p7 - final

Final Assessment

KAPLAN PUBLISHING of 8

ACCA FINAL ASSESSMENT

Advanced Audit and Assurance

JUNE 2009

QUESTION PAPER

Do not open this paper until instructed by the supervisor This question paper must not be removed from the examination hall

Time allowed Reading time: 15 minutes Writing time: 3 hours Section A: Answer BOTH questions Section B Answer TWO out of the three questions

Kaplan Publishing/Kaplan Financial

ACCA P7 (INT) Advanced Audit and Assurance

© Kaplan Financial Limited, 2008 All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

of 8 KAPLAN PUBLISHING

Final Assessment

SECTION A Answer BOTH questions QUESTION 1 You are a manager working for Vitality & Sons, a medium sized firm of chartered certified accountants. You have been charged with finding prospective new clients in the wake of a significant reduction in trade due to the imposition of thresholds for statutory audits. As part of this new role you visited a computer hardware manufacturer and wholesaler, Macrohard Co. The managing director and majority shareholder, Mr Fence, has asked your firm to make a proposal for its audit and the provision of financial advice with a view to obtaining a stock exchange quotation. You make the following notes from your initial meeting. Turnover for the year ended 31 December 2008 was $5mn (2007: $3mn), profit before tax was $1mn (2007: $0.5mn) and total assets were $3mn (2007: $2mn). Despite the apparent improvement in profits Macrohard requires finance to: (a) establish a nationwide customer base by making some of the company’s products

available to the public through high street retail outlets, and (b) set up a division in Germany to purchase supplies; no sales would be made there as

the company faces strong competition. Mr Fence takes personal charge of buying, selling and inventory. He is the main contact with suppliers and customers, and negotiates prices directly with both. He has recently appointed a senior bookkeeper (not a qualified accountant) to help with credit control and to set up more formal accounting systems and procedures. A recently installed computer system provides basic payroll, sales, receivables and inventory information. The software was specifically written to Mr Fence’s requirements by his former brother-in-law, who is an IT graduate but joined the police force after finishing university. Purchasing is recorded manually because of the complexity of foreign currency conversion (many purchases of materials are from European suppliers). The purchase costs and quantities are fed into the inventory system by the bookkeeper. The system can then generate a current listing of PC parts in inventory. At the end of the year inventory totalled $230k (2007: $135k). The annual budget set at the start of the period has always significantly understated actual sales and expenses because of higher than expected growth. Management accounts are produced infrequently. The cost of sales used for the management accounts is computed as a percentage of sales value for different product groups. In the past, this method has proved reasonably reliable when compared with the results which incorporate the annual physical inventory count. However, margins on product lines have recently become much more varied because of negotiations with individual customers and suppliers.



The company is also experiencing a high level of returns because of faulty products. In 2008 these totalled $65k (2007: $40k). These are put back into inventory if they cannot be sold at a discount for cash over the trade counter. There are also small unreconciled amounts (which vary each month) on the sales and purchase ledger control accounts. At 31 December 2008 unreconciled receivables totalled $30k and unreconciled payables totalled $17k (31 December 2007: $11k and $6k respectively). The growth of the business has resulted in the company outgrowing its premises. Mr Fence is negotiating a loan from his bank to cover the cost of new premises to be built to his specification, and contracts for these were recently signed. The design stage is complete and building work has commenced. His bank is waiting for a profit forecast before giving final approval to a $0.8 million loan to finance the building work. Growth has made the company short of cash. It has an overdraft which has increasingly tended to exceed the agreed overdraft limit – hence the employment of the senior bookkeeper to improve credit control. Mr Fence indicates that a large receipt from a major customer, expected at the beginning of next month, is to be used to clear some of the tax payment arrears as well as repaying his loan account of $80,000. Mr Fence is recently divorced. The settlement with his former wife has left him without a home and he needs to increase his emoluments to provide himself with new accommodation. Mr Fence is dissatisfied with his existing firm of accountants which prepares and audits the annual financial statements. His dissatisfaction is partly because of the unreconciled amounts on the ledgers and partly because his accountants have failed to suggest how he can take increased emoluments to meet his personal needs. Required: (a) Using the information provided, write a report to the intended audit partner that

identifies and explains the principal business risks facing Macrohard. Your explanation should consider the financial statements consequences of the identified risks.

Note: there are 2 professional marks available for the report. (14 marks)

(b) Discuss the factors that the engagement partner should consider before deciding whether or not the firm should make a proposal for this engagement. (8 marks)

Consequent to discussions with Mr Fence, Vitality & Sons made a proposal for the audit of Macrohard Co. Given the strong reaction to your proposal and the lack of competitive proposals you consider it likely that you will be offered the role of auditor. Required:

(c) Define ‘money laundering’ and state the procedures that should be considered

before, and on the acceptance of, the audit appointment of Macrohard Co. (5 marks) (d) The initial fee estimate quoted in the proposal was $20k. This was based upon an

assessment of the total amount of time required to complete the audit. What other factors should be considered when deciding the basis of fees? (5 marks)

(Total: 32 marks)


Final Assessment

QUESTION 2 You are a senior manager at Borthwick LLP, a firm of chartered certified accountants. You have been approached by Phil Vickery, the finance director of a company called Stayburys, with regard to providing advice on a potential acquisition of a target company called Nutto. Stayburys, a limited liability company, is a major food retailer. Further to the recent success of its national supermarkets in the UK it has extended its operations throughout Europe and, most recently, Asia. It is now experiencing rapid growth in both markets. You recently attended a meeting with Mr Vickery during which you ascertained the following information. Nutto provides training in management, communications and marketing to a wide range of corporate clients, including multi-nationals. The ‘Nutto’ name is well regarded in its areas of expertise. Nutto is currently wholly-owned by The Barrier Corporation, an international publisher of management texts, whose shares are quoted on a recognised stock exchange. Nutto has a national and an international presence in the training market. The National business comprises ten training centres. The audited financial statements of this geographic segment show revenues of $20 million and profit before taxation of $2.7 million for the year to 31 December 2008. Most of the National business’ premises are owned but some are held on a long lease basis. Trainers in the National business are all employed on a full-time basis. The International business has seven training centres across Europe and Asia. For these segments, revenue amounted to $9.4 million and profit before tax $3.3 million for the year to 31 December 2008. Most of the International business’ premises are held on operating leases. International trade receivables at 31 December 2008 amounted to $3.6 million. Although the international centres employ some full-time trainers, the majority of trainers provide their services as freelance consultants. Required: (a) Define ‘due diligence’ and describe the purpose of a due diligence review. (2 marks) (b) Discuss the difference between an assignment to provide due diligence services and

a statutory year-end audit. (5 marks) (c) Identify and explain the matters you should consider before accepting an

engagement to conduct a due diligence review of Nutto.

