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Answers

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Part 2 Examination - Paper 2.6(INT)

Audit and Internal Review (International Stream) June 2003 Answers

1 (a) Performance

(i) The company has increased its revenues by 12% and its gross profit by 16% which in a competitive market is very

good (if not entirely credible) however, increased operating expenses have resulted in a reduction in operating profits of

20%.

(ii) The gross margin is very high; this is not abnormal in this sector, especially for software (although the margin is high

for hardware), but it may also be the result of errors, because the information has been produced very quickly. This is also

true of the other figures.

(iii) Total expenses as a percentage of revenue have increased substantially with the result that operating profit as a

percentage of revenue has reduced by around a third.

(iv) The increase in the selling expenses as a percentage of revenue may reflect the need for the company to spend more

on advertising.

(v) The increase in the distribution costs as a percentage of revenue may reflect inefficiencies in the method of distribution

in an industry that separates these functions.

(vi) The administrative expenses as a percentage of revenue have halved although they do not represent a significant amount

in absolute terms.

(vii) The reduction in operating profits has been partially offset by increased net interest receivable but profit before tax is still

down 10%.

(viii) The reduction in profit before tax and the increased tax charge have resulted in a reduction in profit after tax of over

40%.

(ix) Total dividends have been increased, despite the lower profits.

(x) The reduction in earnings per share is partly due to the reduction in profits but there is insufficient information to state

whether it is also attributable to an increase in the number of shares, although this seems likely.

(b) Higher risk areas and audit procedures

Gross margin and operating expenses

(i) I would obtain a detailed schedule of revenue and cost of sales showing the opening and closing inventory figures for

both software and hardware and I would perform a detailed review of changes on, say, a monthly, quarterly and halfyearly

basis.

(ii) I would ascertain the accounting policies for revenue recognition for both software and hardware and ensure that they

were in accordance with relevant International Accounting Standards. I would then test the application of these policies to

individual transactions. IAS 38 Intangible Assets requires that certain development costs be capitalised in the balance sheet

and that research costs and costs that do not meet the criteria for capitalisation be expensed.

(iii) I would seek to establish why all three categories of operating expenses have changed so dramatically, by enquiry and

by obtaining a schedule of operating expenses and a breakdown of the cost of sales figure.

(iv) I would perform detailed analytical procedures on operating expenses and cost of sales/gross margins, on a quarterly

and monthly basis and I would also perform detailed testing of transactions in these areas in order to ensure that

misclassifications have not occurred.

(v) Audit evidence provided by balance sheet work on the inventory figures (such as analytical procedures performed on

the inventory levels and attendance at the inventory count) will also provide evidence in relation to cost of sales.

(vi) It is possible that some reclassifications or even errors have been made - some costs appearing as operating expenses

might properly belong in cost of sales. It certainly seems odd that whilst sales have increased by 12%, the cost of sales

figure has hardly increased at all. The reduction in administrative expenses should also be investigated.

(vii) I would obtain schedules relating to non-current assets and establish the extent to which these had contributed to anincrease in depreciation costs. I would enquire as to the nature of the additions and their purpose. Additional non-current

assets would also be expected to contribute to revenues. If the change in the earnings per share figure is (partly) a result

of a new issue of shares, it may be that the cash generated has been used for investment in non -current assets.

(viii) Because of the possibility of errors, I would increase my sample sizes during tests of controls over the recording,

processing and posting of transactions that are posted to revenue, cost of sales and operating expense accounts.

(ix) I would perform detailed substantive testing on samples of transactions in these areas from source documentation (such

as licensing documentation, payroll records, purchase invoices for components etc.) through to the daybooks, ledgers, and

schedules supporting the income statement (for completeness), and vice versa.

(x) The extent of substantive procedures will depend on the extent to which controls are shown to be effective and I would

be particularly careful to follow up any errors discovered in both tests of controls and substantive testing. I would also pay

particular attention to any unauthorised, substantial or late adjustments.

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Interest receivable

(xi) I would ask for a breakdown of, and explanation for, the increase in net interest receivable. I would perform further

analytical procedures on the interest costs and income and ensure that these are in line with current interest rates and

the types of investments held by the company.

Taxation

(xii) It seems strange that the tax figure has increased so dramatically. I would ask for copies of the tax calculations for

detailed review, and to corroborate explanations provided by management.

Dividends and earnings per share

(xiii) I would enquire as to why dividends had increased, despite the lower profits, and establish whether this trend can bemaintained in the face of falling profits. I would also enquire as to whether the company has a ny plans to restructure in

line with trends in the industry, what the company intends to do about the competition, and whether there is any

possibility of a take-over.

