2015 ACCA P7 Revision Kit BPP

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Paper P7
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the questions, solutions and guidance provide the
• Banks of questions on every syllabus area
Practice & Revision Kit

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• Answers with detailed guidance on approaching
revising for the exam.
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• Three mock exams with full answers and guidance

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PAPER P7 E
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ADVANCED AUDIT AND
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ASSURANCE
(INTERNATIONAL)
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BPP Learning Media is an ACCA Approved Learning Partner – content for the ACCA
qualification. This means we work closely with the ACCA to ensure our products fully
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prepare you for your ACCA exams.

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In this Practice and Revision Kit, which has been reviewed by the ACCA examination
team, we: I
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 Discuss the best strategies for revising and taking your ACCA exams
 Ensure you are well prepared for your exam
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 Provide you with lots of great guidance on tackling questions

 Provide you with three mock exams
 Provide ACCA exam answers as well as our own for selected questions
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Our Passcard and i-pass products also support this paper.

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FOR EXAMS UP TO JUNE 2015

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First edition 2007
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Eighth edition June 2014
ISBN 9781 4727 1113 7

(previous ISBN 9781 4453 6658 6)
e-ISBN 9781 4727 1177 9

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British Library Cataloguing-in-Publication Data All rights reserved. No part of this publication may be
A catalogue record for this book reproduced, stored in a retrieval system or transmitted, in
is available from the British Library any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior
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written permission of BPP Learning Media Ltd.

Published by
BPP Learning Media Ltd
We are grateful to the Association of Chartered Certified
BPP House, Aldine Place
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Accountants for permission to reproduce past

London W12 8AA
examination questions. The suggested solutions in the
practice answer bank have been prepared by BPP
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Learning Media Ltd, except where otherwise stated.
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Printed in the United Kingdom by

RICOH UK Limited
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Your learning materials, published by BPP Learning

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Contents
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Page
Finding questions
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Question index .................................................................................................................................................................. v
Topic index .................................................................................................................................................................... viii
Helping you with your revision ..................................................................................................................... ix
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Revising P7
Topics to revise................................................................................................................................................................. x
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Question practice .............................................................................................................................................................. x
Passing the P7 exam........................................................................................................................................................ xi
Exam information ........................................................................................................................................................... xvi
Examinable documents ................................................................................................................................................. xvii
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Useful websites ............................................................................................................................................................. xxi
Analysis of past papers ................................................................................................................................................ xxii
Questions and answers

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Questions..........................................................................................................................................................................3
Answers ..........................................................................................................................................................................81
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Exam practice
Mock exam 1
 Questions ............................................................................................................................................................345
 Plan of attack .......................................................................................................................................................353
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 Answers...............................................................................................................................................................354
Mock exam 2
 Questions ............................................................................................................................................................373
 Plan of attack .......................................................................................................................................................381
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 Answers...............................................................................................................................................................382
Mock exam 3 (December 2013)
 Questions ............................................................................................................................................................405
 Plan of attack .......................................................................................................................................................413
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 Answers...............................................................................................................................................................414
ACCA examiner's answers
 June 2013............................................................................................................................................................439
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 December 2013 ...................................................................................................................................................455
Review form
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iii
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A note about copyright
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What does the little © mean and why does it matter?
Your market-leading BPP books, course materials and e-learning materials do not write and update themselves.
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Breach of copyright is a form of theft – as well as being a criminal offence in some jurisdictions, it is potentially a
serious breach of professional ethics.
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With current technology, things might seem a bit hazy but, basically, without the express permission of BPP
Learning Media:
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 Scanning, ripcasting or conversion of our digital materials into different file formats, uploading them to
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iv Finding questions
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Question index
The headings in this checklist/index indicate the main topics of questions, but questions are expected to cover
several different topics.
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Questions set under the old syllabus paper Audit and Assurance Services (AAS) are included because their style and content
are very similar to that of the current P7 exam. The questions have been amended to reflect the current exam format.
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Time Page number
allocation
Marks Mins Question Answer
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Parts A and B: Regulatory environment and
professional and ethical considerations
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1 Lark (6/12) 15 27 3 81
2 Plant (12/12) 16 29 3 84
20 36 4 87
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3 Becker (12/08)
4 Peaches (12/09) 16 29 5 91
5 Retriever (6/13) 25 45 5 93
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6 Smith & Co (6/08) 17 31 6 99
7 Carter (6/10) 20 36 7 102
8 Dedza (Pilot paper) 20 36 7 105
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9 Clifden (6/09) 17 31 8 108
Part C: Practice management
10 Hawk Associates (AAS 6/04) 15 27 9 111

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11 Grape (12/09) 36 65 9 114

12 Ingot & Co (Pilot paper) 20 36 10 121
13 Nate & Co (12/07) 20 36 11 123
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14 Wexford (6/11) 18 32 12 126

15 Spaniel & Bulldog (6/13) 20 36 12 129
16 Raven (6/12) 15 27 13 132
17 Dragon Group (6/09) 34 61 13 135
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Part D and E: Audit of historical financial

information and other assignments
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18 Pulp (6/08) 17 31 16 140

19 Aspersion (AAS 12/01) 20 36 16 143
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20 Mac (6/10) (amended) 26 47 17 147

21 Distant 15 27 18 151
22 Juliet (6/10) 20 36 19 153
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23 Apricot (12/09) 16 29 19 156

24 Poppy (12/08) 20 36 21 158
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25 Magpie (6/12) 37 67 21 161

26 Beech (12/11) 18 32 23 167
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27 Setter (6/13) 20 36 24 170

28 Lamont (AAS 6/07) 20 36 25 174
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Finding questions v
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Time Page number
allocation
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29 Papaya (12/09) 36 65 25 176
30 Bill (6/11) (amended) 39 70 26 181
31 Mulligan (12/07) 20 36 28 187
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32 Parker (6/13) 35 63 29 190
33 Lapwing (6/12) 33 59 31 196
34 Azure Airline (AAS 12/04) 35 63 33 201
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35 Island (12/07) (amended) 32 58 34 206
36 Meadow (AAS 12/02) (amended) 29 52 36 211
37 Butler (6/11) (amended) 32 58 38 215
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38 Grohl (12/12) 40 72 40 220
39 Champers (6/09) (amended) 36 65 42 226
40 Grissom (6/10) (amended) 38 68 44 231
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41 Jacob (6/11) 18 32 45 236
42 Cusiter (AAS 6/07) 29 52 46 239
43 Oak (12/11) (amended) 41 74 48 242
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44 Geno Vesa Farm (AAS 6/05) 26 47 50 248
45 Cedar (12/11) 18 32 51 252
46 Willow (12/11) (amended) 27 49 52 254
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47 Jovi (12/12) 28 50 53 258
48 Kobain (12/12) 16 29 56 262
49 Cuckoo Group 34 61 57 264
50 Bluebell (12/08) (amended) 36 65 58 267
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51 Robster (6/09) (amended) 17 31 60 273

52 Efex Engineering (Pilot paper) (amended) 34 61 60 276
53 Bateleur Zoo Gardens 34 61 62 279
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54 Sci-Tech (12/07) (amended) 34 61 63 284

55 Rosie (6/08) (amended) 36 65 65 289
56 Medix (6/08) (amended) 36 65 67 294
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Part F: Reporting
57 Yew (12/11) 18 32 69 300

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58 Snipe (6/12) 15 27 70 302

59 Nassau Group (6/11) 18 32 70 304
60 Cinnabar Group (AAS 6/02) 15 27 71 307
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61 Poodle (6/13) 20 36 72 310

62 Dexter (12/08) 20 36 73 313
63 Johnston and Tiltman (AAS 6/06) (amended) 15 27 73 317
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64 Lychee (12/09) 16 29 74 319

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65 Grimes (6/10) 20 36 74 322

66 Pluto (6/09) 17 31 75 325
67 Cleeves (AAS 12/06) 15 27 75 328
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68 Blod (6/08) 17 31 76 330

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vi Finding questions
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Time Page number
allocation
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69 Axis & Co (Pilot paper) 15 27 77 333
70 Dylan (12/12) 16 29 77 334
71 Bertie & Co (12/07) 20 36 78 337
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Mock exam 1
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Mock exam 2
Mock exam 3 (December 2013 paper)
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Finding questions vii
Topic index
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Listed below are the key Paper P7 syllabus topics and the numbers of the questions in this Kit covering those
topics. If you need to concentrate your practice and revision on certain topics or if you want to attempt all available
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questions that refer to a particular subject, you may find this index useful.
Syllabus topic Question numbers
A REGULATORY ENVIRONMENT
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1 International regulatory frameworks for audit and assurance services 20(d)
2 Money laundering 1(a), 8, 11(c), 13(a)
3 Laws and regulations 39, 56(b), 67(a)
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B PROFESSIONAL AND ETHICAL CONSIDERATIONS
1 Code of Ethics for Professional Accountants 1(b), 3-9, 13, 14(a), 15(a), 16, 22(b),
25(b), 56(a), 68(b), 70(a)
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2 Fraud and error 15(b)–(c), 20(d), 66(a)
3 Professional liability 15(d), 42(d), 66(b), 68(c)
C PRACTICE MANAGEMENT
1 Quality control 2, 11, 12, 18(c), 35(c), 43(b), 66(c)
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2 Advertising, publicity, obtaining professional work and fees 4, 10
3 Tendering 9(b), 17(b)
4 Professional appointments 7, 14(a), 17(a), 21(b), 33(a), 56(a),
D
1(i)
AUDIT OF HISTORICAL FINANCIAL INFORMATION ria
Planning, materiality and assessing the risk of material misstatement
70(a)
14(b), 22(b), 25(a), 29-30, 32(a)–(b),

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35–40, 43(a), 44, 47-51, 52(c)–(d),
53(a), 54, 56(b)–(d)
1(ii) Evidence 18(a), 24, 47(c)
1(iii) Evaluation and review 11(a), 18(b), 19, 26-28, 33(b), 36(b),
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37(b), 38(b)–(c), 39(c), 40(c), 44(b),

46, 47(d), 52(c)–(d), 54(b)–(c),
55(b), 58(a), 61(a), 62(a), 63(a),
64(a)
2 Group audits 25(a), 40, 49-50, 55(c), 59(b), 67(b)
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E OTHER ASSIGNMENTS
1 Audit-related services 41, 55(a)
2 Assurance services 31(a)-(b), 34, 71(b)–(c)
3 Prospective financial information 21, 23, 33(a), 37(a), 42(a)–(c)
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4 Forensic audits 20(c), 31(c), 45(a)–(b), 52(a)–(b)

5 Internal audit 20(a)–(b)
6 Outsourcing 20(a)–(b), 54(a)
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F REPORTING
1 Auditor's reports 37(b), 57, 58(b), 59–60, 61(b),
62(b)–(c), 63(b), 64(b), 65(a), 66(b),
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67(b), 68(c), 69, 70(b), 71(a)

2 Reports to those charged with governance and management 68(a)
3 Other reports 68(a)
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G CURRENT ISSUES AND DEVELOPMENTS

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1 Professional and ethical 22(a), 45(c)

2 IFAC developments 4
3 Transnational audits 17(c)
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4 Social and environmental auditing 32(c), 33(b), 50(c)

5 Other current issues 22(a), 24(a)
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viii Finding questions
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Helping you with your revision
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BPP Learning Media – Approved Learning Partner – content
As ACCA’s Approved Learning Partner – content, BPP Learning Media gives you the opportunity to use exam team
reviewed revision materials. By incorporating the examiner’s comments and suggestions regarding syllabus
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coverage, the BPP Learning Media Practice and Revision Kit provides excellent, ACCA-approved support for your
revision.
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Tackling revision and the exam
Using feedback obtained from the ACCA exam team review:
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 We look at the dos and don’ts of revising for, and taking, ACCA exams
 We focus on Paper P7; we discuss revising the syllabus, what to do (and what not to do) in the exam, how
to approach different types of question and ways of obtaining easy marks
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Selecting questions
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We provide signposts to help you plan your revision.
 A full question index
 A topic index listing all the questions that cover key topics, so that you can locate the questions that provide
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practice on these topics, and see the different ways in which they might be examined
Making the most of question practice

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At BPP we realise that you need more than just questions and model answers to get the most from your question
practice.
 Our Top tips provide essential advice on tackling questions, presenting answers and the key points that
answers need to include.
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 We show you how you can pick up Easy marks on some questions, as we know that picking up all readily
available marks often can make the difference between passing and failing.
 We include marking guides to show you what the examiner rewards.
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 We include examiner’s comments to show you where students struggled or performed well in the actual exam.
 We refer to the 2014 BPP Study Text (for exams up to June 2015) for detailed coverage of the topics
covered in questions.
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 In a bank at the end of this Kit we include the official ACCA answers to the June and December 2013
papers. Used in conjunction with our answers they provide an indication of all possible points that could be
made, issues that could be covered and approaches to adopt. Note that the official ACCA answers for the
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2013 exams have not been updated for technical changes coming into effect for exams up to June 2015.
However, the BPP model answers for these questions have been updated.
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Attempting mock exams

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There are three mock exams that provide practice at coping with the pressures of the exam day. We strongly
recommend that you attempt them under exam conditions. Mock exams 1 and 2 reflect the question styles and
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syllabus coverage of the exam; Mock exam 3 is the December 2013 paper.
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Helping you with your revision ix
Revising P7
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Topics to revise
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Paper P7 is a challenging higher level paper consisting of two compulsory case-study style questions in Section A
(worth a total of 60 marks) and two out of three short scenario questions in Section B (worth a total of 40 marks).
The P7 examiner, has stated that planning and risk assessment are key areas which are likely to form part of a
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compulsory question. Evidence is also likely to feature in Section A. Reporting could come up in either a
compulsory or optional question (although it has tended to be optional), similarly ethical and professional issues.
Current issues could come up anywhere on the paper so it is important that students do not ignore this area and
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make sure they keep up to date by reading Student Accountant and reviewing the accountancy and financial press.
It has been a feature of P7 in recent years for questions to mix together several different syllabus areas. One
consequence of this is to make it more difficult for candidates to avoid areas of the syllabus that they do not like.
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One of the general features of Professional level papers is the availability of professional marks. These will generally
be awarded in Section A and comprise four marks. They will be awarded for the degree of professionalism with
which answers are presented. For example, if you are asked to set out your answer as a letter or a report, marks will
be awarded for presentation – using the correct heading at the start, and including an appropriate introduction and
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conclusion. Other professional marks could be awarded for the form of your answer such as the structure or logical
flow of arguments. You should assume that if a question asks for a certain format, that there will be some
professional marks available.
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To summarise, although this paper does contain an optional element, we strongly advise that you do not selectively
revise certain topics – any topic from the syllabus could be examined anywhere on the paper. Selective revision will
limit the number of questions you can answer and hence reduce your chances of passing.
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Question practice
You should use the Passcards and any brief notes you have to revise the syllabus, but you mustn't spend all your
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revision time passively reading. Question practice is vital; doing as many questions as you can in full will help
develop your ability to analyse scenarios and produce relevant discussion and recommendations.
Make sure you leave enough time in your revision schedule to practise Section A questions, as these questions are
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compulsory in the exam. The scenarios and requirements of Section A questions are more complex and will
integrate several parts of the syllabus, so practice is essential. Also ensure that you attempt all three mock exams
under exam conditions.
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x Revising P7
Passing the P7 exam
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Displaying the right qualities and avoiding weaknesses
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(a) Reading time
You have 15 minutes of reading time – make sure you use it wisely. Given that Section A will consist of two
compulsory questions, worth 60 marks in total, you could spend the time analysing and planning these
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questions and doing them first, and then choose and tackle the optional questions from Section B.
(b) The following are examples of things to avoid – and note our comments about action to take in each case.
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Failure to complete the paper This problem can be avoided by ensuring that you have a very disciplined exam
technique and that you set times in which to answer questions and, when that
time is over, you move on to the next question. Lots of practice at answering
questions in timed conditions will help you to discipline yourself in this way.
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Remember, it is easier to get marks at the outset of answering a question
(when all the marks are still available) than to get the last few remaining marks
for a question (when you have made all the easy points and are struggling with
the most difficult aspects of the question).
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Not reading the question We recommend that you read each question more than once. Try to force
yourself to read slowly as well. Although the exam is time-limited, reading the
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question properly is a good investment.
Lack of comprehension and These are higher level skills which you have to learn at this level and the best
analytical skills way to enhance them is to practise as many questions as you can. In addition,
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once you have completed your own answer, you should always work through
the suggested answer referring back to the question so that you can see the
links that have been made.
Lack of lower level assumed You should endeavour not to commence your P7 studies until you have
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knowledge completed your F8 studies. It is not possible to pass P7 unless you have a very
firm understanding of basic auditing theory. The same goes for paper P2; it is
important that you retain your knowledge of corporate reporting from paper P2,
and that you are up to date with the latest standards and developments.
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Lack of awareness of current You should ensure that you keep up to date with current issues in the auditing
issues and business world, by reading examiner articles as a minimum, but preferably
by keeping an eye on the accountancy press throughout your studies.
Failure to respond in a The answer to this problem is to practice lots of questions, read other people's
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practical/commercial way answers to questions in this Kit and on the ACCA website and to try and think
about how you would respond in practice if it were one of your clients.
Lack of relevant practical You may not be able to do anything about this if you are not employed in a
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experience relevant field. However, if you can, do. For example, if you can discuss with
your managers the necessity of getting relevant experience and they are able to
meet that need, try and obtain as much relevant experience as you can. If not,
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the best you can do is follow the advice for the previous point, which should
stand you in good stead.
Inability to reach a You must get into the habit of drawing conclusions where the requirement is to
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conclusion/make a decision do so. Again, practise questions where this is required, and, when reading
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questions note whether you are required to draw a conclusion or make a

decision.
Poor exam technique/time This point links to the first point made above. There is a great deal of guidance
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allocation concerning exam technique in this kit. Read it and put it into practice.
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Revising P7 xi
Using the reading time
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We recommend that you spend the first part of the 15 minutes reading time choosing the Section B questions you
will do, on the basis of your knowledge of the syllabus areas being tested and whether you can fulfil all the question
requirements. Remember that Section B questions can cover different parts of the syllabus, and you should be
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happy with all the areas that the questions you choose cover. We suggest that you should note on the paper any
ideas that come to you about these questions.
However don't spend all the reading time going through and analysing the Section B question requirements in
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detail; leave that until the three hours' writing time. Instead you should be looking to spend as much of the reading
time as possible looking at the Section A scenario, as this will be longer and more complex than the Section B
scenarios and cover more of the syllabus. You should highlight and annotate the key points of the scenario on the
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question paper.
Choosing which questions to answer first
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Spending most of your reading time on the compulsory Section A questions will mean that you can get underway
with planning and writing your answer to the Section A questions as soon as the three hours start. It will give you
more actual writing time during the one and a half hours you should allocate to it and it's writing time that you'll
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need. Comments from examiners of other syllabuses that have similar exam formats suggest that students appear
less time-pressured if they do the big compulsory questions first.
During the second half of the exam, you can put Section A aside and concentrate on the two Section B questions
you've chosen.
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However our recommendations are not inflexible. If you really think the Section A questions looks a lot harder than
the Section B questions you've chosen, then do those first, but DON'T run over time on them. You must leave
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yourself plenty of time to tackle the Section A questions. When you come back to it, having had initial thoughts
during the reading time, you should be able to generate more ideas and find the question is not as bad as it looks.
Remember also that small overruns of time during the first half of the exam can add up to your being very short of
time towards the end.
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Tackling questions
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Scenario questions
You'll improve your chances by following a step-by-step approach to Section A scenarios along the following lines.
Step 1
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Read the background

Usually the first couple of paragraphs will give some background on the company and what it is
aiming to achieve. By reading this carefully you will be better equipped to relate your answers to the
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company as much as possible.
Step 2 Read the requirements

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There is no point reading the detailed information in the question until you know what it is going to
be used for. Don't panic if some of the requirements look challenging – identify the elements you are
able to do and look for links between requirements, as well as possible indications of the syllabus
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areas the question is covering.
Step 3
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Identify the action verbs

These convey the level of skill you need to exhibit and also the structure your answer should have. A
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lower level verb such as define will require a more descriptive answer; a higher level verb such as
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xii Revising P7
evaluate will require a more applied, critical answer. It should be stressed that higher level
requirements and verbs are likely to be most significant in this paper.
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Action verbs that are likely to be frequently used in this exam are listed below, together with their
intellectual levels and guidance on their meaning.
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Intellectual level
1 Define Give the meaning of
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1 Explain Make clear
1 Identify Recognise or select
1 Describe Give the key features
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2 Distinguish Define two different terms, viewpoints or
concepts on the basis of the differences between
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them
2 Compare and Explain the similarities and differences between
contrast two different terms, viewpoints or concepts
2 Contrast Explain the differences between two different
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terms, viewpoints or concepts
2 Analyse Give reasons for the current situation or what has
happened
3 Assess
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Determine the strengths/weaknesses/
importance/significance/ability to contribute
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3 Examine Critically review in detail
3 Discuss Examine by using arguments for and against
3 Explore Examine or discuss in a wide-ranging manner
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3 Criticise Present the weaknesses of/problems with the

actions taken or viewpoint expressed, supported
by evidence
3 Evaluate/critically Determine the value of in the light of the
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evaluate arguments for and against (critically evaluate

means weighting the answer towards
criticisms/arguments against)
3 Construct the case Present the arguments in favour or against,
as
supported by evidence
3 Recommend Advise the appropriate actions to pursue in terms
the recipient will understand
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Also make sure you identify all the action verbs; some question parts may have more than one.
Step 4 Identify what each part of the question requires

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Think about what frameworks or theories you could choose if the question doesn't specify which one
to use.
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When planning, you will need to make sure that you aren't reproducing the same material in more
than one part of the question.
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Also you're likely to come across part questions with two requirements that may be at different
levels; a part question may for example ask you to explain X and discuss Y. You must ensure that you
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fulfill both requirements and that your discussion of Y shows greater depth than your explanation of
X (for example by identifying problems with Y or putting the case for and against Y).
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Revising P7 xiii
Step 5 Check the mark allocation to each part
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This shows you the depth anticipated and helps allocate time.
Step 6 Read the whole scenario through, highlighting key data
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Put points under headings related to requirements (eg by noting in the margin to what part of the
question the scenario detail relates).
Step 7
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Consider the consequences of the points you've identified
Remember that you will often have to provide recommendations based on the information you've
been given. Consider that you may have to criticise the code, framework or model that you've been
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told to use. You may also have to bring in wider issues or viewpoints, for example the views of
different stakeholders.
Step 8
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Write a brief plan
You may be able to do this on the question paper as often there will be at least one blank page in the
question booklet. However any plan you make should be reproduced in the answer booklet when
writing time begins.
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Make sure you identify all the requirements of the question in your plan – each requirement may have
sub-requirements that must also be addressed. If there are professional marks available, highlight in
your plan where these may be gained (such as preparing a report).
Step 9 Write the answer ria

Make every effort to present your answer clearly. The pilot paper and exam papers so far indicate that
ate
the examiner will be looking for you to make a number of clear points. The best way to demonstrate
what you're doing is to put points into separate paragraphs with clear headers.
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Discussion questions
Remember that depth of discussion will be important. Discussions will often consist of paragraphs containing 2-3
sentences. Each paragraph should:
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 Make a point
 Explain the point (you must demonstrate why the point is important)
 Illustrate the point (with material or analysis from the scenario, perhaps an example from real-life)
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In this exam a number of requirement verbs will expect you to express a viewpoint or opinion, for example
construct an argument, criticise, evaluate. When expressing an opinion, you need to provide:
 What the question wants. For instance, if you are asked to criticise something, don't spend time discussing
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its advantages. In addition if a scenario provides a lot of information about a situation, and you are (say)
asked to assess that situation in the light of good practice, your assessment is unlikely to be favourable.
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 Evidence from theory or the scenario – again we stress that the majority of marks in most questions will be
given for applying your knowledge to the scenario.
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xiv Revising P7
Gaining the easy marks
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Knowledge of the core topics that we list under topics to revise should present you with some easy marks. The pilot
paper suggests that there will be some marks available on certain part questions for definitions, explanations or
descriptions that don't have to be related to the scenario. However don't assume that you can ignore all the
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scenarios and still pass!
As P7 is a Professional level paper, 4 professional level marks will be awarded. Some of these should be easy to
obtain. The examiner has stated that some marks may be available for presenting your answer in the form of a
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letter, presentation, memo, report or briefing notes. You may also be able to obtain marks for the style and layout of
your answer.
Reports should always have an appropriate title. They should be formally written, with an introductory paragraph
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setting out the aims of the report. You should use short paragraphs and appropriate headings, with a summary of
findings as a conclusion.
Memoranda and Briefing notes should have the following information at the beginning:
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Subject; name of recipient; name of author; date
The language can be less formal than a report but the content should still have an introduction and conclusion, and
be divided into small paragraphs with appropriate headings.
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Letters should be addressed appropriately to the correct person and be dated. They should have a short
introductory paragraph, a conclusion and should be in a formally writing style. Letters beginning with 'Dear
Sir/Madam' should end with 'Yours faithfully'.
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Revising P7 xv
Exam information
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The exam paper
The exam is a three-hour paper consisting of two sections.
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Section A will consist of two compulsory 'case study' style questions. These will include detailed information
including, for example, extracts from financial statements and audit working papers. The questions will include a
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range of requirements covering different syllabus areas.
Section B questions will tend to be more focused towards specific topic areas, such as ethical issues and auditor's
reports. Short scenarios will be provided as a basis for these questions.
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Number of
marks
Section A: Two compulsory questions:
Question one 35
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Question two 25
Section B: Choice of two from three questions (20 marks each) 40
100
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Question format
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The format of questions in P7 is different between section A and section B. Section A questions will feature
scenarios, with simple requirements such as 'Respond to the email', or 'Draft the briefing notes as requested'. You
will have to work out for yourself what you need to include in your answer, using the breakdown of the mark
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allocation which will be included within the scenario. Section B questions will feature requirements akin to those in
your previous ACCA exams.
Students should be aware that future P7 papers will feature a fixed question format for Question One. The question
will be for 35 marks and will feature instructions in the form of an email included within the question scenario itself.
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Four professional marks will be available in each paper.

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xvi Revising P7
Examinable documents
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A full list of examinable documents was not available at the time the BPP Study Text for this paper went to print.
Therefore the list of examinable documents for Paper P7 is printed in full below.
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The accounting knowledge that is assumed for Paper P7 is the same as that examined in Paper P2. Therefore,
candidates studying for Paper P7 should refer to the Accounting Standards listed under Paper P2.
Note. P7 will only expect knowledge of accounting standards and financial reporting standards from Paper P2.
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Knowledge of exposure drafts and discussion papers will not be expected.
Title F8 P7
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International Standards on Auditing (ISAs)
Glossary of Terms  
International Framework for Assurance Assignments  
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Preface to the International Standards on Quality Control, Auditing, Review,  
Other Assurance and Related Services
ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in  
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Accordance with ISAs
ISA 210 Agreeing the Terms of Audit Engagements  
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ISA 220 Quality Control for an Audit of Financial Statements 
ISA 230 Audit Documentation  
ISA 240 The Auditor's Responsibilities Relating to Fraud in an Audit of Financial  
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Statements
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements  
ISA 260 Communication with Those Charged with Governance  
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ISA 265 Communicating Deficiencies in Internal Control to Those Charged with  

Governance and Management
ISA 300 Planning an Audit of Financial Statements  
ISA 315 Identifying and Assessing the Risks of Material Misstatement through  
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Understanding the Entity and Its Environment

ISA 320 Materiality in Planning and Performing an Audit  
ISA 330 The Auditor's Responses to Assessed Risks  
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ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation  

ISA 450 Evaluation of Misstatements Identified During the Audit  
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ISA 500 Audit Evidence  

ISA 501 Audit Evidence – Specific Considerations for Selected Items  
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ISA 505 External Confirmations  

ISA 510 Initial Audit Engagements – Opening Balances  
ISA 520 Analytical Procedures  
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ISA 530 Audit Sampling  

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ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting Estimates  
and Related Disclosures
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ISA 550 Related Parties 

ISA 560 Subsequent Events  
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Revising P7 xvii
Title F8 P7
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International Standards on Auditing (ISAs)
ISA 570 Going Concern  
ISA 580 Written Representations  
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ISA 600 Special Considerations - Audits of Group Financial Statements (Including the 
Work of Component Auditors)
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ISA 610 Using the Work of Internal Auditors  
ISA 620 Using the Work of an Auditor's Expert  
ISA 700 Forming an Opinion and Reporting on Financial Statements  
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ISA 705 Modifications to the Opinion in the Independent Auditor's Report  
ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the  
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Independent Auditor's Report
ISA 710 Comparative Information – Corresponding Figures and Comparative Financial  
Statements
ISA 720 The Auditor's Responsibilities Relating to Other Information in Documents  
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Containing Audited Financial Statements
International Standards on Assurance Engagements (ISAEs)
ISAE 3000
ISAE 3400
Information
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Assurance Engagements other than Audits or Reviews of Historical Financial
The Examination of Prospective Financial Information

 

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ISAE 3402 Assurance Reports on Controls at a Service Organisation 
ISAE 3420 Assurance Engagements to Report on the Compilation of Pro Forma Financial 
Information Included in a Prospectus
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International Auditing Practice Notes (IAPNs)

IAPN 1000 Special considerations in auditing financial instruments 
International Standards on Quality Control (ISQCs)
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ISQC 1 Quality Controls for Firms that Perform Audits and Reviews of Financial 
Statements, and Other Assurance and Related Services Engagements
International Standards on Related Services (ISRSs)
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ISRS 4400 Engagements to Perform Agreed-Upon Procedures Regarding Financial 

Information
ISRS 4410 Compilation Engagements 
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International Standards on Review Engagements (ISREs)

ISRE 2400 Engagements to Review Financial Statements  
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ISRE 2410 Review of Interim Financial Information Performed by the Independent 

Auditor of the Entity
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xviii Revising P7
Title F8 P7
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Exposure Drafts (EDs)
Proposed ISA 700 (Revised), Forming an Opinion and Reporting on Financial 
Statements
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Proposed ISA 701, Communicating Key Audit Matters in the Independent 
Auditor's Report

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ISA 720 (Revised) The Auditor's Responsibilities Relating to Other
Information in Documents Containing or Accompanying Audited Financial
Statements and the Auditor's Report Thereon

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Proposed ISA 260 (Revised), Communication with Those Charged with
Governance
Proposed ISA 570 (Revised), Going Concern 
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Proposed ISA 705 (Revised), Modifications to the Opinion in the Independent 
Auditor's Report
Proposed ISA 706 (Revised), Emphasis of Matter Paragraphs and Other 
Matter Paragraphs in the Independent Auditor's Report
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Proposed Conforming Amendments to ISA 210, ISA 230, ISA 540 and ISA 
710
IESBA Responding to a Suspected Illegal Act
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ISAE 3000 (Revised) Assurance Engagements other than Audits or Reviews
of Historical Financial Information


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Other Documents
ACCA's 'Code of Ethics and Conduct'  
IESBA's 'Code of Ethics for Professional Accountants' (Revised May 2013) 
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ACCA's Technical Factsheet 145 – Anti Money-Laundering Guidance for the 

Accountancy Sector
The UK Corporate Governance Code as an example of a code of best practice 
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(Revised September 2012)

The UK Corporate Governance Code as an example of a code of best practice 
in relation to audit committees
IAASB Practice Alert Challenges in Auditing Fair Value Accounting Estimates 
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in the Current Market Environment (October 2008)

IAASB Practice Alert Audit Considerations in Respect of Going Concern in the 
Current Economic Environment (January 2009)
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IAASB Applying ISAs Proportionately with the Size and Complexity of an 

Entity (August 2009)
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IAASB XBRL : The Emerging Landscape (January 2010) 

IAASB Auditor Considerations Regarding Significant Unusual or Highly 
Complex Transactions (September 2010)
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IAASB Questions and Answers Professional Skepticism in an Audit of 

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Financial Statements (February 2012)

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Revising P7 xix
Title F8 P7
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IESBA Staff Questions and Answers on Implementing the Code of Ethics 
IAASB Staff Questions & Answers - Applying ISQC1 Proportionately with the 
Nature and Size of a Firm (October 2012)
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IAASB A Framework for Audit Quality Consultation Paper (January 2013) 
Note. Topics of exposure drafts are examinable to the extent that relevant articles about them are published in
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Student Accountant.
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xx Revising P7
Useful websites
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The websites below provide additional sources of information of relevance to your studies for Advanced Audit and
Assurance.
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 www.accaglobal.com
ACCA's website. The students' section of the website is invaluable for detailed information about the
qualification, past issues of Student Accountant (including technical articles) and a free downloadable
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Student Planner App.
 www.bpp.com
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Our website provides information about BPP products and services, with a link to the ACCA website.
 www.ft.com
This website provides information about current international business. You can search for information and
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articles on specific industry groups as well as individual companies.
 www.ifac.org
This site has links to the International Auditing and Assurance Standards Board for up-to-date information
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on auditing issues.
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Revising P7 xxi
Analysis of past papers
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The table below provides details of when each element of the syllabus has been examined and the question number
and section in which each element appeared.
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Covered
in Text D J D J D J D J D J D J D
chapter 13 13 12 12 11 11 10 10 09 09 08 08 07 PP
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Regulatory
environment
1 International 2(d) 5
regulatory (b)
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frameworks for audit
and assurance
services
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1 Money laundering 3(a) 2 4 5(a),
(c) (a) 5(b)
1 Laws and regulations 3 4
(b) (b)
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Professional and
ethical
considerations
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2 Codes of ethics for 1 1 1(a), 1(b), 2(b) 3 2 (a) 3(b), 4 4 4 4 4 5(b)
professional (c) (b) 3(b) 3(b), (a) 4 (b) 4 (b) 5 (b)
accountants 4 2 4 (b) 4
(a) (c)
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3 Fraud and error 4 2(d) 5
(a) (a)
3 Professional liability 5(b) 5
(c)
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Practice
Management
4 Quality control 2 1(b) 2 5 3 1 3,
(a) (b) (c) (c) (c) 5(b)
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5 Advertising, publicity, 1(b) 4 (a) 4

obtaining (b)
professional work and
fees
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5 Tendering 3 (a) 2
(b)
2
(c)
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5 Professional 3 4 (a) 2 1
appointments (a) (a) (c)
2
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(c)
Assignments
6,7,8, The audit of historical 1, 1 1, 2, 1(a), 1(a), 1, 1(a), 1, 1, 1 1 1 1
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9,10 financial information 3, (a) 3(a)– 2(b), 2(a) 2, 2(c), 3(b), 2 (a) (a) (a) (a)
including: 5 3 (b), 3(a) –(b), 3 3(a) 5(a) (a) 1 1 1 1
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(i) Planning, 4 5(a) –(b), 3(a) (b) –(c) – (b) (b) (b) (b)
materiality and (b) 5(a) –(c), (b) 1 3, 3 2
assessing the 5(a) 5 (c) 5 (a) (b)
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5 –(b) 3 3 2
risk of
(b) (a) (b) (c)
misstatement
(c)
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xxii Revising P7
Covered
in Text D J D J D J D J D J D J D
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chapter 13 13 12 12 11 11 10 10 09 09 08 08 07 PP
(ii) Evidence 3 2
(b) (d)
(iii) Evaluation and
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review
11 Group audits 1 5 1(a) 5 2 2 1(a),
(b) (a) (b) (d) (b) 1(b)
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2 1(c),
(c) 1(d)
Other assignments
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12 Audit-related services 2 4 3 5
(b) (c)
12 Assurance services 2(a), 3 2 3
2(b) (b) (a) (a)
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3
(b)
13 Prospective financial 2(a) 2 3
information (a)
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14 Forensic audits 2 3(c) 4(a) 2(c) 2 3 2(a),
(b) –(b) (c) 2(b)
2(c),
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2(d)
15 Social and 2(b) 2(a), 1
environmental 2(b) (c)
auditing
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15 Public sector audit of
performance
information
16 Internal audit and 4 2(b), 2
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outsourcing (a) (b) (a)

Reports
17 Auditor's reports 5 5 5 5(b) 5(a) 5 5(a) 5(a) 5 5 4
(b) –(b) (a) (b) (a)
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17 Reports to 5(b) 5
management (a)
17 Other reports 3
(b)
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Current issues and

developments
1,2,3 Professional, ethical 4(c) 4(b) 4
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and corporate
governance
11 Transnational audits
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2(
d)
15 Social and
environmental
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auditing
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18 Other current issues 4(a) 3(a) 4 5

(a) (a)
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Revising P7 xxiii
IMPORTANT!
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The preceding table gives a broad idea of how frequently major topics in the syllabus are examined. It should not be
used to question spot and predict for example that Topic X will not be examined because it came up two sittings
ago. The examiner's reports indicate that the examiner is well aware some students try to question spot. You can
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assume that she will therefore take care to ensure that the exams avoid falling into a predictable pattern, and may
examine the same topic two sittings in a row for example.
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xxiv Revising P7
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Questions
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REGULATORY ENVIRONMENT AND PROFESSIONAL AND ETHICAL CONSIDERATIONS
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Questions 1 to 9 cover Regulatory environment and Professional and ethical considerations, the subjects of Parts A
and B of the BPP Study Text for Paper P7.
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1 Lark (6/12) 27 mins
(a) You are a manager in Lark & Co, responsible for the audit of Heron Co, an owner-managed business which
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operates a chain of bars and restaurants. This is your firm's first year auditing the client and the audit for the
year ended 31 March 20X2 is underway. The audit senior sends a note for your attention:
'When I was auditing revenue I noticed something strange. Heron Co's revenue, which is almost entirely
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cash-based, is recognised at $5.5 million in the draft financial statements. However, the accounting system
shows that till receipts for cash paid by customers amount to only $3.5 million. This seemed odd, so I
questioned Ava Gull, the financial controller about this. She said that Jack Heron, the company's owner, deals
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with cash receipts and posts through journals dealing with cash and revenue. Ava asked Jack the reason for
these journals but he refused to give an explanation.
'While auditing cash, I noticed a payment of $2 million made by electronic transfer from the company's bank
account to an overseas financial institution. The bank statement showed that the transfer was authorised by
l.b
Jack Heron, but no other documentation regarding the transfer was available.
'Alarmed by the size of this transaction, and the lack of evidence to support it, I questioned Jack Heron,
asking him about the source of cash receipts and the reason for electronic transfer. He would not give any
answers and became quite aggressive.'
Required ria
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(i) Discuss the implications of the circumstances described in the audit senior's note; and (6 marks)
(ii) Explain the nature of any reporting that should take place by the audit senior. (3 marks)
(b) You are also responsible for the audit of Coot Co, and you are currently reviewing the working papers of the
audit for the year ended 28 February 20X2. In the working papers dealing with payroll, the audit junior has
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commented as follows.
'Several new employees have been added to the company's payroll during the year, with combined payments
of $125,000 being made to them. There does not appear to be any authorisation for these additions. When I
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questioned the payroll supervisor who made the amendments, she said that no authorisation was needed
because the new employees are only working for the company on a temporary basis. However, when
discussing staffing levels with management, it was stated that no new employees have been taken on this
year. Other than the tests of controls planned, no other audit work has been performed.'
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Required
In relation to the audit of Coot Co's payroll, explain the meaning of the term 'professional skepticism', and
recommend any further actions that should be taken by the auditor. (6 marks)
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(Total = 15 marks)
2 Plant (12/12) 29 mins

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(a) You are an audit manager in Weller & Co, an audit firm which operates as part of an international network of
firms. This morning you received a note from a partner regarding a potential new audit client:
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'I have been approached by the audit committee of the Plant Group, which operates in the mobile
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telecommunications sector. Our firm has been invited to tender for the audit of the individual and group
financial statements for the year ending 31 March 20X3, and I would like your help in preparing the tender
document. This would be a major new client for our firm's telecoms audit department.
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The Plant Group comprises a parent company and six subsidiaries, one of which is located overseas. The
audit committee is looking for a cost effective audit, and hopes that the strength of the Plant Group's
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Questions 3
governance and internal control mean that the audit can be conducted quickly, with a proposed deadline of
31 May 20X3. The Plant Group has expanded rapidly in the last few years and significant finance was raised
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in July 20X2 through a stock exchange listing.'
Required
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Identify and explain the specific matters to be included in the tender document for the audit of the Plant
Group. (8 marks)
(b) Weller & Co is facing competition from other audit firms, and the partners have been considering how the
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firm's revenue could be increased. Two suggestions have been made:
1 Audit partners and managers can be encouraged to sell non-audit services to audit clients by including
in their remuneration package a bonus for successful sales.
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2 All audit managers should suggest to their audit clients that as well as providing the external audit
service, Weller & Co can provide the internal audit service as part of an 'extended audit' service.
Required
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Comment on the ethical and professional issues raised by the suggestions to increase the firm's revenue.
(8 marks)
(Total = 16 marks)
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3 Becker (12/08)
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You are a senior manager in Becker & Co, a firm of Chartered Certified Accountants offering audit and assurance
services mainly to large, privately owned companies. The firm has suffered from increased competition, due to two
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new firms of accountants setting up in the same town. Several audit clients have moved to the new firms, leading to
loss of revenue, and an over staffed audit department. Bob McEnroe, one of the partners of Becker & Co, has asked
you to consider how the firm could react to this situation. Several possibilities have been raised for your
consideration:
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1 Murray Co, a manufacturer of electronic equipment, is one of Becker & Co's audit clients. You are aware that
the company has recently designed a new product, which market research indicates is likely to be very
successful. The development of the product has been a huge drain on cash resources. The managing director
of Murray Co has written to the audit engagement partner to see if Becker & Co would be interested in making
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an investment in the new product. It has been suggested that Becker & Co could provide finance for the
completion of the development and the marketing of the product. The finance would be in the form of
convertible debentures. Alternatively, a joint venture company in which control is shared between Murray Co
and Becker & Co could be established to manufacture, market and distribute the new product.
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2 Becker & Co is considering expanding the provision of non-audit services. Ingrid Sharapova, a senior
manager in Becker & Co, has suggested that the firm could offer a recruitment advisory service to clients,
specialising in the recruitment of finance professionals. Becker & Co would charge a fee for this service based
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on the salary of the employee recruited. Ingrid Sharapova worked as a recruitment consultant for a year
before deciding to train as an accountant.
3 Several audit clients are experiencing staff shortages, and it has been suggested that temporary staff
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assignments could be offered. It is envisaged that a number of audit managers or seniors could be seconded
to clients for periods not exceeding six months, after which time they would return to Becker & Co.
Required
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Identify and explain the ethical and practice management implications in respect of:
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(a) A business arrangement with Murray Co (7 marks)

(b) A recruitment service offered to clients (7 marks)
(c) Temporary staff assignments (6 marks)
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(Total = 20 marks)
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4 Questions
4 Peaches (12/09) 29 mins
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(a) Following the International Audit and Assurance Standards Board's Clarity Project, many revised and redrafted
ISAs were effective for audits of financial statements for periods ending on or after 15 December 2010. One of
the objectives of the Clarity Project was to clarify mandatory requirements. This was done by changing the
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wording used in the ISAs to indicate requirements which are expected to be applied in all audits. Some argue
that this introduced a more prescriptive (rules-based) approach to auditing, and that a principles-based
approach is more desirable.
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Required
(i) Contrast the prescriptive and the principles-based approaches to auditing; and (2 marks)
(ii) Outline the arguments for and against a prescriptive (rules-based) approach to auditing. (5 marks)
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(b) You are a manager in the audit department of Peaches & Co, a firm of Chartered Certified Accountants. One
of your responsibilities is to act as a mentor to new recruits into the department. A new junior auditor, Glen
Rambaran, has asked you to answer some questions which relate to issues encountered in his first few weeks
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working at Peaches & Co. The questions are shown below.
(i) When I was on my initial training course, there was a session on ethics in which the presenter talked
about being intimidated by a client. I assume this does not mean physical intimidation, so what is an
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intimidation threat? (3 marks)
(ii) I know that Peaches & Co is facing competition from a new audit firm, and that our firm is advertising
its services in a national newspaper. What are the rules on advertising for new clients? (3 marks)
(iii)
Required
lowballing. What is lowballing and is it allowed?
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I heard one of the audit managers say that our firm had lost an audit client to a competitor because of
(3 marks)
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For each of the three questions raised, provide a response to the audit junior, in which you identify and
explain the ethical or professional issue raised.
(Total = 16 marks)
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5 Retriever (6/13) 45 mins

(a) Kennel & Co, a firm of Chartered Certified Accountants, is the external audit provider for the Retriever Group
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(the Group), a manufacturer of mobile phones and laptop computers. The Group obtained a stock exchange
listing in July 20X2. The audit of the consolidated financial statements for the year ended 28 February 20X3 is
nearing completion.
You are a manager in the audit department of Kennel & Co, responsible for conducting engagement quality
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control reviews on listed audit clients. You have discussed the Group audit with some of the junior members
of the audit team, one of whom made the following comments about how it was planned and carried out:
'The audit has been quite time-pressured. The audit manager told the juniors not to perform some of the
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planned audit procedures on items such as directors' emoluments and share capital as they are considered to
be low risk. He also instructed us not to use the firm's statistical sampling methods in selecting trade
receivables balances for testing, as it would be quicker to pick the sample based on our own judgement.
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'Two of the juniors were given the tasks of auditing trade payables and going concern. The audit manager
asked us to review each other's work as it would be good training for us, and he didn't have time to review
everything.
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'I was discussing the Group's tax position with the financial controller, when she said that she was struggling
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to calculate the deferred tax asset that should be recognised. The deferred tax asset has arisen because
several of the Group's subsidiaries have been loss-making this year, creating unutilised tax losses. As I had
just studied deferred tax at college I did the calculation of the Group's deferred tax position for her. The audit
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manager said this saved time as we now would not have to audit the deferred tax figure.
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Questions 5
'The financial controller also asked for my advice as to how the tax losses could be utilised by the Group in
the future. I provided her with some tax planning recommendations, for which she was very grateful.'
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Required
In relation to the audit of the Retriever Group, evaluate the quality control, ethical and other professional
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matters arising in respect of the planning and performance of the Group audit. (13 marks)
(b) The audit committee of the Group has contacted Kennel & Co to discuss an incident that took place on
1 June 20X3. On that date, there was a burglary at the Group's warehouse where inventory is stored prior to
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despatch to customers. CCTV filmed the thieves loading a lorry belonging to the Group with boxes containing
finished goods. The last inventory count took place on 30 April 20X3.
The Group has insurance cover in place and Kennel & Co's forensic accounting department has been asked to
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provide a forensic accounting service to determine the amount to be claimed in respect of the burglary. The
insurance covers the cost of assets lost as a result of thefts.
It is thought that the amount of the claim will be immaterial to the Group's financial statements, and there is
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no ethical threat in Kennel & Co's forensic accounting department providing the forensic accounting service.
Required
In respect of the theft and the associated insurance claim:
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(i) Identify and explain the matters to be considered, and the steps to be taken in planning the
forensic accounting service; and
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(ii) Recommend the procedures to be performed in determining the amount of the claim.
Note. The total marks will be split equally between each part. (12 marks)
(Total = 25 marks)
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6 Smith & Co (6/08) 31 mins
You are an audit manager in Smith & Co, a firm of Chartered Certified Accountants. You have recently been made
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responsible for reviewing invoices raised to clients and for monitoring your firm's credit control procedures. Several
matters came to light during your most recent review of client invoice files:
Norman Co, a large private company, has not paid an invoice from Smith & Co dated 5 June 20X7 for work in
respect of the financial statement audit for the year ended 28 February 20X7. A file note dated 30 November 20X7
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states that Norman Co is suffering poor cash flows and is unable to pay the balance. This is the only piece of
information in the file you are reviewing relating to the invoice. You are aware that the final audit work for the year
ended 28 February 20X8, which has not yet been invoiced, is nearly complete and the auditor's report is due to be
issued imminently.
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Wallace Co, a private company whose business is the manufacture of industrial machinery, has paid all invoices
relating to the recently completed audit planning for the year ended 31 May 20X8. However, in the invoice file you
notice an invoice received by your firm from Wallace Co. The invoice is addressed to Valerie Hobson, the manager
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responsible for the audit of Wallace Co. The invoice relates to the rental of an area in Wallace Co's empty warehouse,
with the following comment handwritten on the invoice: 'rental space being used for storage of Ms Hobson's
speedboat for six months – she is our auditor, so only charge a nominal sum of $100'. When asked about the
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invoice, Valerie Hobson said that the invoice should have been sent to her private address. You are aware that
Wallace Co sometimes uses the empty warehouse for rental income, though this is not the main trading income of
the company.
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In the 'miscellaneous invoices raised' file, an invoice dated last week has been raised to Software Supply Co, not a
client of your firm. The comment box on the invoice contains the note: 'referral fee for recommending Software
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Supply Co to several audit clients regarding the supply of bespoke accounting software'.
Required
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Identify and discuss the ethical and other professional issues raised by the invoice file review, and recommend what
action, if any, Smith & Co should now take in respect of:
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6 Questions
(a) Norman Co (8 marks)
(b) Wallace Co (5 marks)
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(c) Software Supply Co (4 marks)
(Total = 17 marks)
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7 Carter (6/10) 36 mins
You are a manager in the audit department of Carter & Co, and you are dealing with several ethical and professional
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matters raised at recent management meetings, all of which relate to audit clients of your firm:
1 Fernwood Co has a year ending 30 June 20Y0. During this year, the company established a pension plan for
its employees, and this year end the company will be recognising for the first time a pension deficit on the
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statement of financial position, in accordance with IAS 19 Employee Benefits. The finance director of
Fernwood Co has contacted the audit engagement partner, asking if your firm can provide a valuation service
in respect of the amount recognised.
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2 The finance director of Hall Co has requested that a certain audit senior, Kia Nelson, be assigned to the audit
team. This senior has not previously been assigned to the audit of Hall Co. On further investigation it
transpired that Kia Nelson is the sister of Hall Co's financial controller.
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3 Collier Co has until recently kept important documents such as title deeds and insurance certificates in a safe
at its head office. However, following a number of thefts from the head office the directors have asked if the
documents could be held securely at Carter & Co's premises. The partners of Carter & Co are considering
offering a custodial service to all clients, some of whom may want to deposit tangible assets such as
4
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paintings purchased as investments for safekeeping. The fee charged for this service would depend on the
value of item deposited as well as the length of the safekeeping arrangement.
Several audit clients have requested that Carter & Co provide technical training on financial reporting and tax
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issues. This is not a service that the firm wishes to provide, and it has referred the audit clients to a training
firm, Gates Co, which is paying a referral fee to Carter & Co for each audit client which is referred.
Required
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Identify and evaluate the ethical and other professional issues raised, in respect of:
(a) Fernwood Co (6 marks)
(b) Hall Co (6 marks)
(c) Collier Co (5 marks)
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(d) Gates Co (3 marks)

(Total = 20 marks)
8 Dedza (Pilot paper)

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36 mins
(a) Comment on the need for ethical guidance for accountants on money laundering. (5 marks)
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(b) You are senior manager in Dedza & Co, a firm of Chartered Certified Accountants. Recently, you have been
assigned specific responsibility for undertaking annual reviews of existing clients. The following situations
have arisen in connection with three clients.
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(i) Dedza was appointed auditor to Kora Co last year, and has recently issued an unmodified opinion on
the financial statements for the year ended 31 March 20X8. To your surprise, the tax authority has just
launched an investigation into the affairs of Kora on suspicion of underdeclaring income.
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(7 marks)
(ii) The chief executive of Xalam Co, an exporter of specialist equipment, has asked for advice on the
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accounting treatment and disclosure of payments being made for security consultancy services. The
payments, which aim to ensure that consignments are not impounded in the destination country of a
major customer, may be material to the financial statements for the year ending 31 December 20X8.
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Xalam does not treat these payments as tax deductible. (4 marks)

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Questions 7
(iii) Your firm has provided financial advice to the Pholey family for many years and this has sometimes
involved your firm in carrying out transactions on their behalf. The eldest son, Esau, is to take up a
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position as a senior government official to a foreign country next month. (4 marks)
Required
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Identify and comment on the ethical and other professional issues raised by each of these matters and state
what action, if any, Dedza & Co should now take.
Note. The mark allocation is shown against each of the three situations. (Total = 20 marks)
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9 Clifden (6/09) 31 mins
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(a) The IESBA's Code of Ethics for Professional Accountants states that a professional accountant is required to
comply with five fundamental principles, one of which is the principle of 'professional competence and due
care'.
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Required
Explain what is meant by the term 'professional competence and due care', and outline how firms of
Chartered Certified Accountants can ensure that the principle is complied with. (4 marks)
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(b) You are a senior manager in Clifden & Co, and you are responsible for the audit of Headford Co, a
manufacturer of plastic toys which are exported all over the world. The following matter has been brought to
your attention by the audit senior, who has just completed the planning of the forthcoming audit for the year
ending 30 June 20X9.
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During a discussion with the production manager, it was revealed that there have been some quality control
problems with the toys manufactured between March and May 20X9. It was discovered that some of the
plastic used in the manufacture of the company's products had been contaminated with a dangerous
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chemical which has the potential to explode if it is exposed to high temperatures. Headford Co did not recall
any of the products which had been manufactured during that time from customers, as management felt that
the risk of any injury being caused was remote.
Your firm has been invited to tender for the provision of the external audit service to Cong Co. You are aware
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that Cong Co operates in the same industry as Headford Co, and that the two companies often enter into
highly publicised, aggressive advertising campaigns featuring very similar products. Cong Co is a much
larger company than Headford Co, and there would be the opportunity to offer some non-audit services as
well as the external audit.
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Required
Assess the ethical and professional issues raised, and recommend any actions necessary in respect of:
(i) The contaminated plastic used by Headford Co; and (8 marks)
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(ii) The invitation to audit Cong Co. (5 marks)

(Total = 17 marks)
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8 Questions
PRACTICE MANAGEMENT
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Questions 10 to 17 cover Practice management, the subject of Part C of the BPP Study Text for Paper P7.
10 Hawk Associates (AAS 6/04)
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27 mins
You are a training manager in Hawk Associates, a firm of Chartered Certified Accountants. The firm has suffered a
reduction in fee income due to increasing restrictions on the provision of non-audit services to audit clients. The
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following proposals for obtaining professional work are to be discussed at a forthcoming in-house seminar.
(a) 'Cold calling' (ie approaching directly to seek new business) the chief executive officers of local businesses
and offering them free second opinions. (5 marks)
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(b) Placing an advertisement in a national accountancy magazine that includes the following.
'If you have an asset on which a large chargeable gain is expected to arise when you dispose of it, you should
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be interested in the best tax planning advice. However your gains might arise, there are techniques you can
apply. Hawk Associates can ensure that you consider all the alternative fact presentations so that you
minimise the amount of tax you might have to pay. No tax saving – no fee!' (6 marks)
(c) Displaying business cards alongside those of local tradesman and service providers in supermarkets and
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libraries. The cards would read:
'Hawk ACCA Associates
For PROFESSIONAL Accountancy, Audit,
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Business Consultancy and Taxation Services
Competitive rates. Money back guarantees'
(4 marks)
Required
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Comment on the suitability of each of the above proposals in terms of the ethical and other professional issues that
they raise.
Note. The mark allocation is shown against each of the three issues. (Total = 15 marks)
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11 Grape (12/09) 65 mins

You are a manager in Grape & Co, a firm of Chartered Certified Accountants. You have been temporarily assigned as
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audit manager to the audit of Banana Co, because the engagement manager has been taken ill. The final audit of
Banana Co for the year ended 30 September 20X9 is nearing completion, and you are now reviewing the audit files
and discussing the audit with the junior members of the audit team. Banana Co designs and manufactures
equipment such as cranes and scaffolding, which are used in the construction industry. The equipment usually
follows a standard design, but sometimes Banana Co designs specific items for customers according to
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contractually agreed specifications. The draft financial statements show revenue of $12.5 million, net profit of
$400,000, and total assets of $78 million.
The following information has come to your attention during your review of the audit files.
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During the year, a new range of manufacturing plant was introduced to the factories operated by Banana Co. All
factory employees received training from an external training firm on how to safely operate the machinery, at a total
cost of $500,000. The training costs have been capitalised into the cost of the new machinery, as the finance director
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argues that the training is necessary in order for the machinery to generate an economic benefit. After the year end,
Cherry Co, a major customer with whom Banana Co has several significant contracts, announced its insolvency, and
that procedures to shut down the company had commenced. The administrators of Cherry Co have suggested that
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the company may be able to pay approximately 25% of the amounts owed to its trade payables (creditors). A trade
receivable of $300,000 is recognised on Banana Co's statement of financial position in respect of this customer.
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Questions 9
In addition, one of the junior members of the audit team voiced concerns over how the audit had been managed. The
junior said the following.
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'I have only worked on two audits prior to being assigned the audit team of Banana Co. I was expecting to attend a
meeting at the start of the audit, where the partner and other senior members of the audit team discussed the audit,
but no meeting was held. In addition, the audit manager has been away on holiday for three weeks, and left a senior
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in charge. However, the senior was busy with other assignments, so was not always available.
'I was given the task of auditing the goodwill which arose on an acquisition made during the year. I also worked on
the audit of inventory, and attended the inventory count, which was quite complicated, as Banana Co has a lot of
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work-in-progress. I tried to be as useful as possible during the count, and helped the client's staff count some of the
raw materials. As I had been to the inventory count, I was asked by the audit senior to challenge the finance director
regarding the adequacy of the provision against inventory, which the senior felt was significantly understated.
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'Lastly, we found that we were running out of time to complete our audit procedures. The audit senior advised that
we should reduce the sample sizes used in our tests as a way of saving time. He also suggested that if we picked an
item as part of our sample for which it would be time consuming to find the relevant evidence, then we should pick a
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different item which would be quicker to audit.'
Required
In respect of the specific information provided:
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(a) Comment on the matters to be considered, and explain the audit evidence you should expect to find during
your file review in respect of:
(i) The training costs that have been capitalised into the cost of the new machinery; and
(b)
(ii)
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The trade receivable recognised in relation to Cherry Co.
Evaluate the audit junior's concerns regarding the management of the audit of Banana Co.
(12 marks)
(10 marks)
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(c) There are specific regulatory obligations imposed on accountants and auditors in relation to detecting and
reporting money laundering activities. You have been asked to provide a training session to the new audit
juniors on auditors' responsibilities in relation to money laundering.
Required
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Prepare briefing notes to be used at your training session in which you:

(i) Explain the term 'money laundering'. Illustrate your explanation with examples of money laundering
offences, including those which could be committed by the accountant
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(ii) Explain the policies and procedures that a firm of Chartered Certified Accountants should establish in
order to meet its responsibilities in relation to money laundering (10 marks)
Professional marks will be awarded in part (c) for the format of the answer, and the quality of the
explanations provided. (4 marks)
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(Total = 36 marks)
12 Ingot & Co (Pilot paper) 36 mins

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You are a manager in Ingot & Co, a firm of Chartered Certified Accountants, with specific responsibility for the
quality of audits. Ingot was appointed auditor of Argenta Co, a provider of waste management services, in July 20X8.
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You have just visited the audit team at Argenta's head office. The audit team is comprised of an accountant in charge
(AIC), an audit senior and two trainees.
Argenta's draft accounts for the year ended 30 June 20X8 show revenue of $11.6 million (20X7 – $8·1 million) and
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total assets of $3.6 million (20X7 – $2.5 million). During your visit, a review of the audit working papers revealed the
following.
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(a) On the audit planning checklist, the audit senior has crossed through the analytical procedures section and
written 'not applicable – new client'. The audit planning checklist has not been signed off as having been
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reviewed. (4 marks)
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10 Questions
(b) The AIC last visited Argenta's office when the final audit commenced two weeks ago on 1 August. The senior
has since completed the audit of tangible non-current assets (including property and service equipment)
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which amount to $0.6 million as at 30 June 20X8 (20X7 – $0.6 million). The AIC spends most of his time
working from Ingot's office and is currently allocated to three other assignments as well as Argenta's audit.
(4 marks)
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(c) At 30 June 20X8 trade receivables amounted to $2.1 million (20X7 – $0.9 million). One of the trainees has
just finished sending out first requests for direct confirmation of customers' balances as at the end of the
reporting period. (4 marks)
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(d) The other trainee has been assigned to the audit of the consumable supplies that comprise inventory
amounting to $45,000 (20X7 – $37,000). The trainee has carried out tests of controls over the perpetual
inventory records and confirmed the 'roll-back' of a sample of current quantities to book quantities as at the
year end. (3 marks)
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(e) The AIC has noted the following matter for your attention. The financial statements to 30 June 20X7 disclosed,
as unquantifiable, a contingent liability for pending litigation. However, the AIC has seen a letter confirming that
the matter was settled out of court for $0.45 million on 14 September 20X7. The auditor's report on the
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financial statements for the year ended 30 June 20X7 was unmodified and signed on 19 September 20X7. The
AIC believes that Argenta's management is not aware of the error and has not brought it to their attention.
(5 marks)
Required
l.b
Identify and comment on the implications of these findings for Ingot & Co's quality control policies and procedures.
Note. The mark allocation is shown against each of the five issues. (Total = 20 marks)
13 Nate & Co (12/07) ria 36 mins

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You are an audit manager in Nate & Co, a firm of Chartered Certified Accountants. You are reviewing three situations,
which were recently discussed at the monthly audit managers' meeting:
1 Nate & Co has recently been approached by a potential new audit client, Fisher Co. Your firm is keen to take
the appointment and is currently carrying out client acceptance procedures. Fisher Co was recently
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incorporated by Marcellus Fisher, with its main trade being the retailing of wooden storage boxes.
2 Nate & Co provides the audit service to CF Co, a national financial services organisation. Due to a number of
errors in the recording of cash deposits from new customers that have been discovered by CF Co's internal
audit team, the directors of CF Co have requested that your firm carry out a review of the financial information
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technology systems. It has come to your attention that while working on the audit planning of CF Co, Jin
Sayed, one of the juniors on the audit team, who is a recent information technology graduate, spent three
hours providing advice to the internal audit team about how to improve the system. As far as you know, this
advice has not been used by the internal audit team.
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3 LA Shots Co is a manufacturer of bottled drinks, and has been an audit client of Nate & Co for five years. Two
audit juniors attended the annual inventory count last Monday. They reported that Brenda Mangle, the new
production manager of LA Shots Co, wanted the inventory count and audit procedures performed as quickly
as possible. As an incentive she offered the two juniors ten free bottles of 'Super Juice' from the end of the
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production line. Brenda also invited them to join the LA Shots Co office party, which commenced at the end
of the inventory count. The inventory count and audit procedures were completed within two hours (the
previous year's procedures lasted a full day), and the juniors then spent four hours at the office party.
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Required
(a) Define 'money laundering' and state the procedures specific to money laundering that should be considered
before, and on the acceptance of, the audit appointment of Fisher Co. (5 marks)
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(b) With reference to CF Co, explain the ethical and other professional issues raised. (9 marks)
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(c) Identify and discuss the ethical and professional matters raised at the inventory count of LA Shots Co.
(6 marks)
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(Total = 20 marks)
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Questions 11
14 Wexford (6/11) 32 mins
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(a) Your firm has been approached by Wexford Co to provide the annual audit. Wexford Co operates a chain of
bookshops across the country. The shops sell stationery such as diaries and calendars, as well as new books.
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The financial year will end on 31 July 20X1, and this will be the first year that an audit is required, as
previously the company was exempt from audit due to its small size.
The potential audit engagement partner, Wendy Kwan, recently attended a meeting with Ravi Shah, managing
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director of Wexford Co regarding the audit appointment. In this meeting, Ravi made the following comments.
'Wexford Co is a small, owner-managed business. I run the company, along with my sister, Rita, and we
employ a part-qualified accountant to do the bookkeeping and prepare the annual accounts. The accountant
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prepares management accounts at the end of every quarter, but Rita and I rarely do more than quickly review
the sales figures. We understand that due to the company's size, we now need to have the accounts audited.
It would make sense if your firm could prepare the accounts and do the audit at the same time. We don't want
a cash flow statement prepared, as it is not required for tax purposes, and would not be used by us.
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'Next year we are planning to acquire another company, one of our competitors, which I believe is an existing
audit client of your firm. For this reason, we require that your audit procedures do not include reading the
minutes of board meetings, as we have been discussing some confidential matters regarding this potential
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acquisition.'
Required
Identify and explain the professional and ethical matters that should be considered in deciding whether to
(b)
accept the appointment as auditor of Wexford Co.
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Wexford Co's financial statements for the year ended 31 July 20X0 included the following balances.
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Profit before tax $50,000
Inventory $25,000
Total assets $350,000
The inventory comprised stocks of books, diaries, calendars and greetings cards.
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Required
In relation to opening balances where the financial statements for the prior period were not audited:
Explain the audit procedures required by ISA 510 Initial Audit Engagements – Opening Balances, and
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recommend the specific audit procedures to be applied to Wexford Co's opening balance of inventory.
(8 marks)
Note. Assume it is 7 June 20X1. (Total = 18 marks)
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15 Spaniel & Bulldog (6/13) 36 mins

You are a manager in Groom & Co, a firm of Chartered Certified Accountants. You have just attended a monthly
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meeting of audit partners and managers at which client-related matters were discussed. Information in relation to
two clients, which were discussed at the meeting, is given below:
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(a) Spaniel Co
The audit report on the financial statements of Spaniel Co, a long-standing audit client, for the year ended
31 December 20X2 was issued in April 20X3, and was unmodified. In May 20X3, Spaniel Co's audit
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committee contacted the audit engagement partner to discuss a fraud that had been discovered. The
company's internal auditors estimate that $4.5 million has been stolen in a payroll fraud, which has been
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operating since May 20X2.

The audit engagement partner commented that neither tests of controls nor substantive audit procedures
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were conducted on payroll in the audit of the latest financial statements as in previous years' audits there
were no deficiencies found in controls over payroll. The total assets recognised in Spaniel Co's financial
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12 Questions
statements at 31 December 20X2 were $80 million. Spaniel Co is considering suing Groom & Co for the total
amount of cash stolen from the company, claiming that the audit firm was negligent in conducting the audit.
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Required:
Explain the matters that should be considered in determining whether Groom & Co is liable to Spaniel Co in
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respect of the fraud. (12 marks)
(b) Bulldog Co
Bulldog Co is a clothing manufacturer, which has recently expanded its operations overseas. To manage
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exposure to cash flows denominated in foreign currencies, the company has set up a treasury management
function, which is responsible for entering into hedge transactions such as forward exchange contracts.
These transactions are likely to be material to the financial statements. The audit partner is about to
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commence planning the audit for the year ending 31 July 20X3.
Required:
Discuss why the audit of financial instruments is particularly challenging, and explain the matters to be
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considered in planning the audit of Bulldog Co's forward exchange contracts. (8 marks)
(Total = 20 marks)
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16 Raven (6/12) 27 mins
You are a senior manager in the audit department of Raven & Co. You are reviewing two situations which have arisen
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in respect of audit clients, which were recently discussed at the monthly audit managers' meeting:
1 Grouse Co is a significant audit client which develops software packages. Its managing director, Max
Partridge, has contacted one of your firm's partners regarding a potential business opportunity. The proposal
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is that Grouse Co and Raven & Co could jointly develop accounting and tax calculation software, and that
revenue from sales of the software would be equally split between the two firms. Max thinks that Raven &
Co's audit clients would be a good customer base for the product.
2 Plover Co is a private hospital which provides elective medical services, such as laser eye surgery to improve
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eyesight. The audit of its financial statements for the year ended 31 March 20X2 is currently taking place. The
audit senior overheard one of the surgeons who performs laser surgery saying to his colleague that he is
hoping to finish his medical qualification soon, and that he was glad that Plover Co did not check his
references before employing him. While completing the subsequent events audit procedures, the audit senior
found a letter from a patient's solicitor claiming compensation from Plover Co in relation to alleged medical
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negligence resulting in injury to the patient.

Required
Identify and discuss the ethical, commercial and other professional issues raised, and recommend any actions that
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should be taken in respect of:

(a) Grouse Co (8 marks)
(b) Plover Co (7 marks)
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(Total = 15 marks)
17 Dragon Group (6/09)

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61 mins
(a) Explain four reasons why a firm of auditors may decide not to seek re-election as auditor. (6 marks)
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You are Jennifer Meadows, a newly-qualified audit supervisor in Unicorn & Co, a global firm of Chartered Certified
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Accountants, with offices in over 150 countries across the world. Unicorn & Co has been invited to tender for the
Dragon Group audit (including the audit of all subsidiaries). You work in a department within the firm which
specialises in the audit of retail companies, and have just received the following email from Cameron Wells, a senior
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partner in the department.

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Questions 13
To: Jennifer Meadows
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From: Cameron Wells
Date: June 20X9
Subject: The Dragon Group
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Jennifer,
We are currently considering tendering for the audit of a new client called the Dragon Group.
The Dragon Group is a large group of companies operating in the furniture retail trade. The group has expanded
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rapidly in the last three years, by acquiring several subsidiaries each year. The management of the parent company,
Dragon plc, has decided to put the audit of the group and all subsidiaries out to tender, as the current audit firm is
not seeking re-election. The financial year end of the Dragon Group is 30 September 20X9.
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I recently held a meeting with Edmund Jalousie, the group finance director, in which we discussed the current group
structure, recent acquisitions, and the group's plans for future expansion. I made some notes from the meeting, on
the basis of which I would like you to prepare some briefing notes for me which:
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(i) Recommend and describe the principal matters to be included in the firm's tender document to provide the
audit service to the Dragon Group; and (10 marks)
(ii) Evaluate the matters that should be considered before accepting the audit engagement, in the event of us
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being successful in the tender. (7 marks)
You'll need to collect my meeting notes from my secretary.
Thanks,
Cameron Wells
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Meeting notes – Dragon Group
Group structure
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The parent company owns 20 subsidiaries, all of which are wholly owned. Half of the subsidiaries are located in this
country, and half overseas. Most of the foreign subsidiaries report under the same financial reporting framework as
Dragon Co, but several prepare financial statements using local accounting rules.
Acquisitions during the year
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Two companies were purchased in March 20X9, both located in this country:
 Mermaid Co, a company which operates 20 furniture retail outlets. The audit opinion expressed by the
incumbent auditor on the financial statements for the year ended 30 September 20X8 was modified by a
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material misstatement over the non-disclosure of a contingent liability. The contingent liability relates to a
court case which is still ongoing.
 Minotaur Co, a large company, whose operations are distribution and warehousing. This represents a
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diversification away from retail, and it is hoped that the Dragon Group will benefit from significant economies
of scale as a result of the acquisition.
Other matters
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The acquisitive strategy of the group over the last few years has led to significant growth. Group revenue has
increased by 25% in the last three years, and is predicted to increase by a further 35% in the next four years as the
acquisition of more subsidiaries is planned. The Dragon Group has raised finance for the acquisitions in the past by
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becoming listed on the stock exchanges of three different countries. A new listing on a foreign stock exchange is
planned for January 20Y0. For this reason, management would like the group audit completed by 31 December 20X9.
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Required
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(b) Respond to the partner's email. (17 marks)

Professional marks will be awarded in part (b) for the clarity and presentation of the evaluation. (4 marks)
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14 Questions
(c) (i) Define 'transnational audit', and explain the relevance of the term to the audit of the Dragon Group.
(3 marks)
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(ii) Discuss two features of a transnational audit that may contribute to a high level of audit risk in such an
engagement. (4 marks)
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(Total = 34 marks)
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Questions 15
AUDIT OF HISTORICAL FINANCIAL INFORMATION AND OTHER ASSIGNMENTS
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Questions 18 to 56 cover Audit of historical financial information and other assignments, the subject of Parts D
and E of the BPP Study Text for Paper P7.
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18 Pulp (6/08) 31 mins
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(a) Discuss why the identification of related parties, and material related party transactions, can be difficult for
auditors. (5 marks)
You are an audit manager responsible for providing hot reviews on selected audit clients within your firm of
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Chartered Certified Accountants. You are currently reviewing the audit working papers for Pulp Co, a long standing
audit client, for the year ended 31 January 20X8. The draft statement of financial position of Pulp Co shows total
assets of $12 million (20X7 – $11.5 million).The audit senior has made the following comment in a summary of
issues for your review:
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'Pulp Co's statement of financial position shows a receivable classified as a current asset with a value of $25,000.
The only audit evidence we have requested and obtained is a written representation from management stating that:
1 The amount is owed to Pulp Co from Jarvis Co
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2 Jarvis Co is controlled by Pulp Co's chairman, Peter Sheffield
3 The balance is likely to be received six months after Pulp Co's year end
'The receivable was also outstanding at the last year end when an identical written representation was provided, and
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our working papers noted that because the balance was immaterial no further work was considered necessary.
'No disclosure has been made in the financial statements regarding the balance. Jarvis Co is not audited by our firm
and we have verified that Pulp Co does not own any shares in Jarvis Co.'
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Required
(b) In relation to the receivable recognised on the statement of financial position of Pulp Co as at 31 January 20X8:
(i) Comment on the matters you should consider (5 marks)
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(ii) Recommend further audit procedures that should be carried out (4 marks)
(c) Discuss the quality control issues raised by the audit senior's comments. (3 marks)
(Total = 17 marks)
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19 Aspersion (AAS 12/01) 36 mins

You are the manager responsible for the audit of Aspersion, a limited liability company, which mainly provides
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national cargo services with a small fleet of aircraft. The draft accounts for the year ended 30 September 20X8 show
profit before taxation of $2.7 million (20X7 – $2.2 million) and total assets of $10.4 million (20X7 – $9.8 million).
The following issues are outstanding and have been left for your attention.
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(a) The sale of a cargo carrier to Abra, a private limited company, during the year resulted in a loss on disposal of
$400,000. The aircraft cost $1.2 million when it was purchased in September 1999 and was being
depreciated on a straight-line basis over 20 years. The minutes of the board meeting at which the sale was
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approved record that Aspersion's finance director, Iain Jolteon, has a 30% equity interest in Abra. (7 marks)
(b) As well as cargo carriers, Aspersion owns two light aircraft which were purchased in 20X5 to provide
business passenger flights to a small island under a three year service contract. It is now known that the
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contract will not be renewed when it expires at the end of March 20X9. The aircraft, which cost $450,000
each, are being depreciated over fifteen years. (7 marks)
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16 Questions
(c) Deferred tax amounting to $570,000 as at 30 September 20X8 has been calculated relating to accelerated
capital allowances at a tax rate of 30% under the full provision method (IAS 12 Income taxes). In a budget
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statement in October 20X8, the government announced an increase in the corporation tax rate to 34%. The
directors are proposing to adjust the draft accounts for the further liability arising. (6 marks)
Required
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For each of the above points:
(i) Comment on the matters that you should consider
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(ii) State the audit evidence that you should expect to find in undertaking your review of the audit working papers
and financial statements of Aspersion.
(Total = 20 marks)
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Note. The mark allocation is shown against each of the three issues. Assume that it is 11 December 20X8.
20 Mac (6/10) (amended) 47 mins
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Mac Co is a large, private company, whose business activity is events management, involving the organisation of
conferences, meetings and celebratory events for companies. Mac Co was founded ten years ago by Danny Hudson
and his sister, Stella, who still own the majority of the company's shares. The company has grown rapidly and now
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employs more than 150 staff in 20 offices.
You are a manager in the business advisory department of Flack & Co. Your firm has just been engaged to provide
the internal audit service to Mac Co. In your initial conversation with Danny and Stella, you discovered that currently
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there is a small internal audit team, under the supervision of Lindsay Montana, a recently qualified accountant.
Before heading up the internal audit department, Lindsay was a junior finance manager of the company. The
members of the internal audit team will be reassigned to roles in the finance department once your firm has
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commenced the provision of the internal audit service.
Mac Co is not an existing client of your firm, and to gain further understanding of the company, you held a meeting
with Lindsay Montana. Notes from this meeting are shown below.
Notes of meeting held with Lindsay Montana on 1 June 20X0

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The internal audit team has three employees, including Lindsay, who reports to the finance director. The other two
internal auditors are currently studying for their professional examinations. The team was set up two years ago, and
initially focused on introducing financial controls across all of Mac Co's offices. Nine months ago the finance director
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instructed the team to focus their attention on introducing operational controls in order to achieve cost savings due
to a cash flow problem being suffered by the company. The team does not have time to perform much testing of
financial or operational controls.
In the course of her work, Lindsay finds many instances of management policies not being adhered to, and the
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managers of each location are generally reluctant to introduce controls as they want to avoid bureaucracy and
paperwork. As a result, Lindsay's recommendations are often ignored.
Three weeks ago, Lindsay discovered a fraud operating at one of the offices while reviewing the procedures relating
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to the approval of new suppliers and payments made to suppliers. The fraud involved an account manager
authorising the payment of invoices received from fictitious suppliers, with payment actually being made into the
account manager's personal bank account. Lindsay reported the account manager to the finance director, and the
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manager was immediately removed from office. This situation has highlighted to Danny and Stella that something
needs to be done to improve controls within their organisation.
Danny and Stella are considering taking legal action against Mac Co's external audit provider, Manhattan & Co,
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because their audit procedures did not reveal the fraud.

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Danny and Stella are deciding whether to set up an audit committee. Under the regulatory framework in which it
operates, Mac Co is not required to have an audit committee, but a disclosure note explaining whether an audit
committee has been established is required in the annual report.
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Questions 17
Required
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(a) Evaluate the benefits specific to Mac Co of outsourcing its internal audit function. (6 marks)
(b) Explain the potential impacts on the external audit of Mac Co if the decision is taken to outsource its internal
audit function. (4 marks)
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(c) Recommend procedures that could be used by your firm to quantify the financial loss suffered by Mac Co as
a result of the fraud. (4 marks)
(d) Prepare a report to be presented to Danny and Stella in which you:
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(i) Compare the responsibilities of the external auditor and of management in relation to the prevention
and detection of fraud (4 marks)
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(ii) Assess the benefits and drawbacks for Mac Co in establishing an audit committee (4 marks)
Professional marks will be awarded in respect of requirement (d) for the presentation of your answer, and the
clarity of your discussion. (4 marks)
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(Total = 26 marks)
21 Distant 27 mins
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The performance of all schools in Farland is subject to annual audits, conducted by audit firms, which examine
schools in terms of a range of metrics determined by the national government of Farland. The framework for
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measuring performance in the public sector in Farland is relatively new, and has been the subject of not
inconsiderable public debate. Its detractors have claimed that it is irrelevant and that it fails to measure the real
performance of schools.
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Distant Primary School is located in Village Creek, an inner-city area of Farland's capital, Far City. It is a former
industrial zone, which now suffers from high levels of unemployment and crime. Many of its residents are among the
poorest 20% of Farland's population, whose children qualify to receive free school meals from the government.
Among Distant Primary School's pupils is a relatively high proportion of children born outside Farland, for whom
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English was not their first language.
Attendance levels at Distant Primary are poor, and the school has received reports from concerned citizens of school
children wearing dishevelled uniforms being in the city centre at times when they should have been at school.
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Distant Primary School is required to report on key performance indicators (KPIs) in areas spanning the breadth of
its activities. On the basis of these indicators, Far City's regulator of schools has recently assessed Distant Primary
School's performance to be poor.
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Distant Primary's KPIs included the following.
Area measured KPI

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Academic performance % pupils achieving A grade in June exams at age 11

School attendance Average % pupils absent from registration 8:30 am
Participation in sport Number of trophies won by school sports teams
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Uniform % pupils whose school uniform is in line with regulations

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18 Questions
Required
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Using the information available:
(a) Critically assess the usefulness of the KPIs on which Distant Primary School is required to report, suggesting
possible ways of improving upon any inadequacies you may find (7 marks)
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(b) Recommend alternative KPIs to measure performance in each area (2 marks)
(c) Identify audit procedures to provide assurance on the accuracy of the alternative KPIs which you have
recommended (6 marks)
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(Total = 15 marks)
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22 Juliet (6/10) 36 mins
(a) Auditors should accept some of the blame when a company on which they have expressed an unmodified
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audit opinion subsequently fails, and they should also do more to highlight going concern problems being
faced by a company.
Required
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Discuss this statement. (8 marks)
(b) You are the manager responsible for the audit of Juliet Co, and you are planning the final audit of the financial
statements for the year ending 30 June 20X0. Juliet Co is a supplier of components used in the manufacture
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of vehicle engines. Due to a downturn in the economy, and in the automotive industry particularly, the
company has suffered a decline in sales and profitability over the last two years, mainly due to the loss of
several key customer contracts. Many of Juliet Co's non-current assets are impaired in value, and a
significant number of receivables balances have been written off in the last six months.
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In response to the deteriorating market conditions, the management of Juliet Co decided to restructure the
business. The main manufacturing facility will be reduced in size by two-thirds, and investment will be made
in new technology to make the remaining operations more efficient, and to enable the manufacture of a wider
variety of components for use in different types of engines and machinery. In order to fund this restructuring,
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the management of Juliet Co approached the company's bank with a request for a significant loan. You are
aware that without the loan, Juliet Co is unlikely to be able to restructure successfully, which will raise
significant doubt over its ability to continue as a going concern.
Your firm has been asked to advise on the necessary forecasts and projections that the bank will need to see
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in order to make a decision regarding the finance requested. Management has also requested that your firm
attend a meeting with the bank at which the forecasts will be discussed.
Required
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(i) Identify and explain the matters that should be considered, and the principal audit procedures to be
performed, in respect of the additional funding being sought. (6 marks)
(ii) Comment on the ethical and other implications of the request for your firm to provide advice on the
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forecasts and projections, and to attend the meeting with the bank. (6 marks)
(Total = 20 marks)
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23 Apricot (12/09) 29 mins

Your audit client, Apricot Co, is intending to purchase a new warehouse at a cost of $500,000. One of the directors of
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the company, Pik Choi, has agreed to make the necessary finance available through a director's loan to the company.
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This arrangement has been approved by the other directors, and the cash will be provided on 30 March 20X0, one
day before the purchase is due to be completed. Pik's financial advisor has asked to see a cash flow projection of
Apricot Co for the next three months. Your firm has been asked to provide an assurance report to Pik's financial
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advisor on this prospective financial information.

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Questions 19
The cash flow forecast is shown below.
January 20X0 February 20X0 March 20X0
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$'000 $'000 $'000
Operating cash receipts:
Cash sales 125 135 140
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Receipts from credit sales 580 600 625
Operating cash payments:
Purchases of inventory (410) (425) (425)
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Salaries (100) (100) (100)
Overheads (175) (175) (175)
Other cash flows:
Dividend payment (80)
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Purchase of new licence (35)
Fixtures for new warehouse (60)
Loan receipt 500
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Payment for warehouse (500)
Cash flow for the month (15) (45) 5

Opening cash 100 85 40
85 40 45
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Closing cash
The following information is relevant:
1 Apricot Co is a wholesaler of catering equipment and frozen food. Its customers are mostly restaurant chains
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and fast food outlets.
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Customers who pay in cash receive a 10% discount. Analysis has been provided showing that for sales made
on credit, 20% of customers pay in the month of the sale, 60% pay after 45 days, 10% after 65 days, 5%
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after 90 days, and the remainder are bad debts.
3 Apricot Co pays for all purchases within 30 days in order to take advantage of a 12% discount from suppliers.
4 Overheads are mainly property rentals, utility bills, insurance premiums and general office expenses.
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5 Apricot Co needs to have a health and safety licence as it sells food. Each licence is valid for one year and is
issued once an inspection has taken place.
6 A profit forecast has also been prepared for the year ending 31 December 20X0 to help with internal planning
and budgeting.
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This is the first time that Apricot Co has requested an assurance report, and the directors are unsure about the
contents of the report that your firm will issue. They understand that it is similar in format to an auditor's report, but
that the specific contents are not the same.
Required
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(a) Recommend the procedures that should be performed on the cash flow forecast for the three months ending
31 March 20X0 in order to provide an assurance report as requested by Apricot Co. (11 marks)
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(b) Explain the main contents of the report that will be issued on the prospective financial information. (5 marks)
(Total = 16 marks)
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20 Questions
24 Poppy (12/08) 36 mins
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(a) Financial statements often contain material balances recognised at fair value. For auditors, this leads to
additional audit risk.
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Required
(b) You are the manager responsible for the audit of Poppy Co, a manufacturing company with a year ended
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31 October 20X8. In the last year, several investment properties have been purchased to utilise surplus funds
and to provide rental income. The properties have been revalued at the year end in accordance with IAS 40
Investment Property, they are recognised on the statement of financial position at a fair value of $8 million,
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and the total assets of Poppy Co are $160 million at 31 October 20X8. An external valuer has been used to
provide the fair value for each property.
Required
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(i) Recommend the enquiries to be made in respect of the external valuer, before placing any reliance on
their work, and explain the reason for the enquiries. (7 marks)
(ii) Identify and explain the principal audit procedures to be performed on the valuation of the investment
properties. (6 marks)
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(Total = 20 marks)
25 Magpie (6/12) 67 mins

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You are a manager in Magpie & Co, responsible for the audit of the CS Group. An extract from the permanent audit
file describing the CS Group's history and operations is shown below:
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Permanent file (extract)
Crow Co was incorporated 100 years ago. It was founded by Joseph Crow, who established a small pottery making
tableware such as dishes, plates and cups. The products quickly grew popular, with one range of products becoming
highly sought after when it was used at a royal wedding. The company's products have retained their popularity over
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the decades, and the Crow brand enjoys a strong identity and good market share.
Ten years ago, Crow Co made its first acquisition by purchasing 100% of the share capital of Starling Co. Both
companies benefited from the newly formed CS Group, as Starling Co itself had a strong brand name in the pottery
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market. The CS Group has a history of steady profitability and stable management.
Crow Co and Starling Co have a financial year ending 31 July 20X2, and your firm has audited both companies for
several years.
(a) You have received an email from Jo Daw, the audit engagement partner:
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To: Audit manager

From: Jo Daw
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Regarding: CS Group audit planning

Hello
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I have just been to a meeting with Steve Eagle, the finance director of the CS Group. We were discussing
recent events which will have a bearing on our forthcoming audit, and my notes from the meeting are
attached to this email. One of the issues discussed is the change in group structure due to the acquisition of
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Canary Co earlier this year. Our firm has been appointed as auditor of Canary Co, which has a year ending
30 June 20X2, and the terms of the engagement have been agreed with the client. We need to start planning
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the audits of the three components of the Group, and of the consolidated financial statements.
Using the attached information, you are required to:
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(i) Identify and explain the implications of the acquisition of Canary Co for the audit planning of the
individual and consolidated financial statements of the CS Group (8 marks)
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Questions 21
(ii) Evaluate the risks of material misstatement to be considered in the audit planning of the individual and
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consolidated financial statements of the CS Group, identifying any matters that are not relevant to the
audit planning (18 marks)
(iii) Recommend the principal audit procedures to be performed in respect of the goodwill initially
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recognised on the acquisition of Canary Co (5 marks)
Thank you.
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Attachment: Notes from meeting with Steve Eagle, finance director of the CS Group
Acquisition of Canary Co
The most significant event for the CS Group this year was the acquisition of Canary Co, which took place on
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1 February 20X2. Crow Co purchased all of Canary Co's equity shares for cash consideration of $125 million,
and further contingent consideration of $30 million will be paid on the third anniversary of the acquisition, if
the Group's revenue grows by at least 8% per annum. Crow Co engaged an external provider to perform due
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diligence on Canary Co, whose report indicated that the fair value of Canary Co's net assets was estimated to
be $110 million at the date of acquisition. Goodwill arising on the acquisition has been calculated as follows.
$ million
Fair value of consideration:
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Cash consideration 125
Contingent consideration 30
155
Less fair value of identifiable net assets acquired
Goodwill
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45
To help finance the acquisition, Crow Co issued loan stock at par on 31 January 20X2, raising cash of
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$100 million. The loan has a five-year term, and will be repaid at a premium of $20 million. 5% interest is
payable annually in arrears. It is Group accounting policy to recognise financial liabilities at amortised cost.
Canary Co manufactures pottery figurines and ornaments. The company is considered a good strategic fit to
the Group, as its products are luxury items like those of Crow Co and Starling Co, and its acquisition will
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enable the Group to diversify into a different market. Approximately 30% of its sales are made online, and it is
hoped that online sales can soon be introduced for the rest of the Group's products. Canary Co has only ever
operated as a single company, so this is the first year that it is part of a group of companies.
Financial performance and position
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The Group has performed well this year, with forecast consolidated revenue for the year to 31 July 20X2 of
$135 million (20X1 – $125 million), and profit before tax of $8.5 million (20X1 – $8.4 million). A breakdown
of the Group's forecast revenue and profit is shown below.
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Crow Co Starling Co Canary Co CS Group

$ million $ million $ million $ million
Revenue 69 50 16 135
Profit before tax 3.5 3 2 8.5
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Note. Canary Co's results have been included from 1 February 20X2 (date of acquisition), and forecast up to
31 July 20X2, the CS Group's financial year end.
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The forecast consolidated statement of financial position at 31 July 20X2 recognises total assets of
$550 million.
Other matters
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Starling Co received a grant of $35 million on 1 March 20X2 in relation to redevelopment of its main
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manufacturing site. The government is providing grants to companies for capital expenditure on
environmentally friendly assets. Starling Co has spent $25 million of the amount received on solar panels
which generate electricity, and intends to spend the remaining $10 million on upgrading its production and
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packaging lines.
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22 Questions
During the year to 31 July 20X2 it was discovered that an error had been made by a member of Crow Co's
finance department which had resulted in the overstatement of deferred revenue by $10,000 in the prior
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period.
On 1 January 20X2, a new IT system was introduced to Crow Co and Starling Co, with the aim of improving
financial reporting controls and to standardise processes across the two companies. Unfortunately, Starling
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Co's finance director left the company last week.
Required
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Respond to the email from the partner. (31 marks)
Note. The split of the mark allocation is shown within the email.
(b) Magpie & Co's ethics partner, Robin Finch, leaves a note on your desk:
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'I have just had a conversation with Steve Eagle concerning the CS Group. He would like the audit
engagement partner to attend the CS Group's board meetings on a monthly basis so that our firm can be
made aware of any issues relating to the audit as soon as possible. Also, Steve asked if one of our audit
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managers could be seconded to Starling Co in temporary replacement of its finance director who recently left,
and asked for our help in recruiting a permanent replacement. Please provide me with a response to Steve
which evaluates the ethical implications of his requests.'
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Required
Respond to the note from the partner. (6 marks)
(Total = 37 marks)
26 Beech (12/11) ria 32 mins

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You are a manager in the audit department of Beech & Co, responsible for the audits of Fir Co, Spruce Co and Pine
Co. Each company has a financial year ended 31 July 20X1, and the audits of all companies are nearing completion.
The following issues have arisen in relation to the audit of accounting estimates and fair values.
(a) Fir Co
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Fir Co is a company involved in energy production. It owns several nuclear power stations, which have a
remaining estimated useful life of 20 years. Fir Co intends to decommission the power stations at the end of
their useful life and the statement of financial position at 31 July 20X1 recognises a material provision in
respect of decommissioning costs of $97 million (20X0 – $110 million). A brief note to the financial
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statements discloses the opening and closing value of the provision but no other information is provided.
Required
Comment on the matters that should be considered, and explain the audit evidence you should expect to find
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in your file review in respect of the decommissioning provision. (8 marks)

(b) Spruce Co
Spruce Co is also involved in energy production. It has a trading division which manages a portfolio of
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complex financial instruments such as derivatives. The portfolio is material to the financial statements. Due to
the specialist nature of these financial instruments, an auditor's expert was engaged to assist in obtaining
sufficient appropriate audit evidence relating to the fair value of the financial instruments. The objectivity,
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capabilities and competence of the expert were confirmed prior to their engagement.
Required
Explain the procedures that should be performed in evaluating the adequacy of the auditor's expert's work.
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(5 marks)
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(c) Pine Co
Pine Co operates a warehousing and distribution service, and owns 120 properties. During the year ended
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31 July 20X1, management changed its estimate of the useful life of all properties, extending the life on
average by ten years. The financial statements contain a retrospective adjustment, which increases opening
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Questions 23
non-current assets and equity by a material amount. Information in respect of the change in estimate has not
been disclosed in the notes to the financial statements.
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Required
Identify and explain the potential implications for the auditor's report of the accounting treatment of the
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change in accounting estimates. (5 marks)
Note. Assume it is 5 December 20X1. (Total = 18 marks)
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27 Setter (6/13) 36 mins
You are the manager responsible for the audit of Setter Stores Co, a company which operates supermarkets across
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the country. The final audit for the year ended 31 January 20X3 is nearing completion and you are reviewing the
audit working papers. The draft financial statements recognise total assets of $300 million, revenue of $620 million
and profit before tax of $47.5 million.
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(a) Assets held for sale
Setter Stores Co owns a number of properties which have been classified as assets held for sale in the
statement of financial position. The notes to the financial statements state that the properties are all due to be
sold within one year. On classification as held for sale, in October 20X2, the properties were re-measured
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from carrying value of $26 million to fair value less cost to sell of $24 million, which is the amount
recognised in the statement of financial position at the year end. (8 marks)
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(b) Sale and leaseback arrangement
A sale and leaseback arrangement involving a large property complex was entered into on 31 January 20X3.
The property complex is a large warehousing facility, which was sold for $37 million, its fair value at the date
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of the disposal. The facility had a carrying value at that date of $27 million. The only accounting entry
recognised in respect of the proceeds raised was to record the cash received and recognise a non-current
liability classified as 'Obligations under finance lease'. The lease term is for 20 years, the same as the
remaining useful life of the property complex, and Setter Stores Co retains the risks and rewards associated
with the asset. (7 marks)
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(c) Distribution licence

The statement of financial position includes an intangible asset of $15 million, which is the cost of a
distribution licence acquired on 1 September 20X2. The licence gives Setter Stores Co the exclusive right to
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distribute a popular branded soft drink in its stores for a period of five years. (5 marks)
Required
Comment on the matters to be considered, and explain the audit evidence you should expect to find during your file
review in respect of each of the issues described above.
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Note. The split of the mark allocation is shown against each of the issues above.
(Total = 20 marks)
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24 Questions
28 Lamont (AAS 6/07) 36 mins
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You are the manager responsible for the audit of Lamont Co. The company's principal activity is wholesaling frozen
fish. The draft consolidated financial statements for the year ended 31 March 20X8 show revenue of $67.0 million
(20X7 – $62.3 million), profit before taxation of $11.9 million (20X7 – $14.2 million) and total assets of $48.0 million
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(20X7 – $36.4 million).
The following issues arising during the final audit have been noted on a schedule of points for your attention.
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(a) In early 20X8 a chemical leakage from refrigeration units owned by Lamont caused contamination of some of
its property. Lamont has incurred $0.3 million in clean up costs, $0.6 million in modernisation of the units to
prevent future leakage and a $30,000 fine to a regulatory agency. Apart from the fine, which has been
expensed, these costs have been capitalised as improvements. (7 marks)
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(b) While the refrigeration units were undergoing modernisation Lamont outsourced all its cold storage
requirements to Hogg Warehousing Services. At 31 March 20X8 it was not possible to physically inspect
Lamont's inventory held by Hogg due to health and safety requirements preventing unauthorised access to
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cold storage areas. Lamont's management has provided written representation that inventory held at
31 March 20X8 was $10.1 million (20X7 – $6.7 million). This amount has been agreed to a costing of Hogg's
monthly return of quantities held at 31 March 20X8. (7 marks)
l.b
(c) Lamont owns a residential apartment above its head office. Until 31 December 20X7 it was let for $3,000 a
month. Since 1 January 20X8 it has been occupied rent-free by the senior sales executive. (6 marks)
Required
March 20X8, for each of the above issues:

(i) Comment on the matters that you should consider; and
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In undertaking your review of the audit working papers and financial statements of Lamont Co for the year ended 31
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(ii) State the audit evidence that you should expect to find.
29 Papaya (12/09)
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65 mins
(a) ISA 520 Analytical procedures requires that the auditor performs analytical procedures during the initial risk
assessment stage of the audit. These procedures, also known as preliminary analytical review, are usually
performed before the year end, as part of the planning of the final audit.
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Required
(i) Explain, using examples, the reasons for performing analytical procedures as part of risk assessment.
(ii) Discuss the limitations of performing analytical procedures at the planning stage of the final audit. (6 marks)
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(b) Explain and differentiate between the terms 'overall audit strategy' and 'audit plan'. (4 marks)
You are the manager responsible for the audit of Papaya Co, a listed company, which operates a chain of
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supermarkets, with a year ending 31 December 20X9. There are three business segments operated by the company
– two segments are supermarket chains which operate under internally generated brand names, and the third
segment is a new financial services division.
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The first business segment comprises stores branded as 'Papaya Mart'. This segment makes up three quarters of
the supermarkets of the company, and are large 'out of town' stores, located on retail parks on the edge of towns
and cities. These stores sell a wide variety of items, including food and drink, clothing, household goods, and
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electrical appliances. In September 20X9, the first overseas Papaya Mart opened in Farland. This expansion was a
huge drain on cash resources, as it involved significant capital expenditure, as well as an expensive advertising
/fr
campaign to introduce the Papaya Mart brand in Farland.

The second business segment comprises the rest of the supermarkets, which are much smaller stores, located in
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city centres, and branded as 'Papaya Express'. The Express stores offer a reduced range of products, focusing on
food and drink, especially ready meals and other convenience items.
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Questions 25
The company also established a financial services division on 1 January 20X9, which offers loans, insurance services
and credit cards to customers.
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The following information was provided during a recent meeting held with the finance director of Papaya Co. All of
the matters outlined in the notes below are potentially material to the financial statements.
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Notes from meeting held 29 November 20X9
On 31 August 20X9, Papaya Co received notice from a government body that it is under investigation, along with
three other companies operating supermarket chains, for alleged collusion and price fixing activities. If it is found
o t.
guilty, significant financial penalties will be imposed on Papaya Co. The company is vigorously defending its case.
To help cash flows in a year of expansion, the company raised finance by issuing debentures which are potentially
convertible into equity on maturity in 20Y5.
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To manage the risk associated with overseas expansion, in October 20X9, the company entered for the first time into
several forward exchange contracts which end in February 20Y0. The contracts were acquired at no cost to Papaya
Co and are designated as hedging instruments.
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The property market has slumped this year, and significant losses were made on the sale of some plots of land
which were originally acquired for development potential. The decision to sell the land was made as it is becoming
increasingly difficult for the company to receive planning permission to build supermarkets on the land. Land is
recognised at cost in the statement of financial position.
l.b
Papaya Co has 35 warehouses which store non-perishable items of inventory. Due to new regulation, each
warehouse is required to undergo a major health and safety inspection every three years. All warehouses were
inspected in January 20X9, at a cost of $25,000 for each inspection.
Required
Using the specific information provided in respect of Papaya Co:
ria
ate
(c) Explain the information that you would require in order to perform analytical procedures during the planning
of the audit. (6 marks)
(d) Assess the risks of material misstatement to be addressed when planning the final audit for the year ending
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31 December 20X9, producing your answer in the form of briefing notes to be used at the audit planning
meeting. (16 marks)
Professional marks will be awarded in part (d) for the format of the answer, and for the clarity of assessment
provided. (4 marks)
tud
(Total = 36 marks)
30 Bill (6/11) (amended) 70 mins

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(a) You are a senior audit manager in Suki & Co, a firm of Chartered Certified Accountants. This morning you
have been re-assigned to the audit of Bill Co, a long-standing audit client of your firm, as the manager
previously assigned to the client has been taken ill. Bill Co has a year ending 30 June 20X1, and the audit
planning has been largely completed by the previously assigned audit manager, Tara Lafayette, who had been
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recruited by your firm four months ago.

Bill Co is a property development company, specialising in the regeneration and refurbishment of old
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industrial buildings, which are sold for commercial or residential use. All property developments are
performed under specifically negotiated fixed-price contracts. The company was founded 35 years ago by two
brothers, Alex and Ben Bradley, who own the majority of the company's share capital. Alex and Ben are
nearing retirement age, and are planning to sell the company within the next two years. The forecast revenue
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for the year ending 30 June 20X1 is $10.8 million, and the forecast profit before tax is $2.5 million. The
forecast statement of financial position recognises total assets of $95 million.
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26 Questions
You have just received the following email from the audit engagement partner.
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To: Audit manager
From: Audit partner
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Regarding: Bill Co – audit planning
Hello,
o t.
Thanks for taking on the role of audit manager for the forthcoming audit of Bill Co.
(i) I have just received some information on two significant issues that have arisen over the last week,
from Sam Compton, the company's finance director. This information is provided in Attachment 1.
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I am asking you to prepare briefing notes, for my use, in which you explain the matters that should be
considered in relation to the treatment of these two issues in the financial statements, and also explain
the risks of material misstatement relating to them. I also want you to recommend the planned audit
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procedures that should be performed in order to address those risks. (16 marks)
(ii) In addition, please critically evaluate the planning that has been completed by the previously assigned
audit manager. Relevant details are provided in Attachment 2, which contains notes made by her, and
l.b
placed on the current year audit file. Make sure you include discussion of any ethical matters arising
from the notes, and recommend any actions you think necessary. (11 marks)
Thanks.
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Attachment 1: Information from Sam Compton, finance director of Bill Co
In the last week, two significant issues have arisen at Bill Co. The first issue concerns a major contract
ate
involving the development of an old riverside warehouse into a conference centre in Bridgetown. An architect
working on the development has discovered that the property will need significant additional structural
improvements, the extra cost of which is estimated to be $350,000. The contract was originally forecast to
make a profit of $200,000. The development is currently about one third complete, and will take a further
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15 months to finish, including this additional construction work. The customer has been told that the
completion of the contract will be delayed by around two months. However, the contract price is fixed, and so
the additional costs must be covered by Bill Co.
The second issue concerns one of Bill Co's specialist divisions, which trades under the name 'Treasured
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Homes' and which deals exclusively in the redevelopment of non-industrial historic buildings such as castles
and forts. These buildings are usually acquired as uninhabitable ruins, and are then developed into luxury
residences for wealthy individuals. The management of Bill Co decided last week to sell this division, as
although it is profitable, it generates a lower margin than other business divisions. 'Treasured Homes'
operates separately from the rest of the business, and generates approximately 15% of the total revenue of
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the company. In a board minute dated 1 June 20X1, it was noted that 'interest has already been expressed in
this division from a potential buyer, and it is hoped that sale negotiations will soon commence, leading to sale
in August 20X1. There is a specific office building and some other tangible assets that will be sold as part of
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the deal. These assets are recorded at $7.6 million in the financial statements. No redundancies will be
necessary as employees' contracts will transfer to the new owners.'
Attachment 2: Planning Summary – Bill Co, year ending 30 June 20X1, prepared by Tara Lafayette,
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manager previously assigned to the audit

The planning for the forthcoming audit is almost complete. Time has been saved by not carrying out
procedures considered unnecessary for this long-standing audit client. Forecast accounts have been obtained
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and placed on file, and discussions held with management concerning business developments during the
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year. Analytical procedures have been performed on the statement of profit or loss and other comprehensive
income, but not on the statement of financial position, as there did not appear to be any significant
movements in assets or liabilities since last year.
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Questions 27
Management confirmed that there have been no changes to accounting systems and controls in the financial
year. For this reason we do not need to carry out walk-through tests or review our documentation of the
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systems and controls.
Management also confirmed that there have been no changes to business operations, other than the potential
sale of 'Treasured Homes'. All divisions are operating normally, generating sufficient profit and cash. For this
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reason, the business risk of Bill Co is assessed as low, and no further comments or discussions about
business operations have been placed on file.
The matter that will demand the most audit work is the valuation of properties currently under development,
o t.
especially the determination of the percentage completion of each development at the reporting date.
Historically, we have engaged a property valuation expert to provide a report on this area. However, Bill Co
has recently employed a newly qualified architect, who will be happy to provide us with evidence concerning
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the stage of completion of each property development contract at the year end. Using this person to produce
a report on all properties being developed will save time and costs.
Bill Co has recently completed the development of a luxury new office building in Newtown. Several of the
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office units are empty, and the management of Bill Co has offered the office space to our firm for a nominal
rent of $100 per year.
Required
l.b
Respond to the partner's email. (27 marks)
Note. The split of the mark allocation is shown within the partner's email.
Professional marks will be awarded for the format and clarity of your response. (4 marks)
(b)
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Ben and Alex Bradley have a sister, Jo, who runs an interior design company, Lantern Co. During a review of
board minutes, performed as part of the planning of Bill Co's audit, it was discovered that Bill Co has paid
$225,000 to Lantern Co during the year, in respect of refurbishment of development properties. On further
ate
enquiry, it was also found that Lantern Co leases an office space from Bill Co, under an informal arrangement
between the two companies.
Required
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(i) Explain the inherent limitations which mean that auditors may not identify related parties and related
party transactions. (4 marks)
(ii) Recommend the audit procedures to be performed in relation to Bill Co's transactions with Lantern
Co. (4 marks)
tud
31 Mulligan (12/07) 36 mins

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You are an audit manager in Webb & Co, a firm of Chartered Certified Accountants. Your audit client, Mulligan Co,
designs and manufactures wooden tables and chairs. The business has expanded rapidly in the last two years, since
the arrival of Patrick Tiler, an experienced sales and marketing manager.
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The directors want to secure a loan of $3 million in order to expand operations, following the design of a completely
new range of wooden garden furniture. The directors have approached LCT Bank for the loan. The bank's lending
criteria stipulate the following.
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'Loan applications must be accompanied by a detailed business plan, including an analysis of how the finance will be
used. LCT Bank need to see that the finance requested is adequate for the proposed business purpose. The business
plan must be supported by an assurance opinion on the adequacy of the requested finance.'
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The $3 million finance raised will be used as follows.

/fr
$'000
Construction of new factory 1,250
Purchase of new machinery 1,000
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Initial supply of timber raw material 250

Advertising and marketing of new product 500
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28 Questions
Your firm has agreed to review the business plan and to provide an assurance opinion on the completeness of the
finance request. A meeting will be held tomorrow to discuss this assignment.
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Required
(a) Identify and explain the matters relating to the assurance assignment that should be discussed at the meeting
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with Mulligan Co. (8 marks)
(b) State the enquiries you would make of the directors of Mulligan Co to ascertain the adequacy of the $3 million
finance requested for the new production facility. (7 marks)
o t.
During the year the internal auditor of Mulligan Co discovered several discrepancies in the inventory records. In a
statement made to the board of directors, the internal auditor said:
'I think that someone is taking items from the warehouse. A physical inventory count is performed every three
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months, and it has become apparent that about 200 boxes of flat-packed chairs and tables are disappearing from the
warehouse every month. We should get someone to investigate what has happened and quantify the value of the
loss.'
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Required
(c) Define 'forensic accounting' and explain its relevance to the statement made by the internal auditor.
(5 marks)
l.b
(Total = 20 marks)
32 Parker (6/13) 63 mins
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You are an audit manager in Hound & Co, responsible for the audit of Parker Co, a new audit client of your firm. You
are planning the audit of Parker Co's financial statements for the year ending 30 June 20X3, and you have just
attended a meeting with Ruth Collie, the finance director of Parker Co, where she gave you the projected results for
ate
the year. Parker Co designs and manufactures health and beauty products including cosmetics.
You have just received an email from Harry Shepherd, the audit engagement partner:
To: Audit manager

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From: Harry Shepherd, Partner

Subject: Parker Co
tud
Hello,
I understand you met with Ruth Collie at Parker Co recently and that you are planning the forthcoming audit.
To bring me up to date on this new client, I would like you to use the information obtained in your meeting to
prepare briefing notes for my use in which you:
as
(a) Perform preliminary analytical procedures and evaluate the audit risks to be considered in planning the
audit of the financial statements, and identify and explain any additional information that would be
relevant to your evaluation; and (24 marks)
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(b) Discuss any ethical issues raised and recommend the relevant actions to be taken by our firm.
(7 marks)
ea
Thank you.
e
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Questions 29
PARKER CO – STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
m/
Notes 30 June 20X3 30 June 20X2
Projected Actual
$'000 $'000
Revenue 7,800 8,500
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Cost of sales 1 (5,680) (5,800)
Gross profit 2,120 2,700
Operating expenses (1,230) (1,378)
o t.
Operating profit 890 1,322
Finance costs (155) (125)
Profit before tax 735 1,197
Taxation (70) (300)
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Profit for the year 665 897
Note 1. Cost of sales includes $250,000 relating to a provision for a potential fine payable. The advertising regulatory
authority has issued a notice of a $450,000 fine payable by Parker Co due to alleged inappropriate claims made in an
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advertising campaign. The fine is being disputed and the matter should be resolved in August 20X3.
PARKER CO – STATEMENT OF FINANCIAL POSITION
Notes 30 June 20X3 30 June 20X2
l.b
Projected Actual
$'000 $'000
Non-current assets
Property, plant and equipment
Intangible asset – development costs
Current assets
2
ria 21,500
2,250
23,750
19,400
–
19,400
ate
Inventory 2,600 2,165
Trade receivables 900 800
Cash – 1,000
3,500 3,965
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Total assets 27,250 23,365
Equity
Share capital 8,000 8,000
Revaluation reserve 3 2,500 2,000
tud
Retained earnings 1,275 1,455

11,775 11,455
Non-current liabilities
2% preference shares 3,125 3,125
as
Bank loan 3,800 2,600

Obligations under finance leases 4,900 4,000
11,825 9,725
Current liabilities
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Trade payables 1,340 1,000

Taxation 50 300
Obligations under finance leases 860 685
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Provisions 500 200

Overdraft 900 –
3,650 2,185
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Total equity and liabilities 27,250 23,365
Notes
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2 The development costs relate to a new range of organic cosmetics.

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3 All of the company's properties were revalued on 1 January 20X3 by an independent, professionally
qualified expert.
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30 Questions
Notes from your meeting with Ruth Collie
m/
Business review
Parker Co is facing difficult trading conditions. Consumer spending is depressed due to recession in the economy.
The health and beauty market remains very competitive and a major competitor launched a very successful new
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cosmetics range during the year, which led to a significant decline in sales of one of Parker Co's most successful
brands. It has been necessary to cut prices on some of the company's product ranges in an attempt to maintain
market share. However, a new brand using organic ingredients is being developed and is due to launch in
September 20X3.
o t.
Financial matters
Cash flow has been a problem this year, largely due to the cash spent on developing the new product range. Cash
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was also needed to pay dividends to both equity and preference shareholders. To help to reduce cash outflows,
some new assets were acquired under finance leases and an extension to the company's bank loan was negotiated in
December 20X2.
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Human resources
In December 20X2 Parker Co's internal audit team performed a review of the operation of controls over the
processing of overtime payments in the human resources department. The review found that the company's
specified internal controls procedures in relation to the processing of overtime payments and associated tax
l.b
payments were not always being followed. Until December 20X2 this processing was split between the human
resources and finance departments. Since then, the processing has been entirely carried out by the finance
department.
Expansion plans
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Management is planning to expand Parker Co's operations into a new market relating to beauty salons. This is a
growing market, and there is synergy because Parker Co's products can be sold and used in the salons. Expansion
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would be through the acquisition of an existing company which operates beauty salons. A potential target, Beauty
Boost Co, has been identified and preliminary discussions have taken place between the management of the two
companies. Parker Co's managing director has asked for our firm's advice about the potential acquisition, and
specifically regarding the financing of the transaction. Beauty Boost Co is an audit client of our firm, so we have
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considerable knowledge of its business.

Required
Respond to the email from the audit partner. (31 marks)
tud
Professional marks will be awarded for the presentation, logical flow and clarity of explanation of the briefing notes.
(4 marks)
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(Total = 35 marks)
33 Lapwing (6/12) 59 mins

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(a) You are a manager in Lapwing & Co. One of your audit clients is Hawk Co which operates commercial real
estate properties typically comprising several floors of retail units and leisure facilities such as cinemas and
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health clubs, which are rented out to provide rental income.

Your firm has just been approached to provide an additional engagement for Hawk Co, to review and provide
a report on the company's business plan, including forecast financial statements for the 12-month period to
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31 May 20X3. Hawk Co is in the process of negotiating a new bank loan of $30 million and the report on the
business plan is at the request of the bank. It is anticipated that the loan would be advanced in August 20X2
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and would carry an interest rate of 4%. The report would be provided by your firm's business advisory
department and a second partner review will be conducted which will reduce any threat to objectivity to an
acceptable level.
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Questions 31
Extracts from the forecast financial statements included in the business plan are given below:
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STATEMENT OF PROFIT OR LOSS (EXTRACT)
Notes FORECAST UNAUDITED
12 months to 12 months to
31 May 20X3 31 May 20X2
co
$'000 $'000
Revenue 25,000 20,600
Operating expenses (16,550) (14,420)
o t.
Operating profit 8,450 6,180
Profit on disposal of Beak Retail 1 4,720 –
Finance costs (2,650) (1,690)
Profit before tax 10,520 4,490
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STATEMENT OF FINANCIAL POSITION
Notes FORECAST UNAUDITED
31 May 20X3 31 May 20X2
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Assets $'000 $'000
Non-current assets
Property, plant and equipment 2 330,150 293,000
Current assets
l.b
Inventory 500 450
Receivables 3,600 3,300
Cash and cash equivalents 2,250 3,750
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6,350 7,500
Total assets 336,500 300,500
Equity and liabilities
Equity
ate
Total equity 198,400 192,600
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Long-term borrowings 2 82,500 52,500

Deferred tax 50,000 50,000
Current liabilities
Trade payables 5,600 5,400
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Total liabilities 138,100 107,900

Notes
1 Beak Retail is a retail park which is underperforming. Its sale is currently being negotiated, and is
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expected to take place in September 20X2.

2 Hawk Co is planning to invest the cash raised from the bank loan in a new retail and leisure park which
is being developed jointly with another company, Kestrel Co.
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Required
In respect of the engagement to provide a report on Hawk Co's business plan:
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(i) Identify and explain the matters that should be considered in agreeing the terms of the engagement
Note. You are not required to consider ethical threats to objectivity. (6 marks)
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(ii) Recommend the procedures that should be performed in order to examine and report on the forecast
financial statements of Hawk Co for the year to 31 May 20X3 (13 marks)
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32 Questions
(b) You are also responsible for the audit of Osprey Co, which has a financial year ended 31 May 20X2. The audit
engagement partner, Bill Kingfisher, sent you the following email this morning.
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To: Audit manager
From: Bill Kingfisher, audit engagement partner, Osprey Co
co
Regarding: Environmental incident
Hello,
o t.
Osprey Co's finance director called me yesterday to explain that unfortunately over the last few weeks, one of
its four factories leaked a small amount of toxic chemicals into the atmosphere. The factory's operations were
halted immediately and a decision has been taken to permanently close the site. Though this is a significant
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event for the company and will result in relocation and some restructuring of operations, it is not considered
to be a threat to its going concern status. Costs of closure of the factory have been estimated to be
$1.25 million, which is expected to be material to the financial statements, and a provision has been set up in
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respect of these costs.
Osprey Co is keen to highlight its previous excellent record on socio-environmental matters. Management is
preparing a report to be published with the financial statements which will describe the commitment of the
company to socio-environmental matters, and state its target of reducing environmental damage caused by
l.b
its operations. The report will contain a selection of targets and key performance indicators to show
performance in areas such as energy use, water consumption and employee satisfaction. Our firm may be
asked to provide an assurance report on the key performance indicators.
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I am asking you to prepare briefing notes for my use in which you:
(i) Recommend the principal audit procedures to be performed in respect of the costs of closure of the
factory; and (6 marks)
ate
(ii) Discuss the difficulties in measuring and reporting on environmental and social performance.
(4 marks)
Thank you.
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Required
tud
Professional marks will be awarded in part (b) for the presentation and clarity of your answer. (4 marks)
(Total = 33 marks)
as
34 Azure Airline (AAS 12/04) 63 mins

Azure, a limited liability company, was incorporated in Sepiana on 1 March 20X8. In April, the company exercised an
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exclusive right granted by the government of Pewta to provide twice weekly direct flights between Lyme, the capital
of Pewta, and Darke, the capital of Sepiana.
The introduction of this service has been well advertised as 'efficient and timely' in national newspapers. The journey
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time between Sepiana and Pewta is expected to be significantly reduced, so encouraging tourism and business
development opportunities in Sepiana.
Azure operates a refurbished 35-year old aircraft which is leased from an international airline and registered with the
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Pewtan Aviation Administration (the PAA). The PAA requires that engines be overhauled every two years. Engine
overhauls are expected to put the aircraft out of commission for several weeks.
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The aircraft is configured to carry 15 First Class, 50 Business Class and 76 Economy Class passengers. The aircraft
has a generous hold capacity for Sepiana's numerous horticultural growers (eg of cocoa, tea and fruit) and general
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cargo.
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Questions 33
The six hour journey offers an in-flight movie, a meal, hot and cold drinks and tax-free shopping. All meals are
prepared in Lyme under a contract with an airport catering company. Passengers are invited to complete a
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'satisfaction' questionnaire which is included with the in-flight entertainment and shopping guide. Responses
received show that passengers are generally least satisfied with the quality of the food – especially on the Darke to
Lyme flight.
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Azure employs ten full-time cabin crew attendants who are trained in air-stewardship including passenger safety in
the event of accident and illness. Flight personnel (the captain and co-pilots) are provided under a contract with the
international airline from which the aircraft is leased. At the end of each flight the captain completes a timesheet
o t.
detailing the crew and actual flight time.
Ticket sales are made by Azure and travel agents in Sepiana and Pewta. On a number of occasions Economy seating
has been over-booked. Customers who have been affected by this have been accommodated in Business Class as
there is much less demand for this, and even less for First Class. Ticket prices for each class depend on many
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factors, for example, whether the tickets are refundable/non-refundable, exchangeable/non-exchangeable, single or
return, mid-week or weekend, and the time of booking.
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Azure's insurance cover includes passenger liability, freight/baggage and compensation insurance. Premiums for
passenger liability insurance are determined on the basis of passenger miles flown.
Required
(a) Identify and explain the business risks facing Azure. (9 marks)
l.b
(b) Describe how the risks identified in (a) could be managed and maintained at an acceptable level by Azure.
(9 marks)
(c) Suggest four measures of operational performance and the evidence that should be available to provide
assurance on their accuracy.
Note. Assume it is 11 December 20X8. ria (6 marks)
ate
The management of Azure is considering producing an integrated report on the company which would include a
range of financial and non-financial information. A particular focus would be the company's attempts to contribute
positively to its social and natural environment.
In order to add credence to the proposed report, management would like to engage a firm of professional
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accountants to provide an assurance report on its contents. It is worried, however, that such a report would be of
little benefit to its users, and would like some clarification about the level of assurance that would be provided, and
the types of conclusion that might be given.
Required
tud
(d) Identify and explain the assurance that might be provided by an assurance engagement on an integrated
report. (5 marks)
(e) Identify the types of possible conclusion which such a report might give. (6 marks)
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Note. You should base your answer on the most recently available technical guidance in this area.
(Total = 35 marks)
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35 Island (12/07) (amended) 58 mins

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You are Sanjay Patel, an audit manager at Pond & Co, a firm of Chartered Certified Accountants. Your client, Island
Co, is a manufacturer of machinery used in the coal extraction industry. You are currently planning the audit of the
financial statements for the year ended 30 November 20X8. The draft financial statements show revenue of $125
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million (20X6 – $103 million), profit before tax of $5.6 million (20X6 – $5.1 million) and total assets of $95 million
(20X6 – $90 million). Your firm was appointed as auditor to Island Co for the first time in June 20X8.
/fr
Island Co designs, constructs and installs machinery for five key customers. Payment is due in three installments:
50% is due when the order is confirmed (stage one), 25% on delivery of the machinery (stage two), and 25% on
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successful installation in the customer's coal mine (stage three). Generally it takes six months from the order being
finalised until the final installation.
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34 Questions
At 30 November, there is an amount outstanding of $2.85 million from Jacks Mine Co. The amount is a disputed
stage three payment. Jacks Mine Co is refusing to pay until the machinery, which was installed in August 20X8, is
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running at 100% efficiency.
One customer, Sawyer Co, communicated in November 20X8, via its legal counsel with Island Co, claiming damages
for injuries suffered by a drilling machine operator whose arm was severely injured when a machine malfunctioned.
co
Kate Shannon, the chief executive officer of Island Co, has told you that the claim is being ignored as it is generally
known that Sawyer Co has a poor health and safety record, and thus the accident was their fault. Two orders which
were placed by Sawyer Co in October 20X8 have been cancelled.
o t.
Work in progress is valued at $8.5 million at 30 November 20X8. A physical inventory count was held on
17 November 20X8. The chief engineer estimated the stage of completion of each machine at that date. One of the
major components included in the coal extracting machinery is now being sourced from overseas. The new supplier,
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Locke Co, is located in Spain and invoices Island Co in euros. There is a trade payable of $1.5 million owing to Locke
Co recorded within current liabilities.
All machines are supplied carrying a one year warranty. A warranty provision is recognised on the statement of
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financial position at $2.5 million (20X6 – $2.4 million). Kate Shannon estimates the cost of repairing defective
machinery reported by customers, and this estimate forms the basis of the provision.
Kate Shannon owns 60% of the shares in Island Co. She also owns 55% of Pacific Co, which leases a head office to
Island Co. Kate is considering selling some of her shares in Island Co in late January 20X9, and would like the audit
l.b
to be finished by that time.
You have just received the following email from Marcus Fish, the engagement partner for the Island Co audit.
To:
From:
Re:
Sanjay Patel
Marcus Fish
Island Co planning meeting
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ate
Sanjay,
Can you draft some briefing notes for me in advance of tomorrow's planning meeting for the Island audit, which you
identify and explain the principal audit risks, and any other matters to be considered when planning the final audit for
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Island Co for the year ended 30 November 20X8.

Thanks,
Marcus
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Required
Prepare the briefing notes. The following marks will be available.
(a) Respond to the partner's email.
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Requirement (a) includes four professional marks. (15 marks)

(b) Explain the principal audit procedures to be performed during the final audit in respect of the estimated
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warranty provision in the statement of financial position of Island Co as at 30 November 20X8. (5 marks)
(c) (i) Identify and describe four quality control procedures that are applicable to the individual audit
engagement. (8 marks)
ea
(ii) Discuss two problems that may be faced in implementing quality control procedures in a small firm of
Chartered Certified Accountants, and recommend how these problems may be overcome.
(4 marks)
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Note. You should assume that it is 4 December 20X8. (Total = 32 marks)

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Questions 35
36 Meadow (AAS 12/02) (amended) 52 mins
m/
You are Minim Sladky, an audit manager in Robert Bracco, a firm of Chartered Certified Accountants. One of your
audit clients, Meadow, is a company listed on a stock exchange with a 30 September accounting year end. The
principal activity of Meadow is retailing under the Vazandt brand name. The retail industry has recently suffered from
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a reduction in consumer spending.
Meadow has two operating divisions: Domestic and International. Each retail division is sub-divided into four
business units: Ladieswear, Menswear, Home Furnishings and Foods. The International retail business consists of
o t.
three broad geographic areas: Africa, South America and the Far East. Robert Bracco is represented by affiliated
offices in all relevant countries.
You have just received the following email from Maxim Gorky, the audit engagement partner.
sp
To: Minim Sladky
From: Maxim Gorky
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Re: Meadow audit
Hello,
I need you to start working on the planning for the Meadow audit.
l.b
Please prepare for me some briefing notes in which you identify and explain the principal audit risks and other matters
to be considered when planning the approach to the final audit of Meadow for the year ended 30 September 20X8.
(17 marks)
You will need to use the information attached to this email.
Thanks, ria
ate
Maxim
Email attachments
1 Financial extracts
For the year ended 30 September
ym
20X8 20X7
Statement of profit or loss $m $m
Revenue 2,585.0 2,638.8
Total operating profit 129.1 120.0
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Provision for loss on operations to be discontinued (Note 1) (83.8) –

Finance cost (net) (4.7) (4.8)
Profit before tax 40.6 115.2
Statement of financial position At 30 September

as
20X8 20X7
Tangible non-current assets $m $m
Land and buildings 950.5 964.0
cc
Store fit-out, fixtures and equipment 448.9 481.8

Inventory (Note 2) 164.2 165.9
Trade and other receivables 22.5 36.9
ea
Cash and cash equivalents 53.7 104.6

e
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36 Questions
Notes
m/
1 The company has announced its intention to close loss-making businesses in Africa, subject to the full
consultation that the Board recognises will need to take place. The decision to close would be taken
only after consultation with employee representative bodies and if no other solution is found during
the consultation. Net closure costs of $83.8m have been provided, covered future trading losses,
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losses on disposal of assets and redundancy costs.
2 Inventory is valued at the lower of cost and net realisable value. Cost is ascertained using the retail
method (ie current selling price less normal gross profit margin).
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2 Segmental information
Revenue Operating profit
20X8 20X7 20X8 20X7
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$m $m $m $m
International
Africa 99.0 96.7 (11.8) (9.0)
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South America 264.0 250.5 11.1 5.3
Far East 38.3 38.9 2.8 (1.2)
Total International 401.3 386.1 2.1 (4.9)
Domestic 2,183.7 2,252.7 127.0 124.9
Total operating activities 2,585.0 2,638.8 129.1 120.0
l.b
Number of stores
20X8 20X7
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International
Africa 14 13
South America 86 87
Far East 4 4
ate
Total International 104 104
Domestic 107 106
Total 211 210
3 International restructure
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On 29 September 20X8, the company announced the intention to:

 Close all African operations (representing 14 stores)
 Sell the South American businesses
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Required
(a) Respond to the partner's email. (17 marks)
Professional marks will be awarded for the format and clarity of your response (4 marks)
as
(b) Describe the audit work that you would undertake to determine whether the accounting treatment and
disclosure for the:
(i) Segmental information
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(ii) International restructuring

are appropriate. (8 marks)
ea

e
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Questions 37
37 Butler (6/11) (amended) 58 mins
m/
(a) Butler Co is a new audit client of your firm. You are the manager responsible for the audit of the financial
statements for the year ended 31 May 20X1. Butler Co designs and manufactures aircraft engines and spare
co
parts, and is a subsidiary of a multi-national group. Extracts from the draft financial statements are shown
below.
o t.
31 May 20X1 31 May 20X0
Draft Actual
$m $m
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Assets
Non-current assets
Intangible assets (Note 1) 200 180
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Property, plant and equipment 1,300 1,200
(Note 2)
Deferred tax asset (Note 3) 235 20
Financial assets 25 35
1,760 1,435
l.b
Current assets
Inventory 1,300 800
Trade receivables 2,100 1,860
Total assets
Equity and liabilities
3,400
5,160
ria 2,660
4,095
ate
Equity
Share capital 300 300
Retained earnings (525) 95
(225) 395
ym
Long-term borrowings (Note 4) 1,900 1,350
Provisions (Note 5) 185 150
2,085 1,500
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Current liabilities
Short-term borrowings (Note 6) 800 400
2,500 1,800
3,300 2,200
5,160 4,095
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Total equity and liabilities

Notes to the statement of financial position:
1 Intangible assets comprise goodwill on the acquisition of subsidiaries ($80 million), and
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development costs capitalised on engine development projects ($120 million)

2 Property, plant and equipment includes land and buildings valued at $25 million, over which a fixed
ea
charge exists.
3 The deferred tax asset has arisen following several loss-making years suffered by the company. The
asset represents the tax benefit of unutilised tax losses carried forward.
e
4 Long-term borrowings include a debenture due for repayment in July 20X2, and a loan from Butler
/fr
Co's parent company due for repayment in December 20X2.

5 Provisions relate to warranties provided to customers.
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6 Short-term borrowings comprise an overdraft ($25 million), a short term loan ($60 million) due for
repayment in August 20X1, and a bank loan ($715 million) repayable in September 20X1.
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38 Questions
You have received an email from the audit partner responsible for the audit of Butler Co:
m/
To: Audit manager
From: Audit partner
co
Regarding: Butler Co – going concern issues
Hello,
I understand that the audit work on Butler Co commences this week. I am concerned about the future of the
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company, as against a background of economic recession, sales have been declining, several significant
customer contracts have been cancelled unexpectedly, and competition from overseas has damaged the
market share previously enjoyed by Butler Co.
sp
(i) Please prepare briefing notes, for my use, in which you identify and explain any matters arising from
your review of the draft statement of financial position, and the cash flow forecast, which may cast
significant doubt on the company's ability to continue as a going concern. The cash flow forecast has
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just been sent to me from the client, and is attached. It covers only the first three months of the next
financial year, the client is currently preparing the forecasts for the whole 12-month period. Please be
sceptical when reviewing the forecast, as the assumptions may be optimistic. (10 marks)
(ii) In addition, please recommend the principal audit procedures to be carried out on the cash flow
l.b
forecast, and identify any additional information that would be needed in order to carry out these
procedures. Your recommendations can be included in a separate section of the briefing notes.
(11 marks)
ria
Thanks.
ATTACHMENT: CASH FLOW FORECAST FOR THE THREE MONTHS TO 31 AUGUST 20X1
ate
31 June 20X1 31 July 20X1 August 20X1
$m $m $m
Cash inflows
Cash receipts from customers 175 195 220
(Note 1)
ym
Loan receipt (Note 2) 150

Government subsidy (Note 3) 50
Sales of financial assets 50
Total cash inflows 225 345 270
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Cash outflows
Operating cash outflows 200 200 290
Interest payments 40 40 40
Loan repayment 60
as
Total cash outflows 240 240 390

Net cash flow for the month (15) 105 (120)
Opening cash (25) (40) 65
cc
Closing cash (40) 65 (55)
Notes to the cash flow forecast:

ea
This cash flow forecast has been prepared by the management of Butler Co, and is based on the following
assumptions.
1 Cash receipts from customers should accelerate given the anticipated improvement in economic
e
conditions. In addition, the company has committed extra resources to the credit control function, in
order to speed up collection of overdue debts.
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2 The loan expected to be received in July 20X1 is currently being negotiated with our parent company,
Rubery Co.
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htt
Questions 39
3 The government subsidy will be received once our application has been approved. The subsidy is
awarded to companies which operate in areas of high unemployment and it subsidises the wages and
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salaries paid to staff.
Required
co
Professional marks will be awarded for presentation, and for the clarity of explanations provided. (4 marks)
o t.
(b) Given the information provided relating to Butler Co, it is likely that the auditor may conclude on completion
of all necessary audit procedures, that the use of the going concern assumption in the financial statements is
appropriate, but that a material uncertainty, or several uncertainties, exist regarding the company's ability to
sp
continue as a going concern.
Required
log
If audit procedures indicate that one or more material uncertainties exist regarding Butler Co's ability to
continue as a going concern, explain the matters that should be considered in forming the audit opinion and
the potential impacts on the auditor's report. (7 marks)
l.b
38 Grohl (12/12) 72 mins
(a)
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You are a manager in Foo & Co, responsible for the audit of Grohl Co, a company which produces circuit
boards which are sold to manufacturers of electrical equipment such as computers and mobile phones. It is
the first time that you have managed this audit client, taking over from the previous audit manager, Bob
ate
Halen, last month.
The audit planning for the year ended 30 November 20X2 is about to commence, and you have just received
an email from Mia Vai, the audit engagement partner:
ym
To: Audit manager

From: Mia Vai, Audit partner, Foo & Co
Subject: Grohl Co – audit planning
tud
Hello,
I am meeting with the other audit partners tomorrow to discuss forthcoming audits and related issues. I
understand that you recently had a meeting with Mo Satriani, the finance director of Grohl Co. Using the
information from your meeting, I would like you to prepare briefing notes for my use in which you:
as
(i) Evaluate the business risks faced by Grohl Co; (12 marks)
(ii) Identify and explain four risks of material misstatement to be considered in planning the audit; and
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(8 marks)
(iii) Discuss any ethical issues raised, and recommend the relevant actions to be taken by our firm.
(8 marks)
ea
Thank you.
Comments made by Mo Satriani in your meeting

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Business overview
/fr
Grohl Co's principal business activity remains the production of circuit boards. One of the key materials used
in production is copper wiring, all of which is imported. As a cost cutting measure, in April 20X2 a contract
with a new overseas supplier was signed, and all of the company's copper wiring is now supplied under this
p:/
contract. Purchases are denominated in a foreign currency, but the company does not use forward exchange
contracts in relation to its imports of copper wiring.
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40 Questions
Grohl Co has two production facilities, one of which produces goods for the export market, and the other
produces goods for the domestic market. About half of its goods are exported, but the export market is
m/
suffering due to competition from cheaper producers overseas. Most domestic sales are made under contract
with approximately 20 customers.
Recent developments
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In early November 20X2, production was halted for a week at the production facility which supplies the
domestic market. A number of customers had returned goods, claiming faults in the circuit boards supplied.
On inspection, it was found that the copper used in the circuit boards was corroded and therefore unsuitable
o t.
for use. The corrosion is difficult to spot as it cannot be identified by eye, and relies on electrical testing. All
customers were contacted immediately and, where necessary, products recalled and replaced. The corroded
copper remaining in inventory has been identified and separated from the rest of the copper.
sp
Work has recently started on a new production line which will ensure that Grohl Co meets new regulatory
requirements prohibiting the use of certain chemicals, which come into force in March 20X3. In July 20X2, a
loan of $30 million with an interest rate of 4% was negotiated with Grohl Co's bank, the main purpose of the
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loan being to fund the capital expenditure necessary for the new production line. $2.5 million of the loan
represents an overdraft which was converted into long-term finance.
Other matters
l.b
Several of Grohl Co's executive directors and the financial controller left in October 20X2, to set up a
company specialising in the recycling of old electronic equipment. This new company is not considered to be
in competition with Grohl Co's operations. The directors left on good terms, and replacements for the
directors have been recruited. One of Foo & Co's audit managers, Bob Halen, is being interviewed for the role
of Grohl Co's business when he was managing the audit.

ria
of financial controller at Grohl Co. Bob is a good candidate for the position, as he developed good knowledge
At Grohl Co's most recent board meeting, the audit fee was discussed. The board members expressed
ate
concern over the size of the audit fee, given the company's loss for the year. The board members would like
to know whether the audit can be performed on a contingent fee basis.
Financial Information provided by Mo Satriani
ym
EXTRACT FROM DRAFT STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 NOVEMBER 20X2
20X2 Draft 20X1 Actual
$'000 $'000
Revenue 12,500 13,800
tud
Operating costs (12,000) (12,800)

Operating profit 500 1,000
Profit/(loss) before tax (300) 200
as
The draft statement of financial position has not yet been prepared, but Mo states that the total assets of
Grohl Co at 30 November 20X2 are $180 million, and cash at bank is $130,000. Based on draft figures, the
company's current ratio is 1.1, and the quick ratio is 0.8.
cc
Required
ea
Professional marks will be awarded for the presentation, structure, logical flow and clarity of your answer.
(4 marks)
e
(b) You have just received a phone call from Mo Satriani, Grohl Co's finance director, in which he made the
/fr
following comments.
'There is something I forgot to mention in our meeting. Our business insurance covers us for specific
occasions when business is interrupted. I put in a claim on 28 November 20X2 for $5 million which I have
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estimated to cover the period when our production was halted due to the problem with the corroded copper.
htt
Questions 41
This is not yet recognised in the financial statements, but I want to make an adjustment to recognise the
$5 million as a receivable as at 30 November.'
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Required
Comment on the matters that should be considered, and recommend the audit procedures to be performed,
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in respect of the insurance claim. (8 marks)
(Total = 40 marks)
o t.
39 Champers (6/09) (amended) 65 mins
You are an audit senior in Carter & Co, working on the audit of Champers Co, and you have received the following
sp
email from Geoff Forest, the engagement partner responsible for the Champers audit.
To: Audit Senior

From: Geoff Forest
log
Date: 2 June 20X9
Subject: Audit of Champers Co
Hi,
l.b
I need you to draft some briefing notes for me to use at the Champers audit planning meeting, which evaluate the
business risks facing Champers Co. (13 marks)
There will be junior staff at the meeting, so you need to explain everything you say clearly, avoiding using any
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technical terms that they might not be familiar with. The permanent file contains a report on Champers that was
produced recently by an external business consultant. You may find this useful.
Please have the notes ready for me to review as soon as you can. I look forward to reading them.
ate
Regards,
Geoff Forest
ym
The following is an extract from the permanent file.

Champers Co operates a large number of restaurants throughout the country, which are operated under four well
known brand names. The company's strategy is to offer a variety of different dining experiences in restaurants
situated in city centres and residential areas, with the objective of maximising market share in a competitive business
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environment.
Key financial information
31 May
20X9 20X8
as
Draft Final
$m $m
Company revenue 1,500 1,350
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Revenue is derived from four restaurant chains, each having a

distinctive brand name:
Happy Monkeys family bistros 800 660
Quick-bite outlets 375 400
ea
City Sizzler grills 300 290

Green George cafés 25 –
Company profit before tax 135 155
e
Company total assets 4,200 3,350

Company cash at bank 116 350
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Business segments
The Happy Monkeys chain of restaurants provides family-friendly dining in an informal setting. Most of the
p:/
restaurants are located in residential areas. Each restaurant has a large children's play area containing climbing
frames and slides, and offers a crèche facility, where parents may leave their children for up to two hours. Recently
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42 Questions
there has been some media criticism of the quality of the child care offered in one crèche, because a child had fallen
from a climbing frame and was slightly injured. One of the Happy Monkeys restaurants was closed in December 20X8
m/
for three weeks following a health and safety inspection which revealed some significant breaches in hygiene
standards in the kitchen.
The Quick-bite chain offers fast-food. The restaurants are located next to busy roads, in shopping centres, and at
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railway stations and airports. Champers Co has launched a significant marketing campaign to support the Quick-bite
brand name. The draft statement of profit or loss and other comprehensive income for the year ended 31 May 20X9
includes an expense of $150 million in relation to the advertising and marketing of this brand. In January 20X9 the
o t.
company started to provide nutritional information on its menus in the Quick-bite restaurants, following pressure
from the government for all restaurants to disclose more about the ingredients of their food. 50% of the revenue for
this business segment is derived from the sale of 'chuckle boxes' – self-contained children's meals which contain a
small toy.
sp
The City Sizzler grills offer a more sophisticated dining experience. The emphasis is on high quality food served in
luxurious surroundings. There are currently 250 City Sizzler grills, and Champers Co is planning to expand this to
500 by May 20Y0. The grills are all situated in prime city centre locations and are completely refurbished every two
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years.
The Green George café chain is a recent addition to the range of restaurants. There are only 30 restaurants in the
chain, mostly located in affluent residential areas. The restaurants offer eco-friendly food, guaranteed to be free from
l.b
artificial flavourings and colourings, and to have been produced in an environmentally sustainable manner. All of the
30 restaurants have been newly constructed by Champers Co, and are capitalised at $210 million. This includes all
directly attributable costs, and borrowing costs capitalised relating to loans taken out to finance the acquisition of the
sites and construction of the restaurants. Champers Co is planning to double the number of Green George cafés
operating within the next twelve months.
Laws and regulations ria
ate
Two new regulations were issued by the government recently which will impact on Champers Co. The regulations
come into effect from September 20X9:
(a) Minimum wage regulation has increased the minimum wage by 15%. One third of Champers Co's employees
earn the minimum wage.
ym
(b) Advertising regulations now forbid the advertising of food in a manner specifically aimed at children.
Three audit juniors are joining your team for the forthcoming audit of Champers Co, and you have asked them to
read through the permanent file to familiarise themselves with the client. One of the juniors has told you that he
tud
appreciates that auditors need to have a thorough understanding of the business of their client, but he does not
know what aspects of the client's business this relates to, or how the understanding is developed.
Required
(a) (i) Identify and explain the aspects of a client's business which should be considered in order to gain an
as
understanding of the company and its operating environment. (6 marks)

(ii) Recommend the procedures an auditor should perform in order to gain business understanding.
(4 marks)
cc
(b) Respond to the partner's email. (13 marks)

Note. Professional marks will be awarded in part (b) for the clarity, format and presentation of the briefing
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notes. (4 marks)
(c) Describe the principal audit procedures to be performed in respect of the amount:
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(i) Capitalised in relation to the construction of the new Green George cafés (5 marks)
(ii) Recognised as an expense for the advertising of the Quick-bite brand (4 marks)
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(Total = 36 marks)
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Questions 43
40 Grissom (6/10) (amended) 68 mins
m/
You are a senior audit manager in Vegas & Co, responsible for the audit of the Grissom Group, which has been an
audit client for several years. The group companies all have a financial year ending 30 June 20Y0, and you are
currently planning the final audit of the consolidated financial statements. The group's operations focus on the
co
manufacture and marketing of confectionery and savoury snacks. Information about several matters relevant to the
group audit is given below. These matters are all potentially material to the consolidated financial statements. None
of the companies in the group are listed.
o t.
Grissom Co
This is a non-trading parent company, which wholly owns three subsidiaries – Willows Co, Hodges Co and Brass Co,
all of which are involved with the core manufacturing and marketing operations of the group. This year, the directors
sp
decided to diversify the group's activities in order to reduce risk exposure. Non-controlling interests representing
long-term investments have been made in two companies – an internet-based travel agent, and a chain of pet shops.
In the consolidated statement of financial position, these investments are accounted for as associates, as Grissom
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Co is able to exert significant influence over the companies.
As part of their remuneration, the directors of Grissom Co receive a bonus based on the profit before tax of the
group. In April 20Y0, the group finance director resigned from office after a disagreement with the chief executive
officer over changes to accounting estimates. A new group finance director is yet to be appointed.
l.b
Willows Co
This company manufactures and distributes chocolate bars and cakes. In July 20X9, production was relocated to a
ria
new, very large factory. One of the conditions of the planning permission for the new factory is that Willows Co
must, at the end of the useful life of the factory, dismantle the premises and repair any environmental damage
caused to the land on which it is situated.
ate
Hodges Co
This company's operations involve the manufacture and distribution of packaged nuts and dried fruit. The
government paid a grant in November 20X9 to Hodges Co, to assist with costs associated with installing new,
environmentally friendly, packing lines in its factories. The packing lines must reduce energy use by 25% as part of
ym
the conditions of the grant, and they began operating in February 20Y0.
Brass Co
This company is a new and significant acquisition, purchased in January 20Y0. It is located overseas, in Chocland, a
tud
developing country, and has been purchased to supply cocoa beans, a major ingredient for the goods produced by
Willows Co. It is now supplying approximately half of the ingredients used in Willow Co's manufacturing. Chocland
has not adopted International Financial Reporting Standards, meaning that Brass Co's financial statements are
prepared using local accounting rules. The company uses local currency to measure and present its financial
statements.
as
Further information
Your firm audits all components of the group with the exception of Brass Co, which is audited by a small local firm,
cc
Sidle & Co, based in Chocland. Audit regulations in Chocland are not based on International Standards on Auditing.
e ea
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44 Questions
You have just received the following email from Warwick Stokes, the audit engagement partner.
m/
To: Audit manager
From: Warwick Stokes
co
Re: Grissom Group audit planning
Hello,
I need you to get started on the planning for the audit of the consolidated financial statements of the Grissom Group.
o t.
We will be holding an audit planning meeting next week, so can you put together some briefing notes to be used at
that meeting? I want you to identify, explain and evaluate the principal audit risks. (18 marks)
Do not consider issues to do with reliance on another auditor, as that will be dealt with separately. The briefing notes
sp
will be the basis of a discussion with the audit team.
Thanks,
log
Warwick
Required
(a) Respond to the email from the engagement partner. (18 marks)
l.b
Professional marks will be awarded in part (a), for the format of the answer, and for the clarity of the
evaluation. (4 marks)
(b) Explain the factors that should be considered, and the procedures that should be performed, in deciding the
(c)
extent of reliance to be placed on the work of Sidle & Co.
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Recommend the principal audit procedures that should be performed on:
(8 marks)
ate
(i) The classification of non-controlling investments made by Grissom Co (4 marks)
(ii) The condition attached to the grant received by Hodges Co (4 marks)
(Total = 38 marks)
ym
41 Jacob (6/11) 32 mins

Jacob Co, an audit client of your firm, is a large privately owned company whose operations involve a repair and
maintenance service for domestic customers. The company offers a range of services, such as plumbing and
tud
electrical repairs and maintenance, and the repair of domestic appliances such as washing machines and cookers, as
well as dealing with emergencies such as damage caused by flooding. All work is covered by a two-year warranty.
The directors of Jacob Co have been seeking to acquire expertise in the repair and maintenance of swimming pools
and hot-tubs as this is a service increasingly requested, but not offered by the company. They have recently
as
identified Locke Co as a potential acquisition. Preliminary discussions have been held between the directors of the
two companies with a view to the acquisition of Locke Co by Jacob Co. This will be the first acquisition performed by
the current management team of Jacob Co. Your firm has been asked to perform a due diligence review on Locke Co
cc
prior to further discussions taking place. You have been provided with the following information regarding Locke Co.
1 Locke Co is owner-managed, with three of the five board members being the original founders of the
company, which was incorporated 30 years ago. The head office is located in a prestigious building, which is
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owned by the founders' family estate. The company recently acquired a separate piece of land on which a new
head office is to be built.
2 The company has grown rapidly in the last three years as more affluent customers can afford the cost of
e
installing and maintaining swimming pools and hot-tubs. The expansion was funded by a significant bank
loan. The company relies on an overdraft facility in the winter months when less operating cash inflows arise
/fr
from maintenance work.

