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ACCA P7 Advanced Audit &

Assurance
(INT)

Course Note

2017

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Lesco Group Limited, April 2018
All rights reserved. No part of this publication may be reproduced, stored in a
retrieval system, or transmitted, in any form or by any means, electronic,
mechanical, photocopying, recording or otherwise, without the prior written
permission of Lesco Group Limited.

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CONTENTS

CHAPTER1 ............................................................... 4

BEFORE THE ENGAGEMENT SERVICES ..................... 4

CHAPTER2 PERFORM AN ENGAGEMENT SERVICE ... 43

STAGE 2: AUDIT PLANNING ................................... 44

STEP 3: ASSESSING INTERNAL CONTROL SYSTEM OF

CLIENTS COMPANY ............................................... 72

IFRS RECAP WITH AUDIT KNOWLEDGE ................. 79

GROUP AUDIT...................................................... 209

PUBLIC SECTOR AUDIT ........................................ 220

STAGE 5 REVIEW STAGE ...................................... 231

STAGE 6 AUDIT REPORT ...................................... 249

NON AUDIT ENGAGEMENT SERVICES .................. 273

CHAPTER3 CURRENT ISSUES ............................... 322

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Chapter1
Before the engagement services

Contents

ADVERTISEMENT ISSUES ..................................................... 5

ADVERTISING CASE:(DEC2010 Q4) NEESON&CO ................. 6

ADVERTISING CASE:(JUNE 2004)HAWK ASSOCAITE ............ 8

TENDERING DOCUMENT ....................................................... 9

PROFESSIONAL APPOINTMENT ISSUES .............................. 10

CASE: TENDERING+FEES (JUNE09 Q2) ............................... 12

QUALITY CONTROL ............................................................. 24

EXAMPLE OF QC: DEC2007 Q1(C) ....................................... 26

ETHICS ............................................................................... 28

EXAM TECHNIQUES RELATING TO ETHICS .......................... 31

CASE: ETHICS JUNE2008 Q4 (SMITH & CO) ........................ 32

CASE: ETHICS DEC2008 Q4(BECKER & CO) ......................... 36

CASE: MONEY LAUNDERING (DEC2009 Q2(C)) ................... 40

EXAMPLE OF ISA250........................................................... 42

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Advertisement issues

Rules Explanation
Any comments about the scale of the firm should
Evidence backed up be backed up with numbers such as number of
offices.

Cant criticise others such as Cant say for example, dont use the service from
competitors our competitors.

Definitely clear Advertisements cant be too vague such as to


improve business efficiency.

Ensure to comply with laws Advertisement cant break the laws and
regulations.

Fundamental ethics Advertisements should be professional, i.e., cant


post the advertisement in the supermarket.

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Advertising Case:(DEC2010 Q4) Neeson&Co

An advertisement could be placed in national newspapers to attract


new clients. The draft advertisement has been given to you for
review:

Neeson & Co is the largest and most professional accountancy and


audit provider in the country. We offer a range of services in addition
to audit, which are guaranteed to improve your business efficiency
and save you tax.

If you are unhappy with your auditors, we can offer a second opinion
on the report that has been given.

Introductory offer: for all new clients we offer a 25% discount when
both audit and tax services are provided. Our rates are approved by
the ACCA.

Required:
Evaluate each of the suggestions made above, commenting on the
ethical and professional issues raised.8marks

Answer to Neeson&Co

Back up

Any comments made by the advertisement should be backed up with


evidence. For example, it says Neeson&Co is the largest and most
professional accountancy provider in the country, sales revenue and
the number of offices should be provided to back up this evidence.

Definitely clear

The advertisement should be definitely clear. The business efficiency


cannot be guaranteed by the firm and therefore this assertion by
Neeson may seem dishonest.

The second opinion offered by Neeson&Co may imply that the audit
work done by Neeson&Co is low and as a result client would not be
happy with the first opinion given and hence second opinion would be
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issued again. Also this comment in the advertisement is not
professional.

Ensure to comply with laws and regulation

The advertisement should comply with laws and regulation.


The guarantee to save tax means maybe Neeson would use some
tricks to help the client save time which may not comply with laws and
regulation because it will not be possible to save tax in every
circumstance.

Fundamental ethics

Neeson&Co cant quote rates which are approved by the ACCA


because the ACCA does not approve any rates and this would be seen
as unprofessional.

Legal obligation

It seems that if taxes cant be saved and also business efficiency


hasn't been improved the client may take potential legal action
against Neeson&Co resulting in further future cash outflow from
Neeson&Co.

Low balling

The 25% of introductory fees is low balling and its not prohibited but
Neeson&Co need to make sure by charging such a low amount of fees
the quality of the work can be maintained, i.e., following ISAs to do
the audit work.

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Advertising Case:(June 2004)Hawk Associate

Displaying business cards alongside those of local tradesman and


service providers in supermarkets and libraries. The cards would
read:

Hawk ACCA Associates


For PROFESSIONAL Accountancy, Audit,
Business Consultancy and Taxation services
Competitive rates. Money back guarantees.

(4marks)

Answer to June 2004 Hawk Associate

Advertisement in the supermarkets and libraries is not professional


and they should advertise their firm using e.g., financial
magazines.

Professional is in capitals and this implies only their firm is


professional while others are not and firms shouldnt criticise
others.

Competitive rate is vague and compare to whom? So this


information is misleading.

Money back guarantees may mean they can help the company
save tax and if not they would give money back to them and this
will:

Firstly, involving some illegal techniques to help the company


save tax and hence its a breach of laws and regulations.

Secondly it implies that the quality of services provided to the


company may not be good and hence give their money back.

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Tendering document

Many countries require listed companies to put their audit out to


tender in a given number of years (normally 5).

Overall, tendering tends to decrease fees charged because of


increased competition.

May be additional professional risks why is audit being put out to


tender? Client may not be satisfied with the current auditor or
attempting to remove the auditor due to disagreements.

Information to obtain prior to responding to tender

Our background
Our quality
The way we do the work is following ISAs.
What does the client require (e.g. services from audit
firm)?
Audit fees
How would you estimate the fee to include in a tender?

Service client needs


Number and grade of staff
Time to be taken
Location of client

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Professional appointment issues

There are a number of issues that need to be taken into account


before accepting an auditor to the clients company:

Factors to consider Explanation


Its very important for auditors to estimate the time
Time to build up knowledge to build up the knowledge relating to clients activity
since if it takes a long period of time to do so, then
auditors may charge a higher fee for this.

Auditors should consider whether to engage an


Expertise expert during the audit, for example, audit the fair
value of the investment property and this would be
considered when setting up the audit fees charged.

Auditors need to consider the clients control system


as well since if the clients control system is weak,
Clients control system then there might be significant audit risks involved.
Hence auditors would need to charge a higher price
based on this because auditors may tend to use
substantive testing approach in this case.

Auditors need to consider whether the clients


company is subject to first year audit and if this is the
case, then there might be significant risks of material
misstatement relating to the financial statements.
Hence more audit work would need to be performed
Opening balance of financial as a result of this and hence this will affect the audit
statement strategy and plan.

If there are outgoing auditors leaving the clients


company, then the new incoming auditor should
perform the professional clearance procedures to
seek the clients permission to see if there are any
matters that the new coming auditors should not
work for the clients company. For example, the
clients management is not honest.

This can refer to lots of things. For example, if


management is aggressive then the company may
Management style be overtrading and it would affect its going concern
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status. Hence from an ethics perspective, we should
not be the auditor for this break up company since
it would create lots of threats to objectivity which
cant be minimised.

A conflict of interest may arise where auditors obtain


price sensitive client information and advise both
parties in a takeover bid. Action stop work for one
Existing clients relationship or both parties.
(conflict of interest)
Safeguards against conflict of interest:
Use separate audit teams;
Sign confidential agreement;
Resign from one of them

If the clients company has pressure in paying for


Pressure on fees auditors fees, then the client may require the
auditors to give the wrong audit opinion.

Reputation of client If the auditors work for a client with a bad reputation
then this would damage the audit firms reputation
as well.

If the client requires auditors to promote its status,


Advocacy threat perhaps when negotiating a bank loan with the bank
and this would threaten auditors objectivity.

Are the auditors competent in completing the audit


Competence work? If not, then the auditor may be sued by the
client for negligence.

Time to start and end the audit would need to be


Time considered since this would affect the auditors
strategy to audit.
Integrity of management If management lies to auditors, then the auditors
cannot issue the opinion on their financial
statements.

Auditors need to consider whether they have enough


Staff and resources resources to carry out the audit work and if this is not
the case, auditors may not finish the work on time.

Risks attached to this engagement letter would need


Easy to be considered by auditors.
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Case: Tendering+Fees (June09 Q2)

The Dragon Group is a large group of companies operating in the


furniture retail trade. The group has expanded rapidly in the last three
years, by acquiring several subsidiaries each year. The management
of the parent company, Dragon Co, a listed company, has decided to
put the audit of the group and all subsidiaries out to tender, as the
current audit firm is not seeking re-election. The financial year end of
the Dragon Group is 30 September 2009.

You are a senior manager in Unicorn & Co, a global firm of Chartered
Certified Accountants, with offices in over 150 countries across the
world. Unicorn & Co has been invited to tender for the Dragon Group
audit (including the audit of all subsidiaries). You manage a
department within the firm which specialises in the audit of retail
companies, and you have been assigned the task of drafting the
tender document. You recently held a meeting with Edmund Jalousie,
the group finance director, in which you discussed the current group
structure, recent acquisitions, and the groups plans for future
expansion.

Meeting notes Dragon Group

Group structure

The parent company owns 20 subsidiaries, all of which are wholly


owned. Half of the subsidiaries are located in the same country as the
parent, and half overseas. Most of the foreign subsidiaries report
under the same financial reporting framework as Dragon Co, but
several prepare financial statements using local accounting rules.

Acquisitions during the year

Two companies were purchased in March 2009, both located in this


country:

(i) Mermaid Co, a company which operates 20 furniture retail outlets.


The audit opinion expressed by the incumbent auditors on the
financial statements for the year ended 30 September 2008 was
qualified by a disagreement over the non-disclosure of a contingent
liability. The contingent liability relates to a court case which is still
on-going.

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(ii) Minotaur Co, a large company, whose operations are distribution
and warehousing. This represents a diversification away from retail,
and it is hoped that the Dragon Group will benefit from significant
economies of scale as a result of the acquisition.

Other matters

The acquisitive strategy of the group over the last few years has led to
significant growth. Group revenue has increased by 25% in the last
three years, and is predicted to increase by a further 35% in the next
four years as the acquisition of more subsidiaries is planned.

The Dragon Group has raised finance for the acquisitions in the past
by becoming listed on the stock exchanges of three different
countries. A new listing on a foreign stock exchange is planned for
January 2010. For this reason, management would like the group
audit completed by 31 December 2009.

Required:
(a)Recommend and describe the principal matters to be
included in your firms tender document to provide the
audit service to the Dragon Group. (10 marks)

(b) Explain FOUR reasons why a firm of auditors may decide


NOT to seek re-election as auditor. (6 marks)

(c) Using the specific information provided, evaluate the


matters that should be considered before accepting the
audit engagement, in the event of your firm being
successful in the tender. (7 marks)

Professional marks will be awarded in part (c) for the clarity and
presentation of the evaluation. (4 marks)

Answer to June2009 Q2

(a)

Recourses
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Detailed background of our firm should be included for example the
expertise and clients we serve.

Clients needs

Because Dragon group is going to go listed onto the stock exchange


we can provide non-audit services such as corporate governance
advice relating to the listing.

We have offices in over 150 countries across the world so we can deal
with audit with your subsidiaries all around the world more effectively.

Way to do the audit

We should include how we perform the audit service to ensure an


appropriate quality of work is maintained such as following ISA to do
the risk assessment.

Also we ensure quality during the audit by having appropriate quality


control procedures during the audit such as hot review on the audit
work we have done.

Extra benefit

We can provide recommendations to address internal control


weakness to management in the management letter as an extra
service for example.

Fees

Fees should be broken down into how its calculated by clearly laying
out different classes of staff involved, such as hourly rate for audit
manager and partner.

(b)

Overdue fees

Where a client hasn't paid their fees which have been outstanding for
some time and such overdue fees would be seen as a loan to the client
which may cause a self-interest threat, i.e., in order to keep the loan
the auditor may issue whatever opinion that client wants so that a
safeguard for this is not to seek re-election.

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Resources

As the company expands the audit firm may not have enough
resources to do the audit any more. Such as the company is listing on
a stock exchange and the audit firm has a lack of relevant experts who
know the regulation of the stock exchange and so the firm may not
seek re-election.

Integrity

When the management doesn't comply with specific accounting


standards such as a deliberate failure to provide a provision in the
financial statements and this action would be seen as a lack of
integrity.

So in order for the audit firm to maintain a good reputation they


should not seek re-election.

Conflict of interest

Such as the existing company we are auditing is damaging the


environment and didn't disclose the fact.

Another company is waiting for our firms tender but they are
competitors and if we audit both companies which would cause a
conflict of interest so we should resign the first company as by
continuing to be an auditor for this company would damage our firms
reputation.

(c)

Evaluation of matters to be considered:

Recourses

As dragon group has expanded rapidly in the last three years so we


must ensure we have enough audit staff to audit those components.

Management integrity

As a qualified opinion issued by the previous auditor over a deliberate


non-disclosure of contingent liability we should question
managements integrity and if they do not integrate then we should
not accept the engagement service because if after conducting the
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service we find information we obtained is fake then it will still have an
impact on our audit opinion.

Previous auditor

It would be necessary to contact the previous auditor to gather


information regarding the non-disclosure of contingent liability with
the clients permission of whether it should be disclosed in the
individual financial statements of Mermaid Co, and at group level.

Experiences

Given Minotaur Co is involved in distribution and warehousing but this


is not a very complicated industry for Unicorn&Co because it has its
offices in over 150 countries and it should have relevant experience
into auditing this e.g., bringing in staff from a different department
more experienced in clients with distribution operations

Time

There will only be 3 months for Unicorn&Co to complete the audit and
Unicorn&Co should consider whether to allocate more resources to
this engagement given this client is large and it needs to spend more
time on it.

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Case: (June2008Q1(c)) Issues to consider

You are a senior audit manager in Mitchell & Co, a firm of Chartered
Certified Accountants. You are reviewing some information regarding
a potential new audit client, Medix Co, a supplier of medical
instruments. Extracts from notes taken at a meeting that you recently
held with the finance director of Medix Co, Ricardo Feller, are shown
below:

Meeting notes meeting held 1 June 2008 with Ricardo Feller

Medix Co is a provider of specialised surgical instruments used in medical


procedures. The company is owner managed, has a financial year ending 30 June
2008, and has invited our firm to be appointed as auditor for the forthcoming year
end. The audit is not going out to tender. Ricardo Feller has been with the
company since January 2008, following the departure of the previous finance
director, who is currently taking legal action against Medix Co for unfair dismissal.

Company background

Medix Co manufactures surgical instruments which are sold to hospitals and


clinics. Due to the increased use of laser surgery in the last four years, demand for
traditional metal surgical instruments, which provided 75% of revenue in the year
ended 30 June 2007, has declined rapidly. Medix Co is expanding into the
provision of laser surgery equipment, but research and development is at an early
stage. The directors feel confident that the laser instruments currently being
designed will eventually receive the necessary licence for commercial production,
and that the laser product will replace surgical instruments as a leading source of
revenue.

There is currently one scientist working on the laser equipment, subcontracted by


Medix Co on a freelance basis. The building in which the research is being carried
out has recently been significantly extended by the construction of a large
laboratory.

A considerable revenue stream is derived from agents who are not employed by
Medix Co. The agents earn a commission based on the value of sales they have
secured for Medix Co during the year. There are many suppliers into the market
and agents are used by all manufacturers as a means of marketing and
distributing their products.

The companys manufacturing facility is located in another country, where


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operating costs are significantly lower. The facility is under the control of a local
manager who visits the head office of Medix Co annually for a meeting with senior
management. Products are imported via airplane. The overseas plant and
equipment is owned by the company and was constructed 12 years ago
specifically for the manufacture of metal surgical instruments.

The company has a bank overdraft facility and makes use of the facility most
months. A significant bank loan, which will carry a variable interest rate, is
currently being negotiated. The terms of the loan will be finalised once the audited
financial statements have been viewed by the bank.

After receiving permission from Medix Co, you held a discussion with
the current audit partner of Medix Co, Mick Evans, who runs a small
accounting and audit practice of which he is one of two partners. Mick
told you the following:

Medix Co has been an audit client for three years. We took over from
the previous auditors following a disagreement between them and the
directors of Medix Co over fees. As we are a small practice with low
overheads we could offer lower fees than our predecessors. We could
also do the audit very quickly, which pleased the client, as they like to
keep costs as low as possible.

During our audits we have found the internal systems and controls to
be quite weak. Despite our recommendations, there always seemed
to be a lack of interest in making improvements to the accounting
systems, as this was seen to be a waste of money. There have been
two investigations by the tax authorities, which we did not deal with,
as we are not tax experts. In the end the directors sorted it all out,
and I believe that the tax matter is now resolved.

We never had a problem getting access to accounting books and


records. However, the managing director, Jon Tate, once gave us
what he described as the wrong cash book by mistake, and replaced
it with the proper version later in the day. We never found out why he
was keeping two cash books, but cash was an immaterial asset so we
didnt worry about it too much.

We are resigning as auditors because the work load is too much for
our small practice, and as Medix Co is our only audit client we have
decided to focus on providing non-audit services in the future.

You have also found a recent press cutting regarding Medix Co:
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Extract from local newspaper business section, 2 June 2008

It appears that local company Medix Co has breached local planning regulations by
building an extension to its research and development building for which no local
authority approval has been given. The land on which the premises is situated has
protected status as a greenfield site which means approval by the local authority
is necessary for any modification to commercial buildings.

A representative of the local planning office stated today: We feel that this is a
serious breach of regulations and it is not the first time that Medix Co has
deliberately ignored planning rules.

The company was successfully sued in 2003 for constructing an access road
without receiving planning permission, and we are considering taking legal action
in respect of this further breach of planning regulations. We are taking steps to
ensure that these premises should be shut down within a month. A similar breach
of regulations by a different company last year resulted in the demolition of the
building.

Required:

Prepare briefing notes, to be used by an audit partner in


your firm, assessing the professional, ethical and other
issues to be considered in deciding whether to proceed
with the appointment as auditor of Medix Co.

Note: requirement (c) includes 2 professional marks. (12 marks)

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Answer: June2008 Q1(c)

Briefing notes
To: Audit partner

From: Audit manager

Date: exam date

Subject: Factors to consider regarding appointment as auditor of


Medix Co

Introduction

This briefing note summarises the main factors we should consider in


deciding whether to take the appointment further.

Time to build up knowledge

Because this is the last month before the financial statement year end
we would question whether we have enough time to quickly build up
the knowledge of Medix company.

Expertise

Given Medix company operates in a very sophisticated industry we


need to question whether we should refer to expertise when doing the
audit and if yes this will increase audit fees charged to the client and
given the client wants to keep the audit costs as low as possible this
may not be acceptable.

Control system

Given Medix company has a weak internal control system we should


not rely on its system but rather we should use a full substantive
testing approach and this increases the costs and also time spent as
well and it may not be acceptable by the client given he wants to keep
the costs down.

Opening balance

Because this is a new audit client we should consider extra work done
on the opening balance of its financial statement given a weak internal
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control system exists.

Management style

Medix company is being sued by the previous finance director and the
previous auditor resigned as a result of a disagreement with the
management so the history shows we may find it difficult to maintain
a good relationship with management.

Fee pressure

Medix company is now struggling to raise finance and so there would


be a risk that after we become its auditor we cant collect our money
back as an audit fee and as a result this creates lots of threats to
objectivity, i.e., intimidation by threatening not to pay for us unless
we give a wrong audit opinion satisfying client.

Reputation

Medix company has been in breach of laws and regulation and this has
impaired its reputation within the industry and if we were to become
its auditor then it will impact on our reputation as well.

Advocacy threat

Medix company has been in breach of laws and if we were to become


an auditor of them then we would be seen as promoting its status
saying clients breach of laws is right and hence this will impair our
objectivity in expressing an audit opinion.

Competence

Medix company is in such a sophisticated industry and we should


question ourselves whether we have the competence to carry out
such an audit, e.g., experience in auditing the work in progress in a
similar industry.

Public interest

Medix company has previously been in breach of laws involving in


activities damaging the environment and its doing harm to public
interest so we would be better not to become its auditor.

Time
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It seems that there would be only 1 month before we start our audit
and given the complexity of the clients business activities we may not
have enough time to carry out such an audit service.

Integrity

Given there are two cash books presented by the managing director,
we can reasonably assume that fraudulent transactions may occur
here and hence we should question the integrity of management and
if they are lying then we shouldn't agree to be their auditor.

Staff and resources

We should consider whether we have enough staff and resources to


carry out the audit given part of Medix companys operations are
overseas and if so we shouldn't agree to be their auditor.

Easy

It seems that Medix company is going to raise finance from the bank
and the audit report may be relied on by the bank as well and this
creates higher risk for us because given time, resources, expertise
analysis maybe we don't have time to carry out this audit as expected.

Conclusion

So from the above analysis it would be better for us not to be an


auditor for Medix company.

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Assurance Engagement Letter

The engagement letter can be either audit or non-audit assurance.


The general contents within the engagement letter would be listed
below:

Subject matter

This explains whether the assurance engagement is audit engagement or


non-audit engagement.

3 parties

3 part involved includes:


Practitioner, i.e., auditor if its audit engagement.
Responsible party, i.e., directors.
Users, i.e., shareholders.

Standards

This explains what standard the auditor needs to comply with, e.g., for audit its
ISAs.

Evidence

This explains how much evidence the auditor needs to obtain, i.e., sufficient and
appropriate audit evidence if its audit.

Report

This explains if either positive audit assurance or negative audit assurance will
be given.

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Quality control

Auditors need to make sure that the quality of the audit work is high.
This means that auditors need to follow the ISAs (International
Standards on Auditing) when performing the audit work.

Quality control can be referred to quality control from the firm as a


whole or for the individual engagement letters.

Quality control from the firm as a whole

Issues Explanation
Audit firm should set strict procedures to employ
Recruiting and training of staff suitable staff and make sure high quality training to
those staff.

If the audit partner doesnt care about audit quality at


Attitude of partner all, for example, the audit partner doesnt employ
suitable auditors to work in the team, this would result
in lots of mistakes made by auditors.

Document policies of the audit During the audit, all of the work should be
work documented properly, for example, for training and
monitoring purposes.

Auditors need to consider whether or not a specialist


A specialist used would be needed into auditing some complicated
elements such as investment property or financial
instruments.

There should be review procedures followed by the


audit firm such as Hot review which is done before the
Review Procedures audit report is signed in order to make sure that any
mistakes during the audit have been corrected. Cold
review will be done and this means after the audit
report is signed, are there any mistakes made by the
auditors and we can learn from these. A peer review is
done by another partner in the assurance firm in
making sure that the audit quality is high as well.

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Quality control from the individual engagement letter

Issues Explanations
Before auditing the clients company, we
Pre-appointment check need to make sure that this client involves
legal activities and its reputation is good.

We should plan carefully relating to each


individual engagement letter. For example,
Planning identifying the risks of material misstatement
of the financial statements and determining
the appropriate audit procedures correctly.

This means we should be able to assign


Planning meeting responsibility to audit different items to
different auditors during the planning
meeting and they know what to do and how
to do it.

This means we need to document all the


works in the audit working papers as audit
Document all the work evidence. This would be kept in the current
audit file. The permanent audit file would also
summarise all of the clients information such
as the companys history etc.

This means when we are assigning the audit


work to auditors, this should be based on
Delegation of work based on knowledge and their knowledge and experience. For
experience example, we cant allow an audit junior to
audit related party transactions.

This means that during the audit, auditors


should be directed and supervised in order to
Direction and supervision of audit work maintain high quality audit work. If they have
any questions during the audit, an
appropriate staff within the audit team should
be able to address it.

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Example of QC: DEC2007 Q1(c)

(i) Identify and describe FOUR quality control procedures that are
applicable to the individual audit engagement; and (8 marks)

(ii) Discuss TWO problems that may be faced in implementing quality


control procedures in a small firm of Chartered Certified Accountants,
and recommend how these problems may be overcome. (4 marks)

Answer to DEC2007 Q1(c)

(i)

Pre appointment checks

Auditors should check the client before accepting this engagement


such as:

Obtaining professional clearance from previous auditors to ensure


theres no problem to accept this engagement letter from previous
auditors perspective.

Considering any conflict of interest among its existing clients.

Due diligence to ascertain if the client is involved in money


laundering activities.

Planning

Auditor should plan their audit before its actually implemented by


clearly setting up an appropriate audit strategy and detailed audit
plan.

Planning meeting

Auditors should hold a planning meeting before audit is implemented


by clearly stating the responsibility of members for example.

Documenting the work

During the audit auditors should document the work properly


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according to ISA.

Direction, supervision and review of work

During the audit there should be an audit supervisor or manager


directing the audit work, e.g., act as a mentor during the audit and if
any problems arise from the audit junior they can go to the supervisor
or manager for a solution.

Audit work should be reviewed after the work has been done, i.e., hot
review on the work before the audit report is signed to identify any
mistakes within the audit work.

Delegate work based on knowledge and experience

Auditors should be delegated work based on knowledge and


experience; this means for example the audit junior should not be
delegated the work to audit fair value.

(ii) Competence

Problem:

In order to keep up to date with the knowledge particularly for ISA


and IFRS staff should be trained but its too expensive to set up
in-house training within the small firm.

Recommendation:

This can be outsourced to an external training company to do because


they can exploit economies of scales and provide a lower cost.

Review

Problem:

It may not be possible to hold an independent review of an


engagement within the firm because of the small number of senior
and experienced auditors.

Recommendation:
An external review service may be purchased.

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Ethics

5 Principles:

Professional behavior

We shouldnt do anything that discredits the ACCAs reputation.

Integrity

Both the accountant and auditor should not lie to others.

Competence and due care

Professional accountants should pass ACCA exams and accumulate


relevant experience and do regular training to continue professional
development.

They should also follow rules to do the work and finish the work within
the reasonable amount of time.

Confidentiality

Professional accountants should keep clients information confidential


and should not disclose them to 3rd parties.

If the clients company is involved in illegal activities we can:


1. Seek legal advice
2. Disclose to those with appropriate authority.

Money Laundering

Definition:

Money laundering is to convert crime money into a legitimate form.

3 stages:

Placing

28
It seems that Heron co receives cash from the customer and this is
placing and cash may be illegal from customers.

Layering

$2m of electronic bank transfer to an overseas financial institution


would be a layering, i.e., creating transactions to cover the true
source of the money.

Integration

Then getting money out from the financial institution of $2m then the
source of money would become legitimate.

Offences:

Auditor committee money laundering activities.

Auditor helps client to establish money laundering system.

Doing tipping off meaning auditors would inform client about the
potential investigation of money laundering activities by other
departments and hence interrupt the investigation process.

Procedures relating to anti-money laundering activities

Train all relevant staff to recognise money laundering issues.

Appoint a money laundering reporting officer to deal with money


laundering activities and this will often be a senior audit partner.

Due diligence review of the clients company including their


address, directors register etc.

Review procedures would be put in place to review working papers


of the clients company to see if they are involved in money
laundering activities.

Quality control procedures would be put in place like a pre appoint


check of the clients company to ascertain if they have previously
engaged in money laundering activities.

29
Objectivity

This means the audit opinion should be trustable.

And there are 6 threats to objectivity:

1. Self-interest threat

In order for the auditor to keep benefit they help to cover up the fraud
by the client making its opinion not objective.

2. Self-review threat

Checking auditors own work would mean the auditor will lose
professional skepticism when trying to audit the client and the opinion
given wouldnt be objective.

3. Advocacy threat

It may seem that the auditor is trying to promote the status of the
clients company making any audit opinion subsequently issued not
objective.

For example, promoting shares in a listed entity when that entity is a


financial statement audit client

4. Familiarity threat

This means there is a close relationship between the auditor and


Client Company and this would mean:

1. Auditor will cover up fraud made by clients company;

2. Auditor may lose professional skepticism when auditing the clients


company.

So it will make the audit opinion not objective.

5. Intimidation threat

Clients Company threatens auditors and in order to keep benefit


auditor would issue whatever opinion that client wants, making it not
objective.

30
6. Management threat

Audit form makes a management decision on behalf of the clients


company and this may run a risk that the clients company would fail.
In order not to be affected by the clients company audit, the firm
would issue an audit opinion which is not trustable.

Exam Techniques relating to Ethics

Matters to be considered relating to ethics and other professional


issues:

Suggested Answer Plan:

Ethics

Threats

Safeguards:

Review the audit work


Rotate the audit partner (At least 7 years for Plc)
Disclosure to audit committees (Fees relating to public listed
client should not exceed 15% of firms total revenue)
Stop doing it
Give up the joint venture agreement;
Resign from the engagement;
Not representing the client in court;
Not acting for the client in the resolution of the dispute;
Not provide internal audit service to a public listed company
using the same audit team.

Other risks factors such as business risks relating to reputation.

31
Case: Ethics June 2008 Q4 (Smith & Co)

You are an audit manager in Smith & Co, a firm of Chartered Certified
Accountants. You have recently been made responsible for reviewing
invoices raised to clients and for monitoring your firms credit control
procedures. Several matters came to light during your most recent
review of client invoice files:

Norman Co, a large private company, has not paid an invoice from
Smith & Co dated 5 June 2007 for work in respect of the financial
statement audit for the year ended 28 February 2007. A file note
dated 30 November 2007 states that Norman Co is suffering poor
cash flows and is unable to pay the balance. This is the only piece of
information in the file you are reviewing relating to the invoice. You
are aware that the final audit work for the year ended 28 February
2008, which has not yet been invoiced, is nearly complete and the
audit report is due to be issued imminently.

Wallace Co, a private company whose business is the manufacture of


industrial machinery, has paid all invoices relating to the recently
completed audit planning for the year ended 31 May 2008. However,
in the invoice file you notice an invoice received by your firm from
Wallace Co. The invoice is addressed to Valerie Hobson, the manager
responsible for the audit of Wallace Co. The invoice relates to the
rental of an area in Wallace Cos empty warehouse, with the following
comment handwritten on the invoice: rental space being used for
storage of Ms Hobsons speedboat for six months she is our auditor,
so only charge a nominal sum of $100. When asked about the invoice,
Valerie Hobson said that the invoice should have been sent to her
private address. You are aware that Wallace Co sometimes uses the
empty warehouse for rental income, though this is not the main
trading income of the company.

In the miscellaneous invoices raised file, an invoice dated last week


has been raised to Software Supply Co, not a client of your firm. The
comment box on the invoice contains the note referral fee for
recommending Software Supply Co to several audit clients regarding
the supply of bespoke accounting software.

Required:

Identify and discuss the ethical and other professional issues


raised by the invoice file review, and recommend what action,
32
if any, Smith & Co should now take in respect of:

(a) Norman Co; (8 marks)

(b) Wallace Co; and (5 marks)

(c) Software Supply Co. (4 marks)

(17 marks)

Answer to June2008 Q4

(a)

Matters to consider:

In order to secure the payment, the audit firm would issue a wrong
audit opinion to maximise its benefit and hence creating a
self-interest threat to objectivity.

The audit firm is not chasing money from the client company which
would suggest there is a good relationship between them and a
familiarity threat exists meaning the audit firm may help the company
conceal some mistakes in the financial statements but still issue a
clean audit report.

Because Norman is suffering poor cash flows and is unable to pay for
an audit firm, this may create an intimidation threat meaning Norman
may threaten not to pay the firm unless a clean audit report is given.

Before accepting an engagement letter to Norman, the auditors


should do a detailed pre-appointment check to ensure this client is a
going concern entity.

Actions:

1. Auditor should raise this issue to the audit committee to secure


payments.

2. Auditors should quickly invoice management about the audit work


service fees.

3. Auditor should have a detailed pre-appointment check client in the


33
future before working for them.

4. Auditors should perform an independent partner check for last


years audit work as well since they havent paid the firm in the last
year.

(b)

Matters to consider:

In order to keep the cheap rental expense of $100, the auditor would
issue a wrong audit opinion and hence this leads to a self-interest
threat.

The $100 nominal value would suggest theres a good relationship


between the client and the audit firm and hence there is a familiarity
threat, meaning auditors would lose professional skepticism when
doing the audit and hence giving a wrong audit opinion.

The nominal $100 would create an intimidation threat as well because


the client would threaten to withdraw this offer unless a clean audit
report is given by the auditors.

This is about managers work and hence its senior so all its work done
would have a big impact on the overall opinion given.

Actions:

1. Partners should perform an independent review on work done by


the audit manager.

2. When necessary report to the ACCA about this issue.

3. Remove managers from the audit team for this client.

4. Carefully check whether there are any relationships that the


manager with other clients and if yes then remove him/her from other
services as well.

(c)

Matters to consider:

34
This will increase business risk because if the software quality is bad
then it would be seen that audit firms work quality would be bad as
well and hence leads to an impairment of audit firms reputation.

Actions:

1. Tell client about the referral fees.

2. Make written confirmation that the client knows about the referral
fees.

3. Make sure that other audit staff involved in the audit have no
further interest in the software company because if they do then any
other threats to objectivity would be created.

35
Case: Ethics DEC2008 Q4 (Becker & Co)

You are a senior manager in Becker & Co, a firm of Chartered Certified
Accountants offering audit and assurance services mainly to large,
privately owned companies.

The firm has suffered from increased competition, due to two new
firms of accountants setting up in the same town. Several audit clients
have moved to the new firms, leading to loss of revenue, and an over
staffed audit department. Bob McEnroe, one of the partners of Becker
& Co, has asked you to consider how the firm could react to this
situation. Several possibilities have been raised for your
consideration:

1. Murray Co, a manufacturer of electronic equipment, is one of


Becker & Cos audit clients. You are aware that the company has
recently designed a new product, which market research indicates is
likely to be very successful.

The development of the product has been a huge drain on cash


resources. The managing director of Murray Co has written to the
audit engagement partner to see if Becker & Co would be interested in
making an investment in the new product. It has been suggested that
Becker & Co could provide finance for the completion of the
development and the marketing of the product. The finance would be
in the form of convertible debentures.

Alternatively, a joint venture company in which control is shared


between Murray Co and Becker & Co could be established to
manufacture, market and distribute the new product.

2. Becker & Co is considering expanding the provision of non-audit


services. Ingrid Sharapova, a senior manager in Becker & Co, has
suggested that the firm could offer a recruitment advisory service to
clients, specialising in the recruitment of finance professionals. Becker
& Co would charge a fee for this service based on the salary of the
employee recruited. Ingrid Sharapova worked as a recruitment
consultant for a year before deciding to train as an accountant.

3. Several audit clients are experiencing staff shortages, and it has


been suggested that temporary staff assignments could be offered. It
is envisaged that a number of audit managers or seniors could be
seconded to clients for periods not exceeding six months, after which
36
time they would return to Becker & Co.

Required:

Identify and explain the ethical and practice management


implications in respect of:

(a) A business arrangement with Murray Co. (7 marks)

(b) A recruitment service offered to clients. (7 marks)

(c) Temporary staff assignments. (6 marks)

(d) I heard one of the audit managers say that our firm had
lost an audit client to a competitor because of lowballing.
What is lowballing and is it allowed?
(3 marks)

(23 marks)

Answer to DEC2008 Q4

(a)

In order to make investment in the product more successful, the


audit firm would issue a favorable audit opinion to the clients
company even though its financial statements are wrong and this
creates a self-interest threat.

By starting up a joint venture it may suggest audit firm and Murray


Company are close friends and hence this creates a familiarity
threat meaning the Audit firm would lose professional skepticism
when doing the actual audit.

The finance is in the form of a convertible loan meaning it can be


converted into cash or equity at the end of the life of project and an
intimidation threat exists meaning if the audit firm is not going to
issue a clean audit report then Murray Company may not pay the
audit firm for cash/equity.

A management threat arises as well because a joint venture is set


37
up and any management decision made by the audit firm may
result in company failure and hence there is a risk that the audit
firm may get sued and hence in order to not be sued by Murray
company, the audit firm would issue whatever opinion that they
want.

By investing in such a project there is a business risk that the audit


firms reputation would be impaired if the project goes badly and
hence there might be less future clients who go to Becker&Co.

Audit firm would have 2 choices including:

1. Accept the offer but IFAC code of ethics says the threats to
objectivity making opinion not objective to be so significant and no
safeguard would put in place to minimise the threat and hence audit
firm would be better not doing audit services for this client.

2. Reject the offer and continue to provide audit service to this client.

(b)

Receiving more income from the audit client would create a


self-interest threat because in order to keep this interest the audit
firm would issue whatever opinion that client wants.

Because Becker & Co would charge a fee for this service based on
the salary of the employee recruited, the higher salary that
Becker&co agrees then the higher the income stream which would
flow into the audit firm and hence producing a greater self-interest
threat.

By recruiting members to do the financial work the employees and


audit firm would become friends and hence familiarity threats are
created because by subsequently checking work done by those
staff, the auditor would lose professional skepticism.

Intimidation threat would be created because if the quality of


recruited staff is poor then the client would sue or require a clean
audit report even though the financial statements are not true and
fair.

If the staff recruited are of poor quality then there would be an


impairment on the audit firms reputation and hence future clients
may not go to Becker&Co for those services including audit
38
services anymore.

(c)

The Audit firm would have an incentive to send higher level staff to
the company and hence earn more fees and this creates a higher
self-interest threat.

After the auditor works on this company they may have a good
relationship with staff there and hence a familiarity threat is
created meaning the auditor would lose professional skepticism
when doing the actual audit or ignore the mistakes staff have made
as well.

If the quality of the auditor sent to clients company is poor then an


intimidation threat would create meaning client would choose to
sue us for negligence or we give a clean audit report in order not
get sued.

The audit manager or partner sent would be so senior and hence


they would have a big impact on the audit work so this needs to be
carefully checked.

(d)

Low balling is when an audit firm charges a low fee to attract audit
service from client in the hope of winning the tender contract and
provide future services to the client.

This is not banned by the ACCA as long as the audit firm can
demonstrate they would complete the work with competence and
due care.

But as the fees are cut back then the auditor may not spend
enough time doing the work and stick to auditing standards and
hence the quality of the audit work would be compromised.

39
Case: Money Laundering (DEC2009 Q2(c))

There are specific regulatory obligations imposed on accountants and


auditors in relation to detecting and reporting money laundering
activities. You have been asked to provide a training session to the
new audit juniors on auditors responsibilities in relation to money
laundering.

Required:
Prepare briefing notes to be used at your training session in which
you:

(i)Explain the term money laundering. Illustrate your explanation


with examples of money laundering offences, including those which
could be committed by the accountant; and

(ii)Explain the policies and procedures that a firm of Chartered


Certified Accountants should establish in order to meet its
responsibilities in relation to money laundering.
(10 marks)

Professional marks will be awarded in part (c) for the format of the
answer, and the quality of the explanations provided.
(2 marks)

40
Answer to DEC2009 Q2(c)

(i)

Definition:

Money laundering is to convert crime money into a legitimate form.

3 stages:

Placing

It seems that Heron co receives cash from customer and this is


placing and cash may be illegal from customers.

Layering

$2m of electronic bank transfer to an overseas financial institution


would be a layering, i.e., creating transactions to cover the true
source of money.

Integration

Then getting money out from the financial institution of $2m then the
source of money would become legitimate.

Offences:

Auditor committee money laundering activities.