(xiv) I would establish whether there had been any share issue during the year that had affected the calculation of the

earnings per share and, if there had been, what was the purpose of the share issue.

2 (a) Importance of inventory counting

(i) Inventory counting is important to auditors of manufacturers, wholesalers, retailers and many service organisations.

Inventory counting is the best way to establish quantities for valuation purposes and it assists management in making

appropriate provisions against obsolete, slow moving and damaged items.

(ii) Inventory counting provides the only direct evidence in relation to the existence of inventory. Performed properly,

counting also provides evidence on cut-off, certain frauds and on the quality of internal controls over inventory.

(iii) Auditors should attend inventory counts where inventory is material to the financial statements (balance sheet or income

statement).

(b) Perpetual inventory system

(i) The purpose of a perpetual inventory system in practice is to control inventory. Such a system involves cyclical counting

procedures during the year. Such procedures avoid the need for reliance on a year-end count. If auditors wish to rely on

the records rather than a year-end count for the purposes of the financial statements they must ensure that the cyclical

counting procedures are adequate and are being properly and consistently applied, particularly in a large dispersed

organisation.

(ii) I would ensure that all inventories had been counted at least once a year and that the records had been kept up to date

and were promptly corrected for any discrepancies discovered as a result of counting.

(iii) I would assess the risk attaching to the different locations and seek to visit those locations where the value or volume

of inventory is substantial, and where controls are weak (i.e. where risk is greater).

(iv) It may be necessary to involve other offices of my firm, or to engage staff from another firm to attend counts, and toco-operate with internal audit, who may wish to conduct their own counts (on which I may wish to rely), or who may

lend staff to my firm.

(v) If using other firms of external auditors, and relying on internal audit work, it is particularly important that I am s atisfied

with the quality of that work and that my involvement is sufficient for my firm to be able to justify its audit opinion.

(vi) My firm may perform visits on a rotational basis throughout the year to ensure adequate coverage of all locations.

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(c) Weaknesses in counting instructions - why they are difficult to overcome

Weaknesses

The date of the count may be inappropriate -

staff (and auditors) will not wish to work

on a public holiday and given that there

is a high level of staff turnover, there is a

possibility that staff will not arrive or will

complete the work too quickly withoutproperly counting the inventory. This is

compounded by the fact that staff are

working individually and may make errors

or attempt to cover up misappropriations.

There may be insufficient time allowed to

prepare the inventory for counting and it is

likely that the shop and warehouse will be

untidy because the business has been busy.

Too much responsibility is in the hands of

Mr Sneg (a lack of segregation of duties).

He is responsible for the assets (the

inventory), the records, the staff and the

adjustments to the records.

It may be necessary for Mr Sneg to be

involved with the count but he should be

responsible together with another

representative of management who is not

involved with the day-to-day control of

inventory (such as the finance director). It

will be too easy for Mr Sneg to hide errors or

falsifications in the inventory records to cover

up errors or misappropriations.

It would be particularly easy for him to falsify

records in relation to, for example, inventory

in stock but already sold and inventory

delivered but not yet paid for.

The add-back of inventory delivered but not

yet paid for appears to be wrong, as a matter

of principle, even if the related invoices are

removed from the revenue accounts.

3 (a) Managing conflicts of interest

Why difficult to overcome

These problems are difficult to overcome

because the shop and warehouse are open

seven days a week and because it is

expensive and difficult to obtain others (who

may not be appropriately experienced) to

perform the count.It might be suggested that the count be

conducted, say, a week before or a week later

and that a roll-forward or roll-back be

performed, but this w ill cause additional

staffing problems and problems with the

movement of inventory. It may be difficult for

the company to change its year-end because

of local regulations. Some of the managers

might be asked to come and help.

This is difficult to overcome because family

owned companies, (even large ones) often

place a substantial amount of trust in valued

employees who would be offended if it were

suggested that it were necessary to checktheir work in some way.

(i) ACCAs Rules of Professional Conduct state that auditors should avoid conflicts of interest (both conflicts between the

firm and clients, and conflicts between clients) wherever possible. In some cases, such as these, they are unavoidable.

(ii) Full disclosure is important - both companies should be fully aware that the firm is acting for the other party.

(iii) One or both companies may object to the firm acting for the other company and the auditor may be forced to make adecision as to which company to resign from. However, this is not an attractive course of action because the audits may

already have commenced and it may be difficult for one of the companies to find a new auditor, quickly.