3 Locke Co enjoys a good reputation, though this was tarnished last year by a complaint by a famous actor who
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claimed that, following maintenance of his swimming pool by Locke Co's employees, the water contained a
chemical which damaged his skin. A court case is on-going and is attracting media attention.
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Questions 45
4 The company's financial year end is 31 August. Its accounting function is outsourced to Austin Co, a local
provider of accounting and tax services.
m/
Required
(a) Explain three potential benefits of an externally provided due diligence review to Jacob Co. (6 marks)
co
(b) Recommend additional information which should be made available for your firm's due diligence review, and
explain the need for the information. (12 marks)
o t.
42 Cusiter (AAS 6/07) 52 mins
sp
You are Trevor Ennui, an audit manager in a firm of Chartered Certified Accountants. You have just received this
email from Douglas Groan, the audit partner for Cusiter Co:
log
To: Trevor Ennui
From: Douglas Groan
Re: Custer Co – review assignment
Hello Trevor,
l.b
Our audit client Cusiter Co has engaged us to review and report on the following prospective financial information,
which it has produced. The information has been produced to support an application for a $250,000 long-term loan
from a bank. The funds from the loan will be invested, on 1 January 20X9, in new plant and equipment that will be
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used to manufacture a new product range following a recent purchase of a patented technology.
Please produce a memorandum for me in which you:

ate
(a) Explain the term 'prospective financial information' ('PFI'); (3 marks)
(b) Explain the matters that should be considered when planning the nature and scope of the examination of
Cusiter Co's forecast statement of financial position and statement of profit or loss as prepared for the bank;
(7 marks)
ym
(c) Describe the examination procedures you should use to verify Cusiter Co's prospective financial information;
and (9 marks)
(d) Discuss the professional accountant's liability for reporting on prospective financial information and the
measures that the professional accountant might take to reduce that liability. (6 marks)
tud
You will need to refer to the attached information when drafting the memorandum.
Thanks,
Douglas
as
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e ea
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46 Questions
Actual year to Actual quarter Forecast year to Forecast year to
31 December to 31 March 31 December 31 December
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20X7 20X8 20X8 20X9
$'000 $'000 $'000 $'000
Non-current assets
co
Intangible asset – Patent 0 0 10 10
Property, plant and equipment 257 262 289 569
Accumulated deprecation (123) (128) (139) (191)
Net book value 134 134 150 378
o t.
Investments 7 6 7 7
Current assets
Accounts receivable 71 65 84 100
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Inventory 50 59 59 69
Cash and cash equivalents 6 7 7 0
127 131 150 169
Total assets 268 271 317 564
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Equity
Share capital 1 1 1 1
Retained earnings 26 30 67 109
l.b
27 31 68 110
Term borrowings 174 174 151 343
Current liabilities
Accounts payable
Accrued expenses
Short-term borrowings
23
21
23
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21
22
23
27
25
46
32
28
51
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67 66 98 111
Total equity and liabilities 268 271 317 564
STATEMENT OF PROFIT OR LOSS $'000 $'000 $'000 $'000

Revenue 394 86 466 556
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Cost of good sold (278) (61) (329) (390)

Gross profit 116 25 137 166
Gross profit % 29.4% 29.1% 29.4% 29.9%
Operating expenses (47) (12) (55) (80)
tud
Earnings before interest and tax (EBIT) 69 13 82 86

EBIT % 17.5% 15.1% 17.6% 15.5%
Interest expense (21) (4) (18) (44)
Earnings before tax 48 9 64 42
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Required
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Professional marks will be awarded for the format and clarity of the answer. (4 marks)
(Total = 29 marks)
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Questions 47
43 Oak (12/11) (amended) 74 mins
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(a) You are a manager in Maple & Co, responsible for the audit of Oak Co, a listed company. Oak Co
manufactures electrical appliances such as televisions and radios, which are then sold to retail outlets. You
are aware that during the last year, Oak Co lost several customer contracts to overseas competitors. However,
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a new division has been created to sell its products directly to individual customers via a new website, which
was launched on 1 November 20X1.
You are about to commence planning the audit for the year ending 31 December 20X1, and you have received
o t.
an email from Holly Elm, the audit engagement partner:
To: Audit manager
sp
From: Holly Elm, Audit partner
Subject: Oak Co – audit planning
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Hello,
(i) I would like you to start planning the audit of Oak Co. You need to perform a preliminary analytical
review on the financial information and accompanying notes provided by Rowan Birch, the finance
director of Oak Co. Using this information and the results of your analytical review, please prepare
l.b
notes for inclusion in the planning section of the working papers, which identify and explain the
principal audit risks to be considered in planning the final audit. Your notes should include any
calculations performed. (23 marks)
(ii)
(2)
ria
Please also recommend the principal audit procedures which should be performed in respect of:
(1) The recognition and measurement of the share-based payment plan, and
The classification of the new lease. (8 marks)
ate
Thank you,
Holly
Financial information provided by Rowan Birch:

ym
STATEMENT OF PROFIT OR LOSS (EXTRACT FROM MANAGEMENT ACCOUNTS)

Notes 11 months to 11 months to
30 November 30 November
tud
20X1 20X0
$'000 $'000
Revenue 25,700 29,300
Cost of sales (15,420) (15,900)
as

Operating expenses 1 (6,200) (7,750)
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Finance costs (1,500) (1,500)

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48 Questions
Notes 11 months to 11 months to
m/
30 November 30 November
20X1 20X0
$'000 $'000
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ASSETS
Non-current assets
Property plant and equipment 2, 3 90,000 75,750
o t.
4 1,250 –
91,250 75,750
Current assets
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Trade receivables 4,928 4,815
Cash and cash equivalents 100 2,350
6,828 8,880
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EQUITY AND LIABILITIES
Equity
l.b
Revaluation reserve 3 10,000 –
Total equity 62,278 54,895
Long-term borrowings
Provisions
5
6 ria 25,000
1,000
5,000
25,000
1,250
ate
Finance lease payable 2 –
31,000 26,250
Current liabilities
Bank overdraft 7 1,300 –
Trade and other payables 3,500 3,485
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4,800 3,485
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Notes
1 Oak Co established an equity-settled share-based payment plan for its executives on 1 January 20X1. 250
executives and senior managers have received 100 share options each, which vest on 31 December 20X3
if the executive remains in employment at that date, and if Oak Co's share price increases by 10% per
as
annum. No expense has been recognised this year as Oak Co's share price has fallen by 5% in the last
six months, and so it is felt that the condition relating to the share price will not be met this year end.
2 On 1 July 20X1, Oak Co entered into a lease which has been accounted for as a finance lease and
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capitalised at $5 million. The leased property is used as the head office for Oak Co's new website
development and sales division. The lease term is for five years and the fair value of the property at the
inception of the lease was $20 million.
ea
3 On 30 June 20X1 Oak Co's properties were revalued by an independent expert.

4 A significant amount has been invested in the new website, which is seen as a major strategic
development for the company. The website has generated minimal sales since its launch last month,
e
and advertising campaigns are currently being conducted to promote the site.
5 The long-term borrowings are due to be repaid in two equal instalments on 30 September 20X2 and
/fr
20X3. Oak Co is in the process of renegotiating the loan, to extend the repayment dates, and to
increase the amount of the loan.
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6 The provision relates to product warranties offered by the company.

7 The overdraft limit agreed with Oak Co's bank is $1.5 million.
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Questions 49
Required
m/
Professional marks will be awarded for the presentation and clarity of your answer. (4 marks)
co
(b) Maple & Co is suffering from declining revenue, and as a result of this, another audit manager has been asked
to consider how to improve the firm's profitability. In a conversation with you this morning he mentioned the
following.
o t.
'We really need to make our audits more efficient. I think we should fix materiality at the planning stage at the
maximum possible materiality level for all audits, as this would reduce the work we need to do.
sp
'I also think we can cut the firm's overheads by reducing our spending on training. We spend a lot on
expensive training courses for junior members of the audit team, and on Continuing Professional
Development for our qualified members of staff.
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'We could also guarantee our clients that all audits will be completed quicker than last year. Reducing the
time spent on each assignment will improve the firm's efficiency and enable us to take on more audit clients.'
Required
l.b
Comment on the practice management and quality control issues raised by the audit manager's suggestions
to improve the audit firm's profitability. (6 marks)
44 Geno Vesa Farm (AAS 6/05) ria 47 mins

ate
Geno Vesa Farm (GVF), a limited liability company, is a cheese manufacturer. Its principal activity is the production
of a traditional 'Farmhouse' cheese that is retailed around the world to exclusive shops, through mail order and web
sales. Other activities include the sale of locally produced foods through a farm shop and cheese-making
demonstrations and tours.
ym
The farm's herd of 700 goats is used primarily for the production of milk. Kids (ie goat offspring), which are a
secondary product, are selected for herd replacement or otherwise sold. Animals held for sale are not usually
retained beyond the time they reach optimal size or weight because their value usually does not increase thereafter.
There are two main variations of the traditional farmhouse cheese; 'Rabida Red' and 'Bachas Blue'. The red cheese is
tud
coloured using Innittu, which is extracted from berries found only in South American rain forests. The cost of Innittu
has risen sharply over the last year as the collection of berries by local village workers has come under the scrutiny
of an international action group. The group is lobbying the South American government to ban the export of Innittu,
claiming that the workers are being exploited and that sustaining the forest is seriously under threat.
as
Demand for Bachas Blue, which is made from unpasteurised milk, fell considerably in 20X7 following the publication
of a research report that suggested a link between unpasteurised milk products and a skin disorder. The financial
statements for the year ended 31 March 20X8 recognised a material impairment loss attributable to the equipment
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used exclusively for the manufacture of Bachas Blue. However, as the adverse publicity is gradually being forgotten,
sales of Bachas Blue are now showing a steady increase and are currently expected to return to their former level by
the end of March 20X9.
ea
Cheese is matured to three strengths – mild, medium and strong – depending on the period of time it is left to ripen
which is 6, 12 and 18 months respectively. When produced the cheese is sold to a financial institution, Abingdon
Bank, at cost. Under the terms of sale, GVF has the option to buy the cheese on its maturity at cost plus 7% for every
six months which has elapsed.
e
All cheese is stored to maturity on wooden boards in GVF's cool and airy sheds. However, recently enacted health
/fr
and safety legislation requires that the wooden boards be replaced with stainless steel shelves with effect from
1 January 20X9. The management of GVF has petitioned the government health department that to comply with the
legislation would interfere with the maturing process and the production of medium and strong cheeses would have
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to cease.
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50 Questions
In 20X7, GVF applied for and received a substantial regional development grant for the promotion of tourism in the
area. GVF's management has deferred its plan to convert a disused barn into holiday accommodation from 20X8
m/
until at least 20Y0.
Required
co
(a) Identify and explain the principal audit risks to be considered when planning the final audit of GVF for the year
ending 31 March 20X9. (14 marks)
(b) Describe the audit procedures to be performed in respect of the carrying amount of the following items in the
o t.
statement of financial position of GVF as at 31 March 20X9.
(i) Goat herd (4 marks)
(ii) Equipment used in the manufacture of Bachas Blue (4 marks)
sp
(iii) Cheese (4 marks)
(Total = 26 marks)
Note. You are not required to apply the principles of IAS 41 Agriculture in answering this question. Assume it is
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11 December 20X8.
45 Cedar (12/11) 32 mins
l.b
You are an audit manager in Cedar & Co, responsible for the audit of Chestnut Co, a large company which provides
information technology services to business customers. The finance director of Chestnut Co, Jack Privet, contacted
you this morning, saying:
ria
'I was alerted yesterday to a fraud being conducted by members of our sales team. It appears that several sales
representatives have been claiming reimbursement for fictitious travel and client entertaining expenses and inflating
actual expenses incurred. Specifically, it has been alleged that the sales representatives have claimed on expenses
ate
for items such as gifts for clients and office supplies which were never actually purchased, claimed for business-
class airline tickets but in reality had purchased economy tickets, claimed for non-existent business mileage and
used the company credit card to purchase items for personal use.
'I am very worried about the scale of this fraud, as travel and client entertainment is one of our biggest expenses. All
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of the alleged fraudsters have been suspended pending an investigation, which I would like your firm to conduct. We
will prosecute these employees to attempt to recoup our losses if evidence shows that a fraud has indeed occurred,
so your firm would need to provide an expert witness in the event of a court case. Can we meet tomorrow to discuss
this potential assignment?'
tud
Chestnut Co has a small internal audit department and in previous years the evidence obtained by Cedar & Co as part
of the external audit has indicated that the control environment of the company is generally good. The audit opinion
on the financial statements for the year ended 31 March 20X1 was unmodified.
Required
as
(a) Assess the ethical and professional issues raised by the request for your firm to investigate the alleged
fraudulent activity. (6 marks)
cc
(b) Explain the matters that should be discussed in the meeting with Jack Privet in respect of planning the
investigation into the alleged fraudulent activity. (6 marks)
(c) Evaluate the arguments for and against the prohibition of auditors providing non-audit services to audit
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clients. (6 marks)
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Questions 51
46 Willow (12/11) (amended) 49 mins
m/
Willow Co is a print supplier to businesses, printing catalogues, leaflets, training manuals and stationery to order. It
specialises in using 100% recycled paper in its printing, a fact which is promoted heavily in its advertising.
co
You are a senior audit manager in Bark & Co, and you have just been placed in charge of the audit of Willow Co. The
audit for the year ended 31 August 20X1 is nearing completion, and the audit engagement partner, Jasmine Berry,
has sent you an email:
o t.
To: Audit manager
From: Jasmine Berry, Audit partner
Subject: Audit completion and other issues – Willow Co
sp
Hello,
The manager previously assigned to the audit of Willow Co has been moved to another urgent assignment, so thank
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you for stepping in to take on the manager's role this late in the audit. The audit report is due to be issued in two
weeks' time, and the audit senior has prepared a summary of matters for your consideration.
I have been asked to attend a meeting with the audit committee of Willow Co tomorrow, so I need you to update me
on how the audit has progressed. I am asking you to prepare briefing notes for my use in which you:
l.b
(a) Assess the audit implications of the three issues related to audit work raised by the audit senior. Your
assessment should consider the sufficiency of evidence obtained, explain any adjustments that may be
necessary to the financial statements, and describe the impact on the audit report if these adjustments are not
(b) ria
made. You should also recommend any further audit procedures necessary. (15 marks)
Explain the matters, other than the three issues related to audit work raised by the audit senior, which should
be brought to the attention of the audit committee of Willow Co. (8 marks)
ate
Thanks
Summary of issues for manager's attention, prepared by audit senior

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Materiality has been determined as follows.

 $800,000 for assets and liabilities
 $250,000 for income and expenses
Issues related to audit work performed:
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(i) Audit work on inventory

Audit procedures performed at the inventory count indicated that printed inventory items with a value of
$130,000 were potentially obsolete. These items were mainly out of date training manuals. The finance
as
director, Cherry Laurel, has not written off this inventory as she argues that the paper on which the items are
printed can be recycled and used again in future printing orders. However, the items appear not to be
recyclable as they are coated in plastic. The junior who performed the audit work on inventory has requested
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a written representation from management to confirm that the items can be recycled and no further
procedures relevant to these items have been performed.
(ii) Audit work on provisions
ea
Willow Co is involved in a court case with a competitor, Aspen Co, which alleges that a design used in Willow
Co's printed material copies one of Aspen Co's designs which are protected under copyright. Our evidence
obtained is a verbal confirmation from Willow Co's lawyers that a claim of $125,000 has been made against
e
Willow Co, which is probable to be paid. Cherry Laurel has not made a provision, arguing that it is immaterial.
Cherry refused our request to ask the lawyers to confirm their opinion on the matter in writing, saying it is not
/fr
worth bothering the lawyers again on such a trivial matter.

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52 Questions
(iii) Audit work on current assets
m/
Willow Co made a loan of $6,000 to Cherry Laurel, the finance director, on 30 June 20X1. The amount is
recognised as a current asset. The loan carries an interest rate of 4% which we have confirmed to be the
market rate for short-term loans and we have concluded that the loan is an arm's length transaction. Cherry
has provided written confirmation that she intends to repay the loan by 31 March 20X2. The only other audit
co
work performed was to agree the cash payment to the cash book. Details of the loan made to Cherry have not
been separately disclosed in the financial statements.
Other issues for your attention:
o t.
Property revaluations
Willow Co currently adopts an accounting policy of recognising properties at cost. During the audit of non-current
sp
assets Willow Co's property manager said that the company is considering a change of accounting policy so that
properties would be recognised at fair value from 1 January 20X2.
Non-current asset register
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The audit of non-current assets was delayed by a week. We had asked for the non-current asset register
reconciliation to be completed by the client prior to commencement of our audit procedures on non-current assets,
but it seems that the person responsible for the reconciliation went on holiday having forgotten to prepare the
reconciliation. This happened on last year's audit as well, and the issue was discussed with the audit committee at
l.b
that time.
Procurement procedures
ria
We found during our testing of trade payables that an approved supplier list is not maintained, and invoices received
are not always matched back to goods received notes. This was mentioned to the procurement manager, who said
that suppliers are switched fairly often, depending on which supplier is the cheapest, so it would be difficult to
maintain an up-to-date approved supplier list.
ate
Financial controller
Mia Fern, Willow Co's financial controller, owns a holiday home overseas. It appears that she offered the audit team
free use of the holiday home for three weeks after the audit, as a reward for the team's hard work. She also bought
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lunch for the audit team on most days.

Required
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Note. The split of the mark allocation is shown within the email.
Professional marks will be awarded for the format and clarity of your answer. (4 marks)
as
47 Jovi (12/12) 50 mins

cc
(a) You are a manager in Sambora & Co, responsible for the audit of the Jovi Group (the Group), which is listed.
The Group's main activity is steel manufacturing and it comprises a parent company and five subsidiaries.
Sambora & Co currently audits all components of the Group.
ea
You are working on the audit of the Group's financial statements for the year ended 30 June 20X2. This
morning the audit engagement partner left a note for you:
'Hello,
e
The audit senior has provided you with the draft consolidated financial statements and accompanying notes
/fr
which summarise the key audit findings and some background information.
At the planning stage, materiality was initially determined to be $900,000, and was calculated based on the
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assumption that the Jovi Group is a high risk client due to its listed status. During the audit, a number of
issues arose which meant that we needed to revise the materiality level for the financial statements as a
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Questions 53
whole. The revised level of materiality is now determined to be $700,000. One of the audit juniors was unsure
as to why the materiality level had been revised. There are two matters you need to deal with:
m/
(i) Explain why auditors may need to reassess materiality as the audit progresses. (4 marks)
(ii) Assess the implications of the key audit findings for the completion of the audit. Your assessment
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must consider whether the key audit findings indicate a risk of material misstatement. Where the key
audit findings refer to audit evidence, you must also consider the adequacy of the audit evidence
obtained, but you do not need to recommend further specific procedures. (18 marks)
o t.
Thank you'
The Group's draft consolidated financial statements, with notes referenced to key audit findings, are shown
below:
sp
DRAFT CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
30 June 20X2 30 June 20X1
Notes Draft Actual
log
$'000 $'000
Revenue 1 98,795 103,100
Cost of sales (75,250) (74,560)
l.b
Operating expenses 2 (14,900) (17,500)
Share of profit of associate 1,010 900
ria
Taxation (3,200) (3,500)
Profit for the year 6,075 8,100
ate
Other comprehensive income/expense for
the year, net of tax:
Gains on property revaluation 3 800 –
Actuarial losses on defined benefit plan 4 (1,100) (200)
ym
Other comprehensive income/expense (300) (200)

Total comprehensive income for the year 5,775 7,900
Notes. Key audit findings – Statement of profit or loss and other comprehensive income
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1 Revenue has been stable for all components of the Group with the exception of one subsidiary,
Copeland Co, which has recognised a 25% decrease in revenue.
2 Operating expenses for the year to June 20X2 is shown net of a profit on a property disposal of $2
million. Our evidence includes agreeing the cash receipts to bank statement and sale documentation,
as
and we have confirmed that the property has been removed from the non-current asset register. The
audit junior noted
3 The property revaluation relates to the Group's head office. The audit team have not obtained evidence
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on the revaluation, as the gain was immaterial based on the initial calculation of materiality.
4 The actuarial loss is attributed to an unexpected stock market crash. The Group's pension plan is
managed by Axle Co – a firm of independent fund managers who maintain the necessary accounting
ea
records relating to the plan. Axle Co has supplied written representation as to the value of the defined
benefit plan's assets and liabilities at 30 June 20X2. No other audit work has been performed other
than to agree the figure from the financial statements to supporting documentation supplied by
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Axle Co.
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54 Questions
DRAFT CONSOLIDATED STATEMENT OF FINANCIAL POSITION
m/
30 June 20X2 30 June 20X1
Notes Draft Actual
$'000 $'000
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ASSETS
Non-current assets
Property, plant and equipment 81,800 76,300
Goodwill 5 5,350 5,350
o t.
Investment in associate 6 4,230 4,230
Assets classified as held for sale 7 7,800 –
99,180 85,880
sp
Current assets
Receivables 8,540 7,800
Cash and cash equivalents 2,100 2,420
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19,240 18,220
Total assets 118,420 104,100
EQUITY AND LIABILITIES
Equity
l.b
Revaluation reserve 3,300 2,500
ria
Non-controlling interest 8 4,350 4,000
Total equity 53,750 48,400
Defined benefit pension plan 10,820 9,250
ate
Long-term borrowings 9 43,000 35,000
Deferred tax 1,950 1,350
Total non-current liabilities 55,770 45,600
Current liabilities
ym
Trade and other payables 6,200 7,300

Provisions 2,700 2,800
Total current liabilities 8,900 10,100
tud
Notes. Key audit findings – statement of financial position

5 The goodwill relates to each of the subsidiaries in the Group. Management has confirmed in writing
that goodwill is stated correctly, and our other audit procedure was to arithmetically check the
as
impairment review conducted by management.

6 The associate is a 30% holding in James Co, purchased to provide investment income. The audit team
have not obtained evidence regarding the associate as there is no movement in the amount recognised
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in the statement of financial position.

7 The assets held for sale relate to a trading division of one of the subsidiaries, which represents one
ea
third of that subsidiary's net assets. The sale of the division was announced in May 20X2, and is
expected to be complete by 31 December 20X2. Audit evidence obtained includes a review of the sales
agreement and confirmation from the buyer, obtained in July 20X2, that the sale will take place.
e
8 Two of the Group's subsidiaries are partly owned by shareholders external to the Group.
9 A loan of $8 million was taken out in October 20X1, carrying an interest rate of 2%, payable annually
/fr
in arrears. The terms of the loan have been confirmed to documentation provided by the bank.
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Questions 55
Required
m/
Respond to the note from the audit engagement partner. (22 marks)
Note. The split of the mark allocation is shown within the partner's note.
(b) The audit engagement partner now sends a further note regarding the Jovi Group:
co
'The Group finance director has just informed me that last week the Group purchased 100% of the share
capital of May Co, a company located overseas in Farland. The Group audit committee has suggested that due
to the distant location of May Co, a joint audit could be performed, starting with the next financial statements
o t.
for the year ending 30 June 20X3. May Co's current auditors are a small local firm called Moore & Co who
operate only in Farland.'
Required
sp
Discuss the advantages and disadvantages of a joint audit being performed on the financial statements of
May Co. (6 marks)
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(Total = 28 marks)
48 Kobain (12/12) 29 mins
l.b
(a) 'Revenue recognition should always be approached as a high risk area of the audit.'
Required
ria
(b) You are a manager in Beck & Co, responsible for the audit of Kobain Co, a new audit client of your firm, with
a financial year ended 31 July 20X2. Kobain Co's draft financial statements recognise total assets of $55
ate
million, and profit before tax of $15 million. The audit is nearing completion and you are reviewing the audit
files.
Kobain Co designs and creates high-value items of jewellery. Approximately half of the jewellery is sold in
Kobain Co's own retail outlets. The other half is sold by external vendors under a consignment stock
ym
arrangement, the terms of which specify that Kobain Co retains the ability to change the selling price of the
jewellery, and that the vendor is required to return any unsold jewellery after a period of nine months. When
the vendor sells an item of jewellery to a customer, legal title passes from Kobain Co to the customer.
On delivery of the jewellery to the external vendors, Kobain Co recognises revenue and derecognises
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inventory. At 31 July 20X2, jewellery at cost price of $3 million is held at external vendors. Revenue of $4
million has been recognised in respect of this jewellery.
Required
Comment on the matters that should be considered, and explain the audit evidence you should expect to find
as
in your file review in respect of the consignment stock arrangement. (6 marks)

(c) Your firm also performs the audit of Jarvis Co, a company which installs windows. Jarvis Co uses sales
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representatives to make direct sales to customers. The sales representatives earn a small salary, and also
earn a sales commission of 20% of the sales they generate.
Jarvis Co's sales manager has discovered that one of the sales representatives has been operating a fraud, in
ea
which he was submitting false claims for sales commission based on non-existent sales. The sales
representative started to work at Jarvis Co in January 20X2. The forensic investigation department of your
firm has been engaged to quantify the amount of the fraud.
e
Required
/fr
Recommend the procedures that should be used in the forensic investigation to quantify the amount of the
fraud. (4 marks)
(Total = 16 marks)
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56 Questions
49 Cuckoo Group 61 mins
m/
You are currently at the planning stage of the audit of the Cuckoo Group, and have just received the following email
from the audit engagement partner.
co
To: Audit manager
From: Audit partner
Re: Cuckoo Group audit
o t.
Hello,
We are currently auditing the consolidated financial statements of the Cuckoo Group. I'd like you to start scrutinising
sp
the accounting policies being used by the group for the valuation of inventory. The group has three principal
subsidiaries; Loopy, Snoopy and Drake Retail. We are not currently the auditors of Loopy as Cuckoo only recently
acquired this subsidiary company. Cuckoo, the holding company, carries on business as a dealer in gold bullion and
other precious metals. It purchased the three subsidiaries in order to diversify its activities. It felt that dealing in
log
commodities was quite risky and wished to spread the operating risk. I've attached to this email a schedule of the
accounting policies proposed by Cuckoo Group regarding the valuation of inventory.
I'd like you to prepare some briefing notes for me, in which you:
l.b
(i) Describe the matters to consider and the audit procedures to carry out as part of the planning and evaluation
of the work of the auditors of Loopy, and (12 marks)
(ii) Discuss whether you feel that the current accounting policies adopted by Cuckoo and its three subsidiaries
Thanks.
regarding inventory are acceptable to us as group auditor.
ria (12 marks)

ate
Email attachment
Cuckoo proposes to include the bullion and other precious metals in the statement of financial position at the year-
end market values. It does not enter into any contracts for the forward purchase or sale of precious metals. Cuckoo
does not manufacture products from the precious metals but simply buys and sells the metals on the bullion
ym
markets.
Loopy manufactures domestic products such as cutlery, small electrical appliances and crockery. The inventory is
valued at the lower of cost or market value applied to the total of the inventory. Cost is determined by using the last
in, first out (LIFO) method of valuation. Overhead costs are allocated on the basis of normal activity and are those
tud
incurred in bringing the inventory to its present location and condition.

Snoopy manufactures similar domestic products to Loopy. The inventory is valued at the lower of cost and net
realisable value for the purpose of the group statement of financial position. However, inventory is further reduced to
its base value for the purpose of the group statement of profit or loss and other comprehensive income. This
as
reduction is not material in the context of the group accounts. Overheads are allocated on the basis of normal activity
levels and the costs incurred in bringing the inventory to its present location and condition.
Drake Retail acts as the retail outlet for approximately 60% of the combined output of Loopy and Snoopy. It values
cc
its inventory at the lower of cost and net realisable value. Inventories mainly consist of goods held for resale. Cost is
computed by deducting the gross profit margin from the selling value of inventory. When computing net realisable
value, an allowance is made for any future markdowns to be made on inventory.
ea
The directors of Cuckoo Group wish the following accounting policy note to be included in the group financial
statements regarding inventory. 'Inventory is stated at the lower of cost and net realisable value and comprises raw
material inventory (including bullion), work in progress and finished goods.'
e
Required
/fr
(a) Respond to the partner's email. (24 marks)

Note. Professional marks will be available for the format and clarity of your response. (4 marks)
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Questions 57
(b) Comment on the extent to which ISA 600 Special Considerations – Audits of Group Financial Statements
(Including the Work of Component Auditors) provides guidance on the following issues in the context of a
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group audit.
(i) Co-operation between auditors
(ii) Multi-location auditors
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(iii) Joint audits (6 marks)
(Total = 34 marks)
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50 Bluebell (12/08) (amended) 65 mins
Bluebell Co operates a chain of 95 luxury hotels. This year's results show a return to profitability for the company,
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following several years of losses. Hotel trade journals show that on average, revenue in the industry has increased by
around 20% this year. Despite improved profitability, Bluebell Co has poor liquidity, and is currently trying to secure
further long-term finance.
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You have been the manager responsible for the audit of Bluebell Co for the last four years. Extracts from the draft
financial statements for the year ended 30 November 20X8 are shown below.
EXTRACTS FROM THE STATEMENT OF PROFIT OR LOSS 20X8 20X7
$m $m
l.b
Revenue (Note 1) 890 713
Operating expenses (Note 2) (835) (690)
Other operating income (Note 3) 135 10
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Operating profit 190 33
Finance charges (45) (43)
Profit/(loss) before tax 145 (10)
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Notes
1 Revenue recognition
Revenue comprises sales of hotel rooms, conference and meeting rooms. Revenue is recognised when a
room is occupied. A 20% deposit is taken when the room is booked.
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2 Significant items included in operating expenses

20X8 20X7
$m $m
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Share-based payment expense (i) 138 –

Damaged property repair expenses (ii) 100 –
(i) In June 20X8 Bluebell Co granted 50 million share options to executives and employees of the
company. The cost of the share option scheme is being recognised over the three year vesting period
as
of the scheme. It is currently assumed that all of the options will vest and the expense is calculated on
that basis. Bluebell Co operates in a tax jurisdiction in which no deferred tax consequences arise from
share-based payment schemes.
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(ii) In September 20X8, three hotels situated near a major river were severely damaged by a flood. All of
the hotels, which were constructed by Bluebell Co only two years ago, need extensive repairs and
refurbishment at an estimated cost of $100 million, which has been provided in full. All of the
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buildings are insured for damage caused by flooding.
3 Other operating income includes

20X8 20X7
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$m $m
Profit on property disposal (iii) 125 10
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58 Questions
(iii) Eight properties were sold in March 20X8 to Daffodil Fund Enterprises (DFE). Bluebell Co entered into
a management contract with DFE and is continuing to operate the eight hotels under a 15-year
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agreement. Under the terms of the management contract, Bluebell Co receives an annual financial
return based on the profit made by the eight hotels. At the end of the contract, Bluebell Co has the
option to repurchase the hotels, and it is likely that the option will be exercised.
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EXTRACTS FROM THE STATEMENT OF FINANCIAL POSITION 20X8 20X7
$m $m
Property, plant and equipment (Note 4) 1,265 1,135
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Deferred tax asset (Note 5) 285 335
Deferred tax liability (Note 6) (735) (638)
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4 Property, Plant and Equipment (extract)
On 31 October 20X8 all of Bluebell Co's owned hotels were revalued. A revaluation gain of $250 million has
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been recognised in the statement of changes in equity and in the statement of financial position.
5 Deferred Tax Asset (extract)
The deferred tax asset represents unutilised tax losses which accumulated in the loss making periods 20X4–
20X7 inclusive. Bluebell Co is confident that future taxable trading profits will be generated in order for the tax
l.b
losses to be utilised.
6 Deferred Tax Liability (extract)
1 December 20X7
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Property, plant and equipment
$m
638
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Charged to equity 88
Charged to tax expense 9
30 November 20X8 735
Required
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(a) Using the specific information provided, identify and explain the risks of material misstatement to be
addressed when planning the final audit of Bluebell Co for the year ended 30 November 20X8. (14 marks)
(b) Describe the principal audit procedures to be carried out in respect of the following.
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(i) The measurement of the share-based payment expense (6 marks)

(ii) The recoverability of the deferred tax asset (4 marks)
(c) A new internal auditor, Daisy Rosepetal, has recently joined Bluebell Co. She has been asked by management
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to establish and to monitor a variety of social and environmental Key Performance Indicators (KPIs). Daisy
has no experience in this area, and has asked you for some advice. It has been agreed with Bluebell Co's audit
committee that you are to provide guidance to Daisy to help her in this part of her role, and that this does not
impair the objectivity of the audit.
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You have just received the following email from the audit engagement partner on the Bluebell audit.
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To: Audit manager

From: Audit partner
Re: Bluebell Co
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Hello,
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I have a meeting with Daisy Roseptal tomorrow for which I need you to prepare some briefing notes. Please
prepare notes that recommend EIGHT KPIs which could be used to monitor Bluebell Co's social and
environmental performance, and outline the nature of evidence that should be available to provide assurance
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on the accuracy of the KPIs recommended.

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Questions 59
Required
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Respond to the partner's email above. (12 marks)
Note. Requirement (c) includes four professional marks. (Total = 36 marks)
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51 Robster (6/09) (amended) 31 mins
Robster Co is a company which manufactures tractors and other machinery to be used in the agricultural industry.
o t.
You are Jo Russell, the manager responsible for the audit of Robster Co, and you are reviewing the audit working
papers for the year ended 28 February 20X9. The draft financial statements show revenue of $10.5 million, profit
before tax of $3.2 million, and total assets of $45 million.
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The audit senior has left you the following note on the audit file, relating to assets recognised in the statement of
financial position for the first time this year.
Leases
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In July 20X8, Robster Co entered into five new finance leases of land and buildings. The leases have been capitalised
and the statement of financial position includes leased assets presented as tangible non-current assets at a value of
$3.6 million, and a total finance lease payable of $3.2 million presented as a payable falling due after more than one
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year.
Financial assets
Non-current assets include financial assets recognised at $1.26 million. A note to the financial statements describes
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these financial assets as investments classified as at 'fair value', and the investments are described in the note as
'held for trading'. The investments are all shares in listed companies. A gain of $350,000 has been recognised in net
profit in respect of the revaluation of these investments.
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Required
(a) In your review of the audit working papers, comment on the matters you should consider, and state the audit
evidence you should expect to find in respect of:
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(i) The leases (8 marks)

(ii) The financial assets (5 marks)
(b) You are aware that Robster Co is seeking a listing in September 20X9. The listing rules in this jurisdiction
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require that interim financial information is published half-way through the accounting period, and that the
information should be accompanied by a review report issued by the company's independent auditor.
Required
Explain the principal analytical procedures that should be used to gather evidence in a review of interim
as
financial information. (4 marks)

(Total = 17 marks)
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52 Efex Engineering (Pilot paper) (amended) 61 mins

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You are Reginald Perrin, an audit manager in Sunshine Audit Co, a firm of Chartered Certified Accountants. You have
just taken a phone call from CJ, a senior partner at the firm, in which he told you:
'We have been asked to carry out an investigation by the management of Xzibit Co. One of the company's
subsidiaries, Efex Engineering Co, has been making losses for the past year. Xzibit's management is concerned
e
about the accuracy of Efex Engineering's most recent quarter's management accounts.'
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CJ talked you through Xzibit's concerns. He then asked you to prepare some briefing notes for him in which you
identify and describe the matters that you should consider and the procedures you should carry out in order to plan
an investigation of Efex Engineering Co's losses. (10 marks)
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Your notes from the conversation with CJ include the following information.
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60 Questions
The summarised statements of profit or loss for the last three quarters are as follows.
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Quarter to
30 June 31 March 31 December
20X8 20X8 20X7
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$'000 $'000 $'000
Revenue 429 334 343
Opening inventory 180 163 203
Materials 318 251 200
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Direct wages 62 54 74
560 468 477
Less closing inventory (162) (180) (163)
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Cost of goods sold 398 288 314
Gross profit 31 46 29
Less overheads (63) (75) (82)
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Net loss (32) (29) (53)
Gross profit (%) 7.2% 13.8% 8.5%
Materials (% of revenue) 78.3% 70.0% 70.0%
l.b
Labour (% of revenue) 14.5% 16.2% 21.6%
Xzibit's management board believes that the high material consumption as a percentage of revenue for the quarter to
30 June 20X8 is due to one or more of the following factors.
1
2
3
Under-counting or under-valuation of closing inventory
Excessive consumption or wastage of materials
Material being stolen by employees or other individuals
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Efex Engineering has a small number of large customers and manufactures its products to each customer's
specification.
The selling price of the product is determined by:
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1 Estimating the cost of materials

2 Estimating the labour cost
3 Adding a mark-up to cover overheads and provide a normal profit
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The estimated costs are not compared with actual costs. Although it is possible to analyse purchase invoices for
materials between customers' orders this analysis has not been done.
A physical inventory count is carried out at the end of each quarter. Items of inventory are entered on inventory
sheets and valued manually. The company does not maintain perpetual inventory records and a full physical count is
as
to be carried out at the financial year end, 30 September 20X8.

The direct labour cost included in the inventory valuation is small and should be assumed to be constant at the end
of each quarter. Historically, the cost of materials consumed has been about 70% of revenue.
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The management accounts to 31 March 20X8 are to be assumed to be correct.

Required
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(a) Define 'forensic auditing' and describe its application to fraud investigations. (5 marks)
(b) Respond to CJ's request. (10 marks)
Note. Professional marks will be available for the format and clarity of answers to part (b) above.
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(4 marks)
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(c) (i) Explain the matters you should consider to determine whether closing inventory at 30 June 20X8 is
undervalued.
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(ii) Describe the tests you should plan to perform to quantify the amount of any undervaluation.
(8 marks)
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Questions 61
(d) (i) Identify and explain the possible reasons for the apparent high materials consumption in the quarter
ended 30 June 20X8.
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(ii) Describe the tests you should plan to perform to determine whether materials consumption, as shown
in the management accounts, is correct. (7 marks)
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(Total = 34 marks)
53 Bateleur Zoo Gardens 61 mins
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Your name is Laura Liver, and you are an audit manager in a firm of Chartered Certified Accountants. You are
responsible for the audit of Bateleur Zoo Gardens (BZG), the principal activity of which is the conservation of
animals. Approximately 80% of the zoo's income comes from admission fees, money spent in the food and retail
outlets and animal sponsorship. The remainder comprises donations and investment income.
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Admission fees include day visitor entrance fees ('gate') and annual membership fees. Day tickets may be pre-
booked by credit card using a telephone booking 'hotline' and via the zoo's website. Reduced fees are available (eg
to students, senior citizens and families).
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Animal sponsorships, which last for one year, make a significant contribution to the cost of specialist diets,
enclosure maintenance and veterinary care. Animal sponsors benefit from the advertisement of their names at the
sponsored animal's enclosure.
l.b
You have just received an email from Charlotte Brain, who is a senior partner in your firm:
To: Laura Liver <[email protected]>
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From: Charlotte Brain <[email protected]>
Date: December
Subject: Bateleur Zoo Gardens
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Dear Laura,
It's that time of the year again, and it falls upon us to get started on the planning for the BZG audit. The new
management team has so far shown itself to be very diligent, and has identified a number of risks that are in need of
further consideration so that they can be managed actively. I'd like you to review the list and then prepare a
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memorandum for me, letting me know what sort of internal controls we'd expect to be in place to help manage each
of the risks (12 marks), as well as what risks of material misstatement arise from each applicable risk (6 marks).
Please also comment on the factors to consider when planning the extent of substantive analytical procedures to be
performed on BZG's income (7 marks).
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Here is the list of applicable risks that management has identified:

(i) Reduction in admission income through failure to invest in new exhibits and breeding programmes to attract
visitors
(ii) Animal sponsorships may not be invoiced due to incomplete data transfer between the sponsoring and
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invoicing departments.
(iii) Corporate sponsorships may not be charged for at approved rates – either in error or due to arrangements
with the companies. In particular, the sponsoring department may not notify the invoicing department of
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reciprocal arrangements, whereby sponsoring companies provide BZG with advertising (eg in company
magazines and annual reports).
(iv) Cash received at the entrance gate ticket offices ('kiosks') may not be passed to cashiers in the accounts
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department (eg through theft).

(v) The ticket booking and issuing system may not be available.
(vi) Donations of animals to the collection (eg from taxation authority seizures and rare breeds enthusiasts) may
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not be recorded.
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Thanks for this. I look forward to reading your thoughts!

Charlotte
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62 Questions
Required
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(a) Respond to Charlotte's email. (25 marks)
Note. Professional marks will be available for the format and clarity of answers to part (a) above.
(4 marks)
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(b) Comment on the responsibilities of management and auditors for internal controls. Discuss auditing and
other current guidance in this area. (5 marks)
(Total = 34 marks)
o t.
54 Sci-Tech (12/07) (amended) 61 mins
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You are James Cotter. You were recently promoted to the level of audit manager at Rab & Co, a large firm of
Chartered Certified Accountants, and are now responsible for the audit of Sci-Tech Co, a pharmaceutical research
company. You are planning the substantive audit procedures to be used in the forthcoming audit of intangible assets
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and operating expenses. Relevant extracts from the financial statements are as follows.
30 November
20X8 20X7
(draft)
l.b
$'000 $'000
Intangible assets: development costs
Cost 2,750 2,000
Accumulated amortisation
Total assets
ria (1,450)
1,300
18,500
(850)
1,150
15,000
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STATEMENT OF PROFIT OR LOSS
Revenue 4,500 3,800
Operating expenses include:
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Research costs 160 200

Amortisation of development costs 600 450
Salary expenses 380 400
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The following is an extract from the notes to the draft financial statements:
'Expenditure on product development is capitalised as an intangible asset from the point at which it is probable that
future economic benefits will result from the product once completed. Any product development costs which do not
meet the above criteria are expensed as incurred as research costs. Two products are currently in the development
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phase: Medex, an antiseptic cream; and Flortex, a medicine to reduce the symptoms of fever.
'Amortisation of development costs commences with commercial production, the amortisation period being the
estimated life span of the product. Currently two products are being amortised over the following periods:
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1 Plummet Cold Cure: five years

2 Blingo Cough Cure: three years
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During the initial planning of the audit, the audit senior made the following note on the working papers:
'Bio-Cert Co is the main competitor of our client. It appears that Bio-Cert Co is developing a rival product to Flortex.
This rival product is expected to be launched in June 20X9, six months prior to the expected launch of Flortex.'
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Sci-Tech Co decided to outsource its payroll function, commencing in June 20X8. The service is being provided by
ProPay Co, a small local company. All of the accounting records relating to payroll are maintained and kept by
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ProPay Co. In previous years the audit of salary expenses was performed using a systems based approach with
limited substantive procedures.
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Sci-Tech Co receives funding from governmental health departments, as well as several large charitable donations.
This funding represents on average 25% of the company's research and development annual expenditure. The
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Questions 63
amount of funding received is dependent on three key performance indicator (KPI) targets being met annually. All
three of the targets must be met in order to secure the government funding.
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Extracts from Sci-Tech Co's operating and financial review are as follows.
KPI target Draft KPI 20X8 Actual KPI 20X7
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Pharmaceutical products
donated free of charge to
health care charities:
1% revenue 0.8% revenue 1.2% revenue
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Donations to, and cost of
involvement with, local
community charities:
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0.5% revenue 0.6% revenue 0.8% revenue
Accidents in the work place:
Fewer than 5 serious accidents
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per year 4 serious accidents 2 serious accidents
In addition to performing the financial statement audit, your firm is engaged to provide an assurance opinion on the
KPIs disclosed in the operating and financial review.
l.b
You have just received an email from Robert Nesbitt, the engagement partner responsible for Sci-Tech:
To: James Cotter <[email protected]>
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From: Robert Nesbitt <[email protected]>
Date: December 20X8
Subject: Sci-Tech planning
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James,
As this is your first job in your new role, I'd like you to prepare a memorandum for me outlining what your approach
will be to a few of the key issues in the Sci-Tech audit and review engagements. In particular, please ensure that you
cover the following.
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(a) Define outsourcing and explain the matters to be in considered in planning the audit of salary expense.
(9 marks)
(b) Matters to consider in relation to the capitalised development costs (5 marks), and evidence that should be
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sought regarding the assertion that development costs are technically feasible (3 marks). (8 marks)
(c) Procedures to perform on the amortisation rate of five years being applied to development costs in relation to
Plummet. (5 marks)
(d) (i) Discuss why it may not be possible to provide a high level of assurance over the stated key
as
performance indicators. (4 marks)

(ii) Describe the procedures to verify the number of serious accidents in the year ended 30 November
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20X8. (4 marks)
I'd like you to get to work on this straight away so that we can get the planning itself done in time.
Regards
ea
Robert
Required
e
Respond to Robert's email. (30 marks)

/fr
Note. Four professional marks will be available for the format and clarity of answers. (4 marks)
(Total = 34 marks)
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64 Questions
55 Rosie (6/08) (amended) 65 mins
m/
Rosie Co is the parent company of an expanding group of companies. The group's main business activity is the
manufacture of engine parts. In January 20X8 the acquisition of Dylan Co was completed, and the group is currently
considering the acquisition of Maxwell Co, a large company which would increase the group's operating facilities by
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around 40%. All subsidiaries are wholly owned. The group structure is summarised below.
Rosie Co
o t.
Timber Co Ben Co Dylan Co
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acquired January 20X1 acquired January 20X5 acquired January 20X8
You are John Hayes, a senior audit manager in Chien & Co, a firm of Chartered Certified Accountants. Today you
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received the following email from Stephen Ferris, who has recently been promoted to the role of audit supervisor,
and who is currently working on the Rosie Group audit.
To: John Hayes, senior manager <[email protected]>

From: Stephen Ferris, audit supervisor <[email protected]>
l.b
Date: June 20X8
Subject: Rosie Group audit
Hello John,
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I am about to start reviewing the working papers completed on the final audit of Rosie Co and the Rosie Group for
the year ended 31 January 20X8. I was hoping you would be able to help me get a few things clear in my mind
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before I do the review.
Goodwill on the acquisition of Dylan Co is recognised in the consolidated statement of financial position at $750,000.
The client has given us this calculation:
$'000
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Cost of investment:
Cash consideration 2,500
Deferred consideration payable 31 January 20X9 1,500
Contingent consideration payable 31 January 20Y2 if Dylan Co's revenue grows 5% per annum 1,000
5,000
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Net assets acquired (4,250)

Goodwill on acquisition 750
Can you tell me what matters I need to consider, and what sort of evidence I should expect to find in respect of the
as
carrying value of the cost of the investment in Dylan Co in the financial statements of Rosie Co? (7 marks)
Also, what procedures should I expect to have been done on the consolidation schedule of the Rosie Group?
(4 marks)
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Thanks for your help with this. I can't wait to get started – this is my first piece of review work and I think it will be
interesting to see things 'from the other side'!
ea
Regards,
Stephen Ferris
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Note. All of the figures in Stephen's email are material to the financial statements of Rosie Co and the Rosie Group.
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Your firm has audited all current components of the group for several years, but the target company Maxwell Co is
audited by a different firm. The management of Rosie Co has provided the audit team with some information about
Maxwell Co to aid business understanding, but little audit work is considered necessary as the acquisition, if it goes
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ahead, will be after the auditor's report has been issued.

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Questions 65
You have just received an email from Leo Sabat, the finance director of the Rosie Group:
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To: John Hayes, <[email protected]>
From: Leo Sabat, Group Finance Director, <[email protected]>
Date: June 20X8
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Subject: Maxwell Co
John,
o t.
It was good to see to you the other day. As promised, please find attached the information you requested on the
Maxwell Co acquisition. I have included audited financial statements for the year ended 31 January 20X8, an
organisational structure, several customer contracts, and prospective financial information for the next two years.
We don't have much available so I'm giving you all we've got!
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I'm hoping that the other directors will agree that an externally provided due diligence investigation should be carried
out urgently, before any investment decision is made. The other directors, though, feel this is not needed as the
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financial statements of Maxwell Co have already been audited.
I need you to prepare a report to the other directors in which you:
 Describe the purpose, and evaluate the benefits of a due diligence investigation to the potential purchaser of a
company, and (10 marks)
l.b
 Compare the scope of a due diligence investigation with that of an audit of financial statements. (4 marks)
Thanks John. I look forward to hearing from you soon.
Best regards,
Leo ria
ate
Required
(a) Respond to Leo Sabat's email. (14 marks)
Note. Four professional marks are available in part (a) for the format and clarity of the answer. (4 marks)
ym
(b) Respond to Stephen Ferris' email. (11 marks)

(c) Maxwell Co is audited by Lead & Co, a firm of Chartered Certified Accountants. Leo Sabat has enquired as to
whether your firm would be prepared to conduct a joint audit in cooperation with Lead & Co, on the future
financial statements of Maxwell Co if the acquisition goes ahead. Leo Sabat thinks that this would enable your
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firm to improve group audit efficiency, without losing the cumulative experience that Lead & Co has built up
while acting as auditor to Maxwell Co.
Required
as
Define 'joint audit', and assess the advantages and disadvantages of the audit of Maxwell Co being conducted
on a 'joint basis'. (7 marks)
(Total = 36 marks)
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e ea
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66 Questions
56 Medix (6/08) (amended) 65 mins
m/
You are Charles Banks, an audit senior in Mitchell & Co, a firm of Chartered Certified Accountants. Gavin Jones is an
audit manager in your firm who has recently returned to practice after working for some years in industry. You have
just received the following email from him.
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To: Charles Banks, audit senior
From: Gavin Jones, audit manager
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Subject: Potential new client – Medix Co
Charles,
I would like you to prepare some briefing notes for me to use to help me decide whether or not to proceed with the
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appointment as auditor to a new client, Medix Co. There are a number of pieces of information that you'll need to
take into account when preparing them.
I recently held a meeting with the finance director of Medix Co, Ricardo Feller, and I've attached my notes from it to
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this email (Attachment 1).
I have also held a discussion with the current audit partner of Medix Co, Mick Evans, who runs a small accounting
and audit practice in which he is one of two partners. I have attached an extract from an email that I recently received
l.b
from him (Attachment 2).
Finally, I have come across an article in a local newspaper that mentions Medix Co, but I haven't had a chance to
read through it yet. I've attached some extracts from it (Attachment 3).
Be sure that your notes include the following.
(a)
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An assessment of the professional, ethical and other issues to be considered in deciding whether to proceed
with the appointment as auditor of Medix Co (10 marks)
ate
(b) (i) A discussion of the relationship between the concepts of 'business risk' and 'risk of material
misstatement' (4 marks)
(ii) Identify and explain the potential risks of material misstatement caused by the breach of planning
regulations discussed in the press cutting. (6 marks)
ym
(c) Identify and explain the principal business risks facing Medix Co. (12 marks)
Thanks for your help with this.
Regards,
tud
Gavin
Attachment 1
Meeting notes – meeting held 1 June 20X8 with Ricardo Feller

as
Medix Co is a provider of specialised surgical instruments used in medical procedures. The company is owner
managed, has a financial year ending 30 June 20X8, and has invited our firm to be appointed as auditor for the
forthcoming year end. The audit is not going out to tender. Ricardo Feller has been with the company since
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January 20X8, following the departure of the previous finance director, who is currently taking legal action against
Medix Co for unfair dismissal.
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Company background
Medix Co manufactures surgical instruments which are sold to hospitals and clinics. Due to the increased use of
laser surgery in the last four years, demand for traditional metal surgical instruments, which provided 75% of
revenue in the year ended 30 June 20X7, has declined rapidly. Medix Co is expanding into the provision of laser
e
surgery equipment, but research and development is at an early stage. The directors feel confident that the laser
/fr
instruments currently being designed will eventually receive the necessary licence for commercial production, and
that the laser product will replace surgical instruments as a leading source of revenue. There is currently one
scientist working on the laser equipment, subcontracted by Medix Co on a freelance basis. The building in which the
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research is being carried out has recently been significantly extended by the construction of a large laboratory.
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Questions 67
A considerable revenue stream is derived from agents who are not employed by Medix Co. The agents earn a
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commission based on the value of sales they have secured for Medix Co during the year. There are many suppliers
into the market and agents are used by all manufacturers as a means of marketing and distributing their products.
The company's manufacturing facility is located in another country, where operating costs are significantly lower.
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The facility is under the control of a local manager who visits the head office of Medix Co annually for a meeting with
senior management. Products are imported via aeroplane. The overseas plant and equipment is owned by the
company and was constructed 12 years ago specifically for the manufacture of metal surgical instruments.
o t.
The company has a bank overdraft facility and makes use of the facility most months. A significant bank loan, which
will carry a variable interest rate, is currently being negotiated. The terms of the loan will be finalised once the
audited financial statements have been viewed by the bank.
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Attachment 2
Extract from email from Mick Evans
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'Medix Co has been an audit client for three years. We took over from the previous auditors following a disagreement
between them and the directors of Medix Co over fees. As we are a small practice with low overheads we could offer
lower fees than our predecessors. We could also do the audit very quickly, which pleased the client, as they like to
keep costs as low as possible.
l.b
'During our audits we have found the internal systems and controls to be quite weak. Despite our recommendations,
there always seemed to be a lack of interest in making improvements to the accounting systems, as this was seen to
be a '"waste of money". There have been two investigations by the tax authorities, which we did not deal with, as we
ria
are not tax experts. In the end the directors sorted it all out, and I believe that the tax matter is now resolved. We
never had a problem getting access to accounting books and records. However, the managing director, Jon Tate,
once gave us what he described as "the wrong cash book" by mistake, and replaced it with the "proper version" later
ate
in the day. We never found out why he was keeping two cash books, but cash was an immaterial asset so we didn't
worry about it too much.
'We are resigning as auditors because the work load is too much for our small practice, and as Medix Co is our only
audit client we have decided to focus on providing non-audit services in the future.'
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Attachment 3
Extract from local newspaper – business section, 2 June 20X8

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It appears that local company Medix Co has breached local planning regulations by building an extension to its
research and development building for which no local authority approval has been given. The land on which the
premises is situated has protected status as a 'greenfield' site which means approval by the local authority is
necessary for any modification to commercial buildings.
as
A representative of the local planning office stated today: 'We feel that this is a serious breach of regulations and it is
not the first time that Medix Co has deliberately ignored planning rules. The company was successfully sued in 20X3
for constructing an access road without receiving planning permission, and we are considering taking legal action in
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respect of this further breach of planning regulations. We are taking steps to ensure that these premises should be
shut down within a month. A similar breach of regulations by a different company last year resulted in the demolition
of the building.'
ea
Required
Respond to Gavin's email. (32 marks)
e
Professional marks will be awarded for the appropriateness of the format and presentation of the notes and the
effectiveness with which the information is communicated. (4 marks)
/fr
(Total = 36 marks)
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68 Questions
REPORTING
m/
Questions 57 to 71 cover Reporting, the subject of Part F of the BPP Study Text for Paper P7.
57 Yew (12/11)
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32 mins
(a) You are the manager responsible for the audit of Yew Co, a company which designs and develops aircraft
engines. The audit for the year ended 31 July 20X1 is nearing completion and the audit senior has left the
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following file note for your attention.
'I have just returned from a meeting with the management of Yew Co, and there is a matter I want to bring to
your attention. Yew Co's statement of financial position recognises an intangible asset of $12.5 million in
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respect of capitalised research and development costs relating to new aircraft engine designs. However,
market research conducted by Yew Co in relation to these new designs indicated that there would be little
demand in the near future for such designs. Management has provided written representation that they agree
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with the results of the market research.
'Currently, Yew Co has a cash balance of only $125,000 and members of the management team have
expressed concerns that the company is finding it difficult to raise additional finance.
l.b
'The new aircraft designs have been discussed in the chairman's statement which is to be published with the
financial statements. The discussion states that 'developments of new engine designs are underway, and we
believe that these new designs will become a significant source of income for Yew Co in the next 12 months.'
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'Yew Co's draft financial statements include profit before tax of $23 million, and total assets of $210 million.
'Yew Co is due to publish its annual report next week, so we need to consider the impact of this matter
urgently.'
ate
Required
Discuss the implications of the audit senior's file note on the completion of the audit and on the auditor's
report, recommending any further actions that should be taken by the auditor. (12 marks)
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(b) You are responsible for answering technical queries from other managers and partners of your firm. An audit
partner left the following note on your desk this morning.
(i) 'I am about to draft the audit report for my client, Sycamore Co. I am going on holiday tomorrow and
want to have the audit report signed and dated before I leave. The only thing outstanding is the written
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representation from management – I have verbally confirmed the contents with the finance director
who agreed to send the representations to the audit manager within the next few days. I presume this
is acceptable?' (3 marks)
(ii) 'We are auditing Sycamore Co for the first time. The prior period financial statements were audited by
as
another firm. We are aware that the auditor's report on the prior period was qualified due to a material
misstatement of trade receivables. We have obtained sufficient appropriate evidence that the matter
giving rise to the misstatement has been resolved and I am happy to issue an unmodified opinion. But
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should I refer to the prior year modification in this year's auditor's report?'
(3 marks)
Required
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Respond to the audit partner's comments.

Note. The split of the mark allocation is shown within the question.
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/fr
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Questions 69
58 Snipe (6/12) 27 mins
m/
You are the partner responsible for performing an engagement quality control review on the audit of Snipe Co. You
are currently reviewing the audit working papers and draft audit report on the financial statements of Snipe Co for the
year ended 31 January 20X2. The draft financial statements recognise revenue of $8.5 million, profit before tax of
co
$1 million, and total assets of $175 million.
(a) During the year Snipe Co's factory was extended by the self-construction of a new processing area, at a total
cost of $5 million. Included in the costs capitalised are borrowing costs of $100,000, incurred during the six-
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month period of construction. A loan of $4 million carrying an interest rate of 5% was taken out in respect of
the construction on 1 March 20X1, when construction started. The new processing area was ready for use on
1 September 20X1, and began to be used on 1 December 20X1. Its estimated useful life is 15 years.
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Required
In respect of your file review of non-current assets, comment on the matters that should be considered, and
the evidence you would expect to find regarding the new processing area. (8 marks)
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(b) Snipe Co has in place a defined benefit pension plan for its employees. An actuarial valuation on 31 January 20X2
indicated that the plan is in deficit by $10.5 million. The deficit is not recognised in the statement of financial
position. An extract from the draft audit report is given below.
l.b
Auditor's opinion
In our opinion, because of the significance of the matter discussed below, the financial statements do not give
a true and fair view of the financial position of Snipe Co as at 31 January 20X2, and of its financial
Standards.
Explanation of adverse opinion in relation to pension
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performance and cash flows for the year then ended in accordance with International Financial Reporting
ate
The financial statements do not include the company's pension plan. This deliberate omission contravenes
accepted accounting practice and means that the accounts are not properly prepared.
Required
ym
Critically appraise the extract from the proposed audit report of Snipe Co for the year ended 31 January 20X2.
Note. You are not required to re-draft the extract of the audit report. (7 marks)
(Total = 15 marks)
tud
59 Nassau Group (6/11) 32 mins

(a) You are the manager responsible for the audit of the Nassau Group, which comprises a parent company and
as
six subsidiaries. The audit of all individual companies' financial statements is almost complete, and you are
currently carrying out the audit of the consolidated financial statements. One of the subsidiaries, Exuma Co, is
audited by another firm, Jalousie & Co. Your firm has fulfilled the necessary requirements of ISA 600 Special
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Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) and is
satisfied as to the competence and independence of Jalousie & Co.
You have received from Jalousie & Co the draft audit report on Exuma Co's financial statements, an extract
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from which is shown below:

'Basis for Qualified Opinion (extract)
'The company is facing financial damages of $2 million in respect of an on-going court case, more fully
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explained in Note 12 to the financial statements. Management has not recognised a provision but has
/fr
disclosed the situation as a contingent liability. Under International Financial Reporting Standards, a provision
should be made if there is an obligation as a result of a past event, a probable outflow of economic benefit,
and a reliable estimate can be made. Audit evidence concludes that these criteria have been met, and it is our
p:/
opinion that a provision of $2 million should be recognised. Accordingly, net profit and shareholders' equity
would have been reduced by $2 million if the provision had been recognised.
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70 Questions
'Qualified Opinion (extract)
m/
'In our opinion, except for effects of the matter described in the Basis for Qualified Opinion paragraph, the
financial statements give a true and fair view of the financial position of Exuma Co as at 31 March 20X1...'
An extract of Note 12 to Exuma Co's financial statements is shown below.
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Note 12 (extract)
The company is the subject of a court case concerning an alleged breach of planning regulations. The plaintiff
is claiming compensation of $2 million. The management of Exuma Co, after seeking legal advice, believe that
o t.
there is only a 20% chance of a successful claim being made against the company.
Figures extracted from the draft financial statements for the year ending 31 March 20X1 are as follows.
sp
Nassau Group Exuma Co
$m $m
Profit before tax 20 4
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Total assets 85 20
Required
Identify and explain the matters that should be considered, and actions that should be taken by the group
audit engagement team, in forming an opinion on the consolidated financial statements of the Nassau Group.
l.b
(10 marks)
(b) A trainee accountant, Jo Castries, is assigned to your audit team. This is the first group audit that Jo has
worked on. Jo made the following comment regarding the group audit:
ria
'I understand that in a group audit engagement, one of the requirements is to design and perform audit
procedures on the consolidation process. Please explain to me the principal audit procedures that are
performed on the consolidation process.'
ate
Required
Respond to the trainee accountant's question. (8 marks)
ym
60 Cinnabar Group (AAS 6/02) 27 mins

tud
(a) Explain the auditor's responsibilities for the appropriateness of the going concern assumption as a basis for
the preparation of financial statements. (5 marks)
(b) You are a manager in the quality control review department of Scheel, a firm of Chartered Certified
Accountants. You are currently responsible for reviewing the appropriateness of your firm's proposed
as
auditor's reports on financial statements.

The draft financial statements of Cinnabar group for the year to 30 June 20X8 disclose the following notes.
Notes
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1 Significant event
During the year, Cinnabar sold a significant amount of its business and certain assets (plant and
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equipment and inventory) and commenced a systematic winding down of its operations. The group's
remaining assets (including property, trade receivables and cash) were sufficient to meet the group's
liabilities, as at 30 June 20X8.
e
2 Accounting policies
/fr
The consolidated financial statements have been prepared under the historical cost convention and in
accordance with applicable accounting standards. As described in Note 1, the group has commenced
the winding down of its operations and remaining assets have been restated to their net realisable
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values.
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Questions 71
There are no other disclosures relating to the going concern basis although the 'significant event' is referred
to in the directors' report under the heading 'principal activities and business review'.
m/
Cinnabar ceased to trade in October 20X8. The auditor's report on Cinnabar's financial statements for the year
ended 30 June 20X7 was unmodified.
co
Required
Comment on the suitability or otherwise of an unmodified auditor's report for Cinnabar for the year ended
30 June 20X8. Your answer should discuss the appropriateness of alternative audit opinions. (10 marks)
o t.
61 Poodle (6/13) 36 mins
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You are the manager responsible for the audit of the Poodle Group (the Group) and you are completing the audit of
the consolidated financial statements for the year ended 31 March 20X3. The draft consolidated financial statements
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recognise revenue of $18 million (20X2 – $17 million), profit before tax of $2 million (20X2 – $3 million) and total
assets of $58 million (20X2 – $59 million). Your firm audits all of the components of the Group, apart from an
overseas subsidiary, Toy Co, which is audited by a small local firm of accountants and auditors.
The audit senior has left a file note for your attention. You are aware that the Group's annual report and financial
l.b
statements are due to be released next week, and the Group is very reluctant to make any adjustments in respect of
the matters described.
(a) Toy Co
ria
The component auditors of Toy Co, the overseas subsidiary, have been instructed to provide the Group audit
team with details of a court case which is ongoing. An ex-employee is suing Toy Co for unfair dismissal and
has claimed $500,000 damages against the company. To comply with local legislation, Toy Co's individual
ate
financial statements are prepared using a local financial reporting framework. Under that local financial
reporting framework, a provision is only recognised if a cash outflow is virtually certain to arise. The
component auditors obtained verbal confirmation from Toy Co's legal advisors that the damages are
probable, but not virtually certain to be paid, and no provision has been recognised in either the individual or
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consolidated financial statements. No other audit evidence has been obtained by the component auditors.
(7 marks)
(b) Trade receivables
On 1 June 20X3, a notice was received from administrators dealing with the winding up of Terrier Co,
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following its insolvency. The notice stated that the company should be in a position to pay approximately
10% of the amounts owed to its trade payables. Poodle Co, the parent company of the Group, includes a
balance of $1.6 million owed by Terrier Co in its trade receivables. (7 marks)
as
(c) Chairman's statement

The draft chairman's statement, to be included in the Group's annual report, was received yesterday. The
chairman comments on the performance of the Group, stating that he is pleased that revenue has increased
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by 20% in the year. (6 marks)
Required
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In respect of each of the matters described:

(i) Assess the implications for the completion of the Group audit, explaining any adjustments that may be
necessary to the consolidated financial statements, and recommending any further procedures
e
necessary; and
/fr
(ii) Describe the impact on the Group audit report if these adjustments are not made.
Note. The split of the mark allocation is shown above against each of the parts.
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(Total = 20 marks)
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72 Questions
62 Dexter (12/08) 36 mins
m/
(a) Compare and contrast the responsibilities of management, and of auditors, in relation to the assessment of
going concern. You should include a description of the procedures used in this assessment where relevant.
(7 marks)
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You are the manager responsible for performing hot reviews on audit files where there is a potential disagreement
between your firm and the client regarding a material issue. You are reviewing the going concern section of the audit
file of Dexter Co, a client with considerable cash flow difficulties, and other, less significant operational indicators of
o t.
going concern problems. The working papers indicate that Dexter Co is currently trying to raise finance to fund
operating cash flows, and state that if the finance is not received, there is significant doubt over the going concern
status of the company. The working papers conclude that the going concern assumption is appropriate, but it is
sp
recommended that the financial statements should contain a note explaining the cash flow problems faced by the
company, along with a description of the finance being sought, and an evaluation of the going concern status of the
company. The directors do not wish to include the note in the financial statements.
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Required
(b) Consider and comment on the possible reasons why the directors of Dexter Co are reluctant to provide the
note to the financial statements. (5 marks)
l.b
(c) Identify and discuss the implications for the auditor's report if:
(i) The directors refuse to include the disclosure note (4 marks)
(ii) The directors agree to include the disclosure note (4 marks)
63 Johnston and Tiltman (AAS 6/06) (amended)

ria (Total = 20 marks)
27 mins
ate
(a) The purpose of ISA 510 Initial audit engagements – opening balances is to establish standards and provide
guidance regarding opening balances when the financial statements are audited for the first time or when the
financial statements for the prior period were audited by another auditor.
ym
Required
Explain the auditor's reporting responsibilities that are specific to initial engagements. (5 marks)
(b) You are the audit manager of Johnston Co, a private company. The draft consolidated financial statements for
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the year ended 30 September 20X8 show profit before taxation of $10.5 million (20X7 – $9.4 million) and
total assets of $55.2 million (20X7 – $50.7 million).
Your firm was appointed auditor of Tiltman Co when Johnston Co acquired all the shares of Tiltman Co in
September 20X8. Tiltman's draft financial statements for the year ended 30 September 20X8 show profit
as
before taxation of $0.7 million (20X7 – $1.7 million) and total assets of $16.1 million (20X7 – $16.6 million).
The auditor's report on the financial statements for the year ended 30 September 20X7 was unmodified.
You are currently reviewing two matters that have been left for your attention on the audit working paper files
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for the year ended 30 September 20X8:

(i) In June 20X7 Tiltman installed a new computer system that properly quantified an overvaluation of
inventory amounting to $2.7 million. This is being written off over three years.
ea
(ii) In November 20X8, Tiltman's head office was relocated to Johnston's premises as part of a
restructuring. Provisions for the resulting redundancies and non-cancellable lease payments
amounting to $2.3 million have been made in the financial statements of Tiltman for the year ended
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30 September 20X8.
/fr
Required
Identify and comment on the implications of these two matters for your auditor's reports on the financial
statements of Johnston Co and Tiltman Co for the year ended 30 September 20X8. (10 marks)
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Questions 73
64 Lychee (12/09) 29 mins
m/
(a) Guidance on subsequent events is given in ISA 560 Subsequent events.
Required
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Explain the auditor's responsibility in relation to subsequent events. (6 marks)
(b) You are the manager responsible for the audit of Lychee Co, a manufacturing company with a year ended
30 September 20X9. The audit work has been completed and reviewed and you are due to issue the auditor's
o t.
report in three days. The draft audit opinion is unmodified. The financial statements show revenue for the
year ended 30 September 20X9 of $15 million, net profit of $3 million, and total assets at the year end are
$80 million.
sp
The finance director of Lychee Co telephoned you this morning to tell you about the announcement yesterday,
of a significant restructuring of Lychee Co, which will take place over the next six months. The restructuring
will involve the closure of a factory, and its relocation to another part of the country. There will be some
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redundancies and the estimated cost of closure is $250,000. The financial statements have not been amended
in respect of this matter.
Required
l.b
In respect of the announcement of the restructuring:
(i) Comment on the financial reporting implications, and advise the further audit procedures to be
performed (6 marks)
(ii)
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Recommend the actions to be taken by the auditor if the financial statements are not amended
(4 marks)
(Total = 16 marks)
ate
65 Grimes (6/10) 36 mins
(a) You are the partner responsible for the audit of Grimes Co, for the year ended 30 April 20Y0. The final audit
ym
has been completed and you have asked the audit manager to draft the audit report. The manager is aware
that there is guidance for auditors relating to audit reports in ISA 706 Emphasis of Matter Paragraphs and
Other Matter Paragraphs in the Independent Auditor's Report. The manager has asked for your assistance in
this matter.
tud
Required
(i) Define an 'Emphasis of Matter paragraph' and explain, providing examples, the use of such a
paragraph. (6 marks)
as
(ii) Define an 'Other Matter paragraph' and explain, providing examples, the use of such a paragraph.
Note. You are not required to produce draft paragraphs. (4 marks)
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(b) You are also responsible for providing direction to more junior members of the audit department of your firm
on technical matters. Several recent recruits have asked for guidance in the area of auditor's liability. They are
keen to understand how an audit firm can reduce its exposure to claims of negligence. They have also heard
that in some countries, it is possible to restrict liability by making a liability limitation agreement with an audit
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client.
Required
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(i) Explain four methods that may be used by an audit firm to reduce exposure to litigation claims.
(4 marks)
/fr
(ii) Assess the potential implications for the profession, of audit firms signing a liability limitation
agreement with their audit clients. (6 marks)
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(Total = 20 marks)
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74 Questions
66 Pluto (6/09) 31 mins
m/
(a) Explain the term 'fraudulent financial reporting', illustrating your explanation with examples. (4 marks)
You are the partner responsible for performing an engagement quality control review on the audit of Pluto Co, a
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listed company. You are currently reviewing the engagement partner's proposed auditor's report on the financial
statements of Pluto Co for the year ended 31 March 20X9. During the year the company has undergone significant
reorganisation, involving the discontinuance of two major business segments. Extracts of the proposed auditor's
report are shown below.
o t.
Basis for adverse opinion arising from disagreement over application of IAS 37
The directors have not recognised a provision in relation to redundancy costs associated with the reorganisation
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during the year. The reason is that they do not feel that a reliable estimate of the amount can be made, and so the
recognition criteria of IAS 37 have not been met. We disagree with the directors as we feel that an estimate can be
made. This matter is more fully explained in a note to the financial statements. We feel that this is a material
misstatement as the profit for the year is overstated.
log
In our opinion, the financial statements do not give a true and fair view of the financial position of the company as of
31 March 20X9, and of its financial performance and its cash flows for the year then ended in accordance with
International Financial Reporting Standards.
l.b
Emphasis of matter
The directors have decided not to disclose the Earnings per Share for 20X9, as they feel that the figure is materially
distorted by significant discontinued operations in the year. Our opinion is not qualified in respect of this matter.
Required
(b) ria
Critically appraise the proposed auditor's report of Pluto Co for the year ended 31 March 20X9.
ate
Note. You are not required to re-draft the extracts from the auditor's report. (9 marks)
(c) Explain the matters to be considered in deciding who is eligible to perform an engagement quality control
review for a listed client. (4 marks)
(Total = 17 marks)
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67 Cleeves (AAS 12/06) 27 mins

tud
(a) The purpose of ISA 250 Consideration of laws and regulations in an audit of financial statements is to
establish standards and provide guidance on the auditor's responsibility to consider laws and regulations in
an audit of financial statements.
Explain the auditor's responsibilities for reporting non-compliance that comes to the auditor's attention
as
during the conduct of an audit. (5 marks)

(b) You are an audit manager in a firm of Chartered Certified Accountants currently assigned to the audit of
Cleeves Co for the year ended 30 September 20X8. During the year Cleeves acquired a 100% interest in
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Howard Co. Howard is material to Cleeves and audited by another firm, Parr & Co. You have just received
Parr's draft auditor's report for the year ended 30 September 20X8. The wording is that of an unmodified
report except for the opinion paragraph which is as follows:
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Audit opinion
As more fully explained in Notes 11 and 15 impairment losses on non-current assets have not been
recognised in profit or loss as the directors are unable to quantify the amounts. In our opinion, provision
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should be made for these as required by International Accounting Standard 36 (Impairment). If the provision
had been so recognised the effect would have been to increase the loss before and after tax for the year and
/fr
to reduce the value of tangible and intangible non-current assets. However, as the directors are unable to
quantify the amounts we are unable to indicate the financial effect of such omissions.
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In view of the failure to provide for the impairments referred to above, in our opinion the financial statements
do not present fairly in all material respects the financial position of Howard Co as of 30 September 20X8 and
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Questions 75
of its loss and its cash flows for the year then ended in accordance with International Financial Reporting
Standards.
m/
Your review of the prior year auditor's report shows that the 20X7 audit opinion was worded identically.
Required
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(i) Critically appraise the appropriateness of the audit opinion given by Parr & Co on the financial
statements of Howard Co, for the years ended 30 September 20X8 and 20X7. (7 marks)
(ii) Briefly explain the implications of Parr & Co's audit opinion for your audit opinion on the consolidated
o t.
financial statements of Cleeves Co for the year ended 30 September 20X8. (3 marks)
(Total = 15 marks)
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68 Blod (6/08) 31 mins
You are the manager responsible for the audit of Blod Co, a listed company, for the year ended 31 March 20X8. Your
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firm was appointed as auditors of Blod Co in September 20X7. The audit work has been completed, and you are
reviewing the working papers in order to draft a report to those charged with governance. The statement of financial
position shows total assets of $78 million (20X7 – $66 million). The main business activity of Blod Co is the
manufacture of farm machinery.
l.b
During the audit of property, plant and equipment it was discovered that controls over capital expenditure
transactions had deteriorated during the year. Authorisation had not been gained for the purchase of office
equipment with a cost of $225,000. No material errors in the financial statements were revealed by audit procedures
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performed on property, plant and equipment.
An internally generated brand name has been included in the statement of financial position at a fair value of
$10 million. Audit working papers show that the matter was discussed with the financial controller, who stated that
the $10 million represents the present value of future cash flows estimated to be generated by the brand name. The
ate
member of the audit team who completed the work programme on intangible assets has noted that this treatment
appears to be in breach of IAS 38 Intangible Assets, and that the management refuses to derecognise the asset.
Problems were experienced in the audit of inventories. Due to an oversight by the internal auditors of Blod Co, the
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external audit team did not receive a copy of inventory counting procedures prior to attending the count. This caused
a delay at the beginning of the inventory count, when the audit team had to quickly familiarise themselves with the
procedures. In addition, on the final audit, when the audit senior requested documentation to support the final
inventory valuation, it took two weeks for the information to be received because the accountant who had prepared
the schedules had mislaid them.
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Required
(a) (i) Identify the main purpose of including 'findings from the audit' (management letter points) in a report
to those charged with governance. (2 marks)
as
(ii) From the information provided above, recommend the matters which should be included as 'findings
from the audit' in your report to those charged with governance, and explain the reason for their
inclusion. (7 marks)
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The finance director of Blod Co, Uma Thorton, has requested that your firm type the financial statements in the form
to be presented to shareholders at the forthcoming company general meeting. Uma has also commented that the
previous auditors did not use a liability disclaimer in their auditor's report, and would like more information about
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the use of liability disclaimer paragraphs.

Required
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(b) Discuss the ethical issues raised by the request for your firm to type the financial statements of Blod Co.
(3 marks)
/fr
(c) In the context of a standard unmodified auditor's report, describe the content of a liability disclaimer
paragraph, and discuss the main arguments for and against the use of a liability disclaimer paragraph.
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(5 marks)
(Total = 17 marks)
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76 Questions
69 Axis & Co (Pilot paper) (amended) 27 mins
m/
You are the manager responsible for four audit clients of Axis & Co, a firm of Chartered Certified Accountants. The
year end in each case is 30 June 20X8.
co
You are currently reviewing the audit working paper files and the audit seniors' recommendations for the auditor's
reports. Details are as follows.
(a) Lorenze Co has changed its accounting policy for goodwill during the year from amortisation over its
o t.
estimated useful life to annual impairment testing. No disclosure of this change has been given in the financial
statements. The carrying amount of goodwill in the statement of financial position as at 30 June 20X8 is the
same as at 30 June 20X7 as management's impairment test shows that it is not impaired.
sp
The audit senior has concluded that a qualification is not required but suggests that attention can be drawn to
the change by way of an emphasis of matter paragraph. (6 marks)
(b) The directors' report of Abrupt Co states that investment property rental forms a major part of revenue.
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However, a note to the financial statements shows that property rental represents only 1.6% of total revenue
for the year. The audit senior is satisfied that the revenue figures are correct.
The audit senior has noted that an unmodified opinion should be given as the audit opinion does not extend
to the directors' report. (4 marks)
l.b
(c) Audit work on the after-date bank transactions of Jingle Co has identified a transfer of cash from Bell Co. The
audit senior assigned to the audit of Jingle has documented that Jingle's finance director explained that Bell
commenced trading on 7 July 20X8, after being set up as a wholly-owned foreign subsidiary of Jingle.
ria
The audit senior has noted that although no other evidence has been obtained an unmodified opinion is
appropriate because the matter does not impact on the current year's financial statements. (5 marks)
ate
Required
For each situation, comment on the suitability or otherwise of the audit senior's proposals for the auditor's reports.
Where you disagree, indicate what audit modification (if any) should be given instead.
ym
70 Dylan (12/12) 29 mins

(a) You are the manager responsible for the audit of Dylan Co, a listed company, and you are reviewing the
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working papers of the audit file for the year ended 30 September 20X2. The audit senior has left a note for
your attention:
'Dylan Co outsources its entire payroll, invoicing and credit control functions to Hendrix Co. In August 20X2,
Hendrix Co suffered a computer virus attack on its operating system, resulting in the destruction of its
as
accounting records, including those relating to Dylan Co. We have therefore been unable to perform the
planned audit procedures on payroll, revenue and receivables, all of which are material to the financial
statements. Hendrix Co has manually reconstructed the relevant figures as far as possible, and has supplied a
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written statement to confirm that they are as accurate as possible, given the loss of accounting records.'
Required
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(i) Comment on the actions that should be taken by the auditor, and the implications for the auditor's
report. (7 marks)
(ii) Discuss the quality control procedures that should be carried out by the audit firm prior to the audit
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report being issued. (3 marks)

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(b) You are also responsible for the audit of Squire Co, a listed company, and you are completing the review of
its interim financial statements for the six months ended 31 October 20X2. Squire Co is a car manufacturer,
and historically has offered a three-year warranty on cars sold. The financial statements for the year ended
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30 April 20X2 included a warranty provision of $1.5 million and recognised total assets of $27.5 million. You
are aware that on 1 July 20X2, due to cost cutting measures, Squire Co stopped offering warranties on cars
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Questions 77
sold. The interim financial statements for the six months ended 31 October 20X2 do not recognise any
warranty provision. Total assets are $30 million at 31 October 20X2.
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Required
Assess the matters that should be considered in forming a conclusion on Squire Co's interim financial
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statements, and the implications for the review report. (6 marks)
(Total = 16 marks)
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71 Bertie & Co (12/07) 36 mins
You are the audit manager for three clients of Bertie & Co, a firm of Chartered Certified Accountants. The financial
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year end for each client is 30 September 20X8.
You are reviewing the audit senior's proposed auditor's reports for two clients, Alpha Co and Deema Co.
Alpha Co, a listed company, permanently closed several factories in May 20X8, with all costs of closure finalised and
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paid in August 20X8. The factories all produced the same item, which contributed 10% of Alpha Co's total revenue
for the year ended 30 September 20X8 (20X7 – 23%). The closure has been discussed accurately and fully in the
chairman's statement and Directors' Report. However, the closure is not mentioned in the notes to the financial
statements, nor separately disclosed on the financial statements.
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The audit senior has proposed an unmodified audit opinion for Alpha Co as the matter has been fully addressed in
the chairman's statement and Directors' Report.
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In October 20X8 a legal claim was filed against Deema Co, a retailer of toys. The claim is from a customer who
slipped on a greasy step outside one of the retail outlets. The matter has been fully disclosed as a material contingent
liability in the notes to the financial statements, and audit working papers provide sufficient evidence that no
provision is necessary as Deema Co's legal counsel has stated in writing that the likelihood of the claim succeeding
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is only possible. The amount of the claim is fixed and is adequately covered by cash resources.
The audit senior proposes that the audit opinion for Deema Co should not be qualified, but that an emphasis of
matter paragraph should be included after the audit opinion to highlight the situation.
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Hugh Co was incorporated in October 20X7, using a bank loan for finance. Revenue for the first year of trading is
$750,000, and there are hopes of rapid growth in the next few years. The business retails luxury hand made wooden
toys, currently in a single retail outlet. The two directors (who also own all of the shares in Hugh Co) are aware that
due to the small size of the company, the financial statements do not have to be subject to annual external audit, but
they are unsure whether there would be any benefit in a voluntary audit of the first year financial statements. The
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directors are also aware that a review of the financial statements could be performed as an alternative to a full audit.
Hugh Co currently employs a part-time, part-qualified accountant, Monty Parkes, who has prepared a year-end
statement of financial position and statement of profit or loss and other comprehensive income, and who produces
summary management accounts every three months.
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Required
(a) Evaluate whether the audit senior's proposed auditor's report is appropriate, and where you disagree with the
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proposed report, recommend the amendment necessary to the auditor's report of:
(i) Alpha Co (6 marks)
(ii) Deema Co (4 marks)
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(b) Describe the potential benefits for Hugh Co in choosing to have a financial statement audit. (4 marks)
(c) With specific reference to Hugh Co, discuss the objective of a review engagement and contrast the level of
assurance provided with that provided in an audit of financial statements. (6 marks)
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(Total = 20 marks)
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78 Questions
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1 Lark
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Text references. Chapter 1.
Top tips. This question examined two connected issues: money laundering and professional skepticism. In part (a),
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you needed to spot that money laundering was taking place. If you weren't sure, then requirement (ii) contains a
little hint by referring to 'any reporting that should take place' – this confirms that there is money laundering going
on in the scenario.
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Part (a)(i) was mainly a matter of explaining what is going on in the scenario. You should be aware of the three
stages of a money laundering regime (placement, layering and integration), and could have scored well by simply
applying them to the scenario. But even if you had forgotten what the stages were, you could still have done well by
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just explaining how each bit of the scenario might be evidence of a money laundering regime.
Part (a)(ii) was more of a test of knowledge, but you should have been able to remember that the senior should
report his suspicions to the MLRO, and that the MLRO then decides what to do about the matter. If you explained
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this well then you could have got two marks out of three here without too much effort.
Part (b) should have been straightforward, as this was a topical area that you should have been aware of – given
that there was an IAASB Q&A paper on this area.
l.b
Easy marks. The point about 'tipping off' is always an easy mark in a question on money laundering. It's one of the
more important things to be aware of in the real world, so markers tend to like it when you mention it. In part (a)(i),
most candidates covered a range of points and the majority correctly discussed fraud and / or money laundering.
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Weaker answers tended to focus on the materiality of the cash transferred to overseas, and seemed not to notice
the client's suspicious behaviour. Candidates are reminded that they will often be expected to identify a key issue in
a question scenario and that in a question of this type it is important to stop and think about what is happening in
the scenario before rushing to start to write an answer.
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With requirement (a)(ii), candidates who had identified money laundering as an issue in (a)(i) usually scored well
here, describing the need to report to the audit firm's Money Laundering Reporting Officer, and what should be
reported to them. Weaker answers discussed the audit report or that the fraud / money laundering should be
reported to the client's management – this is not good advice given that the owner – manager was the person
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acting suspiciously and would have resulted in him being tipped off.
Answers to part (b) were reasonably good, with most candidates able to attempt an explanation of the term, and
most identifying poor controls leading to a possible fraud involving the payroll supervisor.
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Marking scheme
Marks
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(a) (i) Implications of the audit senior's note

Generally 1 mark for each matter discussed relevant to money laundering:
– Definition of money laundering
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– Placement – cash-based business

– Owner posting transactions
– Layering – electronic transfer to overseas
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– Secrecy and aggressive attitude

– Audit to be considered very high risk
– Senior may have tipped off the client
– Firm may consider withdrawal from audit
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– But this may have tipping off consequences

Maximum 6
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Answers 81
(ii) Reporting that should take place Marks
Generally 1 mark for each comment:
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– Report suspicions immediately to MLRO
– Failure to report is itself an offence
– Examples of matters to be reported (identity of suspect, etc)
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– Audit senior may discuss matters with audit manager but senior responsible for
the report
Maximum 3
(b) Professional scepticism
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Generally 1 mark for each comment:
– Definition of professional skepticism
– Explain – alert to contradictory evidence/unusual events/fraud indicator
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(up to 2 marks)
– Part of ethical codes
– Coot Co – evidence is unreliable and contradictory
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– Absence of authorisation is fraud indicator
– Additional substantive procedures needed
– Management's comments should be corroborated
– Control deficiency to be reported to management/those charged with governance
– Audit junior needs better supervision/training on how to deal with deficiencies
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Identified
Maximum 6
Total 15
(a) (i)
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The implication of the circumstances described is that there may be money laundering going on at
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Heron Co, involving its owner-manager Jack Heron.
Money laundering is a process by which criminals may attempt to conceal the origins of the proceeds
of criminal activity. The aim is to transform 'dirty' money, which can be tied to its criminal origin, into
'clean' money which can be spent.
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The fact that Heron Co's revenue is almost entirely cash makes it an ideal 'front' business for a
money laundering regime. The aim here would be to transform the 'dirty' money into revenue from
the legitimate business. What appears to be happening here is that the legitimate cash receipts of
$3.5m are being topped up with $2m 'dirty' money. This is the placement stage of the money
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laundering regime. The idea is that the $5.5m revenue will eventually appear legitimate if it can be
said to all come from a legitimate business (Heron Co).
The $2m electronic transfer is then part of the layering process, which aims to maximise the distance
between the placement of the 'dirty' money and its eventual 'integration' into the financial system as
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'clean' money. The fact that this is an overseas transfer only heightens its suspiciousness, as money
launderers often move money across national boundaries to make it harder to trace.
The fact that Jack Heron has sole responsibility for cash receipts and postings gives him the
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opportunity to launder money in this way. The fact that no documentation was available to support
the transfer means it is possible that it was done to launder money. The fact that Jack did not answer
the senior's questions and became aggressive seems to confirm his desire for secrecy here.
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There is a risk that the senior has 'tipped off' Jack Heron by questioning him about the transfer. This
is itself an offence, although it may be argued here that the senior was not aware that the disclosure
could prejudice any future money laundering investigation.
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From the point of view of the audit, the amount is clearly highly material. It is possible that Lark & Co
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may seek to withdraw from the engagement; however, there is a risk that this could be construed as
'tipping off' if Jack Heron thinks it is because the audit firm has suspicions over money laundering.
The firm should obtain advice from its legal counsel.
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82 Answers
(ii) The audit senior should report the situation to Lark & Co's Money Laundering Reporting Officer
(MLRO). The MLRO is the internal person responsible for receiving and evaluating reports of
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suspected money laundering, and for making any reports to external bodies.
The report would typically include the name of the suspect, the amounts involved, the reasons for
suspicion and the whereabouts of any laundered cash.
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The report must be made as soon as possible, as it is an offence to not report suspicions as soon as
practicable.
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The senior would be allowed to discuss his suspicions with the audit manager – in order to assure
himself that his suspicions were reasonable – but should alert the MLRO himself.
(b) Professional skepticism
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Professional skepticism is an attitude that includes a questioning mind, being alert to conditions which may
indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.
This means being alert to the actual circumstances of the engagement and the work being done, and to the
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possibility that things may not be as they appear to be on first sight, eg that evidence obtained is unreliable,
or may point to fraud. If an auditor is not skeptical in this way then they may not realise that something is
unusual; they may not tailor audit procedures to the actual risk at hand; or they may jump to hasty
conclusions.
l.b
Professional skepticism lies at the heart of auditing, both in the sense that it is part of being a competent
auditor, and that it is an important part of being ethically independent.
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Further actions
The evidence obtained already may not be reliable.
The payroll supervisor's assertion that no authorisation is needed for temporary workers must be
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corroborated. Evidence should also be gathered about the claim that the employees are temporary.
If the supervisor is correct that no authorisation is required for new employees, then this is a major
deficiency of internal controls that should have been identified as part of controls testing. It may be a
management letter point.
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There is a contradiction between the supervisor's claim that there were new temporary staff, and
management's claim that there are no new staff. It should be clarified that when management said there
were no new employees, this included temporary staff.
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It is possible that there is a fraud taking place here, possibly by the payroll supervisor. The new employees
could be 'ghost employees' to whom money is paid via payroll but who do not exist. The money is then
taken criminally, eg by the payroll supervisor or an associate of hers.
The audit junior should be made aware that when he comes across issues like this, he must raise them with
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his supervisor.
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Answers 83
2 Plant
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Chapter references. Chapter 5.
Top tips. Part (a) should not have posed you many difficulties. The contents of the audit tender document are basic
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knowledge at this level. This question is fairly typical of the way this area is examined in P7: here, you really need to
apply your knowledge to the situation of the Plant Group. You can use the basic contents of the tender as a starting
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point, and then bring in points from the scenario where they are relevant. For example, the tender must assess 'the
needs of the prospective client': here, the tender must clarify that all of the subsidiaries will require audits.
There are also points that come out of the scenario itself. These are likely to practical points: here, the proposed
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deadline was very close to the year end, and should be discussed in the tender document as a practical issue.
In part (b), the first suggestion might have been trickier than the second, which was clear-cut. With the first suggestion
(on the bonus for cross-selling to audit clients), you should be able to work out that there is a self-interest threat here.
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You then needed to know that the crucial issue was whether the person was a key audit partner or not.
With suggestion two, you should be well aware of the ethical issues surrounding the provision of internal audit
services, and this part of the question was pretty much just knowledge recall. You should have scored well on this
l.b
part of the question, and if you didn't then you need to make sure that you are happy with this area in the future.
Easy marks. There were easy marks in part (a) for noting that the tight deadline would cause problems – this came
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straight from the scenario and should stand out prominently.
Examiner's comments. Requirement (a) was generally well attempted, with a significant minority of answers
achieving close to full marks. The best answers went through each of the typical contents of a tender document and
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related them specifically to the Group in the question, resulting in focussed and well explained answer points.
Interestingly these answers were often relatively brief, but still managed to attract a high mark through application
of knowledge to the question scenario.
Some answers tended to either be much too brief – sometimes little more than a list of bullet points, or did not
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answer the question requirement, and instead of explaining matters to be included in a tender document,
discussed the matters that may impact client acceptance, such as whether the audit firm has sufficient resources,
and whether a fee dependency would be created. Candidates are advised to read question requirements carefully
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and not to make assumptions about what is being asked for.

Answers to requirement (b) tended to discuss one of the suggestions reasonably well, but then repeat almost
identical points in relation to the second suggestion. There was some overlap given that both involved the provision
of a non-audit service to an audit client, but there were enough separate points that could be made to avoid
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repetition. In relation to the financial incentives for partners and manager selling services to audit clients, hardly any
candidates discussed the issue of the significance of the ethical threat depending on seniority and that partners
couldn't have the arrangement. Many also discussed the self-interest threat in relation to the audit firm rather than
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its personnel.
In relation to the extended audit, most answers explained the self-review threat and suggested appropriate
safeguards, usually that of separate teams. Fewer discussed the need for extended review procedures or for
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separate engagement letters and billing arrangements were the internal audit service provided to an audit client.
Fewer still knew the position of the ethical codes in relation to this matter, and there was very little in the way of
discussion of the topic as a current issue.
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84 Answers
Marking scheme
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Marks
(a) Matters to be included in tender document
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Up to 1½ marks for each matter identified and explained with relevance to the Plant Group
(up to a maximum of 2 marks in total for matters identified only):
– Outline of the audit firm including international network
– Audit firm specialism in telecoms
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– Client audit requirements
– Outline of audit firm's audit methodology
– Deadlines
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– Discuss provision of audit-related services
– Quality control and ethics
– Fees
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– Discuss provision of non-audit services
Maximum 8
(b) Ethical matters
Up to 1 mark for each relevant comment:
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– Explain self-interest threat arising on bonus suggestion
– Significance depends on seniority of person, materiality of compensation
– Partners may not have this arrangement
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– Safeguard could be put in place for other audit team members
– Explain self-review threat arising on internal audit service
– Identify impact on professional skepticism
– Explain management threat arising in internal audit service
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– Safeguards (1 mark each), eg separate team
– Not allowed for public interest clients
– Separate engagement letter/billing arrangements
– Approval of those charged with governance
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Maximum 8
Total 16
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(a) Matters to include in tender

Overview of Weller & Co
A brief overview of the firm's structure. This should state that the firm is part of an international network of
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firms, and that it therefore has access to a considerable depth of audit expertise.
This could be particularly relevant to the audit of the Plant Group's overseas subsidiary.
Areas of expertise
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The firm has a telecoms audit department, and therefore already has staff with expertise in the Plant Group's
specific industry. This may make it particularly well placed to audit the Plant Group.
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Assessment of Plant Group's needs

The Plant Group is composed of a parent and six subsidiaries, and it should be clarified that the tender
includes the audit of each of the subsidiaries as single companies, together with the parent company and the
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group as a whole.
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Audit approach
A brief description of Weller & Co's audit approach. In the case of the Plant Group, this is likely to include
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reliance on the internal controls, which are described as strong. The tender document should point out that
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Answers 85
controls would be tested before they were relied upon, but that if they did prove reliable then the audit
should indeed be cost-effective.
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Deadline
The proposed deadline is just two months after the year end. It would be very difficult to meet such a
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deadline while still maintaining audit quality. It might make it difficult to obtain evidence in specific areas,
such as receivables recoverability or going concern. There is also a risk of putting significant pressure on
the audit team to do work quickly rather than thoroughly, which could result in things being missed.
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The tender should therefore propose a later deadline for audit completion.
Fees
The tender should state the proposed audit fee, together with a breakdown of the fee. The fee proposed
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should be sufficient to ensure that a high quality audit could be conducted.
Non-audit services
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The firm may wish to outline any relevant non-audit services that it could provide to the Plant Group. These
will be curtailed by the fact that the Plant Group is now listed and thus a public interest entity, but there may
still be some areas in which Weller & Co could provide help.
(b) Selling bonus
l.b
The first suggestion would be a 'compensation and evaluation policy', in the terms of the IESBA Code of
ethics. This creates a self-interest threat. If the partner or manager receives a bonus from selling services to
the client, then they might be less willing to disagree with the client during the audit.
The significance of this threat depends upon several factors:

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The proportion of the individual's compensation or performance evaluation that is based on the sale
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of such services
 The role of the individual on the audit team
 Whether promotion decisions are influenced by the sale of such services
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The Code specifically states that a key audit partner shall not be given a bonus based on selling non-audit
services to audit clients. Therefore this bonus should not be offered to key audit partners.
The suggestion is to offer the bonus to audit managers too. This may be ethically acceptable if adequate
safeguards were put in place: the manager's work should be reviewed by another professional accountant. If
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this is not done, then the bonus cannot be offered.

It may also be that if the manager is a particularly senior manager, then their role will be so significant in the
audit team that no safeguard would be sufficient. They should not receive the bonus.
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Internal audit
There are two potential issues here: a self-review threat, and the threat from taking on a management
responsibility.
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Self-review threat
If Weller & Co seeks to rely on work performed by internal audit as part of its external audit, then there will
be a self-review threat if it has itself performed the internal audit. The risk is that the internal audit work
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relied upon is not treated with enough professional skepticism. It may be possible to surmount this problem
by using a team or department that is separate from the external audit team, to perform the internal audit.
Management responsibility
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If firm personnel assume a management responsibility as part of the internal audit, the this threat would be
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so significant that either the internal audit service must not be provided, or the firm must withdraw from the
external audit.
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A management responsibility would be assumed where, for example, the auditor performs internal control
procedures, or takes responsibility for designing, implementing and maintaining internal controls.
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86 Answers
Public interest entities
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If the audit client is a public interest entity (eg a listed company), then internal audit services relating to the
following areas cannot be provided:
 A significant part of controls over financial reporting
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 Accounting systems that generate information significant to the client's accounting records or
financial statements
 Amounts or disclosures that are material to the financial statements
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3 Becker
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Text reference. Chapter 2.
Top tips. Ethical questions where you are asked to consider a number of scenarios come up frequently in this
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exam. The best way to be prepared is to practise as many of this type of question as you can. Always try to explain
the risks fully rather that just stating what they are and try to come up with relevant safeguards.
Easy marks. All three areas were roughly similar in difficulty. If you are well-prepared, this type of question should
not be difficult.
l.b
Examiner's comments. This question focused on ethics and practice management. Answers tended to be
inadequate overall. This is disappointing, given that ethics is regularly tested, and that many candidates seem to
think that the ethics question is the 'easy question'. The scenario relevant to requirement (a) described a business
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opportunity for which an audit client required funding. Most candidates spotted the obvious ethical problems of
making loans to clients, and of having a mutual financial interest. However few candidates really explained why this
is a problem. Many candidates would simply state a type of threat – 'self– interest' and 'intimidation' being the
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most common, with little attempt to explain how the threat arose and if anything could be done to mitigate the
threat. Stronger candidates responded well to the practice management issues, discussing whether the audit firm
has the relevant skills for such a business venture and whether attention would be better focussed on attracting
new audit and assurance clients.
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Requirement (b)'s scenario discussed the audit firm potentially setting up a recruitment advisory service. Similar
problems appeared here, with many candidates stating threats but not explaining them. Some candidates devoted
much of their answer to the fee based on salary, maintaining that it was a contingent fee, banned under ethical
guidelines.
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Requirement (c) tended to be unsatisfactorily answered. Many candidates simply repeated the same comments they
had made for requirement (b), seeming not to realise that the two were entirely different proposals. This shows the
importance of explaining the threats, as similar threats may indeed arise from the possibilities described in (b) and
in (c), but why they arise and the implication for the audit firm is completely different.
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Marking scheme
Marks
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(a) Joint business arrangement

Generally 1-1½ marks per comment:
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– Self-interest independence threats:

Loans to clients generally prohibited
Convertible loan stock would lead to equity stake in client – prohibited
Joint venture arrangement is significant business interest
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Audit firm would share control of JV with audit client

Finance involved likely to be significant
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– Can only proceed with business venture if resign as auditors

– Potentially lucrative business opportunity BUT
Auditors lack commercial experience in this type of venture
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–
– Should spend time on client retention and attraction
Maximum 7
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Answers 87
(b) Recruitment service Marks
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– Explanation of self-interest threat
– Explanation of familiarity threat
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– Explanation of management involvement threat
– Threats increase with seniority of recruitee
– Can look at CVs and draw up shortlist but management to take final decision
– Ingrid lacks specific, recent experience
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– May not be much demand for the service
– Need to train second person – cost implication
– Consider setting up as separate business
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Maximum 7
(c) Temporary staff assignment
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– Explanation of self-review threat
– Explanation of management involvement threat
– Explanation of familiarity threat
– Description of safeguards
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– Problem when secondee returns to audit firm – reassign to other client
– Individual benefits from different work experience …
– But may be offered permanent employment by the client
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– Issues with competence of people seconded
– Eases audit forms over-staffing problem
Maximum 6
Total 20
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(a) Murray Co
Threat to independence and objectivity
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If the investment in Murray Co were to go ahead, Becker & Co would create self-interest and intimidation
threats to their objectivity and independence. The IESBA's Code of ethics for professional accountants states
that the audit firm must be seen to be independent of the client. If Becker & Co and Murray Co are working
together on the new product, the audit firm will not be seen to be independent.
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Loan to audit client

Under the first option, Becker & Co would provide finance in the form of convertible debentures. This is a
loan between the audit firm and its client and creates a self-interest threat to independence. The Code
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specifically states that audit firms should not enter into any loan arrangement with a client that is not a bank
or similar institution and no safeguard would reduce the self-interest threat to an acceptable level. Becker &
Co should therefore not provide finance to Murray Co unless they resign as auditors.
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Equity shares in audit client

The convertible debentures will eventually be converted to equity resulting in Becker & Co holding shares in
Murray. This presents a self-interest threat to independence as Becker & Co will hold a financial interest in
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an audit client. The Code states that an audit firm is not allowed to own a direct financial interest in a client.
Disposing of the equity or resigning from the audit will be the only applicable safeguards in this instance.
Joint venture
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Under the second option, Becker & Co would form a joint venture with Murray Co. This would create a self-
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interest threat to independence as the audit firm and audit client would have an inappropriately close
business relationship. Under the Code, an assurance provider should not participate in such a venture with
an assurance client unless the interest is clearly insignificant. In this case the interest would be significant.
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Becker & Co should therefore not enter into the joint venture unless they resign as auditors of Murray Co.
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88 Answers
Diversification
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Entering into a business arrangement with Murray Co would be a new area of business for Becker & Co. The
firm should consider whether it wants to diversify into an area in which it has little expertise or knowledge. It
would be necessary to carry out a full commercial evaluation and business risk analysis before deciding if
this is a growth strategy the firm would like to pursue.
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Additionally, the firm needs to consider whether it has the time and resources to devote to this new area
without the audit business suffering. Time may be better spent attracting and retaining audit clients, rather
than pursuing new areas of business.
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Business opportunity
If the firm does decide (after research and careful consideration) that this is a business opportunity it would
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be lucrative to pursue, then they should immediately resign as auditors of Murray Co.
(b) Recruitment service
Providing a recruitment service to a client is not specifically prohibited by the IESBA Code of ethics for
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professional accountants. However, the Code does say certain threats to independence could be created.
Self-interest threat
Becker & Co are considering the provision of recruitment services to audit clients, earning fees based on a
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percentage of the salary of the person recruited. This creates a financial self-interest threat to independence.
The firm may be tempted to recommend an individual to a client in order to earn a fee, and not consider
whether that individual is suited to the role.
Familiarity threat
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The provision of recruitment services will create a familiarity threat. During audits, Becker & Co will have to
assess the work of individuals they helped recruit. The firm may be or may be perceived to be less likely to
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criticise or challenge such individuals because this could discredit their recruitment services.
Self-review threat
A self-review threat occurs where an audit firm makes management decisions for an audit client. Becker &
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Co could be seen to be making such decisions by providing recruitment services to audit clients. The firm
could review candidates' CVs and recommend individuals to interview but the final decision of who to recruit
should always rest with the client.
This threat is increased with the seniority of the individual being recruited, for example if Becker & Co were
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to advise on a new finance director. The threat could be reduced by only providing services for the
recruitment of junior staff members.
Demand for services
Becker & Co would need to carry out market research to ensure that there is a demand for recruitment
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services before embarking on any new business venture.

Training costs
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The firm should also consider whether it has the time and resources to enter into a new area of business.
Ingrid Sharapova only worked in recruitment for a year and seems to be the only employee with any
experience. She may require further training in order to recruit finance professionals and update her skills.
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An additional member of staff at Becker & Co will also require some training so the recruitment business can
be kept running whilst Ingrid is away or on sick leave.
If successful, the recruitment business may prove too much for Ingrid to handle alone and the firm will have
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to either train or hire additional staff to assist her.

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Damage to reputation
Becker & Co's reputation could be damaged if the quality of recruitment services is low. This risk can be
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reduced by setting up the recruitment services as a separate company.

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Answers 89
(c) Temporary staff assignments
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Self-review threat
Becker & Co are proposing audit managers and seniors to be seconded to audit clients. This creates a self-
review threat as there is the risk that the manager or senior will be auditing their own work on return to the
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audit firm. Even if the seconded individual is not on the audit team, there is a risk that the audit firm over
relies on work carried out by their own employee.
Safeguards would need to be in place to ensure that staff are not assigned to audit teams for clients where
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they have completed a secondment. This safeguard could cause some internal difficulties at Becker & Co as
clients are likely to request staff who are familiar with their business and have been part of the audit team.
Becker & Co may find that they can no longer allocate the staff with the most experience to clients where
there has been a secondment. This difficulty could be overcome somewhat if staff are seconded to areas
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outside of the finance department.
Management involvement
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By seconding an audit manager or senior, Becker & Co could be or could be perceived to be making
management decisions for audit clients. This poses a problem as it creates a self-review threat to
independence. The threat is greater when a more senior staff member is seconded as there is an increased
likelihood the individual will be making important decisions.
l.b
The firm would need to apply safeguards to ensure that Becker & Co employees are not involved in any
management decisions, responsible for approving or signing agreements or given the authority to enter into
commitments whilst on secondment at the client.
Familiarity threat
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An individual from Becker & Co could be seconded to a client for a time period covering the audit. A
familiarity threat to independence arises as the audit team may be over familiar with the seconded individual
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and not apply professional scepticism.
Reputation risk
Becker & Co's reputation could be adversely affected if seconded staff do not have the correct level of
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expertise for the role in question. The firm should make sure that any seconded employees are suitably
competent and qualified for the seconded role.
Loss of staff
There is a risk that key staff may leave Becker & Co if clients offer them a permanent position. The situation
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could be exacerbated by staff being concerned about redundancy as the audit department is over staffed.
Signed agreements where clients agree not to offer seconded staff permanent roles would reduce this risk.
Benefits
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The main benefit of this suggestion is that it will ease the problems with over staffing in the audit department
in the short term. In the long term, Becker & Co will still need to find new business or consider where they
could reassign excess staff.
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Individuals seconded to clients may learn and gain new perspectives from working in a finance department
rather than in an accountancy firm. These new skills will benefit Becker & Co on their return.
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90 Answers
4 Peaches
m/
Study text references. Chapters 1, 2 and 5.
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Top tips. Part (a) tested around the edge of the syllabus, but you should have been able to score very well, as you
should already be familiar with the arguments in favour of principles- and rules-based approaches from your earlier
studies. In addition to this, the examiner did discuss this issue in an article in Student Accountant shortly before the
exam. This underlines again the advantage that you can gain just by carefully reading the examiner's articles there!
o t.
There is a possibility that students might have been put off by the question text on the IAASB's Clarity Project, but if
you read the requirement you'll see that all you need to do is talk about the different approaches to auditing in
general. Take care in part (ii), though, only to talk about the pros and cons of a prescriptive approach – the question
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is not asking you to talk about a principles-based approach at all (although the advantages of one and pretty much
the same as the disadvantages of the other).
Part (b) was a standard question on ethics. You should have scored well here, as was mainly a test of factual
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knowledge but in the guise of a scenario.
Easy marks. Part (a)(i) should have been very easy. There was an easy mark available for defining lowballing in part
(b)(iii) – an example of the kind of mark you might miss out on if you mess up your timing and don't answer all the
l.b
parts of the question.
Examiner's comments. This was the most popular of the Section B questions. The question focussed on the
IAASB's Clarity Project, and on ethical and professional issues. The topic should not have been a surprise to
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candidates given the importance of this current issue, and the examiner's recent article covering the subject.
Requirement (a) tested candidate's knowledge and understanding of prescriptive and principles-based approaches
to auditing. Generally, this requirement was answered well.
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Requirement (b) contained three sub-requirements, testing candidates understanding of the terms 'intimidation
threat', 'lowballing', and also including a section on the advertising rules which auditors should abide by. Most
candidates could demonstrate that they knew the basic facts about each, but generally did not explain their points in
sufficient detail to score a high mark on requirement (b) as a whole. For example, with regards to lowballing, most
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candidates could state that this involves charging a low fee for the performance of an audit engagement, but not all
candidates then developed the point into issues relating to the quality of the audit performed. It was pleasing that
the requirement on advertising rules was well answered, given that this is a relatively peripheral area of the
syllabus. Unusually for the ethics question, at this sitting it tended to be the optional question in which candidates
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scored the highest mark.

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Answers 91
Marking scheme
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Marks
(a) (i) Prescriptive and principles-based approach to auditing
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– Up to 2 marks for contrast
(ii) Arguments for and against prescriptive approach
– 1 mark for each advantage – clarity, increase in quality, uniformity, easy to
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monitor
– 1 mark for each disadvantage – lack of tailoring, over-auditing, no use of
skill/judgement, process becomes mundane/routine, issues for staff
retention
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– Additional marks may be given for relevant comments on practical issues
related to adoption of clarified ISAs eg additional costs, increase in audit
fee, training needs
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Maximum 7
(b) (i) Intimidation threat
1 mark per comment explained:
– Independence/objectivity threat
l.b
– Example – aggressive individual
– Example – fear of dismissal/legal action
– Link to familiarity (or other) threat
– Safeguards needed
Maximum
(ii) Advertising
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– Must abide by professional principles
– Must not make false/exaggerated claims
– Must not make disparaging remarks about other firms
– Must abide by local rules on advertising generally
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Maximum 3
(iii) Lowballing
– Definition
– Why is problem – low quality audit, not acting with due care/competence
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– Not prohibited but not encouraged

Maximum 3
Total 16
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(a) (i) Rules-based (prescriptive) auditing is where the auditor follows prescribed rules on how to audit a
particular area, but does not use any judgement about how to apply the rules.
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Principles-based auditing is where no detailed rules are prescribed, but where the auditor must apply
more general, guiding principles to the particular area being audited.
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(ii) Advantages
Improved clarity and understandability. Prescriptive auditing standards leave the auditor in no doubt
as to what he needs to do to audit a particular area. He just needs to follow the rules precisely and to
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the letter. As long as he has done this, he will be able to say that he has auditing in accordance with
the standards.
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It can be argued that prescriptive standards lead to an improvement in the quality of audits because
they leave less scope for the auditor to choose how to audit each area, which reduces the risk that
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the auditor might make the wrong choice or might make a poor judgement. This also makes it much
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92 Answers
easier for the regulatory authorities to monitor audit quality, as it is much clearer what the auditor
needs to do in accordance with the standards.
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Disadvantages
The key disadvantage is that it reduces the auditor's ability to take into account the individual
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circumstances of the entity that is actually being audited. There is a danger of just applying the rules
irrespective of whether the audit procedures are appropriate in this particular case. Worse than this,
there may not even be a rule for the particular situation being audited, leaving the auditor in a very
difficult position. This would lead to audit procedures being done that may not be adequate to gather
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sufficient appropriate audit evidence.
Prescriptive approaches diminish the extent to which auditors need to use their own judgement. This
may not be too much of a problem in the case of a simple entity that is straightforward to audit, but it
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can be problematic in the case of a complex entity that is difficult to audit.
There is therefore a danger that a prescriptive approach might actually reduce the quality of audits.
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(b) (i) An intimidation threat is a threat to compliance with the fundamental principle of an auditor's
objectivity, which is a crucial part of his independence.
An example of an intimidation threat would be a client threatening to replace the auditor if the auditor
intends to qualify the audit opinion.
l.b
When an auditor identifies that there is a threat to his independence, he should apply safeguards to
reduce the threat to an acceptably low level. There may, for instance, be a specific mode of recourse
available through the individual regulatory framework that the auditor is operating in.
(ii)
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The ACCA's general rule on advertising is that the medium used should not reflect adversely on the
member, ACCA or the accountancy profession.
ate
In particular, adverts should not discredit the services offered by others, whether by claiming
superiority for the member's or firm's own services or otherwise. They should also not be
misleading, either directly or by implication – they must not make false claims.
It is important that short adverts do not include information about fees. It is possible to mention fees
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in longer adverts, but these must include information about the basis on which fees would be
calculated, such as hourly rates, etc.
(iii) Lowballing is tendering for an audit for a very low fee, with the hope of under-cutting competitors
and winning the audit tender. It is associated with audit firms recovering any losses they incur from
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the low fee, by just raising the fees significantly in future years.
The short answer is that lowballing is allowed, but that the fact that a firm is charging a low fee does
not mean that it can cut costs by doing less audit work. It must do the same amount of work as on
any other audit, ie the amount required to provide reasonable assurance that the financial statements
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are not materially misstated. The danger is that the firm tries to cut back on the audit work done in
order to lessen any loss it is making on the audit – which is a serious risk to its independence.
The ACCA's Code of Ethics and Conduct emphasises that where a firm obtains an appointment with a
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significantly lower fee than competitors, it must be able to demonstrate that the audit has been
conducted in accordance with auditing standards.
5 Retriever
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Text references. Chapters 4 and 14.

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Top tips. In part (a) your approach should be to read through the question, noting quality control and ethical
problems as you go. Just about every line of the junior's comments contains a quality control risk, so you should
/fr
have had plenty to talk about in your answer.

As ever it is important that you stick to the scenario and do not offer too much theory. Your knowledge of ISAs
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should be worn lightly.

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Answers 93
Overall this was a requirement on which you should have looked to score well, possibly making up for part (b)
m/
which was on the whole considerably more difficult.
In part (b)(i), perhaps the most crucial thing is that you understand what the question is asking for. Many
candidates will have struggled on this question, but it is not actually that difficult once you understand how to
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approach it.
The main source of confusion appears to be whether the question is asking for just planned procedures, or whether
it is asking for eg matters to consider in relation to engagement acceptance. Reading the question closely, in the
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second paragraph it is stated that the client has asked Kennel & Co to provide a forensic accounting service. This
means that the engagement has not yet been accepted, in which case the 'matters to consider' that the question
asks for would include matters in relation to the engagement acceptance. This is in contrast to eg Question 1 from
the same exam paper, which was on audit planning in a scenario in which the (audit) engagement had already been
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accepted and was now at the planning stage.
Your answer to part (i) should therefore focus on the issues that need to be clarified in relation to the engagement –
things like resources need, fees, and the form of any reports. These are all relatively easy marks.
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Notice that the final paragraph of the question scenario is really just the examiner's way of telling you not to focus
on any audit or ethical issues there might be here. You might be able to twist the situation to shoe-horn audit issues
or ethics in, but there will not be many marks available for doing so.
l.b
Finally, as a rough guide you should be looking to write paragraphs (not bullet points) here. You should also try to
apply your points to the scenario as much as possible, as there may well be a cap on the number of marks available
for 'identification' only.
this part of the question.

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Part (b)(ii) is more straightforward, and you should have been able to think of enough relevant procedures to pass
Easy marks. Some aspects of the scenario in part (a) were flagrantly absurd, such as not performing procedures on
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directors' emoluments and share capital, or juniors' work not being reviewed. These should have cried out to you,
and there were easy marks for saying not just that this was wrong, but why it was wrong.
Examiner's comments. Answers to part (a) on the whole were satisfactory, and candidates seemed comfortable
with applying their knowledge of quality control requirements and ethical threats to the scenario. Most answers
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were well structured, working through each piece of information and discussing the matters in a relevant way.
There were a number of scripts where the maximum marks were awarded for this requirement.
Unfortunately answers to part (b) were overall unsatisfactory indicating that this is not a well understood part of the
syllabus. Some answers tended to include one or more of the following in relation to the first part of the
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requirement.
 A lengthy discussion of what a forensic investigation is, including long definitions, with no application to the
scenario – this was not asked for. This tended to be based on rote learning and earned few, if any marks.
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 An assumption that management had already quantified the amount to be claimed, and that the forensic
investigation would 'audit' that amount – leading to mostly irrelevant answer points
 A discussion about fraud and the lack of integrity of management for 'allowing' the fraud to take place - this
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was often accompanied by lengthy speculation about the control deficiencies that failed to prevent the
burglary from happening
 A focus on whether adequate safeguards could be put in place to allow the audit firm's forensic accounting
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department to perform the investigation – this is a valid consideration to an extent, but the question did
clearly state that there was no ethical threat
 A discussion on the accounting treatment necessary for the stolen goods – again, not asked for
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94 Answers
Marking scheme
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Marks
(a) Quality control, ethical and other professional matters
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Up to 2 marks for each matter evaluated
(up to a maximum 3 marks for identification only)
– Time pressure
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– Planned procedures ignored on potentially material item
– Sampling method changed – increases sampling risk
– Inappropriate review by juniors
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– Inappropriate delegation of tasks
– Deferred tax – management not competent
– Deferred tax – self-review/management responsibility threat
– Tax planning – non-audit service with advocacy threat
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– Junior lacks experience for this work regardless of ethical issues
– Junior not supervised/directed appropriately
– Overall conclusion
13
l.b
Maximum
(b) (i) Planning the forensic investigation

Up to 1½ marks for each planning matter identified and explained
(up to a maximum 2 marks for identification only)
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– Develop understanding of the events surrounding the theft
– Meeting with client to discuss the investigation
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– Confirm insurance policy details (period covered, what is
covered)
– Agree output of investigation
– Confirm access to necessary information
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– Discuss confidentiality and ability to discuss with

police/insurance company
– Consider resources for the investigation team
– Deadlines/fees
tud
(ii) Procedures to be performed

1 mark for each specific procedure recommended:
– Watch the CCTV to form an impression of the quantity of
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goods stolen
– If possible, from the CCTV, determine the type of goods stolen
– Determine how many items of finished goods are in each box
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– Agree the cost of an individual item to accounting records such

as cost cards
– Perform an inventory count on the boxes of goods remaining in
the warehouse and reconcile to the latest inventory movement
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records
– Discuss the case with the police to establish if any of the goods
have been recovered and if, in the opinion of the police, this is
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likely to happen
– Obtain details of the stolen lorry and agree to the non-current
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asset register
Maximum 12
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Total 25
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Answers 95
(a) The Group obtained a listing during the year which means that its financial statements will be the subject of
particular scrutiny. This raises the overall risk level of this assignment, which means it should be subject to
m/
especially stringent quality control. This does not appear to have been the case.
Engagement quality control review
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The fact that there is an engagement quality control review taking place is an encouraging sign, as it
summons the prospect of some of the more egregious failings of quality control being made good before the
auditor's report is signed.
o t.
Time pressure
The existence of time pressure points to poor planning. The purpose of the audit plan is not only to direct
audit work to appropriate areas of the financial statements, but also to decide on the resources and
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deadlines necessary to complete the audit satisfactorily.
Time pressure increases detection risk. Procedures are likely to be rushed, resulting in a lack of professional
scepticism and misstatements going undetected. This seems to be what has happened here.
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Directors' emoluments
The audit manager described these as low risk, but they are material by nature. Not only are they related
party transactions, they carry a high risk of manipulation as directors may attempt to conceal their
l.b
remuneration from shareholders and other users of the financial statements.
There will also be additional reporting requirements as this is a listed group, which only increases the risk to
the auditor.
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Even if they were low risk, planned audit procedures would still need to be performed. The fact they are high
risk only heightens this necessity.
ate
Share capital
If the group were not listed, then share capital might be low risk. However, the fact it obtained a listing
during the year means that share capital could have changed significantly. This is a highly visible area, and is
therefore high risk.
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Sampling method
ISA 530 Audit Sampling does allow samples to be selected haphazardly, which is effectively the exercise of
judgement which the manager appears to be advocating. However, several points can be made against the
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manager's advocacy of judgmental sampling.

Firstly, the audit plan prescribes statistical sampling. It is possible to deviate from the audit plan, but only if
this would provide better evidence. Yet this is not the manager's stated argument, so the suggestion should
not have been made.
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Secondly, haphazard sampling requires the exercise of judgement which juniors are unlikely to possess in
view of the fact that their firm usually samples statistically. There is a risk that juniors will not understand
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how to select samples in this way, and will simply select eg large balances.
Thirdly, the manager's claim that haphazard sampling is quicker is manifestly false. When done properly,
haphazard sampling requires the exercise of judgement and this takes time. Statistical sampling is much
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quicker to implement as it is relatively mechanical.

In fact the manager's suggestion that this would save time amounts to an incitement to the juniors to select
the samples without due care, perhaps only picking the items that are close to hand. This is a serious breach
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of the IESBA Code of Ethics.

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Trade payables
It is acceptable for juniors to be involved in the audit of trade payables, however the suggestion appears to
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be that one junior has been made responsible for the whole of trade payables on a listed company audit.
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96 Answers
This is clearly unacceptable, as the junior would possess neither the skills nor the time to perform the work
to a satisfactory standard.
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Going concern
Going concern is a difficult area to audit as it usually involves making judgements about a business's future
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prospects, which requires substantial experience. Juniors are very unlikely be able to do this and so should
not have been assigned going concern.
A more senior member of the audit team should have been assigned going concern, such as the audit
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manager or partner.
Taken together with trade payables, this reveals a disturbing failure of direction on the audit, which is a key
quality control.
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Review
It may well be good training for juniors to review each other's work, but this is no substitute for proper
supervision and monitoring by more senior members of the audit team. Being at the same level, juniors are
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unlikely to be able to spot any errors or invalid conclusions drawn, so the reviews are likely to be of little
use. Moreover, the juniors are likely to be very familiar with each other and may be unwilling to criticise each
other's work. The work should have been reviewed by the audit manager.
l.b
The financial controller of a listed company should be able to calculate deferred tax, so the fact that she
could not raises issues about the Group's internal controls. The audit team should therefore revisit the risk
testing will be required.

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assessment done at the audit planning, as deficient internal controls may mean that more substantive
The junior should not have been discussing the tax position with the financial controller in the first place.
ate
Given that the time on the audit is so short, what time there is would be better allocated to performing audit
procedures. This points to a lack of supervision, and also to a need for further training for the audit junior.
Deferred tax asset
This is a good example of the principle of professional competence and due care, which the junior appears
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to have breached. Although the junior has studied deferred tax in college, they lack the experience to know
than in practice the recognition of deferred tax assets is rare. Given that the Group's subsidiaries have been
suffering losses it is not certain that any such asset will be recoverable; making the judgement over the
asset's recoverability requires experience that the junior does not yet possess.
tud
The key ethical issue here is that the auditor must not provide accounting services such as this to listed
clients. The self-review threat so created – whereby the firm would then be auditing accounts that it has
itself prepared – would be deemed by the Code to be insurmountable in this instance.
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The audit manager said that this would save time and that the figure would not need to be audited. This is
wrong. Now that the junior has calculated the figure it will need to be carefully reviewed and re-performed,
and discussed with the management of the Group. The audit manager's suggestion is indicative of a lack of
due care.
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Tax planning
The audit junior should not be providing tax planning recommendations. This is a non-audit service, which
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the junior is providing free of charge and without the required professional skills. There is a self-review
threat here because the tax balances calculated on the basis of the junior's advice would be included in the
audited financial statements. There is a danger that the junior has been taking management decisions. It
would usually be possible for a tax planning service to be provided to a listed client, but the auditor would
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have to put in place safeguards such as separate engagement teams which clearly do not exist here.
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There is a risk that the firm may be the subject of litigation as well as reputational damage if the client relies
on wrong advice given by the junior. Steps should therefore be taken to inform the Group of the situation
and to prevent it from relying on this advice.
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Answers 97
(b) (i) It would be helpful to arrange a meeting with Group management in order to help obtain an
understanding of the theft and the circumstances around it, and to clarify matter in relation to the
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engagement.
The objective should be specified precisely, and clarification may be needed regarding whether
quantification is to be made of the amount to be claimed from the insurer, or of the amount of the
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loss.
It should be clarified whether the Group wants us to investigate the crime itself and to identify the
perpetrator, as this would be a radically different type of investigation which may be outside the
o t.
scope of Kennel & Co's professional competence.
Clarification should be sought on whether the Group has already made any calculations of the
amount to be claimed, in which case it may simply want us to audit its calculation. Alternatively it
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may want us to calculate the loss ourselves from scratch. This would have an effect on fees, which
should also be discussed at the meeting.
Kennel & Co appears likely to have sufficient resources to conduct the investigation as it has a
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forensic accounting department. It should, however, be determined whether the firm has the requisite
staff available for this assignment.
It will be necessary to discuss timings with the Group, and in particular any planned deadlines for
l.b
submission of the insurance claim. Any such deadlines should allow enough time for the work to be
completed without sacrificing quality. This will in turn affect the consideration of whether sufficient
staffing resources are available at the right times.
conduct the investigation.

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It must be confirmed that the assurance team will have full access to any information required to
The Group should have reported the theft to the police, and it may be helpful to obtain a copy of any
ate
police reports available. It should be established whether the perpetrator(s) have been caught, and if
so whether they are likely to be prosecuted. Kennel & Co should be alive to the possibility that the
Group might ask it to act as an expert witness if there were a court case, in which case there may be
an advocacy threat to the firm's independence.
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It is possible that the perpetrator(s) have been caught and that some of the assets have been
recovered. This should be ascertained, and any recovered assets excluded from the calculation of the
loss. It is also possible that these assets may have been damaged, in which case this should be taken
into account.
tud
From the circumstances described it is possible that the thieves may have been Group employees.
This information should be obtained from management.
The insurance policy should be scrutinised. It is stated that assets lost as a result of thefts are
covered, and this should be confirmed. It should also be determined whether there are any
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restrictions in the case of thefts perpetrated by Group employees, as this may affect the amount that
can be claimed. Finally, it should be confirmed that the date of the theft falls within the period
insured.
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Finally, the output of the investigation should be confirmed. The Group may require eg a report to the
insurance company, or alternatively a report addressed to itself but which it can use for the purposes
of the insurance claim. It should be clarified that the report would not be distributable to any other
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parties.
(ii) Procedures
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 Watch the CCTV to determine the quantity of goods stolen, eg how many boxes loaded onto
lorry
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 If possible determine if the boxes contain mobile phones or laptops

 Inspect boxes of goods in the warehouse to determine how many finished goods are in each
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 Agree cost of an individual phone and laptop to accounting records, eg cost cards
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98 Answers
 Perform inventory count on boxes of goods in the warehouse and reconcile to latest inventory
movements
m/
 Discuss the case with police to establish if any goods have been recovered and if this is likely
to happen
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 Obtain details of stolen lorry, eg licence plate, and agree the lorry to non-current asset register
6 Smith & Co
o t.
Top tips. In this type of question it is important to pay attention to the mark allocation and make sure you allocate
sp
your time accordingly. Norman Co is worth eight marks so you need to spend more time on this than the other two.
Easy marks. By suggesting some sensible action points you should be able to score some easy marks in this
question.
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Examiner's comments. It is crucial that in ethics questions, the reason why something is a threat to independence
is fully explained. The answers given to requirements (a) and (b) were usually the same length, despite there being
more marks available for (a). Again, candidates are reminded to be careful with time allocation within each question
l.b
that they attempt. The answers to requirement (c) were generally inadequate. Most candidates seemed not to
appreciate that auditors often make recommendations to clients, and that as long as the client is aware that a
commission will be received by the audit firm, the practice is generally seen as acceptable.
Marking scheme ria

ate
Marks
(a) Norman Co
Generally 1 mark each per comment and action point
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 Poor credit control

 Independence threat – free audit/loan
 Independence threat – self-interest in 20X8 report
 Financial distress leads to going concern threat for the company
tud
– Non payment due to financial distress does not necessitate resignation

 Discuss with client – ethical problem/payment arrangements
 Ethics partner notification
 Assess significance of amount outstanding
 Policy to check prior invoices paid
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 Continue to improve credit control

 Second partner review
 Review of audit work performed on going concern
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Maximum 8
(b) Wallace Co
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– Non arm's length commercial transaction

– Material to audit manager
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– Self-interest/intimidation threat
– Question audit manager's integrity
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– Potential disciplinary action

– Remove Valerie from audit team
– Review all work performed on Wallace Co
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– Consider Valerie's relationship with and likelihood of bias towards

her other clients
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Answers 99
– Disclosure of ethical threat to those charged with governance
– Provide clear communication to all staff regarding transactions with
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clients
Maximum 5
(c) Software Supply Co
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– Self review threat
o t.
– Self-interest threat
– Independence check
– Client disclosure and acknowledgement
– QC monitoring
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Maximum 4
Total 17
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(a) Norman Co
Credit control
l.b
The fees for the 20X7 audit have been outstanding for over twelve months and it seems that little has been
done to collect them. Since the file note states that Norman Co is suffering poor cash flows, the balance may
no longer be recoverable. Credit control has been poorly managed at Smith & Co with regards this client and
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the debt should not have remained outstanding for so long.
Action
Credit control procedures at the firm need to be reviewed to prevent this situation reoccurring. It appears
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that some improvements have already been made with the audit manager now being responsible for
reviewing client invoices raised and monitoring credit control procedures.
Independence
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The overdue fees for the 20X7 audit may make it appear the audit has been performed for free or could
effectively be seen as a loan from Smith & Co to Norman Co. The IESBA Code of Ethics for Professional
Accountants specifically states that an audit firm should not enter into a loan arrangement with a client that
is not a bank or similar institution. It highlights overdue fees as an area where a self-interest threat could
arise and independence is threatened. Smith & Co should not have allowed outstanding fees to build up as
tud
their independence is now compromised.

Action
Smith and Co should discuss the recoverability of the 20X7 audit fee with the audit committee (if one exists)
as
or those charged with governance. A payment plan should be put into place.
If the overdue fees are not paid, the firm should consider resigning as auditors. In this case a valid
commercial reason appears to exist as to why the fees remain unpaid. Smith & Co can remain as auditors
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provided that adequate safeguards are in place and the amount outstanding is not significant. If the overdue
fees are significant, it may be that no safeguards could eliminate the threats to objectivity and independence
or reduce them to an acceptable level.
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The ethics partner at Smith & Co should be informed of the situation. The ethics partner should evaluate the
ethical threat and document the conclusions including the significance of the overdue fees.
20X8 audit
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The 20X7 audit fee and arrangements for payment should have been agreed before Smith & Co formally
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accepted appointment as auditor for the 20X8 audit. Since the 20X8 audit has now almost been completed, it
appears this could not have happened.
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100 Answers
Action
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The ethics partner at Smith & Co should take steps to ensure that there are no outstanding audit fees before
commencing new client work. This could involve a new firm-wide policy that audit managers check payment
of previous invoices.
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Self-interest in 20X8 report
The 20X8 audit report has not yet been signed. This creates a self-interest threat to Smith & Co's objectivity
and independence because the issue of an unqualified audit report may enhance their prospects of securing
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payment of the overdue 20X7 audit fees.
Action
The working papers for the 20X8 audit of Norman Co should undergo an independent review by the
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engagement quality control reviewer.
Going concern
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Norman Co is known to be having cash flow problems and so there is an issue of whether the company is a
going concern for the 20X8 audit report.
Action
Smith & Co should carry out a review of the 20X8 audit working papers on going concern. It may be
l.b
necessary to carry out further audit procedures to ensure that sufficient evidence has been gathered to
support the audit opinion.
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(b) Wallace Co
Business relationship
Under the IESBA's Code of Ethics, persons in a position to influence the conduct and outcome of the audit
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should not enter into business relationships with a client, except where they involve the purchase of goods
and services from the client in the ordinary course of business, are on an arm's length basis and are clearly
inconsequential to each party.
As audit manager of Wallace Co, Valerie Hobson has influence over the outcome of the audit and should only
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rent the warehouse space if the conditions prescribed by the Code are met. Since the warehouse space is
already known to be used for rental income, this transaction is in the ordinary course of business. However,
the note on the invoice about only charging a nominal sum indicates that the transaction is not on an arm's
length basis. The criteria in the Code have therefore been breached. It is also worth noting that the
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transaction may represent a material discount for Valerie Hobson.

Action
Valerie Hobson should not retain the position of audit manager at Wallace Co and a new manager should be
assigned. All planning work for the 20X8 audit should be independently reviewed as planning decisions may
as
have been influenced by the transaction. The situation should be disclosed to those charged with
governance at Wallace Co and the audit committee, if one exists.
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Valerie Hobson has created a self-interest threat, by renting the warehouse space at a reduced rate. Valerie's
objectivity could be biased by her desire to please Wallace Co so that she can benefit financially.
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Action
Valerie Hobson may need to be disciplined for her actions by Smith & Co who could also send her for ethics
training. Smith & Co should investigate for evidence of bias in other audits where Valerie Hobson has had
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influence.
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Answers 101
(c) Software Supply Co
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Smith & Co may have entered into an inappropriate close business relationship by accepting a fee for
recommending Software Supply Co to audit clients. This could be seen as a self-interest threat and
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compromise the independence and objectivity of Smith & Co. The business relationship can be allowed to
continue provided that Smith & Co put safeguards in place.
Action
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Smith & Co should ensure that where Software Supply Co has been used by a client the following
safeguards exist.
 Audit staff have no financial or personal interest in Software Supply Co.
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 The arrangement between Smith & Co and Software Supply Co has been fully disclosed.
 Smith & Co should obtain written confirmation that the client is aware of the referral fee.
Additionally, Smith & Co should monitor the quality of the products supplied to ensure they are not
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associated with inferior goods.
7 Carter
l.b
Top tips. This question looks at a number of ethical dilemmas. Care must be taken when reading the information to
ensure that the key issues are identified. It can be easy to become sidetracked by minor details or basic
misunderstandings and end up missing the point of the question.
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Easy marks. Parts (a) and (d) were probably the easiest, but the easiest marks were the first few in each part of the
question – and to get these, it was crucial that you kept to your timings for each part.
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Examiner's comments. As usual, the 'ethics question' was the most popular of the optional questions. This
question contained four brief ethical situations, from which candidates were required to identify and evaluate the
ethical and other professional issues raised. Answers were mixed in quality – some were sound, but many did little
more than identify threats but provided no discussion or evaluation of those threats identified.
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Requirement (a) was well answered, with almost all candidates able to identify and explain the self-review threat
and to suggest appropriate safeguards. Few candidates however considered the key issues of the materiality of the
pension deficit to the financial statements, and the highly subjective nature of the valuation.
In requirement (b), most candidates could identify the familiarity threat to objectivity, though this was often not well
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explained, and most suggested that the best safeguard would be to exclude Kia from the audit team. Inevitably,
many candidates wanted to see Kia disciplined for her 'gross misconduct' and reported immediately to ACCA.
In requirement (c), most candidates identified the potential self-interest threat created but few could go further to evaluate
the potential risk exposure to the firm or additional costs that may be incurred if such a service were offered.
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In requirement (d), the situation was dealt with well, with most candidates able to identify and explain the threats
and to suggest that full disclosure would be the best course of action.
On the whole this ethics question produced better answers than ethics questions in previous examinations.
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However, candidates' performance is hampered by the fact that often only one ethical issue or threat per
requirement is dealt with in their answers, which tend to be too brief for the marks available. Many candidates wrote
the same amount for each requirement, despite the fact that requirements (a) and (b) were worth twice the marks
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of requirement (d).
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102 Answers
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Marking scheme
Marks
(a) Fernwood Co
co
Up to 1 mark each point explained:
– Self-review threat (restrict to ½ mark if not explained)
– Provision of non-audit service
– Threat depends on materiality of balance
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– Threat depends on degree of subjectivity
– Can only perform if low threat and safeguards used
– Pension very subjective so unlikely to be able to reduce threat to acceptable level
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– If service provided assess skills and competence
Maximum 6
(b) Hall Co
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– Client should not influence selection of audit team members
– Kia has no experience of the client
– Family relationship creates three objectivity threats (1 mark each explained)
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– Degree of threat depends on level of influence
– Do not assign Kia to the team
– Explain to client why Kia has not been assigned
Maximum 6
(c) Collier Co
Up to 1 mark each point explained: ria
ate
– Custodial service creates self-interest threat (½ mark if not explained)
– Safeguards to be applied (1 mark each)
– Money laundering consideration
– Consider security of offices/availability of space
– Extra costs eg insurance, more security measures
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– Reputational risk in event of theft/loss of documents

– Confidentiality issues
Maximum 5
(d) Gates Co
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– Referral fee creates self-interest threat
– Allowed if safeguards in place (1 mark for each safeguard)
– Consider quality of service provided
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Maximum 3
Total 20
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(a) The issue is whether there is a self-review threat, as the valuation of the amount recognised would be
recognised in the financial statements. The IESBA Code of Ethics for Professional Accountants states that
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where the valuation service relates to a material amount in the financial statements, and the valuation
involves a significant degree of subjectivity, the self-review threat created could not be reduced to an
acceptable level. If this is the case, the firm must choose between providing the audit and providing the
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valuation service.
Carter & Co therefore needs to assess the materiality of the figure, and the degree of subjectivity involved. If
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it considers that safeguards could reduce the threat to an acceptable level, then it can go ahead with both the
audit and the valuation service. Safeguards may include:
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 Using separate personnel for the valuation service and the audit
 Performing a second partner review
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Answers 103
 Confirming that the client understands the valuation method and the assumptions used
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There is a further question over whether an audit firm would be likely to possess the requisite competence to
provide such a valuation service. Professional competence and due care is a fundamental ACCA ethical
principle, which in this context would mean that the firm should only do work which it is professionally
qualified to do. The firm would therefore have to ensure that it could perform the work competently.
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(b) There are a number of possible threats to Carter & Co's independence here:
 Familiarity: Kia may fail to exercise professional scepticism.
o t.
 Intimidation: the financial controller may be able to intimidate and influence Kia's work.
 Self-interest: Kia may have an interesting in not causing problems for her relative, and may be
unwilling to challenge them if required to do so.
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To assess the severity of the threat, the degree of influence held by the family member and by Kia must be
considered. As financial controller and audit senior respectively, both would have some influence over the
financial statements. It would therefore be unlikely that Kia would be able to be assigned to this audit
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engagement.
Furthermore, allocation of staff to audit teams should be the decision of Carter & Co alone. Staff should be
allocated on the basis of their experience and skills. There is a risk of the audit team possessing an
l.b
inappropriate mix of experience and skills for this audit if Carter & Co were not able to select the audit team,
which may impair audit quality. The fact that Kia has not worked on this client before suggests that this may
be the case. It is therefore crucial that Carter & Co exercise a free choice over the composition of the audit
team.
(c)
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Usually documents such as title deeds are held by the audit client, but sometimes the service is provided by
the accountant.
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Appropriate safeguards to be used in the provision of a custodial service could include:
 Keeping the assets physically separate from the firm's assets
 Keeping orderly documentation regarding the assets and be ready to account for them to the client
when requested
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 Establishing strict controls over physical access to the assets

 Complying with all relevant laws and regulations in respect of holding the assets
Confidentiality is also a key issue – the firm must ensure that documentation is only ever given to the client
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and to no-one else.