The mark allocation includes 2 professional marks for presentation, flow and clarity of your answer. (15 marks)

(d) Illustrate how the following might be used in the due diligence review of Nutto:

(i) enquiry; and (5 marks) (ii) analytical procedures. (5 marks) (Total: 32 marks)



SECTION B Answer TWO out of the three questions QUESTION 3 You are a senior audit manager at Hetfield LLP, a firm of chartered certified accountants. During a recent independence review of your key audit clients you identified the following situations: (1) During the year ended 30 November 2008 your firm commenced a five-year contract

to provide internal audit services to Damage Inc. Over the course of the year the internal audit team carried out a risk assessment exercise and an evaluation of the internal control systems supported by tests of control. (5 marks)

(2) Lars Trujillo, the managing director and sole shareholder of Hammett, a private

company, received an offer from Ulrich Enterprises, also an audit client, for the entire share capital of Hammett.

Mr Trujillo has agreed in principle to sell his shares to Ulrich Enterprises. The purchase consideration is likely to consist of an initial cash payment based on the net assets of Hammett, as at 28 February 2009, and a deferred cash payment, which is contingent on the operating profit growing by an average of 5% over the next two years. Mr Trujillo and the management of Ulrich Enterprises have requested, independently from each other, that your firm: • acts as advisers in respect of the negotiations; and • that you provide an assurance report on the calculation of the amount of the

net assets at 28 February 2009. (5 marks)

Required: (a) Discuss the ethical and professional issues raised by the situations described above.

NB: the mark allocation for each section is noted above. (10 marks)

(b) Discuss the role and function of an audit committee. (8 marks)

(Total: 18 marks)


Final Assessment

QUESTION 4 You are the manager at Chandler Harris, a medium sized firm of chartered certified accountants. You have recently been reviewing work compiled during the year-end audits of four large clients. The year-end in each case is 31 December 2008 and you have identified the following issues: (a) Thorn Co is a subsidiary of Rose Co. Serious going concern problems have been

noted during this year’s audit. Thorn will be unable to trade for the foreseeable future unless it continues to receive financial support from the parent company. Thorn has received a letter of support (‘comfort letter’) from Rose Co. The audit senior has suggested that, due to the seriousness of the situation, the audit opinion must at least be qualified ‘except for’. (4 marks)

(b) Bramble Co has changed its accounting policy for intangible assets during the year

from straight line amortisation to annual impairment testing. No disclosure of this change has been given in the financial statements. The carrying amount of intangible assets in the statement of financial position as at 31 December 2008 is the same as at 31 December 2007 because management’s tests concluded that no impairment was necessary. The audit senior has concluded that a qualification is not required but suggests that attention can be drawn to the change by way of an emphasis of matter paragraph. (5 marks)

(c) The directors’ report of Briar Co states that investment property rental forms a major

part of revenue. However, a note to the financial statements shows that property rental represents only 1·6% of total revenue for the year. The audit senior is satisfied that the revenue figures are appropriately stated. The audit senior has noted that an unqualified opinion should be given as the audit opinion does not extend to the directors’ report. (4 marks)

(d) Audit work on the after-date bank transactions of Tarbaby Co has identified a transfer

of cash from Fox Co. Following discussions with the finance director, the audit senior has documented that Fox commenced trading on 7 January 2009, after being set up as a wholly-owned foreign subsidiary of Tarbaby. The audit senior has noted that although no other evidence has been obtained an unmodified opinion is appropriate because the matter does not impact the current year’s financial statements. (5 marks)

Required: For each situation, comment on the suitability or otherwise of the audit senior’s proposals for the auditors’ reports. Where you disagree, indicate what audit modification (if any) should be given instead. Note: the mark allocation is shown against each of the four issues. (Total: 18 marks)



QUESTION 5 You are the manager responsible for the audit of Madison Co. The company’s principal activity is wholesaling frozen food. The draft consolidated financial statements for the year ended 31 December 2008 show revenue of $33.5 million (2007 – $31.15 million), profit before taxation of $5.95 million (2007 – $7.1 million) and total assets of $24·0 million (2007 – $18.2 million). The following issues arising during the final audit have been noted on a schedule of points for your attention: (a) In early 2008 a chemical leakage from refrigeration units owned by Madison caused

contamination of some of its property. Madison has incurred $150,000 in clean up costs, $300,000 in modernisation of the units to prevent future leakage and a $15,000 fine to a regulatory agency. Apart from the fine, which has been expensed, these costs have been capitalised as improvements. (6 marks)

(b) While the refrigeration units were undergoing modernisation Madison outsourced all

its cold storage requirements to Elric Warehousing Services. At 31 December 2008 it was not possible to physically inspect Madison’s inventory held by Elric due to health and safety requirements preventing unauthorised access to cold storage areas.

Madison’s management has provided written representation that inventory held at 31 December 2008 was $5.05 million (2007 – $3.35 million). This amount has been agreed to a costing of Elric’s monthly return of quantities held at 31 December 2008. (6 marks)

(c) Madison owns a residential apartment above its head office. Until 31 December 2007 it was let for $1,500 a month. Since 1 January 2008 it has been occupied rent-free by the senior sales executive. (6 marks)

Required: For each of the above issues: (i) comment on the matters that you should consider; and (ii) state the audit evidence that you should expect to find, in undertaking your review of the audit working papers and financial statements of Madison Co for the year ended 31 December 2008. NOTE: The mark allocation is shown against each of the three issues.

(Total: 18 marks)


Final Assessment

ACCA

Paper P7 (INT)

Advanced Audit and Assurance June 2009

Final Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the final assessment questions and submitted them for marking.

KAPLAN PUBLISHING Page 1 of 29


© Kaplan Financial Limited, 2008 All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

Page 2 of 29 KAPLAN PUBLISHING

Final Assessment

ANSWER 1 (a) REPORT

To E. Nergy From H. Ealth Date 12 February 2009 Subject Macrohard Co – Prospective client risk assessment

Introduction Please find below an analysis of the business and financial statements risks of a potential new client; Macrohard Co. General external risks Macrohard operates in a fast paced, hi-tech industry. This creates the constant threat of technological obsolescence due to the development of superior products. If Macrohard do not develop their products with this technology then they could lose business and they may end up with unmarketable inventories that require writing off on the statement of financial position/balance sheet. Macrohard will also be sensitive to interest rate and exchange rate volatility. Given their overdrafts, potential loans and foreign supplies there is a significant risk that finance charges could be misstated and that monetary items are incorrectly translated at the year-end in the financial statements. Increased losses due to rate movements could also have severe impact on profits and the ability of the business to continue as a going concern. Growth Business risk is increased by the proposed expansion and diversification of the company. This could have numerous impacts on the business and the financial statements. Firstly; increased supplies of overseas components will further increase Macrohard’s exposure to foreign exchange losses. This could lead to errors in the financial statements regarding year end retranslations of foreign monetary balances, such as payables. Secondly; the company is already experiencing cash flow difficulties. Further rapid growth could worsen this position due to: the company extending credit terms to entice new customers; having to meet the burden of added finance charges due to increased gearing; and being unable to cope with increased demand upon accounting/credit control systems. This could lead to severe cash flow shortages which would make the assessment of the going concern basis of accounting a risk area. The increased pressure on the infant systems would also increase control risk, which could potentially indicate that more errors pass to the draft accounts undetected.



