CPA A1.2 AUDIT PRACTICE & ASSURANCE SERVICES Revision Guide

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CPA

Certified Public Accountant Examination
Stage:
Advanced Level 1
Subject Title: A1.2 Audit Practice &
Assurance Services

Revision Guide

LOSSARY

INSIDE COVER - BLANK

CONTENTS

Title

Page

Study Techniques

3

Examination Techniques

4

Assessment Strategy

9

Learning Resources

10

Sample Questions

12

Sample Solutions

36

2

STUDY TECHNIQUE
What is the best way to manage my time?
•

Identify all available free time between now and the examinations.

•

Prepare a revision timetable with a list of “must do” activities.

•
Remember to take a break (approx 10 minutes) after periods of
intense study.

What areas should I revise?
•

Rank your competence from Low to Medium to High for each topic.

•

Allocate the least amount of time to topics ranked as high.

•

Allocate between 25% - 50% of time for medium competence.

•

Allocate up to 50% of time for low competence.

How do I prevent myself veering off-track?
•

Introduce variety to your revision schedule.

•

Change from one subject to another during the course of the day.

•

Stick to your revision timetable to avoid spending too much time on one topic.

Are study groups a good idea?
•

Yes, great learning happens in groups.

•

Organise a study group with 4 – 6 people.

•

Invite classmates of different strengths so that you can learn from one another.

•

Share your notes to identify any gaps.

3

EXAMINATION TECHNIQUES
INTRODUCTION
Solving and dealing with problems is an essential part of learning, thinking and intelligence.
A career in accounting will require you to deal with many problems.
In order to prepare you for this important task, professional accounting bodies are placing
greater emphasis on problem solving as part of their examination process.
In exams, some problems we face are relatively straightforward, and you will be able to deal
with them directly and quickly. However, some issues are more complex and you will need to
work around the problem before you can either solve it or deal with it in some other way.
The purpose of this article is to help students to deal with problems in an exam setting. To
achieve this, the remaining parts of the article contain the following sections:
•

Preliminary issues

•

An approach to dealing with and solving problems

•

Conclusion.

Preliminaries
The first problem that you must deal with is your reaction to exam questions.
When presented with an exam paper, most students will quickly read through the questions
and then many will … PANIC!
Assuming that you have done a reasonable amount of work beforehand, you shouldn’t be
overly concerned about this reaction. It is both natural and essential. It is natural to panic in
stressful situations because that is how the brain is programmed.
Archaeologists have estimated that humans have inhabited earth for over 200,000 years. For
most of this time, we have been hunters, gatherers and protectors.
In order to survive on this planet we had to be good at spotting unusual items, because any
strange occurrence in our immediate vicinity probably meant the presence of danger. The
brain’s natural reaction to sensing any extraordinary item is to prepare the body for ‘fight or
flight’. Unfortunately, neither reaction is appropriate in an exam setting.
The good news is that if you have spotted something unusual in the exam question, you have
completed the first step in dealing with the problem: its identification. Students may wish to
use various relaxation techniques in order to control the effects of the brain’s extreme
reaction to the unforeseen items that will occur in all examination questions.

4

However, you should also be reassured that once you have identified the unusual item, you
can now prepare yourself for dealing with this, and other problems, contained in the exam
paper.

A Suggested Approach for Solving and Dealing with Problems in Exams.
The main stages in the suggested approach are:
1.

Identify the Problem

2.

Define the Problem

3.

Find and Implement a Solution

4.

Review

1.

Identify the Problem

As discussed in the previous section, there is a natural tendency to panic when faced with
unusual items. We suggest the following approach for the preliminary stage of solving and
dealing with problems in exams:
Scan through the exam question
You should expect to find problem areas and that your body will react to these items.
PANIC!!
Remember that this is both natural and essential.
Pause
Take deep breaths or whatever it takes to help your mind and body to calm down.
Try not to exhale too loudly – you will only distract other students!
Do something practical
Look at the question requirements.
Note the items that are essential and are worth the most marks.
Start your solution by neatly putting in the question number and labelling each part of your
answer in accordance with the stated requirements.
Actively reread the question
Underline (or highlight) important items that refer to the question requirements. Tick or
otherwise indicate the issues that you are familiar with. Put a circle around unusual items that
will require further consideration.
5

2.

Define the Problem

Having dealt with the preliminary issues outlined above, you have already made a good start
by identifying the problem areas. Before you attempt to solve the problem, you should make
sure that the problem is properly defined. This may take only a few seconds, but will be time
well spent. In order to make sure that the problem is properly defined you should refer back
to the question requirements. This is worth repeating: Every year, Examiner Reports note that
students fail to pass exams because they do not answer the question asked. Examiners have a
marking scheme and they can only award marks for solutions that deal with the issues as
stipulated in the question requirements. Anything else is a waste of time. After you have reread the question requirements ask yourself these questions in relation to the problem areas
that you have identified:
Is this item essential in order to answer the question?
Remember that occasionally, examiners will put ‘red herrings’ (irrelevant issues) into the
question in order to test your knowledge of a topic.
What’s it worth?
Figure out approximately how many marks the problem item is worth. This will help you to
allocate the appropriate amount of time to this issue.
Can I break it down into smaller parts?
In many cases, significant problems can be broken down into its component parts. Some parts
of the problem might be easy to solve.
Can I ignore this item (at least temporarily)?
Obviously, you don’t want to do this very often, but it can be a useful strategy for problems
that cannot be solved immediately.
Note that if you leave something out, you should leave space in the solution to put in the
answer at a later stage. There are a number of possible advantages to be gained from this
approach:
1)
It will allow you to make progress and complete other parts of the question that you
are familiar with. This means that you will gain marks rather than fretting over something
that your mind is not ready to deal with yet.
2)
As you are working on the tasks that you are familiar with, your mind will relax and
you may remember how to deal with the problem area.
3)
When you complete parts of the answer, it may become apparent how to fill in the
missing pieces of information. Many accounting questions are like jigsaw puzzles: when you
6

put in some of the parts that fit together, it is easier to see where the missing pieces should go
and what they look like.

3.

Find and Implement a Solution

In many cases, after identifying and defining the problem, it will be easy to deal with the
issue and to move on to the next part of the question. However, for complex problems that
are worth significant marks, you will have to spend more time working on the issue in order
to deal with the problem. When this happens, you should follow these steps:
Map out the problem
Depending on your preferred learning style, you can do this in a variety of ways including
diagrams, tables, pictures, sentences, bullet points or any combination of methods. It is best
to do this in a working on a separate page (not on the exam paper) because some of this work
will earn marks. Neat and clearly referenced workings will illustrate to the examiner that you
have a systematic approach to answering the question.
Summarise what you know about the problem
Make sure that this is brief and that it relates to the question requirements. Put this
information into the working where you have mapped out the problem. Be succinct and
relevant. The information can be based on data contained in the question and your own
knowledge and experience. Don’t spend too long at this stage, but complete your workings as
neatly as possible because this will maximise the marks you will be awarded.
Consider alternative solutions
Review your workings and compare this information to the question requirements. Complete
as much of the solution as you can. Make sure it is in the format as stipulated in the question
requirements. Consider different ways of solving the problem and try to eliminate at least one
alternative.
Implement a solution
Go with your instinct and write in your solution. Leave extra space on the page for a change
of mind and/or supplementary information. Make sure the solution refers to your workings
that have been numbered.

4.

Review

After dealing with each problem and question, you should spend a short while reviewing your
solution. The temptation is to rush onto the next question, but a few moments spent in

7

reviewing your solution can help you to gain many marks. There are three questions to ask
yourself here:
Have I met the question requirements?
Yes, we have mentioned this already. Examiner Reports over the years advise that failure to
follow the instructions provided in the question requirements is a significant factor in causing
students to lose marks. For instance, easy marks can be gained by putting your answer in the
correct format. This could be in the form of a report or memo or whatever is asked in the
question. Likewise, look carefully at the time period requested. The standard accounting
period is 12 months, but occasionally examiners will specify a different accounting period.
Is my solution reasonable?
Look at the figures in your solution. How do they compare relative to the size of the figures
provided in the question?
For example, if Revenue were 750,000 and your Net Profit figure was more than 1 million,
then clearly this is worth checking.
If there were some extraordinary events it is possible for this to be correct, but more than
likely, you have misread a figure from your calculator. Likewise, the depreciation expense
should be a fraction of the value of the fixed assets.
What have I learned?
Very often in exams, different parts of the solution are interlinked. An answer from one of
your workings can frequently be used in another part of the solution. The method used to
figure out an answer may also be applicable to other parts of your solution.
Conclusion
In order to pass your exams you will have to solve many problems. The first problem to
overcome is your reaction to unusual items. You must expect problems to arise in exams and
be prepared to deal with them in a systematic manner. John Foster Dulles, a former US
Secretary of State noted that: The measure of success is not whether you have a tough
problem to deal with, but whether it is the same problem you had last year. We hope that, by
applying the principles outlined in this article, you will be successful in your examinations
and that you can move on to solve and deal with new problems.

8

ASSESSMENT STRATEGY
Examination Approach
The subject should be approached on the basis that it is a final professional stage
examination. It builds on the knowledge gained at Intermediate Level in relation to the
core auditing issues. The 50-mark case-study question presents opportunities for students
to display logical and analytical thinking and critical analysis. Questions require students
to write reports, which must be tailored to the technical knowledge of the target audience.
Students are also presented with the opportunity to demonstrate professional judgment and
ethical sensitivity.

Particular attention must be paid to the interaction between the various elements of the
syllabus and other subjects studied. Students are expected to select and integrate relevant
syllabus material from Audit Practice and Assurance Services and other subjects as
appropriate. They must also be able to appraise and defend the audit function and its
impact on financial statements.

Examination Format
Assessment is by an open-book examination of 3.5 hours’ duration. The examination
consists of Section A, with one compulsory question, based on a case-study (worth 50% of
the marks for the examination) and Section B, with a choice of two out of three optional
questions, which may refer also to material in the major case-study and/or be based on
minor case studies, each worth 25% of the marks for the examination.

Marks Allocation
Section A
Compulsory Question
(case study)

50

Section B
Choice of 2 questions out of 3
(25 marks each)

50

Total

100
9

LEARNING RESOURCES
Core Texts
The Audit Process, Principles, Practice & Cases 4th edition/Gray and Manson / Cengage
2008 / ISBN 978184406782
Guide to Using International Standards on Auditing in the Audits of Small- and MediumSized Entities /2nd Edition 2010 / IFAC / ISBN 978-1-60815-076-2 556. Published in two
volumes freely available for download from:
Volume 1:
http://web.ifac.org/media/publications/5/guide-to-using-internationa-1/guide-tousinginternationa-1.pdf
Volume 2:
http://web.ifac.org/media/publications/5/guide-to-using-internationa-1/guide-tousinginternationa-2.pdf

Technical Material
1. Assurance and Quality Control Standards.
•
•
•
•

International Standards on Auditing
International Standards on Assurance Engagements (ISAEs).
International Standards on Review Engagements (ISREs).
International Standards on Quality Control (ISQC 1)

2. Financial Accounting and Reporting Standards
•
•

International Financial Reporting Standards (IFRSs)
The International Auditing Standards (IASs) are available from the International
Accounting Standards Board website at www.iasb.org

Manuals
A1.2 Audit Practice & Assurance Services – Institute of Certified Public Accountants of
Rwanda

10

Supplementary Texts and Journals
Principles of External Auditing 3rd ed / Porter, Hatherby, Simon / Wiley 2008 / ISBN 9780-47001825-5
Cosserat / Modern Auditing / Wiley / 3rd Edition 2009 / ISBN 9780470319734

Useful Websites (as at date of publication)
www.icparwanda.com
http://www.ifac.org/sites/default/files/publications/files/ifac-code-of-ethics-for.pdf
www.iaasb.org – International Auditing & Assurance Standards Board.
www.ifac.org – The International Federation of Accountants.
www.ifrs.org/ - The International Financial Reporting Standards Foundation.
www.frc.org.uk/ - The Financial Reporting Council.