(iv) The auditor should probably not, therefore, resign unless forced to do so - this might be prejudicial to the interests of

one of the clients.

(v) It is important in such cases that different teams of staff, and different engagement partners work on the respective

audits.

(vi) Internal procedures within the firm should be set up to prevent confidential information from one client being transferred

to the other and the interests of one firm damaging the interests of the other. Such procedures are sometimes known as

Chinese Walls.

(vii) If two completely separate offices could work on the two engagements, so much the better.

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(b) Main requirements of IAS 37

IAS 37

IAS 37 states that a provision is a liability of

uncertain timing or amount. It should only be

recognised when there is a present obligation

(legal or constructive) arising from past

events and it is probable that a transfer of

economic benefits will be required to settlethe obligation and a reliable estimate of the

amount can be made.

IAS 37 states that a contingent liability is

either a possible obligation arising from past

events whose existence will be confirmed by

uncertain future events outside the control of

the entity or, a present obligation arising from

past events that is not recognised because a

transfer of economic benefits is not probable,

or because the amount of the obligation

cannot be measured with sufficient certainty.

IAS 37 states that a contingent asset is a

possible asset arising from past events whose

existence will be confirmed by uncertainfuture events ouside the control of the entity.

Contingent assets should only be disclosed

where an inflow of economic benefits is

probable. If they are virtually certain, a

contingency does not exist at all and the

income may be accrued.

It also states that expected re -imbursements

(such as those arising from insurance

contracts) should be recognised only where

they are virtually certain and treated as

separate assets. The net expense may be

recognised in the income statement.

A brief description of the nature of each class

of contingent liability should be made unless

the possibility of the transfer of benefits is

remote. Where practical, an estimate of the

financial effect, an indication of the relevant

uncertainties, and the possibility of any

reimbursement should be disclosed. Similar

provisions apply to contingent assets.

(c) Sufficient audit evidence and audit reports

Application

If the firm can obtain sufficient appropriate

audit evidence to show that Tourex and/or

Pudco are likely to have to make a payment,

and that the amount can be reliably

estimated, a constructive obligation seems to

exist and provision should be made.

If Tourex and/or Pudco are uncertain as to

whether a payment will have to be made, or if

they are certain but the amount cannot be

estimated, a contingent liability should be

disclosed in the accounts.

This might apply to Tourex in its claim

against the food company. It seems unlikely

that there is sufficient certainty relating to theclaim and therefore no disclosure should be

made.

If either Tourex or Pudco hold insurance

against such events, and it is probable that

the insurance claim will be met, a contingent

asset may need to be disclosed. If there is

any uncertainty, there should be no

disclosure. If it is virtually certain that the

claim will be met, a separate asset should be

recognised.

(i) The main problem for the auditors will be gaining sufficient evidence to determine whether any amounts should be

provided for and/or disclosed in the financial statements of the two companies.

(ii) The lawyers refuse to provide anything other than informal evidence and this will almost certainly not be sufficient toform an audit opinion.

(iii) Unless audit evidence can be obtained elsewhere - a qualified opinion, except for, on the basis of a limitation in the

scope of the audit may be needed for both companies as the amounts involved are material.

(iv) However, it may be possible to take the view that there is a significant uncertainty, the resolution of which is depend ent

on future events that are outside the direct control of the entity, and that an emphasis of matter paragraph is therefore

appropriate, rather than a qualification to the auditors opinion.

(v) It may be possible for the auditors to suggest to the companies that it would be very helpful for the lawyers to provid e

some indication as to their view of the likely outcome and the amounts involved, in order to avoid a qualified opinion.

(vi) The auditors should also take note of the progress of any legal proceedings and any proceedings that may be instigated

by the public health authorities as such authorities might impose significant fines, and they might even close the

businesses down, which has implications for the going concern status of both.

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4 (a) Reliance on work of internal auditors

(i) As requested, the external auditors will seek to rely on the work of internal audit to the maximum extent possible. This

might cover planning, risk assessment, tests of controls and substantive testing.

(ii) In all cases, the external auditor should be aware that the purpose of internal audits work will not be primarily directed

towards the financial statements.

(iii) In relation to the cyclical audit of internal controls, it may be possible to rely on the work of internal audit in relation to

all of the areas noted, but only if the internal controls audited affect the financial statements. It may be that internal

audits work on operations and customer support is less relevant than its work in other areas.

(iv) In relation to the four-year review of internal controls - the extent of reliance will depend on how long ago the last review

was conducted. If it was conducted recently, it will provide help in relation to the external auditors assessment of the

accounting and internal control systems.

