p2 - audit practice april 08

8/3/2019 P2 - Audit Practice April 08

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NOTESYou are required to answer Questions 1 and 2 and any two out of Questions 3 to 5.(If you provide answers to all of Questions 3 to 5, you must draw a clearly distinguishable line through theanswer not to be marked. Otherwise, only the first two answers to hand for these three questions will bemarked.)

TIME ALLOWED:3.5 hours, plus 10 minutes to read the paper.

INSTRUCTIONS:During the reading time you may write notes on the examination paper but you may not commence

writing in your answer book.

Marks for each question are shown. The pass mark required is 50% in total over the whole paper.

Start your answer to each question on a new page.

You are reminded that candidates are expected to pay particular attention to their communication skills

and care must be taken regarding the format and literacy of the solutions. The marking system will take

into account the content of the candidates' answers and the extent to which answers are supported with

relevant legislation, case law or examples where appropriate.

List on the cover of each answer booklet, in the space provided, the number of each question(s)

attempted.

The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.

AUDIT PRACTICE

PROFESSIONAL 2 EXAMINATION - APRIL 2008


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Page 1

THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

AUDIT PRACTICEPROFESSIONAL 2 EXAMINATION - APRIL 2008

Time allowed: 3.5 hours plus 10 minutes to read the paper. Answer Questions 1 and 2

and two out of Questions 3, 4 and 5.

1. As the Manager responsible for new clients, you have visited Sure Scaffolding Ltd., to plan the 2008 audit. SureScaffolding Ltd. supplies scaffolding and several other types of equipment to the building industry,

During your initial audit planning visit, in April 2008, you ascertained the following:

1. Twenty years ago Rick Bates incorporated what had previously been a small building business run in

partnership by his father and his uncle.

2. As the years passed Ricks two friends, Norman Coleman and Dessie Kenneally acquired a shareholding

in the business and became Directors.

3. The business was successful but unspectacular in the first ten years but from 1996 coinciding with the

boom in the building industry it began to flourish.

4. Highlights from recent financial statements are as follows:

(2008 figures are yet to be subject to audit)

Extracts from the audited financial statements year ended 30th June. Forecast

2002 2003 2004 2005 2006 2007 2008

M M M M M M M

Turnover 5.0 8.0 11.0 15.0 17.0 17.0 14.0

Profit before tax 0.9 1.6 3.0 5.0 6.0 5.4 0.3

Dividend payout ratio (%) 80% 85% 90% 85% 80% 92% 215%

Debt/Equity ratio (%) 50% 50% 72% 80% 85% 102% 106%

5. Sure Scaffolding Ltd. has in recent times tended to exceed its agreed overdraft facility. Rick has indicated

that a large receipt from a major customer expected at the end of July 2008 is to be used to pay tax arrears

and repay his loan to the company of 1.5M.

6. Rick is currently negotiating a bank loan to finance the cost of new premises. Contracts with builders have

been signed and the building work commenced in March 2008. Under a complicated deal, a reduced price

is being paid in return for Sure Scaffolding Ltd. supplying services to the building company at other sites

free of charge in 2009. The bank is waiting for audited financial statements before giving final approval of

a 3M loan.

7. The company has traditionally been regarded as thinly capitalised mainly because the Directors have

always awarded themselves handsome salaries and benefits and in some years also taken considerable

dividends.8. In September 2007, Dessie Kenneally, who owned 20% of the shares and was the Operations Director;

was killed in a fall while inspecting a site. His shares passed to his wife but she takes no active part in the

running of the business. In March 2008 her legal representatives contacted Sure Scaffolding Ltd.

demanding 6M in compensation from the company, claiming that negligence on the part of the company

caused her husbands death. The companys insurers and lawyers are currently discussing the claim. The

Health & Safety Authority are currently investigating the accident.

9. Later the same month, an employee luckily escaped serious injury when a piece of scaffolding fell on him

at a building site. He has agreed not to sue over the incident but has been offered promotion and a pay

increase. The Health & Safety Authority are unaware of this incident.


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REQUIREMENT:

In a memo dated 29 April 2008 to your audit partner Ms. Holly Tree, you are asked to focus on the identification,

ranking, and treatment of at least THREE key audit planning issues (KAPIs), which potentially represent a risk of

material misstatement in the financial statements due to important developments in this clients environment,

organisation, activities or operations.

G You should begin your memo by identifying and briefly explaining how each of the components of audit

risk will be affected by the information described above. (4 marks)

G You should identify and justify each KAPI in order of importance, stating your overall planned audit

approach for each KAPI. (10 marks)

G You should list the specific audit procedures to be executed (or courses of action to be followed) based on

the key financial statement assertions. (10 marks)

G Conclude your memo with a brief review of pertinent audit management and quality control

procedures in line with ISA (UK & Ireland) 220 - Quality control for audits of historical financial

information. (6 marks)

Your answer should demonstrate your exercise of professional judgment and understanding of an audit riskbased approach as well as taking into account the information provided.

