Answers

Part 2 Examination – Paper 2.6(INT)Audit and Internal Review (International Stream) June 2005 Answers

1 (a) According to ISA200. Objective and general principles governing an audit of financial statements:

Audit risk

Audit risk is the risk of giving an inappropriate opinion on the financial statements; for example failing to qualify when thefinancial statements contain a material error. Audit risk has three individual components in the formula:

Audit Risk = Inherent Risk x Control Risk x Detection Risk

Inherent risk

This is the risk of an assertion to a misstatement that could be material, either individually or when aggregated with othermisstatements, assuming there are no related controls.

Control risk

This is the risk that the internal control system will fail to prevent or detect a material error. The auditor’s preliminaryassessment of controls will help determine control risk.

Detection risk

This is the risk that the auditor will fail to detect a misstatement that exists in an assertion that could be material. For a givenlevel of audit risk, the acceptable level of detection risk bears an inverse relationship to the assessment of the risk of materialmisstatement at the assertion level.

(b) (i) Audit risks

Over-trading

The turnover of Parker is growing quite rapidly, although this growth is not matched in net profits. The company hasbeen expanding into the Internet, and plans to introduce other product lines for sale in this division. There is the riskthat the business will exhaust any cash reserves as it continues to expand but does not generate sufficient additionalcash to pay for that expansion. In this situation suppliers may go unpaid and at the extreme the business will be forcedinto liquidation. Therefore the financial statements may not adequately disclose doubts about going concern.

Internet trading

The decision to expand the Internet business may cause other problems for Parker. Selling of books and CDs appear tobe related as they are both forms of entertainment and the customer knows what the product is like. Selling toys mayfall into a similar category, but garden furniture and clothes are different. Garden furniture is bulky and will certainlycost more to deliver while clothes are sold more on taste and a high level of returns can be expected. Specific risks withthis decision therefore relate to:

The overall ability of management to run the business given their apparent lack of knowledge of Internet trading.

– The need to setup and manage systems for the sales of many new products.

– The need to allow for a much larger volume of returns.

– The possibility of inventory obsolescence if Parker overstocks on clothes which go ‘out of fashion’.

Control environment

The whole environment in which the control systems should be operating appears weak. There are errors in thesystems, the extent of which are not known, and the directors and the accountant do not appear to be inclined to attemptto remedy the situation. The skills of the accountant may also be questioned because he appears to have beenappointed not on merit, but from some personal relationship with the directors. Other errors may also have occurredwhich have not been detected. The risk is that the financial statements may have material errors in them.

Bank loan

The directors require additional finance to expand the business. To provide this finance it is likely that the bank willrequire sight of the audited financial statements; the directors of Parker expect the audit to be completed prior to meetingthe bank. The auditor may need to write to the bank to disclaim reliance on the audit report for the purposes of makinga bank loan. There is a risk to the audit firm of being sued if the bank relies on the report and sustains financial loss.There is also a risk to Parker that the loan is not obtained and the company goes into liquidation. The financialstatements may need to be prepared on a breakup basis.

First year of audit

The audit is also risky for the audit firm because it is the first year of an audit and the client has expectations about thetype of auditor’s report to be produced. The accounting systems also appear to be unreliable, again increasing the riskof material error. The audit firm must ensure that sufficient time and resources are allocated to the audit to ensure thatthe audit opinion can be supported. Pressure from the directors to complete the audit quickly will have to be resisted.

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(ii) Going concern work

Review the financial position of the company in detail. Budgets and cash flow forecasts showing income and expenditurefor at least the next 12 months must be reviewed. The accuracy of these forecasts can be determined in part by checkinghow accurate past forecasts were. If the directors have not produced this information, then the auditor will ask them toproduce it.

If not already done so, obtain a standard audit bank confirmation letter. Check the letter for overdraft and loan facilitiesto ensure that they have not been exceeded. Also check review dates (although it appears this will be three monthsafter the end of the year) and confirm with directors what accounting information will be expected at these dates.

Review correspondence with the bank for signs of strain with the bank. A poor relationship implies that further loansmay not be granted and alternative finance will be required. However, it is unlikely that any details of the relationshipwith their client will be provided by the bank.

Make enquiries with the directors regarding the availability of other finance which will be necessary for the plannedexpansion. Obtain supporting evidence for this finance, such as letters confirming amounts available and interest ratespayable.

As close as possible to the date of the auditor’s report, review the most recent management accounts to help determinethe extent of any additional finance required.

Obtain a letter of representation from the directors confirming their responsibility for preparing cash flow forecasts andfor the overall going concern status of Parker.

Use all the evidence obtained to take a view on the going concern status of Parker and review the adequacy of disclosure(if any) in the accounting policy note to the financial statements.

2 (a) Management representations are a form of audit evidence. They are contained in a letter, written by the company’s directorsand sent to the auditor, just prior to the completion of audit work and before the audit report is signed.

Representations are required for two reasons:

Firstly, so the directors can acknowledge their collective responsibility for the preparation of the financial statements and toconfirm that they have approved those statements.

Secondly, to confirm any matters, which are material to the financial statements where representations are crucial to obtainingsufficient and appropriate audit evidence.

In the latter situation, other forms of audit evidence are normally unavailable because knowledge of the facts is confined tomanagement and the matter is one of judgement or opinion.