Finally; the company may be seeking to protect margins by sourcing inferior quality supplies. There is evidence of increasing product defects and returns during 2008. From a business perspective this could lead to the loss of customer goodwill and reduced repeat trade, not to mention the damaging effect on Macrohard’s reputation. In terms of the financial statements the following areas will all become high risk: • Warranty provisions: at 1.3% of turnover and 2.2% of total assets the returned

goods are highly material to the accounts. Sufficient provisions will be required for these returns;

• The collectability of receivables: it is likely that significant credit notes will be raised for these material returned goods. These will need to be removed from receivables at 31 Dec 2008.

• Inventory: this is highly material to the accounts at 7.7% of total assets. It will be important to assess the valuation of returned goods, which are placed back into inventories, to ensure their costs are still recoverable.

Cash flow The current cash flow crisis may have serious implications and repercussions for the business. Macrohard are currently in arrears with tax payments. This could ultimately lead to penalties and interest may be accruing on tax liabilities still outstanding. Provisions for all costs accruing on outstanding tax bills will be required as at 31 December 2008. An inability to pay debts on time may also lead to suppliers withdrawing credit facilities or, in the worst case scenario, refusing to supply Macrohard. This would place an even bigger cash burden on Macrohard as it would be likely that new suppliers would seek credit references and also refuse them credit. This could have severe implications on the company’s ability to trade as a going concern. Serious consideration must be given to the basis of preparation of the accounts. Given the current cash position of the company the bank may refuse the application for the loan. The contracts for the building work have already been signed and construction has commenced. Failure to secure funding could have a disastrous effect on the business. Once again they would possibly be subject to penalties for breaking the terms of the contract. They will at least have to pay any legal fees incurred, design fees and fees for construction to date. Without the loan this would again impact the going concern assessment of the financial statements. It will also be important to assess whether any provisions will be required for unavoidable costs of terminating the contract. Historic problems with credit control could be exacerbated by anticipated growth. The employment of a bookkeeper may not necessarily solve this problem given that the bookkeeper’s primary function will be to maintain the accounting records of the business. This in itself appears as though it will provide some challenge given the obvious weaknesses in the system due to the material unreconciled differences and the difficulties experienced processing meaningful management accounts. This may be heightened by the fact the bookkeeper is not a qualified accountant. In all there is concern over the accounting and credit control environment and control risk must be perceived as high. This will increase the risk of errors in the accounts, particularly understated provisions for non-collectable receivables.


Final Assessment

Managing director The company operates under the dominant influence of Mr Fence, who is also the majority shareholder. As a result he is able to abuse his authority and put the remaining shareholders’ investments at risk, for example; by committing the company to a building contract without consultation and without the necessary funding secured. The company’s systems may also be prone to error because the organisation structure appears inadequate to cope with the size and growth of the business. This would be particularly evident if Mr Fence were absent for any period of time. Given the lack of a qualified accountant, or experienced supervisor of any form, it is likely that errors would pass undetected to the draft accounts. There also appears to be a high risk of management bias, leading to manipulation of the accounts, because: • The bank are basing their loan decision on profit forecasts; • Mr Fence is seeking repayment of his director’s loan; • Mr Fence is seeking to increase his emoluments. One way of achieving this

might be to introduce some form of performance bonus based on profits. Financial information and internal systems The annual budget and management accounts are not sufficiently accurate to provide information for decision-making purposes. There are also discrepancies in the control accounts that could indicate that proper accounting records have not been kept. Whilst the difference on the payables ledger is immaterial at 0.6% of total assets the difference on the receivables ledger represents 1% and, hence, is a material discrepancy. It must also be considered that the new computer system, which may be prone to initial ‘teething problems’ could lead to errors. If the system proves to be deficient in any way it may be difficult to rectify the problem because: the author of the software works for the police force, and is unlikely to assist given that he is now Mr Fence’s ex-brother-in-law; Macrohard do not appear to employ an IT specialist; and they do not appear to have any maintenance contracts. Given these doubts it is considered highly unlikely that the management team (Mr Fence) will have reliable information upon which to base strategic decisions and this casts doubts upon the businesses future success. It also suggests that the control environment is weak and that there is a high risk of errors in the unaudited financial statements. Conclusions Macrohard appear to be facing a number of serious business risks, most of which appear to relate to the chosen methods of operation and internal growth strategies. In combination they appear to suggest there is significant doubt over the company’s ability to continue as a going concern into the foreseeable future. The poor internal controls, the cash flow difficulties being experienced and the perceived deteriorating quality of the products could all conspire against the business in the short term. All these factors must be considered before we decide to nominate ourselves as auditors.



(b) Factors to consider before making a proposal for the audit

Standard considerations Independence In accordance with the Ethical Code of Conduct, Vitality & Sons must consider whether they are in a position to carry out the engagement independently. They must consider whether there are any relationships with the client or their shareholders to avoid any self interest threats. Vitality should also consider whether they perform any other accounting services for the client to avoid any self review threats. This could become a problem in the future because Mr Fence has indicated he would like to receive advice about a potential stock market flotation. It must be considered whether Vitality can provide this service and the audit service without compromising their ethical position. Expertise and resources Vitality must consider whether they are capable of carrying out the engagement with the requisite level of professional competence and due care. In order to do this they must ensure they have sufficient, experienced staff available to adequately plan, perform, supervise and review the engagement. They must also consider whether they have the skills, knowledge and capacity to advise on the potential flotation. Vitality must not indicate now that they can perform this service in order to win the audit, only to let down their client in the future. Contact with previous auditor Vitality will need to request permission from Macrohard to communicate with their existing auditor, in accordance with the Rules of Professional Conduct, to obtain professional clearance. If such permission is not given they would not proceed any further with the proposal. Given Mr Fence’s disputes regarding emoluments it will be vital to assess what demands he has placed upon the outgoing auditor and whether, in the outgoing auditor’s opinion, this had any effect on their objectivity or, indeed, whether Mr Fence displayed any intimidating behaviour. Specific considerations Mr Fence The close involvement of Mr Fence with the company makes this person’s integrity a key factor in our decision whether or not to make a proposal. Currently he seems unaware that the company is a separate legal entity and that as such he cannot treat it as an extension of himself. This will become more critical should the company obtain a stock exchange quotation. It should be considered whether Vitality & Sons can develop a professional relationship with Mr Fence without being subjected to intimidation due to his demands to improve his personal emoluments and repay his loan account.


Final Assessment

Risk Any company wishing to obtain a stock exchange quotation must be a high-risk client. In addition, we know that a profit forecast is soon to be prepared, which the company hopes will lead to final approval of the $0.8 million bank loan for building work (work which has already commenced). Although no specific mention has been made, it seems likely the bank will require an accountant’s report to be produced on this forecast. These two factors in combination suggest that there will be significant external 3rd party interest in any audit reports produced and this makes Macrohard a very risky potential client. Going concern Many of the points covered so far indicate potential going concern problems, for example: • a need for new finance • exceeding overdraft limits • tax payment arrears • overdue amounts from customers • faulty products • over-reliance on Mr Fence. The assessment of going concern will become a significant risk area of the audit. More importantly, from a credit control perspective, Vitality & Sons must be certain that they can recover any fees from Macrohard. Given their current situation it might be considered too risky to offer the company any form of credit and serious consideration should be given to whether to offer any services at all. Audit evidence A number of factors indicate problems with the availability of reliable audit evidence. In the main, these problems arise from poor accounting systems and a high possibility of management override. It may, of course, be possible that the recently recruited bookkeeper could improve the current systems but there is insufficient information with regard to the calibre of this recruit. This may make it difficult to support audit objectives and, ultimately, this could impose a limitation in scope. Potential qualification Any going concern uncertainty must be adequately disclosed in the financial statements. If there is not adequate disclosure, a qualification would result. Although this in itself is not a reason for declining to make a proposal, it would – given the circumstances discussed – appear prudent to assess Mr Fence’s possible reaction to such an outcome.