[Total: 30 Marks]

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2. Your firm was appointed External Auditor of Woodlands Electrical Limited in June 2007, and you are carrying outthe audit of the financial statements for the year ended 30 April 2008. Woodlands Electrical is a small company

with turnover of about 4.5 million, which sells televisions, DVDs, audio equipment, and accessories to the

general public. The company has three separate outlets, each on the outskirts of small towns in the same county.

A Director runs each outlet. Two of the Directors are brothers and the other is an old classmate from university.

They have been in business together for about 7 years. There are no Non-Executive Directors and no outside

influences on the Board.

Normally this company would be exempt from the requirement to have an audit, but it has lost this exemptionbecause it failed to comply with the conditions specified in Section 32 of the Companies Act, 1999. Specifically,

its annual company returns (to the Registrar of Companies) were not made on time. You notice from

correspondence with the accountants who previously acted for this company, that the attitude of the Directors and

Management to compliance with laws and regulations, is described as relaxed.

From recording and evaluating controls in the company's accounting systems, your investigations have shown

that there are too few staff to provide a proper division of duties in the accounting systems, and other checks to

overcome the weaknesses in the division of duties are inadequate. So, you have concluded that control risk is

moderate to high for most accounting systems. Thus, you have decided to adopt a predominantly substantive

approach to the audit.

Your audit work on balance sheet items has shown there are no material errors, with the possible exception of

the understatement of VAT and PAYE/PRSI liabilities. This possibility arises because you are concerned that

revenue may be understated, and audit work has failed to obtain reliable evidence of some expenditure. The

vouchers for this expenditure have been generated by the company's staff and provide very limited information

on the expense incurred. Sales are made to the general public, who pay in cash, by cheque, credit or debit card

(laser card).

The company does not produce interim accounts: your firm produced the financial statements directly from the

books and records of the company. There is no inventory control system and sales receipts are recorded using

a till. The sales assistant records the value of each item sold, but no description. However, for high value items

(for example televisions and more expensive DVDs) a hand-written invoice is made out which describes the

product. The company retains a copy of this sales invoice. The customer can use the sales invoice if a refund orrepair of the product is needed.

REQUIREMENT:

(a) Assess briefly the following in the context of the Woodlands Electrical Ltd.:G Control Environment.G Corporate Governance arrangements.

(6 marks)

(b) Describe the problems that arise, and the extra audit procedures that are necessary as a result of the following

circumstances as outlined aboveG Your firm was not appointed as Auditor until after the beginning of the year subject to audit.

(4 marks)G The previous financial statements were un-audited. (4 marks)

(c) Set out, in a form suitable for inclusion in a report to Management, the two most significant weaknesses in the

control systems of Woodlands Electrical Ltd., the potential consequences of these weaknesses, and your

recommendations for improvements to address these weaknesses. (6 marks)

(d) Describe in detail the audit work you would perform in the case of this particular client to verify the adequacy of

the provisions for VAT and PAYE. (5 marks)

(e) Having performed the tests you describe above you conclude that there is a liability for underpaid VAT and PAYEof the order in total of 5,000 excluding interest and penalties. Discuss the Auditors obligations to report this

matter to third parties other than the Management or the shareholders. (5 marks)

[Total: 30 marks]Page 3


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Page 4

3.(a) ISA (UK and Ireland) 260 - Communication of audit matters to those charged with governance - requires the

Auditor to communicate certain matters of governance interest to those charged with governance on a timely

basis during the course of the audit. As the Auditor is engaged by, and reports to, the shareholders, briefly assess

the importance of the communication required by ISA 260 in the context of the Auditors responsibilities as a

whole. (6 marks)

(b) You work for the Institute of Certified Public Accountants in Ireland as a technical advisor to members in practice.You have received the following query from the Partner with responsibility for quality control in Konrath & Co., a

6-Partner practice in the midlands.

In performing the audit of Healys Importers Ltd, the Audit Senior found some significant deficiencies in the

internal controls over the companys foreign exchange operations. This concerned the Audit Senior because she

knew that foreign exchange operations were a high risk area for many companies. She reported these

deficiencies to the partner of the engagement, Patrick Fitzpatrick. Mr. Fitzpatrick agreed that the matter was one

of high importance and decided to report it to Healys Importers Manager of Foreign Exchange Operations, Mick

Gleeson.

The matter was reported to Mr. Gleeson who agreed with the conclusions of the Auditors about the poor controls

in foreign exchange. He assured Mr. Fitzpatrick that the problem would be remedied before the next audit. Mr.

Fitzpatrick was convinced that Mr. Gleeson realised the significance of the problem and would act promptly. Mr.

Fitzpatrick decided not to report the matter to the Board of Directors, or to the Audit Committee. An unqualified

audit report was issued but in line with the audit firms policies included the following paragraph: -

This report is made solely to the Companys members, as a body, in accordance with Section 193 of the

Companies Act, 1990. Our audit work has been undertaken so that we might state to the Companys members

those matters we are required to state to them in an auditors report and for no other purpose. To the fullest extent

permitted by law, we do not accept or assume responsibility to anyone other than the Companys members as a

body, for our audit work, for this report, or for the opinions we have formed.