In addition Carter & Co should be vigilant in respect of money laundering regulations. The tangible assets
could be purchased using the proceeds of crime, and as such the firm in would be deemed to be involved
with money laundering. The firm would have to be careful to ascertain the true origin of the assets.
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A further issue is whether Carter & Co has sufficient security to offer such a service. Employment of extra
security methods such as alarm systems and CCTV could be costly. This could be compounded if, in order
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to maximise the revenue from this source of income, Carter & Co were tempted to concentrate on holding
high value assets, as these would attract the highest fees.
If there were ever a problem such as documents being lost, then Carter & Co would face major reputational
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risk. This risk, along with the extra costs discussed above, may outweigh the relatively small revenue stream
that the service would provide.
(d) Referral fees are not prohibited by IESBA's Code of Ethics, but a self-interest threat can arise, as the audit
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firm receives financial benefit for each audit client referred. The referrals and payments to Carter & Co can
continue, provided that safeguards are put in place, such as:
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 Disclosing to audit clients that a referral fee arrangement exists, and the details of it
 Receiving confirmation that audit clients are aware of the referral arrangement
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 Receiving confirmation from all employees of Carter & Co that they have no interest in Gates Co
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104 Answers
Carter & Co may also wish to consider the quality of the training provided by Gates Co. Any problems with it
could cause damage to Carter & Co's reputation.
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8 Dedza
co
Text references. Chapters 1, 2 and 5.
Top tips. This question on ethical and professional issues is typical of the type of Section B question you should
expect. It is split into two parts. In part (a), you need to comment on the need for ethical guidance on money
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laundering.
In part (b), the question is split into three mini scenarios, each worth between four and seven marks. Look at the
question requirement carefully – as well as identifying the issues raised, you need to state what action the firm
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should take. Make sure you do this – these are fairly straightforward marks to achieve.
Easy marks. Again this is a challenging question but approaching it with your knowledge of the ethical guidance
and being able to apply it will help you in part (b).
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Marking scheme
Marks
l.b
(a) Need for ethical guidance for accountants
Generally 1 mark a point up to
Ideas (illustrative)
– Legal responsibilities
– Risk of offence
– Confidentiality
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ate
– Other reporting responsibilities
– Professional etiquette
– Accountants working in other jurisdictions
Maximum 5
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(b) Ethical and other professional issues

Generally ½ mark each issue identified + 1 mark each comment/action
Ideas
(i) Tax investigation
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– New client (relatively) – CDD

– 'Professional etiquette' – change in professional appointment
– Quality control eg second review
– Criminal property includes proceeds of tax evasion
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– Money laundering offence?

– Suspicion of fraud (intent) vs error in incorrect tax returns
– Disclosure by Dedza vs voluntary (confidentiality)
– Need for STR
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(ii) Advice on payments

– Not a tax issue
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– Corruption and bribery/extortion – designated categories of

offence
– Clear intent
– Seriousness in context of domestic laws
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– Need to report to FIU?

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(iii) Financial advisor

– Designated non-financial profession
– Customer due diligence/record keeping
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– Politically exposed person (PEP)

– Reputational risk
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Answers 105
Marks
– Additional measures
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– Refusal to act 15
Total 20
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(a) Need for ethical guidance
Accountants are in a position where they deal with other people's money and financial matters. Therefore
o t.
they may unwittingly, or worse, intentionally, be drawn into other people's criminal activity in relation to
money laundering.
For example, there are a number of regulations relevant to professionals such as accountants which
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accountants must therefore comply with relating to appointing money laundering officers and making
reports of suspicions of money laundering. It is also a criminal offence to continue to act if there is a
suspicion that a transaction relates to criminal proceeds.
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It is also a criminal offence to prejudice a money laundering investigation by letting the person being
investigated know something is happening. This offence is called 'tipping off'.
There are substantial criminal penalties for these offences and accountants are at rise in incurring these
l.b
penalties.
Although there is some legal protection given, some of these requirements appear to be at odds with the
accountant's duty of confidentiality to a client (particularly the requirement to report knowledge or suspicion
of criminal activity).
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The ACCA produced a Factsheet for members (Technical Factsheet 94) summarising the responsibilities of
members. Principles that ensure compliance with the OECD's Financial Action Task Force on Money
ate
Laundering recommendations were included in the ACCA's Professional Conduct Regulations. This includes
guidance on:
 Internal controls and policies relating to staff training
 Client identification procedures
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 Record keeping (minimum five years)

 Recognition of what constitutes suspicion
 Reporting of suspicious transactions
 Not tipping-off potential suspects
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(b) (i) Kora Co

Client acceptance procedures
As Kora, a relatively new client, is being investigated for tax fraud, it is possible that Dedza's quality
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control and other procedures on acceptance of a client may not be as robust as would be ideal, and
that they have accepted a client without obtaining sufficient knowledge and understanding.
In accepting a new client, Dedza should have completed the following:
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 Obtained references about key personnel in the company and the company
 Obtained professional clearance from the previous auditors
 Carried out procedures in line with Dedza's anti-money laundering policies which should
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include detailed client identification procedures and customer due diligence

It is possible that Dedza did not obtain appropriate references or obtain professional clearance. There
is no reason why the client identification procedures would necessarily have raised any issues if Kora
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has previously had a clean record.

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Concealed, previously undiscovered fraud?

Alternatively, given that under-declaring income is a fraud, it is possible that staff at Kora were under-
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declaring income and concealing the fact, and that both the old and the new auditors were unaware
that it was going on. There is not necessarily any suggestion that negligent audits were carried out.
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106 Answers
Confidentiality
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Dedza has a duty of confidentiality to its client, and the partners and staff of Dedza must ensure that
they do not breach their duty of confidentiality if asked questions by the tax authority during the
course of their investigation.
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This may be complicated by the fact that if Kora has been underdeclaring income, this may become
an investigation into the crime of money laundering, in which case, Dedza may have legal duties of
disclosure that are not subject to the duty of confidentiality and for which they have protection under
qualified privilege.
o t.
Members are entitled to make disclosures to defend themselves and their professional reputation,
and if the investigation includes members of the tax department of Dedza personally, they may need
to make disclosures in their own interests.
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Actions to take
Dedza should take legal advice on disclosures that they are required to make and disclosures that
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they are not permitted to make before they make any disclosures to the tax authorities in the course
of this investigation.
Tutor's note. It is assumed in this answer that the investigation is a public investigation into tax
l.b
irregularities which Kora Co is fully aware of. If it were a secret money laundering investigation,
Dedza would also need to be wary of committing the offence of 'tipping off' and letting staff of Kora
Co know that the company was under investigation.
(ii) Xalam Co
Ethical matters ria
ate
In terms of carrying out future audits of Xalam Co, there are two ethical issues which are relevant
here:
(1) The auditors must ensure that they do not find themselves in a position where they are to be
auditing their own work (a self-review threat).
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(2) The auditors must not breach the IESBA's general rule that they should not make
management decisions on behalf of the company.
Preparation of the financial statements
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Given that management is responsible for the preparation and presentation of financial statements,
then it is the responsibility of management to determine how items are presented in financial
statements. The auditors must therefore ensure that they do not take management responsibility in
determining how the items are accounted for.
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However it is reasonable for a company to ask advice from its auditors on how to account for a
difficult item, so it is important for the audit firm to get the balance right. In this instance, the item
involved is substantial and likely to be material to the financial statements. Given that the company
has a tax policy in relation to them, it appears that this is not a new expense to the company, hence
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the provisions of IAS 8 Accounting policies, changes in accounting estimates and errors become
relevant. This states that a company should only change its accounting policy towards an item if
required to do so by an accounting standard, or if the change in policy would give a more reliable and
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relevant reflection of the substance of the transaction.

Tax deductible
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Whether the matters are tax deductible or not depends on the tax legislation of the jurisdiction in
which Xalam operates. If there is any doubt as to whether these expenses should be tax deductible or
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not, Dedza should recommend that Xalam obtains tax advice. Given that the matter is material, it may
or may not have a material effect on the tax charge reported in the statement of profit or loss. If
Dedza disagrees with the tax treatment of this matter, and the matter is material to the reported tax
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charge, then Xalam would have to modify its audit report over this issue.
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Answers 107
It is possible that these 'payments' are more like bribes to various parties to ensure that business
runs smoothly. Bribery is illegal and the auditor should clearly advise against such payments.
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Actions to take
The audit manager should clarify the nature of the chief executive's request.
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If the company has requested advice as a separate engagement and intends to pay separately from
the audit for this service, then it would be inappropriate to accept an engagement on those terms.
However, if this matter has been raised in the context of the audit service and it is clearly the giving of
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advice (for example, clarifying that under IAS 8 the accounting policy should not change unless fairer
presentation would result) rather than the provision of a management service, then it may be
acceptable for Dedza to give advice about the accounting issue.
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If the payments amount to a bribe, then this casts serious doubts on the integrity of the directors of
Xalam. The auditors should resign from their position. Xalam benefits from these payments in
receiving income from the related customer. This could constitute money laundering. Dedza must
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therefore make an appropriate money laundering report.
(iii) Pholey family
Carrying out transactions on behalf of a client
l.b
Particularly in the light of the money laundering requirements incumbent on accountants and
auditors, it is extremely ill-advised for auditors to carry out transactions on behalf of their clients, in
case they inadvertently carry out the crime of money laundering.
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In addition, being asked to carry out a transaction on behalf of a client might give rise to a suspicion
of money laundering that the accountant was required to report to the appropriate authority.
Actions to take
ate
Dedza should stop carrying out transactions for clients, however innocent they may have been in the
past, so as to avoid any suspicion or any problem arising.
Politically exposed persons (PEPs)
Esau's new position as a senior foreign government official makes him a politically exposed person
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(PEP). This increases the reputational risk for Dedza as there will be more publicity if something goes
wrong.
Actions to take
tud
The senior partner at Dedza should be alerted of the change in circumstances and judge whether the
firm should continue to act as advisors for Esau and the Pholey family given the increased risk. If the
relationship continues, the firm should take reasonable measures to establish the source of Esau's
wealth and conduct ongoing monitoring of Dedza's relationship with Esau.
as
Dedza should also ensure that it has a risk management system in place to determine whether
individuals are PEPs on acceptance or if circumstances change.
9 Clifden
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Top Tips. Part (a) was straightforward, requiring you only to explain some book knowledge in an area of the
syllabus that you should be very familiar with by this stage in your studies. Note that only two marks are available
for each part of the requirement. Part (b)(i) was a difficult requirement, and you would probably have run out of
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ideas before getting to eight marks. Try to generate as many ideas as you can, and don't be tempted to move on
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before you've used up your time allocation. Part (b)(ii) was probably easier than (b)(i). The important thing for both
of these parts was not to overlook the professional issues. The examiner likes candidates to think about the audit
from a commercial point of view as well as just a technical one.
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Easy marks. Part (a) contained marks just for showing your knowledge, so make sure you got these.
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108 Answers
Examiner's comments. As noted in previous Examiners' Reports, candidates seem to think that the 'ethics
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question' is an easy option, but the performance of candidates in this question continues to be disappointing. Some
answers to part (a) were sound, including a clear definition, and a number of practical suggestions. However, some
candidates could not provide a definition other than 'professional competence is when you are competent to take on
a professional engagement,' which does not add anything to what is given in the question.
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Answers to (b)(i) were often limited to brief comments relating to the client's lack of integrity, and the need to recall
the products. Many candidates missed the main point of the requirement, which was the auditor's duty to maintain
confidentiality, and whether that duty should be breached in this case in the public interest. A significant proportion
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of candidates focussed entirely on what the client should do in this situation, (better quality control, sack the
production manager, put a notice in newspapers, etc), and hardly mentioned the ethical and professional issues
relating to the audit firm at all. Although the mark allocation for (b)(ii) was lower than that of (b)(i), most candidates
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wrote the same, or more, for (b)(ii). Answers here tended to be adequate.
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Marking scheme
Marks
(a) Competence and due care
l.b
Generally 1 mark per comment from ideas list:
– Definition competence, including for example:
– Competence – attain knowledge/skills
– Competence – maintain knowledge/skills
– Definition due care
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– To ensure compliance: training, study support, QC, appraisals, etc
Max 2 marks for definition/explanation of term and 2 marks for compliance comments
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Maximum 4
(b) (i) Plastic ingredients
Generally 1 mark per comment/specific action to be taken:
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– Management lack integrity

– Encourage management to disclose
– Auditors' duty of confidentiality
– Consider law and regulations
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– Consider disclosure in public interest

– Legal advice
– Consider resignation
– Seek evidence/information re matter
– Impact on financial statements and planned audit procedures
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– Safety of staff attending inventory count

Maximum 8
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(ii) Audit of Cong Co

Generally 1 mark per comment/specific action to be taken:
– Conflict of interest – explain why
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– Disclosure to both parties

– Other safeguards (1 mark each max 3)
– Commercial considerations
Maximum 5
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Total 17
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Answers 109
(a) Professional competence and due care
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An accountant must have the knowledge and skill to offer a service based on current developments in the
profession. Having once attained the requisite level, he must then make sure that he maintains it, for
example by keeping up to date with changes in legislation, practices and techniques.
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The accountant must then actually act in line with this level of knowledge and skill, making sure that he does
in fact apply current practises and techniques, for instance. This would include practical considerations,
such as making sure there is enough time to do the work with due care, or ensuring that any staff being
used act with professional competence and due care themselves.
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Compliance by firms
Firms should only use staff who are competent to do the work assigned to them, as shown by a combination
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of professional qualifications and experience. This can be achieved by recruiting staff with the requisite
competence, or by providing training where it is needed.
The second element is quality control. Firms must ensure that all engagements are actually performed with
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due care. This would entail the use of review procedures, with more senior staff reviewing the work of junior
staff, as well as the use of hot and cold review.
(b) (i) Ethical issues
The fact that management has decided not to recall any of the contaminated products casts doubt
l.b
over its integrity. Its assertion that the risk of injury being caused is remote should be treated with
scepticism. Even in spite of there being a low level of risk, it would still be right for management to
announce the problem, so that customers could return any defective products. There is a risk that
concerns.
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management's assessment of risk may have been determined by commercial rather than ethical
The failure of Headford's quality controls in this regard, when taken together with these doubts over
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management's integrity, puts into question the quality of the control environment. This would affect
Clifden's assessment of control risk at the planning stage of the audit.
Clifden & Co should seek to persuade management to announce the problem to the public. If
management refuse to disclose it, then Clifden needs to weigh up its duty of confidentiality against
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the need to disclose in order to protect Headford's customers. The IESBA Code of Ethics states that
auditors should not disclose information to the public unless there is a legal right or duty to do so.
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements provides
guidance here. There may be industry-specific regulations in the case of children's toys, under which
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Clifden & Co may have a duty to report to a relevant statutory authority.

Even if this is not the case, there may be a duty to disclose in the public interest. This is a difficult
area, as it is not clear whether in this circumstance there would be sufficient public interest in
disclosure to override the auditor's duty of confidentiality. Clifden & Co would need to obtain more
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information about the contamination, and about the basis for management's assessment of the risk
of injury being 'remote'.
If it becomes clear that the issue is of sufficient severity and management still refuses to disclose it,
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then Clifden & Co should consider resigning from the audit as a last resort.
Professional issues
There is a possibility that a contingent liability already exists here. This will need to be considered as
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part of the audit planning process, taking into account the need to ensure that the requirements of
IAS 37 have been complied with.
There is a possibility that there will be some sales returns of faulty items, in respect of which Clifden
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needs to consider whether a provision might be required.

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Since the items were produced up to a month from the year end, there is a chance that some of them
remain in inventory. It may therefore be necessary to write off a significant proportion of inventory,
so Clifden needs to ensure that the correct adjustments have been made.
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There may also be a risk to the safety of audit staff attending a year-end inventory count. Careful
consideration needs to be given to this matter, perhaps with Headford making special provisions in
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110 Answers
order to keep any affected items safe. It may be that audit staff cannot attend the inventory count, in
which case there may be a difficulty in obtaining sufficient audit evidence in respect of inventory.
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(ii) Ethical issues
The principle issue raised is the possibility of a conflict of interests between the audit client, Headford
co
Co, and the potential client, Cong Co. There is likely to be a difference here between clients'
perceptions of a conflict of interests, and the reality for the audit firm.
The way to tackle any perceived conflict is to use disclosure so that the clients can see that it has
been dealt with. Clifden & Co should tell each company about the services being offered to the other
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in respect of which they might perceive there to be a conflict. The audit of Cong Co should only be
accepted once both companies have given their consent.
It would also be wise from a commercial point of view to provide the firms with information about
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how any potential conflict of interest would be prevented from arising. This would include informing
them of the following safeguards, which should be implemented if both audits do go ahead.
 Each audit should have separate engagement teams
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 Engagement teams briefed clearly on the need to ensure confidentiality
 Review of safeguards by an independent partner
Professional issues
l.b
In the event that the firms do not consent to Clifden & Co auditing both of them, the decision as to
which firm to audit needs to be made on commercial grounds. On this basis, Cong Co is a much
larger company to which some non-audit services could be sold, so higher fee income could
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probably be generated than from the Headford audit. However, since the overall profitability of the job
would depend on the costs involved, the decision could only be taken once more detail is known
about exactly what would be involved. Given the professional and ethical doubts that exist over the
audit of Headford Co, it is likely that the Cong Co audit would be the more attractive.
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Clifden & Co also needs to consider whether it has sufficient resources to audit a company as large
as Cong Co, particularly if both companies were to be audited together as the strain on resources
would be greater as a result of having two separate engagement teams.
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10 Hawk Associates
tud
Top tips. Break each section of this question into discrete parts. As noted below, some parts are easier than others
and there are easy marks to be had. If you break each part down, you can ensure that you gain the one or two
marks available for each little section and gain good answer coverage. For example in part (a), focus on cold calling,
then on second opinions, then on free services. There are three areas for five marks, so if you comment on each,
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you should pass this section of the question. The answer below has been broken down into sections indicated by
the subheaders. If you indicate your answer has been so broken down, then it is easier for a marker to give you
marks in each section.
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Easy marks. Each of these segments contains an item which has basic ACCA or IESBA guidance connected with it
which you should be able to outline. For example, in (a), if you are not sure about cold calling, you should have
learnt the rules about second opinions. In part (b), you might be unsure about contingent fees, but you should
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know the rules concerning an advert. You will gain easy marks outlining the guidance relating to each of these
items.
Examiner's comments. The question called for an extension of lower level auditing knowledge on obtaining
professional work in the areas of advertising, fees and firms' names. Easy marks were thrown away if candidates
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did not state one way or the other whether each of the proposals was suitable.
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In part (a), most candidates knew little about 'cold calling'. Many homed in on second opinions, but incorrectly
supposed that a free audit was being offered. Candidates should not drop jargon into their answers which they do
not properly understand.
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Answers 111
In part (b), although most candidates had some idea of the basic rules on advertising, few were able to relate them
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to the suggested advertisement and thereby explain why it was inappropriate. However, candidates who took time
to sift through the wording for ideas earned good marks.
Few candidates observed in part (c) that offering such a wide range of services conflicted with the increasing
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restrictions on the provision of non-audit services set out in the opening paragraph of the scenario.
Marking scheme
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Marks
Generally 1 mark each comment
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Ideas
– Whether prohibited
– Permitted (ACCA)
– Commercial/competitive practice
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– Fundamental principles apply
– 'Free' – when permitted
– Second opinions – discouraged
l.b
Tax planning advertisement
– Advertising restrictions
– The 'best'?
– How ensure?
– Assertion of 'all'
– Exposure to litigation
– Contingency fees
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Business cards
– Where advertised
– Size of advertisement
– Use of ACCA name
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– PROFESSIONAL
– Range of non-audit services
– Basis of asserting 'competitive rates'
– 'Money back'
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– Cannot guarantee opinions

(a) Maximum 5
(b) Maximum 6
(c) Maximum 4
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Total 15
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(a) Cold calling and second opinions

Cold calling
ACCA's general rule about advertising is that 'the medium used should not reflect adversely on the
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accountancy profession'. Cold calling is generally unpopular, but this does not necessarily make it
unprofessional. However, advertisements must be in line with ACCA guidance that it should not discredit
other members of the profession by claiming superiority for the member's own services, it should not be
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misleading and it should be legal, honest, decent, clear and truthful.

Cold calling itself is legal (in many states) and there is no reason why it should not be honest and truthful.
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However, it may present a problem in terms of clarity, as it is oral and therefore there is scope for
misunderstanding on the part of the companies being rung, and the customer being misled. In addition, any
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advertising technique that results in harassment is inappropriate.

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112 Answers
Specifically, as we shall see below, cold calling about second opinions may discredit other members of the
profession.
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Second opinions
A second opinion is where a company is unhappy with the audit opinion that the auditor has proposed and
therefore seeks an opinion from a different firm of auditors as to whether another audit opinion might be
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possible.
If a client requests a second opinion from an auditor, it is generally considered acceptable to give one if
certain conditions are met. These are that the second firm of auditors communicates with the first set to
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ensure that they have access to all the information (to ensure that the second opinion is not formed
negligently) and the two firms of auditors communicate frequently during the process to ensure that the first
firm are not pressurised into giving a second opinion.
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However, an audit firm offering to give second opinions does not appear to be so acceptable. This
immediately gives the impression that all audit opinions are negotiable, and automatically puts pressure on
the first firm of auditors. If the second firm is under pressure to give a different opinion (otherwise the
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service they have offered is negligible) then different opinions might be formed negligently.
In addition, the service they are providing discredits other auditors as it makes the suggestion that such a
service is necessary, that is, that other auditors may have drawn incorrect or inappropriate audit
conclusions.
l.b
Free service
Offering a free service is not prohibited so long as the client is not misled about the potential fees for future
services.
Conclusion
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In general terms, cold calling potential customers is not inappropriate for an audit firm. However, if it is
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used, it should be done so with great care so as not to mislead potential customers. It would probably be
appropriate for small services other than audit-related services. Specifically, auditors should not offer
services to give second opinions as this discredits the profession.
(b) Tax planning advert
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Tax planning
Tax planning is an important part of many accountancy firms' portfolios. People in business want to operate
tax efficiently and it is a perfectly legitimate service.
Advertising
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ACCA's guidance on advertising was outlined above. It must not discredit the services of other accountants,
it must not be misleading and it must not fall short of the British Code of Advertising Practice, meaning that
it must be legal, decent, clear, honest and truthful.
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In this advert, Hawk Associates claim to give 'the best' tax planning advice, which both implies the services
of others are not as good (in other words it discredits them) and also may not be a claim they can live up to,
opening the firm up to liability. In addition, the advert promises to consider 'all' the tax planning options
available, which is an exaggerated claim and may also open them up to liability if they do not achieve this
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promise. In other words, the advert exaggerates the extent of Hawk Associates' service and is therefore
potentially misleading.
In addition, the advert could imply to a potential client lacking in integrity that legitimate taxes might be
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avoided, and while the advert does not make any illegal suggestions, it could be read to mean that taxes can
be avoided by any means (ie, potentially illegally). The firm should ensure that it is seen to uphold the
professional standard of integrity.
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Answers 113
Contingent fees
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The advert offers a contingent fee (that is, a charge will only be made if a tax saving is made). Contingent
fees on assurance work are prohibited because the risks to independence are too great to be safeguarded
against. Tax consultancy is not assurance work and there are circumstances in which the IESBA would
allow contingent fees for non assurance work. The firm should consider issues such as the range of fee
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amounts (which could be a substantial range), the degree of variability, the basis on which the fee is to be
determined, whether the outcome of the work is to be reviewed by a third party (it is likely to be reviewed by
tax authorities) and the effect of the transaction on any assurance engagement performed.
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Given that audit clients might want to take up such an offer and that the work is likely to be scrutinised by
the tax authorities, it is unlikely to be appropriate to offer contingent fees for work of this nature. If
contingent fees were offered, then safeguards would need to be put into place by the firm, and the extent of
these safeguards could not be explained in an advert of this size, making the advertising of the fees (or lack
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of them) potentially misleading.
Conclusion
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The advert breaches the ACCA's guidance as it discredits other members. It is misleading as it implies a
level of service which the firm cannot guarantee and therefore exposes the firm to liability. In addition,
contingent fees are likely to be inappropriate as audit clients might accept this offer.
(c) Business cards
l.b
Use of ACCA designation
Hawk Associates are unlikely to be entitled to refer to themselves as Hawk ACCA Associates without
permission from the ACCA, which is unlikely to be given. The firm is entitled to refer to itself as Hawk
Use of the word professional ria

Associates, Chartered Certified Accountants, if 51% or more of the partners are ACCA members.
The highlighted use of the word professional appears inappropriate. Firstly it implies that other accountants
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are not professional, which is discrediting to the profession. In addition, the fact that Chartered Certified
Accountants are professional is implied; it is not an additional selling point.
Competitive rates
There appears to be little basis for advertising that rates are competitive – with whom? for what? and it
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would be better to advertise that fees are reasonable and can be discussed in detail with the firm.
Money back guarantees
It is unclear in what circumstances a client would receive money back but it appears to be a claim that a firm
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of accountants should not make. A guarantee to give money back is akin to receiving a loan or dealing in
contingent fees and it is inappropriate for a firm providing assurance services.
Location of advertisement
In principle, there is no issue in advertising in the local supermarkets and libraries where local businesses
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and tradesmen advertise. However, the brevity of the advert could lead to it being misleading due to the
complexity of some of the services being offered, and it might be more advisable to run expanded adverts in
different media.
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Conclusion
The advertisements are inappropriate as they imply a discredit to the profession, they are potentially
misleading and they should not offer money back guarantees.
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11 Grape
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Study text reference. Chapters 9, 6 and 2.

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Top Tips. The scenario gives you the figures to calculate materiality in a fairly obvious way (by stating that the 'draft
financial statements show revenue of $12.5m, net profit of $400,000, and total assets of $78m'). This is almost
always a hint that you're going to have to calculate materiality at some point in your answer, and the opportunity to
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do so comes up straight away in part (a)(i)'s requirement for 'matters to consider' in relation to audit evidence.
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114 Answers
These are easy marks, so to make sure you get them, calculate materiality, and then apply it to the scenario by
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stating whether or not the matter in question is actually material.
Part (a)(i) was a tricky requirement. If you read the question carefully, you could have noticed that it is asking for
the 'audit evidence you should expect to find during your file review' in relation to the 'training costs that have
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been capitalised'. In other words, you're being asked for the evidence that you would find for the training costs as
non-current asset additions in the year, given that the audit team have not yet realised that the accounting
treatment is wrong. This is tricky, but these questions do come up. When they do, it's important not to panic. Read
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the requirement very carefully – as long as you answer the requirement, you should get marks for every (correct)
thing that you say. Once you've understood the requirement correctly, it's actually a very straightforward question
on audit evidence.
Part (b) should have been straightforward, as there were plenty of points in the scenario that you should have
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picked up on. You should have been looking to pass this part of question well – but without exceeding the time
allocation for it!
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Part (c) did require you to go into quite a lot of detail about money laundering. If you have trouble remembering the
policies and procedures (part (ii)), then you could try just thinking of the sorts of procedures that firms could
implement in order not to get caught money laundering, as many of them are fairly common-sense.
Easy marks. There is one mark for just writing a conclusion to your answer to part (b), indicated by the word
l.b
'evaluate' in the requirement. As a general point, this examiner does like candidates to write introductions and
conclusions to their answers, so get into the habit of writing something, no matter how short.
As usual, make sure you get at least two of the four professional marks available in part (c).
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Examiner's comments. This question was the best answered on the paper. It was pleasing to see that many
candidates appeared to have read and understood the examiner's article on audit evidence and matters to be
considered, as the quality of answers was undoubtedly better than previous sittings. Most candidates could discuss
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the relevant accounting treatments with a degree of confidence, most determined materiality, and most could come
up with several specific pieces of audit evidence.
Approximately 10% of answers agreed with the accounting treatment for the capitalised training costs, which is not
allowed. A further disappointment was how few candidates considered any inventory held by Banana Co in relation
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to its insolvent customer, which would need to be considered in terms of obsolescence.

For requirement (b), the vast majority of answers were sound, with almost all candidates able to identify some, if
not all, of the quality control issues in the scenario. The lack of a planning meeting, inappropriate delegation of
work, poor direction and supervision were identified by most. Some candidates considered not only the most
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obvious issues from the scenario, but also the overall impact on the audit, and went beyond simply repeating points
from the scenario. However, some candidates failed to really evaluate the quality control issues, and did little more
than copy out sentences from the question, providing little explanation and development of the issue identified.
Requirement (c) was on money laundering. This topic seemed to polarise candidates. Well prepared candidates
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performed very well here, and while most candidates could at least define money laundering, a significant minority
of candidates attempted this requirement inadequately, if at all. Some candidates did not attempt this requirement.
Candidates are reminded that money laundering is a crucial issue that auditors must consider with every client
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engagement, and the anti-money laundering rules are an important part of the syllabus.
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Marking scheme
Marks
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(a) (i) Training Costs

Generally 1 mark per matter/evidence point:
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Matters
– Correct calculation and assessment of materiality
– Cannot capitalise training costs
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– Expenditure does not create an asset which the entity controls

– Potential qualification re disagreement
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Answers 115
Evidence Marks
– Schedule of costs (½ only)
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– Agree costs to supporting documentation
– Agree costs to cash book/bank statement (½ mark only)
– Cut-off procedure
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– Compare to budgeted cost
– Confirm cost to approved plan/budget
Maximum 6
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(ii) Trade receivable
Matters
– Correct calculation and assessment of materiality (max 1½ marks)
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– Receivable impaired
– Consider any inventory in relation to Cherry Co
– Potential qualification re disagreement
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– Impact of the two issues together on the audit opinion
Evidence
– Initial correspondence with administrators of Cherry Co
– Confirmation with the administrators
l.b
– Agreement to receivables ledger
– Recalculations of impairment losses
– Review of inventory schedules
(b)
Maximum
Quality control matters
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Up to 1½ marks for each point evaluated from ideas list, plus 1 mark for overall
6
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conclusion
– No audit planning meeting – lack of direction
– Absence of manager and senior – lack of supervision
– Junior assigned difficult audit work (goodwill and WIP)
– Junior helped out with inventory count – lack of understanding/supervision
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– Junior asked to challenge FD – inappropriate delegation

– Audit running out of time – poor planning?
– Changed sample size – inappropriate response to time pressure
– Changed item selected in sample – inappropriate response to time pressure
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Maximum 10
(c) Money laundering briefing notes
Professional marks to be awarded for format (heading, introduction, conclusion) – 1
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mark, and clarity of explanation – 1 mark

Generally up to 1½ marks for each explanation from list below:
– Definition of money laundering (1 mark)
– Examples of money laundering activities (½ mark each up to 3 marks)
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– Procedures – appoint MLRO

– Procedures – enhanced record keeping systems
– Procedures – know your client
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– Procedures – staff training

– Procedures – internal controls, monitoring and management of compliance
Maximum – technical 10
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Professional marks 4
Total 36
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116 Answers
(a) (i) Matters to consider
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Materiality
$500,000
Materiality on revenue: = 4%
$12.5m
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$500,000
Materiality on net profit: = 125%
$400,000
$500,000
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Materiality on total assets: = <1%
$78m
The training costs are not material to the statement of financial position. They would, however, be
material to revenue and profit if they were reclassified as expenses, turning a profit into a loss.
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Accounting treatment
The training costs are currently recognised as non-current assets. This is not in accordance with
IAS 16 Property, plant and equipment, which states that the costs of training staff should always be
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treated as an expense, as they do not meet the definition of an asset, which requires that the entity
has control of the asset. This is very unlikely to be the case with training costs, as the staff will
probably have the right to leave the company, meaning that Banana Co would not receive any
subsequent economic benefit from having trained them.
l.b
The training costs should be treated as an expense in the statement of profit or loss.
Audit opinion
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If Banana Co does not amend its financial statements, the audit opinion will be modified due to a
material misstatement. This would probably be an 'except for' qualification as the misstatement is
material but not pervasive.
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Evidence
The file should contain:
 A review of the nature of the expenses themselves to verify that they are classified correctly
and that they are in fact training costs
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 Testing of entries selected according to sampling procedures detailed in the audit plan to
supporting documentation, such as purchase invoices, and agreement of payment of related
payables to the cashbook and to bank statements
 Evidence that a sample (selected according to audit plan) of entries are included in the
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accounts in the correct period

Testing for completeness and that all invoices that should have been accrued for were in fact accrued
for.
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(ii) Matters to consider

Materiality for whole receivable
$30,000
Materiality on revenue: = 2.4%
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$12.5m
$300,000
$400,000
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$300,000
Materiality on total assets: = <1%
$78m
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The receivable is not material to the statement of financial position. It would, however, be material to
the statement of profit or loss if an impairment loss were recognised in relation to it.
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IFRS 9 Financial Instruments requires receivables to be recognised at fair value. The fair value of the
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Cherry Co receivable is the 25% that the administrators suggest it may be able to pay, ie $75,000.
$225,000 should therefore be recognised as an impairment loss in the statement of profit or loss.
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Answers 117
Calculating materiality for the impairment loss:
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$225,000
Materiality on revenue: = 1.8%
$12.5m
$225,000
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$400,000
This is clearly material to profit for the year.
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Inventory
As Cherry Co is a customer, it is possible that Banana Co is holding inventory or work in progress
that was ordered by Cherry Co. Grape & Co needs to ascertain whether this is the case, and if so
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whether the inventory can in fact be sold. If it cannot be, then it may be impaired and should be
written down, recognising the loss in profit for the year.
Audit opinion
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If Banana Co does not amend its financial statements, the audit opinion will be modified due to a
material misstatement. This would probably be an 'except for' qualification as the misstatement is
material but not pervasive.
l.b
If the misstatement in respect of the receivable is taken together with the misstatement in respect of
the training costs, the overall result may be that Grape & Co judges the statement of profit or loss to
be rendered meaningless (pervasive effect). In this case it would issue an adverse audit opinion.
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Audit evidence
 External documentation confirming the insolvency of Cherry Co and the possible repayment of
only 25% of the receivable
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 Confirmation from the administrator of the 25% to be paid, including an indication of when
this is likely to happen
 Agreement of the amount owed from the receivables listing to the ledger
 Review of inventory documentation, and evidence of enquiries made of management,
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regarding the value and the potential recoverability of any inventory relating to contracts with
Cherry Co
 Calculations regarding the amount to be recognised as an impairment loss
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(b) Selection of engagement staff

The fact that the junior had only worked on two audits before this is not a problem. However, it is important
that they be given work appropriate to their level of skill and experience. This does not appear to have
happened here, as detailed below.
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No audit planning meeting

The audit planning meeting, led by the partner, is a crucial part of the audit. It is the best way of giving the
team an understanding of the client, and should discuss both the overall strategy and the detailed audit plan,
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perhaps going into difficulties that have been experienced in previous years and which could come up again.
The discussion should focus on what individual members of the team need to do. This is particularly
important for less experienced and junior members of the team.
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Audit manager away

The manager should not have given the senior responsibility for the audit while they were away on holiday
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for three weeks. It is important that an audit is properly supervised, and it may have been more appropriate
for another manager to take responsibility for the audit.
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Senior busy
Not only is there a question mark over whether they have the experience to manage the audit, but the senior
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is also busy with other assignments and thus unable to devote sufficient time to this one. It is very important
that someone is available to supervise junior members of the audit team. This is not happening here.
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118 Answers
It is also possible that the lack of attention paid by both the manager and the senior has led to the
misstatements in respect of the trading costs and trade receivables not being picked up by the audit team.
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Junior auditing goodwill and inventory
Goodwill is a complex accounting area to audit, and should not be given to a junior to do. The same can be
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said of inventory and in particular work-in-progress. A junior is very unlikely to have developed the
judgement needed to audit these areas. This seems to be the case here, as shown by the junior's error at the
inventory-take (see below).
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Inventory-take
The junior helped the client's staff to count raw materials at the inventory-take, when they should instead
have been observing that the client's staff were counting them correctly and in accordance with the count
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procedures. This would seem to imply that the junior had not been properly briefed on their responsibilities
at the inventory-take, as this is a relatively basic error.
It is likely that more audit evidence will be needed to be done on inventory as a result of this error.
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Junior asked to challenge FD
It is not appropriate for a junior to be asked to challenge a client's finance director regarding an accounting
issue that they are unlikely to understand fully. This should have been done by either the audit manager or
the partner, as they would be in a position to understand the technical issues involved, and would carry
l.b
sufficient authority with the client to make the challenge effective.
Running out of time to complete procedures
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Pressure of time is an important contributor to audit risk. Audit time budgets should allow staff enough time
to complete the audit to the required quality. It is also possible that the lack of supervision of the audit
team's work has led to the audit being conducted inefficiently, with inadequate monitoring of progress and
discussion of issues as they arise.
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Reduction of sample sizes
It is clearly unacceptable to reduce sample sizes as a way of saving time. The sample sizes detailed in the
audit plan should have been designed to gather sufficient appropriate audit evidence. Reducing the sample
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size beneath this point increases detection risk, and the risk of the auditor giving the wrong opinion.
Basis of sample selection
Selecting a sample on the basis of the ease of finding evidence for an item, is not an appropriate basis.
Indeed, this might actively increase detection risk as it means by definition that those items for which
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evidence is not readily available, or might not even exist, are not tested.
Conclusion
The litany of failures above suggests that this engagement has not been adequately supervised, and that the
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audit work performed is inadequate in some areas. A detailed review should be performed so that any other
shortcomings can be addressed.
Doubt is also cast over the sufficiency of the firm's quality control procedures. This matter should be
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referred to the relevant partner for consideration.

(c) (i) Briefing notes for training session
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By: Audit manager

Subject: Money laundering
Introduction
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These notes explain what money laundering is, using examples of offences including those that could
be committed by an accountant. They also explain the policies and procedures that a firm of
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Chartered Certified Accounts should establish in order to meet its responsibilities in relation to
money laundering.
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Answers 119
Definition
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Money laundering is the process by which criminals attempt to conceal the true origin and ownership
of the proceeds of their criminal activity, allowing them to maintain control over the proceeds and,
ultimately, providing a legitimate cover for their sources of income.
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Explanation
The money laundering process has three stages:
1 Placement: getting money (usually cash) into the system in the first place. This could be by
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making bank deposits, making investments (eg in a unit trust), or through a 'front' business,
which is a legitimate business that is used to launder money (eg a betting shop, which
legitimately receives high levels of cash, could be used to deposit stolen cash).
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2 Layering: using lots of different transactions to create so many 'layers' of transactions
between the initial placement of 'dirty' money and the money that is taken out at the end, that
it is difficult to trace.
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3 Integration: extracting funds from the laundering system, and 'integrating' them back into the
world of legitimate and use-able money.
Examples of offences
l.b
 Handling the proceeds of criminal activities.
 Arranging the acquisition or use of criminal property. This may include becoming involved
with tax evasion.

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Tipping off – when the MLRO or any individual discloses something that might prejudice any
investigations
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(ii) Appoint a 'Money Laundering Reporting Officer' (MLRO) and implement internal reporting
procedures
The MLRO should have a suitable level of seniority and experience. Individuals should make internal
reports of money laundering to the MLRO. The MLRO must then consider whether to report to SOCA,
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and document this process.

Train individuals
Train individuals to ensure that they are aware of the relevant legislation, know how to recognise and
deal with potential money laundering, how to report suspicions to the MLRO, and how to identify
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clients.
Internal procedures
Establish internal procedures appropriate to forestall and prevent money laundering, and make
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relevant individuals aware of the procedures. Procedures should cover:

 Client acceptance
 Gathering 'know your client' (KYC) information
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 Controls over client money and transactions through the client account
 Advice and services to clients that could be of use to a money launderer
Verify client identities
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The firm must be able to establish that new clients are who they claim to be. They should verify the
identity of new and existing clients, and keep the evidence of this on file – typically, copies of
evidence such as passports, driving licences and utility bills. For a company this will include identities
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of directors and certificates of incorporation.

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Record keeping
Maintain records of client identification, and any transactions undertaken for or with the client.
Special care needs to be taken when handling clients' money to avoid participating in a transaction
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involving money laundering.

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120 Answers
Conclusion
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There are a number of ways that the accountant could become involved in money laundering. It is
important that a firm has adequate procedures in place to ensure that it does not fall foul of anti-
money laundering legislation, and that it ensures that these procedures are adhered to.
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12 Ingot & Co
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Top tips. This question for 20 marks on quality control is split further into five mini scenarios. You need to consider
each of the scenarios carefully and their impact on the firm's quality control policies and procedures. Remember to
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consider materiality where possible – you are given draft figures for revenue and total assets in the introductory
information so are expected to use them where relevant. Make sure that the points you make are succinct and well
explained and can be related to quality control. Use a separate sub-heading for each mini scenario and consider the
mark allocation against each one.
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Easy marks. This is a tough question and there are no easy marks as such. Make sure your answers are coherent
and logical for each mini scenario and this will help you to score marks.
l.b
Marking scheme
Marks
Implications of findings
Generally up to 1½ marks each (good) implication
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Specific finding ideas
– Relevant ISAs
(a) APs mandatory at planning stage (520) Maximum 4
(e) Subsequent events (560)
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– Materiality (ISA 320)

(b) Non-current assets 17% Maximum 4
(c) Receivables 58% Maximum 4
(d) Inventory 1.25% Maximum 3
(e) Prior period error 12.5% Maximum 5
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– Inappropriate procedures?
Inventory 'roll back' (immaterial)
– Inappropriate timing
External confirmations (ISA 505) – too late?
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QC at audit firm level ideas/Conclusions

– Professional behaviour
– Skills and competence
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– Assignment/delegation
– Consultation
– Acceptance of clients
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– Monitoring
Total 20
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(a) Analytical procedures

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Analytical procedures can be used at all stages of the audit, but ISA 520 Analytical Procedures states that
they must be used at the planning and review stages. At the planning stage, analytical procedures are a very
useful tool as they assist in identifying areas of potential audit risk and therefore help direct the approach
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that the audit will take.

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Answers 121
The audit plan should have been prepared by the audit supervisor and reviewed by the audit manager and
partner. It should have been finalised before the commencement of the audit. The fact that the AIC has not
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signed off the planning checklists indicates that the memo might not have been finalised. This may mean the
audit plan is not sufficient to ensure the audit is completed adequately and competently.
(b) AIC's review
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The audit senior appears to have been assigned to low risk tangible non-current assets which comprise 17%
of total assets. Audit work on receivables on the other hand has been assigned to a trainee – this is a more
risky area of the financial statements as it comprises 58% of total assets and has doubled from the previous
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year.
The plan appears to be significantly flawed which is likely to result in a poor quality and perhaps even
negligent audit. It is implied that the partner has not reviewed the plan which it is her duty under auditing
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standards to do.
It is also doubtful whether the audit is being suitably supervised since the AIC is working on three other
assignments at the same time and it is unclear whether sufficient time has been spent on the audit of
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Argenta.
(c) Trade receivables
A receivables confirmation is a common method used to obtain audit evidence of the amount outstanding at
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the year end of a sample of receivables. However, given that it is now several weeks after the year end and it
may take a while to obtain all the responses from the confirmation requests, the team should have
considered whether other audit procedures to provide evidence of this material balance would have been
more suitable in the circumstances, eg after-date cash.
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There is also an indication that the trainees are not being adequately supervised and their work reviewed.
This should have been done on a continuing basis throughout the final audit.
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(d) Inventory
Inventory comprises an immaterial balance in the financial statements of Argenta (1.25% of total assets).
The audit approach used – tests of controls and roll-back – is therefore unsuitable for such an immaterial
and low risk balance.
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Adequate planning, including preliminary analytical procedures, would have identified a far more suitable
audit approach for this account balance. Also adequate review of trainees' audit work by the senior and AIC
on a continuous basis would have identified areas of concern.
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(e) Events after the reporting period

This is a material subsequent event (the settling of litigation) which occurred before the signing of the prior
year's audit report was not picked up. This is a quality issue as it suggests that somebody did not properly
complete the subsequent events procedures as required by ISA 560 Subsequent events before the audit
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report was signed. Alternatively it could be that the procedures were carried out and management
deliberately or in error gave audit staff the wrong information about the litigation, or that the matter was not
referred to in the representation letter (which would be a different quality control problem, as under ISA 580
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Written representations, this matter should have been referred to in a written representation from
management).
As this matter is material to the financial statements, this error does require adjustment in the current
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financial statements in accordance with IAS 8 Accounting Policies, Changes in Accounting Estimates and
Errors. The AIC should therefore appraise the client of the situation so that the financial statements can be
adjusted.
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If management fail to adjust the financial statements and the matter is material, this would result in Ingot
having to modify the 20X8 audit report, because the provision should have been recognised last year, so the
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current year statement of profit or loss is incorrect.

If this matter was included in the written representation last year and was incorrect, the auditors must
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consider the effect this has on the quality of representations made by management in the current year's
audit and must also consider whether it means that there was a lack of sufficient evidence about the prior
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122 Answers
year figures that would lead either to more work being required to substantiate the comparatives, or a
modified audit opinion in respect of the comparatives. It might also lead to the need to report by exception
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on the fact that the auditors were not given all the information and explanations they required for their audit
in respect of the comparatives.
This situation is likely to result in additional audit work being carried out (as discussed above) and therefore
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it is possible that the audit engagement partner will have to allocate additional staff to the audit for 20X8.
Lastly, the audit partner should ensure that the year-end 20X8 audit is carried out more effectively. Attention
should be paid in particular to the written representation from management and to the subsequent events review.
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13 Nate & Co
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Top tips. In part (a) it is important to make your answer specific to the scenario, it is not just a straight 'textbook
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knowledge' requirement. In parts (b) you need to focus on explaining and discussing the issues, it is not enough
to state facts from the question or to quote from the Code of Ethics and Conduct. You need to apply your
knowledge to the facts given and show that you understand why they may be seen as problematic. In part (c) it is
important to notice that you are not merely being asked for a definition but you must also link this with the
l.b
quotation given in the question.
Easy marks. There are not many easy marks to be found in this question – each requirement demands professional
judgement and application of knowledge. The basic definition in part (a) and the broad issues relating to the
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acceptance of the appointment are probably the easiest elements.
Examiner's comments. Requirement (a) asked candidates to define money laundering and to state procedures
relevant to money laundering that should take place on the acceptance of a new audit client. Candidates appeared to
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have prepared for the topic of money laundering, as the definitions were usually sound. Unfortunately, few
candidates could provide many, if any, specific procedures. A significant minority of answers suggested that Fisher
Co should appoint an MLRO, totally misunderstanding the facts of the scenario, ie that Fisher Co is a potential audit
client, not a firm of auditors. Only the best answers discussed 'know your client' procedures, and the need for
clarification in the engagement letter of matters to do with money laundering.
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Candidates should remember to allocate their time carefully between question requirements. Most scripts contained
answers to requirements (a), (b) and (c) of a similar length, when it is clear that the mark allocation differs
significantly for requirement (b).
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Marking scheme
Marks
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(a) Money laundering

Definition – 1 mark
Procedures – generally 1 mark each
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Ideas list:
– Client identity
– Client business activity
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– Client address
– Client principal shareholders and directors
– Engagement letter clarification
Maximum 5
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(b) Ethical and professional issues

Generally 1–1½ marks per issue explained
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– Extra work on control deficiencies

– Review work of internal audit
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– Expand audit testing

– Cost/budget implication
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Answers 123
– 2 partner review
– Lack of supervision and direction
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– Lack of understanding of extent of responsibilities
– Inappropriate advice
– Provision of non-audit service
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– Safeguards
Maximum 9
(c) Ethical and professional issues
Generally 1–1½ marks per issue explained
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– Perception of bribe
– Modesty of gift
– Interference with count procedures
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– Review of work performed
– Possible reperformance/alternative procedures
– Lack of professional behaviour
QC issues
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–
Maximum 6
20
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(a) Money laundering
Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the
providing a legitimate cover for their sources of income.

Money laundering procedures – before acceptance
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proceeds of their criminal activity, allowing them to maintain control over the proceeds and, ultimately,
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The firm should carry out client identification procedures, such as:
 Obtaining evidence that the client exists, such as looking at the certificate of incorporation and
establishing the identities of all directors (Mr Fisher and any others) by taking copies of passports or
driving licenses
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 Conducting a Companies House search on Fisher Co

 Confirming the registered address (by obtaining headed paper)
 Obtaining a list of shareholders and directors
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Money laundering procedures – after acceptance

The firm should obtain 'know your client' information, such as:
 The expected patterns of Fisher Co's business, are there peak seasons for selling wooden storage
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boxes, are there any major clients or suppliers?

 The business model of the client (in this instance Marcellus Fisher appears to be acting individually
through a company – does he own any other companies and what activities do they have?)
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 The source of the client's funds (is Mr Fisher the only investor, or are there others, does the company
also have debt finance and, if so, from whom?)
The firm should include a paragraph about money laundering responsibilities in the engagement letter.
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(b) CF Co
Ethical and professional considerations in connection with audit
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There seems to have been a failure in quality control over the planning of the audit if an audit junior found
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time to spend three hours offering informal advice on the systems rather than carrying out planning work.
As an audit junior, he should have been supervised, and the senior member of staff should have prevented
him giving this informal advice.
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It would have been appropriate for the audit team to make formal advice on systems in a management letter
that was therefore reviewed by the audit partner and documented between the parties. The informal advice
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124 Answers
given was inappropriate and does create the possibility that the firm will be liable if the advice was found to
be inappropriate.
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The audit junior appears to misunderstand his role on the audit team and therefore should be given
additional training in what is expected of an audit junior. The firm's initial training procedures should be
reviewed to see if this is a general failing of that training.
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The errors in the system will also have an impact on the audit which the firm should consider and take steps
about. The increased control risk over cash deposits from customers should lead to extended testing in this
area, which is likely to be significant to CF Co. Due to the problems in controls, additional substantive testing
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should be carried out.
The extent of the problems in controls should be determined, to discover if the problem is more widespread
than cash deposits and whether it continued throughout the year. The auditors should review internal audit's
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work to assess this, and the materiality of the errors should be documented. Then the approach to any other
areas affected should be documented.
The industry is highly regulated and such breaches might result in the need for the firm to report the client
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to the Financial Services Authority. This would also lead to the need to qualify the audit report for non-
compliance with laws and regulations.
The failure to record client monies correctly is also an indication that money laundering might have
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occurred, and this suspicion should be raised in a report to the firm's money laundering reporting officer,
who must review the evidence and determine whether to make a report to SOCA.
Ethical and professional considerations in connection with proposed review
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When considering whether to accept an additional service at an audit client, the firm must consider whether
it will adversely impact on the independence of the audit. Two key things to consider are:
(i) The nature of the work
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(ii) The fee level
In this instance, the firm have been asked to carry out a review of the financial information technology
system as a result of errors found in it by the internal audit department, with a view to improving it. The firm
must make sure that it follows the guidance of the Code of Ethics and conduct in relation to non-audit
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services provided to audit clients.

The auditors are likely to review the IT systems and possibly rely on them as part of their audit, so carrying out an
engagement to improve the systems represents a self-review threat. The firm should assess whether the risk is
too great for the firm to take on the engagement, or whether appropriate safeguards might be applied.
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In this instance, appropriate safeguards might include using staff not involved with the audit to carry out this
engagement. The firm would have to ensure that the staff members used are suitably qualified. The audit
junior, who is a recent IT graduate, appears to be qualified to be involved in such an engagement. If he were,
he should not be involved with the audit again.
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If the firm decides it can reduce the self-review threat to a reasonable level to accept the engagement, then it
must consider whether a self-interest threat is raised by taking on additional work for the same client.
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As the review would be a one-off exercise, the fees would also be a one-off amount and would not affect the
recurring fee income from the client. As a result, it is unlikely to threaten the independence of the audit
sufficiently to decline the engagement.
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(c) LA Shots Co
Control problems
It is a problem in the control over the inventory count that the office party was scheduled to start 'at the end
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of the inventory count', because it meant that the staff involved in the count were motivated to complete the
count quickly rather than well. It would have been better if the party did not start until a specified later time.
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The control environment for the count appears to have been poor, as the person in charge of the count
seems keen to get it finished fast, with the implication being that this was rather than well. She may also
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have been unaware that it is inappropriate to offer gifts and hospitality to auditors, but this should be
communicated to her.
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Answers 125
Giving inventory away during the inventory count is also a sign of poor controls, as ideally there would be no
unnecessary movements of inventory during the count.
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Due to these problems with controls, it might have been appropriate for the auditors to have extended samples and
taken longer over their procedures due to the higher control risk, but in the event, they did the opposite.
Ethical problems
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The Code of Ethics states that a gift or hospitality from a client affects independence unless it is clearly
insignificant. In this case, while bottles of juice and attendance at an office party may seem insignificant,
whether they were or not should have been determined by a more senior member of the audit team than the
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juniors, probably their manager. Given that the juniors accepted the incentives and then appeared to be
motivated by them, their independence does appear to have been compromised.
These matters should be discussed with the juniors and disciplinary action taken, particularly if they
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attended the party in work hours without permission from their manager.
Quality control
The fact that two audit juniors with so little understanding of what they should have done on being offered
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incentives, were sent out on this inventory count may be a sign that it was not planned or reviewed properly.
Possible action to take
As the inventory count was carried out so recently, it is probable that the firm could carry out other
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procedures now in order to ensure that they can rely on the figure for inventory in the financial statements if
the manager determines that it is not possible to rely on the work carried out by the juniors. The work
should be reviewed and concluded on as a point of priority to determine this.
14 Wexford ria
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Top tips. Part (a) contained a lot of matters for you to consider, both audit risks and ethical issues. The mark
scheme offers up to two marks per matter that is identified and explained, and restricts the number of identification
marks to three out of ten. You should therefore be looking to get at least three identification marks, but it is crucial
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here that you explain your points fully and clearly.

Part (b) was more difficult. ISA 510 is not examined very often, so you may have struggled to recall its specific
requirements. Here the number of marks available for general points on ISA 510 is capped at two, and you needed
to concentrate on applying your knowledge to the audit of inventory in this situation. Although you aren't told in the
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question that there is this cap on marks, in paper P7 you should always be looking to apply your knowledge to the
scenario. If you did this, you should have been able to score well.
Easy marks. There were some fairly easy marks in part (a) for things that almost come straight out of the scenario,
such as the issue of unaudited opening balances, or the potential limitation on the scope of the audit.
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Examiner's comments. This was the most popular of the optional Section B questions. Unfortunately candidates'
obvious lack of knowledge of the requirements of ISA 510 on opening balances meant that for many this was
actually an inadequate choice of question.
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Requirement (a) involved a new potential new audit client, and candidates were asked to identify and explain the
matters that should be considered in deciding whether to accept the audit appointment. Candidates who had
practised previous similar exam questions would have been well prepared, and there were many sound answers.
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Candidates were comfortable in discussing the specific ethical issues relevant to the scenario including self-review,
confidentiality and conflicts of interest, and it was good to see a good number of answers refer to the requirements
of ISA 210 on audit preconditions, which had been the subject of a recent Examiner's article.
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Some answers were not made specific to the scenario, and discussed general matters such as resourcing, fees and
engagement letters. It was interesting to see so many candidates being overly critical of the client's part-qualified
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accountant, who was often accused of incompetence, lack of integrity, and even fraudulent activities.
Requirement (b) dealt with opening balances and was inadequately answered by the majority. Some candidates
could explain the audit procedures required by ISA 510, but few could recommend more than a couple of specific
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procedures in relation to the opening balance of inventory as specified in the requirement.

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126 Answers
Many answers gave procedures for non-current assets, receivables and cash which were not asked for, and many
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forgot that the company in the question had not been audited before, leading to irrelevant discussion of 'previous
auditor's working papers'. Many suggested impossible procedures, eg 'reperform last year's inventory count' and
very few picked up on the major issue of obsolescence given the company's inventory comprise calendars and
diaries.
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Marking scheme
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Marks
(a) Acceptance issues
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Up to 2 marks per matter identified and explained (max 3 marks for identification):
– Initial engagement – higher risk
– Lack of internal control – higher risk
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– Non-audit service – ethical issue
– Cashflow statement – management lack understanding of responsibility
– Conflict of interest – ethical issue
– Limitation on scope – precondition not met
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Maximum 10
(b) ISA 510 requirements
1 mark per principal audit procedure (to max 2):
–
–
–
Read prior year financial statements
Determine whether brought forward correctly ria
Determine whether appropriate accounting policies applied to opening balances
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– Specific procedures on certain items eg if risk of material misstatement
– Review for consistency of accounting policies in current period
1 mark per procedure specific to opening inventory (to max 6):
– Review records of prior year inventory count
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– Reconcile results of current year inventory count back to opening balances

– Analytical procedures on gross profit
– Sales value confirmation for items in opening inventory
– Discussion with management re any inventory write offs relevant to opening balances
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– Review of management accounts for any inventory write offs relevant to opening balances
– Analytical procedures such as inventory turnover periods
Maximum 8
Total 18
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(a) First year audit

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The fact that this is a first year audit means that the opening balances on Wexford Co's statement of
financial position have not been audited. Sufficient appropriate evidence must be obtained about these
balances. If this cannot be obtained, then this is likely to lead to a modified auditor's opinion.
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Internal controls
Wexford is a small owner-managed business, with only one part-qualified accountant. Internal controls are
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therefore likely to be weak, with limited scope for segregation of duties, for example. There is a high risk of
management override of controls, with only one part-qualified accountant and owner(s).
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The effectiveness of internal controls should be assessed in line with ISA 315 Identifying and Assessing the
Risks of Material Misstatement through Understanding the Entity and Its Environment. If control risk is high,
then more audit evidence will need to be obtained.
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Answers 127
Accounts preparation
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The IESBA Code of Ethics states that there may be a self-review threat to independence and objectivity where
a firm prepares and audits financial statements for the same entity.
As Wexford Co is not a public interest entity, both services could be provided if safeguards are put in place to
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reduce this threat to an acceptable level. This might include the financial statements being prepared by a separate
team from that which conducts the audit. The firm must consider whether it has the resources to do this.
A further risk is that the firm becomes involved in making managerial judgements for the client. As long as
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the work undertaken is of a technical nature, this should not be the case. The auditor should be careful that
any adjustments to the amounts included in the financial statements are approved in advance by
management.
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Statement of cash flows
IAS 7 Statement of cash flows requires entities to prepare a statement of cash flows if they are to comply
with IFRS. If one is not prepared, then the financial statements will not have been prepared in accordance
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with IFRS. The auditor's opinion would therefore be modified – probably an adverse opinion.
The fact that Ravi has made this comment calls into question his knowledge of financial reporting, as well as
the strength of the control environment in place at Wexford. This may affect the assessment of control risk.
Conflict of interest
l.b
If the firm takes on the audit of Wexford, it will be auditing two direct competitors. This is a potential threat
to objectivity, and the Code of Ethics requires that the threat be reduced to an acceptable level by applying
safeguards. If the threat cannot be reduced, then the firm should either resign from its existing audit
assignment, or not take on the audit of Wexford.
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Safeguards would include disclosure of the conflict to both companies, and the use of separate engagement
teams for each audit. The firm would again need to evaluate whether it has the resources to do this.
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Potential limitation on scope
If board minutes cannot be accessed, there may be an inability to obtain sufficient appropriate audit
evidence.
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The auditor has the right of access to all information that is relevant to the preparation of the financial
statements, and ISA 210 Agreeing the Terms of Audit Engagements requires the auditor to obtain the
agreement of management to provide such information as one of the preconditions of accepting the audit
engagement. If management does not agree to this, then the engagement should not be undertaken.
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(b) ISA 510 procedures

ISA 510 requires that the auditor read the financial statements for information relevant to opening balances,
including disclosures.
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The auditor then obtains evidence about whether the opening balances contain misstatements that are
material to the current year's financial statements. The first thing to do here is to verify that he prior period's
closing balances have been brought forward correctly.
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The auditor then determines whether the opening balances reflect accounting policies in line with IFRS.
Specific audit procedures may then be performed in specific areas of the financial statements. This would be
required if there is a risk that the opening balances contain misstatements that could materially affect the
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current period's financial statements.

Finally, the auditor determines whether accounting policies are consistent between the opening balances and
the current period. Any changes must be accounted for and disclosed in accordance with IAS 8 Accounting
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Policies, Changes in Accounting Estimates and Errors.

Specific procedures for inventory
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 Inspect records of inventory counts held at the prior period end (31 July 20X0), to confirm that
opening inventory agrees to accounting records
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 Observe an inventory count at the current period year end (31 July 20X1) and reconcile closing
inventory quantities back to opening inventory quantities
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128 Answers
 Perform analytical procedures on gross profit margins, comparing the opening and closing gross
profit margins year on year for the various types of items held in inventory
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 Verify that inventory is held at the lower of cost and net realisable value. Test a sample of the values
of items sold in the current financial year of items held in opening inventory, and compare this with
cost
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 Inspect management accounts for evidence of inventory items written off in the current period. This
is important for inventory of calendars and diaries which are likely to be obsolete
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 Discuss with management whether there are any slow moving items of inventory within opening
inventory
 Perform analytical procedures such as inventory turnover calculations to highlight slow moving
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inventory from the opening balance
15 Spaniel & Bulldog
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Top tips. Part (a) represented a little bit of a twist on this issue. Usually one might expect questions on auditors and
fraud to require candidates to state that the auditor is not responsible for preventing and detecting fraud. While you
l.b
should have done this here, there was also the twist that the auditor appears to have been negligent in performing
the audit.
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Part (b) was difficult, and was actually a good reason for not choosing this question as one of your options. The
choice of optional questions is very important to whether or not you pass, and choosing this question is likely have
meant gambling that you would score enough on part (a) to offset your relative losses on part (b).
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That being said, it was possible to pass this part of the question with some fairly generic remarks on the audit of
financial instruments, mentioning things like the complexity of the accounting standards in this area and the
difficulty in determining the correct treatment.
Easy marks. Calculating materiality in part (a) was easy, as was listing out the three things to prove in order to
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prove negligence.
Examiner's comments. There were some excellent answers to requirement (a). The best ones clearly outlined the
factors that have to be proven to determine negligence, and applied them methodically to the scenario. Some
answers tended to only provide a rote-learnt description of responsibilities in relation to fraud, and usually failed to
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reach an appropriate conclusion. With little application to the scenario there is limited scope for marks to be
awarded.
On requirement (b), answers here were extremely mixed in quality. Satisfactory answers focused on why financial
instruments generally are difficult to audit, discussing their complex nature, the changing landscape of financial
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reporting requirements, the potential for both client and auditor to lack appropriate knowledge and skills, and the
frequent need to rely on an expert.
Inadequate answers did not include much reference to audit at all, and simply listed out financial reporting rules,
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with no consideration of audit implications other than saying that financial instruments are complex and subjective.
There were very few references to relevant ISA requirements, and little evidence that the audit of complex matters
such as financial instruments had been studied at all, even though it is a topical current issue.
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Marking scheme
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Marks
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(a) Fraud and auditor's liability

Generally up to 2 marks for each point explained:
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– Not auditor's primary responsibility to detect fraud unless it is

material in impact on financial statements
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Answers 129
– Determine that the payroll fraud would have been material (include
calculation)
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– Reasons why fraud is hard to detect
– Audit firm may not have been sufficiently skeptical
– Non-adherence to ISAs on controls assessment and evidence obtained
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– Discuss whether duty of care owed to client
– Discuss breach of duty of care
– Identify financial loss suffered and firm likely to have been negligent
Maximum 12
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(b) Audit of financial instruments
Generally up to 1½ marks for each point explained:
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Why is audit of financial instruments challenging?
– Financial reporting requirements complex
– Transactions themselves difficult to understand
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– Lack of evidence and need to rely on management judgement
– Auditor may need to rely on expert
– May be hard to maintain attitude of skepticism
– Internal controls may be deficient
l.b
Planning implications
– Obtain understanding of accounting and disclosure requirements
– Obtain understanding of client's financial instruments
– Consider internal controls including internal audit

– Determine materiality of financial instruments ria
– Determine resources, ie skills needed and need for an auditor's expert
– Understand management's method for valuing financial instruments

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Maximum 8
Total 20
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(a) Responsibilities
Detecting fraud is the primary responsibility of management, not the auditor. However, the matter is
complicated because the auditor is required to give reasonable assurance that the financial statements
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are not materially misstated as a result of fraud (or error). Moreover, auditors are required by
ISA 240 The auditor's responsibilities relating to fraud in an audit of financial statements to identify and
assess the risks of material misstatement due to fraud. This means that an audit conducted in line with
ISAs should obtain evidence specifically in relation to fraud.
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The audit process is, however, subject to inherent limitations which are particularly pertinent to the problem
of fraud. Fraud may involve sophisticated attempts at concealment, which can make it difficult to detect.
Furthermore, there may be collusion by management which makes the auditor's task even more difficult. It
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is therefore quite possible for the auditor to have conducted an audit in accordance with ISAs, but still have
failed to detect a material misstatement resulting from fraud.
Materiality
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The total amount stolen is 5.6% of total assets. If it was stolen at a constant rate, then 8/12 months fall
within the year in question, which is $3m or 3.8% of total assets. This is material, and appears to have result
in an incorrect auditor's opinion having been expressed.
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Conduct of audit
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Professional scepticism is a key weapon in the auditor's attempt to detect misstatements resulting from
fraud. The audit of Spaniel does not appear to have been conducted with an attitude of professional
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scepticism, possibly as a result of it being a long-standing audit client.

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130 Answers
However, irrespective of the auditor's specific duties in relation to fraud, sufficient appropriate evidence does
not in any case seem to have been obtained in relation to payroll. ISAs require the auditor to design and
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perform tests of controls in each period under audit. Substantive evidence should have been obtained in
relation to payroll. This is particularly important given that payroll is likely to be a material area.
On this basis it is apparent that the audit was not conducted in accordance with ISAs. The audit partner may
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therefore find it very difficult to defend the conduct of the audit.
Negligence?
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Three things must be proved for the auditor to be found to have been negligent:
 A duty of care existed
 The duty of care was breached
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 A financial loss resulted from the negligence
As there is a contract between Groom & Co and Spaniel, a duty of care can be shown to have existed (in this
case, to the shareholders as a body).
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The financial loss here would be the value of the theft, although it is not clear whether the auditor could be
held responsible for the full amount of the theft.
It is likely that Groom & Co were negligent, and that Spaniel would be able to prove this in court.
l.b
(b) Audit of financial instruments
Financial instruments themselves may be difficult to understand. Management themselves may fail to
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understand the risks involved with them, which may expose the entity to substantial risks.
Financial reporting requirements in this area can be complex, which increases the risk of misstatement. It is
possible that neither management nor the auditor will properly understand how the instruments should be
accounted for.
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Accounting for financial instruments may also involve an element of subjectivity, eg in determining fair
values. Fair values may be estimated with the use of models which will involve making assumptions.
Therefore is therefore a risk that the assumptions made by management are not reasonable.
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Given the presence of subjectivity, it is all the more important that the auditor is professionally sceptical in
this area, although this is likely to be difficult.
Alternatively, some financial instruments may be fairly simple to audit, eg where there is an active market, it
may be possible to agree fair values to a broker's report. This would of course be subject to the
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requirements of ISA 500 Audit evidence in relation to the use of a management's expert.
It may be necessary to make use of an auditor's expert, in which case the auditor must ensure that the
expert is independent and competent, and must evaluate the suitability of the expert's work as audit
evidence. This may not be straightforward to do, given the complexity of the subject matter. Using an
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auditor's expert may also have the effect of increasing the audit fee, which should be explained to and
discussed with the client.
Matters to consider
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The company's treasury management function has only been set up recently, so it is possible that there will
be problems in an area such as this. Internal controls may not be well established, so the auditor will need to
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spend time obtaining an understanding of them. This increases audit risk in this area.
Consideration should be given to the level of competence of staff in the new department. If they are skilled in
this area then they may be new to the company, in which case there may be difficulties integrating the
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department with the rest of Bulldog's finance function. Alternatively, there is a risk that staff do not have
adequate knowledge or experience in this area.
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It will be necessary to obtain an understanding of the kinds of financial instruments Bulldog uses to hedge
transactions, including Bulldog's reasons for entering into them and the kinds of risks it may be exposed to
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thereby.
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Answers 131
The materiality of the instruments should be considered, bearing in mind especially the possibility that
transactions with either no, or very little, initial value may turn out to have effects on the financial statements
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that are material. Some types of derivative financial instruments may fall into this category.
Management's method for valuing financial instruments should be considered, and the auditor must choose
whether to audit management's valuation model, or whether to construct a model of its own. This would
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depend on the assessed reliability of internal controls in this area.
16 Raven
o t.
Top tips. The main difficulty that many students will have faced with part (a) is that eight marks are available for
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what seems like quite a clear-cut issue. However, if you read the requirement carefully you will have seen that it is
not only about ethics, but the 'commercial and other professional issues' raised by the scenario. This question is
typical of the current examiner's approach to P7 in that it mixes together different areas – here, ethics and
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commercial matters. To answer this part well, you needed to know the main categories of ethical threat and then
think whether any circumstances in the scenario fell into any of these categories.
Part (b) may have been a bit easier, with seven marks for an issue that is clear-cut and that there is quite a lot to
write about. The main thing here is to be skeptical and question the information in the scenario – eg whether there
l.b
really is a connection between the surgeon's comments and the solicitor's letter. The best approach here is often to
break the scenario down into parts and take each one in turn.
Easy marks. Part (b) contains easy marks for just recognising that there may be a breach of law and regulations in
respect of the possibly unqualified surgeon.
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Examiner's comments. Sound answers to part (a) used a logical approach, being prompted by the question
requirement to discuss in turn the ethical issues, then commercial issues, then professional issues and leading to a
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set of recommended actions. Weaker answers tended to just list in bullet point format all of the possible threats to
objectivity without any real discussion or development of the threats specific to the scenario. Candidates are
reminded that the IESBA's Code of Ethics for Professional Accountants provides a framework for the evaluation of
threats to objectivity, including the identification of threats, the evaluation of the significance of threats identified,
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and the use of professional judgement in deciding whether the application of safeguards can reduce threats
identified to an acceptable level.
In part (b), most candidates identified that the main issues for the audit firm to consider related to a potential
breach of law and regulations by the hospital, and that the audit firm should consider disclosure in the public
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interest. Most answers identified that confidentiality was in issue, and that the matter should be firstly discussed
with those charged with governance.
Some candidates focussed on disciplinary action to be taken against the employee of the hospital, and on the
possibility that the hospital's management were somehow colluding with the employee to deliberately breach law
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and regulations and commit some type of fraud, which missed the point. Weaker answers also failed to consider
the financial statement and therefore audit implications of a letter claiming negligence, which could lead to the
recognition of a provision or disclosure of a contingent liability, and could potentially have going concern
implications. These matters were relevant as the audit was ongoing.
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Marking scheme
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Marks
For each requirement, generally 1 mark for each matter discussed:
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(a) Grouse Co
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Generally 1 mark for each matter discussed relevant to money laundering:

– Situation is a close business arrangement giving rise to threat to objectivity
– Explain self-interest threat
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– Explain intimidation threat

– Only acceptable if financial interest immaterial and relationship insignificant
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132 Answers
– Sale of software to audit clients would require full disclosure of financial benefit
– Sale of software to audit clients creates self-review threat
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– Sale of software perceived as providing non-audit service
– Risks heightened for listed/public interest entities
– If enter business arrangement must withdraw from audit of Grouse Co
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– Commercial consideration – demand for product
– Commercial consideration – experience of partners
Maximum 8
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(b) Plover Co
– Potential breach of law and regulations
– Further understanding to be obtained
– Consider potential impact on financial statements
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– Discuss with those charged with governance
– Management should disclose to relevant regulatory body
– Auditor could disclose in public interest
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– Issues with confidentiality
– Take legal advice
– Extend audit work in relation to the legal claim
– Risk of material misstatement
l.b
– Consider integrity of audit client
Maximum 7
Total 15
(a) Close business relationship ria

ate
Grouse Co's proposal would create very significant threats to Raven's independence.
This would be a 'close business relationship' per the IESBA Code of Ethics, and may give rise to self-interest
and intimidation threats. The Code states that unless the financial interest is immaterial, and the business
relationship insignificant, then no safeguards can reduce the threat to an acceptable level. Therefore Raven
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should not enter into this relationship if it still wants to be Grouse's auditor.
It should be remembered that independence includes independence in appearance. A joint venture with an
audit client would probably have a severe effect on how Raven appeared, so even if it had been acceptable
on ethical grounds, the fact that it looks so bad may well have ruled it out anyway.
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Selling to clients
In addition to the close business relationship, Grouse is also proposing that the software be sold to Raven's
audit clients. There are several issues here.
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Firstly, there is a self-interest threat to Raven's independence if its joint venture is selling to its clients. It
may be possible to reduce this to an acceptable level by using the safeguard of disclosing the relationship to
clients, along with the benefit that Raven would receive from any sales.
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Secondly, there would be a self-review threat if any of the audit clients used the accounting and tax software
to prepare its financial statements. It may be possible to use an auditor's expert here; however, accounting
software is usually pervasive to the internal controls over financial reporting, so it may be that the expert
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would have to be used to conduct most of the audit. This would be extremely expensive and impracticable.
Thirdly, the use of the firm's accounting and tax software could be seen as a non-audit service. This could
create a perception of taking on management's responsibilities. The risk would be greater still for clients that
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are public interest entities, and the firm should not be involved in any tax calculations for these clients.
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Taking into account these factors, Raven must choose between selling the software to its clients, and
continuing to act as their auditor. It would not be possible to sell this software to clients and continue to
audit them. Raven must therefore make a business decision to choose between the potential income from
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the software, and the loss of audit fees from every client to whom the software is sold. Raven should also
take into account the loss of the audit fee from Grouse itself.
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Answers 133
The software joint venture therefore represents a major diversification from audit to the preparation of
accounting and tax software. This is a major decision that must be considered very carefully, taking into
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account the firm's long-term interests, where its expertise really lies, and the potential risks from
diversifying into such an unknown area.
(b) Unqualified surgeon?
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The audit senior has heard that one of the surgeons has not finished his medical qualification. This may be
connected to the solicitor's letter that was later found which alleged medical negligence. As an auditor, we
need to deal with each issue separately.
o t.
ISA 250 Consideration of laws and regulations in an audit of financial statements states that compliance with
laws and regulations is management's responsibility, and that it is not the auditor's responsibility to either
prevent or detect it. However, if – as here – we become aware of possible non-compliance then we must
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consider its effect on the financial statements.
As auditors we have no expert knowledge of medicine, and it is possible that we may be jumping to
conclusions about whether the surgeon is qualified to do his work. It may be, for example, that he is a
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qualified doctor, and the 'medical qualification' he is hoping to finish is merely a further qualification that is
not a requirement for his work as a surgeon. Although he was glad that Plover did not check his references,
this could be a separate issue from whether or not he is qualified.
l.b
We must therefore obtain further evidence about this surgeon's qualifications, and whether they meet the
requirements for his job. This could entail simply reviewing the personnel file, which may contain evidence
about his qualifications.
Effect of unqualified surgeon
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If we find that the surgeon is not qualified to do his job, then we must consider the effect on the financial
statements. There are two main risks:
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(i) Risk of litigation resulting from errors made by the surgeon
(ii) Risk of action by regulatory bodies
In relation to (i), this is potentially a very serious problem. If the surgeon has made many errors then this
could result in multiple patients suing the company. The potential cost of these actions is not know, but
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could be very considerable indeed. It is even possible that Plover's ability to continue as a going concern
could be affected. Further evidence must be obtained about the extent of further errors and possible legal
actions. It may be necessary to obtain advice from our legal counsel.
In relation to (ii), the medical profession is highly regulated and it is possible that Plover will be fined by any
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relevant regulatory authorities. There is a legal question about whether Plover's management could be found
guilty of possible negligence as a result of breaking its duty of care to patients. It may be necessary to obtain
legal advice here.
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It is even possible that any licences which Plover requires to operate will be removed, and that its ability to
continue as a going concern will be in doubt. It may be necessary to use an auditor's expert here to advise of
the possible regulatory consequences, and/or to obtain legal advice.
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Control failure?
The surgeon's comment that his references were not checked raises questions about the effectiveness of
Plover's internal controls over recruitment. It will be necessary to obtain evidence about whether or not
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there are other employees in this position – the main issue being that there could be other employees (eg
surgeons) who are not qualified to do their work. Uncovering these could lead to the discovery of further
liabilities.
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Public interest?
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If the surgeon is not qualified, then it is possible that management will not disclose this to the relevant
authorities. In this case, it may be necessary to make this disclosure in the public interest. This is a difficult
issue to decide, as the auditor must balance the duty of confidentiality that is owed to Plover, with the duty
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to the public. Matters to consider here include the gravity of the situation, whether members of the public
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134 Answers
may be affected, and the likelihood of further non-compliance. This will all depend on whether the surgeon
was in fact unqualified, and on what impact this may have had on patients.
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Disclosure in the public interest would require careful consideration, and it may be necessary to obtain legal
advice before doing so.
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Legal claim
The letter that was found in the subsequent events review may be evidence of a liability under
IAS 37 Provisions, contingent liabilities and contingent assets. The key question is whether the event in
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question took place before or after the year end. The crucial date here is likely to be the date on which the
medical service was provided.
If the surgery was after the year end, then this is a non-adjusting event and no provision is necessary. If the
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surgery was before the year end, then a provision may be required. This will depend on how probable it is
that Plover will have to pay to settle the claim, with a provision being necessary if it is probable that a
payment will be made. If the matter is material and Plover's management refuse to make any necessary
provisions or disclosures, then it may be necessary to express a qualified auditor's opinion.
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17 Dragon Group
l.b
Top Tips. Part (a) is a relatively straightforward standalone requirement, which you should have been able to pass,
perhaps identifying and explaining three reasons, and simply identifying a fourth within the time available. Note that
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the model answer below contains five reasons, whereas only four are necessary to gain full marks (the extra reason
is provided to illustrate the style of answer required). Part (b) was probably the hardest part of this question. You
should try to strike a balance between making general remarks about what a tender document should include, and
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sticking to the specific information given in the scenario. There were four professional marks on offer here, making
it particularly important to structure your answer and express your points as clearly and concisely as possible. Part
(c) should have been straightforward provided that you knew what a transnational audit was. In our answer to part
(c)(i) we have provided three features, but only two were required to gain full marks.
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Easy marks. Parts (a) and (c) were standalone, knowledge-based requirements that you should have scored well
on.
Examiner's comments. In part (a)(i), too few candidates actually provided an explanation of the reasons they gave.
Secondly, the requirement asked for four reasons. It is a waste of time to provide more than the required number of
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reasons. In part (b), sound answers appreciated that the point of the tender document is to sell your audit firm's
services to the client. Those candidates who tailored their answer to the question scenario tended to do well.
However, candidates who provided a list of points to be included in any tender scored inadequately Weak answers
simply stated vague comments: 'we should discuss fees', 'we should set a deadline,' etc. Answer to the
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requirement for matters to consider re: acceptance were weak, despite this being a regularly examined syllabus
area. Most answers were not tailored to the question, and just provided a list of questions or actions. Requirement
(c) was the worst answered on the paper. Clearly, very few candidates had studied the issue of transnational audits,
and answers displayed a lack of knowledge.
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Marking scheme
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Marks
(a) Identify and explain using examples why an audit firm may not seek re-election
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Generally 1/2 mark for identification and 1 mark for explanation/example, any four:
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– Disagreement
– Lack of integrity
– Fee level
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– Late payment of fees

– Resources
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Answers 135
Marks
– Overseas expansion
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– Competence
– Independence
– Conflict of interest
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Maximum 6
(b) Contents of tender document
Up to 1 1/2 marks per matter described:
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– Outline of firm
– Specialisms
– Audit requirement of Dragon Group
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– Outline audit approach (max 3 marks if detailed description)
– QC
– Communication with management
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– Timing
– Key staff/resources
– Fees
– Extra services
Maximum 10
l.b
Matters to consider re acceptance
Professional marks to be awarded for clarity of evaluation, use of headings, and conclusion
based on points discussed.
–
–
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Generally 1/2 mark for identification – cap at max 3, 1 further mark for explanation, from ideas list.
Large and expanding group – availability of staff now and in the future
Use of overseas offices
4
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– Visits to overseas audit teams
– Skills/experience in retail/foreign subsidiaries consolidation
– Timing – tight deadline
– Mermaid Co – implication of prior year qualification
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– Minotaur Co – implication of different business activity

– Highly regulated – risk/additional reporting requirements
– Reason for previous auditors leaving office
Maximum 7
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(c) (i) Define transnational audit and relevance to Dragon Group

1 mark for definition
2 marks for relevance to Dragon Group
Maximum marks 3
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(ii) Audit risk factors in a transnational audit

2 marks per difference explained:
– Auditing standards
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– Regulation of auditors
– Financial reporting standards
– Corporate governance/control risk
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Maximum 4
Total 34
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(a) Reasons for not seeking re-election

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Disagreement with client

The auditor may have disagreed with the client in past, for instance over accounting treatments. There is a
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possibility that the relationship between auditor and client could break down, which would make very it
difficult to carry out the audit effectively.
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136 Answers
Resources
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An auditor may find that it lacks the resources to carry out an audit, perhaps because the client has grown
rapidly so that the firm lacks the staff to provide a big enough audit team.
Competence
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An auditor might believe itself not to be competent enough to carry out the audit, perhaps because the client
operates in an industry with highly specialised accounting requirements, in respect of which the firm lacks
the necessary expertise.
o t.
Ethics – management's integrity
The auditor might feel that it has reason to doubt the integrity of management, for instance because of a
breakdown in relationship, or an unproven suspected fraud. This would lead to a breakdown in the
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relationship between auditor and management.
Ethics – fee level
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The fees necessary to make a profit may have reached an inappropriate level, for instance 15% of total
practice income in line with ACCA guidance. If the fees are too high, there is considered to be an
independence problem because the audit opinion might be influenced by a fear of losing the client.
(b) Briefing Notes
l.b
To: Cameron Wells
From: Jennifer Meadows
Date: June 20X9
Subject: The Dragon Group
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These briefing notes outline the matters to include in our tender document for the Dragon Group audit.
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Fees
The proposed fee should be included, along with an explanation of how it is calculated. This would include
details of the charge-out rates of the staff likely to be used on the audit, along with estimates of the amount
of time the audit would be likely to take.
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Dragon Group's needs and how Unicorn & Co could meet them
(i) An explanation of the need for each subsidiary (as well as Dragon Co) to have its own individual
audit, and for the consolidated financial statements then to be audited too.
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That Unicorn & Co is a large firm and would be capable of auditing a large group such as this.
(ii) The Dragon Group may also need some non-audit services (see below).
That Unicorn & Co can provide a variety of non-audit services, should they be required.
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(iii) Several subsidiaries prepare accounts under local accounting rules, so the auditor of these
That Unicorn & Co is a global firm with offices in over 150 countries. It would well placed to audit
under local accounting rules, and to audit their consolidation into the group accounts.
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(iv) The Dragon Group operates in the furniture retail trade.

That Unicorn & Co has a specialist retail department and therefore has the experience to audit the
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group efficiently.
Proposed audit approach
This section should include a description of the methodology to be used in the audit. For instance:
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(i) How the firm would acquire knowledge of the business

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(ii) Methods used in planning and risk assessment

(iii) Procedures used to gather audit evidence
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Answers 137
Brief outline of Unicorn & Co
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A short history of the firm, including a description of its organisational structure, the services it can offer
and the locations in which it operates.
Other services
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A description of any other services Unicorn & Co can offer, such as offering advice in relation to the
proposed stock exchange listing. Careful consideration should be given to ethical requirements relating to
independence when offering other services to a potential audit client.
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Key staff
Details of the proposed engagement partner and of his experience that is relevant to this audit. Details
should also be given of the approximate size and composition of the audit team, together with a description
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of the relevant experience of key members of that team.
Communication with management
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An outline of the various communications will be made to management over the course of the audit. This
may include information on the way in which these reports could add value to the Dragon Group's business,
for instance the production of a written report on the effectiveness of internal control procedures.
Timing
l.b
Details should be provided of the timeframe envisaged for the various aspects of the audit. This might
include details of when the subsidiaries would be audited, when the consolidation process would be audited,
and an estimate of by when the group audit opinion could be completed.
Conclusion
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This is a large, transnational group, carrying a high level of risk. Unicorn & Co should take on the audit only
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once it is sure that it is able to do so, and is assured of a fee that adequately compensates it for the level of
risk involved in undertaking the audit.
Matters to consider before accepting engagement
Size of Dragon Group
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The Dragon Group is large and expanding group of companies, and would therefore require a high level of
resources to audit. Unicorn & Co must consider whether it has sufficient staff available to audit a growing
group of this size.
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Overseas subsidiaries
Half of the subsidiaries are located overseas. Unicorn & Co has a large number of overseas offices which
could perform some or all of the overseas audits. However, these offices may not all have specialist retail
audit departments, so consideration needs to be given to whether there is enough experienced staff to carry
as
out the audit.

If some of the overseas audit work needs to be done by auditors outside of Unicorn & Co, then this work
would need to be evaluated in order to express an opinion on the group financial statements.
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Relevant expertise
As Unicorn & Co has a department specialising in retail audits, it is likely that it will have sufficient expertise
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in this country.
As a large auditing firm, it is also likely that Unicorn & Co will have staff sufficiently experienced in auditing
the consolidation process to audit the consolidation of the Dragon Group's results.
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Time pressure
/fr
The group's year end is 30 September 20X9, and management wants the audit completed by 31 December 20X9.
This represents a tight deadline, given that the audit involves a large number of subsidiaries located in
several different countries and reporting under a number of different accounting rules. The fact that this
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would be the first year that Unicorn & Co would have audited the group also makes the deadline tight. There
is also a possibility that management do not fully understand what is required for an audit.
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138 Answers
Planned listing
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Management are planning a new listing on a foreign stock exchange. This will increase the risk of
management manipulation of the accounts, as management may under pressure to report favourable
results. Audit risk is also increased by the fact that as a result of the listing, the financial statements will be
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subject to heavy scrutiny by regulators.
Previous auditor
Unicorn & Co should consider the reason for the group seeking to change its auditor, as this might affect the
o t.
decision to accept the engagement. On the face of it, it appears likely that the quickly-growing group has
outgrown its previous auditors, but Unicorn & Co should still seek to obtain the reason for the change from
the previous auditors.
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Mermaid Co
Mermaid Co's previous auditors expressed a qualified audit opinion. Unicorn & Co should gather
information about the related contingent liability, part of which would involve contacting the previous
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auditors. Management's refusal to disclose the contingent liability may indicate a lack of integrity on their
part, which would increase audit risk. Consideration then needs to be given to whether any future non-
disclosure would be material to the group financial statements.
l.b
Minotaur Co
Minotaur Co operates in a different business area from the rest of the group, so Unicorn & Co must consider
whether it has staff available with the appropriate level of expertise. This difficulty should be straightforward
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for a firm of Unicorn & Co's size to overcome.
(c) (i) A transnational audit means an audit of financial statements which are or may be relied upon outside
the audited entity's home jurisdiction for purposes of significant lending, investment or regulatory
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decisions.
This will include the Dragon Group because it is listed on the stock exchange, and also because it is
listed on the stock exchanges of several different countries, and is therefore bound by regulations
emanating from more than one national jurisdiction.
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The fact that the group contains many overseas subsidiaries means that their accounts are likely to
be relied upon both at home and abroad, and so are transnational in nature.
(ii) Regulation and oversight of auditors differs from country to country
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In some countries audits are self-regulated, whereas in others a legislative approach is used. There is
a risk that auditors of transnational groups may not be sufficiently aware of the requirements in all of
the relevant countries.
Differences in auditing standards from country to country
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Although International Standards on Auditing are now in operation in many countries, these
standards are frequently modified by individual countries. Moreover, not all countries have adopted
the standards.
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There is a risk that auditors may not have the required understanding of the relevant auditing
standards in each country.
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Variability in audit quality in different countries

It may be the case that the quality of auditing required may differ between relevant countries. There is
a risk either that the auditor does not perform an audit that is up to the required standard in some
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countries, or that the audits performed on some overseas subsidiaries are not up to the standard
required to express an opinion on the group financial statements.
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Answers 139
18 Pulp
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Top tips. The examiner has stated that paper 'P7 will continue to test financial statement areas that are relatively
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hard to audit, and areas which are the subject of specific auditing standards, in this case ISA 550 Related Parties'.
You would have struggled with this question if you had not learnt and understood this standard.
In part (b) it is important to plan and structure your answer to make sure that all relevant points are included. Think
o t.
about what headings to use and what needs to be included under each heading.
Easy marks. Listing the disclosure requirements of IAS 24 Related party disclosures was straightforward for part
b(i). In addition you should have been able to gain some easy marks for making some suitable comments in
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part (c).
Examiner's comments. Despite the clue given in requirement (a), a surprising number of candidates did not
mention that the transaction described in the scenario appeared to be a related party transaction. Those that did
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pick up on this fact failed to develop or explain the point fully, and although there were many comments along the
lines of 'the transaction should be disclosed', hardly any answers provided an indication of what exactly should be
disclosed and why.
On the whole the answers to (b)(i) were confused, resulting in inadequate answers to (b)(ii), where audit
l.b
procedures should have been recommended. Very few candidates suggested that the auditor should try to
understand the nature of the transaction in question ('normal' trade receivable or loan), with procedures usually
restricted to vague comments like 'inspect invoice' – but what is it being inspected for, and would there even be an
invoice? Answers to audit procedure questions must be much more specific.
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Requirement (c) was often not attempted. Some candidates seemed to want to punish this year's audit senior for
the deficiencies in the audit which happened in the previous year. Better answers discussed a need for the training
of audit staff with respect to related parties, and the need for a thorough review of this relatively high risk section of
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the audit.
Marking scheme
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Marks
(a) Problems in identifying related parties and transactions
Generally 1–1½ marks per problem
tud
Ideas list:
– Complex/subjective definition of related party
– Reluctance of management to disclose
– Hard to identify from accounting system
– Deliberate concealment for fraud/window dressing
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– Materiality relatively complex to apply

Maximum 5
(b) (i) Matters to consider
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Generally 1–1½ mark for each matter identified

Ideas list:
ea
– Immaterial by monetary amount – only award mark if

calculation provided
– Material by nature
– Whether this is a one-off transaction
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– IAS 24 – whether meets definition of related party

– IAS 24 – matters to be disclosed (1/2 mark per specific
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disclosure point required)

– IAS 24 – breach and impact on audit report – only give mark
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for specific reference to except for disagreement

– Recoverability of balance
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140 Answers
– Possible misclassification – could be a non-current asset
investment
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Maximum 5
(ii) Audit procedures
Generally ½ –1 mark for each comment
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Ideas list:
– Specific written representations from Peter Sheffield
(1/2 mark per specific point requested)
o t.
– Terms of transaction from written documentation
– Develop understanding of nature of transaction
– Review of Jarvis Co financial statements
(1/2 mark per specific item looked for in the review)
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Maximum 4
(c) Quality control issues
Generally 1 mark for each comment
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Ideas list:
– Not identified as high risk area
– Inexperienced member of team/poor training given
– Inadequate review of working papers
l.b
– Maximum 3
Total 17
(a) Difficulties in identification

Related parties ria
ate
Related parties are defined by IAS 24 Related party disclosures and can be complex, subjective and difficult
to identify. It is not always immediately obvious to management or the auditor whether a party is related.
For example, IAS 24 states a party is related to an entity when the party 'controls, is controlled by, or is
under common control with, the entity'. Control may not always be easy to identify within a complex multi-
national group or if the controlling party is a trust, it may be difficult to prove who, if anyone, controls it.
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There is frequently little or no documentary evidence of related parties and so the auditor often has to rely
on management's written representations for their disclosure. If management wish to hide a related party, it
may prove difficult for the auditor to identify it through normal audit procedures.
tud
Related party transactions

Management systems are not designed to distinguish related parties or produce a summary of their
transactions. Management will generally have to carry out additional work to identify and collate related
party information. If this work is not completed, it may prove difficult for the auditor to detect all related
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party transactions.
Management may conceal a related party transaction in full or in part. This could be because they are
motivated by more than ordinary business considerations, for example, to enhance the presentation of the
cc
financial statements (as part of a fraud or window dressing). If management conceal a related party
transaction, it will be very difficult for the auditor to identify.
ea
Related party transactions may be material in substance rather than size, so difficult to detect using
ordinary audit procedures. It may also be difficult for the auditor to determine whether transactions are
material to related parties who are individuals, such as directors and their families.
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Answers 141
(b) (i) Matters to consider
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Disclosure
The rules of IAS 24 state a party is related to an entity when the party 'controls, is controlled by, or is
under common control with, the entity'. Since Jarvis Co is controlled by Peter Sheffield, it seems a
related party relationship exists. Further audit procedures should be undertaken to confirm that this is
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the case. If so, the $25,000 receivable with Jarvis Co is part of a related party transaction.
IAS 24 requires the following to be disclosed for a related party transaction.
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 Names of the transacting related parties
 A description of the relationship
 A description of the transaction and the amounts included
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 The amounts due to or from the related party at the end of the year
 Any other element of the transaction necessary for an understanding of the financial
statements
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Pulp Co financial statements should be amended so that the correct disclosure of the related party
transaction with Jarvis Co is made. If Pulp Co do not make this change, the audit report should be
modified to qualified with an 'except for' disagreement paragraph.
Materiality
l.b
The receivable balance is 0.02% ($25,000/$12m) of total assets so would not be classified as
material by its amount. However, as the transaction is with a related party it may be material in nature
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and so it should be considered whether it has been made on normal commercial terms.
Recoverability
The receivable has been in existence for over a year and so its recoverability needs to be taken into
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account. The representation from Pulp Co should be viewed with professional scepticism since the
same representation was made in the previous year. If found to be a bad debt, then the balance
should be written off, and the statement of profit or loss debited with the expense.
Misclassification
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If Pulp Co are able to prove that the receivable is recoverable in the long term it may be reclassified
as a non-current receivable. However, it could be argued that the balance is effectively a non-current
asset investment, and if so, should be reclassified as such.
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One-off transaction
The transaction between Pulp Co and Jarvis Co may not be a one-off and there could be further
undisclosed related party transactions between the companies.
(ii) Further audit procedures
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 Written representations should be obtained from Peter Sheffield which contain:

– The exact nature of his control over Jarvis Co. For example, his percentage
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shareholding if he is a shareholder
– Whether he believes the $25,000 receivable with Jarvis Co to be recoverable and a
specific date by which the amount is be expected to be repaid
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– Confirmation there are no more transactions between Jarvis Co and Pulp Co or any
further outstanding balances
 The terms of any written confirmation of the $25,000 receivable with Jarvis Co should be
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reviewed to see if Pulp Co is due interest for late payment. The terms of the confirmation
should be analysed for details of any security offered.
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 The purpose of the $25,000 receivable with Jarvis Co should be discussed with Peter Sheffield
in order to ascertain whether the balance is a trade receivable or an investment.
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 The board minutes should be inspected for evidence of the transaction with Jarvis Co and any
discussion regarding its recoverability.
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142 Answers
 The most recent audited financial statements of Jarvis Co should be reviewed as to:
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– Whether Peter Sheffield has been disclosed as the ultimate controlling party or key
management personnel
– Whether there is any disclosure of a $25,000 related party liability with Pulp Co
– Whether Jarvis Co would be able to pay the $25,000 from liquid assets (perform a
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liquidity analysis)
(c) Quality control issues
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There is evidence that this audit is poor from a quality control perspective.
The receivable with Jarvis Co was identified in the 20X7 audit together with the details about Peter Sheffield.
Therefore, this should have been identified as a high risk area during the planning stage of the 20X8 audit.
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Suitable procedures should have been designed to confirm completeness, existence and valuation of related
party transactions rather than just relying on written representations.
The audit work should have been carried out by a suitable member of staff and then reviewed by a more
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senior member of the team. As the related party transaction was not identified as a high risk area during the
planning stage, it is likely that an inexperienced team member was assigned to carry out the work.
The review carried out by the audit senior and manager in the prior year was inadequate as it did not
l.b
identify the weakness of written representations as a source of evidence for the transaction.
19 Aspersion
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Top tips. When faced with a general requirement such as 'comment on matters you should consider' it is important
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to thoroughly record your thought processes and not to omit anything which you feel is obvious. For example, for
each of the situations in this question, you need to write down your 'alarm bells', in other words, the problems you
feel could exist in the situation. This will lead to you then explaining the implications of these problems for the
financial statements, and therefore the things you will need to find out and confirm in discovering whether a true or
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fair view has been given. Remember that there are certain matters which an auditor should always consider, such
as materiality. The examiner has clearly given you scope in the scenario to consider materiality, so not to do so will
lose you marks.
Easy marks. Section (a) was probably the most straightforward here.
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Examiner's comments. This question was answered relatively well apart from item (3) on deferred tax – candidates
were very hazy about whether an adjustment would be appropriate and some completely failed to even attempt this
section. However, it should have been answered much better.
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Candidates need to be able to recognise the principle accounting issues involved in this type of question. These were:
(a) Related party transaction (IAS 24)
Relatively good marks were gained here. Candidates that did particularly well spent sufficient time identifying
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the audit evidence they would look for. Weaker candidates who insisted that the transaction 'must be on an
arm's length basis' scored few marks.
(b) Impairment (IAS 36)
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Most candidates missed the point and got bogged down with discussion on depreciation rates when the
issue was impairment. A disappointing majority of candidates suggested (incorrectly) that the carriers
should have been depreciated over three years. That some candidates believed that the two light aircraft
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should have been accounted for as a construction contract under IAS 11 was very worrying.
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(c) Deferred tax (IAS 12)

The majority of candidates clearly felt so nervous about the accounting of deferred tax that they failed even
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to go 'back to basics' and consider whether the event after the reporting period was adjusting or non-
adjusting.
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Answers 143
Advice to candidates who do not know a relevant Accounting Standard is to revert to principles (eg the
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change in rate does not give rise to a liability because it did not apply at the end of the reporting period).
Nevertheless, some marks were gained for the audit evidence part where most candidates managed to
suggest that they would need a copy of the calculation and would need to re-perform casts etc.
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Although it was not in the marking scheme, those exceptionally perceptive candidates who pointed out that
writing down the assets in (b) for impairment would have an impact on the deferred tax provision were
awarded marks.
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References to any documentation supporting 'payments of deferred tax' showed a staggering lack of
understanding of the concept of deferred tax.
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Marking scheme
Marks
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(i) Matters
Maximum 5 marks any one issues  3 Maximum 12
Ideas
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– Materiality (assessed)
– Relevant IASs (eg 1, 10, 12, 24, 36)
– Risk (eg completeness assertion)
– Implications for auditors' report (eg explanatory para)
(ii) Audit evidence
Generally 1 mark each item of audit evidence (source)
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Maximum 5 marks any one issues  3 Maximum 12
Ideas
– Oral vs written
– Internal vs external
– Auditor generated
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– Procedures (relevant, reliable, sufficient) Maximum 20
(a) Maximum 7
(b) Maximum 7
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(c) Maximum 6
Total 20
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(a) Sale of cargo carrier to Abra

(i) Matters to consider
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A cargo carrier has been sold to a party which is potentially related to Aspersion under the
requirements of IAS 24. A loss has been made on that disposal of a non-current asset.
Materiality
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The loss on disposal has reduced profit before tax by $400,000. This 14% reduction is material to
profit.
Related party transaction?
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Iain Jolteon, the finance director who approved the sale of the cargo carrier, has a substantial equity
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interest in Abra, the company to whom it was sold. As such, Abra appears to fall within the criteria of
a related party under IAS 24.
This connection would appear stronger if Mr Jolteon owned shares in Aspersion or was a director in
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Abra, and if Abra was controlled by his close family members.

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144 Answers
Implication
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The transaction should be disclosed in the financial statements as a related party transaction. This
disclosure should include:
 The names of the transacting related parties
 A description of the relationship between the parties
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 A description of the transactions
 The amounts involved
 Any money outstanding due to the company/related party
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Other related parties
The auditors should consider, and be alert for evidence of, other related parties and transactions.
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Reasons for the sale
The fact that a large loss has been made on the sale raises other matters for the auditor to consider:
 Whether the sale has been made at an undervalue (this may have tax implications)
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 Why the machine was sold:
– Maintenance problem
– Reduction in operations
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– Movement in technology rendering others obsolete
 Whether the depreciation policy was incorrect (over 20 years)
These questions will lead the auditor to review the remaining non-current assets to ensure that they
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are not impaired and that the depreciation policies are reasonable.
Disclosure of loss on sale
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As this item is material it would be disclosed separately in accordance with IAS 1 Presentation of
financial statements.
(ii) Audit evidence
The following evidence will be sought:
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 A copy of the sales agreement

 A copy of any valuation report carried out on the asset
 Evidence of receipt of the proceeds through the bank
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 The calculation of the loss (this should be checked for accuracy)

 Notes of discussions with management about procedures and the related internal controls for
the identification of related party transactions
 Results of reviews of board meetings, share registers and other statutory records
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 Written representations from management regarding the completeness and accuracy of

related parties and transactions and that they have been accounted for appropriately
 A copy of the disclosure note which is to be included in the financial statements
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(b) Light aircraft

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Aspersion owns two light aircraft which are used to service a contract which will not be renewed
when it comes up in six month's time.
Materiality
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The total cost of the aircraft was $900,000. They have been owned in the region of three years, and
have been depreciated over 15 years. Therefore, their carrying value is in the region of $720,000.
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This represents 7% of total assets and is therefore material to the statement of financial position.
Impairment
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The aircraft were purchased to service a contract which will not be renewed when it expires six
months after the end of the reporting period. This significant change in the market in which the
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Answers 145
assets operate indicates impairment of the asset and requires management to carry out an
impairment review under IAS 36. The auditors need to establish whether this has been carried out.
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Management intentions
The auditors need to discover what management's future intentions for the assets are:
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 Sale
 Alternative use
These intentions will impact on the impairment review.
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Impairment loss
If an impairment loss has been identified, the auditors need to discover:
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 Whether it is material (  $100,000, say)
 Whether it has been properly disclosed in the financial statements
(ii) Audit evidence
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 A copy of the service contract and any correspondence
 Results of inspection of the aircraft (to ascertain condition)
 Notes of enquiries of management to ascertain
l.b
– Future intentions
– Whenever an impairment review was carried out
(c)

Deferred tax
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Evidence from the impairment review – for example, any draft sales agreements, cash flow
projections relating to value in use, any contracts relating to new uses for the aircraft
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Deferred tax has been provided for in respect of accelerated capital allowances in accordance with IAS 12.
Materiality
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The tax provision amounts to 21% of profit before tax and is therefore material. The increase in the
provision, of $76,000, is not material to profit before tax.
IAS 12 – rate of tax to use
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IAS 12 requires that deferred tax is calculated at a rate of tax that is 'substantively enacted' and
expected to apply to the period when the deferred tax is to be settled. Substantively enacted generally
means that it has been made into law, not merely suggested or announced.
In this instance, therefore, the directors are proposing to amend the provision to apply a tax rate that
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is not substantively enacted, but has merely been announced.

Implication
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If the directors do make the provision bigger, they will no longer be complying strictly with the
requirements of IAS 12. The auditors should discuss the matter with the directors and dissuade them
from making such an addition to the provision.
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However, the additional provision is immaterial to the financial statements, so the auditors are
unlikely to conclude that the deferred tax balance does not give a true and fair view.
(ii) Audit evidence
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 A copy of all the calculations made in relation to the tax balances

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 The client's schedules relating to the tax basis used

 Agreement of tax rate to tax legislation
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 Schedules of non-current assets used in tax calculations agreed to non current asset register/
general ledger
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146 Answers
 Audit programme for non-current assets with evidence of verification of changes (eg additions)
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 A reconciliation of the tax expense with the accounting profit
 Minutes of directors' meetings confirming details of any major additions etc in non current
assets
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20 Mac
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Top tips. For part (a) remember that you need to apply your answer to the company in the question – don't just list
things you've learned from the study text! For part (b), it is important that you show that you aware of the what
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ISAs 610 and 402 say, and again that you are specific to the scenario in the question. Part (c) should have been
quite straightforward provided that you were specific in your answer, and part (d) was probably the easiest part of
the question. Don't miss out on the presentation marks!
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Easy marks. These are available in part (d).
Examiner's comments. The majority of candidates responded reasonable well to this question, though many
answers did not reach their full potential by not being applied to the question scenario. A number of candidates
performed well on requirement (a), some achieving the maximum six marks. These candidates identified the benefits
l.b
and explained the point with specific reference to Mac Co, as required. A significant number of candidates provided
disadvantages of outsourcing the internal audit function – which was not asked for, and earned no marks.
Candidates must read the requirement carefully to avoid this kind of mistake.
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For requirement (b), the majority of answers were too brief and vague, simply saying that the external auditor would
be able to place more reliance on internal controls, but failing to develop the answer beyond that observation.
Requirement (c) asked for procedures that could be used to quantify the loss suffered by Mac Co as a result of the
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fraud. On the whole, answers were unsatisfactory. Many candidates began their answer with an unnecessary
description of forensic audit, while other wasted time suggesting controls that should have been in place to prevent
the fraud from happening in the first place.
For requirement (d), the section dealing with responsibilities in relation to fraud was generally well dealt with. The
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section dealing with audit committees was less well answered, though most candidates managed to at least explain
a couple of benefits of establishing a committee. Drawbacks were often not provided or were just one word answers
eg 'costly' or 'bureaucratic'. The main problem with answers however was a lack of application to the question
scenario – eg candidates seemed to forget that they were advising the directors of a company which had recently
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suffered a fraud and failed to point out that a stronger control environment which an audit committee would help to
create would deter further frauds from occurring.
Marking scheme
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Marks
(a) Benefits of outsourcing internal audit
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Up to 1½ marks per point evaluated:

– Improved quality/experience
– Greater authority
– Bigger resource base
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– Independent viewpoint
– Better ability to focus and prioritise issues
– Finance function benefits from staff reassigned
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Maximum 6
(b) Impact of outsourcing on the external audit
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Generally 1 mark per point:

– Assess extent of reliance per ISA 610/402
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– Likely to place greater reliance than previously

– Impact on audit strategy – less substantive procedures
– More efficient audit/lower fees
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Answers 147
– Need to document and evaluate changes to systems/controls
– Access to information and working papers
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Maximum 4
(c) Procedures regarding fraud
Up to 1 mark per procedure:
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– Review process for adding approved suppliers to list
– Review all payments authorised by the account manager
– Use CAATs to identify suppliers with same bank details
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– Supplier statement review
– Select invoices and trace to supporting documentation
– Consider likelihood of insurance reimbursement
– Consider prosecution of account manager and recovery of funds
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Maximum 4
(d) Report to client on audit committees
Professional marks to be awarded for format (heading, introduction, conclusion) – 1 mark,
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and clarity of explanation, use of language appropriate to client – 1 mark
Generally 1 mark for each comment from list below:
(i) Responsibilities in relation to fraud:
– Management primary responsibility
l.b
– Management responsible for controls and culture of entity
– Auditor only responsible for detection of frauds with material financial statement impact
– Auditor not responsible for prevention but does make recommendations on controls
– Both review strength of systems and controls
(ii) Benefits and drawbacks
– Increase confidence/credibility
– Stronger control environment
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– Bring external experience/expertise
– Provide impartial consultation
– Easier to raise finance/gain listed status
– Problems in recruitment
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– Expense
Total 26
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(a) Staff
Lindsay only qualified recently, and the two other internal auditors are still studying for their professional
qualifications. There is therefore a question mark over whether the team as a whole is sufficiently technically
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competent and experienced to do the work required of it.

An external provider would have access to good quality staff. This would improve the quality of work done,
and would release Mac Co from the burden of training unqualified staff.
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Authority
It appears that Lindsay's recommendations lack sufficient authority for them to be taken seriously by
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managers, possibly because she is only recently qualified and was previously a junior manager. An external
provider may command greater authority, so that its recommendations may be more likely to be followed.
Independence
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At present the internal audit team reports to the finance director, and there is therefore a chance of it being
reluctant to criticise the finance department overtly. An external provider would be under no such
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restrictions.
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148 Answers
Resources
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The internal audit department appears to be under-resourced, as it lacks the time to perform much testing of
financial or operational controls. Outsourcing would give immediate access to a well-resourced internal audit
function.
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Focus
At present internal audit seems to lack focus, or a specific remit. Its work seems to be determined by the
finance director's priorities. An external provider would be able to focus on the full range of internal audit
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work.
Staff to finance department
Moving Lindsay and her team into the finance department is likely to improve the control environment and
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the embedding of controls procedures within the organisation, as the team will bring with it the perspective
they have gained from working in internal audit.
(b) ISA 610 Using the Work of Internal Auditors and ISA 402 Audit Considerations Relating to an Entity Using a
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Service Organisation should be considered here. In line with ISA 610, the auditor will have to consider:
 Internal audit's organisational status, and relevant policies and procedures
 Internal audit's competence
l.b
 Whether internal audit's approach is systematic and disciplined
The external auditor will then evaluate the specific internal audit work they are interested in. ISA 402 requires
the auditor to consider the impact that outsourcing internal audit will have on Mac Co's accounting and
control systems.
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It is likely that Manhatten & Co will place more reliance on an outsourced internal audit function than on the
present internal audit team, as such a function is likely to provide work of better quality. This may lead to a
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reduced audit fee, which will be helpful for Mac Co in view of its concerns over cash flow.
If new internal control procedures are implemented as a result of outsourcing internal audit, this may
increase the amount of audit work required. Alternatively, the amount of audit work could decrease if new
procedures are very significantly better than the old ones.
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(c) Procedures to quantify loss include:

 Use of computer techniques to identify other payments made to the account manager's bank
account, and consideration of whether these payments are legitimate
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 Review of all suppliers to whom payments were approved by this manager, and comparison with the
list of approved suppliers
 Testing a sample of payments to each supplier back to invoice, and then tracing the transaction
through to existence in the form of delivery notes, etc
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 Review terms of insurance cover taken out by Mac Co with a view to a possible claim
 Discussion with legal counsel over whether any reimbursement might be received from the manager
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in the event of charges being pressed

(d) Report
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To: D. & S. Hudson

Re: Auditor's responsibilities on fraud; audit committees
Introduction
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The objectives of this report are to explain the responsibilities of the external auditor and management
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regarding fraud, and to outline the benefits and drawbacks of Mac Co establishing an audit committee.
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Answers 149
(i) Responsibilities on fraud
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According to the International Standard on Auditing (ISA) 240 The Auditor's Responsibilities Relating
to Fraud in an Audit of Financial Statements, the primary responsibility for preventing and detecting
fraud lies with those charged with governance and management of an entity. Management does this
by establishing a system of operational and financial controls, along with an appropriate cultural
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environment for those controls, to reduce the risk of fraud taking place.
The auditor's responsibility is to obtain reasonable assurance that the financial statements are free
from material misstatement, whether due to fraud or error. The auditor is only responsible for
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detecting fraud, therefore, insofar as it affects the accounts (by causing a material misstatement). For
instance, the fraud recently perpetrated by an account manager in Mac Co may not have had a
material impact on the financial statements, in which case the auditor would not have been
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responsible for detecting it.
There is some overlap between the responsibilities of management and the auditor on internal
controls, in that both have to make an assessment of the effectiveness of controls. It is possible that
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the auditor may recommendation to management ways for it to improve the effectiveness of controls.
The key difference, however, is that it is the responsibility of management alone to implement a
system of controls that prevent and detect fraud.
(ii) Audit committees
l.b
The benefits to Mac Co of an audit committee include:
 Increased confidence in the credibility of financial reports. This may help Mac Co to raise

external finance in the future if required.
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The committee would specialise in financial reporting problems and to some extent discharge
the directors' responsibilities in that area. This would free the executive directors to devote
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their attention to management.
 In case of conflict between the executive directors (eg the finance director) and the employees
(eg internal audit), the committee may provide an impartial body for the external auditor to
consult.
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 Establishing the committee should help improve the control environment, which would help to
prevent future frauds, and may improve the efficiency and the cost of the external audit.
 An audit committee is a requirement of many corporate governance codes, and if in future
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Mac Co wishes to seek a listing, it would have to establish an audit committee anyway.
 Members of the audit committee would bring valuable business skills and knowledge into the
company. They would be non-executive directors, who would provide impartial advice and
guidance to the executive directors. This could be particularly valuable in a family-owned
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business such as Mac Co.

The drawbacks to Mac Co of an audit committee include:
 Cost. Members of the committee should ideally have a high level of experience and expertise,
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for which they would require a substantial fee.

 It can be difficult to recruit audit committee members with a level of experience sufficient for
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the committee to be really effective.

Conclusion
This report distinguishes between the responsibility of management, for preventing and detecting fraud and for
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establishing a system of internal controls to do this, and that of the auditor, which is for detecting material
misstatements.
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An audit committee would provide Mac Co with a number of benefits, particularly in view of what may be a relatively
weak control environment at present. However, the costs and difficulties associated with establishing such a
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committee must be considered carefully.

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150 Answers
21 Distant
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Text reference. Chapter 15
Top tips. This question looks at the topic of the audit of performance information in the public sector. Part (a)
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covers the audit of performance measured in terms of KPIs, and may have proved difficult. The key to scoring well
on this question is thinking practically about the scenario, and in particular about any differences you can spot
between what the KPI is intended to measure, and what it actually measures in reality. Note that you do not need to
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come up with exactly the same points as the model answer in order to score well.
Marking scheme
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Marks
Assessment of usefulness
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(a) ½ mark per valid point, up to 2 marks in total per KPI 7
(b) ½ mark per valid KPI recommended 2
(c) ½ mark per valid procedure identified 6
Total 15
l.b
Academic performance – % pupils achieving A grade in June exams at age 11
(a)
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This KPI is specific and measurable. It specifies a definite set of exams for a definite set of pupils, and the
percentage of pupils achieving an A grade is clearly measurable.
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However, it does suffer from several difficulties.
First, focusing on just one set of exams runs the risk of anomalous results which are not statistically
significant. Poor performance on this metric could simply be unlucky, and the same set of pupils sitting an
exam on a different day could perform significantly differently. This could be remedied by using a metric that
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includes more than one set of exams, for example exams for more than one year group, or winter and
summer exams.
Second, by measuring A grades alone only the relatively small number of pupils at the top of the
achievement spectrum are focused on, ie those who are capable of achieving an A grade. The performance
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of many of the pupils is not included in this KPI. This could be improved upon by measuring a broader
spectrum of achievement, for example the % of pupils achieving grades A to C (on a range of A to F).
Third, it is likely to be the case that many of Distant Primary's pupils are from socially disadvantaged
backgrounds, which may mean that in absolute terms they achieve fewer top grades than pupils from more
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socially advantageous backgrounds. One way of trying to control for this would be to measure not the
absolute grades achieved by pupils, but rather their relative improvement (or deterioration) during their time
at the school. This could be measured by for example as the change in the percentage of pupils achieving
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grades A to C from year to year. The school as a whole could be measured as the average percentage
change.
(b) An alternative KPI in this area might be:
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Average % change in % pupils achieving grades A to C in end of year examinations from ages 7 to 11.
(c) Evidence should be obtained from published examination results for all end of year exams taken by pupils
aged 7 to 11. From this it would be possible to recalculate the total number of grades A, B and C as a % of
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the number of pupils sitting the exam. The average % change from year to year could then be calculated
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from this.
School attendance – Average % pupils absent from registration 8:30am
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(a) This KPI fails to specify a time period over which the average is to be calculated. This could be specified as
the annual average.
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The KPI makes the mistake of identifying attendance at registration at 8:30am with attendance throughout
the school day. Some school pupils have been reported as being in the city centre when they should have
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been at school. It is therefore possible that they were in attendance at registration at the beginning of the day
before running away from school. The extant KPI would fail to register this absenteeism, a failing which
could be rectified by taking a register at various points during the day, eg at the start of every lesson.
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Annual average % pupils absent per school lesson
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(c) Evidence should be obtained by inspecting registers taken at the start of every lesson. If this data were input
in electronic form then calculating the % of pupils absent from each lesson should be straightforward. This
would be the total number of pupil-lesson absences as a % of the total number of pupil-lessons attended.
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Participation in sport – Number of trophies won by school sports teams
(a) It is possible that a school more of whose pupils participate in school sports may win more trophies than
one of whose pupils fewer participate in sports. This is, however, a poor measure of participation.
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It is possible that pupils may participate in school sports without affecting the number of trophies won.
Many pupils may participate without ever winning a trophy or contributing to trophy-winning teams. These
pupils should be included in any measure of participation.
A better measure might therefore refer to the amount of time spent playing sport, and to the proportion of
l.b
pupils who play it. Focusing on time, one might measure the number of pupils playing sport for at least three
hours per week. Focusing on the proportion of pupils participating, one might measure the percentage of
pupils playing at least some (eg one hour) sport per week.
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Annual average % pupils playing sport for at least two hours per week
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(c) On the assumption that sport is played in Physical Education lessons, both the average attendance of these
lessons and their average weekly duration would need to be verified.
Attendance could be extracted from registers kept in lessons, calculating the proportion of pupils attending
lessons for the year to generate an average per week.
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Duration could be assessed by inspecting school timetables for evidence of lesson duration.
Uniform – % pupils whose school uniforms are in line with regulations
(a) This KPI is less problematic than many of the others given. Its chief defect is that it fails to take account of
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the underlying population of the pupils attending their school, and in particular the lack of economic means
of many of their families.
Put simply, it is possible that many of those pupils whose uniforms are not in line with regulations are in this
state because their parents cannot afford to buy them new uniforms as required. The KPI needs to take this
as
into account, for example by measuring only the percentage of pupils not receiving free school meals.
% pupils not receiving free school meals whose school uniforms are in line with regulations
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(c) This KPI should be tested by recalculation of the required percentage, adjusting for pupils receiving free
school meals.
ea
Procedures here would include selecting a sample of pupils for inspection in respect of their uniforms,
perhaps at unannounced dates during the school year.
22 Juliet
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Top tips. The first part of this question was difficult, and doubtless many candidates would struggle to make up 8
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marks here. It is important with discussion questions that you plan your answer before you write. If you don't plan,
there is a danger that you will change your mind about what you want to say while you are already writing.
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152 Answers
This will only waste time and will be unlikely to score marks. You need to plan your answer, and divide your
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discussion into clearly structured paragraphs. Within each paragraph, you should aim to have an introduction, a
point, and a conclusion.
It is also important that you didn't go over time on this part of the question – perhaps through struggling to write
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clearly – as there were some easier marks to be had in part (b).
Easy marks. Part (b)(ii) was probably the easiest part of the question, as most of the ethical implications should
come out of the scenario.
o t.
Examiner's comments. Candidates were asked to discuss firstly whether auditors should accept some of the blame
when a company on which they have expressed an unmodified opinion subsequently fails, and secondly whether
auditors should do more to highlight going concern problems. Very few answers were worthy of more than a few
marks, most answers simply listing the auditor's responsibilities from ISA 570 Going Concern, with no discussion
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at all of the statement provided in the question. Those who did refer to the statement provided tended to just state
whether or not they agreed with it but provided no discussion at all. Answers were especially poor at discussing
whether auditors should disclose more in relation to going concern, with most just describing the various ways that
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going concern issues may affect the audit opinion. It is inadequate that at this level of examination candidates seem
simply unable to express an opinion of their own or base a reasoned discussion around a statement provided to
them, especially around such a significant current issue facing the profession.
Candidates were firstly asked in requirement (b)(i), for six marks, to identify and explain the matters that should be
l.b
considered, and the principal audit procedures that should be performed in respect of the funding being sought.
The main problem with answers were that they did not focus as required on the additional funding being sought,
but instead discussed more generally the plight of the company.
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Requirement (b)(ii) was the best answered requirement of this question. Most candidates correctly identified and
went on to explain the self-review, management and advocacy threats created by the situation, and many discussed
the potential liability issue caused by attending the meeting.
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Marking scheme
Marks
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(a) Discussion
Up to 2 marks for comments discussed from ideas list
– Management responsibility for risk assessment
– Auditor should be aware of going concern issues
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– Auditor must not take on management role

– Misunderstanding of roles of management and auditor
– Auditor may be to blame if overlooked a fraud/other matter
– Financial statements contain disclosure on risk assessment
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– Users may not be financially literate

– Auditors could make problems more visible and understandable
Maximum 8
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(b) (i) Matters and procedures on funding

Up to 1 mark each point:
Matters:
ea
– Area of critical importance to the audit

– Bank reluctant to confirm arrangements
– Assets impaired – little collateral to offer
– Have alternative providers been discussed?
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– Potential impact on FS and audit report if significant doubt remains over going
concern
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Procedures:
– Review assumptions used in forecasts and projections
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– Management representation on reasonableness of assumptions used

– Review potential finance for adequacy
– Consider if any previous defaults
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Answers 153
Marks
– Consider terms of finance – can the company meet repayment terms?
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– Written confirmation from bank
– Discuss with bank
– Discuss with management
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Maximum 6
(ii) Ethical and other implications
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– Advice is a non-audit service
– Self-review threat
– Advocacy threat
– Management threat
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– Safeguards should be used to reduce threats
– Firm may decide that no safeguards can reduce threats to an acceptable level
– Attending meeting could create legal proximity
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Maximum 6
Total 20
(a) The concept of an expectations gap between auditors and the public is a key lens through which assertions
l.b
such as this one can be viewed. The first part of the statement would appear to assert that the auditor is in
some way responsible for the failure of a company. This is not the case: those charged with governance are
responsible for risk assessment and risk management. It is not the role of the auditor to become involved
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with the entity's risk management processes – indeed, this could be deemed to constitute a management
role, which would compromise the auditor's independence.
However, it is true that the auditor should gain an understanding of the client's business; this is a crucial
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requirement of ISAs. Amongst other things, it is necessary for an auditor to audit management's
assessment of the appropriateness of the going concern assumption, for which a good understanding of the
business risks faced by the client is necessary. The auditor must judge whether the going concern
assumption used is appropriate. However, this is never a matter of cut-and-dried logic: it is a judgement,
based on an assessment of risk. It is in the nature of risk for there to be uncertainties, and it is in the nature
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of judgement to contain elements of doubt.

It is therefore to be expected that there will be cases where the auditor has judged the going concern
assumption to be appropriate, and yet the company fails within the year. The question is not whether the
assumption was proved correct by subsequent events, but whether the auditor's assessment was
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reasonable and in line with auditing standards.

There is more scope for discussion on the question of whether auditors should do more to highlight
problems. This may be the responsibility of management; it would be possible for regulators and setters of
accounting standards to require increased disclosure on going concern. For example, financial statements
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could be required to provide more narrative detail regarding the risks faced by an entity.
At present, auditors should disclose the presence of material uncertainties over going concern by way of an
emphasis of matter paragraph in the auditor's report, and if they deem the assumption to be inappropriate
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then the opinion would be modified. It may be possible for these disclosures to be made clearer than they
are, or for auditors to use their report to draw users' attention to any parts of the financial statements that
are significant to the assessment of going concern.
ea
In conclusion, it is unfair to require auditors to accept the blame for company failures which are the proper
responsibility of management, although it may be argued that more could be done by auditors to highlight
going concern problems where they exist.
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(b) (i) The central issue here is going concern; there are a number of indications that Juliet Co may not be a
going concern. For instance: declining sales and profitability over two years; the loss of key
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customers; the impairment of assets; debts going bad. Most significant of all is the question of
whether the loan will be obtained.
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If Juliet Co does not obtain the loan, then the financial statements must contain disclosures regarding
the material uncertainty over going concern. The auditor's report should contain an emphasis of
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154 Answers
matter paragraph discussing the uncertainty and referring to the note. If the financial statements do
not contain these disclosures, then the auditor's opinion would need to be either qualified or adverse.
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Procedures in respect of the loan include:
 Obtain and review the forecasts and projections prepared by management and consider if the
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assumptions used are in line with business understanding.
 Obtain a written representation confirming that the assumptions used in the forecasts and
projections are considered achievable in light of the economic recession and state of the
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automotive industry.
 Obtain and review the terms of the loan that has been requested to see if Juliet Co can make
the repayments required.
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 Consider the sufficiency of the loan requested to cover the costs of the intended restructuring.
 Review the repayment history of any current loans and overdrafts with the bank, to form an
opinion as to whether Juliet Co has any history of defaulting on payments. (Any previous
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defaults or breach of loan conditions makes it less likely that the new loan would be
advanced).
 Discuss the loan request with the company's bankers and attempt to receive confirmation of
l.b
their intention to provide the finance, and the terms of the finance.
 Discuss the situation with management and those charged with governance, to ascertain if
any alternative providers of finance have been considered, and if not, if any alternative
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strategies for the company have been discussed.
 Obtain a written representation from management stating management's opinion as to
whether the necessary finance is likely to be obtained.
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(ii) Ethical
These forecasts are crucial for the assessment of whether the company is a going concern. There is a
self-review threat if the auditor is both advising on the preparation of the forecasts, and auditing them
as part of its work on going concern under ISA 570 Going concern.
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The issue is given added weight by ISA 570's insistence that where cash flow is important for the
assessment of going concern, particular consideration should be given not only to what the forecasts
say, but to their reliability. This exacerbates the potential impact of the self-review threat.
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There is potentially an advocacy and management threat, as the auditor is advising on a matter
significant to the company's operational existence, and promoting the company's position to the
potential provider of finance.
The auditor must consider whether safeguards can be put in place to reduce these threats to an
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acceptable level. For instance, a separate team could help prepare the forecasts, and management
could be asked to provide representations to the effect that they alone are responsible for the
forecasts.
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If the firm decides that the threat is still not reduced to an acceptable level, then either, or both, of the
services should not be provided.
Other
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A further issue is that if the auditor does attend the meeting with the bank, it must be careful not to
create the impression that it is responsible for the forecasts, or is in any way guaranteeing the future
existence of the company. In legal terms, attending the meeting and promoting the interests of the
client could create legal 'proximity', which increases the risk of legal action against the auditor in the
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event of Juliet Co defaulting on the loan.

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Answers 155
23 Apricot
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Study text reference. Chapter 13.
Top tips. Part (a) should have been straightforward, provided that you had prepared this area. A good approach
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might be just to go down the forecast thinking about what procedures you could do to test each row of figures. The
additional information given at the bottom of the question is the examiner's attempt to give you some context for
the forecast. What you need to do is use this information to think of procedures that use this information to test the
forecast. It should be possible to think of a procedure relating to virtually every point of information given – just as
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you should be able to think of a point for virtually every line in the forecast itself.
Note that our answer to this part of the question gives more points that you could probably have written down in
the exam, although it is by no means comprehensive. Your approach should be to make sure that you get enough
sp
good points down in the time available. You should concentrate on properly developing the points that you do
make, rather than taking the familiar 'scatter-gun' approach that so often characterises weaker students. It is also a
good idea to try to cover all of the areas of the question (ie of the forecast), as you will probably be able to make
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stronger points over a number areas (by saying the obvious things that there are to say about each) than you would
if you get bogged down in just one area of the question. Make sure you stick to your time!
Part (b) saw the examiner returning to an area that she mentioned in her last examiner's report as being poorly
understood by students. If you had been diligent and had read her report, you would have revised this area carefully
if this was your real exam. It would be a good idea for you to do this! The actual content of the question was not
l.b
difficult, again provided that you had revised it thoroughly.
This time, our answer does represent something that a student could achieve in an exam – see the examiner's
answer for something more comprehensive. You will notice that as this is a standalone, knowledge-based
applied to the scenario.

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requirement, the answer can be based closely on the content of the study text – although it must still of course be
Easy marks. Marks were available in part (a) just for saying 'agree the opening cash balance to the bank
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statement/reconciliation', and 'cast the forecast'. These are very obvious marks, and would be applicable to virtually
any other question relating to the audit of cash flow forecasts. Ignore them at your peril!
There is also an easy ½ mark in part (b) for saying that the report should have a title and an addressee.
Examiner's comments. This was by far the least popular of the optional questions in Section B, but those that did
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attempt the question tended to perform well.

Requirement (a) asked candidates to recommend the procedures that should be performed on the cash flow
projection. The majority of answers produced many specific procedures, based on the information provided.
Candidates that approached the answer logically and worked through each item on the cash flow forecast to derive
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appropriate procedures performed very well. However, some answers were limited to enquiry with management,
which restricted the marks that could be awarded.
Requirement (b) asked for an explanation of the main contents of the assurance report that would be provided.
Most candidates could make an attempt at a list of contents, but very few answers provided sufficient explanation of
as
the content identified, eg most could identify that a statement of negative assurance would be provided, but few
explained what that meant. Some answers provided a contrast between an audit and an assurance report, which
was not asked for. The main problem with answers to this requirement is that they were just too brief for the marks
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available.
Marking scheme
ea
Marks
(a) Procedures on cash flow forecast
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Generally 1 mark per specific procedure from ideas list:

– Accuracy checks – recalculation
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– Agree opening cash position

– Recalculate patterns of cash in and out for credit sales and purchases
– Agree patterns using aged receivables analysis/working capital ratios
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– Agree discounts received and allowed to invoices/contracts/correspondences

– Agree derivation of figures from profit forecast
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156 Answers
– Agree monthly salary expense to payroll
– Review content of overheads – check non-cash expenses not included
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– Review for missing outflows eg tax and finance charges
– Agree premises costs eg to legal documents
– Discuss timing of fixtures cash flow
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– General enquiries with the preparer of the forecast
Maximum 11
(b) Content of an assurance report
Up to 1 mark per point if explained:
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– Title/addressee (½ mark)
– Identification of PFI
– Management responsibility
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– Purpose of PFI
– Restricted use of PFI
– Negative assurance opinion re assumptions
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– Opinion on presentation
– When may qualifications be necessary/explanation of errors found
– Reference to engagement letter (½ mark)
– Statement/reference to procedures carried out (½ mark)
Maximum 5
l.b
Total 16
(a) General procedures

(i) Check that the forecast casts. ria
ate
(ii) Check that the opening cash balance agrees to bank reconciliations and statements.
(iii) Enquire as to who prepared the forecast, and verify that they are competent to do so (evidence eg by
being a chartered certified accountant).
Operating cash receipts
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(i) Enquire as to the basis for the forecast rise in both cash and credit sales receipts.
(ii) Perform analytical procedures on historical information to confirm reasonableness of forecast
revenues, taking into account knowledge of the business.
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(iii) Confirm split between cash and credit sales to past trends and to knowledge of the business.
(iv) Recalculate cash receipts from credit sales from revenue figures in profit forecast and ageing
structure of receivables.
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(v) Verify that the 10% discount for cash payment has been taken into account when calculating cash
received from cash sales.
(vi) Enquire as to who Apricot's major customers are and confirm that they are to continue trading with
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Apricot, eg that none are going into administration.

Operating cash payments
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(i) Confirm that forecast is prepared on the assumption that all purchases are paid for within 30 days.
(ii) Confirm that 12% supplier discount is received from suppliers' invoices, supplier statements, etc.
(iii) Confirm that forecast is prepared on the assumption of receiving the 12% supplier discount.
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(iv) Verify the accuracy of the statement that suppliers are paid within 30 days by reviewing aged
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payables analyses for historical information.

(v) Agree the salary payments to payroll information.
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(vi) Review the overheads to ensure that non-cash items such as depreciation are not included.
(vii) Enquire as to the reason for no outflows for taxation (eg Corporation Tax, VAT).
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Answers 157
Other cash flows
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(i) Agree the cost of the licence to supporting information from the health and safety authority, and
confirm the cost of $35,000.
(ii) Enquire as to the likelihood of actually receiving the licence – whether the inspection will be passed.
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For example: if the inspection has already taken place, ask what the result was; if it has not taken
place, consider the use of a health & safety expert.
(iii) Agree the fixtures outflow of $60,000 to underlying information, eg to supplier quotations.
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(iv) Confirm that the fixtures outflow will take place during March – this seems unlikely given that the
premises will only be bought on 30 March. This may cast doubt over the reliability of other
information in the forecast.
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(v) Agree the $500,000 to be paid for the premises to documentation and verify that it is complete.
(b) In accordance with the requirements of ISAE 3400, the report should contain the following:
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(i) Title and addressee
(ii) Identification of the prospective financial information (PFI) being reported on
(iii) A reference to the purpose of the PFI, which in this case is to provide assurance to Pik Choi's
l.b
financial advisor regarding Apricot Co's cash flow forecast
(iv) A statement of negative assurance as to whether the assumptions provide a reasonable basis for the
prospective financial information
(v)
(vi)
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An opinion as to whether the prospective financial information is properly prepared on the basis of
the assumptions and is presented in accordance with the relevant financial reporting framework
Date of the report, auditor's address and signature
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24 Poppy
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Top tips. In part (a) make sure that you cover the three components of audit risk to provide enough discussion to
score top marks. Always give reasons when requested as in part (b) (i). Part (b) of this question required very
specific accounting knowledge and you may have found this difficult if you did not know your P2 reporting topics.
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Easy marks. As long as you remembered to refer to audit risk throughout part (a) you should have scored well
here.
Examiner's comments. The question dealt with a high profile topical issue – the recognition of items in financial
statements at fair value, and the auditing implications of this. Requirement (a) was a discussion as to whether
as
having items recognised at fair value would lead to an increase in audit risk. A small minority of answers were
sound, referring to the current trend in financial reporting for fair value accounting, and linking this to the various
elements of audit risk. However, many answers focused incorrectly on materiality, and while many were strong on
the financial reporting issues, this was not often successfully linked to audit risk implications. The recent
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examiner's article on financial reporting issues for the auditor had clearly not been read by many candidates.
Requirement (b) provided a brief scenario setting the scene of an audit client which has revalued several investment
properties. Requirement (b)(i) asked for a recommendation and explanation of enquiries that should be made
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before relying on the work of an external valuer. Most candidates successfully recommended enquiries, but a
number then failed to explain the reason for the enquiries. Requirement (b)(ii) asked the candidate to 'identify and
explain principal audit procedures to be performed on the valuation of the investment properties'. Answers here
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were unsatisfactory. This requirement was the most misread of all on the paper. Many answers repeated the points
made in (b)(i). Unfortunately many candidates wasted a lot of time here on writing completely irrelevant answers.
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158 Answers
Marking scheme
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Marks
(a) Discuss whether recognition of fair values leads to increased audit risk
Generally 1 mark per point
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 Introduction referring to widespread need to recognise fair values due to
financial reporting requirements
 Example of item recognised at fair value (other than investment property)
 Discussion of inherent risk – subjectivity
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 Discussion of inherent risk – deliberate manipulation
 Discussion of inherent risk – complexity
– Discussion of control risk – non routine transactions
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 BUT may lead to increased level of monitoring
 Discussion of detection risk
 Conclusion
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Cap marks at 5 if no attempt is made to produce a rounded discussion (ie should
not assume that fair value automatically increases audit risk)
Maximum 7
(b) (i) Enquiries regarding valuer
l.b
Generally ½ mark per enquiry and 1 mark per point of explanation from ideas
list:
 Membership of professional body
 Whether a license is held
 Reputation – references, etc
 Experience with Poppy Co's type of property
 Experience with preparing valuations under IAS 40
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ate
 Financial interest
 Personal interest
Up to 4 marks for assessment of reliability, up to 2 marks for assessment of
objectivity
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Maximum 7
Generally 1 mark per procedure from ideas list:
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 Review written instructions

 Evaluate assumptions
 Check consistent method used
 Check date of report close to year end
 Method to follow IAS 40 fair value framework
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 Physical inspection
 Review of purchase documentation
 Subsequent events
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 Management representation
Maximum 6
Total 20
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(a) Fair value and audit risk

The measurement of an asset or liability at fair value can be due to a requirement of IFRS or a conscious
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choice by the entity. Examples of items measured at fair value include properties and financial instruments.
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IFRS 13 Fair value measurement contains extensive guidance in this area.

Items measured at fair value are often material balances in the statement of financial position and so will
require the auditor to collect sufficient appropriate evidence to ensure they meet the requirements of the
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applicable accounting standard. Guidance for auditors can be found in ISA 540 Auditing accounting
estimates, including fair value accounting estimates, and related disclosures.
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Answers 159
Through understanding the entity and its environment as required by ISA 315, the auditor will gain
knowledge of the balances which have been measured at fair value and then assess their impact on the audit
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strategy and risk.
Audit risk is a product of inherent risk, control risk and detection risk and the impact of material balances
recognised at fair value on each of these is discussed here.
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Inherent risk
Fair value measurements are inherently subjective in nature as they generally involve making estimates
based on a number of assumptions. Management may not be sufficiently experienced or skilled to make
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these assumptions. Assumptions can also be manipulated by individuals to obtain the most favourable fair
value in the financial statements, in other words window-dressing.
The calculation of fair value is complex for many balances, for example, actuarial calculations used to value a
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pension fund. This makes them inherently more difficult to audit as the likelihood of an error is higher in
complex calculations.
However, not all fair value balances are so complex and subjective, for example, the valuation of assets
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which are regularly bought and sold on open markets. This type of balance will not increase audit risk as a
fair market price can be readily ascertained.
Control risk
Fair value measurements are not routine transactions and are likely to only take place once a year. They are
l.b
therefore more likely to fall outside the system of controls set up by the entity to deal with regular
transactions. This increases the likelihood that controls are not as strong as in other more routine areas.
However, as the fair value balances are often material, management are more likely to closely monitor any
fair value measurement which will reduce the control risk.
Detection risk ria
Detection risk will be minimised through proper planning of audit work. There is a risk that the audit team
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may lack the knowledge to make an assessment of the fair value measurement themselves and may rely too
heavily on the work of an auditor's expert. This could result in an increased risk of errors not being detected.
Conclusion
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A large number of material balances measured at fair value may increase audit risk in the financial
statements, but this is not always the case. Not every balance will contain a material misstatement and the
risk associated with each balance will need to be individually assessed.
(b) (i)
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Enquiry Reason
What is the professional certification of the valuer? To determine the competence of the valuer
Is the valuer a member of a recognised professional so the reliability of the valuation can be
assessed
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body/industry association, such as an institute of

chartered surveyors, and how long has the valuer
been a member for?
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Do any professional or other standards and

regulatory or legal requirements apply?
What assumptions and methods are used by the
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management's expert, and are they generally

accepted within that expert's field and appropriate
for financial reporting purposes?
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The nature of internal and external data or

information the expert uses
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Is there any relevant evidence regarding the

reputation of the valuer of which the auditor should
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be aware? For example, professional references.

