Practice Questions: SF Planning and Performing Engagements

Question 1

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

Answer 1

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

Question 2

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.

Answer 2

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

Question 3

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.

Answer 3

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

Question 4

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.

Answer 4

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

Question 5

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.

Answer 5

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

Question 6

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?

Answer 6

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

Question 7

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)

Answer 7

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)

Question 8

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.

Answer 8

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

Question 9

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

Answer 9

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

Question 10

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.

Answer 10

• 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

Question 11

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.

Answer 11

• 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

Question 12

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

Answer 12

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

Question 13

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

Answer 13

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

Question 14

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.

Answer 14

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

Question 15

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.

Answer 15

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.

Question 16

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.

Answer 16

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

Question 17

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

Answer 17

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.

Question 18

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.

Answer 18

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

Question 19

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

Answer 19

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

Question 20

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.

Answer 20

• 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

Question 21

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.

Answer 21

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

Question 22

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.

Answer 22

• 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

Question 23

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

Answer 23

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.

Question 24

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.

Answer 24

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

Question 25

Using analytical procedures, identify factors which may indicate a risk of misstatement in the payroll of Geese for the year ended 31 December 20X2

Answer 25

• Average gross pay in 20X1 was £23,901 (£2,175,000/91)
• Expected average gross pay for 20X2 is (£24,379 (£23,901 × 1.02)
• Total expected payroll in 20X2 of £2,072,000 (£24,379 × 85)
• Actual payroll is £117,000 higher than expectation (£2,189,000 – £2,072,000)
• This is 10.8% of PBT and therefore material
• May indicate overstatement of gross pay
• Payroll taxes deducted in 20X1 were 30% of gross pay (£652/£2,175)
• Payroll taxes deducted in 20X2 were 25% of gross pay (£548/£2,189)
• Suggests either an understatement of amounts paid/due to HMRC
• May indicate cut-off error at year end
• Or may be further evidence of overstatement of gross pay
• Note: Marks were awarded for alternative calculations.

Question 26

You are planning the external audit of Canary Ltd (Canary) for the year ended 28 February 20X3.

During a meeting with Canary’s finance director she told you that the payroll function had been outsourced to Cockatoo Ltd, a payroll service organisation, on 1 June 20X2.

Requirement
State the implications of the above for the audit of the financial statements of Canary for the year ended 28 February 20X3.

Answer 26

Implications for the audit
Firm will need to audit the following:
- Payroll figures prepared by Canary for period 1 March to 31 May 20X2 •
- Payroll figures prepared by Cockatoo for period 1 June 20X2 to 28 February 20X3 •
- Accuracy of transfer of any payroll balances at 1 June to new system •
- Accuracy of transfer of any standing data to new system •

Firm will need to the following:
- Gain an understanding of services provided by Cockatoo •
- Assess Cockatoo’s reputation and competency •
- Ascertain access to audit evidence from Cockatoo •
- Including any assurance that can be obtained regarding effectiveness of internal controls •
May need to place reliance on description of Cockatoo’s systems and controls provided by its management and any report prepared by audit of Cockatoo on its opinion on management’s description.

May be higher risk due to changes in process and transfers of data in the first year.

May need to allocate the following:

• More time to audit payrolls before and after changeover •
• More experienced staff to mitigate higher risk

Question 27

You are responsible for the audit of Petro plc (Petro), a company engaged in oil refining. Given the potentially hazardous nature of the company’s activities, compliance with health and safety at work regulations is central to Petro’s operations.

Consequently, management has strict procedures, including monitoring, in place to ensure compliance.

Requirement
Identify the business risks to which accidental breaches of these regulations could expose Petro and the implications for the financial statements in the event of such breaches.

Answer 27

Business risks
Legal claims by victims •
Statutory fines/penalties •
Rectification costs •
Adverse impact on profit  •
Adverse impact on cash flow •
Loss of reputation •
Forced closure/going concern •

Implications for financial statements

Liabilities/provisions •
Contingencies/uncertainties/disclosures •
Impairment of assets •
Basis of preparation/break-up basis

Question 28

You are planning the audit of Homeco Ltd (Homeco), which operates a chain of retail stores selling household goods.
Customers pay by cash or credit card. The company has standardised operating procedures in all stores including the use of electronic point of sale systems which record the sale of an item and update the inventory records.

The inventory records are checked through periodic counting by store staff. In order to reduce the number of visits to stores by your firm, the audit plan requires the evaluation of the internal control procedures exercised by the head office of Homeco over operations at its stores.

