1. MANM398 Auditing
Answer:
Solution To Part A
Question 1
It is to be noted that the auditor firm, “Mole & Co.” is certainly not responsible for detection
and prevent of fraud according to ISA 240. ISA 240 states that it is the management or
persons charged with the responsibility of governing and overseeing the day-to-day
operations to timely detect and prevent any kind of fraudulent activity. So, it is not the
responsibility of the auditor to detect or prevent fraud. However, ISA 240 also states that
the auditor should possess as well as acquire “reasonable assurance” that the financial
statements prepared by the organisation is free from any kind of “material misstatements”,
“fraud” and errors.”
Audit risk
Response
There is an inherent risk of overstating the expenses. The last CFO of Ratty Ltd left the
organisation just before the year end complaining about the fraudulent expenses. This issue
was also raised by the newly appointed CFO.
The substantive procedures concerning the test of various expenses must be carried out by
the auditors in order to obtain reasonable assurance regarding the presence of fraudulent
expenses transactions such as verification of purchase invoices regarding different incurred
expenses such as advertising. Confirmation can also be drawn from the vendors if suspicion
arises.
2. Inherent risk in the “Intangible asset” account as the account might be overstated. It is to be
noted that within the year, Ratty have incurred a total of £1.2m million towards
development of certain new products which are at different stages of development
including an unsuccessful attempt of developing a vaccine for Covid-19. The whole amount
has been capitalized by Ratty just to portray and added net profit because of the loan
covenant where it states of maintenance of a specific amount of net profit every year. This is
why the entire amount of £1.2m million has been capitalized and not recorded as an
expense which is not advisable according to IAS 38 because the vaccine development
attempt has failed and many new products are in different stages of development where
there is no fixed proof that the assets have entered it final development phase and ready to
be used or sold.
There should be a substantive review of all development expenditure just in order to prove
that all assets which has been capitalised met the capitalisation criteria as stated under IAS
38.
Inherent risk in the “Sales account” as there are enhanced reported cases of sales return
within the year and post the year end concerning the sales effected during the year. So,
there may be situation of overstatement of sales just to enhance and maintain the net profit.
All sales related transactions must be substantially checked in details both concerning the
test of balances and test of transactions juts to prove that all sales transactions and sales
return transactions have been properly accounted for. There should be “Inspection” of all
sales return invoices on a random basis and verified against the transactions passed within
the sales ledger to check that all sales returns transactions have been accounted for.
Inherent risk the inventory account. It has been reported by the auditor who attended the
inventory count of Ratty stated that there was actual movement of inventory when the
count was taking place.
3. Physical inventory check is to be re-done. Inspection of all relevant documentation
concerning the inward and outward movement of inventory is to be checked for both
completeness and Accuracy.
Inherent risk within the “Plant and equipment account” as the surplus plant was sold for a
profit of £130,000 which is to be investigated.
The documents concerning the sale of the machinery must be reviewed such as sales
invoices. An additional “Confirmation” may also be drawn from the purchaser regarding the
data and purchase price. The accounting policy especially concerning depreciation must be
checked to review the accuracy of the calculation and accounting for the sale of surplus
plant.
The two substantive audit procedures which Mole & Co. should carryout during the audit of
Ratty’s inventory firstly includes “Physical inventory count.” The physical inventory count
has already been done but there are noticeable glitches such as movement of inventory
during count so re-counting should be conducted. The second procedure may include taking
out random samples from the inventory records and tracing it back to the warehouse
records which would check for the existence of the inventory. The record for outward
movement of inventory as per the warehouse records could be verified against the delivery
confirmation receipts to check for existence and accuracy.
The two ethical principles which are at risk here if Mole & Co intends to accept the internal
audit function apart from providing the external audit service and discussing such matter
while playing golf with the new CFO of the audit client are “Objectivity” and “Professional
behaviour.” The “Objectivity” is at risk because there may be an undue influence by the new
CFO and presence of conflict of interest if the internal audit function is accepted by Mole
which might affect the professional judgement of Mole as an external auditor. Apart from
this fact there is a “Familiarity” threat to the independence of the auditor may rise if the
auditor accepts the invitation to visit the golf club and play golf with the current audit
client’s CEO amidst the on-going external audit. The “Professional behaviour” may be at risk
if Mole intends to accept the internal audit service along with the performance of the
external audit because the law, rules and regulations stipulates an external auditor to
perform certain other assurance services such as internal audit for the same client under an
external audit.
According to the recent changes being integrated within the “Sarbanes Oxley Act of 2002”,
the external auditors cannot specifically rely on the management’s version or narrative on
4. the internal controls or audit to reach a desired conclusion. The external auditors are now
not allowed by the Act to carryout similar audit strategies which has been adopted by the
internal audit. Now, internal audit function may portray the management’s narrative and
hence the external auditors must not rely on it and should carry out an independent
independent assessment of the fairness and reliability of the financial records that is
whether it is reasonably devoid of material misstatement, frauds and errors. Hence, the
offer of conducting an “Internal audit function” along with an external audit performance
should not be done by “Mole & Co.” So, Mole should not accept the offer of the current CFO
of Ratty.
The two limitations of external audit firstly include that the external audit is very time
consuming and a costly affair where there is a substantial need of time to conduct the audit
and involvement of a substantial outflow of funds to the external auditor or audit firm for
conduction of the audit. The second limitation is that the external audit being a costly affair
does not provide an absolute assurance and only provides a mere “reasonable assurance” as
it is based upon “test checks” and choice of samples which may not completely reveal the
presence of all fraudulent transactions or errors.