Does the valuer hold a licence to carry out a To establish that the valuer is suitably
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160 Answers
Enquiry Reason
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valuation of investment properties (if applicable)? experienced in valuing the type of
investment property held by Poppy Co
What experience does the valuer hold in the To ensure that fair values have been
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valuation of investment properties and their reached using methods permitted by
recognition at fair value? IAS 40 Investment property
Is the valuer related to the entity in any way, for To determine the objectivity of the valuer so
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example, by being a close family member of a that the auditor can judge the independence
director at Poppy Co? of the valuation
Does the valuer have any financial interest in Poppy To assess the method by which Poppy Co
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Co, such as shares? has appointed the valuer
Is the fee received by the valuer reasonable and at If the fee was not at market price (for
market price? example too high) the valuer's
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independence may have been threatened in
order to provide the required result
(ii) Procedures
 Inspection of the written instructions given to the valuer by Poppy Co which should include
l.b
the objectives and scope of the work, the intended use of the valuer's work and the extent of
the valuer's access to records and files
 Consideration of the assumptions and methods used by the valuer to ensure they are


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reasonable based on other audit evidence and the auditor's previous knowledge of Poppy Co
An evaluation of the method used to measure fair value to ensure consistency with IAS 40
Examination of the valuation report to ensure each property has been valued consistently and
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that the date of valuation is reasonably close to Poppy Co's year end
 Physical inspection of the valuation properties to ensure their condition is in line with the
valuation report
 Inspection of purchase documentation for the investment properties to ensure that any
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revaluations made in the year of purchase are reasonable and not significantly different from
the purchase price
 A review of subsequent events for additional evidence on the valuation of the investment
properties
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 Written representations from management concerning the reasonableness of any stated

assumptions in determining fair value
 Evaluate the appropriateness of that expert's work as audit evidence for the relevant assertion
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25 Magpie
Text references. Chapters 4, 6, 7 and 11.
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Top tips. Part (a)(i) was a fair requirement, but one that may have left you struggling for ideas to make up eight
marks. The requirement divides itself naturally into two parts, with four marks each for the individual company and
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the consolidated financial statements. Make sure you noticed what point we were at in the audit process: it is audit
planning, after the engagement has been accepted but before the audit work as such has begun. Comments relating
to specific procedures will get no marks here, and neither will comments relating to eg audit acceptance
procedures.
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Part (a)(ii) was the longest part of the question, and was a fairly typical test of applying your knowledge to the
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scenario. The question did require perhaps a bit more financial reporting knowledge than in some previous sittings
of P7 – IFRS 3, IFRS 9 and IAS 20 came up – but you should not have struggled with any of it. Passing this part of
the question is a matter of working steadily through the issues contained in the scenario. You can flag to your
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marker that you are answering the question by specifically stating for each issue something like 'the risk here is',
and then using auditing terminology to pick out where there may be eg an understatement or an overstatement.
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Answers 161
It should be possible to pass part (a)(iii) fairly easily, as there is one mark available per specific procedure. You
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therefore only need three good, specific procedures to get three/five marks. As with many questions asking for
audit procedures in a specific area of financial reporting, a good approach is to think of each of the specific figures
involved, and then think of what could go wrong with each of them and how you would test them. The question
makes it easy for you here, as you have a goodwill calculation laid out for you. All you need to do is think of one or
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two good procedures for each figure in the calculation, and hey presto, you have passed the requirement!
Part (b) contained three tricky ethical scenarios. Even if you were not sure of the final answer in a given situation,
you can try approaching questions like this by (1) working out what the issue is, perhaps using the general types of
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threats as a guide (self-interest, self-review, advocacy, familiarity and intimidation); then (2) trying to think of
safeguards that might remove the issue; and then (3) if no safeguards would make the threat go away,
recommending that the auditor doesn't do it.
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Easy marks. There were plenty of easy marks in part (a)(iii) for thinking of procedures – provided you had not gone
over time on the long part (ii) that preceded them.
Examiner's comments. With respect to requirement (a)(i), most answers identified the main planning implications,
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such as the determination of component and group materiality levels, the audit firm's need to obtain business
understanding and assess the control environment in relation to the new subsidiary, and practical aspects such as
the timings and resources needed for the group audit. Weaker answers tended to just list out financial reporting
matters, eg that in the group financial statements related party transactions would have to be disclosed, and inter-
l.b
company balances eliminated, but failed to link these points sufficiently well to audit planning implications.
Answers to (a)(ii) tended to cover a wide range of points but very often did not discuss the points in much depth.
For example, almost all candidates identified that accounting for goodwill can be complex, leading to risk of
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misstatement, but few candidates explained the specific issues that give rise to risk. Many answers also went into a
lot of detail about how particular balances and transactions should be audited, recommending procedures to be
performed by the auditor, which was not asked for. Weaker answers simply stated an issue, for example, that a
grant had been received, and said the risk was that it would not be accounted for properly. Clearly this is not really
ate
an evaluation, as required, and will lead to minimal marks being awarded.
It was pleasing to see many candidates determining the materiality of the transactions and balances to the
individual company concerned and to the group. However, candidates are reminded that materiality should be
calculated appropriately, eg the materiality of an asset or liability should be based on total assets and not revenue.
ym
Generally candidates did well on requirement (a)(iii), with many providing well described, relevant procedures.
Most answers to the final part of the question went through the issues in order and identified the ethical threats that
arose. However, a lot of answers took a scattergun approach, and said that all of the issues would give rise to the
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same threats of familiarity, management, self-review and self-interest, but then did not go on to explain how, or
why, the threats arose and whether it would be possible for safeguards to reduce the threats to an acceptable level.
as
Marking scheme
Marks
(a) (i) Audit implications of Canary Co acquisition
cc
Up to 1½ marks for each implication explained (3 marks maximum for identification):

– Develop understanding of Canary Co business environment
– Document Canary Co accounting systems and controls
ea
– Perform detailed analytical procedures on Canary Co

– Communicate with previous auditor
– Review prior year audit opinion for relevant matters
e
– Plan additional work on opening balances

– Determine that Canary Co is a significant component of the Group
/fr
– Plan for audit of intra-company transactions

– Issues on auditing the one month difference in financial year ends
– Impact of acquisition on analytical procedures at Group level
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– Additional experienced staff may be needed, eg to audit complex goodwill

Maximum 8
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162 Answers
(ii) Risk of material misstatement
Up to 1½ marks for each risk (unless a different maximum is indicated below):
m/
– General risks – diversification, change to group structure
– Goodwill – contingent consideration – estimation uncertainty (probability of
payment)
co
– Goodwill – contingent consideration – measurement uncertainty (discounting)
– Goodwill – fair value of net assets acquired
– Goodwill – impairment
– Identify that the issues in relation to cost of investment apply also in Crow Co's
o t.
individual financial statements (1 mark)
– Loan stock – premium on redemption
– Loan stock – accrued interest
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– Loan stock – inadequate disclosure
– Identify that the issues in relation to loan stock apply to cost of investment in
Crow Co's individual financial statements (1 mark)
– Online sales and risk relating to revenue recognition (additional 1 mark if
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calculation provided of online sales materiality to the Group)
– No group accounting policy for online sales
– Canary Co management have no experience regarding consolidation
– Financial performance of Crow Co and Starling Co deteriorating (up to 3 marks
l.b
with calculations)
– Possible misstatement of Canary Co revenue and profit
– Grant received – capital expenditure
–
–
–
–
Grant received – amount not yet spent
Prior period error – clearly trivial
New IT system ria
Starling Co – no finance director in place at year end
ate
Maximum 18
(iii) Goodwill
Generally 1 mark per specific procedure (examples shown below):
– Confirm acquisition date to legal documentation
ym
– Confirm consideration details to legal documentation

– Agree 100% ownership, eg using Companies House search/register of
significant shareholdings
– Vouch consideration paid to bank statements/cash book
tud
– Review board minutes for discussion/approval of acquisition

– Obtain due diligence report and agree net assets valuation
– Discuss probability of paying contingent consideration
– Obtain management representation regarding contingency
– Recalculate goodwill including contingency on a discounted basis
as
Maximum 5
(b) Ethical matters
Generally 1 mark per comment:
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– Reasonable for partner to attend board meetings

– But must avoid perception of management involvement
– Partner must not be appointed to the board
ea
– Seconded manager would cause management and self-review threat

– Safeguards could not reduce these threats to an acceptable level
– Some recruitment services may be provided – interviewing/CV selection
e
– But avoid making management decision and put safeguards in place

Maximum 6
/fr
Total 37
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Answers 163
(a) (i) Planning implications of Canary Co acquisition
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Individual financial statements
ISA 315 Identifying and Assessing the Risks of Material Misstatement through Understanding the
Entity and Its Environment requires us to understand the entity and its environment, and internal
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control.
To understand Canary Co ('Canary') and its environment, we must consider any relevant regulatory
factors, eg whether it uses the same financial reporting ('FR') framework as the group; the nature of
o t.
the entity's operations, ownership and governance, and the kinds of transactions and balances that
should be expected in the financial statements; and its selection and application of accounting
policies, and whether they are in line with its business and the FR framework.
sp
To understand Canary's internal controls, we must consider its accounting systems as well as any
other controls relevant to the audit. Our understanding of these controls must be documented. This is
particularly important with a new audit client because we have not had time to build up knowledge of
the entity, and so need to place special emphasis on this area now.
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IT is likely to form a significant part of Canary's systems (since 30% of sales are online), and these
will be different from the rest of the group. We should consider if we need to use an auditor's expert
in this area.
l.b
It will be necessary to perform detailed analytical procedures on Canary at the planning stage. This
will be necessary to determine planning materiality, and to help identify any significant events or
transactions in the period.
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ISA 300 Planning an Audit of Financial Statements requires us to communicate with Canary's
predecessor auditor, asking if there is anything we should be aware of that may influence our plan.
We should also review the prior period audit opinion and report.
ate
Finally, we will need to perform additional procedures on Canary's opening balances, as these were
audited by a predecessor auditor.
Consolidated financial statements
ym
The first thing to consider is whether Canary is a significant component according to ISA 600 Special
Considerations-Audits of Group Financial Statements (Including the Work of Component Auditors).
Canary's forecast revenue is 11.9% (16/135) of group revenue, and profit is 23.5% (2/8.5), so it is
definitely a significant component.
tud
Although we are both the group auditors and Canary's individual auditors, we still need to (i)
consider whether audit evidence obtained for the individual company is sufficient and appropriate for
the group, and (ii) perform procedures on matters relevant to the consolidated accounts. This
includes procedures to determine whether intra-group balances have been eliminated, and whether
as
IFRS 3 has been applied correctly in relation to the acquisition itself.

A particular issue is that Canary's 30 June year end is different from the rest of the group. In practice
this will usually be changed soon after the company is acquired, so we need to obtain evidence to
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determine whether or not this has happened. This matter is absolutely crucial to the audit. If the year
end has not been changed, then additional procedures must be performed on Canary's financial
information so that its financial statements as at 31 July 20X2 can be consolidated.
ea
Care must be taken when performing analytical review at a group level, as Canary's figures are only
included since the acquisition date and will not be comparable with the whole-year figures of the rest
of the group.
e
Finally, the new acquisition introduces new complexities into the audit, so we must ensure that these
aspects of the audit are done by staff with appropriate levels of experience, eg the goodwill asset and
/fr
the contingent consideration.

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164 Answers
(ii) General
m/
There are several factors which together mean that this is a high risk audit: there has been a
significant acquisition, a move into a new line of business, and the introduction of new IT systems
relating to financial reporting.
co
Goodwill
Goodwill is material to the financial statements, at 8.2% of total assets (45/550).
The contingent consideration is a significant audit risk. It is currently recognised in full as an asset,
o t.
which is in line with the IFRS 3 Business combinations requirement to recognise it at its fair value at
the acquisition date. However, this amount should be discounted to its present value, because the
consideration is not payable until 1 February 2015. As this has not been done, goodwill appears to be
sp
overstated.
A further risk relates to the valuation of identifiable net assets. This has been done by a
management's expert in the context of a due diligence review. ISA 500 Audit evidence requires the
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auditor to evaluate the expert's competence, capability and objectivity; to obtain an understanding of
their work; and to evaluate the work's appropriateness as audit evidence. The auditor's evaluation of
each of these issues should be documented.
IAS 36 Impairment of assets requires goodwill to be tested for impairment annually, and there is no
l.b
mention of this having been done at the year end. There is therefore a risk that goodwill may be
overstated.
Loan stock
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The loan stock issued is material, at 18.2% of total assets (100/550).
The premium of $20m should be recognised as a finance cost over the period of the loan using the
ate
amortised cost method, in line with IFRS 9 Financial instruments. The risk is that this has not been
done, and that finance costs are understated.
An interest cost of 5% is also payable in arrears, and there is a risk of further understatement of
finance costs if this has not been accrued for.
ym
These issues apply to both the group accounts and Crow Co's individual company financial
statements.
Online sales
tud
Canary's online sales represent 30% of its revenue, with approximately $4.8m (0.3 × 16) included in
the group accounts – a figure that should be even higher in future, when a full year's revenue will be
included in the group accounts.
There is a risk that IAS 18 Revenue's requirements on when revenue should be recognised are not
as
met. This will be heavily dependent on the reliability of the IT system involved, its appropriateness for
financial reporting, and its integration with the accounting system.
E-commerce can also represent a business risk as it may expose Canary to eg lost sales or
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reputational damage if its website does not operate effectively. With online sales at 30% of revenue,
any significant problems in this area could affect Canary's status as a going concern.
Canary's management
ea
Canary's management have no prior experience of the consolidation process at the CS Group, so it is
possible that the process will operate inefficiently and that errors will be made. It is likely that more
audit work will need to be done on the consolidation of Canary's results than on the rest of the group.
e
Financial performance
/fr
At first sight, the group's results are encouraging – revenue is up 8% and profit before tax is up
1.2%. However, this is not comparing like with like: the prior year figures do not include any of
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Canary's results, whereas the current year figures include Canary for six months.
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Answers 165
If we include only Crow Co and Starling Co's results and compare them with the prior year, then a
different picture emerges:
m/
20X2 20X1
Crow + Starling Group
forecast actual % change
co
Revenue 119 125 (4.8%)
Profit before tax 6.5 8.4 (22.6%)
Instead of profit and revenue both growing, the picture these figures paint is of profit and revenue
o t.
shrinking. This may be for operational reasons, but it is also possible that there has been a
misstatement, with either costs being overstated or revenue understated.
Government grant
sp
The grant is material, at 6.4% of total assets (35/550).
There are two issues in relation to the grant. The first is that in line with IAS 20 Accounting for
Government Grants and Disclosure of Government Assistance, this is a grant related to assets. This
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may either be deducted from the cost of the related assets (in this case, solar panels), or recognised
as deferred income that is released systematically into profit or loss. At the year end only $25m of the
$35m grant had been spent, so some of the grant should be deferred until the next year. There is a
risk that this has not been done, and eg the $35m has simply been recognised in income during the
l.b
year.
The second issue is that the grant is for capital expenditure on environmentally friendly assets, but
Starling Co intends to spend the remaining $10m on upgrading its production and packing lines. This
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seems unlikely to meet the conditions of the grant, and it is possible that some of it will need to be
repaid if it is spent in this way. The matter is likely to be material to the group, at 1.8% of total assets
(10/550).
ate
Prior period error not relevant
Deferred revenue in the prior period was overstated by $10,000. This is 0.014% of Crow Co's
forecast revenue (= 100,000 / 69,000,000), and 0.29% of profit. It is clearly immaterial, and is not
relevant to the audit planning.
ym
New IT system
The new IT system, which is relevant to financial reporting, represents a risk of material
misstatement per ISA 315. There are two main issues: firstly, errors may have been made in
transferring the data from the old to the new system; and secondly, the new system is likely to take
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time to bed in, and it is possible for teething problems to lead to a loss of data.
New FD
The fact that Starling Co's FD has recently left increases the risk of errors as it deprives the company
as
of accounting skills it may need when producing its financial statements, and for the consolidation
process. It may also make the audit more difficult to conduct, as it may not be possible to obtain
explanations that are needed if there is no FD.
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Finally, the reasons for the FD leaving should be ascertained, as it is possible that there has been a
disagreement over accounting policies, or even a fraud.
(iii) Audit procedures on goodwill
ea
 Obtain the legal purchase agreement and confirm the acquisition date
 Confirm (from the legal agreement) the consideration, and details of the contingent
consideration
e
 Confirm that Canary is wholly owned by Crow Co through a review of its register of
/fr
shareholders
 Agree cash payment of $125 million to cash book and bank statements
p:/
 Review board minutes for discussion regarding, and approval of, the purchase of Canary
 Obtain due diligence report on Canary and confirm estimated fair value of net assets
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166 Answers
(b) Partner at board meetings
m/
It is acceptable for the audit engagement partner to attend board meetings. There are even some times when
the partner should attend, eg to raise issues with management and/or those charged with governance.
The important thing is that the partner does not take on a management role, and that they are not involved in
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any discussions that are not relevant to the audit. If the partner served as a director of an audit client, then
the self-review and self-interest threats created would be insurmountable.
Audit manager secondment
o t.
This is a temporary staff assignment, and is acceptable as long as it is for a short period of time, and no
management responsibilities are taken on. In this case, the member of staff would probably be involved in
making management decisions as they would be the finance director. They would not be under the control of
the audit client.
sp
It is therefore unlikely that any safeguards could reduce this threat to an acceptable level, so no member of
staff should be seconded into this role.
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Recruitment help
It is possible for help to be provided with recruitment, but only if the auditor does not make any
management decisions. It would be possible to eg review a shortlist of candidates' CVs, but only against
criteria set out by the CS Group itself.
l.b
If help is provided then the final decision about recruitment must be left to the client. Safeguards should also
be put in place, such as obtaining written acknowledgement from the client that they are responsible for the
recruitment decision.
26 Beech ria
ate
Top tips. Part (a) was for eight marks, and may at first sight have appeared quite a stretch. On seeing the mark
allocation, though, you should read the scenario information very closely as it is packed with hints of what you need
to discuss. Virtually every sentence gives rise to a matter to consider; the audit evidence should then flow from this.
ym
If you approached the question sensibly then you should have been able to score 4–6 marks without too much
difficulty.
Part (b) was difficult, and you may have struggled to find enough to say. Make sure that you don't go over your
time allotment by agonising about what to write, especially given that part (c) was quite a bit easier. You should
tud
have enough knowledge in this area to be able to pass this part of the question, much of which is common sense.
Note that discussions of the expert's competence or objectivity were not relevant here, as the requirement relates to
evaluating work already done by the expert, rather than the process of instructing them.
Part (c) should not have posed many difficulties. Notice that as the question asks for the implications for the
as
auditor's report – rather than just the opinion – there is a mark available for describing the effect on the layout and
wording of the report itself.
cc
Easy marks. There were easy marks in part (c) for explaining why the accounting treatment is incorrect.
Marking scheme
ea
Marks
(a) Fir Co
Generally 1 mark per matter/evidence point explained:
e
Matters:
– Whether a present obligation exists
/fr
– Assumptions used in estimate are complex/subjective

– Investigate why provision fallen in value
– IAS 37 disclosure requirements not met
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– IAS 1 disclosure requirements not met

– Potential misstatement due to insufficient disclosure
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Answers 167
Evidence: Marks
– Supporting documentation regarding existence of obligation
m/
– Assess whether assumptions in line with business understanding/other evidence
– Discuss assumptions and estimation method with management
– Review supporting documentation (operating licence/government agreement)
co
– Assess controls in place
– Written representation
– Review of draft notes to financial statements
Maximum 8
o t.
(b) Spruce Co
Generally 1 mark for each procedure:
Share-based payment plan:
sp
– Consider whether expert has followed auditor's written instructions
– Ensure expert's findings consistent with other evidence obtained
– Ensure expert's work considers events after the year end where necessary
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– Compare expert's results with those determined by management
– Reperform calculations
– Consider suitability of models used in the expert's work
– Evaluate assumptions and ensure in line with auditor's understanding
– Verify source data
l.b
– Agree figures and terms to supporting documentation
Maximum 5
(c) Pine Co
Generally 1 mark per matter explained:
– Consider whether change in estimate is valid
ria
– Incorrect accounting treatment used (up to 2 marks for detailed explanation)
ate
– Insufficient notes to the financial statements
– Discuss with management and encourage amendments value
– Opinion to be qualified 'except for' due to material misstatement
– Description of reason for qualification to be provided in auditor's report
Maximum marks 5
ym
Total 18
tud
(a) Fir Co
Matters to consider
IAS 16 Property, plant and equipment requires that where there is an obligation to dismantle an asset, then
the costs of doing so should be provided for, and included in the cost of the asset. The question here is
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whether an obligation exists in accordance with IAS 37 Provisions, contingent assets and contingent
liabilities. It is not sufficient for Fir Co merely to 'intend' to incur the costs, rather; there must be a legal or
constructive obligation as a result of a past event. If there is no such obligation, then no provision should be
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recognised.
The provision should be for the present value of the future outflow of economic benefits. Measuring a
provision for costs to be incurred in 20-years' time is inherently risky. For example, the cost to be incurred
ea
may only be an estimate; the remaining useful life of the power stations is definitely just an estimate; the
selection of a discount rate to calculate the present value involves judgement and is therefore not certain.
The provision has decreased in value since last year, which is unusual as provisions normally increase over
e
time as the present value is built up. This could mean that circumstances have changed, or may signal new
measurement assumptions being made. It may also be a sign of profit-smoothing, as earnings have
/fr
effectively been shifted from last year's statement of profit or loss into this year's. The reasons for this need
to be investigated.
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168 Answers
The note to the financial statements does not conform to IAS 37's requirement to provide narrative
m/
information, including disclosure of the reasons for making the provision together with any uncertainties in
relation to them. The notes should also analyse the movement in the year. Unless this is remedied then this
is a material misstatement which may lead to a qualified audit opinion.
co
Audit evidence
 Review of evidence that there is an obligation to dismantle, eg from regulatory authorities
 Review of management's calculations used to measure the provision, considering their consistency
o t.
with other audit evidence obtained (eg that the remaining life of the assets is 20 years)
 Review of documentation supporting management's assumptions (eg to support the estimated cost
of decommissioning)
sp
 Discussion with management about reasons for the fall in the provision, and evaluation of these
reasons (eg regarding IFRS, knowledge of the entity)
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(b) Spruce Co
The expert should have been provided with clear written instructions covering the objectives of the work and
any specific issues to address. The first procedure would therefore be assessing whether the work done
meets these objectives, whether it has been performed in accordance with any standards specified, and that
l.b
it is consistent with the applicable financial reporting framework.
The expert's work should be reviewed to confirm that the correct source data was used, and that it relates to
the right financial instruments in the right period. Any assumptions made by the expert should be compared
ria
with eg similar assumptions used by management in preparing the financial statements.
Any evidence contained in the report should be reviewed for consistency with our understanding of the
entity and with other audit evidence obtained.
ate
Evidence used by the expert should be agreed to supporting documentation, and any calculations contained
in the work should be reperformed, eg fair value movements.
The appropriateness of any models used by the expert should be evaluated.
ym
(c) Pine Co
IAS 8 Accounting policies, changes in accounting estimates and errors requires a change in accounting
estimate to be accounted for prospectively, not retrospectively as has been done here; retrospective
accounting should only be used for a change in accounting policy.
tud
There should be no change to opening assets or equity; these are therefore materially misstated here
(overstatement). The extension of the properties' useful life would probably decrease the depreciation
expense, resulting in an overstatement of profit. Also it is not clear why all of the properties' useful lives
as
have been extended; IAS 16 requires that the useful life is the period over which an asset is expected to be
used. There is a risk that the useful lives used are not appropriate, and that the financial statements are
materially misstated.
cc
IAS 8 requires disclosure of the nature and amount of the change in estimate; as this has not been done,
there is a material misstatement in respect of IAS 8's disclosure requirements.
The matter should be discussed with management, who should be asked to amend the financial statements.
ea
If satisfactory amendments are not made then the auditor's report will contain a qualified opinion. This will
be 'except for' a material misstatement, as the amount is material but not pervasive.
The opinion paragraph in the auditor's report is headed 'Qualified opinion'. Immediately before this is a
e
paragraph headed 'Basis for qualified opinion', which describes the matter giving rise to the qualification and
quantifies the effects of the misstatement.
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Answers 169
27 Setter
m/
Top tips. Don't forget to calculate materiality, as these are easy marks.
co
Your general approach to questions of this sort should be to state the correct accounting treatment of the issue at
hand, and then compare this with what has actually happened in the question. Even if you're not absolutely certain
of what the correct treatment is (part (b) was tricky here), you can still score marks by setting out the requirements
o t.
of the standard. (But note that marks will be limited for 'identification' only, so you should not spend too long doing
this.)
Part (a) should have been OK, as the question contained quite a lot of information that should have help remind you
sp
of the requirements of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. Note that there are no
marks available for naming the standard, so do not waste time in the exam doing so – especially when its name is
as long as this one!
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Part (b) was hard, as the correct accounting treatment was not entirely obvious. However, you could still have
scored well by picking up the easier points (eg that the property should be stated at $37m not $27m), and by
talking about the criteria from the standard (eg the transfer of risks and rewards and the useful life of the asset).
Part (c) was probably the easiest part of this question, so it was important here that you had not run out of time and
l.b
could therefore pick up plenty of the marks that were available. Note in particular that there are many more marks
available if you adjust your amortisation calculation for the mid-year acquisition, compared with simply dividing the
cost by the useful life.
ria
Easy marks. If you calculated materiality correctly for each part of the question, then you would have scored an
easy 1.5–2 marks (½ mark for each calculation).
ate
Examiner's comments. Candidates were well prepared for this type of question, and as one of the optional
questions, it was attempted by the majority of candidates. On requirement (a), most answers were satisfactory,
largely because candidates were confident in explaining the relevant financial reporting requirements and applying
them to the brief scenario.
ym
On requirement (b), some answers were excellent, covering all of the financial reporting issues and correctly
concluding that the treatment was wrong and if not corrected could have implications for the auditor's opinion.
Inadequate answers discussed the points in a vague manner, seeming uncertain as to whether the accounting
treatment was correct or not, resulting in the suggestion of a few unclear audit evidence points.
tud
On requirement (c), candidates seemed more comfortable with this requirement than the preceding one, and many
discussed all of the relevant financial reporting concerns, particularly in relation to amortisation and/or impairment
of the asset.
Overall this was a well attempted question by many. I would however point out that candidates need to think
as
carefully when calculating and commenting on materiality. Most candidates calculated the materiality of every figure
given in the question in relation to each of revenue, profit before tax and assets. By this stage in their studies
candidates should appreciate that often this is not necessary, for example there is little relevance in calculating an
cc
item of expense in relation to assets. Performing all of these calculations must take some time, and the irrelevant
calculations will not generate marks.
e ea
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170 Answers
m/
Marking scheme
Marks
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(a) Assets held for sale
Generally 1 mark for each matter considered/evidence point explained:
Matters:
o t.
– Assets held for sale are material (calculation)
– Amount written off is not material (calculation)
– Conditions required to classify assets as held for sale (up to 2 marks)
sp
– Re-measurement at classification appears correct
– Further impairment review may be needed at year end
– Depreciation should not be charged after reclassification
– Disclosure in notes to financial statements
log
Evidence:
– Board minutes at which the disposal of the properties was agreed by
management
l.b
– Details of the active programme in place to locate a buyer
– A copy of any minutes of meetings held with prospective purchasers
of any of the properties
before October 20X3

– Subsequent events review
ria
– Written representation from management that the assets will be sold
ate
– Confirm depreciation ceased on reclassification
– Details of any impairment review conducted by management
Maximum 8
ym
(b) Sale and leaseback

Matters:
tud
– Asset is material (calculation)

– On disposal the asset should be re-measured to fair value
– Apparent profit should be deferred and amortised
– Accounting treatment currently not correct
as
– Discuss materiality of adjustments needed

– Implication for auditor's opinion
– Treatment as a finance lease appears correct
cc
Evidence:
– A copy of the lease to confirm that the arrangement is a finance lease
– Physical inspection of the property complex
ea
– A copy of insurance documents

– Confirmation of the fair value of the property complex, possibly using
an auditor's expert
– Agreement of the $37 million cash proceeds to bank statement and
e
cash book
/fr
– A schedule showing the adjustment required in the financial

statements
– Minutes of a discussion with management regarding the accounting
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treatment and including an

Maximum 7
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Answers 171
(c) Distribution licence Marks
m/
Matters:
– Materiality of the asset (calculation)
co
– Identify event as intangible asset that should be capitalised
– Identify that no amortisation has been charged
– The non-amortisation is not material
o t.
Evidence:
– A copy of the licence
– Agreement of cost to bank statement and cash book
sp
– Discussion with management regarding the non-amortisation
– Sales records of the soft drink since 1 September 20X2
Maximum 5
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Total 20
l.b
(a) Matters
The assets held for sale are material to the financial statements at 8% of total assets (= $24m ÷ $300m).
The amount written off is not material, at less than 1% of revenue (= $2m ÷ $620m) and 4.2% of profit
before tax (= $2m ÷ $47.5m).
ria
Assets are classified as held for sale if they meet the following criteria (among others):
ate
 Management is committed to a plan to sell
 The assets are available for immediate sale in their present condition
 An active programme exists to locate a buyer
 The sale is highly probable, within 12 months of reclassification
ym
The accounting treatment appears to be correct, measuring the assets at the lower of carrying amount and
fair value less costs to sell.
The classification took place mid-year, so an impairment review should be conducted as it is possible that
the assets have become impaired by the year end.
tud
Depreciation should have ceased from when the reclassification took place in October.
Evidence
 Copy of board minutes to show management's intention to sell assets
as
 Physical inspection of assets to confirm that they are saleable in present condition
 Evidence of programme to locate buyer, eg copies of advertisements, correspondence with estate
cc
agent
 Written representation for management's commitment to sell within 12 months
ea
 Copy of management's impairment review

 Confirmation that $2m written off is recognised in profit or loss
 Confirmation that depreciation ceased on reclassification
e
(b) Matters
/fr
The carrying value of $27m is material at 9% of total assets (= $27m ÷ $300m).

The leaseback appears to be a finance lease because:
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 The risks and rewards of ownership are with Setter Stores

 The lease term is for the remaining useful life of the asset
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172 Answers
Therefore the initial accounting entry appears correct. However, further entries are needed. The sale
proceeds of $37m should become the asset's cost, with the asset being derecognised ($27m) and then re-
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recognised at $37m.
This leaves a gain of $10m on signing the lease, which should be recognised over the useful life of the asset
– at the year end it is deferred income. The following entries should therefore be made.
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Dr Property, plant and equipment $37m
Cr Property, plant and equipment $27m
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Cr Deferred income $10m
The deferred income should be amortised over the useful life of 20 years, resulting in other income
recognised in the statement of profit or loss. However, the amount recognised in the current year is $nil
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because the transaction took place at the year end.
Depreciation should also be charged over 20 years. The amount recognised in this period, however, will be
based on the old carrying value of $27m.
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As the finance lease is for 20 years, the effect of discounting is likely to be material. The liability should be
recognised at its present value, with the effect of discounting being recognised as a finance cost in future
periods.
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As they stand the financial statements appear to be misstated in respect of deferred income and non-current
assets. The misstatement is material at 3.3% of total assets (= $10m ÷ $300m). If this is not corrected then
the audit opinion must be qualified on the grounds of a material misstatement.
Evidence
 ria
A copy of the signed lease should be on file, with confirmation of its major clauses affecting its
classification as a finance lease
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 Copy of insurance documents showing that Setter Stores is responsible for insurance
 Copy of board minutes of discussion of lease for indication of whether this is a finance lease or an
operating lease
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 Agreement of $37m cash received to bank statement

 Confirmation of fair value of $37m, possibly using an auditor's expert
(c) Matters
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The licence is material at 5% of total assets (= $15m ÷ $300m).

The asset can be recognised if:
 It is probable that future economic benefits will flow to the entity
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 The cost can be measured reliably

As the licence has been acquired separately, it should be treated as an intangible non-current asset.
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Amortisation should be recognised based on the useful life of five years, but this does not appear to have
been done. This gives an additional expense of $1.25m (= ($15m ÷ 5 years) × 5 months). This amount is not
material at less than 1% of revenue ($1.25m ÷ $620m) and 2.6% of profit before tax ($1.25m ÷ $47.5m).
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Evidence
 A copy of the licence, confirming five- year term and cost of $15m
 Agreement of $15m cash paid to bank statement
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 Minutes of discussion with management of non-amortisation of the licence

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 Sales information in relation to the soft drink to confirm the probability of receiving economic
benefits
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Answers 173
28 Lamont
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Top tips. This is a scenario question on audit evidence. It is worth 20 marks in total but there are three short
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scenarios so consider each separately and it won't seem so daunting. Where you are asked for matters to consider,
make sure you explain these properly. For the audit evidence part, bulleted lists should be fine but make sure your
answers aren't vague as vague statements won't score any marks. You should also make sure that you mention
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materiality in your answers – you are provided with draft account figures so you should use them.
Easy marks. There aren't easy marks as such on this question but you will be able to score points for considering
materiality and for stating the audit evidence you should expect to find in each circumstance.
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Examiner's comments. Students did not take an appropriate approach to materiality issues in the question. In part
(i), many students did not identify the main issues in the scenarios, such as the capital v expenditure or the related
party transaction. The audit evidence required in part (ii) was often vague and therefore students did not score well
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where this was the case.
Marking scheme
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Marks
(i) Matters
Maximum 6 marks each issue × 3
Ideas
 materiality (appropriately assessed)
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 relevant IFRSs (eg IAS 2, 16, 24, 36, 40)
 fundamental concepts (capital vs revenue)
 risks (eg valuation (obsolescence)/disclosure)
(ii) Audit evidence
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Generally 1 mark each item of audit evidence (source)

Maximum 6 marks each issue × 3 Maximum 12
Ideas (ISA 500)
 documented on WP file – current vs PY
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 internal (eg age analysis) vs external (eg monthly returns)

 auditor generated (analytical procedure)
 results of procedures by which obtained (eg physical inspection)
Maximum 20
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(a) Maximum 7
(b) Maximum 7
(c) 6
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Maximum
Total 20
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(a) Chemical leakage

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 The clean-up costs of $0.3m should not have been capitalised as an asset but should have
been written-off to the statement of profit or loss. This amount represents 0.6% of total assets
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and 2.5% of profit before tax so is not material but should be adjusted for in the financial
statements.
 The modernisation costs of $0.6m represent 1.2% of total assets and 5% of profit before tax
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and are therefore material to the accounts. Their capitalisation would be correct in accordance
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174 Answers
with IAS 16 Property, plant and equipment if the expenditure restores the economic benefits
of the refrigeration units.
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 The fine of $30,000 incurred by Lamont is immaterial but has been correctly written-off to the
statement of profit or loss.
(ii) Audit evidence
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 Invoices to support the clean-up costs and modernisation costs
 Correspondence from the regulatory agency to confirm the amount of the fine
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 Bank statement and cash book extracts to show payment of the amounts involved
 Board minutes referring to the chemical leakage
 Physical inspection of the refrigeration units to confirm the modernisation costs incurred
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(b) Inventory held by Hogg Warehousing
 Inventory is material to the statement of financial position, comprising 21% of total assets,
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therefore the auditors need to obtain sufficient, appropriate audit evidence of its valuation at
the year end.
 Inventory has increased from the year before by 51% which is very high – the reason for this
increase needs to be investigated further.
l.b
 A written representation from management with a point on the value of inventory held at the
year end is not sufficient audit evidence as there should be other more reliable audit evidence
available to confirm the $10.1 million figure.

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If the inventory figure cannot be adequately verified, this may result in a limitation on the
scope of the audit, and a modification of the auditor's opinion on the grounds of an inability to
obtain sufficient appropriate audit evidence.
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 Although the quantity of inventory held by Hogg Warehousing can be provided, this does not
provide evidence of its valuation at the year-end date. Given that inventory comprises fish, it
may be that some of the inventory might be damaged and therefore its value would be less.
Inventory may therefore be overstated in the financial statements.
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(ii) Audit evidence

 Written representation from management referring to the value of year-end inventory
 Correspondence between Lamont and Hogg Warehousing regarding the inventory held by
Hogg Warehousing on behalf of Lamont
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 Hogg's monthly returns of quantities held

 Correspondence relating to the health and safety issues preventing access to cold storage
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 Analytical procedures on inventory, such as month by month comparisons to the previous
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year, to try to ascertain why the value of inventory has increased so much this year
(c) Residential apartment
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 The senior sales executive is a related party in accordance with IAS 24 Related party
disclosures as he would be a member of key management.
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 A related party transaction has therefore occurred by virtue of the senior sales executive using
the residential apartment of the company even though no money has exchanged hands –
IAS 24 defines a related party transaction as 'a transfer of resources, services or obligations
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between a reporting entity and a related party, regardless of whether a price is charged'.
 IAS 24 requires related party transactions to be disclosed in the financial statements as they
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are material by their nature. The standard details what is required for disclosure, but it
includes the names of the related parties, the relationships, the amounts involved and a
description of the transactions.
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Answers 175
(ii) Audit evidence
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 Rental agreement to confirm charge of $3,000 per month and identification of the other party
 Deeds to confirm ownership of the apartment by Lamont
 Physical inspection of the apartment to confirm its existence and that it is being occupied
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 A written representation from the directors of Lamont to confirm all related parties and related
party transactions have been disclosed and appropriately accounted for in line with the
applicable framework
 A written representation from the senior sales executive stating that he is occupying the
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apartment rent-free
29 Papaya
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Study text reference. Chapter 6.
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Top tips. Part (a) may have seemed a little tricky, and you may have struggled to think of enough ideas to gain
marks, although in reality it was not a difficult requirement. You needed to stay calm and think practically about
what an auditor would gain from doing analytical procedures at the planning stage, and about the practical
limitations of those procedures. If you did this, you should have been able to pass this part of the question.
l.b
Part (b) should have been straightforward, as the distinction is a relatively simple one to understand. The key here
was to make sure that you explained each term in enough detail to gain the marks.
The answer to part (c) was in a way obvious because no financial information was included within the question. You
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could have generated ideas by just thinking of all the information you could use in an ideal world when auditing this
kind of company – ie a large listed company with a number of different operating divisions. It is important then to
make sure you apply your ideas to the scenario in the question – take heed of the examiner's warning in the
requirement to use 'the specific information provided'.
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A good way to approach answering an 'explain' requirement like this would be, for each point, first to identify the
piece of information needed, and then to give a reason why this is needed.
Part (d) should have been straightforward, provided that you have heeded the examiner's advice (in a recent article)
to keep up with your financial reporting knowledge for auditing. It was important to realise that only risks of
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material misstatement were being asked for – candidates have often been caught out in the past by not reading the
question properly, and subsequently just writing down any risk they can think of in a kind of scatter-gun approach.
Take care not to do this! The risks themselves should have been readily identifiable in the question. As usual, work
through the scenario with a pen in hand, writing down risks of material misstatement as you see them. This is
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essentially a question of finding bits of accounting that might have been done incorrectly, then phrasing this in your
answer in terms of a risk of material misstatement. It is always worth including sentences in your answer like 'The
risk is that xxx', just to make it clear to the examiner that you're answering the question.
Easy marks. Make sure you get the professional marks in part (d). There are four marks available for using the right
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format (heading, introduction, conclusion), and for 'clarity of explanation' – essentially this means that you should
write clearly and avoid waffle, but making sure that you write in full sentences and that everything you say makes
sense. You could think about having a standard form of words ready to use in an introduction or conclusion so that
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you don't have to use up timing thinking about what to write in the exam.
Examiner's comments. In a departure from previous sittings, question one was answered inadequately by a
majority of candidates. Many candidates seemed to lack a basic understanding of the use of analytical procedures
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at the planning stage of the audit. On the risks of material misstatement, many answers were vague, and despite
being lengthy, did not address the question requirement.
In the first part of requirement (a), most candidates could suggest that analytical procedures should help to identify
risks, a point suggested in the question, but fewer identified that such procedures would help the auditor to develop
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business understanding. Most candidates used examples to illustrate their comments, as required, but on the whole
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the examples were weak and did not help to explain why the procedure was being carried out. The answers to the
second part of the requirement were extremely disappointing. The vast majority of candidates seemed not to have
read the last eight words of the requirement, so failing to discuss the limitations of analytical procedures at the
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planning stage of the audit.

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176 Answers
Requirement (b) asked candidates to explain and differentiate the terms 'audit strategy' and 'audit plan'. Some
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candidates performed well here, but some candidates mixed up the two terms or failed to differentiate between
them. Many also re-used wording from the question requirement, for example 'the audit strategy is the strategy for
the audit, 'the audit plan is the plan for the audit'. Clearly such comments add no value and cannot be awarded
credit.
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Requirement (c) was based on the scenario, and candidates performed well if they applied their knowledge to the
question scenario. However, the majority of candidates failed to do this, and instead produced a list of vague bullet
points, referring to information that would be required for the planning of any audit. Most candidates listed prior
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year accounts, management accounts, a cash flow statement, and little else.
Some candidates wrote at great length in answering requirement (d), but unfortunately quantity does not equate to
quality. It was at times frustrating to see pages of writing scoring few marks, because points made were either
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irrelevant, technically incorrect, or not actually explaining the risk to the auditor. Many candidates provided
numerous examples of substantive procedures or audit impacts ('we must discuss the court case with lawyers', 'we
must see who can audit the overseas division'), again not relevant to the requirement.
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Marking scheme
l.b
Marks
(a) (i) Reasons for performing analytical procedures during risk assessment
Up to 1 mark for each reason, and 1 mark for relevant example:
(ii)
–
–
Maximum
Develop business understanding + example
Identify risks + example
Limitations of analytical procedures at planning

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1 mark each point explained (limit to ½ mark if just identified):
– Does not cover whole period
– Year end procedures not yet carried out
– Weaker controls/different reporting framework
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– Small entities may lack interim financial data

Maximum 3
(b) Explain and differentiate between the terms 'audit plan' and 'overall audit strategy'
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– Up to 2 marks for each explanation

– 1 mark for each point of comparison or comment on timing
Maximum 4
(c) Identify, with reasons, information needed for analytical procedures
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Generally ½ mark for identification, 1 further mark for reasons, from ideas list.
– Disaggregation by business segment ie supermarkets v financial services
– Separate out the different brands of supermarket
– Separate out the foreign division
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– Information regarding one-off items

– Information regarding new accounting policies/treatments
– Budget information
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– Industry/competitor comparisons
Maximum 6
(d) Risks of material misstatement
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Professional marks to be awarded for format (heading, introduction, conclusion) – 1

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mark, and clarity of explanation – 1 mark

Generally ½ mark for identifying risk of material misstatement, up to further 2 marks for
explanation
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– Lack of disclosure of contingent liability/understatement of provision (IAS 37)

– Incorrect recognition and measurement of separate components of convertible
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Answers 177
debenture (IAS 32)
– No recognition of financial asset or liability regarding derivative/incorrect
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measurement/lack of disclosure (IFRS 7)
– Impairment of land (IAS 36)
– Undervaluation of PPE if inspection cost not capitalised (IAS 16)
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– Operating segments – risk of non-disclosure (IFRS 8)
– Risk of capitalisation of internally generated brand (IAS 38)
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Total 36
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(a) (i) Understanding of business
Performing analytical procedures at the planning stage of the audit can help an auditor to develop an
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understanding of the client's business. An auditor can glean a lot of information from analysis of
prior period and draft accounts. He can find out, for example, which are the client's key revenue
streams, or which are the main areas of capital expenditure required for it to operate in this area. This
is particularly relevant for a new client, as the auditor will have a particularly acute need to find out
l.b
even the first and most basic facts about a client's business. For example, calculating a client's profit
margin would allow the auditor to compare it with others in the industry, and so gauge the client's
performance.
Identify risks
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Performing analytical procedures can also help identify key audit risks. For example, it might be that
a highly material intangible asset has been capitalised in the draft statement of financial position, or
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that operating profits have increased by 20% in an industry where the trend is for a decline. Both of
these circumstances would point to a need to carry out more audit work in those areas.
This means that an auditor can work out a strategy that is specifically tailored to the risks of this
particular engagement. This will help to minimise detection risk, and by allowing the auditor to direct
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work to risky areas will reduce the chance of doing work that is unnecessary.
(ii) There are several key limitations. Firstly, the figures will likely only be in draft form. Any analytical
procedures performed on these figures may be invalidated by adjustments that are usually only made
at the period end, such as the calculation of a finance lease liability.
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Secondly, the information will not cover the entire accounting period. It is not always straightforward
to extrapolate figures from just a part of the year to cover a full year, particularly when seasonality
has to be taken into account. Analytical procedures performed on this information may therefore be
misleading.
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Thirdly, the information might not be produced on the same basis as the previous year, particularly if
internal management accounts are being used. Care should be taken when extracting figures from
management accounts so that it can be used to make meaningful analytical comparisons.
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Finally, if the client is a small entity then it might not have a formal reporting system in place during
the year, so that no proper information is available before the year end accounts are produced.
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(b) ISA 300 Planning an audit of financial statements distinguishes between the overall audit strategy, which
sets out in general terms how the audit is to be carried out, and the audit plan, which details the specific
procedures that need to be carried out in order to implement the strategy and complete the audit.
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Considerations in establishing the strategy include:

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(i) Characteristics of the engagement

(ii) Reporting objectives, timing of the audit and nature of communications
(iii) Significant factors, preliminary engagement activities and knowledge gained on other engagements
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(iv) Nature, timing and extent of resources

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178 Answers
By contrast, the audit plan draws these general requirements together into a schedule of the work that is
required to reduce audit risk to the level required to give reasonable assurance. It deals with the actual
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procedures, including risk-assessment procedures, that are required at the assertion level (in respect of
specific areas of the financial statements) to gather audit evidence.
The strategy is conceptually prior to the plan, and in theory should be prepared before it. In reality, though,
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they are interrelated, as changes in one may result in changes in the other.
(c) Financial information would be required including details of the nature and amounts of all the income and
expense items, as well as all assets and liabilities, acquisitions and disposals.
o t.
This should be broken down into Papaya's four main business segments – the Papaya Mart supermarket
chain, the overseas Papaya Marts in Farland, the Papaya Express chain and the new financial services
division. This would allow each part of the business to be analysed separately. This is necessary because
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each will probably have different levels of revenue, profit margins and structures of assets and liabilities, so
that analytical procedures performed on Papaya as a whole would be meaningless.
Separate information is needed for the financial services division as it operates in a completely separate line
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of business from the rest of the company. It is likely to have a very different profit structure from the rest of
the business. In particular, it is likely to require much less capital than the other divisions, which would
affect ratios such as asset turnover and return on capital employed.
l.b
Separate information would be needed for the different supermarket brands because they are likely to have
different profit margins. Specifically, the convenience 'Express' stores are likely to a high turnover of lower-
margin items when compared with the more upmarket 'Mart' stores. As they operate in different markets,
any trends that affect one might not necessarily affect the other.
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Separate information would be useful for the new foreign operation in Farland. As it is operating in a
different market from the other stores, it is likely to be subject to different trends. Also as this is its first year,
there are likely to have been costs associated with the start-up that should not be taken together with the
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rest of the group's results.
Analysis of the Farland operations could be hampered by the accounts being in a foreign currency, which
could be helped by providing the accounts in their original denomination. Finally, as this is the first year of
operations, it would be useful to compare actual results with budgeted results, as well as making a
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comparison with competitors' accounts.

This last point applies equally to the new financial services division, for which no comparatives will exist
either, making comparison with budget and with the industry as a whole more important.
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The auditor should request details of any one-off entries affecting the accounts for the period, including
details of the advertising costs associated with the Farland start-up, which may need to be considered
separately from the rest of the accounts.
Equally, the auditor should request details of any changes in the accounting policies used, or in estimation
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techniques. It will be necessary in particular to enquire whether the Farland division's accounts have been
prepared in accordance with IFRS or with some other accounting principles.
(d) Briefing Notes
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Author: A Student
Subject: Papaya risks of material misstatement
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Date: December 20X9

Introduction
These notes assess the risks of material misstatement to be addressed when planning the 20X9 audit for
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Papaya Co.
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Business segments
Papaya is divided into divisions that would be operating segments under IFRS 8 Operating segments. There
is a risk that the disclosures required by IFRS 8 have not been made. There should be a note to the financial
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statements disclosing information about the performance of each segment. The risk of non-disclosure is
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Answers 179
particularly acute in respect of the new financial services division, and the new overseas operations in
Farland.
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Internally generated brands
The supermarket chains operate under internally generated brand names, which per IAS 38 Intangible Assets
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cannot be capitalised unless they have a readily ascertainable market value. There should be no non-current
asset in the financial statements in respect of brands.
In particular, there is a risk that some of the advertising expenditure made in relation to the Farland
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expansion has been recognised as an asset. This would be an overstatement of non-current assets.
Business risk
The recently established financial services division is a departure from Papaya's core business. Financial
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services is potentially a risky area to trade in, and there is a possibility that if the new division is not
successful, significant losses could be made. This is particularly pertinent in view of the difficulties
experienced by providers of financial services during the recent banking crisis. In view of the strain exerted
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on Papaya's cash resources by the recent Farland expansion, there is a risk of the financial statements being
prepared on the going concern basis when this is inappropriate.
Collusion and price fixing
Significant financial penalties will be imposed on Papaya if it is found guilty of collusion and price fixing. The
l.b
situation needs to be assessed with reference to IAS 37 Provisions, contingent liabilities and contingent
assets and the Framework definition of a liability. There are four possible situations with respect to IAS 37:
the liability could be certain, probable, possible or remote. In this case the liability is not remote. If the
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liability is certain or probable then a provision should be created, measured at the fair value of the future
cash outflow. The risk in this case is that there is no provision, and that profit is therefore overstated and
liabilities understated.
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The liability could also be possible. In this case it should be disclosed in a note to the financial statements.
The risk is that adequate disclosure is not made.
Debentures
In accordance with IAS 32 Financial instruments: disclosure and presentation, the convertible debentures
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issued during the year should be split in the statement of financial position between an equity and a debt
element. IAS 32 requires Papaya to split the debentures into a debt component calculated as the present
value of the debenture on maturity, and an equity component calculated as the balancing figure.
There is a risk that IAS 32 has not been followed, either by failing to use split accounting or by calculating the
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split incorrectly. This would lead to misstatements of debt and equity in the statement of financial position, and
may affect the statement of profit or loss through miscalculation of the finance cost of the debt.
Forward contracts
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The categorisation of the forward contracts as hedging financial instruments is an acceptable option in line
with IFRS 9 Financial instruments, but there is a risk that the forward contracts do not meet IFRS 9's
qualifying criteria for hedge accounting. According to IFRS 9, the contracts should be recognised at their fair
value, which can be either an asset or a liability, and any gain or loss on the hedging instrument should be
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recognised in profit or loss. The accounting requirements of IFRS 9 in relation to hedging instruments are
complex, and there is a risk that they have not been accounted for correctly. This risk is acute, given the
novelty of the Papaya Mart operation which suggests that it may lack experience of accounting for this area,
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giving rise to increased control risk. It is possible that either assets or liabilities may be under- or over-
stated, or that gains and losses are not reported in profit or loss.
IFRS 7 Financial instruments: disclosures must also be applied. There is a risk that adequate disclosures are
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not made in respect of the contracts.

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Land
The significant losses made on the sale of some plots of land should be separately disclosed in the
statement of profit or loss. There is a risk that this has not been done.
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180 Answers
The losses made on land sold also suggest that the land currently recognised at cost in the statement of
financial position may be impaired. IAS 36 Impairment of assets requires an impairment review to be carried
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out in this case, and that any impairment losses are recognised. There is a risk of this not happening,
overstating both non-current assets and profit.
Warehouses
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IAS 16 Property, plant and equipment requires that the cost of the health and safety inspections be
capitalised and then depreciated over three years. This would spread the economic benefit of having had
them over their useful life. There is a risk that the $25,000 has been recognised during the period as an
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expense in full, understating both profit and non-current assets.
Conclusion
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The above risks of material misstatement should be discussed at the audit planning meeting, and a plan
formulated to reduce the risk of material misstatement in relation to them to a level required in order to give
reasonable assurance that the financial statements present a true and fair view.
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30 Bill
Text reference. Chapter 9
l.b
Top tips. As this was a large question, it was vital that you worked methodically and kept to your timings
throughout its sub-sections.
You should have noticed when reading the question that the second paragraph of the information gives figures for
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calculating materiality. Remember, whenever a question includes these figures, it is very likely that you will have to
calculate materiality at some point in your answer. These are easy marks, so be sure to get them.
Part (a)(i) should have been relatively straightforward, provided that your financial reporting knowledge is up to
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scratch. This is relatively in-depth financial reporting for P7, and is a good example of the kind of knowledge you
need to be able to demonstrate. Assuming that you are comfortable with the accounting, the question itself should
have been within your grasp if you are systematic and address all parts of the requirement for each of the two
accounting issues.
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Part (a)(ii) tested of your knowledge of ISAs and your ability to apply them. Your examiner has stated that
knowledge of ISAs is a common weakness amongst candidates. You should have scored well on this part of the
question, and may have found yourself going over your allocated time of 20 minutes (11 marks × 1.8). Make sure
you stick to your timings, or you will struggle later in the paper.
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Part (b) was relatively difficult. Part (b)(i) required you to think on your feet, as it did not ask you to explain how
something should be audited, but rather to reflect on the difficulties involved in doing so. You should be looking to
score at least 2–3 marks here. It's important not to panic, and to make sure you don't go over your time trying to
think of things to write – especially given that the next part of the question was a bit easier. Part (b)(ii) should have
been simpler, and required you to recommend audit procedures. A good bullet pointed list should have been able to
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score 3–4 marks (one mark per good, specific point).

Easy marks. Calculating materiality in part (a). There is one mark just for drawing an overall conclusion to the
notes in part (a), which you should get (make sure you include a subheading, 'conclusion', signal to the marker that
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you want this mark!).

Examiner's comments. In answers to requirement (a)(i), most candidates recognised the loss-making nature of
the contract described in the scenario, and correctly calculated the loss, and the majority then went on to discuss
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the risk of material misstatement that profit would be overstated if the loss were not recognised in full. However,
having gone this far, many candidates then went on to consider other potential accounting issues and different
financial reporting standards, leading to confused answers and often contradictory advice. No conclusion was
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provided and the contradictory comments clearly detract from the overall quality of an answer. Some candidates
simply could not decide which financial reporting standard was most relevant. It was common to see answers of
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this type stretching over many pages, when all that was needed was a succinct discussion of the loss making
contract in the context of IAS 11, which could be done in a few short paragraphs. This wasted time and meant
answers were overly long and largely irrelevant.
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Answers 181
On the whole answers to requirement (b)(i) were satisfactory. However, answers to (b)(ii) were often
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unsatisfactory, as many candidates ignored the question requirement and just provided a rote-learnt list of
procedures to identify related party transactions in general, not focussing on the transactions in the scenario. Even
those that did think about the scenario provided inadequate procedures eg 'check the lease is market rate' – but not
explaining how the auditor should do this.
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Marking scheme
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Marks
(a) (i) Loss-making contract

Generally 1 mark per comment on matter/risk of material misstatement/evidence point:
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– Identify loss-making status of contract (only ½ mark if no calculation of loss)
– Per IAS 11 the loss must be recognised in full
– Risk of MM is overstated profit if loss not recognised
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– Penalties for late completion may exist
– Risk of MM is overstated profit/understated liabilities if not recognised
– Incentive for loss not to be recognised due to planned sale of company
– Consideration of materiality
l.b
Evidence:
– Obtain budget and recompute anticipated loss
– Agree fixed price to contract
–
–
–
–
Review contract for late-completion penalty clauses
Review internal architect's report
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Inspect quote or other supporting document for amount of additional costs
Consider use of an expert regarding amount of additional costs
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– Discuss estimate of additional costs and timeframe with contractors
– Review cash flow forecasts
Held for sale disposal group
Generally 1 mark per comment on matter/risk of material misstatement/evidence point:
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– Identify 'Treasured Homes' as a disposal group per IFRS 5

– Explain why meets criteria for treatment as a disposal group
– Assets should be presented separately and tested for impairment
– Risk of material misstatement is overvalued assets and incorrect presentation
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– Identify 'Treasured Homes' as a discontinued operation per IFRS 5

– Risk of material misstatement is incorrect presentation of its results in SoPLOCI
and SoCF
– Consideration of materiality
as
Evidence:
– Review board minutes to confirm management's commitment to the sale
– Inspect any documents relevant to the negotiation
– Inspect 20X2 budgets to confirm 'Treasured Homes' not included
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– Obtain and review management's impairment test on the disposal group

– Confirm disclosures made according to IFRS 5 in draft financial statements
Maximum (max 8 marks each issue) 16
ea
(ii) Critical evaluation of planning

Up to 2 marks for each point evaluated from ideas list, plus 1 mark for overall
conclusion:
e
– Insufficient analytical review performed

– No systems work or controls evaluation carried out
/fr
– Inadequate assessment and documentation of business risk

– Inappropriate to plan to use client employee as auditor's expert
– Ethical threats raised by offer to use office space
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– Conclusion (1 mark)
Maximum 11
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182 Answers
Marks
Professional marks for the overall presentation of the briefing notes, and the clarity of
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the explanation and assessment provided 4
(b) (i) Limitation on identification of related party relationships and transaction
1 mark each point explained (to maximum 4 marks):
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– Management not aware of relationship or transaction
– Subjectivity/complexity in deciding on who or what is a related party
– Deliberate concealment of relationship or transaction
– Accounting systems do not specifically identify related party transactions
o t.
– Transactions at nil value especially hard to detect
1 mark each specific procedure (to maximum 4 marks):
sp
– Review invoices/inspect cash book to confirm amount of cash paid
– Review payables ledger to confirm any amount outstanding
– Consider if transaction is arm's length by comparing value to non-related party
transaction
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– Discuss/obtain written representation on details of informal lease
– Review any written documentation that may exist regarding the lease
– Review disclosures on draft financial statements
Maximum 8
l.b
Total 39
(a) Briefing notes

To: Audit partner ria
ate
From: Audit manager
Re: Bill Co audit plan
Introduction
ym
The following notes explain the risks of material misstatement (MM) and matters to consider, in relation to
Bill Co (Bill), and then recommend audit procedures to address these risks.
The notes then evaluate the planning done so far, including ethical matters, before recommending actions to
perform.
tud
(i) First issue (Bridgetown)

Matters to consider
Contract loss
as
This appears to be a loss-making contract. In accordance with IAS 11 Construction contracts, the
loss should be recognised immediately when expected costs exceed revenue.
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This is the case here as the additional expected costs of $350,000 turn the previously expected profit
of $200,000 into a loss of $150,000.
At 6% of profit before tax, the loss is material to forecast profit before tax.
ea
Possible penalties
The contract will be completed two months late. This may result in penalties being incurred by Bill for
e
late completion. These should be provided for in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets.
/fr
Possible management bias

Alex and Ben plan to sell the company in the next two years, and therefore may seek to increase its
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value.
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Answers 183
Risks of MM
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Contract loss
There is a risk that profit is overstated by up to $350,000 if the loss is not recognised in full in line
with IAS 11. There is also a risk that the expected costs of $350,000 have not been recognised in the
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FSs at all.
Possible penalties
The risk is that if there are indeed penalties and no provision has been made, then liabilities are
o t.
understated and profits are overstated by the amount of those penalties.
Possible bias
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The risk is that a provision, or a loss on a contract, are not recognised in an effort to increase Bill's
valuation.
Audit procedures
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Inspect basis of estimate for the $350,000 extra costs, eg architect's report.
 Discuss $350,000 estimate with employees to assess if it is reasonable.
 Discuss two-month additional timeframe with employees to assess if it is reasonable.
l.b
 Recalculate forecast profit of $200,000 (loss of $150,000 including extra costs).
 Inspect the signed contract to verify the price and to check if there are any penalties for late
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completion.
 Review FS for provisions in relation to penalties.
 Consider using an auditor's expert to estimate the contract costs to completion.
ate
Second issue (Treasured Homes)
Matters to consider
Discontinued operations
ym
The sale of the division appears to be a discontinued operation in accordance with

IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. It meets IFRS 5's
requirements as it is an independent business division which can be distinguished operationally
and for financial reporting purposes.
tud
The division's results for the year should be presented separately as a discontinued operation on the
face of the statement of profit or loss. Comparatives will also need to be restated.
Disposal group
as
The assets of the division are a disposal group per IFRS 5.

At 8% of total assets, the amount is material to the forecast statement of financial position.
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IFRS 5 requires that a disposal group is recognised as held for sale where the assets are available for
sale in their present condition, the sale is highly probable, and these conditions are met before the
year end.
ea
This is the case here, as a buyer is interested in the division and a sale is expected in August 20X1,
two months after the year end.
In accordance with IFRS 5, the assets in the disposal group should be measured at the lower of their
e
carrying amount and their fair value less costs to sell, and should no longer be depreciated. They
/fr
should be presented separately in the statement of financial position.

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184 Answers
Risks of MM
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Discontinued operation
The risk is that the division's results are not presented separately in the statement of profit or loss, in
line with IFRS 5, or that comparatives are not restated.
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Disposal group
The risk is of non-compliance with IFRS 5 if the disposal group is not presented separately in the FS,
and is not measured in accordance with IFRS 5. Measurement would be incorrect if depreciation is
o t.
charged, for instance.
Audit procedures
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 Review board minutes for evidence that the sale is imminent.
 Obtain calculations of the disposal group's fair value less costs to sell, and of its carrying
amount.
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 Obtain evidence of the estimated fair value, possibly by engaging an auditor's expert valuer.
 Confirm that results of the discontinued operation are presented separately in the statement of
profit or loss.
l.b
 Confirm that the disposal group is presented as assets held for sale in the statement of
financial position.
(ii) Critical evaluation of audit plan
ria
The notes provided indicate that the audit has not been planned in line with the requirements of ISAs.
Ethics – long association
ate
The IESBA Code of Ethics states that a familiarity threat to independence may arise with long-
standing audit clients. This appears to be the case here, as some analytical procedures have not been
performed because of past experience with the client. It may be necessary to implement further
safeguards to reduce this threat to an acceptable level.
ym
Analytical procedures
The need for analytical procedures must be reviewed each year in line with the requirements of ISAs,
including the need for procedures not done in previous years.
tud
No procedures have been performed on the statement of financial position, on the basis that there did
not appear to be any significant movements. This is not an adequate reason for not performing more
detailed procedures, but is in fact just an inadequate procedure itself. It may be the case that, given
other changes in the accounts, movement would be expected in assets and liabilities, so 'no
as
movement' is not in itself a sign that nothing is wrong.

Forecast accounts
Forecast accounts have been placed on file, but it is not clear if any procedures have been performed
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using them, for example to assess the adequacy of the going concern basis. Discussions have been
held with management, but it is not clear whether the forecasts have been assessed in the light of
these discussions.
ea
Controls testing
Management said there were no changes to internal controls in the year, but no walkthrough tests
were performed to verify whether this is in fact the case. Walkthrough tests should have been
e
performed to ascertain whether controls are operating as described.

/fr
The auditor is effectively relying on previous years' audit work which showed that the long-standing
controls were adequate in the past. However, they may no longer be suitable. ISA 315 Identifying and
Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment
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requires that the auditor obtain an understanding of the entity's internal controls. This has not been
done here.
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Answers 185
Business risk
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Business risk has been assessed as low on the basis that all divisions are 'operating normally'.
However, ISA 315 requires that the auditor obtain evidence of the specific objectives and strategies of
the entity, and of its performance in relation to these objectives. This does not appear to have been
done.
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ISA 315 states that business risks need to be identified in relation to financial reporting. Without
assessing specific business risks, this cannot be done.
o t.
Moreover, past performance is not necessarily a guide to the future. No assessment appears to have
been done of the business environment and of the risks it may pose to the entity.
Risk assessment (material misstatement)
sp
ISA 315 requires that the risks of material misstatement be assessed both at the financial statement
level and at the assertion level. No risk assessment appears to have been carried out at the assertion
level.
log
Property valuation/stage of completion
It is right that an expert be engaged to provide evidence regarding property valuations. In previous
years this was an auditor's expert, this year it is a management's expert.
l.b
ISA 500 Audit evidence requires that the competence, capabilities and objectivity of the
management's be assessed. This has not been done here.
The architect is newly qualified, which may cast doubt over whether she has sufficient experience and
competence to do this work.
ria
The architect is employed by the entity, which according to ISA 500 is an indication that she may be
less objective than if she were engaged for a specific task. Furthermore, there is a risk that the
ate
business owners, who intend to sell the business, may seek to inflate the valuations in order to
achieve a better price on the sale.
Therefore the architect's work cannot be relied upon for the purposes of the audit. An auditor's expert
should be engaged to provide independent valuations.
ym
Office space rent

The IFAC Code of Ethics states that gifts and hospitality may create a self-interest threat to
independence. Suki & Co must assess the nature, value and intent of the offer.
tud
The fact that the rent is of a nominal amount means that the effective value of the gift is likely to be
substantial.
The intent is not clear, but it could be considered a bribe, given in the hope of obtaining an
unmodified audit opinion before the sale of the company.
as
The offer should therefore be declined.

Conclusion
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The audit has been inadequately planned, and fails to meet the requirements of ISAs. There are also a
number of ethical threats to Suki & Co's independence.
ea
Actions include possible further training for Tara Lafayette, and a reconsideration of the firm's ethical
safeguards in place regarding long association with audit clients.
(b) (i) Related party transactions (RPTs) are difficult to identify because management may not themselves
e
be fully aware of what constitutes a RPT, and may not therefore disclose all RPTs to the auditor.
IAS 24 Related party disclosures requires a degree of subjective judgement in deciding who is a
/fr
related party. This makes it less likely that management will be able to prepare adequate disclosures
in line with IAS 24.
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186 Answers
Management may deliberately attempt to conceal RPTs, for example because they are being used to
manipulate the financial statements. This is particularly difficult for the auditor to address, as
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knowledge of related parties must come largely from representations made by management.
Finally, accounting systems are not set up to identify RPTs separately from transactions in the
normal course of business.
co
(ii) Audit procedures include:
 Review invoices from Lantern Co to verify the amount of the expense. Confirm cash payments
o t.
to the cash book
 Inspect Lantern Co's trade payables account to confirm any amount outstanding at the year
end
sp
 Compare the cost of refurbishment carried out by Lantern Co to the cost of refurbishment
carried out by other suppliers, to determine if the transaction is at arm's length
 Discuss the informal lease with management, and obtain a written representation regarding
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the nature of the arrangement, and whether any amount is payable to Bill Co
 Confirm through enquiry with management the date the lease arrangement commenced, and
the expected period of the lease
l.b
 Enquire if any written documentation exists regarding the lease arrangement, if so, review and
place on file
 Review disclosures made (if any) regarding these transactions in the draft financial
31 Mulligan
statements
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ate
Top tips. In part (a) it is important to take time to plan your answers. In this question you should have taken to time
to think of the main matters that need to be discussed prior to accepting any type of assurance assignment, and
these would work well as sub headings in your answer. You should also make sure that you use the scenario to
ym
make your answer practical. In part (b) you need to think about how the forecasts would have been put together in
the first place, and what could have gone wrong in the process to help you generate some relevant enquiries. In
part (c) it is important to notice that you are not merely being asked for a definition but you must also link this with
the quotation given in the question.
tud
Easy marks. There are not many easy marks to be found in this question – each requirement demands professional
judgement and application of knowledge. The basic definition in part (c) and the broad issues underlying part (a)
are probably the easiest elements.
Examiner's comments. In requirement (a), candidates were asked to explain the matters that would be discussed
as
at a planning meeting with their client. Answers were often blighted by two common factors.
Firstly, many comments were vague, examples of common vague points being 'discuss terms with management',
'outline the scope of work' and 'agree a fee for the assignment'. These comments on their own do not answer the
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requirement which is to explain the matters to be discussed. Candidates need to be much clearer in exactly what
they mean – what does 'discussing terms' actually entail? How do you 'outline the scope of work'? Answers that
are not even full sentences will rarely score well.
ea
The second common problem comes back to the issue that candidates lack commercial sense. The vast majority of
answers to requirement (a) stated that at the meeting they would discuss 'whether we are competent to take on the
work'. Surely this is not something you would raise at a meeting with your client having just agreed to do the work.
e
Similarly many candidates wanted to 'ask the management if they are competent to produce the figures'. I think that
most clients would be quite insulted to be interrogated as to their competence in drafting some basic budgeted figures.
/fr
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Answers 187
Marking scheme
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Marks
(a) Matters to be discussed at planning meeting
Generally 1 mark per matter specific to the scenario
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Ideas list:
 Exact contents of business plan
o t.
 Recipient of report
 Confirmation report for information only
 Deadlines
 Liability issues
sp
 Evidence availability
 Fees
 Professional regulations
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 Personnel
 Complaints procedure
Maximum 8
(b) Enquires regarding adequacy of finance requested
l.b
Generally 1 mark per specific enquiry stated
Ideas list:
 Who prepared?
 Availability of internal finance?
 Operating cycle?
 Raw materials required?
ria
ate
 WIP period?
 Documentation to support costs?
 Inflation effects?
 Training costs?
 Advertising costs?
ym
 Finance costs?
Maximum 7
(c) Forensic accounting
tud
Definition – 1mark
1 mark for each comment relevant to scenario:
 Investigate whether theft has actually occurred
 Example of factor other then theft that could have caused discrepancy
as
 Evidence to prove financial consequence of theft

 Evidence to prove identity
Maximum 5
20
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Total
e ea
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188 Answers
(a) Matters to discuss with Mulligan management
m/
(i) Content of report/extent of assurance
The firm should ascertain exactly what the business report will include and explain exactly what the
assurance will relate to. It will differ from an audit report which gives assurance that figures are true
and fair as the opinion will be limited as to whether the requested finance is adequate for purpose,
co
not whether all the information presented in the report is true and fair.
(ii) Form of assurance
The firm should make clear what form their assurance report will take as it will be different from the
o t.
audit report that Mulligan's directors are used to. The auditors should explain that the assurance
given will be in the form of negative assurance and should ensure that this form of assurance will
satisfy the bank.
sp
(iii) Distribution of assurance report
The firm should ensure that the client only intends to publish the report to the bank and that they will
be the sole authorised users of the assurance report and that use will be restricted to determining
whether to advance this finance.
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(iv) Limitation of liability
The auditors should negotiate the limits of their liability with regard to this engagement and
particularly state that their report is for information only and will not give rise to a liability to the bank.
l.b
(v) Deadlines
The firm should ascertain when the client want the report finished by and ensure that there is
sufficient time to carry out thorough procedures and draw a conclusion, and also that it has
appropriate staff available at the time required to meet the deadlines, otherwise the deadlines should
(vi)
be renegotiated.
Procedures and evidence ria
The audit firm should set out the types of procedures they will perform and the type of evidence they
ate
will seek. As they will not have legal audit privileges in respect of this assignment, they should ensure
that the client intends to provide them with all the information and explanations they require to
provide the requested assurance and that explanations will be confirmed in writing if required.
(vii) Engagement letter
ym
The firm should set up an engagement letter for this engagement as it will not be covered by the
engagement letter associated with the audit for this client.
(viii) Administrative matters
The exact dates the firm's staff will attend client premises should be agreed and the client should be
tud
told who the staff members likely to be attending will be. In addition, matters relating to the fee and
billing procedure should be finalised before work is carried out.
(b) Adequacy of finance
There should be sufficient finance to cover the costs of the new factory, starting the new business unit and
as
working capital requirements to start production.

Questions
cc
(i) Will the new venture be financed entirely by the bank or is Mulligan also advancing some capital?
This is to establish whether the business plan is complete.
(ii) Who prepared the forecasts? This is to establish whether they have been prepared by someone with
ea
experience of preparing such budgets as this will give assurance as to whether the budgets are
reasonable.
(iii) Are figures in the forecasts supported by evidence such as quotations for machinery or building
work? This is to see the degree of estimation included in the plans.
e
(iv) Has the cost of finance been included in the forecasts? The cost of obtaining the finance appears to
/fr
be missing from the initial forecast and will be a significant cost that should be included within the
business projections.
(v) How long before the products can be sold and begin to fund themselves? The budget does not
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contain any contingency and it is important to discover how tight the production schedule is and
whether it is realistic.
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Answers 189
(vi) Have all construction costs been included in the cost projection – for example, the costs of electricity
or the cost of employees not being used in the their usual roles?
m/
(vii) What is the timescale for the construction? Does the projection take account of inflation if necessary?
(viii) Does the projection contain budgets for all raw materials required? Currently it only seems to include
timber, but there may be other items needed to make the product.
co
(ix) What are the advertising costs based on? These must be appropriate to the specific product, so if
they are based on the costs associated with other products of the company, they may not be
sufficient.
o t.
(x) What is the commercial viability of the new product? The auditor should look at market research
because ability to pay the loan back will be an important factor for the bank.
(c) Forensic accounting
sp
Forensic accounting is undertaking a financial investigation in response to a particular event, such as fraud,
where the findings of the investigation may be used as evidence in court or otherwise to help resolve
disputes. In addition, the forensic accountant will often give advice on improving systems to prevent the
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problems occurring again.
In this case, the investigation the internal auditor is suggesting would be a forensic accounting investigation,
the purpose of which in this case would be likely to form the basis of an insurance claim by the company if it
has been subject to a repeated theft of inventory. It is likely that a company such as Mulligan would turn to
l.b
their trusted professional advisers in relation to such an investigation, that is, their external auditors.
In this case, two matters should be determined:
(i)
(ii)
Whether theft has taken place
The value of that theft
ria
There could be other reasons for inventory disappearance if controls are not strong. For example, inventory
ate
could have been identified as obsolete and disposed of or sold in a special sale but the inventory records not
updated for this fact, or items could have been moved to a different location and simply not counted during
the inventory count.
If the auditors concluded that theft had taken place, procedures should be carried out to determine by whom
ym
the theft was carried out and the value of the inventory stolen. Evidence found could be used to initiate
criminal proceedings against the wrongdoer and also as the basis of any insurance claim.
32 Parker
tud

Top tips. In part (a) you needed to stick to the material in the question. There are no marks available for pre-learned
as
knowledge, so do not be tempted to recite information, eg on obtaining an understanding of the entity and its
environment, or on the theory of audit risk.
Try to strike a balance between words and numbers. Marks for calculations tend to be capped, so if you spend
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almost all your time performing calculations then you are unlikely to pass the question. The BPP answer given here,
for example, contains more calculations than would be needed to reach the cap.
Equally, it is important that you do not go to the other extreme and perform too few calculations, as these are some
ea
of the easiest marks on the whole paper. Note that marks are available for:
 Trends, eg that revenue has decreased by 8.2%. This would normally get a half mark.
 Ratios, eg that gross profit has fallen from 31.8% to 27.2%. You must calculate the ratio for both years (so
e
that a comparison can be made), which normally gets a mark.

/fr
Any adjustments or additional calculations you can make will tend to look good to the marker and will score well, eg
adjusting cost of sales for the effect of reclassifying the provision.
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190 Answers
In terms of organising your answer, little advantage is to be gained from dividing your answer into the different
m/
components of audit risk. You are advised to stick to picking risks out of the information in the question and then
evaluating them.
You should note that the audit engagement has already been accepted, so there are no marks available for matters
co
in relation to client acceptance (eg contacting the previous auditors). Again, you are advised to stick to evaluating
the audit risks that are present in the scenario.
Finally, there are plenty of marks available for explaining additional information that is needed. You can gain an easy
o t.
mark on most of the audit risks by simply thinking of some relevant information that would be helpful. However,
you must take care not to start recommending audit procedures here, as that is not what is asked for.
In part (b), the main pitfall would be discussing ethical issues from throughout the scenario. What is being asked
sp
for here are issues of professional ethics for the auditor, ie relating to auditor independence. No marks are available
for discussing whether Parker's management is ethical, or whether the human resources arrangements might give
rise to the possibility of ethical failings or fraud.
log
Easy marks. Some of the four professional marks were easy to come by. To get them you must include a header,
an introduction and a conclusion, and make sure that your answer is written clearly and concisely, without waffling!
Calculations in part (a) are easy marks, as long as you perform them quickly and accurately.
l.b
Marking scheme
Marks
(a) Audit risk
ria
Audit risk evaluation, preliminary analytical review and additional information requests
ate
In relation to the matters listed below:
Up to 2 marks for each audit risk/area from preliminary analytical review evaluated
1 mark for each ratio and comparative calculated (½ mark for a trend) to a maximum
of 6 marks
ym
1 mark for each additional information request to a maximum of 5 marks

– Profitability
– Liquidity
– Solvency
tud
– Going concern
– Provisions
– Finance costs
– Tax expense
as
– Development costs
– Property revaluation
– Overtime payments control risk
– New client detection risk
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– Opening balances
Maximum 24
ea
(b) Ethical matters

– Conflict of interest threat to objectivity
e
– Evaluate significance of threat and potential safeguards

– Contact both parties to request consent to act
/fr
– Identify safeguards (1 mark each)

– If consent not obtained cannot act for both parties
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– Explain why corporate finance service creates advocacy threat

– Explain why corporate finance service creates self-review threat
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Answers 191
– Identify safeguards (1 mark each)
Maximum 7
m/
Professional marks for the overall presentation, structure and logical flow of the briefing notes,
and for the clarity of the evaluation and explanations provided.
Maximum 4
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35
o t.
BRIEFING NOTES
To: Harry Shepherd
sp
From: A Manager
Date: 3 June 20X3
Subject: Parker Co (Parker)
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Introduction
The following briefing notes contain: the results of preliminary analytical procedures in relation to the Parker Co
audit; an evaluation of the audit risks to be considered in planning the audit; and a discussion of ethical issues
l.b
raised along with a recommendation of relevant actions for our firm.
Analytical procedures are contained in an Appendix at the end of these notes. All figures quoted are in $000.
ria
(a) Trading
Revenue declined by 8.2%, but cost of sales only declined by 2.1%. The two are not in line, as would be
expected. This points to a possible overstatement of cost of sales.
ate
Indeed, cost of sales does appear to have been overstated by the misclassification of a provision there,
which should have been classified within operating expenses. Removing the provision from cost of sales
gives a decline of 6.4% (= (5,680 – 250) / 5,800), which is closer to the 8.2% fall in revenue. This degree of
discrepancy might be explained by eg not all costs of sales being fully variable.
ym
This misclassification casts doubt over the efficacy of Parker's internal controls. This increase in control risk
may mean that more substantive testing will be required.
The decline in revenue is dramatic, but if anything a steeper decline might be expected given Parker's price
cutting and the economic conditions. Revenue may therefore be overstated.
tud
It is possible that the price cuts may not have been properly reflected in reported revenue. Further
information is needed here, such as a detailed breakdown of revenue by product line, including information
about prices and volumes.
as
Profitability
Parker's profitability has dropped during the year, with the projected operating margin of 11.4% (20X2: 15.6%).
This is worrying, but the projections do still show a profit. However, as indicated later in these notes, some
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adjustments may be required to the financial statements which would worsen the picture further. This gives
rise to significant uncertainties over Parker's future profitability, and so also its going concern.
Fine provision
ea
IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires a provision to be recognised where:
 There is a present obligation as a result of a past event. The past event here was the inappropriate
e
advertising
/fr
 An outflow of resources embodying economic benefits is at least probable

The fact that Parker has recognised a provision at all implies that it thinks an outflow of resources is
probable. Therefore it is likely that an obligation exists.
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192 Answers
Further information is required here on why management has only recognised 250. We would need to
examine the notice from the regulatory authority.
m/
As this is a one-off event, IAS 37 requires measurement at the most likely amount, which in this case is
likely to be the full 450. The required adjustment of 200 is material to net profit.
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Finance costs
Finance costs have risen by 24%, presumably as a result of the increase in debt finance during the year.
Some initial calculations suggest that this may be understated. Interest-bearing debt at the year end is
o t.
12,725, against which there is a finance cost of 155. This implies an interest rate of 1.2%, which is very low.
Further information needed would include:
sp
 Bank loan agreement, with details of interest rates and any restrictive covenants imposed
 Bank overdraft agreement, with details of interest rat
 Finance lease agreements, with details of interest rate implied in the lease
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Taxation
The tax charge has fallen by 76.7%, and looks low. Indeed, the implied tax rate in 20X3 is 9.5% (= 70 / 735),
which is significantly lower than the 25% (= 300 / 1,197) in 20X2.
l.b
The charge in the statement of profit or loss (70) does not agree to the liability (50), so there must be some
misstatement. It seems likely that the tax computation has not yet been performed for the projected figures,
and that adjustments will need to be made once this is done. The amount is material to profit for the year.
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Taken together with the misclassification of the provision to cost of sales, this is further evidence of poor
internal controls over financial reporting at Parker.
Further information needed would be the ledger accounts for both tax figures, along with tax computations
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for the expense.
Revaluation
The revaluation of PPE has given rise to a revaluation reserve, but the statement of profit or loss and other
comprehensive income does not include a revaluation gain, or indeed any other comprehensive income at
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all. This appears to be a material misstatement, which could be argued to be pervasive.

We will be able to place some reliance on the management's expert's valuation, in line with ISA 500 Audit evidence.
Further information is needed on the expert's qualifications and independence, as well as a copy of the
report itself.
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Given Parker's imperfect internal controls, it is possible that the depreciation may not have been remeasured
at the point of the revaluation, leading to an understatement of expenses. Parker may have revalued assets
selectively, whereas it is required to revalue all assets within a class. Finally, extensive disclosures are
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required in the notes to the financial statements, and there is a risk that these have not been made.
The main risk with the revaluation is that assets are overstated. Given Parker's poor profitability and liquidity
position (see below), management has an incentive to overstate assets. There is therefore a risk of
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management bias in the revaluation.

Development costs
Further information is required regarding the costs capitalised, as there is a risk that Parker is capitalising
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internally generated brands, which is prohibited by IAS 38 Intangible Assets. This would be in line with the
possible management bias discussed above.
IAS 38 requires only development costs to be capitalised, with research costs being expensed. Given that
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operating expenses fell by 10.7% during year – more than the fall in revenue – it appears unlikely that
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significant research costs have been treated as expenses. Therefore it is very likely that assets are
overstated.
Costs can only be capitalised if they meet specific criteria, such as the probability of future economic
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benefits flowing to Parker, and that costs can be measured reliably. The first criterion here is problematic,
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Answers 193
since it depends on the claim that there is a market for the product, and that Parker has the financial
resources to complete the development.
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It is possible that Parker's new range will arrive on the market too late to compete effectively with the
competitor's new range. Further information is required, such as details of market research conducted.
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Parker is also currently in dire straits when it comes to liquidity (see below), which raises doubts over its
ability to complete the development.
At 2,250, the amounts involved here are highly material. If only half of these were expensed, it would
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completely wipe out profit for the year, from a profit of 625 to a loss of 500.
Finance leases
New assets were acquired under finance leases. There is a risk that these are in fact operating leases, and
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that assets may therefore be overstated.
Liquidity
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The bank balance of 900 at the end of 20X2 is projected to have become an overdraft of 1,000 by the end of
20X3. The current ratio has nearly halved, from 1.8 to 0.96, meaning that current assets do not cover
current liabilities.
Receivables days have risen from 34 to 42. This could be down to poor credit control; we already know that
l.b
Parker's internal controls may not be entirely reliable. Alternatively, it could indicate the presence of
irrecoverable receivables not provided for, which would further reduce assets and profit were provision to be
made for them.
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Inventory days have risen from 136 to 167. This could be a sign of inventory obsolescence; this is
particularly likely given the competition that Parker is facing. If net realisable value is lower than inventory
cost then write-downs may be required, which would affect both assets and profit.
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Payables days have risen from 63 to 86. This is a sign of cash flow difficulties, with Parker struggling to pay
its suppliers (a feat made difficult by its slow debt collection from its customers). This could damage
supplier relationships, leading to interest charges or lost discounts, or to the breakdown of relationships.
This could make trading very difficult for Parker.
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Parker is currently dependent on its overdraft for trading. If the overdraft were withdrawn, then it would be
virtually impossible for it to continue as a going concern. Further information is needed here regarding the
overdraft limit and the date of any reviews.
Solvency
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Interest cover has fallen from 10.6 to 5.7. The fall is worrying, although 5.7 is not a terrible figure. That
being said, given that finance costs may be understated, the figure could become worse once appropriate
adjustments are made.
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Gearing has risen from 0.8 to 1. This is high, and may make it harder to raise finance in future. Given
Parker's liquidity problems, it appears unlikely that the bank would want to renew the bank loan again, which
would again affect going concern. Further information is needed regarding the terms of the loan, and in
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particular the repayment date.

Further information is needed on Parker's preference shares, as these may be redeemable. If they were to be
redeemed then Parker may not be able to make the required payment or issue new shares, which could hit
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going concern.
Going concern
Parker's plan to get itself out of its current difficulties appears to be twofold: increased sales from the new
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product in development, and synergies from the acquisition of Beauty Boost Co.
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More information is needed regarding the projected sales from the new product. Cash flow forecasts in
particular are crucial, as at present it appears that Parker is haemorrhaging cash and needs to start receiving
substantial inflows very soon.
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194 Answers
The proposed acquisition of Beauty Boost Co may indeed provide some synergies, but it appears unlikely
that any savings would be significant enough to restore profitability. More likely, it would leave Parker with
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still more debt, which it would then have to find more cash to service.
In any event, in view of its solvency position it appears unlikely that Parker will be able to raise sufficient
funds to make the acquisition.
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There is a risk that Parker will not make sufficient disclosure of the doubts that exist over going concern. It
is also possible that the financial statements will have to be prepared under an alternative assumption to
going concern – eg the break-up basis – but this would only become clear once audit evidence has been
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obtained in this area.
Control risk
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As discussed, several factors point to high control risk on this engagement. In addition, Parker's internal
auditors found deficiencies in the controls over payroll, which may mean that more substantive testing will
need to be performed. The change during the year from HR to the finance department represents a risk, as
procedures may not have been followed properly during the handover. Moreover, there is a risk of a lack of
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segregation of duties now that payments are handled by the finance department alone.
New client
As Parker is a new client, detection risk is increased as we will lack cumulative understanding of the
l.b
business and its environment. We must therefore focus particularly on developing this understanding at the
planning stage.
Appendix
Revenue decrease
Cost of sales decrease
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8.2%
2.1%
20X3 20X2
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Finance costs increase 24%
Taxation decrease 76.7%
Operating expenses decrease 10.7%
Operating profit margin 11.4% 15.6%
Current ratio 0.96 1.8
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Interest cover (operating profit/equity) 5.7 10.6

Gearing 1 0.8
Receivables days 42 34
Inventory days 167 136
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Payables days 86 63
(b) Ethical issues
Potential acquisition – conflict of interest
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There is a potential conflict of interest here, as Hound & Co may effectively be advising both sides of a
potential acquisition negotiation. The IESBA Code of Ethics requires safeguards to be applied here. Crucially,
both parties should be informed of the potential conflict, and should be asked for their consent to the
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arrangement. If either party declines, then the engagement should not be accepted.
If both say yes, then safeguards could include:
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 Separate engagement teams, separated by information barriers

 Confidentiality agreements signed by employees and partners of Hound & Co
Potential acquisition – self-review
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There is also a self-review threat in relation to the due diligence, as we will be performing procedures on
financial statements which we have already audited. Safeguards here would include:
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 Separate engagement teams

 Pre-issuance review of the non-audit service report by an independent professional accountant
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Answers 195
Financing – advocacy
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Providing advice on financing raises an advocacy threat if Hound & Co is asked to represent Parker's
interests, for example to any potential lenders. Such a role should therefore be avoided.
Financing – management role
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There is a risk that we could be seen as playing (or could actually play) a management role. This would be
the case if eg we recommended a particular form of finance to Parker. The threat can be mitigated by making
it clear that any decisions rest with Parker's management, and that we are providing them with advice only.
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Financing – self-review
There may be a self-review threat here if the financial statements come to include amounts in relation to any
financing obtained using our advice. Possible safeguards include:
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 Using a separate corporate finance team from the audit team
 Pre-issuance review of the corporate finance service, and of the relevant area of the financial
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statements, by an independent professional accountant
If safeguards would not reduce the threat to an acceptable level, the engagement should not be accepted.
Conclusion
l.b
From the above it can be concluded that the audit of Parker Co is of relatively high risk overall, with
particular risks in relation to overstatement of assets, understatement of expenses, and the company's
ongoing solvency and liquidity problems.
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Several important ethical issues are raised by Parker's request, and these must be considered carefully
before any engagements are accepted.
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33 Lapwing
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Top tips. In part (a)(i), you should obviously take heed of the warning not to discuss ethical threats. It is abundantly
clear that ethics are not being tested here, both from the question itself (which states that 'a second partner review
… will reduce any threat … to an acceptable level') and from the requirement.
Many of the matters to consider here involve simple clarification of exactly what is being done, ie exactly what form
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the report will take, exactly what information will be reported on, exactly who the report is for, and so on. You could
try to generate ideas by simply thinking about what is practically involved in the engagement, and what needs to be
considered from a practical and commercial point of view. Alternatively, you could use as a starting point ISAE
3400's list of matters to be agreed – but if you do this, make sure that you're applying your answer to the scenario.
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In part (a)(ii) there is one mark available for each procedure. Remember that procedures need to be specific. In
addition to just listing the procedures, you should state why you would perform it as well. For example, don't just
write 're-perform calculations', but 're-perform calculations to check arithmetical accuracy'.
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This part of the question should not have been too difficult, and could be approached by simply working through all
the information given – both the text and the financial statements – and thinking of the procedures you could
perform to audit it. If you are going to pass P7, you need to be scoring at least 7–8 on a question like this.
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In part (b), it is absolutely crucial that you notice the requirement to write briefing notes, as this is worth up to four
marks. Remember to write an introduction and a conclusion, as well as the usual 'briefing notes' headings.
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It was important in part (b)(i) that you read the requirement very closely. It is only asking for procedures 'in respect of
the costs of closure of the factory', not in relation to any possible provision for the toxic chemical leak itself. As ever, if
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you wrote about provisions for cleaning up environmental damage then this would not have earned any marks.
The requirement itself was actually quite straightforward. You needed to identify that an IAS 37 provision for
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restructuring was being made (the clue is the use of the word 'restructuring' in the scenario), and then recall the
IAS 37 requirements. You can generate audit procedures from there.
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196 Answers
Part (b)(ii) should not have been too difficult. The model answer here is much longer than yours needed to be; you
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should be looking for three or four well-made points to pass this part of the question.
Easy marks. A half mark was available in part (a)(ii) for saying 'Re-perform calculations to confirm arithmetic
accuracy of the financial statements'. The four presentation marks were easy marks, although you do of course
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have to earn them.
Examiner's comments. On requirement (a)(i), most answers discussed that negative assurance should be given,
and explained the importance of determining the intended user of the report including issues to do with the use of a
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liability disclaimer. A significant number of candidates achieved high marks on this requirement. Weaker answers
discussed only matters such as fee arrangements and deadlines, which, while relevant, are not enough to score
well. Some answers discussed ethical issues, which specifically were not required, and others explained matters
that would be more relevant to the initial acceptance of the engagement rather than agreeing terms with the client,
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such as whether the firm had the competence to perform the work.
The best answers to (a)(ii) made good use of the forecast financial statements that had been provided, and gave
procedures that were both well described and relevant to the specific content of the financial statements. Many
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candidates also performed analytical procedures to determine unusual trends and relationships in the figures and
information provided, which helped to generate very exact procedures.
Weaker answers tended to state simple enquiries, for example 'ask management who prepared the forecasts', or
l.b
'ask why sales has increased' without any further development. Another problem arose in answers that seemed not
to realise that the figures were forecasts, so source documentation would not be available in the same way that it is
for an audit of historical information. For example, many answers suggested agreeing assets purchased to invoices
from suppliers, or the forecast increase in share capital to share certificates, but these items would not yet exist as
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they relate to future transactions. Another problem with weaker answers was that they tended not to always provide
procedures, and seemed to be drifting into an assessment of potential material misstatements, which was not
asked for.
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The second part of this question was generally not well answered. Answers were often lacking in focus. Sound
answers recommended a range of procedures specific to the types of cost that would normally be included in a cost
of closure provision, such as redundancy costs. Very few candidates recognised that the date at which an obligation
arose in relation to the closure of the factory was crucial, and many could recommend little more than asking for
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management representations.
Requirement (b)(ii), for four marks, was a discussion on the difficulties in measuring and reporting on
environmental and social performance. Candidates often struggled to write more than a few bullet points here, and
sometimes wrote from the point of view of the auditor trying to obtain evidence on key performance indicators.
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However, most answers did identify difficulties in defining performance measures on what can be quite intangible
matters, and many also discussed the problems in quantifying socio-environmental issues.
Marking scheme
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Marks
(a) (i) Matters to be considered in agreeing the terms of the engagement
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Up to 1½ marks for each matter identified and explained (2 marks maximum for
identification):
– Management's responsibilities
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– Intended use of the information and report

– The contents of the business plan
– The period covered by the forecasts
– The nature of assumptions used in the forecasts
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– The format and planned content of the assurance report

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Maximum 6
(ii) Procedures on forecast financial information
Up to 1 mark for each procedure (brief examples below):
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– General procedures examples:

o Re-perform calculations
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Answers 197
Marks
o Consistency of accounting policies used
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o Discuss how joint venture has been included
o General analytical procedures
– Procedures on statement of profit or loss:
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o Discuss trends – allow up to 3 marks for calculations performed and
linked to procedures
o Review and compare breakdown of costs
o Recalculate profit on disposal, agreement of components to supporting
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documentation
– Procedures on statement of financial position:
o Agree increase in property, plant and equipment to capital expenditure
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budget
o Discuss working capital trends – allow 2 marks for calculations
performed and linked to procedures
Agree movement in long-term borrowings to new loan documentation
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o
o Obtain and review forecast statement of changes in equity and confirm
validity of reconciling items
Maximum 13
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(b) (i) Audit procedures on costs of closure
Generally 1 mark per specific procedure, examples given below:
– Review board minutes for discussion and date of decision
– Review detailed, formal plan and date of its approval
–
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Review any public announcement and the date it was made
Physically inspect factory prior to year end for evidence of dismantling of
assets
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– Consider whether costs included are relevant (redundancies and lease
cancellation fees are the most common type of relevant costs included)
– Agree relevant costs to supporting documentation
– Review note to financial statements for accuracy and completeness
Maximum 6
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(ii) Problems in measuring and reporting on social and environmental performance

Up to 1½ marks per comment discussed:
– Difficulties in defining and measuring targets and KPIs
– Problems in quantifying some measures, eg employee satisfaction
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– Inadequate systems and controls to accurately measure

– Difficult to compare between companies or over time
Maximum 4
Professional marks for the overall presentation of the notes, and the clarity of the explanation and
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assessment provided.
Maximum 4
Total 33
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(a) (i) The terms of the engagement to report on the business plan should be agreed in an engagement
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letter for this assurance engagement. The following matters should be considered.
Intended use of the business plan
It should be confirmed that the report will be provided to the bank, as this may establish Lapwing &
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Co as potentially liable to the bank.

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Distribution of report
Clarification should be sought over whether the report will be distributed to any other parties. It may
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be necessary for the report to include a liability disclaimer.

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198 Answers
Elements of business plan covered
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The engagement is to report on the business plan, but clarification is needed about whether this
means the business plan as a whole, or merely the forecast financial statements included in it. This
will affect the extent of Lapwing & Co's possible liability, and the extent of procedures required.
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Nature of assumptions
It should be clarified whether the plan's assumptions are best estimates or hypothetical. If the
assumptions are clearly unrealistic, then ISAE 3400 The examination of prospective financial
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information states that the auditor should not accept the engagement.
Period covered
The forecast financial statements are for 12 months. It should be clarified that this is the only period
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on which assurance is to be provided. Clarification is also needed over whether the other elements of
the business plan refer to only this period.
Fees and practical matters
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The level of fees should be confirmed, together with billing arrangements. Practical matters to
confirm include the timing of the report, which will enable Lapwing & Co to ensure that it has
adequate resources (eg staff) available to perform the engagement.
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Form of report
The planned form of the report should be agreed in advance in order to avoid any misunderstandings.
The report would use a negative form of words to provide limited assurance.
Respective responsibilities
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It should be confirmed that management is responsible for preparing the business plan, and for
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providing the auditor with all relevant information.
(a) (ii) General procedures
 Re-perform calculations to check arithmetical accuracy.
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 Agree unaudited figures for period to May 20X2 to management accounts to assess their
reliability.
 Confirm that accounting policies applied consistently between the periods and audited
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 Assess accuracy of past forecasts by comparison with actual figures.

 Consider reasonableness of trends in light of auditor's understanding of Hawk Co.
 Review correspondence with bank about negotiated terms of the loan, and confirm major
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terms and interest rate directly with bank.

Statement of profit or loss
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 Discuss 21.4% increase in revenue with management, and consider if reasonable.

 Operating margin rises from 30% to 33.8%. Ask for explanation from management and
consider if reasonable.
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 Discuss sale of Beak Retail, including likelihood of sale and any likely terms. Review board
minutes for details about the sale.
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 Recalculate profit on disposal, and agree proceeds to any draft legal documentation.
 Consider reasonableness of finance costs. New loan should add $1m ($30m × 4% × 10 / 12),
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but finance costs are up by only $960,000 – need to ascertain the reason for this.
Statement of financial position
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 Non-current assets are up $37.15m, but the loan which financed this investment was only for
$30m. Enquire about other possible sources of finance used for this increase.
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Answers 199
 Review reconciliation of movement in non-current assets, confirming that Beak Retail assets
are derecognised.
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 Confirm that any assets relating to the joint venture with Kestrel are accounted for in line with
IFRS 11 Joint arrangements.
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 Discuss the planned $5m increase in equity (is this to help finance the increase in assets?).
Discuss what form this will take (ie rights issue, or at full market price).
 Agree the increase in non-current assets to capital expenditure budgets.
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 Agree cash figure at May 20X2 to bank reconciliation and statement.
 Receivables days are predicted to fall from 58 days (3,300 / 20,600  365) to 53 days
(3,600 / 25,000  365), improving the company's cash position. The reasons for this should
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be discussed with management, and considered for reasonableness.
 Payables days are predicted to fall from 137 days (5,400 / 14,420  365) to 124 days
(5,600 / 16,550  365), worsening the company's cash position. The reasons for this should
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be discussed with management, and considered for reasonableness.
 Agree the increase in long-term borrowings to documentation obtained for the new loan
 Discuss the deferred tax provision, and establish why there has been no movement (which is
l.b
unexpected, given the capital expenditure).
 Discuss the movement on retained earnings, which have risen only by $0.8m, in spite of a
profit before tax of $10.52m. It may be that a dividend is planned.
(b) Briefing Notes
For: Bill Kingfisher
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By: Audit manager
Date: June 20X2
Re: Osprey Co audit
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Introduction
These briefing notes recommend the principal audit procedures in respect of the costs of closure of the
factory, and discuss the difficulties in measuring and reporting on social and environmental performance.
tud
(i) Audit procedures on factory closure costs

Osprey Co has provided $1.25m for closure costs. This is a provision for restructuring and is
accounted for in line with IAS 37 Provisions, contingent liabilities and contingent assets.
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 Review board minutes for discussion of closure, which should have been made before
31 May 20X2.
 Obtain the closure plan, and review for whether it is sufficiently detailed to meet IAS 37's
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requirements.
 Discuss with management whether actions have been taken to implement the plan, or whether
the plan has been communicated to those affected by it, eg the factory workers.
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 Obtain a breakdown of the $1.25 provided for, and review to ensure that only direct costs
arising from the restructuring are included.
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 Cast the schedule.

 Agree a sample of costs to supporting documentation.
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 Enquire whether any gain has been made on the sale of assets, as this should not be included
in the provision.
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 Review the financial statement disclosures in respect of the provision, to ensure that they are
sufficiently accurate and detailed to meet IAS 37's requirements.
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200 Answers
(ii) Measuring environmental and social performance
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The underlying reasons why environmental and social performance can be hard to measure are that it
is often difficult or impossible to quantify, and that a company's environmental and social effects may
be pervasive to the natural and social worlds around it.
Companies often try to overcome these inherent difficulties by establishing Key Performance
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Indicators (KPIs) which attempt to quantify the effect on society and the environment. There are
difficulties with every aspect of setting KPIs here:
Firstly, a degree of subjectivity is involved in determining which issues require KPIs. This is usually
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done on the basis of stakeholder analysis, but this is very far from being an exact science.
Secondly, the selection of KPIs to measure the effect on stakeholders can be difficult and somewhat
arbitrary. This is particularly the case when the effects are qualitative. In Osprey's case, for example,
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the satisfaction of its employees is a very difficult thing to measure meaningfully.
Thirdly, once the KPIs have been selected, it can be difficult to define them precisely. For instance,
Osprey's target of 'reducing environmental damage' is not specific, and is hard to measure.
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Something more specific and quantifiable is needed if a measurement is to be made.
Finally, there is little uniformity across different companies in terms of KPI selection and
measurement. This is to some extent unavoidable because every company's environmental and
social impact will be different. This makes it difficult to draw comparisons across industries, or even
l.b
within the same company over time.
Conclusion
ria
These briefing notes have identified the principal audit procedures to be performed in relation to Osprey Co's
provision for restructuring. The notes also discuss the difficulties involved in the attempt to measure and
report on environmental and social performance.
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34 Azure Airline
Top tips. Part (a) requires you to identify and explain six risks in order to obtain full marks (½ a mark for identifying
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a risk and one mark for explaining it). The answer below contains more than this for illustration. Most of the risks
identified below are signalled in the question. However, it is acceptable to use your general knowledge to identify a
risk not signposted in the question, such as the fact that the price of fuel can escalate, and Azure needs fuel to
operate. In part (b) you are basically asked for controls for the risks, and you must think widely about how the risks
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could be managed. For example, think about the lease contract. It must have contingencies and protections for
Azure's operation in it. It is important that you do not spend so much time on parts (a) and (b) that you do not
attempt part (c), even if you feel that it is hard. Again, use your common sense to think about practical measures in
the airline industry. What performance factors are important to the company? The question indicates that efficiency
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and timeliness are important - think about how these could be measured.
Easy marks. There are no easy marks per se in this question. The easier marks are available for identifying risks from
the question in the first place. Harder marks are then available for explaining those risks and how to mitigate them.
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Examiner's comments. When asked to 'identify' candidates must be brief (eg using sub-headings and not copy out
chunks of text from the question. Most candidates correctly identified the major business risks (half a mark each)
though fewer went on to explain them well (one mark each). Far too many answers focused irrelevantly on
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competition. In part (b) candidates who tabulated their answers to parts (a) and (b) generally scored more highly
overall, as they produced balanced answers. Candidates attempting (a) first, in isolation, tended to overrun and
marks awarded to part (a) were restricted to the maximum available (nine) with not enough time being given to
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parts (b) and (c) or later questions. Weaker candidates did not appreciate the business reality of the situation and
the need to answer within the constraints imposed. For example, suggestions to 'buy a newer plane', 'buy another
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plane', 'employ own captain and co-pilot', were inappropriate to an entity operating just two days a week.
Candidates should take note that they are provided with information relevant to the whole question. So for example,
every item of information did not need to be translated into a risk in the answer to parts (a) and (b). The reference
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to timesheets was a pointer to evidence requirements for part (c) – even where this part was attempted many
candidates did not read, or ignored, the underlined words and failed to answer the question set.
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Answers 201
Marking scheme
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Marks
(a) Business risks
Generally ½ mark for identification + 1 mark each point of explanation 9
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Ideas
Environment risks
 Competition
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 Weather
 Emergency
Financial risks
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 Overhaul costs
 Fuel prices
 Lease obligations
 Economy
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 Loss of revenue
Compliance risks
 Rights to operate
 Safety management
l.b
Operations risks
 Age of aircraft
 Poor service levels (eg catering, timely operation)
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 Passenger/crew safety
 Over-bookings
(b) Risk management processes
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Generally 1 mark each point 9
Ideas
Accept the risk
 Low impact risks
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 Benchmark (or could reduce risk)

Reduce the risk
 By implementing improved internal controls
 Staff training
 Hedge against it (eg fuel prices)
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Avoid unacceptable risks

 Non-compliance
Transfer the risk
 By insurance (amount/type)
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 Contractual risk sharing

(c) Operational performance measures
Generally ½ mark each measure (eg efficiency, capacity) Maximum
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6
½ – 1 mark each source of evidence
Ideas
Performance measures
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 Types of performance measure (eg efficiency, capacity)

 Numbers/proportions/%s
o Fights
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o Passengers
o Cargo (tonnes)
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Audit evidence
 Oral vs written
 Internal vs external
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 Auditor generated
 Procedures (relevant, reliable, sufficient)
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202 Answers
(d) Level of assurance Marks
Up to 1 mark for each well-explained point Maximum 5
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 Choice of reasonable or limited assurance
 Explanation of reasonable assurance
 Positive form of words
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 Explanation of limited assurance
 Negative form of words
(e) Types of conclusion
Up to 1 mark for explanation of each type of conclusion Maximum 6
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Total 35
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(a) Business risks
(i) Leasing of equipment and specialist staff. As Azure leases its equipment and the most specialised
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of its staff from another airline, there is a risk that its equipment and/or pilots could be withdrawn
leaving it unable to operate.
(ii) Conditions of exclusive right. The PAA requires Azure's aircraft engines be overhauled biannually.
There is a risk that Azure will be unable to meet this condition, if the lessor company does not agree
l.b
to regular overhaul or that it will be too expensive for Azure to meet this requirement and it could lose
the right to operate, or its exclusivity, opening it up to competition. There may be other conditions
which Azure has to meet, such as the two weekly flights being a minimum.
(iii)
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Necessary service suspension. As Azure is required to overhaul its engines every two years, there
will be a significant period every two years where Azure will either have to incur the cost of leasing
other planes (assuming this is possible) or will have to suspend services. The cost of leasing other
planes might be prohibitively expensive or the disruption to service might mean that conditions
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relating to the right to operate might not be met. As Azure only has one plane, service would also be
interrupted if there was an emergency relating to the plane, such as fire or a crash.
(iv) Age of aircraft. The aircraft being leased is old. This raises operational risks (it may not always be
able to fly due to necessary maintenance), finance risks (it may require regular repair) and
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compliance risks (it may not meet environmental or safety standards, now or in the future).
(v) High proportion of expensive seats. The plane leased by Azure has a high proportion of unrequired
expensive seats and therefore insufficient (overbooked) cheaper seats. Although Azure can appease
customers by upgrading them, this means the airline is operating well below capacity.
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(vi) Cargo. The flight route results in the airline carrying a large amount of horticultural produce. This
raises various risks – that Azure might be liable to passengers if their cargo degrades in transit, that
the airline might be liable for any breaches of law by its passengers (for example, if prohibited items
are transferred into Pewta or Sepiana, many countries prohibit the importation of animals or meat
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products or plants).
(vii) On-board services. Customers are currently dissatisfied with the food provision on the flight and
there is a risk that food prepared in Lyme may become less appealing and even dangerous when
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served on a Darke to Lyme flight (when it has been prepared a substantial time earlier, given a six
hour flight, at least an hour's turn around time, and time for getting to the airline in the first place). If
the food makes customers ill, Azure might be faced with compensation claims.
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(viii) Pricing. There is a complex system of pricing and a large number of sales agents, and Azure is at risk
of operating at a sales value less than required to cover costs (for example, if too many of the
cheapest tickets are sold).
(ix) Safety. The airline industry has stringent safety conditions and Azure may face customer boycott or
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difficulty in recruiting staff if safety requirements are not met.

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(x) Fuel. The aircraft cannot fly without fuel, which can be a scarce or high-cost resource. If fuel prices
escalate due to world conditions, the company might not be able to meet the costs of operating.
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Answers 203
(b) Managing risks
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(i) Lease. Azure must ensure that the terms of the contract with the international airline ensure that
aircraft and staff cannot be withdrawn without reasonable notice, and that in the event of withdrawal,
substitutes will be given.
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(ii) Conditions. Azure must ensure that all staff are aware of any conditions and the importance of
meeting them. However, this risk must simply be accepted as there is little Azure can do about
conditions imposed on them by the governing body of their industry.
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(iii) Service suspension. Azure must have contingency plans for service suspension, such as ensuring
their contract with the international airline ensures alternative aircraft will be made available to them
in the event of maintenance or damage to the aircraft, or by making arrangements to lease from a
different airline in the event of emergency. As a minimum, Azure must ensure that the airline they
sp
lease from would give them financial compensation in the event of aircraft or staff not being available
so that Azure's customers could be compensated.
(iv) Age of aircraft. Azure should have plans in place to be able to lease/afford newer planes if required to
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by law. Again, this could be written into their contract with the airline. Azure should manage cash
flow and borrowing facilities so as to be able to afford ongoing maintenance when required.
(v) High proportion of expensive seats. Azure should negotiate a reconfiguration of the plane with the
lessor so that business and first class seating could be reduced and more economy seats made
l.b
available. If this is not possible with the current lessor, Azure should investigate leasing differently
configured planes from another company. If it is not feasible to adjust the plane seating, Azure
should consider its pricing and on-board facilities policies to make business and first class seats
more attractive to customers. As the seats are not being sold anyway, it is probable that a reduction
(vi) ria
in prices would increase overall revenue, although this might reduce potential profit.
Cargo. Azure should publish a cargo policy to ensure that customers are aware of their legal
obligations. They should ensure that staff are sufficiently trained to discuss the contents of baggage
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with customers and are aware what items Azure should not carry. They should insure against lost
and damaged cargo.
(vii) On-board services. Azure should consider entering into a contract with a company in Darke to
provide food for the Darke to Lyme journey. Obviously they must not breach any existing contract
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with the Lyme company and so in the meantime should review the type of food provided. For
example, it might be safer to only offer cold food, for example sandwiches and cake until a Darke
contract can be set up. Even if a new contract is set up, it might still be best to offer cold food as
there is less chance of health problems arising as a result of serving cold food rather than hot food.
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(viii) Pricing. As discussed above, Azure should review the pricing policy. They should also establish limits
on how many of certain types of tickets (non-refundable/single etc) can be issued for one flight and
they should institute a centralised system to ensure that each agent is aware when limits have been
reached. As the agents must be linked to a similar system already (to be aware of whether tickets are
available for sale) this should not be too difficult to achieve.
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(ix) Safety. The company should appoint a member of staff to be specifically responsible for safety
operations (such as training, updating for legal requirements, educating passengers) and should
ensure that staff are regularly appraised about safety issues.
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(x) Fuel. The company could take out hedging contracts against the cost of fuel. Other than this, there is
little they can do about this matter, and it is another risk that has to be accepted.
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(c) Measures of operational performance

(i) Passengers/flight. The airline could have a target number of passengers per flight and must review
actual numbers against target. Evidence of the number of passengers per flight will be easy to obtain
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as it will be a safety requirement that Azure maintains significant records concerning its passengers.
Evidence: ticketing information, check-in records.
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(ii) Time of flight/check-in. The airline must have target times for flight time and check-in time and
review the percentage difference which occurs on a regular basis. The flight times can be obtained
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from the pilot's timesheet and the check-in times could be monitored by asking passengers how long
they have been waiting as they check-in. Evidence: timesheets, airport records.
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204 Answers
(iii) Customer satisfaction. The airline should record customer satisfaction and have a target level which
it hopes to achieve and maintain. This could be measured by customers completing questionnaires
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which ask them to rate the service, according to pre-designed ratings (for example, poor, adequate,
good, excellent). Evidence: completed questionnaires.
(iv) Safety. The airline should have targets for safety, for example, no accidents/number of days or staff
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achieving safety qualifications. Evidence: accident log books and staff certificates and training
records.
(d) Level of assurance
o t.
The engagement in question would be an assurance engagement, and would be performed on information
other than historical financial information. The relevant technical guidance is therefore contained within ISAE
3000 (Revised) Assurance Engagements Other than Audits or Reviews of Historical Financial Information.
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Such an engagement could be either a reasonable assurance engagement or a limited assurance
engagement. Management is therefore in a position to choose which is most appropriate to its needs, and to
the needs of users.
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If the engagement were performed as a reasonable assurance engagement, then this would be a higher level
of assurance than a limited assurance engagement. It would mean that the practitioner has reduced
engagement risk to an acceptably low level, and would contain a conclusion expressed in a positive form of
l.b
words.
If the engagement were performed as a limited assurance engagement, then this would leave a level of risk
that is acceptable in the circumstances but is higher than for a reasonable assurance engagement. The
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assurance provided would be limited but nevertheless meaningful, and would enhance users' confidence in
the integrated report to a degree that is clearly more than inconsequential.
The conclusion of a limited assurance engagement would be expressed in a negative form of words, such as
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'No matter(s) has come to the practitioner's attention to cause the practitioner to believe the subject matter
information is materially misstated.'
(e) Types of conclusion
Irrespective of whether the level of assurance being provided is reasonable or limited, the types of
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conclusion which the practitioner may express in line with ISAE 3000 are as follows. The meaning of each
type of conclusion, however, depends on the level of assurance being provided.
Reasonable assurance Limited assurance

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Unmodified Subject matter is prepared, in No matter(s) has come to the

all material respects, in line attention of the practitioner that
with criteria. causes the practitioner to believe
that the subject matter information
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is not prepared, in all material

respects, in line with criteria.
Unmodified but with Emphasis Need to draw users' attention to a matter presented or disclosed in the
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of Matter paragraph subject matter that is fundamental to users' understanding

Unmodified but with Other Need to communicate a matter other than those that are presented or
Matter paragraph disclosed in the subject matter information that is relevant to users'
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understanding of the engagement, the practitioner's responsibilities or

the assurance report
Qualified due to material There is a material misstatement, but its effects are not pervasive.
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misstatement
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Qualified due to scope limitation A scope limitation exists and the effect of the matter could be material
but not pervasive.
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Adverse A misstatement is both material and pervasive.

Disclaimer of conclusion A scope limitation exists and the effect of the matter could be pervasive.
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Answers 205
35 Island
m/
Top tips. In this style of case study question you make sure you read the question thoroughly. Time spent reading
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and re-reading the scenario and spotting all the clues there will certainly pay dividends in part (a) of the
requirements.
In part (b) it is important to give enough detail on each procedure to meet the requirement to 'explain'. It is not
o t.
enough to state vague points such as 'obtain written representations'. In part (c)(i) it is important to take time to
think up four procedures that you can describe in some detail, as the mark allocation tells you that you can obtain
two marks for each one. Don't just start to write about the first ones that come to mind. In (c)(ii) the mark
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allocation indicates that you only need to give one mark's worth of discussion on each problem and can expect
another one mark for suggesting a practical solution to each.
Easy marks. Parts (b) and (c) contain the easiest marks in this question, as (b) is simply asking for procedures on
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a fairly common item in the financial statements and marks can be gained in (c) for reasonable knowledge of the
quality control standards. The danger is that you could spend too long on part (a) and miss out on these.
Examiner's comments. Many candidates clearly misunderstood the concept of audit risk, and confused audit risk
with business risk, leading to wholly inappropriate comments. In addition, many candidates wasted valuable time in
l.b
the examination by producing a detailed discussion of the coal mining industry, how the industry is in decline, and
how environmentally unfriendly the industry is. This may be true, but it does not answer the question. The marking
guide for part (a) included four professional marks. Candidates should be aware that ignoring the instruction to
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produce the answer in a certain format means that the professional marks cannot be awarded.
Marking scheme
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Marks
(a) Principal audit risks/planning matters
Generally ½ mark each risk/matter identified
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Up to 1 further mark for significant issues explained:

 Revenue recognition
 Legal claim
 Going concern
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 Valuation of inventories
 Warranty provision
 CEO incentive to manipulate figures and disclosures
 Disputed receivable
 Cancelled orders
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 Overseas supplier
 Related party disclosure
 CEO influence on audit team
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Up to ½ further mark for obvious matters explained:

 New client
 Tight deadline
ea
Up to 4 marks for format of briefing notes and clarity of explanation

Maximum 15
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206 Answers
(b) Audit procedures for warranty provision Marks
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Generally 1 mark per procedure
 Review contracts
 Review correspondence
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 Recalculate (max ½ mark)
 Review board minutes
 Consider assumptions
 Compare actual current year expenditure to prior year provision
o t.
 Post year-end expenditure
Maximum 5
(c) (i) Four QC procedures for individual audit assignment
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2 marks per procedure described (½ mark max if only identified and not described):
 Client acceptance
 Engagement team
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 Direction
 Supervision
 Review
 Consultation
l.b
 Ref ISQC 1/ISA 200 – 1 mark max
Maximum 8
(ii) Two QC problems in small firm
2 marks per problem = 1 mark for problem,
1 mark for recommendation:
Ideas list:
 Consultation
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 Training/CPD
 Review procedures
 Specialist experience
 Working papers
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Maximum 4
Total 32
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(a) Principal audit risks

Revenue recognition
Risk: revenue is materially overstated.
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Island recognises its revenue in three stages, 50% on order confirmation, 25% on delivery and 25% on
installation.
It is important that Island meets the accounting requirements of IAS 18 Revenue in recognising this income.
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This standard states that entities should only recognise revenue when the significant risks and rewards of
the ownership of the goods have been transferred to the purchaser.
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It is certain that significant risks and rewards have not passed to the purchaser at order completion stage
and arguable that only risks have transferred (not rewards) at delivery stage, therefore Island is recognising
a significant amount of revenue before it is entitled to do so by IAS 18.
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Bad debt
Risk: receivables and profit materially overstated.
/fr
The disputed debt with Jack Mines is 3% of total assets and 50% of profit and is therefore material. If the
debt will not be paid, assets and profit will be overstated unless the debt is written off.
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Answers 207
Possible liability
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Risk: liabilities are understated.
The auditors need to investigate whether the claim by Sawyer is likely to result in a liability to Island,
because, although the CEO of Island is not taking it seriously, it may have to be disclosed or even recognised
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in the financial statements. The fact that Sawyer are communicating through legal counsel suggests that
they are taking the matter seriously. In addition, the fact that Island has a warranty provision, suggests that
there is precedent for Island making payments in respect of faulty installations.
o t.
If the auditors conclude that it is probable that Island will have to pay damages to Sawyer then the liability
should be recognised in the financial statements and if Island does not do so, they will be understating
liabilities in the financial statements.
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Valuation of work-in-progress
Risk: work-in-progress is under or overstated.
Work-in-progress is nearly 9% of total assets and is therefore material. Given the nature of the product,
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valuation is likely to be sensitive to degree of completeness. The calculations of work-in-progress valuation
were carried out two weeks before the year-end. It is not clear why this was necessary.
The risk is that work-in-progress will be materially over or under valued and this risk is increased by the gap
l.b
between the valuation and the yearend as additional calculations will have to be carried out between the
valuation date and the year-end date.
It will be important for the auditors to assess that the calculations of completeness and the absorption of
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overheads and other costs such as labour have been carried out consistently with prior years and that the
roll-forward has been carried out correctly. This will be made more difficult by the fact that it is the first time
they have audited Island.
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Warranty provision
Risk: warranty provision is understated.
The warranty provision is based on estimates made by the CEO which makes it inherently risky. This risk is
increased by the CEO's incentive to have good results (see below). The risk is that the provision will be
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understated, and the fact that it has risen insignificantly from the prior year when revenue has increased
more significantly suggests that the provision may well be understated. The auditors must ensure that the
provision is calculated consistently with previous years. (Again, this is made more difficult by the fact that
this is the first year they have audited Island.)
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CEO incentive
Risk: CEO has incentive to present a better than realistic picture in financial statements.
As the CEO is going to be selling shares in Island, she has an incentive to manipulate the results to obtain
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the best price. This increases the inherent risk associated with the entire audit and the auditors must ensure
that they have their professional scepticism intact and corroborate evidence solely emanating from her. This
will be a particular problem where accounting matters are affected by her judgement, such as the warranty
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provision.
Overseas supplier
Risk: foreign currency translation may be incorrect.
ea
The fact that Island now has an overseas supplier subjects them to foreign exchange risk and the risk in the
financial statements is that the liability will be over or understated due to translation error. The liability is not
itself material to the statement of financial position, and the translation error would have to be substantial to
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be material to the statement of profit or loss and other comprehensive income. The auditors should ensure
/fr
that appropriate controls over foreign exchange translation have been set up in relation to this new supplier.
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208 Answers
Related party transactions
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Risk: related party disclosures may be incorrect or lacking.
The fact that Kate Shannon controls Island and Pacific makes these related entities. There are several risks in
connection with related parties – first that the relevant disclosures in respect of these related parties and any
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transactions that they might have might be omitted from the financial statements and second that there
might be other related parties/related party transactions omitted from the financial statements and third that
the auditors have little chance of discovering other related parties unless they are told about them.
o t.
Other matters
Kate Shannon has imposed a tight reporting deadline of January 20X8 on the audit. This increases audit risk
as it reduces audit evidence provided by the course of events (such as the legal case developing or a
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customer paying a debt).
In addition, it means that the audit firm may have to use additional staff on the audit which will increase the
cost of the audit and this should be discussed with Kate Shannon.
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(b) Audit procedures in respect of warranty provision
The warranty provision is an accounting estimate. The audit of accounting estimates is governed by
ISA 540 Auditing accounting estimates, including fair value accounting estimates, and related disclosures.
l.b
Under the standard, the following procedures should to be carried out in the audit of Island.
 Determine whether events occurring up to the date of the auditor's report provide audit evidence
regarding the accounting estimate.


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Test how management made the accounting estimate and the data on which it is based.
Test the operating effectiveness of the controls over how management made the accounting
estimate, together with appropriate substantive procedures.
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 Develop a point estimate or a range to evaluate management's point estimate.
In the audit of Island, reviewing events up to the date of the auditor's report may be of limited use due to the
tight reporting schedule. The auditors will therefore:
 Perform recalculations to compare with those of Kate Shannon (it is unlikely that they will make use
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of an auditor's expert)
 Obtain relevant data used to make calculations by Kate Shannon
 Consider whether it is accurate, complete and reliable
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 Recalculate to ensure calculation is correct

 Review contracts to gain understanding of legal requirements in relation to warranties
 Carry out analytical procedures on warranty provisions year on year and budgets against actual
payments and discuss any variations with Kate Shannon
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 Compare previous estimates with actual warranties paid out to see if assumptions are reasonable
 Review board minutes for discussions of warranties and to ensure that the provision has been
authorised by the board
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 Check the calculation made matches the accounting policy disclosed in the financial statements
 Consider whether the assumptions are consistent with other audit evidence and management's stated
intentions
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 Review any warranty payments made after the reporting period and conclude whether they are
consistent with budgets and projections
 Agree cash spent in respect of warranty payments to bank details and supplier invoices or employee
job sheets (if done by employees)
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 Review post year-end client correspondence to see if any warranty issues are raised
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 Obtain written representation from Kate Shannon stating she believes the significant assumptions
made in the estimation of the warranty provision are reasonable
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Answers 209
(c) Quality control policies and procedures
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(i) Procedures relevant to an individual audit
Acceptance/continuance
Audit firms are required to carry out acceptance procedures and then ensure annually that nothing
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has changed that would have affected acceptance in the first place. Procedures include:
 Obtaining information on new clients from previous auditors and third parties such as bankers
and other sources
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 Assessing the integrity of the client
 Ensuring firm is able to carry out the assignment
 Ensuring there is no ethical barrier to carrying out the assignment
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 Carrying out money laundering procedures
Engagement team
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The audit partner must select the appropriate staff to carry out audit work and bear in mind such
factors as:
 Qualification
 Experience
l.b
 Training requirements
Direction

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The audit must be directed by the partner by carrying out the following procedures:
Holding a planning meeting to ensure that all members of staff associated with the audit
understand their role with regard to it
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 Informing all members of staff of their responsibilities
 Sharing information about the nature of the business and any significant issues for the year
 Identifying and discussing the risks associated with the audit
 Outlining the detailed approach towards the audit work
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Supervision
Each member of the audit team is supervised by persons senior to them on the team. The level of
supervision depends on the seniority. For example, an audit senior will attend an audit with an audit
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junior whereas a manager will supervise a senior by telephone and meeting. Supervision includes:
 Tracking of audit progress by the audit manager
 Addressing significant issues during the audit and modifying the audit approach accordingly
Review
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Audit work will be routinely reviewed by a more senior member of staff, for example, an audit senior
will audit an audit junior's work, and an audit manager reviews the audit file. Ultimately, the audit
partner will review the file. Review includes:
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 Ensuring that the work has been carried out in accordance with the plan
 Significant matters have been raised for further consideration
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 Work performed supports the conclusions reached and is appropriately documented

 Evidence obtained is sufficient and appropriate
 Objectives of audit work have been achieved
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Consultation
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The audit partner should arrange consultation on difficult or contentious matters.

(ii) Problems for small firms
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The most obvious areas of problems for small firms are when multiples of people are required to
carry out quality control procedures, therefore review and consultation. The firm may lack the
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210 Answers
human resources to carry out reviews and consultations, particularly at the experienced level. It may
be necessary to come to agreements with other firms to provide a forum for such reviews and
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discussions.
In addition, there may be problems with initial and ongoing training or with particular specialist
knowledge if the firm does not have a lot of staff. Again, entering into agreements with other firms to
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pool resources in such cases may help with these problems.
36 Meadow
o t.
Top tips. This is a demanding question looking at high level planning issues. Having said that, if you go back to
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basics this will provide you with a sensible plan of attack and a sensible structure. For example when thinking about
risks you can consider the elements of audit risk (inherent risk, etc). When considering other planning matters
remember that these normally include materiality, accounting treatments, evidence and other practical matters.
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Always make sure that you read the requirement carefully. In part (a) you are asked to respond to the email which
requires you to prepare briefing notes in which you identify and explain the risks. You also need to note that the
question refers to this as being the final audit. Part (b) should be more straightforward although a good
understanding of some accounting issues is required.
l.b
Easy marks. These are available for identifying risks, but you must explain the risks to score well. Make sure you
get the professional marks available too,
Examiner's comments. Part (a) was poorly answered with some candidates regurgitating the risk model. Others
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failed to read the requirement carefully. For example, even though the question stated that the information provided
should be used many still went on to speculate, particularly in respect of control issues.
Few candidates demonstrated a knowledge of the retail method of inventory valuation, however many did make
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reference to materiality as an 'other matter' which was pleasing. It should be noted that it is as important to
recognise a matter as not material eg receivables as it is to recognise material issues.
Answers to part (b) were disappointing with few candidates demonstrating a sound knowledge of segmental
reporting.
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Marking scheme
Marks
tud
(a) Principal audit risks/matters

Generally ½ mark each risk/matter identified and up to 1½ for a description 17
Ideas – 'general'
as
 Inherent risks
o Entity (eg multiple locations)
o A/c balances (eg non-current assets, inventory, provisions)
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o Going concern
 Materiality (assessed/quantified)
 Final audit strategy ('conclusion')
ea
o Audit (or business) risk model – justified

o Analytical procedures (illustrated)
 Documentation (amended)
 Logistics (multiple locations, store visits)
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Ideas – 'specific'
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(1) Financial extracts

 Reliability
 Non-current assets  = depreciation?
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 Impairment? (IAS 36)

 Receivables (low risk)
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Answers 211
(i) Provision for discontinuance
– Material
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– A discontinuance? (IFRS 5)
– Recognition of restructuring provision (IAS 37)
(ii) Inventory valuation
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– Permitted IAS 2
– How applied
(2) Segment information
 IFRS 8
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(3) International restructure
 South American sale (see also (i) above)
 IAS 8 & IAS 10
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(b) Audit work
Generally 1 mark each point contributing to a description to a maximum 5 marks 8
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for each of (i) and (ii)
Ideas
 Procedures
 Sources of evidence
l.b
o Internal and external
o Oral and written
o Auditor-generated
 Subsequent events
Professional marks for the format and clarity of answer
Total ria 4
29
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(a) Briefing notes
For: Maxim Gorky
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By: Minim Sladky

Re: Meadow audit
These briefing notes identify and explain the principal audit risks and other matters to be considered when
planning the approach to the final audit of Meadow for the year ended 30 September 20X8.
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Audit risks and other matters

Risks
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 The business operates in the retail industry. Transactions tend to be high volume, low value
transactions often carried out in cash. (Trade receivables are therefore likely to be immaterial and
therefore low risk.)
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 There is a risk that it will be difficult to establish completeness of income. In addition there is the
potential of theft.
 The company operates under the Vazandt brand name. Emphasis on a single brand increases risk as
ea
any damage to the brand name in one area/business unit could affect the other areas/business units.
 The retail industry has suffered from a reduction in consumer spending. This may have the following
impact.
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Inventory valuation will need to be considered particularly in respect of luxury items, for example
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home furnishings and expensive clothes. (Food is less likely to be affected.) Inventory will be
overstated if cost exceeds net realisable value. This may be the case if there are material amounts of
slow-moving inventory. Under the retail method the gross profit margin would need to take account
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of any price reductions.

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212 Answers
Management may feel under pressure to overstate revenues and profits (and understate expenses) in
order to present the results in the most favourable light. Ultimately the viability of the company could
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be affected although going concern does not seem to be a critical issue at this stage.
 The company operates in Africa, South America and the Far East. Inherent risk may be increased by
the diverse nature of these geographical locations.
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 The business is entering a period of reorganisation. This increases the risk of asset impairment,
particularly in respect of the African and South American businesses.
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Materiality
Preliminary materiality will be in the region of $17.7 million. This is the mid-point based on the assessment
of revenue, total assets and profit before tax (see below). If this figure represents a significant change to the
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initial assessment, testing levels may also need to be modified.
½%–1% revenue = $12.9m–25.85m
1%–2% total assets = $16.4m–32.8m
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5%–10% PBT = $6.2m–12.4m
Accounting treatments
(i) African operations
l.b
Tutorial note. There are essentially three issues here; the provision for the loss, the discontinuance
of the African operations and the potential for a restructuring provision.
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The provision for the loss at $83.8m is material to the accounts (67% of operating profit).
IAS 37 Provisions, contingent liabilities and contingent assets prohibits the recognition of provisions
for future operating losses as there is no obligation to incur losses at the end of the reporting period.
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The announcement on 29 September does not seem to be sufficient to give rise to a constructive
obligation (which is needed if a restructuring provision is going to be included) as:
 There is no formal plan being implemented as yet
 The company has not raised a valid expectation that it will carry out the plan
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If a restructuring provision is appropriate it should only include costs which are necessarily entailed
by the restructuring and not associated with the ongoing activities.
In order for the results of the African operations to be disclosed as discontinued operations the IFRS
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5 definition must also be applied. In this case they do seem to constitute a separate line of business
or geographical area of operations and do seem to be part of a single coordinated plan. However, to
be classified as 'assets held for sale' management must, amongst other things, be committed to a
plan to sell the assets, and must be actively searching for a buyer. The decision has not yet been
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finalised as it is still subject to consultation. On this basis the condition may not be met.
(ii) Sale of South American business
This is merely mentioned in a draft note and there does not seem to be any attempt to present the
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information re the South American business as a discontinued operation. As things stand this
appears to be the correct treatment.
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Assets should be reviewed for impairment as a consequence of the decision to sell.

(iii) Segmental information
This needs to comply with IFRS 8. Meadow has provided information based on geographical
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segments.
South America is a reportable segment on the basis that it constitutes 10% of total revenue.
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Africa is a reportable segment on the basis that it constitutes more than 10% of the operating losses.
The Far East does not meet either of the above tests in 20X8 but it could be argued that it is
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significant in that it is the only international operation which is not being sold or closed.
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Answers 213
(iv) Inventory valuation
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The appropriateness of the retail method as a means of establishing cost should be considered. In
this case as Meadow is a retail organisation this is not uncommon.
The way in which gross profit margins are established for deduction from selling price should be
assessed (see earlier point on risk).
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Additional write-downs may be required as a result of the termination of the African operations.
Audit evidence
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Due to the number of locations (211 stores) the auditor will have taken a risk-based approach.
Substantive procedures will have placed heavy reliance on analytical procedures due to the following
factors.
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 Availability of disaggregated information (trend analysis by store, by business unit, by location)
 The nature of the retail business (uniform operations, multiple locations, constant relationship
between gross profit and revenue)
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 The nature of the transactions (high volume, low value) making analytical procedures the most
efficient
The reliability of the results depends on the accuracy of the information. The reliability of the draft financial
statements should therefore be taken into account.
l.b
Practical aspects
Robert Bracco is represented by affiliated offices. The work of these will need to be coordinated in particular
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in respect of the attendance at inventory counts.
Conclusion
There are a number of specific audit risks in relation to the audit of Meadow, and the audit strategy and plan
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will need to show how these risks will be reduced to an acceptable level.
(b) Audit procedures
(i) Segmental information
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 Check that geographical segments have been determined on a basis which is consistent with
the previous year.
 Agree the segment totals to the corresponding figure in the statement of profit or loss.
 Check the arithmetical accuracy of the information.
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 Check that each reportable segment meets the definition in accordance with IFRS 8 and that
the way in which management have identified the different segments appears reasonable.
 Determine the way in which management have allocated revenues and expenses to the various
segments. Test check the accuracy of these.
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 If common costs have been allocated determine whether the way in which this has been done
with reference for example to management accounts.
(ii) International restructuring
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 Review board minutes approving the decision to close the African operations and to dispose
of the South American operations.
 If available, obtain the detailed plan regarding the closure of the African operation. In
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particular the date on which the plan will be implemented will be relevant.
 Obtain copies of any press announcements made.
 Perform a review from the date of the financial statements up to the date of the audit report to
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determine any progress made, for example, actual closures of African stores.
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214 Answers
37 Butler
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Top tips. Part (a)(i) required you to critically review a cash flow forecast and a statement of financial position for
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ten marks. This should have been relatively straightforward. Your approach should be to look over the main figures
in each statement, and think about whether they have gone up or down, and what their movement (or non-
movement) might indicate. Each of the notes provided by the examiner is there for a reason, and will probably give
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rise to something to write in your answer. The main problem with this part of the question would have been the
time constraint (10 marks = 18 minutes), so you should make sure you don't waffle, and divide your time logically
between the two statements being analysed.
Note that the marks available for just identification (rather than explanation) are capped at three marks out of ten.
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Instead of writing lots of superficial points, you should look to make fewer points but which are better-explained.
Part (a)(ii) should have been OK, as most of the points should arise naturally out of your work on the cash flow
forecast in (a)(i). The mark scheme give one mark per 'specific procedure', and the examiner has commented in the
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past that candidates are often not specific enough in their answers to get the mark. Make sure that each point you
make is specific enough to get ½ - 1 mark.
Part (b) tests an area – audit reports – that you should be comfortable with, and on a topic that should be familiar
(going concern). You should have scored well here, although to get the top marks would not have been easy,
l.b
particularly if you had gone over time in part (a).
Easy marks. The professional marks in part (a) should be easy to get. There are also a lot of relatively easy marks
throughout part (a); the difficulty here is making enough of them within the time available.
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Examiner's comments. The answers to this question were generally unsatisfactory. The majority of candidates
seemed to ignore the instruction in requirement (a)(i), providing an answer that did little more than work down the
statement of financial position, calculating the materiality of each balance, and discussing the accounting treatment
ate
of each item, saying nothing about going concern. Only when turning to the cash flow forecast did these answers
say anything about going concern, and then the comments were usually restricted to the likelihood of the company
receiving a loan and a subsidy.
For requirement (a)(ii), most candidates could provide at least a few well explained procedures – the most common
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focusing on the loan from the parent company and the government grant. Some procedures were not well explained
eg 'check the price of the financial asset' without saying how this could be done. Most candidates identified the
extreme optimism of the cash flow forecast and that the closing cash position was negative, but not many
candidates could recommend sound procedures to verify the claims of management regarding cash receipts from
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customers, which was a key issue.

Requirement (b) dealt with the impact of multiple going concern uncertainties on the auditor's report, for seven
marks. Although some candidates scored well on this requirement, the majority again failed to answer the question
as set, and discussed every conceivable auditor's report that could be issued for a client with going concern
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problems. The question stated that 'the use of the going concern assumption is appropriate', yet many candidates
ignored this and spent a lot of time discussing what should happen if the use of the going concern assumption
were not appropriate. Most candidates earned a few marks by discussing the use of emphasis of matter
paragraphs, but often the description of the paragraph was brief. Only a minority correctly focussed their answers
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on the requirement for management to disclose significant uncertainties in the notes to the financial statements,
and that the adequacy of these disclosures would drive the auditor's opinion on the financial statements. Overall
answers were very inadequate.
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Answers 215
Marking scheme
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Marks
(a) (i) Going concern matters
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Up to 1½ marks per matter identified and explained (maximum 3 marks for identification):
– Negative cash position
– Net liabilities position
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– Recurring losses
– Possible adjustment to deferred tax and development intangible asset exacerbate
net liabilities position (allow 3 marks max)
– Fixed charge over assets
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– Significant short term liabilities
– Potential misclassified provisions
– Forecast to remain in negative cash position
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– Assumptions re sales optimistic
– Receipt of loan and subsidy not guaranteed
– Assumption of sale value of financial assets could be optimistic
Maximum 10
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(ii) Procedures on cash flow forecast
Generally 1 mark per specific procedure:
– Enquire regarding and consider validity of assumption re cash sales
– Inspect any supporting documentation re additional resources for credit control
–
–
–
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Seek written confirmation from Rubery Co re loan
Review financial statements of Rubery Co re adequacy of resources
Inspect subsidy application
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– Seek third party confirmation that subsidy will be awarded
– Confirm cash outflows for operating expenses and interest appear reasonable
– Enquire about potentially missing cash outflows
– Agree date and amount of short term loan repayment to loan documentation
– Agree opening cash to cash book and bank statements
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Maximum 8
Additional information
Generally ½ mark per specific piece of information
Maximum 3
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Professional marks for presentation and clarity of explanations 4

(b) Matters to be considered and potential impacts on auditor's report
1 mark each point explained:
– Disclosure of material uncertainty required by IAS 1
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– Auditor considers adequacy of disclosure

– If disclosure adequate – no qualification
– If disclosure adequate – include EOM paragraph
– If disclosure inadequate – material misstatement leading to qualification or adverse
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opinion
– If disclosure inadequate – basis of opinion paragraph explains material uncertainty
– If multiple uncertainties – opinion may be disclaimed in rare circumstances
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Maximum 7
Total 32
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216 Answers
(a) Briefing notes
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To: Audit partner
From: Audit manager
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Re: Butler Co going concern
Introduction
These briefing notes contain an assessment of Butler Co's status as a going concern, based on a review of
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the draft statement of financial position (SOFP) and the cash flow forecast for the first three months of the
next year.
These notes also recommend principal audit procedures for the cash flow forecast.
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(i) Draft SOFP
Cash
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Butler Co has a negative cash balance, with an overdraft of $25m. This will make it difficult for Butler
to raise the working capital it will need to operate in the short term, unless this overdraft can be
extended. However, this is unlikely to be able to continue indefinitely.
l.b
Loan repayment
Butler has a total of $775m in loans repayable during the coming year. It appears unlikely that Butler
will have the cash available to make this repayment (especially given the cash outflow forecast for the
Net liabilities
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three months to August 20X1), unless it is able to raise additional finance.
Butler has negative equity and net liabilities of $225m. It has significant retained losses of $525m,
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and made a retained loss of $620m in the year ended 20X1.
These are both conditions specified by ISA 570 Going concern as casting doubt over the going
concern assumption.
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Working capital
Butler is drawing heavily on its working capital to extend its cash operating cycle:
Cashflow
$m
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Trade receivables (increase = $2,100 – $1,860) (240)

Trade payables (increase = $2,500 – $1,800) 700
Total cash inflow 460
Butler has effectively raised $460m through taking more credit from its suppliers, and still has a
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negative cash balance.

Inventory
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The value of inventory held at the year end increased by $500m (= $1,300 – $800). This represents
an effective cash outflow, and may be a sign of weak revenue during the year. Some of this inventory
may be obsolete and in need to writing down.
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Fixed charge
Fixed charges exist over assets valued at $25 million. If Butler fails to make repayments to the
creditor holding this charge, the assets could be seized, disrupting Butler's operations.
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Development costs
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Development costs of $120m have been capitalised. IAS 38 Intangible assets states that these costs
can only be capitalised if the entity has the resources to complete the development. As this is
arguably not the case here, the costs should be recognised as expenses.
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Answers 217
Deferred tax asset
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A deferred tax asset of $235m has been recognised. However, such an asset can only be recognised
in accordance with IAS 12 Income taxes to the extent that the inflow of future economic benefits is
probable. IAS 12 specifically states that the existence of unused tax losses, as here, is evidence that
there will be no such inflow. The tax asset should not be recognised.
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Provisions
Provisions of $185m have been classified as non-current liabilities. However, a portion of warranty
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payments are very likely to be due within the next year, so at least some of this amount should be
within current liabilities.
Parent company
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Butler is a subsidiary of a multi-national group, and it is possible that its parent company will support
Butler even if it is not a going concern on its own. Were this the case, written representations would
need to be obtained from the parent company, along with evidence that it is capable of supporting
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Butler.
However, the $150m loan expected to be received in July 20X1 is unlikely to be sufficient to ensure
Butler's survival.
l.b
Cash flow forecast
Overall position
For the three months to August 20X1 Butler expects a cash outflow of $30m (= ($40m) + $65m +
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($55m)). This means it is unlikely to be able to repay its short term borrowings in September. Had
the forecast covered four months not three, it would probably have shown a significantly gloomier
picture.
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Cash from customers
The assumption that there will be an economic recovery and that this will lead to increased cash
receipts is open to question. There may be little or no economic recovery, and cash receipts still may
not improve in any case.
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The commitment of extra resources to credit control is a wise move given the cash outflow in this
area during 20X1, but any estimate of the improvement in cash receipts resulting from this is very
uncertain.
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Financial assets
$50m is expected to be received from selling financial assets, which is twice their carrying amount at
the year end. This $50m is very optimistic, particularly if they have been measured at their fair value
in the SOFP.
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Loan from parent

The expected loan receipt of $150m is still being negotiated, and may not actually be agreed or
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received.
Government subsidy
The application for the government subsidy has not yet been approved, so there is significant doubt
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over whether this amount will be received.

Operating outflows
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Operating cash outflows exceed inflows for all three months of the forecast. This is the underlying
basis for the company's ability to continue as a going concern in the long term.
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(ii) Audit procedures for cash flow forecast

 Discuss with management the reasons for assuming that cash collection from customers will
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improve due to 'anticipated improvement in economic conditions'. Consider the validity of the
reasons in light of business understanding.
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218 Answers
 Enquire as to the nature of the additional resources to be devoted to the credit control
function, eg details of extra staff recruited.
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 For the loan receipt, inspect written documentation relating to the request for finance from
Rubery Co.
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 Obtain and review the financial statements of Rubery Co, to consider if it has sufficient
resources to provide the amount of loan requested.
 For the subsidy, inspect the application made to the subsidy awarding body and confirm the
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amount of the subsidy.
 Read any correspondence between Butler Co and the subsidy awarding body, specifically
looking for confirmation that the subsidy will be granted.
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 Regarding operating expenses, verify using previous months' management accounts, that
operating cash outflows are approximately $200 million per month.
 Enquire as to the reason for the increase in operating cash outflows in August 20X1.
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 Verify, using previous months' management accounts, that interest payments of $40 million
per month appear reasonable.
 Confirm, using the loan agreement, the amount of the loan being repaid in August 20X1.
l.b
 Enquire whether any tax payments are due in the three month period, such as sales tax.
 Agree the opening cash position to cash book and bank statement/bank reconciliation, and
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cast the cash flow forecast.
 Ensure that a cash flow forecast for the full financial year is received as three months' forecast
is inadequate for the purposes of the audit.
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Additional information needed
 Loan agreement from Rubery Co, showing the amount of the loan received, the date it will be
received, the repayment schedule, and any terms and conditions
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 Rubery Co's audited financial statements and auditor's report

 Copy of subsidy application made to awarding body
 Copy of confirmation that subsidy was awarded, including details of the amount receivable
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 Management accounts for January to May 20X1

 Copies of tax returns and any correspondence with the tax authorities
 Accounting records, including cash books, bank statements and any reconciliations
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Conclusion
Butler Co is experiencing significant difficulties generating the cash that it needs to continue as a going
concern. Even if it does receive a loan from its parent company, significant doubts remain over whether the
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going concern assumption is appropriate in this case.

