Assurance

1. AUDIT & ASSURANCE
Time allowed – 2½ hours
Total marks – 100
[N.B. – The figures in the margin indicate full marks. Questions must be answered in English. Examiner will
take account of the quality of language and of the manner in which the answers are presented.
Different parts, if any, of the same question must be answered in one place in order of sequence]
Marks
1. (a) Your firm has been approached by Snipe Ltd. to accept appointment as external auditor for
the year ending 30 June 2012. In the auditor’s report on the financial statements for the year
ended 30 June 2011, the previous auditor issued a qualified opinion due to disagreement
over the accounting policy for inventory valuation. This matter was cited by the previous
auditor in response to your firm’s letter requesting information that might influence your
firm’s decision as to whether to accept the engagement. In addition, the previous auditor
stated that the audit fees due for the year ended 30 June 2011 remain unpaid.
Identify and explain the ethical issues arising from the above and identify any actions
your firm should take in respect of this matter before deciding whether it should accept
the appointment as external auditor. 4
(b) Airship plc (Airship) provides transport and warehousing services to the grocery industry.
Your firm is the external auditor of Airship for the year ended 31 December 2011. During the
course of the audit work the audit senior discovered that, in order to meet delivery schedules,
the transport manager has authorised false overtime payments for the lorry drivers.
Explain why this matter should be considered by the external auditor and state the
actions that your firm should take. 4
(c) Your firm is the external auditor of GR Ltd. (GR) for the year ending 31 March 2012. On
15 March 2012 the directors of GR engaged a firm of expert property valuers to provide
an independent valuation of the company’s freehold land and buildings. The directors
intend to recognize freehold land and buildings at this valuation in the financial
statements for the year ended 31 March 2012.
State the audit procedures that your firm should plan to undertake in order to place
reliance on the valuation provided by the firm of expert property valuers. 3
(d) BSA 265 – Communicating deficiencies in internal control to those charged with governance
and management requires external auditors to communicate significant deficiencies in
internal controls identified during the audit to those charged with governance.
Identify and explain the attributes that are required to make such communications effective. 4
(e) You are the audit senior on the external audit of Dug Ltd. (Dug) for the year ended 31
January 2012. In January 2012 Dug sold some office equipment to the wife of Dug’s
Managing Director. The audit junior has noted that the sale has not been disclosed in the
note to the financial statements detailing related party transactions and has suggested the
inclusion of an emphasis of matter paragraph in the audit report to highlight this issue.
Comment on the suitability or otherwise of the audit junior’s suggestion. 4
(f) During the external audit of Tuna Ltd. for the year ended 31 March 2012, the following
matters were discovered:
(i) cash receipts from customers, listed as outstanding lodgements in the bank
reconciliation at the year end, were cleared through the bank on 21 April 2012; and
(ii) a sales credit note, relating to a pre-year-end delivery of inventory, was issued to a
major customer on 20 April 2012.
Explain why these matters should be investigated further. 6
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2. – 2–
2. Your firm has recently been appointed external auditor of Ecowaste Ltd. (Ecowaste) for the
year ended 31 March 2012. The previous auditors, from whom your firm has obtained
professional clearance, were not re-appointed because the managing director of Ecowaste,
John Green, who is also the majority shareholder, believes that your firm has the
appropriate expertise to assist with his plans to expand the business. The expansion plans
involve the acquisition of small companies in the same industry sector and John Green
would like your firm to undertake due diligence investigations over the next five years on
the target companies. The due diligence work will include, among other procedures, a
review of the financial statements of the target companies. Your firm has a number of other
clients operating in the same industry sector.
Ecowaste’s principal activity is the provision of waste management services which include
the collection, transfer, recycling and disposal of waste materials. The company’s activities
are overseen by a regulatory body which issues licences to companies operating waste
management services. The regulatory body has the power to modify, suspend or revoke the
licences which are granted for periods up to ten years. The licences set out the operational
criteria and the working practices to be adopted to meet those criteria.
