PROFESSIONAL LEVEL EXAMINATION lta nts MONDAY DECEMBER 2014 (2½ hours) AUDIT AND ASSURANCE This paper consists of SIX short-form questions (20 marks) and THREE long-form questions (80 marks) Ensure your candidate details are on the front of your answer booklet Answer each question in black ballpoint pen only Co ns u Short-form Questions (1 – 6) Answer the short-form questions in note form only Complete sentences are not required Answers to short-form questions must be submitted in numerical order Long-form Questions (7 – 9) Answers to each long-form question must begin on a new page and must be clearly numbered Use both sides of the paper in your answer booklet The examiner will take account of the way in which answers are presented When the assessment is declared closed, you must stop writing immediately If you continue to write (even completing your candidate details on a continuation booklet), it will be classed as misconduct A IMPORTANT You MUST enter your candidate number in this box GC Question papers contain confidential information and must NOT be removed from the examination hall DO NOT TURN OVER UNTIL YOU ARE INSTRUCTED TO BEGIN WORK Copyright © ICAEW 2014 All rights reserved Page of Your firm’s business plan states “in respect of tenders for new external audit work, we will be aggressive in our prices to win the work, specifically where the prospective client is likely to generate significant additional fees from non-audit services such as tax and advisory work” lta nts Identify the ethical issues presented by this statement (3 marks) Your firm sets its senior employees targets for generating fees from their external audit clients, including fees for non-audit services One of the criteria for progression within the firm is achieving these targets Identify and explain the threat to the objectivity of the senior employees and state, with reasons, whether or not these arrangements are appropriate (3 marks) Your firm is the external auditor of Magpies Ltd (Magpies) for the year ended 30 November 2014 On 15 November 2014, the directors of Magpies engaged a firm of expert property valuers to provide an independent valuation of the company’s freehold land and buildings The directors intend to recognise freehold land and buildings at this valuation in the financial statements for the year ended 30 November 2014 Co ns u State the audit procedures that your firm should plan to undertake to determine whether reliance can be placed on the valuation provided by the firm of expert property valuers (3 marks) During your firm’s external audit of Bluebirds Ltd (Bluebirds), the audit manager informed the firm that he intends to resign and accept an invitation to become the financial controller of Bluebirds The audit manager first discussed the role with Bluebirds’ finance director at the planning meeting for this year’s audit, two months ago Identify and explain the threats to objectivity in respect of this matter and state how your firm should address these issues (3 marks) Your firm is the external auditor of Peacock Energy plc (Peacock) for the year ended 30 November 2014 Peacock is a company engaged in the extraction of oil and gas On 29 September 2014 an oil rig exploded causing extensive damage to the surrounding environment The legal issues are complex and could take many years to resolve Expert lawyers acting for Peacock have advised that the possible range of outcomes in respect of compensation payable by Peacock could be a liability between zero and £30 billion The total assets of Peacock at 30 November 2014 are £291 billion A State, with reasons, the implications for the auditor’s report on Peacock’s financial statements for the year ended 30 November 2014 if the directors of Peacock: adequately disclose; or not disclose GC (i) (ii) this issue in the notes to the financial statements (4 marks) Explain why it is important for an external audit firm to assess the integrity of a prospective client’s management prior to accepting an audit engagement (4 marks) QUESTION COMPLETES THE SHORT-FORM QUESTIONS LONG-FORM QUESTIONS (7 – 9) FOLLOW Copyright © ICAEW 2014 All rights reserved Page of Your firm has recently been appointed as the external auditor of Hyena Ltd (Hyena), an unlisted company, which operates fitness clubs across the UK The outgoing auditors did not seek re-appointment following the conclusion of the previous year’s audit lta nts You are the senior responsible for planning the external audit for the year ended 30 November 2014 and the engagement partner has asked you to consider the following key areas of audit risk: (1) (2) (3) Revenue Payroll Fitness equipment The engagement partner has provided you with the following extracts from the financial statements and additional information to assist with your analytical procedures: Statement of profit or loss for the year ended 30 November Profit before tax 2013 (audited) £’000 75,937 15,522 10,188 11,749 9,049 Co ns u Revenue 2014 (draft) £’000 94,123 Statement of financial position as at 30 November Non-current assets Fitness equipment Additional information to assist with analytical procedures 2014 (draft) 2013 (actual) 150 Payroll Employees’ total gross pay (£’000) Average number of employees in year Company-wide pay rise (effective December 2013) 50,150 2,959 2% 47,225 2,685 - Fitness equipment Loss on sale of fitness equipment Depreciation charge for fitness equipment (1,650) (1,941) (1,890) GC A Number of fitness clubs (all operating for a full year) 135 The engagement partner has also provided you with the following information: Hyena’s fitness clubs are of similar size and layout and are equipped with the latest fitness equipment Revenue grew steadily at approximately 5% pa over the five years ended 30 November 2013 However, the number of fitness clubs remained constant at 135 during this period On December 2013 Hyena opened 15 new fitness clubs Copyright © ICAEW 2014 All rights reserved Page of Customers pay by one of three methods:  on a pay-per-session basis in cash or by debit card at the fitness club reception; by monthly subscription paid by direct debit into Hyena’s head office bank account; or by payment in advance to head office for a discounted annual package The annual package runs for 12 months from the date the package is paid for lta nts   In September 2014, the company launched a new online registration and subscription management system Initially, Hyena suffered operational problems with the system resulting in some monthly subscriptions being paid twice Management is confident that refunds have been made for all monthly subscriptions that were affected Reports by Hyena’s internal audit function highlighted a number of deficiencies in the payroll system and this led to the directors outsourcing the management of the payroll to Zebra Ltd, a payroll service organisation, from June 2014 A follow up report by the internal audit function confirms that these deficiencies have now been addressed Co ns u Hyena replaces the fitness equipment in each fitness club over a five-year period The fitness equipment is imported from manufacturers in the USA who invoice Hyena in US dollars All costs associated with setting up the equipment, including time spent by Hyena’s employees, are capitalised The cost less any estimated residual value is depreciated on a straight-line basis over the estimated useful life of the fitness equipment During a meeting with Hyena’s finance director, she: (i) requested that the engagement partner is appointed as a non-executive director and attends the audit committee’s quarterly meetings so your audit firm can be made aware of any issues promptly; (ii) requested that your firm calculates the amounts to be included in respect of taxation in the financial statements; and (iii) offered members of the audit team a free one-year package to a fitness club of their choice A The proposed fees for audit and non-audit services amount to 1% of the firm’s annual fee income Requirements State the responsibilities of an outgoing firm of external auditors relating to a change of appointment as set out in the ICAEW Code of Ethics Give reasons for each of the responsibilities GC (a) You are not required to refer to the Companies Act 2006 provisions in respect of the