(b) IAS 1 Presentation of Financial Statements requires that in this situation the financial statements be prepared
on the going concern basis, but that they contain disclosures regarding the material uncertainty over its
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appropriateness.
The auditor must therefore assess whether these disclosures have been made, and if they are sufficient.
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Emphasis of matter
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If the disclosures are sufficiently detailed then IAS 1 has been complied with. The auditor will express an
unmodified opinion, but the audit report will contain an emphasis of matter paragraph.
This paragraph should highlight the disclosures in the financial statements, and should describe the nature
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of the material uncertainty. It should state that the auditor's opinion is not modified in respect of this matter.
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Answers 219
Finally, it should include any relevant financial information, eg the amount of net liabilities at the end of the
reporting period.
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Modified opinion
If the disclosures are not sufficiently detailed, or if no disclosures are made, then the auditor expresses a
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modified opinion (usually qualified, not adverse) on the basis of a material misstatement. This is because the
disclosure requirements of IAS 1 have not been adhered to.
A qualified or an adverse opinion is accompanied by a paragraph headed either 'Basis for qualified opinion'
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or 'Basis for adverse opinion' (as appropriate), in which the material misstatement is described.
Disclaimer of opinion
It is possible, but in practice very rare, that multiple uncertainties might exist, each of which would in itself
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have led to a modified opinion. In this case, a disclaimer of opinion should be issued.
38 Grohl
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Chapter references. Chapters 2, 6, 9 and 10.
Top tips. This was a fairly standard P7 question on audit planning, and should have been within your capabilities.
l.b
Part (a)(i) required you to evaluate business risks. Your approach here should be to read the scenario closely,
noting the risks as they occur. There were plenty of risks there for your 12 marks.
Part (a)(ii) was on the risks of material misstatement. Four risks were needed for eight marks, so that's two marks
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per well-developed risk. One possible pitfall here might have been talking about risks to do with the auditors
themselves (eg that the Board members leaving might make it difficult to obtain explanations), when these are not
part of the 'risk of material misstatement'.
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Part (a)(iii) covered ethics in the scenario. The parts of the scenario that were relevant here should have stood out,
although you might have struggled to write eight marks' worth of material here. It is important, then, that you do
not try to 'pad' your answer with irrelevant information, as this will not earn you marks. With a focused and
systematic discussion, you should have been able to pass this part of the question.
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Part (b) should not have been difficult. The issue was fairly clear-cut, and there were plenty of marks available for
some fairly straightforward points. Most of the procedures are really common sense, and come straight from the
scenario itself.
Easy marks. There were easy marks in part (b) for the matters to consider – the insurance claim was obviously
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implausible. Also in part (a), it is basic knowledge for ethics questions that a contingent fee is not appropriate for an
audit engagement. Make sure you get some of the professional marks as well.
Examiner's comments. It was clear that the majority of candidates were familiar with audit planning questions and
seemed comfortable with the style of the question and with the amount of information that had been given in the
as
scenario. There was little evidence of time pressure despite the length of the question.
Requirement (a)(i) was by far the best answered requirement of the exam, with most candidates identifying and
explaining a range of relevant business risks, which on the whole were developed in enough detail.
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For candidates who achieved lower marks on this requirement, the problem was that they did not develop their
discussion enough to achieve the maximum marks per point. Some of the answers just repeated the business issue
as stated in the question without discussing any of the impact on the business at all. Most candidates discussed
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going concern, which was relevant, but instead of relating going concern to specific matters such as liquidity
problems and the large loan, it was simply mentioned as a conclusion in relation to every business risk discussed,
and therefore was not specific enough to earn credit. Many answers could have been improved in relation to
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business risk evaluation by including some simple analysis of the financial information made available, for example
through the calculation of profit margins and trends. This would have been an easy way to develop the point that
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financial performance was suffering, as well as liquidity being poor.

Answers were very mixed for requirement (a)(ii). Some candidates clearly understood the meaning of a risk of
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material misstatement, and could apply their knowledge to the question requirement, resulting in sound
explanations. However, despite this being a regularly examined topic and the cornerstone of audit planning under
the Clarified ISAs, the majority of answers were unsatisfactory.
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220 Answers
First, many candidates included a discussion about this being a first year audit which would result in a risk of
material misstatement, but this was both incorrect and showed that the question had not been read carefully
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enough. Then, when attempting to explain a risk of material misstatement, many candidates could do little more
than state a financial reporting rule, and then say the risk was that 'this would be incorrectly accounted for'. It was
not clear if this type of vague statement was down to candidates being reluctant to come to a decision about
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whether a balance would be over or understated, or if they thought that their answer was specific enough. Very few
answers were specific enough on the actual risk of misstatement to earn credit.
Answers to requirement (a)(iii) were mixed, and generally the answers in relation to the contingent fee were better
o t.
than those in relation to employment at a client company. On the contingent fee most candidates seemed confident
in their knowledge, and correctly identified that a contingent fee is not allowed for an audit engagement, and
recommended sensible actions such as ensuring a discussion of the matter with those charged with governance.
The majority of candidates had the correct knowledge here, and could apply appropriately to the question. As usual,
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candidates appear reasonably comfortable with the ethics part of the syllabus, but are reminded that to score well
on ethical requirements in P7, they must do more than just identify a threat.
With respect to requirement (b), the audit procedures that were recommended were mixed in quality. Most
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candidates suggested a review of the terms and conditions of the insurance policy to see if the situation was
covered, and most also recommended reviewing the actual claim and contacting the insurance provider. All of these
are valid and appropriate procedures and generally were well described. Some answers tended to state that the
matter should be 'discussed with management' with no further explanation, or that 'an expert should be consulted'
l.b
but with no description of what evidence the expert should be asked to provide, or even who the expert should be.
Too many candidates seemed to want to rely on representations and discussions about the possible outcome of the
insurance claim when there were other stronger sources of audit evidence available.
Marking scheme ria

ate
Marks
(a) (i) Business risks
Up to 2 marks for each business risk evaluated (up to a maximum of 3 marks in total if
risks identified but not evaluated):
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– Exchange rate risk

– Imports – transportation costs and potential for disrupted supply
– Reliance on one supplier
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– Quality control issues

– High-tech/competitive industry
– Reliance on key customer contracts
– Regulatory issues
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– Liquidity/solvency issues
– Poor profitability
– Change in key management
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Maximum 12
(ii) Risk of material misstatement
Up to 2 marks for each risk of material misstatement identified and explained to a
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maximum of four risks (up to a maximum of 2 marks in total for identification only):
– Initial translation of foreign exchange transactions
– Retranslation and exchange gains and losses
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– Obsolete inventory
– Refunds to customers
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– Capitalisation of borrowing cost to new production line

– Impairment of old production line
– Loan classification, measurement and disclosure
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Maximum 8
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Answers 221
Marks
(iii) Ethical issues
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– Explain why familiarity threat arises
– Explain why intimidation threat arises
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– Significant connections should be evaluated
– If significant connections remain, firm should resign
– If continue with audit, consider modifying audit approach and change audit team
o t.
– Review any work recently performed on Grohl Co audit by Bob Halen
– Consider firm's policies and procedures
– Contingent fee not acceptable
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– The basis for calculation of the audit fee must be agreed with client
Maximum 8
Professional marks:
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Generally 1 mark for heading, 1 mark for introduction, 1 mark for use of headings within the
briefing notes,
1 mark for clarity of comments made
Maximum 4
l.b
(b) Insurance claim
Generally 1 mark per matter/procedure:
Matters:
– Accounting treatment for contingent asset
– Claim may not be covered by insurance
– Amount of the claim seems unreasonable
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– Materiality
– Potential risk of material misstatement and impact on report
Procedures:
– Inspect claim and supporting documentation
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– Inspect insurance terms and conditions

– Review correspondence
– Communicate with insurance provider
– Enquiry with lawyers
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Maximum 8
Total 40
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(a) Briefing Notes

For: Mia Vai
By: Audit manager
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Date: Dec 20X2

Subject: Grohl Co audit planning
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Introduction
These notes will evaluate the business risks faced by Grohl Co; identify and explain four risks of material
misstatement to be considered in audit planning; and discuss relevant ethical issues and recommend actions
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to be taken by our firm.

(i) Evaluation of business risks
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Overseas supplier
Copper wiring is a key production material, and is imported from overseas. There is therefore a risk
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of unstable supply as a result of it being transported over a long distance, across borders. Any of the
following could pose problems.
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222 Answers
 A rise in fuel prices could affect the cost of materials
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 Political instability could lead to difficulties transporting across borders
 Goods may not be subject to the same regulatory standards as those in Grohl's own
jurisdiction, and could be of poor quality
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 Environmental disruption could affect eg shipping or aviation, and lead disruption of the
supply of materials
If there were a stock out of this key material then this would severely affect Grohl Co's production,
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and its ability to supply its customers. This could lead to a loss of revenue and of customer goodwill.
Exchange rate risk
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Purchases are made in a foreign currency, and fluctuations are not hedged against. This leaves Grohl
Co exposed to the risk of price rises, which could affect both its cash position and its short-run
profitability. It may be advisable for the company to use forward contracts to help mitigate this risk.
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Key supplier
Grohl Co is reliant on just one supplier for all its copper wiring. It is thus exposed to any risks
resulting from problems with this supplier, eg price rises, problems with supply, quality control.
l.b
Grohl Co also moved all of its copper purchases to just one new supplier, before having used the
supplier for a trial period. It was therefore highly exposed to any problems with the new supplier.
Competitive pressure
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Grohl Co operates in a competitive industry and is subject to price competition from overseas. There
is a risk that Grohl will be unable to keep its prices low enough to compete on this basis. It may need
to consider alternative strategies.
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The industry is dynamic and subject to rapid change, so in order to remain competitive Grohl Co
must adapt quickly to any changes. It may not have sufficient resources to do this.
Quality control
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Quality problems with the new copper supply have led to goods being returned by customers. This
seems likely to be related to the use of a new, cheaper supplier. There is a risk of losing customers as
a result of poor quality products, which may be particularly dangerous in this competitive market.
It may be necessary in future for Grohl Co to test the quality of copper purchased. This would incur
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costs, which would in turn put further pressure on Grohl Co's already tight operating margins.
New regulations
New regulations come into force after the year end. There is a risk that these may not be complied
with, which could lead to significant penalties. These could be fines, or could result in suspending
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production.
New loan
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The new $30m loan is significant at 1/6 (16.7%) of total assets. It is not know what proportion of net
assets this constitutes. Annual interest on the loan is 4% × $30m = $1.2m, which is a significant
amount in the context of a loss of $300,000 before tax and a cash balance of only $130,000.
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The fact that Grohl Co has a $2.5m overdraft may be indicative of a cash shortage, a view that is
borne out by low current and quick ratios. There is a risk that Grohl Co may not be a going concern
for the next year.
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Management change
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The loss of several executive directors means that key business expertise has been lost, which might
have been especially important given Grohl Co's current financial position.
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Answers 223
Profitability
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Draft revenue is down by $1.3m from 20X1, or 9.4%. Operating profit has fallen by $500,000, or
50%, and the operating margin has fallen from 7.2% to 4%, a fall of 46%.
Grohl Co has made a pre-tax loss of $300,000, although this does not appear to include the finance
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costs from the new loan (finance costs for 20X2 are the same as 20X1). If these were included, then
the loss would be about $0.5m higher, at $0.8m. This is a large loss, and may again indicate going
concern problems.
o t.
(ii) Risks of material misstatement
Foreign exchange
There is a risk of non-compliance with IAS 21 The Effects of Changes in Foreign Exchange Rates.
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IAS 21 requires that non-monetary items are recognised at the historical rate, which is the rate at the
date of the transaction. This would include income and expenses in the statement of profit or loss.
There is a risk that non-monetary items are not recognised at the correct historical rate, leading to
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under- or over-statement of these items.
IAS 21 requires monetary items to be measured at the closing rate. Thus any foreign currency
payables and receivables must be retranslated at the year end, with any exchange gain or loss being
recognised in the statement of profit or loss. There is a risk that the wrong rate is used, or that items
l.b
are translated using the wrong rate. There is also a risk that on exchange gain or loss is recognised in
relation to payables and receivables settled during the year.
Product recall
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Grohl Co may be liable to customers in relation to faulty goods supplied. Although the issue appears
to be resolved, it is possible that there may be further liabilities which should be recognised in line
with IAS 37 Provisions, contingent liabilities and contingent assets. There is thus a risk that
ate
provisions are understated.
There is a risk that the accounting treatment of the product recall was incorrect. Any revenue
recognised on recalled items should be cancelled against the corresponding receivables balance. The
risk is therefore that revenue and receivables may be overstated.
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New production line

The construction of the new production line is likely to result in new non-current assets which should
be recognised in line with IAS 16 Property, plant and equipment. There is a risk that this has not been
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done correctly, leading to either under- or over-statement of assets.

The production line is likely to be a qualifying asset in line with IAS 23 Borrowing costs, so all directly
attributable borrowing costs should be capitalised. It is not clear how much of the $0.5m finance cost
from the new loan would be capitalised, as the loan appears to have been used only 'mainly' for the
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new production line.

Old production line – impairment
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The new regulations coming into force after the year-end indicate that the existing production may be
impaired. IAS 36 Impairment of Assets requires management to conduct an impairment review. If
this is not done adequately, then non-current assets and profit may be overstated.
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(iii) Ethical issues

Audit manager joining client
An audit manager from Foo & Co may leave to become a financial controller at Grohl Co. According
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to the IESBA Code of Ethics, this could create familiarity and intimidation threats.
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The audit team may be so familiar with Bob Halen that they lose independence, for example they may
not challenge him if this is necessary. They may fail to exercise enough professional skepticism. Bob
is also likely to be familiar with Foo & Co's audit methodology, so would be well placed to think of
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ways of hiding things from the audit team.

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224 Answers
The IESBA Code states that if a 'significant connection' remains between the firm and the individual
who joined the client, then no safeguard could mitigate the threat and the firm should withdraw from
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the engagement. This would be the case if:
 Bob is entitled to benefits or payments from Foo & Co, unless in line with fixed pre-
determined arrangements
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 Bob is owed an amount by the firm that is material to the firm
 Bob continues to participate in the firm's business or professional activities
o t.
Alternatively, if there is no significant connection then safeguards may be necessary. The threat here
is significant, as Bob was in charge of the Grohl Co audit only very recently, and would have
maintained contact with Grohl Co's management.
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Safeguards might include reviewing any work that Bob has done on the audit, although there is not
likely to be much of this as planning is only just starting.
Contingent fee audit
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The IESBA Code clearly states that an audit firm may not enter into a contingent fee arrangement, as
the self-interest threat would be too great for safeguards to reduce to an acceptable level.
Conclusion
l.b
Grohl Co is facing some significant business risks, which may affect the going concern assertion.
There are a number of significant risks of material misstatement in relation to which the audit plan
should design procedures to obtain sufficient appropriate audit evidence. The ethical issue with Bob
(b)
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Halen requires that safeguards be put in place, and it should be communicated to Grohl Co's Board
that the audit cannot be performed on a contingent fee basis.
Matters to consider
ate
At $5m, the claim represents 40% of draft revenue, and would turn a loss of $0.3m into a profit of $4.7. It is
therefore highly material.
This is a contingent asset. IAS 37 requires that contingent assets are not recognised, unless it is virtually
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certain that the inflow of economic benefits will take place.

At the moment, it is not certain that the claim will even be paid, even if is more likely to be paid than not.
Whether or not it is paid will depend on the specific terms of the insurance policy, which would need to be
considered in detail and light of any communications with the insurer and/or Grohl Co's legal counsel.
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Regarding the value of the claim, production was halted for just one week so 40% of annual revenue is far
too high. It is very unlikely that this amount will be received.
Procedures
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 Obtain a copy of the insurance claim made and confirm that $5 million is claimed.
 Enquire into the basis of the $5 million claimed, and review any supporting documentation such as
extracts of management accounts showing lost revenue for the period of halted production.
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 Inspect the terms of the insurance policy, to determine whether production halted in these specific
circumstances would be covered.
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 Seek Grohl Co's permission to contact the insurer to ask about the status of the claim, and request
written confirmation of any payment that may be made.
 Review correspondence between Grohl Co and the insurance provider, looking for confirmation of
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any amounts to be paid.

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Answers 225
39 Champers
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Top Tips. In part (a)(i), there is a ½ mark available for just mentioning ('identifying') each aspect that needs to be
co
considered, so try to get lots of these (you only need to recall information from the study text) – but don't go
overboard here, as the marks available for identification will be capped. Then try to explain as many of them as you
can within the time allocated to this part of the question. In part (a)(ii), try to explain at least three procedures
o t.
within the time available.
Part (b) is a standard question on business risks, and you should be scoring well on this part. Remember that you
need to say enough about each risk (without waffling) to get the marks – don't just produce a list. There are 13
marks available here, so you should be looking to get around 8–10 of them on a requirement like this. Finally, be
sp
careful not to exceed the time allotted to this part of the question if you find you have lots to write. Part (c)(i) is for
five marks, so you should seek to describe at least three principle audit procedures to pass the question. Part (c)(ii)
is more difficult, so you should seek to get at least 2–3 marks on this part, making sure that your answer is
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properly focused on the requirement.
Easy marks. Make sure you get the four professional marks for: use of format and using appropriate language for
an audit junior.
l.b
Examiner's comments. Some candidates performed well overall, especially those who spent an appropriate amount
of time on each of the question requirements. In part (a), few candidates recognised the need to understand the
internal control environment, and fewer still mentioned the importance of understanding the relevant financial
reporting framework and performance measures of the client. Candidates tended not to gain the professional mark
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available for the clarity of their answer, because explanations were often confused, repetitive, or non-existent.
Candidates also need to bear in mind that professional marks are awarded partly for the quality of language used.
Common weaknesses is part (b) included: failure to use the financial information provided to identify risks;
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focussing on risk of material misstatement, which was not a requirement of the question; trying to link every risk
identified to a going concern risk.
For part (c)(i), few candidates could suggest anything other than 'check the relevant invoices' or 'check the amount
was approved'. Most candidates in part (c)(ii) failed to read the requirement, and the scenario, both of which stated
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that the advertising costs had been expensed. Most discussed the merits of recognising the amount as an
intangible asset, which as well as being completely irrelevant is also technically incorrect.
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Marking scheme
Marks
(a) (i) Identify and explain aspects of understanding business and environment
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Generally ½ mark for identification and 1 mark for explanation:

– External factors
– Entity and accounting policies
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– Objectives, strategies and business risks

– Performance measures
– Internal control
ea
Maximum 6
(ii) Recommend procedures to gain understanding
Generally 1 mark per procedure described:
– Inquiry
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– Analytical procedure
– Observation
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– Inspection
Maximum 4
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226 Answers
Marks
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(b) Business risk
Note. Professional marks to be awarded for format, use of introduction and conclusion,
use of language that an audit junior could understand. 4
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Generally ½ mark for identification, 1 further mark for explanation, from ideas list
1 mark to be given for each appropriate calculation eg trends, materiality
– Risk of damage to brand name/bad publicity re injury to child and closed
o t.
restaurant
– Investment needed in play areas to prevent health and safety problems
– Damage to the Happy Monkeys brand name may cross to other brand names
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– Compliance risk re health and safety regulations – food preparation
– Fall in revenue from Quick-bite business segment
– The above linked to reduced demand for fast food/more emphasis on healthy eating
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– Advertising ban could reduce revenue
– Rapid expansion plans for City Sizzler chain – danger of overtrading
– Potential lack of cash for the capital expenditure and on-going refurbishment costs
– Potential lack of cash for continued advertising
l.b
– Green George chain – need to monitor supply chain
– PBT fallen 13% – poor cost control?
– Minimum wage legislation will increase operating costs significantly next year
–
–
–
Cash position worsened during year
Cash based business – risk of fraud
Internal structure may need addressing
Maximum
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ate
(c) (i) Audit procedures on amounts capitalised
Generally 1 mark per specific audit procedure
Ideas list:
– Agree sample of costs to invoice/tender documents
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– Review capex budget and discuss variances actual v budget

– Agree interest rate of finance cost to terms of finance
– Agree period of capitalisation correct by reference to date of completion
of restaurants
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– Review list of items capitalised to ensure all capital in nature

Maximum 5
(ii) Audit work for advertising expense
Generally 1 mark per specific audit procedure
as
Ideas list:
– Agree sample of costs to invoices/reports from consultants
– Analytical review
– Discuss with relevant personnel/review of business plan
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– Inspect budgets
– Physically inspect the advertising
– After-date invoice review
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– Assess date advertising conducted

Maximum 4
Total 36
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(a) ISA 315 Identifying and assessing the risks of material misstatement through understanding the entity and
its environment identifies the main aspects of a client's business that must be considered in gaining an
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understanding of the company and its environment. This process is crucial to an auditor's assessment of the
audit risks that it then seeks to reduce to an appropriate level during the audit.
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Answers 227
(i) Aspects to be considered
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(1) Industry, regulatory and other external factors. For instance, some industries require
businesses to carry specific levels of capital (such as 'bonded' travel agents). An auditor
would need to gain knowledge of these regulations to assess their impact on the audit. This
could also affect audit planning. If a client operates in an industry with unusual accounting
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treatments (construction or insurance, for example), it would be wise to choose an audit team
with experience of that industry.
(2) Nature of the entity. An auditor must understand the legal structure of the entity (company or
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group). Complex ownership structures might increase the risk of misstatement – for instance
if subsidiaries' results are not consolidated correctly.
(3) Selection, application and reasons for changes of accounting policies. An auditor must
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understand the entity's accounting policies together with the reasons for them being selected.
This would include consideration of whether or not they are in line with the applicable financial
reporting framework.
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(4) Objectives, strategies and related business risks. Business risks are the risks that the
company may not achieve its objectives. The main way this affects audit risk is that if there is
a high risk of the company failing to meet its objectives (or if it adopts a risky strategy to try
to meet them), there is a risk that the company may not be a going concern. Any financial
statements prepared on the going concern basis would then be likely to be misstated.
l.b
(5) Measurement and review of the entity's financial performance. The auditor should
understand how the entity's performance is assessed, because management could seek to
manipulate the results so that it looks like the company is doing better than it is. This might
(6)
trigger bonus payments, for example.
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Internal control. This is an absolutely crucial area in assessing audit risk, as the auditor may
seek to place reliance on the entity's internal controls. The assessment of control risk would
ate
have a direct effect on audit strategy. This would include assessing the entity's control
environment.
(ii) Procedures recommended
(1) Inquiries of management. This would usually be the first place to start – management should
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be the best people to give the auditor information on the aspects of the company and its
environment referred to in ISA 315. The auditor could also consult others, such as an internal
audit department.
(2) Analytical procedures. It is crucial to perform analytical procedures to gain an understanding
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of the major areas of the financial statements, as well as the dominant trends and anomalies
(in financial information, and between financial and non-financial information). This will allow
the auditor to assess the areas where there is a higher risk of material misstatement.
(3) Observation. Observing internal control activities, for instance, could help to cement the
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auditor's understanding of how they operate.

(4) Inspection. Documents such as business plans or internal control manuals may contain
valuable information on how the entity operates. Inspecting these would supplement the
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inquiries already made of management.

(b) Briefing notes
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To: Champers audit team

From: Geoff Forest
Subject: Champers Co business risks
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Introduction
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These notes evaluate the business risks currently faced by Champers Co.
Happy Monkeys children's crèches
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A child was slightly injured during the year in an incident at one of the crèches. The media criticism that was
received could lead to significant damage of the Happy Monkeys brand, particularly given that the family-
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228 Answers
friendly orientation of the restaurants appears to be an important selling point. Although revenues from this
segment rose 21% compared with 20X8 ((800 – 660) / 660 = 21%), this negative publicity probably did
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result in some lost revenue.
It is possible that regulatory bodies could take action as a result of this incident, with the potentially
disastrous consequence of the crèches or even the whole restaurants being shut down.
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If it wants to protect the Happy Monkeys brand, Champers will probably need to spend money to improve
the standard of child care offered in the crèches. It would be difficult for it to do this given its falling cash
balance ($116m in 20X9; $350, in 20X8). It would therefore have to divert funds away from other projects,
o t.
such as the expansion of the City Sizzler grills.
Revenue derived from Happy Monkeys restaurants makes up 53% of total revenue (= 800 / 1500), so any
damage to this revenue stream could have a significant effect Champers as a whole.
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Happy Monkeys – health and safety
One restaurant was actually closed during the year as a result of significant breaches in kitchen hygiene
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standards. Health and safety authorities often have significant powers, and it is crucial that Champers'
restaurants comply with them. Moreover, this could cause significant damage to the Happy Monkeys brand,
and even to the other brands that Champers owns by way of association with it. If this was to happen
revenues could drop sharply, which would clearly affect Champers' ability to meet its objective of
l.b
maximising market share.
The effect of damage to the Happy Monkeys brand on Champers as a whole could be very significant indeed,
owing to the fact that it makes up 53% of Champers' total revenue in 20X9.
Quick-bite chain
 Marketing campaign ria
ate
A significant marketing campaign was launched to support the Quick-bite brand, costing $150m in
20X9. This represents 10% of Champers' total revenue for the year, and is a significant expense.
Indeed, this outlay may have been partly responsible for the decrease in cash during the year, and
because of Champers' poor cash position this level of spending is unlikely to be sustainable in the
future.
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 Falling revenue
Revenue from this segment fell by 6% in 20X9. The fact that this happened even though $150m was
spent on advertising during the year is a worrying sign, and may be indicative of a significant
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reduction in demand. This is borne out by the pressure exerted by government for the restaurants to
provide nutritional information in its menus, which the company rightly responded to. It is possible
that this highly competitive industry is experiencing falling demand as a result of increased public
awareness of the importance of eating healthily. This would appear to cast significant doubt over the
as
wisdom of the company having spent such a large amount on advertising during the year.
 New advertising regulations
50% of Quick-bite's revenue derives from 'chuckle boxes' sold to children. These sales are likely to
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be affected by the new advertising regulations coming into force from September 20X9. Champers
will have to consider how it is going to tackle this problem going forward.
City Sizzler grills
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 Expansion plans
Champers is planning to double the number of City Sizzler grills from 250 to 500 by the end of the
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current financial year. Given that the restaurants operate in the higher quality end of the market, this
is likely to require significant expenditure to acquire new prime locations and to refurbish the
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locations acquired.
It is possible that Champers may not be able to afford this level of investment in the next year, owing
to its already declining cash balance. There is a risk that it will begin to expand the chain, but then
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run out of cash once it has started.

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Answers 229
There is a possibility that Champers will have to raise new funds in order to finance the expansion.
Given the scale of its plans, it may struggle to raise the necessary funds. If it takes on new debt, this
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would expose the company to increased liquidity risk if it cannot make the required repayments.
 Refurbishment costs
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Champers plans to refurbish each City Sizzler grill every two years. This is likely to represent a
significant and ongoing drain on Champers' cash resources, and there is a risk that Champers will
not be able to afford it. Champers should therefore consider whether it can reduce the outlay in some
way, perhaps by extending the amount of time between refurbishments from two to three years.
o t.
Green George cafes
Champers plans to double the number of cafes within the next 12 months. This would probably be costly,
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and again there is a question mark over its affordability to Champers. The combination of the plans to
expand the Green George cafes and the City Sizzler grills, as well as a potential fall in revenue from the
Quick-bite outlets as a result of increased regulatory pressure, represents a significant risk to the future
success of Champers as a whole.
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This risk is exacerbated by the fact that Champers financed the expansion in the Green George cafes by
taking on debt, which may pose a threat to the company's liquidity if Champers fails to keep up with the
necessary repayments.
l.b
Falling cash balance
Champers' cash balance fell by $234m from $350m at 31 May 20X8 to $116m at 31 May 20X9, a fall of
69%. At this rate it will run out of money approximately 180 days into the year (116 / 234 × 365). It is vital
to Champers' ongoing survival that this trend is stemmed.
Falling profits ria
ate
Champers' profit after tax fell by 13% from $155m in 20X8 to $135m in 20X9. This may be a result of some
one-off expenses, such as the $150m advertising expenses in respect of the Quick-bite chain, or any
expenses related to the investment in the City Sizzler grills and the Green George cafes. However, it is crucial
that Champers' management considers its cost-control procedures in the future. This is particularly
pertinent in view of the impending 15% increase in the minimum wage, which will significantly increase
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Champers' costs, as it will affect a third of employees in the labour-intensive restaurant industry.
Conclusion
The business risks currently faced by Champers are not insignificant, and there is even a risk that it may not
tud
survive the next financial year if its inability to generate sufficient cash inflows is not countered.
(c) (i) Agree costs to invoice
The audit team should agree a sample of costs capitalised to supporting documents. Labour costs
as
should be agreed to payroll records and timesheets. Materials costs should be agreed to supplier
purchase invoices. Costs relating to site acquisitions should be agreed to legal papers, such as
completion statements.
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Agree finance costs to contracts

Interest rates should be agreed to original finance agreements, and the interest charge for the period
should be recalculated. If the rates are derived from an underlying figure (such as a central bank base
ea
rate), the rates applied should be agreed.

Agree cut-off for finance costs
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Per IAS 23 Borrowing costs, capitalisation must cease when the related asset is available for use, so
the date on which this was the case should be agreed to underlying operational documentation, eg
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surveyor's reports.
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230 Answers
Agree classification between revenue and capital expenditure
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A sample of costs capitalised should be agreed to underlying documentation (such as purchase
invoices) and the classification agreed. There is a risk that eg staff training costs could have been
capitalised.
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Compare actual vs budget
Compare actual with budgeted capital expenditure, and discuss any significant variances with the
appropriate employee (eg the manager for that budget area). If necessary carry out substantive
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testing in order to verify the actual amounts where there are significant variances.
(ii) Analytical procedures
Compare the current year expense with the prior year, discussing any significant variances with an
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appropriate employee (eg a marketing manager) and performing substantive procedures if necessary.
Compare actual expenditure with budgeted expenditure, discussing with an employee and performing
further procedures if required.
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Agree sample of costs to underlying documentation
Costs should be agreed to purchase invoices or other supporting documentation, and then to the
actual advert itself, which may exist in archive form for eg newspaper adverts. If judged necessary,
l.b
costs could be traced to purchase orders and then to budgets, making enquiries of management in
relation to any costs not budgeted for.
Cut-off testing
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Review after-date advertising invoices and ensure that those relating to the 20X9 financial year are
accrued for.
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Review the dates on which advertising actually took place and verify that adverts taking place after
the year end are accounted for correctly as prepayments.
Understanding of the business
Discuss the nature of the advertising expenditure with an appropriate employee, in order to form an
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expectation of the expense likely to be incurred and to design specific testing procedures.
40 Grissom
tud

Top tips. To answer this question well, some time spent planning would be very advisable prior to launching into
your answer. In part (a), remember to consider practical aspects and keep in mind the mark allocation – you need
as
to make10 to 15 well-explained points to achieve the maximum potential marks available, and you should be able to
generate these from the clues in the question scenario. In part (b), you need to make sure you apply your
knowledge of group audits to the scenario – there are lots of clues in the question, and it is important that you pick
up on them.
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Easy marks. You should be able to score reasonably well in part (a) if you use the information provided to you in
the question scenario and explain the matters fully. Similarly part (b) should be fairly straightforward on ISA 600.
ea
Examiner's comments. Overall performance on this question varied considerably. Candidates who answered the
specific question requirements scored well. However, despite the requirements of (a) and (c) covering familiar
issues seen in many previous papers, a significant proportion of candidates did not answer the specific question
requirements, leading to largely irrelevant answers scoring very few marks
e
Many scripts contained the following errors.

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 Discussion of business risk without linking the business risk to risk of material misstatement (eg 'there is a
risk of failing to comply with relevant laws and regulations', or 'there is a risk that inventories are obsolete')
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 Including audit procedures (which were not asked for)

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Answers 231
 Long description of the components of audit risk (inherent, control and detection risks) with no application
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to the scenario
 Explanations too vague to earn marks (eg 'the risk is it is not accounted for properly' or 'the risk is that the
accounting standard is not followed')
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 Discussing reliance on the component auditor (which the requirement explicitly said should not be
considered)
Many candidates included the inevitable references to going concern problems, even though there was no hint in
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the scenario that the group faced operational or financial difficulties. Also, some candidates misread the scenario,
leading to inappropriate comments.
A significant minority of candidates did not attempt to earn the four professional marks available for this
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requirement. Candidates are reminded that resources are available on ACCA's website providing guidance on the
importance of professional marks.
Overall performance on this requirement was unsatisfactory. Candidates are reminded that group audit
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engagements are an important part of the P7 syllabus, and the requirements and practical implications of the
Clarified ISA 600 should be studied in detail.
l.b
Marking scheme
Marks
(a) Evaluation of audit risks and other matters to be considered
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½ mark for identification (to a maximum of 5 marks) and up to 1½ further marks for
evaluation and ½ mark for correct reference to relevant IAS/IFRS (max 1 mark)
– Classification of non-controlling interests
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– Auditors lack knowledge of activities of non-controlling interests
– Bonus and potential earnings management
– Change of accounting estimates (IAS 8)
– Lack of group finance director
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– Capitalisation of dismantling costs (IAS 16)

– Provision – discounting and finance charge (IAS 37)
– Deferral of grant income (IAS 20)
– Potential provision or contingent liability (IAS 37)
– Mid-year acquisition
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– Goodwill on acquisition – subjective (IFRS 3)

– Retranslation of Brass Co financial statements (IAS 21)
– Retranslation of goodwill
– Adjustments necessary to bring in line with group accounting policies
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– Intra-group transactions
Maximum 18
Professional marks for presentation of answer, clarity of explanations 4
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(b) Evaluation of audit risks and other matters to be considered

1 mark per comment on matters/procedure
– Ethics
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– Competence/qualifications
– Skills/resources
– Quality control
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– Monitoring activities
Maximum 8
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(c)(i) Principal audit procedures for non-controlling interests

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– Confirm % shareholding acquired

– Confirm if Grissom Co appointed any board members
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232 Answers
Marks
– Consider relationship with other shareholders
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– Discussion of involvement
– Written representation re involvement
Maximum 4
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(ii) Principal audit procedures for condition attached to grant
– Confirm 25% to terms of grant
– Ascertain from grant document:
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– The period required to demonstrate reduction
– The amount that would be repaid if condition breached
– Review results of monitoring performed
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Maximum 4
Total 38
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(a) Briefing notes
To: Audit team
Re:
l.b
Grissom Co audit risks June 20Y0
Introduction
These notes consider the principal audit risks to be considered in planning the audit of the Grissom Group
financial statements for June 20Y0.
Grissom Co ria
ate
Non-controlling interests
There is an inherent risk that these investments have been classified incorrectly as associates.
IAS 28 Investments in associates and joint ventures requires Grissom to have significant influence over the
investee. If this is not the case, the investments should be treated as trade investments. Alternatively they
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may be joint arrangements if control is shared jointly with one or more other entities.
These two investments are in areas quite different from the group's core activity. There is thus a risk that the
group's finance team may not have applied appropriate accounting policies – eg deferring revenue for the
travel agent – resulting in misstatement of the group accounts.
tud
Bonuses and accounting estimates

The existence of profit-based bonuses for directors represents an inherent risk of manipulation, with income
and profit being overstated, and expenses being understated.
as
The fact that the group finance director left after a disagreement over accounting estimates may indicate that
senior management have indeed attempted to manipulate the financial statements. It is crucial that
professional scepticism is exercised in this area. There is a risk that IAS 8 Accounting Policies, Changes in
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Accounting Estimates and Errors has not been adhered to, for instance if change in accounting policy has
been mistaken for a change in accounting estimate.
Group finance director resigned
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There is a risk that the financial statements, and in particular the consolidation, have not been properly
prepared in the absence of a finance director overseeing the preparation process.
Moreover, the audit team may find it difficult to obtain appropriate explanations from management if there is
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no finance director, or if a new one is appointed who is not responsible for the accounts being audited.
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Answers 233
Willow Co
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New factory
The relocation to a new, very large factory may represent an increase in Willow's operational gearing, which
may create a business risk to going concern if cash flow problems result. These could be exacerbated by any
teething problems resulting from the new factory.
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Dismantling costs
IAS 16 Property, Plant and Equipment requires the dismantling costs to be capitalised as non-current assets,
o t.
and a provision created against them. Account should be taken of the effect of discounting if this is material,
and a finance charge included in the statement of profit or loss to represent the unwinding of the discount.
The risk is that the provision has not been created, and that assets and liabilities are therefore understated,
and that the depreciation expense is understated, which would result in profit being overstated. There is also
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a risk that the provision has not been measured correctly in accordance with IAS 37 Provisions, Contingent
Liabilities and Contingent Assets, eg in respect of the effect of discounting.
Hodges Co
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Government grant
IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that the grant
income is matched to the costs it is intended to compensate for. This will result in deferred revenue being
held on the statement of financial position. There is a risk that this has not done, leading to liabilities being
l.b
understated and profit being overstated.
IAS 20 also requires that a grant is recognised only when there is reasonable assurance that Hodges will
meet the condition specified by the government. Where there is doubt over this, a provision should be
profits overstated.
Brass Co
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recognised in line with IAS 37. The risk is that this has not been done, and that liabilities are understated and
ate
Consolidation
The subsidiary was acquired mid-year, and there is a risk that its results have not been consolidated from
the correct date. If they are included from too early a date and the company is profitable, then group profits
may be overstated.
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The acquisition should be accounted for in line with IFRS 3 Business combinations. There is a risk that
goodwill has not been calculated correctly, and that the fair values of Brass Co's assets and liabilities have
not be estimated reliably.
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Accounting standards
Brass Co's accounts must be restated so that they are in line with the group's accounting policies, which
should conform to IFRS. This is a risky process, particularly in the absence of a group finance director, and
there is a risk that Brass Co's accounts may not be in line with IFRS.
as
Intra-group trading
Brass Co supplies about half of Willow Co's ingredients. There are therefore a significant number of intra-
group transactions which need to be eliminated from the group accounts. There may also be inventories
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containing unrealised profit, which needs to be provided for. The risk is that this has not been done,
potentially overstating revenues, expenses, assets and liabilities.
Conclusion
ea
There are a number of risks which must be addressed during the planning of the audit of the Grissom Group
financial statements for June 20Y0.
(b) Factors to consider
e
Guidance is provided in ISA 600 Special Considerations – Audits of Group Financial Statements (Including
/fr
the Work of Component Auditors). Brass Co is a significant component of the group, and Sidle & Co are
component auditors. As group auditors we should obtain an understanding of the component auditor,
focusing on:
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 Whether Sidle & Co complies with ethical requirements

 Sidle & Co's professional competence
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234 Answers
 Whether the group audit team will be able to be sufficiently involved in the component auditor's work
 Whether Sidle & Co works in a regulated environment
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Ethics
Sidle & Co should, per ISA 600, be subject to the same ethical requirements as the group auditor,
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irrespective of regulations applicable in Chocland. These are contained in the IESBA's Code of Ethics for
Professional Accountants and the ACCA's Code of Ethics and Conduct.
Professional competence
o t.
As group auditor, Vegas & Co should check that Sidle & Co:
 Understand ISAs. Chocland audit regulations are not based on ISAs, so Vegas & Co must ensure that
the work performed by Sidle & Co conforms to the requirements of ISAs.
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 Have sufficient resources and skills to perform the necessary work. Various complex accounting
issues will be involved in preparing the group accounts, such as the measurement of fair values on
consolidation. The group auditor must assess whether Sidle & Co has the resources and skills to do
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this.
 Understand IFRSs. Chocland has not adopted IFRSs, and there is a risk that Sidle & Co is not
competent to audit Brass Co's accounts after they have been adjusted to comply with IFRSs.
l.b
Procedures to perform
 Obtaining and reviewing the ethical code adhered to by Sidle & Co, and comparing it to those
followed by Vegas & Co


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Obtaining a statement from Sidle & Co that it has adhered to this code
Establishing through discussion or questionnaire whether Sidle & Co is a member of an auditing
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regulatory body, and the professional qualifications issued by that body
 Obtaining confirmations from the professional body Sidle & Co belong to, or the authorities licensing it
 Determining through discussion whether Sidle & Co is a member of a network of audit firms
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 Discussion of the audit methodology used by Sidle & Co in the audit of Brass Co, and compare it with
those used under ISAs (eg how the risk of material misstatement is assessed)
 A questionnaire or checklist could be used to provide a summary of audit procedures used
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 Ascertaining the quality control policies and procedures used by Sidle & Co, both firm-wide and
those applied to individual audit engagements
 Requesting any results of monitoring or inspection visits conducted by the regulatory authority under
which Sidle & Co operates
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 Communicating to Sidle & Co an understanding of the assurances that our firm will expect to receive,
to avoid any subsequent misunderstandings
(c) (i)  Determine the percentage shareholding acquired, using purchase documentation.
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 Confirm that the percentage shareholding is between 20 and 50% of equity shares.
 Obtain a list of directors (eg using published financial statements) for the companies to
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confirm whether Grissom Co has appointed director(s) to the boards.

 Discuss with the directors of Grissom Co their level of involvement in policy decisions made
at the companies.
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 Obtain a written representation detailing the nature of involvement and influence exerted over
/fr
the companies (eg a letter from the investee's board of directors confirming the voting power
of Grissom Co).
 Consider the identity of the other shareholders and the relationship between them and
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Grissom Co. This may reveal that the situation is in substance a joint venture and would need
to be accounted for as such.
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Answers 235
(ii)  Obtain the grant document and review the terms to verify that 25% reduction is specified.
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 Determine over what period the 25% reduction must be demonstrated.
 Review the terms to establish the financial repercussions of breaching the condition – would
the grant be repayable in full or in part, and when would repayment be made.
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 Obtain documentation from management showing the monitoring procedures that have been
put in place regarding energy use.
 Review the results and adequacy of any monitoring that has taken place before the year end to
o t.
see if the condition has been breached (eg compare electricity meter readings pre and post
installation of the packing line, to confirm reduced levels of electricity are being used).
 Discuss energy efficiency of the packing lines with an appropriate employee to obtain their
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views on how well the assets are performing.
41 Jacob
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Top tips. Part (a) was of around average difficulty. You should have been able to pass this part of the question by
l.b
making sure that you only provide three benefits, and explaining each of them well.
Part (b) should have been simpler than part (a). It was important here that you didn't go over your time limit, but
that you wrote enough (in terms of quality, not quantity!) to gain marks for each thing you say. The key to actually
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getting marks is to be specific about what information you are asking for, and making sure that everything you say
is relevant to the scenario. It is a waste of time asking for information that is relevant to due diligence in general,
but not to Locke Co in particular. Also, it is no good just stating what information you need, you have to make sure
that you say why you need it.
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Easy marks. There were plenty of easy marks in part (b), for example, saying that more information needs to be
obtained regarding the court case against Locke Co.
Examiner's comments. This was the second most popular of the optional questions, and focussed on due
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diligence. Requirement (a), for six marks, required an explanation of three benefits of an externally provided due
diligence review to the audit client. This was reasonably well answered, though many answers were not made very
specific to the scenario and tended to discuss the benefits of any due diligence review rather than an externally
provided one.
Requirement (b), for 12 marks asked for additional information to be made available for the firm's due diligence
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review. Answers were satisfactory, and the majority of candidates did not struggle to apply their knowledge to the
scenario, usually providing some very focussed answers dealing well with the specifics of the question scenario.
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Marking scheme
Marks
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(a) Benefits of due diligence

Up to 2 marks for each benefit explained (only three benefits required):
– Identify and value assets and liabilities to be acquired
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– Identify and allow planning for operational issues

– Provision by external experts – technically competent and time efficient
– Assessment of potential impact of court case
– Evaluation of the liquidity position of Locke Co
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– Enhanced credibility provided by an independent review

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Maximum 6
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236 Answers
Marks
(b) Information required
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Generally ½ mark for identification and up to 1 further mark for explanation
(maximum 3 marks for identification):
– Service contracts of directors
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– Organisational structure
– Lease/arrangement regarding head office
– Details of land purchased
– Planning permission for new head office
o t.
– Prior year accounts and management accounts
– Forecasts and budgets
– Loan agreement
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– Overdraft facility details
– Legal correspondence
– Customer satisfaction surveys
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– Details of warranty agreements
– Outsourcing agreement
Maximum 12
Total 18
l.b
(a) One benefit of due diligence here is that it will help in assigning a valuation to Locke Co. The review would
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seek to identify all of Locke Co's potential assets and liabilities and provide a value for them. This valuation
may include amounts not included within the financial statements, for example any contingent assets or
liabilities that are not required to be recognised or disclosed by IAS 37. Armed with this valuation,
management would be in a better position to negotiate a price for the business.
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A second benefit is that the review should obtain further information about the company's operations. For
example, it may be able to obtain further information about the extent of Locke Co's possible liability relating
to its court case. It may also be able to provide an indication of the extent to which Locke Co's reputation
may be tarnished by the court case.
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A third benefit is that since the due diligence review is prepared externally, the directors' time is freed up to
concentrate on operational matters. The review will be prepared time-efficiently, and the independence of the
firm providing the review helps contribute to the good governance of Jacob Co.
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Tutorial note. The answer above includes three benefits (as required). Credit will be awarded for explanation
of any three benefits which are specific to the scenario.
(b) Further information should include:
Employment contracts
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Contracts for directors and other key personnel should be obtained. It may be that Jacob will seek to
terminate the employment of directors after the acquisition. The contracts should be inspected for any
amounts payable on termination.
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Organisational structure
It may be that Jacob will want to keep hold of key personnel. In order to identify them, an organisational
ea
structure should be obtained.

Lease agreements re: building
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Jacob may wish to relocate away from the building owned by the family estate, in which case the signed
lease agreements should be inspected for any penalty clauses for early termination.
/fr
New head office – purchase documentation

Documents relating to the land purchase should be obtained to ascertain its value should Jacob wish to sell
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it, or to see whether it might be put to an alternative use. Alternatively, it may be possible for the land not to
be included in the acquisition.
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Answers 237
Details should be obtained of any other commitments made in relation to the new head office. For example,
construction contracts may have been entered into; these should be obtained, along with details of any
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possible penalties for termination.
Audited financial statements
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Audited financial statements should be obtained in order to verify that Locke has indeed grown rapidly in the
last three years.
These will also provide information helpful for the valuation of assets, the existence of contingent liabilities,
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etc.
Finally, they will allow an assessment to be made of Locke's liquidity, which may be particularly important in
view of its use of an overdraft facility during the winter months.
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Management accounts and forecasts
These should be obtained for future periods in order to assess Locke's possible future profitability.
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Asset valuations
Any significant non-current assets should be assessed for their market value, if they are held in the accounts
at historical cost.
Signed bank loan agreement
l.b
This should be obtained in order to ascertain the repayment terms, the interest rate, as well as any charges
security over the company and/or its assets.
Jacob's own exposure to risk.

Overdraft details
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The amount of the loan may be significant, as purchasing a company with high financial gearing may affect
ate
Details such as the maximum facility available to Locke, the interest rate, and when it is due for renewal.
It is possible that Locke may be a significant drain on Jacob's cash resources during the winter months, so
Jacob will need to assess its own ability to take on such a possible commitment.
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Information from legal counsel

This should be obtained regarding the court case with the famous actor. This should ascertain the extent of
Locke's probably liability, along with the timescale for the case.
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Information on bad publicity

The bad publicity from the legal case may affect Locke's ability to generate revenue in future, so information
about the extent of the possible brand damage should be sought.
Information on Locke's 'good reputation'
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This claim should be substantiated as far as possible, for example by reference to industry journals,
customer satisfaction surveys, levels of customer complaints, etc.
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Contract with Austin Co

This should be examined in order to understand exactly what services Austin provides, and what the cost of
these services is. Jacob may wish to bring some of these activities back in-house.
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238 Answers
42 Cusiter
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Text reference. Chapters 3 and 13.
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Top tips. This is a question on prospective financial information but don't let that put you off – instead think of it as
another assurance engagement which needs to be planned in the same way that any other engagement, such as the
external audit, would. So when you come to parts (b) and (c), think about the planning issues and the work you
would have to do on the prospective financial information, remembering what kind of assurance you can provide on
o t.
such an engagement. Don't panic just because this isn't an external audit engagement. Work through the
information in the scenario logically and carefully and you will be well on your way to passing this question.
Easy marks. Easy marks are available in part (a) of the question for explaining what prospective financial
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information is.
Examiner's comments. In part (a), some candidates were mixed up and described PFI as assurance work done by a
professional accountant, rather than the subject matter on which work is done. Many candidates digressed into the
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level of assurance that would be given for a PFI engagement and/or disclaimers of responsibility and the uses of
PFI. In part (b), candidates had to explain the matters that should be considered when planning the nature and
scope of the examination of Cusiter's forecast statement of financial position and statement of profit or loss as
prepared for the bank. The majority of candidates did not read the question, and instead wrote everything they
l.b
could think of relating to this assignment. There were easy marks for those who considered an 'ideas list' (including
purpose of the PFI, assurance required, nature of engagement, period covered, etc). However it was not enough to
simply identify these as matters – these needed to be explained in order to score well.
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In part (c), candidates had to describe the examination procedures to verify Cusiter's PFI. Some students
mentioned analytical procedures very vaguely but then others calculated lots of ratios without explaining the
procedures that would verify the PFI. In part (d), candidates had to discuss the professional accountant's liability
ate
for reporting on PFI and the measures that the professional accountant might take to reduce that liability. There
were some sound answers from well-prepared candidates who considered the 'how', 'why', 'when' and 'to whom'
of a professional accountant's liability. There were very easy marks to be obtained for the measures to reduce
liability. Other answers dwelt at length on just one aspect and therefore scored poorly as a result.
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Marking scheme
Marks
(a) PFI
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Generally 1 mark each point of explanation Maximum 3

Ideas
 Definition
 Forecast vs
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 Projection
(b) Matters to be considered

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Generally ½ mark each relevant matter identified + up to 1 mark for explanation Maximum 7
Ideas
 Purpose of PFI – external vs internal use
ea
 Report/level of assurance required – 'negative'

 Nature of engagement = examination to obtain evidence
 Examination = inquiry + analytical procedures
 Period covered
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 Management's previous experience, if any, preparing PFI

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 Basis of preparation of forecast

 Any standards/guidelines followed
 Time and fee budget
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Answers 239
(c) Examination procedures Marks
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Generally 1 mark each point contributing to a description of procedures Maximum 9
Ideas
 Procedure ideas
 General (to both forecast statement of financial position and statement of
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profit or loss)
 Specific (to forecast statement of financial position or statement of profit
or loss)
o t.
 Arithmetic accuracy
 Tenders for new equipment
 Assumptions, bases, etc (eg useful lives)
 Analytical procedures (eg inventory turnover, average collection period)
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 vouching to available historic financial information
(d) Professional accountant's liability
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Generally 1 mark each point contributing to a discussion of liability/measure to Maximum 6
reduce
Ideas
 How liability arises
l.b
 To whom liable
Measures to reduce
 Disclose assumptions
 Caveats



Warnings
Disclaimers
Reporting
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 Wording
 Terms of engagement
 Liability cap
 Indemnity
4
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Professional marks
Total 29
MEMORANDUM
tud
To: Douglas Groan

From: Trevor Ennui
Re: Cusiter Co – prospective financial information
as
This memorandum explains the term 'prospective financial information' (PFI); explains the matters to consider
when planning the review of Cusiter Co's PFI; describes the procedures that should be used to verify Cusiter Co's
PFI; and discusses the professional accountant's liability for reporting on prospective financial information and the
measures that the professional accountant might take to reduce that liability.
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(a) Prospective financial information

PFI relates to information that is based on assumptions about events that may occur in the future and
ea
possible actions by an entity. It is therefore highly subjective. PFI can be of two types: forecasts and
projections.
Forecasts consist of PFI based on assumptions as to future events which management expects to take place
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and the actions management expects to take (best-estimate projections).

Projections are PFI based on hypothetical assumptions about future events and management actions, or a
/fr
mixture of best-estimate and hypothetical assumptions.

PFI can include financial statements or one or more elements of financial statements and may be prepared
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as an internal management tool, for example, to assist in evaluating a possible capital investment or for
distribution to third parties, for example, in a prospectus (to provide potential investors with information
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240 Answers
about future expectations) or in an annual report (to provide information for shareholders) or in a document
for the information of lenders which may include cash flow forecasts.
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(b) Matters to consider in planning the nature and scope of examination of Cusiter's forecast statement of
financial position and statement of profit or loss
Basis of preparation
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The firm must consider how the information has been produced – it may be based on historic financial
information which has been adjusted appropriately or it may include new information and assumptions
about future performance.
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Use of the PFI
The information has been produced in order to support a loan application to the bank and therefore is only
for the use of the bank. It will not be published and available for other users.
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Assurance provided
A review of PFI will provide only negative assurance as the information is very subjective and based on
assumptions about future performance. The opinion will be based on whether the information has been
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properly prepared on the basis of the assumptions and whether it has been presented in accordance with the
relevant financial reporting framework.
Nature of the review
The nature of the review of the prospective financial information will involve the use of analytical procedures,
l.b
inquiry and corroboration from management.
Preparation of the PFI
The firm will need to consider who prepared the information and any prior experience in preparing PFI.
Evidence
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For the forecast for the year ended 31 December 20X8, the firm should be able to find actual evidence for the
first three months as this forecast includes some historical financial information.
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(c) Examination procedures to verify the PFI
A review of PFI uses inquiry, analytical review and corroboration from management. The following
procedures should therefore be carried out as part of the review.
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The information should be recast and all the sub-totals and totals agreed.
The accuracy of the comparative information should be agreed to the audited accounts for that year to
confirm it is complete and accurate. Similarly the figures for the first three months of 20X8 should be agreed
to the trial balance and ledger.
tud
Analytical procedures should be performed on the prospective financial information by comparing it to the
actual figures in the prior year. Any unusual variances should be investigated further by discussing with
management. For example, revenue is forecast to grow by 18% from 20X7 to 20X8 and 19% from 20X8 to
20X9. Since the investment is taking place in 20X9, we would expect revenue growth to be greater in this
as
year. Management should explain why this is not the case and when the investment can be expected to start
earning revenues.
A reasonableness check between statement of financial position and statement of profit or loss items should
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be undertaken. For example, the inventory turnover period at each of the quarter dates presented is 66, 88,
65 and 65 days respectively. Management should be able to explain the reason for the increase in days in
the quarter to 31 March 20X8 and show how they expect to be able to reduce this ratio to the forecast
amounts.
ea
The terms of borrowings should be examined to ensure that the forecast takes account of all repayments
that are required.
e
Tender and quotation documents for new machinery should be examined to verify the additional cost within
non-current assets for the year ended 31 December 20X9.
/fr
The reasonableness of assumptions used should be considered by discussing with management.

The review should consider whether the desired loan of $250,000 will be sufficient to match the costs
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forecast in the prospective financial information, given that the new plant and equipment is forecast to cost
$280,000.
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Answers 241
Information should be reviewed for consistency with IFRS.
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(d) The accountant's liability for reporting on PFI
A report on PFI can only provide negative assurance because of its subjective nature as it is based on
assumptions of future results. Reviews of PFI are generally done for the bank to obtain a loan or extend
borrowing. So if the forecast results do not materialise, the bank may lose money and the firm who reviewed
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the information could find itself in court as a result.
To determine whether the firm is liable, the criteria generally applied are that the firm is liable to persons
with whom there is proximity only or whose relationship approaches privity and to persons of a limited
o t.
group for whose benefit the information was supplied or who knew that the recipient was going to receive
the information and to persons who can reasonably be foreseen to rely on the information.
To reduce the liability, the accountant must ensure that the report contains sufficient caveats as to the
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achievability of the forecasts. The report should also refer to the fact that the engagement was undertaken in
accordance with ISAE 3400 The examination of prospective financial information (or relevant national
standards or practices applicable to the examination of PFI).
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The report should include a statement that it is the management who is responsible for the prospective
financial information, including the assumptions on which it is based, not the assurance firm.
Another important point to include is that the information is for restricted use, so it should include who it
has been prepared for and who is entitled to rely on it. Reference should also be made to the fact that the
l.b
engagement to review the PFI was undertaken in accordance with the terms of the engagement.
The terms of the engagement should include an appropriate liability cap. In some cases, it may be possible
to obtain indemnity from the client in respect of claims from third parties.
Conclusion
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An engagement to report on PFI can only provide a lower level of assurance than a statutory audit, and is likely to
ate
place reliance on analytical review. There are a number of steps that an accountant should take to restrict his
liability in relation to such a report.
43 Oak
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Top tips. In part (a)(i) you do not actually need to do that many calculations. If you were to do only calculations but
with no discussion then your marks would be capped to just four, or 17% of this part of the question. You need to
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do much more than just crunch the numbers if you are to pass the question. The trends in the financial statements
should be fairly evident from just comparing the current year's figures with the previous year's. Once you've
identified the basic trends (here, falling revenues and falling cash, leading to doubts over going concern), you
should be in a position to select a few key ratios – such as interest cover, and the liquidity ratios. As ever, you need
as
to focus less on the calculations than on what the numbers tell you. The principal audit risks should just come out
of your analytical review and the notes to the draft financial statements – each note gives rise to an audit risk of
some sort.
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The appearance of IFRS 2 in this question was quite technical, and you may have struggled to remember the
accounting requirements in this area. In this case there would still have been some general points to make, such as
the inherent risk of not complying with a complex accounting standard, or the risk of understatement of expenses
ea
and equity.
In part (a)(ii), you should be able to generate ideas by recalling the requirements of IFRS 2 and IAS 17. You may
have found IAS 17 easier, in which case you should not have gone over your allotted time on IFRS 2.
e
In part (b), there were plenty of easy marks to be had. There were three issues here, corresponding to two marks
each. You should have been looking to get at least 4–5 for this part of the question.
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Easy marks. The two professional marks were easy to come by. To get them you must include a header, an
introduction and a conclusion, and make sure that your answer is written clearly and concisely, without waffling!
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242 Answers
Marking scheme
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Marks
(a) (i) Audit risks and preliminary analytical review
Up to 2 marks for each audit risk/area from preliminary analytical review assessed (to include 1 mark
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for each ratio and comparative as long as explained, to a maximum of 4 marks for calculations):
– Profitability
– Liquidity
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– Going concern
– Management bias
– Operating expenses
– Share-based payment (up to 3 marks)
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– Lease
– Revaluation
– Intangible asset
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– Current assets
– Long-term borrowings
– Provision
Maximum 23
(ii) Principal audit procedures
l.b
Generally 1 mark per audit procedure:
(1) Share-based payment plan:
– Review and obtain understanding of the terms of the share-based payment plan
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– Confirm 10% increase in share price and continued service as conditions
– Review assumptions used to determine fair value of share options
– Consider appropriateness of the model used
ate
– Consider use of an auditor's expert for the valuation of share options
– Review assumptions relating to expected staff turnover
– Perform sensitivity analysis
(2) Lease:
– Obtain and review lessor signed copy of lease
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– Confirm length of lease and estimated life of property and compare

– Ascertain responsibility for repairs and insurance
– Review lease for indicators of substance of lease
– Recalculate present value of minimum lease payments and compare to fair value
tud
– Agree payments made to cash book and bank statement

– Recalculate finance charge
Maximum 8
Professional marks for the overall presentation of the notes, and the clarity of the explanation
as
and assessment provided. One mark is specifically awarded for the presentation of the results of
analytical procedures.
Maximum 4
(b) Practice management and quality control issues
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Generally 1 mark per comment from ideas list:

– Raising materiality level increases detection/audit risk
– Materiality judgemental and should be specifically determined for each client
ea
– Should not fix materiality at planning stage – against ISA 320

– Training promotes a culture of high quality auditing
– Cutting training is contrary to the principles of ISQC 1
e
– Audit teams will not be up to date on current developments

– Quicker audits cannot be guaranteed
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– Short-cuts will reduce audit quality and increase detection risk

– The manager's suggestions are inappropriate
Maximum 6
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Total 41
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Answers 243
(a) Notes re: Oak Co audit planning
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Introduction
These notes outline the principal audit risks in relation to Oak Co ('Oak'), and contain the results of the
preliminary analytical review, on the basis of the draft financial statements to 30 Nov 20X1. Analytical review
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calculations are contained in an appendix to these notes.
(i) Liquidity
There are uncertainties about Oak's liquidity, as well as its ability to continue as a going concern.
o t.
Cash has fallen from an asset of $2,350 in 20X0 to a net liability (overdraft) of $1,200 in 20X1. The
current ratio has fallen from 2.5 in 20X0 to 1.4 in 20X1, and the quick ratio has dropped from 2.1 in
20X0 to 1 in 20X1. This is a worrying situation.
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This has been accompanied by a lengthening of the cash operating cycle, with receivables days rising
from 55 days in 20X0 to 64 days in 20X0; inventory being held for longer, from 36 days in 20X0 to
39 days in 20X1; and payables being paid more slowly, from 73 days in 20X0 to 76 days in 20X1.
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Oak is taking longer to pay its suppliers, is receiving payment more slowly from customers, and has
more items left unsold in inventory.
Although individually these changes may not signal going concerns problems, taken as a whole they
are contributing to a substantial worsening of Oak's liquidity position, resulting in it having to make
l.b
use of an overdraft to continue trading. The audit plan must therefore focus on going concern as a
key area of audit risk.
Profitability
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Oak's worsening liquidity situation has been accompanied by falling profitability, which has not yet
been remedied by the launch of its new website. Revenues have fallen, and although costs of sales
have also dropped, they have not done so to the same extent, resulting in falling margins. The gross
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margin fell from 46% in 20X0 to 40% in 20X1, and the operating margin fell from 19% to 16% over
the same period. The return on capital employed (ROCE) fell from 7& to 4.4%.
This is before taking into account a number of material accounting judgements affecting the figures
for 20X1, which if not permissible would significantly worsen these figures, especially the ROCE
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which would be hit by falling capital and falling profits. (Adjustments discussed below.)
Oak has incurred significant finance costs each year, which are fixed in relation to profit. As a result,
interest cover has fallen from 3.7 to 2.7. This is acceptable for this year, but is unlikely to be so in the
future if profits continue to fall, and particularly if any refinancing of Oak's loans resulted in a higher
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finance cost.
Finance cost
Finance costs have remained static, which may be as expected for long-term loan if this loan requires
as
fixed interest payments. However, the overdraft taken out during the year would be likely to result in
charges, so the finance cost appears to be understated.
Management bias
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The background of falling profits and a shortage of cash gives management a motive to manipulate
the financial statements, especially in view of the fact that the loan is being renegotiated.
Manipulation could be to increase profitability, or to present a better view of Oak's net assets than is
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in fact the case.

Share-based payment
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This is an equity-settled share-based payment, to be accounted for in line with IFRS 2 Share-based
payment. This is a complex area and is therefore inherently risky to audit.
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No expense has been recognised in the draft accounts, so the risk is understatement of expenses and of
equity. IFRS 2 distinguishes between the estimation of the fair value of the options, and of the number
of options that will vest. In estimating the fair value of the options, the market price of the shares will be
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taken into account. But in estimating how many options will vest, market conditions are not taken into
account. Instead, an expense should be recognised as though the condition will be satisfied.
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244 Answers
Finance lease
m/
$5m has been capitalised in respect of a finance lease. But the signs are that this is an operating
lease per IAS 17 Leases: the lease term is only five years, which is unlikely to be a major part of the
remaining useful life of a property suitable to be a head office.
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The $5m capitalised is well below the property's fair value of $20m. This may be a sign that non-
current assets are understated, if the lease is indeed a finance lease. It is not clear what the $5m cost
refers to, ie whether it is a lease payment, or perhaps a deposit. If it is a payment, then the total
minimum lease payments could be in excess of the asset's fair value, at $5m x 5 years = $25m. This
o t.
would seem to indicate that the lease is indeed a finance lease.
These considerations are inconclusive; there is an audit risk that the leases are not accounted for in
line with IAS 17, so audit work needs to be focused on this material area. If the lease is really a
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finance lease, then non-current assets are significantly understated. If it is an operating lease, then
operating expenses may be understated by the difference between the lease payments and any
depreciation expense on the capitalised asset; it is not clear whether depreciation has been charged
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in the draft accounts, so it is not certain what the effect of correcting the wrong treatment would be
on operating expenses.
Revaluation
l.b
The revaluation is very material at $10m, which is 10.2% of total assets and represents almost the
whole increase in total assets from 20X0 to 20X1, besides the retained earnings. This is an inherently
risky area to audit.
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The independent expert providing the revaluation is a management's expert per ISA 500 Audit
evidence. ISA 500 requires the auditor to evaluate such an expert's competence, capabilities and
objectivity; to obtain an understanding of their work; and to evaluate the appropriateness of their
work for the revaluation. It is important to approach the audit of this area with professional
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scepticism.
IAS 16 Property, plant and equipment requires that the entire class of assets to which an asset
belongs should be revalued. There is a risk that only some properties have been revalued, which
would result in an overstatement of assets. IAS 16 also contains extensive disclosure requirements,
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which must have been adhered to.

There is a risk that depreciation has not been calculated using the revalued carrying amount. There is
also a risk that the deferred tax consequences of the revaluation have not been taken into account
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and that liabilities are therefore understated.

Website asset
There is a risk costs have been capitalised but not in accordance with IAS 38 Intangible assets.
Specifically, costs relating to planning the website must be expensed, as should be costs incurred
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once it is operational.
An asset should only be recognised if it meets the definition of an asset, ie that it will generate an
inflow of future economic benefits. Given that the website has only generated minimal sales since its
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launch, it is possible that the asset is overstated and should be impaired.

Working capital
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Inventory has been moving more slowly this year than last, so there is a risk of obsolete inventory
not having been written off, leading to an understatement of expenses.
Receivables have taken longer to collect, so there is a risk that the allowance for irrecoverable
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receivables has not included some debts that may not be collected.
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Loan
The loan payment of $12.5m is due on 30 September 20X2. Oak does not have sufficient cash to
make this payment at present, so unless its cash position improves considerable over the coming
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year, it will be wholly dependent on finding alternative finance. If this is not forthcoming then Oak
may not be able to continue trading.
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Answers 245
The $12.5m is due within the next year and so should be shown as a current asset. If this change is
not made, then the financial statements are materially misstated.
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Provision
The amount of the provision has been reduced by 20%, which is a greater fall than the fall in revenue
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to which it should relate. There is therefore a risk that both the provision and the related expense are
understated.
Overdraft
o t.
The overdraft of $1.3m is nearing the limit of $1.5m. Over the last 11 months Oak has lost cash at an
average rate of $323,000 per month (= ($2,350 – $1,300 – $100) / 11). If this continues, it will hit its
overdraft limit within a month. This could make it unable to pay its debts as they fall due.
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(ii) (1) Share-based payment
 Obtain details of the plan to ascertain its the major terms, including:
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– Grant date and vesting date
– Number of executives and senior managers awarded options
– Number of share options awarded to each individual
l.b
– Required conditions attached to the options
– Fair value of share options at grant date
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 Examine the conditions attached to the options, to confirm the 10% increase in share,
and continued service.
 Review the assumptions used, and inputs into, the option pricing model used to
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estimate the fair value of the share options.
 Consider the appropriateness of the model used to estimate this fair value.
 Consider using an auditor's expert, eg a chartered financial analyst, to examine the fair
value of share options used in the calculations.
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 Obtain and review a forecast of staffing levels or employee turnover rates relevant to
executives and senior managers over the vesting period and consider whether
assumptions used appear reasonable.
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 Check the sensitivity of the calculations to a change in the assumptions used in the
valuation.
(2) Lease
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 Review the major clauses of the signed lease contract to ascertion whether risk and
reward has transferred to Oak.
 Confirm the length of the lease and compare it to the estimated life of the property.
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 Ascertain from the lease contract who is responsible for repairs and maintenance of
the property. If this is the lessor, then it is an operating lease.
 Scrutinise the lease contract for indications that the lease is a finance lease, eg the
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existence of a bargain purchase option, legal title passing to Oak at the end of the
lease.
 Recalculate the present value of minimum lease payments and compare them with the
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fair value of the leased property at the inception of the lease.

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 Agree amounts paid to the lessor to the cash book and bank statement.
 Recalculate the finance charge expensed, and agree the rate of interest to the lease
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contract.
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246 Answers
Conclusion
m/
The audit of Oak Co poses significant engagement risks, particularly in relation to going concern. The audit
team must be particularly alive to the possibility of management bias. The principal audit procedures in
relation to the share-based payment and finance lease have been outlined.
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Appendix: calculations
Ratio 20X1 20X0
Receivables days (12 months) 4,928 / 28,036  365 = 64 4,815 / 31,964  365 = 55
o t.
Inventory days (12 months) 1,800 / 16,822  365 = 39 1,715 / 17,345  365 = 36
Payables days (12 months) 3,500 / 16,822  365 = 76 3,485 / 17,345 x 365 = 73
Current ratio 6,828 / 4,800 = 1·4 8,880 / 3,485 = 2·5
Quick ratio 5,028 / 4,800 = 1 7,165 / 3,485 = 2·1
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Gross margin 10,280 / 25,700 = 40% 13,400 / 29,300 = 45·7%
Operating margin 4,080 / 25,700 = 15·9% 5,650 / 29,300 = 19·3%
ROCE 4,080 / 62,278 + 31,000 = 4.4% 5,650 / 54,895 + 26,250 = 7%
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(b) Materiality
ISA 320 Materiality in planning and performing an audit requires that materiality be considered at all stages
of an audit, and revised as necessary. Therefore fixing materiality at the planning stage would mean that
l.b
Maple & Co's audits do not comply with ISAs.
It is true that a higher materiality threshold would, all things being equal, result in smaller sample sizes and
less audit work. However, materiality is a matter of judgement; the same materiality threshold cannot just be
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applied to all audits, since the circumstances of each engagement will be different. If inherent risk is higher,
for instance, then it is likely that materiality will be set lower in order that audit quality remains consistent.
Moreover, materiality reflects the level of audit engagement risk being taken on. Raising the materiality
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threshold in general would mean taking on more risk, and therefore reducing audit quality.
Training
It is a requirement that qualified members are professionally competent to perform their work, which in an
audit department means being up to date with the latest professional developments. Cutting CPD spending
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would make it harder to do this. Moreover, if staff are not up to date with the latest developments then it is
likely that audit quality will be reduced, as they may not be fully aware of what is required of them.
Cutting spending on the training of junior staff is not in itself a problem, however; staff must be competent
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to perform the work asked of them, and if training is not provided then this may not be the case. Further,
ISQC 1 requires a firm to institute an internal culture that emphasises quality; if training is not provided, then
ISQC 1 may not be complied with.
Quicker audits
as
Guaranteeing quicker audits to clients is unprofessional, and may prejudice audit quality. It is not possible to
determine in advance the work that needs to be done on an audit, and hence the length of time it will take to
do it. Hence requiring that audits be completed more quickly may lead to a reduction in audit quality and
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increased risk being taken on.

In addition, a guarantee that an audit be done quicker than last year will be inappropriate where there is a
change of circumstances at a client resulting in more audit work needing to be done.
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Answers 247
44 Geno Vesa Farm
m/
Top tips. Make sure that you read this question carefully, not least the requirement so that you are clear what type
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of risks you are trying to assess. Then work through the requirement again, highlighting or jotting down the risks
highlighted in the question. Work through the risks you have identified, making sure that they are all audit risks, or,
if they are business risks, assessing what the related audit risks would be, so that when you commit the risks to
o t.
paper, you are sure that you are answering the question properly. Remember that for 14 marks, you should aim to
identify about nine or ten risks – working on the assumption that the examiner usually allocates half a mark for
identifying and one mark for explaining. In part (b), try and think in basic terms about what you are trying to prove
about the assets and what evidence will therefore be relevant. Make sure you are relevant to the scenario as well.
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New kids will not have purchase invoices – they have been born into the business!
Easy marks. These are available are for identifying risks, but harder marks are awarded for explaining those risks.
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Examiner's comments. Candidates who ignored the fact that this was an audit risk question struggled on this part.
Candidates are reminded that when asked to 'identify', they should be brief. Some candidates seemed focused
solely on going concern risks. There are only so many marks that can be awarded for reference to 'going concern'.
Better candidates differentiated themselves by simply recognising the impairment reversal, the sale and repurchase
l.b
of maturing inventory, a current liability if the grant should be repayable. The weakest candidates who, for example,
expressed concern that all the inventory was sold to one customer, clearly had no grasp of the scenario in which
sales were made to retail outlets.
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Part (b) consisted of three parts for 12 marks – only four points needed for each part to score 100%. Many
answers did not answer the question set, most typically ignoring the reference to 'carrying amount', preferring to
write an irrelevant answer point for each item on a rote-learned list of financial statement assertions.
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Marking scheme
Marks
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(a) Principal audit risks

Generally ½ mark for identification + 1 mark each point of explanation 14
Ideas
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Industry
 'Farming' (weather, etc)
 Bad press etc
Goat herd
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 Goats – non current tangible assets

 Kids – inventory/current assets
Rabida Red
 Cost , supply problems  going concern
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 Socio-environmental reporting
Bachas Blue
 Contingent liability/going concern?
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 Impairment reversal (IAS 36)

 Value in use
Cheese
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 Sale and repurchase/substance over form

 Expensing of finance costs (IAS 23)
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 Non-compliance with legislation  provision

 Compliance with legislation  discontinued operations
Grant
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 Reason for implementation being deferred

 Repayable?  impact on cash flow
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248 Answers
(b) Audit work on carrying amounts Marks
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Generally 1 mark each point
12
Max 4 each statement of financial position item × 3
Ideas
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 FS assertions (valuation = quantity × price)
 Qty exists?
 Price = cost? Depreciable amount? MV?
 Procedures
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– Analytical
– Enquiry
– Inspection
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– Observation
– Computation
Total 26
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(a) Audit risks
Nature of the business
l.b
The company is a farm which produces farmhouse cheese that is sold by mail order. Farming is inherently
risky as it is affected by many conditions which are outside the direct control of management. These include
adverse effects of the weather and possible disease. The product sold appears to be a luxury product so
Compliance ria
sales are likely to fluctuate due to economic and seasonal factors.
Farming and food production are heavily controlled businesses where there is a vast amount of legislation
ate
which must be complied with. There is a risk that the business will fail to meet the required standards and
may be fined as a result. Any adverse publicity eg if fines relate to animal welfare issues may affect sales.
Nature of the assets
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One of the key assets of the business will be the goat herd. This asset may be valued incorrectly if a clear
distinction is not made between those animals which are held for sale (ie inventory) and those which are
selected for herd replacement (ie tangible non-current assets).
There is a risk that the value of the production animals in the statement of financial position and charges
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made to the statement of profit or loss (eg for depreciation and fair value adjustments) would be misstated
if:
(1) The split of animals between production and held for sale is not carried out accurately
(2) Useful lives are not assessed in a reasonable manner
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(3) Residual values are not estimated correctly

(4) Impairment reviews are not undertaken
(5) Fair values cannot be estimated reliably
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Completeness may be an issue as the kids are born into the herd and as such there is no documentary
evidence as there would be for purchased assets. Accurate records of kids born will be required to ensure
that all animals are valued. Revenue would also be understated if kids were deliberately not recorded and
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subsequently sold for cash.

For animals held for sale there may be difficulties in assessing cost and net realisable value. It may prove
difficult to sell animals held after they have reached their optimum size and weight so NRV may fall. The cost
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of goats is likely to be based on an estimate of the cost of raising the animal (as it will not have a purchase
price as such).
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Availability of Innittu
This is an essential ingredient of Rabida Red cheese. Recent increases in the price of this raw material may
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affect sales if passed on to the customer or will affect profitability if borne by the company. Future supplies
of this product may be further restricted. Depending on the company's ability to diversify into alternative
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Answers 249
ranges this may raise going concern issues. Any associated bad publicity regarding the exploitation of
workers and the threat to the rain forest could also impact on going concern.
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Bachas Blue
This product has been connected with a skin condition. There is a risk that contingent liabilities will be
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understated if there is any litigation against the company.
Although the effect of the bad publicity has been short lived the product is unlikely to be able to recover a
second time if further health problems are proved.
o t.
The impairment loss recognised in relation to the equipment used exclusively for the manufacture of Bachas
Blue may now need to be reversed if there has been a change in the estimates used to determine the asset's
recoverable amount since March 20X8. The recoverable amount will need to be recalculated and is likely to
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be based on value in use. If future cash flows are not estimated on a reasonable basis, the asset and credit
to the statement of profit or loss will be misstated.
Sale and repurchase agreement
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The sale and repurchase agreement with Abingdon is in substance a loan secured on the inventory. There is
a risk that the cash received might be treated as sales revenue. GVF should continue to recognise the cheese
as inventory and the proceeds recognised as a liability.
l.b
The 7% interest should be treated as borrowing costs and recognised as having been incurred. Under
IAS 23 Borrowing costs, costs cannot be capitalised for non-qualifying assets, which include inventories
which require a substantial period to get ready for sale.
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Health and safety legislation
The new legislation came into effect in 1 January 20X9 and it is unclear as to whether the company has
complied. If it has not complied there is a risk of penalties and fines being incurred. Provision for these may
ate
be required in the financial statements.
If the legislation has been complied with this may have had a significant effect on the ability of the business
to produce medium and strong cheese. This represents a significant part of production. If these products are
no longer available the business may no longer be viable.
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There is also a risk that plant and equipment is overstated. The carrying value of the old shelves would need
to be written off (assuming that they have no further use) and equipment used specifically in the production
of medium and strong cheese may have suffered impairment.
Grant
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The decision by management to defer the plan to convert the barn may mean that the terms of the grant are
no longer met. The grant may be repayable and if this is the case it should be presented as a liability in the
statement of financial position.
(b) Audit work
as
(i) Goat herd

 Physical inspection of the herd to confirm the existence and condition of the animals. On a
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test basis check for evidence of ownership eg branding stamp

 Discuss with management the system by which they distinguish between production animals
and those held for sale. Perform tests of controls on the system.
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 For production animals (tangible non-current assets):

– Agree value attributed to a sample of animals to market prices
– Compare depreciation policy with farming industry norms industry norms
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– Check depreciation policy has been applied and calculated for a sample of animals
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– Perform a 'proof in total' or reasonableness check on the depreciation charge for the
herd
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250 Answers
 For animals held for sale (inventory):
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– Observe inventory count and assess adequacy of procedures
– Review management calculations for costs included in the carrying value of animals
and assess whether they are appropriate in nature eg feed, vets bills, housing. (As the
kids will have been born into the herd there will be no invoice cost)
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– For a sample of animals compare carrying value at 31 March 20X9 with market values
(ii) Equipment
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 Check that brought forward balances for cost and accumulated depreciation agree to previous
year's working papers and accounts.
 Agree the cost of any new equipment purchased for the production of Bachas Blue.
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 Check that the depreciation policy applied to this category of asset has been consistently and
appropriately applied.
 For the previously impaired asset:
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– Check the basis of the current calculation of value in use (This should be the present
value at the estimated future cash flows – IAS 36)
– Compare the future cash flows with budgeted cash flow figures taking into account any
l.b
other knowledge of the business which might result in variations eg any information
regarding other health scares associated with the product
– Check that sales of Bachus Blue are returning to their former level by comparing current
sales levels and budgeted sales for 20X9 with sales levels before the adverse publicity
–
–
minutes ria
Agree any assumptions made by discussion with management and review of board
Check the period over which the cash flow projections have been made (normally a
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maximum of five years – IAS 36)
– Determine the basis on which the discount rate has been calculated. Reperform the
calculation and check that management have considered the current assessment of the
time value of money and the risks specific to this asset.
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– Calculate the assets depreciated carrying value (ie its value if the asset had not been
originally impaired) and compare with the current carrying value. (The reversal
impairment loss cannot result in the asset being valued at an amount which exceed its
depreciated carrying value – IAS 36)
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(iii) Cheese
WIP
 Attend the inventory count and determine the process by which the stage of maturity is
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assessed and therefore costs attributed.

 Obtain a schedule showing the breakdown of costs and check that the basis on which they have
been recharged is reasonable. (For example, the milk used is produced by the herd. The cost of
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milk will therefore be an estimation of the cost of producing it rather than a purchase price.)
 Check the system by which the age of inventory is monitored. Confirm that cheese which is
not available for sale for more than 12 months after the year end has been disclosed as a non-
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current asset.
Finished goods
 Review the terms of the sale and repurchase agreement with Abingdon to confirm that it is in
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substance a secured loan.

 At the inventory count ensure that all cheese including that 'owned' by Abingdon is included in
/fr
the count total.

 Review costing records to confirm that the 7% interest is included for every six months which
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elapses after maturity. Perform tests of control on controls over ageing of mature inventory.
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Answers 251
 Obtain confirmation from Abingdon of the outstanding liability at 31 March 20X9. This will be
the difference between the value of cheese purchased by Abingdon and the amount
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repurchased by GVF.
 Discuss with management the need to write down the value of inventory. The net realisable
value of cheeses held on the new stainless steel shelving may be less than cost
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 Confirm the adequacy of disclosure. The carrying amount of inventory pledged as security
should be disclosed.
o t.
45 Cedar
sp
Top tips. Part (a) was a typical ethics question, in the context of a forensic audit. You needed to run through the
three steps given by the IESBA Code, applying them to this scenario.
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Part (b) should also have been within your grasp provided you were up to speed with your knowledge of this area,
although you may have struggled to get more than 3–4 marks here. You should still have passed this part of the
question though.
Part (c) was a current issue. You needed to think on your feet here, but as with all requirements of this sort it is
l.b
actually not difficult to score well. There are six marks available, so you need to look to make 2–3 strong points
both for and against. Notice that the requirement is to evaluate the arguments; the easiest way to show that you're
doing this is to draw some sort of conclusion at the end of your answer.
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Easy marks. Part (a) contained some marks on identifying and evaluating threats that were almost pure knowledge.
Marking scheme
ate
Marks
(a) Ethical and professional issues
Generally 1 mark per issue assessed:
– Non-audit service creates self-review threat
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– Non-audit service creates advocacy threat

– Significance of threat to be evaluated
– Significance depends on materiality and subjectivity
– Examples of safeguards (1 mark each)
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– Competence to provide service

– Resources to provide service
– Confidentiality agreements
Maximum 6
as
(b) Matters to be discussed

Generally 1 mark for each matter explained:
– Purpose, nature and scope of investigation
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– Confirm objectives of investigation

– Time-scale and deadline
– Potential scale of the fraud
– How fraud reported to finance director
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– Possible reasons for fraud not being detected by internal controls

– Resources to be made available to investigation team
– Whether matter reported to police
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Maximum 6
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(c) Provision of non-audit services

Generally 1 mark per comment discussed and 1 mark for conclusion:
– Simple way to eliminate threats to objectivity
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– Examples of threats eg lucrative nature of non-audit services

– Benefit to audit market of outright prohibition
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252 Answers
Marks
– Benefits to client of auditor providing non-audit services
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– Benefits to audit firm of providing non-audit services
– Safeguards should be used to reduce threats arising
– Principles-based approach versus prescriptive approach
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Maximum 6
Total 18
o t.
(a) There are two main threats to Cedar & Co's independence in relation to this engagement: advocacy and self-
review. The IESBA Code of ethics requires a firm to identify threats to independence, evaluate their
significance, and then apply safeguards to reduce them to an acceptable level. If this is not possible then the
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engagement must be declined.
Threats
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The advocacy threat arises because acting as an expert witness in court for the client may be construed as
representing the client's interests.
The self-review threat arises if the work done to investigate the fraud, particularly work done to quantify the
loss incurred and to evaluate the client's systems and controls, is relied upon in a future audit. This is
l.b
particularly risky if the amount of the fraud is material to the financial statements. There may also be a self-
review threat to the fraud investigation if knowledge acquired as part of the audit is relied upon there.
Evaluation of threats
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The firm must consider the potential materiality of the issue, and the extent to which judgement must be
exercised in quantifying it. If the fraud is material and the investigation would involve judgement, then
safeguards could not reduce it to an acceptable level.
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Safeguards
Safeguards could include:
 Separate engagement teams for the forensic investigation and the audit
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 Having an independent professional accountant review the forensic investigation

 Subjecting the audit to a hot review by a second partner
The situation must be disclosed to those charged with governance of Chestnut Co.
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Ability to do work
The Code of ethics requires that a professional accountant only undertake assignments they are competent
to do. Forensic investigations are often only undertaken by individuals with specialist training and
experience, which Cedar & Co may not possess. If it does not, then the assignment should be declined.
as
(b) First of all it is necessary to identify the precise objectives of the investigation. If the aim is to quantify the
loss then this will involve less risk (and less work) than if the aim is to gather evidence to use in court or to
support an insurance claim. The terms of the engagement should also be discussed, with a view to including
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them in an engagement letter.

The expected time scale for the engagement, along with the matter of costs and possible fees, should be
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discussed. From this the resources needed can be determined, and their allocation planned, eg staff may
need to be diverted from other assignments.
The best approach to meet the objectives, within time and cost limits, should be discussed. This will involve
discussion of how the fraud came to light, along with the likely scale of the fraud. A key question at this
e
stage is how many sales representatives were involved, as this will help indicate the scale.
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The reasons why the fraud was not detected or prevented should be discussed. The role of internal audit
should be discussed, as it is possible that internal auditors could have been involved in covering up the
fraud.
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Answers 253
Whether the engagement includes making recommendations about systems and controls to help prevent
future frauds should be discussed.
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Enquire whether Chestnut Co's internal auditors are available to assist in the investigation, which may affect
considerations of timing and cost.
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It will be necessary to confirm that the team will have unrestricted access to any individuals and documents
that they need to conduct their investigation.
(c) In favour of prohibition
o t.
The key argument is that audit quality would be improved by eliminating at a stroke a whole range of threats
to independence. It is very difficult to argue that this would not be the case, so the arguments against
prohibition tend to involve claiming not that it would not work, but that it is either unnecessary or would
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involve foregoing various benefits to auditors providing non-audit services.
The main issue here is that, being profit-making entities, auditors have an incentive to take on fee-earning
work to the detriment of their independence. The argument is that given profit-making auditors, there is an
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insoluble conflict between the need to increase income by providing sometimes-lucrative non-audit services,
and keeping the self-interest threat to an acceptable level.
A more sophisticated argument for prohibition is that it does not matter whether or not auditors actually are
compromised by selling non-audit services to audit clients; what matters is that they are perceived to be so
l.b
compromised. This raises the spectre of the expectations gap, and it is argued that if the gap may never be
fully overcome then it is best for auditors to do what is necessary for users to perceive them to be
independent.
Against prohibition
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The first common argument against prohibition is that it actually benefits the client to have the auditor
provide non-audit services. There may be cost savings to the client if the auditor provides the non-audit
ate
services, as the auditor will already possess knowledge of the client acquired as part of the audit.
It is argued that audit quality may actually be improved, because the auditor may get to know the client
better by providing the non-audit services.
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Another major argument against prohibition is that it is simply not necessary. Ethical standards distinguish
between engagements where threats cannot be reduced to an acceptable level, which should not be
undertaken, and those where safeguards are sufficient. It is argued here that a blanket ban on all non-audit
services simply fails to take account of this distinction.
tud
Conclusion
There are powerful arguments on both sides here, and it is likely that this debate will continue in practice for
some time to come.
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46 Willow
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Top tips. In part (a) you were given three situations. Make sure you read the requirement carefully here, as there
were a number of things to consider – you might have missed, for example, the requirement to recommend any
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further procedures. The trick with each of these issues is to take on a sceptical frame of mind. The audit work on
inventory, for instance, appears to be complete as long as a written representation is obtained. But even if you did
not remember the detailed requirements of ISA 580, you should have been able to question whether such a
representation would be reliable, and to point out that it needs to be backed up by evidence. The further procedures
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are then just ways of obtaining this evidence.

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Part (b) was deceptively difficult. On the face of it there should be two easy marks for each of the four issues, but in
reality the first issue in particular was not easy. You should, however, have been able to gather together enough
marks to pass the question.
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254 Answers
Easy marks. The professional marks should be easy to come by. There were relatively easy marks in part (b) in
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relation to the ethics of accepting gifts and hospitality.
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Marking scheme
Marks
(a) Audit implications
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Generally up to 1½ marks for each implication assessed and 1 mark for
each impact on the financial statements identified:
Inventory:
– Comment on individual materiality
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– Value at lower of cost and NRV and impact on profit
– Written representation not sufficient evidence
– Recommend procedures (1 mark each)
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Legal claim:
– Immaterial individually but material to profit when combined with
inventory adjustment
– Financial statements materially misstated when two issues combined
l.b
– implication for opinion
– Suitability of verbal representation as source of evidence
– Recommended procedures (1 mark each)
Current assets:
– Material by nature but not material in monetary terms
– Identification of related party transaction ria
– Disclosure in notes to financial statements inadequate – implication
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for opinion
– Interest should have been accrued
– Recommended procedures (1 mark each)
Maximum 15
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(b) Issues for attention of audit committee

Generally up to 2 marks for each matter discussed:
– Property revaluations
– Delay in receiving non-current asset register affects audit efficiency
– Weak controls in procurement department
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– Lack of approved supplier list on integrity of supply chain

– Threat to objectivity from financial controller's actions
Maximum 8
Professional marks for the overall presentation of the briefing notes, and
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the clarity of the explanation and assessment provided

Maximum 4
Total 27
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Briefing notes
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To: Jasmine Berry, Audit engagement partner

From: Audit manager
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Re: Willow Co audit

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Introduction
These notes assess the matters raised by the audit senior, and explain the issues to be raised with the client's audit
committee. Some further audit evidence needs to be obtained, as outlined in the first part of these notes.
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Answers 255
(a) Matters raised by senior
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(i) Inventory
This area is not material to net assets or to income and expenses, but could become so in
combination with any other immaterial misstatements detected. Unless this is the case, there would
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be no effect on the audit report.
IAS 2 Inventories requires inventory to be measured at the lower of cost and net realisable value
(NRV). If the NRV is zero, then an expense of $130,000 will be incurred, reducing both and assets by
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the same amount.
ISA 580 Written representations states that a written representation is not of itself sufficient
appropriate audit evidence. Therefore further evidence must be obtained.
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The assertion that must be tested here is that NRV is not less than $130,000. The finance director's
claim that the inventory can be recycled would therefore need to be supported by evidence that the
NRV of this recycled inventory would not be less than $130,000.
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Further procedures include:
 Making enquiries from an operations director to ascertain whether or not the materials could
be recycled
l.b
 Obtaining documentary evidence of the costs of recycling together with the potential selling
price of recycled materials
 Reviewing invoices raised after the period end for evidence that the materials have in fact been
(ii)
recycled and sold on
Provisions ria
ate
This area is not material to net assets or to income and expenses, but could become so in
combination with any other immaterial misstatements detected.
IAS 37 Provisions, contingent liabilities and contingent assets requires that a provision be recognised
where it is probable that there would be an outflow of resources embodying economic benefits, as is
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the case here. If this adjustment is not made then liabilities and expenses are both understated. There
is also unlikely to be adequate disclosure of the circumstances surrounding the case.
When combined with the inventory misstatement, the result is a total misstatement of $255,000,
which is material to income and expenses. If neither adjustment is made then the audit opinion is
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qualified.
The verbal confirmation that the case will probably be paid is not sufficient, and written confirmation
from the lawyers is required. The finance director's refusal to provide this evidence may constitute a
limitation on the scope of the audit if the evidence cannot be obtained elsewhere, and throws into
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question management's integrity. This should trigger a re-assessment of any written representations
from management relied on elsewhere in the audit, for example in relation to inventory.
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 Review correspondence with lawyers for evidence regarding the outcome of the legal claim
 Review board minutes for evidence about the claim
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(iii) Current assets

A loan to a director is material by nature, irrespective of its monetary value. In line with
IAS 24 Related party disclosures Cherry is key management personnel and thus a related party. The
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financial statements must therefore disclose the loan principal amount, the amount outstanding at
the year end, together with the terms of the loan including details of any security offered.
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As the loan is not disclosed in the financial statements, there is a material misstatement in respect of
IAS 24. If no adjustment is made then the audit opinion is qualified.
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It is possible that the interest payment has not been made or accrued for. If not, then interest of
4%  $6,000 = $40 should be accrued (the adjustment is immaterial).
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256 Answers
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 Review the written terms of the loan to confirm the interest rate and any other conditions
 Review list of accruals to see whether interest has been accrued
(b) Property
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A move from recognising properties at cost to at fair value would be acceptable in line with
IAS 16 Property, plant and equipment, as long as it is applied across an entire class of assets. The
Committee should be aware of the benefits and drawbacks of such a change. Benefits include more relevant
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information on the values of properties, and quicker recognition of fair value gains in the financial
statements. But the drawbacks include the need to remeasure fair value at each period end. It may also be
necessary to employ an external expert to estimate fair values, which could be costly.
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Asset register
The delay in receiving the non-current asset register would have impaired audit efficiency, and potentially
resulted in greater audit costs and therefore fees.
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The fact that the issue was discussed with the committee last year but then recurred, suggests some sort of
controls failure; either the last year's discussion was not acted upon by the committee, or at some other
point. In both cases the reason for this needs to be ascertained.
l.b
The fact the financial controller has been on holiday at the start of the audit for two years running is not just
unhelpful, but may be indicative of something deeper awry, such as fraud.
Procurement
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No explanation is actually given for why invoices are not matched to goods received notes; there is no
reason why this cannot be done if suppliers are changed frequently, for example. Without this control, it is
possible that invoices are paid without goods ever being received. There is also a risk of fraud if this is done
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intentionally, either delivering goods to another address or using dummy invoices. The committee should
seek to improve controls in this area as a matter of some urgency.
Frequently switching suppliers is not itself a problem, but again this would not seem to totally preclude
maintaining a list of approved suppliers – it only means that such a list would be a long one. If totally new
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suppliers really are being used so frequently, then there may be issues with quality rather than price.
There are a number of ethical issues here. First, the offer of three weeks' use of her holiday home needs to
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be considered in light of the IESBA's Code of Ethics' requirements on gifts and hospitality. In this case the
value of the offer is likely to mean that no safeguards could prevent the auditors' independence being
impaired, so the offer should be declined. If the team considers that Mia Fern intends to influence the
outcome of the audit by making the offer, then this casts doubt on her integrity. The audit committee should
be notified of this situation.
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The gifts of lunches are unlikely to impair independence as they are likely to be of an insignificant monetary
value. Provided that this is the case, they may be accepted.
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Conclusion
Further audit evidence needs to be obtained on a number of issues, some of which may involve a material
misstatement, and there are a number of matters to be brought to the attention of the audit committee.
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Answers 257
47 Jovi
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Chapter reference. Chapter 6.
Top tips. You may have found part (a)(i) difficult, and therefore struggled to write enough for four marks here. You
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would have score well if you knew ISA 320 Materiality in Planning and Performing an Audit well, but if you did not
then there was no need to panic. The basic issue here can be worked out using common sense: the auditor would
change materiality if they become aware of something that affects materiality. The requirement here is to 'explain',
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so giving examples is always going to be helpful. If you could think of just one good example, then you could get
50% on this part of the question.
In part (a)(ii), you could have worked out that there were nine notes (audit findings) and 18 marks available, which
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equates to two marks per note. This was not an easy question. Your approach should be to work through each
issue in turn, trying to think of what the problem might be, and not forgetting to think about whether the audit
evidence was adequate. Note the importance of reading the question here (and remembering the requirement as
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you are writing), as candidates who recommended specific audit procedures would have wasted their time.
Part (b) should not have been too difficult. To score six marks you should have looked to make two to three points
both for and against. To score well here you need to apply your knowledge to the scenario. Although joint audits are
a current issue, you are not being asked for your opinion on the issue generally; you are being asked about a joint
l.b
audit of the financial statements of May Co. You therefore need to think about the specific scenario. The examiner
tends to like students who make points like 'the small local firm will probably offer a cheaper audit service than
Sambora & Co', as this is something that can only really be said about this specific situation.
was a difficult question.

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Easy marks. There were easy marks in part (b) for some of the pros and cons of the joint audit, but all in all this
Examiner's comments. Answers to requirement (a)(i) were usually limited here to a definition of materiality and a
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suggestion of how an appropriate materiality figure is determined, and few answers actually answered the question
requirement. Those that did tended to focus on risk assessment and the auditor uncovering new information about
the client as the audit progresses. These points are both valid, but very few answers discussed them, or any other
relevant points, in sufficient detail.
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Requirement (a)(ii) is a good example of a question requirement where candidates were expected to think on their
feet and not rely on rote learnt facts. The candidates that did as the question instructed and took time to think about
the information in the scenario scored well, and there were some sound answers. However the majority of
candidates could not apply their knowledge to this scenario, leading to unfocussed answers that did not actually
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answer the question requirement. Answers were on the whole unsatisfactory. Candidates tended to approach the
key audit findings in a logical way, working though them in the order presented in the question. However, for each
key audit finding most answers simply stated that audit evidence was not adequate without explaining why, and
then gave a list of audit procedures, which was specifically not asked for.
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On requirement (b), some answers seemed to confuse a joint audit with an audit involving component auditors, and
some used the fact that the foreign audit firm was a small firm to argue that it could not possibly be competent
enough to perform an audit or have a good ethical standing. Most answers identified the cost implications for the
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client, and the advantage of involving a local firm who would have knowledge of the local law and regulations.
Marking scheme
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Marks
(a) (i) Materiality
Up to 1 mark for each comment:
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– Recognise materiality is subjective

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– Auditor's business understanding may change during the audit, making some
balances and transactions material
– Client's circumstances may change during the audit, making some balances and
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transactions more material

– Adjustments to the accounts mean materiality has to be revised
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258 Answers
– Recognise the high-risk status of the client
Maximum 4
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(ii) Audit completion issues
Up to 2 marks for each audit completion issue assessed:
– Property disposal/sale and leaseback
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– Property revaluation
– Actuarial loss
– Goodwill impairment
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– Goodwill classification into assets held for sale
– Associate
– Presentation of assets held for sale (separate and not netted off)
– Measurement of assets held for sale
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– Lack of disclosure of discontinued operation
– Non-controlling interest
– Finance cost and loan
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Maximum 18
(b) Joint audit
Up to 1 mark for each advantage/disadvantage discussed:
– Retain local auditors' knowledge of May Co
l.b
– Retain local auditors' knowledge of local regulations
– Sambora & Co can provide additional skills and resources
– Cost effective – reduce travel expenses, local firm likely to be cheaper
– Enhanced audit quality
– But employing two audit firms could be more expensive
– Problems in allocating work – could increase audit risk
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Maximum
Total 28
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(a) (i) Revising materiality

Auditors must reassess materiality if they become aware of new information that would have resulted
in a different materiality level being set at the planning stage.
Planning materiality is likely to have been based on draft financial statements, but during the course
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of the audit it could become clear that the final financial statements will be substantially different. For
example, the carrying amount of assets held at fair value could be much lower than originally
expected, which would affect the amounts in the statement of financial position. In that case, the
auditor would need to set materiality again, on the basis of the actual results and position.
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Alternatively, something could happen during the audit, eg the client could decide to dispose of a
subsidiary. This could change the appropriate materiality level, as well as performance materiality.
The auditor should take this into account and revise materiality.
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(ii) Statement of profit or loss and other comprehensive income

Copeland revenue
Copeland's 25% drop in revenue indicates that goodwill relating to this subsidiary may be impaired.
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There is a risk that this goodwill has not been impaired when it should have been.
Property disposal
At $2m, the property disposal is material.
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The option to repurchase the property in five years' time points to the possibility that this could not
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be a genuine sale, but a finance arrangement whose economic substance is that of a secured loan. In
this case the audit evidence obtained is inadequate, and further evidence needs to be obtained to
determine the substance of the transaction.
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Answers 259
If this is indeed a secured loan (in substance), then the asset will be recognised in the statement of
financial position, and the cash receipt will be recognised as a loan (liability). Finance costs will be
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accrued over the period of the loan – five years.
If this is the case, then profit has been materially overstated, and liabilities understated.
Property revaluation
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The gain of $800,000 was just below initial materiality of $900,000, but above the current materiality
level of $700,000. Audit procedures must now be performed in this area, as it is possible that there
could be a material misstatement here.
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Actuarial loss
The actuarial losses are material, at $1.1m, as is the defined benefit liability of $10.82m.
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Axle Co is a service organisation, and ISA 402 Audit considerations relating to an entity using a service
organisation requires the auditor to obtain an understanding of this organisation. This can be obtained:
 From the Group itself, we should gain an understanding of how Axle Co arrives at its
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valuation, its systems and its controls
 By obtaining a report from the auditor of Axle Co (the service auditor), which contains an
opinion on the description of Axle Co's systems and controls
l.b
This has not been done, and we have no information about how the plan assets and liabilities were
valued, or how reliable their valuation might be. The audit team must therefore obtain this
information before the service organisation's representation can be relied upon.
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Goodwill impairment
There is an indicator that goodwill relating to the Copeland subsidiary is impaired, but this does not
appear to have been considered by the audit team. Audit procedures must be performed on the
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assumptions used by management in conducting this review. The reasons why the 25% fall in
revenue has not resulted in impairment must be specifically addressed.
Associate
The statement of profit or loss includes $1.01m share of profit of associate. The figure in the
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statement of financial position should include (at a minimum) the amount brought forward, plus any
profit attributable, less any dividends received. It is thus highly unlikely that this figure would not
have changed since last year.
Trading division held for sale
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The division held for sale is part of a subsidiary. Therefore, some of the goodwill relating to this
subsidiary may need to be reclassified as part of the disposal group of assets held for sale. Although
it is possible that no goodwill will need to be reclassified, evidence needs to be obtained that this is
the case.
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The statement of financial position contains one line within assets for 'assets classified as held for
sale'. This disclosure is incorrect: the assets held for sale should be a separate section within
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'assets'.
It appears that this $7.8m could be a net figure, which again is incorrect – there should also be a
separate section within 'liabilities' showing the liabilities from the disposal group. Audit procedures
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should be performed to ascertain whether this in fact a net figure, in order to get the classification
right.
Although there are assets held for sale from a trading division, the statement or profit or loss shows
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no discontinued operations. IFRS 5 Non-current Assets Held for Sale and Discontinued Operations
requires the post-tax profit or loss of discontinued operations to be shown as a single line. This
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appears to be a material misstatement, and audit procedures should be performed to determine

whether it is or not – whether there are any discontinued operations.
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260 Answers
Non-controlling interest
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There is no disclosure in relation to the non-controlling interest in the statement of profit or loss and
other comprehensive income. Both profit for the year and total comprehensive income attributable to
the non-controlling interest should be disclosed.
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New loan
Finance costs should be included of $8m × 2% × 9 / 12 = $120,000. However, finance costs have
only risen by $40,000. No loans appear to have been paid off during the year, as long-term
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borrowings have increased by exactly the $8m received for the new loan. Therefore, finance costs
appear to be understated.
The amount is not material of itself, but should be accumulated together with any other
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misstatements that are discovered as they could become material in aggregate.
(b) Advantages of joint audit
In the case of May Co, Sambora & Co would not currently have much understanding of May Co's
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business. It would therefore make sense to continue to make use of Moore & Co's accumulated
understanding of the client's business.
The fact that May Co is located in Farland means that it could be subject to accounting, legal and
l.b
professional regulations that are different from those under which Sambora & Co are accustomed to
operating. It makes sense to continue to use the local auditors' knowledge of this potentially very
different regulatory framework.
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There may be some cost savings in using Moore & Co, as a result of the fact that Sambora & Co
would no longer need to send the whole audit team out of Farland to conduct the audit procedures. It
is also possible that Moore & Co might charge lower fees than Sambora & Co, so using Moore &
Co's staff to perform procedures could work out cheaply.
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Audit quality should increase as a result of a joint audit. As new auditors, Sambora & Co will be
approaching the audit with a fresh outlook, unprejudiced by previous events and may be able to spot
new issues or offer different solutions from those previously identified by Moore & Co.
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Disadvantages of joint audit

A key disadvantage is the uplift in costs that results from the unavoidable duplication of work
between the two auditors.
Moore & Co may use a different audit approach and methodology from Sambora & Co, leading to
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disagreements throughout the audit about which is the correct way to proceed. This could result in a
loss of efficiencies, as time is spent agreeing on the best audit approach rather than carrying out
actual audit work. If either audit firm's approach is followed exclusively, some of the benefits of a
joint audit will be lost.
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Answers 261
48 Kobain
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Chapter references. Chapters 10 and 14.
Top tips. Part (a) was a discussion of a current issue. This is a fairly standard area for a discussion, and you should
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have been able to think of enough good points to pass this part of the question.
Remember that with discussion requirements, you will need to discuss both sides of the issue – in this case,
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agreeing with the statement and disagreeing with it. You do not need to come to a firm conclusion. You will already
be familiar with IAS 18 from your studies at papers F7 and P2, so you should be aware of some of the complexities
that exist in this area. You should also be aware of IAS 240's presumption that there is a risk of fraud here.
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Part (b) was relatively straightforward. The accounting issue was clear, and you should have had no trouble
determining that there was a misstatement here. The examiner gave you the figures to calculate materiality, so you
should have done this and stated whether or not the issue was material.
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Part (c) was a bit of detail on forensics, and again should not have been too difficult. You needed to think on your
feet to come up with four good procedures that would be needed to quantify the fraud. The starting point has to be:
how much was paid to the sales representative, as this is the highest amount that could have been taken. You then
need to work out how many of this person's sales were genuine, which you could do by finding underlying
documentation from the customer, or from elsewhere within Jarvis Co's accounting system.
l.b
Easy marks. There were easy marks in part (b) for applying materiality to the misstatement in the question.
Examiner's comments. Answers to requirement (a) were mixed. There were some sound answers, which often
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used simple examples to illustrate the type of situation where revenue recognition is complex or subjective, with
construction contracts, hotel deposits and the provision of services being common and pertinent examples. Many
answers also referred to the problems of manipulation of revenue, and again sound answers illustrated the point
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with a simple example, the most common being pressure on management to maximise revenue or profit. It was
however unsatisfactory that so few answers referred to ISA 240 The Auditor's Responsibilities Relating to Fraud in
an Audit of Financial Statements, specifically the fact that ISA 240 requires the auditor to use a presumption that
there are risks of fraud in revenue recognition.
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Requirement (b) was generally well attempted, with most candidates discussing that the accounting treatment
adopted for the consignment stock arrangement was not compliant with IAS 18 Revenue, and correctly determining
the impact on profit, and the overall materiality of the transactions to the financial statements. Candidates were less
competent at explaining the audit evidence they would expect to find, and the answers here were usually limited to a
review of the terms of the consignment stock arrangement, and evidence of an inventory count.
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Regarding requirement (c), only a minority of candidates realised that procedures should focus on testing the
validity of the sales that the sales representative had claimed to have generated – and these candidates then usually
recommended some specific, valid procedures. Other answers were inadequate, and relied on evidence from
'discussing with management' or 'interviewing the suspect' – but without actually recommending the questions
as
they would ask. Some answers simply did not answer the question, and instead of providing procedures gave an
explanation of the steps involved in a forensic investigation or focussed on how they would 'catch' the culprit and
punish them.
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Marking scheme
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Marks
(a) Revenue recognition
Up to 1½ marks for each matter discussed:
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– Revenue often a subjective area

– Revenue often a complex area
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– Adequacy of internal controls

– Link to fraudulent financial reporting/earnings management
– Example of deliberate manipulation of revenue
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– Cash-based business particularly high risk

– Small/simple entities not high risk
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262 Answers
Marks
Maximum 6
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(b) Kobain Co
Up to 1 mark for each matter/evidence:
Matters
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– Risk and reward not transferred to external vendor
– Kobain Co retains managerial involvement
– Revenue recognised too early
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– Materiality
– Implication for auditor's opinion
– Opening balances could be misstated
Evidence
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– Confirm terms of arrangement by review of signed contract
– Consider whether terms of contract mean that revenue should be recognised
– Confirmation of inventories held by external vendors
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– Determine amount of returns normally made under the contract
– Attendance at external vendors inventory count
– Supporting documentation on opening balances
Maximum 6
l.b
(c) Investigative procedures on false revenue claims
Generally 1 mark per procedure:
– Obtain all claims made by the sales representative
– Agree all sales to supporting documentation
– Conduct external confirmation of sales made
– Reconcile claims to sales ledger/control accounts
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ate
– Conduct analytical procedures
Maximum 4
Total 16
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(a) Whether or not revenue recognition is a high risk area of the audit depends to a large extent on the particular
audit in question. It is possible that a company's revenue recognition could be simple: a small company, for
example, might have only one revenue stream that is straightforward to audit. In this case, revenue
recognition might not be particularly high risk in comparison with other parts of the audit.
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Alternatively, if a company receives a lot of cash sales then this would increase the risk of misstatement.
There is a risk, for instance, of cash being stolen before it is recorded as revenue. There may also be a risk
here in relation to money laundering.
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An element of subjective judgement is often involved in applying IAS 18 Revenue, which can make this a
risky area to audit, particularly with larger companies. For example, there may be difficulties determining the
exact time at which revenue should be recognised, and in which reporting period. This can easily become a
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material issue. Where management is required to use its judgement there is a risk of material misstatement
if they make inappropriate or wrong judgements.
Revenue recognition can also be highly complex. Transactions may involve several elements which might
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pertain to differing reporting periods. In a sale which includes a warranty, for example, the revenue relating
to the warranty should not all be recognised when the sale takes place, but should be matched to the period
of the warranty.
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ISA 240 The auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements states that there
should be a presumption that there is a risk of fraud in relation to revenue recognition. There is a risk of
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fraudulent financial reporting in particular, as this area is susceptible to management bias and earnings
manipulation.
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There could be issues particular to the company, eg if management receives a bonus that is linked to
revenue or earnings figures, then this may provide a motive to commit fraudulent financial reporting.
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Answers 263
(b) Matters to consider
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IAS 18 Revenue requires that revenue be recognised where the significant risks and rewards of ownership
have been transferred, and the entity does not retain managerial involvement with the goods.
Kobain Co retains legal title to the goods while they are with the vendor, and when they are sold, this title
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passes straight to the customer. Thus Kobain Co still legally owns the jewellery when it is with the vendor.
Kobain Co retains the ability to change the selling price of the jewellery when it is with the vendor. This
constitutes managerial involvement. Kobain Co is also exposed to the risk of inventory not being sold, as
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unsold inventory must be returned back to it after nine months. Hence in addition to retaining legal title,
Kobain Co also retains the significant risks and rewards of ownership.
This would suggest that Kobain Co should only recognise revenue once the vendor has sold an item on to a
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customer. However, Kobain Co currently recognises revenue as soon as the item is delivered to the vendor.
This appears to be incorrect.
The required adjustments would derecognise revenue of $4m, recognise inventory of $3m, and reduce
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retained earnings by $1m. Profit before tax would be reduced by $1m or 6.7%, which is material. The
understatement of inventory by $3m is also material at 5.5% of total assets. If these adjustments are not
made, then the audit opinion should be qualified 'except for' a material misstatement.
Audit evidence
l.b
 Copies of sales contracts with key vendors and confirmation of their terms
 Review of contract terms to determine if Kobain Co retains risks and rewards relating to, and

managerial involvement with, the goods
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Enquiries into the proportion of goods usually returned from vendors, to form an understanding of
potential levels of obsolete goods
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 Results of auditor's test counts of inventory at a selection of vendors' premises to ensure the
existence of goods held on consignment
(c) Procedures
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 Obtain all claims submitted by the sales representative since January 20X2 and total the amount of
these claims.
 Reconcile the sales per the sales commission claims to the sales ledger control account.

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Agree all sales per the sales commission claims to eg customer-signed orders, and to other
supporting documentation confirming that window installation took place, eg customer-signed
agreement of work carried out.
 Obtain external confirmations from customers of the amount they paid for work carried out.
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49 Cuckoo Group
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Text references. Chapters 9 and 11

Top tips. The audit of groups is a topic which is likely to require quite a sophisticated approach. In this question, it
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is combined with inventory valuation and disclosures. You must be comfortable with the issues discussed in part
(a). Part (b) is good practice at considering accounting issues.
Easy marks. This is a difficult question, requiring a sound knowledge of group audits. Part (b) is probably the most
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straightforward if you take a methodical approach. Be sure to get the professional marks too.
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(a) Briefing notes

For: Audit partner
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By: Audit manager

Re: Cuckoo Group audit
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264 Answers
Introduction
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These notes describe the matters to consider and the procedures to apply as part of the planning and
evaluation of the auditors of Loopy; and discuss the acceptability of the group's accounting policies in
relation to inventory.
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(i) As group auditors of the Cuckoo Group we have sole responsibility for our opinion on the group
accounts even if part of the group has been audited by others. Therefore we would wish to ensure
that we are confident in placing reliance on the work of the auditors of Loopy (the 'component'
auditors) and that sufficient appropriate audit evidence has been gathered for us to express an
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opinion on the financial statements of the group as a whole.
Law gives us the right to require that the component auditors give us such information and
explanations as we may reasonably require.
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As a matter of courtesy we will inform the directors of Cuckoo Group of our intention to communicate
with the auditors of Loopy.
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We will first obtain an understanding of the component auditor. This would involve an assessment of:
 Whether the component auditor is independent and understands and will comply with the
ethical requirements that are relevant to the group audit
l.b
 The component auditor's professional competence
 Whether the group engagement team will be involved in the work of the component auditor
to the extent that it is necessary to obtain sufficient appropriate audit evidence

auditors ria
Whether the component auditor operates in a regulatory environment that actively oversees
This may be dealt with by meeting the component auditors (most appropriate in this first year), by
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questionnaire or a combination of both. If Loopy is significant to the group, we may wish to review
the component auditors' working papers. In an extreme situation, where we felt we could not rely on
Loopy's auditors' work, we would need to reperform some or all of their work.
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As the group auditor, we are responsible for setting the materiality level for the group financial
statements as a whole, and for components which are individually significant such as Loopy. This
would be set at a lower level than the materiality level of the group as a whole. The component
auditor will then perform a full audit based on the component materiality level.
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Depending on whether or not Loopy is significant to the financial statements of the group as a whole,
we would then review the component auditor's overall audit strategy and audit plan, and perform risk
assessment procedures to identify and assess risks of material misstatement at the component level.
We would then discuss with the component auditor the component's business activities that are
as
significant to the group, and the susceptibility of the component to material misstatement of the
financial information due to fraud or error. We would then review the component auditor's
documentation of identified significant risks of material misstatements.
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It would then be necessary to review a questionnaire completed by the component auditor

highlighting key issues identified during the audit. The effect of any uncorrected misstatements
should also be evaluated. On the basis of this review we would then determine whether any additional
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procedures are necessary, such as further procedures to gather audit evidence, participating in any
meetings between the component auditors and management, or reviewing any other relevant parts of
the component auditor's documentation.
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(ii) Cuckoo
The valuation of the bullion and precious metals contravenes IAS 2 Inventories, which requires that it
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should be valued at the lower of cost and net realisable value. However depending upon the rate of
turnover and fluctuations in market prices, this method is recognised as an acceptable way of valuing
commodities and so departure from IAS 2 needs to be stated and justified in the financial statements.
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The auditors would also perform tests to assess the difference between cost and market value and
whether this was material.
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Answers 265
Loopy
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LIFO is not an acceptable method of valuing inventory under IAS 2. In addition the standard requires
that cost or valuation is determined for separate items of inventory or of groups of similar items and
not on a total basis.
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The auditors of Loopy will need to determine whether adjustment is needed to ensure that the
inventory valuation conforms to IAS 2. Audit qualifications in the company and group accounts (if no
adjustment is made) will depend on materiality.
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Snoopy
Base inventory valuation is not acceptable. In addition the statement of financial position and
statement of profit or loss should show the same value for inventory.
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However the immateriality of the adjustment in the group accounts may mean that it can be ignored.
If it is material in the company's own accounts a modified auditor's opinion may be required if the
directors of Snoopy wish the adjustment to stand.
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Drake Retail
The methods used in allocating costs to inventory need to be selected with a view to providing the
fairest possible approximation to the expenditure actually incurred in bringing the product to its
present location and condition. The practice of retail outlets using selling price less normal gross
l.b
profit margin is given as an example of an acceptable method of approximating to cost. Records
must be kept of mark-ups and any subsequent mark-downs, to ensure that the calculation still gives
an approximation to cost.
Conclusion
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There are a number of problems with the accounting policies used across the Cuckoo Group in
relation to inventory.
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(b) (i) Cooperation between auditors
The group engagement team has the right to require from auditors of subsidiaries the information
and explanations they require, and to require the group management to obtain the necessary
information and explanations from subsidiaries. However, in practice, the degree of cooperation may
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be limited by factors such as the component auditor not being subject to the requirements of ISAs,
but of different national practice or the group auditor not having any legal right to contact the
auditors of a component of the company preparing group accounts. ISA 600 states that the group
auditor should not accept a group audit if there are restrictions on his communication with
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component auditors.
(ii) Multi-location audits
ISA 600 applies when the financial information of any component is included in the financial
statements audited by the group auditor. A component is defined as an entity or business activity for
as
which group or component management prepares financial information that should be included in the
group financial statements. Clearly any of these could be in a different location to the parent
company, so ISA 600 does apply to multi-location audits.
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However, there is no specific guidance in ISA 600 or other standards on how to deal with the
particular problems caused by such multi-location situations. ISA 315 recognises that multi-locations
might give rise to a risk but does not suggest any solutions in a group context. This is an area where
additional guidance is required.
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(iii) Joint audits

ISA 600 specifically excludes the situation where two or more auditors are appointed as joint
auditors.
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Joint audits are rare because they are often costly, as both sets of auditors are responsible for the
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audit opinion and therefore work can be replicated. However, they are used in some countries, for
example, France. In addition, in the wake of the Enron scandal joint audits have been proposed as a
potential solution to such problems occurring again.
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Given this, joint audits are an area which requires guidance to be produced by the IESBA and the
IAASB.
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266 Answers
50 Bluebell
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Top tips. This question may appear daunting at first because of the amount of numerical data presented. In part (a)
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make sure you take a methodical approach working through the information to structure your answer. Credit will
only be given for risks of material misstatement so do not waste time describing other types of risk here. Part (b)
asks for audit procedures on share-based payments and deferred tax assets. In an article in Student Accountant
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published not long before this question was set, the examiner had hinted that more complex areas were likely to be
examined in detail. If you had read this article then the topics examined here would not have come too much of a
surprise.
Easy marks. Part (c) is probably the easiest part of this question as it does not require any knowledge of complex
sp
accounting topics. Make sure you present your answer as briefing notes to get the four professional marks.
Examiner's comments. Requirement (a) asked the candidate to 'identify and explain risks of material misstatement
to be addressed when planning the final audit'. This requirement should not have been a surprise, as risk of
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material misstatement had appeared in the previous exam, and a recent examiner's article had discussed how
financial reporting issues impacted on the auditor at the planning stage of the audit.
Requirement (b) asked candidates to describe principal audit procedures in respect of specific assertions relevant
to the share-based payment expense, and deferred tax asset. Requirement (b)(i) focused on the measurement of
l.b
the expense, (b)(ii) on the recoverability of the asset. Unfortunately, the majority of candidates ignored the
assertions and instead provided procedures irrelevant to the requirement, for example, on the calculation of tax
rather than the likelihood of it providing a future benefit to the company. The second problem was that many so-
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called procedures provided were not actually audit procedures at all, but a vague hint as to what the auditor might
do. For example, there were many 'procedures' along the lines of 'check calculation of share -based payment
expense' – yes, the auditor would need to do this, but how? The 'how' is the audit procedure.
ate
Requirement (c) tended to be either extremely well answered, or extremely inadequately answered. Sound answers
provided specific key performance indicators (KPI) relevant to a chain of hotels, and clear sources of evidence.
While inadequate answers did usually attempt to recommend KPIs relevant to hotels, they would usually describe
the policies that a company should have in place rather than the KPI that would measure the success of such a
policy.
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Candidates should remember that most of the marks awarded in the paper are for application skills.
Marking scheme
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Marks
(a) Risks of material misstatement
Generally ½ mark each risk/matter identified
½ mark for reference to correct IFRS/IAS – maximum 2 marks
as
Maximum 2 marks for materiality calculations

Up to maximum marks for significant issue explained as below:
 Revenue recognition (2 marks + 1 mark for providing trend/calculation) IAS 18
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 Share-based payment (3 marks) IFRS 2

 Provision for repairs (2 marks) IAS 37
 Insurance reimbursement (1 mark)
 Understatement of operating expenses (2 marks)
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 Impairment of properties (1 mark) IAS 36

 Property disposals (3½ marks)
 Property revaluation (1½ marks) IAS 16
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 Deferred tax on property revaluation (1½ marks) IAS 12

 Deferred tax asset (2 marks + 1 mark for recalculating profit for any suggested
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changes) IAS 12
 Going concern (1 mark)
Maximum 14
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Answers 267
Marks
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(b) (i) Audit procedures
 Agree components of calculation to scheme documentation
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(½ mark per item agreed max 2)
 Recalculate + check vesting period
 Agreement of grant date, fair values, etc to specialist report
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 Review of forecast staffing levels
 Management representation
 Discussion with HR re assumptions used
Maximum 6
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 Obtain client tax comp + deferred tax schedules, recalculate
 Form independent estimate of amount
 Profitability forecasts – assumptions
 Profitability forecast – time period fro loses to be utilised
l.b
 Tax authority agreement on c/f of losses
Maximum 4
(c) Social and environmental KPIs
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Up to 4 professional marks for format, logical structure and use of language
appropriate to internal auditor ie free from jargon, all comments clearly explained
Tabular format not required
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Generally ½ mark per KPI, ½ mark per evidence point. Can increase to 1 mark (for
either) if the point is very specific to a hotel business.
Ideas list
Employees:
– Training spend
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– Absenteeism rates
– Employee engagement index
Customers
– Customer satisfaction rate
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– Number of complaints
– Number of accidents
– Repeat business rates
Community
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– Charitable donations
– Free use of hotel facilities
Environment
– Waste recycling
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– Energy efficient items purchased

– Carbon footprint
Maximum 12
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Total 36
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(a) Risks of material misstatement

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Revenue recognition
Bluebell Co recognises income when a room is occupied in line with IAS 18 Revenue. A deposit of 20% is
taken when the room is booked and this revenue should be deferred and shown as a liability on the
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statement of financial position. There is a risk of material misstatement that deposit revenue is recognised
immediately leading to an overstatement of revenue and an understatement of liabilities. It is worth noting
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268 Answers
that revenue has increased by 24.8% at Bluebell Co. This is above the industry average of 20% and could be
a result of deposit revenue being recognised in the incorrect period.
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Share-based payment expense
The calculation of the share-based payment expense is complex and any inaccuracies or incorrect
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assumptions may cause it to be over or understated in the financial statements. In particular, the
assumption of 0% staff turnover in three years sounds dubious and this needs to be investigated in order to
judge the accuracy of the expense.
o t.
The model used to assess the fair value of the share options must comply with IFRS 2 Share-based
payment. If a prohibited model is used, then the financial statements will not comply with accounting
standards. Fair value must also be measured at the grant date in order to calculate the expense or the
financial statements will be inaccurate.
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Damaged property repair expenses
A provision of $100m has been made for flood damage to three hotels. However, since flood damage to
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hotels is already covered by insurance, it appears this provision was made in error. Hence there is a risk that
operating expenses are overstated in the financial statements.
Additionally, under IAS 37 Provisions, contingent liabilities and contingents assets, a provision can only be
recognised if an entity has a legal or constructive present obligation as a result of a past event. Bluebell Co
l.b
may be intending to repair the damaged properties but it would be difficult to argue this is because of a legal
or constructive obligation, rather than a desire to obtain future operating profits. Therefore, a risk that the
financial statements do not fully comply with the requirements of IAS 37 exists.
Impairment of properties
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The properties must be written down to their recoverable amount. It is not stated whether the damaged
properties have been tested for impairment. However it seems likely that some impairment loss should be
ate
recognised during the year, given the level of flood damage.
Other operating expenses
If the two new items included in operating expenses are excluded, other operating expenses have fallen from
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$690m in 20X7 to $597m in 20X8. This does not seem in line with the increase in revenue in the business. If
sales of rooms have increased it would be expected that the associated costs would also increase, for
example the costs of cleaning the rooms. This could highlight a possible understatement of other operating
expenses in the statement of profit or loss. However, it may be that the decrease is reasonable and due to
the hotels being able to increase their rates rather than increases in occupancy that would lead to increased
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costs.
Profit on property disposal
The statement of profit or loss includes $125m profit on the disposal of hotels where Bluebell Co is retaining
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a hotel management contract. Bluebell Co has an option to repurchase the hotels in fifteen years and this
purchase seems likely. The transaction will need to be investigated in more detail during the audit. The
substance of the transaction could be a sale and repurchase, rather than merely a sale, in which case the
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properties should remain on the statement of financial position. Thus, there is a risk that property and assets
are understated and operating income is overstated.
If evidence proves the hotels should have remained on the statement of financial position, depreciation and
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operating expenses will also be understated. Bluebell Co will have stopped depreciating the hotels in March
20X8 when they were sold, eight months before the year end.
Additionally, finance charges should be accrued for any sale and repurchase agreement and allocated over
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the period of the agreement. If the hotel sale and repurchase have not been correctly shown, then it is
unlikely that finance charges have been included and are possibly understated.
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Property revaluation
Property has been revalued during the year and a revaluation gain of $250m has been made. Since Bluebell
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Co are known to be seeking long-term funding to solve their liquidity problems, there is a risk that the
properties have been overvalued in order to strengthen their net assets and make the company a more
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Answers 269
attractive lending prospect. The basis of the valuation will need to be examined during the audit to ensure
that any revaluations comply with IAS 16 Property, plant and equipment.
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As per IAS 12 Income taxes, a deferred tax provision should be recognised on the revaluation of a property
for which the debit is charged to equity. If any properties are found to have been overvalued, then the related
deferred tax provision and equity charge will also be overstated.
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Deferred tax asset
Under IAS 12 Income taxes, deferred tax assets can only be recognised where the recoverability of the asset
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can be demonstrated. Bluebell Co will therefore need to show that future profits will be generated for the
unutilised tax losses to be offset against. If this is not possible, the deferred tax asset should be limited to
the amount of profits that can be measured with reasonable certainty.
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The statement of profit or loss currently shows a profit of $145m before tax, the first profit after several
years of losses. However, this profit may need to be adjusted to take into account the items discussed
previously and could turn out to be a loss. If so, it may be difficult for Bluebell Co to demonstrate a flow of
future profits and the deferred tax asset is more likely to be overstated.
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Going concern
Bluebell Co has suffered several years of losses, has poor liquidity and is trying to raise long-term finance to
secure its future. The going concern of the company may be a problem and if so, will require disclosure in
l.b
the financial statements. There is a risk of material misstatement that the incorrect disclosure requirements
are made.
(b) Procedures
(i) Share-based payment expense

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Review contractual documentation for the share-based payment scheme and agree the
ate
following to the management calculation of the $138m expense.
– Number of employees and executives in scheme
– Number of options per employee
– Length of vesting period
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– Grant date of the share options

– Any performance conditions attached to the options
 Re-perform the management calculation of the share-based payment expense, ensuring fair
value is spread correctly over the vesting period.
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 Agree the fair value of the options to a specialist report calculating their fair value.
 Assess whether the specialist report is reliable and objective evidence.
Check that fair value is calculated at the grant date.
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 Enquire of directors as to why the forecast staff turnover is 0% during the three year vesting
period and evaluate the assumptions used in making this forecast.
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 Perform sensitivity analysis to assess the effect on the expense for changes in the
assumptions used, especially 0% staff turnover.
 Discuss the reasonableness of the 0% staff turnover assumption with human resources at
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Bluebell Co.
 Obtain written representations from management confirming that the assumptions used in
measuring the expense are reasonable and there are no share-based payment schemes in
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existence that have not been disclosed to the auditors.

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(ii) Recoverability of deferred tax asset

 Check the arithmetical accuracy of Bluebell Co's deferred tax and corporation tax
computations.
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 Agree the figures used to any tax correspondence and the financial statements.
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270 Answers
 Calculate an independent estimate of the deferred tax asset and compare this to
management's estimate.
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 Obtain profitability forecasts and ensure there are enough forecast taxable profits for the
losses to be offset against.
 Evaluate the reasonableness of the assumptions used in the profitability forecast.
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 Assess the length of time it will take to generate enough profits to offset the tax losses and
judge whether recognition of the asset should be restricted.
 Check tax correspondence to ensure that Bluebell Co can carry the losses forward and offset
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these against taxable profits.
(c) Key performance indicators
Briefing notes for meeting with Daisy Rosepetal, internal auditor Bluebell Co
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Guidance on social and environmental key performance indicators (KPIs)
Introduction
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These notes detail social and environmental KPIs that could be used at Bluebell Co and the evidence that
would be necessary for each.
KPIs
l.b
Social
KPI Nature of evidence

Percentage female employees
Number of customer accidents at a hotel ria
Human resources permanent files
Hotel log of accidents which should include a
description of incident and whether the emergency
ate
services needed to be called
Customer satisfaction scores – for example scores Customer satisfaction surveys
out of ten for cleanliness of room or efficiency of
staff
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Number of customer complaints Hotel log of complaints

Number of refunds issued via sales system
tud
Environmental
KPI Nature of evidence

Percentage of waste recycled at hotel Amount invested in recycling facilities at hotel for
both guests and staff
as
Amount spent on environmentally friendly products Preferred suppliers list will contain suppliers
such as energy efficient light bulbs or rubbish bins stocking these products
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with separate sections for recycling in all rooms Products visible throughout hotels
Percentage change in utilities usage since prior year Supplier bills for gas, water and electricity to
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compare the cost and volume supplied versus the

previous year
Comparison of actual to budgeted use of utilities
with explanations for unexpected variances
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Answers 271
Percentage of sustainable or recycled materials Project plans for new hotels or refurbishment
used in building new hotels or when undertaking
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details
refurbishment Invoices from suppliers detailing sustainable or
recycled materials
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Conclusion
The KPIs listed are just some of the possible measures which could be used at Bluebell Co. The company
should ensure the environmental and social targets it sets are quantifiable and that evidence is available for
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each. The exact KPIs chosen will need to fit in with the overall priorities of the hotel chain.
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l.b
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ate
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as
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272 Answers
51 Robster
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Top Tips. Part (a)(i) was straightforward and you should have done enough to pass this part. The examiner has
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given you the figures to calculate materiality, so you should do this straight away. You can then use you knowledge
of IAS 17 to generate matters to consider, and then use this in turn to think of audit procedures. Eight marks are
available for this part, so you might develop three matters to consider and three pieces of audit evidence in order to
o t.
pass the question. Part (a)(ii) was simple provided that you knew IFRS 9 well. This is an example of the importance
of keeping a good grasp of your knowledge of accounting standards from your P2 paper. Part (b) was on a slightly
obscure part of the syllabus, but if you read the question carefully you would have seen that it was possible to pass
the question by just explaining three analytical procedures that were relevant to interim accounts.
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Easy marks. The marks for calculating materiality in part (a), and for identifying the correct accounting standards.
Examiner's comments. In part (a)(i), evidence points tended to be quite brief, and better answers provided specific
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pieces of evidence that should be sought. Part (a)(ii) was generally unsatisfactorily answered, and the information
given in the question was often misinterpreted. Candidates tended to know the number of the relevant financial
reporting standard for financial assets, but not the technical content of that standard. Requirement (b) was
unsatisfactorily answered by almost all candidates. Candidates are repeatedly reminded that non-audit engagements
l.b
are part of the syllabus, and likely to feature regularly in the examination.
Marking scheme
(a) (i) Leases

ria Marks
ate
Matters:
– Classification of lease
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– IAS 17 indicators of finance lease

– Split between land and buildings
– Finance charge
– Depreciation
tud
– Disclosure
Evidence:
– Lease clauses re risk and reward
– Recalculate Present Value of Minimum Lease Payment v fair value
– Recalculate depreciation and finance charge
as
– Cash book for payments

– Review of disclosures
– Split current/non-current payable
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Maximum 8
(ii) Financial assets
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Matters:
– Classification as held for trading
– Assets shown at fair value – could be subjective
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– Disclosure
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Answers 273
Evidence Marks
– Agree purchase price
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– Agree fair value
– Recalculate gain
– Review of disclosures in notes
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– Review of disclosure in OFR/other information published with financial
statements
Maximum 5
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(b) Interim financial information
– Comparisons with past data eg to preceding period, to corresponding interim last
year, to last audited accounts
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– Comparisons to anticipated results
– Comparisons of non financial data/ratios
– Comparisons to similar entities
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– Disaggregation of data
Maximum 4
Total 17
l.b
Materiality
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Both the non-current assets recognised and the total finance lease payable are material at 8% and
7.1% of total assets respectively (breaching the 2–5% threshold).
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 Whether the leases have been classified correctly as finance leases in line with IAS 17 Leases
The assertion that the leases are finance leases means that they are in substance assets rather
than expenses. This means that Robster Co must have the risks and rewards of ownership,
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including:
– Responsibility for repairs and maintenance
– Transfer of legal title at the end of the lease term
– The lease is for most of the assets' useful life
tud
– The present value of the minimum lease payments is substantially all of the assets' fair
value
 The leases result in finance charges against profit and loss, calculated using the actuarial
method.
as
 The leases are for land and buildings. According to IAS 17, only the buildings element of the
lease can be capitalised, as a land lease is always an operating lease. The leases should have
been split into land and buildings elements, and each part accounted for separately.
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Audit evidence
 A copy of Robster Co's workings in relation to the finance leases
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 Check the additions and calculations of the workings.

 To verify that the leases are classified correctly as finance leases, review the lease contracts
for indicators of transfer of the risks and rewards of ownership, such as:
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– That Robster is responsible for repairs and maintenance of the assets

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– That legal title is transferred to Robster at the end of the lease term
– Confirmation that the leases are for the major part of the assets' useful lives
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– That the present value of the minimum lease payments is substantially all of the assets'
fair value
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274 Answers
 Recalculation of the finance charges charged against profit and loss
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 Agreement of interest rates used in calculations to lease agreements
 Recalculation of depreciation charges applied to non-current assets
 Verification that the land elements are classified as operating leases, and that there is no non-
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current asset recognised in respect of the land
 Recalculation of operating lease expenses, on a straight-line basis over the lease term
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(ii) Matters to consider
Materiality
The financial assets of $1.26m are material at 2.8% of total assets. The gain of $350,000 is material
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at 10.9% of profit before tax.
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 IFRS 9 Financial instruments sets out the categories that financial instruments must fall into,
along with the appropriate accounting treatment for each. The initial classification of the
financial assets as 'held for trading investments' is therefore a crucial area of judgement as it
determines the accounting treatment – in this case, at fair value. This means measuring the
l.b
fair value at the year end, and recognising any gains or losses directly in profit or loss.
 The assets should therefore have been purchased in order to sell them in the short term, and
must be part of a whole portfolio of instruments that are managed together with a view to
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short-term profit.
Audit evidence
 A schedule showing all the investments held in this category and the fair values of each
ate
 Agreement of the fair values to external evidence such as year end market price (current bid
price)
 Recalculation of the total gain or loss as the overall movement in fair value over the course of
the year
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 Review of the internal controls and procedures followed by the trading department. Testing to
confirm that details (quantities, dates, etc.) shown on the schedule can be relied upon
 Analytical procedures to confirm that there is a portfolio of investments that are traded
frequently with a view to short-term profit. Corroboration by a review of events after the year
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end
(b) According to ISRE 2410, the auditor's analytical procedures should include the following.
 Comparing the interim financial information (IFI) with forecasts and budgets, obtaining explanations
as
from management for any discrepancies

 Comparing the IFI with prior periods, such as the same period in the last financial year
 Comparing the IFI with other entities in the same industry
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 Analytical procedures designed to identify relationships and unusual items that may reflect a material
misstatement
 Considering the nature of any corrected or uncorrected misstatements in last year's financial
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statements
 Considering any significant risks that were identified in the audit of the year end financial statements
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Answers 275
52 Efex Engineering
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Text references. Chapters 12 and 14
Top tips. This is another 34-mark compulsory Section A question so again, as for Question 1, it is key that you stick
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to time for both the question in total and each of the four parts.
You should be able to score well in part (a) which is knowledge-based on forensic auditing. Make sure you answer
the question requirement fully – ie describe its applications as well as define what it means.
o t.
In part (b), use the clues in the scenario to help structure your answer. When you are asked for procedures, make
sure these are specific and well explained – vague answers will not score well.
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In parts (c) and (d), the questions are split into two requirements. Again when describing tests, make sure they are
specific and well thought out. Use sub-headings to give more structure to your answers, as well as to improve
presentation.
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Easy marks. Easier marks on this question are available in part (a) which is knowledge-based. You should make
sure you get the professional marks available in part (b). Using the information in the scenario should help you
score marks in the other parts of this question.
l.b
Marking scheme
Marks
(a) 'Forensic auditing'

Generally 1 – ½ mark each point
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Ideas
Definition
– Eg of Institut des Fraud Auditeurs de Fraude (IFA-IAF)
– Audit (examination) + forensic (legal)
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Application to fraud investigation

– Irregular nature of fraud
– Objective(s)
– Reactive vs proactive (preventative)
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Maximum 10
(b) Prior to commencing investigation
Generally 1 mark each matter/ procedure
Ideas
Matters
as
– Terms of reference (obtaining is a procedure)

– Purpose/scope of investigation
o Possible understatement of inventory at 30/6
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o High material consumption in quarter to 30/6

o To give credence to y/e amount (next quarter to 30/9)
– Scope of access to records relevant to the investigation (any
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restriction?)/Information to be supplied
– Staffing – level/experience/number/availability/other client
commitments
– Degree of reliance to be placed on report
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By whom? – insurer?
– Timeframe – before next (= annual) physical count
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– Form of report required – Any caveats?

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276 Answers
Procedures Marks
 Discuss assignment with directors – responsibilities etc
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 Obtain engagement letter (terms are a matter)
 Agree investigative fee
Note. Two professional marks are included
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Professional marks – up to 4
Tutorial note. There is no maximum to be awarded for each of matters and procedures as answer points
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about matters may be constructed as procedures (and vice versa). Marks should be awarded for either/or (not
both).
(c) Inventory undervaluation
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Generally up to 1½ marks each matter explained 1 mark each test max 8 Maximum 8
Ideas
(i) Matters
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 Omission from count
 Cut-off
 Scrap/waste etc
(ii) Tests
l.b
 Physical inspection
 Arithmetic checks
 Cut-off tests
 Analytical procedures
 Tests on production records/pricing
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Tutorial note. Tests must address understatement of inventory at 30 June.
ate
(d) High materials consumption
Generally up to 1½ marks each matter explained 1 mark each test Maximum 7
Ideas
(i) Matters
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 cut-off
 losses
 obsolescence etc
 major contracts
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 change of supplier
(ii) Tests
 physical inspection
 arithmetic checks
 cut-off tests
as
 tests of control
Tutorial note. Matters must address overstatement of materials consumption in the quarter to 30 June.
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Total 34
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(a) Forensic auditing

Forensic auditing is the process of gathering, analysing and reporting on data, in a pre-defined context, for
the purpose of finding facts and/or evidence in the context of financial or legal disputes or irregularities and
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giving preventative advice in this area.

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Forensic auditing is a rapidly growing area and demand for this has arisen in part due to the increased
expectation of corporate governance codes for company directors to take very seriously their responsibilities
for the prevention and detection of fraud. Fraud investigations can involve:
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 Quantifying losses from theft of cash or goods

 Identifying payments or receipts of bribes
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Answers 277
 Identifying intentional misstatements in financial information, such as overstatement of revenue and
earnings and understatement of costs and expenses
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 Investigating intentional misrepresentations made to auditors
Forensic accountants may also be engaged to act in an advisory capacity to assist directors in developing
more effective controls to reduce the risks from fraud.
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(b) Briefing notes
To: CJ, Senior partner
o t.
From: Reginald Perrin, Audit manager
Date: July
Subject: Efex Engineering Co
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Introduction
These briefing notes contain an outline of the matters to consider and the procedures to perform in respect
of the investigation of Efex Engineering Co.
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Matters to consider in planning
 Whether our firm has the necessary resources and experience to carry out the investigation of Efex
Engineering's losses
l.b
 What reliance is to be placed on the report that we produce as a result of the investigation and
whether it will be relied upon by any third parties such as lenders
 What type of report it is to be and what level of assurance will be given


potential conflicts of interest ria
Whether any potential independence issues exist with other clients that our firm has and therefore
What level of detail is required in terms of the work to be undertaken

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Procedures to carry out
 Review staff availability and timings to assess whether sufficient resource for the investigation exists.
 Discuss with the management of Xzibit the scope of the investigation and its purpose (eg whether
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any third parties will be relying on it or whether it is an internal report only) and other issues such as
expected timing, fees etc.
 Clarify the terms of reference of this engagement in writing from the management of Xzibit.
 Draft an engagement letter for this investigation and obtain agreement of terms in writing from the
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management of Xzibit.
(c) (i) Matters to consider re. undervaluation of inventory
 Inventory will be undervalued if cut-off has not been appropriately applied therefore particular
as
focus needs to be on this area of the quarter-end count.

 Inventory will be undervalued if not all inventory items have been included in the count
therefore the investigation should focus on the procedures in place for the quarterly counts.
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 Inventory will be undervalued if the valuation methods are incorrect. Inventory is valued
manually so the investigation should examine how items of inventory, such as scrap are
valued.
ea
(ii) Procedures to carry out

 Obtain inventory counting instructions in place at Efex Engineering and review to make an
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assessment of their adequacy for the quarterly counts, together with discussion with
appropriate staff at Efex Engineering.
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 Perform analytical procedures using figures from the quarterly management accounts, such
as comparisons between 30 June and 31 March.
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 Discuss scrap and wastage policy with warehouse staff.