Fees These are always an important factor in any proposal. However, there can be no doubt Macrohard would be a high-fee client and it should be considered how sensitive Mr Fence will be to the fee basis and the principle of charging on an hourly basis.

(c) Money laundering procedures

Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the proceeds of criminal activity, allowing them to maintain control over the proceeds, and ultimately providing a legitimate cover for their sources of income. The objective of money laundering is to break the connection between the money, and the crime that it resulted from. Procedures performed prior to and on acceptance of a client include: (i) Client due diligence:

• Establish the identity of the entity, its business activity, the key individuals involved and its address by: – Obtaining a certificate of incorporation; – Obtaining a copy of the registered address; – Obtaining a copy of the register of shareholders and directors.

• If the client is an individual, obtain official documentation including: – Passport; – Photographic drivers licence; – Recent utility bills.

(ii) Consider whether the commercial activity makes business sense (i.e. it is not

just a ‘front’ for illegal activities) (iii) Client understanding:

• Pre-engagement communication may be considered, to explain to Mr Fence, and any other directors, the nature and reason for client acceptance money laundering procedures.

• Best practice also recommends that the engagement letter should include a paragraph outlining the auditor’s legal responsibilities in relation to money laundering to avoid any problems if a conflict of interest with confidentiality arises.

(d) Basis of setting a fee

Many principles should be considered when setting a fee level as well as simply the amount of time the engagement will take. Such considerations include: • the nature and custom of fee setting with reference to certain specialist areas,

such as stock market flotations; • the seniority and experience of the individuals involved in the engagement; • the degree of risk and responsibility required by the engagement;


Final Assessment

• the urgency of the work and the nature of deadlines imposed by the client; • the overhead base of the firm completing the assignments; • the natures of expenses incurred by staff performing the work, such as travel

and subsistence costs if visiting numerous and distant offices/locations; • the nature and volume of any specific additional outputs requested by the

client; • the requirement to attend additional meetings and make presentations, such

as meetings with audit committees.

MARKING SCHEME

(a) Business risks Generally ½ mark each risk identified and up to 1 marks for a thorough discussion Ideas • Technology & obsolescence (max 1) • Interest/exchange rate volatility (max 1) • Expansion:

- Foreign exchange - Cash flow - Product defects

• Cash flow: - Tax penalties - Supplier relations - Loan refusal - Worsening credit control

• MD dominance and bias (max 2) • Information provision and control environment (max 2) Up to 2 marks for presentation of structured report and clarity of explanation 14 marks

(b) Factors to consider prior to proposal Generally 1 mark per explained consideration (½ mark for simply listing point) Ideas • Independence/ethics:

- Self interest - Self review

• Competence/resources • Professional clearance • Integrity of MD • 3rd party exposure • Going concern • Evidence quality/availability • Possible qualification • Fees 8 marks



MARKING SCHEME – continued

(c) Money laundering Generally 1 mark per definition/explained point Ideas • Definition of money laundering • Client due diligence:

- Businesses - Individuals

• Commercial consideration • Pre-engagement communication • Engagement letter 5 marks

(d) Basis of fees Generally 1 mark for each explained consideration Ideas • Nature/custom of work performed • Seniority/experience • Risk • Urgency/deadlines • Overheads • Expenses • Reporting requirements • Additional meeting requirements 5 marks

TOTAL FOR QUESTION 1 32 MARKS


Final Assessment

ANSWER 2 (a) Purpose of a ‘due diligence’ review

‘Due diligence’ may be defined as the process of systematically obtaining and assessing information relevant to the acquisition of a target company on behalf of a client. The purpose of such an assignment is to identify and assess issues relevant to a client’s acquisition of a subsidiary in order to reduce the risks associated with the acquisition to an acceptable level.

(b) Difference between due diligence and audit

Requirements

Year end audits are legally required for all limited companies exceeding the minimum audit thresholds. They are also subject to strict regulations in the guise of International Standards of Auditing.

Due diligence is initiated at the request of directors and subject to fewer prescribed rules. An outline of the processes that should be followed can be found in: ISRE 2400 Engagements to Review Financial Statements; ISRS 4400 Engagements to Perform Agreed Upon Procedures Regarding Financial Information; ISAE 3400 The Examination of Prospective Financial Information; and ISAE 100 Assurance Engagements. Audience

An audit opinion is offered to the shareholders of the business subject to audit. In contrast, the reports from due diligence engagements are provided to the directors of the company.

Form of assurance The opinion offered on an audit is one of reasonable assurance. This means that sufficient, appropriate evidence has been gathered to support an opinion as to whether the accounts are free from material misstatement. Absolute assurance cannot be given for reasons such as: the use of accounting estimates; the nature of fraud (i.e. it is hidden); and the necessary use of audit sampling. As the timescale for a due diligence review is often relatively short but wide in scope clients may not always request the expression of an opinion. However the accountant will be engaged to report upon certain criteria requested specifically by the client. If sought, the assurance offered would be limited assurance. Wording of opinion In an audit report a positive statement of opinion is offered as to whether the accounts are – or are not – a true and fair representation of the position and performance of the business under scrutiny.



In a limited assurance report a negative statement of opinion is given. This indicates whether anything has come to light during the review to indicate a departure from the criteria initially agreed with the client. Evidence During an audit evidence is usually gathered using a mixture of analytical review, enquiry, inspection of documentation, observation of procedures, and recomputations of certain balances. During due diligence evidence is restricted, at least initially, to analytical review and enquiry. Further corroborative evidence might be sought if any material concerns were identified.

(c) Matters to be considered before accepting the engagement

(Although candidates may approach this from a rote-learned list of ‘matters to consider’ it is important that answer points be tailored as far as possible to the scenario to gain full marks). The purpose and audience of the report Borthwick should identify what the relationship is between Phil Vickery and Stayburys to identify what authority he has to approach them to undertake the assignment. It is important to verify whether it is worthwhile incurring costs putting a proposal together. The purpose of the assignment must also be clarified. Mr Vickery’s request was for Borthwick ‘to advise on a bid’. It should be made clear to Stayburys that Borthwick cannot make decisions on their behalf. They can only provide a report stating facts of material interest and it is up to Stayburys’ management team to decide whether or not to bid and, if so, how much to bid. It should be made clear from the beginning that any report produced/opinion provided will be for the board of directors of Stayburys only and that a reference to this disclaimer will be made in the final engagement report. Borthwick should discuss this with Stayburys and confirm a distribution list for the report. If the directors wish to pass the report to any third parties, such as a bank to make any loan decisions, then this will significantly increase the risk of the engagement and this will be reflected in the fee. The scope of the engagement It seems likely that Stayburys will be interested in acquiring all of Nutto’s business as its areas of operation coincide with Stayburys’. However, it must be confirmed whether Stayburys is interested in the whole company or merely acquiring the national or international business of Nutto. Borthwick should seek clarification of what Mr Vickery means by ‘advice on a potential acquisition.’ A series of criteria/objectives would need to be agreed with the client before Borthwick could confirm whether they have the competence and resources available to perform the engagement.