auditor who has not sought re-appointment (6 marks) Copyright © ICAEW 2014 All rights reserved Page of Justify why the items listed as (1) to (3) in the scenario have been identified as key areas of audit risk and, for each item, describe the procedures that should be included in the audit plan in order to address those risks lta nts (b) You should present your answer in a two-column format using the headings: (i) (ii) Justification; and Procedures to address each risk Your answer should include reference to the results of your analytical procedures (26 marks) (c) Explain the threats to objectivity of the audit firm arising from the matters listed as (i) to (iii) in the scenario and describe the safeguards, if any, that should be put in place to mitigate those threats (8 marks) GC A Co ns u Total: (40 marks) Copyright © ICAEW 2014 All rights reserved Page of The University of Downton (the University) has recently bought a disused freehold factory adjacent to its campus The University wants to expand and has received planning permission to demolish the factory and construct an engineering workshop and classrooms for teaching purposes lta nts Rob Grantham, the University’s finance director, has prepared cash flow forecasts in respect of the expansion plans for the five years ending 31 December 2019, which are to be submitted to the University’s bank in support of a loan to finance the project The University has requested that your firm examines and provides an assurance report on the cash flow forecasts Rob has provided the following additional information about the project:        Three firms have submitted tenders for the demolition and site clearance work and these are awaiting evaluation by the University Tenders have not yet been invited for the building contract but the build cost has been estimated by the University’s director of estates at £2,500 per square metre Landscaping works are expected to be minimal as the new building will occupy the whole of the site The University currently has no engineering provision, therefore all equipment for the workshops and classrooms will be purchased The whole project will be managed on behalf of the University by Crawley and Co, a firm of quantity surveyors The University is applying for a government grant to assist with the building cost The grant amounts to 40% of the building cost and is payable to the University on completion of the build However, the grant is conditional on the workshop and classrooms being in use by September 2016 To help finance the project the University is planning to sell playing fields, identified by the University’s estates strategy as being surplus to requirements, to a property developer Investment appraisals show that, once completed, the project is expected to generate additional cash inflows from student fees which will be in excess of the additional running costs incurred Co ns u  (i) “We will request from management written confirmation concerning representations made to us in connection with the examination.” “The level of assurance will not be the same as for an external audit.” GC (ii) A Your firm is currently finalising its terms of engagement with the University for the review of the cash flow forecasts Rob has asked for an explanation of the following phrases used in your firm’s draft engagement letter: Copyright © ICAEW 2014 All rights reserved Page of Requirements From the information provided in the scenario, identify the key receipts and payments that you would expect to be included in the cash flow forecasts for the five years ending 31 December 2019 in respect of the expansion plans For each receipt and payment, you should identify the specific matters you would consider when reviewing the reasonableness of the assumptions underlying that receipt or payment (12 marks) (b) Draft a response to Rob which: lta nts (a) lists the general representations that should be obtained from management as part of the assurance work on the cash flow forecasts and explains why such representations are required; and (ii) explains how and why the level of assurance provided by the report on the cash flow forecasts differs from the level of assurance provided by an auditor’s report on annual financial statements (8 marks) Total: (20 marks) GC A Co ns u (i) Copyright © ICAEW 2014 All rights reserved Page of lta nts You are responsible for the external audit of Speedy Shifters plc (Speedy), a haulage contractor operating from a head office and 65 depots throughout the UK During the external audit for the year ended 30 November 2014, you identified the following significant internal control deficiencies: (1) Speedy does not keep a list of approved suppliers from which to purchase replacement parts for its fleet of trucks and vans (2) Speedy does not have a business continuity plan to enable it to recover its management information and finance systems quickly in the event of a systems failure (3) Drivers at some depots are regularly scheduled to exceed the legal limit for driving hours, because of a shortage of drivers (4) The audit committee has not complied with its own terms of reference which require it to:   approve annual plans of work to be undertaken by the internal audit function; and monitor the effectiveness of the internal audit function through the use of performance measures Requirement Co ns u 9a Draft points for inclusion in your firm’s report to those charged with governance and management at Speedy For each internal control deficiency identified above, you should outline the possible consequence(s) of the deficiency and provide recommendation(s) to address each deficiency You should present your answer in a two-column format using the headings: Consequences; and Recommendations (14 marks) GC A (i) (ii) Copyright © ICAEW 2014 All rights reserved Page of Your firm is the external auditor of Letterbox Group Ltd (Letterbox) for the year ended 30 November 2014 Letterbox is an international trading group with a head office in London On November 2014, Letterbox acquired 100% of the ordinary share capital of Pampas Holdings (Pampas), a company operating in South America, which is audited by Santos, another firm of external auditors lta nts 9b Your enquiries have found that Santos will not grant your firm access to its external audit working papers nor provide any other information in respect of their audit of Pampas The directors of Letterbox have stated that your firm will not be given access to the accounting records of Pampas and have refused to disclose further information about the activities of Pampas Letterbox’s draft financial statements show consolidated profit before tax for the year ended 30 November 2014 of £19.2 million Included within this figure is profit before tax of £2.4 million in respect of one month’s trading for Pampas Requirements Discuss the implications of the above for the auditor’s report on the consolidated financial statements of Letterbox for the year ended 30 November 2014 (ii) Discuss whether or not it is appropriate for your firm to continue to act as Letterbox’s external auditor (6 marks) Total: (20 marks) GC A Co ns u (i) Copyright © ICAEW 2014 All rights reserved Page of Audit and Assurance - Professional Level – December 2014 MARK PLAN AND EXAMINER’S COMMENTARY lta nts The marking plan set out below was that used to mark this question Markers were encouraged to use discretion and to award partial marks where a point was either not explained fully or made by implication More marks were available than could be awarded for each requirement This allowed credit to be given for a variety of valid points which were made by candidates General comments The pass rate was comparable with recent sittings with the short-form questions (SFQ) scoring the highest average mark Candidates continue to demonstrate strengths in the areas of ethics, audit reporting and the identification of key audit risks However, many candidates failed to use detailed analytical procedures to justify the audit risks in answers to question 7(b) and lost marks It was pleasing to note a significant improvement in the standard of answers to the SFQs compared to recent sessions with an increase in the number of candidates presenting their answers in note form However, many