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278 Answers
 Examine details of scrap and discuss figures with appropriate staff to establish whether there
are any reasons for wastage being higher in this quarter.
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 Test cut-off is correct by tracing the last goods delivery notes and despatch notes to the
invoices.
 Recast additions on inventory sheets to verify accuracy.
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(d) (i) Reasons for high materials consumption in quarter ended 30 June 20X8
If closing inventory has been undervalued or undercounted, this could explain a high materials
o t.
consumption in this quarter. It could also be due to excessive consumption or wastage of materials.
If recorded inventory has been stolen from production areas this could be another contributory factor
to a high materials consumption in this quarter.
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If cut-off was incorrectly applied, then this would affect the materials consumption, ie if goods
delivered after the year end were incorrectly included as purchases in the quarter then this would give
rise to a higher materials consumption. Also if revenue is understated due to incorrect cut-off, then
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materials consumption as a % of revenue will be overstated.
(ii) Procedures to carry out
 Test cut-off of purchases and sales has been done correctly by matching purchase invoices to
l.b
goods received notes and matching despatch notes to invoices raised around the quarter-end
date.
 Compare value of inventory identified as obsolete or damaged at the quarter-end to the

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previous quarter-end, discussing discrepancies with appropriate staff.
Discuss levels of scrap and wastage with warehouse managers to ascertain normal levels and
understand how it arises.
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 Review a sample of credit notes received after the quarter-end to identify any returned
materials.
 Inspect scrap materials to confirm it is not suitable for manufacture and therefore is not
included in inventory.
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53 Bateleur Zoo Gardens

tud

Top tips. This question appears daunting because of the unusual context the question is set in. A zoo is an unusual
context in which to think of internal controls and the assets such as animals are also unusual. However, the
question is actually reasonably straightforward. Try and think of the practical business and financial statement
as
implications of the zoo. Animals are assets in this context, which are impaired if people don't want to come and see
them. Unrecorded donations are in effect unrecorded additions to non-current assets. The risks have been identified
for you, you have to focus on how those risks might be controlled. Make sure you read the question properly and
answer it. For example, in part (a), you are planning to use analytical procedures as substantive procedures for
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income. You will not gain marks talking about analytical procedures at the planning stage or at the review stage.
Easy marks. Some of the internal controls required in part (a) are more straightforward than others. Do not panic if
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the first applicable risk seems complicated. Read through the question completely and identify the more
straightforward ones, for example, cash misappropriation, and you can gain easy marks listing controls and risks of
material misstatement applicable in this area, which would not be out of place in the lower level auditing paper.
Examiner's comments. In part (a), candidates mostly sought to address internal controls selected from 'compare'
e
or other mnemonics – failing to appreciate that these are only specific control procedures. Candidates needed to
/fr
consider more pervasive controls and monitoring activities also … Regarding the next part of (a), few candidates
recognised that failure to record reciprocal advertisement arrangements would result in an understatement of
advertising expense (and sponsorship income). Most candidates did not read the requirement of analytical
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procedures and did not answer the question.

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Answers 279
Marking scheme
m/
Marks
(a) Internal controls
Generally 1 mark each point, max 3 any one risk 12
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Ideas
 Control procedures/specific controls
 Control environment/pervasive controls
 Monitoring activities (including reconciliations)
o t.
Risk of material misstatement
Generally 1 mark each point 6
Ideas
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Assets
 Impairment (IAS 36)/overstatement (tangibles)
 Useful lives
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 Existence assurance (tangibles, cash)
 Completeness (tangibles, receivables)
Profit and loss account
 Admission fees (understatement)
l.b
 Sponsorship income/advertising expense understatement (SIC 31)
Reserves
 Existence/disclosure
Disclosure risk
 Going concern (IAS 1)
Substantive analytical procedures
Generally ½ mark each factor + up to 1 mark a comment
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Ideas (ISA 520)
 Audit objectives
 Nature of entity
 Degree of disaggregation of information
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 Availability of information
 Reliability of information
 Relevance of information
 Source of information available
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 Comparability of information
 Expectation of relationships
 Materiality
 Other audit procedures
 Accuracy of predictions
as
 Inherent and control risk assessments

 Tests of controls
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(b) Internal control effectiveness

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 Responsibilities of management and auditors

 Sarbanes – Oxley Act
 ISA 330 5
34
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Total
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280 Answers
(a) Memorandum
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For: Charlotte Brain
By: Laura Liver
Date: December
Subject: BZG audit
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Introduction
This memorandum sets out both the risks of material misstatement arising from the applicable risks
identified by the management of BZG, and internal controls that could implement in order to manage those
o t.
risks. It then comments on the factors to consider when planning analytical procedures in respect of BZG's
income.
Internal controls Financial statements risks
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(i) Lack of investment in new  Regular review of admission Existing assets (animals and non
exhibits fees/visitor numbers/lapsed current assets such as enclosures)
memberships and sponsorships may be impaired if they are not
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 Regular (monthly/quarterly/ generating income in use.
annually) review of competitors' Impairment tests in line with IAS 36
service/assets should be carried out. Ultimately,
failure to invest in the assets of the
l.b
 Annual capital expenditure
budget for animals/attractions zoo might lead to going concern
and approval of it problems. There may be disclosure
risk if correct disclosures under
ria
 Annual review of additions of IAS 1 are required and have not
animals/attractions in year been made.
against budget
(ii) Failure to invoice animal  Regular reconciliation between Income may not be recorded
ate
sponsorships sponsorships and sponsorship completely.
income
 Pre-numbered sponsorship
documentation
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 Sequence checking of
sponsorship documentation by
invoicing staff
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 Monitoring of instances of lack

of data transfer
 Investment in automatic
computerised data transfer
as
between sponsorship/invoicing
departments
(iii) Rates for corporate sponsorship  Approved price list Income and expenses may not be
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 Price list reviewed annually recorded completely if sponsorship

is given in exchange for advertising.
 Approved discount list Ultimately, if sponsorship is
 Key official to authorise recurringly undercharged, going
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discounts for new clients concern might be affected.

 Sharing of discount information
with invoicing department
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 Review of sponsorship income

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vs budget to identify any

shortfalls
 Review of advertising cost vs
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budget to identify 'free'

advertising (and associated sales)
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Answers 281
Internal controls Financial statements risks
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(iv) Cash misappropriation  CCTV in ticket booths to record Income will be understated if cash is
cash sales misappropriated at source (and by
 Electronic till records kept and implication, the sale is not
recorded).
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reconciled to cash received by
cashiers in accounts department
 More than one officer at each
o t.
gate
 Reconciliation of ticket stubs
with cash
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 Secondary gate to ensure that all
visitors have been issued with a
ticket/to collect ticket stubs
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(v) Booking/ticket issuing system  Contingency plans (see below) Loss of sales in this manner could
unavailable required affect the going concern status of
 Manual tickets kept in entrance the company, but other than that
gate ticket offices there may be no impact on the
financial statements of sales lost in
l.b
 Telephone booking system this manner.
alternative to website if website
unavailable
(vi) Donations of animals not

 Maintenance/downtime of
website at anti-social hours
ria
 Animal register to be maintained Assets may be understated if new
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recorded  Regular reconciliations between assets have not been valued and
animals in zoo and animals in included in non current assets in
register accordance with IAS 16.
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Analytical procedures (income)

The auditor should consider the following matters:
(1) The plausibility and predictability of the relationships identified for comparison and evaluation
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For example, the relationship between current year income and prior year income is plausible unless
there have been any major changes in the year (for example, new attractions) and should be predictable
even if there have been changes. For example, the impact of a new attraction should be predictable on
the basis of prior new attractions. In addition, BZG's income will be seasonal, and there should be clear
and predictable patterns of sales in high summer season and in school holidays.
as
(2) The objectives of the analytical procedures and the extent to which their results are reliable
The objectives will be to give evidence about the completeness of sales income and the results are
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likely to be reliable, given the plausibility and predictability of sales income as outlined above.
However, the risks affecting sales income discussed above ((ii) and (iii)) would merit some other
substantive work being carried out in this risk area.
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(3) The detail to which the information can be analysed

The auditor should consider what records are available with regard to sales: monthly sales figures,
daily sales figures, electronic till receipt records, prior year records in the same detail, sales budgets,
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in order to assess how detailed the level of analytical review he is going to be able to carry out. The
types of sale (sponsorship, retail outlets, gate entry) are distinct and their records should be distinct
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which will allow greater detail of analysis on sales generally to be made.

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282 Answers
(4) The availability of the information
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The information outlined above should be easily available to the auditor if it exists. In addition, non-
financial information, such as number of visitors, should be available, giving the auditor scope to
assess whether actual income is consistent with income for that number of visitors etc.
(5) The relevance of the information
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For example, if the auditor is comparing budget to actual, he should ascertain whether the budget
was realistic or a tough target. He should be able to verify this by reference to the budget setter, or to
o t.
sales meeting minutes or prior year budgetary practice. Information from gates (ie number of
visitors) will be more relevant if there is no other method of gaining access to the zoo.
(6) The comparability of the information available
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For example, if the auditor intended to compare BZG's results with those of a competitor zoo, he
should bear in mind whether the zoos have comparable attractions, target markets and opening
times. However, as the zoo is fairly specialised, more meaningful comparisons are likely with prior
period information from BZG itself.
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(7) The knowledge gained during previous audits
If comparing income last year to this year, it may be that there were significant new attractions in the
prior year that will impact on the comparison with this year.
l.b
(8) Materiality and risk
As sales is a material balance and could potentially contain single items (large sponsorship deals)
that are individually material, some additional substantive procedures are likely to be necessary, for
ria
example on sponsorship. In addition, given the control problems in connection with income, control
risk is higher and additional substantive tests may be required on income completeness.
Conclusion
ate
Controls are suggested above that would appropriate to help manage the significant risks of material
misstatement that arise from the applicable risks identified by management. There are a number of factors
that must be considered when planning substantive analytical procedures in respect of BZG's income.
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(b) Effectiveness of internal financial controls

Responsibilities
Management is responsible for ensuring that internal financial controls are effective. This is often a process
tud
that management employ an internal audit department to carry out.

In the UK, auditors of listed companies are required by the UK Corporate Governance Code to review the
company's corporate governance statement which will include a review of the Board's review of the
effectiveness of internal controls.
as
An auditor must test the effectiveness of internal controls if seeking to rely on them for audit evidence. The
auditor is not required to report to management directly on their effectiveness, unless engaged specifically
to do so in an engagement other than the audit.
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Current guidance
Although auditors have always had the option of testing internal control effectiveness as part of their audit,
ISA 330 The auditor's response to assessed risks makes it more likely that they will do so than was
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previously the case. The standard states that auditor's shall design and perform tests of controls to obtain
sufficient appropriate audit evidence as to the operating effectiveness of relevant controls when:
(a) The auditor's assessment of risks of material misstatement at the assertion level includes an
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expectation that the controls are operating effectively; or

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(b) Substantive procedures alone cannot provide sufficient appropriate audit evidence at the assertion
level.' Controls will be tested if the auditor believes the controls to be effective. This will result in tests
of controls being performed regularly because it is likely that auditors will expect a company's
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internal control system to be operating effectively more often than not.

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Answers 283
In the US, the Sarbanes-Oxley Act requires CEOs and CFOs to certify that they are responsible for internal
control and have reported on their effectiveness and that all major control deficiencies and management
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frauds have been reported to the auditors. Auditors in the US are required to report on management's report
about internal control effectiveness.
In the UK, the UK Corporate Governance Code has recently been revised with more emphasis being put on
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non-executive directors paying attention to such matters as internal control effectiveness if they are
members of the non-executive audit committee.
o t.
54 Sci-Tech
Text references. Chapters 9, 12, 15 and 16.
sp
Top tips. Time management is critical in this question (there are six separate requirements) so work out how much
time you can allocate to each part of the question and stick to this. If you miss out whole parts of questions you are
log
at very high risk of failing.
In part (a) as well as showing that you understand outsourcing, you need to consider the outsourcing of payroll in
this particular scenario. Knowledge of ISA 402 will gain some marks but it is important to apply this to the specifics
of this question. In part (b) your financial reporting knowledge will be vital as will your ability again to use the detail
l.b
in the scenario. In part (c)(i) it is important to describe the procedures in some detail. Part (d) would appear
difficult as there is no specific technical material on which to base an answer. What was needed here was a
commonsense approach, thinking about factors that affect the levels of assurance, and the natures of information
that would be likely to exist about the particular performance indicators given in the question.
ria
Easy marks. Parts (a),(b) and (c) contain the easiest marks in this question, as in each of these parts there is an
element of technical knowledge, either from ISAs or from your financial reporting knowledge that will give you a
foundation for your answers. Also be sure to get some of the professional marks that are available.
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Examiner's comments. Part (b) focussed on the audit of development costs which had been capitalised as an
intangible asset. The answers were on the whole rather disappointing. Requirement (b)(i) required a discussion of
matters to be considered in deciding on the appropriateness of capitalising the development costs. Most candidates
could reel off the criteria for capitalisation under IAS 38 Intangible Assets, which is relevant, but few candidates
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then went on to apply the criteria to the scenario provided. It is very important that candidates appreciate that at this
level of professional examination, few marks can be awarded for the rote-learning and regurgitating of facts, such
as accounting standards criteria, without any application to the question.
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In answering the final requirement, which invited candidates to suggest procedures used to verify the number of
serious accidents reported, the marks awarded to scripts were polarised. Many candidates seemed to think that the
auditor has access to absolutely any kind of evidence that they could wish for. Common sources of evidence
referred to included the private medical records of employees, police reports on 'dangerous' incidents, hospital
admissions data, interviews with ambulance drivers/paramedics/doctors and death certificates.
as
Candidates need to appreciate that although the auditor will have access to books and records held by their client,
they will not be able to access external and possibly highly confidential information as a means to gather evidence.
The above examples show of a lack of commercial, or even, common sense.
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e ea
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284 Answers
Marking scheme
m/
Marks
(a) Outsourcing – definition and matters to be considered
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Matters to be considered – generally 1½ marks for each matter explained:
 Materiality
 Accessibility
 Control issues (extend to 2 marks for detailed answer)
o t.
 Independent records
 Compliance
 Transactions
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Up to 2 marks for clarity of explanation
Maximum 9
(b) Recognition of development costs
 Materiality – max 2 marks
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 IAS 38 criteria – max 1 mark
 Application of criteria to scenario – max 3 marks
Maximum marks 5
Evidence on technical feasibility
l.b
 Review documentary evidence of scientific test results
 Discuss test results
 Licences
 Analytical procedures
 Board minute review ria
ate
Maximum 3
(c) Evidence on amortisation rate
 Market research results
 Actual sales patterns
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 Management assumptions
 Discussion of sales trends
 Correspondence with retail outlets
 Advertising budgets
tud
Maximum 5
(d) (i) KPI assurance difficulties
 Discussion of problems in defining KPI terms
(max 2 marks)
 Discussion of difficulty in gathering evidence
as
(max 2 marks)
Maximum 4
(ii) Procedures on number of accidents
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Ideas list:
 Review log book
ea
 Discuss and clarify criteria

 HR/payroll records
 Employee correspondence
 Board minute review
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 Legal letter review

 Discuss with employees
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Maximum 4
Professional marks for format and clarity of answer. 4
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Answers 285
Memorandum
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To: Robert Nesbitt
From: James Cotter
Subject: Sci-Tech planning
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Introduction
This memorandum explains the matters to be covered by the planning document for the Sci-Tech audit and the
review assignment.
o t.
(a) Outsourcing/payroll expense
Outsourcing is the process of purchasing key functions from an outside supplier (service organisation). In
other words, it is contracting-out certain functions, for example, internal audit, or information technology,
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or, in this case, the payroll function.
Audit of salary expense – matters to consider
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The audit firm must ensure it follows the guidelines of ISA 402 Audit considerations relating to entities using
a service organisation. This requires them to consider an approach to parts of the audit affected by a service
organisation.
Materiality
l.b
Salaries are 7% of revenue and are separately disclosed in the statement of profit or loss. In addition, an
element of salary cost for research and development staff will be included in research and development
costs. Salary costs are therefore material for the audit.
Audit approach
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The fact that salary costs have been audited by systems audit in the past implies that when the payroll was
ate
carried out in-house, there was a good control environment and effective controls.
As ProPay now control the payroll function, the auditors need to determine the audit approach they will take
to salaries now.
In order to continue with a systems approach, they will need to be satisfied that a good system of control
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over payroll exists at ProPay. If they are not so convinced, they may need to take a substantive approach.
The fact that a company with good controls over its payroll is prepared to outsource to ProPay suggests that
ProPay has good controls. However, the auditors must not rely on this assumption but determine this for
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themselves.
Accessibility
In order to make the determinations discussed above, the auditors really need access to ProPay's books and
records. However, they have been engaged by Sci-Tech, not ProPay. It is not certain that they will be granted
as
such access. The auditors should ask Sci-Tech to request that its auditors are allowed access to Pro-Pay's
records. If the auditors were involved in the process of obtaining the contract with Pro-Pay it is likely that
such access has been negotiated. If not, it may have been overlooked.
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If such access is declined, the auditors will have to consider other means of gaining the assurance they
require about ProPay's systems. They may be able to get this assurance from:
 Third-party reports about ProPay, such as the auditor's report of Pro-Pay or reports of any regulatory
ea
agency
 Other reports, such as ProPay's internal auditor's reports, if made available to clients
 Requested procedures by ProPay's external or internal auditors
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If the auditors are unable to obtain the assurance they require about ProPay's systems or access to records
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to carry out proposed substantive tests, this would constitute an inability to obtain sufficient appropriate
audit evidence which would result in the need for a qualification.
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286 Answers
Compliance
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The auditors need to ensure that Sci-Tech is still fulfilling its legal obligations in respect of maintaining
financial records in respect of payroll, despite the administrational burden being carried by Pro-Pay.
Records
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The auditors should determine whether Sci-Tech keep any payroll records or whether solely ProPay keep the
records. If Sci-Tech kept some records, these would provide corroboration of the figures kept by ProPay.
(b) Matters to consider in determining whether capitalised development costs are correctly capitalised
o t.
(i) Materiality
The auditors will be concerned with whether the capitalised development costs are correctly
capitalised only if there is a risk of material misstatement. In this case, net book value of development
sp
costs is 7% of total assets, so they are material.
Analytical review
log
Capitalised development costs have risen fairly significantly on the previous year and research costs
have fallen. However, given the nature of the asset and the fact different projects will have different
cost and feasibility structures, this is not necessarily indicative that research costs have been
capitalised wrongly.
l.b
Accounting standard criteria
The key issue in determining whether development costs have been correctly capitalised is whether
the costs meet the criteria in IAS 38 Intangible Assets.
(2)
ria
There are six criteria, all of which must be met for a development cost to be capitalised:
(1) Completion of the work will be technically feasible.
The business intends to complete the asset and sell it.
ate
(3) The business will be able to sell the asset.
(4) The business can demonstrate how future economic benefits will be generated
(5) Adequate resources exist to complete the development and sell the asset
(6) Expenditure attributable to the development of the asset can be measured reliably.
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There is a risk that all these criteria might not be met and therefore that the development costs are
overstated. In particular, the auditors should consider:
 Whether the developed products meet government criteria for sale (for example, do they have
a license) otherwise they may not be saleable
tud
 Whether the existence of a competitor (specifically to the drug Flortex) means that the drug is
no longer saleable
 Whether the funding that makes completion of the work technically feasible will continue
(particularly since in 20X8 the company has broken one of its KPIs on which the funding is
as
dependent)
(ii) Evidence of technical feasibility
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 Establishing the existence of, and reviewing, scientific tests on the development such as
safety testing
 Reviewing the adverse results of such tests and ensuring that corrective action has been taken
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and tested
 Enquiring whether appropriate licenses have been applied for/granted and reviewing
correspondence in relation to such licenses
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 Reviewing board minutes for discussion of technical feasibility and plans for products
(c) Audit procedures on validity of amortisation rate re Plummet
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 Obtain copies of the market research carried out in respect of Plummet to determine whether it
supports an expected life span of five years
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 Compare budget and forecast sales to date in Plummet's life to determine whether actual sales are in
accordance with what market research suggested
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Answers 287
 Discuss sales trends with sales manager to ensure that actual performance continues in line with
expectations
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 Consider contracts with retailers/order book to ensure that future sales are still in accordance with
market research and budgets
 Obtain future budgets and ensure finance is still expected to be available to support Plummet's useful
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life expectation
(d) Key performance indicators
o t.
(i) Level of assurance over meeting KPIs
There are two main reasons why the level of assurance given in relation to the KPIs can not be a high
level of assurance:
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 Lack of precision in the description of the KPIs
 Likely lack of appropriate audit evidence
Lack of precision
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The KPIs are defined imprecisely and are also subjective. For example:
 Donated product should be 1% of revenue, but what price will be free product be valued at –
cost or retail price?
l.b
 Similarly, how will 'donations' to local charities be valued if these donations are more than
just financial donations, such as the use of Sci-Tech's expert employees or products?
 'Serious' accidents should be fewer than five, but what constitutes 'serious'?
Audit evidence
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Some of these matters may be well documented, such as cash donations or accidents, because of
health and safety procedures, but others, such as time spent by employees at local charities, may not
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be so well documented.
(ii) Evidence in relation to serious accidents
 Obtain and review health and safety accident log-books for all Sci-Tech's premises and review
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the number of accidents.

 Discuss the definition of 'serious' with the directors and obtain written verification of this
definition.
 Select a number of accidents designated serious and not-serious and review associated
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correspondence, payroll records and compensation payments to determine whether the

accidents have been properly designated serious or not.
 Review correspondence with legal advisors to ascertain if any action has been taken in
relation to accidents not designated serious by the directors.
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 Review board minutes to obtain directors' opinions on the increase in serious accidents in
20X7.
 Review correspondence and reports from regulatory bodies to ensure that controls over
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health and safety reporting are considered to be strong.

 Discuss health and safety controls with health and safety officer to ensure that all accidents
are reported.
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288 Answers
55 Rosie
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co
Top tips. As always, time management is key in this question – there are five separate requirements so work out
how much time you can allocate to each part of the question and stick to this. If you miss out whole parts of
questions you are at very high risk of failing, to pass the question and ultimately the whole paper.
o t.
Group audits are a key current topic. Having a good understanding of the basics and keeping up to date with the
articles in Student Accountant would have helped you here.
Easy marks. Part (c) contained some easy marks for a simple definition and some sensible suggestions of
advantages and disadvantages relevant to the scenario. Some easy professional marks were available if you set out
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your report correctly.
Examiner's comments Requirement (b)(i) asked for 'matters to consider' and 'evidence you would expect to find'
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regarding the cost of an investment made during the year. The wording of the requirement should be familiar, as
this type of question has appeared regularly in advanced audit examinations. However, most candidates were
completely unable to restrict their answer to the cost of investment as shown in the scenario, and launched into a
discussion of the accounting treatment of goodwill. This was not asked for.
l.b
Requirement (b)(ii) was also not well answered. The majority of candidates seemed not to know the contents of a
consolidation schedule, or how to audit it. However, those candidates who had read the relevant article in Student
Accountant tended to score well on this requirement.
Marking scheme ria Marks

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(a) (i) Purpose and benefits of due diligence
Award up to 4 professional marks for good style of report with clear 4
explanations and logical flow
Generally 1 to 1½ marks for each point
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 Introduction
 Fact finding
 Verify specific representations
 Identify and value assets, especially intangibles, and contingencies
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 Tool to aid negotiation of consideration

 Operational issues identified – staff, suppliers, customers, contracts
 Consideration of commercial impact – synergies and drawbacks
 Benefit of external provision – free up management time,
as
independent investigation
 Enhanced credibility
Maximum 10
(ii) Due diligence scope – comparison to audit
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Generally ½ mark for identification and 1 mark for explanation

 Wider scope – more information sources
 No detailed testing of transactions/balances – unless specifically
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agreed
 No detailed evaluation of internal systems and controls
 Greater use of analytical procedures, reduced scope for substantive
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procedures
 Forward looking
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Maximum 4
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Answers 289
(b) (i) Dylan Co Marks
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Generally 1 mark per procedure and 1 mark per matter
No marks to be awarded for discussion of materiality as scenario
states that all figures are material No marks awarded for discussion of
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goodwill – this is not asked for
 Completeness – missing professional fees
 Agree consideration to legal documentation
 Agree cash consideration to bank statement
o t.
 Deferred consideration – discounted per IFRS 3
 Recalculate (1/2 mark only)
 Agree reasonable discount factor used
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 Contingent consideration – only accrue if probable per IFRS 3
 Review forecasts and assumptions
Maximum 7
(ii) Principal audit procedures
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Generally 1 mark per specific procedure
 Agree figures to individual co financial statements
 Cast and cross cast schedule
 Agree brought down figures
l.b
 Recalculate consolidation adjustments – award ½ mark for each
adjustment clearly identified, max 2 marks
 Reconcile opening and closing reserves
(c) Joint audit

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 Agree only post acquisition reserves consolidated for Dylan Co
Maximum 4
ate
Advantages and disadvantages – 1 mark each & max 3 marks each
Advantages
 Knowledge sharing
 Increase resource availability
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 Easier to meet tight deadline

 Improve audit quality
 New insight of new auditor
 Current issue – increase competition
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Disadvantages
 Higher cost for client
 Bureaucracy
 Difference in audit approach
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 Problems in working together

 Joint liability
Maximum 7
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Total 36
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(a) Report to Leo Sabat

To: Leo Sabat
From: Chien & Co
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Subject: Due Diligence

Date: June 20X8
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Introduction
The aim of this report is to set out the purposes and benefits of a due diligence investigation and to explain
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how the scope of such an investigation differs to that of an audit of financial statements. This report is solely
for the use of the intended user and should not be relied upon by any third party.
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290 Answers
Due diligence is a specific type of review assignment where an advisor is engaged by a company making an
investment, typically an acquisition. The advisor will perform an assessment of the material risks associated
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with the transaction to ensure the company has all the necessary facts before making a judgment. Thus, due
diligence minimises the risk of making the wrong investment decision.
(i) Purpose and benefits of a due diligence investigation
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Information collecting
A due diligence investigation will gather information on a target company, such as Maxwell Co,
regarding:
o t.
 Details of business operations
 Financial performance
 Financial position (for example any hidden covenants or contingent liabilities)
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 Legal issues
 Tax situation
Armed with this information, Rosie Co can make an informed decision on whether to acquire Maxwell
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Co. Any potential problems should be uncovered before the company is acquired, and the risk of
unpleasant surprises after the purchase is minimised.
Verification of specific written representations
l.b
Due diligence work should corroborate verbal representations made by the vendor to the potential
acquirer. For example, management at Maxwell Co may have stated that the company has no legal
claims against it. Due diligence work would be able to verify this kind of representation giving
confidence to the potential acquirer.
Identification of assets and liabilities
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A due diligence investigation will ensure that all assets and liabilities of the target company are
ate
identified. It is particularly important to identify any contingent liabilities and understand the potential
cost to the acquirer if the liability crystallises. This work can be complex and so it may be advisable
for Rosie Co to use the expertise of an external due diligence provider.
Operational risk
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A due diligence investigation will identify operational risks in the target company which are not
apparent from examining financial information alone. For example, the patent of a key engine part
manufactured by Maxwell Co may be about to expire or a key customer may wish to renegotiate
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terms. The issues discovered could mean that Rosie Co decides the acquisition of Maxwell Co is too
risky or alternatively may offer a useful bargaining tool in negotiating the consideration paid.
Acquisition planning
Post-acquisition strategy will also be assessed during a due diligence investigation. Potential
as
economies of scale and operational synergies will be highlighted to the acquirer along with the costs
of any necessary reorganisation. The due diligence report may be able to advise Rosie Co how best to
integrate Maxwell Co into the existing group structure.
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It is worth noting here that as Rosie Co has only just completed the acquisition of Dylan Co in
January 20X8, the group may find it difficult to integrate Maxwell Co as it is already in a period of
immense change. Additionally, it may be difficult to secure funding for the acquisition so soon after
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the payment for Dylan Co has been made and the group should examine its liquidity before deciding
to proceed.
Management time
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It is possible for due diligence to be performed by directors of the acquiring company. Although this
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can be cheaper for the acquirer it has several drawbacks, the main one being that due diligence can
be incredibly time-consuming for the directors, leaving them little time to carry out their day-to-day
activities. Additionally, the directors may lack the experience and expertise in acquisitions that a
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professional due diligence advisor can offer.

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Answers 291
Credibility
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A third party review will add to the credibility of the investment decision in Maxwell Co and give
shareholders some comfort over the consideration paid.
(ii) Scope
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The table below summarises the key differences in scope between a due diligence investigation and
an audit of financial statements.
Due diligence Audit
o t.
Draws on a wide range of information including Concentrates on the most recent set of
cash flows, profit forecasts, business plans and financial statements
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management accounts
Provides a reviewed set of information to the client Provides assurance that data is free from
material misstatement
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No detailed audit procedures performed unless Detailed audit procedures performed
specifically requested or a cause for concern
Mainly uses analytical procedures where sets of In addition to analytical procedures,
data are compared, for example, to each other, substantive procedures are used where
l.b
benchmarks and competitors samples of information are tested and
agreed to supporting documentation
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Forward looking – looks at forecasts and future Backward looking – concentrates on the
expectations for a business most recent set of financial statements and
only looks at future events that are relevant
to these
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No testing of systems and controls unless Systems and controls will be evaluated and,
specifically requested if appropriate, tested
Conclusion
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Due diligence provides management with the confidence to make investment decisions based on all
the available facts. It can be carried out by management but it is often better to employ a specialised
advisory firm.
tud
(b) (i) Dylan Co

Matters to consider
 Whether the cost of investment provided by the client is complete and accurately stated in
accordance with accounting standards. In particular legal and professional fees should not be
as
included, in line with IFRS 3 Business combinations.

 Whether the cash consideration of $2.5m was paid before the year end and if not, that the
liability has been correctly recognised on the statement of financial position
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 Whether the $1.5m deferred consideration has been discounted to its present value at the date
of the acquisition as required by IFRS 3 (unless immaterial to the financial statements). There
is a risk that the liability and cost of investment is overstated if discounting has not taken
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place.
 Whether the revenue of Dylan Co is likely to grow by 5% per annum resulting in the payment
of $1m contingent consideration. If so, has an accrual been made for the $1m?
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Evidence
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 Agreement of cost of investment in Dylan Co and payment dates of consideration per the
client schedule to legal documentation signed by both Dylan Co and Rosie Co
 Agreement of $2.5 million cash consideration paid to Rosie Co's bank statement and cash
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book (if prior to year end)

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292 Answers
 Inclusion of $2.5m cash consideration paid to Rosie Co as accrual within 'Accounts payables:
falling due within one year' on the individual company and consolidated statement of financial
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position (if payment occurs after year end)
 Board minutes detailing approval of acquisition of Dylan Co
 Recomputation of discounting calculations performed on deferred and contingent
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consideration
 Agreement that pre-tax discount rate used which reflects the current market assessment of
the time value of money (for example, by comparison to Rosie Co's weighted average cost of
o t.
capital)
 Revenue and profit projections of Dylan Co are arithmetically correct
 An assessment of the assumptions used in the projections for Dylan Co and agreement they
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are comparable with the auditor's understanding of the business
(ii) Principle audit procedures
 Compare the audited accounts of Timber, Ben and Dylan Co to the consolidation schedules to
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ensure figures have been transposed correctly.
 Verify the arithmetical accuracy of the consolidation schedule by checking it casts horizontally
and vertically.
 Review consolidation adjustments to ensure they are appropriate and comparable to the prior
l.b
year.
 Recalculate all consolidation adjustments, including goodwill, elimination of pre-acquisition
reserves, cancellation of intercompany balances, fair value adjustments and accounting policy

adjustments.
ria
Consider whether the previous treatment of Timber Co and Ben Co is still correct and that the
brought forward figures agree to prior year audited financial statements and audit working
ate
papers.
 Ensure that Dylan Co has been appropriately treated as an acquisition, and that any post
acquisition profits have been correctly included.
 Prepare a reconciliation of movements on group reserves.
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(c) Joint audit

A joint audit is one where two or more auditors are responsible for an audit engagement and jointly produce
an auditor's report to the client.
tud
Advantages
 A joint audit of Maxwell Co will result in time savings as Chien & Co can use the knowledge
accumulated by Lead & Co in previous audits (for example, on Maxwell's business, systems, controls
and prior audit issues). This is important for Chien & Co as any risks inherent in Maxwell Co could
as
affect their overall risk assessment of the group.

 Maxwell Co is expected to increase operating facilities by 40% and so will be a significant addition to
the Rosie group. As sole auditors, Chien & Co may struggle to adequately resource the audit of
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Maxwell Co as this will be at the same time as the audit of other companies in the group. A joint audit
will mean there is sufficient resource to be dedicated to all group companies.
 The audit of all subsidiaries in the Rosie group will need to be completed before the group audit
ea
starts. A joint audit will ensure that there is enough resource to meet the tight deadlines for the
individual subsidiary audits.
 Audit quality of Maxwell Co should increase as a result of a joint audit. As new auditors, Chien & Co
will be approaching the audit with a fresh outlook, unprejudiced by previous events and may be able
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to spot new issues or offer different solutions to those previously identified by Lead & Co.
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Answers 293
Disadvantages
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 A joint audit will probably be more expensive for Maxwell Co. The client should receive an improved
service to justify the increased fee but it could be argued that the cost is not necessary.
 Chien & Co may use a different audit approach and methodology to Lead & Co leading to
disagreements throughout the audit about the correct way to proceed. This could result in a loss of
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efficiencies as time is spent agreeing on the best audit approach rather than carrying out actual audit
work. If either audit firm's approach is solely followed, some of the benefits of a joint audit will be
lost.
o t.
 Lead & Co may be uncooperative as they believe they will eventually be replaced by Chien & Co as
sole auditor.
 Both audit firms are jointly liable and must both sign the auditor's report. This may make it more
sp
complicated if any litigation arises as it is harder to see where any fault lies.
56 Medix
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Top tips. This question was especially time consuming, particularly in part (a). Always make sure that you plan
l.b
your time at the start of a question and stick to it.
In parts (a) and (b)(ii) it is important to explain the risks and not just identify them. Make sure the risks are tailored
to the scenario.
but are time-consuming. ria

Easy marks. Part (b)(i) contains some easy marks for auditing concept definitions. Parts (a) and (c) are not difficult
Examiner's comments. On the whole, there were some strong answers to this question, with many excellent
ate
answers to requirement (a) in particular, with a significant minority of candidates achieving full marks in this part of
the question. However, failure to read and understand the scenario or the question requirements meant that many
answers were disappointing.
One of the main problems noted with requirement (a) is that many candidates spent too long on this section, at the
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expense of time that would have been better spent on the optional questions. Candidates should be aware that
failing to attempt four questions, as required, is unlikely to lead to success in this paper.
Requirement (b) produced the worst answers to Question 1. Most candidates attempted a definition of the two
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terms, but the discussion of the link between them was weak.
Common weaknesses in answers to (c) included:
 Failure to produce the answer in the required format – meaning that full professional marks could not be
awarded
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 Listing general acceptance considerations rather than making the comments specific to Medix
 Making comments that are wholly inappropriate to the scenario. An example of this is where many answers
urged the audit partner to 'make contact with the previous auditor to find out matters we should be aware
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of'. This shows that many candidates simply failed to read the question carefully enough, as approximately
one third of the information provided in the scenario comes from a discussion that has already taken place
with the outgoing auditor in which his reasons for vacating office were outlined.
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 Lack of prioritisation. At this level it is important to try to prioritise issues, which will then help to reach a
logical conclusion.
 Failure to reach a conclusion as to whether or not the appointment should go ahead – note that
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requirements containing the verb 'assess' should contain a conclusion. Failing to reach a conclusion
restricts the professional marks that can be awarded.
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294 Answers
Marking scheme
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Marks
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(a) Principal business risks
Generally ½ mark each risk identified
Up to 1 further mark for significant issues explained:
 Declining demand for main product and revenue/cash flow implication
o t.
 R+D represents cash drain
 Lack of management focus on long term strategy
 Breach of planning – risk of facility being shut down and bad publicity
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 Regulated industry and reliance on licence for commercial production
 Over reliance on scientist
 Reliance on agents
 Commission payments – high risk of fraud
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 Overseas manufacturing plant – hard to control and maintain quality
 High and volatile costs of importing goods
 Capital expenditure likely in near future
 Future exposure to fluctuating interest rates
l.b
 Non compliance with tax regulations – fines and penalties
 Legal action – finance director and planning office
 Weak controls, risk of fraud
 Owner-managed business
(b)
Maximum
(i) Business risk and risk of material misstatement ria
Generally ½ mark per definition and 1 mark per comment
12
ate
 Business risk leads to specific RoMM
 Business risk leads to general RoMM
 Relationship regarding going concern
Maximum 4
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(ii) Risks of material misstatement – breach of planning regulations

2 marks per risk explained (½ mark max if only identified and not
described):
 Overstatement of tangible non-current assets
 Overstatement of other assets (max 1 mark)
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 Possible understatement of provision/non disclosure of

contingency
 Possible understatement of provision for demolition costs
 Going concern (max 1 mark)
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 Reference to IAS 36, IAS 37 (½ mark each)

Maximum 6
(c) Briefing notes
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Up to 2 professional marks for clarity of discussion, style appropriate for audit

partner
2 professional marks for format, introduction and conclusion provided
1–2 marks per issue discussed
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Note. Comments must be derived from the information provided in order to be

awarded marks.
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Answers 295
Ideas list: Marks
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– Poor reputation of Medix Co
– Potential advocacy threat from frequent litigation
– Public interest in the company
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– Potential liability to lender
– Short timeframe to build business knowledge
– Aggressive management style
– Incentive to manipulate financial statements
o t.
– Poor systems and controls
– Extra work on opening balances (max 1 mark)
– Need expertise in this regulated industry
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– Fee pressure
– Creditworthiness
– Possible management fraud
– Indicator of money laundering
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– Question competence of previous auditors
Maximum 14
Total 36
l.b
Briefing notes
To:
From:
Date:
Subject:
Charles Banks
Gavin Jones
June 20X8
Medix Co
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ate
Introduction
These notes consider the professional, ethical and other issues to be considered in deciding whether to proceed
with the appointment as auditor of Medix Co. They also discuss the concepts of business risk and risk of material
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misstatement, and include a discussion of the business risks facing Medix Co.
(a) Professional, ethical and other issues
(i) Sign of fraud or money laundering
tud
Mick Evans, the current audit partner has informed us that Jon Tate, the owner and managing
director of Medix Co has kept two cash books. This requires further investigation but is a possible
sign of fraud or money laundering. This offence alone is enough for Mitchell & Co to seriously
consider rejecting the appointment.
as
(ii) Legal actions and investigations

Medix Co has recently been subject to two tax investigations, and legal action is presently being taken
by both the former finance director and the local planning department. The local planning department
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has also successfully sued the company previously. The reputation of Mitchell & Co may be damaged
by accepting a client who has been subject to so many legal actions and investigations. It is not
entirely clear from the previous auditors whether the tax investigations have now been resolved and
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as a result, there is a risk we could be exposed to an advocacy independence threat.

(iii) Negative publicity
The local newspaper recently reported on the current and past legal action by the local authorities
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against Medix Co. This negative publicity is something we may not wish to be associated with.
/fr
(iv) Timeframe and resources

Given it is now June and Medix Co has a 30 June 20X8 year end, the time frame for planning the
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audit and gaining a thorough understanding of the business and its processes is tight. Mitchell & Co
should ensure there are adequate staff available to complete the work with the necessary industry
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296 Answers
expertise before accepting this appointment. It should be noted that the previous audit partner has
stated that Medix Co like a 'quick audit'. If accepted, we should ensure that our proposed approach
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causes the least disruption to the client whilst maintaining the necessary levels of documentation and
testing required for a quality audit.
(v) Potential liability to bank
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Medix Co are in the process of negotiating a bank loan, the terms of which will be finalised once the
audited financial statements have been viewed by the bank. The bank will be using the audited
financial statements as the basis of its decision and relying heavily on our auditor's opinion. It may
o t.
be sensible to reject the audit engagement as it could expose Mitchell & Co to an unnecessarily high
level of liability to the bank, especially given that this is a time-pressured first year audit. However,
disclaimers may be sufficient to limit our liability.
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(vi) Management bias
Medix Co will be aware that the bank is basing their financing decision on the audited financial
statements. There is a risk that the company may deliberately misstate the financial statements in
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order to gain the bank's approval. Mitchell & Co will need to be aware of this risk before carrying out
any audit work.
(vii) Potentially aggressive management style
l.b
The previous finance director is currently taking legal proceeding against Medix Co and the auditors
prior to the current practice resigned due to a disagreement over fees. This indicates that
management at the company are aggressive and so it may be difficult for Mitchell and Co to form a
ria
good working relationship with them. The problem is compounded by the fact that the company is
owner-managed.
(viii) Internal systems and controls
ate
The current auditors have said they have found internal controls at Medix Co weak. Mitchell and Co
would therefore not be able to rely on internal controls or carry out a controls-based audit. A fully
substantive approach would be necessary and we should consider whether we have sufficient
resource as this is always a more time-consuming approach than a controls-based audit.
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(ix) Opening balances

As per ISA 510 Initial audit engagements – opening balances, opening balances need to be verified
for all new audit clients. Detailed procedures will need to be carried out at Medix Co due to the weak
internal control environment and the possible incompetence of the current auditor who ignored a
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potential money laundering indicator. It is worth noting that Medix Co is the only audit client of the
current auditor.
(x) Fees
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The current auditor has indicated that Medix Co may pressure us to keep the audit cost as low as
possible. We should only accept the audit engagement if the company are willing to pay us a
reasonable fee, especially given the extra work that will be required for such a high risk assignment.
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There is a chance that Medix Co will be unable to pay their audit fees as the company appears to be
experiencing cash flow difficulties. If such a self-interest threat to our independence arises we will be
unable to continue as auditors.
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(b) (i) Business risk and risk of material misstatement

Business risk is the risk inherent to the company in its operations and includes all risks facing the
business.
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Risk of material misstatement is the risk of material misstatement in the financial statements.
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In response to business risk, management institute a system of controls. These will include controls
to mitigate against the risk that the financial statements are materially misstated, which is an aspect
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of business risk.
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Answers 297
Business risks and their associated controls could affect specific or more general parts of the
financial statements. For example, the use of sales agents has been identified as a specific business
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risk at Medix Co. The associated risk of material misstatement is that sales are overstated. A more
general business risk that will affect all areas of the financial statements is the weak control
environment at Medix Co.
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If a business risk materialises, the going concern basis of the financial statements could be affected,
especially if the risk affects the continued existence of the business. For example, at Medix Co there
is a business risk that licences may not be granted for the laser surgical instruments. If the licence
o t.
was refused and the company carries on experiencing cash flow problems, there is a risk that the
financial statements could be incorrectly prepared on a going concern basis.
(ii) Risks of material misstatement – breach of planning regulations
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Tangible non-current assets overstated. From the press cutting, it appears that the local authority
aims to close the R&D building before year end. There is therefore a risk that the building is
overvalued on the statement of financial position. Under IAS 36 Impairment of assets, the directors at
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Medix Co should carry out an impairment review if there is any indication assets are impaired. If the
carrying amount exceeds the recoverable amount (the higher of fair value less costs to sell and value
in use), the building should be impaired and the impairment loss recognised as an expense.
The recoverable amount of the building is likely to be lower than the carrying value if it cannot be
l.b
used as intended. If the local authority is successful and the building is shut down, the recoverable
amount is likely to be nil. This is because the building has no value in use, cannot be used for trading,
and has no market value as it will probably be demolished.
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Other assets overstated. Any other tangible assets within the building (such as laboratory
equipment) are likely to have a carrying value that exceeds their value in use and should also be
tested for impairment. The risk of material misstatement is that their value is overstated on the
ate
statement of financial position.
Possible understatement of provision/non-disclosure of contingency. The press cutting indicates
the local authority may once again take legal action against Medix Co and so this raises the question
of whether a provision needs to be made. IAS 37 Provisions, contingent liabilities and contingent
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assets states that a provision should only be recognised if:

 An entity has a present obligation (legal or constructive) as a result of a past event
 A transfer of economic benefits will probably be required to settle the obligation
 A reliable estimate can be made of the amount of the obligation
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If the local authority instigates legal action before year end, Medix Co will need to assess the
probable outcome and whether a provision needs to be made. There is a risk of material
misstatement that no provision will be made and liabilities and expenses understated.
as
If the local authority has not started legal proceedings before year end, then Medix Co should
disclose a contingent liability in a note to the financial statements. The risk of material misstatement
is that the correct disclosure is not made.
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No provision for demolition costs. If the local authority rule that Medix Co must demolish the
building before year end, a provision should be made for demolition costs. There is a risk of material
misstatement that the company does not make the provision, leaving liabilities and expenses
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understated.
Going concern assumption is incorrect. All the above, especially the possibility that the research and
development building is shut down, may impact the viable future of the company resulting in a risk of
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material misstatement that the going concern status is incorrect.

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(c) Principal business risks

(i) Demand for main revenue stream falling. Revenue and profits at Medix Co have fallen as demand
for metal surgical instruments has rapidly declined. Medix Co makes use of the bank overdraft facility
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most months and a falling revenue will only exacerbate any cash flow problems the company has.
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298 Answers
(ii) Laser instrument R&D in early stage. Although demand for metal surgical instruments has been
falling for four years, research and development into the growing area of laser instruments has only
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just started. This suggests a short-term outlook and little investment in long-term strategy by the
company.
(iii) Little cash for R&D. Research and development is a significant cash outflow for any business. The
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monthly use of the bank overdraft indicates Medix Co are already having cash flow problems and
may find it difficult to fund R&D into laser instruments. If the company cannot invest in this area and
demand for metal surgical instruments continues to fall, there is a risk the business is no longer
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viable.
(iv) Only one scientist working on R&D. The future survival of Medix Co seems to depend on their ability
to sell laser instruments, yet the company has just one sub-contracted scientist working in this area.
Relying so heavily on one sub-contracted member of staff is a very risky strategy for a business. If
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this scientist were to leave the company, Medix Co would lose knowledge crucial for securing the
continued existence of their business. Research and development would be on hold until a new
scientist could be recruited which, given this is such a specialised role, could take some time.
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(v) R&D scientist is freelance. There is nothing to suggest that Medix Co have taken out patents on
designs from the subcontracted scientist. There is a risk that the scientist could be using the designs
while freelancing for competitors of Medix Co unless patents are taken out.
(vi) Licences. The new laser products require licences before they can be produced commercially. If
l.b
these are not granted, the future of the company could be at risk and cash invested in R&D will have
been wasted.
(vii) Use of sales agents. The commission-based sales agents are not employed by Medix Co. It may be
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in an agent's best interest to promote a competitor's products resulting in reduced revenues for the
company. Additionally, there is a risk that an unscrupulous agent could overstate sales in order to
increase his or her commission. Since the control environment has been described as weak by the
previous auditor, there is a high risk this fraud may go undetected.
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(viii) Overseas manufacturing plant. Communication difficulties generally make it harder to control
production overseas. There may be language barriers and different time zones mean it simply takes
longer for important information to be relayed or discussed. It will also be harder for Medix Co to
monitor the quality of production in an overseas plant. Quality is important for a highly regulated
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industry such as surgical instruments and inferior products could have a significant impact on sales.
(ix) Foreign currency fluctuations. The overseas plant will need to make payments in the local currency
of the country where it is based, exposing Medix Co to the risk of fluctuations in exchange rates.
(x) Air transport. Since Medix Co have chosen to import most of their products by air, they are exposed
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to fluctuations in the price of fuel.

(xi) Tax investigations. Two previous investigations by the taxation authorities indicate Medix Co may
have broken tax regulations. Any further breaches could result in serious penalties or fines.
(xii) Breach of planning regulations. If the local planning authority are successful, the extension to the
as
R&D facility will have to be demolished. This could result in a substantial delay to the crucial laser
instrument R&D as it may take some time to find suitable new premises. The local planning office
may also impose fines which could cause Medix Co further cash flow problems. The building may
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have to be impaired at year-end, and the reduced net asset position on the statement of financial
position will make it harder to generate capital. Sales could fall as a consequence of the bad publicity.
(xiii) Exposure to interest rates. The company is currently negotiating a significant bank loan which will
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carry a variable interest rate. If interest rates rise, the company will need to make increased interest
payments further aggravating the cash flow problems at Medix Co.
(xiv) Legal action by prior finance director. Medix Co could be subject to substantial costs and negative
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publicity if the legal case is lost.

(xv) Capital expenditure. The company's manufacturing plant is twelve years old and was built
/fr
specifically for the production of metal surgical instruments. Provided the R&D is successful, the
company is hoping to switch to production of laser instruments and a substantial capital outlay will
be necessary to adapt the plant. This could prove difficult for Medix Co in light of their cash flow
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problems.
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Answers 299
(xvi) Weak control environment. The previous auditors have commented that the control environment at
Medix Co is poor. Jon Tate, the managing director, seems to have a dominant management style with
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frequent disagreements and violation of tax and local planning laws. This raises the chance of
management disregard for, and override of, controls resulting in an increased opportunity for fraud
or management decisions being made on inaccurate financial information.
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Conclusion
There are several areas in which we should gather further information before making a final decision on
whether to accept Medix Co as an audit client. The information gathered so far indicates that Medix Co
o t.
would be a high risk client, and we need to consider whether we are willing to accept the engagement given
this knowledge.
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57 Yew
log
Top tips. Part (a) was a typical question on audit reports, this time mixed in with IAS 38 and some issues around
audit completion. You should have had plenty to say here; the main difficulty would have been staying within the
time limit of 21 minutes for this part of the question.
l.b
Part (b) contained just two short situations for only three marks each. The situations were fairly straightforward, so
how you did came down to your knowledge.
Easy marks. A lot of part (a) was easy – for example, stating that the treatment of the development costs was not in
line with IAS 38.
Marking scheme
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ate
Marks
(a) Yew Co
Generally up to 1½ marks for each matter discussed/recommended:
– Calculate and comment on materiality
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– No probable economic benefit – IAS 38 recognition criteria not met

– Lack of finance – IAS 38 recognition criteria not met
– Consider whether sufficient appropriate evidence obtained
– Financial statements contain material misstatement and implication for auditor's
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report
– Could indicate fraudulent financial reporting
– Lack of cash may indicate going concern problems – extend audit procedures
– Audit work should be subject to 2nd partner review
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– Consider asking for a delay in issuing financial statements if necessary for further
evidence to be sought
– Discuss apparent inconsistency in chairman's statement wording
– Discuss accounting treatment, potential qualification and chairman's statement
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wording with those charged with governance

– Include Other Matter paragraph in report if material inconsistency remains
Maximum 12
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(b) (i) Signing of audit report

– Date report when all necessary evidence received, including written
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representations
– Especially important with regard to subsequent events
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– Contrary to ISA 700 to sign report prior to receiving written representations

Maximum 3
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300 Answers
(ii) Prior year auditor's opinion Marks
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– Generally auditors do not refer to third parties in their report
– But optional to refer to predecessor auditor unless prohibited by law and
regulations
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– If reference made, should be in Other Matter paragraph
– Describe contents of reference made to predecessor auditor
– If prior year modified, explain this in Other Matter paragraph
Maximum 3
o t.
Total 18
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(a) The intangible asset is material to profit (54% of profit before tax) and to the statement of financial position
(6% of total assets).
IAS 38 Intangible assets states that for development costs to be capitalised, the existence of a market – or
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the entity's ability to use the asset itself – must be demonstrable. The audit team has obtained
documentation and a written representation which confirms that this is not the case.
IAS 38 also requires the entity to have the financial resources to bring the asset to the market. As Yew Co is
short of cash, this may not be the case.
l.b
As a result, the financial statements appear to be materially misstated, and that the $12.5m should be
treated as expenses. The matter must be discussed with management, who should be asked to amend the
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The matter should also be discussed with the chairman, as it is possible that he has different information
which could change our assessment of the situation. If this is not the case, and if the financial statements
are not amended, then the audit opinion will be qualified 'except for' a material misstatement (but one which
ate
is not pervasive).
The fact that Yew Co is finding it difficult to raise finance casts doubt over going concern. Further work may
need to be done in this area. If there is significant doubt then disclosures should be included in the financial
statements, and an emphasis of matter paragraph in the auditor's report in respect of going concern.
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If a modified opinion is expected to be expressed, then it may be necessary to consult externally on the
effects of doing this, or at a minimum subjecting the audit work to review by another partner.
Consideration needs to be given to whether the misstatement is an indication of fraudulent financial
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reporting, and a possible lack of management integrity. The fact the company is struggling to raise finance
provides a motive for it to inflate its results and statement of financial position. If this is the case, then any
written representations relied upon elsewhere in the audit must be reconsidered.
If the development costs should not be capitalised and the financial statements are amended, then there will
as
be an inconsistency with the chairman's statement. First, the chairman should be asked to amend his
statement. If this is not done then ISA 720 The auditor's responsibilities relating to other information in
documents containing audited financial statements comes into play. ISA 720 states that in these
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circumstances, an Other Matter paragraph should be included within the auditor's report.
(b) (i) ISA 700 Forming an opinion and reporting on financial statements requires that the audit report only
be signed once sufficient appropriate audit evidence has been obtained on financial statements.
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Written representations from management are audit evidence, so logically there is not sufficient
appropriate audit evidence until these are received.
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It is therefore not appropriate to sign the report and date it before these are received.
(ii) It is not generally appropriate to refer to third parties in an auditor's report, as this may give the
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impression that someone other than the auditor is responsible for the report.
However, ISA 710 Comparative information – corresponding figures and comparative financial
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statements permits reference to be made to a predecessor auditor's report; this is the auditor's own
choice.
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Answers 301
This reference should be made in an Other Matter paragraph, included directly after the Opinion
paragraph, which states that the financial statements for the prior period were audited by a
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predecessor auditor, states what opinion was expressed, and the date of their report.
58 Snipe
co
o t.
Top tips. Part (a) was deceptively simple. This was a straightforward financial reporting-based requirement, and
you should have been able to score well on it. You might have noticed that the question gave you quite a few
numbers. When a question includes numbers like this then the examiner probably wants you to do something with
them. In this case, you will almost certainly have to calculate the materiality of the issue. It is then obvious that you
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need to say whether the treatment given in the question is correct, and comment on its materiality.
Part (b) should have been straightforward, as long as you knew the formats for auditor's reports with modified
opinions, per ISA 705. It is 'bread and butter' at this level to be able to criticise an auditor's report, and the report in
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this scenario had a number of errors that you should have noticed straight away – in particular the naming of the
paragraphs, the order of the paragraphs, and the failure to quantify the misstatement.
Easy marks. There were plenty of easy marks in part (a) for applying IAS 23 to the scenario.
l.b
Examiner's comments. Candidates should have been familiar with the type of requirement found in part (a), as it
commonly features in P7. Sound answers contained a calculation and explanation of the materiality of the asset and
of the borrowing costs that had been capitalised, followed by a discussion of the appropriate accounting treatment,
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including whether the borrowing cost should be capitalised, and when depreciation in relation to the asset should
commence.
Weaker answers said that it was not possible to capitalise borrowing costs, or incorrectly thought that the
ate
construction should be accounted for as some kind of long-term construction contract. Procedures in the weaker
answers tended to rely on management representations and recalculations of every figure provided in the question.
There were some sound answers to part (b), and candidates' performance in questions of this type has shown a
definite improvement. Some answers not only identified but also provided an explanation of the problems with the
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audit report. The majority of answers suggested that an 'except for' qualification may be more suitable than an
adverse opinion, and correctly calculated the materiality of the pension plan deficit to support their discussion. A
significant proportion of answers picked up on the incorrect order of the paragraphs in the report and on the
incorrect wording used in the headings, and on the lack of explanation that had been provided in the report
regarding the material misstatement. Fewer answers discussed the inappropriate use of the phrase 'deliberate
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omission'.
The weaker answers tended to just list out bullet points with no explanation, limiting the amount of marks that
could be awarded. Other weaker answers attempted to discuss the appropriate accounting treatment for the
pension, often incorrectly.
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Marking scheme
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Marks
(a) New processing area
ea
Generally 1 mark for each matter/specific audit procedure:

Matters:
– Materiality calculation
e
– Borrowing costs are directly attributable to the asset

– Borrowing costs should be capitalised during period of construction
/fr
– Amounts are correctly capitalised

– Depreciate from September 20X1
– Additions to non-current assets should be disclosed in note
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302 Answers
Evidence: Marks
– Review of costs capitalised for eligibility
m/
– Agreement of sample of costs to supporting documentation
– Copy of approved capital expenditure budget/discuss significant variances
– Agreement of loan details to loan documentation
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– Recalculation of borrowing costs, depreciation, asset carrying value
– Confirmation of completeness of disclosure in notes to financial statements
Maximum 8
(b) Auditor's report
o t.
– Inappropriate headings
– Paragraphs wrong way round
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– Amounts not quantified
– Impact on financial statements not described
– Unclear from audit report if any accounting taken place for the pension plan
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– No reference made to relevant accounting standard
– Use of word 'deliberate' not professional
– Materiality calculation
– Discuss whether adverse opinion appropriate (up to 2 marks)
Maximum 7
l.b
Total 15
(a) Matters to consider

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At $5m, the total cost of the area is 2.9% of total assets (= 5 / 175) and is likely to be material to the
statement of financial position. The borrowing costs are less than 1% of total assets and not material to the
ate
statement of financial position. However, they represent 10% of profit before tax and are therefore material
to the statement of profit or loss.
IAS 23 Borrowing costs requires directly attributable costs to be capitalised as tangible non-current assets.
This would include the borrowing costs, which are capitalised over the period of construction. This would be
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the six months from 1 March to 1 September. The date when the asset started being used is not relevant to
this calculation.
The borrowing costs that should be capitalised over this period are stated correctly at $100,000
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(= $4m  5%  6 / 12).
Depreciation should be charged on the asset from the time it is in the location and condition necessary for it
to be operated, which in this case is also 1 September. Depreciation will be from 1 September to 31 January,
which is five months, and will be calculated using a useful life of 15 years. Thus the statement of profit or
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loss should include a depreciation charge of $138,889 (=$5m (total cost of asset including borrowing costs)
/ 15 years  5 / 12).
Evidence
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 A breakdown of the components of the $4.9 million capitalised costs (excluding $100,000 borrowing
costs) reviewed to ensure all items are eligible for capitalisation
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 Agreement of a sample of the capitalised costs to supporting documentation (eg invoices for tangible
items such as cement, payroll records for internal labour costs)
 A copy of the approved budget or capital expenditure plan for the extension
e
 An original copy of the loan agreement, confirming the amount borrowed, the date of the cash
receipt, the interest rate and whether the loan is secured on any assets
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 Documentation to verify that the extension was complete and ready for use on 1 September, such as
a building completion certificate
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 Recalculation of the borrowing cost, depreciation charge and carrying value of the extension at the
year end, and agreement of all figures to the draft financial statements
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Answers 303
 Confirmation that the additions to property, plant and equipment are disclosed in the required note to
the financial statements
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(b) Paragraph format
ISA 705 Modifications to the opinion in the independent auditor's report states that for an adverse opinion,
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the report should:
 Explain the reasons for the adverse opinion in a paragraph entitled 'Basis for Adverse Opinion'. This
paragraph is placed immediately before the opinion paragraph.
o t.
 Express an adverse opinion in a paragraph entitled 'Adverse Opinion'
The draft auditor's report for Snipe Co does not do this: both paragraphs are titled incorrectly, and are
placed in the wrong order.
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'Explanation' paragraph
The explanation of the basis for the adverse opinion is not sufficient. ISA 705 states that the matter must be
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quantified where this is practicable: the paragraph should state that the plan is in deficit by $10.5m.
The paragraph should describe the impact of this omission on the financial statements. In this case, it
should state that if the deficit had been recognised then this would increase total liabilities, and reduce
shareholders' equity, by $10.5m.
l.b
Reference should be made to the relevant accounting standard, in this case IAS 19 Employee benefits, as
this would help improve users' understanding of the misstatement.
Wording
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The explanation paragraph describes the omission as 'deliberate'. This is an unprofessional choice of words,
but more importantly it is a matter of judgement whether or not the omission is deliberate. By making this
ate
assertion, the auditor leaves himself open to the risk of litigation if the client takes this to be defamatory.
Adverse opinion?
It is open to question whether this issue alone would result in an adverse opinion. At 6% of total assets
(= 10.5 / 175) the matter is definitely material, but may not be pervasive. An adverse opinion should only be
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expressed where the misstatement is both material and pervasive.

It may be that there are other matters (eg other misstatements) that have caused the firm to express an
adverse opinion. In this case, ISA 705 requires the firm to describe all other identified matters that would
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have required a modification of the auditor's opinion.
59 Nassau Group
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Top tips. Part (a) of this question was deceptively difficult. At first sight it may appear to be a standard question on
group audits, but delve into it more deeply and you will find that it is actually relatively tricky. The key issue is
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making sense of what has already happened: the component auditor has sent you a draft report.
This report contains a qualified opinion which appears to be drafted correctly – you need to draw on your
knowledge of ISA 705 Modifications to the Opinion in the Independent Auditor's Report to make this assessment. If
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you didn't know ISA 705 well enough to do this correctly, then you might have struggled with this question.
The auditor says in the report that a provision should have been made, but in Note 12 to the financial statements,
management says that the probability of an outflow is only 20%, so no provision is necessary. The question for the
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group auditor (which is you!) is: who is right? In order to decide this, the auditor must review the audit evidence
that the component auditor based its conclusion on. If the evidence is sufficient and appropriate, then the draft
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audit report is OK; if the evidence is not sufficient and appropriate, then either further evidence must be obtained, or
the draft audit report is wrong.
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You then have to think about the matter practically: what would happen from here? If Exuma is right, then the draft
auditor's report is wrong. If the auditor is right, then Exuma may change the financial statements.
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304 Answers
If this does not happen, then the group accounts may or may not need changing, all of which will have an impact on
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the group auditor's report.
This is quite a lot of work for the ten marks on offer, and you should make sure that you do not go over time on this
part of the question. The important thing is to be scoring marks with each point you make.
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Part (b) should have made up for the difficulty of part (a). If you had revised the audit procedures on the
consolidation the most of this was just knowledge.
Easy marks. Calculating materiality in part (a) was easy – but don't just do the figures, make sure you say what you
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are doing and conclude on whether or not the matter is material to the group, and on whether the component is
significant or not.
Most of part (b) was easy, if you knew it. If not, then there is a very easy mark available for suggesting checking the
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'arithmetical accuracy' of the consolidation schedule.
Examiner's comments. Requirement (a), for ten marks, asked candidates to identify and explain the matters that
should be considered and the actions that should be taken by the group audit engagement team in forming an
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opinion on the consolidated financial statements. Most candidates gained marks by calculating the materiality of the
provision to the group and to the individual financial statements of the subsidiary. However, few determined the
materiality of the component itself to the group.
Candidates are usually happy to be critical of auditors in question scenarios, but in this case when it was actually
l.b
appropriate to raise concerns over the evidence (or lack of it) obtained to support the qualified opinion, very few
answers tackled this issue. However, some candidates did waste time criticising the extract audit report that had
been provided – this was not asked for – and implied that candidates had not read the question requirement at all.
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In relation to requirement (b), many candidates clearly knew the consolidation process very well, but had trouble
expressing this knowledge in terms of audit procedures. Many answers simply described what should happen in a
consolidation, and thought that by including the words 'check' or 'ensure' every so often that would be enough eg
'check goodwill calculation', 'ensure all subsidiaries included' but didn't actually say how these things should be
ate
done. However, despite these problems most answers were satisfactory.
Marking scheme
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Marks
(a) Matters/actions
Up to 2 marks for each matter/action identified and explained
tud
(max 3 marks for identification):

– Exuma Co is a significant component
– Matter is material to individual and group financial statements
– Accounting treatment/qualification for Exuma Co's financial statements
– Review of audit work performed
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– Consideration of further audit work

– Discuss with group management and those charged with governance
– Request that Exuma Co's management adjust financial statements
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– Adjustment could be made on consolidation

– Impact on group opinion if no adjustment made
Maximum 10
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(b) Principal procedures on consolidation

Generally 1 mark per procedure explained:
– Test controls
– Review group instructions
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– Recalculate adjustments
– Reconcile inter-company balances
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– Review fair values/consider need for expert

– Consider consistency of accounting policies
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– Recalculate deferred tax implications

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Answers 305
Marks
– Agreement to component financial statements
m/
– Consider treatment of non-controlling interests
– Arithmetical accuracy of consolidation schedule
Maximum 8
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Total 18
(a) Materiality to group
o t.
ISA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of
Component Auditors) states that a component is significant (material to a group) where a chosen
benchmark is more than 15% of the same figure for the group as a whole.
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Exuma Co's profit before tax is 20% of group profit before tax (PBT), and total assets is 23.5%. Exuma is
therefore a significant component.
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Materiality of issue
The $2m legal claim represents 50% of Exuma's PBT, and 10% of total assets.
The claim is also material to the group, at 10% of PBT and 2.4% of total assets.
l.b
Qualified opinion – Exuma
Jalousie & Co have expressed a qualified opinion on Exuma in relation to IAS 37 Provisions, Contingent
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Liabilities and Contingent Assets. Audit evidence was obtained that led the auditor to conclude that the
Note 12 to the financial statements of Exuma material misstates the probability of the claim against the
company being successful. Presumably Jalousie & Co must have obtained audit evidence that the claim's
chance of success was not 20% as stated, but was 50% or more. This would mean that a liability should
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have been recognised in accordance with IAS 37.
This misstatement is material but is unlikely to be deemed pervasive, the qualified opinion is correct
provided that the audit evidence obtained is sufficient and appropriate.
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Audit evidence
Exuma Co is material to the group, as is this specific issue. The group auditor should therefore review
Jalousie & Co's audit evidence in relation to it.
tud
The key question is the assessment of the probability of the court-case being lost, and the consequent
future outflow of $2m. The group auditor should discuss the matter with Jalousie & Co's audit
engagement partner. Audit evidence should include copies of all legal correspondence, as well as written
representations from Exuma's management regarding their accounting treatment of the matter.
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Depending on the strength of this evidence, it may have been appropriate for Jalousie & Co to have used
an auditor's expert to provide a separate legal opinion on the matter.
Further evidence
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The group auditor may determine that further audit evidence needs to be obtained, such as the opinion of
an auditor's expert is this has not been sought. This can be done either by collaboration with the
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component auditor, or by the group auditor alone.

It is possible that there is not sufficient appropriate evidence to qualify the opinion on this matter, and that
Exuma Co's management is correct. In this case, Jalousie & Co would have to redraft its auditor's report
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to show an unmodified opinion.

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Impact on group – discussion with group management

The matter should be discussed with group management in order to ascertain what the impact will be on
the group financial statements and auditor's report. There are a number of possible outcomes, examined
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below.
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306 Answers
Exuma's financial statements changed
m/
The group auditor should request that Nassau Group's management ask Exuma to adjust its financial
statements and recognise a provision. This would mean that Jalousie & Co's audit report, which has not
yet been issued, could potentially be issued with an unmodified opinion if the adjusted financial statements
are not materially misstated.
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Only group accounts changed
If Exuma's financial statements are not adjusted, then the group financial statements themselves could still
o t.
be adjusted to rectify the material misstatement. The auditor's opinion on Exuma would still be qualified,
but the group auditor's report would not be modified in relation to this matter.
No adjustment made at all
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If no adjustment is made to Exuma's or the Nassau Group's financial statements, then the group audit
opinion is qualified ('except for') due to a material misstatement. The work of the component auditor
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would not be referred to in the group auditor's report.
(b) The audited accounts of each subsidiary should be agreed to the schedules used in the consolidation
process, as figures may not have been transposed correctly. Verify that all six subsidiaries are included on
the schedule, and that the consolidation schedule agrees to the group financial statements.
l.b
The consolidation schedule should be arithmetically checked by casting and cross-casting.
All consolidation adjustments should be reviewed and recalculated, for example pre-acquisition reserves
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and goodwill for subsidiaries, along with any fair value adjustments. It will be necessary to agree
adjustments to underlying documents, eg some of the figures making up goodwill may be agreed to prior
year financial statements.
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All intercompany balances should be reconciled, and a schedule obtained of intercompany transactions to
ensure that they are eliminated from profit and loss.
Procedures should be performed to verify that subsidiary items that should be carried in the group
accounts at fair value have been, where they may be measured in the subsidiaries' financial statements on
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a different basis, eg properties which must be carried at fair value in the group, but which may be at
depreciated cost in the subsidiary.
The auditor should verify that accounting policies have been applied consistently across the group, and
that where adjustments need to be made for the group accounts these have been made correctly (eg
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because of foreign subsidiaries which operate under different financial reporting requirements).
The deferred tax consequences of consolidation and fair value adjustments should be reviewed for
completeness, and calculations re-performed for accuracy.
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60 Cinnabar Group
cc

Top tips. Part (a) to this question is relatively straightforward asking for an explanation of the auditor's responsibility
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in respect of going concern. This part of your answer is one of the few opportunities to score marks for rote-learned
knowledge. Part (b) is much more biased towards higher skills and is therefore more difficult. It is important that you
score well in part (a) to compensate for lost marks in part (b). Make sure you distinguish between auditors' and
directors' responsibilities. In part (a) it is the auditors' responsibilities which are relevant.
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In part (b) you need to take the information at face value. It is quite clear that the company is not a going concern
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so don't hedge your bets! Make sure you discuss alternative forms of the auditor's report which are relevant, rather
than every other form of auditor's report that you can think of.
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Easy marks. These are available in part (a) of the question. You should be able to score well in this section as this
part of the requirement is knowledge-based.
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Answers 307
Examiner's comments. Surprisingly few came close to scoring full marks in part (a). Most correctly stated the key
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point which was that the auditors' responsibility was to assess the appropriateness of the going concern basis
being used but few went further than this basic point. Answers to part (b) were weak and showed a clear lack of
focus and planning. Many did not take in the key facts in the question. For example, it was clear that the company
was not a going concern and the two notes provided did relate to the same issue.
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Marking scheme
o t.
Marks
(a) Explanation of auditor's responsibilities for going concern

Generally 1 mark each comment Maximum 5
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Ideas (ISA 570)
 Consider ability to continue as going concern
 Assess management's procedures
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 Gather evidence
 Document concerns
 Obtain written representation from management
 Assess disclosure
 Qualify auditor's report (as appropriate)
l.b
(b) Proposed auditor's report
Generally 1 mark a comment Maximum 10
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Ideas
 Meaning of unqualified/'T&F'
– Appropriate accounting policies (IAS 1)
– Adequate disclosure
ate
– In accordance with legislation
 Going concern – a pervasive concept
 Basis of preparation (going concern or other)
 Disclosure required (IAS 1/ISA 570)
 Sufficiency of evidence (NOT appropriate)
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 Vs material misstatement
 Materiality vs pervasive
 Unmodified (not appropriate)
 Adverse opinion (if going concern basis used)
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 Explanatory para (if additional disclosure made)

 'Except for'
Total 15
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(a) Auditors' responsibilities

These are:
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 To obtain sufficient appropriate audit evidence about the appropriateness of management's use of the
going concern assumption in the preparation and presentation of the financial statements
 To conclude whether there are any material uncertainties about the entity's ability to continue as a
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going concern, based on the audit evidence obtained

 To determine whether management has performed an assessment of the entity's ability to continue
as a going concern and if so, to evaluate this and discuss it with management. If not, to determine
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the basis for management's intended use of the going concern assumption
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 To remain alert throughout the audit for evidence that may cast significant doubt on the entity's
ability to continue as a going concern

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To consider the same period as that used by management in making its assessment. This should be
at least twelve months from the year-end date
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308 Answers
 When events or conditions have been identified which cast significant doubt on the entity's ability to
continue as a going concern, to obtain sufficient appropriate audit evidence to determine whether or
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not a material uncertainty exists. The auditor should do this by performing additional audit
procedures including:
– Requesting management to make an assessment of the entity's ability to continue as a going
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concern if they have not already done so
– Reviewing management's plans for future action and cash flow forecasts
– Considering any additional facts or information that have become available since management
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made its assessment
– Seeking written representations from management regarding its plans for future action and
their feasibility
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 Where the auditors consider that there is a significant level of concern about the ability of the
company to continue but do not disagree with the preparation of the financial accounts on a going
concern basis, to issue an unmodified opinion provided that disclosures are adequate. The auditor
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would also include an emphasis of matter paragraph.
 If the disclosures are inadequate, to issue a qualified or adverse opinion depending on the
circumstances
 If the auditor disagrees with the basis of preparation, to issue an adverse opinion on the basis that
l.b
the financial statements are seriously misleading
(b) Suitability of the auditor's report
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Unmodified report
From the information in the disclosure notes it is apparent that the company is not a going concern. However it
is not clear on which basis the financial statements have been prepared. They may have been prepared:
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 On the going concern basis: or
 On an alternative basis.
An unmodified auditor's report means that:
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 The accounts give a true and fair view

 They have been prepared in accordance with statute
If the accounts have been prepared on a going concern basis an unmodified opinion would not be
appropriate as this does not reflect the true position of the company. The results would be misleading as the
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readers would make assumptions about the company's ability to continue, which are clearly not the case. In
addition to the inappropriate basis of preparation, disclosure is inadequate as the notes to the accounts do
not highlight the significant problems the company is facing. In this respect they are not properly prepared.
If the accounts have been prepared on an alternative basis an unmodified opinion would still not be valid.
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This is due to the inadequacy of disclosure. The going concern assumption is a fundamental principle.
Readers of accounts assume the company is viable unless it is clearly stated otherwise. In this case even
though the basis of preparation is correct the lack of disclosure means that they are not properly prepared.
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Alternative opinions
The 'except for' or disclaimer of opinion would not be appropriate irrespective of the basis of preparation as
the issue is not one of uncertainty. The company has liquidated assets and we are told that the company has
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ceased to trade in October.

If the financial statements have been prepared on a going concern basis an adverse opinion should be
expressed. This would be due to a material and pervasive misstatement as a result of the basis of
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preparation. For example assets and liabilities are likely to be misclassified as non-current, when they should
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be classified as current. The opinion would be adverse as the misstatement is pervasive to the overall true
and fair view.
If the accounts have been prepared on an alternative basis reflecting that the company is not a going
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concern, for example the break-up basis, provided that this has been applied correctly the auditor would
agree with this treatment.
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Answers 309
However a qualified 'except for' auditor's opinion should be issued on the grounds of a material
misstatement in respect of the adequacy of the disclosure regarding the basis of preparation.
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61 Poodle
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Top tips. Part (a) was quite a nice question part. You could perhaps have written lots here, in which case it would
o t.
have been important to have stuck to your time allocation of 12 minutes. Make sure that you address each part of
the requirement – including eg further procedures necessary.
Part (b) was perhaps complicated by a possible confusion over whether Terrier was a subsidiary of Poodle. Its dog-
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related name may have suggested that it was, but the examiner's answer indicates that it was not. The fact that
'trade receivables' and 'trade payables' were referred to may be taken to indicate that the transactions were not
group transactions.
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Part (c) was another nice question, provided of course that your technical knowledge was of a sufficient standard. It
was right at the very end of this exam paper, which is testament to the importance of sticking to your timings –
otherwise you may have missed out on easy marks here.
Easy marks. Calculating materiality in parts (a) and (b). There are also easy marks for describing the 'Basis for
l.b
Qualified Opinion' paragraph whenever the opinion is modified – many candidates miss out on these.
Examiner's comments. Many candidates chose to attempt this question, which focussed on audit completion and
audit reports, despite clearly having very little knowledge and understanding of audit reports. Performance tended
to be weak on this question overall.
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On requirement (a), most candidates explained how an adjustment should be made at Group level and that if not
made, the audit opinion should be qualified due to material misstatement. Some answers insisted, incorrectly, that
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the adjustment should be made in the subsidiary's individual financial statements. The fact that the audit evidence
so far obtained was insufficient was not always identified, and only a minority of answers suggested the further
audit procedures that should be conducted.. Some answers were confused about the impact on the opinion and
suggested various options including adverse, disclaimer or in some cases, both.
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In respect of requirement (b), many candidates correctly identified this as an adjusting event after the reporting
period, and determined that the amount was highly material. Some answers tended to focus on the going concern
status of both companies, or suggested that the matter should be disclosed in both sets of financial statements but
not adjusted for. Comments on the audit opinion were also mixed here, with many incorrectly stating that the issue
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should be highlighted in an emphasis of matter paragraph if not adjusted by Group management.

Very few candidates considered the issues of (a) and (b) in aggregate. This was important because in aggregate the
potential adjustments had a significant impact on Group results, and a discussion of whether this would result in an
adverse opinion was relevant. Candidates are encouraged to always look at the bigger picture and even though the
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scenarios are described separately, they should at some point in the answer be considered collectively. Very few
answers went beyond discussing the impact on the audit opinion. However the question asked for impact on the
audit report, so marks were available for describing the structure and content of the basis of opinion paragraph as
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well as the opinion itself.

Turning to requirement (c), while there were some sound answers from candidates who clearly understood the
implications, unfortunately in many answers there was little else to be said, indicating a lack of knowledge of the
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auditor's responsibilities in relation to other information published with the financial statements, or the impact of
such a misstatement on the auditor's report. Many answers suggested the use, incorrectly, of an emphasis of
matter paragraph, but more suggested that there would be no impact at all on the auditor's report, and that the
chairman's statement was nothing to do with the auditor's responsibilities.
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310 Answers
Marking scheme
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Marks
Audit completion and procedures
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Audit completion, adjustments necessary, additional audit procedures,
implications for auditor's report
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Generally up to 1 mark for each point assessed/procedure recommended:
(a) Toy Co
– Potential provision is material to Group accounts (calculation)
– Group accounting policy should be applied
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– Adjustment needed to operating profit and current liabilities
– Recommend additional procedures (1 mark each)
– Material misstatement if not adjusted and qualified opinion
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– Describe 'Basis for Qualified Opinion' paragraph
Maximum 7
(b) Trade receivable
l.b
– Potential impairment of receivables is material to Group accounts (calculation)
– Account for as an adjusting event
– Adjustment needed to operating profit and current assets
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– Recommend additional procedures (1 mark each)
– Material misstatement if not adjusted and qualified opinion
Potential adjustments in aggregate
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(marks can be awarded either in answer to (a) or (b))
– In aggregate, the two matters almost wipe out profit before tax
– Could be considered to be pervasive to financial statements leading to adverse
opinion
– Must be discussed with those charged with governance
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Maximum 7

– Auditor required to read other information which includes the draft
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chairman's statement
– Other information should be consistent with financial statements
– Inconsistencies undermine the audit opinion
– The draft chairman's statement contains a misstatement of fact regarding revenue
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– Review audit work performed on revenue

– Request draft chairman's statement to be amended
– If inconsistency remains, the auditor's report to include an Other Matter paragraph
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– Consider speaking at meeting of shareholders regarding the inconsistency

Maximum 6
Total 20
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(a) Implications
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The value of the claim is material to the group financial statements, at 25% of group profit before tax
(= $0.5m ÷ $2m).
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The treatment in Toy Co's individual financial statements appears correct in line with the local financial
reporting framework. However, these financial statements must be restated in accordance with IFRS for
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consolidation into the group accounts.

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Answers 311
According to IFRS, a provision should be recognised. This is because there is a probable outflow of
resources which can be measured reliably. The omission of the provision means that the financial
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statements are materially misstated.
Procedures
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Verbal evidence is not sufficient for the group audit, and Toy Co's legal advisors should be asked to provide
a written statement that, in their opinion, it is probable that damages will have to be paid.
As this is a material matter which could result in a qualified auditor's opinion, further evidence surrounding
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the claim should be obtained. The claim itself should therefore be reviewed, along with any board minutes
discussing the claim.
Report
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The Group should be asked to adjust the group financial statements for the claim, and it should be explained
to them that if the adjustment is not made then a qualified opinion will be expressed.
The Group's reluctance to make changes, taken together with the impending deadline for releasing the
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financial statements, represents a significant intimidation threat to the auditor's independence. This may call
into question the integrity of the management and the reliability of its written representations.
If the financial statements are not adjusted then the auditor will express a qualified 'except for' opinion on
l.b
the grounds that the financial statements are materially misstated.
The misstatement is not pervasive as it appears to be confined to one specific area of the financial
statements, so an adverse opinion is not necessary.
(b)
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The auditor's report should include a paragraph headed 'Basis for Qualified Opinion' immediately before the
Opinion paragraph, in which the reasons for the qualification are described.
Implications
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The trade receivable is material to the group financial statements, at 2.8% of total assets and 80% of profit
before tax.
ISA 560 Subsequent Events requires the auditor to consider evidence obtained after the year end and before
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the issuance of the auditor's report. The notice constitutes evidence that the receivable is impaired at the
year end; the insolvency of Terrier is therefore an adjusting event.
The receivable is impaired by $1.44m (= $1.6m × 90%), which should be recognised as follows.
Dr Operating expenses $1.44m
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Cr Trade receivables $1.44m

Procedures
A copy of the notice from Terrier's administrators should be obtained to confirm that the company is
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insolvent and that 10% of the debt will be received.

Obtain written confirmation from the administrators regarding the expected timing of the payment.
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Bank receipts post-year end should be reviewed for evidence of the payment being received. However, given
when the notice was received and the tight deadline for the auditor's report, it is not likely that amount will
have been received.
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Report
If the financial statements are not adjusted, then the auditor's opinion will be qualified 'except for' in relation
to this issue.
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Aggregate effect on financial statements

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The overall effect of the provision and the impaired receivable is to reduce net profit by $1.94m, which
would reduce profit before tax to just $60,000.
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It could reasonably be argued that this is a pervasive misstatement, as it affects multiple areas of the
financial statements and is highly material to profit before tax.
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312 Answers
In this case, an adverse auditor's opinion should be expressed.
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The auditor's report should include a paragraph headed 'Basis for Adverse Opinion' immediately before the
Opinion paragraph, in which the reasons for the adverse opinion are described.
(c) Implications
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The chairman's statement is other information, which ISAs require the auditor to read. The auditor is looking
for material inconsistencies with the audited financial statements, which may undermine the credibility of the
financial statements and the auditor's report.
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The chairman's claim that revenue has risen by 20% is materially inconsistent with the financial statements,
which indicate a rise of 5.9%.
Procedures
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ISAs require the auditor first to determine which of the chairman's statement and the financial statements
needs to be amended.
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It will be necessary to review the audit evidence obtained on revenue to ensure that it is sufficient and
appropriate.
Explanation should be obtained from the chairman of how his figure of 20% was arrived at, as it is possible
that this will shed further light on the real figure for revenue. If no further information comes to light and the
l.b
chairman's statement is incorrect, then he should be asked to amend it.
Report
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If management refuses to amend the other information then the auditor's report must be modified to include
an Other Matter paragraph. This would not affect the auditor's opinion, which would be unmodified in this
respect (although it may be modified in other respects, as discussed in parts (a) and (b)).
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This paragraph should be presented immediately after the opinion paragraph, and should describe the
material inconsistency clearly.
The matter should be communicated to those charged with governance. It may be necessary for the auditor
to speak at a shareholders' meeting in order to explain the reasons for including the Other Matter paragraph
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in the report.
62 Dexter
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Top tips. You would have required a good knowledge of going concern to score well in part (a) of this question.
Part (b) required you to come up with some practical and commercial reasons why directors would be reluctant to
include a note to the financial statements addressing the going concern issues the company was facing. Part (c)
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demanded a methodical approach, looking at all possible outcomes for the auditor's report. Reporting is a topic
which is regularly is examined in this exam so make sure you know and understand the different auditor's reports.
Easy marks. This was a relatively straightforward question with a strong emphasis on technical knowledge in parts
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(a) and (c). Provided you knew and could apply the basic principles, these sections were not complicated.
Examiner's comments. Requirement (a) asked candidates to 'compare and contrast the responsibilities of
management, and of auditors, in relation to the assessment of going concern'. The main deficiency in answers to
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this requirement was the lack of any kind of comparison of the responsibilities of management and auditors,
despite the fact that the requirement began with 'compare and contrast'. The other problem was that many
candidates did not restrict their answer, as requested, to the assessment of going concern, but digressed into
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issues such as corporate governance and maintaining shareholder value.

Requirement (b) asked candidates to consider why the directors may be reluctant to provide such a note. Many
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answers were provided here. However, some candidates failed to provide more than a couple of reasons, which is
not enough for the mark allocation.
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Answers 313
Requirement (c) was rarely well answered, and many candidates obviously do not understand the different types of
modifications to auditor's reports at all, let alone the implication for the auditor's report of non-disclosure of going
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concern issues. There was a tendency in (c)(i) to go straight for an adverse opinion, without any discussion of the
level of significance of the non-disclosure. There was also confusion over the use of an adverse opinion and a
disclaimer of opinion. Some candidates put down all possible types of auditor's opinion as their answer in the hope
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that one of them would be correct. In (c)(ii) very few candidates suggested that the auditor should consider the
adequacy of the note if the directors agree to provide one. In this advanced audit paper it is inexcusable that
students do not know these basic facts about the auditor's report. Candidates should also remember that writing
one or two sentences is unlikely to be sufficient to answer an eight mark question requirement.
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Marking scheme
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Marks
(a) Compare and contrast management and auditors' responsibilities regarding going
concern
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Generally 1 mark per explained point
Maximum mark to be capped at 4 where no attempt made to explain similarities or
differences
Maximum 7
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(b) Reluctance to disclose note
– Directors fear they will be held accountable for problems
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– Trigger further financial distress as necessary finance is withheld
– Trigger operational distress due to reactions of suppliers and customers
– Trigger operational problems if key members of staff leave
– Directors may genuinely feel that the financial and operating problems do not
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impact on going concern status
Maximum 5
(c) (i) Auditor's report implication – note not provided

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– Breach of IAS 1 leading to material misstatement

– Opinion could be qualified or adverse
– Judgement needed
– Report to refer to material uncertainty
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Maximum 4
(ii) Auditor's report implication – note provided
Generally 1 mark per comment
– Review adequacy of disclosure
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– If note is sufficient – no breach of financial reporting standards –

unmodified opinion
– Emphasis of matter paragraph to highlight uncertainties
– If note inadequate – qualify 'except for' material misstatement
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Maximum 4
Total 20
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314 Answers
(a) Responsibilities of management and auditors in relation to going concern
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IAS 1
ISA 570 Going concern discusses the responsibilities of management and auditors in relation to the going
concern assumption. It explains management's responsibilities with regards to going concern are detailed in
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IAS 1 Presentation of financial statements. This standard requires management to make an assessment of
an entity's ability to continue as a going concern. If management becomes aware of material uncertainties
casting significant doubt on the entity's ability to continue as a going concern, these must be disclosed.
Management should also disclose if the financial statements are not prepared on a going concern basis and
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if so, the basis on which they are prepared and the reason the entity is not regarded as a going concern.
The auditor is responsible for obtaining sufficient, appropriate evidence about the appropriateness of
management's use of the going concern assumption in the financial statements. Based on the evidence
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collected, the auditor must conclude whether there is a material uncertainty about the entity's ability to
continue as a going concern and then determine the implications for the auditor's report.
Therefore, the main responsibility of management is to assess the entity's ability to continue as a going
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concern, use the correct basis of presentation and make the correct disclosures in the financial statements.
The auditor is responsible for providing an opinion on whether management have fulfilled these obligations
and collecting enough evidence to support this.
Indicators
l.b
Both management and auditors use a range of indicators in making an assessment of going concern. They
will both look at financial indicators, such as adverse key financial ratios, and also operating indicators, for
example the emergence of a highly successful competitor. Management use indicators as part of their day to
analytical procedures.
Procedures
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day management of the business, while auditors do so in order to understand the business and carry out
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Auditors are required to carry out additional procedures if events or conditions are identified that cast
significant doubt on the entity's ability to continue as a going concern. Specifically, these procedures
include:
 Requesting management to make an assessment of going concern if it has not already done so
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 Evaluating management's future plans in relation to the going concern assessment

 If management have prepared a cash flow forecast and this is significant, evaluating the reliability of the
underlying data and underlying assumptions
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 Considering facts or information which have become available since management's assessment
 Requesting written representations from management regarding their plans for future action and the
feasibility of these plans
Management are not required to carry out any additional procedures if there is doubt the entity will continue
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as a going concern. However, they should look into and respond to any difficulties as part of good
governance.
Timing
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As per ISA 570, the auditor shall remain alert throughout the audit for audit evidence of events or conditions
that may cast significant doubt on the entity's ability to continue as a going concern. Similarly, management
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should consider going concern in their ongoing management of the business. The auditor covers the same
period as management in the evaluation of management's assessment of going concern.
(b) Reasons why directors are reluctant to provide a note to the financial statements
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Directors accountable
The directors at Dexter Co may not want to highlight the difficulties the company is experiencing as they will
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be held directly responsible by shareholders and other stakeholders. Even if the problems are a result of an
external force, such as a new competitor, the directors could still be held accountable and will want to
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protect their own interests.

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Answers 315
Trigger further financial distress
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Dexter Co is currently trying to raise finance to cover its operating cash flows. The likelihood of being able to
raise this finance is reduced by including the note in the financial statements as potential lenders will be
concerned about non-repayment. Additionally, it could cause existing lenders to recall their funds early as
they too are worried about the company's ability to pay in the future. The directors may therefore be
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concerned that the note may only exacerbate any financial difficulties Dexter Co is suffering.
Operational problems – customers and suppliers
The directors could be concerned that including the note in the financial statements would lead to operating
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problems, worsening the current situation. Suppliers may choose to withdraw business if they are
concerned about Dexter Co's ability to pay. Customers may be worried that the company will close leaving
them without supplies at short notice and so choose to go elsewhere.
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Operational problems – loss of staff
Employees at Dexter Co may decide to find alternative employment rather than risk redundancy. The
directors may fear that the inclusion of the note will cause valued employees to leave and have a negative
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impact on the business.
Directors do not think going concern is impacted
The directors could genuinely feel the going concern status of the company is not impacted by the problems
l.b
it faces. The directors may believe that they are likely to secure the finance they require to cover their cash
flow difficulties and so the future of the company is secure.
(c) Implications for the auditor's report
(i) The directors refuse to disclose the note
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According to IAS 1, management must disclose any material uncertainties related to events or
conditions that may cast significant doubt upon the entity's ability to continue as a going concern.
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Working papers from the audit of Dexter Co indicate there is significant doubt over the going concern
status of the company. If the directors refuse to include the note, then IAS 1 has not been adhered to.
The auditor will need to modify the auditor's report to express either a qualified or an adverse
opinion, depending on how significant they believe the omission of the note to be. If they believe that
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the non-inclusion of the note is so material and pervasive that a qualification would not be adequate
to disclose the misleading nature of the financial statements, then they should express an adverse
opinion. If the auditors believe that the lack of note is not so material or pervasive that an adverse
opinion is required, then a qualified 'except for' opinion will be adequate.
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A statement that there is a material uncertainty which casts significant doubt on the entity's ability to
continue as a going concern will also need to be included in the auditor's report.
(ii) The directors agree to disclose the note
If the directors include the note and the auditor believes that the use of the going concern
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assumption is appropriate but that a material uncertainty exists, then certain provisions of ISA 570
Going concern will apply. The auditor will need to review the note to ensure that it adequately
describes the cash flow difficulties which have cast significant doubt on Dexter Co's ability to
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continue as a going concern and how management intends to deal with these. He will also need to
ensure the note clearly discloses there is a material uncertainty casting significant doubt on Dexter
Co's ability to continue as a going concern.
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If the auditor find that adequate disclosure is made in the note, then he should express an unmodified
opinion and include an emphasis of matter paragraph in the auditor's report. This paragraph should
highlight the cash flow difficulties Dexter Co is experiencing and that these cast significant doubt on
the entity's ability to continue as a going concern. It should also draw the reader's attention to the
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disclosure note in the financial statements.

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If the auditor finds that the note does not make adequate disclosure in line with IAS 1, then a
qualified or adverse opinion should be expressed as in (i).
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316 Answers
63 Johnston and Tiltman
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Top tips. This question is straightforward if you are comfortable with ISA 510 as part (a) is worth a third of the
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marks for explaining the auditor's responsibilities in initial engagements. Part (b) is trickier as you need to apply
your accounting and auditing knowledge to the question. However, don't be put off by this part of the question;
instead, take each issue in turn and consider materiality and accounting treatment and then the impact on the
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auditor's report. By taking a methodical approach, you should be able to score reasonably well.
Easy marks. These are available in part (a) of the question if you are familiar with ISA 510 Initial audit engagements
– opening balances.
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Examiner's comments. In part (a) the requirement was to explain the auditor's reporting responsibilities specific to
initial engagements. However many candidates did not read the question and produced an answer that related to
new engagements and pre-acceptance procedures. Where answers were answered by considering ISA 510, marks
were not awarded for detailing audit work to verify the balances. In part (b), candidates did not score marks for
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calculating inappropriate materiality figures. Other weaknesses included copying out information from the question,
dealing with issues that had no bearing on the auditor's report, taking a scattergun approach and assuming that an
emphasis of matter was a universal solution.
l.b
Marking scheme
Marks
(a) Auditor's reporting responsibilities for initial engagements
Generally 1 mark each point of explanation
Ideas (ISA 510)
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Sufficient appropriate evidence
 Opening balances
 Prior period's closing balances
 Appropriate accounting policies
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If insufficient  inability to obtain sufficient appropriate audit evidence

 Modified opinion ('except for')
 Disclaimer
 If permitted, qualified/disclaimed on results
(unqualified on financial position)
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Material misstatement  modified opinion/adverse

 Misstatement not properly accounted for
 Inconsistent accounting policies
Prior period modification
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 Modify again if still relevant

(b) Implications for auditor's reports
Generally ½ mark each implication and 1 mark each comment Maximum 10
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Ideas
 Materiality of Tiltman to Johnston
(i) Inventory overvaluation
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 Non-compliance
 Materiality to Tiltman
 Prior year report unmodified  auditor concurred?
 Prior period adjustment needed
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Answers 317
Marks
(ii) Restructuring
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 Materiality to Tiltman
 Constructive obligation?
 Reverse unless employees validly expect
 Disclose non-adjusting event
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 Risk of goodwill overstatement
 Non-compliance
 Not a contingent liability of Johnston
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Overall
 Adjustments needed in Tiltman  unmodified Tiltman (also
Johnston)
 Materiality (combined effect) to Johnston
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 Adjust on consolidation  unmodified Johnston
 No adjustments  'except for' (material misstatement)
Total 15
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(a) Auditor's responsibilities for initial engagements
The auditor must obtain sufficient, appropriate audit evidence that the opening balances do not contain
l.b
misstatements that materially affect the current period's financial statements. The auditor must obtain
evidence that the prior period's closing balances have been brought forward correctly to the current period
or have been restated, if appropriate. The auditor should also obtain sufficient, appropriate audit evidence
properly accounted for and adequately disclosed.

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that appropriate accounting policies are consistently applied or changes in accounting policies have been
If this evidence cannot be obtained, the auditor's report should include a modified opinion (inability to obtain
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sufficient appropriate audit evidence) or a disclaimer of opinion or, in those jurisdictions where it is
permitted, a modified opinion or disclaimer of opinion regarding the results of operations, and an
unmodified opinion on the financial position.
If the opening balances contain misstatements that could materially affect the current period's financial
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statements, the auditor should inform the client's management and the predecessor auditor. If the effect of
the misstatement is not properly accounted for and disclosed, a qualified or adverse opinion will be
expressed.
If the current period's accounting policies have not been consistently applied to the opening balances and
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the change not accounted for properly and disclosed, a qualified or adverse opinion will be expressed.
If the prior period's auditor's report was modified, the auditor should consider the effect of this on the
current period's accounts. If the modification remains relevant and material to the current period's accounts
then the current period's auditor's report should also be modified.
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An Other Matter paragraph should be included in the auditor's report in the case of the prior period financial
statements not having been audited at all, or having been audited by another auditor. This is irrespective of
whether or not they are materially misstated, and does not relieve the auditor of the need to obtain sufficient
appropriate audit evidence on opening balances.
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(b) (i) Inventory should be valued at the lower of cost and net realisable value in accordance with IAS 2
Inventories. The overvaluation of $2.7 million was identified in the year ended 30 September 20X7
and should have been written off then. It should not be written off over three years.
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Inventory is therefore overvalued by $0.9 million in the year ended 30 September 20X8. This
represents 5.6% of Tiltman's total assets and 129% of the profit before tax and is therefore clearly
material. In the prior year, inventory would have been overvalued by $1.8 million, so the reported
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profit then should actually have been a loss.

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The prior period's auditor's report was unqualified, implying that the previous auditor either agreed
with the accounting treatment, or else issued an inappropriate opinion on the financial statements for
the year ended 30 September 20X7. A prior period adjustment is required in accordance with IAS 8
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Accounting policies, changes in accounting estimates and errors, so the comparative figures for the
preceding period should be restated in the financial statements, and an adjustment made to the
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318 Answers
opening balances of reserves for the cumulative effect, as well as being disclosed appropriately in the
notes to the accounts.
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(ii) A provision for $2.3 million has been made in Tiltman's accounts for the redundancies and non-
cancellable lease payments that would result from the restructuring. This represents 14% of the total
assets for the year and is very material.
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According to IAS 37 Provisions, contingent liabilities and contingent assets, a provision should only
be recognised if an entity has a present obligation (legal or constructive) as a result of a past event, it
is probable that a transfer of economic benefits will be required to settle the obligation and a reliable
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estimate can be made of the amount of the obligation.
In this case, it is unlikely that there was a present obligation at the date of the statement of financial
position, given that Tiltman was acquired sometime in September 20X8 and therefore very close to
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the end of the reporting period. Furthermore the provision for restructuring costs should only be
recognised if a formal plan had been prepared and a public announcement made of the plan. If this
had not happened, the provision should not have been recognised in the accounts for the year ended
30 September 20X8. The restructuring should, however, be disclosed in the accounts for the year
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ended 30 September 20X8 as a non-adjusting event in accordance with IAS 10 Events after the
reporting period.
Effect on the auditor's report of Tiltman
l.b
If the adjustments required in respect of the two issues discussed above are made to the accounts, then the
auditor's opinion for Tiltman should be unqualified. However if the amendments are not made, the auditor's
opinion will be qualified on the grounds of a material misstatement. This would be an 'except for'
qualification as the matters are not pervasive to the accounts.
Effect on the auditor's report of Johnston
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If the adjustments required to the financial statements of Tiltman are made then the auditor's opinion on the
financial statements of Johnston will also be unqualified. If the adjustments are not made, they could be
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made on consolidation of Tiltman to avoid a qualification of the opinion on the financial statements of
Johnston. However, an 'except for' qualification would result on the financial position if these adjustments
were not made upon consolidation, but the results of operations would be unqualified.
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64 Lychee
Study text references. Chapter 8.
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Top tips. Part (a) should have been straightforward, provided that you had a good grasp of the material. As usual, a
good answer to this part would have a clear structure. It is often a good idea to start with a definition of the term,
and then explain what that definition means by referring to specific circumstances – in this case, evens occurring
up to the date of the auditor's report, facts discovered after the date of the report, and so on. The examiner is
attuned to the fact that weaker students tend to only be able to make general statements, whereas stronger students
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make specific, accurate statements that are clear about what they are saying. Make sure that your comments are
specific, and avoid rambling!
Part (b)(i) contained some easy marks for knowing the financial reporting implications of a proposed restructuring
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after the year end. The examiner has previously written an article in which she emphasised the importance of
financial reporting knowledge for the P7 paper, so take note! Generally speaking, the financial reporting found in P7
is not going to be as intricate as in P2, but if you don't revise it then you are depriving yourself of the easy marks to
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be found in questions like this one.

Although the financial reporting marks here were easy, the audit marks here were not. Many students would have
struggled to think of enough procedures to make it up to six marks here. What is important in this situation is
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making sure that the procedures you suggest are specific. Notice that the marking scheme only awards marks here
'per specific procedure provided'. The examiner frequently complains that most students are able to write things
/fr
like 'look at the board minutes', but that to get the marks a student would need to be more specific, saying
something like 'verify the approval both of the restructuring plan itself and of the announcement of the plan by
reviewing board minutes'. Being specific in what you write can help you turn your general ideas of what the audit
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procedures might be into actual marks.

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Answers 319
You should have been able to pass part (b)(ii) easily, as this is a major area of the syllabus and you should know it
well. Whenever a question asks you to 'recommend action', the main thing an auditor can do is modify/qualify the
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auditor's report. Marks were therefore available just for identifying the type of modification/qualification, the effect
on the opinion, and then the fact that the auditor's report should contain a description of the reason for the
qualification.
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Easy marks. If you know their names and numbers properly, the ½ mark for referring to the accounting and
auditing standards are easy. The mark in part (b) for just defining subsequent events is easy.
Examiner's comments. Unfortunately, despite the majority of candidates attempting this question, performance
o t.
was on the whole unsatisfactory. Requirement (a) was a fairly factual requirement, asking for an explanation of the
auditor's responsibility in relation to subsequent events. It was obvious that some candidates had studied
ISA 560 Subsequent Events, and those that had done so performed well on this requirement. However, the majority
of candidates clearly knew very little about ISA 560 (making it therefore surprising that they would pick to attempt
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this question), leading to answers which almost exclusively focussed on the financial reporting requirements of
IAS 10 Events After the Reporting Period, while other answers simply listed the various types of auditor's reports
that could be issued in relation to a variety of subsequent events.
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In requirement (b)(i), although some candidates wrote at length, few performed well on this requirement. The main
problems were:
 Incorrect or absent materiality calculations
l.b
 Identifying the event as both adjusting and non-adjusting according to IAS 10, eg stating that the event is
non-adjusting but that a provision should be recognised in the statement of financial position
 Failing to provide any audit procedures at all, other than 'discuss with management'

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Writing at length about going concern issues – though this may be a consideration, the question clearly
states that the factory in question is being closed and relocated, so there is no hint that the company is
insolvent or that operations are likely to cease
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Requirement (b)(ii) asked candidates to recommend the actions to be taken by the auditor if the financial
statements were not amended. The approach taken by many candidates here was to list every possible type of
modification or qualification to the auditor's report, in the hope that one of them would be a correct answer. This
displays a complete lack of understanding of the impact of non-amended financial statements, which is a crucial
area of knowledge for this syllabus. It also indicates a lack of professional judgment skills. Marks are not awarded
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to candidates who attempt to 'hedge their bets' in this manner.
Marking scheme
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Marks
(a) Auditor's responsibility in relation to subsequent events
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– Definition of subsequent events

– Responsibility divided into three distinct periods
– Active duty up-to-date auditor's report issued
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– Examples of procedures up-to-date of auditor's report

– Procedures to be as near to date of report as possible
– No active duty after date report issued
ea
– Facts discovered before financial statements issued – discuss with

management/reissue auditor's report if financial statements revised
– Facts discovered after financial statements issued – discuss with
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management/issue new auditor's report/need emphasis of matter/take legal advice

Maximum 6
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320 Answers
(b) (i) Audit procedures in respect of announcement of restructuring Marks
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1 mark per specific procedure provided:
– Non-adjusting event after the reporting date
– 1 mark for calculation/consideration of materiality which can be awarded in
either (b)(i) or (b)(ii)
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– IAS 10 requires note to financial statements
– Obtain copy of announcement and review for details
– Confirm date of approval and announcement of restructuring
o t.
– Read minutes of board meetings where the restructuring was discussed
– Agree numerical disclosures to supporting documentation
– Consider completeness of the amount disclosed
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– Discuss/review potential note to financial statements
Maximum 6
(ii) Action to be taken if amendments not made
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Marks to be awarded as follows:
1 mark for each comment:
– Material misstatement
– Except for opinion
l.b
– Description of reason for qualification
– Report to those charged with governance
– Raise at AGM
Total
Maximum
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16
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(a) A subsequent event is any event occurring after the date of the financial statements being audited. The
question for the auditor is whether these have been accounted for properly in accordance with
IAS 10 Events after the reporting date.
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ISA 560 Subsequent events divides this into three periods.

Events occurring between the date of the financial statements and the date of the auditor's report
The auditor has an active duty to perform audit procedures to identify events all the way up to when the
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auditor's report is signed.

Procedures would include asking management whether any such events have occurred, or reviewing board
minutes in order to identify events. Examples of enquiries that might be made of management are: has the
entity made any new commitments, borrowings or guarantees? Have any equity or debt instruments been
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issued? Have any assets been destroyed? Have there been any events or developments regarding
contingencies, estimates or provisions?
Facts discovered after the date of the auditor's report but before the financial statements are issued
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The auditor has no active duty to perform procedures (or make enquiries) during this period. However, if it
does discover any facts that require the financial statements to be amended, then it should enquire how
management intends to address them in the financial statements that are issued.
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If this happens and the financial statements are amended, then the auditor should perform extended
procedures on the amendments, and issue a new auditor's report on the amended financial statements.
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Facts discovered after the financial statements have been issued

Again, the auditor has no active duty to perform procedures during this period. As before, if something is
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discovered then it should discuss with management how this is going to be addressed. If management then
amends the financial statements, a revised auditor's report should be issued including an Emphasis of
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Matter paragraph discussing the amendment. If management does not amend the financial statements but
the auditor thinks that they should, then the auditor needs to take legal advice in the relevant national
jurisdiction to prevent reliance on the auditor's opinion.
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Answers 321
(b) (i) The restructuring does not relate to conditions at the reporting date, so under IAS 10 this is not an
adjusting event. IAS 10 requires that this event be disclosed in the financial statements, usually by
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way of a note explaining the event and its financial effect.
Audit procedures would include:
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 Verifying that management have included a note disclosing this event in the financial
statements, and that it is drafted in line with IAS 10
 Agreeing the estimated cost of the closure to underlying calculations and supporting
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documentation, such as staff employment contracts
 Reviewing the announcement for details, and agree these details to the disclosures made in
the financial statements
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 Reviewing board minutes for details of the plan and to verify that it has been approved by the
board
 Discussing the reasons for the plan with management and consider whether it is consistent
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with the auditor's knowledge of the business
(ii) If the financial statements are not amended then they are not in accordance with IAS 10. Considering
the materiality of the cost of closure:
l.b
$250,000
Based on revenue: = 1.67%
$15m
$250,000
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Based on profit: = 8.3%
$3m
$250,000
Based on assets: = <1%
$80m
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The cost of closure is material to the statement of profit or loss, so non-disclosure of this event is a
material misstatement. In line with ISA 705 Modifications to the Opinion in the Independent Auditor's
Report, the auditor should express a qualified 'except for' opinion, as the misstatement is material
but not so pervasive as to render the statement of profit or loss meaningless.
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The auditor's report should contain a paragraph discussing the reasons for the modified opinion, in
which the auditor would explain the nature of the costs not disclosed, state the financial effect of the
costs and state that this is in breach of IAS 10. It would also be helpful for the auditor to state that
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this does not affect profit for the year, but is a disclosure only.
65 Grimes
as

Top tips. Part (a) was a very straightforward knowledge requirement, and you should have found it easy. If you didn't,
you need to make sure you are comfortable with modified auditor's reports, as they are absolutely fundamental to the
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P7 syllabus. Part (b)(i) should also have been straightforward, provided you had revised thoroughly. Part (b)(ii) is a
good example of a question that would have been quite easy if you have been reading around the syllabus, but perhaps
would have been more difficult if you hadn't.
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Easy marks. You should be able to score well in part (b)(i), as this was mainly knowledge, and on (a)(ii), evaluating
the potential impact on the auditor's report – although when this question was actually set, many candidates did not
do well on this part of the question.
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322 Answers
Examiner's comments. This question focussed in part (a) on the requirements of ISA 706 Emphasis of Matter
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Paragraphs and Other Matter Paragraphs in the Independent Auditor's Report. This is an ISA which was revised and
redrafted under the IAASB's Clarity Project, and unfortunately many candidates did not seem aware of the new
requirements. The requirement was for candidates to define an Emphasis of Matter (EOM) and an Other Matter
(OM) paragraph and to provide examples of their use.
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On the whole candidates dealt well with the EOM paragraph, usually giving a good definition and providing several
examples of its use, the most common being in relation to going concern. Many candidates scored the maximum
six marks for this part of the requirement.
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OM paragraphs were not well understood by most candidates. Many incorrectly suggested that it should be used to
explain a qualification of the auditor's opinion, and often no examples of its use were provided. Very few candidates
scored more than half of the four marks available.
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Requirement (b)(i), for four marks, asked candidates to explain four methods that could be used by an audit firm to
reduce risk exposure to litigation claims. On the whole this was answered quite well with a good proportion
receiving maximum marks. However, some candidates failed to explain the methods, and just listed them out in
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bullet points, restricting the credit that could be awarded.
Requirement (b)(ii), for six marks, asked candidates to assess the potential implications for the profession of audit
firms signing a liability limitation agreement with their audit clients. Answers varied tremendously in quality here –
some candidates discussed a range of issues in a reasonable amount of detail, while others produced only list of
l.b
bullet points (eg 'poor quality', 'reputation suffers'). Most candidates could at least identify and briefly explain the
issues of reduced public confidence and reduced quality of audit service provided.
Marking scheme
ria Marks
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(a) (i) EOM paragraph
1 mark each point made – maximum of 2 marks for definition:
– Highlights a fundamental matter
– Audit opinion not qualified
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– Sufficient evidence obtained

– EOM to refer to place matter discussed in financial statements
1 mark each example:
– Uncertainty/going concern, new accounting standard adopted,
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catastrophe
Maximum 6
(ii) Other matter paragraph
1 mark each point made – maximum of 2 marks for definition:
– Communicate a matter not presented in the financial statements
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– Matter relevant to users understanding of audit

– Matter relevant to other reporting responsibilities of the auditor
1 mark each example:
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– Regulatory need, reporting on more than one set of accounts,

restriction of use of audit report
Maximum 4
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(b) (i) Methods of reducing exposure

Up to 1 mark for each method
– Client screening
– Engagement letter
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– Adherence to ISAs and other regulation

– Quality control
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– Disclaimer paragraphs
Maximum 4
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Answers 323
Marks
Implications of liability limitation agreements
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(ii)
Up to 1½ marks each:
– Audit quality
– Less confidence in financial statements
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– Pressure to reduce fees
– Distort audit market
Maximum 6
Total 20
o t.
(a) (i) An Emphasis of Matter (EoM) paragraph is a paragraph in the auditor's report that is appropriately
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presented or disclosed, but which is so important that special emphasis is needed for users.
An EoM is different from a modification to the auditor's opinion. An EoM paragraph does not modify
the opinion; indeed, it should state clearly that this is the case. An auditor should only include an EoM
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if s/he has sufficient appropriate audit evidence that the matter is not materially misstated.
The EoM should provide a clear reference to the matter, and to where the appropriate disclosures and
other information can be found in the financial statements.
l.b
Examples of when an EoM may be used include:
 An uncertainty relating to the future outcome of exceptional litigation
 Early application of a new accounting standard that has a pervasive effect on the financial

statements
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A major catastrophe that has had a significant effect on the entity's financial position
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 Significant going concern issues
(ii) An Other Matter (OM) paragraph has in common with the EoM the fact that it does not modify the
auditor's opinion. However, whereas the EoM refers to a matter within the financial statements, an
OM refers to information that is rightly not present in the financial statements, but which is so
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important for users' understanding of them that it needs to be highlighted in the auditor's report.
Examples of situations include:
 Law, regulation or generally accepted practice may require or permit the auditor to elaborate on
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matters that provide further explanation of the auditor's responsibilities or report.

 The auditor may be reporting on more than one set of financial statements (eg a set of
statements prepared under national reporting framework, and a set of statements prepared
under International Financial Reporting Standards).
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 Any restrictions on the distribution of the auditor's report

The OM is thus a means for the auditor to communicate with users, and should state explicitly that
the matter referred to is not required to be included in the financial statements.
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(b) (i) An audit firm's exposure to litigation claims can be reduced by a number of methods.
Client acceptance procedures
ea
Firms should accept only those clients that carry a low enough risk of litigation for the firm to
manage, given its resources. Screening procedures should be used to identify factors that create
potential exposure, for instance, a new client with going concern problems is likely to carry more risk
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than one without such problems.

Performance of audit work
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Firms should make sure that all audits are carried out with professional standards and best practice,
adhering to the requirements of ISAs. It is crucial in particular that proper documentation is kept, as
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this will be useful in the event of litigation.

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324 Answers
Quality control
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Firms should implement quality control procedures in line with guidance contained within ISQC 1
Quality Controls for Firms that Perform Audits and Reviews of Financial Statements, and Other
Assurance and Related Services Engagements and ISA 220 Quality Control for an Audit of Financial
Statements. This includes both firm-wide procedures and those related to individual assignments.
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Issue of appropriate disclaimers
There is a risk of a legal duty of care arising to a third party even if the auditor is unaware of this
duty. Disclaimers may be used in an attempt to restrict the auditor's duty of care to shareholders, but
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there is no guarantee that they will be effective in law.
(ii) Liability limitation agreements carry several possible implications for the audit profession.
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Audit quality
A key argument against these agreements is that auditors will not be as concerned with the quality of
their work if they know that the consequences of failure are limited.
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Value of audit opinion
If audit quality is reduced, then the auditor's opinion will be relied upon less by users, and will be less
valuable.
Audit fees
l.b
If auditors are exposed to less financial risk, then they are likely to come under pressure to reduce
the reward (in the form of fees) they get for doing so.
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Competition
It is possible that bigger firms will be able to take on more risk than smaller firms, and thus set a
higher liability cap, making them more competitive. This could increase the gap between the bigger
and smaller firms, and thus reduce competition in the market.
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66 Pluto
ym

Top Tips. Part (a) was straightforward, and you should have been looking to score close to maximum marks here.
Note that you don't need to write as much as this model answer contains. Write your best points first, and make
sure that you don't go over your time allocation – which is very easy to do on a requirement that you know well.
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Part (b) was a difficult but fair requirement. Owing to the limited space the examiner has for questions like this, they
will not have included much information that is not relevant. You should therefore think carefully about everything
in the auditor's report as there is likely to be at least one thing you can criticise about it. Go through it sentence by
sentence and think about anything that might be wrong with it. It should go without saying here that you need to
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have a deep understanding of the different types of modified reports and the circumstances in which they apply.
Part (c) would have required you to think on your feet a bit, but you should have been able to do enough to at least
pass this part – provided that you had not gone over your time in the other parts of the question. The key thing here
is to be specific in your matters to be considered, so for instance don't just say that the reviewer needs to be
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'independent', but try to think about what the specific threats to their independence might be.
Easy marks. The knowledge marks available in part (a) for explaining 'fraudulent financial reporting' were easy.
ea
There were also some easy marks available in part (b), for example for pointing out that the opinion should not have
been adverse.
Examiner's Comments. The final question of the paper focussed on auditor's reports, and fraudulent financial
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reporting, which had been discussed in a recent examiner's article. Requirement (a) asked for an explanation of the
term 'fraudulent financial reporting', with some examples to illustrate the explanation. Answers on the whole were
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reasonable, and in terms of illustration, a range of examples were usually provided. Answers to part (b) were on the
whole unsatisfactory. As noted in previous examiners' reports, candidates seem not to understand the concepts
underpinning the qualification of an auditor's report, and have even less comprehension of the use of an emphasis
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of matter paragraph. Looking initially at the adverse opinion, most candidates correctly suggested that a material
misstatement had indeed occurred, and that an adverse opinion may be too harsh, meaning that an except for
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Answers 325
qualification would be more suitable. Most candidates did not appraise the wording of the extract, but there were
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easy marks to be gained here. The best answers rightly criticised the use of the word 'feel' in an auditor's report, as
well as it being inappropriate to put forward the views of the directors in the report. Regarding the emphasis of
matter paragraph, a significant proportion of candidates did not attempt this part of the requirement. Those that did
gained credit for briefly explaining the correct use of such a paragraph, but fewer went on to say why its use in this
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situation was inappropriate.
Requirement (c) asked for an explanation of the matters to be considered in deciding who is eligible to perform an
engagement quality control review for a listed client. Answers tended to be very brief, often in a bullet point format.
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The majority of answers mentioned that it should be a partner with experience who should perform the review.
Though most candidates could suggest that the reviewer should be independent of both the audit team, and the
audit client, few could suggest why.
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Marking scheme
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Marks
(a) Fraudulent financial reporting
Generally 1 mark per comment/example:
l.b
– Material misstatement in financial statements
– Deliberate/intentional
– Manipulation of underlying accounting records
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– Misrepresentation/omission in financial statements
– Misapplication of IFRS
– Earnings management
Maximum 4
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(b) Critical appraisal of auditor's report
Up to 1½ marks per issue explained:
Adverse opinion:
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– Inadequate explanation of material misstatement

– No financial impact given
– Clearer title needed
– Better to refer to IAS 37 in full
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– Clearer reference to note needed

– Explanation of material misstatement should be in separate paragraph
– Should it be except for rather than adverse?
– No reference to impact on statement of financial position
Emphasis of matter:
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– Refers to a breach of financial reporting standards

– Except for material misstatement
– EOM not used for this situation
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Maximum 9
(c) Eligibility to perform an engagement quality control review
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– Technical expertise
– Experience
– Authority
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– Independence from audit team

4
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Maximum
Total 17
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326 Answers
(a) There are two aspects to fraudulent financial reporting. Firstly, it involves misstatements in the financial
statements, either by misstating the information they contain or by omitting information from them.
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Secondly, like all fraud it is not a result of error but of a fraudulent intention. It is the intentional creation of
misstatements in the financial statements.
This falls into three general categories:
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 Manipulation, falsification or alteration of accounting records/supporting documents. An example of
this would be changing the date on a sales invoice so as to manipulate the year-end cut off for
revenue.
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 Misrepresentation (or omission) of events, transactions or other significant information in the
financial statements. An example of this might be failing to include a provision for a future liability.
 Intentional misapplication of accounting principles. An example of this could be misapplying
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IAS 23 Borrowing Costs so as to include interest payments as an expense when they should be
capitalised.
Such fraud may be carried out by overriding controls that would otherwise appear to be operating
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effectively, for example by recording fictitious journal entries or improperly adjusting assumptions or
estimates used in financial reporting.
Aggressive earnings management is a topical issue and, at its most aggressive, may constitute fraudulent
financial reporting.
l.b
(b) Adverse opinion paragraph
The auditor's report does not take the form recommended by ISA 705 Modifications to the opinion in the
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independent auditor's report. The Pluto Co auditor's report contains one section that includes both the
reasons for the auditor's opinion and the auditor's opinion itself. ISA 705, however, requires that there be
two paragraphs, the first entitled simply 'Basis for adverse opinion', and the second 'Adverse opinion'. The
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opinion paragraph should not state the reason for the opinion in its title. The presentation offered in the
Pluto Co auditor's report could be confusing for readers.
There are also some difficulties with the paragraph itself. It is not appropriate for the auditors to give the
argument offered by the directors for not recognising the provision. Details of the directors' view should be
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available in the note to the accounts referred to. The auditor's report should then be giving the auditor's
opinion as to why this constitutes a material and pervasive misstatement.
This leads onto another problem. There is an insufficient amount of detail given regarding the misstatement
itself. It is not enough simply to refer to a note to the accounts, as this note would give details of the
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director's judgement. The auditor's report should refer to a specific note in the accounts, and state why this
is a misstatement. In this context, the word 'feel' is inappropriate to describe the auditor's judgement in an
auditor's report, and may be indicative of a lack of rigour on the part of the auditor. A related point is that the
full name of IAS 37 Provisions, contingent liabilities and contingent assets should be given, as omitting it
could be confusing to readers.
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The paragraph states that the profit for the year is overstated, but it does not say by how much, and does
not discuss the effect on the statement of financial position, where liabilities are understated. An estimate
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should be given of the financial effect of omitting the required provision. After all, it is as a result of their
view that such an estimate can indeed be made that the auditor disagrees with Pluto Co's treatment. The
auditor's report should then also give further details, such as the timings of the probable cash outflow.
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However, perhaps the most important point is that the adverse opinion given may not be correct. An adverse
opinion should be given only when a misstatement is so pervasive that the financial statements are rendered
meaningless by it, but this misstatement would appear to relate to the specific matter of the omission of a
provision. It may be that a modified opinion of the type 'except for' would have been more appropriate.
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Emphasis of matter paragraph

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Non-disclosure of the earnings per share figure is a material misstatement, as per IAS 33 Earnings per
share, it is material by nature. As a listed company, Pluto Co must disclose both basic and diluted EPS
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irrespective of whether or not it feels it to be distorted by discontinuing operations. If it feels this to be the
case, it should simply say so in its directors' report.
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Answers 327
As this is a material misstatement, the auditor's report should be qualified in respect of it. An 'except for'
qualification would appear to be the most appropriate, as the matter is material but not pervasive. A
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paragraph discussing this misstatement should be inserted, in which its financial effect would be quantified
– which in this case would probably mean disclosing the EPS figures.
(c) There are four key matters to consider:
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Technical knowledge
The reviewer must have a high level of technical knowledge if they are to help identify errors in auditing
techniques used, and in the financial reporting in the accounts. They should also have knowledge of any
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relevant industry-specific regulations, such as stock-exchange listing requirements.
Experience
The review should have a substantial amount of audit experience, ideally in the same industry as the client
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being audited.
Independence
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The reviewer should be independent of the engagement team. The key threat is to their objectivity, so care
must be taken to ensure that they are fully independent, for example by limiting the extent to which the
reviewer's perspective is influenced by any discussions with the audit engagement partner.
Authority
l.b
The review should have sufficient authority within the firm for their criticisms to carry weight, and for them
not to be afraid of criticising work done by the engagement team. They would normally need to be at least a
senior manager, but for listed clients a partner would be required.
67 Cleeves ria
ate
Top tips. In this question, part (a) is knowledge-based and you should be able to score well if you are familiar with
ISA 250 Consideration of laws and regulations in an audit of financial statements. In part (b)(i), ensure you go
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through the auditor's report extract carefully as there are seven marks available here. Part (b)(ii) should be fairly
straightforward for three marks so make sure your points are succinct to score well. Note that the requirement in
part (b)(i) asks you to appraise the auditor's opinion for both years.
Easy marks. These should be available in part (a) of the question on ISA 250. Part (b)(ii) should also be
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straightforward for three marks on the impact on the auditor's report of the group financial statements.
Marking scheme
Marks
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(a) Auditor's reporting responsibilities for reporting non-compliance

Generally 1 mark each point of explanation Maximum 5
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Ideas (ISA 250)

– Meaning of non-compliance
To management
ea
– Communicate with those charged with corporate governance

– Timing
– Level of authority
To users of the auditor's report
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– Material
– Not properly reflected  material misstatement 'except for'/adverse
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– Insufficient evidence  limitation 'except for'/disclaimer

To enforcement authorities
– Normally precluded by confidentiality
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– Duty may be overridden

– Take legal advice/consider public interest
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328 Answers
Marks
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(b) (i) Appropriateness of Parr & Co's auditor's opinion
Generally 1 mark a comment Maximum 7

Ideas
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– Auditor's opinion heading
o What is it? ('adverse')
o Reason
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– Reference to notes giving more detail is appropriate
– Non-compliance (IAS 36) – material misstatement
– 'Profit or loss' vs loss – inconsistency
– IAS 36 title should be in full
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– Information is light on detail
o Effects not quantified – but should be quantifiable (maximum being
carrying amount of non-current assets identified as impaired)
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o Why unable to quantify? – inability to obtain sufficient appropriate
audit evidence?
o Non-current assets vs tangible and intangible (what intangible
assets?)
l.b
– Why adverse? vs 'except for' – not pervasive
– Prior year
o ISA 710 Comparative information – corresponding figures and
comparative financial statements
o Not new (no 'as previously reported')
(ii) Implications for auditor's opinion on Cleeves ria
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Generally 1 mark an implication/comment thereon Maximum 3
– Request adjustment in subsidiary's financial statements  unqualified
– Adjust on consolidation  unqualified
– No adjustment  'except for'
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– Disclosure name of other auditor

Total 15
(a) The auditor is not responsible for preventing non-compliance with laws and regulations. However, the
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auditor does have some responsibilities for reporting non-compliance to management, users of the accounts
and to the regulatory and enforcement authorities.
The auditor should, as soon as practicable, either communicate with those charged with governance at the
client or obtain audit evidence that they are appropriately informed regarding any cases of non-compliance.
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If the auditor believes the non-compliance to be intentional and material, he should communicate the
findings as soon as possible. However, if the auditor suspects that senior management at the client,
including the board of directors, are involved, he should report to the next higher level of authority, such as
an audit committee or supervisory board. If this does not exist or the auditor believes his report will not be
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acted upon or is unsure who to report to, he should consider seeking legal advice. In the case of suspected
money laundering, it might be more appropriate to report the matter directly to the relevant authority.
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If the auditor concludes that the non-compliance gives rise to a material misstatement, he should issue a
qualified or adverse opinion. If the auditor is prevented from obtaining sufficient audit evidence to assess
whether non-compliance that might be material or not has occurred or is likely to have, he should express
an unmodified opinion or a disclaimer on the basis of an inability to obtain sufficient appropriate audit
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evidence. If the auditor is unable to determine whether non-compliance has occurred because of limitations
imposed by circumstances rather than by the entity, he should consider the effect on his auditor's report.
/fr
If the auditor becomes aware of an actual or suspected non-compliance which gives rise to a statutory duty
to report, he should make a report to the relevant authority without delay (subject to compliance with
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legislation relating to 'tipping off').

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Answers 329
(b) (i) The title of the opinion section does not clarify whether the opinion is unqualified or qualified.
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The quantitative effects of the failure to recognise the impairment losses have not been set out in the
report, but they should have been – the report simply states that they would increase the loss and
reduce the value of non-current assets if they had been recognised.
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The wording of the opinion indicates that it is an adverse opinion but it is unlikely that this would be
the case – it is more likely to be a modified opinion rather than an adverse opinion if the reason for it
is that impairment losses on non-current assets have not been recognised. Without any
quantifications of the amount involved it is not clear why the auditors consider the matter to be
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'pervasive'.
The title of IAS 36 Impairment of assets should be given in full in the report.
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It is not clear from the wording of the report whether the qualification is on the grounds of material
misstatement or an inability to obtain sufficient appropriate audit evidence. The first sentence
suggests a material misstatement but later in the report, it states that the directors have not been
able to quantify the amounts and this seems to indicate an inability to obtain sufficient appropriate
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audit evidence.
The prior year opinion was qualified on the same basis so the current year report should also be
qualified for the comparatives. This prior year qualification should be referred to in the current year
l.b
auditor's report.
(ii) Howard Co is material to Cleeves. Therefore a modified auditor's opinion on the financial statements
of Howard Co may also affect the consolidated financial statements of Cleeves if the adjustments
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required in Howard Co's accounts are material to the group accounts. If they were immaterial, there
would be no impact on the group auditor's opinion.
If the adjustments required in Howard Co's accounts are made, then there would be no implication
ate
for the auditor's report on the consolidated financial statements. However, if the adjustments are not
made, then it is likely that the auditor's opinion for the consolidated financial statements of Cleeves
would be 'except for'.
68 Blod
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Top tips. In part (a)(ii) make sure that you explain why the matters you have identified have been included. Only
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half a mark is available for each matter identified but a further two marks are available for an explanation.
Easy marks. Part (a)(i) was straightforward and should have gained you two easy marks.
Examiner's comments. Part (a) required candidates to identify the main purpose of including management letter
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points (often referred to as 'findings from the audit') in a report to those charged with governance, and provided a
brief scenario, from which candidates needed to recommend matters that would be included in such a report.
However, some candidates simply repeated facts from the scenario and provided very little comment of their own
as to why the matters they identified should be included.
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Marking scheme
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Marks
(a) (i) Purpose of including findings from the audit in a report to those
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charged with governance

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 Formal communication of key audit matters

 Recommendations made to management
Maximum 2
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(ii) Findings from the audit

Generally ½ mark for identification and up to 2 marks for explanation
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330 Answers
 Capital expenditure controls
o Not material to financial statements
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o But indicates serious deficiency which could allow fraud
to occur
o Recommendations to help management reduce
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business risk
 Internally generated brand name
o Financial statements materially misstated
o Give technical detail to non-financial directors
o t.
o Report to state opinion will be modified unless brand
derecognized
o Management have full facts and can decide whether to
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amend
 Paperwork delays
o Audit inefficiencies and possible increased audit fee
o Management to realise problems caused and react
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Maximum 7
(b) Preparation of financial statements
l.b
 Typing service not prohibited
 But could be seen as part of preparation of financial statements
 For listed client risk is increased
 Safest option to refuse/service could be provided if significant
(c)
safeguards in place
Maximum
Liability disclaimer paragraph
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ate
1 marks for each point
 Content of disclaimer
o Report intended for use by company's members as a whole
o No responsibility accepted to third parties
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o Commonly used but not required by standards

 Advantages
o Potential to limit liability exposure
o Clarifies extent of auditor's responsibility
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o Reduces expectation gap

o Manages audit firm's risk exposure
 Disadvantages
o Each legal case assessed individually no evidence that a
disclaimer would offer protection in all cases
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o May lead to reduction in audit quality

Maximum 5
Total 17
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(a) (i) Purpose of including findings from the audit in a report to those charged with governance
ea
Guidance on 'findings from the audit' or management letter points can be found in
ISA 260 Communication with those charged with governance and ISA 265 Communicating
deficiencies in internal control to those charged with governance and management.
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The purpose of such communication is:

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 To ensure key findings from the audit have been brought to the attention of those charged
with governance and that this has been documented
 To provide recommendations to those charged with governance so they can take appropriate
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action and fulfil their responsibilities, for example in improving internal controls
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Answers 331
(ii) Findings from the audit
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Capital expenditure controls
Purchase of an asset costing $225,000 has not been authorised indicating a deficiency in the controls
over tangible non-current assets.
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Reason for inclusion
The asset is not material for the purpose of the audit ($225,000 / $78m = 0.3% of total assets).
However, the breach in control should still be brought to the attention of those charged with
o t.
governance as it represents a business risk to Blod Co. The risk of fraudulent purchases is greater
where there is a lack of controls over the purchase of non-current assets. This should be explained in
the report to those charged with governance at Blod Co along with recommendations of how the
controls over capital expenditure could be improved.
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Internally generated brand name
An internally generated brand name has been recognised on the statement of financial position. This
is in contravention of the treatment permitted under IAS 38 Intangible assets. The asset is material as
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it represents 13% of total assets ($10m / $78m).
Reason for inclusion
There is a material misstatement in the financial statements which, if unchanged, would result in a
l.b
qualified auditor's opinion. Under ISA 260, the auditor should communicate any expected
modifications to the auditor's report to those charged with governance. The report to those charged
with governance should state that if the financial statements are not modified the auditor's report be
qualified with an 'except for' opinion due to material misstatement. The report should clearly explain
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the permitted IAS 38 treatment and why Blod Co is in breach of this, bearing in mind that the readers
may not be from a financial background. Once the full facts have been given, Blod Co should be given
an opportunity to amend their financial statements and discuss the correct treatment of internally
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generated brands.
Paperwork delays
Documentation of inventory was not available for the auditors on a timely basis. This seems to have
been a consequence of poor organisation.
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Reasons for inclusion

Those charged with governance at Blod Co should be made aware that the audit was delayed as a
result of the late receipt of the inventory documentation. It may be necessary for the firm to bill for
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the extra time. In future, management should make an effort to ensure that documentation is, as far
as possible, readily available to the auditor.
(b) Preparation of financial statements
Preparation of financial statements for clients is allowable however a self-review threat exists where an
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audit firm prepares financial statements and then audits them. There is also a risk that the audit firm may
undertake or be perceived to undertake a management role. Safeguards should be in place to ensure the
risk is reduced to an acceptable level in this situation. For example, staff members other than the audit team
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should be responsible for typing the financial statements.

The IESBA Code of Ethics for Professional Accountants prohibits the preparation of accounts or financial
statements for clients that are public interest entities, unless an emergency arises as the threats to
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objectivity and independence are too high. Unless Blod Co are able to show an emergency situation has
occurred, the audit firm should decline Uma Thorton's request to type the financial statements.
(c) Liability disclaimer paragraph
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Content
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 The report is intended to be used only by the company's members as a body.

 The report is not to be relied upon by any third party.
 Not required by any auditing standards therefore no prescribed content
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332 Answers
Advantages
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 Reduces exposure of the audit firm to liability claims from anyone other than the company or the
company's body of shareholders
 Could help to bridge the 'expectation gap' by clarifying the responsibility of the auditor
 Audit firms can manage their risk exposure in an increasingly litigious environment
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Disadvantages
 Every legal case is unique, and although a disclaimer might protect the audit firm in one
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circumstance, it may not offer any protection in another
 Could encourage low quality audits as there should be no need for a disclaimer if the audit is of a
high enough quality
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69 Axis & Co
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Top tips. This is a fairly straightforward question on auditor's reports, split into three mini scenarios. For each one,
you need to comment on the suitability of the proposed auditor's report, and in any cases where you disagree, you
need to state what modification should apply instead. You should be very comfortable with the topic of auditor's
l.b
reports having studied it in-depth in your previous auditing studies.
The best way to approach this question is to look at each scenario in turn, pulling out the relevant points and
commenting on them. Your answer should conclude with an assessment of the suitability of the proposed auditor's
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report and an alternative where you disagree. Use your financial reporting knowledge to help you where possible.
The mark allocation for each part will assist you with how much time to spend on each scenario – generally about
eight or nine minutes on each one.
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Easy marks. Since auditor's reports should be very familiar to you now, you should be able to score well in this
question, provided your answers are logical and well presented.
Marking scheme
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Marks
Auditor's reports proposals
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Generally 1 mark each comment on suitability and 1 mark each conclusion

(alternative, if any)
Ideas
(a) Change in accounting policy – inadequate disclosure Maximum 6
(b) 'Other information' (ISA 720) Maximum 4
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(c) Subsequent event (ISA 560) Maximum 5

 Misstatement vs inability to obtain evidence
 Material vs pervasive
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 Statutory/professional requirements
 Relevant IFRSs (IASs 1, 8, 36, IFRS 3)
 Disclosure (adequate?) => misstatement
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 Evidence (sufficient?) => inability to obtain sufficient appropriate

audit evidence
 Validity of senior's argument/justification
 Alternative proposal => Conclusion
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Total 15
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Answers 333
(a) Lorenze Co
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The company has changed its accounting policy for goodwill during the year and failed to disclose this in the
financial statements. In accordance with IAS 8 Accounting policies, changes in accounting estimates and
errors, the change in policy should be disclosed in the accounts.
co
An unmodified opinion on the financial statements with the inclusion of an emphasis of matter paragraph is
therefore not suitable as the opinion should be modified on the grounds of a misstatement regarding
disclosure – depending on the materiality of the issue, the modification would either be qualified ('except
for') (if material) or adverse (if pervasive).
o t.
(b) Abrupt Co
Although the auditors are not required to provide an opinion on other information in documents containing
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financial statements, they are required to read the other information and consider its consistency with the
accounts in accordance with ISA 720 The auditor's responsibility in relation to other information in
documents containing audited financial statements.
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There is a material inconsistency between the financial statements and what is stated in the directors' report.
It is the directors' report that contains the misstatement. If the directors refuse amend their report so that it
is consistent with the accounts, then although an unmodified opinion on the financial statements can be
issued, an Other Matter paragraph should be included in the report to highlight this inconsistency.
l.b
(c) Jingle Co
A wholly-owned subsidiary of Jingle has commenced trading on 7 July 20X8, subsequent to Jingle's year
end. It is not clear whether the company was incorporated prior to 30 June 20X8.
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The auditors should obtain more information about Bell. It should be possible to obtain details about its
registration from the companies' registry. If this information is unavailable, this would represent an inability to
obtain sufficient appropriate audit evidence in respect of which the auditors would have to qualify their auditor's
ate
opinion in respect of it.
If the company was incorporated after 30 June 20X8, it requires disclosure in the financial statements as a
non-adjusting event after the end of the reporting period. If these disclosures are not made, the auditors
would have to qualify the auditor's opinion for 20X8 due to a misstatement regarding the disclosure.
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However, assuming the subsidiary was accounted for correctly in the 20X9 financial statements, the 20X9
auditor's report would be unaffected.
If the company was incorporated before 30 June 20X8 then the subsidiary needs to be consolidated in
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Jingle's financial statements and the relevant disclosures have to be made. If this is not the case, then the
auditor's opinion for 20X8 would have to be qualified over a misstatement in respect of the accounting
treatment of the subsidiary Bell. This would also result in the 20X9 auditor's opinion having to be qualified
over the same issue if it was not corrected, as the problem would affect the comparative financial
information in the following year.
as
70 Dylan
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Chapter references. Chapters 4 and 17.

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Top tips. Part (a)(i) on auditor's reports was a fairly difficult question in this area. You should have known that
either a qualified opinion or a disclaimer of opinion would be issued, but the difficulty comes from the fact that you
cannot be entirely sure from the information given in the question.
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Notice that there are marks available here for actions such as communicating with those charged with governance
before issuing a report with a modified opinion. The examiner likes this kind of point because it shows that you are
/fr
thinking practically about what would happen, rather than simply reciting your knowledge about the different kinds
of audit opinions. There are also usually marks available for the format of any modified report, eg stating that there
should be a 'basis for modification paragraph', what the paragraph should say, and that it should be immediately
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before the opinion paragraph.

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334 Answers
Part (a)(ii) required you to have noticed that the company was listed, and that an engagement quality control
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reviewer was necessary. However, even if you had missed this, you still could have thought to yourself, 'What
quality controls would be relevant to this engagement?' A review of the audit file before the audit report is issued
should have been at the top of your list!
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Part (b) was straightforward, as long as you were familiar with the reporting requirements for review engagements
of this sort.
Easy marks. There were easy marks for calculating and applying materiality in part (b).
o t.
Examiner's comments. In requirement (a)(i), most candidates correctly discussed that fact that the auditor was
unable to obtain sufficient, appropriate audit evidence based on the reconstructed records, leading them to explain
that the audit opinion should be disclaimed. Fewer candidates suggested that alternative procedures could be used
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to obtain evidence, and fewer still recognised that as the accounting records were available for eleven months of the
year, the audit report may not necessarily be subject to a disclaimer of opinion, or even qualified at all if alternative
procedures could take place.
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On requirement (a)(ii), sound answers appreciated that because the client in the scenario was listed, an
Engagement Quality Control review would be required, and the answers that described what such a review would
entail achieved the maximum marks. Most answers were too general however, simply describing the quality control
procedures that would be relevant to any audit. Many answers were extremely brief, with little more than a sentence
l.b
or two provided.
Most answers to requirement (b) were good at discussing the accounting treatment for the warranty provision, that
the non-recognition was not appropriate, and the majority correctly assessed the materiality of the issue. Answers
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were inadequate in discussing the impact of this on the review report, being mostly unable to say much more than
the auditor would need to mention it in the review report. There seemed to be a lack of knowledge on anything other
than the standard wording for a review report, with many answers stating that the wording should be 'nothing has
come to our attention' followed by a discussion that there actually was something to bring to shareholders'
ate
attention but with no recommendation as to how this should be done.
Marking scheme
ym
Marks
(a) (i) Actions and implications in respect of the auditor's report on Dylan Co
Up to 1½ marks for each action/implication
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– Insufficient appropriate audit evidence so far obtained

– Possible to extend audit procedures on reconstructed figures/other procedures
– Majority of transactions during the year likely to have sufficient evidence
– If no further evidence available, consider modification to opinion
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– Discuss whether material or pervasive

– Description of audit report contents if opinion modified
– Communicate with those charged with governance
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Maximum 7
(ii) Quality control procedures
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Up to 1 mark for each comment:

– EQCR required as Dylan Co is listed
– EQCR to review sufficiency and appropriateness of evidence obtained
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– EQCR to consider judgement used in forming audit opinion

– EQCR to ensure matters communicated to those charged with governance
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Maximum 3
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Answers 335
(b) Interim financial statement review Marks
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Up to 1½ marks for each matter to be considered in forming conclusion/implication for
report:
– Interim financial information should use applicable financial reporting framework
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– Identify and explain unrecognised provision
– Correct calculation of materiality (1 mark)
– Communicate necessary adjustment to management/those charged with governance
– If amount unadjusted, the conclusion will be qualified
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– Reason for qualified conclusion to be explained in the report
– Consider withdrawing from engagement/resign from audit appointment
Maximum 6
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Total 16
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(a) (i) Actions
We have not performed audit procedures on payroll, revenue and receivables, and have not obtained
sufficient appropriate audit evidence as yet.
l.b
Hendrix Co has reconstructed the figures 'as far as possible', which means that they could still be
materially and pervasively misstated. In any event, their representation is not sufficient audit
evidence.
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It may be possible to perform procedures on the information that Hendrix Co has reconstructed. This
could obtain evidence about revenue and payroll. Receivables could still be tested by a
circularisation.
ate
It is not clear, however, what records may still be in existence: Hendrix Co may have sent information
to Dylan Co during the year. As the virus attack only happened in August, Dylan Co could have 10 or
11 months' information on which it might be possible to perform audit procedures.
As a listed company, Dylan Co may have issued interim financial statements, which could provide
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accounting information for part of the year that could be audited.