Ecowaste’s customers include industrial and retail companies and government bodies. The
majority of work undertaken under renewable contracts covering periods up to ten years.
Payment terms vary from contract to contract, with some customers paying for services in
advance whilst others pay after Ecowaste has provided the service. Ecowaste’s largest
contract expires in July 2013. This contract currently represents 35% of Ecowaste’s revenue
and Ecowaste, along with other companies, has been invited to tender for the new contract.
Ecowaste is entitled to claim a subsidy from the government based on the volume of waste
recycled. The company is required to submit quarterly returns detailing the volume of waste
recycled and the subsidy is paid 30 days following the end of the period covered by the
return. Ecowaste’s procedures and records are subject to periodic inspections by a
government auditor to ensure that the claims for the subsidy are valid.
The company has experienced rapid growth due to an increase in demand for its services.
During the year ended 31 March 2012, the company commissioned a number of capital
projects including state-of-the-art sorting lines at all of its recycling centres and a digestion
plant. The digestion plant is to be used in Ecowaste’s new venture which will involve the
conversion of waste material into biofuel.
The sorting lines were assembled from specialist components sourced from an overseas
supplier using a combination of own and sub-contract labour. They were completed in
December 2011 and came into operation in February 2012. The digestion plant, which is
sited on land purchased from a property company owned by John Green and his wife, was
still in the course of construction at 31 March 2012. The digestion plant is being built by a
construction company under a fixed-price contract which requires stage payments based on
the value of work certified by a surveyor.
The capital projects are funded by a loan repayable in quarterly instalments over ten years.
In addition to the loan, the company has negotiated an increase in its overdraft facitlity in
order to meet its working capital requirements which have increased due to the expansion
of the business.
The accounting function is centralized at head office. However, the processing of payroll is
outsourced to a service organization which provides Ecowaste with monthly payroll
information. Ecowaste uses this information to pay the wages and salaries directly into its
employees’ bank accounts and the relevant payroll taxes to the Government Treasury.
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3. – 3 –
Requirements:
(a) Explain the self-interest and self-review threats arising from the provision of due
diligence services to Ecowaste and describe how your firm should deal with them. 5
(b) Identify, from the information provided in the scenario, the principal areas of audit risk
in respect of the financial statements of Ecowaste for the year ended 31 March 2012. For
each risk:
(i) list the factors which have led you to identify that risk; and
(ii) outline the procedures that should be included in the audit plan in order to address
the risk.
You should present your answer in two-columnar format using the headings (i) audit
risk and factors; and (ii) procedures to address the risk. 20
(c) Describe the benefits to:
(i) clients from having non-audit services provided by their external auditors; and
(ii) firms from providing non-audit services to audit clients and companies who are not
audit clients. 5
3. Khelna Toys Co (Khelna) is a manufacturer of children’s building block toys; they have been
trading for over 35 years and they sell to a wide variety of customers including large and
small toy retailers across the country. The company’s year end is 31 May 2011. The company
has a large manufacturing plant, four large warehouses and a head office. Upon
manufacture, the toys are stored in one of the warehouses until they are despatched to
customers. The company does not have an internal audit department.
Sales ordering, goods despatched and invoicing system.
Each customer has a unique customer account number and this is used to enter sales orders when
they are received in writing from customers. The orders are entered by an order clerk and the
system automatically checks that the goods are available and that the order will not take the
customer over their credit limit. For new customers, a sales manager completes a credit application;
this is checked through a credit agency and a credit limit entered into the system by the credit
controller. The company has a price list, which is updated twice a year. Larger customers are entitled
to a discount; this is agreed by the sales director and set up within the customer master file.
Once the order is entered an acceptance is automatically sent to the customer by mail/email
confirming the goods ordered and a likely despatch date. The order is then sorted by
address of customer. The warehouse closest to the customer receives the order electronically
and a despatch list and sequentially numbered goods despatch notes (GDNs) are
automatically generated. The warehouse team pack the goods from the despatch list and,
before they are sent out, a second member of the team double checks the despatch list to the
GDN, which accompanies the goods.