Requirement
Outline the internal control procedures that you would expect to see exercised by head office over operations at the stores.

Answer 28

Budgetary control/comparison of actual to budget
On a store by store basis
Investigation of variances
Inter-store comparisons
Use of key performance indicators (KPIs)
Eg, margins, revenue per employee/floorspace
Store visits

On surprise basis:
Checking compliance with standard procedures •
Confirm physical inventory agrees with records •
Differences investigated •
Cash counts •
To confirm amounts agree with point of sale (POS) records •
Differences investigated •

Agree POS records to amounts banked:
Differences between POS records and bankings investigated •
Delays in banking investigated •

Review of exception reports:
Slow moving inventory •
Difference between book and actual/review of inventory count results •
Level of refunds •

Review of computer usage to monitor changing of passwords/failed access to system

Rigorous HR procedures/disciplinary procedures

Staff references/training/evaluation/employee verification procedures

Question 29

Garfield Educational (Garfield) is a-not-for-profit entity whose objective is to support 18 to 21 year old students in full-time education in London with their academic studies.

Garfield awards non-repayable grants to students for items such as personal computers and books or for
expenses such as travelling to their place of study.

Students apply to Garfield for support and, if their application is successful, the grant is paid by electronic bank transfer into the students’ bank accounts.

Requirement
State four internal control procedures that should be exercised over the awarding and payment of grants to students

Answer 29

• Applications from students to be on standard forms
• Background checks to confirm that applicants are bona fide, for example, students are 18 to 21 year olds and are in full time education in London
• Adequate documentation is presented to the decision makers •
• Any conflicts of interest are declared and recorded by decision makers •
• Formal authorisation of the grant by decision makers or senior management •
• Records of grant decisions are maintained •
• Evidence that the grant is spent properly, eg, copies of invoices •
• Segregation of duties between awarding and payment of the grant •
• Limits on the amount payable to one student •
• Comparison of bank payments to approved applications •
• Monitoring of procedures to ensure compliance

Question 30

The directors of Madison Ltd (Madison) have prepared an insurance claim for loss of profits following a fire at one of Madison’s factories.

The directors have engaged your firm to review the claim and provide an assurance report, as the directors believe that this will accelerate the processing of the claim.

Requirements
Identify the points, specific to the review of the claim, that your firm should include in its engagement letter and explain why their inclusion is necessary.

Answer 30

Responsibilities of the firm •
- To review the claim –
Responsibilities of Madison •
- To prepare the claim –
- To provide written representations and access to information  –

Limited level of assurance •
- Expressed negatively –
To avoid any misunderstanding and reduce expectations gap •
Identify the intended users of the report •
- Limit liability to unforeseen parties –
Agreement to limit liability •
- Reduce exposure to damages.

Question 31

Contrast the purposes of walk-through tests with the purposes of tests of controls when considering the internal controls of an external audit client.

Answer 31

Walk-throughs:

• Designed to establish that internal controls exist and are as documented •
• Obtain an understanding of the audited entity’s internal controls, accounting systems and processes
• Will influence auditor’s decision whether to plan to rely on internal controls or perform substantive procedures only
• Cannot place reliance on walk-through for purpose of obtaining audit assurance •

Tests of controls

• Designed to obtain sufficient appropriate evidence as to the operating effectiveness of relevant internal controls where:
• Auditor intends to rely on operating effectiveness of controls in determining nature, timing and extent of substantive procedures and to gain assurance on which to base audit opinion
• Substantive procedures alone cannot provide sufficient appropriate audit evidence •
• May allow reduced substantive procedures to be undertaken

Question 32

Your firm has been engaged by Queen Ltd (Queen) to undertake a review of, and provide assurance on, the interim financial information for the six months ended 31 July 20X3.

Queen produces a range of sausages which it sells to supermarkets in the UK and the rest of Europe.
Supermarkets are invoiced in their local currency.

In the six months to 31 July 20X3, Queen opened a number of its own retail outlets in the UK selling directly to the public and has increased sausage production using spare capacity in its factory.

Your preliminary analytical procedures have identified the following as matters of significance to discuss with
management:

Increase in revenue: 5% to 16%
Gross profit margin: 26% to 32%
Operating Margin: 19% fallen to 12%

Requirement
Using the information above, identify the enquiries you should make of the management of
Queen that will help your review of the financial information.