Practically, it may be necessary to request an extension to any deadlines for completion of the audit.
Auditor's report
tud
It is possible that additional procedures may obtain sufficient appropriate evidence, in which case an
unmodified report could be issued.
If this evidence is not obtained, then either a qualified opinion will be expressed, or the auditor will
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disclaim an opinion.
A qualified opinion would be expressed if the auditor judges that the inability to obtain sufficient
appropriate audit evidence is material but not pervasive. The auditor would then state that the
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financial statements give a true and fair view 'except for' the areas where there is insufficient
evidence – payroll, revenue and/or receivables.
A disclaimer of opinion would be made if the problem is both material and pervasive.
ea
Further actions
The details of any potential modification should be communicated in advance to those charged with
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governance, who should be given a chance to provide further explanations.

(ii) Dylan Co is a listed company, so in line with ISA 220 Quality Control for an Audit of Financial
/fr
Statements an engagement quality control reviewer must be appointed. The review must be
completed before the auditor's report is issued.
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The reviewer should review the financial statements and the proposed auditor's report, together with
relevant audit documentation.
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336 Answers
The issue of whether sufficient audit evidence has been obtained in relation to payroll, revenue and
receivables should be paid very close attention, considering in particular whether it might be possible
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to obtain evidence about these balances by any other means. This is important, because if it is in fact
possible to obtain this evidence, then the auditor must not express an opinion saying otherwise.
The review should ensure that there is adequate documentation supporting any judgements made in
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forming the opinion, and that adequate communications have been made where necessary to those
charged with governance.
(b) The review should be conducted in line with ISRE 2410 Review of interim financial information performed by
o t.
the independent auditor of the entity. The key elements of the review are enquiry and analytical procedures,
which do not lead to reasonable assurance.
The applicable financial reporting framework should be the same as for the annual financial statements, so
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IFRS applies.
In line with IAS 37 Provisions, contingent liabilities and contingent assets, a provision should be recognised
for the warranty on the cars. Thus the treatment in the 20X2 annual financial statements appears correct.
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Squire Co has stopped offering warranties on cars sold from 1 July 20X2 onwards. However, it still has an
obligation to honour warranties on cars already sold. Hence it should still provide for the cost of honouring
those warranties. The interim financial statements therefore appear to understate liabilities and overstate
l.b
profit.
If the same warranty provision needed to be recognised in the interim financial statements as at the year
end, this would be $1.5m. This is 5% of total assets (= $1.5m / $30m), and is material.
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The auditor should communicate this misstatement to management. If management does not respond
appropriately, then the auditor must inform those charged with governance.
If appropriate adjustments are not made, then the report should contain a qualified or adverse conclusion.
ate
The report must include a 'Basis for qualified conclusion' paragraph immediately above the 'Qualified
conclusion' paragraph.
71 Bertie & Co
ym

Top tips. In part (a) you should take a two step approach on each part. First look at the information from the point
tud
of view of accounting treatments and decide whether you agree with what has been done. Then move on to think
about the principles of auditor's reporting and decide if you agree with the proposed reports. In parts (b) and (c)
you need to refer to the specific circumstances of Hugh Co, it is not enough to give a 'textbook' answer on the
benefits of audit to smaller entities or on the differences between audit and review.
as
Easy marks. Part (a) should have been the easiest section of this question. The accounting issues were drawn from
core areas and the knowledge required on auditor's reports did not go beyond what could have been tested in paper F8.
Examiner's comments. Requirement (a) produced very mixed results. Some answers displayed a sound knowledge
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of auditor's reports, could differentiate between 'material' and 'pervasive' in the context of auditor's reports, and
knew the purpose of an emphasis of matter paragraph. On the whole, however, answers to requirement (a) were
inadequate. Common problems in requirement (a) included:
ea
 A total lack of understanding about the use and purpose of an emphasis of matter paragraph – candidates
appear to think that an emphasis of matter paragraph can be used by the auditor whenever there is an issue
that they want to bring to the attention of the readers of the auditor's report, when in reality the paragraph is
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very limited in its use

 An inability to comment on the appropriateness of the report suggested by the audit senior in the question
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 A fixation with creating a provision where this would be the incorrect accounting treatment
 A fixation with the going concern concept – the discontinuation of a business segment does not mean that
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the entire company is going to cease to trade

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Answers 337
Requirements (b) and (c) were better. Most candidates could provide benefits for a small company in choosing to
have a financial statement audit. One weakness here was a reluctance to make the answer specific to the question.
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Marking scheme
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Marks
(a) (i) Comment on auditor's report – Alpha Co
o t.
 Discontinued operation
 Cash flow disclosure (max ½ mark)
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 Segmental disclosure (max ½ mark)
 Disagree with senior's proposal
 Material – except for
 Misstatement – reason must be explained in auditor's report
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 Auditor's opinion does not cover other information
Maximum 6
(ii) Comment on auditor's report – Deema Co
l.b
 Accounting treatment of contingency (extend to 2 marks for detailed discussion)
 Unmodified opinion appears correct
 Report does not need to be modified by emphasis of matter paragraph
(b)
 Explanation why emphasis of matter not needed
Maximum
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Benefits to Hugh Co in choosing to have financial statement audit
4
ate
Note. Comments must be specific to Hugh Co
 Improves reliability of figures
 Improve quality of management accounts
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 Detective and preventative control

 Increased assurance for external users
 Reduces accumulation of errors carried down
 Advice provided in letter to management
tud
 May need audit in future years

Maximum 4
(c) Objective of review engagement and assurance provided
Definition/objective – 2 marks maximum
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2 marks for each comment on level of assurance

Note. Needs to be contrasted with audit.
 Limited procedures
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 Limited assurance
Maximum 6
Total 20
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338 Answers
(a) Auditor's reports
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Alpha
The major matter to consider in respect of Alpha's financial statements is whether the discontinued
operations meet the criteria to require separate classification in the statement of profit or loss per
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IFRS 5 Non-current Assets Held for Sale and Discontinued Operations. As the closures were finalised in the
year, there may not be any assets held for sale at the year end, but if there are, these should also be
accounted for correctly under IFRS 5. If these matters are not accounted for and disclosed correctly, the
auditor would have to modify the auditor's opinion on the grounds of a material misstatement, as at 10% of
o t.
revenue, the closures are material.
In order to be separately disclosed, the discontinued operations should be a component that is separately
identifiable from the rest of the business. All the factories produced the same product. If that product is
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different from the products continuing to be made, then it is arguable that a component has been closed as
part of a single co-ordinated plan to dispose of a separate major line of business. As such it should be
disclosed separately.
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If the item produced by the closed factories was the same as the item produced by the other factories which
have not been closed, then the discontinued operations are not separately identifiable unless they are in the
same geographic region and the closure represents a single co-ordinated plan to dispose of a separate
geographical area.
l.b
If the discontinued operations are not separately identifiable either by product or geographical location, there
is no need to make separate disclosure and the financial statements are fairly stated in respect of this matter,
therefore the auditor's report is appropriate.
Deema
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If the matter has been appropriately disclosed in the financial statements as suggested then the audit senior
ate
is right not to modify the auditor's opinion as there is no material misstatement in respect of accounting
treatment and no inability to obtain sufficient appropriate audit evidence.
An emphasis of matter paragraph is used when an unmodified opinion is being given in respect of a
particular issue but, in the auditor's judgment, the matter is of such importance that it is fundamental to
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users' understanding of the financial statements. For example, an emphasis of matter paragraph will be used
where there is a fundamental uncertainty, such as over the going concern status of a company.
In this case, there is no fundamental uncertainty and an emphasis of matter is unnecessary. The item has
been correctly disclosed in the financial statements and an unmodified auditor's opinion with no further
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information can be issued.

(b) Potential benefits of audit to Hugh
Hugh may find having a voluntary audit provides the following benefits.
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(i) Confidence for the entrepreneurs in their part-qualified accountant. An audit would give the two
owner-directors a degree of assurance that their accountant was on the right tracks and that the
management and financial statements produced by him that they are legally responsible for are
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appropriate and reasonable. In addition, it would give them added confidence to make the types of
operational and finance decisions they will have to make as they grow their business.
(ii) Confidence given to banks/other investors. The existence of an external audit gives confidence to
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banks and other investors when they are asked to provide finance, particularly to a new business, such
as Hugh. As Hugh is expanding rapidly, it may find it needs new finance and quickly, in order to
maintain operations. Many new companies are affected by overtrading, when they cannot finance their
operations in order to meet the high sales demand for their product, and ultimately fail as a result.
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(iii) Secondary benefits of additional finance expertise. Hugh might also benefit from having an audit in
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terms of the secondary benefits an audit gives, such as systems review. Although Hugh has a part-
qualified accountant, having other finance professionals being involved with it from the start will benefit
the company in terms of how its systems develop to cope with expanding operations and keep them on
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a good track. In addition, as the business expands, it will have to take on more staff and more complex
controls and systems will be required to protect the entrepreneurs from error and fraud.
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Answers 339
(iv) Getting things right in the first place. An extension of the above argument is that if Hugh's business
is rapidly expanding, it will be required to have an audit soon enough and having auditors involved
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from the start will ensure there is not a shock down the line, when auditors do get involved and
encourage changes when systems have started to settle and be established. In addition, when audits
become mandatory there will be no risk of having to qualify due to lack of evidence about opening
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balances.
(v) Acceptability for tax. The company will be subject to income tax whether or not it has an audit, but
the tax authorities may be more inclined to rely on audited accounts than not, and be less inclined to
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make inspections themselves, which a new business might prefer to avoid.
(c) Objective of a review engagement
A review engagement is an engagement designed to enable an auditor to state whether anything has come to
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his attention to believe that the financial statements are not prepared in accordance with an identified
financial reporting framework. This is on the basis of fewer procedures than would be necessary for an
audit.
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In the case of Hugh therefore, this option would cost them less than an audit but the assurance given to
them would be useful. The usefulness of a degree of assurance has been discussed above. In a review
engagement, the type of assurance given would be limited. This means that the reviewer would state there
was no reason to suppose that anything was wrong rather than I positively believe that nothing is wrong.
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The reviewer would approach the engagement with professional scepticism, for example, as the accountant
is part-qualified, the reviewer would believe that the risk that the financial statements were subject to error
would be higher.
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The types of procedures to be carried out would largely be enquiries of the directors and the accountant.
The cost benefit of a review might be good for the two directors, as they would gain a degree of assurance at
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a much lower cost. However, other parties seeking assurance, such as potential finance providers, might
request the higher level of assurance that audit provides.
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340 Answers
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Mock exams
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ACCA Professional Level
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Paper P7
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(International)
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Mock Examination 1
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Question Paper
Time allowed
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Reading and planning 15 minutes

Writing 3 hours
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Section A TWO compulsory questions to be attempted
Section B TWO questions ONLY to be attempted

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During reading and planning time only the question paper may be annotated
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DO NOT OPEN THIS PAPER UNTIL YOU ARE READY TO START UNDER
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EXAMINATION CONDITIONS
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SECTION A – BOTH questions are compulsory and MUST be
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attempted
Question 1
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Your name is Thom Croft and you are a recently-promoted audit manager in Cup & Co, a firm of Chartered Certified
Accountants. Richard Hill is a senior partner in the firm. You have just received the following email from him.
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To: Thom Croft <[email protected]>
From: Richard Hill <[email protected]>
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Subject: Matthew Manufacturing audit
Thom
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As you know, we have only recently been appointed to the audit of Matthew Manufacturing (MM), a limited liability
company. It is a glass business with 100 employees, manufacturing glasses, jugs and vases.
I would like you to prepare a memorandum for me setting out the business and audit risks relating to this client,
and the kind of audit strategy you feel should be adopted in the audit, stating why you have chosen that strategy,
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and why you have not chosen other possible strategies.
MM sells glassware predominantly to a large high street retailer, but also sells directly to a number of local, cheaper
retailers. The glassware sold to the high street store must be designed to their specification, and cannot be sold to
up but an external consultant but is now run internally.

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anyone else. In recent years MM has made a small but increasing number of sales from its website, which was set
The company has a small accounting function which consists of the chief accountant Mr Crow, who reports directly
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to the managing director and major shareholder, Mr Lofthouse, and an accounts clerk, Debbie. There is a small, PC
based accounting system. Debbie enters invoices into the computer and maintains the manual cash book. Mr Crow
is in charge of preparing management accounts on a monthly basis; the payroll, which is approved monthly by Mr
Lofthouse; the tax affairs of the company; and the tax affairs of Mr Lofthouse. Mr Lofthouse controls purchasing
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and sales, although he has an assistant who produces the paperwork and liaises with Debbie in accounts.
The previous auditors did not offer themselves for re-election due to disputes with Mr Lofthouse, but have stated
that they are aware of no ethical reason which bars your firm from acting. They have passed some relevant working
papers over to your firm, and have met with you to give you some background information on the audit. One of the
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things which they mentioned about the audit was that they have always assessed internal control as poor.
I would also like you to include in your memorandum an explanation of the term 'professional scepticism', and a
brief discussion of its role in the detection of fraud.
Please get to work on this for me straight away. I look forward to reading what you have to say.
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Thanks,
Rich
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Required
Respond to Richard Hill's email. The following marks are available.
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(a) Identify and explain, from the information given, the key:
(i) Audit risks (8 marks)
(ii) Business risks (7 marks)
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(b) Discussion of the audit strategy which you feel should be adopted, and the reasons why you have chosen
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that strategy and not another. (9 marks)

(c) Explanation of the term 'professional scepticism' and comment on its role in the detection of fraud.
(7 marks)
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Professional marks will be available for the format and the clarity of the answer. (4 marks)
(Total = 35 marks)
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Mock exam 1: questions 345
Question 2
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(a) Define the following terms:
(i) Forensic Accounting
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(ii) Forensic Investigation
(iii) Forensic Auditing (6 marks)
You are a manager in the forensic investigation department of your audit firm. The directors of a local
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manufacturing company, Crocus Co, have contacted your department regarding a suspected fraud, which has
recently been discovered operating in the company, and you have been asked to look into the matter further. You
have held a preliminary discussion with Gita Thrales, the finance director of Crocus Co, the notes of this
conversation are shown below.
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Notes of discussion with Gita Thrales
Four months ago Crocus Co shut down one of its five factories, in response to deteriorating market conditions, with
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all staff employed at the factory made redundant on the date of closure.
While monitoring the monthly management accounts, Gita performs analytical procedures on salary expenses. She
found that the monthly total payroll expense had reduced by 3% in the months following the factory closure – not
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as much as expected, given that 20% of the total staff of the company had been made redundant. Initial
investigations performed last week by Gita revealed that many of the employees who had been made redundant had
actually remained on the payroll records, and salary payments in respect of these individuals were still being made
every month, with all payments going into the same bank account. As soon as she realised that there may be a
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fraud being conducted within the company, Gita stopped any further payments in respect of the redundant
employees. She contacted our firm as she is unsure how to proceed, and would like our firm's specialist
department to conduct an investigation.
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Gita says that the senior accountant, Miles Rutland, has been absent from work since she conducted her initial
investigation last week, and it has been impossible to contact him. Gita believes that he may have been involved
with the suspected fraud.
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Gita has asked whether your department would be able to provide a forensic investigation, but is unsure what this
would involve. Crocus Co is not an audit client of your firm.
Required
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(b) Prepare a report to be sent to Gita Thrales (the finance director), in which you:
(i) Describe the objectives of a forensic investigation
(ii) Explain the steps involved in a forensic investigation into the payroll fraud, including examples of
procedures that could be used to gather evidence (13 marks)
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(c) Assess how the fundamental ethical principles of the IESBA's Code of Ethics for Professional Accountants
should be applied to the provision of a forensic investigation service. (6 marks)
(Total = 25 marks)
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346 Mock exam 1: questions
SECTION B – TWO questions ONLY to be attempted
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Question 3
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You are the manager responsible for the audit of Verdi, a long-established limited liability company. Verdi
manufactures, distributes and installs heavy engineering machinery (eg turbines) for the oil and gas industry. The draft
financial statements for the year ended 30 September 20X8 show revenue of $330 million (20X7 – $228 million),
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profit before taxation of $15.9 million (20X7 – $13.7 million) and total assets of $187 million (20X7 – $159 million).
The following issues arising during the final audit have been noted on a schedule of points for your attention.
(a) During the year technological advancement of the manufacturing process resulted in an increase in
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production capacity in three of the company's factory buildings. The remaining factory building became
surplus to Verdi's production requirements. On 29 September 20X8, Verdi contracted to sell this building for
$11.5 million. The building had last been revalued in September 20X5 and had a carrying amount of
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$9.2 million at the date of sale. The gain on disposal has been credited to revenue and the balance of the
revaluation surplus relating to the building, $3.7 million, has been credited against other operating charges
in the statement of profit or loss and other comprehensive income. (8 marks)
(b) $7 million was lent to Verdi on July 20X7 for five years at 5%, to finance investment in manufacturing
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equipment. The loan became repayable on demand on 1 July 20X8 when Verdi failed to pay the annual
interest charge for the first year. On 17 October 20X8 the lender agreed to 'roll over' the overdue interest by
adding it to the principal amount due. The draft financial statements classify the loan as a non-current
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financial liability and the first year's interest charge is accrued in 'trade and other payables'. (6 marks)
(c) Verdi's scale of charges for installing machinery was increased by 40% with effect from 1 January 20X8.
This increase takes into account Verdi now giving a warranty to reinstall any item which fails to perform to
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specification, through an installation defect, for a period of up to three years. The notes to the financial
statements disclose the following.
'The company guarantees all installations of equipment sold since 1 July 20X7. No
provision has been recognised as the amount of the obligation cannot be measured
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with sufficient reliability.'

Installation fees for the year to 30 September 20X8 amounted to $5.2 million of which $1 million related to
the three months to 31 December 20X7. (6 marks)
Required
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In undertaking your review of the audit working papers and financial statements of Verdi for the year ended 30
September 20X8, for each of the above issues:
(i) Comment on the matters that you should consider
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(ii) State the audit evidence that you should expect to find
Note. The mark allocation is shown against each of the three issues. You should assume it is 11 December 20X8.
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(Total = 20 marks)
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Question 4
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(a) Discuss the current auditing guidance for group auditors when requesting a component auditor to perform
work on the financial statements of a component. (8 marks)
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(b) You are an audit manager in Moltisant, a firm of Chartered Certified Accountants, and currently assigned to
the audit of Capri Group. The consolidated financial statements of Capri Group are prepared in accordance
with the accounting standards and guidance issued by the International Accounting Standards Board (IASB).
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The draft financial statements for the year ended 30 June 20X8 show profit before taxation of $6.2 million
(20X7 – $5.5 million) and total assets $32.5 million (20X7 – $29.8 million).
One of the Group's principal subsidiaries, Capri (Overseas), is audited by another firm, Marcel. You have just
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received Marcel's draft auditors' report as follows.
Basis of audit opinion (extract)
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'As set out in Notes 4 and 5, expenditure on finance leases has not been reflected in the statement of
financial position but included in operating expenses and no provision has been made for deferred taxation.
This is in accordance with local taxation regulations.
Opinion
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'In our opinion the financial statements present fairly, in all material aspects the financial position of the
company as at 30 June 20X8, its financial performance and its cash flows for the year then ended…'
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'The draft financial statements of Capri (Overseas) for the year ended 30 June 20X8 show profit before
taxation of $1.9 million (20X7 – $1.7 million) and total assets $6.5 million (20X7 – $6.6 million). The
relevant notes (in full) are:
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(4) Leased assets
During the year the company has incurred expenditure on leasing agreements that give rights
approximating to ownership of non current assets with a fair value of $790,000. All lease payments
are charged to the statement of profit or loss and other comprehensive income as incurred.
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(5) Taxation
This includes current taxes on profit and other taxes such as taxes on capital. No provision is
required to be made for deferred taxation and it is impracticable to quantify the financial effect of
unrecognised deferred tax liabilities.'
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Required
Comment on the matters you should consider before expressing an opinion on the consolidated financial
statements of the Capri Group. (12 marks)
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Question 5
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(a) Explain what the term 'lowballing' means and discuss current guidance in this area. (5 marks)
(b) You are an audit manager in Sepia, a firm of Chartered Certified Accountants. Your specific responsibilities
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include advising the senior audit partner on the acceptance of new assignments. The following matters have
arisen in connection with three prospective client companies.
(i) Your firm has been nominated to act as audit to Squid, a private limited company. You have been
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waiting for a response to your letter of 'professional enquiry' to Squid's auditor, Krill & Co, for
several weeks. Your recent attempts to call the current engagement partner, Anton Fargues, in Krill
& Co have been met with the response from Anton's personal assistant that 'Mr Fargues is not
available'. (5 marks)
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(ii) Sepia has been approached by the management of Hatchet, a company listed on a recognised stock
exchange, to advise on a take-over bid which they propose to make. The target company, Vitronella,
is an audit client of your firm. However, Hatchet is not. (5 marks)
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(iii) A former colleague in Sepia, Edwin Stenuit, is now employed by another firm, Keratin. Sepia and
Keratin and three other firms have recently tendered for the audit of Benthos, a limited liability
company. Benthos is expected to announce the successful firm next week. Yesterday, at a social
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gathering, Edwin confided to you that Keratin 'lowballed' on their tender for the audit as they expect
to be able to provide Benthos with lucrative other services. (5 marks)
Required
now take.
Note. The mark allocation is shown against each of the three issues.
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Comment on the professional issues raised by each of the above matters and the steps, if any, that Sepia should
ate
(Total = 20 marks)
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DO NOT TURN THIS PAGE UNTIL YOU HAVE

COMPLETED THE MOCK EXAM
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352
A PLAN OF ATTACK
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If this had been the real Advanced Audit and Assurance exam and you had been told to turn over and begin, what
would have been going through your mind?
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An important thing to say (while there is still time) is that it is vital to have a good breadth of knowledge of the
syllabus because the question requirements for each question will relate to different areas of the P7 syllabus.
However, don't panic. Below we provide guidance on how to approach the exam.
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Approaching the answer
Use your 15 minutes of reading time usefully, to look through the questions, particularly Questions 1 and 2 in
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Section A which are compulsory, to get a feel for what is required and to become familiar with the question
scenarios.
It is vital that you attempt all the questions in the paper to increase your chances of passing. The best way to do
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this is to make sure you stick to the time allocation for each question – both in total and for each of the question
parts. The worst thing you can do is run over time in one question and then find that you don't have enough time
for the remaining questions.
Section A is compulsory and consists of two long case-study style questions. These may contain detailed
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information such as extracts from financial statements and audit working papers. A range of requirements will be
set for each question, covering areas from across the whole syllabus.
Question 1 is for 35 marks. The scenario is quite long so make sure you have used your reading time well to
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familiarise yourself with it and make some notes on key issues. The key to success in this question is to stay
focussed, don't run over time and answer the questions set. In part (a), notice the requirement to distinguish
between audit risks and business risks – you must explain the risks fully to score well in this part of the question.
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Your answer to part (b) should follow on from your answer to part (a) – make sure you explain fully your chosen
audit strategy as there are nine marks available here. Part (c) is on professional scepticism and fraud so you should
be able to pick up some marks here.
Question 2 is worth 25 marks, and was all on forensics, Part (a) was all knowledge recall, so should not be too
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difficult. Although you are only asked to 'define' each term, there are six marks available for this part, which comes
to two marks for each term. You should therefore make sure that your answer is detailed enough to be worth two
marks for each term. Part (b) was the heart of this question, and was a mixture of knowledge and application
marks. You need to make sure that you stick to your timings here, and that your answer is focused and concise.
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Part (c) offered quite a lot of marks for this area, so you needed to be systematic and detailed in your approach.
Section B contains three questions, from which you must attempt two.
Question 3 is on audit evidence and matters to consider in the context of three mini scenarios. Note the mark
allocation in each. Your answers must be focussed and coherent if you are going to score well and your financial
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reporting knowledge needs to be sound as you will have to apply it in this question.
Question 4 is on the audit report in a group company context. In part (a) you need to discuss current guidance and
you will be able to score well if you also mention the revised ISA 600. In part (b) 12 marks are available so your
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answer needs to be relatively detailed if you are going to score good marks for this part of the question.
Question 5 is on ethical and professional issues. In part (a) you have to explain lowballing and the extent of current
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guidance in this area. Part (b) has three short scenarios on which you have to comment. Note that the requirement
also asks you what steps the firm should now take – don't overlook this part of the question.
Forget about it!

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And don't worry if you found the paper difficult. More than likely other candidates will too. If this were the real thing
you would need to forget the exam the minute you left the exam hall and think about the next one. Or, if it is the last
one, celebrate!
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Mock exam 1: answers 353
Question 1
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Top tips. The first part of this question should be straightforward so long as you are clear about the distinction
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between audit and business risks. In the second part, you might read the question and decide immediately what
kind of audit approach would be appropriate in this situation. However, the question is very clear that it wants you
to explain the strategies you wouldn't apply as well. Therefore, you should approach the answer methodically,
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referring to all the available strategies and why you would or would not use them.
Easy marks. These are available in part (a) – use the information in the scenario to help you pick out the audit and
business risks.
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Marking scheme
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Marks
(a) (i) Audit risks
1½ marks for each clearly explained point
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Maximum 8
(ii) Business risks
1½ marks for each clearly explained point
Maximum 7
(b) Audit strategy
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2 marks for each strategy fully discussed, including the reasons why it
should or should not be chosen
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Maximum 9
(c) Professional scepticism
Definition 1
Link to fraud 1
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Management 1
Concealed nature 1
Not persuaded by past experience 1
Documents 1
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If suspicions raised 1
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Professional marks for format and clarity of answer 4
Total 35
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Memorandum
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For: Richard Hill

By: Thom Croft
Subject: Audit of Matthew Manufacturing
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Introduction
This memorandum sets out the audit and business risks relating to the client Matthew Manufacturing, the audit
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strategy to be adopted, and what the term 'professional scepticism' means and what its role is in detecting fraud.
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354 Mock exam 1: answers
(a) Risks at Matthew Manufacturing
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(i) Audit risks
Inherent risk
 The business is overly reliant on one major customer who is significantly larger than
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Matthew Manufacturing and therefore is likely to have more bargaining power. This will affect
receivables and sales, and could impact upon going concern.
 At a balance level, inventory may be risky because it is by its nature fragile and this could
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cause a degree of obsolete inventory. Much of it is designed to specification and may not be
sold to others, so this could also cause a high level of obsolescence.
 The business is controlled by one man, which could have an impact on going concern, eg if
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anything were to happen to him.
Control risk
 The controls in the business have always been assessed previously as poor.
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 There is likely to be little segregation of duties, although management have a 'hands on',
authoritarian style.
 There is a risk that sales made from the website are not incorporated correctly in the financial
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statements. This risk is heightened by the fact that the controls in MM as a whole are likely to
be poor.
Detection risk
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You have recently been appointed, so this is likely to be the first audit. This is an inherent risk
because you are not going to have all the knowledge of the business which you would have on
an established audit, and risk of not detecting material misstatements is therefore higher.
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(ii) Business risks
Operational risks
 The issue noted above in inherent risk of the business supplying one customer who is
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significantly bigger than them. This means in effect that the customer controls operations
and holds significantly more power over the company than would be good for the company.
 The website represents a security risk. Cyber criminals could gain access to the site and cause
damage to MM's IT systems, or could steal customers' data. This could lead to legal problems
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and reputational damage.

Financial risks
 The company is dominated by one man (Mr Lofthouse) and raising capital if required might
be restricted beyond him. He his likely to have to give personal guarantees to the bank for
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lending, there is no other obvious method of raising finance for the business.
 Lack of segregation of duties leads to higher opportunities for fraud and misappropriation of
cash.
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 The company deals in portable, saleable items at high risk of being thieved.
Compliance risks
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 There are a number of employees so the risk arising from the need to comply with the
employment laws is significant, as the company is unlikely to employ an expert in this area.
 Glass is a dangerous product to work with and this will have health and safety implications.
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(b) Audit strategy

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The first stage of the audit will be to understand the entity. This will include documenting and confirming the
systems and internal control. However, it appears likely that the controls will be assessed as ineffective, or at
best, strongly reliant on the control of the key manager. Therefore, it is extremely unlikely that a systems
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and controls approach will be taken to the audit. It is far more likely that a substantive approach will be
taken.
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Risk
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Audit and business risks have been discussed above. Auditors often take a risk approach to an audit in
connection with a substantive approach. This can either be a business risk approach or an audit risk
approach. Usually it involves an assessment of both as the two issues are related. (ISA 315 requires the
auditor to assess the risks faced by the business as a means of identifying risks of material misstatement in
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the financial statements.)
The business risk approach is often taken for large companies, who have strong controls who are
accustomed to the concepts of risk management and awareness. In a smaller firm, such as Matthew
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Manufacturing, it is less likely that the auditor will be able to rely on the business's own ability to manage
risk effectively. Concerns over the controls of the business indicate that a detailed substantive approach
would be more appropriate.
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There are clear audit risks in this client. It is therefore sensible to take an audit risk approach and focus the
detailed audit tests in the areas of the business where problems are most likely to arise.
Substantive approach
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The fact that a detailed substantive approach is required has been mentioned several times already. This
would suggest that an analytical approach would not be appropriate. This is compounded by the fact that it
is a first year audit and with a lack of knowledge of the business to apply to the financial information, an
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analytical approach would be less effective.
In terms of detailed testing then, two approaches could be taken. The audit could be conducted around the
statement of financial position or the transactions (the transactions, or cycles approach). In my opinion, the
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cycles approach is the more sensible approach for the following reasons.
 Controls are believed to be poor, so there is a substantial chance of transactions being misstated.
Last year's statement of financial position was not audited by our firm.
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 Testing the transactions will give us a significant insight into how the business operates and increase
our knowledge of the business.
Conclusion
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The most appropriate approach is an audit risk approach, combined with a detailed substantive cycles
approach.
(c) Professional scepticism
ISA 240 The auditor's responsibilities relating to fraud in an audit of financial statements requires the auditor
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to 'maintain an attitude of professional scepticism' throughout the audit. The auditor should recognise that
a material misstatement as a result of fraud could exist regardless of the auditor's previous experience of the
client and its management and those charged with governance. This attitude is important when considering
fraud, due to the concealed nature of fraud. It is possible that things might not be as they seem.
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In other words, it is necessary to keep an open mind to the commercial reality of the possibility of fraud
while carrying out an audit and to ensure that all audit evidence gathered is critically assessed. An auditor
should not be persuaded by less-than-persuasive audit evidence as a result of the fact that in the past the
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management and staff of the company have appeared to be honest and trustworthy.
However, the auditor is entitled to take documents on face value unless he has reason to believe otherwise.
In other words, auditors are not required routinely to check whether documents presented to them as audit
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evidence are authentic. If their suspicions are roused, then they would be required to make further enquiry,
for example, they should attempt to obtain evidence from a third party.
Conclusion
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The audit of Matthew Manufacturing presents a number of significant business and audit risks which need to
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be addressed. The appropriate audit approach is an audit risk approach, combined with detailed substantive
testing. Professional skepticism will be necessary throughout the audit, but the auditor has no specific
responsibilities in relation to fraud.
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Question 2
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Top tips. This question looks at the topic of forensic audits. Many of the points were covered in an article published
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by the examiner in Student Accountant shortly before the exam, and you would have scored well if you had read
this article. It is vital that you keep up to date with relevant articles in Student Accountant to do well in this paper.
Easy marks. These are available in parts (a) and (c) of this question as they are both knowledge-based. Part (b) has
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three professional marks available.
Examiner's comments. Requirement (a) asked for definitions of forensic accounting, forensic investigation, and
forensic auditing. There were many sound displays of this factual knowledge, though some candidates who did not
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know the difference between the three tended to write the same thing for each one.
Requirement (b) was the core of the question. Unfortunately, two common problems detracted from the quality of
many answers for this requirement. Firstly, providing tactless and unnecessary comments regarding whether the
assignment should be accepted. Such comments show that candidates had failed to read and understand the
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scenario. Secondly, the procedures suggested where often too vague, or not even procedures at all.
Requirement (c) was not often well answered. This requirement asked for the application of the fundamental ethical
principles to the provision of a forensic investigation service. Many answers were just not applied in any way,
making little or no reference to forensics.
l.b
Marking scheme
(a)
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Definitions – 2 marks per definition (general principle rather then exact wording,
examples can be used to illustrate definition)
Marks
ate
Maximum 6
(b) Report on aims and method of conducting a forensic accounting investigation
Up to 1½ marks per comment:
 Introduction referring to reason behind the report and to clarify contents (1 mark)
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 Aim – clarify fraud taken place

 Aim – discover the perpetrator(s)
 Aim – prosecute the perpetrator(s)
 Aim – quantify losses
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 Method – consider type of fraud – ghost employee

 Method – understand how it could have taken place – controls override
 Method – collect evidence – suffice and relevant – allow up to 2 extra marks here if
examples given of procedures that could be performed
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 Method – interview suspect

 Method – produce reports
 Expert witness
 Advice and recommendations to prevent another fraud
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Maximum 13
(c) Professional ethics – application of fundamental principles
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Up to 1½ marks per comment:

 Integrity (max 1 mark)
 Objectivity
 Professional competence and due care
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 Confidentiality
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 Professional behaviour
1 mark for recognition that principles apply to all professional engagements
Maximum 6
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Total 25
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(a) (i) Forensic accounting is the undertaking of a financial investigation in response to a particular event,
where the findings of the investigation may be used as evidence in court or to otherwise help resolve
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disputes. The event being investigated is often fraud, but forensic accounting work can also involve
business closures or matrimonial disputes.
(ii) A forensic investigation is carried out for civil or criminal cases. These can involve fraud or money
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laundering. The stages in a forensic investigation are similar to an audit of financial statements as
they both involve planning, collection of evidence, review and the production of a final report.
(iii) Forensic auditing is the process of gathering, analysing and reporting on data, in a pre-defined
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context, for the purpose of finding facts and/or evidence in the context of financial or legal disputes
and/or irregularities and giving preventative advice in this area. An example would be establishing the
amount of loss suffered by the plaintiff in a negligence case.
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(b) Report to Gita Thrales
Subject: Forensic investigation into payroll fraud
Introduction
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This report describes the objectives of a forensic investigation and explains how a forensic investigation into
the alleged payroll fraud at Crocus Co would be conducted.
(i) Objectives of a forensic investigation
l.b
When investigating an alleged fraud, such as at Crocus Co, the first objective of a forensic
investigation would be to prove that deliberate fraudulent activity has actually occurred. The
employees may have been left on the payroll in error, rather than a deliberate attempt to
misappropriate cash.
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Once it has been established that a fraud has taken place, a forensic investigation would then aim to
identify the perpetrator or perpetrators of the fraud. Evidence would be gathered for use in any
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potential court proceedings, for example, an interview with the suspected fraudster(s).
Finally, the forensic investigation will try to quantify the financial loss suffered as a result of the
fraud. Legally, no crime has been committed unless Crocus Co has suffered a financial loss.
(ii) Steps involved in a forensic investigation into the payroll fraud
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Establishing the type of fraud that has taken place.

At Crocus Co, redundant employees have not been removed from the payroll. Payments to these
fictitious employees (known as 'ghost employees') are now being made to the fraudster.
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Determining for how long the fraud has been operating

It is likely that the fraud started on the date of the factory closure, but this will need to be confirmed.
Identifying how the fraud operated and was concealed
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The forensic investigation team will determine how the fraud was conducted at Crocus Co and how
the perpetrator concealed their actions. It appears there was a problem with internal controls over
amendments to payroll data. Somehow an employee has been able to make changes to the payroll
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data without being detected until after payments have taken place. A control should have been in
place to ensure that all amendments to payroll data are approved by a more senior member of staff
before any payments are made.
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Gathering evidence
Evidence will be collected by the forensic investigation team and must be sufficient to prove the
following.
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 That a fraud has taken place

/fr
 Who has committed the fraud and how

 The amount of financial loss suffered by Crocus Co
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The evidence must also be relevant to the alleged case. It is important to use a skilled team to collect
the evidence and keep a clear trail of its custody so that it cannot be challenged in court.
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At Crocus Co, evidence could be obtained by the following methods.
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 Reviewing and testing the authorisation procedures for the monthly payroll
 Using computer assisted audit techniques (CAATs) to look for alteration of payroll details
 Using CAATs to search for employees with no contact details, employees who have not taken
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holiday or sick pay and bank account details which are the same for more than one employee
 Reconciling employees' details in the payroll database with human resources records
 Interviewing the suspect and ideally acquiring a confession. This interview is generally delayed
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until there is enough evidence to extract a confession and will form a key part of evidence to
be presented in court.
Reporting
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Once all the evidence has been collected, the forensic investigator will produce a report to the client.
This report will summarise all evidence, detail the amount of financial loss suffered as a result of the
fraud and identify the suspected fraudster. It is likely that this report is used as evidence in court.
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The report may also include advice to the client to help prevent a reoccurrence of the fraud. Advice
given is often in the form of suggested improvements to internal controls and systems.
Court proceedings
l.b
The forensic investigation team is likely to be called as an expert witness in any resulting court case.
Team members will be asked questions about the investigation and to explain the evidence
presented.
Conclusion
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A forensic investigation will prove that a fraud has taken place, identify the perpetrator and quantify
the financial loss suffered. The forensic investigation team will gather sufficient and relevant evidence
ate
on the type of fraud that has taken place, how the fraud occurred and for how long. This evidence
can then be used in court proceedings against the fraudster.
(c) Application of fundamental principles of the IESBA's Code of Ethics for Professional Accountants to a
forensic investigation
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The fundamental principles of the IESBA's Code of Ethics apply to all professional assignments.
Integrity
Forensic accountants are often, by definition, working in an environment dealing with individuals who are
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dishonest and lack integrity. If there is any risk that their own integrity will be compromised they should
decline or withdraw from the assignment.
Objectivity
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The report produced by the forensic investigator will be used as evidence in court and must apply an opinion
which is independent. A useful test of independence is that the investigator would express the same opinion
if given the same instructions by the opposing party. Investigators should not take it upon themselves to
promote the point of view of the party instructing them or engage in the role of advocates. Any perceived
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threats to objectivity will undermine the credibility of the accountant's opinion.

A perceived threat to objectivity may occur when an audit firm asks its auditors to conduct a forensic
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investigation. In this case there would be three threats to the firm's objectivity:
 Advocacy. The audit firm may feel compelled to promote the view of the client in court as they are
concerned about losing an audit client and the resulting fees.
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 Management involvement. The audit firm may be seen as making management decisions about the
implication of the fraud.
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 Self-review. A forensic investigation will require any loss suffered to be quantified. If this amount is
material to the financial statements, the audit firm may end up auditing their own estimation.
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The Code states that appropriate safeguards should be put in place to minimise these threats. If safeguards
cannot reduce the threat to an acceptable level, then the firm cannot provide both services.
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Professional competence and due care
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Forensic investigations may require very specialised skills which require training. Examples of these skills
would include:
 Evidence gathering that requires specific IT skills

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An understanding of the legal framework
 Knowledge of evidence gathering methods and the safe custody of evidence
A firm should consider very carefully whether they have adequate skills and resources before accepting the
assignment. Evidence presented in court could be discredited if the team is thought to be incompetent.
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Confidentiality
Forensic accountants will often be working for one party to a dispute, and have access to very sensitive
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information. Subject, of course, to legal rules of disclosures in court cases, it is clearly essential to maintain
the strictest confidentiality.
Professional behaviour
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Fraud cases and other situations such as takeover disputes can be very much in the public eye. Any lapse in the
professionalism of, say, an expert witness could do serious damage to the reputation of the profession as a whole.
Question 3
l.b
Text reference. Chapters 9 and 10.
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Top tips. As usual with questions of this type, you should ensure that you attempt each part of the question. This
means that the question breaks down into manageable sections of three to four marks each. Use all the information
given to you in the question. Scrutinise dates closely to ascertain whether things impact in the relevant year. In
parts (a) and (b) of this question, timings are crucial to your answer. Remember as well to always comment on
ate
materiality but, as you should note from reading the examiner's comments below, make targeted comments about
materiality. You must judge whether a matter is relevant to the statement of profit or loss and other comprehensive
income or the statement of financial position and calculate its materiality accordingly.
Easy marks. There are no easy marks as such on this paper, but marks are always available for commenting on the
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materiality of things under discussion, and marks are also available for correctly identifying the relevant accounting
standards. It should be straightforward to obtain marks for the audit evidence required for each item too. Please
note the examiner's comments about materiality and audit evidence below however. As she observes, a 'scattergun'
approach, or an unsophisticated approach to audit evidence will not gain marks.
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Examiner's comments. Generally scripts were either very good or very poor. Tabulation is not recommended for
this question. A small minority of candidates were careless in their calculations of materiality, for example saying
3.7 is 2.3% or 0.23% of 15.9, rather than 23%. Better candidates calculated materiality only in relation to relevant
amounts. This is more impressive than the 'scattergun approach' (ie calculating every number as a % of revenue
as
and total assets and profit). Lists of questions are discouraged (for example, 'Should the gain on disposal be
credited to revenue?', or 'Should the loan be classified as non-current?'). These are indeed matters to consider, but
the requirement is to comment on them. On the sale of surplus assets, many candidates picked up on the
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exceptional item, the need for separate disclosure and the fact that the gain should not be included in revenue. Few
commented on the need for further revaluation of all buildings. There was a lot of irrelevant digression into
impairment testing, ignoring the fact that the asset was sold at a profit. A minority debated management's decision
to sell: this was not called for. Many candidates wanted to check the valuation, the valuer's qualification (irrelevant)
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and the existence of the building (sold) and did not mention the most basic sources of evidence – the contract for
sale (though some referred to the 'invoice') and subsequent receipt of funds (in the bank statement). Regarding the
default on loan, there were many ignorant calculations of materiality – the loan balance to profit for example – that
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earned no marks. Candidates must take more care not to write conflicting answer points. Weaker candidates did not
appreciate that the loan was made in the prior year.
/fr
Note that if dates are given in a question it is because the timeframe needs to be understood. When considering
lack of provision for an obligation, candidates must take more care not to write conflicting answer points. Time was
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again wasted debating whether management had made a good/bad business decision (by extending warranties) and
this was not called for.
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Marking scheme
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Marks
(i) Matters
Generally 1 mark each comment maximum 6 marks each issue × 3
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Maximum 12
Ideas
 Materiality (assessed)
 Relevant IASs (eg 1, 10, 16, 18, 37) & 'The Framework' (eg consistency)
o t.
 Risks (eg FS assertions – fair presentation and disclosure, completeness,
appropriate valuation)
(ii) Audit evidence
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Generally 1 mark each item of audit evidence (source) maximum 5 marks each issue × 3
Ideas Maximum 12
 Oral vs written
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 Internal vs external
 Auditor generated
 Procedures (analytical procedures, enquiry, inspection, observation,
computation)
l.b
Maximum 20
(a) Maximum 8
(b)
(c)
Total ria Maximum
Maximum
6
6
20
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(a) Buildings
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 The profit on disposal ($2.3 million) is 14% of profit before tax (and 0.7% of the revenue it is
included in) and is therefore material to the statement of profit or loss and other
comprehensive income.
 The profit should not be included in revenue but disclosed separately in the statement of profit
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or loss and other comprehensive income as an exceptional item.

 The revaluation gain (also material at 23% of profit before tax) should not be credited against
operating charges in the statement of profit or loss and other comprehensive income but
transferred to retained earnings.
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 The total gain relating to the sale of the non-current asset represents 37% of profit before tax
for the year and it relates to a transaction on nearly the last day of the year, so the auditor
should exercise professional skepticism in relation to its timing.
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 The sale should only be recognised in the year if the contract to sell is binding.
 If the contract is not binding before the year-end but is completed before the audit report is
signed, it will be a non-adjusting event after the end of the reporting period requiring
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disclosure in the financial statements.

 If the contract is binding but not completed at the year-end, there will be a material receivable
of $11.5 million (6% of total assets).
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 As the sold asset is a revalued asset, all the assets in the same class will also be revalued as
required by IAS 16.
/fr
 IAS 16 requires that revalued assets are revalued with sufficient regularity that the carrying
amount does not differ materially from that which would be determined using fair value at the
date of the statement of financial position. The valuation on the sold building appeared to be
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out of date, as it sold at 25% above the valuation, which is material, and therefore it will be
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necessary to ensure that the valuations on the other buildings are correct, particularly if the
increase in capacity has increased their value.
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 If management refuse to adjust the profit on disposal and revaluation gain, then these matters
are material and will necessitate a qualified opinion.
(ii) Audit evidence
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 Sale contract for the building – for details of whether the contract is binding, what its value is,
when payment is due
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 Receipt of sale proceeds in bank statement
 Details of carrying amount from prior year file and non-current asset register
 Valuer's certificate for other properties
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(b) Loan
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 $7 million is 3.7% of total assets and is therefore material.
 The interest for the first year of approximately $400,000 is not material to total assets or to
profit before tax.
 The liability may have been misclassified if it was technically payable on demand at the year-
l.b
end (30 September), although classifying it as non-current would be consistent with the prior
year.
 In this instance the condition rendering it on demand has been waived but it was not waived at
the end of the reporting period.


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The waiver of the condition on 17 October is a non-adjusting event after the end of the
reporting period which should be disclosed in the financial statements.
As the loan was technically on demand at the year end, it should all (the original loan and the
ate
outstanding interest) be included in current liabilities.
 As the loan is material to total assets, if management do not reclassify the loan, the audit
report will have to be qualified on the grounds of disagreement.
(ii) Audit evidence
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 Details of the loan (amount, interest rate, conditions) agreed to prior year working papers
 Confirmation of the amounts owed and details of the loan at 30 September from the lenders at
the year end
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 The correspondence to Verdi setting out the waiver of the conditions and the terms of
agreement about the outstanding interest
 Proposed disclosures in the financial statements
(c) Warranty provision
as

 Installation fees in the period covered by the warranty are $4.2 million, and, at 1.2% of
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revenue, are material.

 As a result of its new warranty provision, Verdi has a present obligation (to reinstall) as a
result of a past event (the original installation).
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 Verdi's policy on warranties claims that no provision has been recognised as the amount of
the obligation cannot be measured with sufficient reliability.
 However, IAS 37 requires that where there are a number of similar obligations (giving
warranties as an example), the probability that a transfer will be required in settlement is
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determined by considering the class as a whole.

/fr
 Therefore, although there may only be small likelihood that each individual warranty might be
taken up, there is a larger likelihood that a warranty out of all of them will be taken up.
 IAS 37 therefore determines that a provision for all the warranties should be made.
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 The provision should be for the best estimate of making good all the items sold under
warranty. It is unlikely that Verdi would not be able to make an estimate of these costs,
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particularly as they will have undertaken calculations to establish the 40% increase in the
price of installations.
 Such a provision is likely to be material (the provision would have to be less than $800,000
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(that is, 20% of original sales cost) to be less than 5% of profit before tax).
 Given that the provision is likely to be material, if a provision for warranties is not made in the
financial statements, the auditors would have to qualify their report over this issue, on the
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grounds of disagreement in respect of non-compliance with IAS 37.
(ii) Audit evidence
 The terms of the warranty
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 The costings of the warranty which will have been used to calculate the corresponding
increase in price undertaken in the nine months to 30 September 20X8, agreed on a sample
basis to invoices
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 Costs of any reinstallations already undertaken
 Average cost of an installation (taken from job cards)
 The schedule of installations
Question 4
l.b
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Top tips. This is a demanding question set in the context of a group audit which requires some thought and
planning. The requirement for part (a) is reasonably straightforward but you need to ensure that you discuss
current guidance in this area. Part (b) is more tricky and there is a danger that you can become bogged down in the
ate
detail of accounting treatments. Essentially it is an audit report question. If you can spot this from the outset you
have a better chance of picking up the relevant points.
Easy marks. This is a tough question on group audits. No easy marks are available as such but a logical approach
is the best for this question.
ym
Examiner's comments. In part (b) many failed to spot that this was essentially an auditor's report question. Most
candidates identified that the accounting treatments mentioned were incorrect but many did not make any reference
to the audit report extract. Few identified the correct impact of the matters on the audit report ie 'except for'.
tud
Marking scheme
Marks
(a) Current guidance for auditing group accounts
Generally 1-1½ marks each well-explained point to a maximum of 8
as
(b) Matters to be considered (before expressing an opinion)

Generally 1 mark per comment 12
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Ideas
 Materiality of subsidiary
 Basis para – meaning?
 Non-compliance (IAS 12 and IAS 17)
ea
 Marcel concurs?
 Emphasis of matter should be after opinion para
 Materiality of non-compliance(s)
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 Adequacy of note disclosures

o (4) Finance vs operating
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o (5) Reason for non-compliance?

 Prior year
o Accounting treatment(s), materiality
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o Auditor's report
o How resolved
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Marks
 Request adjustment in subsidiary's fs  unmodified
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 Adjust on consolidation  unmodified
 No adjustment  'except for'
Total 20
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(a) Current guidance on the audit of groups is provided by ISA 600 Special considerations – audits of group
financial statements (including the work of component auditors). The guidance introduces the concept of a
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component as a 'An entity or business activity for which group or component management prepares
financial information that should be included in the group financial statements'.
The stated objective of the ISA is to determine whether to act as the auditor of the group financial
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statements; and if acting as the auditor of the group financial statements:
(i) To communicate clearly with component auditors about the scope and timing of their work on
financial information related to components and their findings
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(ii) To obtain sufficient appropriate audit evidence regarding the financial information of the components
and the consolidation process to express an opinion on whether the group financial statements are
prepared, in all material respects, in accordance with the applicable financial reporting framework
The standard distinguishes between the group engagement team and the component auditors. The group
l.b
engagement partner is responsible for reporting on the group accounts and has sole responsibility for the
audit opinion. Component auditors are auditors who are responsible for reporting on the financial
information of a component included within the financial statements audited by the group engagement team.
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The ISA conforms to the requirements of other ISAs, for example, ISAs 220, 315 and 330, in respect of the
procedures required to accept the group audit, obtaining knowledge about the group and assessing risk. The
group engagement team should gain an understanding of the group as a whole, and assess risks for the
ate
group as a whole and for individually significant components. The group engagement team has to ensure
component auditors are professionally qualified, meet quality control and ethical requirements and will allow
the group engagement team access to working papers or components.
Procedures
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If the group engagement team plans to request a component auditor to perform work on the financial
information of a component, the group engagement team shall obtain an understanding of the following.
(i) Whether the component auditor understands and will comply with the ethical requirements that are
relevant to the group audit and, in particular, is independent.
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(ii) The component auditor's professional competence.

(iii) Whether the group engagement team will be able to be involved in the work of the component auditor
to the extent necessary to obtain sufficient appropriate audit evidence.
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(iv) Whether the component auditor operates in a regulatory environment that actively oversees auditors.
If a component auditor performs an audit of the financial information of a significant component, the
group engagement team shall be involved in the component auditor's risk assessment to identify
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significant risks of material misstatement of the group financial statements. The nature, timing and
extent of this involvement are affected by the group engagement team's understanding of the
component auditor, but at a minimum shall include:
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 Discussing with the component auditor or component management those of the component's
business activities that are significant to the group
 Discussing with the component auditor the susceptibility of the component to material
misstatement of the financial information due to fraud or error
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 Reviewing the component auditor's documentation of identified significant risks of material

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misstatement of the group financial statements. Such documentation may take the form of a
memorandum that reflects the component auditor's conclusion with regard to the identified
significant risks.
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Evaluating the component auditor's work
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The group engagement team shall evaluate the component auditor's communication.
The group engagement team shall:
(i) Discuss significant matters arising from that evaluation with the component auditor, component
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management or group management, as appropriate
(ii) Determine whether it is necessary to review other relevant parts of the component
auditor's audit documentation
o t.
If the group engagement team concludes that the work of the component auditor is insufficient, the group
engagement team shall determine what additional procedures are to be performed, and whether they are to
be performed by the component auditor or by the group engagement team.
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(b) Matters
Risk
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Risk is increased by the fact that the work of the component auditor, Marcel, may prove to be unreliable.
This is evidenced by the confusing nature of the draft audit report.
Materiality
l.b
Capri (Overseas) is material to the group as a whole. It constitutes 30.6% of the group's profit before tax
and 20% of the group's total assets.
The accounting error in respect of leases is material to both the subsidiary's own accounts and the group
2.4% of the total assets of the group.

Accounting treatments
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accounts. The $790,000 of unrecognised assets constitute 12.2% of the total assets of Capri (Overseas) and
ate
(i) Treatment of leased assets
The treatment of leased assets appears to be incorrect. The disclosure note suggests that the lease
agreements give rights approximating to ownership in which case they should be treated as finance
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leases. It is also unclear if the lease payments charged to the statement of profit or loss and other
comprehensive income all relate to this type of lease or if some relate to operating leases (in which
case the correct treatment has been adopted for these elements).
(ii) Treatment of deferred tax
tud
The treatment of deferred tax also appears to be incorrect. It is unclear why no provision has been
made or why it is impractical to quantify the financial effect.
(iii) Adequacy of disclosures
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In addition to the confusing nature of the disclosures provided, key information is also omitted. This
includes details of the relevant standards from which the subsidiary has departed and any reason for
the non-compliance.
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In respect of deferred tax there is a suggestion that the treatment adopted is to accord with local
legislation. This is referred to in the draft audit report. This is an inappropriate use of the report. This
information should be provided in the disclosure notes accompanying the financial statements.
ea
Marcel's auditor's report

The need for an explanatory paragraph in the basis of opinion section is confusing. If the auditor agrees with
the accounting treatments and the level of disclosure as indicated by the unqualified audit opinion there is no
e
need for this explanation.

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This type of disclosure cannot be used in place of a qualification. In any case it does not make it clear
whether the auditor agrees with these treatments or which of the issues are in accordance with local tax
regulations. If it is an emphasis of matter it should be presented after the opinion paragraph. This is to avoid
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giving the impression that the audit opinion is qualified.

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Effect on group audit opinion.
m/
The management of Capri Group could request that the accounts of Capri (Overseas) be redrafted in
accordance with IAS 12 and IAS 17. (As a subsidiary Capri (Overseas) is controlled by Capri Group.) The
audit reports of Capri (Overseas) and Capri Group would then both be unqualified.
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Adjustments for compliance with IAS 12 and IAS 17 could be made on consolidation only. Again the group
auditor's opinion would be unmodified.
If no adjustments are made in the subsidiary's accounts or those of the group the group audit report would
o t.
be qualified on the basis of a material misstatement (except for) in relation to non-compliance with IAS 12
and IAS 17. The effect of non-compliance should be quantified and disclosed.
Question 5
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Top tips. When trying to identify professional and ethical issues, think about general themes such as independence,
integrity, objectivity and confidentiality. Try and relate relevant ethical and professional guidance that you are aware
of to each situation and explain why it is relevant.
l.b
Easy marks. There are easy marks available in this question for knowledge brought forward from your earlier
auditing studies, such as being able to give a definition of lowballing and knowing the etiquette with regard to
professional clearance letters. Easy marks can also be obtained for coming up with simple steps to take in respect
of each issue – for example, if no answer has been received in part (i), it seems logical to repeat the request.
ria
Examiner's comments. The technical content of this question was not difficult.
In part (b)(i), many candidates made a big issue of the preliminary procedures of the professional etiquette already
ate
gone through and ended their answers with Sepia no closer to a resolution to the problem than when they started.
In part (b)(ii), nearly everyone identified a 'conflict of interest' but few stated that they would refuse the assignment.
Many referred to 'Chinese walls' but did not consider how unacceptable to Vitronella the assignment would be.
Those that proposed resigning the audit (of Vitronella) showed a lack of professionalism.
ym
Part (b)(iii) was probably the worst answered part. Many candidates referred the matter to the partner for his/her
decision. Weaker candidates proposed unsuitable 'solutions' (eg that Sepia withdraw their tender). Few candidates
acknowledged that little could be done. Candidates who referred to 'insider dealing' clearly had no understanding of
the term.
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Marking scheme
as
Marks
(a) Lowballing
Generally 1 mark for each well-explained point 5
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(b) Generally 1 mark each comment 15

Maximum 5 marks each of three matters
Ideas
ea
Professional issues raised

 Integrity (management and/or audit firm)
 Objectivity/independence
 Confidentiality
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 Relevant ethical guidance – ie

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(i) Changes in professional appointment

(ii) Corporate finance advice including take-overs
(iii) Fees
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 Meaning of 'lowballing'
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Marks
Steps (ie actions)
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 Obtain … what? … why?
 Ask/advise … who? When?
Total 20
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(a) Lowballing is the practice of a firm quoting a significantly lower fee level for an assurance service than
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would have been charged by the predecessor firm. This creates a significant self-interest threat. If the firm's
tender is successful, the firm must apply safeguards such as maintaining records such that the firm is able
to demonstrate that appropriate staff and time are spent on the engagement and complying with all
applicable assurance standards, guidelines and quality control procedures
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Current guidance in the form of ACCA's Code of ethics and conduct and the IESBA's Code of ethics for
professional accountants states that members can quote whatever fee is deemed appropriate.
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It is not considered unethical for one firm to offer a lower fee than another, however doing so may create
threats to compliance with the fundamental principles. For example, a self-interest threat to professional
competence and due care would arise if the fee quoted was so low that it would be difficult to perform the
engagement in accordance with applicable technical and professional standards.
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Safeguards to mitigate such threats could include making the client aware of the terms of the engagement
and the basis on which fees are charged and what services are covered by the quoted fees, and also
assigning appropriate time and staff to the engagements.
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The International Ethics Standards Board for Accountants of IAASB recently made changes to enhance the
independence and objectivity of accountants performing assurance engagements with a view to
strengthening the independence requirements of the IESBA's Code of ethics for professional accountants.
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(b) (i) Squid
Professional issues
Sepia has requested a professional clearance letter from Krill & Co in respect of the audit of Squid.
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Krill & Co has not responded. Krill & Co has a professional duty of confidence to Squid, and therefore
should have sought permission from Squid to respond to Sepia's request.
The fact that Krill & Co has not responded could indicate that Squid has refused permission for Krill
& Co to respond to Sepia. However, this seems unlikely for two reasons: firstly, that Squid nominated
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Sepia to act as auditors and therefore should have no objection to Krill & Co responding to them and
allowing them to take up that nomination, and secondly, that if Krill & Co had simply been refused
permission to give that clearance, then as a professional courtesy they should have responded to
Sepia informing them that they could not give them the information they requested and why.
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Therefore it is possible that Anton Fargues, on behalf of Krill & Co, is not replying because he has a
concern as to the integrity of the directors of Squid that he does not wish to share with Sepia due to
concerns over confidentiality issues. However, if Squid has given them permission to respond, this
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should not be a problem. Therefore, it appears that Anton Fargues is acting unprofessionally in not
responding to Sepia's request.
Steps
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The manager at Sepia should ask Squid whether the company has given Krill & Co permission to
respond to Sepia, and if they confirm that permission has been given, Sepia should get this
confirmed in writing.
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He should send a duplicate request for professional clearance by recorded delivery so that receipt has
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to be acknowledged by Krill & Co and gives legal evidence that it was received.
This should include a letter stating that lack of response to his letter will be taken to mean that there
are no professional issues preventing Sepia accepting appointment and that if Krill & Co fails to
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respond, Sepia will report Anton Fargues to his professional body for unprofessional conduct.
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If a reply is received, Sepia's actions will then be directed by the contents of the reply.
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If there is still no reply within reasonable time, Sepia should accept the appointment and report Anton
Fargues to his professional body so that his behaviour can be investigated.
(ii) Hatchet
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Professional issues
Sepia has been approached by Hatchet to offer a non-audit service. Sepia does not provide audit
services to Hatchet, so in relation to Hatchet itself, there is no independence bar to accepting
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appointment.
However, the service is advice in relation to a proposed take-over of Vitronella, an audit client of
Sepia. This is likely to raise a conflict of interest such that it is necessary to refuse the appointment.
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This depends on several factors:
 Whether Hatchet or Vitronella object to Sepia offering the services
 What the services are in detail
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 Whether Sepia would be Vitronella's primary advisor in the event of a takeover
(1) The fact that Sepia are Vitronella's auditors is public information reported in the financial
statements. As such, it is likely that Hatchet are aware that Sepia are Vitronella's auditors and
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therefore do not mind. Vitronella, the target company, will be unaware at this point that their
auditors have been asked to advise a company about a proposed takeover of themselves and
might mind very much. Professional advice in respect of such conflicts of interest states that
the firm (Sepia) should make both parties aware of the conflict so that they can decide
whether they want Sepia to be advisors.
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(2)/(3) The professional guidance states that one firm should not be principal advisor to both parties
involved in a takeover. Therefore, if Hatchet wants Sepia to be its principal advisor, and Sepia
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anticipates that as auditor, it is likely to be Vitronella's principal advisor, the partners of Sepia
will have to decide which side they want to advise. Being auditor does not automatically mean
they would be Vitronella's principal advisors, but there is often an advantage to a company in
having its auditor advise in such situations and, providing that the combined fees do not
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cause a problem, there should be no bar to independence in doing so. It is possible that
Vitronella would expect Sepia to act as their principal advisors.
It would not be possible for Sepia to resign from the Vitronella audit in order to be able to be
Hatchet's principal advisors as this would still pose a conflict of interest as far as Vitronella
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was concerned.
If Sepia was not principal advisor to both parties, and both parties agreed, it could advise
Hatchet and do Vitronella's audit. The best way to ensure confidentiality was maintained in
this instance would be to have entirely separate engagement teams and set up strict
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procedures for ensuring information was kept secret, for example, having teams in different
areas of the office or from different offices of a national firm.
Steps
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Sepia should determine whether Hatchet requires Sepia to be their principal advisors in
relation to this takeover. The partners should inform Hatchet that before they accepted any
engagement of this nature they would require permission from Vitronella.
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Sepia should notify Vitronella that Hatchet has asked them to be principal advisor and gauge
the reaction.
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Ultimately it is likely that Sepia would refuse to advise Hatchet due to the conflict of interest
being so great.
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(iii) Keratin
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Professional issues
Lowballing is the practice of tendering for audits at a lower price than the audit can actually be
carried out for, often with the intention of obtaining other, more profitable, work from the audit client.
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Lowballing is not forbidden by professional rules, because it is seen as a reasonable marketing tactic.
However, it is important that the client is aware of the scope of the work that is going to be carried
out and is aware that prices might rise in the future.
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Professional guidance indicates also that auditors must ensure that they do not provide a service
lower than is required by quality standards regardless of the price that it is being done for. Keratin
must ensure that they do not fall into the trap of providing a poor audit service because they have
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tendered at an unreasonable price. They would be putting themselves at risk of being found to be
negligent by a professional body or even in a court of law should problems arise.
Keratin would be within their rights to provide other services to an audit client as long as this did not
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affect the independence of the audit. However, given that the provision of other services to audit
clients is increasingly frowned upon, for example, in the US, where audit firms are prohibited from
providing other services to audit clients, Keratin should be careful of taking such an approach.
Edwin Stenuit may be in breach of a duty of confidentiality to his employer, discussing the firm's
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affairs in such a way at a social gathering.
Steps
Sepia can take no steps against Keratin in the matter of this tender as Benthos is entitled to choose
whichever audit firm they like to do their audit.
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If Keratin is successful, Sepia may have to review its own pricing policy if it is likely to be tendering
against Keratin in the future.
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Sepia could report Edwin Stenuit to ACCA for misconduct as a result of his breach of confidentiality
to his employer, but it is unlikely that they would do so.
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Paper P7
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(International)
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Mock Examination 2
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Question Paper
Time allowed
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Writing 3 hours
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372
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attempted
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Question 1
Jolie Co is a large company operating in the retail industry, with a year ended 30 November 20Y0. You are a
manager in Jen & Co, responsible for the audit of Jolie Co, and you have recently attended a planning meeting with
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Mo Pitt, the finance director of the company. As this is the first year that your firm will be acting as auditor for Jolie
Co, you need to gain an understanding of the business risks facing the new client. Notes from your meeting are:
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Jolie Co sells clothing, with a strategy of selling high fashion items under the JLC brand name. New ranges of
clothes are introduced to stores every eight weeks. The company relies on a team of highly skilled designers to
develop new fashion ranges. The designers must be able to anticipate and quickly respond to changes in consumer
preferences. There is a high staff turnover in the design team.
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Most sales are made in-store, but there is also a very popular catalogue, from which customers can place an order
online, or over the phone. The company has recently upgraded the computer system and improved the website, at
significant cost, in order to integrate the website sales directly into the general ledger, and to provide an easier
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interface for customers to use when ordering and entering their credit card details. The new on-line sales system
has allowed overseas sales for the first time.
The system for phone ordering has recently been outsourced. The contract for outsourcing went out to tender and
overseas phone call centre where staff costs are very low.
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Jolie Co awarded the contract to the company offering the least cost. The company providing the service uses an
Jolie Co has recently joined the Ethical Trading Initiative. This is a 'fair-trade' initiative, which means that any
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products bearing the JLC brand name must have been produced in a manner which is clean and safe for
employees, and minimises the environmental impact of the manufacturing process. A significant advertising
campaign promoting Jolie Co's involvement with this initiative has recently taken place. The JLC brand name was
purchased a number of years ago and is recognised at cost as an intangible asset, which is not amortised. The
brand represents 12% of the total assets recognised on the statement of financial position.
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The company owns numerous distribution centres, some of which operate close to residential areas. A licence to
operate the distribution centres is issued by each local government authority in which a centre is located. One of the
conditions of the licence is that deliveries must only take place between 8 am and 6 pm. The authority also monitors
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the noise level of each centre, and can revoke the operating licence if a certain noise limit is breached. Two licences
were revoked for a period of three months during the year.
To help your business understanding, Mo Pitt has e-mailed to you extracts from the draft statement of profit or loss
and other comprehensive income, and the relevant comparative figures, which are shown below.
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Extract from draft statement of profit or loss and other comprehensive income
Year ending 30 November 20Y0 Draft 20X9 Actual
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$m $m
Revenue:
Retail outlets 1,030 1,140
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Phone and online sales 425 395

Total revenue 1,455 1,535
Operating profit 245 275
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Profit before tax 220 253
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Additional information:
Number of stores 210 208
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Average revenue per store $4.905 million $5.77 million
Number of phone orders 680,000 790,000
Number of online orders 1,020,000 526,667
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Average spend per order $250 $300
Required:
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(a) Prepare briefing notes to be used at a planning meeting with your audit team, in which you evaluate the
business risks facing Jolie Co to be considered when planning the final audit for the year ended
30 November 20Y0. (16 marks)
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Professional marks will be awarded in part (a) for the format of the answer and the clarity of the evaluation.
(4 marks)
(b) Using the information provided, identify and explain five risks of material misstatement. (10 marks)
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(c) Recommend the principal audit procedures to be performed in respect of the valuation of the JLC brand
name. (5 marks)
(Total = 35 marks)
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Question 2
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You are a manager in Newman & Co, a global firm of Chartered Certified Accountants. You are responsible for
evaluating proposed engagements and for recommending to a team of partners whether or not an engagement
should be accepted by your firm.
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Eastwood Co is an existing audit client and is an international mail services operator, with a global network
including 220 countries and 300,000 employees. The company offers mail and freight services to individual and
corporate customers, as well as storage and logistical services.
Eastwood Co takes its corporate social responsibility seriously, and publishes social and environmental key
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performance indicators (KPIs) in a Sustainability Report, which is published with the financial statements in the
annual report. Partly in response to requests from shareholders and pressure groups, Eastwood Co's management
has decided that in the forthcoming annual report, the KPIs should be accompanied by an independent assurance
report. An approach has been made to your firm to provide this report in addition to the audit.
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To help in your evaluation of this potential engagement, you have been given an extract from the draft Sustainability
Report, containing some of the KPIs published by Eastwood Co. In total, 25 environmental KPIs, and 50 social KPIs
are disclosed.
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Extract from Sustainability Report

Year ended 31 October 20Y0 Year ended 31 October 20X9
DRAFT ACTUAL
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CO2 emissions (million tonnes) 26.8 28.3

Energy use (million kilowatt hours) 4,895 5,250
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Charitable donations ($ million) 10.5 8.2

Number of serious accidents in the 60 68
workplace
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Average annual spend on training per $180 $175

employee
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You have also had a meeting with Ali Monroe, the manager responsible for the audit of Eastwood Co, and notes of
the meeting are given below.
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Notes from meeting with audit manager, Ali Monroe
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Newman & Co has audited Eastwood Co for three years, and it is a major audit client of our firm, due to its global
presence and recent listing on two major stock exchanges. The audit is managed from our office in Oldtown, which
is also the location of the global headquarters of Eastwood Co.
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We have not done any work on the KPIs, other than review them for consistency, as we would with any 'other
information' issued with the financial statements. The KPIs are produced by Eastwood Co's Sustainability
Department, located in Fartown. We have not visited Eastwood Co's offices in Fartown as it is in a remote location
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overseas, and the departments based there are not relevant to the audit.
We have performed audit procedures on the charitable donations, as this is disclosed in a note to the financial
statements, and our evidence indicates that there have been donations of $9 million this year, which is the amount
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disclosed in the note. However, the draft KPI is a different figure – $10.5 million, and this is the figure highlighted in
the draft Chairman's Statement as well as the draft Sustainability Report. $9 million is material to the financial
statements.
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The audit work is nearly complete, and the annual report is to be published in about four weeks, in time for the
company meeting, scheduled for 31 January 20Y1.
Your firm has recently established a sustainability reporting assurance team based in Oldtown, and if the
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engagement to report on the Sustainability Report is accepted, it would be performed by members of that team,
who would not be involved with the audit.
Required
(a)
(b)
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Identify and explain the matters that should be considered in evaluating the invitation to perform an
assurance engagement on the Sustainability Report of Eastwood Co.
Recommend procedures that could be used to verify the following draft KPIs.
(11 marks)
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(i) The number of serious accidents in the workplace
(ii) The average annual spend on training per employee. (6 marks)
(c) You have a trainee accountant assigned to you, who has read the notes taken at your meeting with Ali
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Monroe. She is unsure of the implications of the charitable donations being disclosed as a different figure in
the financial statements compared with the other information published in the annual report.
Required
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Prepare briefing notes to be used in a discussion with the trainee accountant, in which you:
(i) Explain the responsibility of the auditor in relation to other information published with the financial
statements
(ii) Recommend the action to be taken by Newman & Co if the figure relating to charitable donations in
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the other information is not amended (8 marks)

(Total = 25 marks)
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Question 3
Clooney Co is one of the world's leading leisure travel providers, operating under several brand names to sell
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package holidays. The company catered for more than 10 million customers in the last 12 months. Draft figures for
the year ended 30 September 20Y0 show revenue of $3,200 million, profit before tax of $150 million, and total
assets of $4,100 million. Clooney Co's executives earn a bonus based on the profit before tax of the company.
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You are the manager responsible for the audit of Clooney Co. The final audit is nearing completion, and the
following points have been noted by the audit senior for your attention:
In July 20Y0, thousands of holiday-makers were left stranded abroad after the company operating the main airline
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chartered by Clooney Co went into liquidation. The holiday-makers were forced to wait an average of two weeks
before they could be returned home using an alternative airline. They have formed a group which is claiming
compensation for the time they were forced to spend abroad, with the total claim amounting to $20 million. The
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items which the group is claiming compensation for include accommodation and subsistence costs, lost income
and distress caused by the situation. The claim has not been recognised or disclosed in the draft financial
statements, as management argues that the full amount payable will be covered by Clooney Co's insurance.
One part of the company's activities, operating under the Shelly's Cruises brand, provides cruise holidays. Due to
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economic recession, the revenue of the Shelly's Cruises business segment has fallen by 25% this year, and profit
before tax has fallen by 35%. Shelly's Cruises contributed $640 million to total revenue in the year to 30 September 20Y0,
and has identifiable assets of $235 million, including several large cruise liners. The Shelly's Cruises brand is not
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recognised as an intangible asset, as it has been internally generated.
On 15 November 20Y0, Clooney Co acquired Craig Co, a company offering adventure holidays for independent
travellers. Craig Co represents a significant acquisition, but this has not been referred to in the financial statements.
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Required:
Comment on the matters that you should consider, and state the audit evidence you should expect to find in your
review of the audit working papers for the year ended September 20Y0 in respect of:
(a) The compensation claim (8 marks)
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(b) Shelly's Cruises (7 marks)

(c) The acquisition of Craig Co (5 marks)
(Total = 20 marks)
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Question 4
(a) You are a manager in Neeson & Co, a firm of Chartered Certified Accountants, with three offices and 12 partners.
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About one third of the firm's clients are audit clients, the remainder are clients for whom Neeson & Co performs
tax, accounting and business advisory services. The firm is considering how to generate more revenue, and you
have been asked to evaluate two suggestions made by the firm's business development manager.
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(i) An advertisement could be placed in national newspapers to attract new clients. The draft
advertisement has been given to you for review:
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Neeson & Co is the largest and most professional accountancy and audit
provider in the country. We offer a range of services in addition to audit,
which are guaranteed to improve your business efficiency and save you
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tax.
If you are unhappy with your auditors, we can offer a second opinion on
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the report that has been given.

Introductory offer: for all new clients we offer a 25% discount when both
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audit and tax services are provided. Our rates are approved by ACCA.
(8 marks)
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(ii) A new partner with experience in the banking sector has joined Neeson & Co. It has been suggested
that the partner could specialise in offering a corporate finance service to clients. In particular, the
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partner could advise clients on raising debt finance, and would negotiate with the client's bank or
other provider of finance on behalf of the client. The fee charged for this service would be contingent
on the client obtaining the finance with a borrowing cost below market rate. (5 marks)
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Required
Evaluate each of the suggestions made above, commenting on the ethical and professional issues raised.
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Note. The mark allocation is shown against each of the issues.
(b) You have set up an internal discussion board, on which current issues are debated by employees and
partners of Neeson & Co. One posting to the board concerned the compulsory rotation of audit firms,
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whereby it has been suggested in the press that after a pre-determined period, an audit firm must resign
from office, to be replaced by a new audit provider.
Required
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(i) Explain the ethical threats created by a long association with an audit client. (3 marks)
(ii) Evaluate the advantages and disadvantages of compulsory audit firm rotation. (4 marks)
(Total = 20 marks)
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Question 5
(a)
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You are the manager responsible for the audit of Willis Co, a large client of your audit firm, operating in the
pharmaceutical industry. The audit work for the year ended 30 August 20Y0 is nearly complete, and you are
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reviewing the draft audit report which has been prepared by the audit senior. You are aware that Willis Co is
developing a new drug and has incurred significant research and development costs during the year, most of
which have been capitalised as an intangible asset. The asset is recognised at a value of $4.4 million, the
total assets recognised on the draft statement of financial position are $55 million, and Willis Co has a draft
profit before tax of $3.1 million.
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Having reviewed the audit working papers, you are also aware that management has not allowed the audit
team access to the results of scientific tests and trials performed on the new drug being developed.
An extract from the draft audit report is shown below.
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Basis of opinion (extract)

Evidence available to us in respect of the intangible asset capitalised was limited, because of restrictions
imposed on our work by management. As a result of this we have been unable to verify the appropriateness
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of the amount capitalised, and we are worried that the asset may be overvalued. Because of the significance
of the item, and the lack of integrity shown by management, we have been unable to form a view on the
financial statements as a whole. Opinion (extract): Disclaimer on view given by financial statements Because
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of the lack of evidence that we could gain over the intangible asset, we are unable to form an opinion as to
whether the financial statements are properly prepared in accordance with the relevant financial reporting
framework.
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Required:
(i) Critically appraise the draft audit report of Willis Co for the year ended 30 August 20Y0, prepared by
the audit senior.
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Note. You are not required to re-draft the extracts from the audit report. (10 marks)
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(ii) Identify and explain any other matters to be considered, and the actions to be taken by the auditor, in
respect of the management-imposed limitation on scope. (5 marks)
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(b) You are also responsible for the audit of Moore Co, with a year ended 30 September 20Y0. The following
notes have been left for your attention by the audit senior.
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'Our audit testing performed so far on trade payables revealed some internal control deficiencies. Supplier
statement reconciliations have not always been performed by the client, and invoices were often not
approved before payment. We have found a few errors in the payables ledger and the individual accounts of
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suppliers making up the trade payables balance, the total of which is material to the statement of financial
position.'
Required
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Recommend the further actions that should be taken by the auditor, and outline any reporting requirements
in respect of the internal control deficiencies identified. (5 marks)
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(Total = 20 marks)
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380
A PLAN OF ATTACK
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Use your 15 minutes of reading time usefully, to look through the questions, particularly Questions 1 and 2 in
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Section A which are compulsory, to get a feel for what is required and to become familiar with the question
scenarios.
It is vital that you attempt all the questions in the paper to increase your chances of passing. The best way to do
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this is to make sure you stick to the time allocation for each question – both in total and for each of the question
parts. The worst thing you can do is run over time in one question and then find that you don't have enough time
for the remaining questions.
Section A is compulsory and consists of two long case-study style questions totalling 60 marks. These may contain
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detailed information such as extracts from financial statements and audit working papers. A range of requirements
will be set for each question, covering areas from across the whole syllabus.
Question 1 is for 35 marks. The scenario is quite long so make sure you have used your reading time well to
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familiarise yourself with it and make some notes on key issues. The key to success in this question is to stay
focussed, don't run over time and answer the questions set. In part (a) you are asked for business risks. This is a
standard P7 question, that should almost be second nature to you by now. Part (b) asks for five risks of material
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misstatement. Make sure you actually give five risks here. Part (c) asked for procedures to test a valuation, which
should have been relatively straightforward.
Question 2 is also worth 25 marks and relates to environmental and social reporting. Part (a) is based on the
scenario, and requires you to be practical in your approach. In part (b) you needed to be precise and come up with
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specific procedures. Part (c) was almost a standalone requirement, and should have been within your reach.
Section B contains three questions, from which you must attempt two. This section will be worth 40 marks and will
use short scenarios.
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Question 3 is on audit evidence and matters to consider in the context of three issues. Note the mark allocation in
each. Your answers must be focussed and coherent if you are going to score well and your financial reporting
knowledge needs to be sound as you will have to apply it in this question.
Question 4 is on ethics and practice management, and deals with advertising, a suggestion on fees and a current
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issue. This was a well-balanced question that should have provided you with a good but fair test of your abilities.
Question 5 is on auditor's reports. Part (a) requires you to critically appraise an auditor's report, and to explain
matters to consider in relation to a limitation on scope. Part (b) examines the impact of a specific area on the
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auditor's report. Throughout this question you were required to think not just about the technical contents of the
auditor's report, but also the practical issues in the auditor's relationship with the client.
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Forget about it!

And don't worry if you found the paper difficult. More than likely other candidates will too. If this were the real thing
you would need to forget the exam the minute you left the exam hall and think about the next one. Or, if it is the last
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one, celebrate!
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Question 1
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Top tips. This question on planning an audit is typical of the kind of question you should expect to have to tackle in
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Section A of this paper. The question is tough but fair, and if you were well-prepared and well practised at
identifying audit risks in scenarios, you should have been able to achieve reasonable marks on it. To tackle
questions like this, you have to devise a strategy along these lines:
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 Make sure you understand the requirement and answer it
 Look for key words and themes in the scenario that indicate audit risk
 Ensure you explain why things are audit risks and why you would use a particular strategy
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 Do not spend too long on the question to the detriment of others
Easy marks. You should be able to score good marks on part (b). Make sure you get some of the professional
marks.
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Examiner's comments. On the whole, candidates seemed to like this question, especially the business risk
evaluation. However, many candidates failed to answer the specific question requirements, thereby denying
themselves marks.
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Answers to requirement (a) tended to display reasonable application skills, with some candidates prioritising the
risks identified, and reaching an overall conclusion. There was much less evidence here of 'knowledge-dumping'
than in answers to other requirements. However, common weaknesses included:
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
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Repeating large chunks of text from the scenario with no explanation provided
Not actually explaining or evaluating a risk identified – just saying 'this is a risk'
Providing detailed definitions of business risk, which was not asked for
Providing audit procedures for risks, again not asked for
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 Providing recommendations for mitigating the risk, not asked for
In addition, it is worth noting that very few candidates used the figures provided in the scenario to identify risk
exposure. The client's revenue and profit had fallen from the previous year, and some simple financial analysis
could have revealed falling profit margins and worsening interest cover. This type of analysis is not difficult or time
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consuming, and is something that demonstrates mark-generating application skills.

Finally, some candidates simply failed to answer the question requirement. A minority of candidates took the
opportunity to provide many pages of answer which just described how you would plan an audit in general. All of
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this was totally irrelevant, and failed to generate any marks.

The quality of answers to requirement (b) was unsatisfactory. Some answers, which were by far the majority,
tended to just outline an accounting treatment with no mention of the actual risk itself. Another common weakness
was to discuss the detection risk which may arise with a new audit client, which is not a risk of material
as
misstatement.
Requirement (c) was better answered, and some candidates scored well, providing well written procedures specific
to the valuation of an intangible asset. Many of those that did not score well had misread the scenario.
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Candidates are reminded that audit procedures must be tailored to the facts of the scenario provided and must
be sufficiently detailed to make sense. 'Get management rep', 'discuss with management' and 'review cost' are
examples of meaningless 'procedures' which earn no credit without further development. In addition there were
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many instances where candidates were obviously trying to generate procedures using a list of words as a prompt.
For example 'observe the asset' or 'inquire about the asset'. Candidates must think carefully and not just use words
as a prompt if they make no sense. Candidates are encouraged to read the examiner's article on exam technique in
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answering questions on audit procedures, published in September 2009 and available on ACCA's website.
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Marking scheme
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Marks
(a) Evaluate business risks
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½ mark for each risk identified (to max 4 marks) and up to 1½ further marks for explanation
Up to 2 marks for calculation of margins, trends, etc
– High fashion items/high staff turnover in design team
o t.
– Obsolete inventory and pressure on margins
– Widespread geographical business model hard to control
– Volume of e-commerce sales – ability of systems to cope
– Security of e-commerce operations
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– Tax and regulatory issues on e-commerce
– Foreign exchange risk on new overseas transactions
– Outsourcing of phone operations – quality issues
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– Outsourcing of phone operations – unpopular with customers
– Long-term sustainability of outsourced function
– Ethical Trading Initiative – supply chain issues
– Potential restrictions on operation of distribution centres
l.b
– Financial performance – general comments on revenue/profitability/margins 16
Professional marks: 2 for presentation, 2 for quality of evaluation 4
(b) Risks of material misstatement

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½ mark for identification up to 1½ further marks for explanation, five matters only
½ mark for reference to relevant accounting standard (1 mark max)
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– Inventory valuation (IAS 2)
– Inventory existence (IAS 2)
– Unrecorded revenue
– Capitalisation of IT/website costs (IAS 38)
– Valuation of brand name (IAS 38)
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– Valuation of properties (IAS 36)

– Recognition of provision/contingent liability (IAS 37)
– Opening balances and comparatives (1 mark only) 10
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(c) Audit procedures: brand name

1 mark per specific procedure
– Agree cost to supporting documentation/prior year accounts
– Review assumptions used in management impairment review
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– Perform independent impairment review

– Review planned level of expenditure to support the brand
– Review results of any marketing/customer satisfaction surveys
– Consider whether non-amortisation is GAAP for this industry
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– Discuss reasons for non-amortisation with management 5
Total 35
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(a) Briefing notes
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Subject: Business risks facing Jolie Co
Introduction
These briefing notes evaluate the business risks facing the new client Jolie Co, which has a financial year
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ending 30 November 20Y0.
Continuing quality of product
o t.
Jolie operates in a dynamic and volatile business environment, with new ranges being introduced every eight
weeks. There is a constant need for talented designers to develop product ranges, and given the high staff
turnover it may be difficult to retain talented staff. The risk is that if Jolie fails to recruit the right designers
the quality of the product could be reduced, which could lead to a fall in revenue. Lower quality products
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could potentially tarnish the JLC brand, which is so crucial to Jolie's success.
Obsolete inventory
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New ranges are introduced every eight weeks, so there is a risk of inventory becoming obsolete if it is not
sold during this short period. Any older inventory may be marked down, which would affect margins.
Margins fell from 17.9% in 20X9 to 16.8% in 20Y0, which could be related to this.
E-commerce – sales volume
l.b
Online sales now account for $255 million ($250 per order  1,020,000 orders). In the previous year, online
sales accounted for $158 million ($300 per order  526,667 orders). This represents an increase of 61.4%
(255 – 158 / 158  100%).
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The risk is that the system may be overwhelmed by the increase in sales volume, which could lead to
difficulties fulfilling orders and potential damage to the all-important JLC brand.
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E-commerce – new systems
There is a risk of system failure associated with any new system, which could result in unfulfilled orders and
hence brand damage.
E-commerce – security
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There is a risk that customers' details held on the system are not kept sufficiently securely. There is a risk
that data protection laws could be breached. If security were to be breached then the brand would be very
likely to suffer.
tud
E-commerce – overseas sales

Making sales overseas exposes Jolie to several new risks. If sales are made in foreign currencies then there
is a risk that the computer system may not be able to handle these sales (eg it could miscalculate foreign
currency prices).
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Overseas sales expose Jolie to potential tax complications, eg extra sales tax to be paid on exported goods,
and additional documentation to comply with foreign regulations.
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Jolie may also now be exposed to foreign exchange risks, and may find its profit margins affected by
currency fluctuations.
Outsourced phone ordering
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Jolie outsourced its phone ordering system to the cheapest provider. If the phone ordering system is not of
a good quality then this may be incongruent with the differentiated, high-quality nature of Jolie's products. If
many errors occur with orders then this may lead to customer dissatisfaction and damage to the brand.
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The location of the call centre overseas, which presumably reflects the low cost, may be a source of
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frustration to customers, and may ultimately lead to a fall in revenue.

However, the risks associated with phone ordering may to some extent be mitigated by the expansion of
e-commerce, which customers may prefer to use.
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Ethical trading initiative
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The fact that Jolie has spent a significant amount money advertising its fair trade credentials leads to a risk
of bad publicity if these credentials were to be undermined. Any ethical failings in the supply chain may be
subjected to public scrutiny, which would again damage the JLC brand.
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Distribution centres
There is a real risk of local authorities revoking distribution centres' licences if conditions are breached
(eg in relation to noise levels). This could pose Jolie significant operational difficulties if any of the centres
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are closed, as with its short inventory turnover period Jolie is especially reliant on its ability to deliver
inventory on time.
Financial performance
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Overall revenue has decreased by $80 million, or 5.2% (80 / 1,535  100). Operating profit has also fallen,
by $30 million, or 10.9% (30 / 275  100). Average spend per order has fallen from $300 to $250.
This may give cause for concern, but operating expenses for 20Y0 are likely to include one-off items, eg the
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costs of the new sales system. The fall in spend per customer could be a symptom of general economic
difficulties. The company has increased the volume of online transactions significantly.
On balance the overall reduction in profit and margins is unlikely to be a significant risk at this year end,
l.b
though if the trend were to continue it may become a more pressing issue.
Jolie Co's finance costs have increased by $3 million, contributing to a fall in profit before tax of 13%. The
company has sufficient interest cover to mean that this is not an immediate concern, but the company
should ensure that finance costs do not escalate.
Conclusion
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Perhaps the most significant risk for Jolie is that it fails to produce products of sufficient quality, which
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relates to its ability to make use of talented designers. The risk of inventory obsolescence is also significant.
The downward trend in Jolie's financial performance needs to be monitored carefully in the future.
(b) Inventory valuation
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IAS 2 Inventories states that inventory must be valued at the lower of cost and net realisable value (NRV).
The high rate of inventory turnover leads to a risk of inventory becoming obsolete and to a fall in its NRV,
and if NRV falls below cost then it will need to be written down. This may be the case with any inventory that
is being sold at a reduced price, or which is slow-moving and may not be sold at all. Jolie's declining overall
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revenue may indicate falling NRVs and hence that inventory is impaired.
Inventory completeness & existence
It will be difficult to count inventory accurately across all of Jolie's 210 stores, and there may be a large
number of goods in transit to keep track of. All of this means that the auditor will find it difficult to obtain
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sufficient evidence over the existence of inventory. There is a risk of fraudulent financial reporting in this
area as it is difficult to verify the levels of inventory actually held.
New systems
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The existence of a new sales system poses the risk of teething problems if the system did not function
properly at first. As a result sales could be recorded incorrectly in the nominal ledger, either through as a
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result of the new system not providing correctly information, or because of problems with the integration of
the system and the nominal ledger.
There may also be a different system in place for the newly-outsourced phone sales, and there is a risk of
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sales being misstated if the systems are not properly integrated.

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Website costs
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The expenditure on the new IT systems may have been capitalised in line with IAS 38 Intangible Assets,
according to which only expenditure in the development phase may be capitalised, with costs before
(eg planning) and after (eg operational) being expensed. The risk is the overstatement of intangible assets.
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Brand name
An intangible asset has been recognised in respect of the JLC brand name, as this was purchased and not
internally generated. This appears to be in line with IAS 38 Intangible assets. At 12% of total assets this
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amount is likely to material to the financial statements.
IAS 38 requires an impairment review to be conducted at the end of each reporting period. If this is not
conducted, the asset could be overvalued. The decline in revenue could be an indicator of impairment.
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The significant advertising expenditure during the year should be expensed, and there is a risk of
overstatement of assets and non-occurrence of expenses if this expenditure has been capitalised.
Property valuation
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Jolie owns numerous distribution centres (rather than leasing them), and there is a risk of these assets
being impaired if their licences are revoked. Additionally, there has been a fall in revenue per store, which is
an indicator of impairment per IAS 36 Impairment of assets.
l.b
(c) Audit procedures on JLC brand
 Agree cost of brand to supporting documentation, eg purchase invoice (if still available).



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Agree cost of brand to prior year audited financial statements.
Review monthly income streams generated by brand, for indication of any decline in sales.
Review results of impairment reviews by management, establishing the validity of any assumptions
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used in the review (eg discount rate used to discount future cash flows; growth rates used to predict
cash inflows).
 Perform independent impairment review on the brand, and compare with management's impairment
review.
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 Review level of planned expenditure on marketing and advertising to support the brand name, and
consider its adequacy to maintain the image of the brand.
 Inquire as to the results of any customer satisfaction surveys, to gain an understanding of the public
tud
perception of JLC as a high fashion brand.

 Consider whether non-amortisation of brand names is a generally accepted accounting practice in the
fashion retail industry by reviewing the published financial statements of competitors.
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 Discuss with management the reasons why they feel that non-amortisation is a justifiable accounting
treatment.
Tutorial note. As this is a first year audit, no marks will be awarded for procedures relating to prior year working
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papers of the audit firm.

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Question 2
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Top tips. This area has not been examined very frequently in recent years, but the fact that it was examined here is
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a warning against trying to question-spot. You must be ready to answer questions on any area of the syllabus.
Part (a) may have been intimidating if you had not revised this area thoroughly, but actually a lot of the points in the
marking scheme are applicable to most kinds of engagement. You could have thought of general points, and then
o t.
applied them to the situation given in the question. Note the examiner's comment about application below; P7
tutors never tire of telling students to apply their knowledge to the question.
Part (b) should have been straightforward, but just as in part (a) you need to make sure you applied yourself to the
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actual question, in part (b) you needed to be as specific as possible in coming up with realistic ways of verifying the
KPIs.
Part (c) should also have been straightforward, provided you knew the answer! There is no substitute for
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knowledge here, especially as this is not a difficult area of the syllabus.
Easy marks. The first few marks in part (b)(i) & (ii) were easy, as you should have been able to think of at least a
few procedures without much effort.
l.b
Examiner's comments. Candidates responded reasonably well to parts of this question, though many answers did
not reach their full potential by not being applied to the question scenario.
Some answers to part (a) were much too brief for the 12 marks available, amounting to little more than a bullet
to pass this requirement.

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point list of matters to be considered but with no application to the scenario. Without application it was not possible
A fair proportion of answers to requirement (b) were sound, with precise procedures recommended. But, many
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recommended procedures relied too much on observation and enquiry, and ignored the fact that the client was a
global company with 300,000 employees which led to some bizarre and meaningless procedures being given, such
as 'observe a serious accident', 'inspect the location of a serious accident', 'ask how much is spent on training',
and 'look at the training room to see how many chairs are there'. None of these could verify the KPIs and are
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pointless.
Requirement (c) was inadequately attempted overall. Answers were usually extremely brief, and it was clear that
most candidates did not know the requirements of ISA 720. Most answers took a guess that the matter would need
to be discussed with management, and that if unresolved there would be some kind of impact on the auditor's
tud
report (an 'except for' opinion was the usual recommendation). But few could say more than this about the issue.
Some candidates assumed that some kind of money laundering was taking place, leading to irrelevant discussions
of reporting the situation to outside authorities. Very few candidates recognised that if uncorrected, the issue
should be included in an Other Matter paragraph, as required by ISA 720. This could imply a lack of knowledge, or
as
that some candidates are studying from out of date learning materials.
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Marking scheme
Marks
((a)) Matters
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(a) Identify and explain acceptance matters
½ mark for each matter identified (to max 4 marks) and up to 1½ further marks for
o t.
explanation
– Objectivity (up to 3 marks allowed)
– Client's specific requirements
– Competence
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– Large scale engagement
– Fee level and profitability
– Time pressure
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– Global engagement
– Risk
– Commercial considerations 11
l.b
(b) (i) Procedures on number of serious accidents
– HR records review
– Accident book review
– Determine criteria for serious accident
– Review legal correspondence
– Review board minutes
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ate
– Review documentation of health and safety inspections
– Ascertain any convictions for breach of health and safety rules
(ii) Procedures on average training spend
– Review approved training budget
ym
– Review components of total spend for misclassified items

– Agree sample of invoices/contracts with training providers
– Agree sample to cash book/bank statement (½ only)
– Recalculate average 6
tud
(c) (i) Auditor's responsibilities regarding other information

1 mark per comment, ½ mark ref to ISA 720
– Definition/examples of other information
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– Implication if inconsistency in financial statements not resolved (qualification)

– Implication if inconsistency in other information (Other Matter paragraph)
– Material misstatements of fact
(ii) Action by Newman & Co
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1 mark per comment

– Review audit work on charitable donations
– Discuss inconsistency with management/those charged with governance
ea
– If refuse to change the figure, reconsider reliance on management

representations
– Implication for audit report 8
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Total 25
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(a) Matters to consider include:
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In accordance with the IESBA Code of Ethics for Professional Accountants ('Code'), a non-audit service
must only be provided to an audit client after careful consideration of whether the firm's independence and
objectivity in respect of the audit may be impaired, and of whether safeguards could be put in place to
reduce this threat to an acceptable level or to eliminate it entirely. If such safeguards cannot be put in place,
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then the audit firm should not accept the non-audit engagement or should withdraw from it.
This assignment would appear to carry particular threats in relation to fee dependence and advocacy.
o t.
Fees
Eastwood is a 'major client' of Newman & Co, and there is a risk that the provision of further, non-audit,
services to Eastwood could lead to a breach in the acceptable level of recurring fees receivable from one
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audit client. In the case of a public interest client such as Eastwood, the IFAC Code states that the public may
perceive an auditor's independence to be impaired where recurring fees are 10% of total fees.
Advocacy
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Newman & Co has been engaged by the client partly in response to the client receiving requests for a
Sustainability Report from shareholders and pressure groups. This is a potentially risky context in which to
provide such a report, as the report is likely to be scrutinised closely. Furthermore, Newman & Co may be
perceived as management's advocate, which would be particularly damaging in the event of any dispute.
l.b
Newman & Co's independence would be strengthened by the fact that assurance work would be carried out
by a separate team from the audit team.
Level of assurance
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Assurance reports may be provided giving varying levels of assurance. It will be necessary to obtain
clarification from Eastwood of the level of assurance that it requires, and whether it requires different levels
ate
of assurance for different KPIs. Clearly, the level of assurance required would affect the level of evidence
required and hence the amount of work that needs to be done, which would in turn affect the fees charged.
This should be clarified before accepting the engagement, and a form and wording for the proposed report
should be agreed with Eastwood.
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Competence
It is possible that Newman & Co may not have staff with the requisite technical competence to undertake
this engagement. The fundamental principle of professional competence and due care requires that
members of an engagement team both possess and apply sufficient skill and knowledge to be able to
tud
perform the assignment.

If Newman & Co does not have staff with this skill and experience then it could contract an expert to do
some of the work, but this would be likely to increase the costs associated with the engagement.
as
Resources
A total of 75 KPIs would be reported on, which means that this is likely to be a relatively large engagement.
A large number of staff would probably be required to work on the engagement.
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It is promising that Newman & Co has a dedicated sustainability reporting assurance team, which should put
it in a good position to undertake the work. However, the fact that the team is new means that careful
consideration must be given to whether it is capable of doing the work required.
ea
Time pressure
It would be very difficult to gather sufficient evidence to provide an assurance report within the four weeks
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left until the annual report is published. This may cause staff to be working under significant time pressure,
which increases the risk of mistakes being made. Newman & Co must clarify when Eastwood intends for the
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assurance report to be published.

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Profitability
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This is a large assignment, probably requiring the team to travel from Oldtown to Fartown to perform the
work. This would clearly involve incurring significant costs, and should be reflected in the level of fees
charged.
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The amount of work that would need to be done, and the short time frame in which to do it, mean that a high
fee could be commanded here.
Travel
o t.
It is likely that members of the assurance department would need to travel to Fartown, and for the
engagement to be accepted they must be willing to do so. It is not clear whether there are any language
barriers to working in Fartown, and whether these might be overcome.
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Risk
The context of the assignment indicates the presence of risks relating to the degree of scrutiny to which the
assurance report would be likely to be subjected. In addition to the presence of interested pressure group
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and shareholders (q.v.), Eastwood is listed on two stock exchanges and is thus fairly high profile. This may
increase the level of evidence that Newman & Co would seek to obtain, which would in turn affect the level of
fee charged.
l.b
Moreover, the inconsistency that has already come to light in respect of the charitable donations figure may
indicate management manipulation of the KPIs, which adds to the risk associated with the assignment.
(b) (i)  Review HR records of the number and type of accidents in the workplace.

 ria
Review accident log books from a sample of locations.
Discuss the definition of a 'serious' accident and establish the criteria applied to an accident to
determine whether it is serious.
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 Review correspondence with legal advisors which may indicate any legal action being taken
against Eastwood.
 Review minutes of board meetings for discussions of serious accidents and repercussions for
ym
the company.
 Discussion with management/legal advisors, of whether Eastwood has any convictions for
health and safety offences during the year.

tud
Enquire whether the company has received any health and safety visits. Review
documentation from any of these for evidence of serious accidents.
 Talk to employees to identify any accidents not recorded in the accident book.
(ii)  Review Eastwood's training budget in comparison with previous years to ascertain the overall
as
level of planned spending on training.

 Obtain breakdown of the total training spend and review for any items misclassified as
training costs.
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 Agree significant components of the total training spend to supporting documentation, eg

contracts and invoices from training providers.
ea
 Agree the total amount spent on significant training programmes to cash book and/or bank
statements.
 Using data on total number of employees provided by the payroll department, recalculate the
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annual training spend per employee.

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(c) Briefing notes
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To: Trainee Accountant
Subject: Other information – auditor's responsibilities
(i) Introduction
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These notes explain the responsibility of the auditor in relation to other information published with
the financial statements, in the context of Eastwood Co's charitable donations.
Auditor's responsibility
o t.
ISA 720 The auditor's responsibilities relating to other information in documents containing audited
financial statements defines as financial and non-financial information included in a document
containing audited financial statements and the auditor's report. This would include Eastwood's
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Sustainability Report.
ISA 720 requires the auditor to read the other information to identify material inconsistencies with
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the audited financial statements, which may raise doubts over the auditor's opinion. If a material
inconsistency is discovered, the auditor must determine whether it is the financial statements or the
other information that should be revised.
If the financial statements need to be revised but are not, and are therefore materially misstated, then
l.b
the auditor's opinion should be modified.
If the other information needs to be revised and is not (but the financial statements are unaffected),
then the auditor's report should include an Other Matter paragraph describing the inconsistency. The
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auditor should consider requesting those charged with governance to consult its legal counsel. In
extreme situations, it may be necessary for the auditor to obtain legal advice itself and to withdraw
from the assignment.
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If the auditor discovers a material misstatement of fact in the other information, which is unrelated to
the financial statements and thus to the auditor's report, then the auditor should communicate this
fact to those charged with governance.
(ii) Eastwood's Sustainability Report contains a material inconsistency with the financial statements;
ym
charitable donations are stated as $10.5m in the Sustainability Report and $9m in the financial
statements.
Audit evidence has been obtained which supports the $9m figure in the financial statements. This
evidence should be reviewed to ensure that it is sufficient and appropriate.
tud
The matter should be discussed with management, who should be asked to change the figure in the
Sustainability Report. If management refuse to make this change then the auditor's report should
include an Other Matter paragraph immediately after the opinion paragraph, which should describe
the inconsistency. The matter should also be communicated to those charged with governance.
as
Eastwood is listed on several stock exchanges, so Newman & Co should consider whether it has any
other responsibilities in relation to any Listing Rules.
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Finally, if management refuses to change the Sustainability Report then this may indicate a lack of
integrity on its part. Any reliance placed on management representations should be reconsidered in
this light.
ea
Conclusion
Newman & Co needs to consider carefully how it will meet its responsibilities in relation to
Eastwood's other information.
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Question 3
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Top tips. As you are reading through the information, jot down the accounting standards you believe are relevant
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and note down the matters to consider that arise from them. Think if any ISAs are relevant as well (this is
particularly important as your examiner has recently commented that candidates tend to show too little knowledge
of the requirements of ISAs). Always comment on the materiality of matters. Bear in mind the mark allocation as
o t.
well. In this question, you should have more to say in parts (a) and (b) than in part (c).
Easy marks. Easy marks are available for assessing and stating the materiality of items raised.
Examiner's comments. For requirement (a), almost all candidates were able to generate marks by calculating the
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materiality of the amount, and describing the basic accounting treatment for provisions. Fewer went on to discuss
the potential impact of the insurance cover, and some answers drifted into a discussion of going concern and other
business risks. Audit procedures were often inadequately focused, with no regard to the scale of the issue.
log
Although most suggested looking at legal documents, candidates rarely mentioned looking at the group claim
document. Some candidates proposed lots of very detailed tests on the validity of individual claims, such as
checking hotel bills and airline tickets.
Requirement (b) was not dealt with well. Very few candidates recognised that the business segment represented a
l.b
cash generating unit that required an impairment test. Even those candidates that did pick up on the impairment
issue could rarely provide evidence points other than 'check the value of the assets' (too vague) or 'inspect the
assets' (irrelevant).
ria
Many candidates successfully discussed the issue in requirement (c). Unfortunately, many candidates wanted to
see the new subsidiary consolidated, even though it had clearly been purchased after the end of the reporting
period. At the other end of the spectrum, some candidates suggested that as the event happened after the year end,
ate
the auditor need not perform any procedures at all.
Marking scheme
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Marks
(a) Compensation claim
1 mark per matter, 1 mark per specific procedure
Matters:
tud
– Materiality
– Provision/contingent liability
– Recoverability under insurance
– Management reluctant to provide
as
Evidence:
– Copy of legal claim
– Legal correspondence
cc
– Press releases/news stories to establish constructive obligation

– Booking conditions to verify legal obligation
– Advice given by the company at the time of the incident
ea
– Copy of insurance contract

– Copy of claim made on insurance
– Written representation on outcome 8
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(b) Shelley's Cruises

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Matters:
– Materiality
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– Impairment of assets (not brand)

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Marks
– Cash generating unit
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– Subjective elements in impairment calculations
Evidence:
– Review management impairment test (max 2 marks if detailed)
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– Discuss future strategy re Shelly's Cruises
– Review post year-end performance/bookings in advance 7
(c) Acquisition of Craig Co
o t.
Matters:
– Non-adjusting event
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– Note to disclose
– Implication for audit report if not disclosed
Evidence:
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– Copy of press release announcing acquisition
– Copy of legal agreement or due diligence report on acquisition
– Review of financial statements to determine significance of
acquisition
l.b
– Review of any note disclosed 5
Total 20
(a) Matters to consider

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The claim is material to profit at 13.3% of profit before tax (20 / 150 × 100%). It is not material to the
statement of financial position at only 0.49% of total assets (20 / 4,100 × 100%).
ate
Management have an incentive to manipulate the financial statements through fraudulent financial reporting,
as their bonus is based on profit before tax. There is a risk that profit may be overstated. They may not want
to provide for the claim because this would reduce profit.
ym
IAS 37 Provisions, contingent liabilities and contingent assets requires a provision to be recognised where,
as a result of a past event, an outflow of economic benefits is probable, the amount of which can be
estimated reliably. If such an outflow is only possible but not probable then it is a contingent liability, and
should be disclosed in a note to the financial statements. Further evidence is required to determine whether
tud
the compensation claim should be provided for or not.

If Clooney can make a claim on its insurance policy in respect of the legal case, then per IAS 37 this is
treated as a separate event, in accordance with IAS 37's requirements on contingent assets. For an asset to
be recognised, IAS 37 states that it should be certain to be received. As in this case receipt of an insurance
as
payment is only probable, no asset should be recognised. The insurance claim should be disclosed by way
of a note.
In addition to the provision that must be created, it may be necessary for Clooney to provide for any legal
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costs associated with defending the claim, which would further reduce its profit for the year.
Evidence
ea
 Copy of claim made by the group of holiday-makers, detailing the $20 million claimed and the basis of
the claim
 Review of correspondence between 'claim group' and the company
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 Correspondence from Clooney's legal counsel, showing their opinion on the likely outcome
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 Copy of any press releases made by Clooney, which could help establish there is a constructive
obligation

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Review of press coverage of the situation, to assess any comments made in public by company
representatives regarding the claim
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 Review of the standard terms and conditions that holiday-makers agree to on booking a holiday – this
could help to establish any legal obligation, eg to cover the cost of accommodation before being
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returned home
 Details of any helpline or other means by which the stranded holiday-makers were given advice at the
time of the incident (eg if the company advised them to book alternative accommodation this may
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imply that the company is liable for the cost)
 Copy of insurance contract detailing level of cover, if any, provided for this situation, and any amount
that will not be covered (eg an excess on the policy)
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 Correspondence between insurance company and Clooney to establish whether an insurance claim has
been made
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 Written management representation stating management's opinion on the outcome of the court case,
and the likelihood of reimbursement from the insurance cover
 Review of invoices received pre- and post- year end in respect of legal costs, to ensure adequately
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included in expenses and accrued for if necessary
(b) Matters to consider
The Shelly's Cruises (SC) operation is material to the financial statements, contributing 20% to revenue
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(640 / 3,200  100%). The identifiable assets of the business segment represent 5.7% of total assets
(235 / 4,100  100%), and are thus material to the statement of financial position.
The brand is (correctly) not recognised as an intangible asset in accordance with IAS 38 Intangible assets,
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so there is no intangible asset that may be impaired. However, in accordance with IAS 36 Impairment of
assets, SC's assets represent a cash generating unit as they are independent of the assets of the rest of the
entity. The question is whether these are impaired.
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The drops in revenue and profit are indicators of impairment per IAS 36. Management must have conducted
an impairment test, calculating the value-in-use of the cash generating unit, and also the fair value less cost
to sell, to determine the recoverable amount of the SC assets collectively. Any impairment loss should be
expensed. Management will want to avoid recognising an impairment loss as it will reduce their bonus
payment.
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The impairment test will involve a number of subjective elements, eg the discount rate used to determine the
present value of cash flows. Management's assumptions here should be approach with professional
scepticism.
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Evidence
 Review management's impairment test, including:
– Assessment that an appropriate discount rate has been used
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– Agreement that the assumptions to determine future cash flows are reasonable
– Agreement that correct carrying value of assets has been used for comparison of recoverable
amount
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– Agreement that all identifiable assets have been included in the cash generating unit
– Recalculation of all figures
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 Discussion with management of the expected future performance of SC

 Review of post-year end management accounts for the performance of Shelly's Cruises
 Review of the level of bookings made in advance for cruises to be taken in the future
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(c) Matters to consider
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In accordance with IAS 10 Events After the Reporting Period, this acquisition is a non-adjusting event
because it does not relate to conditions in place at the end of the reporting period.
However, if it is judged to be sufficiently material then it should be disclosed in a note to the financial
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statements, along with an estimate of its financial effect. As this note has not been included, we should ask
management to include such a note. If they do not do so, then the auditor's opinion must be modified, in
this case to an 'except for' qualification in respect of a disclosure required by IAS 10.
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Evidence
 Copy of press release announcing the acquisition, including the date of the announcement
 Copy of any legal agreement relating to the acquisition, including the date control passes to Clooney
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 Review of any due diligence report received, detailing the value of assets purchased, and the
consideration paid
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 Review of the financial statements of Craig, to determine that it represents a significant acquisition
for the group which requires a disclosure note
 Review of any note provided by management to be included in the financial statements
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Question 4
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Top tips. This question looks at the issue of ethics in the context of practice management. Part (a) should be
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relatively straightforward, provided that you are familiar with the technical content. But even if you were struggling
technically you could have picked up quite a few marks just by working through the material given in the question.
Part (b)(i) offered three marks that were virtually all knowledge, and you should have got at least two of these. Part
(b)(ii) was more difficult, and required you to think on your feet. Remember that everybody would have found this
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question difficult, and that the key is to just get a few clear arguments down on either side, and to draw a
conclusion.
Easy marks. Part (b)(ii) contained the easiest marks in the question.
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Examiner's comments. This was the most popular of the optional questions, and focussed on ethics and practice
management. It was very pleasing to see many candidates achieve a clear pass on both (a) and (b). The few
unsatisfactory answers to part (a)(i) tended to simply repeat extracts from the advertisement and say 'this is
unprofessional'.
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Requirement (a)(ii) was not well answered. While most candidates could state obvious issues, like whether one
person would be enough to provide the service, unfortunately very few clearly distinguished between audit and non-
audit clients, which was a key issue, as the scenario clearly stated that only one third of the audit firm's clients were
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audit clients. Few dealt with the issue of the contingent fee in enough detail, with answers usually saying that it was
'unprofessional' but not elaborating further.
Requirement (b) dealt with the ethical problems raised by long association of audit firms and their clients. For
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seven marks, candidates were asked to explain the ethical threats, and to evaluate the advantages and
disadvantages of compulsory firm rotation. On the whole, this was well answered. Most candidates could identify
and explain to some extent the various ethical threats posed by long association, with the familiarity threat being the
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most common to be discussed. The advantages and disadvantages were often dealt with reasonably well, though a
lot of answers were just bullet point lists with no real evaluation provided at all. For many candidates this was the
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last requirement attempted, so the brevity of answers was probably linked to time management in the exam.
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Marking scheme
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Marks
(a) (i) Evaluation of advertisement
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– Advertising not prohibited but must follow ACCA guidelines
– Cannot be misleading/exaggerated claims
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– Exaggerated claim re size
– Unprofessional claim re 'most professional'
– Cannot guarantee improvements/tax saving
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– Second opinions
– Introductory fee
– Audit and non-audit services
– Fees not approved by ACCA
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– Improper reference to ACCA 8
(ii) Corporate finance
Generally 1 mark per comment explained:
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– Partner is competent
– Advocacy threat
– Self-review threat
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– Identify contingent fee
– Contingent fee not appropriate for audit clients
– Contingent fee allowed for non-audit client with safeguards
– Safeguards should be in place (examples 5
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(b) (i) Long association threat
– Familiarity threat (½ mark only)
– Threat more significant for senior personnel
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– Level of threat depends on various factors

– Lose scepticism
– Code requires partner rotation for listed client 3
Compulsory firm rotation
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(ii)
– Eliminates familiarity threat
– Fresh pair of eyes for audit client
– Loss of fee income
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– Unwilling to invest – lower quality audit

– Loss of cumulative knowledge – lower quality audit
– Increase in cost and audit fee
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– Disruption to client 4
Total 20
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(a) (i) Neither the ACCA Code of Ethics and Conduct nor the IESBA Code of Ethics for Professional
Accountants prohibits advertising. However, a professional accountant must not bring the profession
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into disrepute, and adverts must be both honest and truthful. There are a number of question marks
over whether this is the case with the draft advert here.
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The advert claims that Neeson & Co is the largest accountancy and audit firm in the country, yet the
firm has only three offices and 12 partners. This is neither honest nor truthful. Moreover, the claim
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that the firm is the most professional cannot be proven, and could imply that other firms are not
professional, bringing the profession into disrepute.
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The advert claims that a range of services are guaranteed to improve efficiency, which is not
something that can be guaranteed, particularly given that the advert does not specify which services
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would do this.
The advert guarantees that tax would be saved, but again this cannot be guaranteed as it depends on
the application of tax law in the specific circumstances of each client. To guaranteeing savings in this
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way may create a self-interest threat to the objectivity of tax work done by the firm, as rules may not
be properly applied in order to save tax.
There is a risk of future litigation from clients who do not see improved efficiency or tax savings as a
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result of Neeson & Co's work.
It is possible for an audit firm to give a second opinion on another firm's report, but this is unusual.
The advert may imply that Neeson & Co's opinion would be superior to another firm's, which brings
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the profession into disrepute. Moreover, it may compromise the firm's independence in such case by
creating an expectation that Neeson & Co would not modify its audit report if it were necessary to do
so.
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The 25% 'introductory offer' is effectively lowballing. Although this is not prohibited as such, there is
a risk that if fees are too low then this may result in poor quality work being done. For example, staff
may be assigned to audits who do not have appropriate levels of skill and experience.
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A reduction is offered where both audit and tax services are provided. Non-audit services should only
be provided to an audit client where any threats to auditor objectivity can be reduced to an acceptable
level. Offering such a reduction may create self-review and advocacy threats.
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Finally, the advert claims that rates are approved by the ACCA. This is false, because the ACCA does
not approve specific firms' rates, and in view of the ethical concerns raised above over fees is
disingenuous and dishonest in its intention too.
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(ii) The new partner has experience of the banking sector and therefore appears to be competent in this
area. However, there are a number of problems with the proposed service.
Negotiating financing arrangements on behalf of an audit client creates an advocacy threat to audit
objectivity, as the firm is representing the client's interests to a third party. There may be self-review
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threat if the partner has been in any way involved with the accounting treatment of these
arrangements.
Safeguards should be applied to reduce these threats to an acceptable level. These would include
ensuring that the partner and any other staff members involved in giving advice are not involved in
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the audit. If an auditor's expert is required in relation to financing arrangements then the partner
should not be used in this capacity.
A contingent fee is proposed, which the IESBA Code prohibits outright for audit engagements. For
non-audit services such as this, the contingent fee creates a self-interest threat to audit objectivity.
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Safeguards must be applied to reduce this threat to an acceptable level. Safeguards may include
ensuring that the partner is not involved with the audit.
However, if the fee relates to a matter that is material to the financial statements, or is material to the
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firm, then the threat cannot be reduced to an acceptable level. In this case Neeson & Co must not
take on, or withdraw from, either the audit or the non-audit service.
(b) (i) Long association with an audit client may create familiarity and self-interest threats. This depends on
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a number of factors:
 How long an individual has been involved with the audit
 How senior the individual is
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 The structure of the firm

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 Whether the client's management has changed

 Whether the type of accounting issues has changed
The self-interest threat may arise because the firm does not want to jeopardise a continuing source of
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fee income. The familiarity threat may arise if audit personnel lose their professional scepticism,
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perhaps as a result of a close relationship with client staff, or because there being few problems in
the past might lead the auditor to expect there to be no problems in the future.
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The Code requires that for public interest entities, the key audit partner should be rotated after seven
years, and should not be involved with the audit for two years, including helping with quality control,
or giving the audit team advice on technical or industry-specific issues.
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(ii) The key argument in favour of firm rotation is that the familiarity and self-interest threats are more
thoroughly safeguarded against by changing the whole audit firm instead of eg the partner alone.
This would mean that not only the personnel but the whole infrastructure of the firm would be
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different. This could improve audit quality by bringing a 'fresh pair of eyes' to the audit.
Those who argue against this claim that an acceptable level of independence can be maintained by
applying safeguards within the firm to mitigate the familiarity and self-interest threats.
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It may actually be the case that firm rotation would reduce audit quality. Audit quality is enhanced by
the years of knowledge and experience built up by an auditor in understanding the client entity, and
this would be lost.
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There would also be likely to be an increase in the cost of conducting audits, and hence in the fees
charged, as a result of work that an incoming auditor needs to do, eg to gain an understanding of the
entity and its environment.
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Furthermore, audit firms may be unwilling to invest in systems that might enhance audit quality and
cost-effectiveness, such as bespoke audit software for a client, if they know that they will lose the
audit in a few years' time.
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In conclusion, auditor rotation would probably be costly both for clients and auditors, and may not
increase audit quality, possibly actually having the opposite effect of reducing it.
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Question 5
Top tips. This question tests your knowledge of the auditor's report. In Part (a) make sure that you are very familiar
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with the contents of the audit report, both unmodified and modified. This area comes up in virtually every sitting, so
you just have to be comfortable with it.
Part (b) should have been straightforward. Take note of the examiner's comment (below) about candidates not
mentioning ISA 265; the examiner has stated recently that candidates often do not have adequate knowledge of
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ISAs, so this is an area in which you need to show you can apply your knowledge.
Easy marks. Part (a) contained some easy marks for picking apart the more obvious failings of the audit report
given in the question.
Examiner's comments. This was by far the least popular of the optional questions. Regarding part (a)(i), some
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answers were sound, and worked through the audit report, explaining its deficiencies in a logical manner. Some
answers appreciated that the disclaimer of opinion may be an over-reaction, and that a qualification may be more
suitable.
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Unsatisfactory answers, which were by far the majority, tended not to appraise the audit report at all, and instead
provided lengthy explanations of the accounting treatment for research and development, but completely missed
the point that the auditor was unable to verify if the correct accounting treatment had been applied. Some blamed
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the audit team, rather than the client, for the lack of evidence, and suggested that the whole audit be reperformed.
Coming to part (a)(ii), most candidates suggested that the limitation in scope and its potential impact on the audit
report be taken to audit committee or those charged with governance for discussion, and many also raised
management integrity as an issue. Some candidates tended to repeat what they had written for (a)(i) without further
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development.
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Part (b) was reasonably well attempted, with most answers referring to management letter points, and making
recommendations for improving controls to the client. However, there were very few references to ISA 265, and
only a handful of answers discussed the importance of determining whether a deficiency is significant or not.
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Marking scheme
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Marks
(a) (i) Critical appraisal of audit report
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Up to 1½ marks per comment applied to the scenario
– ½ mark ref ISA 705
– No explanation of imposed limitation
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– Development costs not specifically referred to
– No quantification of the asset
– No reference to potential impact on profit
– ½ mark calculation materiality
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– Disclaimer or qualification more appropriate (2 marks max)
– Incorrect headings used
– Incorrect wording of opinion
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– Unprofessional to refer to management integrity
– 'We are worried' not professional 10
(ii) Further consequences
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– Communicate limitation imposed to those charged with governance
– Communicate proposed modification to those charged with
governance
–
–
–
Consider integrity of management
Consider withdrawal from audit/resignation
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Consider alternative procedures for development costs
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– Audit pre-condition (ISA 210) 5
(b) Actions/implications of control deficiency identified
– Determine if deficiency is a deficiency or significant deficiency – Extend audit
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testing
– If significant report in writing to those charged with governance
– Communication to include description and recommendation
– Communication on a timely basis
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– Insignificant deficiency need not be reported – depends on auditor judgement 5

Total 20
(a) (i) Opinion

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This matter is material to the financial statements; at $4.4m the asset represents 8% of total assets,
and if it has been wrongly capitalised then the resulting adjustment would turn the profit of $3.1m
into a loss of $1.3m.
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Management has not allowed the audit team access to the results of tests which have a bearing on
whether or not an asset should be recognised here, in accordance with IAS 38 Intangible assets. The
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senior is correct to identify this limitation on the audit evidence available, and to recognise that this
affects the opinion that should be given.
The draft auditor's report contains a disclaimer of opinion. ISA 705 Modifications to opinions in the
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independent auditor's report states that such an opinion should be given where the matter in
question is both material and pervasive, so that the auditor cannot reach an opinion on the financial
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statements as a whole. This may be overly harsh on this occasion. The matter is certainly material to
the statement of financial position. In this case it would be appropriate to qualify the auditor's opinion
'except for', on the basis of an inability to obtain sufficient appropriate audit evidence as a result of a
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limitation on the scope of the audit.

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However, as recognising an expense of $4.4m would turn a profit of $3.1m into a loss of $1.3m, the
matter is fundamental to users' understanding of the financial statements, there is an argument for
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issuing a disclaimer of opinion as the senior has done.
Contents of report
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The 'basis of opinion' paragraph should be shown immediately above the 'opinion' paragraph, as
appears to be the case from the extracts given. However, the paragraph headings are not worded
correctly. ISA 705 requires them to be headed 'Basis for Disclaimer of Opinion' and 'Disclaimer of
Opinion' respectively.
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The 'basis of opinion' paragraph should be more precise. It should refer to the relevant accounting
standard (IAS 38), and should explain that a limitation has been imposed by management in respect
of development costs. It should explain that management did not allow access to the results of
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scientific testing relating to these costs, and that the auditor has therefore been unable to determine
whether the accounting treatment of the costs is correct.
The paragraph should then quantify the effect on the financial statements, stating that the asset is
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recognised on the statement of financial position at $4.4m, and that if this were to be treated as an
expense, this would turn the profit of $3.1m into a loss of $1.3m.
The paragraph also contains the unprofessional form of words 'we are worried that the asset may be
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overvalued', which is not appropriate to an auditor's report. A lack of management integrity is
referred to, and although the auditor should have considered the possible effects of this, it is
inappropriate to refer to this in the auditor's report.
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The opinion paragraph itself should use the specific form of words set out in ISA 705, including the
statement that the auditor has been unable to obtain sufficient appropriate audit evidence, and that it
is therefore unable to express an opinion.
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(ii) Communication with those charged with governance
ISA 260 Communication with those charged with governance requires that significant difficulties
encountered during the audit should be communicated, of which this is an example. In addition,
where the auditor expects to modify the opinion, the circumstances leading to this should be
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communicated along with the expected wording.

Alternative procedures
The firm should consider whether evidence can be obtained by any alternative procedures. This may
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be difficult in this case.

Management integrity
The fact that management have imposed a limitation on the scope of the audit casts doubt over their
integrity. The auditor must reconsider any representations made by management in this light. It may
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be necessary for the audit to be subject to an engagement quality control review.

Withdrawing from engagement
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The firm should consider withdrawing from this audit engagement in order to protect its integrity.
ISA 210 Agreeing the terms of audit engagements effectively requires the auditor not to take on next
year's audit, as it is a precondition for an audit that management acknowledges and understands its
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responsibility to provide the auditor with access to all information relevant to the preparation of the
(b) The errors that have been found are already material to the statement of financial position, but further testing
on trade payables is required to see whether they are isolated or whether there are more errors.
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ISA 265 Communicating deficiencies in internal control to those charged with governance and management
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defines internal control deficiencies as misstatements have not been prevented, detected or correctly on a
timely basis as a result either of the absence of a control or of the manner in which a control is designed,
implemented or operated. Both the absence of some supplier statement reconciliations and the absence of
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invoice approval before payment meet this definition.

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We must consider whether this constitutes just a deficiency or a significant deficiency. A significant
deficiency must be communicated to those charged with governance and management on a timely basis
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during the audit, so that action may be taken by management. If the deficiency is not deemed significant
then we must consider whether it is important enough to bring to management's attention.
The written communication of a significant deficiency should include a description of the deficiency, details
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of its possible effects, and recommendations of how management might seek to correct it.
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Paper P7
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(International)
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Mock Examination 3
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December 2013 Real Exam
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Question Paper
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Time allowed
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Writing 3 hours

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403
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404
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answered
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Question 1
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You are an audit manager in Compton & Co, responsible for the audit of the Stow Group (the Group). You are
planning the audit of the Group financial statements for the year ending 31 December 20X3. The Group's projected
profit before tax for the year is $200 million and projected total assets at 31 December are $2,500 million.
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The Group is a car manufacturer. Its operations are divided between a number of subsidiaries, some of which focus
on manufacturing and distributing the cars, while others deal mainly with marketing and retail. All components of
the Group have the same year end. The Group audit engagement partner, Chad Woodstock, has just sent you the
following email.
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To: Audit manager
From: Chad Woodstock, audit partner
Subject: The Stow Group – audit planning
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Hello,
We need to start planning the audit of The Stow Group. Yesterday I met with the Group finance director, Marta
Bidford, and we discussed some restructuring of the Group which has taken place this year. A new wholly-owned
was disposed of.

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subsidiary has been acquired – Zennor Co, which is located overseas in Farland. Another subsidiary, Broadway Co,
I have provided you with a summary of issues which I discussed with Marta, and using this information I would like
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you to prepare briefing notes for my use in which you:
(a) (i) Explain the risks of material misstatement to be considered in planning the Group audit, commenting
on their materiality to the Group financial statements (12 marks)
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(ii) Identify any further information that may be needed (4 marks)

(b) Recommend the principal audit procedures to be performed in respect of the disposal of Broadway Co.
(8 marks)
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Marta has told me that Zennor Co has a well established internal audit team. She has suggested that we use the
internal audit team as much as possible when performing our audit of Zennor Co as this will reduce the audit fee.
The Group audit committee appreciates that with the audit of the new subsidiary there will be some increase in our
costs, but has requested that the audit fee for the Group as a whole is not increased from last year's fee. I have
provided you with some information about the internal audit team and in your briefing notes I would like you to:
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(c) Discuss how Marta's suggestion impacts on the planning of the audit of Zennor Co's and of the Group's
financial statements, and comment on any ethical issue raised. (7 marks)
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Thank you.
Chad Woodstock
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Acquisition of Zennor Co
In order to expand overseas, the Group acquired 100% of the share capital of Zennor Co on 1 February 20X3.
Zennor Co is located in Farland, where it owns a chain of car dealerships. Zennor Co's financial statements are
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prepared using International Financial Reporting Standards and are measured and presented using the local
currency of Farland, the Dingu. At the present time, the exchange rate is 4 Dingu = $1. Zennor Co has the same year
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end as the Group, and its projected profit for the year ending 31 December 20X3 is 90 million Dingu, with projected
assets at the same date of 800 million Dingu.
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Mock exam 3 (December 2013): questions 405
Zennor Co is supplied with cars from the Group's manufacturing plant. The cars are sent on cargo ships and take
approximately six weeks to reach the main port in Farland, where they are stored until delivered to the dealerships.
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At today's date there are cars in transit to Zennor Co with a selling price of $58 million.
A local firm of auditors was engaged by the Group to perform a due diligence review on Zennor Co prior to its
acquisition. The Group's statement of financial position recognises goodwill at acquisition of $60 million.
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Compton & Co was appointed as auditor of Zennor Co on 1 March 20X3.
Disposal of Broadway Co
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On 1 September 20X3, the Group disposed of its wholly-owned subsidiary, Broadway Co, for proceeds of $180
million. Broadway Co operated a distribution centre in this country. The Group's statement of profit or loss includes
a profit of $25 million in respect of the disposal.
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Broadway Co was acquired by a retail organisation, the Cornwall Group, which wished to bring its distribution
operations in house in order to save costs. Compton & Co resigned as auditor to Broadway Co on 15 September 20X3
to be replaced by the principal auditor of the Cornwall Group.
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Zennor Co – Internal audit team
The internal audit team was established several years ago and is headed up by a qualified accountant, Jo Evesham,
who has a lot of experience in designing systems and controls. Jo and her team monitor the effectiveness of
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operating and financial reporting controls, and report to the board of directors. Zennor Co does not have an audit
committee as corporate governance rules in Farland do not require an internal audit function or an audit committee
to be established.
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During the year, the internal audit team performed several value for money exercises such as reviewing the terms
negotiated with suppliers.
Required
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Respond to the instructions in the partner's email. (31 marks)
Note. The mark allocation is shown against each of the instructions in the partner's email above.
Professional marks will be awarded for the structure and presentation of the briefing notes and for the clarity of
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explanations. (4 marks)
(Total = 35 marks)
Question 2
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You are a manager in the business advisory department of Goleen & Co. Your firm has been approached to provide
assurance to Baltimore Co, a company which is not an audit client of your firm, on a potential acquisition. You have
just had a conversation with Mark Clear, Baltimore Co's managing director, who made the following comments:
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'Baltimore Co is a book publisher specialising in publishing textbooks and academic journals. In the last few years
the market has changed significantly, with the majority of customers purchasing books from online sellers. This has
led to a reduction in profits, and we recognise that we need to diversify our product range in order to survive. As a
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result of this, we decided to offer a subscription-based website to customers, which would provide the customer
with access to our full range of textbooks and journals online.
'On investigating how to set up this website, we found that we lack sufficient knowledge and resources to develop it
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ourselves and began to look for another company which has the necessary skills, with a view to acquiring the
company. We have identified Mizzen Co as a potential acquisition, and we have approached the bank for a loan
which will be used to finance the acquisition if it goes ahead.
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'Baltimore Co has not previously acquired another company. We would like to engage your firm to provide guidance
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regarding the acquisition. I understand that a due diligence review would be advisable prior to deciding on whether
to go ahead with the acquisition, but the other directors are not sure that this is required, and they don't understand
what the review would involve. They are also unsure about the type of conclusion that would be issued and whether
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it would be similar to the opinion in an audit report.

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406 Mock exam 3 (December 2013): questions
'To help me brief the other directors and using the information I have provided, I would like you to:
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(a) Discuss three benefits to Baltimore Co of a due diligence review being performed on Mizzen Co. (6 marks)
(b) Identify and explain the matters which you would focus on in your due diligence review and recommend the
additional information which you will need to perform your work. (16 marks)
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(c) Describe the type of conclusion which would be issued for a due diligence report and compare this to an
audit report.' (3 marks)
Mark Clear has sent you the following information about Mizzen Co:
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Company background
Mizzen Co was established four years ago by two university graduates, Vic Sandhu and Lou Lien, who secured
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funds from a venture capitalist company, BizGrow, to set up the company. Vic and Lou created a new type of
website interface which has proven extremely popular, and which led to the company growing rapidly and building
a good reputation. They continue to innovate and have won awards for website design. Vic and Lou have a minority
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shareholding in Mizzen Co.
Mizzen Co employs 50 people and operates from premises owned by BizGrow, for which a nominal rent of $1,000
is paid annually. The company uses few assets other than computer equipment and fixtures and fittings. The
biggest expense is wages and salaries and due to increased demand for website development, freelance specialists
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have been used in the last six months. According to the most recent audited financial statements, Mizzen Co has a
bank balance of $500,000.
The company has three revenue streams:
(1)
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Developing and maintaining websites for corporate customers. Mizzen Co charges a one-off fee to its
customers for the initial development of a website and for maintaining the website for two years. The
amount of this fee depends on the size and complexity of the website and averages at $10,000 per website.
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The customer can then choose to pay another one-off fee, averaging $2,000, for Mizzen Co to provide
maintenance for a further five years.
(2) Mizzen Co has also developed a subscription-based website on which it provides access to technical
material for computer specialists. Customers pay an annual fee of $250 which gives them unlimited access
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to the website. This accounts for approximately 30% of Mizzen Co's total revenue.
(3) The company has built up several customer databases which are made available, for a fee, to other
companies for marketing purposes. This is the smallest revenue stream, accounting for approximately 20%
of Mizzen Co's total revenue.
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Extracts from audited financial statements

Statement of profit or loss and other comprehensive income
Year ended Year ended Year ended Year ended
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30 September 30 September 30 September 30 September

20X3 20X2 20X1 20X0
$'000 $'000 $'000 $'000
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Revenue 4,268 3,450 2,150 500

Operating expenses (2,118) (2,010) (1,290) (1,000)
Operating profit/(loss) 2,150 1,440 860 (500)
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Finance costs (250) (250) (250) –

Profit/(loss) before tax 1,900 1,190 610 (500)
Tax expense (475) (300) (140) –
Profit/(loss) for the year 1,425 890 470 (500)
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There were no items of other comprehensive income recognised in any year.

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Required
Respond to the request from Mark Clear.
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Note. The mark allocation is shown against each of the instructions from Mark Clear above. (Total = 25 marks)
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Question 3
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Dasset Co operates in the coal mining industry. The company owns ten mines across the country from which coal
is extracted before being sold onto customers who are energy providers. Coal mining companies operate under
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licence from the National Coal Mining Authority, an organisation which monitors the environmental impact of coal
mining operations, and requires coal mines to be operated in compliance with strict health and safety regulations.
You are an audit manager in Burton & Co, responsible for the audit of Dasset Co and you are reviewing the audit
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working papers for the year ended 31 August 20X3. The draft financial statements recognise profit before tax
of $18 million and total assets of $175 million. The audit senior has left a note for your attention:
Accident at the Ledge Hill Mine
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On 15 August 20X3, there was an accident at the Ledge Hill Mine, where several of the tunnels in the mine
collapsed, causing other tunnels to become flooded. This has resulted in one-third of the mine becoming
inaccessible and for safety reasons, the tunnels will be permanently closed. However, Dasset Co's management
thinks that the rest of the mine can remain operational, as long as improvements are made to ensure that the mine
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meets health and safety regulations.
Luckily no one was injured in the accident. However, the collapse caused subsidence which has damaged several
residential properties in a village located above the mine. A surveyor has been commissioned to report on whether
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the properties need to be demolished or whether they can be safely repaired. A group of 20 residents has been
relocated to rental properties in the local area and Dasset Co is meeting all expenses in relation to this. The Ledge
Hill Mine was acquired several years ago and is recognised in the draft statement of financial position at $10 million.
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As no employees were injured in the accident, Dasset Co's management has decided not to report the accident to
the National Coal Mining Authority.
Required
In respect of the accident at the Ledge Hill Mine:
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(a) (i) Comment on the matters which you should consider, and
(ii) Describe the audit evidence which you should expect to find,
in undertaking your review of the audit working papers and financial statements of Dasset Co.
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Note. The total marks will be split equally between each part. (14 marks)
(b) In relation to management's decision not to report the accident to the National Coal Mining Authority,
discuss Burton & Co's responsibilities and recommend the actions which should be taken by the firm.
(6 marks)
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(Total = 20 marks)
Question 4
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You are an audit manager in Chester & Co, and you are reviewing three situations which have recently arisen with
respect to potential and existing audit clients of your firm.
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Tetbury Co's managing director, Juan Stanton, has approached Chester & Co to invite the firm to tender for its
audit. Tetbury Co is a small, owner-managed company providing financial services such as arranging mortgages
and advising on pension plans. The company's previous auditors recently resigned. Juan Stanton states that this
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was due to 'a disagreement on the accounting treatment of commission earned, and because they thought our
controls were not very good.' You are aware that Tetbury Co has been investigated by the financial services
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authority for alleged non- compliance with its regulations. As well as performing the audit, Juan would like Chester
& Co to give business development advice.
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The audit of Stratford Co's financial statements for the year ended 30 November 20X3 will commence shortly. You
are aware that the company is in financial difficulties. Stratford Co's managing director, Colin Charlecote, has
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requested that the audit engagement partner accompanies him to a meeting with the bank where a new loan will be
discussed, and the draft financial statements reviewed. Colin has hinted that if the partner does not accompany him
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to the meeting, he will put the audit out to tender. In addition, an invoice relating to interim audit work performed in
August 20X3 has not yet been paid.
Banbury Co is a listed entity, and its audit committee has asked Chester & Co to perform an actuarial valuation on
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the company's defined benefit pension plan. One of the audit partners is a qualified actuary and has the necessary
skills and expertise to perform the service. Banbury Co has a year ending 28 February 20X4, and the audit planning
is due to commence next week. Its financial statements for the year ended 28 February 20X3, in respect of which
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the audit report was unmodified, included total assets of $35 million and a pension liability of $105,000.
Required
Identify and discuss the ethical and other professional issues raised, and recommend any actions that should be
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taken in respect of:
(a) Tetbury Co (8 marks)
(b) Stratford Co (6 marks)
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(c) Banbury Co (6 marks)
(Total = 20 marks)
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Question 5
(a) You are the manager responsible for the audit of Burford Co, a company which designs and manufactures
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engine parts. The audit of the financial statements for the year ended 31 July 20X3 is nearing completion
and you are reviewing the working papers of the going concern section of the audit file. The draft financial
statements recognise a loss of $500,000 (20X2 – profit of $760,000), and total assets of $13.8 million
(20X2 – $14.4 million).
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The audit senior has left the following note for your attention.
'I have performed analytical review on Burford Co's year-end financial statements. The current ratio is 0.8
(20X2 – 1.2), the quick ratio is 0.5 (20X2 – 1.6). The latest management accounts show that ratios have
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deteriorated further since the year end, and the company now has a cash balance of only $25,000. Burford
Co has a long-term loan outstanding of $80,000 with a covenant attached, which states that if the current
ratio falls below 0.75, the loan can be immediately recalled by the lender.'
You are also aware that one of Burford Co's best-selling products, the QuickFire, has become technically
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obsolete during 20X3 as customers now prefer more environmentally friendly engine parts. Historically, the
QuickFire has generated 45% of the company's revenue. In response to customers' preference, $1.3 million
has been spent on designing a new product, the GreenFire, due for launch in February 20X4, which will be
marketed as an environmentally friendly product.
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A cash flow forecast has been prepared for the year to 31 July 20X4, indicating that based on certain
assumptions, the company's cash balance is predicted to increase to $220,000 by the end of the forecast
period. Assumptions include:
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(1) The successful launch of the GreenFire product

(2) The sale of plant and machinery which was used to manufacture the QuickFire, generating cash
proceeds of $50,000, forecast to take place in January 20X4
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(3) A reduction in payroll costs of 15%, caused by redundancies in the QuickFire manufacturing plant
(4) The receipt of a grant of $30,000 from a government department which encourages innovation in
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environmentally friendly products, scheduled to be received in February 20X4

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Required
(i) Identify and explain the matters which cast doubt on the going concern status of Burford Co.
(6 marks)
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(ii) Explain the audit evidence you should expect to find in your file review in respect of the cash flow
forecast. (8 marks)
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(b) Having completed the file review, you have concluded that the use of the going concern assumption is
appropriate, but that there is significant doubt over Burford Co's ability to continue as a going concern. You
have advised the company's audit committee that a note is required in the financial statements to describe
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the significant doubt over going concern. The audit committee is reluctant to include a detailed note to the
financial statements due to fears that the note will highlight the company's problems and cause further
financial difficulties, but have agreed that a brief note will be included.
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Required
In respect of the note on going concern to be included in Burford Co's financial statements, discuss the
implications for the audit report and outline any further actions to be taken by the auditor. (6 marks)
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(Total = 20 marks)
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Answers
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411
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412
A PLAN OF ATTACK
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Use your reading time well, to look through the questions, particularly Questions 1 and 2 in Section A which are
compulsory, to get a feel for what is required and to become familiar with the question scenarios.
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It is vital that you attempt all the required questions in the paper to increase your chances of passing. The best way
to do this is to make sure you stick to the time allocation for each question – both in total and for each of the
question parts. The worst thing you can do is run over time in one question and then find that you don't have
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enough time for the remaining questions.
Section A is compulsory and consists of two long case-study style questions. These may contain detailed
information such as extracts from financial statements. A range of requirements will be set.
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Question 1 is for 35 marks. As ever, the key to success in this question is to stay focused, don't run over time in
each part, and answer the requirements set. In part (a)(i) you need to keep your answer concise and practical.
There were plenty of things to say here from the scenario, so it is important that you are disciplined and make the
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best use you possibly can of the time you have. In part (a)(ii), the first thing is to make sure that you actually
answer the requirement. There are usually lots of marks available for further information. Say what is needed and
why. Part (b) on procedures should be approached methodically, thinking about how you would test the accounting
treatment. Part (c) should have been OK, provided you had not run out of time for this part of the question. It was
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important here to comment on the ethical issue as well as just the issue of using internal audit's work.
Question 2 is worth 25 marks. Note that the professional marks were in Question 1, so there is no need to use a
report format for your answer here. Part (a) was a mix of knowledge and application. If you think about the needs of
the company in the question then that should help you to make relevant points. Crucially, do not explain more than
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three advantages, as any more probably won't be marked. Part (b) was the guts of this question. As ever, stick to
the issues in the scenario and try to think about why Baltimore wants to acquire Mizzen. General points about
matters to consider in due diligence are unlikely to score well. Part (c) was straight knowledge and should have
been easy. You may have wanted to do part (c) before part (b) to make sure you got at least 1½–2 marks here.
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Section B contains three questions, from which you must attempt two. Choose wisely!
Question 3 is on audit matters and evidence in relation to an accident, and some regulations. You should have
scored well on part (a), which focused on the practical issues arising from the scenario. Part (b) was more difficult,
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but if well prepared you should have been able to do enough to pass this part.
Question 4 was a typical P7 ethics question. Notice that part (a) is for eight marks but (b) and (c) are for only six
marks each, so your answer to (a) should have been longer. As ever, try to pick up on practical issues involved.
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State the threat that is present and explain why it is present. Commercial considerations can be a good way to get
marks here, wherever the question asks for 'professional issues'. There are also marks in part (a) for contacting the
previous auditor, which is a professional issue.
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Question 5 is on going concern and reporting. Part (a)(i) should have been straightforward as there was a lot in the
scenario that gave rise to easy points. Don't blow your time on this part! Part (a)(ii) should have been OK, as the
question practically gives you your starting point in the form of the 'assumptions' listed. Part (b) is a very
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commonly examined area and should not have posed significant difficulties by this stage in your studies.
Forget about it!

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Don't worry if you found the paper difficult. More than likely other candidates will have too. If this were the real
thing you would need to forget the exam the minute you left the exam hall and think about the next one. Or, if it is
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the last one, celebrate!

