ACCA P7 (INT) Advanced Audit & Assurance - Study Text

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Answers to practice questions

individual family members. The risk of misstatement or otherwise depends on

the compliance and integrity of those family members.

The company has very few employees amongst whom it can achieve effective

segregation of duties. Any computerisation of systems may improve efficiency

but controls over such systems in small companies are rarely adequate.

Therefore the audit approach is likely to be wholly substitutive.

The auditor will also need to consider the laws and regulations surrounding

this business sector. In order to properly assess risk he will need a detailed

knowledge of such regulations.

15 Systematic Stores

(1) Audit risk

Our firm’s audit approach is designed to allow us to form an opinion on the

financial statements as efficiently as possible.

The identification of risk of misstatement is the key to this approach since we

will direct particular audit attention to areas where we have perceived that

misstatements are likely, but will not waste time checking for errors or

irregularity where we are satisfied the chance of misstatement is so low as to

be immaterial or insignificant.

Risk at the overall entity level

In assessing the possibility of error in the financial statements there are two

aspects to be considered.

(a) Inherent (or business) risk

This first aspect involves an assessment of the inherent risk of

misstatements attaching to your particular business.

This will be affected by such considerations as the nature of the

business, management philosophy, staff numbers and experience,

timetables for accounts production, recent trends in results and the

current financial position within the retail sector.

We would obviously need to discuss many of these matters with you in

more detail before reaching any conclusions. However, our experience

of audits in the retail sector will, we believe, be a considerable advantage

in interpreting and using the information obtained.

In addition, this inherent risk is affected by the computerised nature of

the systems.

Computers process systematically in accordance with the programming

instructions. There is, therefore, a reduction in risk of random errors in

the day-to-day transactions.

The key risks will be in systems development and the prevention of

technical errors and breakdowns in the hardware and software.

Our considerable experience of computer audits allows us to adopt an

approach which takes advantage of this fundamental nature of

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computerised systems, and which uses, rather than ignores, the

computer.

(b) Control risk

This second aspect involves us assessing the control risk, i.e. the risk that

errors are not being prevented or detected and corrected by the

company’s own systems.

Key factors we would consider here might be as follows:

General computer controls

Clearly, the computerised nature of the systems has a fundamental effect

on the audit risk, but may overall reduce the risk dramatically if there

are good general controls over the environment within which the

computer operates.

In particular, we would be concerned with the following:

 Development controls which ensure that the programs are properly

designed, documented and tested before implementation.

 Operational controls which prevent misuse of the system. These

would include not only personnel controls such as adequate training,

but also software and hardware error protection.

 Continuity controls such as back-up procedures to ensure recovery

from a technical breakdown or error without permanent corruption

of files.

 Access or file security controls to prevent unauthorised access to or

amendment of data or program files.

Management control over branches

In particular we will consider the extent to which budgeting and review

systems and the company’s own internal analytical review of results

would identify significant errors or irregularities in branch figures.

Internal audit

If there is an effective internal audit department it will be possible to

place reliance on the work it does to provide evidence as to the accuracy

of the records, either by direct testing or by testing of the operation of

other detailed internal controls.

Risk at the individual account area level

Again, there are areas we might deem inherently high or low risk simply due

to their nature. For example, stock is inherently liable to misstatement due to:

 shoplifting (‘shrinkage’)

 short shelf lives of perishable goods

 losses arising from any bad press surrounding particular products.

However, we will also consider the particular internal controls, and hence

specific control risk, relating to each area. This will involve assessment of both

Answers to practice questions

manual controls (user controls) and computer controls (programmed

application controls).

Where possible, we will seek to take advantage of the additional controls it

will have been possible for you to set up in the computer system, particularly

in relation to stock.

(2) Materiality

A matter is material if its omission or misstatement could influence the

economic decisions of users taken on the basis of the financial statements.

Our audit approach plans to allow us to detect material misstatements and we

will decide in advance of detailed planning, an approximate materiality

threshold (i.e. the threshold below which an error would not be considered

material) based on the size of key account areas in the financial statements.

There is obviously a direct link between risk and the materiality of any area.

The smaller the area the less likely it can be materially misstated.

Thus we will not direct attention to immaterial areas such as petty cash in the

office, unless this is specific work you would like us to carry out as an

additional routine.

There will of course be certain areas which despite their small size are

particularly important, such as disclosure of directors’ transactions.

16 Top Toys

New client

Inherent risk is increased by the lack of cumulative audit knowledge and experience

which means that the new auditors are not aware of error incidence in prior years.

