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ACCA Noter Answer Paper F8 2 6int 2007 jun a
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Part 2 Examination – Paper 2.6(INT) Audit and Internal Review (International Stream) June 2007 Answers 1 (a) Ethical threats
Self review threat If Lime & Co provides audit and other professional services to Green Co, then they will be preparing the financial statements and also auditing those financial statements. This will provide a self-review threat to Lime & Co as they will be auditing their own work. Lime & Co would be advised to tender only for the audit work. Management threat There is a risk that Lime & Co will make decisions that the managers of Green Co should make (for example which accounting policies should apply to the financial statements). It is possible that these type of decisions have been made before, on an informal basis, as the partners in Lime & Co already know and give advice to the managers of Green Co. Advocacy threat This threat arises because Lime & Co may be asked to present details of Green Co’s financial statements and profit forecasts in court to support its application to stop Black Co growing genetically modified (GM) crops. Lime & Co may be seen to support their client in court, which may limit their independence in relation to the audit work. Familiarity threat You have been friends with the managers of Green Co for some time. This means that you may not question the decisions of the managers due to this close personal relationship. As a partner in Lime & Co you will in effect not be independent from your client. Fee income Acceptance of audit and professional services work from Green Co, will result in an increase in fee income. To retain independence, Green Co need to ensure that fee income does not exceed 10% of the total practice income.
Association threat The managers of Green Co, while not being criminals, they appear to lack integrity in their business affairs. The partners in Lime & Co need to decide whether they want to be professionally associated with Green Co; any criminal activity in the future may have an adverse effect on Lime & Co’s reputation and image. Specifically Lime & Co will not want to be seen to be associated with or advising a firm which is breaking the law. Cease trading – payment of fees The farm may lose organic certification if the genetically modified crops continue to be grown next to Green Co’s farm. There is a risk that Lime & Co may not be paid for services provided should Green Co cease trading.
(b) (i) Going concern
IAS 1 Presentation of Financial Statements defines the going concern concept as the assumption that the enterprise will continue in operational existence for the foreseeable future. The farm may lose organic certification if the genetically modified crops continue to be grown next to Green Co’s farm. This means that Green Co may not be a going concern. An entity will normally use the going concern basis unless:
It is being liquidated or has ceased trading, or – The directors have no realistic alternative than to liquidate the company or to cease trading. –
The directors’ responsibilities regarding going concern is to prepare the financial statements of an entity ensuring that the going concern basis is reasonable. They may also prepare cash and/or profit forecasts for at least 12 months into the future to demonstrate that the entity is likely to continue to trade during this time. The auditors’ responsibility regarding going concern is to form an opinion on the appropriateness of management’s assessment of the going concern status of the entity and the adequacy of disclosures, if any. The auditor will collect sufficient and appropriate audit evidence to ensure use of the going concern assumption is valid. To be clear, the auditors are not responsible for ensuring that the company is a going concern; this is a responsibility of the directors.
(c) Audit procedures
In the case of Green Co, audit procedures on going concern will include:
– Obtaining cash and profit forecasts from the directors. Ensure that these have been properly prepared (for example are arithmetically correct) and show that Green will continue trading. Appropriate adjustments should have been made for the decrease in sales resulting from contamination of Green Co’s farm. – Review the order books for Green Co to determine the level of future sales. – Contacting Green Co’s lawyers to determine the progress, if any, on the court case against Black Co. – Review the financial status of Green Co during the audit to identify other indicators of a going concern problem such as failure to repay loans or decrease in sales. – Review correspondence, if any, with the organic certification authority to determine whether Green Co’s organic status has been withdrawn. – Contacting Green Co’s bank to ascertain whether any loan or overdraft agreements are due for renewal and whether these will be renewed. – Obtaining written representation from the directors confirming that they are not aware of any circumstances other than those evaluated by the auditor, so they expect Green Co to continue as a going concern.
2 (a) Factors affecting sufficiency
Assessment of inherent risk As inherent risk increases, then more audit evidence will be required to reduce detection risk. Materiality of the item A decrease in materiality means that more audit evidence will be required to ensure that no material error has occurred. Nature of the accounting and control systems Where the accounting and control systems are poor then more audit evidence is necessary as less reliance can be placed on those systems. Control risk Determine the extent to which the directors have implemented a sound system of internal control; poor internal controls increase control risk, decreasing reliance that can be placed on those controls. Experience from previous audits Good experience from previous audits will decrease the amount of evidence required as the auditor can place reliance on previous review of clients’ systems. Result of audit procedures Where the results of different audit procedures agree with each other then overall less evidence is needed – overall the evidence is more persuasive; however, where results are in conflict then more evidence is required. Quality of information available Some sources of audit evidence are more reliable than others – meaning less evidence is needed when relying on those sources for example, documentary evidence is more reliable than oral evidence.
(b) (i) Trade payables
Audit procedure Reason for procedure Cast the list of trade payables and agree the total to the To confirm that the list is complete, is accurately stated payables ledger and then to the general ledger. in the general ledger and contains no unusual or reconciling items which must be investigated.
Test, on a sample basis that payables on the list agree to To confirm that the list agrees to the payables ledger. the individual ledger balance and from the ledger to the list.
Compare trade payables individually and in total to prior To explain changes in the balances. For example, the year balances and explain any unusual changes. increase in payables could indicate cash flow problems and Metcalf & Co is delaying payment to suppliers in response to this. Comparison may also indicate lack of completeness of the list where payables balances have been omitted.