Answer 32

Enquiries you should make:
Is the revenue increase wholly due to new retail outlets?
Have selling prices increased without a corresponding increase in input costs?
Is increase in overall gross profit margin due to retail outlets having higher gross profit margin?
What was the impact of exchange rates on revenue/selling prices? •
Have raw material costs reduced, eg, bulk purchase discounts or changes in suppliers? •
Has gross profit margin increased due to use of spare capacity in factory/economies of scale?
The fall in operating margin is inconsistent with increase in gross profit margin – could costs have been misallocated between cost of sales and operating expenses?
Have costs of opening and operating the retail outlets led to fall in operating margin? •
Were cut-off procedures in place for revenue and costs?

Question 33

Your firm is the external auditor of Magpies Ltd (Magpies) for the year ended 30 November 20X4.

On 15 November 20X4, the directors of Magpies engaged a firm of expert property valuers to provide an independent valuation of the company’s freehold land and buildings.

The directors intend to recognise freehold land and buildings at this valuation in the financial statements for the year ended 30 November 20X4.

Requirement
State the audit procedures that your firm should plan to undertake to determine whether the valuation provided by the firm of expert property valuers can be used.

Answer 33

Perform background checks on the expert and consider: •
Independence and objectivity –
Qualifications –
Experience/competence/expertise –
Reputation/credibility –
- Obtain a copy of the valuer’s report •
- Consider reasonableness of the basis of valuation/assumptions •
- Review the valuer’s letter of engagement and determine appropriateness of scope •
- Compare valuation to the value of other similar properties in the locality •
- Consider the use of an auditor’s expert.

Question 34

Your subsequent events review, performed during the audit of Ice Ltd for the year ended 31 December 20X4, included reading the minutes of board meetings held after the year end.

Minutes of the board meeting held on 16 February 20X5 identified that the company failed a routine health and safety inspection performed by industry regulators in January 20X5.

Requirement
Outline the further audit procedures you should perform in respect of this matter.

Answer 34

Review report of health and safety regulator •
Ascertain if failure relates to events before the year- end

Ascertain likely actions to be taken against Ice, such as:

• Withdrawal of licence/closure and whether temporary or permanent –
• Fines and likely amounts –
• Review the outcome of similar cases •
• Discuss with directors how they propose to respond to the failed inspection •
• Review press coverage for any adverse comment •
• Review post year-end management accounts to assess impact on company performance •
• Obtain and review updated cash flow forecasts and consider implications for Ice’s ability to meet debts as they fall due
• Consider whether financial statements need amending

Question 35

The risk of management override of internal controls is present in all audited entities.

Requirement
State three procedures that should be included in external audit plans to address this risk

Answer 35

Substantiate journal entries •
Investigate reconciling items •
Review significant accounting estimates and judgements for bias •
Investigate transactions outside the normal course of business •
Review ‘whistle-blowing’ arrangements •
Review internal auditor’s reports •
Interview management to assess its attitude towards the control environment •
Review minutes of management meetings

Question 36

You are responsible for planning the external audit of Squid Ltd (Squid) for the year ending 30 September 20X5. Today, you read a newspaper article stating that Squid, a manufacturer of dried food products, has recalled its leading baby milk powder from supermarkets due to a number of batches being contaminated with substances that may be harmful to babies.

Requirement
Briefly explain the matters you should consider, as part of your audit planning, as a result of reading the newspaper article.

Answer 36

Reasons why milk powder became contaminated •
Whether it resulted from breach of regulations, as may:
- indicate inadequate internal controls/weak control environment –
- indicate lack of management integrity –
- result in fines/penalties from regulators
- result in suspension of licence/closure –

Whether any other areas/items affected •
Whether any babies have been harmed by contamination which may result in:
- legal claims against Squid –
- potential significant uncertainty –

Potential negative impact on Squid’s reputation/bad publicity resulting in loss of revenue •

Increased risk of material misstatement: •
- Refunds for returns –
- Irrecoverable trade receivables –
- Inventory to be written off –
- Provisions/contingent liabilities for legal claims/fines –
- Squid may no longer be a going concern/doubts over going concern (GC): –
GC basis of preparation may not be
appropriate/break-up basis required ◦
Uncertainty over GC may not be adequately
disclosed

Question 37

Becker LLP has been invited to tender for the external audit of Laver plc (Laver) a listed entity.

The principal activity of Laver is the retailing of food, clothing and household goods through its 500 UK stores and its e-commerce platform. The audit committee at Laver has requested that the tender document includes a section on how the external auditor will use data analytics in the course of the audit.

Requirement
List four matters in respect of the use of data analytics routines to be included in the tender document.