candidates continue to waste time writing lengthy answers to the SFQs thereby leaving themselves short of time for the long-form questions Consequently, there was an increase in the number of candidates presenting scripts that displayed time pressure at the end of the paper Short Form Questions (SFQ) Total Marks: 20 Co ns u SFQ1 Identify ethical issues  Statement represents “lowballing”  Not prohibited by Code of Ethics  ES4 states that audit fee must not be influenced by the actual or potential provision of other services  Audit quality may be compromised to stay within budget  Threat to professional competence and due care  Risk of audit failure/inappropriate opinion  If non-audit services obtained, objectivity may be impaired leading to: o self-interest threat o self-review threat o management threat o advocacy threat A Most candidates appreciated that the firm's policy represented lowballing and that such a policy had associated risks in respect of audit quality However, many candidates failed to identify that this represented a threat to the fundamental principle of professional competence and due care Weaker candidates wasted time writing at length about fee dependency and the related thresholds A minority of candidates incorrectly stated that the policy related to charging fees on a contingent basis These candidates did not appreciate that lowballing relates to setting a fee below the market rate whereas a contingent fee relates to an arrangement under which a fee is calculated on a pre-determined basis relating to the outcome or result of a transaction or other event, or the result of work performed Furthermore, contingent fees are not permitted in respect of assurance work Total possible marks ½ mark per point Maximum full marks GC SFQ2 5½ Setting targets to progress within a firm Threat  Self-interest threat  Incentive for progression within the firm Explanation  Senior employees may push services not required by the client/exaggerate the benefits of nonaudit services  Audit quality may suffer/errors may be overlooked/senior employees may be reluctant to raise contentious issues Copyright © ICAEW 2014 All rights reserved Page of 17 Audit & Assurance - Professional Level – September 2014 - inspect ageing of WIP to identify any unbilled / irrecoverable WIP lta nts -for delayed or unapproved commissions obtain direct confirmation from the customer that the commission will be accepted Quality issues with purchases from new suppliers and fluctuating metal prices could lead to cost overruns on fixed-price commissions resulting in WIP having a net realisable value lower than cost Ascertain whether any WIP at the year end includes metals purchased from suppliers where quality issues have arisen The manual transfer of material and payroll costs into the job costing system may result in errors and the increase in the volume of commissions may have led to a backlog in recording material and labour costs Evaluate and test the controls exercised over - the recording of purchases and payroll costs and - the transfer of purchase and payroll costs to the job costing system For a sample of commissions included in WIP at the year end: - vouch entries for labour to payroll/ timesheets - vouch entries for metals/materials to suppliers’ invoices Co ns u Compare fixed price to total costs to date/estimated total costs to identify potential loss making contracts The 20% addition to cover overheads may not be appropriate as the estimate requires the exercise of judgement Ascertain the basis for the 20% addition to direct costs to cover overheads and consider its reasonableness Ensure it is: - based on production/attributable overheads only and - consistent with prior years Re-perform the overhead calculation Some metals are invoiced in suppliers’ local currencies and therefore translation errors may arise (alternatively awarded under trade payables) For a sample of invoices in foreign currencies check the exchange rate to a reliable external source and recalculate the translation Trade receivables Justification Trade receivables days have increased from 26.8 in 2013 to 39.8 in 2014, which exceeds the 30-day credit terms suggesting overstatement Procedures Perform direct confirmation of trade receivables balances and review the aged debt analysis for overdue receivables A Failure to obtain written approval from customers may mean there is no contractual basis on which to commence proceedings for recovery of amounts incurred GC Quality issues with new suppliers have led to an increase in complaints from customers who may withhold payment increasing the risk of the allowance against trade receivables being understated Copyright © ICAEW 2014 All rights reserved Inspect post year-end cash receipts for evidence of recoverability of year-end trade receivable balances Inspect post year-end credit notes for evidence of amounts not recoverable at the year end Review correspondence with customers/legal advisors for evidence of any issues over quality or non-payment Ascertain whether overdue or disputed balances have a signed customer approval and whether the related commission includes metals purchased from suppliers with quality issues Ascertain the basis of the allowance against trade receivables and consider its reasonableness Recalculate the year-end allowance Page of 14 Audit & Assurance - Professional Level – September 2014 Procedures Inspect contracts with new suppliers to ascertain whether there are shorter credit terms in respect of new suppliers lta nts Trade payables Justification Trade payables days have fallen from 39.9 in 2013 to 32.2 in 2014 suggesting understatement For a sample of goods received records in respect of materials received before the year end, trace to invoice to ascertain if the amount should be included in trade payables at the year end For payments made in the period after the year end trace to invoice and ascertain if amounts should be included in trade payables at the year end Where available, request supplier statements and perform a reconciliation with the amounts included in the year-end trade payables ledger Where supplier statements are not available, perform direct confirmation of trade payable balances and investigate any differences Amounts due to suppliers in respect of metals where quality is in dispute may have been omitted from the trade payables ledger Review correspondence with suppliers to ascertain if there are any amounts in dispute, due to quality issues, that are not included in the payables ledger Discuss with management the reasons for not including disputed amounts in year-end trade payables Co ns u Supplier statements are not reconciled to the trade payables ledger which may result in errors or omissions in trade payables not being identified General (awarded in any section but once only) Review the prior year auditor’s working papers for evidence regarding opening balances Evaluate whether procedures performed in current year provide evidence regarding opening balances Answers to this part of the question were generally good It was pleasing to note that the majority of candidates attempted to make use of the financial information provided in the scenario, which has been identified in previous examiner’s reports as a deficiency in answers It was also pleasing to note that many candidates cited procedures to address audit risks that were adequately explained and relevant to the justification of the audit risk Barden is a new audit client and it may be difficult to obtain assurance over opening balances A number of candidates incorrectly digressed into consideration of risks around going concern, citing cash flow issues and providing a number of associated audit procedures Going concern was not identified as a key risk for consideration in this question and consequently there were no marks available for this Most candidates overlooked that the firm had recently been appointed as external auditor and that obtaining assurance over opening balances in each of the key areas of risk may be an issue A Work in progress Most candidates were able to provide some reasons to justify why work in progress was an area of audit risk and provided relevant audit procedures GC The most commonly overlooked justification points were