It is possible that the group auditors would have been appointed had they been

locally represented. In insisting on a local firm, the managing director may well

have been asserting his independence from the parent company. He may think he is

owed a favour in this respect – which may colour initial relationships with the

auditors.

The business

As a prestigious toy retailer, business risk is not unduly high. However, sales will be

seasonal and there is a high risk of stock obsolescence when toys are no longer

fashionable.

Management

Inherent risk is increased because the financial statements are subject to the

dominant influence of John Smith. There may be management bias to overstate

results, for example, to:

 justify the parent company’s retention of the company

 justify the $200,000 bonus or a repeat of it

 ‘empire build’ this location and prevent out-of-town development

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 increase the purchase consideration if the parent company decides to sell Top

Toys.

John Smith is in a position to override controls and abuse his authority. This will

lead to high control risk as suggested by:

 his undermining of the buyer’s authority in ordering 50,000 dolls

 the lack of information about his bonus

 a lack of compliance with parent company’s directives (to develop operations

out-of-town and conduct a year end inventory count).

Limitation of scope

John Smith may attempt to dominate the conduct of the audit and seek to limit

access to staff and accounting records. There is a risk that some disclosable

transactions may not be identified. The known purchase of the 50,000 dolls may be a

related party transaction but there may be other such transactions.

Staff

There is a high risk of errors and even irregularities arising due to:

 lack of training and supervision of trainees

 poor morale (as John Smith appears to consistently undermine the authority of

others).

Going concern

There may be some doubts about the appropriateness of the going concern

assumption. In particular:

 if John Smith retires, he may not be replaced

 proceeding with the out-of-town development may impact on goodwill

 consistently exceeding the major supplier’s credit limit may indicate cash flow

problems

 if supplies are subsequently withheld, another supplier may not be found

 if the bank does not renew the overdraft, continued trading may depend on the

support of the parent company.

Inventories

Specific risks include:

 obsolescence of toys which lose their popularity

 understatement of inventory quantities due to omissions on changeover

 misstatement of inventory quantities due to the lack of system maintenance

 possible overvaluation (e.g. of the 50,000 dolls).

Answers to practice questions

17 Red Recruitment

Circumstance Whytakenintoaccount

Thisisanewaudit

appointment.

Inherentriskisincreasedasthereisalackof

cumulativeauditknowledgeandexperience.

Thecompanyisrelatively

new.



Theconsequentlackofhistoricfinancial

informationwillmakeitdifficulttouseanalytical

proceduresandmarginswillbelargelyirrelevant 

inthistypeofbusiness.

Themanagingdirectorhas

noexperienceofthis

industry.

Thiswillincreaseinherentriskasthebusinessis

less

likelytosucceed.

Themanagingdirectorhasa

vestedinterestinthesuccess

ofthebusiness.

Theremaybebiastooverstateresults.Expenses

maybesuppressed(particularlygiventheway

thesystemoperates)andrevenuemaybe

recognisedbeforeithasbeenearned.

Thereisanapparentlackof

internal

controls.

Thereishighcontrolrisk,particularlyasRoyis

likelytobemoreinterestedindevelopingthe

businessthandevelopingcontrolsystems.

Thecompanyisstillinits

infancyandisonlyjust

operatingwithinitsoverdraft

facility.

Again,theriskofbusinessfailureishighandthe

managing

directormaybemotivatedtooverstate

results.

Bobcaninitiateandexecute

transactionsandhasaccessto

documentsandassets(e.g.

cash)andthereisnoformal

supervisionoverthe

accountingfunction.

Thelackofsegregationofdutiesandsupervision

meansthaterrorsbyBobmaynotbedetected,

therebyincreasing

controlrisk.

Accountingrecordsare

maintainedonaPC.

ThePCenvironmentincreasesbothinherentand

controlrisk.Thereseemtobenoaccesscontrols

andfilesmaybecorruptedbyunauthorised

access.Thelackofgeneralcontrolscouldresultin

asignificantaccountingbreakdown(e.g.inthe

eventof

afire).

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18 PJ’s Powertools

(a) Enquiries and procedures

(1) Provision against warranty claims

Enquiries

 What is the company policy in respect of warranty claims (e.g.

repair, replacement, credit note, refund) and over what timescale?

 What basis/assumptions have been adopted in order to arrive at the

amount provided?

 What changes in the provision have been made compared to the

previous year (e.g. to allow for new/discontinued products)?

 Have any mitigating factors been taken into account (e.g. insurance,

recourse to suppliers of components)?

 Are repairs carried out in-house or sent away?

Procedures

 Read the terms and conditions on sales invoices to identify

circumstances which might make the warranty agreement void (e.g.

servicing must be carried out by authorised third parties).