Six months later, Konrath & Co. were informed that Healys Importers was about to go into liquidation. It appearedthat a sharp decline in the value of the euro resulted in substantial losses on un-hedged futures currency

contracts held by the company. Holding these contracts was a breach of the companys policies and should not

have occurred if the controls in the foreign exchange area were operating effectively. Mr. Gleeson had not

implemented the recommendations for improvements to controls over the foreign exchange system. Mr.

Fitzpatrick has been notified that Konrath & Co. is being sued by a bank who lent the company money after

reading the audited financial statements.

We would be obliged to receive, in confidence your comments on the above situation.

REQUIREMENT:

Write a letter replying to the request outlined above specifically addressing the following points and justifying your

reasoning:

(i) Has the Audit Partner, Mr. Fitzpatrick, been negligent?

(ii) If so, is it likely that the bankers will succeed in their legal action against the audit firm?

(8 marks)

(c) Describe the work the Auditor should have carried out on the foreign exchange contracts. (6 marks)

[Total:20 marks]


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Page 5

4. You are the engagement partner in charge of the audit of the financial statements of the Darmody Group, for theyear ended 31 August 2007. The group comprises of Darmody Ltd. (Darmody), a privately held company and its

wholly owned subsidiary Kris Ltd. (Kris). Both companies are involved in the manufacture and sale of toys. During

the year under review, the management of Kris failed to anticipate the growth in popularity of certain electronic

toys and thus made a substantial trading loss. The Board of Directors of Darmody decided to sell the subsidiary.

The sale was legally completed on 31 July 2007.

A summary draft income statement for the year ended 31 August 2007 (which is shown below) has been

prepared, which divides the group profit between continuing operations (those of Darmody) and discontinuedoperations (those of Kris).

Continuing operations Discontinued operations Total

000 000 '000

Revenue 32,300 12,600 44,900

Profit/(loss) before tax 3,400 (1,650) 1,750

Corporation Tax (250) 165 (85)

Profit/(loss) before exceptional item 3,150 (1,485) 1,665

Loss on sale of subsidiary (note 1) - (742) (742)

Profit/(Loss) for period 3,150 (2,227) 923

Notes to the accounts (extract)

1 Loss on sale of subsidiary. '000

Net assets of Kris at 31 July 2007 3,460

Cash proceeds (2,718)

Loss arising on disposal of subsidiary 742

The results of Kris, included above, have been obtained from the company's management accounts which have

been subject to extensive review by the Group Internal Auditor. Audited accounts of Kris are not available as

Kris's new owners have a different year end from Darmody and Darmody no longer has control over Kris.

In view of the substantial losses of Kris, the Directors of Darmody do not want to include the trading results of

Kris in the group accounts. They have suggested that the loss on disposal of the subsidiary should be shown asan exceptional item.

You have approached the new owners of Kris, and in view of the change in ownership, they have said that they

are not prepared to allow you to carry out an audit of their accounts or to answer questions on the management

accounts to 31 July 2007. However, the Directors of Darmody are prepared to give you as much information about

the preparation of Kris's accounts as they are able.

REQUIRED:

(a) Discuss the factors you would take into account in deciding whether the results of Kris are sufficiently

reliable to be included in the group accounts so that the group receives an unqualified Auditor's report.

(8 marks)

(b) As an External Auditor it is sometimes necessary or desirable to place some reliance on the work of the

Internal Auditor. ISA (UK and Ireland) 610 - Considering the work of internal audit lists some of the factors

to be taken into consideration in deciding on the level of reliance which should be placed.

State with justification which of these factors you consider to be the most important in the context of

the scenario given above. (6 marks)

(c) How you would audit the item in Note 1 to the accounts: 'Loss on sale of subsidiary'? (6 marks)

[Total: 20 marks]


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5.(a) Compare and contrast a compilation report (i.e. a report on financial statements which has not been subject to

audit or review) with a standard audit report in terms of:

G The situations in which the use of each may be appropriate andG The degree of reliance which may be placed on each.

(6 marks)

(b) You are Arthur Henry, Technical Partner in the firm Herbert, Holohan & Co. Certified Public Accountants. The

busy audit season is just coming to a conclusion and you have received a memo from Reginald Herbert,

Managing Partner; in which he requests your advice in relation to two clients whose audit reports he is

currently engaged in drafting.

Client A paid an interim dividend in respect of 2007 based on reserves shown to be available by the 2006 financial

statements laid before the members at the AGM. You have now prepared the accounts for the year ended 31st

December 2007 and there is a deficiency of reserves shown as a result of the dividend payment. This reflects

adverse trading conditions in the second half of the year which could not have been anticipated by the Directors

when they made their decision, honestly and with due care, to approve the dividend.

Client B is a new client and we are completing the audit for the year ended 31 December 2007. The previous

Auditors had issued a disclaimer of opinion on the financial statements for the year ended 31 December 2006

due to multiple inherent uncertainties and going concern issues arising from the following circumstances:

G Client B had defaulted on the repayment of 10 million of unsecured loan stock, which was due in 2006,

and the default constituted a possible violation of other debt agreements.G The interest and principal payments due on the remainder of a separate 10 year credit agreement which

began in 2002 would exceed the cash flows generated from operations in recent years.G The company had disposed of certain operating units. The proceeds of the sale were subject to possible

adjustment through arbitration procedures, the outcome of which was uncertain at the year-end.G Various significant lawsuits were pending against the company.G

The company was in the midst of various tax appeals resulting from a revenue audit in January andFebruary of 2006, which reviewed the previous 10 years Corporation Tax returns.

