Practice Questions: SF Planning and Performing Engagements Flashcards
You are the manager in charge of the external audit of Kerry Ltd (‘Kerry’) for the year ending 31 December 20X7. Kerry operates a chain of retail outlets throughout England.
In January 20X7 Kerry introduced an internal audit function, consisting of a chief internal auditor and five assistants, to undertake monitoring procedures at head office and the retail outlets.
You have made a preliminary assessment of the internal audit function and intend to use its work.
State the matters that you would consider when evaluating the work of Kerry’s internal audit function
Evaluating the work of Kerry’s internal audit function:
- Assessment of the internal audit function remains appropriate
- Work is performed by persons having adequate technical training and proficiency
- Work of assistants is properly supervised, reviewed and documented
- Sufficient appropriate evidence is obtained to be able to draw reasonable conclusions
- Conclusions reached are appropriate in the circumstances
- Any reports prepared are consistent with the results of the work performed
- Any exceptions or unusual matters disclosed by internal audit are properly resolved
Your firm is the group auditor of Narberth Group plc. The financial statements of one of the components which will be included in the financial statements of Narberth Group plc has been audited by another firm of auditors who have modified their auditor’s report on the component’s financial statements.
Requirement
State the matters that should be considered, in respect of the above issue, by the group auditor when reporting on the financial statements of Narberth Group plc.
Matters:
- The nature and significance (materiality) of the matter which is the subject of the modification to the financial statements of Narberth Group plc
- Whether the matter which is the subject of the modification can be resolved when preparing the financial statements of Narberth Group plc
You have conducted analytical procedures on the draft accounts of Blunt Ltd for the year ended 31 October 20X1.
Two of your findings are as follows:
The gross profit margin has decreased from 29% for the previous year to 23% for this year.
(1) The current ratio has decreased from 1.6 at the previous year end to 1.2 at this year end.
(2) The directors had expected a decrease in both these measures but not by as much as shown above.
Requirement
Indicate what errors might be incorporated within the draft accounts to produce these unexpected variations, and in which areas you would carry out extra audit work in order to reach a conclusion.
Errors indicated:
- Inventories, receivables, or cash and cash equivalents could be understated
- Payables or bank overdrafts could be overstated
- Revenue could be understated
- Purchases could be overstated
Areas re extra work: - Inventories, receivables and payables Particularly, - Cut off - Provisions/Write downs
During the course of the audit of your client Sloth plc you notice a balance within receivables entitled ‘advances against directors’ expenses’.
The company’s managing director, who is familiar with the concept of materiality, has questioned your need to audit this balance, which at the year end stands at £12,500. The company’s retained profit for the year is £1.3 million.
Requirement
Prepare brief notes to the managing director explaining your audit approach in respect of this item.
Audit work: ‘Advances’
- Item is material by nature
- Item needs to be disclosed regardless of value
- Director transactions if not disclosed in financial statements, must be disclosed in auditor’s report
- Balance may indicate other related party transactions that need to be disclosed in financial statements
- May be tax liabilities not provided for in financial statements
- Item not quantitatively material
Your client, Neral Ltd, is a family owned and run haulage business. The managing director’s brother runs a manufacturing business, Jaron Ltd, which uses Neral Ltd for its distribution requirements.
Requirements
You are planning the audit of Neral Ltd. Identify the audit risks in respect of this relationship between the two companies and state how you would plan to address these risks.
Audit risks:
- Non disclosure
- Transactions not at arm’s length
Procedures to address:
- Identify full list of related parties at commencement of audit from year working papers
- Review minutes of meetings and shareholders and directors
- List names of statutory books
- Make enquiries with directors and staff during audit
- Obtain written representations on completeness of disclosure
- Review loan agreements for guarantors
- Review transactions between the two parties to ensure arm’s length basis
When planning to use the work of experts and in assessing the results of the work of experts, to what matters should the auditor pay attention?
Planning: Judge the experts’
- Objectives
- Experience/Competence
- Capabilities
Assessing results of work:
Assess appropriateness of audit evidence re financial statement assertions, especially:
- Source data- sufficient, relevant, reliable?
- Assumptions and methods - reasonable?
- Reasons for changes since prior period
- Results of work in light of auditors’ own knowledge of business
During the planning of the audit of Milten Textiles Ltd, the financial controller asked to have a quiet word with you. She tells you that she suspects the payroll clerk is defrauding the company, as she is regularly going on exotic holidays, buying new cars and spending substantial sums of money on home improvements.