 Review the company’s schedule of claims received after the

reporting period, identifying those claims rejected.

 Vouch a sample of related labour costs to payroll/time sheet

analyses showing the cost of service labour.

 Reperform the company’s calculations (e.g. extrapolation of

legitimate claims as a percentage of sales).

 Consider management expertise and previous accuracy in respect of

determining provisions.

 Review correspondence with customers requesting work to be

carried out under warranty or identifying defects.

 Review the terms and conditions of the suppliers of the bought-in

components (e.g. counter claims).

 Review consumer reports of the company’s products.

(2) Depreciation charge

Enquiries

 On what dates was the compressed air system delivered, installed

and made operational?

 Was the system installed by the supplier, a sub-contractor, or by PJ’s

Powertools?

 On what basis have costs other than the purchase price been

capitalised?

 What is management’s policy for setting, reviewing and revising

estimated useful lives/residual values?

Answers to practice questions

Procedures

 Agree purchase price and date to supplier’s invoice.

 Physically inspect the asset and observe its operation.

 If the asset replaced a similar system, ascertain the actual useful life

of the previous system and any residual value.

 Compare estimated useful life and depreciation method applied

(straight line, reducing balance etc) to similar items of equipment

used in the assembly process.

 Reperform the calculation of depreciation in accordance with the

stated policy.

 Assess management’s previous accuracy in estimating the useful

lives of assets, e.g. whether any fully depreciated assets are still in

use, the amount of profits/losses arising on disposal.

(b) Why the audit of provisions is a difficult area for the auditor

By definition, provisions are liabilities of uncertain timing or amount.

Auditors are therefore far more likely to have to exercise their professional

judgement in assessing the adequacy of a provision.

Provisions may be estimates based on forecast information rather than historic

information (e.g. forecast sales returns for a warranty provision) and are

therefore subject to a range of possible outcomes.

Auditors may also find that sufficient independent audit evidence may not be

available to confirm the need for/amount of a provision. Some reliance is

likely to have to be placed on written representations.

In addition, subjective areas such as provisions provide scope for

manipulation making them higher risk areas for the auditor. Management

may be motivated to understate provisions if:

 their remuneration is linked to profit

 a takeover or sale is pending

 lenders may foreclose on loans.

Conversely, overstated provisions create hidden ‘reserves’ which can be

utilised to increase profits in a bad year.

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19 Ready Removals

(a)

Auditwork Reasons

(1)Damagesclaim

 Askthedirectorshowtheypropose 

totre attheclaiminthefinancial 

stateme nts(andonwhatgrounds).

 Thematterispotentiallyma terial–

evenaclaimofjust $10,00 0

represents12.5%oftrad ingprofit.

 Inspecttheinvoice/contractwiththe

customertoasc ertai nthetermsand

conditionsandwhethertheantiques

collectionisidentified .

 Thecustomer’sclaimmaybeinv alid

iftheywer eresponsibleforinsurance

orifhigh‐valueitemsshouldhave

beenspecifie d.

 Reviewcorr espondencewiththe

customerandwithsolicitorsandthe

accidentreport/damagerecord.

 Inordertoobtainconsistentthird

partyeviden cetosuppor tinternal

evidence.

 ExamineReadyRemovals’own

insurancecoverdocu ment ation. 

 ReadyRemovalsmayhaveitsown

insurancecoverto coversuchclaims 

fromcustomers.

 Enquirewhetherthedamagewasan

isolatedincident.

 Toascertainwhet hertheremaybe

othersimil arclaimsforwhich

provisionisne eded. 

(2)Ba d/do ubtful debt

 AskReadyRemovals’directorsfor

theirviewsontherecoverabilityof

thedeb t.

 Thematterismaterialasfull

provisionwouldreducetrading 

profitby37.5%.

 AnalyseSp eedyStorage’saccountto

ascertainwhetheritisstillactiveand

whetheranycashhasbeenreceived.

 Thismayhighlightspecificmatters

forinvestigation.Ifcurrentinvoic es

arebei ngsettled,thiscouldindicate

thatthe$30,000isbeingdisputedor

isinvalid(andtheref ore

irrecoverable).

 Selectasmallsampleoftr ansactions

andvouchtosupp orting 

documentation(e.g.invoicesand

remittanceadvices). 

 Toensurethatabona fidedebtexists. 

 InspectReadyRemoval s’contract

withSpeedy Storageandthe

correspondencefile.

 Specialcredi ttermsmayexist

(thoughtheseareunlikelytoextend

tosix months).Correspondencemay

revealdisputedamountsandsteps

takento recoverthem(e.g.warni ng 

letters).