The status of the above matters at the end of 2007 is as follows:G The company is still in default on 4.6 million of the loan stock due in 2006, but is trying to negotiate a

settlement with the remaining loan holders. A large number of loan holders have settled their claims at

significantly less than par.G The company has renegotiated the 2002 credit agreement which provides for a two year moratorium on

principal payments and interest at 8%. This agreement is conditional on losses in 2007 and subsequent

years not exceeding certain specified limits and requires a certain level of defined cumulative quarterly

operating income to be maintained.G The arbitration proceedings were resolved in 2007.G The legal actions were settled in 2007.G Most of the tax issues have been resolved, and, according to the companys legal council, those remaining

will result in a net cash inflow to the company.


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At 31 December 2007 Client B had a cash balance of 5.5 million and expects to generate a net cash flow of

3.2 million in 2008. The following information is also relevant:

Year Ended Year ended Year ended

31 December 2008 31 December 2007 31 December 2007

Budget M Actual M Budget M

Net Revenues 66.2 60.9 79.8

Gross Margin 34.7 33.6 45.6

Operating Expenses (27.3) (34.7) 5.7Interest-net (5.1) (6.0) -

Other income (expenses) (0.8) 2.1 -

Earnings before tax 1.5 (5.0) (0.2)

Cash Flows M M M

Receipts 69.9 79.7 105.6

Disbursements 66.7 102.5 83.4

Net inflows/(outflows) 3.2 (22.8) 22.2

REQUIRED:

Write a short memo to Mr. Herbert explaining the impact of the issues raised on the respective audit reports of

Client A and Client B. Assume that all the matters raised are material for the companies involved. Marks are

allocated as follows:

Client A (5 marks)

Client B (9 marks)

[Total: 20 Marks]

END OF PAPER


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THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

AUDIT PRACTICE

PROFESSIONAL 2 EXAMINATION - APRIL 2008

Solution 1

Date: 29 April 2008

To: Ms. Holly Tree CPA, Audit Engagement Partner, Sure Scaffolding Ltd.

From: AN Other, Audit Engagement Manager

Re: Key Audit Planning Issues (KAPIs) Year ended 30th June, 2008

Audit Risk Assessment

AR = IR x CR x DR

My comments on the components of the Audit Risk model shown above are as follows:

Audit Risk needs to be set at a low level because we are aware that the company is negotiating to extend its

overdraft facility so although this is a private company the issue of potential liability to 3rd parties may come into

play. Suggest AR = 3%.

Inherent Risk is high or maximum because of the financial state of the company, the loss of the operations director

during the year, and the recent downturn in the building industry.

An initial assessment of control risk is high but it may be possible to test and rely on controls in some limited

areas.

Given the above, detection risk must be low we will need extensive substantive testing on this audit.

KAPI 1: Going ConcernThe following factors appear to impact adversely on SSs ability to continue as a going concern:

FinancialG Substantial decline in profitabilityG Increase in gearingG Directors continuing to extract large dividendsG Liquidity problems; exceeding bank overdraft

OperationalG Significant, well publicised and on-going decline in building industryG Credit crunch making borrowing more difficult and expensive

OtherG Death of key director and threatened litigation following this death.G Also, a 20% shareholder may no longer have an interest in seeing the company continue and may actively seek

to sell her shares or realise them in some way.

Specific audit procedures for us to follow may include:

(a) Analysing and discussing cash flow, profit and other relevant forecasts with management.

(b) Analysing and discussing the entitys latest available interim financial statements.

(c) Reviewing the terms of debentures and loan agreements and determining whether any have been breached

paying particular attention to any breaches of the bank overdraft limit.

(d) Reading minutes of the meetings of shareholders, those charged with governance and relevant committees for

reference to financing difficulties.

(e) Enquiring of the entitys lawyer regarding the existence of litigation and claims and the reasonableness ofmanagements assessments of their outcome and the estimate of their financial implications.

(f) Reviewing events after period end to identify those that either affect the entitys ability to continue as a going

concern.

Page 9

SUGGESTED SOLUTIONS


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KAPI 2: Compliance issues

There are a number of live compliance issues surrounding this client.

Health & SafetyG The death of one director is being investigated by HSA.G Another potentially serious incident has not been reported to them. This itself may be a breach of regulations.

TaxationG

There appear to be tax arrears this could effect the obtaining of a tax clearance certificate and the ability totender for certain types of contract.

Directors LoansG There appear to be loans from at least one Director to the company potential company law and tax issues.

Dividend payoutsG Company is proposing a 215% dividend payout ratio may raise legal issues.

Specific audit procedures will include

(a) Reviewing any correspondence with HSA.

(b) Obtaining legal advice on some of the issues involved especially concerning the accident involving the employee.

(c) Carefully examining correspondence with Revenue especially any potential tax arrears penalty.(d) Enquiring of the directors the position in relation to the loans; obtaining written representations; carefully

considering FS presentation.