that the increase in the volume of commissions may lead to a backlog in recording costs and cut-off issues and that fixed price commissions may result in cost overruns resulting in WIP with an NRV below cost Whilst many candidates correctly identified that the basis for covering overheads may be inappropriate, few candidates were able to describe audit procedures to establish whether the basis of the calculation was appropriate For example, ascertaining whether the calculation was based only on production overheads or considering the consistency of the basis with prior years was rarely cited by candidates Other commonly overlooked audit procedures were vouching year-end work in progress balances to customer approvals for commissions and ascertaining the reasons for any commissions in progress at the year-end which did not have customer approval Many candidates also failed to consider the direction of testing in tests of detail, for example, tracing amounts from payroll records and invoices to the job cost system instead of vouching items included in the yearend WIP balance to payroll records and invoices which is more appropriate given the identified risk of overstatement A number of candidates incorrectly digressed into providing audit procedures in respect of revenue recognition Copyright © ICAEW 2014 All rights reserved Page of 14 Audit & Assurance - Professional Level – September 2014 lta nts Trade receivables There were a number of good answers to this part of the question The justification point most commonly overlooked was that failure to obtain written approval from customers may mean that there is no contractual basis on which to commence proceedings for the recovery of debts Consequently, the associated audit procedures for this point were not provided Other audit procedures commonly overlooked were ascertaining whether disputed balances had a signed customer approval and whether these commissions included metals purchased from suppliers with quality issues Trade payables There were a number of good answers to this part of the question with many candidates correctly identifying most of the justification points Audit procedures were less well answered with commonly overlooked procedures being inspection of contracts with new suppliers to ascertain whether credit terms are shorter and discussing with management the reasons for not including disputed amounts in year-end trade payables A number of candidates correctly identified that the fall in trade payables days may be an indication of cut-off issues However, very few of these candidates were able to go on and cite procedures for testing cut-off, such as examination of payments made after the year-end or goods received records just before the year end Typically, candidates cited “perform cut-off tests” for which only a ½ mark was available Total possible marks Maximum full marks 53 23 Co ns u Part (c) For each of the two internal control deficiencies identified by Howard Ng, outline the possible consequence(s) of the deficiency and provide recommendation(s) to remedy each deficiency Supplier statements are not reconciled with the trade payables ledger Consequences Suppliers may be under paid or not paid on time which could result in: - loss of prompt payment discounts, interest charges or penalties for late payment - damage to supplier relationships, Barden’s account being stopped or tighter credit terms - delays in receiving materials required This may cause delays in starting work on commissions and an inability to complete customer orders on time, resulting in loss of reputation or cancelled orders Recommendations Reconciliations between supplier statements and the trade payables ledger should be undertaken on a regular basis by employees independent of the ordering and recording functions Suppliers may be overpaid in error Errors and fraud are not likely to be detected without supplier statement reconciliations The new procedures should be communicated to employees who should be trained in the new procedures Reconciling items should be investigated and explained A Reconciliations should be reviewed by a manager and signed as evidence of having been reviewed All of the above may result in an adverse impact on Barden’s cash flow and profits GC Metals were ordered and work started on commissions before written approval was obtained from the customer The customer may cancel or fail to approve a commission or may request a design change before approval (1) (2) (3) Any specialist metals already ordered may not (4) have a use in another commission and where work has been started metals and labour costs incurred may be wasted (5) Copyright © ICAEW 2014 All rights reserved The policy of not ordering metals before customer approval should be re-communicated to employees who should be re-trained in the policy A standard document/quote form should be signed by each customer who should be made aware of the policy in Barden’s terms of trading Page of 14 Audit & Assurance - Professional Level – September 2014 (11) (12) Details of commissions should not be passed to the production team until approval has been received from the customer This may be achieved by: – implementation of IT software that prevents ordering of materials without a job number which is only raised after customer approval is obtained, or - authorisation by a manager to purchase materials and commence work lta nts Where inappropriate work has been started this (6) could result in delays to completing commissions and a loss of reputation and customer goodwill (7) Without written customer approval there is no contractual basis on which to commence proceedings for recovery of any costs incurred (8) All of the above may result in an adverse impact on cash flow and profits (9) (10) Purchase orders should be matched to signed customer approvals before an order is sent to the supplier and the purchase order should be signed as evidence of having been matched Co ns u High value orders should be approved by a senior manager or director after checking the order to the customer approval General (awarded in either section but once Recommendations only) Monitoring of compliance with procedures and disciplinary procedures for non-compliance There were a number of very good answers to this part of the question with the majority of candidates identifying several of the points available Answers in respect of both the consequences and recommendations arising from the failure to reconcile supplier statements with the trade payables ledger were generally better than those in respect of work starting before written approval was obtained from the customer Weaker candidates failed to describe their recommendations and consequently lost marks For example, many stated only the converse of the weakness, ie “perform supplier statement reconciliations”, without going on to recommend the frequency with which the procedure should be performed or that there should be a management review evidenced by signature Candidates commonly overlooked the fact that such reconciliations should be performed by employees independent of the ordering and recording functions Some candidates strayed beyond the scope of the given control deficiency and recommended a number of improvements to the purchasing system, such as greater controls over new suppliers including the introduction of approved supplier lists These points did not score any marks GC A In respect of ordering materials before written approval is obtained from the customer, many candidates simply restated the existing company policy of requiring the customer to provide written approval before the design is passed to production Since this company policy had clearly failed, marks were only awarded where candidates were able to identify procedures to remedy the situation, such as implementing a software system that would prevent ordering of materials on unapproved commissions or authorisation of purchase orders by management Total possible marks 30½ Maximum full marks 13 Copyright © ICAEW 2014 All rights reserved Page 10 of 14 Audit & Assurance - Professional Level – September 2014 Question Total Marks: 23 lta nts General comments This was the least well answered of the long-form questions However, it was pleasing to note