11

A1.2 AUDIT PRACTICE & ASSURANCE
SERVICES
REVISION QUESTIONS

12

REVISION QUESTIONS
Question 1
You are an Audit Manager for ABC & Partners, member firm of ICPAR, who has just agreed
to accept the engagement to audit a passenger bus company called Smooth Ride Ltd for the
year ended 31 December 2011.
The company, which is listed, runs passenger bus services between several provincial towns
using buses of various different sizes and sells tickets from a number of locations such as
from depots, and from shops near minor stops across the country. It also sells tickets online. It
does not operate the depots from which the buses begin and terminate their journeys. These
depots are part of the nationwide bus and rail service and the facility to use them is part of the
franchise which Smooth Ride Ltd has been granted.
Smooth Ride Ltd is one of the newer bus service providers in operation and as such was only
awarded a three year franchise to operate its routes, on the basis that if it delivered a timely
service based on sound financial accountability that demonstrates good value-for-money to
customers, it would be awarded a five year extension to the franchise. The existing franchise
expires on 31 December 2012.
In order to start planning the audit in more detail, you have held a meeting with the Finance
Director of Smooth Ride Ltd and have established the following facts. The company operates
out of three main depots which are provided as part of the franchise. Its main assets are the
buses of various sizes and ages, most of which were obtained from the previous franchisee.
Tickets for the journeys are sold through ticket offices in the main depots and from shops near
intermediate stops. The income is passed over on a weekly basis with an agreed percentage
commission deducted. These arrangements have mainly been inherited from the previous
franchisee. Passengers can also book online via a national website run by a centralised agency
that boasts faster processing than any other provider, although its final certification by another
assurance provider is still outstanding following its introduction at the start of the franchise.
The National Passenger Transport Regulator has introduced a new set of ticket types and
tariffs designed to simplify the process of buying tickets, which all franchisees committed to
implementing by 2010.
Smooth Ride Ltd has a charity initiative in place where for each RWF10 of any ticket
purchased, they will donate one cent to good causes. All buses are operated by a single driver
who also checks and sells tickets on the bus for passengers unable to acquire them before
departure. Such tickets are usually sold without any of the discounts available for booking a
number of days in advance. Around 35% of Smooth Ride Ltd’s revenue comes from season

13

tickets purchased in advance by regular commuters who can buy three, six and twelve month
tickets.
You ask about the general state of the company’s finances and systems and are told that they
are “fine” although the company’s Audit Committee has raised concerns about the Internal
Audit function given it’s apparent “….revolving door…” staff turnover issues and whether or
not they are on top of the regulator’s stringent requirements for internal control reviews.
You also mention that you have read in the press about the Regulator deciding to hold an
official inquiry into an incident where one of the company’s buses struck a group of road
maintenance engineering staff in January 2011 resulting in the deaths of two engineering
staff. One particular press report noted that the bus involved “was so old that it carried a pre1986 registration plate.” Nobody on the bus was injured. The Finance Director seems angry
about this, saying that “the press are saying our driver was negligent…it’s tragic but the
roadworks were taking place late at night; we were not informed in advance about them; and
the signage was totally inadequate,…I think they have it in for us because we are new to the
market and trying to do something good for the travelling public.”
You thank the Finance Director for her time and agree to confirm the details of the
forthcoming interim visit as soon as you have discussed them with the engagement partner at
your firm. You are to produce a report for him to review before delivering it to the rest of the
Partners as this is a high profile engagement and the firm wishes to act professionally.

Required:
Draft the report for the Engagement Partner to deliver to the rest of the partners which
addresses the following issues – the mark scheme is indicated for each part of the
requirement:
(a) Determine and justify the Auditor’s assessment of detection risk for Smooth Ride Ltd for
the year ended 31 December 2011.
(4 marks)
(b) (i) List ten inherent, control and detection risks which would particularly concern you as
Auditor of Smooth Ride Ltd and in the case of each risk state why it would be a cause for
concern.
(15 marks)
(ii) In the case of each of the risks identified in part b)i) above state how, if at all, the
identified risks would affect your approach to the audit in terms of the investigations you
would carry out.
(15 marks)
(c) Explain the work required to verify the opening balances for Smooth Ride Ltd.
14

(4 marks)
(d) Discuss the initial work that you should do regarding the carrying value of non-current
assets (i.e. buses) in the financial statements in respect of:
(i) Valuation
(ii) Completeness and existence
Explain why you might encounter difficulties with either of these.
(8 marks)
Note: The report includes 4 Professional/Presentation marks.

15

[Total: 50 marks]

Question 2
You are an Audit Partner with XYZ Ltd, member firm of ICPAR. Among your client
portfolio you have two particular clients, Clients A and B. Client A, a major employer in an
economically depressed small town, receives a major portion of its business from a contract
with Client B. Client A has been in financial difficulty for some years and its financial
viability is in question. If it ever became evident that Client A would lose the contract with
Client B, your firm would probably issue an opinion that expresses the Auditor’s doubt about
Client A’s ability to stay in business.
Client A has been putting forth a major effort to find new customers to supplement its
business and has begun to achieve some success. They are currently negotiating a significant
loan from a bank. While this bank realises that the loan would be risky (especially in the
current recessionary times) and would have serious implications for its own financial position
if the loan were defaulted upon, they are proceeding with granting the loan because they feel
under some political pressure (in the light of the government guarantee and recapitalisation
programme) to be seen to be “facilitating” small and medium businesses. The bank will not
give the loan, however, until they have a chance to look at this year’s audited financial
statements of Client A. After reviewing the un-audited preliminary information, the bank
indicated that the loan will be granted if Client A receives a “clean audit opinion.”
While auditing Client B (a larger company in another city), you, the Audit Partner on both
client engagements discovered that Client B will not be renewing its contract with Client A.
You realise that when Client A loses the contract, it will probably be forced into liquidation.
However, Client B will not be disclosing this information until after the audit report of Client
A must be signed. You are confident that Client A does not know of this upcoming disaster
and further audit work would not disclose it. You discuss the problem with Client B’s
Managing Director who firmly states that this information is not to be revealed at this time.
Client B has been an audit client for a number of years. Recently, your firm has been
attempting to generate some consulting engagements with Client B.
It becomes obvious that if you issue an opinion that expresses your doubt, as Auditor, on
whether Client A can continue as a going concern, it would be equivalent to divulging private
information. Client B might be lost as a client. However, if you do not divulge the
information, the bank will make the loan with the full impact on the bank and the community.
Required:
(a) What steps should an engagement partner take when faced with a situation where there
appear to be conflicting professional and ethical duties imposed upon him/her?
(6 marks)
(b) What are the potential risks for XYZ Ltd of issuing a clean Audit Report to Client A
(assuming there are no other material issues)?
(4 marks)
16

(c) Discuss the merits and disadvantages of each of the following possible courses of action
in respect of the situation outlined above.
I.
II.
III.
IV.

XYZ Ltd resigning as Auditor of one of both entities
XYZ Ltd continuing as Auditors but under a different engagement partner with
different teams for Client A and Client B
Attempting to delay the production of the audit report until after Client B has
made public the decision to discontinue the contract with Client A.
Calling an individual whom you know quite well who is on the bank’s credit
control committee and trying to “suggest” to him that granting the loan might be
a bad idea whilst remaining as non-specific as possible.
(12 marks)

(d) What course of action would you follow in this situation?
(3 marks)
[Total: 25 marks]

17

Question 3
Auto Parts Ltd manufactures car parts. This Company’s unaudited financial statements for the
year ended 31 December 2011, reflect total assets of RWF56 million, total revenues of
approximately RWF73 million, and pre-tax income of RWF6 million. The Company’s audited
financial statements for the year ended 31 December 2010, reflected total assets of RWF47
million, total revenues of approximately RWF60 million, and pre-tax income of RWF5
million. Earnings per share have increased steadily over the past five years, with a cumulative
return of 140% over that period.
During 2011, the Company significantly expanded its property, plant and equipment spending
to accommodate increased orders received by its brake valve division. The company also
accumulated significant levels of tooling supplies, which primarily consist of drill bits and
machine parts utilised in the manufacturing process. The nature of the tooling supplies is such
that the parts wear out relatively quickly and require continual replacement. In prior years, the
Company expensed tooling supplies as they were purchased. However, at the beginning of
2011 the Controller and Chief Financial Officer (CFO) determined that capitalisation of the
tooling supplies would be the preferable method of accounting. The Company changed its
accounting policy accordingly and began to include the tooling supplies in “other current
assets” until the supplies are placed into service, at which time the Company posts a journal
entry to remove the assets and record the costs of the used supplies as an expense.
During the prior year, 2010, the Company incurred roughly RWF650,000 of tooling expense
and held approximately RWF35,000 of the tooling supplies on hand at year-end. The on-hand
supplies were not included in assets on Auto Part’s balance sheet at 31 December 2010. The
amount of supplies on hand at 31 December 2009 was trivial.
In 2011 the Company purchased RWF1,330,000 of tooling supplies, of which the company
used RWF1,000,000 during the year (in addition to the approximately RWF35,000 on hand at
the beginning of the year). The increase of tooling supplies at year-end reflects the company’s
belief that prices would rise on the supplies in the first or second quarter of 2012.
As such, the unaudited financial statements for the year ended 31 December 2011 reflect
RWF1,000,000 of tooling expense on the income statements and RWF330,000 of tooling
supplies as current assets on the balance sheet.
Approximately RWF35,000 of tooling supplies on-hand at the end of the last year were not
included in the RWF1,000,000 tooling expense recorded in 2011 because those costs were
expensed in 2010 under the old accounting policy. Because your accounting firm serves as
External Auditor for Auto Parts, the CFO and the Controller asked your firm for advice on
whether the Company would be required to account for and disclose the accounting policy
change as a change in accounting principle, a change in estimate or an error correction. In the
client’s opinion, the change is not material to the financial statements and, therefore, would
not require disclosure in the 2011 financial statements. The client strongly prefers not to make
any disclosure related to the policy change, as such the 2010 comparative statements would
18

not be adjusted and the 2011 statements would simply reflect the new policy (i.e. decrease in
expense and increase in other current assets) without the added attention of a disclosure.
Required:
(a) Describe whether you agree that capitalisation of the tooling supplies is the preferable
method of accounting for Auto Parts Ltd?
(4 marks)
(b) Assuming the policy change is considered material, how should it be reported and
disclosed in the 2011 financial statements and what effect if any, would the accounting
change have on the Auditor’s report?
(4 marks)
(c) In general, how do Auditors develop an estimate of financial statement materiality? For
Auto Parts, what is your estimate of financial statement materiality? What qualitative
factors might impact your decision about the materiality of the accounting treatment and
the related disclosure?
(12 marks)
(d) Give two reasons for agreeing with and two reasons for disagreeing with management’s
assessment that the accounting change is immaterial and, therefore, requires no
disclosure?
(5 marks)

19

Question 4
(a) Discuss the view that, in current economic circumstances, it is difficult enough to audit
historical or current information and, therefore, Auditors should refrain from offering any
kind of opinion on prospective financial information.
(6 marks)
(b) Assume that Smooth Ride Ltd (discussed in Question 1) has produced a set of projected
financial statements of cash flows and a projected statement of financial position as at 31
December 2011. This will be used for internal control purposes but will also be shown to
financial institutions in relation to applications for finance should the need arise.
Required:
What kind of report (if any) would be appropriate for ABC Ltd to provide on this
document and what are the risks to them of so doing.
(6 marks)
(c) Detail the specific work they should carry out on the Income Statement and the Statement
of Financial Position in the above case prior to producing their report.
(13 marks)
[Total: 25 marks]