Final Assessment

Due diligence is not subject to the same strict regulations of audit and therefore the criteria could be to perform a review of the past historic accounts, or to review the forecasts of Nutto, or to assess the impact on the financial position and performance of the group, or simply to provide technical advice about how to account for the subsidiary company. Each engagement carries different risks and requires different competencies. It will be of vital importance to assess whether Stayburys will impose any urgent deadlines. Borthwick must have sufficient time to find all facts that would be of material interest to Stayburys before disclosing their findings. If the deadlines imposed are soon Borthwick may simply not have the human resources available to complete the assignment. There should also be a discussion of whether there will be any restrictions on Borthwick’s access to information held by Nutto and/or key personnel who will be required for enquiry. Given the degree of secrecy usually surrounding mergers and acquisitions – due to fears of job security – this is common. Ethical and professional issues Borthwick must consider whether they can provide the required services with sufficient competence. They should not accept the engagement unless the firm has sufficient experience in undertaking due diligence assignments. Even then, the firm must have sufficient knowledge of the territories in which the businesses operate to evaluate whether all facts of material interest to Stayburys have been identified. In addition, Borthwick must consider whether it has sufficient resources (e.g. representatives/ associated offices) in Europe and Asia to investigate Nutto’s international business, or whether such investigations can be undertaken efficiently and effectively with domestic staff. As with any engagement, Borthwick must consider any factors which might impair their independence and objectivity when reporting to Stayburys. For example, if Phil Vickery is closely connected with a partner in Borthwick or if Borthwick provides audit services to The Barrier Corporation. Note: Candidates will not be awarded marks for going into ‘autopilot’ on independence issues. For example, this is a one-off assignment so size of fee is unlikely to be relevant. Borthwick LLP holding shares in Nutto is also not possible as it is wholly owned. Rationale for the acquisition Stayburys’ rationale for wishing to acquire Nutto should be ascertained. It is presumably significant that Nutto operates in the same territories as Stayburys. Stayburys may want to provide extensive internal training programs in management, communications and marketing to its workforce. It should be ascertained if there is any existing relationship between Stayburys and Nutto. Stayburys may be a major client of Nutto. That is, Stayburys is currently out-sourcing training to Nutto. Acquiring them would bring training in-house. This will have an important bearing on the expected synergies from the merger. These will be different if the purpose of the investment is purely for internal training or if it is to diversify into other profitable business areas. This will have a significant impact on the focus of the DD work performed and the nature of the report provided.



Other issues It should perhaps be discussed why Stayburys have not requested that their current auditors conduct the due diligence review, especially as they are responsible for (and therefore capable of undertaking) the group audit covering the relevant countries. Borthwick should ask permission to communicate with Stayburys’ current auditor to inform them of the nature of the work they have been asked to undertake and to enquire if there is any reason why they should not accept the assignment. In taking on Stayburys as a new client Borthwick may have a later opportunity to offer other services to Stayburys. This could therefore prove to be a sensible path to take in terms of Borthwick’s strategic growth.

(d) Due diligence procedures

(i) Enquiries

Tutorial note: These should be focussed on uncovering facts that may not be revealed by the audited financial statements or reflected in the forecasts of NUTTO (e.g. off statement of financial position finance, contingencies, commitments and contracts) especially where knowledge may be confined to management.

• Do any members of Nutto’s senior/executive management have

contractual terms that will result in significant payouts to them (e.g. on change of ownership of the company or their being made redundant)?

• What contracts with clients, if any, will lapse or be made void in the event that Nutto is purchased from The Barrier Corp

• Are there any contracts that Stayburys would have to honour if they acquired the trade and assets of Nutto and would there be any financial penalties if they failed to deliver these services?

• What synergy or inter-company trading, if any, currently exists between Nutto and The Barrier Corporation? For example, The Barrier Corp may publish Nutto’s training materials. If Stayburys were to acquire Nutto would The Barrier Corporation be free to cease these services or are there contracts in place enforcing them?

• Do Nutto have any major clients who are in direct competition with Stayburys who, hence, are likely to be lost if Nutto is purchased?

• What are the principal terms of the operating leases relating to the International business’s premises? Most importantly; when are the leases due to expire?

• What penalties should be expected to be incurred if operating leases and/or contracts with training consultants are terminated?

• Has Nutto entered into any purchase commitments since 31 December 2008 (e.g. to buy or lease further premises, or indeed to hire further employees)?

• Who are the best trainers that Stayburys should seek to retain after the purchase of Nutto?


Final Assessment

• What events since the audited financial statements to 31 December 2008 were published have made a significant impact on Nutto’s assets, liabilities, operating capability and/or cash flows? (For example storm damage to premises, major clients defaulting on payments, significant interest/foreign-exchange rate fluctuations, etc.)

• What is the progress of all contingent liabilities disclosed in the accounts to 31 December 2008?

• Are there any unresolved tax issues which have not been provided for in full?

• Are there any loans and, if so, do they contain any covenants? Will the acquisition affect any covenants? For example, term loans may be rendered repayable on a change of ownership.

(ii) Analytical procedures

Note: The range of valid answer points is very broad for this part. The responses below are a guideline only and not an exclusive list. • Review the trend of Nutto’s profit (gross and net) for the last five

years, say, to identify historic performance. Similarly earnings per share and gearing. This should be compared with forecasts. The purpose of which is to, firstly, assess the relative merits and success of the business and, secondly, to ensure that forecasts appear consistent with proven performance and do not look misleading.

• For both the national and international businesses compare: o Historic trends in gross profit, net profit, and return on assets; o Full-time salaries; o Freelance consultancy fees; o Premises costs (e.g. depreciation, lease rentals, maintenance,

etc); o Monthly revenue (also costs and profit) by centre.

• Review projections of future profitability of Nutto against net profit percentage at 31 December 2008 for: o The National business (13.5%); o The International business (35.1%); and o Overall (20.4%).

• Review of disposal value of owned premises against book values. • Compare actual cash balances on a monthly basis and compare

borrowings against loan and overdraft agreements. Identify whether there are any covenants and review their terms.

• Compare the average collection period for International’s trade receivables month on month since 31 December 2008 (when it was nearly five months, i.e. $3.6/$9.4 × 365 days) and compare with the National business. This appears high and should be clarified with directors.

• Compare financial ratios for each of the national centres against the National business overall (and similarly for the International Business). For example: o gross and net profit margins; o return on centre assets; o average collection period; o average payment period; o liquidity ratio.