that many candidates did make a reasonable attempt at parts (a) and (b) which were presented in a different style to those questions previously used to examine engagement acceptance Answers to part (c) were generally poor which is disappointing given this is an area in which candidates should be well rehearsed Part (a) Explain the relevance of each item of information to your firm’s decision on whether to accept appointment as Pytch’s external auditor for the year ending 31 December 2014 Research and development (R&D) involves estimates which are complex and subjective This increases inherent risk including the risk of inappropriate capitalisation of R&D expenditure The firm must have employees available with the relevant audit and industry experience and may need to consider the use of an auditor’s expert The high failure rate of R&D projects may result in Pytch failing to write off nonrecoverable development costs and may give rise to cash flow issues and doubts over Pytch’s ability to continue as a going concern Co ns u The previous auditor qualified the prior year audit opinion due to a limitation on scope This may indicate there will be insufficient appropriate evidence over opening balances or for transactions and account balances in the year to 31 December 2014 This is more likely to be the case as Pytch has not yet replaced its project costing system The firm should not accept an audit engagement where there is a significant limitation on scope The failure of internal controls identified by the previous auditor indicates a weak control environment or a poor management attitude to internal controls and an increase in control risk The firm may need to undertake a substantive approach with no reliance on internal controls The resignation of the previous auditor may indicate issues such as disagreements with Pytch’s directors, concerns over management integrity, intimidation, illegal acts or unpaid fees The withdrawal of the new hair colourant could result in legal claims from consumers or Perfect Ltd There may also be fines arising if any laws or industry regulations were breached The firm may need to audit a significant uncertainty resulting in higher inherent risk and large claims or fines may give rise to doubts over the going concern status The adverse press may result in loss of business or confidence in Pytch’s products which could also give rise to doubts over the going concern status The reports of insufficient testing may raise concerns about management’s integrity The firm may not wish to be associated with Pytch due to the possible damage to the firm’s own reputation GC A Aubrey Swanson’s retirement means that Pytch will lose its founder/leader and key finance provider which may result in a loss of strategic direction Funding issues may arise if finance is not forthcoming from the new shareholders and it is unclear if the remaining board members have the skills to direct the company This gives rise to further risk over the going concern status New directors and management team, who would be unknown to the firm, may need to be brought in and the firm may not wish to be associated with them The sale of Aubery’s shares to Club Ltd and the remaining directors of Pytch gives rise to a risk of management bias Aubery will have an incentive to inflate profits pending the sale A potential conflict of interest also arises between the parties involved and the possible reliance by the future investors on the firm’s audit opinion increases the engagement risk Answers to this part of the question were of a mixed standard Those candidates who systematically worked through each paragraph and explained the relevance of each item of information to the firm's decision whether to accept appointment as auditor scored higher marks A number of candidates reiterated the information given in the scenario but failed to earn marks because they were unable to provide a plausible explanation as to its relevance with many candidates often stating that the information gave rise to “high risk” For example, statements such as "research and development is high risk" were common To earn marks elaboration was required, such as the need to exercise judgement in deciding whether to capitalise or expense research and development costs Although the majority of candidates identified the need for the auditor to have expertise in the industry sector, surprisingly few candidates considered the use of an auditor's expert Other points which were commonly overlooked were those in respect of not accepting an engagement where there was a known significant limitation on scope, the loss of strategic direction following the retirement of the managing director and the higher engagement risk associated with reliance on the financial statements by potential investors Weaker candidates wasted time writing about procedures to be performed and wrote at length about procedures such as professional clearance and client background checks for which no marks were awarded Total possible marks 31 Maximum full marks 13 Copyright © ICAEW 2014 All rights reserved Page 11 of 14 Audit & Assurance - Professional Level – September 2014 Co ns u lta nts Part (b) Prepare a list of questions your firm should ask the directors of Pytch before making a decision to accept appointment as external auditor for the year ending 31 December 2014 Are you willing for the firm to act for both Pytch and Club in light of the potential conflict of interest? Why did the previous auditor resign? Are the directors willing to grant permission for the firm to contact the previous auditor? Have any adjustments or fixes been made to the project costing system to address the deficiencies in internal controls identified in the prior year? What are the potential implications, eg legal claims, of the hair colourant withdrawal for Pytch? What has been the impact of the adverse press on the business? How does management intend to deal with hair colourant issues/withdrawal? What future sources of finance does Pytch have available after Aubery’s retirement? What is the company’s intention regarding the future structure of the board and senior management? How far have the negotiations progressed for the sale of Aubery’s shares to Club? This part of the question was very well answered with many candidates scoring full marks The points most commonly identified were those in respect of the previous auditor, the deficiencies in the costing system and the effects of the adverse publicity The points most commonly overlooked were those in relation to the succession arrangements and the future funding of the business A small minority of candidates failed to score well because they did not tailor their answers to the circumstances of the scenario Total possible marks 10 Maximum full marks Part (c) Assuming your firm accepts appointment as external auditor of Pytch, identify and explain the principal threats to your firm’s independence and objectivity which may arise if it also accepts the additional non-audit engagements requested by the directors Advise on replacement of Pytch’s project costing system The results of the new project costing system will be reflected in amounts included in Pytch’s future financial statements giving rise to a self-review threat The firm may need to place significant reliance on the project costing system in future audits The audit team may rely too heavily on the work performed by the firm during its advice on the project costing system or may be reluctant to point out any deficiencies identified in the system The firm may be expected to make management decisions giving rise to a management threat If management expects the firm to design, provide or implement a system or select an off-the-shelf package, the firm’s views may become too closely aligned with those of management A Advise on an appropriate valuation of the shares to be sold to the other directors and Club Ltd A conflict of interest will arise between the firm and Aubrey and the other directors/Club Ltd as Aubrey will want to maximise the share value whilst the other directors/Club Ltd will want to the minimise the share value The firm may not be able to act in the best interests of all parties A self-interest threat may arise as the firm would not