There is only one payroll clerk who manages the single monthly payroll run.
Requirement
What would be the impact on your audit approach in respect of the information provided by the financial controller?
(Suspected fraud)
Suspected fraud:
- Look for evidence of deficiencies in the systems (eg, from previous management letter)
- Increase professional scepticism
- Evaluation/testing of controls over payroll system to identify deficiencies
- Increase substantive work/sample sizes on wages/payroll costs (eg, leavers deleted properly , existence checks on employees)
- Investigate any apparent override/circumvention of procedures
- Engage payroll clerk in conversation and query lifestyle
- Consider impact on other areas (eg, bank payment approvals)
You have completed the tests of controls in your audit. The only deviations found were that there was no evidence that one particular control had been operated in three cases out of 25 tested.
Requirement
Explain what considerations will determine whether you are able to reduce the substantive procedures in the area of this control.
Consideration re reduction in substantive procedures:
- Reasons for deviations (eg, person responsible on holiday - isolated error)
Whether deviation indicates :
- Lack of operation of control, ie, control failure; or
- Just lack of evidence, eg, no initial evidencing check performed
- Whether quantitative error(s) arose as a result of the deviations (confirming lack of operation of control)
- Whether extended tests prove satisfactory, ie, no further deviations found
- Whether compensating control exists - so monetary errors did not arise
At the audit planning meeting for the year ended 28 February 20X4 with the finance director of Malbec Ltd, you ascertained that payroll processing, which had been outsourced for a number of years, was brought back in-house in December 20X3.
Management was not satisfied with the performance of the service provider and repudiated the contract. The service provider had been responsible for making payments to the employees and the monthly remittances to HMRC. Two of Malbec Ltd’s accounts clerks have been trained in payroll processing.
Requirement
Identify the audit risks in respect of the above matter for the year ended 28 February 20X4 and state how you would address these risks
Risks re payroll processing:
Risk:
- Misstatements of payroll costs and liabilities to HMRC
- Unrecorded interest for late payment
- Unrecorded provision for damages/breach of contract or disclosure as contingent liability for damages
How addressed:
- Evaluate and test controls over payroll processing
- Detailed analytical review procedures
- Confirm payments in respect of PAYE and NIC made on time
- Confirmation of status of any litigation with legal advisers
- Inspect correspondence
Your firm has been appointed as external auditor to Supreme Limos Ltd (Supreme) for the year ended 31 May 20X9. Supreme’s principal activity is the hiring out of limousines.
The company commenced trading on 1 June 20X8 and, although the company’s revenue and assets are below the thresholds for statutory audit purposes, the company’s bank requires the financial statements to be subject to a full audit.
Your initial enquiries reveal that a computer package is used to maintain the accounting records.
These records are maintained by a part-qualified
accountant who is helped by a part-time payroll clerk.
Requirement
State, with reasons, an appropriate approach to the audit of Supreme, which addresses the extent of tests of control and substantive procedures, including analytical procedures.
- Substantive based approach
Lack of internal controls (high control risk) due to: - Lack of segregation of duties; and
- the possibility of unreliable software
- Higher detection risk associated with new audit
- Greater emphasis on tests of details
- Limited use of analytical procedures as there are no prior year comparisons and lack of cumulative knowledge
Your firm is the external auditor of Musicdigit Ltd (Musicdigit). The principal activity of the company is the retail sale of music equipment such as radios and MP3 players. The company provides a free one-year warranty with all items sold. In addition, customers can purchase an extended warranty for either a further two or five years.
In the case of the one-year warranty, Musicdigit agrees to replace items found to be faulty. In the case of extended warranties, Musicdigit agrees to either repair or replace items found to be faulty.
Musicdigit includes a warranty provision in its financial statements to reflect the future cost of fulfilling its obligations under existing warranties
Outline the audit procedures that you would plan to undertake as part of your firm’s audit of the warranty provision at the year end.