(v) In relation to risk management - the relevance of internal audit work depends on the extent to which risks in relation to

reporting in general, and the financial statements in particular, have been addressed separately by management. This

work will be relevant to the external auditors risk assessment and planning.

(b) Information required

(i) The information required to determine the extent of external audit reliance on internal audits cyclical audit will be:

- internal audits systems documentation (the work on information systems and finance may include documentation

of the companys accounting and internal control systems);

- internal audits planning documentation which may cover a risk analysis, tests of controls and sustantive

procedures;

- the results of tests of control and substantive procedures;

documentation on the four-year review of internal controls, particularly in relation to the finance and information

services functions.

(ii) The external auditors should ask to see all documentation relating to the work performed by internal audit on information

services restructuring during the year because the external auditors assessment and testing of systems will be split into two

parts, pre- and post-restructuring.

(iii) Other documentation requested will include internal audits operating procedures manuals and documentation relating

to the recruitment, training and development of internal audit staff, and management responses to internal audit

recommendations. This information is required to enable the external auditor to form an opinion on the competence and

effectiveness of the internal audit function.

(c) Circumstances in which it would not be possible to rely on the work of internal audit

(i) It may not be possible to rely on the work of internal auditors if they:

- are not competent (this relates to experience as well as qualifications);

lack integrity;

- do not properly plan or document their work, or if management does not act on (or at least respond to)

recommendations made;

- do not perform work relevant to the external auditor.

(ii) It will also not be possible to rely on internal audit if internal audit is insufficiently independent within the organisation,

i.e. where internal auditors have insufficient operational freedom, where they are reporting to those who control the

functions that they work on, or where they are reporting on their own work.

(d) External auditor work

(i) External auditors will wish to perform work independently, regardless of internal audit work, in all areas that are material

to the financial statements. For immaterial areas in which internal audit work can be shown by testing and review to be

adequate, it may be possible to rely on the work of internal audit without performing any other work.(ii) Areas material to the financial statements are likely to be long and short-term leasing receivables and inventory. Leases

may be complex and the auditors will wish to ensure that accounting policies are appropriate and that they have been

properly applied. The valuation of inventory will have a direct effect on the profit for the period. This is an area that is

easy to manipulate and external auditors will wish to ensure that this has not happened.

(iii) External auditors will also wish to perform their own risk analysis and final review of financial statements in order to

ensure that no high risk areas have been overlooked.

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5 (a) Information in internal audit reports

(i) Cover page: this normally deals with the subject matter, the distribution list, date, and authors.

(ii) Executive summary: this normally includes an introduction, summary terms of reference, outcome of the work, key risks

identified, key action points/recommendations, further work required.

(iii) Main report contents: this normally includes findings and action points or recommendations (including alternatives), it

gives details of responsibility for actioning the points, costs and time-scales.

(iv) Appendices: these may contain the full terms of reference, tables, questionnaires used, tests performed and any other

relevant information.

(b) Contents of external audit reports

External audit reports include:

(i) A title and addressee, and the signature of the auditor and the date.

(ii) A paragraph detailing the financial statements audited, and the responsibilities of directors and auditors.

(iii) A paragraph explaining the basic procedures involved in an audit and the fact that the audit is conducted in accordance

with International Standards on Auditing.

(iv) A paragraph stating the auditors opinion on the truth and fairness (or fair presentation) of the financial statements and

identifying the financial reporting framework.

(c) Differences - internal and external audit reports

(i) The wording of the external audit report is set out by in ISA 700 The Auditors Report on Financial Statements (and

national standards) and includes references to the financial statements audited, the auditing standards applied, a

summary of the procedures applied and the audit opinion in terms of truth and fairness and compliance with anidentified financial reporting framework.

(ii) The main difference between external and internal audit reports is that external reports are highly summarised, and do

not contain recommendations or action points in respect of internal controls or other matters. Internal and external audit

reports are similar to the extent that they all state what has been done, the overall parameters (law and accounting

standards in the case of external reports, the terms of reference in the case of internal reports) and the overall findings.

But the subject matter (internal controls for internal reports, financial statements for external reports) are different.

(iii) External audit reports are normally produced because of legal requirements and are therefore heavily regulated. Internal

audit reports are produced because management commissions them for control and corporate governance purposes.

(d) Common characteristics

(i) Both internal and external auditors draft their reports on the basis of the findings of their work (in the case of external

auditors this will relate to weaknesses in the structure and operation of controls encountered during the audit).

(ii) The report will be split into three main sections - the issues, the consequences or implications, and therecommendations. There will usually be a split between major and minor matters and some sort of summary or overall

evaluation of the more important matters.