20

Question 5
You are an Audit Manager in the practice of DEF Ltd, a five-partner practice of ICPAR based
in Kigali. Your client XY Ltd has just exceeded the threshold for availing of audit exemption
and thus will require its financial statements to be subject to statutory audit for the first time in
respect of the year ended 31 March 2012. It is early April 2012 and you are planning the
audit. The company will also require an Accountant’s Report on the profit forecasts for 2013
in connection with an application for the continuance of its overdraft facilities from the bank.
XY Ltd is involved in the manufacture, installation and maintenance of “compact
refrigeration solutions” for retail premises and other small businesses. It was set up 3 years
ago, in April 2009, by three key Executives of another refrigeration manufacturer which
closed down after encountering severe financial difficulties. Two of these Executives were
technical experts and the third was the Financial Controller. Each of the three invested all his
or her redundancy compensation in the new business and they also took out second mortgages
on their houses to invest in the new business. The mortgages provided for a 2 year
moratorium on interest and capital payments, the interest being rolled up for that period. The
three executives plan to payout sufficient dividends to themselves to enable them to meet
repayments on these second mortgages from 2012 onwards. The company obtained its bank
facilities subject to the ratio of bank borrowings to shareholders’ funds not exceeding 1:1 at
any time.
Summarised financial information relating to the new business based on the financial
statements for the previous 2 years, the management accounts for the year to 31 March 2012
and projections for the following year are given in Appendix 1.
Towards the end of the year ended 31 March 2012, the Financial Controller left the company
following a disagreement with the technical personnel on budgetary control related to new
product development. The cost of development work on the “super compact freezer” had
significantly exceeded budget. However, the technical personnel would not allow spending to
be curtailed as they believed that a curtailment would seriously delay completion of the
development work on this new generation of products which are expected to generate the
major part of the turnover of the company from the commencement of the financial year
ending 31 March 2014, onwards. The technical personnel expect the development work to be
completed by the end of August 2012. However, they had also maintained that development
work would be complete by November 2011 but this estimate proved to be wildly optimistic.
All development costs have been written off in the accounts of the years in which they were
incurred.
In 2010, the company had only just commenced business and experienced relatively little
competition in building its market share. It achieved substantial increases in quantity terms in
sales in 2011. Further increases in market share after that were much more difficult to achieve
because the total market for the company’s products was stagnant and the recession was
biting. The market is expected to improve slightly in 2013.
21

Gross profits on the sale and installation of refrigeration units have been under pressure and
have been declining. This trend is not expected to change until the new “super compact
freezer” becomes the predominant seller in the company’s range.
Price increases have been implemented in line with inflation and this will continue in the
future. However, manufacturing costs have been increasing faster than inflation and
efficiencies have been deteriorating leading to the squeeze on gross profits. Gross profits on
the maintenance business have been steady at about 33% of billings and this is not expected to
change.
Maintenance contracts are entered into by every customer for whom the company installs a
refrigeration unit. Maintenance is free for the year of installation and thereafter charges are
quite high relative to the sale and installation cost. This is due to the low price charged for the
refrigeration unit itself in anticipation of profitable maintenance business. In the second year,
the annual maintenance fee is 25% of the price paid for the purchase and installation of the
refrigeration unit in the previous year and, in subsequent years, this annual fee is increased in
line with increases in the price of new refrigeration units.
Selling, general and administrative costs include a licence fee of 18% of total turnover which
is payable to the owners of certain technology used in the present range of refrigeration
systems supplied by the company. By careful control of all other expenses and constant
attention to cost saving and efficiency measures, management have succeeded in the year
ended 31 March 2012, in avoiding any increase over the 2011 level, even that due to inflation,
in the selling, general and administrative costs other than the licence fee, and they plan to
repeat this feat again in the year ending 31 March 2013. This is expected to be somewhat
easier because of an anticipated fall in the rate of inflation.
Receivables have remained constant at 3 months on sales and installation turnover and 5.5
months on maintenance turnover and efforts by management to improve these statistics have
not succeeded to date. The number of days inventory (this relates only to sales and installation
business – there are no material inventories relating to the maintenance business) has reduced
steadily over the years. Further reductions in these statistics are not achievable without major
expenditure on computerised systems and no such expenditure is planned for the foreseeable
future. Trade payable days, expressed in terms of cost of new sales and installations, have
fluctuated over the 3 years. Plans for 2013 are to meet a target of 90 days.
Perpetual inventory records are not maintained. Knowing that the company would be
subjected to a full audit in year ended 31 March 2012, you attended the company’s inventory
count for the first time on 31 March 2012 and judged it to be entirely satisfactory.
The table in Appendix 2 sets out relevant facts about the matters referred to in paragraphs
above (all days calculation are based on 360 day year):

22

Requirement:
In early April 2012, you are planning the audit of XY Ltd for the year ended 31 March
2012.
(a) Using all the available information, analyse the significant matters which would cause
you, as Audit Manager, to question whether it was appropriate for the company to prepare
its accounts on the going concern basis and explain briefly why each aspect would
concern you; and
(12 marks)
(b) Indicate what adjustments, if any, you consider it might be necessary for the Directors to
make to the accounts of XY Ltd for the year ended 31 March 2012, if the going concern
basis is not appropriate.
N.B. You are not expected to calculate/quantity the adjustment, merely to state their
nature
(10 marks)
(c) Using the information given in the case demonstrate how the company arrived at these
figures for forecast sales for the year ended 31 March 2013 and briefly evaluate the
reasonableness or otherwise of the figure in the forecast Financial Statements for 2013.
(12 marks)
(d) Set out the accountant’s report which your firm would attach to these forecasts for
submission to the bank in support of an application for a review of banking facilities, on
the supposition that you have come to the conclusion there is a reasonable basis for the
assumptions on which the forecasts are prepared and that those forecasts have been
properly prepared
(10 marks)
(e) Given that your firm did not attend the inventory count at 31 March 2011, and given the
provisions of International Standard on Auditing 501, is it inevitable that the Auditor’s
Report for the year ended 31 March 2012 will suffer a qualification? Justify, with reasons
for your answer.
(6 marks)
[Total: 50 marks]
23

Appendix 1
XY Ltd
Statement of Comprehensive Income for the year ended 31 March
Forecast

Unaudited

As previously
finalised

As
previously
finalised

2013

2012

2011

2010

RWF

RWF

RWF

RWF

Sales

11,240,700

8,802,100

6,230,000

2,670,000

Less cost of sales

(7,253,500)

(5,535,800)

(3,782,500)

(1,513,000)

Gross profit

3,987,200

3,266,300

2,447,500

1,157,000

Operating costs

(3,168,400)

(2,732,300)

(2,269,500)

(1,246,000)

818,800

534,000

178,000

(89,000)

(222,500)

(133,500)

(44,500)

311,500

44,500

(133,500)

Less tax on profit on (284,800)
ordinary activities

(89,000)

0

0

Profit on ordinary 436,100
activities
after
taxation

222,500

44,500

(133,500)

Dividends

(133,500)

(133,500)

0

0

Retained Profits

302,600

89,000

44,500

(133,500)

Interest payable and (97,900)
similar charges
720,900

24

XY Ltd - Statement of Financial Position as at 31 March
Forecast

Unaudited

As previously
finalised

As
previously
finalised

2013

2012

2011

2010

RWF

RWF

RWF

RWF

Property plant and 480,600
equipment

560,700

640,800

720,900

Current Assets
Inventory

854,400

756,500

801,000

667,500

Receivables

3,622,300

2,643,300

1,691,000

445,000

4,476,700

3,399,800

2,492,000

1,112,500

Payables

(1,165,900)

(1,068,000)

(979,000)

(338,200)

Bank borrowings

(1,379,500)

(1,005,700)

(729,800)

(338,200)

Accruals

(623,000)

(596,300)

(445,000)

(222,500)

Tax

(284,800)

(89,000)

0

0

Dividends

(133,500)

(133,500)

0

0

(3,586,700)

(2,892,500)

(2,153,800)

(898,900)

Net Current Assets

890,000

507,300

338,200

213,600

Net Worth

1,370,600

1,068,000

979,000

934,500

Capital and
Reserves

0
1,068,000

1,068,000

1,068,000

Amounts
falling
due within 1 year

Called
capital

up

share 1,068,000

Retained Earnings

302,600

0

(89,000)

(133,500)

Shareholders’ funds

1,370,600

1,068,000

979,000

934,500

25

Forecast

Unaudited

As previously
finalised

As
previously
finalised

2013

2012

2011

2010

RWF

RWF

RWF

RWF

21.82

21.82

20.00

Negligible

Increase in overall
market

4.76%

n/a

n/a

n/a

Inflation
annum

per

1.5%

3.5%

3.5%

3.5%

Gross profits on
sales of units and
installations

36.6%

38%

40%

43.4%

Gross profit
maintenance

33.3%

33.3%

33.3%

33.3%

New Installations

90

90

90

90

Maintenance

165

165

165

165

Market share (% of
new sales)
Increase in number
of new installations

%

on

Receivable days

26

Question 6
Mr Eze is an Audit Partner in the firm of ABC Ltd, a member of ICPAR. He was in the
process of reviewing the audit files for the audit of a new client, Construction Ltd. This
company was in the business of heavy construction. Mr Eze was conducting his first review
after the audit was substantially complete. Normally, he would have done an initial review
during the planning phase as required by his firm's policies; however, he had been
overwhelmed by an on-going Revenue Audit with his largest and most important client. He
rationalised not reviewing audit planning information because (l) the audit was being
overseen by Mrs Jalloh, a Manager in whom he had confidence, and (2) he could "recover"
from any problems during his end-of-audit review.
Now, Mr Eze found that he was confronted with a couple of problems. He found that the firm
may have accepted Construction Ltd without complying with its new-client acceptance
procedures. Construction Ltd came to ABC Ltd on a recommendation from a friend of Mr
Eze. Mr Eze got "credit" for the new business, which was important to him because it would
affect his salary and bonus from the firm. As Mr Eze was busy, he told Mrs Jallohto conduct a
new- client acceptance review and let him know if there were any problems. He never heard
from her and assumed everything was okay. In reviewing Mrs Jalloh’s pre-audit planning
documentation, he saw a check mark in the box "Contact prior auditors" but found no details
indicating what was done. When he asked Mrs Jalloh about this, she responded with the
following:
"I called Mr Ayim (the responsible partner with Construction Ltd’sprior audit firm) and left a
voicemail message for him. He never returned my call. I talked to Mr Gowan (The CEO of
Construction Ltd) about the change, and he told me that he informed Mr Ayimabout the
change and that Mr Ayim said, "Fine, I'll help in any way I can." Mr Gowansaid Mr Ayim
sent over copies of analyses of fixed assets and equity accounts, which Mr Gowangave to me.
I asked Mr Gowanwhy they replaced Mr Ayimʼs firm, and he told me it was over the tax
contingency issue and the size of their fee. Other than that, Mr Gowan said the relationship
was fine."
The tax contingency issue that Mrs Jalloh referred to was a situation in which Construction
Ltd had acquired an expensive piece of equipment at the sale of bankruptʼs assets in the UK
with the intention of using it in their business. However, before it was put into use it was sold
at a very substantial profit. This was a windfall to Construction Ltd, and they recorded it as a
gain, taking the position that it was non-taxable. The prior auditors disputed this position and
insisted that a contingent tax liability existed that required disclosure. This upset Construction
Ltd, but the company agreed to the disclosure in order to receive an unqualified opinion.
Before hiring ABC Ltdas their new auditors, Construction Ltd requested that ABC Ltd review
the situation. ABC Ltd believed the contingency was remote and agreed to the elimination of
the disclosure.
The second problem involved a long-term contract with a customer in Mozambique. The
contract was partially completed as of year-end and had a material effect on the financial
27

statements. When Mr Eze went to review the copy of the contract in the audit files, he found
three things. First, there was a contract summary that set out its major features. Second, there
was a copy of the contract written in Portuguese. Third, there was a signed confirmation
confirming the terms and status of the contract. The space requesting information about any
contract disputes was left blank, indicating no such problems.
Mr Eze's concern about the contract was that to recognise profits on the partially completed
contract, in accordance with IAS 11, the contract had to be enforceable. Often, contracts
contain a cancellation clause that might mitigate against enforceability. As his Portuguese was
rusty (to say the least), Mr Eze couldn't tell whether the contract contained such a clause.
When he asked Mrs Jalloh about this, she responded that she had asked the company's
Operations Director in charge of the project about the contract and he told her that it was their
standard contract. The company's standard contract did have a cancellation clause in it, but it
required mutual agreement and could not be cancelled unilaterally by the buyer.
REQUIREMENT:
(a) Discuss whether ABC Ltd complied with International Standards on Auditing in their
acceptance of Construction Ltd as a new client. What can they do at this point in the
engagement to resolve any deficiencies that may exist?
(12 marks)
(b) Evaluate whether sufficient audit work has been done with regard to Construction Ltd’s
Mozambique contract. If not, what more should be done?
(8 marks)
(c) Consider the extent to which Mr Eze and Mrs Jalloh conducted themselves in accordance
with generally accepted ethical and auditing standards.
(5 marks)
[Total: 25 marks]