Auditor helps client to establish money laundering system.

Doing tipping off meaning auditors would inform client about the
potential investigation of money laundering activities by other
departments and hence interrupt the investigation process.

(ii)

Train all relevant staff to money laundering issues.

Appoint a money laundering reporting officer to deal with money


laundering activities and this will often be a senior audit partner.

41
Due diligence review of clients company including their address,
directors register etc.

Review procedures would be put in place to review working papers


of clients company to see if they are involved in money laundering
activities.

Quality control procedures would be put in place like pre appoint


check of the clients company whether it would involve in money
laundering activities.

Example of ISA250

The purpose of ISA250 Consideration of Laws and regulations in an


audit of financial statements is to establish standards and provide
guidance on the auditors responsibility to consider laws and
regulations in an audit of financial statements.

Required:

Explain the auditors responsibilities for reporting non-compliance


that comes to the auditors attention during the conduct of an audit.
(5marks)

Answer to ISA250

Auditors are not responsible for the non-compliance with laws by


the client.

But if the non-compliance with laws would result in a material


misstatement in the clients financial statements then auditors
should modify its audit report.

Before that auditors should raise this issue to audit committee.

If this is not applicable then the auditor should seek legal advice
first.

If the Client Company is involved in money laundering issues then


the auditor should report this to relevant authority.
42
Chapter2 Perform an engagement service

Audit Flowchart

Step1: Agreement with Client (Covered in Chapter 1)

Step2: Audit planning (Focus on Risk Based Audit)

Step3: Assessing internal control system of clients company

Step4: Substantive testing

Step5: Reviewing

Step6: Audit report

We will start off by focusing on stage 2 audit planning onwards.

43
Stage 2: Audit Planning

Auditor is required to set up an audit strategy as well as an audit plan


before they start auditing clients financial statements.

Auditors are required to use the risks based approach to audit. For
example, they will start from the business risks analysed within
clients company and then they will start analysing risks of material
misstatement or audit risks in the clients financial statements.

Contents

AUDIT FLOWCHART ............................................................ 43

AUDIT STRATEGY ............................................................... 45

IAS 315 .............................................................................. 45

WAYS TO UNDERSTAND CLIENT ......................................... 46

AUDIT PLAN ....................................................................... 48

MATERIALITY ..................................................................... 50

RISK QUESTION EXAM TECHNIQUES .................................. 51

EXAMPLE OF AUDIT PLANNING: JUNE2009 Q1(A) .............. 52

ANALYTICAL PROCEDURE: DEC2009 Q1(A)(B) ................... 55

CASE: BUSINESS RISKS JUNE2008 Q1 (A+B) ..................... 57

JUNE2012 Q1 (RISK OF MATERIAL MISSTATEMENT/AUDIT


RISKS) ............................................................................... 64

44
Audit strategy

Audit strategy sets out the scope, timing, nature and direction of the
audit and it tells the auditor which audit approach should be used, i.e.,
system based or full substantive approach and how the resources
would be allocated.

Within the direction of audit, it requires auditors to firstly understand


the clients business (ISA315 Identifying and Assessing the Risks of
Material Misstatement through Understanding the Entity and Its
Environment) and then deal with preliminary materiality and
performance materiality issues.

IAS 315

ISA 315 Identifying and Assessing the Risks of Material Misstatement


through Understanding the Entity and Its Environment requires that
there are 5 Aspects that auditors need to understand:

Internal control system

Auditors should understand the clients internal control system


because weaknesses in the internal control system will result in
potential material misstatement in the financial statements. For
example a failure to reconcile bank statement and cash book regularly
will result in bank balances within the financial statements being
misstated.

External factors

Auditors should understand clients external factors because this


would impact on the overall financial statements. For example if a new
law and regulation have been passed then the clients existing
activities may not comply with new laws and regulations and so a
penalty will need to be paid by the client, so the client might ignore
this and as a result a failure to provide for a provision according to
IAS37 in its financial statement resulting in understatement of
expenses and liability.

45
Company structure and its accounting policy

Auditors should understand the client companys structure and its


accounting policy because if the structure is very complicated then
when trying to consolidate the group there would be risks of material
misstatement, i.e., inaccurate calculation of goodwill.

Also auditors should understand its accounting policy and ensure they
are consistent with the applicable financial reporting framework

Performance measurement

Auditors should understand the clients performance measurement


because this would have an impact on the financial statement
whether to be misstated. For example if a manager of a company is
measured based on profit before tax and then the manager may have
an incentive to overstate this figure in order to get more bonuses and
as a result a misstatement exists in this figure.

Business strategy, business plan and its related business risks

The business strategy, plan and risk would have an impact on the
companys financial statements whether or not it will be misstated.

For example there is a business risk that the business strategy and
plan would fail leading to a decrease in shareholders wealth and as a
result management may have an incentive to overstate e.g., profit
within the company to make its figure look better and as a result a
misstatement in the profit figure.

Ways to understand the client

Analytical procedure

Auditors should perform analytical procedures to compare financial


information with non-financial information to identify any unexpected
trends between the two, e.g., comparing revenue growth from last
year to this year with economic recession to identify any unexpected
trend.

Compare actual results to the forecasted result to identify any


significant changes to plan;
46
Compare the clients performance and position to industry data to
identify significant variations;

Compare the clients financial statements with prior years financial


statements to identify any unexpected changes in performance or
position.

Enquiry

Auditors should enquire with management about the internal control


systems of the company.

For example:
Have any new competitors or products entered the market?
How does the company manage exposure to exchange rate
risk?
Have there been any changes in senior management during the
year?

Inspection

Auditors should inspect managements business strategy and plans to


identify any business risks which exist/ previous years audit working
papers to better understand the company.

For example:
Organisation charts to identify changes in key staff;

Company strategic objectives to identify how they are


performing in comparison.

Evidence of review of month end reconciliations or review of


aged receivables on a monthly basis;

HR records to identify movements in staff;

News to identify any significant issues such as potential legal


action.

Observation

Auditors should physically observe the internal control operations to


verify they are not just paper work.

47
For example:

The application of controls over the counting of inventory during


the year;

The performance of year end reconciliations such as bank or


supplier reconciliations to ensure they are performed correctly.

Recalculation

Auditors should recalculate figures in the financial statement to verify


its accuracy.

Audit Plan

Audit plan sets out the risk assessment, materiality and potential
audit procedures to be used in stage4 of audit.

Risk equation

The risk assessment is based on risk equation:

Audit risk=Risks of material misstatement X Detection risk

Inherent risk

This is a risk happened in the first place because of its nature.

E.g.:

If the balance is very complicated, then accountants would easily


make a mistake.

If the business changes its operations, then business risks would


change and maybe management cant cope with the changes in the
business environment and hence it may fail. So management would
have an incentive to make the failed company look better to
manipulate the Financial Statements, i.e., window dressing.

In a company dealing primarily with cash, completeness of income


may be difficult to determine because cash is easy to be stolen.

48
Control risk

This is the risk of misstatement because the companys internal


control systems do not prevent or detect an error.

E.g.:

No segregation of duties between the accountant and cashier leading


to cash being stolen, i.e., in a shop using cash, completeness of
income could be confirmed by agreeing the amount that should be in
a cash till to the actual cash in that till.

But there will still be a weakness since the control assumes that the
person operating the till records the cash sale. No recording of sales
means that cash is not included in the total and this could therefore
still be stolen.

Detection risk

This is a risk that errors cant be detected by auditors.

E.g.:

Auditor lacks experience to deal with the issue and cant spot the
mistake.

If auditors want to test the completeness of the income above, the


auditor needs to observe the person using the till to ensure all income
is recorded and hence a failure to do so will increase the detection
risk.

The detection risk can be sampling risk or non-sampling risk.

Sampling risk means that the auditor cant spot the material
misstatements because of lack of time to audit or lack of knowledge.

Non-Sampling risk means that auditors failed to apply audit


procedures correctly. For example, auditors does not use the
statistical sampling method correctly.

49
Audit Risk Equation Relationship

Materiality

Per ISA 320 Materiality in planning and performing an audit sets out
the guidance for preliminary materiality as well as performance
materiality calculation.

It requires the auditors to be aware of materiality at all times.


Materiality is the amount where a change to any figure in the financial
statements would impact the users economic decision of whether to
buy or sell a share of the company.

Preliminary materiality

Benchmark for materiality Financial Statements Impact


calculation
More than 5% of profit before tax Material to statement of profit or loss

More than 0.5% of sales revenue Material to statement of profit or loss

More than 1% of total assets Material to statement of Financial


Position

Performance materiality

This figure is less than preliminary materiality. This is the amount


used by the auditor in planning and performing the audit procedures.
If the balance exceeds the performance materiality, then it may
suggest that this balance is more risky than it should be and hence
auditors would perform some procedures in making sure the balance
would not be materially stated.

And surely, the materiality level is set up by judgement.

50
Risk Question Exam Techniques

1. Business Risks

Step1: Sub heading telling examiner which area you are referring to

Step2: Explain why this is a business risk. For example, if it takes


place, then the profit/sales/cash flow or the company will suffer.
Sometimes you can also refer to reputation of the company will impair
as well.

2. Risks of material misstatement/ Audit Risks

Inherent Risk

Step1: Sub heading telling examiner which are you are referring to

Step2: Materiality Calculation

Step3: Refer to Accounting standards requirements

Step4: There is a risk that this is not followed resulting in material


misstatements in what financial statements and their impact
(Under/Overstatement/Under Disclosure).

Control Risk

Step1: Sub heading telling examiner which are you are referring to;

Step2: Because of this internal control weakness, for example,


finance director left the company and hence the financial statements
(Consolidation) may be materially misstated.

Detection Risk

Step1: Sub heading telling examiner which are you are referring to;

Step2: Because it is the first time the auditor is auditing this company
and hence the auditor may not find out the material misstatements in
the clients financial statements resulting in giving a wrong audit
opinion.
51
Example of Audit Planning: June2009 Q1(a)

Required:

(a)

(i) Identify and explain the aspects of a clients business which should
be considered in order to gain an understanding of the company and
its operating environment; and
(6 marks)
(ii) Recommend the procedures an auditor should perform in order to
gain business understanding.
(4 marks)
Professional marks will be awarded in part (a) for the clarity,
format and presentation of the briefing notes.
(2 marks)

52
Answer to June2009 Q1(a)

(i)

Internal control system

Auditors need to review the clients internal control system including


its control environment, internal control procedures etc. to better
understand whether a control testing approach or full substantive
testing approach to audit would be used.

External factors

Auditors need to review the level of competition within the industry


because for example if the industry is so competitive then in order for
the company to keep up with the industry average profit then the
company would have an incentive to manipulate the financial
statements.

Auditors need to review the laws and regulations as well because if the
clients companys activity is not fulfilling the current laws and
regulations then there might be risks that financial statements would
be misstated, e.g., failure to disclose contingent liability to the note of
the Financial statements.

Performance measurement

Auditors need to review the companys performance measurement as


well because for example if a manager is measured based on profit
then profit would be overstated in order to earn more bonus.

Companys structure and its accounting policy

Auditors need to review its structure and its accounting policy and if
the companys structure is so complicated then during the actual
consolidation there would be potential misstatements to the financial
statements as well.

Companys strategy, plan and its related business risks

For example companys strategy would be a market leader in the


industry so its plan would be launching a new product and there is a
business risk that this may fail resulting in the financial statements
53
being misstated.

(ii)

Perform analytical procedure to identify any unusual transactions


and this can help auditors to identify whether trends for the
financial statements would be reasonable, i.e., consistent with
growth in the economy.

Enquire with internal auditors about internal control systems of the


company to understand its effectiveness.

Inspect business plan by management to understand its potential


business risks.

Observe internal control operations physically to verify internal


control procedures are working effectively.

Recalculate some material balances to verify its accuracy.

54
Analytical Procedure: DEC2009 Q1(a)(b)

ISA 520 Analytical Procedures requires that the auditor performs


analytical procedures during the initial risk assessment stage of the
audit. These procedures, also known as preliminary analytical review,
are usually performed before the year end, as part of the planning of
the final audit.

Required:

(i) Explain, using examples, the reasons for performing


analytical procedures as part of risk assessment; and

(ii) Discuss the limitations of performing analytical


procedures at the planning stage of the final audit.
(6 marks)

(b) Explain and differentiate between the terms overall audit


strategy and audit plan.
(4 marks)

55
Answer to DEC2009 Q1(a)(b)

(i)

It can help auditors better understand the client.

E.g., perform analytical procedures for new clients by comparing


its profit with its competitor would provide the auditor with a better
picture about the relative performance of the entity within its
business environment.

It can help auditors better identify high risk areas.

E.g., preform analytical procedures by comparing its financial


information, e.g. 200% increase in profit with the non- financial
information such as economic recession happens outside the
market would clearly show that revenue may be overstated and
hence this is a high risk area.

(ii)

It may not reflect the whole year figure because this is done based
on interim financial information.

Because its not done at the year-end so some figures such as


impairment should be ignored.

For some companies their internal control system would be weak


during the year and hence the analytical procedure on these
results may not be correct.

(b)

Audit strategy sets out the scope, timing, nature and direction of
the audit and it tells the auditor which audit approach should be
used, i.e., system based or full substantive approach and how the
recourses would be allocated.

Audit plan sets out the risk assessment, materiality and potential
audit procedures to be used.

Audit strategy leads to the audit plan, i.e., if a system based


approach is used then less audit procedures would be included in
56
the audit plan.

Any changes in the audit plan should lead to a change in the audit
strategy as well, e.g., during the audit a material risky balance is
omitted so further procedures should be planned and recourses
allocation schedule would also be changed.

Case: Business Risks June2008 Q1 (a+b)

You are a senior audit manager in Mitchell & Co, a firm of Chartered
Certified Accountants. You are reviewing some information regarding
a potential new audit client, Medix Co, a supplier of medical
instruments. Extracts from notes taken at a meeting that you recently
held with the finance director of Medix Co, Ricardo Feller, are shown
below:

Meeting notes meeting held 1 June 2008 with Ricardo Feller

Medix Co is a provider of specialised surgical instruments used in


medical procedures. The company is owner managed, has a financial
year ending 30 June 2008, and has invited our firm to be appointed as
auditor for the forthcoming year end. The audit is not going out to
tender. Ricardo Feller has been with the company since January 2008,
following the departure of the previous finance director, who is
currently taking legal action against Medix Co for unfair dismissal.

Company background

Medix Co manufactures surgical instruments which are sold to


hospitals and clinics. Due to the increased use of laser surgery in the
last four years, demand for traditional metal surgical instruments,
which provided 75% of revenue in the year ended 30 June 2007, has
declined rapidly.

Medix Co is expanding into the provision of laser surgery equipment,


but research and development is at an early stage. The directors feel
confident that the laser instruments currently being designed will
eventually receive the necessary licence for commercial production,
and that the laser product will replace surgical instruments as a
leading source of revenue.

57
There is currently one scientist working on the laser equipment,
subcontracted by Medix Co on a freelance basis. The building in which
the research is being carried out has recently been significantly
extended by the construction of a large laboratory.

A considerable revenue stream is derived from agents who are not


employed by Medix Co. The agents earn a commission based on the
value of sales they have secured for Medix Co during the year. There
are many suppliers into the market and agents are used by all
manufacturers as a means of marketing and distributing their
products.

The companys manufacturing facility is located in another country,


where operating costs are significantly lower. The facility is under the
control of a local manager who visits the head office of Medix Co
annually for a meeting with senior management. Products are
imported via airplane. The overseas plant and equipment is owned by
the company and was constructed 12 years ago specifically for the
manufacture of metal surgical instruments.

The company has a bank overdraft facility and makes use of the
facility most months. A significant bank loan, which will carry a
variable interest rate, is currently being negotiated. The terms of the
loan will be finalised once the audited financial statements have been
viewed by the bank.

After receiving permission from Medix Co, you held a discussion with
the current audit partner of Medix Co, Mick Evans, who runs a small
accounting and audit practice of which he is one of two partners. Mick
told you the following:

Medix Co has been an audit client for three years. We took over from
the previous auditors following a disagreement between them and the
directors of Medix Co over fees. As we are a small practice with low
overheads we could offer lower fees than our predecessors. We could
also do the audit very quickly, which pleased the client, as they like to
keep costs as low as possible.

During our audits we have found the internal systems and controls to
be quite weak. Despite our recommendations, there always seemed
to be a lack of interest in making improvements to the accounting
systems, as this was seen to be a waste of money. There have been
two investigations by the tax authorities, which we did not deal with,
58
as we are not tax experts. In the end the directors sorted it all out,
and I believe that the tax matter is now resolved.

We never had a problem getting access to accounting books and


records. However, the managing director, Jon Tate, once gave us
what he described as the wrong cash book by mistake, and replaced
it with the proper version later in the day. We never found out why he
was keeping two cash books, but cash was an immaterial asset so we
didnt worry about it too much.

We are resigning as auditors because the work load is too much for
our small practice, and as Medix Co is our only audit client we have
decided to focus on providing non-audit services in the future.

You have also found a recent press cutting regarding Medix Co:

Extract from local newspaper business section, 2 June 2008

It appears that local company Medix Co has breached local planning


regulations by building an extension to its research and development
building for which no local authority approval has been given. The
land on which the premises is situated has protected status as a
greenfield site which means approval by the local authority is
necessary for any modification to commercial buildings.

A representative of the local planning office stated today: We feel


that this is a serious breach of regulations and it is not the first time
that Medix Co has deliberately ignored planning rules. The company
was successfully sued in 2003 for constructing an access road without
receiving planning permission, and we are considering taking legal
action in respect of this further breach of planning regulations. We are
taking steps to ensure that these premises should be shut down
within a month. A similar breach of regulations by a different company
last year resulted in the demolition of the building.

Required:
(a) Using the information provided, identify and explain the
principal business risks facing Medix Co.
(12 marks)
(b) (i) Discuss the relationship between the concepts of
business risk and risk of material misstatement; and
(4 marks)

59
Answer to June2008Q1(a+b)

(a)

Demand

Demand of traditional market is declining.

There is a risk that the continued decline in demand in the traditional


market will result in less profit being made by the company.

R&D

The research and development would be costly for the company.

There is a risk that given the poor liquidity position of the company
because the company seems to make use of the facility most months
and because R&D expenses are a huge cost to the company so the
company may not have enough money to invest in this area hence
making this unsuccessful.

License

Management is confident that the licence will be received for


commercial production in the future.

There is a risk that the license may not be received by the company
given this is a highly regulated country and hence this will make the
future production not successful decreasing shareholders wealth as a
result.

Scientist

There is just one scientist working in the company.

There is a risk that this scientist may leave the company and hence
stop researching and developing of products process and this will
result in the company suffering greater loss given huge expenses
input in the R&D process.

The scientist is subcontracted, not employed by the company.


There is a risk that the scientist may bring his knowledge and research
results out from the company to its competitors and if this is the case
60
the companys financial position will be again threatened resulting in a
decrease in profit and shareholders wealth.

Agent

A large amount of revenue is from the agent.

There is a risk that if the agent is not successful in selling products it


may result in a further decrease in profit and cash flow from the
company.

There is a risk that the agent may try to overstate the sales revenue
in order to maximise commission received and given a weak internal
control system exists within company, this may not be easily
detected.

Overseas location

The manufacturing facility is located overseas.

There is a risk that quality of product may not be guaranteed and if the
quality of the product is poor then it will impact on the demand for
products and hence impair the profitability of company.

There is a risk that the company will have to pay high expenses to
import goods from other countries and hence this will decrease the
profit of the company.

There is a risk that the company will have to suffer foreign exchange
rate risk and hence it will decrease its profit given an increase in the
expenses.

Aged asset

The overseas plant and equipment were built 12 years ago.

There is a risk that given the assets are too old, it may not have
sufficient future capacity to produce new products in the future and
hence decrease profit of the company.

Bank overdraft

The Company relies very much on the bank overdraft and this is more
61
expensive than other bank loans.

There is a risk that it will further impair its profitability because the
company has to pay more as a result of the expensive expense.

Weak internal control system

The internal control system of the clients company is so weak.

There is a risk that fraudulent transactions happened which cant be


detected and it may lead to the company suffering a loss.

Tax authority

Two tax investigations into the company happened.

There is a risk that the company may not comply with tax regulations
which would result in further penalties paid by the company as a
result and hence impair its profitability position.

Shut down

The building has no local authority approval.

There is a risk that the building may be shut down and as a result the
company needs to find another place to build the building which may
be expensive to the company and hence impair its profitability
position.

Regulations

The company has been in breach of local planning regulations.

There is a risk that the company will need to pay a related penalty
which would impair its liquidity position.

Reputation

The company breaches the regulation.

There is a risk that demands for the product by customers will


decrease as a result of the bad publicity the company creates, i.e.,
breaches in regulation.

62
Impairment of building

The building has been impaired last year.

There is a risk that the company may find it more difficult to raise
finance because of a worsened position in its non-current assets.

(b)

(i)

Business risk is the risk that the business fails, i.e., as a result of
this risk the company will have to pay more expenses.

Risk of material misstatement is the risk that the financial


statement of the clients company may be misstated.

Business risk will lead to risks of material misstatement, i.e., in


Medix Co the decline in demand of products by customers is a
business risk and this would lead to risk of material misstatement
in financial statement, i.e., risk of inventory being overstated.

Business risk would relate to going concern status of company as


well. I.e., in Medix Co it is struggling to raise finance given poor
quality assets it has and as a result of the lack of finance it would
impact on its going concern status, i.e., doesn't have enough cash
flow to operate its business.

63
June2012 Q1 (Risk of material misstatement/Audit risks)

You are a manager in Magpie & Co, responsible for the audit of the CS
Group. An extract from the permanent audit file describing the CS
Groups history and operations is shown below:

Permanent file (extract) Crow Co was incorporated 100 years ago. It


was founded by Joseph Crow, who established a small pottery making
tableware such as dishes, plates and cups. The products quickly grew
popular, with one range of products becoming highly sought after
when it was used at a royal wedding. The companys products have
retained their popularity over the decades, and the Crow brand enjoys
a strong identity and good market share.

Ten years ago, Crow Co made its first acquisition by purchasing 100%
of the share capital of Starling Co. Both companies benefited from the
newly formed CS Group, as Starling Co itself had a strong brand name
in the pottery market. The CS Group has a history of steady
profitability and stable management.

Crow Co and Starling Co have a financial year ending 31 July 2012,


and your firm has audited both companies for several years.

Acquisition of Canary Co

The most significant event for the CS Group this year was the
acquisition of Canary Co, which took place on 1 February 2012. Crow
Co purchased all of Canary Cos equity shares for cash consideration
of $125 million, and further contingent consideration of $30 million
will be paid on the third anniversary of the acquisition, if the Groups
revenue grows by at least 8% per annum. Crow Co engaged an
external provider to perform due diligence on Canary Co, whose
report indicated that the fair value of Canary Cos net assets was
estimated to be $110 million at the date of acquisition. Goodwill
arising on the acquisition has been calculated as follows:
$m
Fair value of consideration:
Cash consideration 125
Contingent consideration 30
Less: fair value of identifiable net assets (110)
acquired
Goodwill 45

64
To help finance the acquisition, Crow Co issued loan stock at par on 31
January 2012, raising cash of $100 million. The loan has a five-year
term, and will be repaid at a premium of $20 million. 5% interest is
payable annually in arrears. It is Group accounting policy to recognise
financial liabilities at amortised cost.

Canary Co manufactures pottery figurines and ornaments. The


company is considered a good strategic fit to the Group, as its
products are luxury items like those of Crow Co and Starling Co, and
its acquisition will enable the Group to diversify into a different market.
Approximately 30% of its sales are made online, and it is hoped that
online sales can soon be introduced for the rest of the Groups
products. Canary Co has only ever operated as a single company, so
this is the first year that it is part of a group of companies.

Financial performance and position


The Group has performed well this year, with forecast consolidated
revenue for the year to 31 July 2012 of $135 million (2011 $125
million), and profit before tax of $8
5 million (2011 $8
4 million). A
breakdown of the Groups forecast revenue and profit is shown below:

Crow Co Starling Co Canary Co CS Group


$ million $ million $ million $ million
Revenue 69 50 16 135
Profit before 35 3 2 8.5
tax
Note: Canary Cos results have been included from 1 February 2012
(date of acquisition), and forecast up to 31 July 2012, the CS Groups
financial year end.

The forecast consolidated statement of financial position at 31 July


2012 recognises total assets of $550 million.

Other matters

Starling Co received a grant of $35 million on 1 March 2012 in relation


to redevelopment of its main manufacturing site. The government is
providing grants to companies for capital expenditure on
environmentally friendly assets. Starling Co has spent $25 million of
the amount received on solar panels which generate electricity, and
intends to spend the remaining $10 million on upgrading its
production and packaging lines.

On 1 January 2012, a new IT system was introduced to Crow Co and


65
Starling Co, with the aim of improving financial reporting controls and
to standardise processes across the two companies. Unfortunately,
Starling Cos finance director left the company last week.

Required:
Evaluate the risks of material misstatement to be considered in the
audit planning of the individual and consolidated financial statements
of the CS Group
(18 marks)

Answer to June2012 Q1

Step1: Contingent consideration

Step2: This is more than 1% of total group assets and hence this is
material to the group statement of financial position.

Step3: According to IFRS3 business combination that contingent


consideration of $30m should include the probability of payment and
also should discount to present value.

Step4: Theres a risk that $30m hasn't included the probability of


being paid and hasn't been discounted to its present value resulting in
over/understatement of goodwill figure.

Step1: Net assets

Step2: The fair value of net asset worth of $110m is more than 1% of
total group assets and hence this is material to the group statement of
financial position.

Step3: According to IFRS3 business combination that the fair value of


net assets worth of $110m should net of deferred tax implication.

66
Step4: There is a risk that $110m hasn't included deferred tax
implication, i.e., net of deferred tax liability resulting in misstatement
in identifiable net assets figure.

Step1: Goodwill

Step2: Goodwill worth of $45m is material to the group statement of


financial position because its more than 1% of it.

Step3: According to IAS 36 impairment of assets, management


should conduct an impairment test for goodwill worth at $45m at the
year-end by comparing its carrying value and its recoverable amount.

Step4: There is a risk that an impairment test has not been done
resulting in overstatement of goodwill in statement of financial
position and understatement of expenses in the statement of profit or
loss.

Step1: Loan stock

Step2: This is material to the statement of financial position because


$20m of premium is more than 1% of total asset and the relating
finance cost is more than 0.5% ($5m) of the total sales.

Step3: According to IFRS9 financial instrument when calculating the


fair value of financial liability at inception the repayment at premium
of $20m should be included.

Step4:There is a risk that this is not done which would impact on the
calculation of finance cost and hence resulting in understatement of
expenses in statement of profit or loss and financial liability in the
67
statement of financial position.

Step1: Finance cost

Step 2: Finance cost should be accrued at the year end, i.e., half a
year amounts to $2.5m ($100mX5%X1/2) by DR P/L $2.5m, CR
Interest payable $2.5m.

Step3: This is material to the statement of profit or loss since its more
than 0.5% of sales in Crow.

Step4: There is a risk that this is not done which would result in
understatement of expenses in the statement of profit or loss and
liability in the statement of financial position.

Step1: Online sales

Step2: This is material because 30% of sales are made online.

Step3: According to IFRS 15 Revenue from contracts with customers,


sales revenue is recognised when the risks and rewards of products
have been transferred from seller to buyer; no managerial
involvement on the goods; related expenses can be measured reliably.
So a company should recognise a sales revenue when the above
conditions are met.

Step4: There is a risk that the company may not record the sales
revenue correctly given complexity in online sales system which
would result in the revenue figure being misstated in statement of
profit or loss and relating assets such as receivable or cash being
misstated in statement of financial position.
68
Step1: Canary revenue and profit before tax

Step 2: Canary Co revenue and profit before tax are $16m and $2m
and this is a significant component to the group since its more than
15% of group sales.

Step 3+4: There is a risk that Canary Co may overstate its revenue
and profit before tax figure in order to argue for a better price.

Step1: Group position

Step2: The forecast revenue without including Canary co is $119m


($135m-$16m) and the profit before tax is $6.5m ($8.5m-$2m)
which are less than the actual 2011 figure of $125m and $8.4m.
Step3+4: There is a risk that both revenue and profit before tax
figures are understated given a new incorporation of Canary Co into
the group happens.

Step1: Grant

Step2: Starling Co received a grant of $35m and this is material to the


statement of financial position since its more than 1% of total assets.

Step3: According to IAS20 Government Grant the receipt of grant


should be deferred and released over the life of the asset to recognise
income in the statement of profit or loss.

Step4: There is a risk that Starling Co may recognise the full $35m at
inception and hence this would result in overstatement of revenue in
the statement of profit or loss and understatement of liability in

69
statement of financial position.

Step1: Grant repayment

Step2: Starling Co has not spent the rest of the grant of $10m and this
is more than 1% of total assets and hence its material to the
statement of financial position.

Step3: If Starling Co hasn't spent this $10m on the qualifying assets


then it may become repayable and according to IAS37 provision,
contingent liability and contingent assets if the cash outflow is
possible then a contingent liability should be disclosed to the financial
statement and if the repayment becomes probable then a provision
should be recognised.

Step4: There is a risk that this is not done resulting in either under
disclosure or understatement of expenses in the statement of profit or
loss and liability in the statement of financial position.

Step1: New IT system

Step 2: Because of the unfamiliarity of the system there would be a


risk that errors may occur in transferring data from the old to new
system.

Step 3: This would result in the overall financial statement being


misstated.

Step1: Finance director

Step2: Finance director left Starling Co last week.


70
Step3: This would increase the likelihood of misstatement in the
individual financial statement because of a lack of expertise in the
financial reporting process.

71
Step 3: Assessing internal control system
of clients company

We know that the internal control systems in the clients company will
include:

Control environment. For example, attitudes of the


management relating to internal control.

Control procedures such as installation of CCTV to make sure


that inventories will not be stolen.

Risks management procedures to identify and deal with


different types of risks properly.

Good information system is in place to make sure that


management will receive timely, relevant and reliable
information.

Implementation of the internal control procedures by the


internal auditors.

Sometimes the clients internal control system is not strong enough.


For example, a lack of internal audit department or the internal
auditors are not very competent.

As a result of this, the client may consider outsourcing the internal


audit function to a 3rd party in order to improve its internal control
environment. If this is the case, auditors need to consider whether the
outsourcing option will improve clients internal control environment,
since this will impact on the external audit procedures being
conducted.

If auditors find out that there are some significant internal control
deficiencies, then auditors should report these to the audit
committee.

In the P7 exam, the examiner will not test you about the different
cycles in the F8 so this means you are not required to revise sales;
purchases; wages; cash; inventory cycle in the P7 exam.

72
Case: (June2010 Q2) Internal Control System

Mac Co is a large, private company, whose business activity is events


management, involving the organisation of conferences, meetings
and celebratory events for companies. Mac Co was founded 10 years
ago by Danny Hudson and his sister, Stella, who still own the majority
of the companys shares. The company has grown rapidly and now
employs more than 150 staff in 20 offices.

You are a manager in the business advisory department of Flack & Co.
Your firm has just been engaged to provide the internal audit service
to Mac Co. In your initial conversation with Danny and Stella, you
discovered that currently there is a small internal audit team, under
the supervision of Lindsay Montana, a recently qualified accountant.
Before heading up the internal audit department, Lindsay was a junior
finance manager of the company. The members of the internal audit
team will be reassigned to roles in the finance department once your
firm has commenced the provision of the internal audit service.

Mac Co is not an existing client of your firm, and to gain further


understanding of the company, you held a meeting with Lindsay
Montana. Notes from this meeting are shown below.

Notes of meeting held with Lindsay Montana on 1 June 2010

The internal audit team has three employees, including Lindsay, who
reports to the finance director. The other two internal auditors are
currently studying for their professional examinations. The team was
set up two years ago, and initially focused on introducing financial
controls across all of Mac Cos offices. Nine months ago the finance
director instructed the team to focus their attention on introducing
operational controls in order to achieve cost savings due to a cash flow
problem being suffered by the company. The team does not have time
to perform much testing of financial or operational controls.

In the course of her work, Lindsay finds many instances of


management policies not being adhered to, and the managers of each
location are generally reluctant to introduce controls as they want to
avoid bureaucracy and paperwork. As a result, Lindsays
recommendations are often ignored.

Three weeks ago, Lindsay discovered a fraud operating at one of the


offices while reviewing the procedures relating to the approval of new
73
suppliers and payments made to suppliers. The fraud involved an
account manager authorising the payment of invoices received from
fictitious suppliers, with payment actually being made into the
account managers personal bank account. Lindsay reported the
account manager to the finance director, and the manager was
immediately removed from office. This situation has highlighted to
Danny and Stella that something needs to be done to improve
controls within their organisation.

Danny and Stella are considering taking legal action against Mac Cos
external audit provider, Manhattan & Co, because their audit
procedures did not reveal the fraud.

Danny and Stella are deciding whether to set up an audit committee.


Under the regulatory framework in which it operates, Mac Co is not
required to have an audit committee, but a disclosure note explaining
whether an audit committee has been established is required in the
annual report.

Required:

(a) Evaluate the benefits specific to Mac Co of outsourcing its


internal audit function. (6 marks)

(b) Explain the potential impacts on the external audit of Mac


Co if the decision is taken to outsource its internal audit
function. (4 marks)

(c) Recommend procedures that could be used by your firm to


quantify the financial loss suffered by Mac Co as a result of
the fraud. (4 marks)

(d) Prepare a report to be presented to Danny and Stella in


which you:

(i) Compare the responsibilities of the external auditor and of


management in relation to the prevention and detection of
fraud; and (4 marks)

(ii) Assess the benefits and drawbacks for Mac Co in


establishing an audit committee. (4 marks)

Professional marks will be awarded in respect of requirement (d) for


74
the presentation of your answer, and the clarity of your discussion. (4
marks)
(26 marks)

Answer to June2010 Q2

(a)

Roles assigned

After outsourcing the internal audit function the role of financial


manager may be reassigned to other parts of the company and this
will benefit the company for having extra resources for having such
employees.

External expertise

Because currently there are two internal auditors within the clients
company not being qualified so a decision of outsourcing the internal
audit function will have extra expertise to do the internal service for
client and this will improve the overall internal audit quality as well.

Focus

It seems that the team currently lacks a consistent focus. They are
directed by the finance director, who has changed the focus from
financial reporting controls to operational controls, and it seems the
team is too small to do both. Outsourcing the function will provide as
many staff as necessary to cover a range of activities.

Time

Because currently there are two internal auditors within the clients
company therefore if it outsources the internal audit function it will
have extra resources to focus on other areas of the company.

(b)

Audit strategy

If after outsourcing its internal audit function the internal control


system of the clients company is improved, the external audit firm
may rely on the internal control system and hence spend less time
75
doing the full substantive testing and this would result in less audit
fees charged.

Assessable of the working papers by outsourcing firm

If the outsourcing firms working papers are accessible by the external


auditor and this will reduce the work done by external auditor and
hence reduce the fees charged.

Internal control system changes

If the internal control system changes, this will impact on the amount
of work done by the audit firm and hence impact on its fees as well.

Report

If the external auditor replies on type 2 report then this will decrease
its work load and hence fees charged as well.

(c)

Enquire with the police and lawyer to verify if the amount can be
reimbursed with the clients permission.

Inspect the insurance policy to verify if it covers this situation and


the losses can be reimbursed.

Compare a list of unapproved suppliers to a list of actually


approved suppliers by the company to identify the discrepancies of
suppliers and its related amount.

Use computerised assisted audit techniques to identify the


suppliers with the same bank account to the accountant manager.

(d)

Report to: Danny and Stella Hudson


Content: Responsibilities in respect of fraud; Audit committees
benefits and drawbacks

Introduction: The objective of the report is to compare the


responsibilities of the external auditor and of management in relation
76
to the detection of fraud, and also to outline the benefits and
drawbacks for Mac Co of establishing an audit committee.

(i) Responsibilities of the external auditor and of management


in relation to the detection of fraud

Management has a primary responsibility in establishing a sound


internal control system to prevent and detect fraud.

Management should assess the internal control system continuously.

Auditor would be responsible for the fraud which happened within the
company if they are material to the financial statements. This means
auditors would focus more on the fraud impact on the accounts rather
than its operational issues.

Auditor would assess the internal control system at the planning stage
of audit to determine its audit strategy.

(ii)

Benefits

This can improve the overall internal control system within the clients
company because originally Lindsay reports the internal control
system weaknesses to the finance director and if the control
environment is weak then it will have an impact on the quality of the
internal control system if the finance director refuses to change the
internal control system required by Lindsay.

The audit committee would have more power and status not like
Lindsay who is just the current junior financial manager then they
may adopt the internal control recommendations more easily.

Drawbacks

Its difficult in the real world to recruit staff who are independent and
with relevant skills.

They may not have time to devote to their role as a member of the
committee. This could be a problem for Mac Co, whose business
activities are quite specialised.
77
The audit committee members should expect to receive a fee
commensurate with their level of experience and knowledge, so the
fees may be significant. This could be an issue for Mac Co due to its
cash flow problem.

Conclusion

Its recommended that the internal audit function should be


outsourced and an audit committee should be set up.

78
IFRS Recap with Audit Knowledge

This is very important to your P7 exam since there are 50 marks


overlap between ACCA P2 and P7 relating to the accounting standard
knowledge.

When the clients company is preparing for its financial statements,


for those public listed companies, they are required to follow the IFRS.

IFRS will be tested in Audit Planning; Substantive testing; Audit


review and report stage.