Once despatched, a copy of the GDN is sent to the accounts team at head office and a
sequentially numbered sales invoice is raised and checked to the GDN. Periodically a
computer sequence check is performed for any missing sales invoice numbers.
Fraud
During the year a material fraud was uncovered. It involved cash/cheque receipts from
customers being diverted into employees’ personal accounts. In order to cover up the fraud,
receipts from subsequent unrelated customers would then be recorded against the earlier
outstanding receivable balances and this cycle of fraud would continue.
The fraud occurred because two members of staff ‘who were related’ colluded. One
processed cash receipts and prepared the weekly bank reconciliation; the other employee
recorded customer receipts in the sales ledger. An unrelated sales ledger clerk was
supposed to send out monthly customer statements but this was not performed. The bank
reconciliations had a small unreconciled amount but no-one reviewed the reconciliations
after they were prepared. The fraud was only uncovered when the two employees went on
holiday at the same time and it was discovered that cash receipts from different customers
were being applied to older receivable balances to hide the earlier sums stolen.
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4. – 4–
Required:
(a) Recommend SIX tests of controls the auditor would normally carry out on the sales
system of Khelna, and explain the objective for each test. 9
(b) Describe substantive procedures the auditor should perform to confirm Khelna’s (i) year-
end receivables balance, and (ii) Revenue. 10
(c) Identify and explain controls Khelna should implement to reduce the risk of fraud
occurring again and, for each control, describe how it would mitigate the risk. 6
4. Your firm is the external auditor of Dunlec Ltd. (Dunlec) for the year ended 31 October 2012.
The company is owned by members of the Dunlop family, none of whom is involved in
running the business. Dunlec’s principal activity is the installation of electrical systems for
customers in the retail, construction and industrial sectors in Bangladesh. The company
operates from premises in Dhaka and six freehold divisional depots throughout Bangladesh.
All contracts are fixed-price. Customers pay 95% of the contract price on completion of the work
and withhold 5% of the contract price for up to six months from the date of completion in case
remedial work is required. The materials and components used by the Dunlec are bought from
Bangladesh suppliers who require payment within 30 days of the invoice date.
Dunlec made an operating loss during the year ended 31 October 2012. This was mainly due
to a substantial bad debt in respect of a company which went into liquidation in July 2012,
with insufficient funds to pay unsecured creditors. As a result, Dunlec experienced severe
cash flow problems. In August 2012, to ease its cash flow problems, Dunlec sold its Dhaka
freehold premises and leased new premises. Dunlec used the proceeds to:
• Pay a loan instalment on the due date in September 2012 (final instalment due in
September 2013);
• Pay its overdue tax and related penalties; and
• Reduce the company’s overdraft.
During the year ended 31 October 2012, Dunlec suffered a fall in demand for its services in
the construction sector. The directors have undertaken a strategic review of operations and
have decided to reduce the company’s cost base by:
• Closing two of the divisional depots and putting both premises up for sale. Contracts in
those regions will be serviced by the nearest existing depot; and
• Making 25% of the company’s employees redundant.
The closures and redundancies were announced on 12 November 2012 and the premises
were immediately put up for sale.
As part of their assessment of the company’s ability to continue as a going concern, the
directors have prepared cash flow forecasts. These show that the company can operate
within its current overdraft facility for the two years ending 31 October 2014.
Requirements:
(a) From the information provided in the scenario, identify the specific matters you would
consider when reviewing the assumptions underlying the receipts and payments
included in the cash flow forecasts for the two years ending on 31 October 2014. 8
(b) Discuss the implications for your firm’s audit report in each of the following two
circumstances: 8
(i) Dunlec is not a going concern;
(ii) there is a significant uncertainty about the going concern status of Dunlec.
(c) Identify the parties to whom your firm may be liable for damages if an inappropriate
opinion is provided on the financial statements of Dunlec for the year ended 31 October
2012 and state the circumstances under which those parties may be successful in
claiming such damages against your firm. 4
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