill their responsibilities. Therefore no follow up action was taken for the exceptions noted. Manual review of exception reports generated when the interface between order processing and General Ledger run was not reviewed to ensure that the batch job ran to completion. Identify audit risks, compensating controls and audit response for each of the observations given above. (iv) Your audit manager has requested you to review the walkthrough tests carried out by a junior staff member of the audit team relating to invoicing and order processing. What factors would you want to consider in reviewing walkthrough documentation? (5 marks) (v) The engagement partner has informed you that a quality review partner has been assigned to this engagement. What are the responsibilities of a quality review partner? (4 marks) (vi) Your audit manager is of the view that EXCEL Furniture has a strong control environment in relation to integrity and ethical values. Discuss such control environment in relation to EXCEL Furniture. (5 marks) (vii) At the audit planning meeting you were requested to assess the possibility of using the work carried out by EXCEL Furniture internal audit division. Explain the documentation procedure in your audit file, if you decide to use the work carried out by EXCEL Furniture internal audit division. (5 marks) (Total 40 marks) Question No. 02 Goodsmen (Pvt) Limited is a long standing client of the NFT Associates; a firm of Chartered Accountants. Goodsmen (Pvt) Limited have been shortlisted for a contract by XY Limited and urgently require their financial statements for the year just ended, to be approved by NFT Associates to be forwarded together with the bid documents to the tender board of XY Limited. As the statutory audit will take time to be completed, the client has agreed to accept a review report and an engagement letter has been signed. You, an audit manager of the firm; have been requested to handle this assignment. (b) In respect of the review of the financial Statements, identify the matters should have been included in your firm s letter of engagement relating to: (i) your firm s responsibilities; and (ii) the level of assurance provided; Briefly list the general procedures you would perform in such a review. (5) (4 marks) (Total 10 marks)
Question No. 03 You are a partner at Nimal & Co, a firm of Chartered Accountants providing audit and advisory services. You recently attended a presentation organized by the Institute of Chartered Accountants of Sri Lanka on computer related crime within business. After the presentations you met Piyal, the finance director, of PP Stockbrokers Ltd (PPS), one of your firm s audit clients. He mentions that external audit field work has commenced and at the initial planning meeting for the current year audit, he had offered the manager in charge of the audit a job at PPS as Chief Accountant, and that the audit manager has indicated that he intends to accept the appointment. The conversation moved to the topic of the presentation and Piyal commented that PPS had been a victim of computer crime during the past year. An employee who was dismissed had emailed a computer virus and it had spread through the company IT infrastructure and corrupted some of the data within the on-line share trading system. The company thinks that most of the data files have been sufficiently cleaned and restored. Requirements Outline the ethical issues raised, and any safeguards your firm should adopt, in respect of the fact that the audit manager of the PPS audit, intends to accept appointment as chief accountant at PPS. (7 marks) (b) (i) State the objectives of a system of quality control within an audit firm. (4 marks) (ii) Identify, with reasons, which of the above objectives are likely to be particularly relevant to your audit of PPS. (4 marks) (Total 15 marks) Question No. 04 Slimpack Plc (Slimpack) is a public listed company in Sri Lanka producing packaging material. Silmpack was a family owned company; prior to being listed 5 years ago and the family still own 40% of the shares. The family members who own shares occupy seven of the board positions and occupy the most senior positions in the company. A trusted employee has been recruited as nonexecutive director, immediately after he retired from full-time service. The audit committee consists of this non-executive director and two other family members who are directors. Mr. Sarath Silva, an executive director who chairs the audit committee, believes that audit committees didn t add value to the company. They were, he believed, one of those outrageous demands that regulatory authorities made without considering the individual needs of different companies. He limits the purpose of the audit committee to assessing the independence of the external auditor and monitoring the external audit function and thus the committee meets once a year for this purpose. The last year s meeting with the auditor took a considerable amount of time as none of the audit committee members have a financial background. (6)
Required: Explain the terms Executive Director, Non-executive Director and Independent Nonexecutive Director. (3 marks) (b) According to the Code of Best Practice on Corporate Governance jointly issued by the Institute of Chartered Accountants of Sri Lanka and Securities and Exchange Commission of Sri Lanka, critique (assess critically) the terms of reference and the composition of the audit committee of Slimpack. (c) You as the Finance Manager of the company have been requested by the Audit Committee to draft a Charter (terms of reference) for the Audit Committee. Briefly describe as to what would be included in the Charter. (Total 15 marks) Question No. 05 You are the manager in charge of the external audit of TS Garments Ltd (TSG), a manufacturer of swimwear. The company s pre-tax profit for the year ended 31/3/2008 was Rs. 16 million and its total assets at 31/3/2008 were Rs. 250 million. You have completed the audit fieldwork in respect of the year ended 31 March 2008 and are in the process of finalizing the audit when the following developments take place: In April 2009, TSG learns that a liquidator had been appointed to Sportline Ltd ( Sportline ), one of its customers. Sales to Sportline accounted for less than 1% of the total sales of TSG year ended 31/3/2008, and the sum outstanding from Sportline at the year end was Rs. 320,000. Sportline was to commence a five year contract supplying swimwear to a major sports wear retailer. The manufacture of this contract was to be subcontracted to TSG. In anticipation of this contract by 31/3/ 2008, TSG had invested Rs. 25 million in new specialist plant and machinery and Rs. 3.5 million in raw material inventory ordered to Sportline s specifications. The plant and machinery was financed by bank loans, repayment of which is due in monthly instalments commencing September 2009. TSG had presented a business plan to the bank in support of its loan application, including profit forecasts, prepared on the assumption that the new contract would commence in June 2009. This business plan has since been amended to reflect recent developments. Requirements 1. 2. (b) Describe the possible effects of the above matters on the financial statements of TSG for the year ended 31 March 2008. List the procedures you would undertake relating to the above matters in your subsequent events review. The company's bankers require the revised profit forecasts to be reviewed and reported on by independent accountants. The directors have requested that your firm undertakes this review. Briefly describe the procedures you would follow in reviewing the profit forecasts. (8 marks) (7) (Total 20 marks)