28

Question 7
Electrical Limited is a manufacturer of electrical products.
In 2009, the company purchased premises for RWF6.5m. The company occupies 70% of the
premises. The intention was that the remaining part of the premises should be leased to a
tenant. However, no tenant has as yet been found.
The company made profits before tax of RWF300,000 in the year ended 31 March 2012. This
reported profit was after deduction of finance costs of RWF170,000.
The key items in the Statement of Financial Position at 31 March 2012 are as follows:
Fixed assets

RWF5.4m

Net current assets RWF325k
Bank borrowings RWF3.6m
Future profits before tax, excluding finance costs, as per the company’s business plan are
expected to be:
2013

RWF277,000

2014

RWF305,000

2015

RWF309,000

2016

RWF445,000

2017

RWF500,000

The Directors have stated that it is not possible to obtain a reasonable valuation of the
building.
REQUIRED:
(a) Analyse the appropriate accounting treatment of the 30% of the building which the
company is attempting to lease. (Assume that the 70% / 30% split is material in the
context of the financial statements as a whole).
(5 marks)
(b) What audit tests would you carry out and what audit evidence would you expect to find in
relation to the property to be leased?
(7 marks)

29

(c) Comment critically on the assertion by the Directors that it is not possible to obtain a
reasonable valuation of the building.
(4 marks)
(d) What audit tests would you carry out and what audit evidence would you expect to find in
relation to the forecasted profit before tax? Why is this relevant to the current audit?
(9 marks)
[Total: 25 marks]

30

Question 8
(a) What is meant by “professional scepticism” and why is it important for auditors to
maintain such an attitude to their work. Illustrate your answer by reference to Question 3
above.
(7 marks)
(b) Explain why “earnings management” can present problems for auditors.
(7 marks)
(c) “Audit failure” is always a problem not only for the individual auditor, but also for the
profession as a whole.
Analyse the issues that typically cause audit failure.
(11 marks)

[TOTAL: 25 MARKS]

31

Question 9
You are the Audit Manager in charge of the audit of Company Ltd. for the year ended
December 31 2011. The review of subsequent events disclosed the following items:
1.
January 3 2012: The government approved a plan for the construction of a new railway
line. The plan will result in the compulsory purchase of a portion of the land owned by
Company Ltd. Construction will begin in late 2012. No estimate of the compensation award
is available at this point.
2.
January 4 2012: It emerged that the funds for RWF1,000,000 loan to the corporation
made by the company CEO, Mr Muller, on July 15 2011, were obtained by him from a loan
on his personal life assurance policy. The loan was recorded in the account “loan from
officers.” Mr Muller’s source of the funds was not disclosed in the company records. The
corporation pays the premiums on the life assurance policy, and Mr Muller, wife of the CEO,
is the beneficiary.
3.
January 7 2012: The mineral content of a shipment of ore en route on December 31
2011, was determined to be 72 percent. The shipment was recorded at year-end at an
estimated content of 50 percent by a debit to raw material inventory and a credit to accounts
payable to the amount of RWF824,000. The final liability to the vendor is based on the actual
mineral content of the shipment.
4.
January 29 2012: It emerged that an individual trade receivable account of a material
amount is highly likely to remain unpaid as a result of the unexpected bankruptcy of the
proprietor who ran the business as a sole trader. Apparently, the bankruptcy was declared
after a series of internet-based spread-betting transactions went disastrously wrong.
5.
January 31 2012: As a result of reduced sales, production was curtailed in mid-January
and some workers were laid off. On February 5 2012, all the remaining workers went on
strike. To date the strike is unsettled.
REQUIRED:
Assume that the items described above came to your attention prior to completion of your
audit work on
February 15 2012. For each item:
(a) Give the audit procedures, if any, that would have brought the item to your attention.
Indicate other sources of information that may have revealed the item.
(10 marks)
(b) Discuss the disclosure that you would recommend for the item, listing all details that you
would suggest should be disclosed. Indicate those items or details, if any, that should not

32

be disclosed. Give your reasons for recommending or not recommending disclosure of the
items or details.
(10 marks)
(c) State also the consequences, if any, for the audit report if any of the adjustments or
disclosures you recommend are omitted.
(5 marks)
[Total: 25 marks]

33

Question 10
You are Mr Magoro and you work as a Technical Advisor with ICPAR. It is Monday morning
and you are savouring your early morning cappuccino before beginning your week’s work
when the phone rings.
“Hello Mr Magoro, do you have a minute?” “Yes, sure” you hesitatingly reply. The caller
continues.
“I am one of your recently-qualified members employed in industry and I have a serious
problem. For the moment I would prefer to remain anonymous. I am concerned that the
Senior Executives of the company where I serve as Financial Controller just presented our
bank with fraudulently misstated financial statements. I need some advice quickly about what
to do. At the moment I am on my mobile on the way into work and I need help to decide what
my next step should be when I get into the office this morning. May I briefly describe what is
going on and ask for your opinion.”
“Go ahead and let me see what, if anything, I can do” you reply enthusiastically.
“I am the Financial Controller of a privately-held, small, start-up company I joined seven
weeks ago. On Friday of last week, the company’s Chief Executive Officer (CEO), the
Assistant CEO, and the Finance Director met with representatives of the bank that funds our
line of credit. One of the purposes of this meeting was to provide our most recent quarterly
financial statements. Because of the current difficulties in obtaining credit and because the
company is seriously affected by the recession, the bank stopped our line of credit until we
could present our most recent operating results. It was at that meeting, just three days ago, that
our Senior Executive Team knowingly submitted financial statements to the bank that
overstated sales and receivables.
“Earlier on Friday, prior to the meeting, I vehemently refused to sign the commitment letter
required by the bank because of my concerns about the inclusion of sales transactions to
customers on account that I knew did not meet the Revenue Recognition criteria of IAS 18. I
explained to the CEO, Assistant CEO, and Finance Director that I believed that including
those transactions in the quarterly results would constitute fraud. They continued to insist that
the financial statements needed to reflect the transactions, because without them, the bank
would not continue to fund the line of credit. They accused me of living in an “ivory tower”
and emphasised that companies recorded these types of transactions all the time. Although
they acted like they appreciated my desire for “perfection and exactness”, they made me feel
like it was my lack of experience in the real world that kept me from having a more practical
perspective to a common business practice. Unfortunately, none of the Senior Executives
have accounting-related backgrounds. I am the top-level accounting person at the company”.

34

REQUIRED:
(a) Detail two further questions that you, Mr Magoro, would wish to ask the caller before the
end of the call.
(6 marks)
(b) What responsibility, if any, does the caller have to inform any of the following directly
about what is happening? What are the dangers or difficulties of so doing?
(i)

The Bank.

(ii)

The Police or Rwanda Revenue Authority.
(6 marks)

(c) What are the incentives that are typically present in start-up cases, such as this, that lead
management into engaging in fraudulent practices.
(6 marks)
(d) (i) Which financial statement assertion related to sales transactions did management
violate when it issued falsified financial statements.
(3 marks)
(e) (ii) What types of audit procedure could an External Auditor perform that might help the
Auditor detect this fraudulent activity?
(4 marks)
[Total: 25 marks]

35

A1.2 AUDIT PRACTICE & ASSURANCE
SERVICES
REVISION SOLUTIONS

36

REVISION SOLUTIONS
Solution 1

Report to:

ABC & Partners

From:

Engagement Partner, Smooth Ride Ltd

Date:

November 2011

Subject: Planning issues: Audit for the year ended 31 December 2011

Terms of Reference
As part of our ongoing drive for quality within commercial boundaries, this report is an initial
assessment of the risk factors we face when delivering an opinion for the shareholders of
Smooth Ride Ltd. It is based on discussions between our audit manager and the client’s
finance director and takes into account our likely standpoint on potential risk factors faced by
this firm.
Executive Summary
There are a number of risks that we face by undertaking this engagement. These vary in their
impact and likelihood, but some are significant and we will need to devote sufficient
resources to ensure that we form the right opinion on Smooth Ride Ltd’s financial statements.
Of some concern is the impending franchise renewal, which might lead to greater than
expected risk of client manipulation to ensure successful extension of their franchise. There is
the distinct possibility that our involvement with this client may be limited due to them not
being awarded this franchise extension, although if the results of the inquiry into the deaths of
four trackside engineers point the finger of blame towards our client, we may have to ensure
that any immediate liability or going concern issues are tied up first before considering the
longer term view.
There are a number of risks relating to the integrity of the financial statements – revenue
recognition and completeness, asset valuation, stock issues, charity reporting and internal
controls are the main issues. There are also issues to consider with this client being new to our
firm and as such our approach towards items such as internal audit, opening balances and
material assets are key to managing these risks.
One additional factor that our audit should address is to establish some more facts about our
client from their previous auditors – we must ensure that we pursue any uncertainty about our
client by discussing what matters we can with them, after we have obtained the necessary
permissions from our client. These matters are explained in more detail in the rest of the
report.
37

a)

Overall assessment of detection risk

Detection risk is a product of inherent risk and control risk. Inherent risk in this case must be
assessed as high. The reasons are detailed in the next part of the solution but in summary they
include the fact that the company is essentially new, that its franchise is granted only for a
limited period and that going concern may be questioned if the franchise is not renewed.
Similarly, control risk must be assessed as high because inter alia internal controls have not
been properly tested and there are issues concerning internal audit. Both these points are
addressed further below.
This means that detection risk must be assessed as “lowest.”
b)

i) & ii) Audit risks and their implications
Audit Risk

Why this causes concern
Implications for the audit

Franchise expiry

The possible loss of the franchise 12
months from the year end is fundamental to
this company’s ability to trade, meaning
that the company may no longer be a going
concern. This would need to be discussed
with directors to ensure that the financial
statements are prepared accordingly and
additional evidence sought to verify the
appropriate treatment.

Franchise renewal

The clients desire to extend the franchise
is dependent upon a number of customer
service related factors beyond the scope of
our audit (although we must be mindful of
the consistency of this other information in
the annual report to that which we do audit)
but also on delivering sound financial
accountability. This could lead to a risk of
manipulation of the financial statements to
which we must be alert.

Internal controls

Internal controls have not been tested
properly by Internal Audit leading us to
question whether the company’s systems
are likely to deliver true and fair accounts.
We must factor in sufficient time to review
the systems at our interim visit.
38

and

Internal audit

Internal audit quality has been
questioned by the audit committee due to
staff turnover issues. We can therefore
place little reliance on them until we can
trust the quality of their work- this is
addressed later on in this report by
discussing how best to assess this function.
Until this is done, it may lead to extra
testing being required by our firm.

