Audit and InternalReview(International Stream)

PART 2

TUESDAY 10 JUNE 2003

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A ALL THREE questions are compulsory and MUSTbe answered

Section B TWO questions ONLY to be answered Pape

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Section A – ALL THREE questions are compulsory and MUST be attempted

1 You have been presented with the following draft financial information about Hivex, a very successful company thatdevelops and licences specialist computer software and hardware. Its non-current assets mainly consist of property,computer hardware and investments, and there have been additions to these during the year. The company isexperiencing increasing competition from rival companies, most of which specialise in hardware or software, but notboth. There is pressure to advertise and to cut prices.

You are the audit manager. You are planning the audit and are conducting a preliminary analytical review andassociated risk analysis for this client for the year ended 31 May 2003. You have been provided with a summariseddraft income statement which has been produced very quickly and certain accounting ratios and percentages. Youhave been informed that the company accounts for research and development costs in accordance with IAS 38Intangible Assets.

INCOME STATEMENTYear ended 31 May

2003 2002$’000 $’000

Revenue 15,206 13,524Cost of sales 3,009 3,007

–––––– ––––––Gross Profit 12,197 10,517

Distribution costs 3,006 1,996Administrative expenses 994 1,768Selling expenses 3,002 274

–––––– ––––––Profit from operations 5,195 6,479Net interest receivable 995 395

–––––– ––––––Profit before tax 6,190 6,874Income tax expense 3,104 1,452

–––––– ––––––Net profit 3,086 5,422

–––––– –––––––––––– ––––––

Retained profits 1,617 3,983–––––– –––––––––––– ––––––

Dividends paid $1,469,000 $1,439,000

Accounting ratios and percentagesEarnings per share 0·43 1·04Performance ratios include the following:Gross margin 0·80 0·78Expenses as a percentage of revenue:Distribution costs 0·20 0·15Administrative expenses 0·07 0·13Selling expenses 0·20 0·02Operating profit 0·34 0·48

Required:

(a) Using the information above, comment briefly on the performance of the company for the two years.(8 marks)

(b) Use your answer to part (a) to identify the areas that are subject to increased audit risk and describe thefurther audit work you would perform in response to those risks. (12 marks)

(20 marks)

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2 Some organisations conduct inventory counts once a year and external auditors attend those counts. Otherorganisations have perpetual systems (i.e they conduct continuous inventory counting) and do not conduct a year-end count.

Required:

(a) Explain why year-end inventory counting is important to the auditors of organisations that do not haveperpetual inventory systems. (4 marks)

(b) Describe audit procedures you would perform in order to rely on a perpetual inventory system in a large,dispersed organisation. (4 marks)

(c) Snu is a family-owned company which retails beds, mattresses and other bedroom furniture items. Thecompany’s year-end is 31 December 2003. The only full inventory count takes place at the year-end. Thecompany maintains up-to-date computerised inventory records.

Where the company delivers goods to customers, a deposit is taken from the customer and customers areinvoiced for the balance after the delivery. Some goods that are in stock at the year-end have already been paidfor in full – customers who collect goods themselves pay by cash or credit card.

Staff at the company’s warehouse and shop will conduct the year-end count. The shop and warehouse are openseven days a week except for two important public holidays during the year, one of which is 1 January. Thecompany is very busy in the week prior to the inventory count but the shops will close at 15.00 hours on 31 December and staff will work until 17.00 hours to prepare the inventory for counting. The company has ahigh turnover of staff. The following inventory counting instructions have been provided to staff at Snu.

(i) The inventory count will take place on 1 January 2004 commencing at 09.00 hours. No movement ofinventory will take place on that day.

(ii) The count will be supervised by Mr Sneg, the inventory controller. All staff will be provided with pre-printed,pre-numbered inventory counting sheets that are produced by the computerised system. Mr Sneg will ensurethat all sheets are issued, and that all are collected at the end of the count.

(iii) Counters will work on their own, because there are insufficient staff for them to work in pairs, but they willbe supervised by Mr Sneg and Mrs Zapad, an experienced shop manager who will make checks on the workperformed by counters. Staff will count inventory with which they are most familiar in order to ensure thatthe count is completed as quickly and efficiently as possible.

(iv) Any inventory that is known to be old, slow-moving or already sold will be highlighted on the sheets. Staffare required to highlight any inventory that appears to be soiled or damaged.

(v) All inventory items counted will have a piece of paper attached to them that will show that they have beencounted.

(vi) All inventory that has been delivered to customers but that has not yet been paid for in full will be addedback to the inventory quantities by Mr Sneg.