(e) Carefully calculating distributable profits and comparing to the proposed dividend payment.

KAPI 3 Undisclosed liabilities:

Litigation following accident Dessie KenneallyG There is a potentially very significant liability here (see KAPI 1 above). There is also the possibility of a penalty

being imposed by the HSA.

Accident EmployeeG

The company may still be exposed on this point should the worker decide to pursue a case later.

Cost of new premisesG The arrangement here to provide the contractors with free services in 2009 essentially means that a liability to

the value of those services may exist at 30 June 2008 and, if it does, it may need to be reflected in the financial

statements. These would also affect the value of the asset.

Potential penalties for breaches of law and regulationG There is always the possibility of penalties being imposed for any of the issues mentioned in KAPI 2 above.

Specific audit procedures will include:

Cost of new premises carefully read the contract and identify the commitment to the contractors in the future. Ensure

all monies already paid are clearly identified and capitalised. Consider the self-supply elements. Carefully check for VAT

implications. Seek representation from directors.

Other points already covered above.

KAPI 4 Audit Risk and our exposure

For all of the reasons discussed above this represents a high-risk audit. In particular we are aware that a profit forecast

and, by implication, the audited financial statements will be used by the bank before giving approval to a 3M loan which

is currently being considered. It follows that under the Bannerman case we could be exposed to the bank in this regard.

We will need to give careful consideration to our audit report and we will need to include a Bannernan paragraph in

that report.

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Audit Management & Quality Control Issues (ISA 220)

Under ISA 220 the engagement is responsible for the followingG overall quality control of the audit engagement;G evaluation of compliance with ethical requirements and independence;G acceptance and continuance of client relationships and specific audit engagements;G assignment of an engagement team with the appropriate capabilities, competence and time;G direction, supervision and performance of the audit engagement in compliance with professional standards and

regulatory and legal requirements;G ensuring that an engagement quality control review is undertaken for audits of financial statements of listed

entities and resulting issues discussed before the auditor's report is issued.G ensuring appropriate consultation is undertaken on difficult or contentious matters.

In particular in relation to staffing when it coming to staffing an audit the engagement partner is obliged to consider the

following:G IndependenceG Family relationshipsG Business relationshipsG Fee income %G Whether firm provides non audit services to client (if so, needs a different audit team)G Problems/disagreements in pastG Integrity of managementG Type of business and associated risks

Clearly in this case we will need to you utilise experienced staff and focus on the KAPIs as indicated above.

Marking Scheme for Question 1

Question 1 Marks

Audit Risk 1

Inherent Risk 1

Control Risk 1Detection Risk 1

4

Four KAPIs

Going Concern, Compliance Issues, Undisclosed liabilities, Our Exposure

Mentioning/Identification (1*4) 4

For an explanation of the reasons/importance of each KAPI (11/2*4) 6

10

Specific Procedures

For details of specific procedures to be followed (1 mark for any 8 procedures) 8

For rationale, general sense of the solution, and professional skills 2

10

Quality Control Issues

Client Acceptance and/or continuance procedures/Independence issues 11/2

Engagement Team 11/2

Review procedures including considering the need for second partner/QC review 11/2

Provision of non-audit services 11/2

6

[Total: 30 marks]

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SOLUTION 2

(a) Control Environment The control environment sets the tone of an organisation, influencing the control

consciousness of its people. It is the foundation for all other components of internal

control, providing discipline and structure; in general it is poor in this case because of

the attitude of management etc.

Corporate Governance This is a small entity so internal control procedures need not be very elaborate.

However, the company should consider the benefits some outside influence on theboard. It should also consider introducing a method of formally assessing risk.

(b)

(i) We will need to gain extra assurance as to opening BS position. It may be impossible to verify certain amounts

which could lead to a qualified audit report.

Part of the current year will also have past so there may be difficulty in verifying income statement items. Also,

there is less time to consider these issues. Internal Controls are poor and so not of much help.

ii) The fact that the previous financial statements were un-audited compounds the above. This may make

qualification more likely. We will need a full audit on the opening BS. This also complicates the position re

comparatives. Even if we are able to somehow retrospectively audit the opening BS this still leaves thecomparative income statement un-audited. At the very least an emphasis of matter would be needed in the audit

report to point this out. It could be argued that a qualification is needed. It may be that the best we can hope for

is an audit report qualified on the grounds that the comparatives are not audited. (ISA 510 & ISA 710). There is

also an issue about the standard of books and records maintained given that the company would not have

anticipated that they would be subject to audit.

(c)

There are several other possible controls that would not be prohibitively expensive. Examples are as follows:

The introduction of a formal risk analysis procedure to establish areas in which the co is exposed would be

helpful.

Improved security arrangements could be considered such as close circuit television cameras to allowcloser supervision of shops.

Page 12

arrangements

Weakness Consequence Recommendation

The lack of a properly functioninginventory control system Inventory losses due tomisappropriation

Holding too much or too little

inventory

Difficulty verifying the correctness

of inventory for financial reporting

and other purposes.

