ACCA F8 (INT) Audit & Assurance - 2010 - Study text - Emile Woolf Publishing
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Strengths Significance
Howitemsaretobemarked
(andwhere)isnotspecified.
Counteditemsmu st beclearlyidentifiableto
ensurethecompletenessofthecount,prevent
double‐countingandfacilitatesubsequen t
checking(seebelow).
Ther eistobenocheckonthe
counts.
Some,ifnotall,countssh ouldbeindependently
countedbyacheckertoconfirmtheaccuracyof
thefirstcount.
Overall evaluation
The instructions are currently inadequate. A new set of instructions should be
drafted to deal, in particular, with:
the roles of warehouse personnel
how inventory is to be identified, quantities recorded and counts checked
the additional inventory movements which could occur (e.g. raw material
supplies from suppliers).
32 Debtco
(a) Factors in selecting sample
The objective of the test
The objective is likely to be to test for overstatement. Therefore the sample
should be weighted towards the higher value items.
High risk items
In selecting the sample, certain types of account should be considered for
inclusion. These include:
overdue accounts
credit balances
accounts on which round sum payments are received
nil balances
as they may indicate errors or possible bad debts.
Individually significant items
The eight largest balances should be confirmed as any balance over $50,000,
represents 25% of profit before tax and is therefore individually material.
Items to be confirmed
Balances or specific invoices can be confirmed. Balances would be preferable
in the first instance as the percentage of the receivables ledger confirmed will
be greater.
Method of sample selection
Random, systematic or judgement sampling could be used. Systematic
sampling would be preferable, as there is no bias. It could also be weighted
towards higher value items.
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Method of confirmation
This should be a positive request as opposed to a negative request. However,
there is a choice to be made between whether the balance is supplied or not.
The latter may provide stronger evidence but the former may lead to more
replies.
(b) Procedures
Planning
Discuss with management any customer balances which they consider
should not be confirmed (e.g. credit balances).
Plan the sample size to take account of such factors as materiality.
Agree the client’s reconciliation of the total of the individual balances (on
the receivables ledger) to the balance per the receivables ledger control
account (in the nominal ledger).
Arrange when the requests are to be sent.
Performing
Review all request letters to verify that they are on client’s headed
notepaper and signed by an appropriate client official.
If the balance is provided, ask for any difference to be reconciled to an
enclosed statement.
Enclose a reply paid envelope (addressed to the audit firm) in each request
letter.
Mail the letters from the audit firm’s office.
Following up the results
Record all replies on a control schedule.
Non-replies may be followed up with a second letter or (with the client’s
approval) fax or telephone.
If direct confirmation is not obtained, examine customer orders, despatch
records, invoices and after-date payments (for evidence of existence and
amount due).
Disputed balances or invoices should be investigated by the client (in the
first instance).
For invoices on a customer’s statement but not included in the customer’s
records, agree invoice details to despatch records (to confirm existence at
the confirmation date).
For cash claimed to be in transit by the customer (not on the statement)
agree the amount and date on which it was received to cash book receipts
and bank records.
For returns, agree amounts to after-date credit notes and, if material,
confirm that the client has included them in a year end accrual.
Summarise and evaluate the results. Review the nature and effect of any
errors.
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33 Cash and bank
(a) Four matters which would be included in a bank confirmation letter
Account balances
Any balances held by the bank (current, deposit or loan balances) will be
confirmed by them. This will provide the auditor with reliable third party
evidence in respect of amounts held or owed at the year end.
Assets held as security
The letter would detail any charges held by the bank over the client’s assets.
This information is needed by the auditor so that he can check that adequate
disclosure has been made in the financial statements.
Other assets held
This would include particulars of assets such as title deeds and share
certificates. This information provides evidence substantiating the ownership
and existence of other assets such as property and investments.
Outstanding interest and charges
This information substantiates the accruals figure at the year end.
(b) Audit evidence
(i) Cash at bank and bank loan
Reperform the year end bank reconciliation(s) and review earlier
monthly reconciliations.
Agree a sample of reconciling items (e.g. unpresented cheques,
outstanding lodgements) to supporting documentation and to post
year end bank statements.
For outstanding lodgements check that paying-in slips are dated by
the bank as pre year end.
Ensure cut-off is correct by reviewing transactions either side of the
year end.
Obtain a bank confirmation letter.
Check that any accounts opened or closed during the year were
authorised.