Contents

IAS1 PRESENTATION OF FINANCIAL STATEMENTS ............ 83

IAS2 INVENTORIES ............................................................ 84

AUDIT QUESTION (DEC2009 Q2) IAS2 ............................... 85

AUDIT QUESTION (DEC 2011 Q2) IAS 2 ............................. 86

AUDIT QUESTION (DEC 2014 Q5) IAS 2 ............................. 88

IAS8 ACCOUNTING POLICIES, CHANGES IN ACCOUNTING


ESTIMATES AND ERRORS ................................................... 89

AUDIT QUESTION [DEC2011 Q3] IAS 8 .............................. 90

IAS10 EVENTS AFTER THE REPORTING PERIOD ................. 92

AUDIT QUESTION ISA560 [DEC2009 Q5] ........................... 93

IAS12 INCOME TAXES ........................................................ 97


79
AUDIT QUESTION: [DEC2008 Q1] IAS 12 ........................... 98

IAS16 PROPERTY, PLANT AND EQUIPMENT ........................ 99

IAS17 LEASES .................................................................. 101

AUDIT QUESTION [JUNE2009Q3] LEASES ........................ 106

JUNE 2015 Q2 SALE AND LEASEBACK ............................... 108

IAS 19 EMPLOYEE BENEFIT .............................................. 112

AUDIT QUESTION (JUNE2012 Q5(B)) IAS19 .................... 113

DEC 2012 Q2 DEFINED BENEFIT PLAN .............................. 115

IAS 20 ACCOUNTING FOR GOVERNMENT GRANTS AND


DISCLOSURE OF GOVERNMENT ASSISTANCE .................... 117

AUDIT QUESTION [JUNE2010 Q1 (C)(II)] IAS 20 ............ 118

IAS 21 THE EFFECTS OF CHANGES IN FOREIGN EXCHANGE


RATES ............................................................................... 120

AUDIT QUESTION: GRISSOM CO (JUNE2010 Q1).............. 121

IAS 23 BORROWING COSTS.............................................. 123

IAS 24 RELATED PARTY TRANSACTIONS .......................... 126

AUDIT QUESTION:[JUNE2008 Q3]RPT.............................. 129

80
IAS28 INVESTMENTS IN ASSOCIATES .............................. 133
AUDIT QUESTION [JUNE2010 Q1] IAS28 ......................... 134

FINANCIAL INSTRUMENTS IAS32,37,39 IFRS9 ................ 135

AUDIT QUESTION IAS32,39 IFRS7 ................................... 142

AUDIT QUESTION: JUNE2013 Q4 (B) FINANCIAL INSTRUMENT


......................................................................................... 144

IAS33 EARNINGS PER SHARE ........................................... 147

AUDIT QUESTION (JUNE2015 Q1) IAS 33 EPS ................. 148

AUDIT QUESTION[JUNE2009 Q5 PLUTO] IAS 33 .............. 149

IAS 36 IMPAIRMENT OF ASSETS ...................................... 150

AUDIT QUESTION: IMPAIRMENT IAS36............................ 153

AUDIT QUESTION: [DEC2010 Q3] IAS36 .......................... 155

IAS 37 PROVISIONS, CONTINGENT LIABILITIES AND


CONTINGENT ASSETS ....................................................... 157

AUDIT QUESTION [DEC2007 Q1(B)] PROVISION ............. 160

AUDIT QUESTION DEC2014 Q5(B) IAS37 ......................... 162

IAS38 INTANGIBLE ASSETS.............................................. 165

AUDIT QUESTION [JUNE2008 Q5] IAS 38 ........................ 168

81
AUDIT QUESTION [DEC2011 Q1] IAS 38 .......................... 170
IAS40 INVESTMENT PROPERTY ........................................ 171

AUDIT QUESTION [DEC2008 Q3] IAS40 ........................... 174

IAS 41 AGRICULTURAL ACCOUNTING ............................... 177

IFRS2 SHARE-BASED PAYMENT ........................................ 181

AUDIT QUESTION [DEC2008 Q1(B)(I)] IFRS2 .................. 184

IFRS5 NON-CURRENT ASSETS HELD FOR SALE AND


DISCONTINUED OPERATIONS .......................................... 186

AUDIT QUESTION [DEC2007(A) ] IFRS 5 ......................... 190

AUDIT QUESTION2 [JUNE2011 Q1A]IFRS 5 ..................... 192

IFRS8 OPERATING SEGMENTS .......................................... 195

AUDIT QUESTION1 IFRS8 [DEC2009 Q1(D)] .................... 197

IFRS10,11,12 ................................................................... 199

AUDIT QUESTION [SHIRE DEC2005] IFRS11 .................... 201

IFRS13 FAIR VALUE MEASUREMENT ................................. 202

AUDIT QUESTION [DEC2008 Q3(A)]FAIR VALUE .............. 205

IFRS 15 REVENUE FROM CONTRACTS WITH CUSTOMERS


......................................................................................... 207

82
IAS1 Presentation of Financial Statements

Accounting Issues

Public listed companies are required to prepare for the following


financial statements:

1. Statement of financial position;


2. Statement of profit or loss and other comprehensive income;
3. Statement of changes in equity;
4. Statement of cash flow.

If companies are going concern entities, then the financial statements


should be prepared for under the going concern basis. If not, then the
company should prepare for its financial statements under break up
basis.

IFRS is just principle based accounting standard and management


can depart from it.

Audit Works

Inspect the financial statements to ensure the company has used


break up basis, i.e., to reclassify all non-current assets and
liabilities into current assets and liabilities if company is not a going
concern entity.

Inspect disclosures made by management regarding certainties


about going concern status of the company is adequate.

Obtain a written representation from management to confirm


company is a going concern entity at the review stage.

83
IAS2 Inventories

Accounting Issues

The aim of inventory is held for sale. Inventory is normally within 1


year and if the inventory is carried for more than 1 year, the auditor
needs to consider whether to write off the inventory as an expense
(slow moving inventory) or is this a window dressing behavior done by
management to window dress its liquidity position.

Initial measurement:

The initial cost of inventory would be including all costs of purchase,


plus the costs of conversion and other costs incurred in bringing the
inventories to their present location and condition.

Subsequent measurement:

Value at the lower of cost and net realisable value (estimated selling
price-Estimated costs to sell). Costs are usually measured using FIFO,
Weighted average cost. (LIFO is banned)

Audit Works

Initial measurement:

Costs should be agreed to invoices and purchase


agreement and bank statement and cash book;

If manufactured, costs should be agreed to material


requisitions, timesheets, personnel records;

Subsequent measurement:

NRV should be agreed to post year-end selling prices and


invoices.

Inspect inventory condition and if its damaged then it


should be valued using NRV.

84
Audit Question (DEC2009 Q2) IAS2

Banana Co designs specific items for customers according to


contractually agreed specifications. And you are at the review stage of
audit.

After the year end, Cherry Co, a major customer with whom Banana
Co has several significant contracts, announced its insolvency, and
that procedures to shut down the company had commenced.

The amount of contract is $50,000 while the total asset within


statement of financial position is $500,000.

Required:
Comment on the matters to be considered relating to the above
inventory.

Answer to DEC 2009 Q2

Materiality

The inventory of $50,000 accounts for 10% of total asset and its
material to statement of financial position.

Accounting treatment

Because the inventory is for specific use and Cherry Co is in insolvency


and hence inventory cant be used by Cherry co and they are with no
use any more so according to IAS2 the value should be written down
to lower of cost and net realisable value according to IAS2.

Audit opinion

If this is not done properly then a qualified audit opinion with an


except for qualification due to material misstatement should be given.

(Tutor tips: this is at the review stage of audit and hence any matters
to be considered should be taking into account the impact on audit
report if the adjustment is not done properly)

85
Audit Question (DEC 2011 Q2) IAS 2

Audit work on inventory

Materiality has been determined as follows:


$800,000 for assets and liabilities
$250,000 for income and expenses

Audit procedures performed at the inventory count indicated that


printed inventory items with a value of $130,000 were potentially
obsolete. These items were mainly out of date training manuals. The
finance director, Cherry Laurel, has not written off this inventory as
she argues that the paper on which the items are printed can be
recycled and used again in future printing orders. However, the items
appear not to be recyclable as they are coated in plastic. The junior
who performed the audit work on the inventory has requested a
written representation from management to confirm that the items
can be recycled and no further procedures relevant to these items
have been performed.

Required

Assess the audit implications of the issue related to audit work raised
by the audit senior. Your assessment should consider the sufficiency of
evidence obtained, explain any adjustments that may be necessary to
the financial statements, and describe the impact on the audit report
if these adjustments are not made. You should also recommend any
further audit procedures necessary.
(5Marks)

86
Answer from ACCA DEC 2011 Q2

The potentially obsolete inventory is not material to either profit or


assets. However, when combined with other potential adjustments
there could be a material impact on profit for the year.

IAS 2 Inventories requires that items are measured at the lower of


cost and net realisable value. If the items cannot be sold, the net
realisable value is zero, so the items should be written off completely
unless they can be recycled for future use. The adjustment to write off
the inventory would reduce assets and reduce gross profit by
$130,000.

A written representation has been requested on this matter. According


to ISA 580 Written Representations, written representations can
provide necessary audit evidence, but they do not provide sufficient
appropriate audit evidence on their own about any of the matters with
which they deal. The fact that management provides reliable written
representations does not affect the nature or extent of other audit
evidence that the auditor obtains. Written representations should
therefore support other evidence obtained by the auditor.

The written representation is insufficient audit evidence, and further


audit procedures are necessary to determine whether the potentially
obsolete items are made from material that can be recycled. I
recommend the following:

Physically inspect the items to see if some of the material could be


recycled (e.g. the covers may be coated with plastic but the pages
may not be and therefore are recyclable).

Enquire of relevant personnel such as a production manager


whether the plastic coating is unsuitable for recycling by the company.

Consider if the items could be sold to a company specialising in


recycling plastic material, in which case the items would have a
realisable value.

Review any invoices raised after the year end for evidence that the
items have been sold, to determine whether a net realisable value
exists.

87
Audit Question (DEC 2014 Q5) IAS 2

You are performing an engagement quality control review on the audit


of Bradley Co, as it is a significant new client of your firm. The financial
statements recognise revenue of $2 5 million, and total assets of $35
million.

The estimate relates to slow-moving inventory in respect of a


particular type of steel alloy for which demand has fallen.
Management has already recognised a provision of $35,000, which is
considered insufficient by the auditor.

Required:

Explain the matters which should be discussed with management in


relation to each of the uncorrected misstatements. (3marks)

Answer from ACCA DEC 2014 Q5

The additional slow-moving inventory provision which the auditor


considers necessary is not material on an individual basis to either
profit or to the statement of profit or loss or the statement of financial
position, as it represents only 0 4% of revenue and less than 1% of
total assets.

Since this misstatement is not material to the financial statements


and hence auditors can communicate with the management regarding
this issue.

If this misstatement is not corrected then it would have no impact on


the auditors report as well.

88
IAS8 Accounting Policies, Changes in
Accounting Estimates and errors

Accounting Issues

Accounting Policy:

Measurement basis of the figure, e.g., value the inventory using


FIFO but now use weighted average method; use replacement cost
rather than historic cost.

Recognition basis of the figure, e.g., recognise as an expense


before but now for asset(e.g. IAS 23 borrowing costs)

Presentation basis of the figure, e.g., recognise the depreciation


expense into cost of sales now rather than in administrative
expenses before.

If there is a change in laws / accounting standards and you are


required to do so or it gives a fairer presentation to the users of FS
then the company should change the accounting policy using the
retrospective adjusting method.

Accounting estimates:

If there are any changes in accounting estimates, the prospective


adjusting method will be applied.

Allowance for receivables;

Useful life/ depreciation method of the non-current assets;

Warranty provision relating to return of goods from customers.

Previous years accounting error:


If there are any errors in the previous years financial statements, the
retrospective adjusting method will be applied.

Misuse of the accounting standard last year;

Fraud happened last year;


89
Omit some figures in last years account.

Audit works

Inspect the changes in accounting policy and ensure its consistent


and properly disclosed.

Inspect the changes in accounting estimate and verify the nature and
the amount have been disclosed properly.

Audit question [DEC2011 Q3] IAS 8

Pine Co operates a warehousing and distribution service, and owns


120 properties.

During the year ended 31 July 2011, management changed its


estimate of the useful life of all properties, extending the life on
average by 10 years.

The financial statements contain a retrospective adjustment, which


increases opening non-current assets and equity by a material
amount.

Information in respect of the change in estimate has not been


disclosed in the notes to the financial statements.

Required:

Identify and explain the potential implications for the


auditors report of the accounting treatment of the change in
accounting estimates. (5 marks)

90
Answer to audit question [DEC2011 Q3] IAS 8

Materiality

The increase in non-current asset amount is material by question.

Accounting treatment

This is a change in accounting estimate not a change in accounting


policy so this does require prospective adjustment not retrospective
adjustment.

This means management shouldn't restate the opening balance of


non-current asset and retained earnings.

Audit report implication

If management has corrected this mistake then an unmodified audit


report would be given.

If management still insist to restate the opening balance of


non-current assets and retained earnings then a modified audit report
with a qualified audit opinion would be given with an exception for
material misstatement in the financial statement.

Auditor should explain the reasons why a qualified audit opinion would
be given in the basis of opinion paragraph.

And this paragraph would be placed before the actual opinion


paragraph.

91
IAS10 Events after the Reporting Period

Accounting Issues

This is the event happened between financial statement year end and
the financial statements are authorised to be issued to the
shareholders to be discussed at the AGM (annual general meeting).
They will be either adjusting events or non-adjusting events

Adjusting events

Change in judgments, estimate or assumptions after the year end.

1: Inventory sold at a loss? Change in assumptions that closing


inventory should be valued at the lower of cost and net realisable
value (IAS 2);

2: Customers go bankrupt so that recoverability of the receivable


balance at the year-end has been changed.

3: If the company is involved in going concern problems after the year


end and because the financial statements should be prepared under
going concern basis and now this is changed.

Non-adjusting events

Theres no link between financial statement figures at the year end


and events after the FS year end.

1: Fire destroyed the inventory after the year end (cant predict!)

2: Dividends are declared after the year end or share issues after the
year end (no link between figures and events)

92
Audit works

Auditors will have active responsibility or passive responsibility. And


this is according to ISA560 subsequent events.

Audit question ISA560 [DEC2009 Q5]

(a) Guidance on subsequent events is given in ISA 560 (Redrafted)


Subsequent Events.

Required:
Explain the auditors responsibility in relation to subsequent
events. (6 marks)

(b) You are the manager responsible for the audit of Lychee Co, a
manufacturing company with a year ended 30 September 2009. The
audit work has been completed and reviewed and you are due to issue
the audit report in three days. The draft audit opinion is unmodified.
The financial statements show revenue for the year ended 30
September 2009 of $15 million, net profit of $3 million, and total
assets at the year-end are $80 million.

The finance director of Lychee Co telephoned you this morning to tell


you about the announcement yesterday, of a significant restructuring
of Lychee Co, which will take place over the next six months. The
restructuring will involve the closure of a factory, and its relocation to
another part of the country. There will be some redundancies and the
estimated cost of closure is $250,000. The financial statements have
not been amended in respect of this matter.

Required:

In respect of the announcement of the restructuring:

(i) Comment on the financial reporting implications, and


advise the further audit procedures to be performed; and
(6 marks)
(ii) Recommend the actions to be taken by the auditor if the
financial statements are not amended.
(4 marks)
(16 marks)
93
Answer to ISA560 [DEC2009 Q5]

(a)

Events between FS year end and audit report is signed:


Auditor would have active responsibility to identify any subsequent
events.

Procedures would include for example:

Enquire with management to verify any subsequent events have


occurred.

Reading minutes of meetings of shareholders and management to


verify any subsequent events have occurred.

Reviewing the latest interim financial statements to verify if any


subsequent events have occurred.

Events between audit report signed and the FS are issued:

Auditor would have a passive responsibility to identify any subsequent


events.

I.e., they don't need to perform procedures actively to identify those


events.

But management would have the responsibility to tell auditors any


subsequent events.

If any events occurred which would materially affect the FS then this
matter should be discussed with management.

If this matter has been dealt with by management either disclose or


amend it then auditors should perform additional audit procedures
relating to this issue and a new audit report would be issued.

If management refuses to deal with this event and it is material to the


FS then a qualified audit opinion should be issued by auditors.

Events after financial statements are issued:

Auditor would have a passive responsibility to identify any subsequent


94
events.

I.e., they don't need to perform procedures actively to identify those


events.

If any events occurred which would materially affect the FS then this
matter should be discussed with management.

If this matter has been dealt with by management either disclose or


amend it then auditors should perform additional audit procedures
relating to this issue and a new audit report would be issued.

If management refuses to deal with this event and it is material to the


Financial Statements, then a qualified audit opinion should be issued
by auditors.

(b)

(i)

Materiality:

Based on revenue: $250,000/15 million = 167%


Based on profit: $250,000/3 million = 8
3%
Based on assets: $250,000/80 million = <1%

So this is material to the statement of profit or loss and other


comprehensive income.

Accounting:
A note detailing the nature of the event and the amount should be
provided according to IAS10.

Audit procedures:

Enquire with management and read board minutes relating to this to


gain an understanding about the reason for the restructuring.

Inspect the note to the financial statements which should disclose the
non-adjusting event, providing a brief description of the event, and an
estimate of the financial effect.

Inspect a detailed copy of the announcement about the nature of the


restructuring, i.e., the number of employees to be affected.
95
Agree the $250,000 potential cost of closure to supporting
documentation like a schedule showing the number of staff to be
made redundant and these should be supported by payroll details.

(ii)

Auditor should raise this issue to those charged with governance,


i.e. the audit committee, to persuade them to correct this
misstatement.

If misstatement still exists then the auditor should modify his audit
report by giving a qualification of audit opinion due to material
misstatement in the financial statements.

Auditor should explain the reasons for the qualification in the basis
of opinion paragraph and this is before the actual opinion
paragraph.

Auditor can choose to raise this issue to the annual general


meeting to shareholders.

96
IAS12 Income Taxes

Accounting issues

Current tax

Companies have to pay tax on taxable profits. The tax charge is


normally ESTIMATED at the end of the financial year and charged to
the statement of profit or loss, and paid in the following year.

Since the amount paid is likely to differ from the estimated tax charge
originally recognised, a balance will be left on the taxation liability
account being an under or over provision of the tax charge.

Deferred tax

Deferred tax liability is a future liability recognised today. Deferred tax


is based on temporary difference (timing difference between
accounting and tax law). So the amount we owe to the tax authority
will be finally paid back to them in the subsequent years.

Deferred tax asset is future tax deduction and this is based on


deductible temporary difference. The recoverability of the deferred
tax asset will be based on whether the company will have future
taxable profit to set off against the losses and if the answer is yes,
then we can recognise the deferred tax asset. The recoverability of
Deferred Tax Asset will be limited depending on the forecast profit the
company will make.

Typically, in P7, Deferred Tax Asset is most commonly tested.

Audit Works
So we usually focus on the profit forecast, management accounts for
the company performance to estimate the company future profit
making ability to establish if it can utilise the deferred tax asset
(unutilised losses) to set against the future profit.

97
Audit question: [DEC2008 Q1] IAS 12

(b) Describe the principal audit procedures to be carried out in


respect of the following:

(ii) The recoverability of the deferred tax asset.


(4 marks)

Answer to [DEC2008 Q1] Income taxes

Principal audit procedures recoverability of deferred tax asset

Agree figures in the current and deferred tax calculation to tax


correspondence.

Inspect the profitability forecast to agree there is enough forecast


taxable profit to offset against the loss.

Perform analytical procedure by evaluating assumptions used in


the forecast to ensure its in line with auditors business
understanding.

Perform analytical procedure by assessing time taken to generate


profit to recover tax losses and if it takes many years to generate
such profit and the recognition of deferred tax asset would be
restricted.

Inspect tax correspondence to verify theres no restriction for


company to carry forward and use losses against future taxable
profits.

98
IAS16 Property, Plant and Equipment

Accounting Issues

Initial measurement

Capital expenditure

Capital expenditure is the costs of acquiring non-current assets.


According to IAS 16 the following costs may be capitalised in the
statement of financial position on acquisition of a non-current asset:

Initial cost (purchase price); Import duty not refundable (if asset is
bought from other country); Installation costs; Intended use relating
costs (lawyer, surveyor costs); Delivery costs; Finance cost.

Revenue expenditure

Revenue expenditure is expenditure on maintaining the capacity of


noncurrent assets. Costs that are regarded as revenue expenditure
should be expensed in the statement of comprehensive income and
may not be capitalised according to IAS 16 are: Repairs expenses;
Insurance expenses; Maintenance expense.

After weve purchased the non-current asset, the accountant needs to


record that non-current asset into the non-current asset register.

A non-current asset register is generally maintained in the finance


department.

Companies can purchase specifically designed packages or a register


can simply be maintained on an Excel spreadsheet.

And this is used to reconcile the NCA in the NCA register to the
individual asset in place, i.e., an example of control procedure by
company.

Subsequent measurement

Cost model: Cost-accumulated depreciation*=Carrying value

The depreciation method should be reviewed each year to see


99
whether or not it is reasonable. A change in the depreciation method
should be treated as a change in accounting estimate and prospective
adjusting method according to IAS 8 should be applied. I.e., disclose
the depreciation method in the note of the financial statements.

Revaluation Model: Revalued amount

IAS 16 the test was whether the expenditure was Capital or Revenue
e.g. an improvement could be capitalised but maintenance or repair
could not be capitalised.

If there are costs incurred in the following circumstances, then it


should be capitalised:

Economic benefits are excessed


Component treated separately
Major overhaul cost

Revaluation

If revaluation policy per IAS 16 is adopted (i.e. the business has a


choice), and if so the following rules must be applied per the
standard:

No cherry picking (If a company chooses to revalue an asset


they must revalue all assets in that category.)

Regular (Revaluations must be regular but IAS 16 doesn't


specify how often)

Revalued amount (Subsequent depreciation must be based on


the revalued amounts.)

Revaluation reserve (Gains from revaluations are taken to


revaluation reserve rather than retained earnings unless they
are sold)

Audit work

If the PP&E is impaired, then the company should make sure an


impairment test is properly conducted by management. Also the
discount rate used by management to determine value in use of the
asset should be verified for reasonableness.
100
IAS17 Leases

Accounting issues

There are 2 types of leases: Finance lease or Operating lease.

5 scenarios of Finance Lease

So the substance over form concept behind it can be summarised as


follows:

1. Ownership of asset has been transferred from lessor to lessee.

2. Lessee has the option to purchase asset at a price which is


sufficiently lower than its FV.

3. Lease term is almost the same as the major part of economic


life of asset. (IFRS doesn't specify the period but US GAAP has
given us guidance of >75 %.)

4. At the start of the lease, PV of minimum lease payment is close


to FV of asset. (Again, IFRS doesn't specify the percentage but
US GAAP has given us a guidance of >90%.)

5. Leased assets are specified nature and can only be used by


lessee and they can be used by others if any significant
modification to assets occurs.

Other circumstances implying this is a finance lease:

If a lessee cancels the contract, lessee compensate for the losses to


the lessor.

Any gains or losses after the lease contract, lessee would accrue
(responsible for it);

Land is normally to be operating lease unless the title of the land has
been transferred to the lessee.

101
Risks and rewards

But the idea behind it is when the majority risks and rewards has been
transferred from the lessor to lessee then its considered to be a
finance lease.

Risks Rewards

Costs of repairing, maintaining and Use of assets for almost all of its
insuring the assets. useful life.
Risk of obsolescence Use of the assets is not disrupted.
Risks of losses from idle capacity of
the asset (if machine breaks down
then lessee bears the loss)

Accounting Treatment

Lessee Lessor
Finance lease:
Initial measurement DR PPE (include DR lease receivable
transaction cost and CR CR lease asset
cash)
CR lease liability
Subsequent measurement PPE:
DR P/L-depreciation
expense
CR accumulated
depreciation

Lease liability: DR cash (from lessee)


DR lease liability CR lease receivable
(Exclude the deposit and CR P/L-interest income
CR Cash)
DR P/L-finance cost
CR cash
Operating lease:
Expense the lease Expense the lease revenue
payment on a straight received on a straight line
line basis basis
DR cash
DR P/L CR P/L
CR cash Account for it under IAS 40
Investment Property
102
Present value of minimum lease payment:

Present value of minimum lease payment= Sum of rental payable and


residual value (perhaps this would be guaranteed by the lessee if
there is fall in value.)

Lease term= non-cancellable period relating to the lease period +


secondary period if lessee has an option to lease the asset at the end
of the lease period.

Discount rate= implicit interest rate at the start of the lease contract
(IRR) or lessees borrowing costs.

Sale and finance leaseback

This is a way to finance the business.

Sell asset and lease for most/all of useful life

Profit on sale is spread over the lease period

Sale element of transaction

DR cash (sale proceeds)


CR PPE (CV)
CR/DR deferred income (gain on sale-release over lease
term)

Lease element of transaction

DR PPE (PV of min lease payment)


CR lease liability

Sale and operating lease back

(a) Sale as fair value:


Derecognise the asset at sale date and take the profit
immediately to income statement.

SP=FV>CA

103
(b) Sale above fair value:
Defer the additional gain and spread over the lease period.

SP>FV>CV

(c) Sell below fair value:


If the seller is short of cash and therefore has to sell at a loss
take the WHOLE loss to the income statement on disposal.

If the seller has the benefit of below market rentals for the lease
of the asset then defer the loss over the lease period.

SP<FV>CV

Accounting question

Finco Ltd has 4 sale and leaseback transactions during the year which
can be shown as follows:

Description Sale Fair Book(carrying)


proceeds value value
$m $m $m
1. Sale and finance lease back 50 50 32

2. Sale at fair value operating 80 80 55


lease back
3. Sale at overvalue and 85 65 70
operating lease back
4. Sale at undervalue and 65 85 60
operating lease back

Required:
Show how to deal with the above transactions.

104
Answer

1.
DR Bank 50 2.
CR Deferred income 18 DR Bank 80
CR PPE 32 CR P/L 25
CR PPE 55
DR PPE 50
CR Finance Lease Liability 50

3. 4.
DR Cash 85 DR Bank 65
DR P/L (Impairment) 5(FV-BV) DR Prepayment 20(85-65)
CR PPE 70 CR PPE 60
CR Deferred Income 20(85-65) CR P/L 25 (FV-BV)

Audit work

1. The main piece of audit evidence is the lease agreement, as this will
allow the auditor to:

Agree the length of the lease


Agree the lease payments
Assess how much of the rights and obligations of ownership
have been transferred.

2. For operating leases, any prepayment or accrual should be


recalculated.

3. For finance leases, the present value of minimum lease payments


should be recalculated and the discount rate agreed as appropriate.

105
Audit question [June2009Q3] leases

Robster Co is a company which manufactures tractors and other


machinery to be used in the agricultural industry. You are the
manager responsible for the audit of Robster Co, and you are
reviewing the audit working papers for the year ended 28 February
2009. The draft financial statements show revenue of $10 5 million,
profit before tax of $3
2 million, and total assets of $45 million.

Two matters have been brought to your attention by the audit senior,
both of which relate to assets recognised in the statement of financial
position for the first time this year:

Leases
In July 2008, Robster Co entered into five new finance leases of land
and buildings. The leases have been capitalised and the statement of
financial position includes leased assets presented as non-current
assets at a value of $3 6 million, and a total finance lease payable of
$3 2 million presented as a non-current liability.

Required:

(a) In your review of the audit working papers, comment on


the matters you should consider, and state the audit evidence
you should expect to find in respect of the leases. (8marks)

Answer to audit question1 [June2009Q3]

Matters to consider

Materiality

The amount recognised in non-current assets accounts for 8% of total


assets, and the total finance lease payable accounts for 71% of total
assets so they are material to the statement of financial position.

Accounting treatment

Whether this is finance lease or operating lease, the key is to see


whether risk and reward of ownership of assets has been passed
from lessor to lessee.
106
Indicators where risks and rewards have been transferred:

1. Robster Co is responsible for repairs and maintenance of the assets

2. Robster Co can obtain this asset at nominal value at the end of


asset life.

3. The lease period is almost the same as useful life of the assets

4. The present value of the minimum lease payments is amounts to


most of the fair value of the asset.

Finance cost associated with leases would need to be expensed to


statement of profit or loss.

Leased asset should be depreciated over the shorter of lease term


and economic useful life of assets.

The finance lease payable recognised $3 2 million should be split


between current and non-current liabilities in the statement of
financial position.

Audit evidence

A review of the lease contract including consideration of the major


clauses of the lease which indicate whether risk and reward has
passed to Robster Co.

A calculation of the present value of minimum lease payments and


comparison with the fair value of the assets obtained from the
lease contract at the start of the lease.
A recalculation of the finance charge expensed during the
accounting period, and agreement of the interest rate used in the
lease contract.

Agreement to the cash book of amounts paid to the lessor.

A recalculation of the depreciation charged, and agreement that


the period used in the calculation is the shorter of the lease term
and the useful life of the assets.

A recalculation and confirmation of the split of the total finance


lease payable between current and non-current liabilities.
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June 2015 Q2 Sale and Leaseback

The Adder Group (the Group) has been an audit client of your firm for
several years. You have recently been assigned to act as audit
manager, replacing a manager who has fallen ill, and the audit of the
Group financial statements for the year ended 31 March 2015 is
underway. The Groups activities include property management and
the provision of large storage facilities in warehouses owned by the
Group. The draft consolidated financial statements recognise total
assets of $150 million, and profit before tax of $20 million.

(a) The audit engagement partner, Edmund Black, has asked you to
review the audit working papers in relation to two audit issues which
have been highlighted by the audit senior. Information on each of
these issues is given below:

(i) In December 2014, a leisure centre complex was sold for proceeds
equivalent to its fair value of $35 million, the related assets have been
derecognised from the Group statement of financial position, and a
profit on disposal of $8 million is included in the Group statement of
profit or loss for the year. The remaining useful life of the leisure
centre complex was 21 years at the date of disposal.

The Group is leasing back the leisure centre complex to use in its
ongoing operations, paying a rental based on the market rate of
interest plus 2%. At the end of the 20-year lease arrangement, the
Group has the option to repurchase the leisure centre complex for its
market value at that time.

Required:

Comment on the matters to be considered, and explain the


audit evidence you should expect to find in your review of the
audit working papers. (8marks)

108
Answer to June 2015 Q2 Sale and Leaseback

Matters to consider:

The sale and leaseback transaction is material to the Group statement


of financial position. The proceeds received on the sale of the property,
equivalent to the fair value of the assets, represents 23 3% of Group
assets, and the carrying value of the assets disposed of were $27
million ($35 million $8 million), representing 18% of Group assets.
In addition, the profit recognised on the disposal represents 40% of
the Groups profit for the year, so it is highly material to the statement
of profit or loss.

The accounting treatment may not be in accordance with IAS 17


leases. The property has been derecognised and a profit on disposal
recognised, but this is only appropriate where the leaseback is an
operating lease arrangement, whereby the risk and reward of the
asset has been transferred to the purchaser.

However, in this case it appears that the leaseback may actually be a


finance leaseback, which is essentially a financing arrangement, and
should be accounted for by following the substance of the transaction.
The leaseback appears to be a finance lease because the Group is
bearing the risk and reward of ownership it bears the risk of adverse
changes in the market price of the property up to the point of
repurchase, and also bears the risk of adverse changes in the market
interest rate. It is also benefitting from the continued use of the
property and the profit which it may generate. In addition, the lease is
for a major part of the assets remaining useful life.

If the leaseback is a finance lease, the asset should remain recognised


in the Groups financial statements, and the apparent profit made on
disposal should be deferred and amortised over the lease term.

Therefore the Groups profit is materially overstated, and the total


assets and liabilities are materially understated. An adjustment
should be recommended to management, whereby the asset would
be reinstated, measured at fair value, with a finance lease liability
established, and the apparent profit moved to the statement of
financial position and recognised as deferred income.

The following adjustments should be recommended to management:

109
DR Property, plant and equipment $35 million

CR Obligations under finance lease $35 million

Being the recognition of finance leased assets and obligations.

DR Statement of profit or loss $8 million

CR Deferred income $8 million

Being the removal of profit on disposal from profit, and recognition as


deferred income.
If the adjustment is not made, the group financial statements will
contain a material misstatement, with implications for the auditors
opinion, which would be modified due to a material misstatement
following the misapplication of IAS 17 to the sale and leaseback
transaction.

The finance charge which has accrued since the inception of the lease
should be quantified, its materiality determined, and the appropriate
adjustment communicated to management.

The auditor should also consider the impact of the accounting


treatment on depreciation, as this should now be recalculated based
on the higher carrying value of the asset and the shorter useful life of
20 years. If an adjustment is not made to depreciate the property
complex from the date of the sale and leaseback transaction based on
the new, higher depreciation charge, then operating expenses will be
understated.

Audit Evidence:

A copy of the lease, signed by the lessor, and a review of its major
clauses to confirm that risk and reward remains with the group, and
that the arrangement is a finance leaseback.

Review of forecasts and budgets to confirm that economic benefit is


expected to be generated through the continued use of the property
complex.

Physical inspection of the property complex to confirm that it is being


used by the Group.

Confirmation of the fair value of the property complex, possibly using


110
an auditors expert, in which case the experts report should be
included in the audit working papers.

Where fair value has been established using an auditors or


management expert, evaluation of the experts work including
confirmation that the fair value is determined according to the
applicable financial reporting framework, and that all assumptions are
reasonable.

Agreement of the $35 million cash proceeds to bank statement and


cash book.

Minutes of a discussion with management regarding the accounting


treatment and including an auditors request to amend the financial
statements.

A copy of insurance documents stating that the group is responsible


for insuring the property complex.

Recalculation of finance charge and depreciation expense in relation


to the leased asset.

111
IAS 19 Employee Benefit

Accounting Issues

Short term benefit: Long term benefit:

DR P/L Shares (IFRS2)


CR Cash/Liability Bonus, etc.

Monetary benefit:
Wages and salary (Accounting: easier than pension
Paid sick leave accounting. Only to show costs,
Compensated absence asset and liability if company has
invested their money in other
Non-monetary salary: instrument before paying for
Medical care, housing, cars cash.)
etc.

Termination benefit: Post-employment benefit:


Pensions etc.
Redundancy payments;
Early retirement payments Therere two types of pensions.
etc.
Defined contribution
(accounting: expense and scheme
liability) Defined benefit scheme
(value determined by
actuary each year)

Audit work

Perform analytical procedures on scheme costs to verify its


reasonableness. (For example, an ageing workforce may be on higher
average salaries and nearer retirement, which may suggest a higher
liability to the company or strong stock market performance may
indicate that scheme assets should have grown faster than predicted,
leading to a surplus).

Agree the valuation figure, e.g., closing assets and liabilities to the
112
most recent actuarial valuation.

Assess the reliability, experience, qualifications, experience and


independence of the actuary.

Compare actuarys assumptions with other audit evidence (e.g. staff


turnover assumptions with personnel records).

Inspect a list of assets from the schemes investment manager to


verify the existence of assets.

Recalculate the pension expense recorded in the statement of profit or


loss to verify its accuracy.

Audit question (June2012 Q5(b)) IAS19

Snipe Co has in place a defined benefit pension plan for its employees.
An actuarial valuation on 31 January 2012 indicated that the plan is in
deficit by $105 million. The draft financial statements recognise
revenue of $8 5 million, profit before tax of $1 million, and total
assets of $175 million

The deficit is not recognised in the statement of financial position. An


extract from the draft audit report is given below:

Auditors opinion
In our opinion, because of the significance of the matter discussed
below, the financial statements do not give a true and fair view of the
financial position of Snipe Co as at 31 January 2012, and of its
financial performance and cash flows for the year then ended in
accordance with International Financial Reporting Standards.

Explanation of adverse opinion in relation to pension


The financial statements do not include the companys pension plan.
This deliberate omission contravenes accepted accounting practice
and means that the accounts are not properly prepared.
Required:

Critically appraise the extract from the proposed audit report


of Snipe Co for the year ended 31 January 2012. (7 marks)

113
Answer to June2012 Q5(b)

Basis of opinion paragraph:

Any qualified audit opinion is given then a basis of qualification


opinion paragraph should be placed before the actual opinion
paragraph. In this case its an adverse opinion so the basis for the
adverse opinion should be placed before the actual opinion paragraph.

In the basis of opinion paragraph the $10.5m of defined benefit


pension plan should be quantified.

And the auditor needs to state whether this $10.5m would be material
to the financial statement.

In the basis of opinion paragraph this auditor should state whether


this $10.5m would be a deficit or surplus.

Also the auditor needs to state if the deficit has been recognised then
liabilities would increase by $10.5m and equity would decrease by
$10.5m.

Auditor needs to consider whether other accounting entries have been


omitted as well such as service cost, gain on asset, finance costs,
actuarial gains and losses because these would impact on the
statement of profit or loss as well.

There should be reference to IAS19 employee benefit to tell users that


this standard has been breached.

The word deliberate is not professional and auditor should use The
plan may have been omitted in error and an adjustment to the
financial statements may have been suggested by the audit firm and
is being considered by management.

Qualified opinion paragraph

Because the deficit of $10.5m only represents 6% of total asset and


its material to the financial statement but not pervasive so an adverse
opinion would not be correct and auditor should issue an except for
qualification opinion due to material misstatement in the financial
statement.

114
DEC 2012 Q2 Defined Benefit Plan

Remeasurement component relating to defined benefit plan in 2011


was -$200 but -$1,100 in 2012.

The actuarial loss is attributed to an unexpected stock market crash.


The Groups pension plan is managed by Axle Co a firm of
independent fund managers who maintain the necessary accounting
records relating to the plan. Axle Co has supplied written
representation as to the value of the defined benefit plans assets and
liabilities at 30 June 2012.

No other audit work has been performed other than to agree the
figure from the financial statements to supporting documentation
supplied by Axle Co.

Required

Assess the implications of the key audit findings for the completion of
the audit. Your assessment must consider whether the key audit
findings indicate a risk of material misstatement. Where the key audit
findings refer to audit evidence, you must also consider the adequacy
of the audit evidence obtained, but you do not need to recommend
further specific procedures. (2marks)

Answer to DEC 2012 Q2

The loss recognised is material to the financial statements, but only


limited procedures have been conducted. Axle Co is a service
organisation, and audit procedures should be carried out according to
ISA 402 Audit Considerations Relating to an Entity Using a Service
Organisation. Auditors are required to gain an understanding of the
service organisation either from the user entity, which in this case is
the Jovi Group (the Group), or by obtaining a report on the service
organisation.

The procedures that have been conducted so far are not sufficient, as
written confirmation and agreement to Axle Cos records do not
provide evidence as to the basis of the valuation of the pension plan,
which has a material impact on the group financial statements. The
audit team themselves should perform procedures to provide
evidence as to the measurement of the plan and the actuarial loss,
115
and not simply rely on the accounting records of the service
organisation.

116
IAS 20 Accounting for Government Grants and
Disclosure of Government Assistance

Accounting Issues

A Government grant is the cash or asset given by the government to


help the company if it fulfills the conditions set by government.

This may be categorised as:

Capital Grants: Revenue Grants:

Grants which are made to Grants which are made for other
contribute towards the acquisition purposes like paying wages.
of the asset.

When recognised?

A grant can be recognised in the FS when:


Entity complies with the condition set by government
The grants will be received.

Usually we will use the deferred income method to reverse the


deferred income over the useful life of asset.

And this is based on the Accrual concept or Matching principle.

Disclosure

Accounting policy adopted, including method of presentation (net


off or separate method?)

Nature and extent of government grants recognised and other


forms of assistance received (e.g., buy a machine?)

Unfulfilled conditions and other contingencies attached to


recognised government assistance (e.g. repayment?)

117
Audit work

Inspect the grant agreement to verify:

-What is the grant for?

-The total amount of the grant

-The conditions under which it would have to be repaid.

Inspect cashbook and bank statements to verify receipt of the


grant.

Inspect Board Minutes to assess whether the company has done


anything (or is about to do anything) that might make the grant
repayable.

Recalculate any release of deferred grant income to ensure it


matches with the related expense.

Audit Question [June2010 Q1 (c)(ii)] IAS 20

Hodges Co

This companys operations involve the manufacture and distribution


of packaged nuts and dried fruit. The government paid a grant in
November 2009 to Hodges Co, to assist with costs associated with
installing new, environmentally friendly, packing lines in its factories.
The packing lines must reduce energy use by 25% as part of the
conditions of the grant, and they began operating in February 2010.

Recommend the principal audit procedures that should be


performed on the condition attached to the grant received by
Hodges Co. (4 marks)

118
Answer to [June2010 Q1 (c)(ii)]

1. Inspect the grant agreement to verify:

-The conditions of 25% reduction in energy use is stated.

- Financial impact if the company is to repay the grant and


determine whether company would pay in part or in full.

2. Inspect Board Minutes about whether management has put


procedures regarding energy saving into place to assess whether the
company has done anything (or is about to do anything) that might
make the grant repayable.

3. Enquire with management about how energy efficiency is


monitored to verify whether conditions have been breached by the
company.

4. Enquire with employees about their views on how well the packing
lines are performing to verify whether the conditions have or would be
breached by company.

119
IAS 21 The effects of Changes in Foreign
Exchange Rates

Accounting issues

(i) Foreign transaction:

When you purchase/sell goods from/to other company in other


countries

Step1: You need to firstly translate this transaction in functional


currency (this is the currency that when youre trying to prepare your
trial balance) at spot rate.