Answer 37

• Comparing the last time an item was bought with the last time it was sold, for cost/NRV purposes
• Inventory ageing and how many days inventory is in stock by item •
• Analyses of revenue trends split by product or region •
• Analyses of gross margins and sales, highlighting items with negative margins •
• Matches of orders to cash and purchases to payments •
• Three-way matches between purchases/sales orders, goods received/despatched documentation and invoices

Question 38

During the external audit of Murray plc (Murray), your firm is planning to use data analytics routines to gain assurance that revenue is fairly stated in the financial statements for the year ended 31 May 20X6.

The principal activity of Murray is the retailing of discounted branded goods, including designer clothing, beauty products and household goods, at up to 60% off their recommended retail prices.

Sales are made through Murray’s 25 retail outlets, located in cities throughout the UK, and through its website. All retail outlets use electronic point of sale
(EPOS) systems and the website has online ordering and payment facilities.

Requirement
List four data analytics routines that your firm could perform on data from Murray’s information
systems.

Answer 38

• Analyses of revenue trends split by product or region
• Analyses of gross margins and sales, highlighting items with negative margins •
• ‘Can do did do testing’ of user codes to test whether
  segregation of duties is appropriate, and whether any inappropriate combinations of users have been involved in processing transactions
• Identify who is raising journals and when •
• Compare the number of manual vs system-generated journals •
• Year on year comparisons of journal entries

Question 39

During the course of the audit of Novak Ltd (Novak) it was discovered that the company does not routinely update its anti-malware software.

Requirement
In respect of this internal control deficiency, draft points for inclusion in your firm’s report to those charged with governance and management at Novak.

You should outline the possible consequence(s) of the deficiency and provide recommendations to address it.

Answer 39

Internal control deficiency
Novak does not have procedures in place to ensure that its anti-malware software is routinely updated

Possible consequences
- Hackers may be able to access Novak’s system
Deliberate sabotage could take place •
Malicious programs could be inserted into the system •
Loss, theft or misuse of data •
Reputational damage •
Failure to protect legally defined personal data •

Recommendations

• Policy to be updated, implemented and communicated to staff •
• Responsibility for updates to be allocated to a designated person who should sign off to confirm that updates have taken place
• Designated person should report compliance on a regular basis •
• Monitoring of procedures and disciplinary action for breaches of policy

Question 40

During the year ended 31 May 20X6, Federa Ltd (Federa) outsourced its payroll processing to a service organisation which provides Federa with monthly payroll information relating to its employees.

Federa uses this information to pay the wages and salaries directly into its employees’ bank accounts and the relevant payroll taxes to the tax authorities.

Requirement
Identify the business risks arising out of Federa outsourcing its payroll processing and explain
the implications for the financial statements.

Answer 40

Risks of outsourcing payroll function
- Loss, theft or misuse of personal data •
- Reputational damage •
- Fines for late submission to the tax authorities •
- Fines for breach of data protection legislation •
- Potential material misstatements in the financial statements, such as: •
Failure to recognise provisions –
Failure to disclose contingent liabilities in respect of fines

Question 41

During the year ending 30 November 20X6, the audit committee of Baikal plc (Baikal) is scheduled to meet three times. One of the terms of reference of the audit committee of Baikal is to monitor the effectiveness of the outsourced internal audit function.

Requirement
List the matters that should be considered by the audit committee at its meetings during the year ending 30 November 20X6 that will help it to meet this term of reference.

Answer 41

Matters that should be considered by the audit committee to monitor the performance of the internal audit function:
Audit committee to consider the internal audit function’s:
- Planned programme of work –
- Arrangements for direction and supervision of work –
- Completed reports –
- Independence and objectivity –

Establishment of performance indicators such as:

• Actual time compared to budget –
• Actual work completed compared to planned work –
• Number of recommendations accepted –
• Feedback from users –
• Numbers of qualified staff used –

Monitoring of performance indicators

Question 42

Siloe Ltd is a small company that has made operating losses for several years. Its ability to continue to operate as a going concern depends on it receiving further loan financing within the next three months.

List factors that may give rise to risks of misstatement at the financial statement level and factors that give rise to risks of misstatement at the assertion level at Siloe Ltd

Answer 42

• Risk that financial statements are prepared on the going concern basis of accounting, which may not be appropriate
• Alternative basis of accounting may be required, such as the liquidation basis

Assertion level

• Assets will need to be written down for impairment to their net realisable values
• Non-current assets and liabilities will need to be reclassified as current •
• Disclosure would need to be made in relation to the basis of accounting used