Buses

We are told that this is a material
balance but we must be sure that all items
have been accounted for correctly. Given
that the majority of this was obtained from
the previous franchisee, it is possible that it
may have been in existence for some time
and that asset transfer records might have
been incomplete or inaccurate. The report
discusses the extra work and likely
difficulties involved in more detail later on.

Online ticketing system

We must be aware of the importance of
new technologies and any additional routes
for revenue to flow into the company, to
ensure that it is complete, accurate, not
overstated, recorded in the correct period
and that our client has the right to it (e.g.
certain tickets might include the provision
of additional services such as inclusive
parking, onward travel, etc.). Given the
national provider’s failure to certify the
system to date, we must be cautious about
revenue from this route and review it
thoroughly.

National tariffs

As new tariffs have recently been
implemented, revenues should be recorded
that match those sold to customers. We
should plan to test that all tickets have been
correctly recorded and not accounted for at
previous rates or types (e.g. unused return
portions should be accounted for at cut-off
accordingly).
39

New client

We must remember that this is a new
client and as such has no track record,
meaning that we should brief the audit team
to be especially vigilant for any issues that
might help us in forming our opinion as
well as spending extra time familiarising
ourselves with this new client and its
systems and procedures. [Tutorial point: it
is tempting to discuss why the previous
auditors are no longer in place, but it is
assumed that nothing untoward was
discovered at the acceptance stage, or else
the engagement would not have been
accepted in the first place.]

Season tickets

Given that a material amount of
revenues are effectively payments in
advance, there is a risk of revenue
recognition being abused by the client to
bolster its profits. We must be mindful of
the cut-off work required and review the
policy for accounting for such income.

Inquiry into deaths

The circumstances surrounding the
incident where two engineers were killed
by one of our client’s buses are unclear at
the moment, leading to an inquiry to
determine the full facts. We must be aware
of the possibility of our client being found
negligent and consider whether or not there
are any going concern issues or potential
fines that may require the correct
accounting treatment. We must monitor the
situation closely. We are told that nobody
on the bus was injured but we should be
mindful of the possibility of claims from
passengers in relation to trauma and stress.

Charity donations

The company’s initiative to pay 0.1% of
revenues in donations to charity needs to be
reviewed to ensure it is correctly accounted
for. Given the various tariffs in place,
discounts offered and season tickets sold,
the amounts payable to charity need to
40

comply with the expectation from
passengers or a risk of breaching
advertising standards may be posed.
Similarly, there may be regulations to be
complied with by our client and to some
extent ourselves – we must be mindful that
our audit report might be seen as some tacit
form of assurance for this initiative.
[Any 10 of the above points is sufficient for full marks; consideration will also be given
for other relevant points]
c)

Opening balances

As you will all be aware, any new engagement is risky due to a lack of knowledge about the
client and its industry. One factor that relates to Smooth Ride Ltd is making sure that there are
no material misstatements in its opening balances, given this is the first year of audit for our
firm and this client. ISA 510 Opening Balances provides guidance here:
- Obtaining the opening balances from the previous year’s financial statements
- Making sure that these balances have been correctly brought forward into the new financial
year’s financial statements
- Ensuring that there are no material changes in accounting policy that affect the
appropriateness of using these figures
Once this work is complete, in the course of a normal audit we would review the previous
year’s working papers to ensure that any issues carried forward have been appropriately
treated in the new year’s statements. Given that this is our first year of audit, we should
already have obtained sufficient appropriate evidence from the previous auditor to help in this
matter at the acceptance stage.
Our only further problem area would then be in the event of a prior year modified report, as
this may have serious implications for our current year report (e.g. if closing stock has been
modified last year, that will lead to a modification in the new year’s cost of sales). Again, the
previous auditor’s working papers should provide us with some guidance on this risk area.
d)

Specific audit work on material items – buses

Despite there being a number of significant issues addressed within the audit risks and
internal audit sections of this report, we must also plan for significant amounts of work to
verify the carrying amounts relating to the buses on the balance sheet. The transfer of such a
franchise from any previous holder to a current one is unlikely to have resulted in the removal
of the existing assets and replacement with those of the latter – our client will therefore
probably have obtained assets that have been in operation for many years and will have had to
make sense of the information that came with them.

41

The main issues for us to consider are valuation and quantity. For the former, we need to
review the records for valuation of assets between depreciated historic cost fair value or
revaluation per FRS 15/IAS 16. For some very old assets, revaluations may have assumed
certain useful remaining lifetimes that may no longer be appropriate. Similarly, under FRS
11/IAS 36 assets may have become impaired but such a judgement may be hard for us to act
on alone so the use of an expert may be required. Overall, the quality of information and
evidence available to us may be limited which will make our task more challenging.
Quantity of assets is our second main issue here – both completeness (understatement) and
existence (overstatement) risks exist here to ensure that the amount of assets included are
accurate. We will need to verify the items both acquired and disposed of during the year via
board minutes as well as physical verification and reconciliation via the asset register.
Completeness testing will require vouching from original documents to the financial
statements ultimately, while existence testing will work in the opposite direction.
Fundamentally, we face a significant issue in obtaining prima facie evidence of existence due
to the general nature of this industry – unless our client has geo-synchronous asset tracking
which we can trust, at any point in time their buses could be anywhere in this network and
only likely to be “off duty” for a number of hours overnight, making physical verification of
such assets extremely difficult.
Conclusions
This report has identified the major areas of audit risk that we face with our client Smooth
Ride Ltd. The impacts on the audit are many and varied and we must take these factors into
account when producing the detailed audit plan for the team to use when they start the interim
audit in the new year.

42

Solution 2

(a) Three steps that should be undertaken in this regard are:

-

Discuss the problem with other partners in the audit firm particularly the ethics
partner
Seek counselling and advice on a confidential basis with an independent advisor or
from ICPAR to obtain an understanding of the possible courses of action.
Consider seeking legal advice on the particular circumstances

(b) The main potential risk is that Client A will go into liquidation and that XYZ Ltd will
suffer as a result. This could mean both reputational damage (being associated with giving
a clean audit report to a firm that subsequently fails) or it could even mean that it could
face litigation from the creditors of the failed firm most likely the bank. It could be argued
that XYZ Ltd owed a specific duty of care to the bank. It could be further argued that
XYZ Ltd signed off on the financial statements knowing them to be misleading. The issue
the courts would then have to decide was whether the duty of care to the bank was
secondary to the duty of confidentiality to Client B. It could be argued that even if this
prevailed it would still be very expensive for the audit firm in terms of time, legal costs,
and probably still some reputational damage.
(c) i) XYZ Ltd resigning as auditors to one or both firms would clearly extricate the firm
from this particular dilemma but it would mean loss of one or both clients and it would
also mean having to make the statement of circumstances of resignation to the entities and
to the Registrar of Companies (remove -under S185 Companies Act 1990). At the very
least legal advice would be required on this point.
ii) Using different audit teams and erecting “Chinese Walls” are recognised as useful ways
of enhancing the independence of the auditor and preventing conflicts of interest arising or
influencing the audit decision. If we are to continue to audit both these clients into the
future there is clearly a case to be made for this here. However, in this particular instance
the damage has (as it were) already been done and we must now deal with the dilemma
that we have.
iii) If this is a feasible option it may present a pragmatic, if imperfect, solution to our
dilemma. The problem will be that Client A may want the report to be produced sooner
rather than later and may be liable to penalties if there is excessive delay. These penalties
could arise either from the late filing of Company’s Office or tax returns. We have to be
very careful not to break any confidences to Client A or not to act with a lack of integrity
by, for example, presenting Client A with a spurious or untruthful reason for the delay.
43

iv) The kind of behaviour suggested here whilst possibly tempting is unacceptable
because it amounts to unprofessional behaviour and implies at least a partial breach of
confidentiality. It could also undermine the bank’s opinion of financial statements
produced by XYZ Ltd in the future.
(d) This question is open-ended and attempted to illicit the candidate’s own opinion. Marks
will be awarded according to the logic and consistency of the proposals.

44

Solution 3
(a) The client’s change in policy is appropriate. Auto Parts Ltd likely purchases tooling
supplies in large quantities in order to take advantage of supplier discounts and in the
current year they increased their purchases in anticipation of a price increase. It appears
that the items purchased can remain in inventory for weeks or months creating a future
economic benefit. The preferred accounting method for tooling supplies is to capitalise the
on-hand tooling supply in other assets and then expense supplies as they are placed in
service. The decision regarding capitalisation or expense is based on the concepts of
future economic value, the matching principle, classification, and disclosure. Accrual
accounting requires expenses to be matched to the revenues they help produce in a given
period.
(b) Theoretically, it appears that there are 3 possible ways to account for the policy change: a
change in accounting principle, a change in accounting estimate, or a fundamental
accounting error.
The best argument for considering the client’s policy change as a change in accounting
principle seems to be that the client previously used the cash method to account for
tooling supplies and now will use the accrual method of accounting. A change in
accounting principle requires that financial statements for each individual prior period
presented shall be adjusted to reflect the period-specific effects of applying the new
accounting principle. However, given that the prior year transactions were considered
immaterial, it may be that the client’s policy change is not a change in accounting
principle.
The best arguments for considering the policy change a change in accounting estimate
seems to be that the client previously estimated useful life of the supplies as zero and now
the useful life is indefinite and will be expensed as used.
If the change qualifies as a change in accounting estimate the financial statements would
be affected as follows:
- The current year’s financial statements as well as future statements will be reported
consistent with the new policy. Therefore the policy change in 2011 resulted in a
RWF330,000 reduction in expense (and a related increase to net income) and a
RWF330,000 increase to other current assets when they capitalised unused tooling
supplies in 2011. A footnote would be added to discuss the change.
- Retrospective application to prior periods’ financial statements is not required.
Therefore, no adjustment should be made for the RWF35,000 expensed in 2010, but still
on hand at the beginning of 2011.
The third was the policy change could be characterised is the correction of a fundamental
error. The
prior way of accounting for tooling supplies, the cash method, is not
consistent with GAAP as such the change in policy represents a correction of an
accounting error.
45

Given that the cash basis is not acceptable under GAAP it seems this policy change is
best considered a correction of accounting error. To properly account for a correction in
accounting error, the change in policy would be disclosed and when the comparative
2010 and 2011 statements are issued, 2010 would be adjusted to show RWF35,000 more
in other assets and RWF35,000 less in expense. Similarly, the 2011 statements would
show RWF35,000 more in expense.
However, regardless of how the change is accounted for, the impact on 2011 is similar in
magnitude because of the small amount of inventory on hand at the beginning of 2011.
The primary issue the auditor and client need to resolve is a determination of whether the
effect of the change is material and will require disclosure.
Even if the client and auditor decide to account for the change as a correction of an error,
the previously issued 2010 annual report would not need to be recalled and restated
because the impact on 2010 is so small. Rather the adjustment would be made to the 2010
comparative financial statements presented in the 2011 annual report.
(c) Materiality is commonly defined as follows: “A misstatement in the financial statements
can be considered material if knowledge of the misstatement would affect the decision of
a reasonable user of the financial statements.” The determination of materiality requires
professional judgment. While professional standards provide relatively little specific
guidance on how to assess what is material to a reasonable user, auditing firms have
developed policies and procedures to assist auditors. These policies and procedures often
suggest that the auditors apply a percentage to various bases (e.g. net income before tax,
total assets, total revenues, etc.) Because materiality is a relative rather than an absolute
concept, the materiality assessment for one client may differ significantly from that of
other clients of similar size. Student assessments of materiality will likely differ. For
example certain “rules of thumb” are often used. It is generally accepted that 5% of net
income before tax now represents a generally accepted upper bound. For the current year
audit of Auto Parts, this rule of thumb would yield an estimate of planning materiality of
approximately RWF300,000 (RWF6 million X 5%). Based purely on a quantitative
analysis, it appears that the amount of tooling inventory in question (the RWF300,000
recorded as an asset) falls very near to the materiality threshold of 5%.
Several qualitative factors would influence the auditor’s assessment of materiality. The
following list identifies some of the qualitative factors:
(a) Degree of misstatement. The policy change implemented in 2011 will also not result
in a misstatement in 2011 and any correction to 2010 would be very slight. In fact, the
change in accounting policy results in a better treatment of tooling supplies in the most
recent financial statements. Given that net income is not misstated, the auditor faces an
issue that involves a matter of presentation and disclosure.
(b) Impact on trends. Auto Part’s earnings per share have steadily increased over the
past five years with a cumulative return of 140% over that period. Capitalising on46