Step2: You need to retranslate the monetary item (Bank, receivable,


payable, NCL, CL) at the year end and leave non-monetary items
(NCA, CA).

(ii) Foreign subsidiary:

Statement of financial position: Closing rate


Statement of profit or loss: Average rate

To group company: Exchange differences on the subsidiary are taken


to Equity.

In the SFP: Reserves

In the statement of profit or loss and other comprehensive income:


other comprehensive income

To single company: Exchange differences are taken to statement of


profit or loss.

Audit works

1, Agree the exchange rates used for all retranslation against


published rates.

120
2, Inspect exchange differences and check they have been recognised
in the correct place (statement of profit or loss or equity as
appropriate).

Audit question: Grissom Co (June2010 Q1)

Brass Co
This company is a new and significant acquisition, purchased in
January 2010. It is located overseas, in Chocland, a developing
country, and has been purchased to supply cocoa beans, a major
ingredient for the goods produced by Willows Co. The company uses
local currency to measure and present its financial statements.

Required:

Risk of material misstatement of the above.

Answer to June2010 Q1

Company financial statements are denominated in different


currencies.

1. According to IAS21 The Effects of Changes in Foreign Exchange


Rates before consolidation, assets, liabilities, should be retranslated
using closing exchange rate but for income and expense they should
be retranslated using average rate.

There is a risk that the company has used the wrong rate to translate
the above resulting in misstatement of assets, liabilities, income and
expense.

2. Gains or losses relating to retranslation should be recognised in


equity or other comprehensive income.

There is a risk that gains or losses have been recorded in the


statement of profit or loss leading to misstatement in profit or loss and
equity.

3. Goodwill should be retranslated using the closing year end rate and
gains or losses should be taken into equity.
121
There is a risk that this is not done resulting in a misstatement of the
goodwill figure.

122
IAS 23 Borrowing Costs

Accounting issues

It should be a qualifying asset

The asset takes a substantial period of time to get ready for its
intended use or sale. Examples:
Inventories that require a substantial period of time to bring
them to a saleable condition, e.g., a big ship DR Inventory CR
Cash/Financial Liability
Manufacturing plants- DR PPE CE Cash / Financial Liability
Power generation facilities
Investment properties - DR Investment property CR Cash/
Financial Liability

The amount to capitalise?

Borrowing costs temporary investment income

General funds raised not specific for the asset? (use weighted average
borrowing cost X asset value)

When to capitalise?

Ceased to be capitalised

When the asset is intended for use, not necessarily actually for use.

Disclosure

Amount of borrowing cost capitalised during the period

Capitalisation rate used

Audit work

Obtain breakdown of borrowing costs and recalculate them to verify


its accuracy.

123
Agree interest payments to bank statements and cash book.

Agree interest payments to loan documentation.

Inspect the loan agreement to verify whether this loan is directly


attributable to the asset and if not average rate may be used.

Audit question:[June2012 Q5] IAS23

You are the partner responsible for performing an engagement quality


control review on the audit of Snipe Co.

You are currently reviewing the audit working papers and draft audit
report on the financial statements of Snipe Co for the year ended 31
January 2012. The draft financial statements recognise revenue of
$85 million, profit before tax of $1 million, and total assets of $175
million.

During the year Snipe Cos factory was extended by the


self-construction of a new processing area, at a total cost of $5
million.

Included in the costs capitalised are borrowing costs of $100,000,


incurred during the six-month period of construction.

A loan of $4 million carrying an interest rate of 5% was taken out in


respect of the construction on 1 March 2011, when construction
started.

The new processing area was ready for use on 1 September 2011, and
began to be used on 1 December 2011. Its estimated useful life is 15
years.

Required:

In respect of your file review of non-current assets:


Comment on the matters that should be considered, and the
evidence you would expect to find regarding the new
processing area. (8 marks)

124
Answer to June2012 Q5

Matters to be considered

Materiality
The total cost of the new processing area of $5 million represents
2 9% of total assets and is material to the statement of financial
position. The borrowing costs are not material to the statement of
financial position, representing less than 1% of total assets; but they
are material to profit because it represents 10% of profit before tax.

Accounting
According to IAS23 the borrowing costs should be capitalised if its a
qualifying asset and the period to capitalise would be during the
period of construction and when construction is substantially
completed then it should be ceased to be capitalised.

New processing area was ready for use on 1 September, so


capitalisation of borrowing costs should have ceased at that point. It
seems that the borrowing costs have been appropriately capitalised at
$100,000 ($4m x 5% x 6/12).

There should therefore be five months depreciation included in profit


for the year ended 31 January 2012, amounting to $138,889 ($5m/15
years x 5/12).

Evidence

A breakdown of the components of the $4 9 million capitalised


costs (excluding $100,000 borrowing costs) reviewed to ensure all
items are correct for capitalisation.

A copy of the approved budget or capital expenditure plan for the


extension.

An original copy of the loan agreement, confirming the amount


borrowed and the interest rate.

Recalculation of the borrowing cost, depreciation charge and agree


of all figures to the draft financial statements.

125
IAS 24 Related Party Transactions

Accounting issues

Parties are related if one party has control or significant influence over
the other party.

Related party transactions are transactions between related parties.

Company should disclose the following elements:


Transaction: purchase/sale of goods?
Parties: X Company; Y Company.
Relationship: e.g., parent and subsidiary
Value: $
Date

If A controls (>50%) or joint controls (=50%) B and have significant


influence over C then A&B are related parties, A&C are related parties
as well. Also B&C are related parties because A could have power to
force one sub to do something against another.

If A have significant influence over B&C then A&B, A&C are related
parties but B&C are not related parties because A cant control over B
or C to do something.

If a person has significant influence or control over A then this person


&A are related parties. (Particularly if this person is a member of the
key management team in A or close family)

IAS 24 states there are particularly some situations which may be


related parties transactions:

Associate and subsidiary

Key management

Post-employment benefit: pension plan

Close family
126
Examples of Related Parties

127
Audit work

To find out who the related parties are:

Inspect shareholder register

Inspect Board Minutes for evidence of directors raising related


party issues

Inspect prior year related party disclosures

Inspect abnormal contract to identify:

At a price other than market price

At an odd time

Between 2 companies who have no obvious reason to do


business

Lacking in overall business logic.

Inspect the disclosure relating to related parties transactions to


ensure the following details have been disclosed:

Transaction

Parties

Relationship

Value

Date

128
Audit question:[June2008 Q3]RPT

(a) Discuss why the identification of related parties, and


material related party transactions, can be difficult for
auditors. (5 marks)

You are an audit manager responsible for providing hot reviews on


selected audit clients within your firm of Chartered Certified
Accountants. You are currently reviewing the audit working papers for
Pulp Co, a long standing audit client, for the year ended 31 January
2008. The draft statement of financial position (balance sheet) of Pulp
Co shows total assets of $12 million (2007 $11 5 million).The audit
senior has made the following comment in a summary of issues for
your review:

Pulp Cos statement of financial position (balance sheet) shows a


receivable classified as a current asset with a value of $25,000. The
only audit evidence we have requested and obtained is a
management representation stating the following:

(1) That the amount is owed to Pulp Co from Jarvis Co,

(2) That Jarvis Co is controlled by Pulp Cos chairman, Peter Sheffield,


and

(3) That the balance is likely to be received six months after Pulp Cos
year end.

The receivable was also outstanding at the last year end when an
identical management representation was provided, and our working
papers noted that because the balance was immaterial no further
work was considered necessary.

No disclosure has been made in the financial statements regarding


the balance. Jarvis Co is not audited by our firm and we have verified
that Pulp Co does not own any shares in Jarvis Co.

Required:

(b) In relation to the receivable recognised on the statement


of financial position (balance sheet) of Pulp Co as at 31
January 2008:

129
(i) Comment on the matters you should consider. (5 marks)

(ii) Recommend further audit procedures that should be


carried out. (4 marks)

(c) Discuss the quality control issues raised by the audit


seniors comments. (3 marks)
(17 marks)

Answer to june2008 Q3

(a)
Definition

Related party transaction is difficult to define. I.e. transactions


between parties related by control or influence are disclosed. But its
difficult to define control or influence in the real life.

Accounting system

Its difficult to separate related party transactions from other


transactions unless management has classify the related party sales
into other categories of sales.

Disclosure

Disclosure of related party transactions may be reluctant by


management because its confined to management.

Apply

Its difficult to apply materiality concept because some of the related


party transactions are not material by amount and auditors may not
spot this during the audit.

Concealment

Business may conceal related party transaction in order to cover up


the fraud so auditor may find it harder to reveal these transactions.

130
(b) (i)

Matters to consider:

Accounting standards

According to IAS24 related party transactions only two senior


persons in two different companies are not related parties unless
one has significant influence or control over another.

In the working paper because Javis company is controlled by Pulbs


chairman so the transaction between the two would be a related
party transaction.

The receivable balance has been over 1 year and current assets are
within 1 year and so management should consider the
recoverability of this receivable and write off as a bad debt
expense.

Maybe its because the management is going to window dress the


financial statement because by classifying the non-current assets
into current assets this would make the liquidity position of
company look better.

Materiality

$25,000 is not material by amount but its related part transaction so


its material by nature.

Audit report implication

The classification of the receivable would constitute a material


misstatement.

The lack of disclosure of related party transaction would constitute a


material misstatement so if these are not adjusted then auditor
should issue an except for qualification of audit opinion.

(ii)

Inspect management representation about parties involved in the


transactions, for example, the nature of his control over Jarvis Co.

Inspect management representation from management that there


131
are no further outstanding balances to confirm the completeness of
the disclosure.

Enquire with management about the purpose of the transaction to


verify its in line with auditors business common sense, e.g., should
this be classified as receivable or long term investment.

Inspect the board minutes for evidence of the transaction with Jarvis
co relating to its recoverability.

Auditors can perform analytical procedure by performing a liquidity


analysis of company and if it suggests that the liquidity position of the
company is poor then it is running a risk that management would like
to manipulate the financial position, i.e., window dress the liquidity
position of company.

(c)
Because they failed to spot the weakness of management
representation and it implies there was an inadequate independent
review of work done last year.

No disclosure has been made to related party transaction; this implies


a poor planning meeting of audit has been held.

The delegation of task is not based on knowledge and experience


because the high risk area has been delegated to the audit senior who
may lack of experience to do so.

132
IAS28 Investments in Associates

Accounting issues

The investor will have significant influence if he has invested


20%-50% (Subjective Test) of shares in another company
(associate).

The significant influence is the power to participate into the decision


making process of the company.

Representation on the board of directors

Participation in policy making processes

Material transactions between investor and the entity

Interchange of managerial personnel

Provision of essential technical information

Equity accounting method is used to account for associate.

Audit work

Inspect share certificate to verify the % of shares owned by company.

Inspect directors register and contract to verify their power to affect


policy making decisions.

133
Audit Question [June2010 Q1] IAS28

Grissom Co

This is a non-trading parent company, which wholly owns three


subsidiaries Willows Co, Hodges Co and Brass Co, all of which are
involved with the core manufacturing and marketing operations of the
group. This year, the directors decided to diversify the groups
activities in order to reduce risk exposure.

Non-controlling interests representing long-term investments have


been made in two companies an internet-based travel agent, and a
chain of pet shops. In the consolidated statement of financial position,
these investments are accounted for as associates, as Grissom Co is
able to exert significant influence over the companies.

Required:
Evaluate the principal audit risks to be considered in your planning of
the final audit of the consolidated financial statements for the year
ending 30 June 2010.

Answer to [June2010 Q1] IAS28

Non-controlling interests

Two companies have been accounted for as associate.

According to IAS 28 investment in associate if Grissom co can


demonstrate it has significant influence over those two companies
then they should be accounted for as associate using equity method
otherwise they should be accounted for as simple investments.

There is a risk that Grissom Co has wrongly classified those


companies as associate but rather they should be simple investment
resulting in non-current assets being misstated and profit being
overstated because income from associate is recognised.

134
Financial instruments IAS32,39 IFRS7,9

Accounting issues

Initial Recognition

Become party to contract to the contractual provisions of the


instrument.

Financial Assets Designation

This is a contract if a party is holding then it can give benefit to the


other. For example, Cash; Equity instruments; Receivables.

Financial liability test (base on intention)


Contractual obligation to deliver cash or another financial asset, i.e.,
trade payables; redeemable preference shares.

135
Measurements

Situation 1: Company accepts Finance

Notice: A company issues shares and B company bought it.

If this is the case:

To A Company:

DR Cash [Financial Assets]


CR Share capital
CR Share premium

And also if company A pays transaction cost, then:


DR Share premium
CR Cash.

To B Company:
Since B Company has bought the shares from A company:

DR Financial Asset (Fair value + Transaction cost if FVTOCI)


Or (Fair value only (if FVTPL)
CR Cash

Subsequent measurement:
Take the gains or losses of fair value directly to the OCI or P/L.

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Situation2: Company provides Finance

Financial Assets Initial Measurement Subsequent


Measurement

Fair value through P/L Fair value (With P/L


(If it doesnt belong to the below transaction cost being (Transaction cost is not
categories) expensed into P/L) included)

Investment in equity instrument at Fair value + Transaction OCI


fair value through OCI Costs (Transaction cost
(E.g., Ordinary shares not for trading being capitalised)
purposes)

If an equity investment is not held for


trading, an entity can make an irrevocable
election at initial recognition to measure it
at FVTOCI with only dividend income
recognised in profit or loss.

The amounts recognised in other


comprehensive income (OCI) are not
recycled to profit or loss on disposal of the
investment although they may be
reclassified in equity.

Investment in debt instrument at fair Fair value + Transaction OCI


value through OCI Costs (Transaction cost
(E.g., Hold to collect contractual cash being capitalised)
flows but to sell the part of the financial
Assets. I.e., Debentures that earn interest
and are sold before maturity date).

At Amortised Cost Fair value + Transaction Using Amortised Table


(E.g., Hold to collect contractual Cash Costs (Transaction cost (Transaction cost is
flows. I.e., hold the debentures and earn being capitalised) included when suing
interest until the maturity date.) amortised table)

137
Financial asset de-recognition

1. No rights 2. No R&R (risks and rewards)

This means contractual rights This means risks and rewards of


have been expired. the financial assets have been
transferred.
I.e., we have paid for $20,000
and we have a right to purchase For example, for FVTOCI and
gold on 3rd march 2014. And on FVTPL, investments derecognition
6th march 2014 the option has is when the investment is sold.
expired and hence we remove
$20,000 of financial asset from
SFP.

FVTPL Financial Assets FVTOCI Financial Assets

Proceeds- Carrying Value= DR Cash


Gains/losses CR Financial Asset
CR/DR P/L
DR Cash
CR Financial Asset Then:
DR/CR Finance Cost /
Investment Income DR OCI
CR Retained Earnings
If there is loss, then DR Retained
earnings CR OCI

Financial liability de-recognition

No obligation
This means that the entity has settled their contractual obligations to
deliver cash and in other words, when they pay the loan back.

I.e., we have borrowed $10m from the bank and we have repaid the
loan.

DR financial liability
CR cash

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Compound financial instrument (IAS 32)

Initial Measurement

DR Cash
CR Loan (Fair value of future cash flows)
CR Equity (Balancing Figure)

Subsequent Measurement

The equity component is not remeasured.

The liability component is measured at amortised cost where the


effective rate would be the rate of similar non-convertible liability (i.e.,
the rate used to discount at the initial recognition stage).

Disclosure about financial instrument (IFRS 7)

1: Information about significance of financial instrument

SOFP: P/L:

Financial performance and Separate disclosures for


position for each class of each class of financial
financial instrument; instrument;
Any reclassification, If financial instrument is
de-recognition, not carried at FVTPL then
irrecoverable losses of disclose interest expense
financial instrument, breach on that;
of loan agreements. Disclose any impairment
losses.

Other information:

Information about the nature of financial instrument in detail;


Accounting policy of how to treat those financial instruments;
Fair value of financial instruments (IFRS 13): how to determine
and its value;
Its cash flow relating to the financial instrument.

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2: Information about risks of financial instrument

Qualitative of risks: Quantitative of risks:

Risk exposure- risks included Credit risk-collateral and


and what would happen? the quality of it

Risk management-how to Liquidity risk-how to


manage the risks? manage this risk? (Risk
of default on payment of
Changes in risks from prior interest?)
years-if risk has changed?
Market risks-market
prices change? Such as
bad debts/ Interest rate
changes/ foreign
exchange rate changes.

Derivatives
Company uses derivatives such as future, forward contract etc. to:

Reason 1: Speculation purpose Reason 2: Hedging purpose

Accounting treatment would be to Accounting treatment would be


take the gains or loss of the different from fair value
instrument such as future/ hedge(offset the gains or
forward/option/SWAP directly to the losses from the hedging
statement of profit or loss (P/L). instrument with the hedged
items) and cash flow hedge(no
entries for hedged items until it
takes place and recognise gains
or losses from the hedging
instrument in the OCI and until
it takes place, taking that to the
P/L).

140
Audit work

Perform analytical procedures by assessing valuation model used


to verify its reasonableness.

Inspect disclosures about each financial instrument such as market


risk disclosure about changes in fair value to verify its
completeness.

Agree value of financial instrument to specialist working papers.

Inspect financial instrument contract to verify its in line with


auditors business understanding.

Perform analytical procedures relating to experience, reputation


and the way experts determine the value for financial instrument
to ensure they are competent to do the work.

141
Audit question IAS32,39 IFRS7

To help cash flows in a year of expansion, the company raised finance


by issuing debentures which are potentially convertible into equity on
maturity in 2015.

To manage the risk associated with overseas expansion, in October


2009, the company entered for the first time into several forward
exchange contracts which end in February 2010. The contracts were
acquired at no cost to Papaya Co and are categorised as financial
assets at fair value.

Required:
Assess the risks of material misstatement to be addressed when
planning the final audit for the year ending 31 December 2009.

Answer to Financial Instrument

1. Debentures:

Company has convertible debentures.

According to IAS 32 financial instruments at the inception of the


convertible debenture, it should be split between debt and equity
element. The debt element would be the present value of future cash
flow and equity element would be the balancing figure.
There is a risk that a spit is not done properly resulting in
misstatement in the debt and equity element and profit in statement
of profit or loss because of the misstatement in finance cost.

2. Forward contracts:

This is as financial assets at fair value through profit or loss.


According to IFRS9 financial instrument this should be recognised at
fair value.

There is a risk that this transaction is not recognised at all or they


might be measured wrongly resulting in assets or liabilities in the
statement of financial position, income/expense in the statement of
profit or loss being misstated.

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According to IFRS 7 financial instruments disclosures about the
significance and risks relating to forward contract must be made.

There is a risk of under disclosure per IFRS7 as well.

Audit question: [DEC2011 Q3(b)] (Relating to


3rd party work)

Spruce Co is also involved in energy production. It has a trading


division which manages a portfolio of complex financial instruments
such as derivatives. The portfolio is material to the financial
statements.

Due to the specialist nature of these financial instruments, an


auditors expert was engaged to assist in obtaining sufficient
appropriate audit evidence relating to the fair value of the financial
instruments.

The objectivity, capabilities and competence of the expert were


confirmed prior to their engagement.

Required:
Explain the procedures that should be performed in evaluating the
adequacy of the auditors experts work.
(5 marks)

Answer to DEC2011 Q3(b)

Review the auditors experts working papers and reports to ensure


that the work meets the objectives of the audit.

Evaluate the appropriateness of models used by the expert to


determine fair value.

Compare the findings of the expert with results produced by


management, e.g. compare the fair values determined by the
expert with those determined by management.

Reperform any calculations contained in the experts working


papers, e.g. recalculate movements in fair value on the
143
derivatives.

Agree figures used in calculations to supporting documentation,


e.g. contracts relating to derivative financial instruments.

Audit question: June2013 Q4 (b) Financial


Instrument

Bulldog Co Bulldog Co is a clothing manufacturer, which has recently


expanded its operations overseas. To manage exposure to cash flows
denominated in foreign currencies, the company has set up a treasury
management function, which is responsible for entering into hedge
transactions such as forward exchange contracts. These transactions
are likely to be material to the financial statements. The audit partner
is about to commence planning the audit for the year ending 31 July
2013.

Required:

Discuss why the audit of financial instruments is particularly


challenging, and explain the matters to be considered in planning the
audit of Bulldog Cos forward exchange contracts. (8 marks)

Answer to June2013 Q4 (b)

There are many reasons why financial instruments are challenging to


audit. The instruments themselves, the transactions to which they
relate, and the associated risk exposures can be difficult for both
management and auditors to understand. If the auditor does not fully
understand the financial instrument and its impact on the financial
statements, it will be difficult to assess the risk of material
misstatement and to detect errors in the accounting treatment and
associated disclosures. Even relatively simple financial instruments
can be complex to account for.

The specialist nature of many financial instruments means that the


auditor may need to rely on an auditors expert as a source of
evidence. In using an expert, the auditor must ensure the objectivity
and competence of that expert, and then must evaluate the adequacy
144
of the experts work, which can be very difficult to do where the focus
of the work is so specialist and difficult to understand.

The auditor may also find that there is a lack of evidence in relation to
financial instruments, or that evidence tends to come from
management. For example, many of the financial reporting
requirements in relation to the valuation of financial instruments are
based on fair values. Fair values are often based on models which
depend on management judgement. Valuations are therefore often
subjective and derived from management assumptions which
increase the risk of material misstatement.

It is imperative that the auditor retains professional skepticism in the


audit of financial instruments, but this may be difficult to do when
faced with a complex and subjective transaction or balance for which
there is little evidence other than managements judgement.

There may also be control issues relating to financial instruments.


Often financial instruments are dealt with by a specialist department
and it may be a few individuals who exert significant influence over
the financial instruments that are entered into. This specialist
department may not be fully integrated into the finance function,
leading to the accounting treatment being dealt with outside the
normal accounting system. Internal controls may be deficient and
there may not be the opportunity for much segregation of duty.
However, some companies will have established strong internal
controls around financial instruments, leading to a lower risk of
material misstatement.

In planning the audit of Bulldog Cos financial instruments, the auditor


must first gain an understanding of the relevant accounting and
disclosure requirements. For example, the applicable financial
reporting standards should be clarified, which are likely to be IFRS 9
Financial Instruments and IFRS 7 Financial Instruments: Disclosures.
These standards can be complex to apply, and the auditor should
develop a thorough understanding of how they relate to Bulldog Cos
financial instruments.

The auditor must also obtain an understanding of the instruments in


which Bulldog Co has invested or to which it is exposed, including the
characteristics of the instruments, and gain an understanding of
Bulldog Cos reasons for entering into the financial instruments and its
policy towards them.

145
It is important that the resources needed to audit the financial
instruments are carefully considered. The competence of members of
the audit firm to audit these transactions should be assessed, and it
may be that an auditors expert needs to be engaged. If so, this
should be explained to the client. Instructions will have to be drawn up
and given to the expert to ensure that the work performed is in line
with audit objectives and follows the relevant financial reporting
requirements, for example, in relation to valuing the financial
instruments.

The audit planning should include obtaining an understanding of the


internal control relevant to Bulldog Cos financial instruments,
including the involvement, if any, of internal audit. An understanding
of how financial instruments are monitored and controlled assists the
auditor in determining the nature, timing and extent of audit
procedures, for example, whether to perform tests on controls.
Specific consideration should be given to understanding
managements method for valuing financial instruments for
recognition in the year-end financial statements. The valuation is
likely to involve some form of estimate, and ISA 540 Auditing
Accounting Estimates, Including Fair Value Accounting Estimates and
Related Disclosures requires the auditor to obtain an understanding of
how management makes accounting estimates and the data on which
accounting estimates are based.

Finally, the materiality of the financial instruments should be


determined and the significance of the risk exposure associated with
them should be assessed.

146
IAS33 Earnings Per share

Accounting issues

EPS means how much each share of company may earn. If EPS=10,
this means that for every share within a company then it can earn
$10.

The next question is how can we calculate EPS?

Basic EPS is calculated as:

PAT-irredeemable preference share dividend*


Weighted average number of ordinary shares

* Irredeemable preference share dividend means dividend in this year


only, not a cumulative figure.

If there is a change in capital structure, i.e., bonus or right issue of


shares takes place, then when calculating the weighted average
number of shares, Bonus Fraction will need to be taken into account
as well.

If there is convertible bond or share option being issued, diluted EPS


will need to be calculated.

Listed companies must, on the face of the statement of profit or loss,


present basic EPS as well as diluted EPS.

Audit work

Recalculate basic EPS and diluted EPS.

Ensure any necessary restatements of prior year EPS have been done,
and suitably disclosed.

147
Audit Question (June2015 Q1) IAS 33 EPS

EPS calculation:

Required:

Recommend the principal audit procedures to be performed in the


audit of the EPS. (4marks)

Answer to June2015 Q1

Review board minutes to confirm the authorisation of the issue of


share capital, the number of shares and the price at which they were
issued.

Inspect any other supporting documentation for the share issue, such
as a share issue prospectus or documentation submitted to the
relevant regulatory body.

Confirm that the share issue complies with the companys legal
documentation (e.g. the memorandum and articles of association).

Recalculate the weighted average number of shares for the year to 31


May 2015.

148
Audit question[June2009 Q5 Pluto] IAS 33

You are the partner responsible for performing an engagement quality


control review on the audit of Pluto Co, a listed company. You are
currently reviewing the engagement partners proposed audit report
on the financial statements of Pluto Co for the year ended 31 March
2009. During the year the company has undergone significant
reorganisation, involving the discontinuance of two major business
segments. Extracts of the proposed audit report are shown below:

Emphasis of matter paragraph


The directors have decided not to disclose the Earnings per Share for
2009, as they feel that the figure is materially distorted by significant
discontinued operations in the year. Our opinion is not qualified in
respect of this matter.

Required:

Is there something wrong with the companys accounting treatment?

Is it correct to quote a breach in IAS33 EPS in the emphasis of matter


paragraph?

Answer to June2009 Q5

1. Yes it has done something wrong because for listed companies EPS,
Diluted EPS and its comparatives should be disclosed in the note of
the financial statement to make information comparable.

2. No its not correct because the auditor would include significant


uncertainty about going concern status of the company in the
emphasis of matter paragraph and a failure to disclose the EPS,
diluted EPS and its comparatives would just be a material
misstatement and its nothing to do with significant uncertainty about
going concern status of Pluto.

149
IAS 36 Impairment of Assets

Accounting issues

If there are any impairment indicators relating to the non-current


assets, management needs to carry out an impairment review test by
comparing the carrying value of the asset with its recoverable
amount.

Impairment indicators:

Internal: External:
Asset obsolete or damage; Adverse change in the
Operating losses for the commercial environment
current period; (decrease demand for the
Loss of key employees; asset)
Reconstructions.

Recoverable amount is calculated using the higher of the value in use


and net realisable value.

What can be included in future cash flows? [Recent budgets or


forecasts]

Cash inflow from continuing use of the asset.


Necessary and directly attributable expenses such as overhead
expenses; day to day servicing.
Net cash flows from disposal from selling the assets or paying
for any expenses etc. at the end of the useful life of assets.
You can include inflation but you dont need to, its up to you.
But you should make sure you maintain consistency.

What cant be included? [Your estimate process


(Extrapolate)]
Expenses improving assets further performance but for cash
outflow incurred to maintain assets current conditions are
150
included.
From future restructuring costs which are not committed.
Any cash flows from financing activities are not considered
because they have been considered in the discount rate stated
above.
Any income tax receipt or paid is not considered because the
discount rate is determined on a pre-tax basis and future tax
law may change.
Exclude any financial assets and liabilities such as receivables,
payables.

How to determine Discount rate?


Should be pre tax rate and reflect time value of money and risks
specific to assets like market rate or WACC.

Determination of fair value

If there is a contract relating to the transaction, then we can use the


contract price as the fair value price and minus costs to sell; If there is
no contract then we should see if there is an active market for the
transaction and if yes then we can use the similar transaction price
from the active market minus the costs to sell. If there is no active
market then we can use our best estimate price minus costs of
disposal of this asset.

Impairment reversal

If the asset has been revalued then impairment happens, the


company needs to reverse the revaluation reserve first and charge the
remaining amount to the impairment loss;

If the asset has been impaired before and then been revalued, the
company needs to reverse the impairment loss adjusting for the
additional depreciation saving and charge the remaining amount to
revaluation reserve.

151
Audit work

Inspect a copy of correspondence to verify impairment indicator


exists.

Inspect asset condition to determine whether it would need further


impairment.

Enquire with management to verify their Future intentions to use


or to sell the asset, this forms a basis for the recoverable amount.

Inspect management representation that an impairment test has


been carried out.

Inspect draft sales agreements for impairment review evidence.

Inspect cash flow projections relating to value in use.

Inspect management account after the reporting date of the


company results to confirm an impairment review is necessary (for
CGU).

Review managements impairment review to establish the


reasonableness of value in use by examining its discount factor
used.

Review managements impairment review to establish the


reasonableness of the assumption regarding the future cash inflow,
i.e., in line with sales revenue growth.

152
Audit question: Impairment IAS36

You are the manager responsible for the audit of Aspersion, a limited
liability company, which mainly provides national cargo services with
a small fleet of aircraft. The draft accounts for the year ended 30
September 2008 show profit before taxation of $2.7 million (2007
$2.2 million) and total assets of $10.4 million (2007 $9.8 million).

(b) Aspersion owns two light aircraft which were purchased in 2005 to
provide business passenger flights to a small island under a
three-year service contract. It is now known that the contract will not
be renewed when it expires at the end of March 2009. The aircraft,
which cost $450,000 each, are being depreciated over fifteen years.
(7 marks)

Required:

Comment on the matters that you would consider and the audit
evidence you should find.

Answer: (only 7 points required)

(i)Matters to consider:

Materiality

The depreciated value of aircraft is $720,000($900,000/15 X3) and


its 7% of total assets and its material to the statement for financial
position.

Accounting

According to IAS36 impairment of assets an impairment test would be


carried out if theres an indicator that asset would be impaired. Here
for Aspersion the contract would not be renewed any more so this
would be an impairment indicator. Management should carry out an
impairment test comparing carrying value of asset with its
recoverable amount and the recoverable amount would be
determined using the higher of value in use and net realisable value of
the asset.
153
If an impairment loss is recognised the auditor would need to
determine whether it would be material to the financial statement by
calculating its materiality.

Audit report implication

If the impairment loss is material to the financial statement and hasn't


been recognised by management or has been recognised wrongly
then the auditor would need to qualify their audit opinion with an
exception due to material misstatement.

(ii)Audit evidence

A copy of the service contract and any correspondence to verify the


contract would not be renewed.

Aircraft inspection result to ascertain its condition and determine


whether it would need further impairment.

Notes of enquiries of management to verify their Future intentions


to use or to sell the asset, this forms a basis for a recoverable
amount.

Management representation that an impairment test has been


carried out.

Draft sales agreements for impairment review evidence, i.e., the


determination of net realisable value.

Cash flow projections relating to value in use.

154
Audit question: [DEC2010 Q3] IAS36

Clooney Co is one of the worlds leading leisure travel providers,


operating under several brand names to sell package holidays. The
company catered for more than 10 million customers in the last 12
months. Draft figures for the year ended 30 September 2010 show
revenue of $3,200 million, profit before tax of $150 million, and total
assets of $4,100 million. Clooney Cos executives earn a bonus based
on the profit before tax of the company.

You are the manager responsible for the audit of Clooney Co. The final
audit is nearing completion, and the following points have been noted
by the audit senior for your attention:

One part of the companys activities, operating under the Shellys


Cruises brand, provides cruise holidays. Due to economic recession,
the revenue of the Shellys Cruises business segment has fallen by
25% this year, and profit before tax has fallen by 35%. Shellys
Cruises contributed $640 million to total revenue in the year to 30
September 2010, and has identifiable assets of $235 million,
including several large cruise liners. The Shellys Cruises brand is not
recognised as an intangible asset, as it has been internally generated.

Required:

Comment on the matters that you should consider, and state the
audit evidence you should expect to find in your review of the audit
working papers for the year ended September 2010 in respect of:
Shellys Cruises
(7 marks)

155
Answer to DEC2010 Q3(b)

Matters to be considered

Accounting

According to IAS36 impairment of assets theres an indicator


suggesting the cash generating unit has been impaired, i.e., due to
economic recession. So an impairment review should be performed by
management by comparing carrying value of CGUs and recoverable
amount from the higher of value in use and fair value minus costs to
sell.

Materiality

It accounts for 20% of revenue ($640m/43200m) and 5.7% of total


assets ($235m/$4,100m) and so its material to statement of profit or
loss and statement of financial position.

Audit report implication

If the impairment test is not done by management then auditors


should issue an except for qualification regarding this.

Evidence

Review management account after the reporting date of Shelly


company detailing the performance of Shelly to confirm an
impairment review is necessary.

Obtain a management representation stating performance of


Shelly is bad and an impairment review has been done.

Review managements impairment review to establish the


reasonableness of value in use by examining its discount factor
used.

Review managements impairment review to establish the


reasonableness of the assumption regarding the future cash inflow,
i.e., in line with sales revenue growth.

156
IAS 37 Provisions, Contingent liabilities and
Contingent Assets

Accounting Issues

Provision

A provision is an uncertain future obligation that the business may or


may not have to settle.

You can only recognise the provision if these 3 criteria are met:

(Mnemonics: POR)

P: probable that resources will be transferred to settle the liability


(asset/other resources);

O: present obligation whether its legal (law) or constructive


(published information) from past event;

R: reliable estimate of the amount of payment that can be made.

Double entry

Relating to warranty, refunds Relating to asset clean up:


policy:
DR Asset
DR Relevant expense a/c CR Provision
(Statement of profit or loss and
other comprehensive income) Subsequent measurement would
be to unwind the provision and
CR Provision recognise the corresponding
(Statement of financial position) expenses.

157
Provision for restructuring

P: Probable that resources will be transferred to settle the liability


(asset/other resources);

O: Present constructive obligation (published information) from past


event;

Detailed formal plan


This plan should identify the business is being restructured;
locations affected; staff compensated etc.

Valid expectation
It should create valid expectation that the company either
starts to restructure or announce its plans.

R: Reliable estimate of the amount of payment that can be made.

It should not include the following:


Retraining or relocating existing staff
marketing expense
Investment in new systems and distribution network.

Disclosure for Provision

To show how the opening provision may be reconciled to the closing


provision:

Opening provision $55m


Provision $20m
Closing provision $75m

Contingent liabilities

Situation1

A possible obligation that arises from past events and existence will
only be confirmed by the occurrence or non-occurrence of one or
more uncertain future events not wholly within the control of the
entity.
When it comes to consolidation of the subsidiary, this subsidiarys
158
contingent liability doesnt need to be written off against the
subsidiarys net asset.

Situation2

A present obligation that arises from past events but it fails criteria P
and R (above) of a provision and hence the provision is not
recognised.

When comes to consolidation of the subsidiary, this subsidiarys


contingent liability needs to be written off against the subsidiarys net
asset.

Disclosure for Contingent Liabilities

Nature of contingent liability


Likely financial effect
Uncertainty of the amount and timing

Contingent assets

A contingent asset arises from probable future income.

Situation

It is a probable/possible asset that arises from past events whose


existence is confirmed by the occurrence or non-occurrence of
uncertain future events not wholly within the control of the entity.

If it becomes virtually certain (>95%) that the company can receive


the asset rather than just a contingent asset so that they can
recognise the asset in the financial statements rather than disclose it.

Disclosure for Contingent Asset (when its probable)

Nature of contingent asset


Likely financial effect

159
Audit work

1. Use general analytical procedures to compare provision recorded


year on year to verify its reasonableness.

2. Use CCTRAIN
Claims- correspondence with customer obligation

Correspondence -with layer-determine whether provision, contingent


liability would be needed.
Terms of contract- Companys obligation

Representation/recalculate provision-there are no further expenses


needed to provide for-determine the
exact amount of expenses and liability.
Advice from company to verify who bears the liability.
Insurance company- to verify if any reimbursement can be
obtained by company and this will form
the basis for the amount recognised as
liability.
News-obligation

Audit question [DEC2007 Q1(b)] provision


One customer, Sawyer Co, communicated in November 2007, via its
lawyers with Island Co, claiming damages for injuries suffered by a
drilling machine operator whose arm was severely injured when a
machine malfunctioned. Kate Shannon, the chief executive officer of
Island Co, has told you that the claim is being ignored as it is generally
known that Sawyer Co has a poor health and safety record, and thus
the accident was their fault. Two orders which were placed by Sawyer
Co in October 2007 have been cancelled.

All machines are supplied carrying a one-year warranty. A warranty


provision is recognised on the balance sheet at $2 5 million (2006
$2 4 million). Kate Shannon estimates the cost of repairing defective
machinery reported by customers, and this estimate forms the basis
of the provision.

Required:
Explain the principal audit procedures to be performed during the final
audit in respect of the estimated warranty provision in the balance
sheet of Island Co as at 30 November 2007. (5 marks)
160
Answer to [DEC2007 Q1(b)] Provision

Inspect correspondence with the customer to understand the


claims made by them at the year end.

Inspect correspondence with a lawyer to determine the possibility


that the company can win the case if customers sue the company,
this will form the basis for the company to recognise a provision or
disclose as a contingent liability.

Inspect the terms of contract to understand the obligation of Island


Co.

Recalculate the warranty provision.


Inspect the written representation that there is no further
repairment of assets apart from $2.5m in the statement of
financial position to determine there are no other provision needs
to be provided for or contingent liability disclosed.

Enquire with management to determine advice given by the


company and if the company said they would bear the
compensation costs then this would help in determining the full
provision amounts to be provided for or contingent liability amount
to be disclosed.

Inspect the insurance contract to determine whether the company


can get compensation reimbursement from the insurance
company, if yes then this would reduce the liability that the
company needs to provide for.

Inspect the news regarding this claim by the customer to


determine the companys liability regarding this issue.

General Analytical procedures:

Perform analytical procedures to compare the level of warranty


provision year on year to verify its reasonableness.

Perform analytical procedures to verify assumptions used are


consistent with the auditors understanding of the business

161
Audit question DEC2014 Q5(b) IAS37

The audit of Bradley Cos financial statements for the year ended 31
August 2014 is nearly complete, and the audit report is due to be
issued next week. Bradley Co operates steel processing plants at 20
locations and sells its output to manufacturers and engineering
companies. You are performing an engagement quality control review
on the audit of Bradley Co, as it is a significant new client of your firm.
The financial statements recognise revenue of $2 5 million, and total
assets of $35 million.

The schedule of proposed adjustments to uncorrected misstatements


included in Bradley Cos audit working papers is shown below,
including notes to explain each matter included in the schedule. The
audit partner is holding a meeting with management tomorrow, at
which the uncorrected misstatements will be discussed.

1. DR Restructuring provision $50,000


CR P/L $50,000

A provision has been recognised in respect of a restructuring involving


the closure of one of the steel processing plants. Management
approved the closure at a board meeting in August 2014, but
announced the closure to employees in September 2014. The audit
conclusion is that the provision should not be recognised.

2. DR P/L $10,000
CR Slowing moving inventory

The estimate relates to slow-moving inventory in respect of a


particular type of steel alloy for which demand has fallen.
Management has already recognised a provision of $35,000, which is
considered insufficient by the auditor.

Required:

Explain the matters which should be discussed with management in


relation to each of the uncorrected misstatements (6 marks)

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Answer to DEC2014 Q5(b)

(i)

Restructuring provision

The adjustment in relation to the provision is material to profit,


representing 2% of revenue. It represents less than 1% of total assets
so is not material to the statement of financial position.