- Make enquiries of management as to the basis for the estimate of the warranty provision •
- Compare the prior year provision with the actual warranty claims in the year to ascertain the accuracy of management estimates
- Compare the ‘free warranty’ provision as a proportion of revenue with the same calculation for the prior year and ascertain the reasons for any material variation
- Ascertain the level of provision by warranty type with the number of ‘live’ warranties in that category and compare to the same calculation for prior year
- Review the level of returns occurring after the year end and compare with the assumptions made about rates of returns
- Review the records of repair costs incurred after the year end and compare with the assumptions made
- Check that movement on provision has been recorded as credit/debit in the statement of profit or loss
- Compare the actual provision to the level forecast •
Review the financial statements for appropriate disclosure of provision • - Request that management provide a written representation regarding the reasonableness of the assumptions made
- Review the board minutes for evidence of any product recalls •
- Re-perform management’s calculations •
- Agree the brought forward balance to prior year financial statements
Your firm is the external auditor of GreenEat, a charity established to promote the protection of the environment. GreenEat raises income from the sale of food and drink in cafés located in city centres and from donations made by individuals.
The cafés are managed and staffed by unpaid volunteers. Donations are made to GreenEat through collection boxes located in each café and by post to GreenEat’s headquarters.
Requirement
Identify and explain three key audit risks associated with your firm’s audit of GreenEat’s income
Key audit risks
- High level of cash transactions •
- Could lead to understatement or incomplete income due to error or misappropriation •
- The cafés are run and staffed by volunteers •
- They may be insufficiently trained or have insufficient experience leading to errors •
- Donation income is likely to be unpredictable •
- Auditor unlikely to be able to derive comfort from analytical procedures
External auditors have to consider the implications of any breaches, by their clients, of employment and social security legislation which may come to their attention.
Requirement
State why external auditors should consider these implications and provide two examples of such breaches
Reasons
- May have material impact on the financial statements
- Failure to comply may result in penalties/fines •
- Requiring provision (if probable) or disclosure (if possible) •
- Serious breaches may have going concern implications •
- Due to closure or inability to pay fines •
- May be indicative of poor control environment/lack of management integrity •
- Breaking the law to save costs may be considered to be money laundering •
Examples
- Minimum wage and working time directives •
- Health and safety at work regulations •
- PAYE and NI compliance •
- Pension scheme requirement
When a group engagement team plans to request a component auditor to perform work on the financial information of a component, the team is required to obtain an understanding of the component auditor.
Requirements
State the matters to be considered by the group engagement team when obtaining an understanding of a component auditor.
Whether the component auditor: •
- Understands and will comply with the ethical requirements that are relevant to the group audit and in particular is independent and objective
- Is willing to provide written confirmation of ability to comply with relevant ethical requirements
- Operates in a regulatory environment that actively oversees auditors
- The component auditor’s professional competence •
- Whether the group engagement team will be able to be involved in the work of the component auditor to the extent necessary to obtain sufficient appropriate audit evidence
Explain why it is necessary for the external auditors of companies to have an understanding of the laws and regulations which impact on their clients’ operations.
Having an understanding of the legal and regulatory framework applicable to the client and the industry sector in which it operates is required by ISA (UK) 250A Consideration of Laws and Regulations in an Audit of Financial Statements and ISA (UK) 315 Identifying and Assessing the Risks of Material Misstatement. #
- The auditor is required to assess the controls in place at the client to manage its risk of non-compliance.
- Failure of the client to comply with laws and regulations could have a material impact on the financial statements by necessitating:
- recognition of liabilities; or –
- disclosure of uncertainties resulting from fines and penalties. –
- Large fines or revoking of licences by regulators could also affect the client’s ability to continue as a going concern.
- Breaking laws and regulations in order to save costs may represent fraud or money laundering.
- Non-compliance may also indicate issues in respect of management’s integrity.
During your planning meeting for the external audit of Leo Ltd (Leo), the finance director informed you that the managing director, who owns all of the shares in Leo, is planning to sell his shares in the business.
He has been negotiating with a prospective purchaser who has agreed in principle to purchase the shares. The purchase consideration will be calculated as a multiple of the current year’s profit before tax.
Explain how this matter will affect the overall audit strategy.
Increased risk of window dressing/misstatement/bias •
In order to increase purchase consideration •
Reduce materiality thresholds •
Increase the level of testing •
Emphasis on:
Testing assets and income for overstatement –
Testing liabilities and expenses for understatement –
Increase the level of professional scepticism •
Look carefully at judgement areas •
Place less reliance on management representations •
Use more experienced staff •
Arrange a quality control review
You are planning the audit of Scorpio plc (Scorpio) for the year ending 31 December 20X0.