Even though this is a smallcompany consideration should be

given to the installation of a

properly functioning and integrated

stock control system. This would

be somewhat expensive but on a

turnover of 4.5M it should be

affordable and might well pay for

itself in reduced stock losses

and/or cash misappropriations. It

would also reduce compliance risk

in certain areas e.g. compliance

with the WEEE directive.

No system of budgets or targets

currently exists; the provision of

forecast or interim cash flow or

accounting information is

inadequate

Difficult to assess results; greater

difficulty if applying for financing;

greater susceptibility to fraud and

misappropriation

The introduction of a proper

system of budgets and targets

including the production of interim

and forecast financial statements

and cash flow information.


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(d) Audit work on VAT & PAYE

i) Agree liability to VAT/PAYE returns.

ii) Check for reasonableness; compare to previous year.

iii) Examine correspondence with revenue.

iv) Check sales, purchases, wages per financial statements to VAT returns and P35.

v) Note dates of last VAT, PAYE inspections.

vi) Note carefully any evidence of understatement of revenue; calculate theoretical revenue as purchases

plus mark-up.

vii) Discuss results with directors.viii) Include in LOR, if in doubt.

(f) Obligations to report to third parties may arise from

Criminal Justice Act, 1994 money laundering, to Gardai and Revenue

Company Law Enforcement Act, 2001 companies act offences, not keeping proper books of account, to ODCE

Taxes Consolidation Act 1997, S1079 underpaid tax., to Revenue

Materiality of amount to financial statements is not a consideration.

Obligation arises under CJA and CLEA even if past event, now resolved.

We may wish to take legal advice.


Question 2 MarksPart (a)Control Environment description, importance 11/2

Assessment in this case 11/2

Corporate Governance arrangements description, importance 11/2

Assessment in this case 11/2

Ethical concernsAttitude of management,Self-Review issues (we are preparing the accounts)Breaches of law (ISA 250)Other

Maximum 6Part (b)

Less time to prepare for audit; less knowledge of client 1Difficulties with balances b/f etc 1Need for communication with previous accountant (no previous auditor) 1Possibility of modified Audit Report 1Previous FS un-audited compounds the above 1Particular difficulties with comparatives (at very least need for EOM) 1Status of previous accountant 1Relationship with client audit seen as a punishment 1Other points up to 2Maximum 8Part (c)

For a description of the control (1 *2) 2For giving the rationale as to why it is important (1 * 2) 2For comment about the cost of control (Cost-Benefit) (1*2) 2

6Part (d)For any point mentioned in solution 1*5 5Part (e)Identifying the statutory obligation money laundering 1Other statutory obligations 1Materiality not an issue 1Still need to report even if resolved 1Need for legal advice 1

Other 1Maximum 5Overall Maximum 30

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Solution 3

a) The primary duty of an auditor is to make a report to the shareholders on the truth and fairness of the financial

statements. However, it has long been accepted that giving information to the management about certain matters

that come to the auditors attention during the course of the audit is an important, if secondary, duty of the auditor.

Over the years the emphasis of this giving of information to management has increased in scope and quantity. In

the past auditors were expected to write Letters of Weakness to management detailing any weaknesses they

discovered in internal controls. Now ISA 260 requires the communication of matters of governance interest to

those charged with governance. This puts auditors communications at a whole new level and entails far more

than just weaknesses in internal controls. As can be seen from the answer to part(b) below there may now evenbe direct legal consequences for an auditor who fails to engage in such adequate and robust communication with

the client.

However, auditors duty to report to third parties has also expanded considerably in recent years (e.g. the

provisions of 1994 Criminal Justice Act became applicable to accountants in 2003) and this may impact on the

right and duty to report to management.

b) Technical Department,

ICAPI,

Fancy New Offices,

Dublin 2.

28 April 2008

Quality Control Partner,Konrath & Co.,

CPAs and Registered Auditors,

Main St.,

Somewhere.

Dear Mr. QC Partner,

Thank for your recent query. Having researched the matter I would like to comment as follows:

The facts are similar to the Australian AWA case (1992). In the AWA case the court said that the auditor should

report problems or irregularities found during the course of an audit to an appropriate level of management.

In this case reporting the control weaknesses in the foreign exchange operations to the manager of foreign

exchange operations is probably not an appropriate level of management. It should have been reported to theaudit committee.

After the audit partner had determined that there were significant weaknesses in the internal controls he should

have performed more substantive tests in accordance with ISA (UK and Ireland) 330 - The auditors procedures

in response to assessed risks. This does not appear to have been done as the company held a large number of

un-hedged futures currency contracts that should have been reported in the financial statements.

It would appear that Mr. Fitzpatrick has been negligent.

However, to owe a duty of care the following would have to be established:G The report was prepared on the basis that it would be conveyed to a specific third party.G The report would be conveyed for a purpose that was likely to be relied upon by that third party.G The third party would be likely to act in reliance on that report, thus running the risk of suffering the loss if

the statement was negligently prepared.G The third party did actually rely on the report and did actually suffer loss as a result.

Even if it was established that a duty of care could be owed to the third party the inclusion of the quoted paragraph

in the audit report would probably be sufficient to exclude liability. In the Bannerman* case it was stated that it

was open to the defenders to attach to the accounts a disclaimer of responsibility to the pursuers if they wished

to prevent the emergence of a duty of care owed to the pursuers

* THE ROYAL BANK OF SCOTLAND Pursuers; Against BANNERMAN JOHNSTONE MACLAY AND OTHERS

Defenders:

It would be unlikely that the investor would be successful.