The provision appears to have been recognised too early. IAS 37


Provisions, Contingent Liabilities and Contingent Assets requires that
for a restructuring provision to be recognised, there must be a present
obligation as a result of a past event, and that is only when a detailed
formal plan is in place and the entity has started to implement the
plan, or announced its main features to those affected. A board
decision is insufficient to create a present obligation as a result of a
past event. The provision should be recognised in September 2014
when the announcement to employees was made.

Management should be asked to explain why they have included the


provision in the financial statements, for example, there may have
been an earlier announcement before 31 August 2014 of which the
auditor is unaware.

In the absence of any such further information, management should


be informed that the accounting treatment of the provision is a
material misstatement, which if it remains unadjusted will have
implications for the auditors opinion.

Inventory provision

The additional slow-moving inventory provision which the auditor


considers necessary is not material on an individual basis to either
profit or to the statement of profit or loss or the statement of financial
position, as it represents only 0 4% of revenue and less than 1% of
total assets.

Despite the amount being immaterial, it should not be disregarded, as


the auditor should consider the aggregate effect of misstatements on
the financial statements. ISA 450 does state that the auditor need not
accumulate balances which are clearly trivial, by which it means that
the accumulation of such amounts clearly would not have a material
163
effect on the financial statements. However, at 0
4% of revenue the
additional provision is not trivial, so should be discussed with
management.

This misstatement is a judgmental misstatement as it arises from the


judgements of management concerning an accounting estimate over
which the auditor has reached a different conclusion. This is not a
breach of financial reporting standards, but a difference in how
management and the auditor have estimated an uncertain amount.
Management should be asked to confirm the basis on which their
estimate was made, and whether they have any reason why the
provision should not be increased by the amount recommended by
the auditor.

If this amount remains unadjusted by management, it will not on an


individual basis impact the auditors report.

164
IAS38 Intangible Assets

Accounting issues

Initial recognition

Identifiable You purchase it and youve got a contract.

Control by company- for human assets which


Asset definition are not controllable by business.

Also its probable that future economic benefit


will flow into entity.

Cost Can be reliably measured.

Subsequent measurement

It would depend on whether the intangible assets life is finite (limited,


such as 5-year franchise contract) or indefinite (unlimited life).

If the life is finite, we should amortise it over its useful life using
straight line method.

Double entry

DR amortisation expense (P/L)


CR accumulated amortisation (Statement of financial position)

We can either use a cost model or a revaluation model to do this. Quite


often, intangible asset would be measured using a costs model since
there would not be active markets for intangible assets except for
franchise right/ Fishing license/ Taxi license. For these right/license,
they normally have an active market and hence we can use a
revaluation model to account for these.

If the intangible asset life is indefinite, we need to carry out an


impairment test for it at the end of each reporting period, i.e.,
comparing the carrying value with its recoverable amount (IAS 36
165
impairment of assets).

Research and development costs (R&D)

Research expenses: This means that you search the internet and
other information to see whether the plan is workable. So it should be
expensed to P/L not capitalised as an asset because its not probable
that this can help the company generate into future economic benefit.

Development costs: The application of research findings or other


knowledge to a plan or design for the production of new or
substantially improved materials, devices, products, processes,
systems or services before the start of the commercial production or
use.
The idea behind it is, knowledge on its own would not generate future
economic benefits unless it is being used to do so.

The asset can be used or sold


Economic benefit will be probable to flow into entity
Enough resource to complete the process
The process is technically feasible
Theres management intention to complete the process
The costs of this can be measured reliably.

If the development costs can be capitalised as the asset and put into
commercial production, then we can amortise the asset over its life.

Disclosure

For each class of intangible assets:

The useful life of asset;


Amortisation rates used;
Accumulated amortisation;
A reconciliation between beginning and end of year balances, i.e.,
additions, disposals, revaluation of intangible assets (uncommon)
etc.

166
Audit work for other intangible assets

Agree cost of intangible to purchase documentation

Agree cash outflow relating to this intangible asset to cash book or


bank statement.

Inspect the purchase documentation relating to this intangible asset


to verify the rights of intangible assets actually belong to the
company.

Audit work relating to R&D expense

Inspect detailed business plan to determine how the company


would use this asset.

Inspect customer order if the company is to sell the asset.

Inspect cash flow projections to verify if there is enough cash flow


to carry out the development process.

Inspect statement of cash flow to verify there is enough cash


balance within the company to support the development process.

Inspect the overdraft facility to ensure there are enough resources


to complete the development process.

Inspect result of scientific tests relating to this asset to verify its


technically feasible.

Inspect management representation to ensure the company has


an intention to complete the development process.

Inspect invoices relating to this project to confirm related expenses


can be measured reliably by the company.

167
Audit question [June2008 Q5] IAS 38

An internally generated brand name has been included in the


statement of financial position at a fair value of $10million. Audit
working papers show that the matter was discussed with the financial
controller, who stated that the $10 million represents the present
value of future cash flows estimated to be generated by the brand
name. The member of the audit team who completed the work
programme on intangible assets has noted that this treatment
appears to be in breach of IAS 38 Intangible Assets, and that the
management refuses to derecognise the asset.

Required:

From the information provided above, recommend the matters which


should be included as findings from the audit in your report to those
charged with governance, and explain the reason for their inclusion.
(7 marks)

Answer to [June2008 Q5] IAS 38

Materiality

This is 13% of total asset ($10m/$78m) and its material to the


statement of financial position.

Accounting treatment

Although the company can use the brand to generate into future
economic benefit and it seems to fulfill the asset definition.

But an internally generated brand name is not identifiable and


therefore cannot be recognised as an intangible asset in the
statement of financial position.

Reason to notice to those charged with governance

It can give management an opportunity to correct that material


misstatement before a qualified opinion is given.

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Those charged with governance, i.e. an audit committee, should
co-operate with an external auditor to require management to correct
that material misstatement.

An external auditor should tell the audit committee why a potential


qualification of audit opinion would be given due to a breach in IAS38
intangible assets and state its materiality as well to the financial
statement.

If management still refuses to correct that material misstatement,


then the auditor needs to modify his audit report by issuing an except
for qualification audit opinion due to material misstatement in the
financial statement.

169
Audit question [DEC2011 Q1] IAS 38

Maple & Co

A significant amount has been invested in the new website, which is


seen as a major strategic development for the company. The website
has generated minimal sales since its launch last month, and
advertising campaigns are currently being conducted to promote the
site.

Required:

Identify and explain the principal audit risks to be considered in


planning the final audit

Answer to DEC2011 Q1

Company has developed the website.

According to IAS38 intangible assets the development cost would be


capitalised if it fulfills certain criteria and one of them is that the
company can use this website to generate into future economic
benefit, and given this website has generated minimum sales it cant
be capitalised.

There is a risk that company has capitalised this development cost


and hence overstated the asset within statement of financial position
and understating expense in the statement of profit or loss.

170
IAS40 Investment Property

Accounting issues

Classification of investment property

Investment Earns capital gain or let it out to earn rental


purpose income and if not: Use by company/Owner
occupied: IAS 16; held for sale: IAS2)

Complete Asset has been completed and if not, IAS 16 until


its finished.

And they should be recognised at cost initially.

Considerations

1. It is possible to treat part of a property as an investment property


if these different parts can be separated (sold or leased separately).

2. If the asset is occupied by employees (lease to employees) then


this is not the investment property.

3. The components/assets within the investment property such as


chairs, desks and air conditioner should not be double counted as a
separate investment property.

Subsequent measurement Fair value model (widely used)

Get the fair value:

From price

From similar asset within the area

From value from institution for similar assets

From discount future cash flow

Then any gain/losses should be recognised into the statement of


profit or loss.
171
Gain: Loss:
DR Investment property DR P/L
CR P/L CR investment property

Disclosure for Fair value model

An entity that adopts this must also disclose a reconciliation of the


carrying amount of the investment property at the beginning and end
of the period.
Opening IP value 100
Increase 50
Closing IP value 150

Cost Model (Rarely used)

Recognises the investment property at cost and depreciates over its


useful economic life.

When calculating the depreciation expense, we should ignore the


residual value since the fair value cant be estimated and hence there
would be no residual value for this as well.

Disclosure for Cost model


These relate mainly to the depreciation method. In addition, an entity
which adopts the cost model must disclose the fair value of the
investment property.

Audit work

General assets procedures

Inspect purchase document of investment property to verify the cost


of each building. And because the property was acquired this year
then the price shouldn't be too far away from that as at the year-end
so any big differences between the two would imply a misstatement
exists.

Inspect purchase document of investment property to ensure it


belongs to the company.

172
Inspect investment property physically to determine condition of the
properties supporting the valuation.

Far value procedures

Audit procedures should focus on the appraisal of the work of the


expert valuer. Procedures could include the following:

Inspect the written instructions Co provided to the valuer to get an


understanding about the scope of their work.

Perform analytical procedures to evaluate assumptions used by


valuer in the report are in line with auditors business understanding.

Inspect valuers method used to determine fair value and ensure its
consistent with by IAS40.

Perform analytical procedures by reviewing forecast rental income


from properties as an evidence for valuation.

Inspect the date of the valuation report and ensure its close to the Co
financial statement year end so that fair value used would be
reasonable.

Inspect any subsequent events, e.g., sale of investment property


after the year end, this would provide evidence for property valuation,
e.g., using fair value in the contract price.

173
Audit question [DEC2008 Q3] IAS40

You are the manager responsible for the audit of Poppy Co, a
manufacturing company with a year ended 31 October 2008. In the
last year, several investment properties have been purchased to
utilise surplus funds and to provide rental income. The properties
have been revalued at the year-end in accordance with IAS 40
Investment Property, they are recognised on the statement of
financial position at a fair value of $8 million, and the total assets of
Poppy Co are $160 million at 31 October 2008. An external valuer has
been used to provide the fair value for each property.

Required:

(i) Recommend the enquiries to be made in respect of the


external valuer, before placing any reliance on their work, and
explain the reason for the enquiries; (7 marks)

(ii) Identify and explain the principal audit procedures to be


performed on the valuation of the investment properties.
(6 marks)

Answer to [DEC2008 Q3]Investment Property

(i) Enquiries

Competence

Is the valuer a member of a recognised professional body such as


institute of registered surveyors?

Does the valuer have any necessary licence to carry out valuations
for companies?

How much experience does the valuer have in providing valuations


of the investment properties held by Poppy Co?

Is there any evidence of the reputation of the valuer, e.g.


recommendations from other companies to provide such service?

174
Objectivity

Does the valuer have any financial benefit in Poppy Co, e.g. shares
held in the company?

Does the valuer have any personal relationship with any director or
employee of Poppy Co?

Is the fee paid for the valuation service reasonable and a market
based price?

(ii) Audit procedures

General assets procedures:

Inspect purchase document of the investment property to verify the


cost of each building. And because the property was acquired this
year then the price shouldn't be too far away from that as at the
yearend so any big differences between the two would imply a
misstatement exists.

Inspect purchase document of the investment property to ensure it


belongs to the company.

Inspect the investment property physically to determine the condition


of the properties supporting the valuation.

Far value procedures:

Audit procedures should focus on the appraisal of the work of the


expert valuer. Procedures could include the following:

Inspect the written instructions Co provided to the valuer to get an


understanding about the scope of their work.

Perform analytical procedures to evaluate assumptions used by


valuer in the report are in line with auditors business understanding.

Inspect valuers method used to determine fair value and ensure its
consistent with IAS40.

Perform analytical procedures by reviewing forecast rental income


from properties as evidence for valuation.
175
Inspect the date of the valuation report and ensure its close to the Co
financial statement year end so that fair value used would be
reasonable.

Inspect any subsequent events, e.g., sale of investment property


after the year end, this would provide evidence for property valuation,
e.g., using fair value in the contract price.

176
IAS 41 Agricultural Accounting

Accounting Issues

Examples of agricultural activities

Raising livestock

Cropping

Forestry

Cultivating orchards and plantations

Floriculture

Aquaculture (fish farming)

Recognition of biological assets

The recognition criteria are very similar to those for other assets, in
that animals or plants should be recognised as assets in the following
circumstances.

The entity controls the asset as a result of past events

It is probable that the future economic benefits associated with


the asset will flow to the entity and this can be determined by
formal ownership records, e.g. land title, branding.

The fair value or cost of the asset to the entity can be measured
reliably

Biological assets (animals and plants)

It can be consumable biological asset such as apple and bearer


biological asset such as apple tree.

E.g., small apples may become big apples and it has a biological
transformation process. Initial and year end: FV-estimated
point-of-sale costs

I.e., FV of cattle at a farm is the price for the cattle in the


177
relevant market-commission-tax of getting the cattle to that
market. But it should exclude transportation costs since we
have considered this in the calculation in the fair value, i.e.,
market price minus the transportation costs.

If a fair value cannot be determined because market


determined prices or values are not available. Then the
biological asset can be measured at cost less accumulated
depreciation and impairment losses.

The fair value changes should be split between physical change


and price change. The separate disclosure about this would just
to be recommended by IAS 41 but this is not compulsory.

Agricultural produce harvested from biological assets

FV-costs to sell at the point of harvest. (But it should exclude


transportation costs).

Gains/losses---recognise in statement of profit or loss.

This is an example of inventory and should be accounted for


under IAS 2 Inventories.

Presentation and disclosure

In the statement of financial position biological assets should be


classified as a separate class of assets falling under neither current
nor non-current classifications. This reflects the view of such assets as
having an unlimited life on a collective basis; it is the total exposure of
the entity to this type of asset that is important.

Biological assets should also be sub-classified (either in the statement


of financial position or as a note to the accounts).

Class of animal or plant

Nature of activities (consumable or bearer)

Maturity or immaturity for intended purpose

Agricultural produce should be classified as inventory in the


statement of financial position and disclosed separately either in the
statement of financial position or in the notes.

178
Government grants

An unconditional government grant related to a biological asset


measured at its fair value less estimated point-of-sale costs
should be recognised as income when, and only when, the grant
becomes receivable, i.e., DR cash CR income

If a government grant requires an entity not to engage in


specified agricultural activity (e.g. the EU's set aside grant), an
entity should only recognise the grant as income when, and only
when, the conditions are met, i.e., DR cash CR income

IAS 20 does not apply to a government grant on biological


assets measured at fair value less estimated point-of-sale costs,
i.e., no deferred income method allowed.

However, if a biological asset is measured at cost less


accumulated depreciation and accumulated impairment losses
then IAS 20 does apply, i.e., DR cash CR deferred income and
release deferred income into actual income over the life of
biological assets.

Audit procedures

Refer to IFRS 13 to determine fair value of the biological asset


(Such as refer to 3rd party experts work or perhaps by simply
asking management whether the active market for the
biological asset exists).

Recalculate the value of the agriculture produce to make sure


that the transportation cost is not included to verify its accuracy.

Inspect the disclosure made by the management relating to


biological asset, for example, class for animals have been
disclosed properly.

If there is a government grant that exists, examine the


accounting journal relating to the biological asset grant and
make sure that company has met with the governments
condition, for example by inspecting the business plan by
179
management because the income can be recognised only if the
company has met with the governments condition.

180
IFRS2 Share-based Payment

Accounting issues

Basic idea

It means we pay for something using shares.

Calculation

The question is how can we measure the expense?

Step1: identify the type of scheme. Pay (settle) in shares or cash?

Step2: follow the formula:


Obligation= number of rights expected to vest X FV X timing ratio

Obligation

The total expense we should recognise at the end of the vesting


period.

There may be changes in the expense we recognise each year


because of our estimates and any changes in them would be a change
in accounting estimate and this would be accounted for under IAS8 by
just using prospective adjusting method. In order words, just provide
for it.

Number of rights expected to vest

Number of people left the company + no of people expected to leave


next year

Vesting condition

Companies may require employees to stay within the company for the
next 5 years (vesting period) and hence employees can get the share
option. Or perhaps companies may require employees to achieve
market related performance conditions, for example, share price
should reach $5/share before you can get those share options. Or
perhaps you need to achieve 25% of return on capital employed
before you can get those share options.

181
A change in the estimated number of employees or the vesting
conditions would be a change in accounting estimate and it should be
accounted for using prospective adjusting method.

Fair value (FV)

1. Settled by Equity
(Share option, i.e., exercise price is $5/share to buy a share and the
current share price is $6/share, hence employees need to pay
$5/share to the company in order to buy a share. And after an
employee has bought a share from the company, the employee can
either be the shareholder, i.e., holding that share or sell that share at
$6/share directly onto the market and hence enjoy $1 of capital gain.)

If the fair value of option can be reliably measured then we should use
fair value of the share option at the grant date (written in the contract)
to measure it.

But if the fair value of the option cannot be measured reliably then we
should use intrinsic value of the option to measure it. Intrinsic value
would be calculated as using fair value of the share price exercise
price of the option (written into the contract).

2. Settled by Cash
Share Appreciation Right, i.e., exercise price is $5/share to buy a
share and the current share price is $6/share, hence company would
directly give $1 to employees.

If its settled in cash which means the company will pay cash to the
employees based on the future share price. So if the share price at the
end of the vesting period (the end that employee has worked for the
company) is $50m then CR liability 50m. So the Fair value here will be
the FV of options at the end of each year.

Settlement

If this is equity settled, the company should remove all of the reserve
relating to the share options that it has previously recognised when
receiving money from the employees by:

DR Bank
DR Other components of equity
CR Share capital
CR Share premium
182
If this is cash settled, i.e., share appreciation rights, then the
company should remove all the financial liabilities that it has
previously recognised and pay cash to the employees:

DR Financial liabilities
CR Cash

Timing ratio=year end / vesting period

Audit work

Agree the following calculation by management to the contract:


Number of employees
Number of options granted per employee
Grant date of the share options
Vesting period for the scheme
Required performance conditions attached to the options

Recalculate the share based payment expense to ensure its


accuracy.

Review a forecast of employee turnover rates during the vesting


period to verify its reasonableness and this would help determine
total number of share options granted.

Inspect written representation from management to confirm


assumptions used in the calculation are reasonable.

Agree fair value of share options to specialists report and


calculation.

Agree that the fair value calculated is at the grant date if this is
share options.

Agree that the fair value calculated is at the each year end if this is
share appreciation right.

183
Audit question [DEC2008 Q1(b)(i)] IFRS2

Note2: significant items included in operating expenses:

2008($m) 2007($m)
Share-based payment expense(i) 138 -
Damaged property repair 100 -
expenses(ii)

(i) In June 2008 Bluebell Co granted 50 million share options to


executives and employees of the company. The cost of the share
option scheme is being recognised over the three-year vesting period
of the scheme. It is currently assumed that all of the options will vest
and the expense is calculated on that basis. Bluebell Co operates in a
tax jurisdiction in which no deferred tax consequences arise from
share-based payment schemes.

Required:

Describe the principal audit procedures to be carried out in respect of


the measurement of the share-based payment expense; (6 marks)

Answer to DEC2008 Q1(b)(i)

Agree the following calculation by management to the contract:


Number of employees
Number of options granted per employee
Grant date of the share options
Vesting period for the scheme
Required performance conditions attached to the options

Recalculate the share based payment expense to ensure its


accuracy.

Review a forecast of employee turnover rates during the vesting


period to verify its reasonableness and this would help determine
total number of share options granted.

Inspect written representation from management to confirm


assumptions used in the calculation are reasonable.

184
Agree fair value of share options to specialists report and
calculation.

Agree that the fair value calculated is at the grant date because
this is share options not share appreciation rights.

185
IFRS5 Non-current Assets Held for Sale and
Discontinued Operations

Accounting issues

Non-current assets held for sale

When the non-current asset within your company is about to be sold


to the 3rd party maybe because its falling in value then if some criteria
are fulfilled then you can reclassify this non-current asset into current
asset as NCA HFS and discontinued operations under IFRS5.

Classification

The idea behind the criteria is that you should prove that this sale is
probable:

Selling purposes by management-management is committed to


a plan to sell PP&E; Investment property; Intangible assets.

Available for sale under current condition

Locate a buyer actively

Expected to complete within 12 months from the year end

If the above criteria are proven then the company can reclassify the
non-current asset into non-current asset held for sale under current
asset.

186
Presentation

Non-current asset held for sale would be disclosed like this:

Non-current Assets
PP&E $100
Investment Property $200
Current Assets
Inventories $10
Receivables $20
Cash $10
Non-current assets held for $40
sale
Total assets $380
The non-current asset held for sale can also be referred to the
disposal group which is a group of assets together with liabilities. It
can either be a single machinery (asset) together with account
payable (liability) or it can be the subsidiary.

Disposal group would be disclosed like this:

PP&E $500
Receivable $30
Payable $20

Non-current asset
PP&E $500
Current Assets
Inventory $100
$600
Non-current asset held for sale($500+$30) $530

Total Assets= $1,130

Equity $400

Non-current liabilities $300

Current liabilities $200

Liabilities associated with non-current assets held $20


for sale

Total Equity and liabilities= $1,130

187
Initial measurement

Write down to net realisable value of the asset if its a non-current


asset held for sale. Same idea behind inventory (lower of cost and
NRV)-impaired!

Trick: pick up the lower figure

Double entry: (NRV<CV)

DR non-current asset held for sale (current asset) (SFP)


DR P/L (balancing figure) (P/L)
CR PPE (SFP)

Double entry: (NRV>CV)

DR non-current asset held for sale (current asset) (SFP)


CR PPE (SFP)

Subsequent measurement

No depreciation or amortisation:

Because we are not consuming the asset any more-not for continued
use but for sale.)

Further impairment losses:

DR P/L
CR non-current asset held for sale

Discontinued operations

A discontinued operation is an operation if its closed or sold during


the year or held for sale at the year end.

A discontinued operation should:

1, Dispose of or plan to dispose of a separate major line of


business or geographical area of operations (Major line of
business: e.g., financial service industry; supermarket. geographical
area: Canada division);

2, A subsidiary acquired exclusively with a view to resale.


188
Disclosure

Net cash flow detailing operating, investing and financing


activities.

Single line in the statement of profit or loss and other


comprehensive income showing post tax profit or loss on
discontinued operation.

Audit work

For assets / operations that have been disposed of:

Agree proceeds to sales documentation and bank statements.

Recalculate any gain or loss on disposal and ensure separately


disclosed in the financial statements.

Verify date on sales documentation to prove asset was sold before


year end.

For assets / operations held for sale:

Inspect Board Minutes to confirm intention to sell.

Inspect correspondence with agent to confirm the company is


actively trying to sell the asset.

If the company has advertised the asset for sale, inspect


advertising documentation.

Obtain management representation to confirm Boards intention to


sell.

Inspect correspondence between company and any interested


parties regarding the sale.

If the company has made any announcements regarding the plan


to sell, inspect copies and agree date before year end.

Assess asset / operation for impairment, as a plan to sell often


indicates asset/ operation is not performing as well as company.

189
Audit question [DEC2007(a) ] IFRS 5

Alpha Co, a listed company, permanently closed several factories in


May 2007, with all costs of closure finalised and paid in August 2007.
The factories all produced the same item, which contributed 10% of
Alpha Cos total revenue for the year ended 30 September 2007
(2006 23%). The closure has been discussed accurately and fully in
the chairmans statement and Directors Report. However, the closure
is not mentioned in the notes to the financial statements, nor
separately disclosed on the financial statements. The audit senior has
proposed an unmodified audit opinion for Alpha Co as the matter has
been fully addressed in the chairmans statement and Directors
Report.

Required:

Evaluate whether the audit seniors proposed audit report is


appropriate, and where you disagree with the proposed report,
recommend the amendment necessary to the audit report of:

(i) Alpha Co; (6marks)

190
Answer to [DEC2007(a)] IFRS 5

Accounting treatment

According to IFRS5 non-current assets held for sale and discontinued


operations closure of factories at the year-end should be disclosed in
the financial statements as discontinued operations.

General disclosure would include:

Profit after tax of the discontinued operations


Fair value of the discontinued operations.

Separate disclosure would include:

If product lines of the business would be closed and they are in


separate areas or they are separate products then they should be
separately disclosed.

Materiality

This is material to statement of profit or loss because it accounts for


10% of total revenue

Auditors opinion is not correct given this is a material misstatement in


the financial statement and hence an except for qualification of audit
opinion would be given due to material misstatement.

A basis of qualification audit opinion would need to be placed before


the actual opinion paragraph and it needs to detail the reasons why
qualification audit opinion would be given due to a breach of IFRS5.

191
Audit question2 [June2011 Q1a]IFRS 5

The second issue concerns one of Bill Cos specialist divisions, which
trades under the name Treasured Homes and which deals exclusively
in the redevelopment of non-industrial historic buildings such as
castles and forts.

These buildings are usually acquired as uninhabitable ruins, and are


then developed into luxury residences for wealthy individuals. The
management of Bill Co decided last week to sell this division, as
although it is profitable, it generates a lower margin than other
business divisions.

Treasured Homes operates separately from the rest of the business,


and generates approximately 15% of the total revenue of the
company. In a board minute dated 1 June 2011, it was noted that
interest has already been expressed in this division from a potential
buyer, and it is hoped that sale negotiations will soon commence,
leading to sale in August 2011.

There is a specific office building and some other tangible assets that
will be sold as part of the deal. These assets are recorded at $7 6
million in the financial statements.

No redundancies will be necessary as employees contracts will


transfer to the new owners.

Required:

I am asking you to prepare briefing notes, for my use, in which you


explain the matters that should be considered in relation to the
treatment of these two issues in the financial statements, and also
explain the risk of material misstatement relating to them. I also want
you to recommend the planned audit procedures that should be
performed in order to address those risks.
(8 marks)

192
Answer to [June2011 Q1(a)] IFRS 5

Only 8 points required

Materiality

Treasured Homes is material to the group because it represents 8%


of total assets of the financial statements.

Accounting

A non-current asset held for sale is recognised if management has an


intention to sell the asset; asset is available for sale immediately;
company locates a buyer actively and the sale would be expected to
complete within 12months after the financial statement year end.

Because a buyer is interested in buying it and a sale is expected to


begin in August 2011. Asset is complete and management is going to
sell that to the customer so it can be classified as a non-current asset
held for sale.

As per IFRS5 the asset should be separately disclosed measuring at


the lower of carrying value and net realisable value and the asset is
not depreciated any more.

Its likely that treasured homes meet the definition of discontinued


operation because it operates separately from the normal business
operation and because it accounts for 15% of total revenue so its a
major line of business.

Risk of material misstatement

There is a risk that the classification of non-current asset held for sale
is not made leading to overstatement of non-current asset and
understatement of current asset in the statement of financial position.
Also misstatement in the expenses as well if depreciation continues to
be charged.

There is a risk that separate disclosure for the discontinued operation


is not made.

193
Audit procedures

Obtain a management representation confirming management is


planning to sell the asset.

Inspect board minutes for evidence that management are planning


to sell the asset.

Inspect the asset physically to verify its available for sale.

Inspect the legal correspondence with potential buyer to confirm


company is actively locating a buyer.

Obtain management representation to confirm the sale would be


completed within the next 12 months after the financial statement
year end.

Confirm that separate disclosure of discontinued operation has


been made in the statement of financial position, statement of
profit or loss, and statement of cash flows.

Confirm that depreciation has not been charged as required by


IFRS 5.

194
IFRS8 Operating Segments

Accounting issues

This area typically applies only to listed companies.

Reporting

Firstly,

We should decide whether this is an operating segment?

An operating segment would have the following features:

1: It has business activities earning revenue and incurring expenses.


2: The operating results will be reviewed by CEO to make economic
decisions.
3: Theres separate financial information for each segments showing
assets, liabilities, revenue, expenses and profits etc.

Secondly,

Once it fulfills the definition of operating segment then you will need
to decide whether this would be reportable?

An operating segment would be reportable if:


Its more than 10%of Revenue, Assets or Profits of all segments;

If theres a loss then we need to decide whether the loss is higher


than the higher of 10% of total profits and 10% of total loss and if
no then it doesn't fulfill this criteria.

Only one of the criteria needs to be fulfilled.

Thirdly,

195
Once the operating segments are classified but they do not add up to
75% in total then we need to break the other operating segments
down in order to make the total up to 75%.

If other operating segment doesn't fulfill the definition of operating


segment then we can bring them together if they have similar
products/types of customers/distribution methods or regulatory
environment.

Fourthly,

We need to decide how to disclose the operating segments.


Revenue, total assets & liabilities, interest income & expense, tax &
depreciation should be disclosed.

Fifthly,

Some segments would have similar natures and can be combined


together. We need to decide whether those small segments would be
combined together. These segments should have the following similar
characteristics: [MR PPC]

M**
Regulatory requirements
Products/services
Production process
Customer base

Sixthly,

We need to decide if there are any central incurred costs, i.e., head
office costs, how do they be allocated to each segments?
Per IFRS8, this is all up to managements discretion. Lets take a look
at an example of this in the later questions.

196
Audit work

Agree segmental analysis to the totals reported in the Financial


Statements.

Perform analytical procedure by comparing figures with prior year


to ensure consistency of presentation.

Agree this years analysis back to management accounts.

Audit question1 IFRS8 [DEC2009 Q1(d)]

You are the manager responsible for the audit of Papaya Co, a listed
company, which operates a chain of supermarkets, with a year ending
31 December 2009. There are three business segments operated by
the company.

Two segments are supermarket chains which operate under internally


generated brand names, and the third segment is a new financial
services division.

The first business segment comprises stores branded as Papaya Mart.


This segment makes up three-quarters of the supermarkets of the
company, and are large out of town stores, located on retail parks on
the edge of towns and cities. These stores sell a wide variety of items,
including food and drink, clothing, household goods, and electrical
appliances. In September 2009, the first overseas Papaya Mart
opened in Farland. This expansion was a huge drain on cash resources,
as it involved significant capital expenditure, as well as an expensive
advertising campaign to introduce the Papaya Mart brand in Farland.

The second business segment comprises the rest of the supermarkets,


which are much smaller stores, located in city centres, and branded as
Papaya Express. The Express stores offer a reduced range of
products, focusing on food and drink, especially ready meals and
other convenience items.

The company also established a financial services division on 1


January 2009, which offers loans, insurance services and credit cards
to customers.

Required:
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Assess the risks of material misstatement to be addressed
when planning the final audit for the year ending 31 December
2009. (2marks)

Answer to [DEC2009 Q1(d)]IFRS8

According to IFRS8 operating segments for listed companies such as


Papaya Co the information relating to those operating segments
should be disclosed in the note of the financial statements.

There is a risk relating to non-disclosure of information relating to


these operating segments.

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IFRS10,11,12

Accounting issues

IFRS 10 Consolidated Financial Statements

When the investor is exposed or has rights to variable returns


(profit/loss) from its involvement with the investee and has the ability
to affect those returns through its power over the investee.

When Control:

Power instrument:

Majority voting rights and potential voting rights such as convertible


bonds and share options; power to appoint directors on the board.

Activities (relevant).

I like to think about relevant activities which are based on the purpose
of the organisation. Such as if your company is going to manufacture
high fashion clothes then a relevant activity would be to determine the
selling price of the high fashion clothes in the whole market etc.
Participation in preparation of accounts for the company is just an
irrelevant activity.

Returns (either positive or negative)

The returns here could be positive or negative which means through


the direction of the activity within the company then the investor may
be exposed to or have right to profit or loss not necessarily benefit
(profit).

Also the returns are variable which means that if the company is doing
a good job so it earns a larger amount of profit then it will distribute a
larger amount of dividend to shareholders and this is called variable
which is against fixed.

E.g., a preference shareholder is just exposed to the fixed dividend


received from the company so it does not necessarily have control
over the entity.

199
IFRS 11 Joint Arrangements

This is based on the concept of joint control.

JOINTLY CONTROLLED OPRATION

This means that parties do business together using their own assets
and settling their liabilities. The accounting for this follows the
substance over form which means the assets and liabilities remain in
each parties FS and just a sharing of revenue, expense, assets and
liabilities.

JOINTLY CONTROLLED ENTITY

Parties may set up a business together and put their assets and
liabilities in then the assets and liabilities belong to the business
rather than belong to their own. The accounting for this is to use
equity accounting which means the growth of business goes into the
income statement and SOFP where its added to the cost.

IFRS 12 disclosures of interests in other entities

This is a new IFRS on disclosure of group relationships that requires


the ultimate parent to disclose all its relationship with other entities.

The parent company is required by IRS12 to list:


All of its subsidiaries and state the reason why it has control not
significant influence.
All of its associates and state the reasons why it has significant
influence not control.
All of its joint arrangements and state the reasons why it has
joint controls.

Audit work

Inspect their agreement to verify joint control.

Examine the term control by inspecting directors register and


terms to verify their power to govern policy making decision.

Inspect disclosure is appropriate as per IFRS12.

200
Audit question [Shire DEC2005] IFRS11

In July 2008, Shire entered into an agreement to share in the future


economic benefits of an extensive oil pipeline.

Required:

Using the information provided, identify and explain the audit


risks to be addressed when planning the final audit of Shire Oil
Co for the year ending 31 December 2008.

Answer

The agreement to share in future profit seems to be a joint


arrangement.

If there is joint control then we should decide whether this is


joint operation or joint venture.

If its joint operation then assets and liabilities should be


recognised in each parties financial statements.

If its joint venture then Shire should use equity accounting


method.

There is a risk that the above accounting is wrong and hence


financial statements would be materially misstated.

201
IFRS13 Fair Value Measurement

Accounting issues

Definition of fair value

The price that would be received to sell an asset or paid to transfer a


liability in an orderly transaction between market participants at the
measurement date.

How to measure fair value?

There are 3 techniques relating to fair value determination:

Market approach

Where prices and other market-related data is used for similar or


identical assets, liabilities or groups of assets and liabilities. For
example, we can use multiples like P/E to measure fair value.

Income approach

This is where estimated future cash flows may be converted into a


single, current amount stated at present value. Valuation techniques
would include present value techniques; option pricing models such
as Black-Scholes option pricing models etc.

Cost Approach

This reflects the amount that would be required currently to replace


the service capacity of an asset, i.e., current replacement cost.

Inputs requirements

For financial assets, liability and equity instrument(3Levels)

Financial asset is the unconditional right to receive the cash and cash
equivalent.

Level1 Observable (No adjustment) Input

This includes observable inputs (without adjustments) in active


202
markets for identical assets and liabilities at the measurement date.

For example, if you are valuing a financial asset which is traded on a


stock exchange such as the New York Stock Exchange, then you have
an observable market with prices available on the stock exchange and
this would normally be the fair value.

Level2 Observable (With adjustment) Input

These are inputs (with adjustments) other than the quoted price in
the level 1 input and they are observable either directly or indirectly.
This is more general than the level 1 since the level 1 refers to the
specific transaction.

For example, interest rates and yield curve and credit spread used in
conjunction with the valuation multiples when valuing the financial
asset.

Level3: Unobservable inputs (Management best estimate, e.g.,


Cos own data)

For example, own data from the company, e.g., for cash generating
units value, we would use our own cash flows forecasts to determine
it. Also for decommissioning liability, we would use our own data, i.e.,
the estimated cash outflow in order to fulfill the obligation used to
estimate the present value of that future obligation would be the fair
value as well.

Non-financial assets (highest and best use value)

If there is principal market exists, then we should use the value from
the principal market (considering transportation costs only) to
determine the fair value.

If there is no principal market (high volume and frequency of


transactions), but there is most advantageous (profitable) market
exists, then we can use the value from that market to determine fair
value. Again, we should only consider transportation costs when
determining the fair value rather than transaction costs such as tax
expense. Because only transportation costs would change the
characteristics of the asset, i.e., location changes.

203
Audit work

Inspect valuers working papers to verify methods used are in line


with auditors understanding.

Enquire with management about controls over the estimation


process when the valuation for the items is complex as this will
reduce the control risk.

Perform analytical procedures by comparing methods used for


estimates with prior years to ensure consistency.

Consider the use of an outside auditors expert to assess the


estimate and the assumptions on which it is based.

Obtain written representations from management that they


believe the assumptions behind their estimates to be reasonable.

204
Audit question [DEC2008 Q3(a)]Fair Value

(a) Financial statements often contain material balances recognised


at fair value. For auditors, this leads to additional audit risk.

Required:
Discuss this statement. (7 marks)

Answer to [DEC2008 Q3] Fair Value

Inherent risk

This will increase the inherent risk because of its subjectivity in


nature.
For example when determining the fair value for asset using
discounting cash flow, lots of discount rates would be used by
management and it's subjective.

(For example when management tries to use a fair value model for
the asset they may assess the market condition of that asset and
the future intention of how to use that asset to generate into future
economic benefit and they can base on this to give a fair value to
the asset and this is subjective.)

This will increase the inherent risk because its subject to


manipulation by management.
Management sometimes would use a fair value model to value
assets in order to overstate its asset value to attempt window
dressing.

This will increase the inherent risk because of its complexity.


For example, in IAS19 employee benefit when the actuary gives a
fair value to the pension asset or liability then the process is very
complicated and its easy to make mistakes.

Control risk

This will increase control risk because sometimes fair value


determination is beyond the companys control.
For example, when valuing the pension asset and liabilities its up
to the actuary to value them not the company and hence any
205
mistakes happened during the valuation process may not be
detected by the company internal control system.

Detection risk

This will increase detection risk because auditors may lack


knowledge when dealing fair value.
For example, if the auditor has no knowledge about financial
instrument then the auditor may not detect any errors within the
fair value figure of financial asset and hence give a wrong audit
opinion.

206
IFRS 15 Revenue from Contracts with
Customers

Accounting Issue

Five step model [COPAR]

1: Contract Identification
Make sure that this is a contract. For example, it has commercial
substance and the price can be determined.

2. Obligation identified
Obligation can either be explicit or implicit. This means for example, I
say to you, I will do the service for you and charge you $300 then
$300 needs to be recognised as sales; Or perhaps I havent said to
you that I will provide the service (Implicit Obligation) but according
to the companys record, the company has provided service to others
as well, even though the company hasnt said this then we also need
to establish the sales value for this.

3. Price for transaction

Amount expected to be received in exchange for


goods/services

Exclude amounts receivable for third parties (such as


taxes).

Includes variable/contingent consideration (use probability


weighted approach).

4. Allocation of transaction price to obligation


Based on Standard alone selling price.

5. Recognise Revenue

Service sales would be recognised over the service contract life;


If its not service, when you dispatch the goods, recognise the
revenue.

207
Audit procedures

Examine the contract to make sure parties are identified and


commercial substance exists with the distinctive price.

Inspect the contract and make sure that the obligation has been
identified, for example, Party B has the responsibility to provide the
service so that we can recognise associated revenue later on.

Recalculate the sales value and make sure that the taxes etc. will not
be included in the total sales revenue calculation.

Recalculate the sales value and make sure that the sales revenue will
be based on standard alone selling price for the goods or services.

Examine the double entry relating to the sales revenue recognition


and make sure correct basis for the recognition of sales revenue has
been used. For example, either sales basis or costs basis (relating to
construction contract) or whether the company still has managerial
control over the goodsif yes, then we cant recognise the sales
revenue relating to the tangible product, for example.

208
Group audit

Contents

COMPONENTS ................................................................... 210

SIGNIFICANT COMPONENT............................................... 210

ACCESS TO INFORMATION ABOUT COMPONENTS ............. 210

SINGLE ENTITY CONCEPT ................................................. 211

SUBSTANCE OVER FORM CONCEPT ................................... 211

METHOD TO ACCOUNT FOR COMPONENTS ........................ 211

NET ASSETS OF SUBSIDIARY............................................ 211

COMPLEX GROUP .............................................................. 212

CHANGES IN GROUP STRUCTURE ..................................... 212

CASE JUNE2012 Q1(A(I+III)): GROUP AUDIT.................. 214

EXAMPLE OF CHANGES IN GROUP STRUCTURE DEC2013 Q1(B)


......................................................................................... 218

209
Components

Components of group financial statements can include subsidiaries,


associates, joint ventures and branches.