 Conductacompanysearchon

SpeedyStor age.

 Toconfirmthatthecompanyexists

andappearssolvent.Toascertain

whetherthetwocompaniesar e

relatedparties.

Answers to practice questions

 Reviewtheequivalentbalanc e(if

any)inlastyear’sworkingpapers.

 IfSpeedyStorage’sbalancehas 

previouslybeencirculari sed(without

anyr epercus sions),permissionto

confirmthebalancedirectlywith

SpeedyStor agemaybeso ughtfrom

ahigherauthority(thanthefi nancial

accountant).

(3) Overdraft limit



Askthedirectorswhytheyconsider

ReadyRemovalstobeagoing

concern.

 Ifitisnotpossibletodeterminethat

thegoingconcernpresumptionis

appropriatethentherewi llbean

impactontheauditrepor t.

 Reviewthecurrentrefurbishment

programmean drelatedfi nance

arrangements.

 Thegoi ngconcernpr esumptionmay

notbeappropriateiffinanceisnot

forthcomingtofini shthe

refurbishmentproject(e.g.ifthe

companyisunabletotrade).

 Reviewcorr espondencewiththe

bankand prospectivelendersse eking

additional borrowingfacilities. 

 Thecompanyshouldtakestepsto

increaseitsborrowingfacilitiesas

long‐terminvestmen tcannotbe

sustainedonanoverdraft facility.

 Discusswi thdirectorsanyalternative

coursesofactiontoalleviatethecash

flowproblem. 

 Iftherecentinvest mentinnew

removalvanswasforoutright

purchase,saleandleasebackmaybe

arrangedto raisefunds.

(b) Letter of representation (extracts)

(1) No provision is considered necessary in respect of a legal claim by Mr X

for damage to reproduction furniture. No amounts are expected to be

paid, and no similar claims have been received or are expected to be

received.

(2) We confirm our considered view that the company has adequate

resources to continue operations for the foreseeable future (i.e. is a going

concern). This conclusion has been reached based on forecast

expenditure and current and future borrowing arrangements.

Tutorial note

In part (b), the representation for the legal claim assumes that audit work will validate

the assertion that the collection is not antique.

Written representations on the debt from Speedy Storage are not appropriate. If

sufficient evidence cannot be obtained to confirm the recoverability or otherwise of this

debt, the limitation on scope will result in a qualified audit opinion.

Paper P7 INT: Advanced audit and assurance

20 Fine Feathers

(a) Accounting and auditing issues

(1) Amortisation of lease premiums

Accounting issues

Per IAS 16 Property, plant and equipment the depreciable amount of an

asset should be allocated on a systematic basis over its useful life.

If the premiums are associated with periods of reduced rent then it may

be appropriate to charge all/a greater part of the premium to these

periods. The reduced rent charges in the income statement/statement of

comprehensive income would then be matched with the increased

amortisation charge in those periods.

The depreciable amount of an asset is calculated after deducting its

realisable value from its initial cost. If the site is unlikely to be retained

for the whole period of the lease then the company will need to consider

the realisable value.

Unless the premiums are associated with a period of reduced rent, a

straight line basis of amortisation is most likely to be appropriate,

matching the lease cost to the period over which it will generate

revenue.

If the company decides to sublet the site, impairment reviews under

IAS 36 Impairment of assets may be necessary towards the end of each

lease when rents able to be negotiated are likely to be lower.

Auditing issues

Given the company’s continued growth the area will be material.

The terms of each lease are likely to differ, given that they are all in

different cities. It may be difficult to assess for each site:

 whether any premium is associated with a period of reduced rent

 whether the site will be held for the whole of the lease term (i.e.

whether that site will continue to be profitable/prime), and

 if not, what the realisable value of the lease might be.

It may be necessary to use the work of a property expert.

(2) Refurbishment of new sites

Accounting issues

Per IAS 16 cost comprises purchase price plus any costs directly

attributable to bringing the asset to the condition necessary for it to be

capable of operating in the manner intended by management.

Consultants’ costs, labour and material costs etc would all be likely to

meet this definition but rates are non-incremental costs and so should

not be capitalised. Service costs (gas and electricity?) might be

considered incremental provided they relate to the period of

refurbishment but it may be more prudent to write these off.

ACCA P7 (INT) Advanced Audit &amp; Assurance - Study Text - 2010 (Emile Woolf Publishing)

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ACCA P7 (INT) Advanced Audit & Assurance - Study Text - 2010 (Emile Woolf Publishing)