Yours sincerely,

Made-up name,

Technical advisor.

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c) In order to audit the Foreign Exchange contracts the auditor should have;

i. Understood the transactions

ii. Recorded and understood the system for dealing with them.

iii. Confirmed the understanding by walk-through tests

iv. Identified the key controls and tested them.

v. To the extent that any key controls were inadequate, communicated that information to management

without delay.

vi. Included the matter in the letter of representation.vii. Carried out substantive testing on the transactions including

a. Checking authorizations for individual transactions

b. Obtaining third party confirmations

c. Recalculating gains/losses on individual transactions


Question 3 Marks

Part (a)

Primary duty of auditor to report to shareholder 1

Subsidiary duty to report to management 1

Weaknesses in internal control 1Much wider remit in ISA 260 1

Possible legal consequences of not reporting 1

Other reporting responsibilities to be considered 1

Other relevant points (up to 2) 2

Maximum 6

Part (b)

Letter format 1

Dealing with the particular facts was partner negligent & why 2

Prerequisites for shareholder to succeed in legal action 2

Audit Reporting and disclaimers 1

Conclusions was negligent but insufficient proximity 2Bonus references to case law 2

Maximum 8

Part (c)

Understand the transactions 1

Record and understand the system 1

Walk through tests and confirmation of system 1

Communication of weaknesses to management 1

Substantive tests 1

Third party confirmations 1

Letter of Representation 1

Other up to 2

Maximum 6

Overall Maximum 20

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Solution 4

(a) Availability and reliability of information

Since no direct communication with subsidiary management is possible, and audit results are not available, the

auditor should consider the results of Kris in the light of:

(i) the reliability of management accounts in previous years;

(ii) any evidence that this year's management accounts have been prepared on a basis consistent with that

applied in earlier years;

(iii) the amount of information and explanations which the management of Darmody are able to provide fromtheir knowledge acquired whilst still in control of Kris;

(iv) any audit work carried out on an interim visit and the extent to which useful audit evidence may be obtained

by reviewing the work of Darmody's internal auditors on the accounts of Kris in respect of the year ended

31 August 2007;

(v) any year end audit work, such as attendance at inventory count and receivable circularisation, carried out

before control of Kris was lost.

(vi) Materiality level (or acceptable error) in relation to Kris's results

There is no reason to suppose that the reported revenue of Kris is incorrect: the main question mark would be

against the extent of the pre-tax loss. The reliability of the figure for the reported loss would be very dependent

on the matters considered above.

Under the circumstances prevailing, over or understatement of the pre-tax loss would be offset by a

corresponding decrease or increase in the exceptional item, loss on sale of subsidiary. In the light of thiscompensating effect, the auditor of Darmody would be able to accept a higher level of error than would have been

the case if the group structure had continued as before.

(b) During the course of their planning, the external auditors should perform an assessment of the internal audit

function if they consider that it may be possible, and desirable, to rely on some of their work.G If the external auditor can rely on the work conducted by the internal auditor, the volume of detailed work

undertaken by the external auditor may be reduced.G ISA 610 Considering the Work of Internal Auditingsets out the criteria that auditors should use when

obtaining an understanding, and subsequent assessment of, the internal audit function.

General assessment includes:(a) Organisational status i.e. degree of independence

(b) Scope of function

(c) Technical competence

(d) Due professional care.

When the external auditor intends to use the specific work of internal auditing, the external auditor should

evaluate and perform audit procedures on that work to confirm its adequacy for the external auditors purposes.

Factors to consider include:

(a) adequacy of technical training and proficiency

(b) whether work of assistants is properly supervised, reviewed and documented

(c) sufficiency and appropriateness of audit evidence to be able to draw reasonable conclusions

(d) whether conclusions are appropriate and reports are consistent with work performed

(e) whether any exceptions or unusual matters disclosed are properly resolved

All of these are important in the present instance but from the point of view of the external auditors the most

important is probably the sufficiency and appropriateness of the audit evidence to be able to draw reasonable

conclusions therefrom. If this is available it may amount to sufficient evidence for the external auditor to rely on

it.

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(c) Audit of loss on disposal of subsidiary

The auditor of Darmody should check the loss arising on the disposal of its subsidiary Kris as follows.

(i) Confirm that the net assets of Kris at 31 August 2007 are equivalent to the reported net assets at 31 August

2006 less the reported trading loss for the year ended 31 August 2007.

(ii) Consider whether any write-downs to fair value less costs to sell should have been recorded when the

decision was made to sell the subsidiary these would reduce the loss on sale of the subsidiary shown in

the note, but would be reported in the same line of the income statement as the loss so the total would

remain the same.

(iii) The cash proceeds should be confirmed to any agreement in relation to the sale of Kris and agreed to postbalance sheet receipts.

(iv) The sale of the subsidiary should be confirmed to board minutes and a sales agreement.

(v) The journal posting the loss should be traced through to the nominal ledger.