Significant Component

ISA 600.A5 states that a significant component can be identified by


using a benchmark. If component assets, liabilities, cash flows, profit
or turnover (whichever is the most appropriate benchmark) exceed
15% of the related group figure, then the auditor may judge that the
component is a significant component. If a component is financially
significant to the group financial statements then the group
engagement team or a component auditor will perform a full audit
based on the component materiality level.

Access to information about components

The group auditor may not be able to access all the information it
needs about components or component auditors, e.g. because of laws
relating to confidentiality or data privacy. The effect on the group
audit opinion depends on the significance of the component.
If the component is not significant, then it may be sufficient just to
have a complete set of financial statements, the component auditor's
report, and information kept by group management.

If the component is significant then it is possible that there will be an


inability to obtain sufficient appropriate audit evidence about the
component, in which case the audit opinion is either qualified or a
disclaimer of opinion is issued. In this case it would also be impossible
to comply with ISA 600's requirement to be involved with the work of
the component auditor (for significant components), which would also
lead to an inability to obtain sufficient appropriate audit evidence.

Comfort/Support letter

If the subsidiary is not a going concern entity any more but the
subsidiary manager has informed the external auditor that the parent
company within the group is going to help it out. For example, the
parent company will provide sufficient cash to help with its cash flow
210
problems and the subsidiary may refuse to redraft its financial
statements under the break up basis. In order to support this, the
group auditor needs to obtain the comfort letter from the parent
company to get them confirmed that they will help with the
subsidiary.

Single Entity Concept


Based on single entity concept within the group there would be parent
and subsidiary. For associate which is outside the group, any
transactions between among the components need to be adjusted.

Substance over Form Concept

Consolidated statement of financial position would be prepared


showing assets, liabilities which are based on definition of control
whilst for equity which is based on ownership.

When acquiring a subsidiary the excess amount of money paid would


be goodwill (positive-show in the non-current assets). If we spend
less money than its actual net assets then the difference would be
bargain purchase which would be presented in the consolidated
statement of profit or loss and other comprehensive income and
retained earnings.

Method to account for components

For associate/joint venture we use equity accounting method.

For subsidiary we show the excess amount we paid as


non-current asset, i.e., goodwill.

Goodwill would be subject to impairment at each year end but


not amortisation for public listed companies.

Net assets of subsidiary

Net assets should include deferred tax implication, i.e., minus


deferred tax liability and add deferred tax asset back.

211
Complex Group

This means to include sub-subsidiary into the group consolidation.


The date that the sub-subsidiary becomes the component of the
group would be the later of: 1. Subsidiary becomes our subsidiary; 2.
Sub-subsidiary becomes the subsidiary of the subsidiary.

We also need to DR NCI in subsidiary CR Goodwill in Sub-subsidiary


(NCI% X Investment made by parent to subsidiary)

Changes in group structure

This means that the ownership of the group changes and it can be
divided into the following circumstances:

1. From simple investment to associate: Eliminate the simple


investment at the carrying value and use equity accounting
subsequently. DR Investment in associate CR Simple investment CR
gain (P/L).

2. From Associate to Subsidiary: Eliminate the associate and


recognise the goodwill. DR Goodwill (Also consider the 2nd investment
made) CR Investment in Associate CR Gain (P/L)

3. To acquire more shares and remain control:


DR NCI (Reduction)
CR Cash
DR/CR Equity (movement of equity-statement of changes in equity)

4. To sell of shares but remain control:


DR Cash
CR NCI (Increase)
DR/CR Equity (movement of equity-statement of changes in equity)

5. Disposal of the entire shares of subsidiary or simply lose


control:

Step1: Derecognise the assets/liabilities/income/expense of the


subsidiary up to the date that we lose control;

Step2: Calculate the gains/losses as a result of the disposal:

212
Total Business at the date of disposal X
Cash in
Reduction in NCI
Remaining(Simple Investment/Associate etc)

Total Things Left at the date of disposal Y


Unimpaired goodwill
Net assets

Gains/loss= X-Y

213
Case June2012 Q1(a(i+iii)): Group audit

You are a manager in Magpie & Co, responsible for the audit of the CS
Group. An extract from the permanent audit file describing the CS
Groups history and operations is shown below:
Permanent file (extract) Crow Co was incorporated 100 years ago. It
was founded by Joseph Crow, who established a small pottery making
tableware such as dishes, plates and cups. The products quickly grew
popular, with one range of products becoming highly sought after
when it was used at a royal wedding. The companys products have
retained their popularity over the decades, and the Crow brand enjoys
a strong identity and good market share.

Ten years ago, Crow Co made its first acquisition by purchasing 100%
of the share capital of Starling Co. Both companies benefited from the
newly formed CS Group, as Starling Co itself had a strong brand name
in the pottery market. The CS Group has a history of steady
profitability and stable management.

Crow Co and Starling Co have a financial year ending 31 July 2012,


and your firm has audited both companies for several years.

Acquisition of Canary Co

The most significant event for the CS Group this year was the
acquisition of Canary Co, which took place on 1 February 2012. Crow
Co purchased all of Canary Cos equity shares for cash consideration
of $125 million, and further contingent consideration of $30 million
will be paid on the third anniversary of the acquisition, if the Groups
revenue grows by at least 8% per annum. Crow Co engaged an
external provider to perform due diligence on Canary Co, whose
report indicated that the fair value of Canary Cos net assets was
estimated to be $110 million at the date of acquisition. Goodwill
arising on the acquisition has been calculated as follows:
$m
Fair value of consideration: 125
Cash consideration 30
Contingent consideration 155
Less: fair value of identifiable net assets (110)
acquired
Goodwill 45

To help finance the acquisition, Crow Co issued loan stock at par on 31


214
January 2012, raising cash of $100 million. The loan has a five-year
term, and will be repaid at a premium of $20 million. 5% interest is
payable annually in arrears. It is Group accounting policy to recognise
financial liabilities at amortised cost.

Canary Co manufactures pottery figurines and ornaments. The


company is considered a good strategic fit to the Group, as its
products are luxury items like those of Crow Co and Starling Co, and
its acquisition will enable the Group to diversify into a different market.
Approximately 30% of its sales are made online, and it is hoped that
online sales can soon be introduced for the rest of the Groups
products. Canary Co has only ever operated as a single company, so
this is the first year that it is part of a group of companies.

Financial performance and position

The Group has performed well this year, with forecast consolidated
revenue for the year to 31 July 2012 of $135 million (2011 $125
million), and profit before tax of $8
5 million (2011 $8
4 million). A
breakdown of the Groups forecast revenue and profit is shown below:

Crow Co Starling Co Canary Co CS Group


$ million $ million $ million $ million
Revenue 69 50 16 135
Profit before 35 3 2 8.5
tax
Note: Canary Cos results have been included from 1 February 2012
(date of acquisition), and forecast up to 31 July 2012, the CS Groups
financial year end.

The forecast consolidated statement of financial position at 31 July


2012 recognises total assets of $550 million.

Other matters

Starling Co received a grant of $35 million on 1 March 2012 in relation


to redevelopment of its main manufacturing site. The government is
providing grants to companies for capital expenditure on
environmentally friendly assets. Starling Co has spent $25 million of
the amount received on solar panels which generate electricity, and
intends to spend the remaining $10 million on upgrading its
production and packaging lines.

On 1 January 2012, a new IT system was introduced to Crow Co and


215
Starling Co, with the aim of improving financial reporting controls and
to standardise processes across the two companies. Unfortunately,
Starling Cos finance director left the company last week.

Required:

(i) Identify and explain the implications of the acquisition of Canary


Co for the audit planning of the individual and consolidated financial
statements of the CS Group; (8 marks)

(iii) Recommend the principal audit procedures to be performed in


respect of the goodwill initially recognised on the acquisition of Canary
Co. (5 marks)

Answer to June2012 Q1(a)(i)+(iii)

(a) (i)

Individual financial statement:

Auditors should consider the time to start their audit work to avoid
any delay in work because now its June 2012 and the financial
statement year end is July 2012 then its just 1 month away before
auditors start their audit.

Auditors would need to consider performing professional clearance


asking previous auditors of Canary Co about any circumstances
that may influence its audit strategy and audit plan as this is an
initial engagement.

Auditors would need to consider whether an expert would be used


to obtain sufficient and appropriate audit evidence relating to its
sales revenue because 30% of Canary Co sales are made online.

Auditors need to understand the clients company including


understanding its internal control system because a new IT system
was introduced to Crow Co so the auditor should assess whether
there would be further internal control weakness which may lead to
a potential misstatement in its financial statement.

216
Consolidated financial statements:

Auditors would need to consider extra work done on the


transactions occurred in July because Canary and Group have a
different financial statement year end.

Auditors should assess the new materiality because Canary has


been newly introduced into the group so the materiality for the
group has changed.

Auditors should consider whether component would be significant


component and based on calculation revenue of Canary Co would
account for 11.9% of the group (16/135) and profit before tax
would account for 23.5% of the group (2/8.5) so Canary would be
a significant component of the group.

Auditor should consider extra works to be done as well such as


engaging an expert auditing goodwill and auditors should ensure
there enough time to carry out the audit of the group.

(iii) (actions+document(what)+reasons(why/assertions))

Agree the cash consideration of $125m to bank statement and its


cash book.

Obtain the breakdown of contingent consideration and recalculate


it, i.e., on a discount basis to verify its accuracy.

Enquire with management of company about the likelihood of


payment to Canary Co to verify its reasonableness in contingent
consideration.

Inspect external expert report on the valuation of fair value of net


assets at acquisition to verify its accuracy.

Inspect the purchase document of Canary from management to


verify this is approval.

217
Example of Changes in group structure
DEC2013 Q1(b)

On 1 September 2013, the Group disposed of its wholly-owned


subsidiary, Broadway Co, for proceeds of $180 million. Broadway Co
operated a distribution centre in this country. The Groups statement
of profit or loss includes a profit of $25 million in respect of the
disposal.

Required:

Recommend the principal audit procedures to be performed in respect


of the disposal of Broadway Co. (8 marks)

Answer to DEC2013 Q1(b)

Inspect the statement of financial position of Broadway Co as at 1


September 2013 to confirm the value of assets and liabilities which
have been derecognised from the Group.

Inspect prior year Group financial statements and audit working


papers to confirm the amount of goodwill that exists in respect of
Broadway Co and trace to confirm it is derecognised from the Group
on disposal.

Inspect shareholder register of Stow Group and confirm that the Stow
Group is no longer listed as a shareholder of Zennor Co.

Re-perform managements calculation of profit on disposal in the


Group financial statements.

Agree the proceeds received of $180 million to cash book/bank


statements.

Inspect the Group statement of profit or loss and other


comprehensive income to confirm that the profit on disposal is
correctly disclosed as part of profit for the year (not in other
comprehensive income) on a separate line.

218
Inspect managements estimate of the tax due on disposal,
re-perform the calculation and confirm the amount is properly
accrued group financial statements.

Confirm that $180 million is the fair value of proceeds on disposal and
that no deferred or contingent consideration is receivable in the
future.

219
Public Sector Audit

Contents

THERE ARE 2 TYPES OF AUDIT ......................................... 221

FINANCIAL STATEMENT AUDIT ........................................ 221

PERFORMANCE AUDIT ...................................................... 223

PERFORMANCE MEASURES ............................................... 224

REAL LIFE CASES .............................................................. 225

Q COUNTRY A ................................................................... 227

Q HOSPITAL ..................................................................... 229

PUBLIC SECTOR AUDIT REPORTING ................................. 230

220
There are 2 types of audit

Financial Statement Audit

Performance Audit

Financial Statement Audit

Example of public sector financial statements

Income and expenditure summary (Prepared mainly using


cash basis) (Taken from UK Government):

221
Assets and liabilities summary: (Taken from UK Government)

Aim

We need to make sure that the money spent by the government is for
its appropriate target set.

For example, government sets a target to spend $60m into the


education filed so when we are auditing this $60m, we have to make
sure that the $60m has been spent on education filed not anywhere
else.

222
Performance Audit

Example of Performance Report (Taken from UK Government)

223
3Es

Economy

Not being overcharged.

Efficiency

Not extravagance
No tantamount to waste

Effectiveness

Achieve the target set.

Performance Measures

A few examples of the performance measures set in public sector:

Increase the public satisfaction rate by


Police performance
20% this year.

measures Increase the serious violence detection


rate by 20% this year.

Reduce the waiting time for medical


operations;

Hospital performance
Reduce the number of medical errors.

measures

224
Real life Cases

A few real life cases relating to public sector audit:

Case1:
Government allows the agent to sell the land to the public.

Auditors considerations:
Whether this is the best price sold to the public? For example,
corruption activities may take place and hence government may sell
the land at a low price to that individual but this is not fair to other
people in the society.

Case2:
Government has spent $20m to buy a machinery but this does not
exist when auditors are performing the audit.

Auditors considerations:
Whether the asset is stolen by somebody in the government?

Case3:
Government spent $2m to buy a chocolate and a teddy bear.

Auditors considerations:
This is not economic at all and perhaps this may involve corruption
activities.

Case4:
People borrowed books from the library but they did not return them
to the library and hence the library decided to charge $5m as the
penalty to those people. But nobody in the library decided to chase
the money back from those people and subsequently they wrote it off
as bad debt expense.

Auditors consideration:

225
Since the library has not implemented the plan, so auditors can advise
the government to cancel this penalty policy since this is not effective
at all.

Case5:
A college has spent lots of money into refitting the classroom into the
hotel accommodating the overseas students. But there are few
students check-in.

Auditors consideration:
This is not economy (government has spent lots of money into
refitting the classroom) and not efficient (Input is less than output)
and this issue should be disclosed.

Case6:
The fuller faucet is made of up gold and cost the government lots of
money.

Auditors consideration:
This is an example of extravagance and this is not efficient at all.

226
Q Country A

The Department of Transport of Country A is currently undertaking a


large infrastructure project to build a new underground metro system
in the country's second largest city, Dodo. The supreme auditor of
Country A has been tasked with conducting a study of the
Department's role in developing the project and funding it.

Considerable local media attention has been directed at the progress


of the project, focusing on the report of a whistleblower who claimed
that delays mean that it will not be completed on time. In response
the Department has stated that the project will be completed within
its budget of $14bn, and by a deadline in five years' time.

Required:

Identify procedures that should be performed in order to assess:

(a) The Department's management of its financial exposure on the


project;

(b) The Department's confidence that it will meet the prescribed


project schedule

(8marks)

Suggested Answer

(a)
Review overall project expenditure and compare with budgeted
expenditure.

Interview relevant management and staff to determine reasons


for any variations from budget.

Interview key management and staff to identify their


expectations of whether the project will be completed within
budget.

Analyse the Department's business case for the project to


determine whether the planned expenditures will meet the
overall aims of the project.
227
(b)

Review project timetable and compare progress with planned


schedule.

In relation to the whistleblower's claim, identify the delays


referred to and ascertain the impact these are likely to have on
the timetable.

Interview key management and staff to identify their


expectations of whether the project will be completed on time,
and in particular what the effect may be of any delays already
experienced.

Ascertain any knock-on effects that the delays may have, and
enquire of management what actions they have taken to
mitigate these effects.
Review of results of any internal challenges to management in
relation to the delays, i.e. how management responded.

228
Q Hospital

Suggest 2 procedures in measuring the performance of the hospital


relating to:

1. Reduce number of medical errors

2. Improve satisfaction with hospital food

3. Decrease the mortality rates.


(6marks)

Suggested Answer

1. Reduce number of medical errors

Enquire of hospital management what the definition of a medical error


is.

Inspect hospital records and board minutes to confirm the number of


medical errors.

2. Improve satisfaction with hospital food

Review patient feedback questionnaires of the hospitals good quality.

Recalculate the average score generated from the feedback and


compare with prior years.

3. Decrease the mortality rates

Inspect hospital records of the number of deaths.

Review board minutes for evidence of any unrecorded deaths.

229
Public Sector Audit Reporting

This can be in the form of reasonable assurance (In our opinion) or


negative assurance (Nothing has come to our attention suggesting
that).

Elements of the report

Title

Address

Introductory paragraph

Responsibilities paragraph of the management and the assurance


provider

Limitations of the report (for example, havent audited everything;


subjectivity in the performance measurements in the first place)

Summary of the work performed;

Conclusion based on the work performed;

Signature and date

230
Stage 5 Review Stage

Contents

AUDIT FINDINGS.............................................................. 232

OPENING BALANCE........................................................... 232

SUBSEQUENT EVENTS (ISA 560) ...................................... 233

OTHER INFORMATION ...................................................... 234

FINAL ANALYTICAL PROCEDURES .................................... 235

MANAGEMENT WRITTEN REPRESENTATION ..................... 236

CASE: DEC2012 Q2 AUDIT FINDINGS ............................... 238

CASE: JUNE2011 Q3 OPENING BALANCES (ISA510&ISA710)


(B).................................................................................... 245

DEC2010 Q2 NEWMAN & CO(C) [ISA720 OTHER


INFORMATION] ................................................................ 247

231
Audit findings

During this stage, auditors have obtained quite a lot of audit evidence
relating to clients financial statements. Its important for auditors to
think about whether they have obtained sufficient and appropriate
audit evidence before auditors express the opinion on the clients
financial statements.

Auditors would also need to think about whether there are any
additional risks of material misstatements that exist in the clients
financial statements as well and if the answer is yes, then additional
audit procedures will be required.

Opening balance

Since the opening balance will affect the closing balance in the
financial statements.

ISA 510 Initial audit engagements opening balances provides


guidance on opening balances:

When the financial statements for the prior period were not
audited

When the financial statements for the prior period were audited
by a predecessor auditor

If the auditor obtains audit evidence that the opening balances


contain misstatements that could materially affect the current
period's financial statements, the auditor shall perform such
additional audit procedures as are appropriate in the circumstances to
determine the effect on the current period's financial statements.

In all cases where there is a new auditor, the audit report must
contain an Other Matter paragraph immediately below the Opinion
paragraph. This applies whether or not the audit opinion being
expressed is modified.

ISA 510.A8 gives the following example of an Other Matter paragraph


in this case.

232
Example:

Other Matter Paragraph

The financial statements of Jesco plc for the year ended 31 December
2015 were audited by another auditor who expressed an unmodified
opinion on those statements on 31 March 2015.

Subsequent events (ISA 560)

Period1: FS year end to audit report is signed

In this period the auditor will have active responsibility to identify


any subsequent events.

This means the auditors should perform e.g., enquiry with


management whether any subsequent events need to be disclosed
to identify further subsequent events.

Period2: after audit report is signed

In this period the auditor will have passive responsibility to identify


any subsequent events.

This means auditors are not required to perform any further audit
procedures to identify any subsequent events.

But if an event is known to the auditor at the date audit report is


signed then the auditor should assess whether event needs to be
adjusted and how managements going to do with it and additional
audit procedure will be required.

233
Other information

ISA 720 The auditor's responsibilities relating to other information in


documents containing audited financial statements sets out the
requirements of the auditor with respect to other information, on
which the auditor has no obligation to report, in documents containing
financial statements.

Other information is financial and non-financial information other than


the financial statements and the auditor's report, which is included,
either by law, regulation or custom, in a document containing audited
financial statements and the auditor's report thereon.

Examples

1. A report by management or the board of directors on operations


2. Financial summaries or highlights
3. Employment data
4. Planned capital expenditure
5. Financial ratios
6. Names of officers and directors
7. Selected quarterly data like interim financial statements data
8. Integrated reports might qualify as 'other information' from the
perspective of the auditor. This would only be if the integrated
report also contains the audited financial statements. In this
case the auditor would have a responsibility to read the
integrated report just like any other information.

Material inconsistencies

Situations Auditors Responsibilities


Financial statements have been Modify the audit report with
materially misstated but the other qualification of audit opinion.
information is correct.
Financial statements have not been Disclose this in the other matter
materially misstated but the other paragraph in the auditors report.
information is not correct.

234
Final analytical procedures

Going Concern

Going concern means company will continue in business for the


foreseeable future, i.e., more than 12 months.

Management of the company will prepare the financial statement


based on the going concern basis.

Per ISA570 Going Concern, it explains that the auditor should ensure
that the entity being auditing is a going concern + audit procedures
relating to going concern assumption + reporting problems with going
concern.

Indications of going concern problems

The possibilities are extensive but auditors should look out for
potential indicators such as:

Net liabilities

Operating losses

Major debt repayments due

Loss of major customers or suppliers

Loss of key staff

Withdrawal of financing such as overdrafts

Cash flow problems

Technological advancements causing clients product to become


obsolete

Major litigation

235
Ways to see whether company is still a going concern entity

Auditor can perform analytical procedures to calculate receivable


days to identify if theres an increase in receivable days which may
suggest a cash flow problem.

Auditor can re-perform the receivable aged analysis to identify if


there is an increase in receivable days which may suggest a cash
flow problem.

Auditor can perform analytical procedures to calculate inventory


days to identify if theres an increase in inventory days which may
suggest an operational problem, i.e., inventory cant be sold by
company which may affect going concern status of company.

Auditor can enquire with management and obtain their future plan
based on going concern assessment.

Auditor can enquire with management and seek written


representation about the future action by company.

Auditor can bank correspondence to assess the likelihood of the


bank renewing the overdraft facility.

Management written representation

Per ISA 580 Written Representation, it explains the contents within


the written representation letters as well as how to overcome
problems in obtaining management representations.

Steps

Step1: Auditor lists areas for which representations are required.

Step2: Auditor prepares representation letter and sends to


management.

Step3: Management reviews the letter and signs.

Step4: Auditor files letter in audit working papers.

236
Contents: Mnemonics: Briefl

B: Books and records are available to auditors.

R: Related parties are fully disclosed.

I: No plan to abandon product line resulting in the inventory being


obsolete.

E: Events after the reporting period have all been disclosed.

F: Financial statements are not materially misstated and omitted.

L: Laws and regulations are complied with by management.

Accounting policy and estimate

Also management is required to confirm all accounting estimates and


policies they use are reasonable.

237
Case: DEC2012 Q2 Audit findings

(a) You are a manager in Sambora & Co, responsible for the audit of
the Jovi Group (the Group), which is listed. The Groups main activity
is steel manufacturing and it comprises a parent company and five
subsidiaries. Sambora & Co currently audits all components of the
Group.

You are working on the audit of the Groups financial statements for
the year ended 30 June 2012. This morning the audit engagement
partner left a note for you:

Hello,

The audit senior has provided you with the draft consolidated financial
statements and accompanying notes which summarise the key audit
findings and some background information.

At the planning stage, materiality was initially determined to be


$900,000, and was calculated based on the assumption that the Jovi
Group is a high risk client due to its listed status. During the audit, a
number of issues arose which meant that we needed to revise the
materiality level for the financial statements as a whole. The revised
level of materiality is now determined to be $700,000. One of the
audit juniors was unsure as to why the materiality level had been
revised. There are two matters you need to deal with:

Required:

(i) Explain why auditors may need to reassess materiality as the audit
progresses.
(4 marks)
(ii) Assess the implications of the key audit findings for the
completion of the audit. Your assessment must consider whether
the key audit findings indicate a risk of material misstatement.
Where the key audit findings refer to audit evidence, you must also
consider the adequacy of the audit evidence obtained, but you do
not need to recommend further specific procedures. (18 marks)

Thank you

The Groups draft consolidated financial statements, with notes


referenced to key audit findings, are shown below:
238
Draft consolidated statement of profit or loss and other
comprehensive income

Note 30June2012 30June2011


Draft Actual
$000 $000
Revenue 1 98,795 103,100
Cost of sales (75,250) (74,560)
Gross profit 23,545 28,540
Operating expenses 2 (14,900) (17,500)
Operating profit 8,645 11,040
Share of profit of associate 1,010 900
Finance costs (380) (340)
Profit before tax 9,275 11,600
Taxation (3,200) (3,500)
Profit for the year 6,075 8,100
Other comprehensive
income/expense for the year, net
of tax:
Gains on property revaluation 3 800 -
Actuarial losses on defined benefit 4 (1,100) (200)
plan
Other comprehensive (300) (200)
income/expense
Total comprehensive income for 5,775 7,900
the year

Notes: Key audit findings statement of profit or loss and


other comprehensive income

1. Revenue has been stable for all components of the Group with the
exception of one subsidiary, Copeland Co, which has recognised a
25% decrease in revenue.

2. Operating expenses for the year to June 2012 is shown net of a


profit on a property disposal of $2 million.

Our evidence includes agreeing the cash receipts to bank statement


and sale documentation, and we have confirmed that the property has
been removed from the non-current asset register. The audit junior
noted when reviewing the sale document, that there is an option to
repurchase the property in five years time, but did not discuss the
matter with management.

239
3. The property revaluation relates to the Groups head office. The
audit team have not obtained evidence on the revaluation, as the gain
was immaterial based on the initial calculation of materiality.

4. The actuarial loss is attributed to an unexpected stock market crash.


The Groups pension plan is managed by Axle Co a firm of
independent fund managers who maintain the necessary accounting
records relating to the plan. Axle Co has supplied written
representation as to the value of the defined benefit plans assets and
liabilities at 30 June 2012. No other audit work has been performed
other than to agree the figure from the financial statements to
supporting documentation supplied by Axle Co.

Draft consolidated statement of financial position

30 June 30 June
2012 2011
Draft Actual
$000 $000
Assets
Non-current assets
Property, plant and equipment 81,800 76,300
Goodwill 5 5,350 5,350
Investment in associate 6 4,230 4,230
Assets classified as held for sale 7 7,800 -

Current assets
Inventory 8,600 8,000
Receivables 8,540 7,800

Cash and cash equivalents 2,100 2,420


Total assets 118,420 104,100

Equity and liabilities


Equity
Share capital 12,500 12,500
Revaluation reserve 3,300 2,500
Retained earnings 33,600 29,400
Non-controlling interest 8 4,350 4,000
Total equity 53,750 48,400

Non-current liabilities
Defined benefit pension plan 10,820 9,250
Long-term borrowings 9 43,000 35,000
240
Deferred tax 1,950 1,350

Current liabilities
Trade payables 6,200 7,300
Provisions 2,700 2,800
Total liabilities 64,670 55,700
Total equity and liabilities 118,420 104,100

Notes: Key audit findings statement of financial position


5. The goodwill relates to each of the subsidiaries in the Group.
Management has confirmed in writing that goodwill is stated correctly,
and our other audit procedure was to arithmetically check the
impairment review conducted by management.

6. The associate is a 30% holding in James Co, purchased to provide


investment income. The audit team have not obtained evidence
regarding the associate as there is no movement in the amount
recognised in the statement of financial position.

7. The assets held for sale relate to a trading division of one of the
subsidiaries, which represents one third of that subsidiarys net assets.
The sale of the division was announced in May 2012, and is expected
to be complete by 31 December 2012. Audit evidence obtained
includes a review of the sales agreement and confirmation from the
buyer, obtained in July 2012, that the sale will take place.

8. Two of the Groups subsidiaries are partly owned by shareholders


external to the Group.

9. A loan of $8 million was taken out in October 2011, carrying an


interest rate of 2%, payable annually in arrears. The terms of the loan
have been confirmed to documentation provided by the bank.

Required:
Respond to the note from the audit engagement partner. (22
marks)
Note: The split of the mark allocation is shown within the partners
note.

(22 marks)

241
Answer to DEC2012 Q2

(a) You can also talk about change in risk; change in internal control
system; outsourcing its ICS to 3rd party; departure of NEDs during
the year like audit committee collapse; fraud has been found
during the audit etc.
(i)

The auditor shall revise materiality if they become aware of


information during the audit that would have caused the auditors
to determine a different level of materiality initially

During the audit, the auditor becomes aware of a matter which


impacts on the auditors understanding of the clients business and
which leads the auditor to believe that the initial assessment of
materiality was wrong and must be revised. For example, the
actual results of the audit client may turn out to be quite different
to the forecast results on which the initial level of materiality was
based.

Theres a change in the clients circumstances which may occur


during the audit, for example, a decision to dispose of a major part
of the business. This again would cause the auditor to consider if
the previously determined level of materiality were still
appropriate.

If adjustments are made to the financial statements after the initial


assessment of materiality, then the materiality level would need to
be adjusted.

(b)

Operating expenses

The disposal of property involves a recognition from statement of


financial position of $2m but its given the right to repurchase at the
end of the asset life and this may imply that its not a sale but just a
loan. So it may be accounted for under IFRS9 financial instrument.
Further audit work will be needed to verify the substance of the
transaction.

Revaluation

242
The audit evidence relating to this is not sufficient.

Because the materiality has been revised to $700,000 and this


revaluation has exceeded this figure so that further audit procedures
relating to revaluation would need to be carried out.

Actuarial losses

The audit evidence relating to this is not sufficient because auditors


just rely on the records of Alex Co which a service organisation.
So auditors should also gain an understanding of this service
organisation and perform other audit procedures to support its
records.

Goodwill

The goodwill doesn't change but from the evidence of decline in sales
revenue of one subsidiary of 25%, this may mean that there would be
impairment in the goodwill.

So auditors need to challenge the assumption made by management


regarding goodwill.

Associate

Associate in the statement of financial position remains unchanged


but there is profit from associate in the statement of profit or loss and
this is unusual and it may imply that figures in the statement of
financial position is wrong.

Auditors need to enquire with management for the accounting entry


relating to this to assess any potential mistakes.

Assets held for sale

Assets held for sale should be disclosed under current assets rather
than non-current assets in the statement of financial position.

The $7.8m is unclear about whether it would be just the asset or net
of assets and liabilities as a result of the assets held for sale and the
IFRS5 requires there should be a split between assets and liabilities
not to net them off.

It seems that the assets held for sales meet the definition of
243
discontinued operation and so according to IFRS5 there should be a
single line figure disclosed on the face of the statement of profit or
loss and other comprehensive income about the post-tax profit or loss
of the discontinued operation.

Further audit work should be done to ensure the above are corrected.

NCI

Non-controlling interest has been disclosed properly under equity but


in the statement of profit or loss and other comprehensive income it
hasn't disclosed the profit after tax attributable to NCI and also total
comprehensive income attributable to NCI.

So auditors would discuss with management whether this will be


made or not.

Loan

The finance cost accrued for the year should be


$120,000($8X2%X9/12) but there is just an increase in the finance
costs in the statement of profit or loss and other comprehensive
income of $40,000 and this may imply that there would be an
understatement of the finance cost.

So auditors would need to review the notes regarding this to ensure


its accuracy.

244
Case: June2011 Q3 Opening balances
(ISA510&ISA710) (b)

Your firm has been approached by Wexford Co to provide the annual


audit. Wexford Co operates a chain of bookshops across the country.
The shops sell stationery such as diaries and calendars, as well as new
books.

The financial year will end on 31 July 2011, and this will be the first
year that an audit is required, as previously the company was exempt
from audit due to its small size.

(b) Wexford Cos financial statements for the year ended 31 July
2010 included the following balances:

Profit before tax $50,000


Inventory $25,000
Total assets $350,000

The inventory comprised stocks of books, diaries, calendars and


greetings cards.

Required:
In relation to opening balances where the financial
statements for the prior period were not audited:

Explain the audit procedures required by ISA 510 Initial Audit


Engagements Opening Balances, and recommend the specific audit
procedures to be applied to Wexford Cos opening balance of
inventory.
(8 marks)

245
Answer to Q June2011 Q3

(b)

Genera procedures:

Auditor shall read the most recent financial statements for


information relevant to opening balances, including disclosures.

Auditor shall obtain sufficient appropriate evidence about whether


the opening balances contain misstatements that materially affect
the current years financial statements by determining whether the
prior periods closing balances have been correctly brought
forward.

The auditor should determine whether the opening balances reflect


the application of appropriate accounting policies.

Auditor shall obtain sufficient appropriate evidence about whether


the accounting policies reflected in the opening balances have
been consistently applied in the current periods financial
statements, and that any changes in accounting policies have been
accounted for under IAS8.

Specific procedures:

Auditor should inspect records of any inventory counts held at the


prior period year end, 31 July 2010, to confirm the quantity of
items held in inventory agrees to accounting records.

Auditor should observe an inventory count at the current period


year end, 31 July 2011, and reconciliation of closing inventory
quantities back to opening inventory quantities

Auditor should inspect management accounts for evidence of any


inventory items written off in the current financial period to identify
any obsolete inventory.

Auditor should discuss with management regarding any slow


moving items of inventory which were included in opening
inventory.

246
DEC2010 Q2 Newman & Co(C) [ISA720 other
information]

(c) You have a trainee accountant assigned to you, who has read the
notes taken at your meeting with Ali Monroe. She is unsure of the
implications of the charitable donations being disclosed as a different
figure in the financial statements compared with the other
information published in the annual report:

Disclosure note in the financial statement is $9m while in the


sustainability report this is $10m.

Required:

(i) Explain the responsibility of the auditor in relation to other


information published with the financial statements; and

(ii) Recommend the action to be taken by Newman & Co if the


figure relating to charitable donations in the other
information is not amended.
(8 marks)

247
Answer to DEC2010 Q2(c)

(i)
Auditors should read the other information and compare to financial
statements to establish whether financial statements are misstated
or another information paragraph is misstated.

If the financial statements are materially misstated and


management refuses to correct the material misstatement, then
auditors should qualify his audit opinion.

If financial statements are correct but the other information


paragraph is wrong, then auditors should modify his audit report by
adding another matter paragraph.

If any of these material misstatements are not corrected by


management, then auditors should think about withdraw from the
engagement letter but they need to seek legal advice first.

(ii)

Auditors should perform audit procedures to obtain sufficient and


appropriate audit evidence suggesting the $9m in the financial
statements is correct.

If $9m is correct then auditors should present the audit work result
to management telling them the $10m in the sustainability report is
wrong.

If the management refuses to change the disclosure paragraph,


then auditors should add other matter paragraph after the actual
opinion paragraph telling shareholders that there is a material
inconsistency between financial statements and the non-financial
information paragraph.

If management refuses to change the disclosure paragraph then


auditors should need to reconsider the integrity of management and
review its management representation again and where necessary
resign as an auditor.

248
Stage 6 Audit report

Contents

ISA700 ................................................................ 250

PROCESS OF GIVING AN AUDIT REPORT ............. 250

CONTENT OF AUDIT REPORT ............................... 251

TYPES OF AUDIT REPORT .................................... 264

Q HESCO PLC ....................................................... 265

CHAPTER 2 JUNE2011 Q5 NASSAU GROUP .......... 269

249
ISA700

Per ISA 700 Forming an opinion and reporting on financial statements,


it explain the format and content of a standard auditors report.

Process of giving an audit report

1. Has the auditor obtained sufficient and appropriate audit evidence


per ISA 500 audit evidence?

2. Are there any uncorrected misstatements not material per ISA450


Evaluation of misstatements not identified during the audit?

3. Other evaluations are satisfactory per ISA 700?


Are FS prepared in accordance with the financial reporting
framework?
Accounting policies, estimates and disclosure notes are
acceptable?
The FS fairly present all information?

4. Are Financial Statements free from misstatements? (Figures


accuracy and Disclosure note)

If all the above answers are yes, then unmodified audit report would
be issued.

If one of them is no, then modified audit report would be issued.

250
Content of audit report

1. Title: Independent auditors report


2. Addressee to shareholders or those charged with governance
3. Report on the Audit of the Financial Statements
4. Opinion
5. Basis for opinion moved below the opinion paragraph
6. Emphasis of matter paragraph if it is needed (Does not cover
going concern issues)
7. Other matter paragraph if it is needed (Does not cover material
inconsistency between financial and non financial information)
8. Material uncertainty related to going concern if necessary
9. Key audit matters
10. Other information
11. Responsibilities of Management and Those Charged with
Governance for the Financial Statements
12. Auditor's Responsibilities for the Audit of the Financial
Statements
13. Report on Other Legal and Regulatory Requirements
14. Auditors Signature/Address/Date

251
Opinion paragraph

If the auditor expresses an unmodified opinion on financial


statements prepared in accordance with a fair presentation
framework, the opinion shall use one of the following equivalent
phrases:

The financial statements present fairly, in all material


respects, in accordance with [the applicable financial
reporting framework]; or

The financial statements give a true and fair view of in


accordance with [the applicable financial reporting framework].

Basis of opinion paragraph (Exist in every


audit report)

The basis for opinion paragraph must state that the audit was
conducted in accordance with the ISAs, and refer to the Auditors
responsibilities for the audit of the financial statements section which
describes the auditors responsibilities under the ISAs.

The auditor must also state that they are independent of the audited
entity, in accordance with the relevant ethical requirements relating to
the audit.

Finally, the auditor must state that they believe the audit evidence
obtained is sufficient and appropriate to provide a basis for the audit
opinion.

Emphasis of matter

The Emphasis of Matter (EoM) paragraph can be used wherever the


auditor considers it necessary to do so, as long as the matter referred
to is adequately disclosed, and sufficient appropriate audit evidence
has been obtained.

Examples include:

an uncertain outcome to litigation;


252
early application of an accounting standard that has a pervasive
effect on the financial statements in advance of its effective
date;

or a major catastrophe that has had, or continues to have, a


devastating effect on the entity's financial position.

An EoM paragraph is not used when the issue has been covered as a
key audit matter. The auditor must choose whether a matter is simply
a key audit matter, or whether it needs an EoM paragraph.

The EoM paragraph should be positioned immediately after the Basis


for Opinion paragraph in the auditor's report and should be clearly
identified as an Emphasis of Matter.

If there is a Key Audit Matters section in the report, then it is up to the


auditor's judgement whether to place the EoM before this (ie straight
after the Basis for Opinion) or after it.

Example:

Emphasis of Matter

We draw attention to Note 3 to the financial statements which


describes the uncertainty related to the outcome of the lawsuit filed
against the company by Hesco plc. Our opinion is not modified in
respect of this matter.

Other Matter

Circumstances where other matter paragraph is issued:

1. Where prior period financial statements were audited by a


predecessor auditor (ISA 710).

2. Where prior period financial statements were not audited (ISA


710) (note that this does not relieve the auditor of the
obligation to obtain sufficient appropriate audit evidence on
opening balances).

3. When reporting on prior period financial statements in


connection with the current period's audit, if the auditor's
253
opinion on such prior period financial statements differs from
the opinion the auditor previously expressed (ISA 710).

Example:

Other Matter

The financial statements of Besco plc for the year ended December
31, 2015, were audited by another auditor who expressed an
unmodified opinion on those statements on March 31, 2016.

The Other Matter paragraph is included after the Basis for Opinion
paragraph, after any Emphasis of Matter paragraph and after any Key
Audit Matters section.

Material uncertainty related to going concern


if necessary

Where the auditor considers a material uncertainty related to going


concern exists, this should be described in a separate paragraph
headed Material uncertainty related to going concern.

Key audit matters

1. Why the matter was considered to be one of most significance in


the audit and therefore determined to be a key audit matter; and

2. How the matter was addressed in the audit.

Determination of key audit matters (KAMs)

The definition in paragraph 8 of ISA 701 states that KAM are selected
from matters which are communicated with those charged with
governance. Matters which are discussed with those charged with
governance are then evaluated by the auditor who then determines
those matters which required significant auditor attention during the
course of the audit. There are three matters which the ISA requires
the auditor to take into account when making this determination:

1. Areas which were considered to be susceptible to higher risks of


254
material misstatement or which were deemed to be significant
risks in accordance with ISA 315 (Revised), Identifying and
Assessing the Risks of Material Misstatement through
Understanding the Entity and Its Environment.