hand supplies and not disclosing the accounting change will suggest a pre-tax earnings
growth of 20% [RWF6,000,000-5,000,000/RWF5,000,000] while capitalising and
disclosing the accounting change may suggest a pre-tax earnings growth of
approximately
13.5%
[RWF6,000,000-5,000,000-330,000/(RWF5,000,000)].
Additionally, capitalising and not disclosing the accounting change will suggest a
return on assets of 11.7% (RWF6,000,000/[RWF47,000,000+RWF56,000,000]/2)
while capitalising and disclosing the change may suggest a return on assets of 11%
(RWF6,000,000-RWF330,000/[RWF47,000,000+RWF56,000,000-RWF330,000]/2).
Auto Part’s will show an impressive pre-tax earnings growth whether the accounting
change is disclosed. The impact of the disclosure on Auto Part’s return on assets is
minimal.
(c) Client’s justification. Auditors are always concerned about the underlying motivation
in a proposed change, particularly when it results in an increase in net income. If the
auditor believes that the client is making the change for the “wrong” reasons (i.e.
improve earnings trend instead of to better comply with the matching principle) then
they might use a lower assessment of audit materiality with respect to the policy
change in question. To assess the client’s motivation, the auditors would consider
things such as the effect of the change on the client’s trend in reported earnings. In the
Auto Parts case, there may be a concern that management wants to continue to report
high earnings growth. If, for example, a new accounting policy would change the
current year earnings from a negative trend to a positive trend, the auditors may
consider reducing the level of audit materiality with respect to the policy. As
previously noted, disclosure of the policy change will not significantly affect the
earnings trend.
(d) Management Integrity/Audit History. In a situation like Auto Parts where the client
has expressed a preference that may conflict with the auditor’s preference, auditors
carefully consider management integrity and the client-auditor relationship extended
over several previous audit engagements. If, over time, an audit client has been
confrontational and aggressive, then this policy change may be symptomatic of a
larger problem. This may encourage the auditor to take a “hard line” on such issues
and use a lower materiality assessment. Alternatively, if (1) the auditor-client
relationship has been positive, 2) similar issues have not been common in prior year
engagements, and 3) the auditor believes that management has a high degree of
materiality associated with an accounting policy change. In the actual case, the
auditors had a positive history with the client, and the auditors believed management
possessed a high degree of integrity.
Other qualitative factors students may include:
- Whether the misstatement arises from an item capable of precise measurement or whether
it arises from an estimate and, if so, the degree of imprecision inherent in the estimate
- Whether the misstatement hides a failure to meet analysts’ consensus expectations for the
enterprise
- Whether the misstatement affects the registrant’s compliance with loan covenants or
47

other contractual requirements
- Whether the misstatement has the effect of increasing management’s compensation – for
example, satisfying requirements for the award of bonuses or other forms of incentive
compensation
(d) It could be argued that disclosure must be made for two reasons: (1) GAAP requires
disclosure and (2) without disclosure of the new method the new tooling supply asset
account of RWF330,000 with an accompanying net income boost is material. Most likely
any disclosure for this policy change would appear in the footnote discussing “other
assets.”
It could also be argued that the auditors could concur with management due to the fact
that the tooling supplies on-hand at the end of the prior year was immaterial and the
client’s change is appropriate given the economic circumstances in the current year (the
client basically pre-paid for tooling supplies). The effect on the current year was
considered potentially material due to the quantitative size; however; in considering the
qualitative factors discussed above, the auditor could take the view that any attempt on
behalf of management to inappropriately manage earnings or trends and the client/audit
history had been positive. Even if the adjustment to 2010 and disclosure regarding the
change is not made in the financial statements, the auditor would inform the audit
committee of the change in accounting policy as well as any proposed audit adjustments
(ISA 260, “The Auditor’s Communication With Those Charged With Governance”).

48

Solution 4

(a) There is no doubt that current uncertainties make the giving of opinion on the financial
statements of entities more difficult. It is harder to obtain reliable information and such
reliable information as is available (i.e. the historic cost of assets) is likely to be less
relevant. Even current information is harder to capture given the dynamism of the
environment.
It is therefore, true, that auditors need to be extremely cautious about giving opinions of
any description about prospective financial information (PFI). Nevertheless, some PFI
statements are reasonable and carefully prepared while others are not. An accountant’s
report can help to distinguish between them. Auditors must only ever give “limited
assurance” reports which provide assurance in negative terms viz. “nothing has come to
our attention that causes us to believe that the underlying assumptions do not provide a
reasonable basis for the forecast” (ISAE 3400).
Such reports should also include a warning that actual events may not turn out as forecast
and the reports should be restricted in their distribution to those for whom they are
specifically prepared (e.g. lending institutions).

(b) The appropriate report for a projected set of financial statements is, again, specified in
ISAE 3400. A properly worded report will minimise any risks to them. The report should
state that:
- A projection is being reported upon. (A projection is less certain than a forecast)
- Management is responsible for the projection
- The assumptions are set out in a note and may be hypothetical
- The projection has been prepared for a particular purpose and may not be suitable for
other purposes.
The other caveats as specified in part (a) of this solution should also be included.
The risk of not wording the report correctly is that ABC could be accused of not properly
complying with best practice and/or more seriously be subject to litigation probably by a
third party claiming that they relied on the report and that it was misleading.
(c) The following work would be performed:
General procedures
1) Meet with management to determine the process for preparing the forecast information
2) Identify and document internal controls over the process. Consider the role played by the
internal audit department
3) Obtain backing schedules for the information, cast and ensure they are numerically
accurate
4) Review the accounting policies used and ensure they are consistent with previous periods
49

5) Discuss the need to produce a full income statement taking account of any proposed tax,
interest and dividend payment
6) Produce a letter of engagement
7) Obtain management representation with regard to the completeness and accuracy of
information and assumptions used. Also, this should contain a statement that it is
management’s responsibility to produce the information.
Income Statement
8) I would compare the forecast sales for the year with those in the previous audited
financial statements
9) Consider the reasonableness of any change in revenue by reviewing the performance of
similar companies in the same sector and reviewing the wider economic climate
10) Obtain a detailed analysis of revenue and cost, perform a detailed analytical review and
discuss the unusual movements with the relevant Directors of Smooth Ride Ltd.
11) Compare the level of expenses with those in prior year. Certain expenses should be fixed
and remain static. Others will vary according to sales levels. Any significant fluctuations
would be investigated further.
Statement of financial position
12) I will check the value of non-current assets to the most recent audited accounts. Possible
impairment of assets will be discussed with the directors
13) I would recalculate depreciation for each period and check the accounting policies against
those used in previous financial statements
14) I would calculate the age of inventories, receivables and payables and compare them with
past financial statements. Any significant variations would be investigated further.
15) Discuss with management the possibility of obtaining equity finance
16) Calculate key ratios and compare them year on year such as ROCE, asset turnover,
current asset and quick asset ratios. Review any current bank agreement check that bank
covenants are not breached.
17) Discuss the need to include any provisions for contingencies, such as warranties
18) I would agree the cash figure and the level of overdraft and loans to agreements with the
banks and financial institutions.

50

Solution 5
(a) Enterprises rarely cease to carry on business without prior indications, either of inability
to meet debts as they fall due or of other problems that raise questions about the
continuation of business. It is useful to differentiate between internal and external matters
which may call going concern into question. The solution below assesses the issues
arising underneath these headings.
Internal matters
i)

The three key executive personnel in the company comprise of two technical experts
and the third being the financial controller. The financial controller has left the
company following a disagreement with the technical personnel on budgetary control
related to new product development. The loss of the financial controller and the
probably inadequate attention subsequently being paid to matters of financial control
is a matter of considerable significance and has implications for the company’s
ability to continue as a going concern.
ii) The new “super compact freezer” is expected to generate the major part of the
turnover of the company from the commencement of the financial year ending 31
March 2014 onwards. The cost of development work on this new generation of
freezers has significantly exceeded budget. The technical personnel expect the
development work to be completed by the end of August 2012. However, they had
also maintained that development work would be complete by November 2011 but
this estimate proved to be wildly optimistic. The company would appear to be totally
dependent upon the successful development of this new generation of products. In
the event that this new series of freezers is not successful and/or does not come on
stream in time, the company’s ability to continue in trade must be in doubt.
External matters
(i)

Financing from payables:
The company’s financing appears to be unduly dependent upon being able to extract
generous credit terms from payables. The plans for 2013 are to meet a target of 90
payables days. This is optimistic in the light of other information relating to the
company’s trading prospects. To the extent that the company cannot obtain this
amount of credit from its payables, it is unlikely that its bankers will be prepared to
increase the level of bank financing into the company.

(ii)

Bank finance:
Bank borrowings have grown from RWF338,200 in 2010 to RWF1,005,700 in 2012.
The company obtained its bank facilities subject to the ratio of bank borrowings to
shareholders funds not exceeding 1:1 at any time. Currently, the company is slightly
over this limit and it must be doubtful whether the bank will be willing to
significantly increase its level of financing to the company.

(iii) Short-term Finance for Long-term Needs:
All of the bank borrowings are shown as being due within 1 year. This means that
the company is seeking to develop its new generation of products through reliance
on short-term finance. This is an obvious miss-match in that the company should be
51

seeking to utilise long-term financing for the development of new products. The
dependence on short-term finance for long-term needs will inevitably give rise to
problems.
(iv)

Under capitalisation:
Allied to the point made in (iii) above, it is evident that the company is undercapitalised. The three key personnel invested their redundancy compensation in the
new business and also took out second mortgages on their houses to invest in the
business. Nonetheless, the amount of capital invested of just over one million RWF
is insufficient for the company’s long-term needs. It is difficult to see where the
executives are going to be able to raise additional capital. Allied to this is the
problem that confronts them following the resignation of the financial controller, in
that they are immediately faced with the problem of buying out his stake of the
company. It is difficult to see where they are going to be able to generate funds to do
this.

(v)

Low liquidity/profitability:
The company is not very profitable. Margins are low and continue to fall.
Manufacturing costs are increasing faster than inflation and the market is stagnant.
The market is expected to improve only slightly in 2013. Any improvement cannot
be expected deriving from the new generation of freezers for at least another two
years. The company’s liquidity situation is likely to continue to deteriorate in the
interim period.

(vi)

Gearing:
The company’s gearing continues to deteriorate. The debt/equity ratio has undergone
a very significant change from 2010 to 2012. There would appear to be nothing on
the horizon which is going to change this situation in the near future. This will cause
banks and payables to view the company’s financial position with increasing
concern.

(vii) Dividend policy:
The company’s dividend policy is imprudent in view of the company’s liquidity
situation. However, the executives are dependent on sufficient dividends being paid
to enable themselves to meet repayments on their second mortgages from 2012
onwards. It is difficult to see how the company will be able to continue its current
dividend policy.