(vi) The notes to the financial statements should be checked to ensure that adequate disclosure of the disposal

and any write downs to fair value less costs to sell are given. The treatment as an 'exceptional' item

appears to be in accordance with the positioning in IFRS 5, however, the loss on disposal should be shown

net of the tax effect (here, presumably a tax saving if tax losses can be carried forward).


Question 4 Marks

Part (a)Auditor should consider results of subsidiary in light of

- Reliability of previous years management accounts 1

- Accounts prepared on a consistent basis 1

- How much information from management of Kris 1

- Audit work carried out during interim audit 1

- Any other work before control was lost 1

Extent of pre-tax loss is debatable 1

Over-statement or under-statement of pre-tax loss will cancel out 1

Therefore higher risk or materiality may be acceptable 1

Other relevant points (up to 2) 2

Maximum 8Part (b)

General background of relying on IA work 11/2

Specific factors mentioned in ISA 610 (1/2 mark each) 21/2

Applicability to this case 2

Other relevant points 1

Maximum 6

Part (c)

Confirm net assets at 31-08-07 1

Any recording of write-downs necessary 1

Confirmation of cash proceeds 1

Confirm authorisation for sale to board minutes 1

Trace journal to nominal ledger 1

Check notes to FS 1

Other relevant points 1

Maximum 6

Overall Maximum 20

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Solution 5

(a) A standard audit report is given following a conventional audit. It gives reasonable (though not absolute)

assurance to a user that the financial statements subject to audit show a true and fair view and also covers

various other matters required by statute in the jurisdiction in which it is produced e.g. Irish reports will state

whether or not proper books of account have been kept by the company. The opinion is typically worded in a

positive way e.g. In our opinion the financial statements give a true and fair view

A review report follows a review. A compilation report is produced in a situation where an accountant prepares

financial statements but does not audit them. No assurance can be taken from a compilation report, they aretypically used for the financial statements of sole traders and partnerships.

(b) Date: 29 April 2008

To: Mr. Reginald Herbert CPA, Managing Partner.

From: Arthur Henry, Technical Partner

Re: Audit Report Queries Various Clients

Client A:

Notes to the accounts (and the Directors Report) should explain what has happened indicating that there was no

reserve deficiency when the decision was made to distribute the funds.

Assuming that this information is given, an explanatory paragraph (technically an emphasis of matter) should beincluded in the audit report. Otherwise, we run the risk of giving the impression that we failed to notice the matter!!

If the notes to the accounts do not explain what has happened we would need to give the information in the audit

report. This would constitute an except for qualification except for the non-disclosure of certain information etc.

Client B:

There is no question that last year Client B was suffering multiple inherent uncertainties and, for that reason, it

was reasonable of the previous auditors to disclaim their opinion on the financial statements.

The situation this year is much improved. The arbitration and legal proceedings are now settled so there is less

uncertainty. The tax appeals appear largely settled although you would need evidence of this.

The matters in relation to the 2002 credit agreement are much improved and there is also less uncertainty on this

point than previously. However, this could unravel if the various conditions are not met.The budgeted projections for year ended 31 December 2008 are encouraging but more evidence would be

needed that the preconditions for the moratorium will be fulfilled. In particular it is worth noting that in 2007 the

projected loss was only 200,000 while the actual loss came in at 5,000,000. We would need evidence that this

type of situation will not be repeated.

Assuming that this does not give rise to a problem that leaves only the default on the 4,600,000 of loan stock

as outstanding. As long as this problem continues there has to be a doubt about the going concern of Client B.

However, if the circumstances are properly disclosed in the financial statements an emphasis of matter

modification in the financial statements may be all that is necessary.

If details of going concern issues are not given in the financial statements then the appropriate treatment is to

qualify the audit report on the financial statements by reason of disagreement with the non-disclosure. This could

either be an except-for qualification or an adverse opinion. The threat of such an opinion should be enough to

induce the client to disclose the information and avoid a qualification.

I hope you find the above useful.

Kind Regards,

Arthur

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Question 5 Marks

Part (a)

Audit Reports (AR) and Compilation Reports (CR)

AR follows conventional audit 1

Expressed in positive terms 1

CR is used following the preparation of financial statements 1

Gives no assurance 1Typical uses of a CR 1

AR has statutory basis, CR does not 1

Other relevant point 1

Maximum 6

Part (b)

Possible bonus mark for correct format i.e. letter etc. 1

Client A:

Notes to the accounts should explain what has happened 1

If so, auditor should refer to this in AR technically EOM 1

If notes do not explain what has happened auditor should the information 1

This is an except for qualification 1

Other relevant point 1Maximum 5

Client B:

Last years auditor correct to disclaim 1

Certain matters cleared up this year : Arbitration & legal issues 1

Tax matters need evidence 1

2002 credit agreement sorted but could unravel 1

Last years budgets inaccurate; need more evidence 1

Still significant uncertainty re loan in default GC still in some doubt 1

Unmodified report still not an option 1

If properly disclosed, then EOM may be sufficient 1

If not properly disclosed then disagreement is appropriate 1Other relevant points up to 2

Maximum 9

Overall Maximum 20

p2 - audit practice april 08

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