Note any rights of set-off.
Confirm details of security given for the loan and ensure disclosure
of such security is adequate.
Check interest rates, terms of loan etc to the loan agreement.
Check that loan repayments due within the next year are disclosed in
current liabilities.
(ii) Cash
Review system for ensuring security of travellers’ cheques and cash.
Count floats, cash and travellers’ cheques at year end.
Verify that unbanked cash was banked after the year end.
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34 Payables ledger balances
(a) Arguments for each approach
Suppliers are more likely to reply if the balance is given as there is less work
involved for them. However, there may be a temptation just to agree the
balance without checking it for timing differences or errors.
If the balance is given, the supplier may reconcile any difference. This is not
possible if no balance is stated. In addition, the existence of any difference will
alert the supplier to a potential need to take action.
If the balance is not given, suppliers may gain the impression that the client’s
records are so inadequate that the client does not know what the balance
should be.
(b) Other substantive procedures to verify the amount of trade payables
Examine supplier statement reconciliations. Balances should have been
agreed/reconciled by the client and the detail on the statement agreed
with the client’s records.
Test the reconciliation of the list of payables ledger balances to the balance
on the payables ledger control account.
Match after date payments to year end balances.
Review cut-off procedures and test by reference to last delivery
notes/goods received records prior to the year end and first ones after the
year end.
Compare trade payables balances this year end to last year end and
investigate any differences.
(c) Substantive procedures re the existence of unrecorded liabilities
Enquire as to whether directors are aware of any actual or contingent
liabilities other than those recorded in the financial statements.
Review minutes of directors’ meetings.
Examine:
− after date cash book (for post year-end payments of unrecorded year-
end liabilities)
− purchase invoices received post year end (to check that if they relate to
pre year-end purchases, that those purchases have been accrued for)
− sales returns made post year end (to see if a returns allowance is
needed).
Compare liabilities last year end to this year end to see if similar categories
of liabilities have been omitted this year.
Request the directors to confirm the completeness of liabilities in the letter
of representation.
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35 Audit of accounting estimates
(a) Difficulty of auditing accounting estimates
Accounting estimates are just that – estimates. They are not capable of precise
measurement and management will have used their judgement in arriving at
those estimates. The auditor must therefore use his judgement in assessing
whether those estimates are reasonable.
Because most of such estimates are made by management, independent audit
evidence may be limited. Much of the evidence in respect of the estimates will
depend on the reliability of management themselves.
Because of the subjectivity attached to estimates they are a means by which
the financial statements could be manipulated. This is therefore a high risk
area of the audit.
(b) Audit evidence re provision for damages
Examine contract with the customer to establish the nature of the
contract.
Review correspondence with the customer and legal advisors to assess
the likely outcome.
Review events after the reporting period to establish if the claim was
subsequently agreed or settled.
Consider the possibility of other, similar breaches for which a provision
is necessary.
Obtain management representations, confirmed in writing, that all
contingencies have been disclosed.
36 Izzard Electronics
(a) Management representation letter – reliability and need for other evidence
Normally, the management representation letter is drafted by the auditor, but
it is written on the client’s headed notepaper and signed by the directors.
Alternatively, the letter may be written by the directors, but contain matters
requested by the auditors.
As audit evidence, it is written evidence (which is better than oral evidence)
but it is evidence from within the company and thus it is not as independent a
source of evidence as most other evidence obtained by the auditor (e.g. third
party evidence and evidence obtained directly by the auditor).
Arguably, evidence from the directors may be less reliable than evidence from
the company’s employees, as there may be more pressures and motivation for
the directors to mislead the auditor (e.g. because of external pressures on them
to produce good results). However, statements from the directors may be more
reliable than those from employees, as they will have a better understanding
of the situation and, in their position as directors, should be aware of the
importance of the statements they make to the auditor. Under most systems of
company law, a company director commits an offence if he knowingly or
recklessly makes a misleading, false or deceptive statement to the auditor. The
directors should be aware of such provisions and this should make them
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cautious of what they say to auditors, particularly when it is later put down in
writing.
In some relatively immaterial areas, the auditor may accept the directors’
statements without seeking further evidence. However, in most situations, the
auditor should attempt to find alternative evidence to support (or refute) the
directors’ representations. Thus, in determining whether all sales income has
been recorded in the financial statements, the auditor should obtain other
evidence and would probably be negligent if the directors’ representations
were relied on entirely.