• Compare key performance indicators across the centres for the year to 31 December 2008 and 2007 to date. For example: o number of corporate clients; o number of delegates; o number of training days; o average revenue per delegate per day; o average cost per consultancy day.

• Review lease agreements and contracts of employment to ensure such costs are appropriately forecast.

• Identify any possible restrictive terms within agreements and contracts that could result in penalties against Stayburys if their acquisition proceeds.

• Review the forecasts for the year to 31 December 2008 and compare to actual, audited results. This will help assess the ability of Nutto’s management to accurately forecast.

MARKING SCHEME

(a) Due diligence Generally 1 mark each thoroughly explained point Ideas • Definition • Purpose 2 marks

(b) Due diligence versus audit Generally 1 mark per thoroughly discussed point (½ mark for simply listing rote learned points without explanation) Ideas • Requirements • Audience • Assurance:

- Reasonable (+ explanation) - Limited (+ explanation)

• Wording of opinion • Evidence gathered 5 marks

(c) Matters to consider prior to accepting engagement Generally ½ mark per point identified and a further 1 mark for thorough explanation. NB: Rote learned responses that do not refer to the unique circumstances in the scenario should score max ½ mark Ideas • Purpose & audience:

- Authority of Phil Vickery - Ultimate decision - 3rd Parties

• Scope: - Trade & assets purchase? - Advice sought/objectives - Deadlines/other restrictions


Final Assessment

MARKING SCHEME – continued

• Ethics/professional issues: - Competence/resources - Independence

• Rationale: - Strategy - Synergies expected

• Other issues: - Professional clearance (max 1 mark) - Additional services (max 1 mark) 2 professional marks for: structure, headings, use of short paragraphs (no bullet points), clarity of explanation, relevance to scenario, relevance to accepting engagement 15 marks

(d) (i) Enquiries Generally 1 mark for each well explained consideration Ideas • Director payments • Client contracts • Trade with Barrier Corp • Clients in competition to Stayburys • Leases • Purchase commitments • Trainers worth retaining • PBSEs • Contingencies • Tax issues • Loan covenants 5 marks

(ii) Analytical reviews Generally 1 mark for each well explained consideration Ideas • Historic profits • National vs. International • Forecast profits • Covenants review • Receivables days review • Relevant ratio analysis • Relevant KPI analysis • Lease agreements • Restrictive terms • Forecasts vs. actual 5 marks




ANSWER 3 (a) Ethical/professional issues and responses

(1) Damage Inc Ethical issues Where internal and external audit services are provided by the same firm, a self-review threat exists. This is particularly apparent when internal audit services review the control environment of the client because this also has to be assessed by the audit team as part of their audit risk assessment. It should also be considered whether Hetfield can objectively report on the internal control system of Damage Inc. Internal audit is part of this control system, therefore Hetfield would have to make an assessment of its own competence. Given that Hetfield is likely to consider its own staff competent it is possible that it will not conduct the audit with the necessary due care, choosing instead to rely too heavily on the work of the internal audit team. Internal audit may design its procedures with a view to enabling the external audit team to reduce its workload. Again this means that the internal audit would not be completed with the necessary objectivity to perform the required services for Damage Inc. Hetfield must also consider the role of the internal audit function. Very often internal audit make recommendations for improving internal control systems. It is vital that Hetfield does not begin making decisions for Damage Inc as this exposes it to a significant risk of negligence. Professional issues Hetfield must plan the audit to address areas of audit risk. The objectives of internal audit are not the same and, therefore, the outputs from the internal audit services cannot be entirely relied upon. Hetfield may rely on the work of the internal audit team provided that they are satisfied with: the standard of work performed; the competence of the staff undertaking the work; and that the evidence is sufficient to support the audit risk assessment and to support the audit opinion. The usefulness of internal audit evidence must be considered at the planning stage of the external audit, when audit procedures are being designed. To mitigate the threat posed by performing internal audit services and making decisions on behalf of management Hetfield must satisfy themselves that the client will, at all times, be responsible for: • operating the overall system of internal control; • determining the scope, risk and frequency of the internal audit procedures to be

performed; • considering and acting on the findings and recommendations provided by internal

audit.


Final Assessment

To reduce the risk of self review different partners and teams should be allocated to perform the two services. This will also contribute to ensuring that each engagement is planned, performed and reviewed with a view to fulfilling their unique, respective objectives; not complementing the other service. At the planning stage the relevant partner should ensure that staff used in the internal audit team are either specialists in internal audit or suitably competent for this service. Sufficient reviews should take place to ensure that both engagements have been adequately performed and that there are no instances where quality has been compromised. In light of the situation an ethics partner review, or a partner not involved in either engagement, would appear appropriate. If it is considered that both services cannot be offered without compromising the independence of Hetfield then they should resign from one of the roles. (2) Hammett Ethical issues There is an obvious conflict of interest if Hetfield operates as adviser: both Hammett and Ulrich Enterprises are clients. Hammett will be seeking the best possible price for the sale of the shares and Ulrich Enterprises will be seeking to negotiate a reduced price for the purchase. Hetfield cannot objectively advise both parties in this matter. In addition there is a danger that confidential information relating to the sale/purchase could be leaked to the opposite side as Hetfield will be privy to both parties. There is also a risk that Hetfield may not act with total objectivity. It may act in favour of Ulrich Enterprises to safeguard future audit income streams. Professional issues If Hetfield accepts the engagement it should plan to use different partners and staff with separate reporting lines to establish ‘Chinese walls.’ This will help prevent the transfer of confidential data. This should also ensure that each team acts competently by working towards the objectives of their respective client. Hetfield must also plan to use experienced corporate finance/due diligence staff to advise and report in this manner to ensure that the work is performed with the necessary due care. It will be vital that a senior partner, not involved in the engagement, regularly reviews working files and general progress to ensure that independence (or quality) is not being impaired. If adequate safeguards cannot be put in place Hetfield should only advise one party in this matter, or – more prudently – should refuse to act on behalf of either client. At the very least Hetfield should discuss this conflict of interest with both parties and explain their ethical position. They may wish to advise their clients that their interests may, in the circumstances, be better served by a more independent firm.



If either Hammett or Ulrich Enterprises (or both) still wish to proceed with the engagement then written consent should be obtained confirming both parties are aware of the issues discussed above.

(b) Audit Committee

Having established an audit committee the company must determine its role and function. The objectives will depend upon the nature of the company and the regulatory regime under which it operates. Therefore the business segment and the country will be important factors to consider in establishing the role and function of the audit committee but general considerations include:

• The appointment of the external auditor, the setting of audit fees to be paid,

and reviews of such fees, and any matters of external auditor dismissal or resignation.

• Review the nature and extent of non-audit services provided by the external auditor.

• Discussions with the external auditor before the audit commences regarding the nature and scope of the audit.

• If more than one audit firm is used, to co-ordinate the activities of the various parties involved.

• Review the interim and annual financial statements before submission to the board.

• Review compliance with regulatory requirements. This includes that accounting policies are in line with any legal regulations, corporate governance requirements, stock exchange reporting requirements and professional accounting standards.