(b) Possible adjustments
i)

Property, plant and equipment would need to be re-stated to their “break-up” value.
This is likely to be significantly lower than the amount at which they are currently
stated in the Statement of Financial Position.

ii)

The collection of receivables always poses problems in a “break-up” situation. A
thorough review of the receivables’ balances is required to establish the amount
52

therein that is collectable, and as a result to make increased provision for bad debts.
iii)

Inventories will inevitably show a reduction on their current Statement of Financial
Position amount as inventories will now be disposed of in a forced-sale situation.

iv)

The concept of classifying assets as “property, plant and equipment” and “current
assets” in the Statement of Financial Position can no longer apply in a “break-up”
situation. All assets become immediately available for disposal and the Statement of
Financial Position would need to re-classify the property, plant and equipment as
“current” assets. Likewise, all liabilities become payable immediately in these
circumstances.

v)

In addition to the liabilities currently shown in the Statement of Financial Position, it
is likely that these may require to be increased as further provision may be required
for closure costs and redundancy costs arising following the “break-up” of the
company.

vi)

In view of the fact that XY Ltd also enters into maintenance contracts with
customers, an element of the purchase price may be treated as deferred income and
released to the Income Statement in the second and subsequent years. If the
Statement of Financial Position is not prepared on a “going concern” basis such
income may now be realised in full and hence the Income Statement and Statement
of Financial Position may need to be adjusted in this respect. However, the further
possibility of claims arising from customers whose maintenance contracts cannot
now be honoured would also have to be considered.

(c) Calculation of 2013 sales
2011 sales
2,670,000 X 25%

667,500
6,230,000
5,562,500

Service Income
Total
Products

2012 sales
Products (5,562,500*1.20)
Service

6,675,000

2011 sales of 5,562,500 X 25%
2011 service income

1,390,625

667,500 X 1.10

690,863
Round to

53

2,081,488
8,756,488
8,800,000

2013 sales
Products (6,675,000*1.05*1.0476)
Service Income
2012 Sales (6,675,000*0.25)

7,097,621
1,668,750

2012 Service Income (2,124,875*1.05)

2,112,710

Sum
Round to

3,801,462
10,899,081
11,240,000

Short fall

Shortfall 6%

340,919

The above working shows how the company arrived at the calculation of sales and cost of sales for
the year ended 31 March 2013 having started with the last available audited sales for the year ended
31 March 2011. The figures in the forecast are certainly arithmetically correct and are (allowing for
trivial rounding adjustments) exactly in line with forecasts. The reasonableness of the forecasts
themselves is, of course, an entirely different question and one which the auditor must assess
separately in the light of his/her knowledge of the economy, the business, and the industry in which it
operates.
(d) Auditor’s report to…
We have examined the attached forecast Income Statement and forecast Statement of Financial
Position of XY Ltd for the year ended 30 June 2013 in accordance with the International Standard on
Assurance Engagements applicable to the examination of prospective financial information.
Management is responsible for the forecast including the assumptions set out in Appendix 2 on which
it is based.
Based on our examination of the evidence supporting the assumptions, nothing has come to our
attention which causes us to believe that these assumptions do not provide a reasonable basis for the
forecast. Further, in our opinion the forecast is properly prepared on the basis of the assumptions and
is presented in accordance with International Financial Reporting Standards.
Actual results are likely to be different from the forecast since anticipated events frequently do not
occur as expected and the variation may be material.
DEF
ICPAR
5 July 2012

(e) Audit report
It is a fairly common occurrence that a qualified “except for” report is issued where there is a change
of auditors, or in this case a company is subject to audit for the first time. However, this may not be
inevitable and a qualification can possibly be avoided. Inventory is clearly material in the financial
statements of XY Ltd.
54

If the audit report is qualified - an 'except for' opinion is given on the grounds of a limitation of the
scope of the work performed because the auditors were unable to obtain sufficient appropriate
evidence in relation to opening inventory.
Opening Inventory affects both the comparative inventory figure in the Statement of Financial
Position and Income Statement, and the profit figure for the current year. Disclosure is also made in
the audit report whether adequate information and explanations are given, and whether proper
accounting records have been kept. Inventory records are required to be kept.
If the company wishes to avoid such a qualification, there are several possibilities.
The audit firm should establish what inventory records (short of perpetual records) are kept and what
inventory control procedures are undertaken. For example, an inventory count at the opening date
may well have occurred albeit we as auditors did not attend it. Provided that records are adequate this
may provide some comfort on opening inventories. Analytical procedures on records of inventory
levels and on gross margins (which are likely to be stable) will also assist in providing comfort on the
opening position.
Given that there are no regular inventory counts, provided that adequate records have been kept,
detailed substantive procedures on the opening figure may be possible by reference to purchases and
sales records as well as analytical procedures.
If we can satisfy ourselves by these alternative means it may be possible to avoid a qualification but in
the circumstances described this seems somewhat unlikely.

55

Solution 6
This question illustrates the common problem of an audit partner having to allocate his
scarcest resource - his time. In this case, Mr Eze neglects a new client for an existing one and
causes himself several serious problems.
(a) ISQC 1 requires that firms maintain client acceptance procedures. ABC Ltd has such a
policy; however, whatever enforcement mechanism for compliance with it must not be
sufficient, as Construction Ltd was accepted without the procedures being completed.
More to the point, the need for adequate communication by a successor auditor with the
predecessor auditor is abundantly clear. In this case, Mrs Jalloh initiated a communication,
but then left it incomplete when the predecessor auditor did not return her call. She
rationalized this away by accepting representations from the new client. Of course, the
predecessor auditor may be able to offer information that conflicts with the new client’s
best interest. It is not appropriate or in accordance with auditing standards to consider
management’s representations in lieu of a direct communication with the predecessor
auditor. The client should not have been accepted until a sufficient communication
occurred.
Can this be remedied? Yes and no. Whilst communication with the predecessor auditor
before accepting the engagement is required, a communication with the predecessor
auditor should be conducted now, presumably by Mr Eze. However, if alarming
information were obtained, ABC Ltd would find itself in the awkward position of having
accepted a client it might not want. In that case, if it decides to withdraw from the
engagement, it may be breaching a contractual obligation. If it continues, it may be taking
an unwanted level of business and/or audit risk.
A related implication is the wisdom of Mr Eze’sassumption about Mrs Jalloh’s competence
and how that affects her performance on the engagement. Mr Ezerelied on Mrs
Jallohextensively, yet Mrs Jalloh’s performance on the new client acceptance was
deficient. Does this mean that Mrs Jalloh’s performance in other areas was deficient as
well? Certainly, Mr Eze can do a thorough review of Mrs Jalloh’s work, but a review may
or may not reveal all engagement deficiencies.
Mr Eze’s handling of this engagement also implies something about his attitude and
objectivity. This was an initial engagement, yet he delegated almost all responsibility up to
final review to Mrs Jalloh. He got credit for bringing in the new client, which directly
benefited him in terms of his salary and bonus. It would be against his best interest to not
accept (withdraw from) this client. If he is unwilling to “do the right thing” here, how will
he handle other difficult audit problems?
b) In the audit of long-term contracts, it is essential to obtain assurance that the contract is
enforceable so that income can be recognized in the manner permitted by IAS 11. It is also
important to consider other aspects of the contract that relate to various accounting aspects,
such as price and other terms, cancellation privileges, penalties, and contingencies. In this
56

case, Mrs Jalloh has concluded that the signed contract, written in Portuguese, is
Construction Ltd’s “standard” contract, based on the client’s representation. Of course,
Auditing Standards require that management’s representations, a weak form of evidence,
be corroborated with other evidence where possible. Mrs Jalloh might argue that the
confirmation obtained constitutes such evidence.
Mrs Jalloh’s argument may seem logical with regard to enforcement, however, the
confirmation form refers to existing disputes. It says nothing about contractual clauses that
may foreshadow enforceability. For that reason the audit program requires the contract to
be read. How would an auditor know whether the contract form was that of a standard
contract without reading it? Furthermore, it may be unrealistic to assume there is such a
thing as a “standard” contract in the first place. Long-term and short-term contracts are the
result of negotiation and often contain special clauses and changed language.
In this case, not reading the contract was an insufficiency and the Portuguese-language
copy should be translated (either by a member of the audit team whose level of Portuguese
is demonstrably beyond reproach or, failing that, by an independent professional translator)
and read by the auditors.
c) Compliance with GAAS is a matter that is always subject to professional judgment. One
professional auditor may conclude he or she has complied with GAAS, and another would
conclude that GAAS has been violated, so these matters are very seldom clear cut.
However, in this case, it appears that Mr Eze and Mrs Jalloh may have violated GAAS in
the following ways:
International Standards on Auditing 220 & 300 state that the auditor must adequately plan
the work and must supervise any assistants. More generally, the audit partner should
participate in planning, at least with a timely review. This would be more important than
otherwise in the situation of a first-time engagement, as we have here. Similarly, some
level of on-going partner supervision would seem prudent and logical. Mr Eze, apparently,
did not really participate at all until final review.
ISA 500 states that the auditor must obtain sufficient appropriate audit evidence by
performing audit procedures to afford a reasonable basis for an opinion regarding the
financial statements under audit. As discussed above, the work on the Mozambique
contract was deficient and further evidence is required.
In addition, it might be argued that Mrs Jalloh was not proficient as an auditor because of
her failures with the new client acceptance procedures and the Mozambique contract.
Similarly, it might be argued that due professional care was not taken both by Mrs Jalloh
and by Mr Eze for delegating so much to Mrs Jalloh.

57

Solution 7
a) IAS 40 applies. IAS 40 states that:
If the owner uses part of the property for its own use, and part to earn rentals or for capital
appreciation, and the portions can be sold or leased out separately, they are accounted for
separately. Therefore the part that is rented out is investment property. If the portions
cannot be sold or leased out separately, the property is investment property only if the
owner-occupied portion is insignificant. [IAS 40.10] It would therefore appear that the
30% could be accounted as an investment property.
IAS 40 permits entities to choose between: [IAS 40.30]
•

a fair value model, and

•

a cost model.

One method must be adopted for all of an entity's investment property. Change is permitted
only if this results in a more appropriate presentation. IAS 40 notes that this is highly
unlikely for a change from a fair value model to a cost model.
Fair value model
Investment property is re-measured at fair value, which is the amount for which the property
could be exchanged between knowledgeable, willing parties in an arm's length transaction.
[IAS 40.5] Gains or losses arising from changes in the fair value of investment property
must be included in net profit or loss for the period in which it arises. [IAS 40.35]
Fair value should reflect the actual market state and circumstances as of the balance sheet
date. [IAS 40.38] The best evidence of fair value is normally given by current prices on an
active market for similar property in the same location and condition and subject to similar
lease and other contracts. [IAS 40.45] In the absence of such information, the entity may
consider current prices for properties of a different nature or subject to different conditions,
recent prices on less active markets with adjustments to reflect changes in economic
conditions, and discounted cash flow projections based on reliable estimates of future cash
flows. [IAS 40.46]
Cost Model
After initial recognition, investment property is accounted for in accordance with the cost
model as set out in IAS16, Property, Plant and Equipment – cost less accumulated
depreciation and less accumulated impairment losses. [IAS 40.56]
b) The company might therefore be permitted to carry the 30% of the building at fair value.
The audit tests that would be necessary to check that the property does qualify as an
investment property would probably include the following.
a.

Inspect the property.
58

b.

Establish the current use being made of this part of the property.

c.

Check that the 30% of the property is physically identifiable and in some way
separable from the remainder(own entrance, sanitation facilities etc.) and is a
usable unit in itself.

D

Confirm that the property is ready for immediate occupation.

e.

Confirm that it has been maintained in good condition (e.g. no damp).

f.

Seek evidence that it is actively “on the [rental] market”

g.

Check the reasonableness of the lease terms being offered.

h.

Confirm with the letting agent/auctioneer that there is a reasonable chance of
letting the property.

i.