2. Significant auditor judgments in relation to areas of the financial


statements that involved significant management judgment. This
might include accounting estimates which have been identified by
the auditor as having a high degree of estimation uncertainty.

3. The effect on the audit of significant events or transactions that


have taken place during the period.

KAMs are part of every listed company auditor's report, and can be
included by other auditors if needed. KAMs do not constitute a
modification of the report or of the opinion. They are a part of the
standard report which must be tailored to each company's
circumstances.

KAMs are not a substitute for disclosures, for EoM/OM paragraphs, nor
for modified opinions. KAMs must always relate to matters already
included within the financial statements.

The auditor must do four main things:

1. Determine the matters which should be described as KAMs and


auditors should make sure that the KAMs are from information
which has already existed in the financial statements. If
something is not disclosed but the auditor thinks it should be,
then the auditor should ask management to disclose it.

2. Communicate the KAMs in the auditor's report with general


introduction of KAMs first, and then details about KAMs will be
after.

3. Communicate the KAMs to those charged with governance

4. Keep appropriate audit documentation

The auditor may choose not to communicate a matter identified as a


KAM, but only under specific circumstances:

1. Law or regulation precludes public disclosure about the matter;


or
255
2. In extremely rare circumstances, the auditor determines that
the matter should not be communicated in the auditor's report
because the adverse consequences of doing so would
reasonably be expected to outweigh the public interest benefits
of such communication. This shall not apply if the entity has
publicly disclosed information about the matter. For example,
money laundering since inclusion of suspicions of money
laundering as a KAM would be tipping off.

No KAMs:

It is possible that there might not be any KAMs to communicate. ISA


701 does allow for this possibility, but only extremely rare situations,
eg for a listed entity which has very limited operations (eg if it has not
traded during the period). In this case the auditor's report still has a
section on KAMs, but states that there were none to
communicate.

Other information

A report by management or those charged with governance on


operations

Financial summaries or highlights


Employment data
Planned capital expenditures
Financial ratios
Names of officers and directors
Selected quarterly data

ISA 720 states that the auditor shall read the other information to
identity material inconsistencies with the audited financial
statements. If a material inconsistency is identified, the auditor shall
determine whether the audited financial statements or other
information is misstated.

If the financial statements is materially misstated but management


refuses to correct the misstatement, the auditor shall modify the audit
opinion.

If the other information is materially misstated and needs to be


revised but management refuses, the auditor shall communicate this
256
matter to those charged with governance and:

Include an Other information section in the auditor's report that


describes the material inconsistency, or

Withdraw from the engagement (where this is legally


permitted).

257
Example of Audit Report:

INDEPENDENT AUDITOR'S REPORT

To the Shareholders of BEC Company [or Other Appropriate


Addressee]

Report on the Audit of the Financial Statements

Opinion

We have audited the financial statements of BEC Company (the


Company), which comprise the statement of financial position as at
December 31, 2016, and the statement of profit or loss and other
comprehensive income, statement of changes in equity and
statement of cash flows for the year then ended, and notes to the
financial statements, including a summary of significant accounting
policies.

In our opinion, the accompanying financial statements present fairly,


in all material respects, (or give a true and fair view of) the financial
position of the Company as at December 31, 2016, and (of) its
financial performance and its cash flows for the year then ended in
accordance with International Financial Reporting Standards (IFRSs).

Basis for Opinion

We conducted our audit in accordance with International Standards


on Auditing (ISAs). Our responsibilities under those standards are
further described in the Auditor's Responsibilities for the Audit of the
Financial Statements section of our report. We are independent of the
Company in accordance with the International Ethics Standards Board
for Accountants' Code of Ethics for Professional Accountants (IESBA
Code) together with the ethical requirements that are relevant to our
audit of the financial statements in [jurisdiction], and we have fulfilled
our other ethical responsibilities in accordance with these
requirements and the IESBA Code. We believe that the audit evidence
we have obtained is sufficient and appropriate to provide a basis for
our opinion.

Key Audit Matters

Key audit matters are those matters that, in our professional


258
judgment, were of most significance in our audit of the financial
statements of the current period. These matters were addressed in
the context of our audit of the financial statements as a whole, and in
forming our opinion thereon, and we do not provide a separate
opinion on these matters.

Revenue Recognition
The amount of revenue and profit recognised in the year on the sale of
Product A and aftermarket services is dependent on the appropriate
assessment of whether or not each long-term aftermarket contract for
services is linked to or separate from the contract for sale of Product
A. As the commercial arrangements can be complex, significant
judgment is applied in selecting the accounting basis in each case.

In our view, revenue recognition is significant to our audit as the


Group might inappropriately account for sales of Product A and
long-term service agreements as a single arrangement for accounting
purposes and this would usually lead to revenue and profit being
recognized too early because the margin in the long-term service
agreement is usually higher than the margin in the Product A sale
agreement.

Our audit procedures to address the risk of material misstatement


relating to revenue recognition, which was considered to be a
significant risk, included:

Testing of controls, assisted by our own IT specialists, including,


among others, those over: input of individual advertising
campaigns terms and pricing; comparison of those terms and
pricing data against the related overarching contracts with
advertising agencies; and linkage to viewer data; and

Detailed analysis of revenue and the timing of its recognition


based on expectations derived from our industry knowledge
and external market data, following up variances from our
expectations.

Other Information

Management is responsible for the other information. The other


information comprises the [information included in the X report, but
does not include the financial statements and our auditor's report
thereon.]

259
Our opinion on the financial statements does not cover the other
information and we do not express any form of assurance conclusion
thereon.

In connection with our audit of the financial statements, our


responsibility is to read the other information and, in doing so,
consider whether the other information is materially inconsistent with
the financial statements or our knowledge obtained in the audit or
otherwise appears to be materially misstated. If, based on the work
we have performed, we conclude that there is a material
misstatement of this other information, we are required to report that
fact. We have nothing to report in this regard.

Responsibilities of Management and Those Charged with


Governance for the Financial Statements

Management is responsible for the preparation and fair presentation


of the financial statements in accordance with IFRSs and for such
internal control as management determines is necessary to enable
the preparation of financial statements that are free from material
misstatement, whether due to fraud or error.

In preparing the financial statements, management is responsible for


assessing the Company's ability to continue as a going concern,
disclosing, as applicable, matters related to going concern and using
the going concern basis of accounting unless management either
intends to liquidate the Company or to cease operations, or has no
realistic alternative but to do so.

Those charged with governance are responsible for overseeing the


Company's financial reporting process.

Auditor's Responsibilities for the Audit of the Financial


Statements

Our objectives are to obtain reasonable assurance about whether the


financial statements as a whole are free from material misstatement,
whether due to fraud or error, and to issue an auditor's report that
includes our opinion. Reasonable assurance is a high level of
assurance, but is not a guarantee that an audit conducted in
accordance with ISAs will always detect a material misstatement
when it exists.

Misstatements can arise from fraud or error and are considered


260
material if, individually or in the aggregate, they could reasonably be
expected to influence the economic decisions of users taken on the
basis of these financial statements.

As part of an audit in accordance with ISAs, we exercise professional


judgment and maintain professional skepticism throughout the audit.
We also:

Identify and assess the risks of material misstatement of the


financial statements, whether due to fraud or error, design and
perform audit procedures responsive to those risks, and obtain
audit evidence that is sufficient and appropriate to provide a
basis for our opinion. The risk of not detecting a material
misstatement resulting from fraud is higher than for one
resulting from error, as fraud may involve collusion, forgery,
intentional omissions, misrepresentations, or the override of
internal control.

Obtain an understanding of internal control relevant to the audit


in order to design audit procedures that are appropriate in the
circumstances, but not for the purpose of expressing an opinion
on the effectiveness of the Company's internal control.

Evaluate the appropriateness of accounting policies used and


the reasonableness of accounting estimates and related
disclosures made by management.

Conclude on the appropriateness of management's use of the


going concern basis of accounting and, based on the audit
evidence obtained, whether a material uncertainty exists
related to events or conditions that may cast significant doubt
on the Company's ability to continue as a going concern. If we
conclude that a material uncertainty exists, we are required to
draw attention in our auditor's report to the related disclosures
in the financial statements or, if such disclosures are
inadequate, to modify our opinion. Our conclusions are based
on the audit evidence obtained up to the date of our auditor's
report. However, future events or conditions may cause the
Company to cease to continue as a going concern.

Evaluate the overall presentation, structure and content of the


financial statements, including the disclosures, and whether the
financial statements represent the underlying transactions and
events in a manner that achieves fair presentation.
261
We communicate with those charged with governance regarding,
among other matters, the planned scope and timing of the audit and
significant audit findings, including any significant deficiencies in
internal control that we identify during our audit.

We also provide those charged with governance with a statement that


we have complied with relevant ethical requirements regarding
independence, and to communicate with them all relationships and
other matters that may reasonably be thought to bear on our
independence, and where applicable, related safeguards.

From the matters communicated with those charged with


governance, we determine those matters that were of most
significance in the audit of the financial statements of the current
period and are therefore the key audit matters. We describe these
matters in our auditor's report unless law or regulation precludes
public disclosure about the matter or when, in extremely rare
circumstances, we determine that a matter should not be
communicated in our report because the adverse consequences of
doing so would reasonably be expected to outweigh the public interest
benefits of such communication.

Report on Other Legal and Regulatory Requirements

[The form and content of this section of the auditor's report would
vary depending on the nature of the auditor's other reporting
responsibilities prescribed by local law, regulation, or national
auditing standards. The matters addressed by other law, regulation or
national auditing standards (referred to as 'other reporting
responsibilities') shall be addressed within this section unless the
other reporting responsibilities address the same topics as those
presented under the reporting responsibilities required by the ISAs as
part of the Report on the Audit of the Financial Statements section.

The reporting of other reporting responsibilities that address the same


topics as those required by the ISAs may be combined (i.e., included
in the Report on the Audit of the Financial Statements section under
the appropriate subheadings) provided that the wording in the
auditor's report clearly differentiates the other reporting
responsibilities from the reporting that is required by the ISAs where
such a difference exists.]

The engagement partner on the audit resulting in this independent


262
auditor's report is [name].

[Signature in the name of the audit firm, the personal name of the
auditor, or both, as appropriate for the particular jurisdiction]

[Auditor Address]

[Date]

263
Types of Audit Report

Can be unmodified audit report [Clean audit report] and modified


audit report [Dirty audit report].

Modified audit report can be

Modified audit report without qualification of opinion: this means


auditors can add Emphasis of matter paragraph if they think there is
significant uncertainty about going concern status of company or
other matter paragraph is financial information does not equal to
non-financial information such as directors report/chainman
statement.

Modified audit report with qualification of opinion: [types]

Extent/nature Misstatement Cant obtain sufficient and


appropriate audit evidence

Material Except for qualification Except for qualification

Material+ Pervasive Adverse Disclaimer of opinion

264
Critique Style Audit Report Question

Q Hesco plc

Hesco plc has in place a defined benefit pension plan for its employees.
An actuarial valuation on 31 January 2016 indicated that the plan is in
deficit by $105 million. The deficit is not recognised in the statement
of financial position. An extract from the draft audit report is given
below:

Explanation of adverse opinion in relation to pension

The financial statements do not include the companys pension plan.


This deliberate omission contravenes accepted accounting practice
and means that the accounts are not properly prepared.

Auditors opinion

In our opinion, because of the significance of the matter discussed


below, the financial statements do not give a true and fair view of the
financial position of Hesco plc as at 31 January 2016, and of its
financial performance and cash flows for the year then ended in
accordance with International Financial Reporting Standards.

Key Audit Matter

The amount of revenue and profit recognised in the year on the sale of
Product A and aftermarket services is dependent on the appropriate
assessment of whether or not each long-term aftermarket contract for
services is linked to or separate from the contract for sale of Product
A. As the commercial arrangements can be complex, significant
judgment is applied in selecting the accounting basis in each case.

In our view, revenue recognition is significant to our audit as the


Group might inappropriately account for sales of Product A and
long-term service agreements as a single arrangement for accounting
purposes and this would usually lead to revenue and profit being
recognized too early because the margin in the long-term service
agreement is usually higher than the margin in the Product A sale
agreement.

Other Matter
265
We draw attention to Note 3 to the financial statements which
describes the uncertainty related to the outcome of the lawsuit filed
against the company by Hesco plc. Our opinion is not modified in
respect of this matter.

Required:

Critically appraise the extract from the proposed audit report


of Hesco plc for the year ended 31 January 2016.

Note: you are NOT required to re-draft the extract of the audit report.

(7 marks)

266
Answer to Hesco plc

The title for the paragraphs are not correct.

Firstly, explanation of adverse opinion in relation to pension should be


basis of adverse opinion.

And this should be placed after opinion paragraph.

Auditors opinion should be Qualified Opinion/Adverse Opinion


paragraph.

The matter is not quantified. The paragraph should clearly state


the amount of $10 5 million, and state that this is material to the
financial statements.

The paragraph does not say whether the pension plan is in surplus
or deficit, i.e. whether it is an asset or a liability which is omitted
from the financial statements.

There is no description of the impact of this omission on the


financial statements. Wording such as if the deficit had been
recognised, total liabilities would increase by $10
5 million.

No reference is made to the relevant accounting standard IAS 19


Employee Benefits. Reference should be made in order to help
users understanding of the breach of accounting standards that
has been made.

The use of the word deliberate when describing the omission of


the pension plan is not professional and the plan may have been
omitted in error and an adjustment to the financial statements
may have been suggested by the audit firm and is being considered
by management.

It is unlikely that this issue alone would be sufficient to give rise to


an adverse opinion so an except for qualification should be issued
because this is just material misstatement not pervasive.

Key audit matter paragraph does not include how the matter was
addressed in the audit. For example, Our audit procedures to
address the risk of material misstatement relating to revenue
recognition, which was considered to be a significant risk, included:
267
Testing of controls, assisted by our own IT specialists, including,
among others, those over: input of individual advertising
campaigns terms and pricing; comparison of those terms and
pricing data against the related overarching contracts with
advertising agencies; and linkage to viewer data

Other matter paragraph is used where:

1. Where prior period financial statements were audited by a


predecessor auditor (ISA 710).

2. Where prior period financial statements were not audited (ISA


710) (note that this does not relieve the auditor of the obligation to
obtain sufficient appropriate audit evidence on opening balances).

3. When reporting on prior period financial statements in


connection with the current period's audit, if the auditor's opinion
on such prior period financial statements differs from the opinion
the auditor previously expressed (ISA 710).

But in this case, the lawsuit issues should be reported by using


emphasis of matter paragraph.

The paragraph should be place after the basis of opinion paragraph.

268
Matter to be Considered Style Question

Chapter 2 June2011 Q5 Nassau Group

You are the manager responsible for the audit of the Nassau Group,
which comprises a parent company and six subsidiaries. The audit of
all individual companies financial statements is almost complete, and
you are currently carrying out the audit of the consolidated financial
statements. One of the subsidiaries, Exuma Co, is audited by another
firm, Jalousie & Co. Your firm has fulfilled the necessary requirements
of ISA 600 Special Considerations Audits of Group Financial
Statements (Including the Work of Component Auditors) and is
satisfied as to the competence and independence of Jalousie & Co.

You have received from Jalousie & Co the draft audit report on
ExumaCos financial statements, an extract from which is shown
below:

Qualified Opinion (extract)

In our opinion, except for effects of the matter described in the Basis
for Qualified Opinion paragraph, the financial statements give a true
and fair view of the financial position of Exuma Co as at 31 March
2011...

Basis for Qualified Opinion (extract)

The company is facing financial damages of $2 million in respect of an


on-going court case, more fully explained in note 12 to the financial
statements. Management has not recognised a provision but has
disclosed the situation as a contingent liability. Under International
Financial Reporting Standards, a provision should be made if there is
an obligation as a result of a past event, a probable outflow of
economic benefit, and a reliable estimate can be made. Audit
evidence concludes that these criteria have been met, and it is our
opinion that a provision of $2 million should be recognised.
Accordingly, net profit and shareholders equity would have been
reduced by $2 million if the provision had been recognised.

An extract of Note 12 to ExumaCos financial statements is shown


269
below:

Note 12 (extract)

The company is the subject of a court case concerning an alleged


breach of planning regulations. The plaintiff is claiming compensation
of $2 million. The management of Exuma Co, after seeking legal
advice, believe that there is only a 20% chance of a successful claim
being made against the company.

Figures extracted from the draft financial statements for the year
ending 31 March 2011 are as follows:

Nassau Group Exuma Co


$million $million
Profit before tax 20 4
Total assets 85 20

Required:

Identify and explain the matters that should be considered, and


actions that should be taken by the group audit engagement team, in
forming an opinion on the consolidated financial statements of the
Nassau Group.

(10 marks)

270
Answer to June2011 Q5

Matters to consider

Significant component
A significant component is defined as a component identified by the
group audit engagement team that is of individual significance to the
group. Exuma Co meets the definition of a significant component
because it contributes 20% of group profit before tax, and 235% of
group total assets. Exuma Co is therefore material to the group
financial statements.

Materiality
The legal case involves a claim of $2 million. This is material to the
Exuma Co financial statements as it is 50% of profit before tax, and
10% of total assets. This is also material to the group financial
statements because its 10% of group profit before tax, and 24% of
group total assets.

Qualified opinion
An except for qualification opinion is issued by auditors because they
believe that the cash outflow for this is probable rather than possible
and as long as there is enough audit evidence shows this is the case
then this opinion is appropriate.

Group auditors
Because the individual financials statements are material to the group
and so Jalousie&Cos work should be carefully reviewed by group
audiotrs.

The matters should be discussed with the group engagement audit


team as well as those changed with governance about the impact on
the group audit opinion as a result of this matter.

If theres correct amendment in the Exuma Co financial statement


then there would be unqualified audit opinion issued to that financial
statement.

If ExumaCos financial statements are not amended, an adjustment


could be made on consolidation of the group financial statements to
include the provision.So opinion on ExumaCos financial statements
would be qualified, but the group audit opinion would not be qualified
as the matter causing the material misstatement has been corrected.
271
If no adjustment is made, either to ExumaCos financial statements,
or as a consolidation adjustment in the group financial statements,
and if the group engagement partner disagrees with this accounting
treatment, then the group audit opinion should be qualified due to a
material misstatement.

Actions

Auditors should inspect copy of the actual claim showing the $2


million claimed against the company.

Auditors should inspect a written representation from management


detailing managements reason for believing that there is no probable
cash outflow.

The group engagement partner may consider engaging an external


expert to provide an opinion as to the probability of the court case
going against Exuma Co given the subjective nature of this
matter.(ISA600 further procedures)

272
Non Audit Engagement Services

Contents

OVERVIEW OF ASSURANCE ENGAGEMENTS ...................... 274


INTERIM FINANCIAL INFORMATION (ISRE 2410) ............ 275
INTERIM FINANCIAL INFORMATION DEC2012 Q5(B)....... 276
PROSPECTIVE FINANCIAL INFORMATION (NEGATIVE
ASSURANCE GIVEN) ......................................................... 278
CASE: JUNE2012 Q2(A) PFI .............................................. 281
DUE DILIGENCE REVIEW .................................................. 286
DUE DILIGENCE REVIEW CHAPTER 2 JUNE2008 Q2.......... 287
CASE DEC2013 Q2 (B) DUE DILIGENCE REVIEW ............... 292
FORENSIC ACCOUNTING................................................... 300
FORENSIC AUDIT CHAPTER 2 DEC2008 Q2 ................. 305
SOCIAL AND ENVIRONMENTAL AUDIT .............................. 311
SOCIAL & ENVIRONMENTAL AUDIT DEC2008 Q1(C) ......... 314
JUNE2012 Q2(B)(II): SOCIAL & ENVIRONMENTAL AUDIT 316
DEC2010 Q2(B) SOCIAL & ENVIRONMENTAL AUDIT......... 318
INTEGRATED REPORT ....................................................... 319
JUNE 2015 Q5 (C)............................................................. 320

273
Overview of Assurance Engagements

Audit engagement (6 stages)

Single/Group Company Audit;

Public Sector Audit (Can either be reasonable or negative


assurance)

Audit related services (3 types)

1. Review engagement

The person carrying out the review engagement is called a


practitioner not an auditor. A 'practitioner' is defined as 'a
professional accountant in public practice'.

Interim financial information;

Prospective financial information;

Due diligence review.

2. Agree upon procedure

Forensic investigation/audit;

Due diligence investigation.

3. Compilation service

This means to prepare the account for the client or doing tax
computation for the client.

Other assurance engagements


This includes social and environmental audit (verifying KPIs.)/
Integrated Report.

274
Interim financial information (ISRE 2410)

Practitioner is required to:

Obtain an understanding of the entity and its environment such


as its internal control systems.

Enquire of management about the effect of changes in entitys


business activities which may imply that there is a change in
internal control systems.

Enquire of management about any significant changes in


internal control and the potential effect of any changes on the
preparation of interim financial information.

Identify types of material misstatement and the likelihood of


occurrence. (Same as Auditing the Statutory financial
statements.)

Considering any risks of management override of controls that


were identified in the audit of the previous years financial
statements.

Select enquiries and analytical procedures that will enable them


to conclude whether anything has come to their attention to
believe the interim financial information has not been prepared
in accordance with the applicable financial reporting framework.

Read prior year files relating to the audit and interim financial
statement review to enable auditor to identify matters that may
affect the current year interim financial information.

Enquire of management about the result of managements


assessment of the risk that the interim financial information
may be materially misstated as a result of fraud.

275
Interim financial information DEC2012 Q5(b)

You are also responsible for the audit of Squire Co, a listed company,
and you are completing the review of its interim financial statements
for the six months ended 31 October 2012. Squire Co is a car
manufacturer, and historically has offered a three-year warranty on
cars sold. The financial statements for the year ended 30 April 2012
included a warranty provision of $1 5 million and recognised total
assets of $27 5 million. You are aware that on 1 July 2012, due to
cost cutting measures, Squire Co stopped offering warranties on
cars sold. The interim financial statements for the six months ended
31 October 2012 do not recognise any warranty provision.

Total assets are $30 million at 31 October 2012.

Required:

Assess the matters that should be considered in forming a


conclusion on Squire Cos interim financial statements, and
the implications for the review report.
(6 marks)

276
Answer to DEC2012 Q5(b)

Matters to be considered: General:

Reviews on interim financial statement for Squire Co are based on


analytical procedures and enquiry.

The IAS 37 provisions, contingent liabilities and contingent assets


should be applied both on annual financial statements and interim
financial statements here.

Materiality:

Warranty provision is 5.5% of total assets ($1.5m/$27.5m) and


hence its material to the financial statements.

Accounting:

After 1 July 2012 there is no obligation for Squire to provide


warranties on cars to customers but Squire has a liability for
customers before 1 July 2012 and so Squire should recognise
expenses and liability for those customers and here its financial
statements would understate liability and expenses.

Implications:

Before qualifying the conclusion auditor should communicate this to


management or audit committee to require an adjustment.

If this is not made then auditors should modify his/her conclusion,


for example, Based on our review, with the exception of the matter
described in the previous paragraph, nothing has come to our
attention that causes us to believe that the accompanying interim
financial information does not give a true and fair view.

Before qualification of opinion auditors should include the reasons


about qualification in the basis of opinion paragraph which is before
the actual opinion paragraph.

Auditors would also consider whether to resign as an auditor for


both review engagement and audit engagement if the above
adjustments are not made.

277
Prospective financial information (Negative
Assurance Given)

Company directors are producing PFI, either voluntarily or because it


is required by regulators, for example, in the case of a public offering
of shares; or the company wants to borrow money from the bank; or
the PFI would just be used by management to support a possible
capital investment.

PFI can be

Forecast

PFI based on assumptions as to future events which management


expects to take place and the actions management expects to take
(best-estimate assumptions). Normally within 12 months.

Projection

PFI based on hypothetical assumptions about future events and


management actions which are not necessarily expected to happen.
Normally 3-5years. This is a what if approach, for example, what if we
purchase company in the future etc.

Factors to Consider for Acceptance

1. The intended use of the information

2. Whether the information will be for general or limited


distribution

3. The nature of the assumptions, that is, whether they are best
estimate or hypothetical assumptions

4. The elements to be included in the information

5. The period covered by the information

278
Procedures

Letter of engagement

Knowledge of client

Obtain copy of forecast and cast

Accounting policies same as other financial information

Evidence supporting forecast

Assumptions supporting forecast

Check forecast against any actual results

Letter of representation

Report

Examples

Analytical review Verification

Profit Forecast: Comparison of the basis Verify projected


of projected income to expenditure figures to:
similar existing projects
in the firm Quotations;
Market rate prices
Review of current in the
market prices for that advertisement;
product or service Interest rate
assumptions
which can be
compared to the
bank's current
rates.

Capital Expenditure Comparison with Projected costs


Forecast: prevailing market rates should be verified
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for investment property to estimates and
where such information quotations;
is available.

Cash forecast: The auditor should If there is no


check the cash forecast comparable profit
for consistency with any forecast, the
profit forecasts; income and
expenditure items
should be verified
as they would
have been on a
profit forecast.

Compare the
reasonableness of
available finance to Confirm sources
Working capital: cash flow forecasts. of short-term and
long-term finance
Assess the to evidence from
reasonableness of external finance
projected working providers.
capital ratios such as
trade receivables days
and the assumptions
made in calculating
these.

Reports on prospective financial information


Title

Addressee

Identify the information

Standard of work

Management responsibility

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Distribution of report
Negative assurance

Results achievable?

Date

Practitioner

Case: June2012 Q2(a) PFI

(a) You are a manager in Lapwing & Co. One of your audit clients is
Hawk Co which operates commercial real estate properties typically
comprising several floors of retail units and leisure facilities such as
cinemas and health clubs, which are rented out to provide rental
income.

Your firm has just been approached to provide an additional


engagement for Hawk Co, to review and provide a report on the
companys business plan, including forecast financial statements for
the 12-month period to 31 May 2013. Hawk Co is in the process of
negotiating a new bank loan of $30 million and the report on the
business plan is at the request of the bank. It is anticipated that the
loan would be advanced in August 2012 and would carry an interest
rate of 4%. The report would be provided by your firms business
advisory department and a second partner review will be conducted
which will reduce any threat to objectivity to an acceptable level.

Extracts from the forecast financial statements included in the


business plan are given below:

Statement of profit or loss (extract):

Note FORECAST UNAUDITED


12 months 12 months
to 31 May to 31 May
2013 2012
$000 $000
Revenue 25,000 20,600
Operating expenses (16,550) (14,420)
Operating profit 8,450 6,180
Profit on disposal of Beak Retail 1 4,720 -
Finance costs (2,650) (1,690)
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Profit before tax 10,520 4,490

Statement of Financial
Position:
FORECAST UNAUDITED
31 May 31 May
2013 2012
$000 $000
Assets
Non-current assets
Property, plant and equipment 2 330,150 293,000
Current assets
Inventory 500 450
Receivables 3,600 3,300

Cash and cash equivalents 2,250 3,750


Total assets 6,350 7,500
Equity and liabilities
Equity
Share capital 105,000 100,000
Retained earnings 93,400 92,600
Total equity 198,400 192,600

Non-current liabilities
Long-term borrowings 2 82,500 52,500
Deferred tax 50,000 50,000
Current liabilities
Trade payables 5,600 5,400
Total liabilities 138,100 107,900
Total equity and liabilities 336,500 300,500

Notes:

1. Beak Retail is a retail park which is underperforming. Its sale is


currently being negotiated, and is expected to take place in
September 2012.

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2. Hawk Co is planning to invest the cash raised from the bank loan in
a new retail and leisure park which is being developed jointly with
another company, Kestrel Co.

Required:

In respect of the engagement to provide a report on Hawk Cos


business plan:

(i) Identify and explain the matters that should be considered


in agreeing the terms of the engagement; and

Note: You are NOT required to consider ethical threats to objectivity.


(6 marks)

(ii) Recommend the procedures that should be performed in


order to examine and report on the forecast financial
statements of Hawk Co for the year to 31 May 2013. (13 marks)

Answer to June2012 Q2(a)

(a) You can add other points such as time to finish, time to build up
knowledge, fees calculation, report to whom, follow which standards
etc.

Managements responsibilities

It should set out managements responsibilities for the preparation of


the business plan and forecast financial statements, including all
assumptions used, and for providing the auditor with all relevant
information and source data used in developing the assumptions. This
is to clarify the roles of management and of Lapwing & Co, and reduce
the scope for any misunderstanding.

The intended use of the business plan and report

It should be confirmed that the report will be provided to the bank and
that it will not be distributed or made available to other parties. This
will establish the potential liability of Lapwing & Co to third parties.

The period covered by the forecasts

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This should be confirmed when agreeing the terms of the engagement,
as assumptions become vague as the length of the period covered
increases, e.g., it should confirm whether a 12-month forecast period
is sufficient for the banks purposes.

The planned contents of the assurance report

It should confirm the planned elements of the report avoid any


misunderstanding with management. E.g., Lapwing & Co should
clarify that their report will contain a statement of negative assurance
as to whether the assumptions provide a reasonable basis for the
prospective financial information, and an opinion as to whether the
prospective financial information is properly prepared on the basis of
the assumptions and is presented according to the relevant financial
reporting framework.

(b)

General procedures

Re-perform calculations to confirm the accuracy of the forecast


financial statements.

Agree the unaudited figures for the period to 31 May 2012 to


management accounts, and agree the cash figure to bank
statement or bank reconciliation.

Confirm the consistency of the accounting policies used in the


preparation of the forecast financial statements with those used in
the last audited financial statements.

Consider the accuracy of forecasts prepared in prior periods by


comparing with actual results and discuss with management the
reasons for any significant variances.

Forecasted statement of profit or loss

Discuss the reason for the 21


4% increase in revenue with
management to verify its reasonableness.

Discuss the reason for the increase in operating profit with


management from 30% to 33.8% to verify its reasonableness.

Request confirmation from the bank of the potential terms of the


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$30 million loan being negotiated, to confirm the interest rate is at
4%.

Review relevant board minutes regarding the sale of BREAK


RETAIL, to obtain understanding of the likelihood of the sale, and
the main terms of the sale negotiation.

Forecasted statement of financial position

Agree the increase in property, plant and equipment to an


authorised capital expenditure budget.

Discuss the planned increase in equity with management to


understand the reason for any planned share issue, its date and
the nature of the share issue, i.e., issue at full market price.

Review a forecast statement of changes in equity to ensure that


movements in retained earnings appear reasonable given
forecasted profit is $10.52m but theres just an increase in
retained earnings of $800,000 so there must be a planned to pay
out dividend.

Agree the increase in long-term borrowings to documentation


relating to the new loan.

Discuss the deferred tax liability with management to understand


why no movement on the balance is forecast given theres a
planned increase in capital expenditure.

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Due Diligence Review

A due diligence engagement is where an advisor (often an audit firm)


is engaged by one company planning to acquire another to perform an
assessment of the material risks associated with the transaction
(including the assessment of the financial as well as non-financial
information of another company), to ensure that the acquirer has all
the necessary facts and that the perceived business opportunities are
in fact real. This is important when determining purchase price.
Similarly, due diligence can also be requested by sellers.

The Due Diligence can either be a review engagement which includes


the negative assurance to the users or it can be an agreed-upon
procedure where no assurance will be given.

Categories of due diligence

Financial

Financial due diligence (a review of the financial position and


obligations of a target to identify such matters as covenants and
contingent obligations)

Non-Financial

1. Operational and IT due diligence (extent of operational and IT


risks, including quality of systems, associated with a target
business)

2. People due diligence (key staff positions under the new


structure, contract termination costs and costs of integration)

3. Regulatory due diligence (review of the target's level of


compliance with relevant regulation)

4. Environmental due diligence (environmental, health and safety


and social issues in a target)

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Due diligence review Chapter 2 June2008 Q2

Rosie Co is the parent company of an expanding group of companies.


The groups main business activity is the manufacture of engine parts.
In January 2008 the acquisition of Dylan Co was completed, and the
group is currently considering the acquisition of Maxwell Co, a large
company which would increase the groups operating facilities by
around 40%. All subsidiaries are wholly owned. The group structure is
summarised below:

Rosie Co

Timber Co Ben Co
Dylan Co
Acquired Jan 2001 Acquired July 2005
Acquired Jan 2008

You are an audit manager in Chien& Co, a firm of Chartered Certified


Accountants, and you, are reviewing the working papers completed
on the final audit of Rosie Co and the Rosie Group for the year ended
31 January 2008. Your firm has audited all current components of the
group for several years, but the target company Maxwell Co is audited
by a different firm.

The management of Rosie Co has provided the audit team with some
information about Maxwell Co to aid business understanding, but little
audit work is considered necessary as the acquisition, if it goes ahead,
will be after the audit report has been issued. Information provided
includes audited financial statements for the year ended 31 January
2008, an organisational structure, several customer contracts, and
prospective financial information for the next two years. This seems to
be all of the information that the directors of Rosie Co have available.
The finance director, Leo Sabat, is hoping that the other directors will
agree that an externally provided due diligence investigation should
be carried out urgently, before any investment decision is made,
however the other directors feel this is not needed, as the financial
statements of Maxwell Co have already been audited. Leo has asked
you to prepare a report to explain to the other directors the purpose of
due diligence, and the difference between due diligence and an audit
of financial statements, which will be presented at the next board
meeting.

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Goodwill on the acquisition of Dylan Co is recognised in the
consolidated statement of financial position (balance sheet) at
$750,000. The calculation provided by the client is shown below:

$000
Cost of Investment:
Cash consideration 2,500
Deferred consideration payable 31 January 2009 1,500

Contingent consideration payable 31 January 2012 if Dylan 1,000


Cos revenue grows 5% per annum
5,000
Net assets acquired (4,250)

Goodwill on acquisition 750

All of the figures in the schedule above are material to the financial
statements of Rosie Co and the Rosie Group.

Required:

(a) Prepare a report to Leo Sabat (the finance director), in


which you should:

(i) Describe the purpose, and evaluate the benefits of a due


diligence investigation to the potential purchaser of a
company; and (10 marks)

(ii) Compare the scope of a due diligence investigation with


that of an audit of financial statements. (4 marks)

Note: requirement (a) includes 2 professional marks.

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Answer to June2008 Q2

(a)

Report
To: finance director
From: auditor
Date: exam date
Subject: due diligence

Introduction:
The report details the objective and benefit of due diligence review as
well as the comparison between it and audit.

(i) Purpose and benefit of due diligence

Management representation

By conducting such a due diligence investigation, the management


representation can be reviewed for its reasonableness. E.g., if the
management representation said, the company isnt involved in the
tax investigation and by conducting due diligence review we can
subsequently find whether this representation is true.

Information gathering

By conducting such a due diligence investigation and gathering


enough information as to whether or not to acquire the company any
potential problems can be revealed.

Reduce management involvement

By allowing external audit firm to do the service then the


management may save a lot of time by not checking the numbers
themselves but focus more on their core operation of the business.

Reveal operational problems

By conducting due diligence review operational issues such as high


rate of labour turnover can be revealed and it may help to form the
decision by company of whether or not going to acquire this company.

Increase confidence of investment decision


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By conducting due diligence this will increase shareholders
confidence and investment decisions to make subsequent acquisition
easier.

Reveal assets and liabilities

By conducting due diligence, it will reveal potential liability such as


contingent liability which may help the company negotiate the price
for the acquisition.

Also goodwill and other intangible assets are not recognised


separately in the financial statement but by conducting due diligence
review the assets can be revealed as well.

(ii) Comparison between due diligence investigation and audit

Time

Due diligence here relates to the purchase of another company so it


may require it to be completed as soon as possible.

The audit of financial statement may take a couple of months to


complete.

Assurance

The due diligence review provides negative assurance or its just


agreed upon procedures, i.e., checking what client asks for.

Audit of financial statement would require positive assurance given


and this requires auditors should follow ISA to do the audit work.

Direction

Due diligence requires forward looking by identifying any potential


problems that exist with the target company.

Audit of financial statement requires backwards looking to identify


any material misstatement in the financial statements.

Systems

Due diligence does not require auditors to test the client system.

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An audit assurance service would require auditors to test client
systems because this forms a basis of whether auditors would use a
system based approach to audit or full substantive testing approach.

Conclusion

Since due diligence provides a lot of benefit you can reasonably


consider this to happen before purchasing the target company.

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Case DEC2013 Q2 (b) Due Diligence Review

You are a manager in the business advisory department of Goleen &


Co. Your firm has been approached to provide assurance to Baltimore
Co, a company which is not an audit client of your firm, on a potential
acquisition. You have just had a conversation with Mark Clear,
Baltimore Cos managing director, who made the following comments:

Baltimore Co is a book publisher specialising in publishing textbooks


and academic journals. In the last few years the market has changed
significantly, with the majority of customers purchasing books from
online sellers. This has led to a reduction in profits, and we recognise
that we need to diversify our product range in order to survive. As a
result of this, we decided to offer a subscription-based website to
customers, which would provide the customer with access to our full
range of textbooks and journals online.

On investigating how to set up this website, we found that we lack


sufficient knowledge and resources to develop it ourselves and began
to look for another company which has the necessary skills, with a
view to acquiring the company. We have identified Mizzen Co as a
potential acquisition, and we have approached the bank for a loan
which will be used to finance the acquisition if it goes ahead.

Baltimore Co has not previously acquired another company. We


would like to engage your firm to provide guidance regarding the
acquisition. I understand that a due diligence review would be
advisable prior to deciding on whether to go ahead with the
acquisition, but the other directors are not sure that this is required,
and they dont understand what the review would involve. They are
also unsure about the type of conclusion that would be issued and
whether it would be similar to the opinion in an audit report.

Company background

Mizzen Co was established four years ago by two university graduates,


Vic Sandhu and Lou Lien, who secured funds from a venture capitalist
company, BizGrow, to set up the company. Vic and Lou created a new
type of website interface which has proven extremely popular, and
which led to the company growing rapidly and building a good
reputation. They continue to innovate and have won awards for
website design. Vic and Lou have a minority shareholding in Mizzen
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Co.

Mizzen Co employs 50 people and operates from premises owned by


BizGrow, for which a nominal rent of $1,000 is paid annually. The
company uses few assets other than computer equipment and
fixtures and fittings. The biggest expense is wages and salaries and
due to increased demand for website development, freelance
specialists have been used in the last six months. According to the
most recent audited financial statements, Mizzen Co has a bank
balance of $500,000.

The company has three revenue streams:

1. Developing and maintaining websites for corporate customers.


Mizzen Co charges a one-off fee to its customers for the initial
development of a website and for maintaining the website for two
years. The amount of this fee depends on the size and complexity of
the website and averages at $10,000 per website. The customer can
then choose to pay another one-off fee, averaging $2,000, for Mizzen
Co to provide maintenance for a further five years.

2. Mizzen Co has also developed a subscription-based website on


which it provides access to technical material for computer specialists.
Customers pay an annual fee of $250 which gives them unlimited
access to the website. This accounts for approximately 30% of Mizzen
Cos total revenue.

3. The company has built up several customer databases which are


made available, for a fee, to other companies for marketing purposes.
This is the smallest revenue stream, accounting for approximately
20% of Mizzen Cos total revenue.