(iii) The draft report will often be discussed with management, partly to confirm the findings, and partly to establish

managements likely responses - these can be incorporated into the report itself.

(iv) Reports will usually go through several redrafts (particularly in large organisations) and the report will then be issued. If

management have not commented at an earlier stage, some sort of response may be expected at a later stage.

(v) It is normal to follow up on recommendations or agreed action points at a later stage in order to establish how the issues

have been dealt with.

6 (a) Internal controls

(i) Controls contributing to the orderly and efficient running of the business, safeguarding the assets and adherence to

management policies would include the following:

- physical controls over access to the assets such as the locking of doors and the maintenance of an appropriate fire

and flood resistant environment;

- insurance against disaster and contingency plans;

the use of passwords for access to computers and plant and equipment;

- the numerical or other tagging of all equipment, referenced to an asset register;

performing periodic asset audits;

- internal regulations requiring staff who take equipment such as laptops and motor vehicles home to ensure that

they are secure, and prohibiting staff from using their own software on company equipment;

- the maintenance of firewalls and virus checking software.

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(ii) Controls contributing to the prevention of fraud and error, and the completeness and accuracy of the accounting records

would include the following;

- the preparation and monitoring of capital expenditure budgets together with authorisation of capital expenditure,

disposals and depreciation rates by independent persons at an appropriate level within the organisation who do

not have day-to-day responsibility for the related records or assets;

- the maintenance of an asset register that is reconciled to the general ledger and the assets themselves;

the periodic checking and review of asset lives, and fully depreciated assets, to ensure that assets are being

depreciated correctly, over an appropriate period of time.

(b) Description

(i) Judgement and statistical sampling

Judgement sampling uses the auditors judgement to select the number of items to be tested, which items to be tested,

and to interpret the results. Statistical sampling uses probability theory to do the same. Some judgement is always used

in statistical sampling in the assessment of materiality and in the determination of what constitutes tolerable error, for

example.

(ii) Representative sample

A representative sample is one whose characteristics are the same as, or similar to, the characteristics of the population as a

whole. All sample selection methods attempt to select samples that are representative.

For example, a sample of invoices that have not been properly authorised in 5% of cases will be representative of all

invoices if the population as a whole also has around 5% of invoices not authorised.

(iii) Tolerable error

Tolerable error is the maximum error that the auditor is prepared to accept and still conclude that the audit objective has b eenachieved.

For example, in relation to receivables, the auditor may be prepared to form the conclusion that receivables are not

materially misstated if sampling shows that the receivables population has a value that is within plus or minus, say, 5% of

the figure in the financial statements.

(iv) Different methods of sample selection

Random selection requires the use of random number tables in order to select a representative sample.

Haphazard selection may be deemed to approximate to random selection provided that no bias is displayed.

Interval (or systematic) selection involves taking every nth item, starting at random. Monetary unit sampling is also a form

of systematic selection.

Block selection methods (taking one full part of the population) will probably not result in a representative selection.

Block selection might involve obtaining confirmation of receivables from one region of the country only, for example.

NB: Only two examples are required.

(v) Extrapolation of errors

Errors found in a sample are extrapolated across the population as a whole, in order to enable the auditor to form a

conclusion on whether the population is materially misstated. It is important to remember that there is not necessarily

a direct, linear relationship between errors in samples and errors in the populations from which they are drawn.

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Part 2 Examination - Paper 2.6(INT)

Audit and Internal Review (International Stream) June 2003 Marking Scheme

Marks

1 (a) Performance

Up to 1 mark per point to a maximum of 8

(b) Higher risk areas and audit procedures

Up to 15 marks per point to a maximum of 12

Total 20

2 (a) Importance of inventory counting


(b) Perpetual inventory system


(c) Weaknesses in counting instructions - why they are difficult to overcome


Total 20

3 (a) Managing conflicts of interestUp to 15 marks per point to a maximum of 6

(b) Main requirement of IAS 37


(No more than 4 marks for the requirements of IAS 37)

(c) Sufficient audit evidence and audit reports


Total 20

4 (a) Reliance on work of internal auditors


(b) Information required


(c) Circumstances in which it would not be possible to rely on the work of internal audit


(d) External auditor work


Total 20

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Marks

5 (a) Information in internal audit reports


(b) Contents of external audit reports


(c) Differences - internal and external audit reports


(d) Common characteristics


Total 20

6 (a) Internal controls


(b) Description


(NB: not more than two marks per item) ____

Total 20

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