• Discuss problems and reservations arising from the external audit. This can be very useful to the external auditor wanting to avoid a breach of confidentiality on a matter the auditor would like to discuss.

• Review the external auditor's management letter and management response. The audit committee should be in a position to ensure that the points made by the external auditor are followed up.

• Review the company's internal control systems and their effectiveness. • Review any internal audit programme, ensuring that there is close co-

ordination and co-operation between the internal audit function and the external auditors.

• Consider, and report on, the major findings of internal investigations and management's response. As such the committee also provides a channel for ‘whistleblowing.’


Final Assessment

MARKING SCHEME

(a) Ethical and professional issues Generally 1 mark for each issue that is thoroughly discussed. No marks should be awarded for rote learned responses that could relate to any scenario. Students must apply their knowledge to the scenario and explain the issues they identify to receive credit Ideas Damage Inc • Self review • Objectivity • Due care • Designing complimentary services when objectives are different • Management decisions • Separate teams • Specialist IA staff • Reviews • Resign Hammett • Conflict of interest • Confidentiality • Objectivity • Separate teams • Experienced CF staff • Review • Decline • Written confirmation 10 marks

(b) Role/function of an audit committee Generally 1 mark per explained procedure to a maximum of 8 Ideas • Appoint & set fees • Review services • Discuss nature/scope • Co-ordinate multiple auditors • Review accounts • Review compliance • Discuss audit issues • Review management letter • Review internal controls • Review internal audit • Whistleblowing 8 marks




ANSWER 4 (a) Thorn Co

If a letter of support had not been received, then a qualified opinion on the grounds of a disagreement (about the appropriateness of the going concern presumption) would be required. However, as the matter would be pervasive to the accounts an adverse opinion would be appropriate (ISA 570 Going Concern). However, the company has received a letter of support from its parent company that, if honoured, should enable Thorn to continue trading. If this evidence (together with other evidence such as written management’s representations) is considered to be sufficient to support the appropriateness of the going concern presumption, and the need for parental support is adequately disclosed in the accounts of Thorn, then a qualified opinion will not be necessary. If the evidence is sufficient, but the disclosure in Thorn’s accounts is inadequate, an ‘except for’ opinion would be made, again on the basis of a disagreement. If the letter of support does not provide sufficient evidence (e.g. if there are doubts about Rose’s ability to provide the required finance), then there will be significant uncertainty regarding Thorn’s ability to continue as a going concern. This should be disclosed in an emphasis of matter paragraph contained in the auditor’s report. Such a disclosure does not require a qualified opinion (unless, of course, the disclosures in Thorn’s accounts continue to be inadequate). Conclusion The audit senior’s proposal is unsuitable. The auditor’s report should be unmodified (assuming that disclosures are adequate).

(b) Bramble Co

In order to show fair presentation, in all material respects, the financial statements of an entity should contain not only accurate figures, but also sufficient disclosure in relation to those figures in order to allow the user to understand them. (As required by IAS 8 which state that policies should be applied consistently from year to year.) If this is not the case, then the change will need to be disclosed in a note to the financial statements together with a prior year restatement and adjustment to opening profit reserves. Failure to disclose the reasons for the change in policy and its financial effects means that the financial statements do not comply with the relevant financial reporting framework. A qualified opinion is therefore required on the grounds of a disagreement on disclosure (IAS 8). Assuming the matter to be material (but clearly not pervasive), an ‘except for’ opinion should be expressed. The main purpose of an emphasis of matter paragraph is to describe a matter of significant uncertainty which has been taken into account in forming the audit opinion. This usually relates to contingencies that could impact the going concern assessment if they conclude adversely. Such a paragraph highlights a note in the financial statements that more extensively discusses the matter. An emphasis of matter paragraph cannot therefore be used to ‘make good’ a lack of disclosure.


Final Assessment

Conclusion The audit senior’s proposal is unsuitable. Unless all aspects of the change (including reason and effect) are adequately disclosed an ‘except for’ qualification will be required on the grounds of disagreement and the emphasis of matter should be removed.

(c) Briar Co

The audit opinion states whether the financial statements: • are presented fairly, in all material respects (or give a true and fair view) in

accordance with the financial reporting framework; and • comply with statutory requirements (where appropriate). The directors’ report is not a part of financial statements prepared under financial reporting regulations. However, auditors have a professional responsibility to read other information in documents containing audited financial statements (e.g. the directors’ report in an annual report) to identify material inconsistencies with the audited financial statements (or material misstatements of fact). A material inconsistency exists when other information contradicts information contained in the audited financial statements. Clearly, ‘major’ is inconsistent with 1.6%. If the inconsistency is resolved (e.g. because the directors’ report is corrected to state something along the lines of ‘... major part of other income...’) an unmodified auditor’s report will be given. If the inconsistency is not resolved, the audit opinion on the financial statements cannot be qualified (because the inconsistency is in the directors’ report and the financial statements are not misstated). In this case, an explanatory paragraph may be used to draw the reader’s attention to the inconsistency between the audited accounts and the other, unaudited components of the annual report. Conclusion An unqualified opinion on the financial statements is appropriate. If, however, the inconsistency is not resolved, it should be reported in a separate explanatory paragraph, after the opinion.

(d) Tarbaby Co

The cash transfer is a non-adjusting event after the reporting period. It indicates that Fox was trading after the reporting period. However, that does not preclude Fox having commenced trading before the year end. The finance director’s oral representation is wholly insufficient evidence with regard to the existence (or otherwise) of Fox Co at 31 December 2008. If it existed at the reporting date its financial statements should have been consolidated as part of Tarbaby Group.



The lack of evidence that might reasonably be expected to be available (e.g. legal papers, registration payments, etc) suggests a limitation on the scope of the audit. If such evidence has been sought but not obtained then the limitation is imposed by the entity (rather than by circumstances). The nature of the limitation (being imposed by the entity) could have a pervasive effect if the auditor is suspicious that other audit evidence has been withheld. In this case the auditor should disclaim an opinion. Whilst the transaction itself may be immaterial, the information concerning the existence of Fox may be material to users and should therefore be disclosed (as a non-adjusting event). The absence of such disclosure, if the auditor considered necessary, would result in a qualified ‘except for’, opinion. If Fox indeed existed at the reporting date and had material assets and liabilities then its non-consolidation would result in all components of the financial statements being misstated and would therefore have a pervasive effect. This would warrant an adverse opinion on the basis of a disagreement with (IAS 27). Conclusion Additional evidence is required to support an unqualified opinion. If this were not forthcoming a disclaimer may be appropriate.