Scorpio’s principal activity is the manufacture of a range of electrical appliances. In today’s newspapers, there are headlines about Scorpio recalling one of its most popular products due to electrical faults which, in a number of cases, have caused fires.
Requirement
Explain why this matter should be considered when planning the audit of Scorpio for the year ending 31 December 20X0
Likely to have material impact on financial statements:
Refunds for returns •
Allowance to reduce inventory to NRV for faulty inventory
Increase in provisions for warranties •
Provisions/contingencies relating to legal claims •
Adverse publicity may impact on going concern.
Your firm has been engaged by the management of Divot plc (Divot) to undertake a review of and provide an assurance report on the interim financial information of Divot for the six months ended 31 May 20X1.
The terms of the engagement include applying analytical procedures to the interim financial information. Divot operates in the textile sector and has a comprehensive system for reporting financial results to the board of directors, including comparison against budget.
Requirement
Outline how you should use analytical procedures when reviewing the interim financial information and state the limitations of using analytical procedures as a source of evidence.
Comparisons with: Previous corresponding six months • Month by month • Industry sector data • Budget/forecast • Relationships between figures/changes in ratios Use of proofs in total Obtain plausible explanations for significant movements
Limitations
- A good knowledge of the business is required to understand results •
- Consistency of results may conceal an error •
- May be a tendency to carry out procedures mechanically, without appropriate professional scepticism
- Requires an experienced member of staff to be done properly •
- Reliable data may not be available •
- Lack of comparability if business is growing/changing
Animal Welfare is a not-for-profit entity which derives some of its income from donations made by the public through collecting boxes in retail outlets and restaurants.
Following a number of thefts of cash collected through collecting boxes and, in some cases, theft of the collecting boxes, the trustees of Animal Welfare have requested that your firm undertakes a comprehensive review of the internal controls exercised over the collection, custody and recording of cash donated through collecting boxes.
Requirement
Describe four internal control procedures that should be exercised over the system of cash donations received through collecting boxes
Four from the following:
- All of the boxes to be uniquely numbered
- Register of numbers and to whom distributed/where located
- Provision of means of securing boxes to counters (eg, chains) •
- Sealing of boxes so that opening before collection by entity is apparent •
- Regular collection of boxes from retail outlets and restaurants by trusted persons •
- Dual control (ie, two people) over opening and counting of cash donated •
- Immediate recording of amounts in boxes •
- Prompt banking of cash •
- Independent reconciliation of amount recorded with bank records
During the external audit of Albatross Ltd for the year ended 31 March 20X1, it was discovered that a sales credit note, relating to a large pre-year-end delivery of inventory, was issued to a customer on 21 April 20X1.
Requirement
Explain why the external audit team should investigate this matter.
- May be window dressing/cut off error
May be material misstatements in financial statements if: - Excluded from inventory •
- Included in sales and receivables •
- Goods are faulty/no allowance for cost below NRV •
May be indicative of: - Need for further allowances to reduce inventory to NRV re additional returns/items in inventory
- Lack of management integrity/unreliable management representations
Your firm is the external auditor of Dust Ltd (Dust), an industrial cleaning company. Dust has recently applied to its bank for a loan to fund the replacement of all its cleaning equipment.
If the application is successful Dust will dispose of its existing cleaning equipment which is included in the statement of financial position as tangible non-current assets.
As part of its application, Dust has submitted profit and cash flow forecasts to the bank for the three years ending 30 June 20X4.
The bank has requested that the forecasts are examined and reported on by independent accountants and Dust has appointed your firm to undertake this examination.
In respect of the purchase and disposal of the cleaning equipment, identify the key items that you would expect to be included in:
- the profit forecasts; and
- the cash flow forecasts.
For each item identified, state the specific matters you would consider when reviewing that item for reasonableness.
Profit forecast
Profit/loss on disposal of old equipment
- Prudent estimate of sales proceeds (alternative: estimate based on market value) •
- Calculated using carrying amount at the expected time of sale •
Depreciation of old and new equipment
- Appropriate estimate of useful life for new equipment
- New equipment depreciated from point available for use •
- Old equipment depreciated up to point of sale •
Interest on bank loan
- Accrued to the end of each year •
Cash flow forecast
Cash proceeds from sale of old equipment
- Prudent estimate of sales proceeds (alternative: estimate based on market value)
Cash payments to acquire new equipment
- In line with expected cost of such equipment or quotes obtained •
Bank loan
Amount and timing in line with the application made to the bank •
Interest payments in line with anticipated loan agreement (alternative: at a realistic rate of interest)
General
Timing of payments and receipts appear realistic and are consistent with items in the profit forecast
An engagement to review financial statements provides a moderate level of assurance that the financial statements are free from material misstatement, whereas an external audit engagement provides a reasonable level of assurance that the financial statements are free from material misstatement.