In addition, the auditor must consider whether the directors’ representations
are consistent with the other information he has obtained. If this evidence is
consistent, then the directors’ representations will reinforce the evidence
obtained by the auditor. However, if the other evidence obtained by the
auditor is not consistent with the directors’ representations, the auditor should
be extremely careful before accepting what the directors say. The auditor
should seek further evidence to either refute or confirm the directors’
statements. If there is a material difference between the other evidence and the
directors’ representations, the auditor will probably have to qualify his audit
report.
(b) If the directors refuse to sign the management representation letter
The auditor should ask the directors why they are refusing to sign the letter.
The auditor should explain the following:
It is a normal procedure for the auditor to draft the management
representation letter and ask the directors to sign it.
The audit opinion will be based mainly on audit work which does not
involve representations from directors. However, directors’
representations are helpful in providing further evidence that the financial
statements are free from material error.
Company law requires the directors to sign the financial statements. This
provides evidence that the directors believe the financial statements are
free from material error. Thus, this is similar to the directors signing the
management representation letter.
If the directors are still unwilling to sign the letter, the auditor should
ascertain which paragraphs they are unhappy about. The wording of these
paragraphs should be discussed to see if alternative wording can be agreed.
However, it would probably be unacceptable to remove the paragraphs where
the directors confirm completeness of income or the validity of expenditure.
If the directors continue to refuse to sign the letter, the auditor should be put
on his guard that the directors may be hiding something. Both of these areas
create strong suspicion of potential fraud. Cash sales could be
misappropriated and the directors could be putting personal expenses
through as business expenditure.
The auditor should therefore carry out additional audit procedures in the
areas over which the directors are refusing to sign.
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If these additional procedures fail to provide adequate evidence then:
the audit report should be qualified on the grounds of a scope limitation,
and
the auditor should consider the reliability of other representations
obtained from the directors during the course of the audit.
37 Subsequent events
Inventory of finished goods
Post year end sales can be reviewed to check sales prices and therefore the net
realisable value of inventories. A lack of post year end sales may indicate that an
allowance for obsolescence is needed.
Correspondence with customers may provide evidence of product faults or
other problems which may indicate that an allowance for returns or legal claims
is needed.
Credit notes issued after the year end may provide evidence of product faults
which may indicate that an allowance for returns or obsolescence is needed.
Trade receivables
Post year end cash receipts provide evidence as to the recoverability of year end
balances.
Correspondence with customers may provide evidence of disputes which may
affect the recoverability of individual year end balances.
Trade payables
Post year end payments to suppliers may provide evidence of unrecorded year
end liabilities.
Correspondence with suppliers may provide evidence of unrecorded year end
liabilities.
Bank overdraft
Post year end receipts and payments may provide evidence of the likelihood of
the company staying within its overdraft facility (as, if it does not, and the
facility is withdrawn or secured on key assets, then the going concern of the
company may be in doubt).
Correspondence with the bank may indicate whether support is ongoing or
likely/about to be withdrawn.
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38 Eden Electronics
(a) Types of modified opinions
ISA 705 Modifications to the opinion in the independent auditor’s report states that
modified opinions are issued in the following circumstances:
(i) The auditor has been unable to obtain sufficient appropriate audit
evidence
This is often referred to as a ‘limitation on scope’ modification. If the
possible effect of a limitation on scope is ‘material and pervasive’, the
auditor is unable to express an opinion on the financial statements. He
will thus express a disclaimer of opinion.
An example might be where a company’s accounting records have been
completely destroyed by fire and therefore the financial statements may
include a significant amount of information which has been estimated.
In such circumstances, the auditor will be unable to form an opinion as
to whether the financial statements show a true and fair view, and a
disclaimer of opinion must be given.
If the auditor concludes that the possible effect of the disclaimer is
‘material but not pervasive’, he will give a qualified opinion, using the
phrase ‘except for’.
An example might be where a material amount of a company’s sales are
cash sales over which there was no system of control on which the
auditor could rely and there were no other satisfactory audit procedures
which are able to confirm that cash sales are correctly recorded.
(ii) The financial statements are materially misstated
Here, the auditor disagrees with the amount, classification, presentation
or disclosure of an item in the financial statements. If the matter is
material and pervasive to the view given by the financial statements, an
adverse opinion will be given.