Extracts from audited financial statements

Statement of profit or loss and other comprehensive income

293
Required:

To help me brief the other directors and using the information I have
provided, I would like you to identify and explain the matters which
you would focus on in your due diligence review and recommend the
additional information which you will need to perform your work.
(16 marks)

Answer from ACCA

Equity owners of Mizzen Co and involvement of BizGrow

The nature of the involvement of the venture capitalist company,


BizGrow, is a crucial issue which must be the starting point of the due
diligence review. Venture capitalists provide equity when a company
is incorporated, and typically look for an exit route within three to
seven years. Mizzen Co was incorporated four years ago, so it will be
important to determine whether BizGrow retains its original equity
holding in Mizzen Co, and if so, whether the acquisition of BizGrows
shares by Baltimore Co would be compatible with the planned exit
route.

Key skills and expertise

It appears that the original founders of Mizzen Co, Vic Sandhu and Lou
Lien, are crucial to the success of Mizzen Co and it would be in
Baltimore Cos interests to keep them involved with the business.
However, Vic and Lou may wish to focus on further work involving IT
innovation rather than Baltimore Cos planned website and without Vic
and Lous expertise the acquisition may be much less worthwhile.
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However, there could be other employed personnel with the necessary
skills and experience to meet Baltimore Cos needs, or much of the
skill and expertise could be provided from freelancers, who will not be
part of the acquisition.

Internally generated intangible assets

Mizzen Co is likely to have several important internally generated


intangible assets, which will not be recognised in its individual
accounts but must be identified and measured as part of the due
diligence review. First, Vic and Lou have innovated and developed new
website interfaces, and the review must determine the nature of this
intellectual property (IP), and whether it belongs to Vic and Lou or to
Mizzen Co. The measurement of this asset will be very difficult, and it
is likely to form an important part of the acquisition deal if Baltimore
Co want to acquire the IP to use in its new website.

There are also several customer databases which need to be


measured and included in the list of assets acquired, which again may
be difficult to measure in value. It is important for the due diligence
review to confirm the relevance of the databases to Baltimore Cos
operations, and that the databases contain up-to-date information.

Premises

Mizzen Co currently operates from premises owned by BizGrow and


pays a nominal rent for this. Presumably if the acquisition were to go
ahead, this arrangement would cease. The due diligence review
should consider the need for new premises to be found for Mizzen Co
and the associated costs. Possibly there is room for Mizzen Co to
operate from Baltimore Cos premises as the operations do not appear
to need a large space. The rental agreement may be fixed for a period
of time and cancellation may incur a penalty.

Other tangible assets

Mizzen Co appears to own only items such as computer equipment


and fixtures and fittings. It needs to be clarified whether these assets
are owned or held under lease, and also whether any other tangible
assets, such as vehicles, are used in the business. Any commitments
for future purchases of tangible assets should be reviewed.

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Accounting policy on revenue recognition

Mizzen Co has some fairly complex revenue streams, and the due
diligence review should establish that the accounting policies in place
are reasonable and in line with IFRS15 Revenue from contracts with
customers. The revenue generated from website development and
maintenance should be split into two components, with the revenue
for website development recognised once the website has been
provided to the customer, but the revenue for maintenance spread
over the contract period. There is a risk that revenue is recognised too
early, inflating Mizzen Cos profit. The revenue recognition policy for
annual subscriptions should also be scrutinised, with revenue relating
to future periods being deferred.

Sustainability and relevance of revenue streams

The financial statements indicate that revenue has increased each


year, and that in the last year it has increased by 23
7%. This is an
impressive growth rate and work must be done to analyse the
likelihood of revenue streams being maintained and further growth
being achieved. For example, the proportion of website development
and two-year maintenance contracts which are renewed should be
investigated. Not all of Mizzen Cos revenue streams seem very
relevant to Baltimore Cos operations, so how these may be managed
post-acquisition should be considered.

Operating expenses

The financial extracts indicate a potentially unusual trend in relation


to operating expenses. In 2011 and 2012, operating expenses
represented 60% and 58 3% of revenue respectively. In 2013, this
had reduced to 49 6%. This may be due to economies of scale being
achieved as the company grows, or possibly expenses are
understated or revenue overstated in 2013. As freelance web
designers have been used in 2013, operating expenses may have
been expected to have increased in proportion to revenue. The due
diligence review should perform detailed analysis on the operating
costs incurred by the company to gain assurance that expenses are
complete and accurately recorded.

With the exception of 2010, the finance cost has remained static at
$250,000 per annum. The due diligence review must uncover what
this finance cost relates to, and whether it will continue
post-acquisition. It may be a bank loan or it could be a payment made
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to BizGrow, as venture capitalist companies often impose a
management charge on companies which they have invested in.
Baltimore Co will need to understand the nature of any liability in
relation to this finance charge.

Cash position and cash management

Mizzen Cos cash position should be confirmed. Given that the


company appears to have limited need for capital expenditure and
working capital, and given the level of profits which has been made in
the last three years, it could be expected that the company would be
cash-rich. The due diligence review should confirm how the cash
generated by the company since incorporation has been used, for
example, in dividend payments to BizGrow and to Vic and Lou.

Additional information required

Contract or legal documentation describing the nature of the


investment which BizGrow made when Mizzen Co was incorporated,
and detailing the planned exit route.

A register of shareholders showing all shareholders of Mizzen Co

An organisational structure, in order to identify the members of


management and key personnel and their roles within Mizzen Co.

A list of employees and their roles within the company, and their
related obligations including salary, holiday entitlements, retirement
plans, health insurance and other benefits provided by Mizzen Co, and
details of compensation to be paid in the case of redundancy.

A list of freelance web designers used by Mizzen Co, and a


description of the work they perform. The key terms of contracts or
agreements with freelance web designers.

A list of all IT innovations which have been created and developed by


Mizzen Co, and details of any patent or copyright agreements relating
to them. Agreements with employees regarding assignment of
intellectual property and confidentiality.

Copies of the customer databases showing contact details of all


people or companies included on the list.

A list of companies which have contracts with Mizzen Co for website


297
development and maintenance.

A copy of all contracts with customers for review of the period for
which maintenance is to be provided.

A breakdown of the revenue which has been generated from making


each database available to other companies, and the dates when they
were made available.

A summary of the controls which are in place to ensure that the


database details are regularly updated.

A copy of the rental agreement with BizGrow, to determine whether


any penalty is payable on cancellation.

Non-current asset register showing descriptions and values of all


assets used in the business. Copies of any lease agreements, for
example, leases of computer equipment, photocopiers, etc.

Details of any capital expenditure budgets for previous accounting


periods, and any planned capital expenditure in the future.

Mizzen Cos stated accounting policy on revenue recognition.

Systems and controls documentation over the processing of


revenue receipts.

An analysis of expenses included in operating expenses for each


year and copies of documentation relating to ongoing expenses, such
as salaries and other overheads.

Copies of management accounts to agree expenses in the audited


accounts are in line and to perform more detailed analytical review.

The full set of financial statements and auditors reports for each
year since the companys incorporation, to:
Confirm the assets and liabilities recognised
Agree the level of dividends paid each year
Review all of the accounting policies used in preparing the
financial statements
Find the details of any related party transactions that have
occurred
Review the statement of cash flows for each year.

298
Any agreements with banks or other external providers of finance,
including finance advanced and relevant finance charges, or
confirmation that no such finance has been provided to Mizzen Co.

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Forensic Accounting

Forensic accounting

Forensic accounting uses investigative and auditing techniques to


examine on the clients financial statements which would be used in
court.

Forensic accounting includes both forensic investigation ad forensic


auditing.

Forensic investigation

A forensic investigation is a process (practical steps) whereby a


forensic accountant carries out procedures to gather evidence.

This involves planning stage, testing stage, review stage and report
produced.

Forensic auditing

Forensic auditing is the specific use of audit procedures within a


forensic investigation to gather evidence.

This could include performing analytical procedures to determine the


amount of an insurance claim.

This will be the agreed-upon procedure with no assurance given.

Examples

1. Fraud Investigations

Fraud Investigations such as investigations into the theft of company


funds; tax evasion and insider dealing. A forensic accountant can
perform the works such as due diligence review/interview with the
staff and detailed inspection of the documentary evidence. This is
commonly tested in the exam.
300
Other fraudulent transactions would include:

Payroll fraud

Either it can be a ghost employee, i.e., employee left the company but
still getting paid with the amount goes into account managers
account.

Or it can be the employee claiming more payroll expense from


company but actually they havent worked for so long.

Teeming and lading (misappropriation of assets, cash)

We sold an inventory and recognise sales revenue and receive cash.


Then what the companys going to do is to steal that cash and then
say we recognise a receivable.

Then another customer pays for the company and the manager would
use the cash to cover up the first receivable balance etc.

Fictitious customers

The manager would create a fake customer and sells the goods to him
and then send the goods to him (fake customer=manager himself)
without actually getting paid.

Collusion with customers

The customer is real.

The manager would sell the goods to the customer and then send to
him without actually getting paid.

The after a short while both customer and manager disappear or the
customer goes into liquidation with the goods being shared between
customer and the manager.

Fake supplier

The manager created a fake supplier and pays the money from the
company to him.

Normally the bank details of the fake supplier would be same as the
manager.

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Paying for goods not received

Manager ordered the goods but the supplier hasnt supplied the goods
to the company.

Then managers would pay for them using money from the company
and then the supplier went away, with money shared between the
manager and the supplier.

Manipulation of bank reconciliations or cash books

For example, within the cash book there has been a cash outflow of
$500 to supplier Abut that supplier is the manager! And this means
the manager would transfer the cash out to his own account.

Also cash outflow of $500 in the bank statement then a manager


would manipulate that in the cash book so they are equal to each
other.

Misuse of pension fund or other assets.

Instead of using the pension funds to do investment, what the


manager does is to steal these funds into their own pocket.

Disposal of assets to employees

The asset is ok and can be used by the company but the manager
states that the company should replace this old asset with the new
one and hence dispose of the old asset to employees with a very low
price.

2. Insurance claims investigation


Insurance claims investigation relating to property losses; personal
liability claims; medical malpractice and wrongful dismissal. A
forensic accountant can perform the work, such as identification of an
appropriate method of calculating the losses.

3. Professional negligence investigation


For example, investors suffered a loss as a result of relying on a
professional adviser. A forensic accountant can perform work such as
reviewing the case relating to the amount of losses suffered by the
302
investors by performing suitable calculations.

4. Partnership disputes
For example, funds being distributed. The forensic accountant can
perform the work such as analysis of recent years accounting records
to quantify the assets value as well as profits being made.

Objectives (HOPE)

Fraud happened

It should make sure that this is a fraud happening and not a mistake.

Obtain evidence

Forensic investigation should obtain sufficient and appropriate


evidence relating to the investigation.

Prosecute the perpetrator

This would involve interviewing the suspected fraudster and if they


are proved to commit the fraud then the company should prosecute
them.

Quantify economic losses

The investigation should quantify the financial loss suffered by the


company.

Steps involved in the forensic investigation

Planning

Type of fraud.

How the fraud happened.

Their actions so far.

Has the client made contact with the insurance company?

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Scrutinise the terms of the insurance contract.

Resources and skills needed.

Make sure that we can have access to the full information in the
clients company and being able to discuss with police and the
insurance company without fear of breaching confidentiality.

Who would be the expert witness as well?

Evidence gathering

Using the techniques in normal audit such as analytical


procedures; enquiries etc.

Investigative skills

Report produced

A summary of the procedures performed;

A summary of the results of procedures;

Any limitations in the scope of the engagement;

A conclusion relating to the amount of any losses suffered by


the client.

Expert witness in court

Advice

Advice given to the company of how to stop these internal


control weaknesses in the future.

Ethics requirements

Professional behaviour

Its likely that forensic investigation would be a matter of public


interest and much of the media are focusing on this, so the forensic
accountant should have a highly professional attitude towards this to

304
avoid damaging the reputation of the firm.

Integrity

The forensic accountant should not lie to the court and his client, and
should retain the highest integrity when carrying out the work.

Competence and due care

The forensic accountant should have cumulative knowledge in audit


and in this area to carry out the work and they should follow
recognised standards to do the work as well.

Confidentiality

During court, the forensic accountant is required by the court to


reveal information discovered during the investigation.

But outside the court the forensic accountant should retain faultless
confidentiality by not disclosing the clients information without their
permission.

Objectivity

The outcome of the forensic investigation must be perceived as


objective because it forms part of the legal evidence presented at
court.

The self-review threat may arise because the investigation is likely to


involve the estimation of an amount (i.e. the loss) and then the
forensic accountant can find out whether this is true.

Forensic audit Chapter 2 DEC2008 Q2

(a) Define the following terms:

(i) Forensic Accounting;

(ii) Forensic Investigation;

(iii) Forensic Auditing. (6 marks)

You are a manager in the forensic investigation department of your


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audit firm. The directors of a local manufacturing company, Crocus Co,
have contacted your department regarding a suspected fraud, which
has recently been discovered operating in the company, and you have
been asked to look into the matter further. You have held a
preliminary discussion with Gita Thrales, the finance director of
Crocus Co, the notes of this conversation are shown below:

Notes of discussion with Gita Thrales

Four months ago Crocus Co shut down one of its five factories, in
response to deteriorating market conditions, with all staff employed
at the factory made redundant on the date of closure.

While monitoring the monthly management accounts, Gita performs


analytical procedures on salary expenses. She found that the monthly
total payroll expense had reduced by 3% in the months following the
factory closure not as much as expected, given that 20% of the total
staff of the company had been made redundant. Initial investigations
performed last week by Gita revealed that many of the employees
who had been made redundant had actually remained on the payroll
records, and salary payments in respect of these individuals were still
being made every month, with all payments going into the same bank
account. As soon as she realised that there may be a fraud being
conducted within the company, Gita stopped any further payments in
respect of the redundant employees. She contacted our firm as she is
unsure how to proceed, and would like our firms specialist
department to conduct an investigation.

Gita says that the senior accountant, Miles Rutland, has been absent
from work since she conducted her initial investigation last week, and
it has been impossible to contact him. Gita believes that he may have
been involved with the suspected fraud.

Gita has asked whether your department would be able to provide a


forensic investigation, but is unsure what this would involve. Crocus
Co is not an audit client of your firm.

Required:

(b)
(i) Describe the objectives of a forensic investigation; and

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(ii) Explain the steps involved in a forensic investigation
into the payroll fraud, including examples of procedures
that could be used to gather evidence.
(11 marks)

(c) Assess how the fundamental ethical principles of IFACs


Code of Ethics for Professional Accountants should be
applied to the provision of a forensic investigation service.
(6 marks)
(23 marks)

Answer to DEC2008 Q2 Forensic Audit

(a) (i)

Forensic accounting

Forensic accounting uses investigative and auditing techniques to


examine the clients financial statements which would be used in
court.

Forensic accounting includes both forensic investigation and forensic


auditing.

Forensic investigation

A forensic investigation is a process whereby a forensic accountant


carries out procedures to gather evidence.

This involves a planning stage, a testing stage, a review stage and the
production of a report.

Forensic auditing

Forensic auditing is the specific use of audit procedures within a


forensic investigation to gather evidence.

This could include performing analytical procedure to determine the


amount of an insurance claim.

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(b) (i)

Fraud happened

It should make sure that this is a fraud, i.e., a ghost employee not a
mistake made within company.

Obtain evidence

Forensic investigation should obtain sufficient and appropriate


evidence whether or not there are employees grouping together to
commit the fraud.

Prosecute the perpetrator

This would involve interviewing with the suspected fraudster and if


they are proved to commit the fraud then the company should
prosecute them.

Quantify economic losses

The investigation should quantify the financial loss suffered by Crocus


Co as a result of the fraud which shows a detailed amount suffered by
the firm.

(ii)

Type of fraud

Forensic investigation would firstly identify the types of fraud and in


this case it is a ghost employee methodology, e.g., an employee who
has left company but is still getting paid.

How the fraud happened

Forensic investigation would walk through the internal control system


to see how the fraud would have happened.
For example, there should be a control procedure to ensure that any
amendments made to payroll data must be approved by a senior
manager and its likely that this is breached.

Evidence gathering

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The investigation needs to gather sufficient and appropriate evidence
of a fraud that has happened, who committed the fraud, and the
economic losses as well.

For example, a forensic accountant would discuss the fraud with


management.

Investigative skills

This is to establish how the controls that should have been operating
in the payroll system were breached.

Skills would include:

Review of authorisation of monthly payroll.


Interview with the suspect(s), with the aim of extracting a confession

Report produced

This summarises the number of perpetrators and the losses suffered


by the company.

Expert witness

The investigator would likely be the expert witness to present the


above findings in court and they may be asked questions regarding
the investigation performed.

Advice

The investigator would give advice to the company of how to avoid the
same problems happening in the future by improving its internal
control system.

(C)

Professional behavior

Its likely that forensic investigation would be a matter of public


interest and much of the media are focusing on this so the forensic
accountant should have a highly professional attitude towards this to
avoid damaging the reputation of the firm.

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Integrity

The forensic accountant should not lie to court and his client and
should retain the highest integrity when carrying out the work.

Competence and due care

The forensic accountant should have cumulative knowledge in audit


and in this area to carry out the work and they should follow
recognised standards to do the work as well.

Confidentiality

During the court the forensic accountant is required by the court to


reveal information discovered during the investigation.
But outside the court the forensic accountant should retain faultless
confidentiality by not disclosing the clients information without their
permission.

Objectivity

The outcome of the forensic investigation must be perceived as


objective because it forms part of the legal evidence presented at
court.

The self-review threat may arise because the investigation is likely to


involve the estimation of an amount (i.e. the loss) and then the
forensic accountant finds out whether this is true.

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Social and environmental audit

Most companies now adopt corporate social responsibility policies.

This means that a company should not only focus on profit but also
focus on people (society) and planet (environment). The examiner
may ask you to come up with different KPIs relating to society and
environment as well as the evidence in the exam.

When planning the engagement, its important that we understand


the entity as well as the appropriateness of the KPIs chosen and make
sure that they are quantifiable and specific.

The assurance can be positive or negative assurance.

Social Audits

1. Establishing whether the firm has a rationale for engaging in


socially responsible activity.

2. Identifying that all current environmental programmes are


congruent with the mission of the company.

3. Assessing objectives and priorities related to these


programmes.

4. Evaluating company involvement in such programmes past,


present and future problems.

Environmental Audits

1. Agreeing Performance Indicators: determining in what areas


targets should be set, and at what level they should be set. This
might be influenced by, for instance, the need to meet legal
requirements (so that the metrics would be set in areas that are
relevant to those requirements). Examples of Performance
Indicators include:

Emissions (pollution, greenhouse gases, waste)


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Consumption (water, gas, electricity, non-renewable
feedstocks)

2. Performance measurement: the measurement of actual


performance in terms of the agreed Performance Indicators.

3. Reporting compliance: reporting on the implications of the


results for compliance with the targets specified in Performance
Indicators.

In order to do this, the environmental auditor will carry out the


following steps:

1. Obtain a copy of the company's environmental policy

2. Assess whether the policy is likely to achieve objectives:


Meet legal requirements
Meet jurisdiction Standards
Satisfy key customers'/suppliers' criteria

3. Test implementation and adherence to the policy by:

Discussion

Observation

'Walk-though tests' where possible

Problems with social and environmental audit

It is difficult to measure social and environmental performance for a


number of reasons.

Firstly, targets and KPIs are not always precisely defined.

Secondly, targets and KPIs may be difficult or impossible to quantify.

Thirdly, systems and controls are often not established well enough to
allow accurate measurement, and the measurement of
socio-environmental matters may not be based on reliable evidence.

Finally, it will also be difficult to make year on year comparisons for


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the same company, as targets may change in response to business
activities.

Impact on audit

Accounting Example

Provisions (IAS 37) Site restoration costs;

Contingent liabilities (IAS 37) Because of pending legal action;

Non-current assets subject to


Impairment of assets (IAS 36) environmental contamination and cant
be used anymore;

Because the entity is contaminating the


Going concern considerations environment and the entity may be
(IAS 1) facing with significant penalties from the
country.

In the exam, the examiner may test you about the social and
environmental audit with practical audit procedures relating to the
above elements.

313
Social & Environmental Audit DEC2008 Q1(C)

A new internal auditor, Daisy Rosepetal, has recently joined Bluebell


Co. She has been asked by management to establish and to monitor
a variety of social and environmental Key Performance Indicators
(KPIs). Daisy has no experience in this area, and has asked you for
some advice. It has been agreed with Bluebell Cos audit committee
that you are to provide guidance to Daisy to help her in this part of her
role, and that this does not impair the objectivity of the audit.

Recommend EIGHT KPIs which could be used to monitor


Bluebell Cos social and environmental performance, and
outline the nature of evidence that should be available to
provide assurance on the accuracy of the KPIs recommended.
Your answer should be in the form of briefing notes to be used
at a meeting with Daisy Rosepetal. (12 marks)

Answer to DEC2008 Q1(c)

Briefing Note
To: Bluebell co
From: Auditor
Date: exam date
Subject: KPI
Introduction: This briefing note will detail eight KPI and nature of
evidence relating to KPIs.

KPIs Nature of evidence


Social-employees
% female employees accounts for total Personnel files will show this
number of staff
Reduction in Staff turnover of 25% from last leavers documentation from payroll
year to this year records

Social customers
Increase in Customer satisfaction rates of Surveys or questionnaires completed by
30% with service provided from last year to customers
this year
Increase in Level of repeat bookings of 15% Customer account details from the sales
from last year to this year system would indicate multiple
bookings.
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Decrease in level of complaints by customer Management log book of complaints
by 20% from last year to this year. received

Social community
Increase in donation of 35% from last year Cash book will show value of any
to this year expressed as value/profit. donations

Environment
35% decrease in water use from last year to Comparison of utilities costs using
this year. suppliers bills received.
35% decrease in carbon footprint from last Board authorisation of any payments
year to this year. made for carbon footprint.

Conclusion:

Its very important to quantify every KPIs measures and keep control
over them.

315
June2012 Q2(b)(ii): Social & Environmental
Audit

(b) You are also responsible for the audit of Osprey Co, which has a
financial year ended 31 May 2012. The audit engagement partner, Bill
Kingfisher, sent you the following email this morning:

To: Audit manager


From: Bill Kingfisher, audit engagement partner, Osprey Co
Regarding: Environmental incident

Hello

Osprey Cos finance director called me yesterday to explain that


unfortunately over the last few weeks, one of its four factories leaked
a small amount of toxic chemicals into the atmosphere. The factorys
operations were halted immediately and a decision has been taken to
permanently close the site. Though this is a significant event for the
company and will result in relocation and some restructuring of
operations, it is not considered to be a threat to its going concern
status. Costs of closure of the factory have been estimated to be
$125 million, which is expected to be material to the financial
statements, and a provision has been set up in respect of these costs.

Osprey Co is keen to highlight its previous excellent record on


socio-environmental matters. Management is preparing a report to be
published with the financial statements which will describe the
commitment of the company to socio-environmental matters, and
state its target of reducing environmental damage caused by its
operations. The report will contain a selection of targets and key
performance indicators to show performance in areas such as energy
use, water consumption and employee satisfaction. Our firm may be
asked to provide an assurance report on the key performance
indicators.

I am asking you to prepare briefing notes for my use in which you:

(ii) Discuss the difficulties in measuring and reporting on


environmental and social performance.
(4 marks)
Thank you.

316
Answer to June2012 Q2(b) (ii)

Measuring and reporting on social and environmental


performance

It is difficult to measure social and environmental performance for a


number of reasons.

Firstly, targets and KPIs are not always precisely defined. For example,
Osprey Co may state a target of reducing environmental damage
caused by its operations, but this is very vague.

Secondly, targets and KPIs may be difficult or impossible to quantify,


with Osprey Cos planned KPI on employee satisfaction being a good
example.

Thirdly, systems and controls are often not established well enough to
allow accurate measurement, and the measurement of
socio-environmental matters may not be based on reliable evidence.
In Osprey Co it may not be possible to quantify how much toxic
chemical has been leaked from the factory.

Finally, it will also be difficult to make year on year comparisons for


the same company, as targets may change in response to business
activities. For example, if Osprey Co were to expand its operating, its
energy and water use would increase, making its performance on
environmental matters look worse.

317
DEC2010 Q2(b) Social & Environmental Audit

Recommend procedures that could be used to verify the following


draft KPIs:

(i) The number of serious accidents in the workplace; and


(ii) The average annual spend on training per employee.
(6 marks)

Answer to DEC2010 Q2(b)

(i) (Only 3points required)


Review number and type of accidents in the workplace records held
by human resources department.

Discuss the definition of a serious accident and establish criteria


applied to an accident to determine whether it is serious.

Review minutes of board meetings for discussions of any serious


accidents.

(ii)
Review Eastwood Cos approved training budget comparing to
previous years to ascertain the overall level of planned spending on
training.

Agree significant components of the total training spend to


supporting documentation such as contracts and invoice with
training providers.

Agree the total amount spent on training programmes to cash book


and bank statements.

318
Integrated report

An exam question will not necessarily state that 'prospective financial


information' is being examined, so you may have to spot it. It is
possible, for example, that an integrated report (a topical area) could
include forecast financial information.

The International Integrated Reporting Council (IIRC) issued its


'International IR Framework' in 2013, which aims to help speed the
adoption of integrated reporting across the world. The IIRC has its
headquarters at ACCA, and the ACCA appears keen to integrate
integrated reporting into its qualifications.

The aim is to create transparency of the company and also


consistency (applying integrated reporting to companies from all
around the world).

Content

Organisational overview

Governance

Opportunities and risks

Strategy and resource allocation

Business model

Performance

Future outlook

319
June 2015 Q5 (c)

For the first time this year, the financial statements are presented as
part of an integrated report. Included in the integrated report are
several key performance indicators, one of which states that Darren
Cos profit before tax has increased by 20% from the previous year. (6
marks)

Required:

Discuss the implications of the matters described above on the


completion of the audit and on the auditors report, recommending
any further actions which should be taken by the auditor.

Answer from ACCA for June 2015 Q5(c)

The key performance indicators (KPIs) included in an integrated


report are by definition other information according to ISA 720 The
Auditors Responsibilities Relating to Other Information in Documents
Containing Audited Financial Statements. Other information is defined
as financial and non-financial information which is included, either by
law, regulation or custom, in a document containing audited financial
statements and the auditors report.

According to ISA 720, the auditor is required to read the other


information to identify material inconsistencies, if any, with the
audited financial statements. There appears to be an inconsistency
because the KPI states that profit before tax has increased by 20%,
but the increase shown in the financial statements is 12 5%. The
auditor must use professional judgement to determine if this is a
material inconsistency.

Assuming that this is deemed to be a material inconsistency, the


auditor should consider whether the financial statements or the other
information should be amended. The audit completion procedures,
including final analytical review and review of all working papers will
determine whether the profit before tax figures as stated in the
financial statements need to be amended. From the discussion above,
it is likely that some adjustment to profit before tax will be needed
regardless of the inconsistent KPI.

It is most likely that the KPI included in the integrated report should
320
be changed in agreement with the movement in profit shown in the
adjusted financial statements, and management should be asked to
make the necessary change to the KPI. If management refuses to do
this, and the material inconsistency remains, the auditor should
include an Other Matter paragraph in the audit report to describe the
material inconsistency. The Other Matter paragraph should be placed
immediately after the Opinion paragraph and the Emphasis of Matter
paragraph.

The auditor may also seek legal advice if management refuses to


amend the KPI to remove the material inconsistency. All of the
matters affecting the auditors report should be discussed with those
charged with governance

321
Chapter3 Current Issues

Contents

JOINT AUDIT .................................................................... 323


TRANSNATIONAL AUDIT................................................... 323
AUDIT GUIDANCE ............................................................. 323
AUDIT FOR SMALL COMPANY ........................................... 323
AUDITORS INDEPENDENCE .............................................. 324
AUDITORS LIABILITY ...................................................... 324
JUNE2009 Q2(D) TRANSNATIONAL AUDIT ....................... 325
DEC2009 Q4 AUDIT APPROACHES .................................... 328
JUNE2008 Q2(C) JOINT AUDIT ......................................... 330
DEC2010 NEESON&CO(B) Q4............................................ 332
JUNE2010 Q5(B) AUDITORS LIABILITY........................... 334

322
Joint audit

This is where 2 or more firms perform audit services to a clients


company and they would have same responsibility to the opinion.

Transnational audit

This is where the audited financial statements would be used by


shareholders in the foreign country for raising money and for legal
purposes.

For example, a company in the UK is raining debt finance/Equity


finance in China.

For example, an international charity taking donations through


various national branches and making grants around the world.

Also within the group, there are lots of different components from all
around the world that need to be audited. Since the auditing
standards, accounting standards, as well as corporate governance
requirements are different from countries to countries, its possible
that the audit will be performed according to different standards and
this could lead to inconsistency and poor quality for the group audit as
a whole.

Audit guidance

This would include rules based to audit and if this is the case auditors
need to follow detailed rules in every situation with no judgment.
Another one would be principle based to audit where auditors follow
the regulatory framework to audit rather than detailed rules and
hence auditors would use their judgment in different situations for
different clients.

Audit for small company

This would have its own advantages and disadvantages. Advantages


would be to utilise expertise to help business growth by accepting
advice from the audit firm but the biggest disadvantage would be its
323
very expensive for the small audit firm to have such audit services.

Auditors Independence

How to increase the auditors independence? The solution would


include things like auditors rotation like key audit partners for one
client should be rotated every 7 years.

Auditors liability

How auditors liability arises?

Auditors know who uses it and their plan. For example, they
know shareholders would use the audit report to make their
investment decision so they are liable to shareholders. But if
auditors dont know who is going to use their audit report and
their plan then surely they are not liable to those guys.

Auditors have done poor quality work (negligence).

Users of the audit report would lose money as a result of using


the audit report.

If the above criteria are fulfilled, then auditors are liable to those
ones.

How to minimise the liability?

1. Disclaimers;

2. Professional indemnity insurance (PII);

3. Joint audit;

4. Quality control.

324
June2009 Q2(d) Transnational Audit

The Dragon Group is a large group of companies operating in the


furniture retail trade. The group has expanded rapidly in the last three
years, by acquiring several subsidiaries each year. The management
of the parent company, Dragon Co, a listed company, has decided to
put the audit of the group and all subsidiaries out to tender, as the
current audit firm is not seeking re-election. The financial year end of
the Dragon Group is 30 September 2009.

You are a senior manager in Unicorn & Co, a global firm of Chartered
Certified Accountants, with offices in over 150 countries across the
world. Unicorn & Co has been invited to tender for the Dragon Group
audit (including the audit of all subsidiaries). You manage a
department within the firm which specialises in the audit of retail
companies, and you have been assigned the task of drafting the
tender document. You recently held a meeting with Edmund Jalousie,
the group finance director, in which you discussed the current group
structure, recent acquisitions, and the groups plans for future
expansion.

Meeting notes Dragon Group

Group structure
The parent company owns 20 subsidiaries, all of which are wholly owned. Half of
the subsidiaries are located in the same country as the parent, and half overseas.
Most of the foreign subsidiaries report under the same financial reporting
framework as Dragon Co, but several prepare financial statements using local
accounting rules.

Acquisitions during the year

Two companies were purchased in March 2009, both located in this country:

(i) Mermaid Co, a company which operates 20 furniture retail outlets. The audit
opinion expressed by the incumbent auditors on the financial statements for the
year ended 30 September 2008 was qualified by a disagreement over the
non-disclosure of a contingent liability. The contingent liability relates to a court
case which is still on-going.

(ii) Minotaur Co, a large company, whose operations are distribution and
warehousing. This represents a diversification away from retail, and it is hoped that
the Dragon Group will benefit from significant economies of scale as a result of the
325
acquisition.

Other matters

The acquisitive strategy of the group over the last few years has led to significant
growth. Group revenue has increased by 25% in the last three years, and is
predicted to increase by a further 35% in the next four years as the acquisition of
more subsidiaries is planned. The Dragon Group has raised finance for the
acquisitions in the past by becoming listed on the stock exchanges of three
different countries. A new listing on a foreign stock exchange is planned for
January 2010. For this reason, management would like the group audit completed
by 31 December 2009.

Required:

(i) Define transnational audit, and explain the relevance of


the term to the audit of the Dragon Group;
(3 marks)
(ii) Discuss TWO features of a transnational audit that may
contribute to a high level of audit risk in such an
engagement.
(4 marks)

326
Answer to June2009 Q2 (d)

(d)

(i)
Definition:
Transnational audit is the audit of a clients financial statement which
would be relied on by investors outsider the home country for the
purpose of raising finance, investment or regulatory issues.

Relevance:
Because Dragon is seeking listing on the stock exchange, and clearly
its audited financial statement would be used by investors outside the
home country, this is a transnational audit.

(ii)
Features:
Application of ISAs
For some countries they are using their own auditing standards and
these may be different from ISAs and hence when auditing those
countries risks arises because different rules exist, i.e., ISA requires
to gain an understanding of the client first to better identify risks
within the clients company while local auditing standards may not
include this.

Corporate governance rules


In some countries there are very prescriptive corporate governance
requirements, which the auditor must consider as part of the audit
process. In this case the auditor may need to carry out extra work
over and above local requirements in order to ensure group wide
compliance with the requirements of the jurisdictions relevant to the
financial statements.
However, in some countries there is very little corporate governance
regulation at all and controls are likely to be weaker than in other
components of the group. Control risk is therefore likely to differ
between the various subsidiaries making up the group.

327
DEC2009 Q4 Audit Approaches

As a result of the International Audit and Assurance Standards Boards


Clarity Project, many revised and redrafted ISAs that have been
issued will become effective for audits of financial statements for
periods beginning on or after 15 December 2009. One of the
objectives of the Clarity Project is to clarify mandatory requirements.
This has been done by changing the wording used in the ISAs to
indicate requirements which are expected to be applied in all audits.
Some argue that this will introduce a more prescriptive (rules-based)
approach to auditing, and that a principles-based approach is more
desirable.

Required:

(i) Contrast the prescriptive and the principles-based


approaches to auditing; and
(2 marks)

(ii) Outline the arguments for and against a prescriptive


(rules-based) approach to auditing.
(5 marks)

328
Answer to DEC2009 Q4

(i)

Prescriptive based to audit means an auditor must follow detailed


rules during the audit in every situation.

Principle based to audit means auditors would follow a regulatory


framework during the audit and auditors would have a choice of how
to apply the rules in different situations.

(ii)

For:
Because of rules based to audit auditors must follow detailed rules
and hence this will improve clarity of auditing standards.

This will improve audit quality as well since auditors follow all of the
rules during the actual audit.

Against:
This will lead to over or under auditing because for small companies
their transactions are relatively simple and hence there is no need to
carry out a variety of procedures but just focus on those simple
transactions. Under auditing means for some businesses auditors just
follow the rules and they may ignore performing additional
procedures to audit some more risky balances.

Lack of judgment in auditing would lower down the audit quality as


well because the rules are not applicable to every client.

329
June2008 Q2(c) Joint Audit

Maxwell Co is audited by Lead & Co, a firm of Chartered Certified


Accountants. Leo Sabat has enquired as to whether your firm would
be prepared to conduct a joint audit in cooperation with Lead & Co, on
the future financial statements of Maxwell Co if the acquisition goes
ahead. Leo Sabat thinks that this would enable your firm to improve
group audit efficiency, without losing the cumulative experience that
Lead & Co has built up while acting as auditor to Maxwell Co.

Required:

Define joint audit, and assess the advantages and disadvantages of


the audit of Maxwell Co being conducted on a joint basis.
(7 marks)

330
Answer to June2008 Q2(c)

Definition:

This means two or more audit firms would have the same
responsibility in giving the audit opinion to the financial statements.

Advantages:

This will help two firms get together and build up knowledge of the
new subsidiary especially for the high risk areas they have identified
before.

Two firms working together would mean resources would be shared


and hence make the audit more efficient and audit opinion would be
given with better quality.

Allowing two or more firms to work together means it should be able


to complete the work before the deadline.

Allowing two or more firms to work together and this would enable
new blood to come into the audit, meaning this will help auditors find
out more risky areas by holding a discussion among audit firms and
hence increase the overall opinion given.

Disadvantages:

Its more expensive for the client to pay these two audit firms rather
than just one.

Two audit firms would have different approaches to audit especially in


materiality determination, risk assessment and actual substantive
procedures and hence its difficult for them to work together
effectively.

When professional negligence happens then both audit firms would


suffer equal liability and they may blame each other for negligence
and make the litigation process more complicated as a result.

331
DEC2010 Neeson&Co(b) Q4

(b) You have set up an internal discussion board, on which current


issues are debated by employees and partners of Neeson& Co. One
posting to the board concerned the compulsory rotation of audit firms,
whereby it has been suggested in the press that after a
pre-determined period, an audit firm must resign from office, to be
replaced by a new audit provider.

Required:

(i) Explain the ethical threats created by a long association


with an audit client.
(3 marks)
(ii) Evaluate the advantages and disadvantages of compulsory
audit firm rotation.
(4 marks)
(20 marks)

332
Answer to Dec2010 Q4(b)

(i)

A familiarity threat would be created because of the long association


with the audit client and this would be a threat to objectivity because
auditors would lose professional skepticism when doing the audit, i.e.,
failure to challenge the client.

So key audit partners are required to be rotated every 7 years.

Self-interest threat may arise due to lack of objectivity because


auditors may become sympathetic to their clients interest after the
long association with client.

(ii)

Advantages:

It would eliminate the familiarity threat. By not only rotating the


key partner, but the entire audit firm, it is argued that the auditors
independence is not compromised, and that this adds credibility to
the auditors reports and to the profession as a whole.

It can also be argued that clients would benefit from a fresh pair of
eyes after a number of years. A new audit firm can offer different
insights from a fresh point of view.

Disadvantages:

From the audit firms perspective, there will be a loss of fee income
when forced to resign as auditor.

Compulsory rotation undermines this accumulation of knowledge


and experience and hence a new audit firm will have to spend more
time into auditing the client and hence it's more expensive to the
client as well.

333
June2010 Q5(b) Auditors liability

(b) You are also responsible for providing direction to more junior
members of the audit department of your firm on technical matters.
Several recent recruits have asked for guidance in the area of
auditors liability. They are keen to understand how an audit firm can
reduce its exposure to claims of negligence. They have also heard that
in some countries, it is possible to restrict liability by making a liability
limitation agreement with an audit client.

Required:

(i) Explain FOUR methods that may be used by an audit firm to


reduce exposure to litigation claims;
(4 marks)

(ii) Assess the potential implications for the profession, of


audit firms signing a liability limitation agreement with their
audit clients. (6 marks)

334
Answer to June2010 Q5(b)

(b) (i)

Disclaimers

Audit firms can include a disclaimer paragraph in the audit report. This
is an attempt to restrict the duty of care of the audit firm to the
shareholders of the company, thereby attempting to restrict legal
liability to that class of shareholders.

Professional indemnity insurance (PII)

Auditors can buy the PII before providing the audit service in case
something goes wrong then the company can reimburse the expense
from the insurance company.

Joint audit

By engaging two audit firms to do the audit they have the same
responsibility in giving the audit opinion, so this reduces the risk
exposure to litigation claims if it happened.

Quality control

Firms must ensure they have sufficient quality control procedures to


do the audit and document the work, i.e., staff would follow ISAs to do
the work and so this would reduce the risk to a litigation claim.

(ii)

Audit quality

Auditors could become less concerned with the quality of their work,
in the knowledge that if there was a claim against them, the financial
consequences are limited.

Value of the audit opinion

And once of the consequences would be users of the financial


statements will place less reliance on the audit opinion, resulting in
less credible financial statements.

335
Reduction on audit fees

Firms may be under pressure from clients to reduce their audit fees if
the risk exposure is reduced.

Reduce competition

The ability to set a cap on an auditors liability could distort the audit
market because bigger audit firms may have the ability to set a high
cap, which creates a disadvantage to smaller audit firms.

336

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