Requirement
State how the planned procedures for an engagement to review financial statements, and provide a moderate level of assurance, would differ from those planned for an external audit engagement, to provide reasonable assurance, in respect of cash at bank.
- Planned procedures for review engagement will be limited largely to inquiries of company personnel and analytical procedures whereas an audit will involve tests of details and potentially tests of controls
- A review engagement plans to obtain less evidence than an audit engagement
Bank reconciliation:
- A review engagement would make inquiries of client personnel regarding old or unusual reconciling items whereas an external audit would trace a sample of reconciling items to supporting documentation
- An external audit would obtain evidence of items that should be included as reconciling to ensure they are included on the bank reconciliation
- A review engagement would make inquiries regarding transfers between bank accounts whereas an external audit would vouch transfers between bank accounts
Bank confirmation letter:
- A bank confirmation letter would be obtained as part of external audit procedures but not for a review engagement where any encumbrances or restrictions on accounts would be identified through inquiry
You are the supervisor on the external audit of Plummer Ltd (Plummer) for the year ended 31 13.24
December 20X1.
While performing the planned audit procedures in the week commencing 12 March 20X2, the audit team noted the following issues in the schedule of unadjusted errors:
- The balance on a trade receivable account, totalling £435,000, remains unpaid and is in dispute. No allowance against the receivable has been made.
- Goods despatched and delivered to a customer on 2 January 20X2 were included at £260,000 in both revenue and trade receivables at 31 December 20X1. A member of the engagement team attended the year-end inventory count and obtained a copy of the count records.
The draft financial statements of Plummer for the year ended 31 December 20X1 show profit before tax of £11.3 million.
Requirement
Explain why further audit procedures are required and, for each of the issues, identify one relevant audit procedure to address the issue noted
The potential misstatements are not material in isolation:
Disputed receivable: 3.8% of profit before tax •
Cut off error: 2.3% of profit before tax •
However, potential misstatement in aggregate is £695,000 which is 6.1% of draft profit before tax
This could be material in aggregate as it falls into the 5–10% of profit range
Additional work is therefore required to ascertain:
- if any adjustment is required to the financial statements
- whether there are further errors in the financial statements that might be material •
The impact on the audit opinion will need to be considered in light of further findings.
Disputed trade receivable
One relevant procedure such as: Review any additional correspondence up to date of auditor’s report for indication of whether amount will be paid.
Cut-off error
One relevant procedure such as: Review year-end inventory count records to ascertain whether the inventory delivered post year end was correctly included in the inventory listing.
Glossy Ltd (Glossy) operates a national chain of hair salons in the UK. It plans to engage BuildaWeb Ltd (BuildaWeb) to design and build a new website and online appointment system.
Design will commence on 2 January 20X3 and the new website and online appointment system will be available to customers from 1 June 20X3.
In addition, BuildaWeb will host and maintain the website for a fixed monthly fee plus a charge for each online appointment made.
Glossy has applied to its bank for a loan to fund the new website and online appointment system.
The bank has requested a cash flow forecast for the year ending 30 September 20X3 and an independent examination of and report on the cash flow forecast.
Your firm has agreed to perform the independent examination and prepare the report.
Requirement
Identify the key payments to BuildaWeb that you would expect to be included in the cash flow forecast for the year ending 30 September 20X3. For each payment identified, state the specific matters you would consider when reviewing that item for reasonableness.
Payments to BuildaWeb for design and build
- In line with quote and any deposit/staged payments included in correct months •
Payments to BuildaWeb for hosting and maintenance
- Included monthly and on the date per proposed maintenance agreement •
- The fixed fee is in line with quote and included from June 20X3 •
Payments to BuildaWeb for charge per appointment
- In line with estimated number of appointments on website •
- Which are realistic in relation to current appointment volumes •
- Expected growth in appointments as customers adopt the online booking system appropriately reflected
All outflows in line with BuildaWeb credit terms