Required:

Describe the weaknesses in Snu’s inventory counting instructions and explain why these weaknesses aredifficult to overcome. (12 marks)

(20 marks)

3 [P.T.O.

3 Your firm is the external auditor to two companies. One is a hotel, Tourex, the other is a food wholesaler, Pudco, thatsupplies the hotel. Both companies have the same year-end. Just before that year-end, a large number of guestsbecame ill at a wedding reception at the hotel, possibly as a result of food poisoning.

The guests have taken legal action against the hotel and the hotel has taken action against the food wholesaler.Neither the hotel nor the food wholesaler have admitted liability. The hotel is negotiating out-of court settlements withthe ill guests, the food wholesaler is negotiating an out-of-court settlement with the hotel. At the balance sheet date,the public health authorities have not completed their investigations.

Lawyers for both the hotel and the food wholesaler say informally that negotiations are ‘going well’ but refuse toconfirm this in writing. The amounts involved are material to the financial statements of both companies.

Required:

(a) Describe how ACCA’s Rules of Professional Conduct apply to this situation and explain how the externalauditors should manage this conflict of interest. (6 marks)

(b) Outline the main requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets and applythem to this case. (7 marks)

(c) Assuming that your firm continues with the audit of both companies, for each company describe thedifficulties you foresee in obtaining sufficient audit evidence for potential provisions, contingent liabilities andcontingent assets, and describe how this could affect your audit reports on their financial statements.

(7 marks)

(20 marks)

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Section B – TWO questions ONLY to be attempted

4 Your firm is the newly appointed external auditor to a large company that sells, maintains and leases office equipmentand furniture to its customers and you have been asked to co-operate with internal audit to keep total audit costsdown. The company wants the external auditors to rely on some of the work already performed by internal audit.

The internal auditors provide the following services to the company:

(i) a cyclical audit of the operation of internal controls in the company’s major functions (operations, finance,customer support and information services);

(ii) a review of the structure of internal controls in each major function every four years;

(iii) an annual review of the effectiveness of measures put in place by management to minimise the major risks facingthe company.

During the current year, the company has gone through a major internal restructuring in its information servicesfunction and the internal auditors have been closely involved in the preparation of plans for restructuring, and in therelated post-implementation review.

Required:

(a) Explain the extent to which your firm will seek to rely on the work of the internal auditors in each of the areasnoted above. (6 marks)

(b) Describe the information your firm will seek from the internal auditors in order for you to determine the extentof your reliance. (6 marks)

(c) Describe the circumstances in which it would not be possible to rely on the work of the internal auditors.(4 marks)

(d) Explain why it will be necessary for your firm to perform its own work in certain audit areas in addition torelying on the work performed by internal audit. (4 marks)

(20 marks)

5 [P.T.O.

5 Reports produced by internal auditors are different from audit reports produced by external auditors performing auditsunder International Standards on Auditing. The reports are produced for different purposes, and are directed atdifferent users. They differ substantially in both form and content.

Internal audit reports often comprise the following:

(i) A cover page;

(ii) Executive summary;

(iii) The main report contents;

(iv) Appendices.

Required:

(a) List and briefly describe the general categories of information that you would expect to find in an internalaudit report under each of the four headings above. (4 marks)

(b) List the main contents of most external audit reports. (4 marks)

NB: You are not required to reproduce a full external audit report.

(c) Explain why the contents of external audit reports prepared under International Standards on Auditing andinternal audit reports are different. (4 marks)

(d) Some reports produced by internal auditors are similar to the report to management (management letter) oninternal controls and other matters that are produced by external auditors during the course of the audit. Thesteps taken by internal and external auditors in drafting, issuing and following up such reports are also similar.

Required:

Describe the common characteristics of the steps taken by internal and external auditors in producing reports tomanagement. (8 marks)

(20 marks)

6 (a) Internal controls over non-current assets are designed to ensure the orderly and efficient running of the business,adherence to management policies, safeguarding of assets, the prevention of fraud and error and thecompleteness and accuracy of the accounting records.

Required:

List the internal controls that a small printing company with office equipment, motor vehicles and plant andmachinery should have in place to achieve the objectives described above. (10 marks)

(b) Audit sampling is a technique for drawing conclusions about the characteristics of a population by testing asample drawn therefrom. Internal and external auditors use it for both tests of controls, and substantive testing.

Required:

Describe the following:

(i) Judgement sampling and statistical sampling;

(ii) A representative sample;

(iii) Tolerable error;

(iv) Two different methods of selecting a representative sample;

(v) The extrapolation of errors.

NB: Parts (i) – (v) carry equal marks. (10 marks)

(20 marks)

End of Question Paper

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