Consider including the matter in a letter of representation.

c) The Directors’ contention that it is not possible to obtain a reasonable valuation of the
building is highly questionable.
For example, are there any similar buildings in the area that have recently been put on the
market and/or been sold? What do commercial property price indices for the area say is
happening to prices? The Directors are seeking to rent part of the property – how are they
deciding what rent to ask for?
d) If the auditor wishes to place any particular reliance on the forecasted profit before tax s/he
should carry out the following tests:
(1) Meet with management to determine the process for preparing the forecast information
(2) Identify and document internal controls over the process. Consider the role played by the
internal audit department.
(3) Obtain backing schedules for the information, cast and ensure they are numerically
accurate.
(4) Review the accounting policies used and ensure they are consistent with previous
periods.
(5) Discuss the need to produce a full income statement taking account of the proposed tax,
interest and dividend payment.
(6) Produce a letter of engagement
(7) Obtain management representation with regard to the completeness and accuracy of
information and assumptions used. Also this should contain a statement that it is
management's responsibility to produce the information.
59

Solution 8
a) In every audit, the exercise of professional scepticism is paramount. In many audit failures
involving fraud, inadequate professional scepticism is frequently cited as a significant
reason why the material misstatement was not detected by the auditor.
Due professional care requires the auditor to exercise professional scepticism. Professional
scepticism is an attitude that includes a questioning mind and a critical assessment of audit
evidence. Auditing Standards state that an auditor should neither assume that management
is dishonest nor assume unquestioned honesty.
Gathering and objectively evaluating audit evidence requires the auditor to consider the
competency and sufficiency of the evidence. Since evidence is gathered and evaluated
throughout the audit, professional scepticism should be exercised by the auditor throughout
the whole audit process.
The auditor neither assumes that management is dishonest nor assumes unquestioned
honesty. In exercising professional scepticism, the auditor should not be satisfied with less
than persuasive evidence because of a belief that management is honest.
b) Earnings management is when companies 'manage' the presentation of their income by
using aggressive accounting tactics. At one end of the spectrum, it is creative accounting to
present a picture, at the opposite end, it is fraudulent financial reporting. It can be done by
managing accounting assumptions, estimates and provisions or discovering loopholes or
alternative treatments in accounting standards to enable management to present the
position and performance of the company according to the requirements of management.
This presents difficulties to the auditor because of the fact that this can constitute
fraudulent financial reporting, and the auditor has to determine the line between fine tuning
of accounting policy and intentional misapplication of accounting principles, and the
difference between innocent choices and deliberate fraud.
The materiality of such matters can be problematical to auditors. A matter might be
numerically insignificant, but the fact that management are seeking to influence wrongly
the information being presented to users of financial statements might be material by its
nature.
Sometimes, earnings management can result in high management overriding internal
controls to ensure that the results are presented as they wish. This can be difficult for
auditors to detect and would significantly affect the auditors' judgments concerning control
risk (as the control environment would be extremely high risk). This would impact on the
whole of the audit.
The auditor would have to scrutinise journals and year-end adjustments very carefully as
this is where major changes might be effected. The problem for the auditors in these

60

circumstances is that often the only available evidence for such changes might be
management representations, which may be inherently untrustworthy.
Earnings management might take place over a large period of time and appear relatively
innocent - for example, creating legitimate reserves in the good times and releasing them in
the bad times so that the effect of changing times is smoothed out in financial reporting.
However, the auditor can overcome some of these problems by focusing on key risk areas,
such as revenue recognition, accruals and liabilities, provisions and reserve accounting.
c) The consequences of perceived or actual audit failure have long been a key issue faced by
the auditing profession.
The collapse of Enron in the US and of Parmelat in Europe undermined public confidence
in the audit and brought down share values across the world. Together with the demise of a
'Big Five' firm, an event which had often been considered but never thought possible, these
events have been the driving force behind some of the biggest changes to the regulatory
environment in which both companies and auditors operate.
The nature of audit failure
In broad terms if can be argued that there are two types of audit failure:
Actual audit failure
This could be the result of incompetence. For example the audit may not have been carried
out in accordance with auditing standards or perhaps the individuals involved did not have the
required skills and experience to identify the key risk areas which needed to be addressed.
Alternatively, it could be due to negligence. For example the auditor may issue a 'clean' audit
opinion where this is not appropriate as he is keen to retain the client.
Perceived audit failure
In both of the above situations the auditor is directly at fault, although this does not always
have to be the case. Where there are instances of fraud, particularly where management are
involved, it is possible that the auditor may carry out the audit competently and in accordance
with best practice and still conclude that the accounts are true and fair when they are not. In
this situation it is the public's perception of failure which is the issue (sometimes referred to as
the expectation gap). Similar concerns are voiced when company failures are not anticipated
by auditors and shareholders therefore are not warned. The auditor has not failed in his
responsibilities but the audit has failed to deliver the guarantee which the public perhaps
expects.
The issues raised
The specific issues raised by audit failures depend on the individual circumstances. However
typically these have included the following:
61

Ethical issues
In many countries ethical standards are issued and the monitoring of compliance with them is
performed by the profession itself. Audit failures highlight concerns about whether this
method of self-regulation is appropriate or effective.
Questions are also raised about the integrity of the auditors where close relationships have
developed between the audit firm and the client.
In particular the issue of the provision of non-audit services has been a contentious one.
Where the fees for other services vastly outweighs those received for the audit it may be
difficult for the auditor to argue that his view is impartial. This was one of the key issues
raised by the Enron collapse.
Similarly, where senior executives in finance roles were former auditors their judgement is
likely to be perceived to be influenced by this.
Accounting issues
Prescriptive 'rules-based' accounting may lead to companies being able to creatively account
for items in a way that could make financial statements appear better than they might actually
seem to people in practice. For example, companies might offer each other free advertising in
a 'swap' but account for these as sales, making sales appear greater than they are in actual fact.
This does not help the auditor, as this creates a true and fair view according to accounting
rules, but might not appear true and fair in practice to users of accounts.

62

Solution 9
a) and b)
The answers to part A and part B are given for each of the five events, listed sequentially by
event number. The first part of the answer is for a) and the second part answers b)
1) The government’s approval of a plan for the construction of railway would have come to
the auditor’s attention through inquiries of officers and key personnel, review of the
minutes of the meetings of the board of directors and shareholders, and reading of local
newspapers.
The details of the item would have to be disclosed as a separate footnote. If they were not
disclosed as required and assuming that the matter is considered material the auditors
would be obliged to give the detail in their Audit Report. This would constitute a
qualified “except for” report due to inadequate disclosure.
2) It is improbable that the auditor would learn the source of the RWF1,000,000 unless it
was revealed in a discussion with the CEO or his personal accountant or unless the
auditor prepared the CEO’s personal income tax return. In the latter case, the interest
charges would have led the auditor to investigate the use to which the funds were put.
Setting out the loan in the balance sheet as a loan from an officer would be sufficient
disclosure. The source from which the officer obtained the funds would not be disclosed
because it is the officer’s personal business and has no effect upon the corporation’s
financial statements. Furthermore, disclosure of the funds’ source might be construed as
detrimental to the officer.
There is, however, one related point the auditor might wish to consider. Since Mrs Muller
is the beneficiary it would appear that the payment of the premiums by the company
should be considered as part of the CEO’s remuneration package. This has potential
tax consequences for both the CEO and the company. Although it is unlikely that these
would be material to the company in a numeric sense they could impact on the issue of
the disclosure of directors’ remuneration. However, that apart, there should be no impact
on the Audit Report.
3) The additional liability for the ore shipment would have been revealed to the auditor in
scanning January transactions. Routine examination of 2012 transactions and related
documents such as purchase contracts would have caused the auditor to note the time
for subsequent follow up to determine the final liability. In addition the client’s letter of
representation might have mentioned the potential liability.
The item would not require separate disclosure, but would be handled by adjusting the
financial statement amounts for purchases, ending raw materials inventory, and accounts
payable by the amount of the additional charge, RWF362,560. [(0.72 - 0.50)/0.50 = 0.44;
0.44 x 824,000 = RWF362,560]. Assuming the matter to be material, non-adjustment
63

would lead to a qualified Audit Report most likely on the grounds of “except for”
disagreement.
4) The audit procedures that would bring this matter to the attention of the auditors could
include discussions with management, the receivables circularisation, review of post
year-end receipts or reviews of correspondence with customers.
This would appear to be an adjusting post balance sheet event as per IAS 10. The only
question is whether or not the customer was effectively bankrupt at December 31st 2011.
If not, then it is a non-adjusting post balance sheet event. The difference means that in the
former case the figures in the financial statements will require adjustment viz. Dr. Bad
Debts expense Cr. Trade Receivables. In the latter case, the circumstances will be noted
as a non-adjusting post-balance sheet event. In either case, if the adjustment is not made a
qualified Audit Report “except for” disagreement would appear to be appropriate.
5) Through inquiries of management, review of financial statements for January, scanning
of transactions, and observations, the auditor would learn of the reduced sales and of the
strike.
Disclosure would have to be made in the financial statements of these conditions because
such disclosure could be critical to an understanding of the financial statements. Even if
such disclosure was made, depending on the exact circumstances the Audit Report might
have to specify that a fundamental inherent uncertainty existed as to the ability of the
entity to continue as a going concern. This is a modified Audit Report with an emphasis
of matter. Failure to mention the matter in the financial statements would oblige the
auditor to give the information in the audit report and to qualify the Audit Report due to
disagreement. The qualification could be either “except for” or adverse depending on the
auditor’s assessment of the situation.

64

Solution 10
(a)

Two further questions would be:
•

Are you sure these are deliberate and definite breaches of IAS 18 and not merely
interpretations that might yet be sanctioned by your auditors?

•

Do you think these practices are limited to just this quarter or have they been going
on for longer?

(b) It is important to state at the outset that the caller has no legal responsibility to inform
anybody outside the firm about what is going on. Such obligations as exist to inform the
Police or the Revenue Authority do not apply to employees. The caller may feel that
there is some moral obligation to inform the bank. However, such a course of action
should not be undertaken lightly, if at all, and certainly not without first obtaining legal
advice.
The dangers of precipitously informing the bank include the facts that unless the caller
could very clearly demonstrate the correctness of his/her allegations, the caller would
leave him/herself open to charges of, at best, breach of confidentially or at worst
defamation against the senior management. Either of these would probably result in
dismissal.
Also, the caller should be reassured that the figures presented to the bank are the
responsibility of the senior management of the company and that as long as the caller
has disassociated him/herself from those figures it is unlikely that any adverse
consequences will follow for the caller. Indeed the caller’s refusal to sign the bank
commitment letter should act as a “red flag” to the bank. Nevertheless, the caller might
usefully be advised to take legal advice about whether or not continued employment in
such an atmosphere is tenable.
(c)

The incentives to engage in fraudulent activities probably include the following:
•

As a start-up company management most probably faced tremendous obstacles in
getting the business up and running as an established competitor in the market
place. For example, the company may not have been meeting its targets due to the
recession. The company faced a severe shortage of credit at a very difficult time.

•

As a result management needed to show outside lenders that the business was
viable. Their reputation as successful entrepreneurs may also be at stake.

•

In the light of the above making “adjustments” to the financial statements may
have seemed an easy option especially in view of the fact that management
probably did not fully understand accounting conventions anyway and saw their
actions as, at worst, a “victimless crime”.

65

(d)
(i) Management would appear to have violated the “occurrence” assertion in relation to
sales inasmuch as they recorded sales that did not, in fact, occur as having occurred.
Depending on the exact nature of what they were doing they may also have violated the
cut-off assertion if they recorded sales in one period that properly belonged in the
following period.
(ii) Several possible audit procedures could be performed that might detect this fraudulent
activity. The mailing of confirmations to customers associated with the recorded
transactions may identify misstatements in the recorded receivable balances for the
prematurely recorded revenue transactions.
Other audit procedures might include the selection of transactions from the sales journal
(or equivalent accounting record) and the examination of the related documentation for
those transactions, including the customer’s purchase order and shipping
documentation.
Well-designed analytical procedures might also highlight the potential for misstatement,
if the recorded amounts are not consistent with the auditors pre-determined expectations
based on prior year trends or other operating data. Finally, inquiry of key personnel
involved in key personnel involved in accounting, shipping, and sales might reveal
unusual activities.

66



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