Final Assessment

MARKING SCHEME

Generally 1 mark to be awarded for each thoroughly explained point

(a) Thorn Ideas • No letter: qualify, disagreement, adverse • Letter & disclosure: no qualification • No disclosure: qualify, disagreement, except for • Insufficient evidence of support: emphasis of matter • Senior’s proposal unsuitable 4 marks

(b) Bramble Ideas • Need for consistency, prior year adjustment and disclosures (IAS

8) (1½ max) • Non-compliance: qualify, disagree, except for • Explanation of purpose need of emphasis of matter (1½ max) • Senior’s proposal unsuitable 5 marks

(c) Briar Ideas • Responsibility re. director’s report • 1.6% vs. ‘major’ • Resolved: unmodified • Unresolved: no qualification & explanatory paragraph • Senior’s opinion re. qualification appropriate 4 marks

(d) Tarbaby Ideas • Set up of subsidiary is PBSE • Oral rep insufficient evidence • Possible pervasive limitation in scope: disclaimer • Non disclosure of PBSE: qualify, disagree, except for • Non consolidation (IAS 27): qualify, disagree, adverse • Senior’s proposal requires further evidence to support 5 marks




ANSWER 5

(a) Chemical leakage

(i) Matters

$15,000 fine is very immaterial (just 1/4% profit before tax). This is revenue expenditure and it is correct that it has been expensed to the statement of comprehensive income. $0.15 million represents 0.6% total assets and 2.5% profit before tax and is not material on its own. $0.3 million represents 1·2% total assets and 5% profit before tax and is therefore material to the financial statements. The $0.15 million clean-up costs should not have been capitalised as the condition of the property is not improved as compared with its condition before the leakage occurred. Although not material in isolation this amount should be adjusted for and expensed, thereby reducing the aggregate of uncorrected misstatements. It may be correct that $0.3 million incurred in modernising the refrigeration units should be capitalised as a major overhaul (IAS 16 Property, Plant and Equipment). However, any parts scrapped as a result of the modernisation should be treated as disposals (i.e. written off to the statement of comprehensive income). The carrying amount of the refrigeration units at 31 December 2008, including the $0.3 million for modernisation, should not exceed recoverable amount (i.e. the higher of value in use and fair value less costs to sell). If it does, an allowance for the impairment loss arising must be recognised in accordance with IAS 36 Impairment of Assets.

(ii) Audit evidence

A breakdown/analysis of costs incurred on the clean-up and modernisation amounting to $0.15 million and $0.3 million respectively. Agreement of largest amounts to invoices from suppliers/consultants/sub-contractors, etc and settlement thereof traced from the cash book to the bank statement. Physical inspection of the refrigeration units to confirm their modernisation and that they are in working order. (Do they contain frozen food?) Sample of components selected from the non-current asset register traced to the refrigeration units and inspected to ensure continuing existence. $15,000 penalty notice from the regulatory agency and corresponding cash book payment/payment per the bank statement. Written management representation that there are no further penalties that should be provided for or disclosed other than the $30,000 that has been accounted for.


Final Assessment

(b) Outsourced cold storage (i) Matters

Inventory at 31 December 2008 represents 21% of total assets and is therefore a very material item in the statement of financial position. The value of inventory has increased by 50% though revenue has increased by only 7.5%. Inventory may be overvalued if no allowance has been made for slow-moving/perished items in accordance with IAS 2 Inventories. Inventory turnover has fallen to 6.6 times per annum (2007 – 9.3 times). This may indicate a build up of unsaleable items. Tutorial note: In the absence of cost of sales information, this is calculated on revenue. It may also be expressed as the number of days sales in inventory, having increased from 39 to 55 days. Inability to inspect inventory may amount to a limitation in scope if the auditor cannot obtain sufficient audit evidence regarding quantity and its condition. This would result in an ‘except for’ opinion. Although Elric’s monthly return provides third party documentary evidence concerning the quantity of inventory it does not provide sufficient evidence with regard to its valuation. Inventory will need to be written down if, for example, it was contaminated by the leakage (before being moved to Elric’s cold storage) or defrosted during transfer. Madison’s written representation does not provide sufficient evidence regarding the valuation of inventory as presumably Madison’s management did not have access to physically inspect it either. If this is the case this may call into question the value of any other representations made by management. Whether, since the reporting date, inventory has been moved back from Elric’s cold storage to Madison’s refrigeration units. If so, a physical inspection and roll-back of the most significant food lines should have been undertaken.

Tutorial note: Credit will be awarded for other relevant accounting issues. For example a candidate may question whether, for example, cold storage costs have been capitalised into the cost of inventory. Or whether inventory moves on a FIFO basis in deep storage (rather than LIFO).

(ii) Audit evidence

A copy of the health and safety regulation preventing the auditor from gaining access to Elric’s cold storage to inspect Madison’s inventory.

Analysis of Elric’s monthly returns and agreement of significant movements to purchase/sales invoices.

Analytical procedures such as month-on-month comparison of gross profit percentage and inventory turnover to identify any trend that may account for the increase in inventory valuation (e.g. if Madison has purchased replacement inventory but spoiled items have not been written off).



Physical inspection of any inventory in Madison’s refrigeration units after the reporting date to confirm its condition. An aged-inventory analysis and recalculation of any allowance for slow-moving items. A review of after-date sales invoices for large quantities of food to confirm that fair value (less costs to sell) exceed carrying amount. A review of after-date credit notes for any returns of contaminated/perished or otherwise substandard food.

(c) Rent-free accommodation (i) Matters

The senior sales executive is a member of Madison’s key management personnel and is therefore a related party. The occupation of Madison’s residential apartment by the senior sales executive is therefore a related party transaction, even though no price is charged (IAS 24 Related Party Disclosures). Related party transactions are material by nature and information about them should be disclosed so that users of financial statements understand the potential effect of related party relationships on the financial statements. The provision of ‘housing’ is a non-monetary benefit that should be included in the disclosure of key management personnel compensation (within the category of short-term employee benefits). The financial statements for the year ended 31 December 2008 should disclose the arrangement for providing the senior sales executive with rent-free accommodation and its fair value (i.e. $1,500 per month).

Tutorial note: Since no price is charged for the transaction, rote-learned disclosures such as ‘the amount of outstanding balances’ and ‘expense recognised in respect of bad debts’ are irrelevant.

(ii) Audit evidence

Physical inspection of the apartment to confirm that it is occupied. Written representation from the senior sales executive that he is occupying the apartment free of charge. Written representation from the management board confirming that there are no related party transactions requiring disclosure other than those that have been disclosed. Inspection of the lease agreement with (or payments received from) the previous tenant to confirm the $1,500 monthly rental value.


Final Assessment

MARKING SCHEME

Generally 1 mark to be awarded for each thoroughly explained point

(a) Chemical leakage Ideas Matters • Materiality • Non-capitalisation of clean up costs • Capitalisation of modernisation (IAS 16) • Impairment (IAS 36) Evidence • Cost breakdown • Inspect invoices • Physical inspection • Inspect cash book • Written mgt rep 6 marks

(b) Outsourced cold storage Ideas Matters • Materiality • Slow moving inventory • Insufficient evidence • Limitation in scope – ‘except for’

Evidence • H&S regulation • Analytically review monthly returns • Analytically review margins • Physical inspection • Aged inventory review 6 marks

(c) Rent-free accommodation Ideas Matters • Related party matters (IAS 24) • Material by nature • Non-monetary benefit • Disclosure

Evidence • Physically inspect • Written mgt rep • Inspect lease agreement 6 marks

TOTAL FOR QUESTION 18 MARKS


p7 - final

Documents