wish to act against the interests of the other directors/Club Ltd for fear of losing future audit work A self–review threat arises as the shares purchased by Club Ltd may be material to Club Ltd’s financial statements The firm may not sufficiently scrutinise the valuation of Club’s investment during the subsequent audit of Club Ltd’s financial statements and it may be reluctant to highlight any errors in the valuation GC Answers to this part of the question were disappointing, mainly due to poor performance in respect to the threats associated with the advice on the share valuation The majority of candidates appreciated that the advice on the replacement of the costing system posed self-review and management threats and were able to provide plausible explanations of these threats In relation to the share valuation, many candidates identified self-interest and self-review threats but were unable to provide plausible explanations In respect of the self-interest threat, many candidates wasted time writing about fee dependency failing to appreciate that these engagements were one-off and would not impact on regular fee income In respect of the selfreview threat, the majority failed to appreciate that this would arise in respect of Club's financial statements after the acquisition had taken place and not in the financial statements of Pytch A number of candidates incorrectly identified an advocacy threat in relation to the share valuation A significant minority of candidates ignored the instruction, in the requirement, not to list safeguards and wasted time describing the safeguards to be applied in each of the two non-audit engagements Total possible marks 11ẵ Maximum full marks Copyright â ICAEW 2014 All rights reserved Page 12 of 14 Audit & Assurance - Professional Level – September 2014 Question Total Marks: 17 lta nts General comments This was the best answered long-form question with the majority of candidates demonstrating good knowledge of audit reports A significant minority of candidates’ answers were very brief suggesting poor time management Part (ai) Identify and explain the factors which may give rise to a going concern risk and describe the procedures that should be included in the audit plan to address the risk Factors Footnote has lost its entire inventory and may not have adequate insurance or funds to replenish it The directors have decided to cancel and refund all outstanding orders and the company may not have sufficient cash resources to cover refunds, resulting in cash flow issues The cancellations may also result in an adverse impact on the company’s reputation and a loss of future business The company’s products are handcrafted by overseas artists meaning Footnote is unlikely to be able to replenish inventory quickly which will impair its ability to resume trading A Co ns u Procedures Ascertain from management its plans to obtain funding, replenish inventory and restart trading Evaluate the directors’ assessment of Footnote’s going concern status Review the company’s revised cash flow forecast, for a period of at least 12 months from the reporting date/date of approval of the financial statements, to ascertain the impact of replacing inventory and issuing refunds In particular: - consider the reasonableness of the assumptions made; - perform sensitivity analysis; and - ascertain if Footnote can meet its debts as they fall due Ascertain the extent of outstanding orders which require a refund Review the insurance policy/correspondence to ascertain the extent of insurance cover and the likelihood of Footnote receiving an insurance pay-out Review post year-end cash receipts for any monies received from the insurance claim Inspect the minutes of board meetings for evidence of any post year-end developments/ management plans Review the financial statements for appropriate disclosures regarding the going concern status of Footnote Obtain written representation from management as to the feasibility of its future plans and whether Footnote is able to continue as a going concern This part of the question was generally well answered as the majority of candidates appreciated that the destruction of inventory would hinder the company's ability to generate revenue and that the refunds would have an adverse impact on cash flow In addition, most candidates identified that the uncertainty over the insurance cover would hinder the company's ability to resume trading However, only a minority of candidates identified the constraints in respect of the overseas supply chain The majority of candidates identified the need to examine cash flow forecasts and the underlying assumptions but few cited procedures to consider the potential size of refunds that would need to be paid A number of candidates wasted time listing procedures without tailoring them to the circumstances of the scenario, for example, examination of covenants within loan agreements Total possible marks 15 Maximum full marks GC Part (aii) Assuming your firm considers that Footnote is not a going concern, state whether you would modify the audit opinion if the financial statements are prepared: (1) on a break-up basis with adequate disclosure included in the notes to the financial statements; or (2) on a going concern basis Give reasons for each conclusion and describe the modifications, if any, to the audit report (1) Financial statements prepared on a break-up basis with adequate disclosure The audit opinion will be unmodified as there is no material misstatement (disagreement) and no limitation on scope The audit report will be modified with an emphasis of matter paragraph immediately after the opinion paragraph This will draw users' attention to the notes explaining that the financial statements are prepared on a break-up basis as it is fundamental to users’ understanding of the financial statements The audit report will include a statement that the opinion is not modified in respect of this matter Copyright © ICAEW 2014 All rights reserved Page 13 of 14 Audit & Assurance - Professional Level – September 2014 Co ns u lta nts (2) Financial statements prepared on a going concern basis The audit opinion will be modified due to misstatement (disagreement) The matter is material and pervasive as it is not confined to specific elements of the financial statements An adverse opinion will be issued as required by ISA 570 Going Concern A paragraph describing the matter giving rise to the modification will be included immediately before the opinion paragraph and headed "basis for adverse opinion” Candidates who had carefully read and understood the requirement generally did very well in this part of the question However, A small minority of candidates ignored the statement in the requirement "your firm considers that Footnote is not a going concern" and wasted time writing about audit opinions applicable to uncertainty about the going concern Financial statements prepared on a break-up basis with adequate disclosure The majority of candidates correctly identified that the opinion should be unmodified However, a small minority failed to consider the use of an emphasis of matter paragraph to direct the users' attention to the note in the financial statements Financial statements prepared on going concern basis The majority of candidates correctly identified that the circumstances warranted an adverse opinion Weaker candidates hedged their opinions, thereby demonstrating that they were unaware of the requirement in paragraph 21 of ISA 570 Going Concern to provide an adverse opinion when financial statements have been prepared on an inappropriate basis Total possible marks 9½ Maximum full marks GC A Part (b) State whether you would modify the audit opinion Give reasons for your conclusion and describe the modifications, if any, to the audit report The audit opinion will be modified due to overstatement of inventory The error is 2.4% of total assets and 13.9% of profit before tax and therefore material The matter is not pervasive as the material misstatement is confined to specific areas of the financial statements (inventory) therefore a qualified (‘except for’) opinion will be issued The audit report will include a paragraph, describing the matter giving rise to the modification, immediately before