An example might be where a company has not provided for large
losses expected to arise on contracts being worked on. In such
circumstances the auditor may give an adverse opinion because he
concludes that the significance of the matter is pervasive to the view
given by the financial statements.
If the matter is material, but not pervasive, then a qualified opinion will
be given using the phrase ‘except for’.
An example might be where a company has not made an allowance
against a debt outstanding at the year end when the customer has
subsequently gone into liquidation. In such circumstances, the auditor
will give an ‘except for’ opinion disagreeing with the lack of an
allowance against the doubtful debt.
(b) Eden Electronics
The situation of Eden Electronics would lead to a qualified opinion on the
grounds that the auditor has been unable to obtain sufficient appropriate
audit evidence. The main elements of the audit report would therefore consist
of the following:
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(i) Title – indicating that it is the report of an independent auditor.
(ii) Addressee – report to the shareholders.
(iii) Introductory paragraph identifying the entity and its financial
statements that have been audited.
(iv) Management’s responsibility section – describing management’s
responsibilities for internal controls, accounting policies and accounting
estimates.
(v) Auditor’s responsibility section – describing the process of audit and
stating that the audit was conducted in accordance with ISAs. The last
sentence in this section will refer to the fact that the audit evidence
obtained was sufficient and appropriate to provide evidence for this
qualified opinion.
(vi) Basis of opinion paragraph describing the matter which has given rise to
the modification and quantifying it if possible. It will be possible here to
refer to the monetary amount at which inventory is included in the
financial statements, over which the auditor has been unable to obtain
sufficient evidence.
(vii) Opinion paragraph stating that in the auditor’s opinion except for the
possible effects of the above matter, the financial statements give a true
and fair view/have been prepared in accordance with the applicable
financial reporting framework.
(viii) The report would be signed (as registered auditors), the address given,
and dated.
39 Posh Perfumes
(a) Further information
Whether the supplier difficulties are temporary or permanent.
Whether the supplier is taking action to overcome its problems (and
whether Posh Perfumes is considering offering financial support to the
supplier).
Legal advice taken with regards to the possibility of negotiating a break
clause in the agreement with the store.
Any costs/penalties arising from the above.
Legal advice taken with regards to the possibility of altering the agreement
to cover an alternative acceptable product or sub-leasing to a competitor to
mitigate costs.
The nature and extent of Posh Perfumes’ other activities and its ability to
expand trade in those areas.
What the current level of inventories is and whether it is sufficient to tide
over the company until supplies are resumed or an alternative product is
found.
Willingness of Posh Perfumes’ bankers to extend/grant any overdraft
facility.
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(b) Possible forms of opinion
Where the going concern assumption is appropriate but a material uncertainty
exists the auditor must consider whether the financial statements:
adequately disclose the principal events or conditions that may cast
significant doubt on the entity’s ability to continue as a going concern and
management’s plans to deal with those events or conditions, and
disclose clearly that there is a material uncertainty related to events or
conditions that may cast significant doubt on the entity’s ability to
continue as a going concern.
If there is adequate disclosure then the auditor should express an unmodified
opinion but should use an emphasis of matter paragraph to highlight the
uncertainty and to draw attention to the relevant note in the financial
statements.
If there is not adequate disclosure then the auditor should express a qualified
or adverse opinion.
Where the going concern assumption is inappropriate the auditor should
express:
an adverse opinion if the financial statements have been prepared on a
going concern basis
an unmodified opinion if the financial statements have been prepared on
an alternative acceptable basis (e.g. break-up basis) and there is adequate
disclosure of this basis. An emphasis of matter paragraph may be required.
40 Creed Computers
(1) Inventory records and PCs held by directors
Weaknesses
The inventory records are not a reliable record of actual inventory held
because:
customer returns have not been recorded
some items recorded as being in inventory are missing
Some ‘missing’ items are held at directors’ own homes.
Implications
Year end inventories may be misstated if reliance is placed on year-end
inventory records instead of a year-end count.
Inventory losses may go unnoticed until the next physical count delaying
insurance claims and making theft more likely.
Customers may not be given credit for goods returned such that trade
receivables will be overstated and there may be a loss of customer
goodwill.
PCs ‘borrowed’ by the directors are unlikely to still be suitable for resale at
their full value and may need to be written down in the financial
statements.
Orders could be accepted which cannot be fulfilled if decisions are taken
based on incorrect inventory records.