Select a sample of individual payables accounts for testing, Material balances should always be tested to ensure focusing on material balances, zero balances and a sample correctness and test a large amount of payables by of other items. value. Some zero balances are tested to ensure that invoices have not been omitted from one supplier.
Audit procedure Reason for procedure Select population from purchase invoices received after Confirm completeness of recording of purchase invoices. the year-end. Trace to evidence of goods receipt and where goods received prior year-end, ensure invoice amount included in purchase accrual. Obtain year-end supplier statements (either from Metcalf & Agree the payables balance to independent third party Co or direct from the individual supplier via a circularisation evidence to confirm accuracy, completeness and letter). Agree the balance on the statement to the individual existence of the ledger balance. account in Metcalf & Co’s payables ledger. Where necessary, reconcile the balances taking into account cash and invoices in transit. Take a sample of purchase invoices recorded in the To ensure that liabilities recorded in the PDB are purchase day book (PDB) just prior to the year end and represented by goods received during that year, and trace to goods received note (GRN), ensuring that the goods recorded in the correct period (cut-off testing). were received prior to the end of the year. Take a sample of GRNs prior to the end of the year and To ensure completeness of recording of amounts trace to purchase invoice or the ‘goods received not invoiced’ payable. accrual in the financial statements. Take a sample of GRNs just after the end of the year and To ensure that the purchases figure is not overstated in trace to purchase invoice. Ensure that the invoice is this year’s financial statements. recorded in the PDB after the year-end. List all debit balances and obtain an explanation from the To confirm why the balance arose and consider client. re-classifying the amounts as receivables. Debit balances may indicate control weaknesses with additional implications for audit testing.
Audit procedure Reason for procedure Cast the list of accruals and agree individual amounts to Confirm that the list is complete, the balances are the general ledger accounts. accurately stated in the general ledger and contains no unusual or reconciling items which must be investigated.
Compare individual accruals with amount in the prior year To account for unusual differences and identify accounts. omissions from the list this year.
Agree accruals to payments made after the end of the year To help ensure the accuracy of the amounts paid and for example, amounts payable for tax deducted from wages confirm that the accruals are genuine. payments to remittance to the tax authority. Review payments after the year-end to determine whether To confirm completeness of the accruals listing. any accruals are required. Where the need for an accrual is identified, ensure this is included in the accruals list.
Check calculations of individual accruals to supporting To check that the accrual has been calculated correctly documentation for example, tax deductions from wages to and therefore testing for over or understatement of each to the amount shown on the payroll as deducted from wages accrual. for the last month of the year.
(iii) Provision for legal action
Audit procedure Reason for procedure Discuss the provision with the directors. To attempt to confirm whether the company is liable for the payment and confirm that an out-of-court settlement is appropriate.
Obtain a letter from Metcalf & Co’s lawyers. To provide evidence on whether Metcalf may be liable for payment and check the amount provided is approximately correct. Review any correspondence with the customer. To help determine Metcalf & Co’s liability and determine whether the customer may accept the out-of-court settlement. Obtain a letter of representation from the directors. To confirm that the directors are considering settlement out of court.
If possible, trace the payment made after the end of the To confirm the accuracy of the amount stated in year to receipt from the customer stating that the payment is accruals. accepted in ‘full and final settlement’ i.e. no other payments are expected to be made.
3 (a) Report to audit committee
Inventory control and Sales System Seed division
12 June 2007 The internal audit of the inventory and sales system identified the following weaknesses: Weakness Potential effect of weakness Recommendation Recording of orders Orders placed on the Internet site are Customers will be sent incorrect The computer systems are amended so transferred manually into the inventory goods resulting in increased customer that order details are transferred directly and sales system. Manual transfer of complaints. between the two computer systems. This order details may result in information will remove manual transfer of details being transferred incompletely or limiting the possibility of human error. incorrectly, for example, order quantities may be incorrect or the wrong product code recorded. Control over orders and packing lists Each order/packing list is given a Packing lists can be lost resulting Orders/packing lists are controlled with a random alphabetical code. While this either in goods not being despatched numeric sequence. At the end of each is useful, using this type of code to the customer (if the list is lost prior day, gaps in the sequence of packing lists makes it difficult to check to goods being despatched) or the returned to accounts are investigated. completeness of orders at any stage customer’s credit card not being in the despatch and invoicing process. charged (if lost after goods despatched but prior to the list being received in the accounts department).
Obtaining payment The customer’s credit card is charged Rhapsody Co will not be paid for the Authorisation to charge the customer’s after despatch of goods to the goods despatched where the credit credit card is obtained prior to despatch of customer, meaning that goods are company rejects the payment request. goods to ensure Rhapsody Co is paid for already sent to the customer before Given that customers are unlikely to all goods despatched. payment is authorised. return seeds, Rhapsody will automatically incur a bad debt.
Completeness of orders The computer system correctly Entire orders may be overlooked and The computer is programmed to review ensures that order details are consequently sales and profit the order file and orders where there is no available for all charges to customer understated. corresponding invoice for an order, these credit cards. However, there is no should be flagged for subsequent overall check that all orders recorded investigation. on the inventory and sales system have actually been invoiced.
Summary We look forward to arranging a meeting to discuss these weaknesses with you in more detail. Note to candidates: the marking scheme shows other valid points.
(b) Advantages of having an audit committee to Rhapsody include:
It provides the internal audit department with an independent reporting mechanism compared to reporting to the – directors who may wish to hide or amend unfavourable internal audit reports. The audit committee will assist the internal auditor by e