the opinion paragraph and headed "basis for qualified opinion” This part of the question was very well answered with the majority of candidates scoring full marks A minority of candidates confused the purpose of an emphasis of matter paragraph (ie to draw users' attention to a note in the financial statements) with the purpose of a basis for qualified opinion paragraph (ie an explanation for the modified opinion) Total possible marks 5½ Maximum full marks Copyright © ICAEW 2014 All rights reserved Page 14 of 14 PROFESSIONAL LEVEL AND STAGE EXAMINATION lta nts MONDAY JUNE 2014 (2½ hours) AUDIT AND ASSURANCE This paper consists of SIX short-form questions (20 marks) and THREE written test questions (80 marks) Ensure your candidate details are on the front of your answer booklet Answer each question in black ball point pen only Co ns u Short-form Questions (1 – 6) Answer the short-form questions in note form only Complete sentences are not required Answers to each short-form question must begin on a new page and must be submitted in numerical order Written Test Questions (7 – 9) Answers to each written test question must begin on a new page and must be clearly numbered Use both sides of the paper in your answer booklet The examiner will take account of the way in which answers are presented A IMPORTANT GC Question papers contain confidential information and must NOT be removed from the examination hall You MUST enter your candidate number in this box DO NOT TURN OVER UNTIL YOU ARE INSTRUCTED TO BEGIN WORK Copyright © ICAEW 2014 All rights reserved Page of Grover Ltd (Grover) has headquarters in London and is an external audit client of Tyler LLP (Tyler), an ICAEW firm of chartered accountants Tyler has received a telephone call from the City of London Police requesting that the firm discloses information about transactions undertaken by Grover in order to assist the Police with their enquiries State, with reasons, the actions to be taken by Tyler lta nts (4 marks) Your firm is the external auditor of Lyndon Ltd (Lyndon) which operates a Formula motor racing team During the year ended 31 March 2014 Lyndon became wholly-owned by Ulysses, an organisation based in Thailand where your firm has an office Lyndon is dependent on Ulysses to provide finance in order that Lyndon may continue operating The directors of Lyndon have provided your firm with an email, sent to the directors by Ulysses, confirming that Ulysses will continue to provide funding for at least twelve months from the reporting date No audit work has been performed on the email confirmation The directors of Lyndon have prepared the financial statements for the year ended 31 March 2014 on the going concern basis Co ns u Comment on the reliability of the email confirmation as audit evidence and outline any audit work that should be undertaken in respect of the email confirmation (4 marks) Explain why it is necessary for the external auditors of audited entities to have an understanding of the laws and regulations which impact on their clients’ operations (2 marks) Garfield Educational (Garfield) is a-not-for-profit entity whose objective is to support 18 to 21 year old students in full-time education in London with their academic studies Garfield awards non-repayable grants to students for items such as personal computers and books or for expenses such as travelling to their place of study Students apply to Garfield for support and, if their application is successful, the grant is paid by electronic bank transfer into the students’ bank accounts State FOUR internal control procedures that should be exercised over the awarding and payment of grants to students (4 marks) The directors of Madison Ltd (Madison) have prepared an insurance claim for loss of profits following a fire at one of Madison’s factories The directors have engaged your firm to review the claim and provide an assurance report, as the directors believe that this will accelerate the processing of the claim A Identify the points, specific to the review of the claim, that your firm should include in its engagement letter and explain why their inclusion is necessary (4 marks) State the purpose of including an emphasis of matter paragraph in an audit report and give one example of a circumstance when an emphasis of matter paragraph may be necessary (2 marks) QUESTION COMPLETES THE SHORT-FORM QUESTIONS GC WRITTEN TEST QUESTIONS (7 – 9) FOLLOW Copyright © ICAEW 2014 All rights reserved Page of Described below are situations which have arisen in respect of the provision of services by your firm to five unrelated external audit clients Clement Ltd (Clement) lta nts Henry Portland, a former audit manager, left your firm on 31 March 2014 On 31 May 2014 he unexpectedly joined Clement as its finance director Henry was the manager responsible for the external audit of Clement for the three years ended 30 June 2013 Ewart Ltd (Ewart) Lloyd North, a partner, informed your firm on 31 May 2014 that he had accepted an invitation to join Ewart as a non-executive director Lloyd has acted as the engagement quality control reviewer for Ewart for the two years ended 30 June 2013 Grafton Ltd (Grafton) Co ns u A fee of £25,000 for a one-off assurance engagement requested by the directors of Grafton to support an application for loan finance remains unpaid Payment was due on 31 December 2013 The directors refuse to pay the fee because the loan application was unsuccessful The engagement partner is meeting the directors to discuss the outstanding fee on 16 June 2014 Planning work on the external audit of the financial statements for the year ending 30 June 2014 is in progress Ramsay Ltd (Ramsay) Benjamin Bute is the audit partner responsible for the external audit of Ramsay In accordance with your firm’s policies, Benjamin is due to be rotated off the audit team as he has been the audit partner for ten years However, the finance director of Ramsay has requested that Benjamin continues as the audit partner as he believes that this will help the audit run smoothly Winston plc (Winston) A The audit committee of Winston, a listed company, is impressed by your firm’s external audit work and has invited your firm to tender for the internal audit function The combined fee for both the external and internal audit work will be less than 5% of your firm’s total expected fee income Requirements Explain why objectivity and independence are important principles in the context of an external audit engagement (3 marks) GC (a) (b) Identify and explain the threats to your firm’s objectivity presented by each of the situations above and state the steps your firm should take to address those threats (14 marks) Copyright © ICAEW 2014 All rights reserved (17 marks) Page of Corazon Ltd (Corazon) is a retailer of photographic equipment operating from 65 stores throughout the UK Your firm has recently been appointed as external auditor of Corazon for the year ending 30 June 2014 following the resignation of the previous auditor The directors approached your firm to act as auditor because of its reputation in providing professional services to the retail sector lta nts You are the audit senior and the engagement partner has asked you to consider the following key areas of audit risk: (1) (2) (3) Going concern Inventory Provision for redundancy costs The engagement partner has provided you with the following extracts from the financial statements: Statement of profit or loss for the year ending 30 June Loss before tax 2013 (audited) £’000 102,998 (48,608) 54,390 (14,100) (1,923) 2014 (estimated) £’000 2013 (audited) £’000 12,300 8,319 12,000 5,749 16,000 3,049 7,900 9,700 4,000 2,400 4,140 2,206 4,000 - Co ns u Revenue Cost of sales Gross profit 2014 (estimated) £’000 90,100 (52,500) 37,600 Statement of financial position as at 30 June Current assets Inventory Non-current liabilities Bank loan Directors’ loans A Current liabilities Trade payables Overdraft (facility £10 million) Bank loan Provision for redundancy costs GC In addition, the engagement partner has provided you with the following information: Recent trading conditions have been difficult for Corazon, because the demand for its cheaper cameras has collapsed as most mobile phones now incorporate a high quality camera