Question 2
In the case of “Crocodile.com”, where a key customer has made default in payment of
£300,000 standing to his account at the year end and the finance director has said that he
will write off the outstanding amount as bad debt in the next financial year, the audit report
should be modified and an “Qualified” report is to be offered as the subsequent in question
is an “Adjusting type.” The amount has been outstanding in the present years and any bad
debt is to be written off from the balance sheet of the financial year ended September, 2021
and not from 2022.
Peter And Wendy Ltd.:
In this case of “Peter and Wendy Ltd.”, the tax authorities have started an enquiry
concerning the tax affairs of the company on November, 2021 which is beyond the balance
sheet date and nothing has been finalised nor can be said before the inquiry gets completed.
This is thus a subsequent event of “non-adjusting type.” Here, the management have already
mentioned the situation as “notes to financial statements” which is enough and hence the
report does not need any modification and hence an “Unqualified audit report” can be
offered to “Peter and Wendy Ltd.”
Homes For Dogs (HFD):
Here, in this case of HFD, the audit report is to be modified because the charity, HFD have
recently received a government grant of £250,000 and have credited the entire amount to
the “P/L Account” which is not at all the correct accounting treatment and in place of it it
should have been credited to the “P/L Account” over the entire useful life of te asset being
purchased with such a grant. The “Director of Finance” has not agreed to change the
5. accounting treatment irrespective of possession of the knowledge that the present
accounting treatment is a wrong one. This wrong accounting treatment have caused
material errors in calculation and misstatement within the financial statements. So, there is
detected material misstatement and the management is not willing to cooperate with the
auditor in incorporating the changes mentioned by the auditor. Hence, an “Adverse” audit
report should be offered.
Hook Ltd.:
Here, in this case of “Hook Ltd”, the audit report should be modified. This is because the
balance sheet contains a “non-current asset”, “a new constructed property” at cost
amounting to £3.2 million wherein there is an inclusion of a “project management fees”
amounting to £250,000. There has been no substantial proof existing regarding the
calculation of the “project management fees” by the “Director of Finance.” The “Director of
Finance” have estimated the cost all by himself without any concrete evidence of the actual
costs incurred for the project management. The “profit before tax” for the year is amounted
to £780,000 and hence it can be concluded that the amount of “project management fees” is
material. Therefore, there can be material misstatements or errors in calculation present
within the material “project management fees” for which no satisfactory audit procedures
have been run. Hence, a “Qualified” audit report is to be offered here in this regard.
Solution To Part B
Question 3
The “Letter of Representations” is a special letter which is provided at the end of the audit
process and is considered as an eminent part of the audit evidence to preserved and used by
the auditor as and when required especially when any legal suit is filed against the auditor.
It is to be considered that an “Audit engagement letter” is provided by the auditor to the
firm and its management at the beginning of the audit which contains all relevant
information on the audit to be conducted such as scope, purpose, duration and many more.
It can be used by the management as a document and may be produced at the court of law if
any dispute arises between the auditor and the client. Hence, it is a legally enforceable
document that confirms the legal contract between the auditor and the audit firm. Now, if
the auditor needs to be sued for any professional misconduct such as negligence, then this
document of audit engagement letter comes into use. On the other hand, the “Letter of
Representation” which is provided at the end of the audit process is provided by the officers
of the client under audit that is the executives to the auditor or the audit firm who have
conducted the audit. However, it is to be specifically noted here that this particular letter is
also drafted by the auditor himself and then is sent to the management of the audit client to
duly sign on it and then return it to the auditor who would then preserve such a document
as an important audit evidence.
6. It is to be noted that the primary purpose of this report is to set out the responsibilities of
the persons to be charged with the role of managing the company. The executives of the
client company under audit this provide the much-needed representations regarding their
true responsibilities and also certifies their knowledge on certain key matters which have
been undertaken by them or by any of their subordinates under their delegation of
authority. Thus, the primary aim of the “Letter of Representation” according to ISA 580, is to
eradicate any kind of confusion regarding the true role and function of the management
personnel and different their true actions from that of the auditor. So, the specific types of
representations which are required and mostly seen on a “Letter of Representation”
includes the following:
The prepared financial statements are in conformity with the applicable frameworks for
financial reporting.
The “Letter of Representation” also portrays that all transactions and related information
have duly recoded within the financial statements to best of the knowledge of the
executives.
Certification regarding the appropriateness of future plan and correct accounting policies.
Representations of specific assertions thereby certifying those used assertions.
Certification of the fact that the internal control responsibility lies on the able shoulders of
the management personnel.
Finally, through the “Letter of Representation”, the management certifies the fact that if
there is any uncorrected misstatement, then such misstatement is completely immaterial.
Now, speaking about the significance of this “Letter of Representation” within the audit
process, it can be said that this letter is an eminent part of the audit evidence because this
letter signifies that the financial statement is prepared according to applicable laws and
frameworks and reveals the true and fair view of the entity under audit. Now, if such a letter
is not duly signed by the management, then it raises doubts regarding the fairness and
reliability of the prepared financial statements itself. Hence, there is a limitation of the
scope of audit itself and as a result the auditor might distance himself from forming an
opinion on the prepared financial statements and ultimately provide a “Disclaimer of
Opinion.”