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Mock exam 3 (December 2013): answers 413
Question 1
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Top Tips. Be sure to get the professional marks here, for which you needed to: write out the heading for 'briefing
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notes'; write an introduction; set out your answer clearly using sub-headings; and write a conclusion. Your
introduction and conclusion do not need to be too long – make sure you write the heading, and try to write a brief
paragraph of about three or four lines. Make sure you get the marks, but don't spend too much time on it!
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Part (a) was on the risks of material misstatement, and therefore excludes detection risks – there are no marks
available for risks that arise from difficulties in auditing the group, such as the need to obtain an understanding of
the newly-acquired subsidiary.
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As ever you are advised not to spend time making general points about group audits, as many candidates in the
real exam will have done. Almost everything you say needs to be based on the scenario, and if it isn't then you're in
danger of spending time writing something which will get no marks.
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It is often the case in P7 that it's relatively easy to score marks for specifying further information – requirement
(a)(ii) here. Be specific – state what information you need, and why you need it (you can think of it as a ½ mark for
each). It is also important to bear in mind here that the requirement is not asking for audit procedures, so there are
no marks for information that would be needed to perform procedures. What you need to think of are pieces of
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information that would be useful at the planning stage of the audit – things like last year's audited financial
statements for Zennor, which we wouldn't have because we didn't audit them. Information on, for example,
exchange rate fluctuations would only be useful for conducting procedures on the foreign subsidiary, and would not
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be useful at the planning stage.
It is important that you calculate materiality, as you are asked to do so by requirement (a)(i). It is best to do this
separately with each item (eg 'goodwill is 2.4% of total assets and is therefore material'), rather than calculating the
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general materiality thresholds at the start of the question. There are no marks for just saying that something is
material without performing a calculation (so if you put thresholds at the start of the question, you would still have
to calculate the materiality of each item in order to get the marks). It's also important that you use the appropriate
benchmark – total assets for statement of financial position items, and profit for items affecting the statement of
profit or loss. Materiality for inventory should be calculated using total assets, with the materiality of any
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impairment being calculated using profit before tax. Likewise goodwill.

Take care in your answer to part (a) not to spend time writing about business risks, eg the risk to the group of
exposure to foreign exchange rate fluctuations. Unless you develop this into an audit risk (and this may be difficult
to do) you won't get any marks for it at all.
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A general point of exam technique that is relevant to this question is to read the question carefully. A careful reading
shows that 'we' (ie Compton & Co) are auditing both the group and its components. This means that you can recite
pre-learned knowledge about group and component auditors from ISA 600.
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Part (b) on procedures for the Broadway disposal should not have been too problematic. This is another area where
you can score well (like 'further information'), as long as you state the procedure, and then state why you are
performing it.
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In part (c), some candidates may have been tempted to write a lot about internal audit and the steps to take before
deciding whether to rely on internal audit work. While this is valid and relevant, it is important not to go over your
time allocation on this part. Finally, note that whenever an 'ethical issue' is raised in P7, this is almost always
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referring to the auditor's ethics – whether Marta or the internal auditors are acting ethically is not really the issue.
Easy marks. The marks for further information are simple marks, as are those for audit procedures on the disposal
of the subsidiary. Not to mention the professional marks.
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ACCA examiner's answers. The ACCA examiner's answers to this question can be found at the end of this Practice
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and Revision Kit.

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414 Mock exam 3 (December 2013): answers
Marking scheme
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Marks
(a) (i) Risks of material misstatement, materiality and further information requests
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Generally up to 1½ marks for each risk identified and explained (to a maximum of 4
marks for identification only):
Zennor Co
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– High fashion items/high staff turnover in design team
– Treatment of exchange gains and losses arising on retranslation
– Goodwill not measured correctly at initial recognition
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– Goodwill not tested for impairment before the year end
– Time apportionment of Zennor Co's income and expenses not correct
– Incomplete or inadequate disclosure
– Cancellation of intercompany balances
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– Disclosure of related party transactions
– Completeness of inventory
Broadway Co
– Derecognition of assets, liabilities and goodwill
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– Time apportionment of profit up to date of disposal
– Calculation of profit on disposal
– Classification and presentation regarding the disposal
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– Treatment in parent company financial statements
– Accrual for tax payable
Generally 1 mark for each of the following calculations/comments on materiality:
– Appropriate retranslation of Zennor Co figures into $
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– Calculate materiality of Zennor Co to the Group
– Determine if Zennor Co is a significant component of the Group
– Calculate materiality of goodwill arising on acquisition
– Calculate materiality of inventory in transit to the Group
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Maximum 12
(ii) 1 mark for each piece of additional information identified:
– Prior years' financial statements and auditor's reports
– Minutes of meetings where the acquisition was discussed
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– Business background, eg from the company's website or trade journals

– Copies of systems documentation from the internal audit team
– Confirmation from Zennor Co's previous auditor of any matters that should be
brought to our attention
– Projected financial statements for the year to 31 December 20X3
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– A copy of the due diligence report

– Copies of prior year tax computations
Maximum 4
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(b) Audit procedures

Generally 1 mark for each well described audit procedure:
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– Confirm the value of assets and liabilities which have been derecognised from the Group
– Confirm goodwill that exists is derecognised from the Group
– Confirm that the Stow Group is no longer listed as a shareholder of the company
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– Obtain legal documentation in relation to the disposal to confirm the date of the disposal
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and confirm that Broadway Co's profit has been consolidated up to this date only
– Agree or reconcile the profit recognised in the Group financial statements to Broadway
Co's individual accounts as at 1 September 20X3
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– Analytical procedures to gain assurance that the amount of profit consolidated from
1 January to 1 September 20X3 appears reasonable
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Marks
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– Reperform management's calculation of profit on disposal in the Group financial
statements
– Agree proceeds received to legal documentation/cash book/bank statements
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– Confirm that no deferred or contingent consideration is receivable in the future
– Confirm that the profit on disposal is correctly disclosed as part of profit for the year
– Confirm that all necessary notes are given in the Group financial statements
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– Obtain the parent company's statement of financial position to confirm that the cost of
investment is derecognised
– Reperform the calculation of profit on disposal in the individual financial statements
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– Reconcile the profit on disposal recognised in the parent company's financial statements
to the profit recognised in the Group financial statements
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– Obtain management's estimate of the tax due on disposal, reperform the calculation and
confirm the amount is properly accrued at parent company and at Group level
– Review any correspondence with tax authorities regarding the tax due
– If the tax is paid in the subsequent events period, agree to cash book and bank statement
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Maximum 8
(c) Reliance on internal audit
Generally 1 mark for each discussion point:
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– Impact on audit strategy, eg reliance on controls
– Impact on audit planning, eg systems documentation/business understanding
– Specific work can be performed, eg inventory counts
– Could lead to significant reduction in audit costs, eg travel costs can be avoided
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– Need to evaluate how much reliance can be placed (objectivity, competence, quality
control, etc) – up to 3 marks
– Reliance will impact on Group audit as well as on individual audit
– Pressure on fee is an intimidation threat
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– Fee unlikely to be maintained given the change in Group structure

Maximum 7
Professional marks to be awarded for:
– Use of headings
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– Introduction
– Logical flow/presentation
– Conclusion
Maximum 4
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Total 35
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Briefing notes
To: Audit Partner
From: Audit Manager
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Subject: Stow Group planning, year end 31/12/X3

Introduction
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Please find below an assessment of the risks of material misstatement in the Stow Group ('Stow') audit, indicating
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any further information needed, the principal audit procedures for the disposal of Broadway Co ('Broadway') and a
discussion of Martha's suggestion and its effect on our audit.
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(a) Risks of material misstatement – Zennor
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Zennor's profit translates to $22.5m, which is 11.3% of Group profit and is thus material. Zennor's total
assets translate to $200m, which is 8% of Group total assets and is also material. Zennor may therefore be
adjudged a significant component of the Stow audit as it is financially significant to it.
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As these are projected figures, materiality will be recalculated at the year end on the basis of Zennor's actual
figures and the closing exchange rate at that date.
Foreign exchange
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IAS 21 The Effects of Changes in Foreign Exchange Rates requires Zennor's assets and liabilities to be
translated at the closing rate on 31/12/20X3, and income and expenses to be translated at the actual rates on
the dates of the transactions. There is a risk that the wrong rates are used, which could over- or under-state
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total assets and profit.
IAS 21 also requires any exchange gain or loss to be recognised within profit or loss ('P/L'). Calculations
here can be complex, so there is a risk of profit being misstated if this is not done correctly. Exchange gains
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or losses on translating a subsidiary's balances are recognised in other comprehensive income ('OCI'), so
there is a risk of this not being done and thus of misclassification of these sums between P/L and OCI.
Goodwill on acquisition must also be retranslated at the year end, and there is a risk of this not being done.
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Inventory
Inventory in transit is likely to be in the region of $58m at the year end. This is 2.3% of total assets and is
material.
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The group's controls need to be robust here in order to mitigate the risk of inventory being recorded
incorrectly. Given that Zennor is newly acquired, there is a risk that this may not be the case. The risk may,
however, be lessened by the presence of an internal audit department in Zennor.
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Revenue and inventory
It is important that the group is clear about who owns the inventory at each point. There are many possible
types of error here, which could lead to misstatements in both the group financial statements and those of
the individual companies. For instance, Stow might consider the inventory as sold and thus recognise
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revenue that would need to be eliminated on consolidation. In its individual accounts, this would be
considered consignment inventory and should not be recognised in revenue. If Zennor did not yet recognise
the inventory, then it would be entirely missing from the group accounts, understating inventory and
overstating revenue.
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Alternatively, both Stow and Zennor could recognise the cars in inventory, leading to an overstatement of
group inventory if this double-counting were not eliminated on consolidation.
Unrealised profit
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If the inventory was recognised as sold to Zennor at a mark-up, then a provision for unrealised profit must
be included. The risk is that it is omitted, which would overstate both inventory and profit.
Related parties
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The intra-group transactions fall within the scope of IAS 24 Related Party Disclosures, and must be
disclosed in the individual financial statements of the group companies. There is a risk that if disclosure is
inadequate, this will be a material misstatement.
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Goodwill
Goodwill of $60m is 2.4% of total assets and is material.
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There are several risks here. First, calculating goodwill requires estimating the fair values of Zennor's assets
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and liabilities. This may involve judgement and can be complex, particularly when dealing with assets that
are hard to value.
Second, it is possible that some assets and liabilities may have been missed, leading to overstatement of
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goodwill.
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Third, the fair value of the consideration transferred could include contingent consideration, which may be
complex to calculate. Improper measurement here could under- or overstate goodwill.
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Fourth, goodwill must be reviewed annually for impairment whether or not there are indicators of
impairment. If this has not been done then goodwill could be impaired, overstating assets and profit.
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It is possible that Stow's management has valued Zennor's net assets on the basis of the due diligence
review. There is a risk that the work of this management's expert is not suitable for this purpose, leading to
misstatements in both net assets and goodwill.
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Mid-year acquisition
Zennor was acquired on 1 February 20X3, one month into the year. There is a risk that Zennor's 20X2 year-
end reserves are mistaken for its pre-acquisition reserves in the group accounts, which would misstate
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group reserves.
There is also a risk of the full year of Zennor's statement of profit or loss being consolidated, rather than
11 months. Assuming profits accrue evenly, this would result in a misstatement of $22.5m  1 / 12 =
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$1.875m in the group accounts. At 0.9% of group profit, this would be immaterial.
Disclosure
IFRS 3 Business Combinations requires extensive disclosures, eg in relation to goodwill. There is a risk that
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these are not included in the group financial statements.
Opening balances
Zennor's prior year financial statements may not have been audited, or were audited by another auditor.
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There may therefore be misstatements in this year's opening balances which could materially misstate both
this year's financial statements (eg the statement of financial position) and the corresponding figures.
Risks of material misstatement - Broadway
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Profit on disposal
The profit on disposal of $25m is 12.5% of group profit and is material.
There is a risk that this has not been calculated correctly. For example, if a contingent consideration is
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involved then its miscalculation could affect the figure for profit on disposal.
Net assets
Broadway's net assets were $155m ($180m proceeds less $25m profit), which is material at 6.2% of assets.
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There is a risk that not all of these balances were derecognised from the group accounts. This could
misstate profit on disposal, or just the group financial statements.
Mid-year disposal
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Broadway was disposed of on 1 September 20X3, meaning that for the first eight months of the year it was
in the Stow group. Its results should therefore be consolidated for this period. The risk is that this has not
been done correctly, overstating group profit.
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Presentation of financial statements

There is a risk that the profit on disposal of $25m is not presented separately on face of the statement of
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profit or loss, as is required by IAS 1 Presentation of Financial Statements.

It is possible that Broadway is a disposal group of assets and a discontinued operation in line with IFRS 5
Non-current Assets Held for Sale and Discontinued Operations. In this case its net assets and liabilities
should have be measured at fair value before disposal. If this was not done, then profit on disposal may be
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misstated.
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Further, IFRS 5 requires Broadway's profit or loss after tax to be disclosed on the face of the statement of
profit or loss as a discontinued operation, together with detailed disclosures in the notes. There is a risk of
material misstatement if this is not done.
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Further information
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 Zennor's prior year financial statements and the auditor's report thereon, to determine approach to
opening balances
 A copy of the local auditor's due diligence report on Zennor
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 Confirmation from Zennor's previous auditor of any matters which should be brought to our attention
 Background on Zennor's business, eg from trade journals or company's website, to gain
understanding of the entity
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(b) Procedures on Broadway disposal
 Recalculate profit on disposal.
 Obtain legal documentation of sale and confirm proceeds of $180m.
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 Agree proceeds of $180m to bank statement.
 Inspect legal documentation for evidence of contingent or deferred consideration.
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 Review register of shareholders to confirm that Stow is no longer a shareholder of the company.
 Review group statement of profit or loss and confirm separate disclosure of profit on disposal.
 Review group statement of profit or loss and confirm disclosure of discontinued operation is in line
with IFRS 5.
l.b
 Review group asset register to confirm that Broadway's assets are not included.
 Confirm that Broadway's results for first eight months of the year are consolidated by reconciling
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consolidated profits to Broadway's individual financial records.
 Perform substantive analytical procedures to confirm that profit consolidated for Broadway is in line
with expectations based on prior periods.
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(c) Internal audit
The immediate impact on planning is that we may be able to rely on the work of the internal auditors. This
may improve the efficiency of our audit, allowing us to rely on Zennor's controls and so reduce the level of
our substantive procedures. This would indeed work to reduce our audit fee by comparison with the
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situation in which Zennor did not have an internal audit function.

The prospective reduction in audit costs is increased still further by the fact that Zennor is located overseas.
By using the work of internal audit, we would avoid the substantial travel costs which would otherwise be
incurred.
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It may be possible to rely directly on the work of internal audit, eg on tests of control they have performed.
Moreover, we may be able to deepen our knowledge of Zennor's systems and controls, as well as its
business in general, through contact with the internal audit team.
The decision about relying on internal audit should be based upon our assessment of its objectivity,
as
competence and the systematic nature of its approach.

Internal audit would appear to be competent on the grounds of it being led by a qualified accountant. We do
not have information about the team as a whole, however, and this would be required before reliance could
cc
be placed on their work. Further information would also be needed on the level of supervision, review and
documentation of the work performed.
Internal audit's standing within the organisation appears to be enhanced by the fact that it reports to the
ea
board of directors. However, this is in reality something which may militate against its objectivity, since it
may thereby be subject to management's potentially baleful influence. The presence of an audit committee
would have helped improve internal audit's independence from management, and might have given its work
weight with those charged with governance.
e
Ethical issue
/fr
Marta's statement that we should rely on the work of internal audit is inappropriate, as this is rightfully the
decision of the external auditor alone.
p:/
The group audit committee's request that the audit fee remain unchanged is inappropriate. Although its
argument is not entirely specious, it overlooks the additional work that is required to audit a new subsidiary,
htt
for instance obtaining an understanding of it at the planning stage. Work would also still be required on the
disposed subsidiary's statement of profit or loss, the majority of which will be consolidated this year.
m/
It is instructive to observe that the audit fee must be charged based on the work done, rather than on the
grounds of a purely commercial bargain between the client and the audit firm. There is a risk that charging
too low a fee may induce the auditor to reduce inappropriately the extent of work performed. The request
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therefore amounts to an intimidation threat to the principle of professional competence and due care.
Conclusion
There audit of the Stow Group contains a high overall risk of material misstatements as a result of the
o t.
substantial group restructuring that took place during the year. Audit procedures must now be designed to
detect any misstatements arising. These may involve relying on the work of Zennor's internal auditors, but it
is important that the audit fee is substantial enough to allow sufficient audit procedures to be performed.
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Question 2
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Top Tips. In part (a) it is crucial that you give only three benefits of due diligence, as any further benefits are
unlikely to be marked. Another thing to avoid doing is writing about what a due diligence review is – this is not
asked for in the requirement, and again receives no marks, serving only to eat into your time.
l.b
Although part (a) could be approached as a simply knowledge-based requirement, there are actually several clues in
the scenario which you may have picked up on in your answer. For example, the fact that 'Baltimore Co has not
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previously acquired another company' suggests that it 'lacks the necessary skills' not just to set up a website, but
to do a due diligence too.
Do not overlook the requirement in part (b) to recommend additional information needed. As long as you state not
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just what you need but also why you need it, you can pick up a lot of marks here with relatively little effort.
Part (c) should have been straightforward, and you may have decided to do this part of the question before part (b).
Note that a due diligence review does not give 'negative assurance' but rather 'limited assurance' which is
expressed in a negative form of words.
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It is also worth noting that although this question features an embedded style of requirement, there are no
professional marks available.
Easy marks. The whole of part (c) was easy – you should have been able to score close to full marks here.
tud
and Revision Kit.
as
Marking scheme
Marks
(a) Benefit of due diligence
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Up to 2 marks for each benefit discussed up to a maximum of three benefits:

– Identification of assets and liabilities
– Valuation of assets and liabilities
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– Review of operational issues

– Examination of financial position and performance
– Added credibility and expertise
e
– Added value for negotiation of purchase price

– Other advice can be given, eg on obtaining finance
/fr
Maximum 6
(b) Areas to focus on and additional information
p:/
Generally up to 1½ marks for each explanation of area to focus on:

– Equity owners of Mizzen Co and involvement of BizGrow
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Marks
– Key skills and expertise
m/
– Internally generated intangible assets
– Premises
– Other intangible assets
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– Accounting policy on revenue recognition
– Sustainability and relevance of revenue streams
– Operating expenses
– Finance charges
o t.
– Cash management
1 mark for each specific additional information recommended:
– Contract or legal documentation dealing with BizGrow's investment in Mizzen Co
sp
– A register of shareholders showing all shareholders of Mizzen Co
– An organisational structure
– A list of employees and their role within the company, obligations and compensation
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– A list of freelance web designers used by Mizzen Co, and a description of the work they
perform
– The key terms of contracts or agreements with freelance web designers
– A list of all IT innovations which have been created and developed by Mizzen Co, and
l.b
details of any patent or copyright agreements relating to them
– Agreements with employees regarding assignment of intellectual property and
confidentiality
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– Copies of the customer databases
– A list of companies which have contracts with Mizzen Co for website development and
maintenance
– A copy of all contracts with customers for review of the period for maintenance
ate
– A breakdown of the revenue that has been generated from making each database available
to other companies, and the dates when they were made available
– A summary of the controls which are in place to ensure that the database details are
regularly updated
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– A copy of the premises rental agreement with BizGrow

– Non-current asset register showing descriptions and values of all assets used in the
business
– Copies of any lease agreements
– Details of any capital expenditure budgets for previous accounting periods, and any
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planned capital expenditure in the future

– Mizzen Co's stated accounting policy on revenue recognition
– Systems and controls documentation over the processing of revenue receipts
– Analysis of expenses included in operating expenses for each year and copies of
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documentation relating to ongoing expenses such as salaries and other overheads

– Copies of management accounts to agree expenses in the audited accounts are in line and
to perform more detailed analytical review
cc
– The full set of financial statements and auditor's reports

– Any agreements with banks or other external providers of finance
Maximum 16
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(c) Conclusion on due diligence

Generally 1 mark for each discussion point:
– Due diligence report to express conclusion using a negative form of words
– Limited assurance due to nature of work performed
e
– Audit opinion is a positive opinion of reasonable assurance

3
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Maximum
Total 25
p:/
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(a) Identifying assets
m/
The review would aim to identify and value the assets and liabilities of the target company. This would
include items not recognised on Mizzen Co (Mizzen)'s financial statements. For example, it is possible that
Mizzen may have intangible assets that are not recognised separately, but which may be valued. These could
become part of any goodwill acquired on acquisition.
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The review would also seek to discover previously hidden liabilities, such as contingent liabilities, which
could potentially be very significant to Baltimore Co.
o t.
Operational issues
The review would focus on operational issues. This might include, for example, an examination of Mizzen's
different revenue streams with a view to assessing how Baltimore might seek to benefit from them after the
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acquisition. The review may also focus on the strategic fit between Baltimore and Mizzen, attempting to
determine the extent to which Mizzen meets Baltimore's needs.
This could involve a review of Mizzen's financial position and performance, focusing in particular on its
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potential for future growth or profitability.
Credibility
Obtaining an external due diligence review would allow Baltimore's management to focus on its own
l.b
operational matters and yet still receive a timely review. Such a review would be conducted by an
independent expert, with experience and knowledge in this area which Baltimore's management lacks, since
it has not previously acquired another company. The review would give the benefit of a sharp, fresh pair of
eyes which might spot things that Baltimore's management may have missed.
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It is for this reason that an externally-provided review would be more credible than an internal one,
something which may help persuade Baltimore's bank to lend it the money which it believes itself to need.
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(b) Equity owners
It is crucial to determine the identity of Mizzen's majority shareholder. It appears likely that this is Bizgrow,
but further information is needed.
This is important because if Bizgrow does own the shares then it is with Bizgrow that Baltimore would need
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to negotiate the purchase of Mizzen. If Bizgrow does not want to sell its shares then Mizzen cannot be
bought. However, it is unclear how Baltimore came to identify Mizzen as an acquisition target in the first
place, and it is possible that Bizgrow may have had something to do with this.
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Funding
It is noted that Vic and Lou secured funds from Bizgrow. The nature of any agreement that was made needs
to be ascertained, as it is possible that Mizzen may owe Bizgrow a substantial amount of money. This would
be material to any decision Baltimore might make about the acquisition.
as
The precise nature of the ongoing relationship between Mizzen and Bizgrow is unclear. It is possible that
Bizgrow is involved with Mizzen at an operational level. Any agreements between the two parties should be
obtained and scrutinised.
cc
Examination of the statement of profit or loss reveals a finance cost of $250,000 which appears to be fixed.
It is unlikely that this is interest on a loan because loan interest would change as the balance is repaid. It is
therefore possible that this is a management charge from Bizgrow, which would be indicative of ongoing
ea
involvement. We would need to understand the nature of any liabilities Mizzen may have in relation to this
charge.
Reputation
e
Mizzen's good reputation, and its having won awards for website design, is key evidence for its expertise in
/fr
this area. This should be verified to external evidence. Customer satisfaction could be gauged by obtaining
the results of any customer satisfaction surveys that may have been conducted.
p:/
htt
Vic and Lou
m/
Vic and Lou appear to be crucial to the success of Mizzen, so Baltimore would want them to be involved in
future. It is not certain, however, that they would want to be involved with Baltimore and its website, and
they may wish to concentrate on their own more innovative work. The acquisition would be much less
attractive to Baltimore were they to leave.
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Vic and Lou's intentions post-acquisition should be determined. It may be possible to structure any future
deal in such a way that Vic and Lou would be required to continue working at Mizzen for a set period after
the acquisition.
o t.
Staff
Mizzen is a business with few tangible assets, which relies heavily on the expertise of its staff, who may
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leave after any acquisition – particularly if Vic and Lou were to leave. It would make little sense to acquire
Mizzen for its staff, only to find that they leave on acquisition.
An organisational structure should be obtained in order to identify management and key personnel within
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Mizzen.
It is also possible that Baltimore may wish to restructure Mizzen after acquisition. In this case it is likely that
redundancy payments would need to be made to staff members losing their jobs. The amount of any
possible liability in this eventuality should be estimated as part of the review.
l.b
Freelancers
Mizzen has been using freelancers recently, which may result in a drop in the quality of work done by
impeccable reputation.
Intangible assets
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comparison with established staff. This should be investigated as it may affect Mizzen's ostensibly
ate
Mizzen has few assets, but is likely to have important intangible assets which would form part of any
goodwill paid on acquisition. Vic and Lou have developed new website interfaces, and it should be
determined whether any resulting intellectual property belongs to them personally or to Mizzen. Valuing
these assets is likely to be difficult.
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Customer databases should also be valued, which again is likely to be difficult owing to the absence of any
active market for assets of this kind.
Premises
tud
It is apparent that the $1,000 nominal rent paid to Bizgrow would increase after the acquisition, so it should
be determined what an equivalent market rent might be for the premises. Alternatively, the premises may no
longer be available, in which case the rent should be ascertained for premises meeting Mizzen's needs. It
may be possible for Mizzen to operate from Baltimore's premises, in which case any opportunity costs
as
should be considered.
Tangible assets
Mizzen's tangible assets need to be valued, and it should be determined whether they are owned or held
cc
under lease, as it is possible that Mizzen may be liable for any future lease payments.
Revenue recognition
ea
The first revenue stream should be split into two components, with the revenue relating to maintenance
being recognised as deferred income and spread over the contract period. There is a risk that revenue is
recognised too early, inflating Mizzen's profit in the short term.
e
/fr
p:/
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Relevance of revenue
m/
Baltimore needs Mizzen to develop a website for it, and it should be asked whether Baltimore might be better
off simply paying Mizzen $10,000 to develop a website rather than acquiring the whole company.
It is clear that Mizzen would have the expertise to do this because it operates its own subscription-based
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website. It should therefore be able to create something of a similar nature for Baltimore.
The third revenue stream in particular does not appear relevant to Baltimore, and it should be considered
how this revenue stream would be managed after the acquisition.
o t.
Revenue increase
Revenue rose 23.7% from 20X2 to 20X3, which is an impressive increase although it is lower than the
60.4% increase from 20X1 to 20X2. The question is whether such a growth rate might feasibly be achieved
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in the future. It will therefore be necessary to scrutinise Mizzen's forecasts and plans for future growth.
Operating expenses
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Operating expenses in 20X2 were 58.3% of revenue, but only 49.6% in 20X3. This is unusual, and may be
indicative of efficiencies being achieved as Mizzen grows. It does not, however, tally with the fact that
freelancers have been used this year, which would be expected to increase operating expenses in relation to
revenue.
l.b
A detailed review needs to be performed on operating expenses to ensure that expenses are complete and
are recorded accurately.
Cash
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Mizzen's cash position should be confirmed to its bank statement. Although the company is not lacking
cash, from its statements of profit or loss one would expect it to be in a better cash position than it is in. It is
possible that cash has been paid out in dividends to shareholders.
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Further information
 Copy of Mizzen's register of shareholders, to determine the identity of the majority shareholder
 Copy of any agreement between Bizgrow and Vic and Lou, to help understand their ongoing
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relationship as well as Bizgrow's planned exit route

 Agreements of any loans received by Mizzen
 Full audited financial statements of Mizzen
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 Details of awards won for website design, including press reports, trade journals, for evidence of
Mizzen's good reputation
 Details of any customer satisfaction surveys conducted by Mizzen
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 Copies of contracts with Vic and Lou

 Copy of organisational structure
cc
 Copies of contracts with key employees containing details of any redundancy payments that might be
due in the future, along with other employee benefits and entitlements that are due to them
 List of freelance designers used by Mizzen, together with copies of contracts
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 Details of any copyrights or patents owned by Vic and Lou or Mizzen

 Copy of rental agreement with Bizgrow, to be scrutinised for details of possible rental payments after
acquisition
e
 Details of tangible non-current assets owned or operated by Mizzen

/fr
 Copies of any lease agreements for non-current assets such as computers or fixtures and fittings
 Copies of projected financial information for the next year
p:/
htt
 Detailed management accounts, including breakdown of operating expenses to ascertain reasons for
rising operating margin
m/
 Details of any dividend payments made over the last three years
(c) Due diligence is a review report, and as such gives only limited assurance. By contrast an auditor's report
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gives reasonable assurance, which is a higher level of assurance. This is because a review engagement
involves obtaining less evidence than is required for an auditor's report, and conducting procedures which
are less thorough.
o t.
The conclusion of a review report is expressed negatively, and would begin with the wording, 'Based on our
review, nothing has come to our attention...'
The conclusion of an auditor's report is phrased positively, and may state that the financial statements do in
sp
fact 'present fairly', or 'give a true and fair view of', the entity's financial position, performance and cash
flows.
Question 3
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Top Tips. This was an optional question in the real exam, and it is likely that those who chose to tackle it did so
l.b
because of part (a). Be sure to calculate materiality for some easy marks, both on the mine as a whole and on the
possible impairment. You may have been tempted to write about the risk to the company's operations – this is
relevant in this case, but only insofar as it casts doubt over the going concern assumption. There are no marks for
discussing business risk as such.
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As is often the case, you can score well by thinking of audit evidence in (a)(ii). Don't go overboard on this because
marks are likely to be capped, but it is important to spend time on this part of the requirement. Note that the
ate
question does not ask for the impact on the auditor's report, so there are no marks available for comments on this.
Part (b) may have been trickier than (a). You needed to know your auditing standards here (ISA 250), and provided
you did then you should have been able to pass this part of the question.
ym
Easy marks. Calculating materiality is simple in part (a).

and Revision Kit.
tud
Marking scheme
Marks
as

Generally 1 mark for each point made:
– Materiality of the mine to total assets
– Impairment review should have been performed
cc
– Materiality of the potential write-off to profit

– No impairment write-off means overstated assets and profit
– Potentially all of the mine may be closed down and therefore impaired
ea
– Equipment which cannot be recovered also needs to be written off

– Improvements to health and safety should be capitalised
– Costs of abandoning/sealing up collapsed tunnels should be expensed
e
– Separate presentation of material impairment costs in financial statements

– Provision to be recognised for damaged properties/relocation costs of local
/fr
residents
– Further claims may be made leading to provisions or contingent liabilities
– The authority may impose fine/penalty – provision or contingent liability
p:/
– Going concern disclosure if accident creates significant doubt

– Break-up basis if authority withdraw company's operating licence
htt
Marks
(ii) Evidence
m/
– Operating licence, reviewed for conditions relating to health and safety and for
potential fines and penalties
– A written representation from management on their intention (or not) to bring the
co
non-compliance to the attention of the National Coal Mining Authority
– A copy of board minutes where the accident has been discussed to identify the
rationale behind the non-disclosure
o t.
– A copy of reports issued by engineers or other mining specialists confirming the
extent of the damage caused to the mine by the accident
– Any quotes obtained for work to be performed to make the mine safe and for
blocking off entrances to abandoned tunnels
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– Confirmation, possibly by physical inspection, that the undamaged portion of the
mine is operational
– A copy of the surveyor's report on the residential properties, reviewed for the
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expert's opinion as to whether they should be demolished
– A review of correspondence entered into with the local residents who have been
relocated, to confirm the obligation the company has committed to in respect of
their relocation
l.b
– Copies of legal correspondence, reviewed for any further claims made by local
residents
– A review of the Ledge Hill Mine accident book, for confirmation that no one was
injured in the accident
–
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A copy of management's impairment review, if any, evaluated to ensure that
assumptions are reasonable and in line with auditor's understanding of the
situation
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– Confirmation that impairment losses have been recognised as an operating
expense
– A review of draft disclosure notes to the financial statements where provisions
and contingent liabilities have been discussed
– A review of cash flow and profit forecasts, forming a view on the overall going
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concern status of the company

Maximum 14
(b) Responsibilities, actions and reporting
Generally 1 mark for each point discussed:
tud
– Management responsible for compliance with laws and regulations

– Auditor responsible for understanding applicable laws and regulations
– There is suspected non-compliance with laws and regulations and further procedures are
necessary
as
– Matter should be discussed with those charged with governance

– Need to understand reason for non-disclosure/encourage management to disclose
– The need for external reporting should be evaluated
cc
– Legal advice may be sought

– Confidentiality may be overridden in some circumstances
Maximum 6
Total 20
ea
(a) (i) The mine is recognised at $10m, which is 5.7% of total assets and is therefore material.
e
Impairment
/fr
The closure of a third of the mine is an indicator that the asset may be impaired. Management should
therefore already have conducted an impairment review in line with IAS 36 Impairment of Assets.
p:/
At a minimum it would appear that no future economic benefit can be derived from one third of the
mine. At $3.3m, this is approximately 18.5% of Dasset's profit before tax and is highly material.
htt
It is possible, however, that the situation is far worse than this. If the whole mine were unusable, then
an impairment loss of $10m would need to be recognised, which at 56% of profit before tax is very
m/
material indeed.
IAS 1 Presentation of Financial Statements requires separate disclosure of individual items of income
or expense, so it is possible that such an impairment loss should be disclosed in this way.
co
Inadequate disclosure would be a material misstatement.
Withdrawal of licence
o t.
It is possible that the National Coal Mining Authority ('NCMA') may withdraw Dasset's licence in
relation to the Ledge Hill mine. This would result in a $10m impairment loss.
Fines could also be imposed in relation both to the accident and to Dasset's failure to report it. These
sp
would need to be either provided for or disclosed in line with IAS 37 Provisions, Contingent Liabilities
and Contingent Assets. This would further reduce profit before tax, and failure to make the required
provisions or disclosures would constitute a material misstatement.
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Expenditure on mine
If the mine were to stay open then the monies spent improving the mine should be treated as capital
expenditure. Clearly the amounts should be expensed if the mine cannot stay open. Any sums spent
restoring the mine to its previous working condition should be treated as expenses, as should any
l.b
expenditure required to make safe the unusable tunnels (which will not provide future economic
benefits).
Provisions
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IAS 37 requires provisions to be recognised for liabilities where there is a present obligation as a
result of a past event. These criteria appear to have been met in the case of the residential properties
because the accident took place before the year end, and the fact that the company is meeting the
ate
residents' expenses implies that it acknowledges its liability to them.
Provision should therefore be made for:
 Any future costs of rental properties for which Dasset may be liable
ym
 Costs relating to repairs or rebuilding of properties in the village for which Dasset may be
liable
 Other future outflows, such as claims for compensation by affected residents. This may be
tud
more difficult to measure and may be less probable to be paid, so consideration should be
given to whether these costs meet the IAS 37 criteria.
The surveyor, a management's expert, should be able to provide a reliable estimate for the first two
categories of cost above.
as
Management integrity
Management's decision not to report the accident to the authorities casts doubt over its integrity, in
which case any written representations received from management should be reviewed and treated
cc
with professional scepticism.

There does not appear to be any liability to Dasset's employees because nobody was injured in the
accident, but given the doubts over management's integrity this claim should be questioned.
ea
Procedures need to be performed to determine whether liabilities and disclosures in the financial
statements are complete.
Going concern
e
In addition to withdrawing the licence for the Ledge Hill mine, the NCMA could withdraw the license for
/fr
the totality of Dasset's operations. This is unlikely, but not impossible, and its effects would be
devastating for Dasset. The financial statements would then need to be prepared on the break-up basis.
p:/
A further risk to going concern arises from the effect of any bad publicity about the accident on
Dasset's future sales.
htt
(ii) Evidence
m/
 Copy of operating licence, reviewed for health and safety conditions and for potential penalties
for non-compliance
 Written representation on management's intention (or not) to inform NCMA of non-
co
compliance
 Board minutes discussing the accident, to identify the rationale behind non-disclosure
 Engineer's reports confirming extent of the damage caused to the mine
o t.
 Quotes obtained for work to be performed to make the mine safe
 Confirmation that the undamaged portion of the mine is operational, eg from reviewing
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engineer's report
 Surveyor's report on the residential properties, reviewed for opinion on whether they should
be demolished
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 Correspondence with relocated local residents, to confirm the obligation the company has
committed to in respect of their relocation
 Copies of legal correspondence, reviewed for any further claims made by local residents
l.b
 Review of the Ledge Hill Mine accident book, for confirmation that no one was injured in the
accident
 Copy of management's impairment review, if any, evaluated to ensure reasonableness of

assumptions
ria
Confirmation that impairment losses have been recognised as expenses
ate
 Review of draft disclosure re. provisions and contingent liabilities
 Review of cash flow and profit forecasts with respect to going concern
(b) In line with ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements Dasset's
management is responsible for ensuring that its operations comply with relevant law and regulations, in
ym
respect of which the auditor has no responsibility as such. The auditor must obtain a general understanding
of the legal and regulatory framework and the entity's compliance with it.
Dasset's management appears in this case not to have complied with NCMA regulations, and has not
informed the NCMA of this. The decision not to inform the authority may be a legitimate one, or it could
tud
signal a belief on the part of management that it needs to hide the accident from the NCMA.
Burton & Co must first obtain an understanding of the nature of the non-compliance and the surrounding
circumstances, evaluating the possible effect on the financial statements and conducting further audit
as
procedures where necessary.

Burton & Co should discuss the non-compliance with those charged with governance, and should obtain a
written representation regarding the reason for the non-disclosure. The auditor should suggest that
cc
management report the incident to the NCMA.

Burton & Co owes Dasset a duty of confidentiality and should therefore not disclose the accident without
Dasset's prior consent. This duty may, however, be overridden where disclosure is in the public interest or is
ea
required by legislation. The auditor should consult with legal counsel to determine whether it has any legal
duty to disclose, or whether disclosure would be appropriate here on public interest grounds.
e
/fr
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Question 4
m/
Top Tips. Your approach to ethics questions such as this should be to work through the scenario with pen in hand,
co
noting the threats as you go. It is important that you try to identify the threats to independence, taking care not to
just list the threats that you think might be present. You then need to say why such a threat is present, and suggest
safeguards to reduce the threat to an appropriate level. It is a good idea to try to evaluate the seriousness of the
o t.
threat, and to give a conclusion to each mini-scenario, such as 'if these safeguards cannot be implemented then the
auditor must decline to tender for this engagement'.
Practical professional and commercial considerations usually score well. The most straightforward example of this
sp
being that the audit firm should consider which of the non-audit services or the audit will be most profitable for it to
continue with.
Be very wary about writing about the risk of % fee thresholds being breached, as your examiner considers these to
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be general points that betoken a lack of application to the scenario at hand. It is not relevant to any of the mini-
scenarios in this question, for example, and you should only mention it in an answer if the scenario specifically
hints that this might be problem.
Easy marks. Calculating materiality in part (c) gets you a full mark (½ for the calculation, ½ for saying it's
l.b
immaterial).
and Revision Kit.
Marking scheme
ria
ate
Marks
(a) Tetbury Co
Generally 1 mark for each point identified and discussed:
ym
– Customer due diligence/know your client procedures to be performed

– Audit firm's competence to audit a financial services client
– Acceptance decision should also include consideration of ethical threats
– Management integrity threatened by past investigation by financial services authority
tud
– Integrity also threatened by possible inappropriate financial reporting

– Management may have intimidated the previous auditor
– Contact previous auditor for further information
– Controls appear weak leading to high audit risk
– Responses to high risk should be considered, eg use of experienced audit team
as
– Confirm client's intention to improve controls

– Threats to objectivity arise from giving business advice – perceived as assuming
management responsibility
cc
– Self-review and self-interest threats created

– Safeguards to be put in place, eg management acknowledge responsibility for business
decisions
ea
Maximum 8
(b) Stratford Co
– Advocacy threat created by attending meeting
e
– Legal proximity may be created by attending meeting

– Intimidation threat from threat of removal from office
/fr
– Consider appropriate safeguards

– Integrity of the managing director questionable
– Overdue fees may represent self-interest threat
p:/
– But amount may be insignificant and not long overdue

Maximum 6
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(c) Banbury Co Marks
– Provision of valuation service creates self-review and self-interest threats to objectivity
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– Service cannot be provided if the pension deficit is material
– Calculate and comment on materiality in 20X3 financial statements
– Other matters to consider including level of subjectivity, lack of informed management
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(1 mark each)
– Safeguards may be used to reduce threat to acceptable level (1 mark each)
Maximum 6
20
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Total
(a) Tetbury Co
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Professional competence
Tetbury operates in the highly-regulated, complex environment of financial services. There is therefore a
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threat to Chester & Co's ability to conduct an audit in this area in line with the principle of professional
competence and due care. This is a self-interest threat as a result of the prospective audit fee.
Customer due diligence
l.b
Given the complex and therefore risky nature of Tetbury's business environment, it is of paramount
importance that Chester & Co conducts customer due diligence procedures before accepting such a client.
The risk of Tetbury being involved in laundering money should be weighed carefully.
Previous auditors
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The fact that the previous auditors resigned suggests that Tetbury's management may lack integrity. There is
a risk that the problems which led to the previous auditors resigning may persist during the tenure of
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Chester & Co.
Chester & Co should ask Tetbury for permission to contact the previous auditors regarding the reasons for
their resignation. They should be asked whether there are any matters of which Chester & Co should be made
aware of in deciding whether to take on the audit. This is a self-interest threat to professional competence and
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due care, because Chester & Co may fail to exercise due care in order to secure the audit fee.
If Tetbury refuses permission to contact the previous auditors, then Chester & Co should withdraw from the
tender process.
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Controls
The fact that the reason given for the previous auditors' resignation points to a poor control environment at
Tetbury. This is particularly worrisome given that it is an owner-managed business, in which the risk of
management override of controls is perennially present. Bearing in mind also the increased need for robust
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internal controls in as highly-regulated an area as financial services, the Tetbury audit would surely be
considered high-risk.
As a high-risk audit, Chester & Co would likely need to perform more audit procedures in order to reduce
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audit risk to an appropriate level. This would be costly, and would need to be reflected in a high audit fee.
The threat to Chester & Co's professional competence is in this light particularly acute. Chester & Co would
need to consider carefully whether the Tetbury audit would be worth such a high risk.
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Financial services authority investigation

The investigation suggests either a lack of integrity or a poor control environment, or both. In any event
Chester & Co ought to find out more about this, for example by contacting the authority for further details.
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Business development advice

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There is a self-interest threat here in relation to the fee. There is a self-review threat as it is possible that the
advice may need to be audited, for example as part of the assessment of the going concern assumption.
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The self-review threat can be mitigated by using separate engagement teams, separated by information
barriers, or by an independent review of the audit work by a professional accountant.
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It is important that Chester & Co avoids taking on management responsibilities, because were they to do so
then the tender must be declined. It can avoid doing so by obtaining written confirmation from Tetbury that
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it acknowledges responsibility for any decisions taken.
(b) Stratford Co
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Meeting
The request to attend the meeting with the bank suggests an advocacy threat, as the audit partner may be
put in the position of supporting the view that the client will continue as a going concern, and that the bank
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should therefore offer it a loan.
Legally, there is a risk of creating proximity between Chester & Co and Stratford which could result in the
bank taking legal action against the auditor in the event of Stratford defaulting on its loan.
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In addition, the financial statements being presented at the meeting are only draft versions and have not
been audited. It is crucial that Chester & Co does not allow Stratford to give the bank the impression that
these financial statements come with any assurance.
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It would probably not be possible to mitigate the advocacy threat with the audit engagement partner
attending the meeting. It may be possible for another partner to attend, however, if it was made clear that
they were not the audit partner and that no assurance was provided in respect of the draft financial
statements.
l.b
Threat
The managing director's threat to put the audit out to tender is an intimidation threat, since if the audit
provided on the draft financial statements.

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partner were to attend the meeting, this may give the bank the false impression that assurance has been
This places a question mark over the managing director's integrity. Chester & Co should communicate with
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those charged with governance on this matter, for example with any other board members or with the audit
committee. Chester & Co should consider resigning from the audit if the threat does not abate.
Fees
Overdue fees represent a self-interest threat, as Chester & Co may not obtain sufficient appropriate evidence
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in relation to the audit opinion it expresses in order to receive the fees owing. There is a risk that this may be
perceived to be a loan made to Stratford.
In this case the fee relates to a debt that is only four months old. The severity of the threat would depend on
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the significance of the amount outstanding.

Chester & Co should request that the audit fee be paid, and should communicate the matter to those
charged with governance. It may also wish to review the efficacy of its own system for credit control.
(c) Banbury Co
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Threats
There is a self-interest threat here in respect of the fee for the non-assurance service.
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A self-review threat is present because the partner's actuarial valuation may need to be audited, in which
case Chester & Co would be reviewing its own work. It is not clear whether the audit partner in question is
an audit engagement partner for the Banbury audit. If this is the case then the service cannot be performed
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unless the engagement partner is changed.

Assuming that the partner involved is not the engagement partner, and subject to the further considerations
below, relevant safeguards here could include:
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 Using separate teams to work on the actuarial valuation and on the audit, separated by information
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barriers
 Independent review of the audit and/or the valuation by an independent professional
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Valuation
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In assessing the significance of the self-review threat, a number of factors must be considered. Chief among
these are:
 The materiality of the valuation to the audited financial statements
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 The degree of subjectivity involved in the valuation
 The extent to which the client is involved in making any judgements necessary to the valuation
If, for instance, the valuation involves a high degree of subjectivity, and cannot be performed according to an
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established methodology then the self-review threat might be considered severe.
Materiality
Banbury is a listed – and therefore public interest – entity, so its auditor must not provide valuation services
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which materially affect the financial statements.
The pension liability was 0.3% of total assets last year and was thus immaterial. If the figures this year are
similar, then materiality would not be a barrier to providing the service.
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Question 5
l.b
Top Tips. As is traditional, this P7 question five includes auditor's reports, in this case combined with going
concern.
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Part (a)(i) was very easy, and you should have passed this part with little difficulty. The only real risk here would be
going over your time allocation. Part (a)(ii) was perhaps harder, but the examiner included a nice little list of
'assumptions' in the question for you to base your suggestions for evidence on. Here you needed to make sure that
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your suggestions were specific – eg you might suggest a source for the evidence, and then state the procedure that
would have been performed on it.
Part (b) was a standard audit report question for P7 – the technical material on auditor reporting should have been
within your grasp. Do not overlook the requirement for 'further actions to be taken by the auditor'.
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Easy marks. Calculating materiality in part (c) gets you a full mark (½ for the calculation, ½ for saying it's
immaterial).
and Revision Kit.
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Marking scheme
Marks
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(a) (i) Going concern indicators

Up to 1½ marks for each going concern indicator discussed, for example:
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– Declining profitability and implication

– Poor liquidity – inability to pay suppliers/employees/overheads
– Poor liquidity – breach of loan covenant and implication
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– Development of new product is a further drain on cash

– Success of new product is not guaranteed
Maximum 6
(ii) Procedures on cash flow forecast
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Generally 1 mark for each well-described procedure:

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– Agreement of the opening cash position to the audited financial statements and general
ledger or bank reconciliation
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– Confirmation that casting of the cash flow forecast has been re-performed
– Review of the results of any market research which has been conducted on the GreenFire
product
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Marks
– Discussion of the progress made on GreenFire's development with a technical expert or
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engineer
– Review of correspondence with existing customers to gauge the level of interest in
GreenFire and confirm if any orders have yet been placed
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– A review of any sales documentation relating to the planned sale of plant and equipment
– Physical inspection of the plant and equipment to be sold, to gauge its condition and the
likelihood of sale
– Review of any announcement made regarding the redundancies
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– Sample testing of a selection of those being made redundant, agreeing the amount they
are to be paid to HR records
– Correspondence from the government department of the $30,000 grant to be received
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– If the grant of $30,000 has been received, agree to cash book and bank statement
– Agreement that the cash flow forecast is consistent with profit and other financial
forecasts which have been prepared by management
– Confirmation that any other assumptions used in the cash flow forecast are consistent
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with auditor's knowledge of the business and with management's intentions regarding
the future of the company
– Comparison of the cash flow forecast for the period August–November 20X3 with
management accounts for the same period
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– Analytical review of the items included in the cash flow forecast, for example, categories
of expenses, to look for items which may have been omitted
Maximum 8
(b) Implications for auditor's report and audit completion
Generally up to 1½ marks for each point discussed:
– Review adequacy of note
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– Evaluate its compliance with applicable financial reporting requirements
If note is adequate:
– No modification of auditor's opinion
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– Emphasis of Matter paragraph to be included (up to 3 marks for discussion of its

contents and positioning)
– Discuss use of EOM with those charged with governance
If note is not adequate:
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– Non-compliance with financial reporting requirements therefore material misstatement

– Auditor's judgement as to whether misstatement is material or pervasive
– Content of Basis of Opinion paragraph
– Discuss modification of opinion with those charged with governance
6
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Maximum
Total 20
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(a) (i) Performance

Burford's decline from a healthy profit to a $0.5m loss is a veritable fall from grace. This appears to
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result from the obsolescence of its QuickFire product and the corresponding disappearance of as
much as 45% of its revenue.
Profitability looks set to tumble still further in the coming year as the effect of the QuickFire's
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absence is felt for the full year.

Although Burford does have a replacement lined up in the form of the GreenFire, any new product will
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take time to gain market share and it is unlikely that such a product will reverse the declining trend in
the immediate future.
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Liquidity
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Burford's worsening current and quick ratios paint a bleak portrait of declining liquidity. With current
liabilities greater than current assets the company may be unable to pay its debts as they fall due, and
may therefore be illiquid. If suppliers are not paid then they may restrict supply or refuse to extend
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credit to Burford, which could make trading impossible.
Moreover, if there are any items of the QuickFire still in inventory then impairment losses may have
to be recognised in respect of them, in which case these ratios will decline even further.
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The outlook of declining revenue and increasing costs (for example, marketing costs to help establish
the new GreenFire) threatens to heap solvency problems on top of the liquidity problems.
Cash position
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Burford's cash balance of $25,000 is very low, at only 0.2% of total assets. It is unlikely that Burford
could survive for long with such little cash. It is not known whether Burford has any overdraft facility
available to it which might help it survive at least a little longer.
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Loan covenant
Given that the current and quick ratios have declined still further since the year end, it is possible that
the covenant has been breached already. If the loan is recalled (as seems likely), the cash balance of
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$25,000 will be insufficient to repay it.
Burford may have to sell assets in order to repay the loan, which could put its future operations in
jeopardy.
GreenFire launch
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Burford's lack of working capital may make it impossible for it to fund the development and launch of
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the new product, which would surely be a fatal blow to its going concern.
(ii) Evidence
 Agreement of opening cash position to audited financial statements to ensure accuracy of
extracted figures
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 Re-cast of forecast to check arithmetical accuracy

 A review of results of market research on GreenFire, to ensure the assumption regarding its
successful launch is appropriate
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 Discussion of progress made on GreenFire's development with a technical expert, to gauge

the likelihood of a successful launch
 A review of correspondence with customers to gauge interest in GreenFire and confirm if any
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orders have been placed

 A review of sales documentation relating to the sale of plant and equipment to confirm that
$50,000 is achievable
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 Physical inspection of plant and equipment to be sold, to gauge its condition and the
likelihood of sale
 A review of any announcement made regarding the redundancies, to confirm the number of
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employees affected and the timing

 Sample testing of a selection of those being made redundant, agreeing the amount to be paid
to HR records, to ensure accuracy of figures in the forecast
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 A review of the application made to the government to confirm the amount of the grant.
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Confirmation to correspondence from government department of the $30,000 to be received

 Agreement that the cash flow forecast is consistent with profit and other financial forecasts
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prepared by management
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 Confirmation that any other assumptions used in the cash flow forecast are consistent with
auditor's knowledge of the business and with management's intentions
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 Comparison of the cash flow forecast for the period August–November 20X3 with
management accounts for the same period, to ensure accuracy of the forecast
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 Analytical review of the items included in the cash flow forecast, for example, categories of
expenses, to look for items which may have been omitted
(b) IAS 1 Presentation of Financial Statements requires detailed disclosures to be made in the situations where
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there is significant doubt over going concern. A brief note is unlikely to suffice, since the note must describe
the reasons for the doubt together with management's plans for dealing with them.
The key issue is whether or not the disclosure is adequate.
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Adequate disclosure
In this case IAS 1 has been complied with, so the financial statements are not materially misstated. In this
case the auditor is nevertheless required to include an Emphasis of Matter paragraph in the auditor's report.
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This would draw users' attention to the disclosure note in the financial statements, and would itself contain a
description of the uncertain conditions around going concern. The paragraph should be placed immediately
after the Opinion paragraph, and should state that the auditor's opinion is not qualified.
l.b
The auditor should communicate with those charged with governance of Burford regarding the modification
of the auditor's report.
Inadequate disclosure
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In this case there is a material misstatement in respect of IAS 1. The question for the auditor is whether the
misstatement is simply material, or both material and pervasive. In the former case, a Qualified Opinion
would be expressed, and in the latter case an Adverse Opinion would be expressed.
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In both cases the Basis for Qualified/Adverse Opinion paragraph would state the reasons for the modified
opinion, and would clearly describe the material uncertainties giving rise to significant doubts about going
concern. This paragraph would be placed immediately before the Opinion paragraph itself.
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The auditor should discuss the situation with those charged with governance, giving them an opportunity to
amend the financial statements in respect of the inadequate disclosure.
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ACCA examiner's answers:

June and December 2013 papers
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Note. The ACCA examiner's answers are correct at the time of going to press but may be subject
to some amendments before the final versions are published.
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437
The June 2013 questions are located in the kit as follows:
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June question number Kit question reference
1 32
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2 5
3 27
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4 15
5 61
The December 2013 questions form Mock Exam 3 in this kit. Please note that the ACCA examiner's
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answers have not been updated for any technical changes coming into effect for exams in 2014 and June
2015.
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438
Professional Level – Options Module, Paper P7 (INT)
Advanced Audit and Assurance (International) June 2013 Answers
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1 Briefing notes
To: Audit Partner
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From: Audit Manager
Regarding: Audit planning issues in relation to Parker Co
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Introduction
These briefing notes include the results of a preliminary analytical review and evaluate the audit risks to be
considered in planning the audit of Parker Co for the year ending 30 June 2013, and identify additional
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information required. In addition, ethical issues will be discussed and appropriate actions recommended.
(a) Results of preliminary analytical review and audit risk evaluation
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The appendix to the briefing notes contains the detailed results of the analytical review performed,
which are evaluated in the following section.
Profitability
Parker Co's profitability has declined, with gross profit falling by 21.5% and operating profit by
l.b
32.7%. The company's revenue has fallen by 8.2%.
Ratio analysis shows that both gross and operating margins have fallen, the projected gross profit
margin at the year end is 27.2% (2012 – 31.8%) and the projected operating margin is 11.4%
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(2012 – 15.6%). The return on capital employed also shows significant decline, falling from 6.2% to
3.8%. The declines can be explained by a price cutting strategy, difficult economic conditions, and
the costs of the legal claim of the company amplify the fall in profitability.
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The trends in profitability cause going concern issues. If the company's results do not improve next
year, for example, if the new organic range of goods is not successful, the company may become
loss-making, especially if margins are squeezed by further price cuts.
Some further information would be helpful to make a more detailed assessment of profitability, for
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example, an analysis of revenue and profit by product range, which would allow margins to be
calculated for individual product ranges to identify those that are particularly underperforming. In
addition, the results of any market research that has been performed on the new organic product
range to evaluate the potential of the development to generate future profit.
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Further adjustments may be necessary to the financial statements, which may reduce the current
year's profit further. These adjustments relate to possible incorrect accounting treatments applied to
the provision, development costs, finance costs and tax expense, which are discussed later in the
briefing notes.
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Liquidity
The company's cash position has deteriorated dramatically during the year, moving from a positive
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cash balance of $1 million, to a projected overdraft of $900,000 at the year end. Analytical review
shows that the current and quick ratios have both deteriorated, and it is projected that current assets
will not cover current liabilities, as the current ratio projected at the year end is 0.96 (2012 – 1.8).
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Parker Co will therefore find it difficult to pay liabilities as they fall due, increasing the going concern
risk.
Payables days have increased from 63 days to 86 days; this indicates that the company is
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experiencing difficulties making payments to suppliers as they fall due. This could result in supplier
relationships deteriorating and they may stop supplying Parker Co if they see them as a 'risky'
/fr
customer. Suppliers may also restrict the credit terms offered to Parker Co, causing further working
capital problems.
Receivables days have increased from 34 to 42; this could be as a result of poor credit control. A
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significant control deficiency could affect our overall risk assessment of the client. Alternatively, the
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Examiner's answers: June 2013 439
increased receivables balance could be the result of irrecoverable debts that require a provision
to be made against them; this could further affect profit levels if such a provision is required.
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The current and quick ratios will deteriorate further if an adjustment is necessary in respect of the
provision, which has been recognised for a potential penalty payment (discussed further below).
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Working capital also seems to be a problem, with inventory holding period, receivables collection
period and trade payables period all increasing. The inventory holding period is perhaps the most
significant, increasing from 136 days to 167 days. This shows that a large amount of working capital
is tied up in inventory, and it is likely that some of these goods are obsolete (for example, ranges of
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cosmetics that are out of fashion) and will never generate a cash flow.
This creates a further audit risk, that the inventory is overstated and needs to be written off to net
realisable value. Any write off necessary will put further pressure on the gross profit margin.
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To help the risk assessment in relation to cash management, a statement of cash flows projected to
the year end would be useful. This is important in order to analyse the main cash generating activities
and, more importantly, where cash has been used during the year. A cash flow forecast for at least
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the next 12 months would also help with going concern assessment.
Solvency
Parker Co's gearing ratio is projected to increase from 0.8 to 1. This indicates a high level of gearing,
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and the company may, as a result, find it difficult to raise further finance if required, again increasing
the going concern risk. The company extended its bank loan during the year and now also has a
significant overdraft. It seems very reliant on finance from its bank, and it may be that the bank will
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be reluctant to offer any further finance, especially in the current economic climate.
It will be important to obtain the details of the bank loan and overdraft, as this will impact on the
going concern assessment. In particular, additional information is needed on the overdraft limit to
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determine how close the current and projected overdraft is to the limit.
The interest cover has fallen from 10.6 to 5.7. Based on these figures, there still appears to be plenty
of profit to cover the finance charges, but of course there is a lack of cash in the company, meaning
that payments of interest and capital may be difficult.
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Finance charge
The finance charge expensed in the statement of profit or loss and other comprehensive income
appears very low when compared to the company's level of interest bearing debt and its overdraft. To
illustrate, the year-end interest bearing debt and overdraft is $12.725 million ($11.825 million non-
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current liabilities + $900,000 overdraft), which when compared to the finance charge for the year of
$155,000 implies an overall interest rate on all interest bearing debt of only 1.2%. This seems very
low, especially when the preference shares have an interest rate of 2%.
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This rough calculation indicates that finance charges may be understated. This may also be the case
for the comparative figures and creates significant audit risk. If the finance cost needs to be
increased, this will further reduce profit before tax and could cause either or both years to become
loss-making.
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There is a risk that the dividend paid to preference shareholders has been incorrectly accounted for
as a distribution from retained earnings, but the correct treatment would be to include the dividend
within finance charges, in accordance with IAS 32 Financial Instruments: Presentation.
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Further information is needed, such as the dates that new finance leases were taken out, the interest
rates applicable to each interest-bearing balance and the annual payment due to preference
shareholders. This will help to assess whether the finance charge is at risk of understatement.
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Tax expense
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The effective tax rate based on the projected figures for 2013 is 9.5% (70 / 735), compared to 25%
(300 / 1,197) in 2012. The tax expense for 2013 seems low and it is possible that a proper estimate
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has not yet been made of tax payable. The statement of financial position shows a tax payable figure
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440 Examiner's answers: June 2013
of $50,000 whereas the tax expense is $70,000. This also indicates that the tax figures are not
correct and will need to be adjusted.
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Provision
A provision in relation to a fine against the company has been recognised in cost of sales. There are
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two audit risks in relation to this item. First, the provision may not be measured correctly. $450,000
is the amount of the potential amount payable, but only $250,000 has been provided. According to
IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised
where there is a present obligation as a result of a past event, a probable outflow of economic benefit
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and a reliable estimate can be made. Assuming that these criteria have been met, it would be
reasonable to expect the full amount of the fine against the company to be provided. Therefore there
is a risk that profit is overstated and current liabilities are understated by $200,000. Additional
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information is needed from management to understand the rationale behind the amount that has
been provided.
Furthermore, the provision has been charged to cost of sales. This is not the normal classification of
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items of this type, which would usually be classified as an operating expense. A presentation risk
therefore arises, which affects the gross and operating profit figures. If the full amount of the
provision were recognised in operating expenses, the operating margin for 2013 would only be 8.9%.
Development cost
l.b
A significant amount, $2.25 million, has been capitalised during the year in relation to costs arising
on development of the new organic product range. This represents 8.3% of total assets. There is a
risk that this has been inappropriately capitalised, as IAS 38 Intangible Assets only permits the
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capitalisation of development costs as an internally generated intangible asset when certain criteria
have been met. There is therefore a risk that non-current assets and operating profit are overstated
by $2.25 million if the criteria have not been met, for example, if market research does not
ate
demonstrate that the new product will generate a future economic benefit. There is also a risk that
inappropriate expenses, such as revenue expenses or costs of developing a brand name for the
organic range of products, have been capitalised incorrectly.
This is a significant risk, as if an adjustment were necessary to write off the intangible asset, the
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profit for the year of $665,000 would become a loss for the year of $1.585 million, and retained
earnings would become retained losses of $975,000. This adds to the going concern risk facing
Parker Co.
Revaluation of properties
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A revaluation during the year has led to an increase in the revaluation reserve of $500,000,
representing 1.8% of total assets. Despite the valuations being performed by an independent expert,
we should be alert to the risk that non-current assets could be overstated in value. This is especially
the case given that Parker Co faces solvency problems resulting in potential management bias to
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improve the financial position of the company. Information is needed on the expert to ensure the
valuation is objective, thereby reducing the audit risk.
There is also a risk that depreciation was not re-measured at the point of the revaluation, leading to
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understated expenses. The revaluation should also have a deferred tax consequence according to
IAS 12 Income Taxes, as the revaluation gives rise to a taxable temporary difference. If a deferred tax
liability is not recognised, the statement of financial position is at risk of misstatement through
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understated liabilities. Currently there is no deferred tax liability recognised, indicating that liabilities
are understated. The same is true for the comparative figures, so an adjustment may be needed in the
opening balances.
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Finally, a further audit risk is incorrect or inadequate disclosure in the notes to the financial
statements. IAS 16 Property, Plant and Equipment requires extensive disclosure of matters such as
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the methods and significant assumptions used to estimate fair values, the effective date of the
revaluation and whether an independent valuer was used, as well as numerical disclosures. The
revaluation gain should also be disclosed as Other Comprehensive Income and there is a risk that
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this disclosure is not made. The financial statements provided by Ruth Collie do not contain any
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items of Other Comprehensive Income and the risk is that the financial statements have not been
prepared in accordance with IAS 1 Presentation of Financial Statements.
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Payroll
Parker Co's internal audit team found control deficiencies when auditing the processing of overtime
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payments. Additional information is needed on the nature of the deficiencies in order to determine the
significance of them, and to plan our approach to the audit of overtime payments. The fact that the
processing is no longer carried out by human resources could indicate that the problems were
significant. We also need to know the monetary value of the overtime payments to determine its
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materiality to the financial statements.
The fact that the finance function is now performing the processing will affect our assessment of
control risk. On one hand, finance department members should be familiar with the operation of
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internal controls and understand their importance, which would reduce control risk. However, as all
of the processing is now done by one department there is less segregation of duty, which could lead
to higher control risk.
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New client
Parker Co is a new client, and therefore our firm lacks cumulative knowledge and experience of the
business. This increases our detection risk somewhat, but this will be mitigated by thorough
l.b
planning, including developing an understanding of the business including the internal control
environment.
There may also be risks attached to the comparative information and opening balances, especially as
Appendix: Results of preliminary analytical review

2013
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the audit risk evaluation has highlighted some potential areas of concern.
2012
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Profitability:
Gross profit margin:
Gross profit/revenue 2,120 / 7,800 = 27.2% 2,700 / 8,500 = 31.8%
Operating profit margin:
Operating profit/revenue 890 / 7,800 = 11.4% 1,322 / 8,500 = 15.6%
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Operating profit margin for 2013

adjusted to include full amount of 890 – 200 / 7,800 = 8.9%
provision
Return on capital employed:
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Operating profit/capital employed 890 / 11,775 + 11,825 = 3.8% 1,322 / 11,455 + 9,725 = 6.2%
Return on capital employed adjusted
to include full amount of provision 890 – 200 / 11,775 + 11,825 = 2.9%
Liquidity:
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Current ratio:
Current assets/current liabilities 3,500 / 3,650 = 0.96 3,965 / 2,185 = 1.8
Quick ratio:
Current assets – inventory/current liabilities 3,500 – 2,600 / 3,650 = 0.25 3,965 – 2,165 / 2,185 = 0.82
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Inventory holding period:

Inventory/cost of sales  365 2,600 / 5,680  365 = 167 days 2,165 / 5,800  365 = 136 days
Receivables collection period:
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Receivables/revenue  365 900 / 7,800  365 = 42 days 800 / 8,500  365 = 34 days
Trade payables payment period:
Trade payables/cost of sales  365 1,340 / 5,680  365 = 86 days 1,000 / 5,800 365 = 63 days
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Gearing:
Gearing ratio:
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Long-term liabilities/equity 11,825 / 11,775 = 1 9,725 / 11,455 = 0.8

Interest cover:
Operating profit/finance costs 890 / 155 = 5.7 1,322 / 125 = 10.6
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Tutorial note. Credit will be awarded for calculation of ratios on alternative bases and using different
assumptions, as long as stated. Credit will also be awarded for relevant trend analysis.
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(b) Ethical matters
Parker Co is intending to acquire Beauty Boost Co, which is an audit client of our firm. This raises an
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ethical issue, as the auditor could be involved with advising both the acquirer and the intended target
company in relation to the acquisition, which could create a conflict of interest. IESBA's (IFAC) Code
of Ethics for Professional Accountants states that in relation to the fundamental principle of
objectivity, an auditor should not allow bias, conflict of interest or undue influence of others to
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override professional or business judgements.
IESBA's Code requires that, when faced with a potential conflict of interest, an auditor shall evaluate
the significance of any threats and apply safeguards when necessary to eliminate the threats or
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reduce them to an acceptable level.
An important safeguard is that both parties should be notified of the potential conflict of interest in
relation to the planned acquisition. The notification should outline that a conflict of interest may exist
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and consent should be obtained from both Parker Co and Beauty Boost Co for our firm, Hound & Co,
to act for both in relation to the acquisition. If the requested consent is not obtained, the auditor
should not continue to act for one of the parties in relation to this matter.
l.b
The auditor shall also determine whether to apply one or more of the following additional safeguards.
 The use of separate engagement teams
 Procedures to prevent access to information (for example, strict physical separation of such

teams, confidential and secure data filing)
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Clear guidelines for members of the engagement team on issues of security and
confidentiality
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 The use of confidentiality agreements signed by employees and partners of the firm
 Regular review of the application of safeguards by a senior individual not involved with
relevant client engagements
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If the conflict of interest creates a threat to objectivity or confidentiality that cannot be eliminated or
reduced to an acceptable level through the application of safeguards, Hound & Co should not advise
Parker Co regarding the acquisition.
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Parker Co has specifically requested advice on financing the acquisition. IESBA's Code has specific
guidance on such activities, which are corporate finance activities.
The provision of such services can create advocacy and self-review threats to objectivity. The
advocacy threat arises as the audit firm could be put in a position of promoting the audit client's
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interests, for example, when negotiating financial arrangements. The self-review threat arises
because the financing arrangements will directly affect amounts that will be reported in the financial
statements on which the firm will provide an opinion.
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The significance of any threat must be evaluated and safeguards applied when necessary to eliminate
the threat or reduce it to an acceptable level. Examples of such safeguards include.
 Using professionals who are not members of the audit team to perform the corporate finance
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service; or
 Having a professional who was not involved in providing the corporate finance service to the
client advise the audit team on the service and review the accounting treatment and any
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financial statement treatment.

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The extent of the self-review threat should be evaluated, for example, by considering the materiality
of the potential financing transactions to the financial statements, and the degree of subjectivity
involved in determining the amounts to be recognised.
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Where no safeguards could reduce the threat to an acceptable level, the corporate finance advice
should not be provided.
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Conclusion
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These briefing notes have evaluated the audit risks to be considered in planning the audit of Parker
Co, and going concern has been highlighted as a particular area of concern. Preliminary analytical
review determined that Parker Co is facing problems with profitability, cash flow and long-term
solvency. Our audit approach should focus on this issue. In addition, some specific areas of risk in
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relation to provisions, finance charges, tax and non-current assets have been identified. Further
information as specified in the briefing notes should be requested from the client in order to
complete our audit planning.
o t.
Our firm should also consider the ethical issues raised by acting for Parker Co and for its potential
target acquisition. Furthermore, the provision of a specific corporate finance service to Parker Co
must be evaluated as safeguards will be needed to reduce threats to an acceptable level.
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2 (a) There are many concerns raised regarding quality control. Audits should be conducted with
adherence to ISA 220 Quality Control for an Audit of Financial Statements and it seems that this has
not happened in relation to the audit of the Retriever Group, which is especially concerning, given the
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Group obtaining a listing during the year. It would seem that the level of staffing on this assignment
is insufficient, and that tasks have been delegated inappropriately to junior members of staff.
Time pressure
l.b
The junior's first comment is that the audit was time pressured. All audits should be planned to
ensure that adequate time can be spent to obtain sufficient appropriate audit evidence to support the
audit opinion. It seems that the audit is being rushed and the juniors instructed not to perform work
properly, and that review procedures are not being conducted appropriately. All of this increases the
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detection risk of the audit and, ultimately, could lead to an inappropriate opinion being given.
Procedures not performed
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The juniors have been told not to carry out some planned procedures on allegedly low risk areas of
the audit because of time pressure. It is not acceptable to cut corners by leaving out audit
procedures. Even if the balances are considered to be low risk, they could still contain
misstatements. Directors' emoluments are related party transactions and are material by their nature
and so should not be ignored. Any modifications to the planned audit procedures should be
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discussed with, and approved by, senior members of the audit team and should only occur for
genuine reasons.
Method of selecting sample
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ISA 530 Audit Sampling requires that the auditor shall select items for the sample in such a way that
each sampling unit in the population has a chance of selection. The audit manager favours non-
statistical sampling as a quick way to select a sample, instead of the firm's usual statistical sampling
method. There is a risk that changing the way that items are selected for testing will not provide
as
sufficient, reliable audit evidence as the sample selected may no longer be representative of the
population as a whole. Or that an insufficient number of items may be selected for testing. The
juniors may not understand how to pick a sample without the use of the audit firm's statistical
selection method, and there is a risk that the sample may be biased towards items that appear 'easy
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to audit'. Again, this instruction from the audit manager is a departure from planned audit
procedures, made worse by deviating from the audit firm's standard auditing methods, and likely to
increase detection risk.
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Audit of going concern

Going concern can be a difficult area to audit, and given the Group's listed status and the fact that
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losses appear to have been made this year, it seems unwise to delegate such an important area of the
audit to an audit junior. The audit of going concern involves many subjective areas, such as
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evaluating assumptions made by management, analysing profit and cash flow forecasts and forming
an overall opinion on the viability of the business. Therefore the going concern audit programme
should be performed by a more senior and more experienced member of the audit team. This issue
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shows that the audit has not been well planned as appropriate delegation of work is a key part of
direction and supervision, essential elements of good quality control.
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Review of work
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The juniors have been asked to review each other's work which is unacceptable. ISA 220 requires
that the engagement partner shall take responsibility for reviews being performed in accordance with
the firm's review policies and procedures. Ideally, work should be reviewed by a person more senior
and/or experienced than the person who conducted the work. Audit juniors reviewing each other's
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work are unlikely to spot mistakes, errors of judgement and inappropriate conclusions on work
performed. The audit manager should be reviewing all of the work of the juniors, with the audit
partner taking overall responsibility that all work has been appropriately reviewed.
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Deferred tax
It is concerning that the client's financial controller is not able to calculate the deferred tax figure.
This could indicate a lack of competence in the preparation of the financial statements, and the audit
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firm should consider if this impacts the overall assessment of audit risk.
The main issue is that the junior prepared the calculation for the client. IESBA's (IFAC) Code of Ethics
for Professional Accountants states that providing an audit client with accounting and bookkeeping
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services, such as preparing accounting records or financial statements, creates a self-review threat
when the firm subsequently audits the financial statements. The significance of the threat depends on
the materiality of the balance and its level of subjectivity.
l.b
Clients often request technical assistance from the external auditor, and such services do not,
generally, create threats to independence provided the firm does not assume a management
responsibility for the client. However, the audit junior has gone beyond providing assistance and has
calculated a figure to be included in the financial statements. The Group is listed and generally the
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provision of bookkeeping services is not allowed to listed clients.
IESBA's Code states that, except in emergency situations, in the case of an audit client that is a public
interest entity, a firm shall not prepare tax calculations of current and deferred tax liabilities (or
ate
assets) for the purpose of preparing accounting entries that are material to the financial statements
on which the firm will express an opinion.
The calculation of a deferred tax asset is not mechanical and involves judgements and assumptions
in measuring the balance and evaluating its recoverability. The audit junior may be able to perform a
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calculation, but is unlikely to have sufficient detailed knowledge of the business and its projected
future trading profits to be able to competently assess the deferred tax position. The calculation has
not been reviewed and poses a high audit risk, as well as creating an ethical issue for the audit firm.
tud
The deferred tax balance calculated by the junior should be assessed for materiality, carefully
reviewed or re-performed, and discussed with management. It is unclear why the junior was
discussing the Group's tax position with the financial controller, as this is not the type of task that
should normally be given to an audit junior.
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Tax planning
The audit junior should not be advising the client on tax planning matters. This is an example of a
non-audit service, which can create self-review and advocacy threats to independence. As discussed
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above, the audit junior does not have the appropriate level of skill and knowledge to perform such
work.
The junior's work on tax indicates that the audit has not been properly supervised, and that the junior
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does not seem to understand the ethical implications created. As part of a good quality control
system, all members of the audit team should understand the objectives of the work they have been
allocated and the limit to their responsibilities.
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(b) (i) Planning a forensic investigation

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Planning the investigation will involve consideration of similar matters to those involved in
planning an audit.
The planning should commence with a meeting with the client at which the investigation is
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discussed. In particular, the investigation team should develop an understanding of the events
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surrounding the theft and the actions taken by the client since it occurred. Matters that should
be clarified with the client include:
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 The objective of the investigation – to quantify the amount to be claimed under the
insurance cover
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 Whether the client has informed the police and the actions taken by the police so far
 Whether the thieves have been captured and any stolen goods recovered
 Whether the thieves are suspected to be employees of the Group
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 Any planned deadline by which time the insurance claim needs to be submitted
 Whether the client has contacted the insurance company and discussed the events
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leading to the potential claim
The insurance policy should be scrutinised to clarify the exact terms of the insurance, to
ensure that both the finished goods and stolen lorry will be included in the claim. The period
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of the insurance cover should be checked, to ensure that the date of the theft is covered, and
the client should confirm that payments to the insurance company are up to date, to ensure
the cover has not lapsed.
The audit firm should also consider the resources that will be needed to conduct the work.
l.b
Kennel & Co has a forensic accounting department, so will have staff with relevant skills, but
the firm should consider if staff with specific experience of insurance claims work are
available.
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The client should confirm that the investigation team will have full access to information
required, and are able to discuss the matter with the police and the insurance company
without fear of breaching confidentiality.
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The output of the investigation should be confirmed, which is likely to be a report addressed
to the insurance company. It should be clarified that the report is not to be distributed to any
other parties. Kennel & Co should also confirm whether they would be required to act as
expert witness in the event of the thieves being caught and prosecuted.
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Tutorial note. Credit will also be awarded for explanations of acceptance issues such as the
need for a separate engagement letter drawn up to cover the forensic investigation, outlining
the responsibilities of the investigation team and of the client. Fees should also be discussed
and agreed.
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(ii) Procedures
 Watch the CCTV to form an impression of the quantity of goods stolen, for example,
how many boxes were loaded onto the lorry.
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 If possible, from the CCTV, determine if the boxes contain either mobile phones or
laptop computers.
 Inspect the boxes of goods remaining in the warehouse to determine how many items
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of finished goods are in each box.

 Agree the cost of an individual mobile phone and laptop computer to accounting
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records, such as cost cards.

 Perform an inventory count on the boxes of goods remaining in the warehouse and
reconcile to the latest inventory movement records.
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 Discuss the case with the police to establish if any of the goods have been recovered
and if, in the opinion of the police, this is likely to happen.
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 Obtain details of the stolen lorry, for example the licence plate, and agree the lorry back
to the non-current asset register where its net book value should be shown.
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3 (a) Matters
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The properties classified as assets held for sale are material to the financial statements as the year-
end carrying value of $24 million represent 8% of total assets. The amount written off the assets'
value at the date of classification as held for sale of $2 million represents less than 1% of revenue
and 4.2% of profit before tax, which on both measures is immaterial to the statement of profit or loss
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and other comprehensive income.
Assets can only be classified as held for sale if the conditions referred to in IFRS 5 Non-current
Assets Held for Sale and Discontinued Operations are met. The conditions include the following.
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 Management is committed to a plan to sell
 The assets are available for immediate sale
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 An active programme to locate a buyer is initiated
 The sale is highly probable, within 12 months of classification as held for sale (subject to
limited exceptions)
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 The asset is being actively marketed for sale at a sales price reasonable in relation to its fair
value
 Actions required to complete the plan indicate that it is unlikely that the plan will be
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significantly changed or
 There is a risk that the assets have been inappropriately classified if the above conditions have
not been met.
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IFRS 5 requires that at classification as held for sale, assets are measured at the lower of carrying
value and fair value less costs to sell. This appears to have been correctly accounted for when
classification occurred in October 2012. Though not specifically required by IFRS 5, an impairment
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review should take place at 31 January 2013, to ensure that there is no further impairment of the
properties to be recognised at the year end. If an impairment review has not taken place, the assets
may be misstated in value.
The assets should not be depreciated after being classified as held for sale, therefore audit
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procedures should confirm that depreciation has ceased from October 2012.
Disclosure is needed in the notes to the financial statements to include a description of the non-
current assets classified as held for sale, a description of the facts and circumstances of the sale and
its expected timing, and a quantification of the impairment loss and where in the statement of profit
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or loss and other comprehensive income it is recognised.

Evidence
 A copy of the board minute at which the disposal of the properties was agreed by
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management
 Details of the active programme in place to locate a buyer, for example, instructions given to
real estate agency, marketing literature
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 A copy of any minutes of meetings held with prospective purchasers of any of the properties,
or copies of correspondence with them
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 Written representation from management on the opinion that the assets will be sold before
October 2013
 Subsequent events review, including a review of post year-end board minutes and a review of
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significant cash transactions, to confirm if any properties are sold in the period after the year
end
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 Details of any impairment review conducted by management on the properties at 31 January

2013
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 A copy of the client's depreciation calculations, to confirm that depreciation was charged up
to October 2012 but not subsequent to the reclassification of the assets as held for sale
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(b) Matters
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The sale and leaseback arrangement relates to an asset with a carrying value of $27 million, which
represents 9% of total assets and is material to the statement of financial position. The fair value of
the asset (cash proceeds) is also material at 12.3% of total assets.
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It appears appropriate to classify the leaseback as a finance lease, as Setter Stores Co retains the risk
exposure of the asset and the economic benefit of using the asset for the remainder of its useful life.
The accounting treatment for a sale and leaseback transaction should follow the requirements of IAS
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17 Leases. Where the leaseback is a finance lease, the substance of the transaction is a financing
arrangement in which the lessee, in this case Setter Stores Co, never disposes of the risks and
rewards of the asset, and so should not recognise a profit or loss on the disposal and should
continue to recognise the asset in the statement of financial position. Any apparent profit, being the
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difference between the fair value of the asset and its carrying value, should be deferred and amortised
over the lease term. The asset should be re-measured to fair value.
Setter Stores Co appears to have incorrectly accounted for the transaction. The following entry
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should have been made on the disposal and leaseback of the property complex.
DR Cash $37 million
CR Property, plant and equipment $27 million
l.b
CR Deferred income $10 million
And the asset and finance lease liability should be recognised at fair value:
DR Property, plant and equipment $37 million
CR Obligations under finance lease
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$37 million
Therefore property, plant and equipment is understated by $10 million and deferred income also
understated by $10 million.
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$10 million represents 3.3% of total assets and is material. An adjustment should be made and, if
not, the audit firm should consider the implication for the auditor's opinion, which may be qualified
on the grounds of material misstatement.
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In forthcoming accounting periods, depreciation should be calculated based on the $37 million
carrying value of the asset allocated over the remaining life of the property of 20 years, and the
deferred income should be amortised over the same period.
Evidence
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 A copy of the lease, signed by the lessor, and a review of its major clauses to confirm that risk
and reward remains with Setter Stores Co, and that the arrangement is a finance leaseback
 A copy of insurance documents stating that Setter Stores Co is responsible for insuring the
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asset
 Physical inspection of the property complex to confirm it is being used by Setter Stores Co
 Confirmation of the fair value of the property complex, possibly using an auditor's expert
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 Agreement of the $37 million cash proceeds to bank statement and cash book
 A schedule showing the adjustment required in the financial statements
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 Minutes of a discussion with management regarding the accounting treatment and including
an auditor's request to amend the financial statements
(c) Matters
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The amount capitalised as an intangible asset is material to the statement of financial position,
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representing 5% of total assets. According to IAS 38 Intangible Assets, an intangible asset is

recognised in the financial statements if it meets the definition of an intangible asset, if it is probable
that future economic benefits will flow to the reporting entity, and if its cost can be reliably measured.
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It would seem appropriate that the licence is recognised as an intangible asset as it has been
purchased as a separable asset without physical substance and has a reliable cost. Management
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should be able to demonstrate the economic benefit that has been, or is expected to be, derived from
the licence.
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As the licence has a fixed term of five years, it should be amortised over that period. However, it
appears that amortisation has not been charged, as the amount recognised at the year end is the
original cost of the licence. Amortisation of $1.25 million (15 million / 5 years  5/12) should have
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been charged from 1 September to the year end. This amount represents less than 1% of revenue
and only 2.6% of profit before tax, and is not considered material to profit.
Evidence
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 A copy of the distribution licence, confirming the five-year period of the licence, and the cost
of $15 million
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 Agreement of the cash paid to the bank statement and the cash book
 Minutes of a discussion with management regarding the apparent non-amortisation of the
licence, including any reasons given for the non-amortisation
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 Sales records in relation to the soft drink and also forecast sales, to determine the future
economic benefit to be derived from the licence
4 (a) Spaniel Co
l.b
It is not the auditor's primary responsibility to detect fraud. According to ISA 240 The Auditor's
Responsibilities Relating to Fraud in an Audit of Financial Statements, management is primarily
responsible for preventing and detecting fraud. The auditor is required to obtain reasonable
or error.
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assurance that the financial statements are free from material misstatement whether caused by fraud
The total amount estimated to have been stolen in the payroll fraud represents 5.6% of Spaniel Co's
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assets. If the amount has been stolen consistently over a 12-month period, then $3 million
(8 / 12  4.5 million) had been stolen prior to the year end of 31 December 2012. $3 million is
material, representing 3.8% of total assets at the year end. Therefore the fraud was material and it
could be reasonably expected that it should have been discovered.
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However, material misstatements arising due to fraud can be difficult for the auditor to detect. This is
because fraud is deliberately hidden by the perpetrators using sophisticated accounting techniques
established to conceal the fraudulent activity. False statements may be made to the auditors and
documents may have been forged. This means that material frauds could go undetected, even if
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appropriate procedures have been carried out.

ISA 240 requires that an audit is performed with an attitude of professional skepticism. This may not
have been the case. Spaniel Co is a long-standing client, and the audit team may have lost their
skeptical attitude. Necessary tests of control on payroll were not carried out because in previous
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years it had been possible to rely on the client's controls.

It seems that ISAs may not have been adhered to during the audit of Spaniel Co. ISA 330 The
Auditor's Responses to Assessed Risks requires that the auditor shall design and perform tests of
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controls to obtain sufficient appropriate audit evidence as to the operating effectiveness of relevant
controls if the auditor's assessment of risks of material misstatement at the assertion level includes
an expectation that the controls are operating effectively. It can be acceptable for the auditor to use
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audit evidence from a previous audit about the operating effectiveness of specific controls but only if
the auditor confirms that no changes have taken place. The audit partner should explain whether this
was the case.
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Substantive procedures have not been performed on payroll either. This effectively means that payroll
has not been audited.
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This leads to a conclusion that the audit firm may have been negligent in conducting the audit.
Negligence is a common law concept in which an injured party must prove three things in order to
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prove that negligence has occurred:
 That the auditor owes a duty of care
 That the duty of care has been breached
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 That financial loss has been caused by the negligence
Looking at these points in turn, Groom & Co owes a duty of care to Spaniel Co, because a contract
exists between the two parties. The company represents all the shareholders as a body, and there is
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an automatic duty of care owed to the shareholders as a body by the auditor.
A breach of duty of care must be proved for a negligence claim against the audit firm to be
successful. Duty of care generally means that the audit firm must perform the audit work to a good
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standard and that relevant legal and professional requirements and principles have been followed. For
an audit firm, it is important to be able to demonstrate that ISAs have been adhered to. Unfortunately,
it seems that ISAs have been breached and so the audit firm is likely to have been negligent in the
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audit of payroll.
Tutorial note. Credit will be awarded for references to legal cases as examples of situations where
audit firms have been found to have been negligent in performing an audit, such as Re Kingston
Cotton Mill.
l.b
Finally, a financial loss has been suffered by the audit client, being the amount stolen while the fraud
was operating.
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In conclusion, Spaniel Co is likely to be able to successfully prove that the audit firm has been
negligent in the audit of payroll, and that Groom & Co is liable for some or all of the financial loss
suffered.
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(b) The audit of financial instruments
There are many reasons why financial instruments are challenging to audit. The instruments
themselves, the transactions to which they relate, and the associated risk exposures can be difficult
for both management and auditors to understand. If the auditor does not fully understand the
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financial instrument and its impact on the financial statements, it will be difficult to assess the risk of
material misstatement and to detect errors in the accounting treatment and associated disclosures.
Even relatively simple financial instruments can be complex to account for.
The specialist nature of many financial instruments means that the auditor may need to rely on an
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auditor's expert as a source of evidence. In using an expert, the auditor must ensure the objectivity
and competence of that expert, and then must evaluate the adequacy of the expert's work, which can
be very difficult to do where the focus of the work is so specialist and difficult to understand.
The auditor may also find that there is a lack of evidence in relation to financial instruments, or that
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evidence tends to come from management. For example, many of the financial reporting
requirements in relation to the valuation of financial instruments are based on fair values. Fair values
are often based on models which depend on management judgement. Valuations are therefore often
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subjective and derived from management assumptions which increase the risk of material
misstatement.
It is imperative that the auditor retains professional skepticism in the audit of financial instruments,
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but this may be difficult to do when faced with a complex and subjective transaction or balance for
which there is little evidence other than management's judgement.
There may also be control issues relating to financial instruments. Often financial instruments are
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dealt with by a specialist department and it may be a few individuals who exert significant influence
over the financial instruments that are entered into. This specialist department may not be fully
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integrated into the finance function, leading to the accounting treatment being dealt with outside the
normal accounting system. Internal controls may be deficient and there may not be the opportunity
for much segregation of duty. However, some companies will have established strong internal
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controls around financial instruments, leading to a lower risk of material misstatement.

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In planning the audit of Bulldog Co's financial instruments, the auditor must first gain an
understanding of the relevant accounting and disclosure requirements. For example, the applicable
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financial reporting standards should be clarified, which are likely to be IFRS 9 Financial Instruments
and IFRS 7 Financial Instruments: Disclosures. These standards can be complex to apply, and the
auditor should develop a thorough understanding of how they relate to Bulldog Co's financial
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instruments.
The auditor must also obtain an understanding of the instruments in which Bulldog Co has invested
or to which it is exposed, including the characteristics of the instruments, and gain an understanding
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of Bulldog Co's reasons for entering into the financial instruments and its policy towards them.
It is important that the resources needed to audit the financial instruments are carefully considered.
The competence of members of the audit firm to audit these transactions should be assessed, and it
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may be that an auditor's expert needs to be engaged. If so, this should be explained to the client.
Instructions will have to be drawn up and given to the expert to ensure that the work performed is in
line with audit objectives and follows the relevant financial reporting requirements, for example, in
relation to valuing the financial instruments.
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The audit planning should include obtaining an understanding of the internal control relevant to
Bulldog Co's financial instruments, including the involvement, if any, of internal audit. An
understanding of how financial instruments are monitored and controlled assists the auditor in
l.b
determining the nature, timing and extent of audit procedures, for example, whether to perform tests
on controls.
Specific consideration should be given to understanding management's method for valuing financial
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instruments for recognition in the year-end financial statements. The valuation is likely to involve
some form of estimate, and ISA 540 Auditing Accounting Estimates, Including Fair Value Accounting
Estimates and Related Disclosures requires the auditor to obtain an understanding of how
management makes accounting estimates and the data on which accounting estimates are based.
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Finally, the materiality of the financial instruments should be determined and the significance of the
risk exposure associated with them should be assessed.
5 (a) Toy Co
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The amount claimed against Toy Co is material to consolidated profit, representing 25% of
consolidated profit before tax. The amount is not material to consolidated total assets, representing
less than 1% of that amount.
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The same accounting policies should be applied across the Group in the consolidated financial
statements. Therefore in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent
Assets, a provision should be recognised in the consolidated financial statements if the amount is
probable to be paid. The adjustment needed is:
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DR Operating expenses $500,000

CR Current liabilities – provisions $500,000
The audit evidence obtained by the component auditors is insufficient. Verbal evidence is not a
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reliable source of evidence. Further audit procedures should be performed, including:

 Obtain written evidence from Toy Co's legal advisors including a statement that in their
opinion the damages are probable to be paid, and the basis of that opinion
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 Review the claim itself to confirm that $500,000 is the amount claimed by the ex-employee
 Inspect the board minutes of Toy Co for evidence of discussion of the claim, to obtain an
understanding as to the reason for the claim and whether it has been disputed by Toy Co
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These further audit procedures may be performed by the component auditor, or by the Group audit
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team.
If, having obtained evidence to confirm that the damages are probable to be paid, the consolidated
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financial statements are not adjusted to include the provision, the consolidated statement of profit or
loss and other comprehensive income will be materially misstated. This would result in a qualified
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'except for' opinion due to the material, but not pervasive, nature of the material misstatement. In
accordance with ISA 705 Modifications to the Opinion in the Independent Auditor's Report, the report
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should contain a paragraph entitled 'Basis for Qualified Opinion' describing the matter giving rise to
the qualification. A quantification of the financial effect of the misstatement should also be given.
The auditor should discuss the need for the adjustment with the client (including those charged with
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governance), and explain that a qualified opinion will result from the material misstatement.
(b) Trade receivable
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The trade receivable is material to the consolidated financial statements, representing 2.8% of total
assets and 80% of profit before tax. The amount that is potentially irrecoverable is 90% of the total
balance outstanding, ie $1.44 million. This amount is also material, representing 2.5% of total assets
and 72% of profit before tax.
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IFRS 9 Financial Instruments requires that impaired trade receivables are recognised at fair value,
which is the present value of estimated cash inflows. According to the information provided by
Terrier Co's administrators, it is likely that 10% of the amount outstanding will be paid and the
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remaining 90% should be written off. The adjustment needed is:
DR Operating expenses (irrecoverable debts expense) $1,440,000
CR Trade receivables $1,440,000
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The amount should be adjusted in the financial statements for the year ended 31 March 2013, even
though notice was not received until May 2013. This is because according to IAS 10 Events After the
Reporting Period, an adjusting event is one that provides additional information about conditions
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existing at the year end.
If the financial statements are not adjusted for the impaired receivable, current assets will be
overstated and profits overstated by $1.44 million. This is a very significant matter as the adjustment
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to profit is highly material.
Tutorial note. Credit will be awarded for comments relating to whether separate disclosure on the
face of the statement of profit or loss and other comprehensive income is appropriate, due to the
material and unusual nature of the item.
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The auditor should perform additional procedures as follows.

 Obtain the notice from Terrier Co's administrators confirming that the company is insolvent
and that only 10% of amounts outstanding is likely to be paid.
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 Obtain a written confirmation from the administrators stating the expected timing of the
payment.
 Check post year-end cash receipts to see if any of the amount outstanding has been received
from Terrier Co.
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 Recalculate the impairment losses and trace the posting of the impairment into the general
ledger and the financial statements.
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If the consolidated financial statements are not adjusted for the irrecoverable amount, both the
statement of financial position and the statement of profit or loss and other comprehensive income
will be materially misstated. This would result in a qualified 'except for' opinion due to the material,
but not pervasive, nature of the material misstatement.
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Aggregate impact on the financial statements

The materiality and overall significance of the two matters discussed above should be considered in
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aggregate. When combined, the adjustment needed to net assets and to operating expenses is
$1.94 million. This adjustment would reduce the draft consolidated profit before tax to only $60,000.
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The combined misstatement could be considered both material and pervasive to the financial
statements as the profit figure is so impacted by the adjustments necessary. In this case, the auditor
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should express an adverse opinion, stating that the financial statements do not show a true and fair
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view. A paragraph should be included above the opinion, entitled 'Basis for Adverse Opinion', which
describes the reason for the adverse opinion and provides quantification.
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The auditor should discuss the need for the adjustment with the client (including those charged with
governance), and explain that a qualified or adverse opinion will result from the material
misstatements. This communication is required by ISA 705.
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ISA 720 The Auditor's Responsibilities Relating to Other Information in Documents Containing
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Audited Financial Statements requires the auditor to read other information, defined as financial and
non-financial information, included in a document containing audited financial statements and the
auditor's report.
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The purpose of reading the other information is to identify material inconsistencies with the audited
financial statements. A material inconsistency arises where the other information contradicts
information in the audited financial statements, and may possibly raise doubt about the audit opinion.
A material inconsistency undermines the credibility of the audit opinion.
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ISA 720 requires that in the event of a material inconsistency being discovered, the auditor shall
determine whether the financial statements or the other information needs to be revised, so that the
inconsistency is removed. If the inconsistency is not resolved, the auditor's responsibilities depend
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on whether it is the other information, or the financial statements that have not been corrected.
In the Group's case, the chairman's statement contains an inconsistency, as according to the
consolidated financial statements, revenue has increased by 5.9%, but the chairman states that
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revenue has increased by 20%.
The audit work performed on revenue should be reviewed to ensure that sufficient and appropriate
evidence has been gained to support the figures in the financial statements.
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The matter should be discussed with management, who should be asked to amend the disclosure in
the chairman's statement. Management should be presented with the results of the audit work, to
justify, if necessary, that the amendment needs to be made. The inclusion of the incorrect figure in
the draft chairman's statement could be a genuine mistake, in which case management should be
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happy to make the change.

If management refuse to change the disclosure in the other information, then the audit report should
contain an Other Matter paragraph. This should be presented immediately after the opinion paragraph
and should describe the inconsistency clearly. The matter should also be communicated to those
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charged with governance.

If the inconsistency remains, the audit firm may wish to speak at a meeting of shareholders of the
Poodle Group to explain the additional paragraph that has been included in the audit report.
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Professional Level – Options Module, Paper P7 (INT)
Advanced Audit and Assurance (International) December 2013 Answers
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1 Briefing notes
To: Audit Partner
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From: Audit Manager
Subject: Planning issues for the Stow Group, year ending 31 December 2013
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Introduction
These briefing notes contain an explanation of the risks of material misstatement to be considered in
planning the audit of the Stow Group. The risks which have been explained focus on a restructuring of the
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Group which has taken place during the year. Materiality has been considered where information permits,
and further information which would be useful in planning the audit has also been identified. The briefing
notes also contain recommended audit procedures to be performed in respect of the disposal of Broadway
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Co. In addition, the Group finance director's suggestion that our firm makes use of the new subsidiary's
internal audit team when performing our audit has been discussed, along with the ethical implication of the
suggestion.
(a) (i)
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and (ii) Zennor Co
Materiality of Zennor Co
To evaluate the materiality of Zennor Co to the Group, its profit and assets need to be
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retranslated into $. At the stated exchange rate of 4 Dingu = $1, its projected profit for the
year is $22.5 million (90 million Dingu / 4) and its projected total assets are $200 million
(800 million Dingu / 4).
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Zennor Co's profit represents 11.3% of Group projected profit for the year (22.5 / 200), and
its assets represent 8% of Group total assets (200 / 2,500). Zennor Co is therefore material to
the Group and is a significant component of it. A significant component is one which is
identified by the auditor as being of individual financial significance to the group.
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The goodwill arising on the acquisition of Zennor Co amounts to 2.4% (60 / 2,500) of Group
assets and is material. Because the balances above, including goodwill, are based on a foreign
currency, they will need to be retranslated at the year end using the closing exchange rate to
determine and conclude on materiality as at the year end.
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Materiality needs to be assessed based on the new, enlarged group structure. Materiality for
the group financial statements as a whole will be determined when establishing the overall
group audit strategy. The addition of Zennor Co to the group during the year is likely to cause
materiality to be different from previous years, possibly affecting audit strategy and the extent
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of testing in some areas.

Risks of material misstatement
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Retranslation of Zennor Co's financial statements

According to IAS 21 The Effects of Changes in Foreign Exchange Rates, the assets and
liabilities of Zennor Co should be retranslated using the closing exchange rate. Its income and
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expenses should be retranslated at the exchange rates at the dates of the transactions.
The risk is that incorrect exchange rates are used for the retranslations. This could result in
over-/understatement of the assets, liabilities, income and expenses that are consolidated,
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including goodwill. It would also mean that the exchange gains and losses arising on
retranslation and to be included in Group other comprehensive income are incorrectly
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determined.
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Examiner's answers: December 2013 455
Measurement and recognition of exchange gains and losses
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The calculation of exchange gains and losses can be complex, and there is a risk that it is not
calculated correctly, or that some elements are omitted, for example, the exchange gain or
loss on goodwill may be missed out of the calculation.
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IAS 21 states that exchange gains and losses arising as a result of the restranslation of the
subsidiary's balances are recognised in other comprehensive income. The risk is incorrect
classification, for example, the gain or loss could be recognised incorrectly as part of profit for
the year.
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Initial measurement of goodwill
In order for goodwill to be calculated, the assets and liabilities of Zennor Co must have been
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identified and measured at fair value at the date of acquisition. Risks of material misstatement
arise because the various components of goodwill each have specific risks attached, for
example:
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 Not all assets and liabilities may have been identified, for example, contingent liabilities
and contingent assets may be omitted
 Fair value is subjective and based on assumptions which may not be valid
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There is also a risk that the cost of investment is not stated correctly, for example, that any
contingent consideration has not been included in the calculation.
Subsequent measurement of goodwill
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According to IFRS 3 Business Combinations, goodwill should be subject to an impairment
review on an annual basis. The risk is that a review has not taken place, and so goodwill is
overstated and Group operating expenses understated if impairment losses have not been
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recognised.
Consolidation of income and expenses
Zennor Co was acquired on 1 February 2013 and its income and expenses should have been
consolidated from that date. There is a risk that the full year's income and expenses have been
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consolidated, leading to a risk of overstated Group profit.

Disclosure
Extensive disclosures are required by IFRS 3 to be included in the notes to the Group financial
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statements, for example, to include the acquisition date, reason for the acquisition and a
description of the factors which make up the goodwill acquired. The risk is that disclosures
are incomplete or not understandable.
Intra-group transactions
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There will be a significant volume of intra-group transactions as the Group is supplying

Zennor Co with inventory. There is a risk that intra-group sales, purchases, payables and
receivables are not eliminated, leading to overstated revenue, cost of sales, payables and
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receivables in the Group financial statements.

There is also a risk that intercompany transactions are not identified in either/both companies'
accounting systems.
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The intra-group transactions are by definition related party transactions according to

IAS 24 Related Party Disclosures, because Zennor Co is under the control of the Group. No
disclosure of the transactions is required in the Group financial statements in respect of intra-
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group transactions because they are eliminated on consolidation. However, both the individual
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financial statements of the Group company supplying Zennor Co and the financial statements
of Zennor Co must contain notes disclosing details of the intra-group transactions. There is a
risk that this disclosure is not provided.
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In addition, the cars may be supplied including a profit margin or mark up, in which case a
provision for unrealised profit should be recognised in the Group financial statements. If this
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456 Examiner's answers: December 2013
is not accounted for, Group inventory will be overstated, and operating profit will be
overstated.
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Completeness of inventory
There is a risk that cars which are in transit to Zennor Co at the year end may be omitted from
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inventory. The cars spend a significant amount of time in transit and awaiting delivery to
Zennor Co, and without a good system of controls in place, it is likely that items of inventory
will be missing from the Group's current assets as they may have been recorded as
despatched from the seller but not yet as received by Zennor Co.
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The inventory in transit to Zennor Co represents 2.3% of Group total assets (58 / 2,500) and
is therefore material to the consolidated financial statements.
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Tutorial note. Credit will also be awarded where answers discuss the issue of whether the
arrangement is a consignment inventory arrangement, and the relevant risks of material
misstatement.
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Further information in relation to Zennor Co:
 Prior years' financial statements and auditor's reports
 Minutes of meetings where the acquisition was discussed
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 Business background, eg from the company's website or trade journals
 Copies of systems documentation from the internal audit team
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 Confirmation from Zennor Co's previous auditors of any matters which they wish to
bring to our attention
 Projected financial statements for the year to 31 December 2013
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 A copy of the due diligence report
 Copies of prior year tax computations
Tutorial note. Credit will also be awarded for discussions of risks of material misstatement
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and relevant audit procedures relating to the initial audit of Zennor Co by Compton & Co, eg
increased risk of misstatement of opening balances and comparatives.
Broadway Co
Materiality
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The profit made on the disposal of Broadway Co represents 12.5% of Group profit for the year
(25 / 200) and the transaction is therefore material to the Group financial statements.
Given that the subsidiary was sold for $180 million and that a profit on disposal of $25 million
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was recognised, the Group's financial statements must have derecognised net assets of
$155 million on the disposal. This amounts to 6·2% of the Group's assets and is material.
This is assuming that the profit on disposal has been correctly calculated, which is a risk
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factor discussed below.

Risk of material misstatement
Derecognition of assets and liabilities
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On the disposal of Broadway Co, all of its assets and liabilities which had been recognised in
the Group financial statements should have been derecognised at their carrying value,
including any goodwill in respect of the company.
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There is therefore a risk that not all assets, liabilities and goodwill have been derecognised
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leading to overstatement of those balances and an incorrect profit on disposal being

calculated and included in Group profit for the year.
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Profit consolidated prior to disposal
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There is a risk that Broadway Co's income for the year has been incorrectly consolidated. It
should have been included in Group profit up to the date that control passed and any profit
included after that point would mean overstatement of Group profit for the year.
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Calculation of profit on disposal
There is a risk that the profit on disposal has not been accurately calculated, eg that the proceeds
received have not been measured at fair value as required by IFRS 10 Consolidated Financial Statements,
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or that elements of the calculation are missing.
Classification and disclosure of profit on disposal
IAS 1 Presentation of Financial Statements requires separate disclosure on the face of the
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financial statements of material items to enhance the understanding of performance during
the year. The profit of $25 million is material, so separate disclosure is necessary. The risk is
that the profit is not separately disclosed, eg is netted from operating expenses, leading to
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material misstatement.
Extensive disclosure requirements exist in relation to subsidiaries disposed of, eg
IAS 7 Statement of Cash Flows requires a note which analyses the assets and liabilities of the
subsidiary at the date of disposal. There is a risk that not all necessary notes to the financial
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statements are provided.
Tutorial note. It is possible that Broadway Co represents a disposal group and a discontinued
operation, and credit will be awarded for discussion of relevant risks of material misstatement
and audit procedures in respect of these issues.
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Treatment of the disposal in parent company individual financial statements
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The parent company's financial statements should derecognise the original cost of investment
and recognise a profit on disposal based on the difference between the proceeds of $180
million and the cost of investment. Risk arises if the investment has not been derecognised or
the profit has been incorrectly calculated.
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Tax on disposal
There should be an accrual in both the parent company and the Group financial statements for
the tax due on the disposal. This should be calculated based on the profit recognised in the
parent company. There is a risk that the tax is not accrued for, leading to overstated profit and
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understated liabilities. There is also a risk that the tax calculation is not accurate.
Tutorial note. As Compton & Co is no longer the auditor of Broadway Co, there is no need for
any further information in relation to audit planning, other than that needed to perform the
audit procedures listed below.
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(b) Procedures to be performed on the disposal of Broadway Co

 Obtain the statement of financial position of Broadway Co as at 1 September 2013 to confirm
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the value of assets and liabilities which have been derecognised from the Group.
 Review prior year Group financial statements and audit working papers to confirm the amount
of goodwill that exists in respect of Broadway Co and trace to confirm it is derecognised from
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the Group on disposal.

 Confirm that the Stow Group is no longer listed as a shareholder of the company.
 Obtain legal documentation in relation to the disposal to confirm the date of the disposal and
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confirm that Broadway

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 Co's profit has been consolidated up to this date only.

 Agree or reconcile the profit recognised in the Group financial statements to Broadway Co's
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individual accounts as at 1 September 2013.

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 Perform substantive analytical procedures to gain assurance that the amount of profit
consolidated from 1 January to 1 September 2013 appears reasonable and in line with
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expectations based on prior year profit.
 Reperform management's calculation of profit on disposal in the Group financial statements.
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 Agree the proceeds received of $180 million to legal documentation, and to cash book/bank
statements.
 Confirm that $180 million is the fair value of proceeds on disposal and that no deferred or
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contingent consideration is receivable in the future.
 Review the Group statement of profit or loss and other comprehensive income to confirm that
the profit on disposal is correctly disclosed as part of profit for the year (not in other
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comprehensive income) on a separate line.
 Using a disclosure checklist, confirm that all necessary information has been provided in the
notes to the Group financial statements.
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 Obtain the parent company's statement of financial position to confirm that the cost of
investment is derecognised.
 Using prior year financial statements and audit working papers, agree the cost of investment
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derecognised to prior year's figure.
 Reperform the calculation of profit on disposal in the parent company's financial statements.
 Reconcile the profit on disposal recognised in the parent company's financial statements to
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the profit recognised in the group financial statements.
Obtain management's estimate of the tax due on disposal, reperform the calculation and
confirm the amount is properly accrued at parent company and at Group level.
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 Review any correspondence with tax authorities regarding the tax due.
 Possibly the tax will be paid in the subsequent events period, in which case the payment can
be agreed to cash book and bank statement.
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(c) Internal audit team and ethical issue

It is not improper for Marta to suggest that Compton & Co use the work of Zennor Co's internal audit
team. ISA 610 Using the Work of Internal Auditors contains requirements relating to the evaluation of
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the internal audit function to determine in what areas, and to what extent, the work of internal audit
can be used by the external audit firm.
It would be beneficial for Compton & Co to use the internal audit team as it may result in a more
efficient audit strategy, for example, the internal audit team's monitoring of controls should have
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resulted in a strong control environment, so a less substantive approach can be used on the audit.
In addition, the internal audit team should be able to provide Compton & Co with systems
documentation and information on control activities which have been implemented. This will help the
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audit firm to build its knowledge and understanding of the new audit client. The internal audit team
will also be able to assist Compton & Co in gaining more general business understanding with
respect to the new subsidiary.
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Compton & Co may also decide to rely on audit work performed by the internal audit team, for
example, they may be asked to attend inventory counts of cars held at the port and awaiting delivery
to Zennor Co.
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All of the benefits described above are particularly significant given Zennor Co's overseas location, as
reliance on the internal audit team would reduce travel time and costs which would be incurred if the
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external auditor had to perform the work themselves. However, there will be a limit to the amount of
work that can be delegated to the internal audit team.
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Before deciding to what extent the work of internal audit can be used, ISA 610 requires the external
auditor to evaluate various matters, including the extent to which the internal audit function's
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organisation status and policies and procedures support the objectivity of the function; the level of
competence of the internal audit team; and whether the internal audit function applies a systematic
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and disciplined approach, including quality control. To perform these evaluations the external auditor
may wish, for example, to discuss the work of the team with Jo Evesham including a consideration of
the level of supervision, review and documentation of work performed, and also review the
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qualifications held by members of the team.
The fact that the internal audit team does not report to an independent audit committee may reduce
the reliance that can be placed on their work as it affects the objectivity of work performed.
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If Compton & Co chooses to use the work of the internal audit team, this will be relevant to the audit
of both Zennor Co's individual financial statements, and the Group financial statements and will affect
the audit strategy of both.
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Marta states that reliance on the internal audit team will reduce the external audit fee, and the Group
audit committee has requested that the Group audit fee remains the same as last year. This implies
an intimidation threat to objectivity. IESBA's (IFAC) Code of Ethics for Professional Accountants
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states that an audit firm being pressured to reduce inappropriately the extent of work performed in
order to reduce fees is an example of an intimidation threat. It should be brought to Marta's attention
that the audit fee will not necessarily be reduced by reliance on internal audit, especially as this is the
first year that Compton & Co have audited Zennor Co, so there will be a lot of work to be performed
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in developing knowledge and understanding of the client whether or not the firm chooses to rely on
the work of the internal audit team.
Conclusion
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The Stow Group's financial statements contain a high risk of material misstatement this year end, due to the
restructuring which has taken place. The audit plan will contain numerous audit procedures to reduce the
identified risks to an acceptable level. Compton & Co may choose to place reliance on Zennor Co's internal
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audit team, but only after careful consideration of their competence and objectivity, and communication
between the external and internal audit teams must be carefully planned for.
2 (a) Three benefits of due diligence to Baltimore Co
One of the objectives of a due diligence review is for the assets and liabilities of the target company
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to be identified and valued. Therefore a benefit of due diligence to Baltimore Co is to gain an

understanding of the nature of assets and liabilities which are being acquired, as not all assets and
liabilities of Mizzen Co are recognised in its financial statements. For example, Mizzen Co has built up
several customer databases, which, being internally generated, will not be recognised as assets in its
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statement of financial position, but these could be valuable assets to Baltimore Co.
A second benefit is that the due diligence review should uncover more information about operational
issues, which may then help Baltimore Co's management to decide whether to go ahead with the
acquisition. For example, only one of Mizzen Co's revenue streams appears to be directly relevant to
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Baltimore Co's expansion plans, so more information is needed about the other operations of Mizzen
Co to determine how they may be of benefit to Baltimore Co. The due diligence review should cover a
wide range of issues, such as reviews of the company's legal and tax positions, which may uncover
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significant matters.
An externally provided due diligence review, as opposed to a review conducted by management of
Baltimore Co, is likely to provide information in a time-efficient, impartial manner. Baltimore Co's
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management has not previously dealt with an acquisition, whereas the audit firm has the financial
and business understanding and expertise to provide a quality due diligence review. A review report
issued by Goleen & Co will add credibility to the planned acquisition, which may help secure the bank
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loan which is needed to fund the acquisition.

Tutorial note. Credit will be awarded for other relevant benefits which are discussed.
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(b) Matters to focus on in the due diligence review
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Equity owners of Mizzen Co and involvement of BizGrow
The nature of the involvement of the venture capitalist company, BizGrow, is a crucial issue which
must be the starting point of the due diligence review. Venture capitalists provide equity when a
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company is incorporated, and typically look for an exit route within three to seven years. Mizzen Co
was incorporated four years ago, so it will be important to determine whether BizGrow retains its
original equity holding in Mizzen Co, and if so, whether the acquisition of BizGrow's shares by
Baltimore Co would be compatible with the planned exit route.
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Key skills and expertise
It appears that the original founders of Mizzen Co, Vic Sandhu and Lou Lien, are crucial to the
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success of Mizzen Co and it would be in Baltimore Co's interests to keep them involved with the
business. However, Vic and Lou may wish to focus on further work involving IT innovation rather
than Baltimore Co's planned website and without Vic and Lou's expertise the acquisition may be
much less worthwhile. However, there could be other employed personnel with the necessary skills
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and experience to meet Baltimore Co's needs, or much of the skill and expertise could be provided
from freelancers, who will not be part of the acquisition.
Internally generated intangible assets
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Mizzen Co is likely to have several important internally generated intangible assets, which will not be
recognised in its individual accounts but must be identified and measured as part of the due diligence
review. First, Vic and Lou have innovated and developed new website interfaces, and the review must
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determine the nature of this intellectual property (IP), and whether it belongs to Vic and Lou or to
Mizzen Co. The measurement of this asset will be very difficult, and it is likely to form an important
part of the acquisition deal if Baltimore Co want to acquire the IP to use in its new website.
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There are also several customer databases which need to be measured and included in the list of
assets acquired, which again may be difficult to measure in value. It is important for the due diligence
review to confirm the relevance of the databases to Baltimore Co's operations, and that the databases
contain up-to-date information.
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Premises
Mizzen Co currently operates from premises owned by BizGrow and pays a nominal rent for this.
Presumably if the acquisition were to go ahead, this arrangement would cease. The due diligence
review should consider the need for new premises to be found for Mizzen Co and the associated
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costs. Possibly there is room for Mizzen Co to operate from Baltimore Co's premises as the
operations do not appear to need a large space. The rental agreement may be fixed for a period of
time and cancellation may incur a penalty.
Other tangible assets
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Mizzen Co appears to own only items such as computer equipment and fixtures and fittings. It needs
to be clarified whether these assets are owned or held under lease, and also whether any other
tangible assets, such as vehicles, are used in the business. Any commitments for future purchases of
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tangible assets should be reviewed.

Accounting policy on revenue recognition
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Mizzen Co has some fairly complex revenue streams, and the due diligence review should establish
that the accounting policies in place are reasonable and in line with IAS 18 Revenue. The revenue
generated from website development and maintenance should be split into two components, with the
revenue for website development recognised once the website has been provided to the customer,
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but the revenue for maintenance spread over the contract period. There is a risk that revenue is
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recognised too early, inflating Mizzen Co's profit.

The revenue recognition policy for annual subscriptions should also be scrutinised, with revenue
relating to future periods being deferred.
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Sustainability and relevance of revenue streams
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The financial statements indicate that revenue has increased each year, and that in the last year it has
increased by 23.7%. This is an impressive growth rate and work must be done to analyse the
likelihood of revenue streams being maintained and further growth being achieved. For example, the
proportion of website development and two year maintenance contracts which are renewed should be
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investigated. Not all of Mizzen Co's revenue streams seem very relevant to Baltimore Co's operations,
so how these may be managed post-acquisition should be considered.
Operating expenses
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The financial extracts indicate a potentially unusual trend in relation to operating expenses. In 2011
and 2012, operating expenses represented 60% and 58.3% of revenue respectively. In 2013, this had
reduced to 49.6%. This may be due to economies of scale being achieved as the company grows, or
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possibly expenses are understated or revenue overstated in 2013. As freelance web designers have
been used in 2013, operating expenses may have been expected to have increased in proportion to
revenue. The due diligence review should perform detailed analysis on the operating costs incurred
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by the company to gain assurance that expenses are complete and accurately recorded.
With the exception of 2010, the finance cost has remained static at $250,000 per annum. The due
diligence review must uncover what this finance cost relates to, and whether it will continue post-
acquisition. It may be a bank loan or it could be a payment made to BizGrow, as venture capitalist
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companies often impose a management charge on companies which they have invested in. Baltimore
Co will need to understand the nature of any liability in relation to this finance charge.
Cash position and cash management
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Mizzen Co's cash position should be confirmed. Given that the company appears to have limited need
for capital expenditure and working capital, and given the level of profits which has been made in the
last three years, it could be expected that the company would be cash-rich. The due diligence review
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should confirm how the cash generated by the company since incorporation has been used, for
example, in dividend payments to BizGrow and to Vic and Lou.
Additional information required
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 Contract or legal documentation describing the nature of the investment which BizGrow made
when Mizzen Co was incorporated, and detailing the planned exit route
 A register of shareholders showing all shareholders of Mizzen Co
 An organisational structure, in order to identify the members of management and key
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personnel and their roles within Mizzen Co

 A list of employees and their roles within the company, and their related obligations including
salary, holiday entitlements, retirement plans, health insurance and other benefits provided by
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Mizzen Co, and details of compensation to be paid in the case of redundancy

 A list of freelance web designers used by Mizzen Co, and a description of the work they
perform.
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 The key terms of contracts or agreements with freelance web designers

 A list of all IT innovations which have been created and developed by Mizzen Co, and details of
any patent or copyright agreements relating to them
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 Agreements with employees regarding assignment of intellectual property and confidentiality

 Copies of the customer databases showing contact details of all people or companies included
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on the list
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 A list of companies which have contracts with Mizzen Co for website development and
maintenance
 A copy of all contracts with customers for review of the period for which maintenance is to be
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provided
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 A breakdown of the revenue which has been generated from making each database available
to other companies, and the dates when they were made available
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 A summary of the controls which are in place to ensure that the database details are regularly
updated
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 A copy of the rental agreement with BizGrow, to determine whether any penalty is payable on
cancellation
 Non-current asset register showing descriptions and values of all assets used in the business
o t.
 Copies of any lease agreements, for example, leases of computer equipment, photocopiers,
etc
 Details of any capital expenditure budgets for previous accounting periods, and any planned
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capital expenditure in the future
 Mizzen Co's stated accounting policy on revenue recognition
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 Systems and controls documentation over the processing of revenue receipts
 An analysis of expenses included in operating expenses for each year and copies of
documentation relating to ongoing expenses, such as salaries and other overheads
l.b
 Copies of management accounts to agree expenses in the audited accounts are in line and to
perform more detailed analytical review
 The full set of financial statements and auditor's reports for each year since the company's
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incorporation, to:
– Confirm the assets and liabilities recognised
– Agree the level of dividends paid each year
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– Review all of the accounting policies used in preparing the financial statements
– Find the details of any related party transactions that have occurred
– Review the statement of cash flows for each year
 Any agreements with banks or other external providers of finance, including finance advanced
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and relevant finance charges, or confirmation that no such finance has been provided to
Mizzen Co
Tutorial note. Credit will be awarded for other relevant information which would be required as part
of the due diligence review.
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(c) Due diligence conclusion

Due diligence is a specific example of a direct reporting assurance engagement. The form of the
report issued in this type of engagement is covered by ISAE 3000 Assurance Engagements other than
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Audits or Reviews of Historical Financial Information, and ISRE 2400 Engagements to Review
Historical Financial Statements also contains relevant guidance.
The main difference between a review report and an audit report is the level of assurance that is
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given. In a review report a conclusion is expressed in a negative form. The conclusion would start
with the wording 'based on our review, nothing has come to our attention...'
This type of conclusion is used because the nature of a due diligence review is that only limited
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assurance has been obtained over the subject matter. The procedures used in a review engagement
are mainly enquiry and analytical review which can only provide limited assurance.
In comparison, in an audit of historical information, the auditor will use a wide variety of procedures
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to obtain evidence to give reasonable assurance that the financial statements are free from material
misstatement. This means that an opinion expressed in a positive form can be given.
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3 (a) (i) Matters which should be considered
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Impairment of assets
The mine is recognised at $10 million, representing 5.7% of Dasset Co's total assets, and
therefore material to the statement of financial position.
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The accident has caused part of the mine to be unusable, which indicates that it has become
impaired. IAS 36 Impairment of Assets requires that an impairment review should be
conducted when there is an indicator of potential impairment, and therefore management
o t.
should have performed a review to determine the recoverable amount of the mine.
If an impairment review has not been performed, and no adjustment made to the carrying
value of the mine, then assets will be overstated and profit overstated. One-third of the mine
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has become unusable, so presumably no future economic benefit can be derived. Therefore
one-third of the mine's carrying value may need to be written off. This amounts to $3.33
million, which represents 18.5% of profit for the year. The impairment write off is therefore
potentially material to Dasset Co's profit.
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A worst case scenario is that more than one-third of the mine is unusable. It could be that all
of the mine is unsafe and should be shut down, or possibly the National Coal Mining Authority
may withdraw its licence to operate the Ledge Hill mine completely. In either case, the
l.b
impairment loss would then be extended to the full value of the mine, increasing the
materiality of the matter in the financial statements.
Another consideration is there is likely to be some equipment which is contained in the
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tunnels which can no longer be used. It is possible that some of the equipment may be
recovered, but it is likely that a large proportion of it will have to be abandoned and written off,
increasing the impairment loss to be recognised.
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IAS 1 Presentation of Financial Statements requires that an individual item of income or
expense which is material should be disclosed separately, and gives impairment of assets as
an example of a circumstance which may warrant separate disclosure.
The costs which have been incurred and are yet to be incurred to ensure the safety of the
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mine in the future should be treated as capital expenditure at the time when the costs are
incurred. There may also be costs to be incurred in making the unusable tunnels safe, for
example, entrances may need to be blocked up. These costs should be expensed as they do
not relate to future economic benefit and so do not meet the definition of an asset. There is a
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risk that capital and revenue expenses have not been appropriately classified.
Provisions and liabilities
There has also been damage caused to some properties situated above the mine. Dasset Co may need
to recognise a provision in relation to any costs it will suffer in relation to repairing or demolishing the
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properties. According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a

provision should be recognised if there is a present obligation as a result of a past event, a
probable outflow of economic benefits, and a reliable estimate can be made.
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It seems that the criteria have been met, as the accident happened before the year end and
gives rise to an obligating event. Dasset Co is meeting all expenses of the residents who have
been relocated, so the company appears to be acknowledging responsibility for the accident
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and its impact on the residential properties. The damage to the properties will result in a cash
outflow for the company whether they have to be demolished or repaired, and the expert
should be able to provide a reliable estimate of the amount. Therefore a provision should be
recognised.
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The company may suffer further cash outflows as a result of the accident, and consideration
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needs to be made as to whether a provision or a contingent liability should be recognised in

respect of them. The residents may claim further damages against the company, for example,
for stress caused by the accident, and compensation for expenses such as damaged fixtures
p:/
in the properties.
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There may also be a clause in the National Coal Mining Authority's operating licence that
imposes a fine on Dasset Co in the event of any non-compliance with health and safety
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regulations. Any such fines may need to be recognised as provisions or contingent liabilities.
There is a risk that provisions have not been appropriately recognised, leading to overstated
profit and understated liabilities, or that contingent liabilities have not been disclosed
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accurately and completely.
Going concern
o t.
Finally, there may be going concern implications as a result of the accident. Given the
relatively small size of the Ledge Hill mine in relation to the company's total operations, it is
unlikely that the closure of part, or even all, of the mine alone would create a risk to going
concern. However, bad publicity may create difficult trading conditions, and a claim for high
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compensation from the group of local residents could place the company's cash flow under
strain. If these factors cast significant doubt on going concern, then disclosures should be
made in the note to the financial statements.
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The very worst case scenario is that the National Coal Mining Authority could withdraw the
company's operating licence completely, which would cause it to cease operational existence.
This may be very unlikely; however, it would mean that the financial statements should be
prepared on the break up basis.
l.b
(ii) Evidence
 A copy of the operating licence, reviewed for conditions relating to health and safety

compliance
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and for potential fines and penalties which may be imposed in the event of non-
A written representation from management on their intention (or not) to bring the non-
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compliance to the attention of the National Coal Mining Authority
 A copy of board minutes where the accident has been discussed to identify the
rationale behind the non-disclosure
 A copy of reports issued by engineers or other mining specialists confirming the extent
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of the damage caused to the mine by the accident

 Any quotes obtained for work to be performed to make the mine safe and for blocking
off entrances to abandoned tunnels
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 Confirmation that the undamaged portion of the mine is operational, eg from reviewing
a specialist's report
 A copy of the surveyor 's report on the residential properties, reviewed for the expert's
opinion as to whether they should be demolished
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 A review of correspondence entered into with the local residents who have been
relocated, to confirm the obligation the company has committed to in respect of their
relocation
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 Copies of legal correspondence, reviewed for any further claims made by local
residents
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 A review of the Ledge Hill Mine accident book, for confirmation that no one was injured
in the accident
 A copy of management's impairment review, if any, evaluated to ensure that
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assumptions are reasonable and in line with auditor's understanding of the situation
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 Confirmation that impairment losses have been recognised as an operating expense

 A review of draft disclosure notes to the financial statements where provisions and
contingent liabilities have been discussed
p:/
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 A review of cash flow and profit forecasts, forming a view on the overall going concern
status of the company
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(b) Responsibilities to report the accident to the National Coal Mining Authority
Dasset Co operates in a highly regulated industry, and Burton & Co must consider the requirements
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of ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements. ISA 250 states
that it is management's responsibility to ensure that operations are conducted in accordance with
relevant law and regulations. The auditor is expected to obtain a general understanding of the
applicable legal and regulatory framework and how the entity is complying with that framework.
o t.
In this case, there is a suspected non-compliance with the National Coal Mining Authority's health
and safety requirements. The accident may have been caused by using unsafe equipment or mining
methods which failed to meet the authority's strict requirements. Management has not informed the
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authority, which may be for a genuine belief that there is no need to make a report concerning the
accident, or it could be because management has something to hide and does not wish to come
under the scrutiny of the authority.
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ISA 250 states that if the auditor becomes aware of information concerning an instance of non-
compliance or suspected non-compliance with laws and regulations, the auditor shall obtain an
understanding of the nature of the act and the circumstances in which it has occurred; and further
information to evaluate the possible effect on the financial statements. Further audit procedures will
l.b
therefore be necessary.
The matter should be discussed with those charged with governance, as required by ISA 250.
Management should be asked to confirm the reason why the authority has not been notified of the
management to disclose the accident to the authority.

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accident, and a written representation should be obtained. Burton & Co may wish to encourage
ISA 250 also requires that the auditor shall determine whether the auditor has a responsibility to
ate
report the identified or suspected non-compliance to parties outside the entity. Burton & Co needs to
carefully evaluate their legal responsibility to report suspected non-compliance to the National Coal
Mining Authority, and legal advice should be obtained to determine the appropriate course of action.
Confidentiality is an issue, as usually auditors cannot disclose information obtained during the audit
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to external parties without the prior consent of the client. However, this may be overridden in some
cases by legislation or court order. In certain cases, disclosure in the public interest may warrant
disclosure without client consent. Again, legal advice would be helpful here, to determine whether
confidentiality can or should be breached and a report made to the National Coal Mining Authority if
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management fail to do so.

4 (a) Tetbury Co
Chester & Co needs to conduct customer due diligence (know your client) procedures to ensure that
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anti-money laundering requirements are adhered to. This is especially important given the highly
regulated nature of Tetbury Co's business. Background checks will need to be made on Juan Stanton
and other members of management, and the nature of the business including the sources of income
must be fully understood before deciding on accepting the audit appointment.
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The competence of the audit firm in relation to the audit of a financial services firm should be
evaluated, as it is a relatively specialised area. This is an ethical matter, with IESBA's (IFAC) Code of
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Ethics for Professional Accountants Code stating that a self-interest threat to professional
competence and due care is created if the engagement team does not possess, or cannot acquire, the
competencies necessary to properly carry out the engagement.
Chester & Co should consider whether it is appropriate to be appointed as auditor to Tetbury Co from
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an ethical point of view. The IESBA Code states that before accepting a new client relationship, a
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professional accountant in public practice shall determine whether acceptance would create any
threats to compliance with the fundamental principles. Threats to integrity may arise from
questionable activities by management of the company or from inappropriate financial reporting.
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It appears that Tetbury Co's management may lack integrity due to its past investigation by the
financial services authority. Chester & Co should find out more about this matter, for example,
m/
reading press reports or contacting the financial services authority for more information.
In addition, the resignation of the previous auditors over a disagreement indicates a possible problem
with management's integrity. There may also be ethical issues, for example, management may have
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intimidated the previous auditors over the financial reporting issue which prompted their resignation.
Chester & Co should request permission to contact the previous audit firm to obtain further
information on the reasons behind the resignation, and if there are any other matters which should be
o t.
considered in deciding whether to take on the audit appointment. It is important that all relevant facts
are known before an acceptance decision is made. A threat to professional competence and due care
arises where the appointment is accepted without full knowledge of relevant information.
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Juan's comment about deficient controls is also a cause for concern, as it indicates that the audit
would be high risk. While this alone does not mean that the audit should not be taken on, Chester &
Co should consider whether the audit risk can be reduced to an acceptable level, for example, by
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using an experienced audit team and a substantive audit approach. As part of its client acceptance
decision, Chester & Co should consider whether the fee for the audit outweighs the risk involved.
The audit firm could apply a safeguard such as securing Juan's commitment to improve the
company's control environment before accepting the client.
l.b
Tetbury Co is owner-managed. This means that management comes to rely on the auditor for advice
and recommendations and the audit firm could be perceived to be taking on the responsibilities of
management. This is especially relevant to Juan's suggestion that the audit firm can provide business
advice.
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According to the IESBA Code, this situation gives rise to potential self-review and self-interest threats
to objectivity. If the audit firm were to assume management responsibilities, then no safeguards can
ate
reduce the threat to an acceptable level. However, providing advice and recommendations to assist
management in discharging its responsibilities is not assuming a management responsibility.
If the audit appointment is accepted, Chester & Co may wish to obtain written confirmation from
management that it acknowledges responsibility for business decisions taken.
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(b) Stratford Co
The request to attend a meeting with the company's bank can give rise to an advocacy threat to
objectivity. IESBA's Code defines an advocacy threat as the threat that a professional accountant will
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promote a client's or employer's position to the point that the professional accountant's objectivity is
compromised. In this case, the managing director may want the audit engagement partner to support
a view that Stratford Co will be able to continue as a going concern and that the loan ultimately will
be repaid. This means that the audit partner is promoting the client which leads to the creation of an
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advocacy threat.
In addition, from a legal perspective, the audit firm must be careful not to create the impression that
they are in any way guaranteeing the future existence of the company or providing assurance on the
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draft financial statements. In legal terms, attending the meeting and promoting the interests of the
client could create legal 'proximity', which increases the risk of legal action against the auditor in the
event of Stratford Co defaulting on any loan provided by the bank.
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It may be possible for a partner other than the audit engagement partner to attend the meeting with
the bank, which would be a form of safeguard against the ethical threat. Chester & Co's partner
responsible for ethics should consider the severity of the threat and whether this, or another
safeguard, could reduce the threat to an acceptable level.
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There is also an intimidation threat to objectivity caused by the managing director's hint at putting the
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audit out to tender. IESBA's Code states that an audit firm being threatened with dismissal from a
client engagement represents an intimidation threat. The managing director's actions should also
lead to questions over his integrity, and the audit firm may wish to consider resigning from the audit
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if the threat becomes too severe.

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Overdue audit fees are a self-interest threat, according to IESBA's Code, which states that a self-
interest threat may be created if fees due from an audit client remain unpaid for a long time,
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especially if a significant part is not paid before the issue of the audit report for the following year.
The audit firm should determine the amount of fee that is unpaid, and whether it could be perceived
to be a loan made to the client. It may be a relatively insignificant amount, and it may not be long
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overdue as it relates to work performed less than four months ago, in which case the threat to
objectivity is not significant.
(c) Banbury Co
o t.
Providing an actuarial valuation service is an example of providing a non-assurance service.
According to IESBA's Code, the provision of such services can create threats to objectivity of self-
review and self-interest. The self-review threat arises because the defined benefit pension plan on
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which Chester & Co has been asked to provide a valuation service is included in the statement of
financial position, and the audit firm would need to audit the figure which has been generated by a
member of the firm. The self-interest threat arises from the fee which would be paid to the firm.
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Chester & Co needs to evaluate the significance of the threats and whether safeguards could be used
to reduce the threats to an acceptable level. In assessing the self-review threat the following factors
should be considered:
 Whether the valuation will have a material effect on the financial statements
l.b
 The extent of the client's involvement in determining and approving the valuation
methodology and other significant matters of judgement


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The availability of established methodologies and professional guidelines
For valuations involving standard or established methodologies, the degree of subjectivity
inherent in the item
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 The reliability and extent of the underlying data
 The degree of dependence on future events of a nature that could create significant volatility
inherent in the amounts involved
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 The extent and clarity of the disclosures in the financial statements

A key matter to be considered is the materiality of the pension plan to Banbury Co's financial
statements. Banbury Co is a listed company, and therefore a public interest entity. The Code states
that an audit firm shall not provide valuation services to an audit client which is a public interest
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entity if the valuations would have a material effect, separately or in the aggregate, on the financial
statements on which the firm will express an opinion.
Based on the 2012 financial statements, the pension liability at the year end represented only 0·3% of
total assets and was immaterial. Chester & Co should consider whether there are any indications that
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the pension deficit may have become more significant during the year, which may have caused the
balance to become material. In which case the audit firm should not provide the valuation service to
Banbury Co.
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An actuarial valuation involves significant subjectivity, for example, in determining the appropriate
discount rate, and in estimating key variables to be used in the calculations. It is also unlikely that
Banbury Co's management will possess sufficient knowledge and experience to have much
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involvement, if any, in the valuation. However, it may be possible to use safeguards to reduce the
threats to an acceptable level.
Examples of such safeguards include:
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 Having a professional who was not involved in providing the valuation service review the audit
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or valuation work performed; or

 Making arrangements so that personnel providing such services do not participate in the audit
engagement.
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5 (a) (i) Going concern
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The information available in respect of Burford Co indicates many events or conditions which
individually or collectively may cast doubt on the use of the going concern assumption in its
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Profitability – Burford Co's performance has deteriorated dramatically in the year, and despite
being profitable in the previous year, it is reporting a loss of $500,000 for the year to
31 July 2013. It is likely that profitability will suffer even more in the next financial year due to
the obsolescence of the QuickFire product which accounted for 45% of revenue. Substantial
o t.
operating losses are an indicator of going concern problems.
Current and quick ratios show that Burford Co's current liabilities exceed its current assets,
meaning that the company is unlikely to be able to pay debts as they fall due. If suppliers go
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unpaid they may restrict supply, causing further working capital problems. There may be
insufficient cash to pay wages or other overheads, or to pay finance charges.
In addition, the company's cash inflows are likely to be very much reduced by the
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obsolescence of its major product, the QuickFire. The development of the replacement
GreenFire product will have put severe strain on cash resources and given the company's
cash position, there may be insufficient funds to complete the development. Hopefully there is
enough cash to complete the development of GreenFire, and to keep the company afloat prior
l.b
to its launch next year. Even then, it will take time for the new product to generate a cash
inflow.
Loan covenant – given the further deterioration in the company's liquidity since the year end,
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it is likely that the current ratio now breaches the terms of the loan covenant. If this is the
case, the loan provider may recall the loan, which Burford Co does not seem to be in a
position to repay. It may be forced to sell assets in order to raise cash for the loan repayment,
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which may not raise the amount required, and would put operations in jeopardy.
(ii) Audit evidence
 Agreement of the opening cash position to the audited financial statements and general
ledger or bank reconciliation, to ensure accuracy of extracted figures
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 Confirmation that casting of the cash flow forecast has been reperformed to check
arithmetical accuracy
 A review of the results of any market research which has been conducted on the
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GreenFire product, to ensure the assumption regarding its successful launch is

appropriate
 Discussion of the progress made on GreenFire's development with a technical expert
or engineer, to gauge the likelihood of a successful launch in February 2014
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 A review of any correspondence with existing customers to gauge the level of interest
in GreenFire and confirm if any orders have yet been placed
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 A review of any sales documentation relating to the planned sale of plant and
equipment to confirm that $50,000 is achievable
 Physical inspection of the plant and equipment to be sold, to gauge its condition and
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the likelihood of sale

 A review of any announcement made regarding the redundancies, to confirm the
number of employees affected and the timing of the planned redundancies
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 Sample testing of a selection of those being made redundant, agreeing the amount
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they are to be paid to human resource department records, to ensure accuracy of

figures in the forecast
 A review of the application made to the government to confirm the amount of the grant
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applied for
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 Confirmation to correspondence from the government department of the $30,000
grant to be received
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 Depending on the timing of audit procedures, the $30,000 may be received prior to
completion of the audit, in which case it should be agreed to cash book and bank
statement
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 Agreement that the cash flow forecast is consistent with profit and other financial
forecasts which have been prepared by management
o t.
 Confirmation that any other assumptions used in the cash flow forecast are consistent
with auditor's knowledge of the business and with management's intentions regarding
the future of the company
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 Comparison of the cash flow forecast for the period August–November 2013 with
management accounts for the same period, to ensure accuracy of the forecast
 Analytical review of the items included in the cash flow forecast, for example,
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categories of expenses, to look for items which may have been omitted
(b) Going concern impact on audit report
The note on going concern should be reviewed by the auditors to ensure that the disclosure
l.b
regarding going concern is sufficiently detailed, and that it includes all relevant matters and is
understandable.
In evaluating the adequacy of the disclosure in the note, the auditor should consider whether the
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disclosure explicitly draws the reader's attention to the possibility that the entity may not be able to
continue as a going concern in the foreseeable future. The note should include a description of
conditions giving rise to the significant doubt, and the directors' plans to deal with the conditions.
This is a requirement of IAS 1 Presentation of Financial Statements.
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Note adequately describes going concern issues
If the note contains adequate information on going concern issues, then there is no breach of
financial reporting standards, and therefore no material misstatement has occurred. The audit
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opinion should not be modified and should state that the financial statements show a true and fair
view, or are fairly presented.
However, in accordance with ISA 570 Going Concern, the auditors should modify the auditor's report
by adding an Emphasis of Matter paragraph to highlight the existence of the material uncertainties
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over Burford Co's going concern status, and to draw users' attention to the note to the financial
statements where the uncertainties are disclosed. The Emphasis of Matter paragraph should contain
a brief description of the uncertainties, and also refer explicitly to the note to the financial statements
where the situation has been fully described.
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ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent Auditor's
Report states that the Emphasis of Matter paragraph should be placed immediately below the
auditor's opinion, and it should re-iterate that the audit opinion is not qualified.
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ISA 570 requires that going concern matters, including the adequacy of related notes to the financial
statements, should be discussed with those charged with governance. ISA 706 also requires that
those charged with governance should be informed by the auditor of the expected inclusion of an
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Emphasis of Matter paragraph in the auditor's report, and the proposed wording of the paragraph.
Note does not contain adequate information on going concern
It could be the case that a note has been given in the financial statements, but that the details are
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inadequate and do not fully explain the significant uncertainties affecting the going concern status of
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the company. In this situation the auditors should express a qualified opinion, as the disclosure
requirements of IAS 1 have not been followed, leading to material misstatement. The auditor would
need to use judgement to decide whether a qualified or an adverse opinion should be given.
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ISA 570 requires that in this case the auditor shall state in the auditor's report that there is a material
uncertainty which may cast significant doubt about the entity's ability to continue as a going concern.
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ISA 705 Modifications to the Opinion in the Independent Auditor's Report provides guidance on the
presentation of the audit report in the case of a modification of the audit opinion. The audit report
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should include a paragraph entitled 'Basis for Qualified Opinion' or 'Basis for Adverse Opinion', which
contains specific reference to the matter giving rise to material or pervasive misstatement. The
paragraph should include a clear description of the uncertainties and should be presented
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immediately before the opinion paragraph.
The situation must be discussed with those charged with governance, who should be given
opportunity to amend the financial statements by amending the note. ISA 705 states that when the
o t.
auditor expects to modify the opinion in the auditor's report, the auditor shall communicate with
those charged with governance the circumstances which led to the expected modification and the
proposed wording of the modification.
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Practice & Revision Kit

For exams up to June 2015

prepare you for your ACCA exams.

 Provide you with lots of great guidance on tackling questions

Our Passcard and i-pass products also support this paper.

FOR EXAMS UP TO JUNE 2015

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Helping you with your revision ..................................................................................................................... ix

Questions and answers

 December 2013 ...................................................................................................................................................455

Part C: Practice management

10 Hawk Associates (AAS 6/04) 15 27 9 111

11 Grape (12/09) 36 65 9 114

14 Wexford (6/11) 18 32 12 126

Part D and E: Audit of historical financial

18 Pulp (6/08) 17 31 16 140

20 Mac (6/10) (amended) 26 47 17 147

23 Apricot (12/09) 16 29 19 156

25 Magpie (6/12) 37 67 21 161

27 Setter (6/13) 20 36 24 170

51 Robster (6/09) (amended) 17 31 60 273

54 Sci-Tech (12/07) (amended) 34 61 63 284

57 Yew (12/11) 18 32 69 300

58 Snipe (6/12) 15 27 70 302

61 Poodle (6/13) 20 36 72 310

64 Lychee (12/09) 16 29 74 319

65 Grimes (6/10) 20 36 74 322

68 Blod (6/08) 17 31 76 330

Mock exam 3 (December 2013 paper)

Finding questions vii

14(b), 22(b), 25(a), 29-30, 32(a)–(b),

37(b), 38(b)–(c), 39(c), 40(c), 44(b),

4 Forensic audits 20(c), 31(c), 45(a)–(b), 52(a)–(b)

67(b), 68(c), 69, 70(b), 71(a)

G CURRENT ISSUES AND DEVELOPMENTS

1 Professional and ethical 22(a), 45(c)

4 Social and environmental auditing 32(c), 33(b), 50(c)

viii Finding questions

Making the most of question practice

Attempting mock exams

Helping you with your revision ix

Passing the P7 exam

questions note whether you are required to draw a conclusion or make a

Choosing which questions to answer first

Read the background

company as much as possible.

Step 2 Read the requirements

areas the question is covering.

Identify the action verbs

3 Criticise Present the weaknesses of/problems with the

evaluate arguments for and against (critically evaluate

Step 4 Identify what each part of the question requires

Step 6 Read the whole scenario through, highlighting key data

Step 9 Write the answer ria

Four professional marks will be available in each paper.

ISA 265 Communicating Deficiencies in Internal Control to Those Charged with  

Understanding the Entity and Its Environment