In addition, an earthquake in China disrupted Corazon’s supply chains early in 2014 and the company sourced inferior quality cameras from elsewhere, which were not popular with customers All purchases are made on 30-day credit terms and are invoiced in the supplier’s local currency Corazon’s website, which has e-commerce features such as online ordering and payment facilities, experienced technical faults resulting in orders being paid for but customers not receiving their orders or receiving duplicate orders Following media criticism, the website was closed on 25 April 2014 until further notice Copyright © ICAEW 2014 All rights reserved Page of lta nts On 30 April 2014, the directors announced a reorganisation involving the closure of 40 unprofitable stores over the next year and a re-launch of the website once improvements are finalised Approximately half of the workforce will be made redundant over the next year through a voluntary redundancy programme Employees who volunteer for redundancy will be offered an enhanced package with terms in excess of the statutory minimum entitlement The directors requested that applications for voluntary redundancy were made by 31 May 2014 The company has standard operating procedures in every store including electronic point of sales (EPOS) systems and maintains a perpetual inventory system, which records the quantities held and the cost price of inventory Quantities on the perpetual inventory system are updated from goods received records, the EPOS systems, the company website and the results of inventory counts The cost price of the inventory is updated from purchase invoices The company carries out inventory counts in the middle of each month at all of its stores During each inventory count, all high value items and 5% of the remaining items are counted The next inventory count is scheduled for 12 June 2014 Co ns u At each month end, the inventory system generates an inventory valuation listing and an aged inventory report The valuation listing includes the cost and quantity on hand for each inventory item The aged report details the length of time each item has been in the store The valuation listing at 30 June 2014 will be used as the basis for the inventory value in the financial statements as no count takes place at the year end The overdraft facility is due for review on 31 August 2014 and the bank has requested audited financial statements by that date together with profit and cash flow forecasts for the two years ending 30 June 2016 The bank loan is repayable in quarterly instalments of £1 million Requirements (a) Identify the matters that should have been considered by your firm before deciding to accept appointment as Corazon’s external auditor (6 marks) (b) Justify why the items listed as (1) to (3) in the scenario have been identified as key areas of audit risk and, for each item, describe the procedures that should be included in the audit plan in order to address those risks A You should present your answer in a two-column format using the headings: (i) Justification; and (ii) Procedures to address each risk (29 marks) GC (c) Identify the parties to whom your firm may be liable for damages if an inappropriate audit opinion is provided on the audited financial statements of Corazon and describe the methods available to your firm to limit its liability to such parties (5 marks) Copyright © ICAEW 2014 All rights reserved (40 marks) Page of lta nts 9a Your firm has recently been appointed as the external auditor of Mansard plc (Mansard), a listed company, which sells pharmaceutical products The company operates from a head office in London and eight offices in Europe Trading conditions in Europe have been difficult and Mansard has recently opened a network of offices in Asia in a drive to increase business Both European and Asian office managers are set targets for generating revenue for their office and they are paid bonuses when the targets are reached During the external audit for the year ended 31 March 2014, you identified the following deficiencies in internal control to be reported to those charged with governance and management at Mansard: Mansard does not have any bribery prevention policies (2) References were not always obtained for all new employees (3) The Italian and German offices did not follow Mansard’s accounting policies when preparing monthly accounting returns for submission to head office Consequently revenue and profits were overstated Requirement Co ns u (1) Draft points for inclusion in your firm’s report to those charged with governance and management at Mansard For each internal control deficiency identified above, you should outline the possible consequence(s) of the deficiency and provide recommendation(s) to address each deficiency (13 marks) NOTE: You should present your answer in a two-column format using the headings: GC A (i) Consequences; and (ii) Recommendations Copyright © ICAEW 2014 All rights reserved Page of 9b Described below are situations which have arisen at two unrelated external audit clients of your firm The year end in each case is 31 March 2014 lta nts Gable Ltd (Gable) Gable is an international company operating in the construction sector The financial statements for the year ended 31 March 2014 include cranes disposed of during the year with a carrying amount of £220,000 Gable has accounted for the proceeds of the disposal in other income in the statement of profit or loss but has not removed the carrying amount of the disposed cranes from the statement of financial position The directors refuse to amend the financial statements in respect of this matter because the buyer of the cranes has not yet collected the cranes which are still on Gable’s premises Co ns u Gable uses sub-contractors who are paid a variable daily rate depending on the location and complexity of the construction project The system used to process the payments to sub-contractors developed a fault during the year and many sub-contractors were paid at incorrect daily rates The directors estimate that £340,000 was overpaid and they have recorded a receivable for this amount at 31 March 2014 At the time of completion of the audit, £25,000 had been received in respect of this balance Your firm’s enquiries during the audit revealed that Gable has not had any success in contacting any of the sub-contractors that are still to reimburse the company as they no longer undertake work for Gable The directors refuse to include an allowance for doubtful debts in respect of the outstanding amount Gable’s total assets at 31 March 2014 are £42.3 million and profit before tax for the year then ended is £7.6 million Hip Ltd (Hip) The managing director of Hip refused permission for your firm to contact Dome Ltd (Dome), a customer, to confirm the balance of £185,000 which was outstanding at 31 March 2014 She claimed that the relationship between the two companies was particularly sensitive and that she did not want to upset that relationship At the time of completion of the audit, £15,000 had been received in respect of the outstanding balance and the managing director is confident that Dome will pay all outstanding amounts No alternative audit procedures were available to establish the existence of the debt A Hip’s total assets at 31 March 2014 are £5.2 million and profit before tax for the year then ended is £1.5 million Requirement GC For each of the situations outlined above, state whether or not you would modify the audit opinion Give reasons for your conclusions and describe the modifications, if any, to each audit report (10 marks) Copyright © ICAEW 2014 All rights reserved (23 marks) Page of ... Letterbox’s external auditor (6 marks) Total: (20 marks) GC A Co ns u (i) Copyright © ICAEW 2014 All rights reserved Page of Audit and Assurance - Professional Level – December 2014 MARK PLAN AND EXAMINER’S... ethics, audit reporting and the identification of key audit risks However, many candidates failed to use detailed analytical procedures to justify the audit risks in answers to question 7(b) and. .. address audit risks that were both adequately explained and relevant to the justification of the audit risk However, weaker candidates continue to cite vague audit procedures not linked to the audit