Obtaining representations does not mean that other evidence does not have to be obtained. Audit evidence will still becollected and the representation will support that evidence. Any contradiction between sources of evidence should, as always,be investigated.

(b) Lion’s Roar

The amount of the claim is material being 50% of profit before taxation.

There is also a lack of definitive supporting evidence for the claim. The two main pieces of evidence available are the claimfrom Lion’s Roar itself and the legal advice from Crighton Ward’s solicitors. However, any claim amount cannot be accuratelydetermined because the dispute has not been settled.

The directors have stated that they believe the claim not to be justified, which is one possible outcome of the dispute.However, in order to obtain sufficient evidence to show how the treatment of the potential claim was decided for the financialstatements, the auditor must obtain this opinion in writing. Reference must therefore be made to the claim in therepresentation letter.

Paragraph for inclusion in representation letter.

‘A legal claim against Crighton-Ward by Lion’s Roar has been estimated at $4 million by Lion’s Roar. However, the directorsare of the opinion that the claim is not justified on the grounds of breach of product specification. No provision has beenmade in the financial statements, although disclosure of the situation is adequate. No similar claims have been received orare expected to be received.’

Depreciation

This matter is unlikely to be included in the letter of representation because the auditor appears to have obtained sufficientevidence to confirm the accounting treatment. The lack of profit or loss on sale confirms that the depreciation charge isappropriate – large profits would indicate over-depreciation and large losses, under-depreciation. The amount also meetsindustry standards confirming that Crighton-Ward’s accounting policy is acceptable. Including the point in the representationletter is inappropriate because the matter is not crucial and does not appear to be based on judgment or opinion. The onlyopinion here appears to be that of the auditor – unless the ‘feelings’ can be turned into some appropriate audit evidence, thematter should be closed.

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(c) Lack of representation letter

The auditor may take the following actions:

Discuss the situation with the directors to try and resolve the issue that the directors have raised. The auditor will need toexplain the need for the representation letter again (and note that the signing of the letter was mentioned in the engagementletter).

Ascertain exact reasons why the directors will not sign the letter. Consider whether amendments can be made to the letterto incorporate the directors’ concerns that will still provide the auditor with appropriate and sufficient audit evidence.

The discussion must clearly explain the fact that if the auditor does not receive sufficient and appropriate audit evidence, thenthe audit report will have to be modified.

The reason for the audit qualification will be uncertainty regarding the amounts and disclosures in the financial statements.An ‘except for’ qualification for the material uncertainty is likely, although a disclaimer may be required, especially if the legalclaim is thought to require a provision.

Even if the letter is subsequently signed, the auditor must still evaluate the reliability of the evidence. If, in the auditor’sopinion, the letter no longer provides sufficient or reliable evidence, then a qualification may still be required.

3 (a) Audit test Reason for test

Discuss with booking clerk how orders are The main problem with the sales system in TT is the lack of recorded from the customer. evidence for the receipt of the telephone order. Checks are

therefore required to ensure that orders are completely and accurately recorded in the Vehicle Management System (VMS) where no input document is available.

Discuss with the directors the recruitment To check on the personnel controls in TT which will be and training of booking clerks. designed to minimise loss of customer orders.

To ensure that staff have appropriate skill and training tooperate the ordering system without losing customer orders.

With client’s permission, attempt to enter To confirm the completeness and accuracy of recording of orders into the VMS from an input terminal. orders by the computer system.

For a sample of confirmed e-mail orders To check for accuracy of transfer of information from the e-mail held in the e-mail programme, trace details to the VMS. onto the VMS ensuring that details of vehicle The method of filing of the e-mails means that completenesshire regarding time and dates are accurately of e-mail orders cannot easily be determined. Audit recorded. software may be able to re-sort the orders.

Review hard copy customer complaint files To check for evidence of orders being sent by customers but and e-mail files on computer for evidence not entered into TT’s sales system. of unfilled orders.

For a sample of bookings in the VMS, To check for completeness of transfer of information between trace details to the list of sales invoices the two programmes. The test can be carried out manually raised maintained in the receivables or using test data. Manual testing may be difficult where ledger programme. there is no obvious audit trail between the two systems.

For a sample of sales invoices in the VMS, To check for accuracy of charging for each individual vehicle hire. agree the rental amount being charged to Evidence of undercharging would indicate that sales are standard charges held in the receivables understated.ledger file.

Cast the list of invoices in the receivables To ensure that the total sales for that month are ledger programme for one month. Trace accurate. Transfer of data to the nominal ledger ensures that total sales to the general ledger programme. the total sales amount is recorded correctly in the ledger.

Cast the monthly sales figures in the The final cast and checking ensures that the financial general ledger and agree to the financial accounts figure is accurate. statements. Investigate any discrepancies. Casting tests can be carried out manually or using

computer audit software.

(b) Audit work on Vehicles.

– Obtain non-current asset register from client. Cast the cost, depreciation and net book value columns of the register andagree to the financial statements of TT.

For a sample of new additions in the non-current asset register:

– Agree to board minute or similar documentation for evidence of authority to purchase vehicle. (Occurrence assertion)

– Agree to the physical asset to confirm existence of the vehicle. Where the vehicle is on hire during the audit visit, obtainalternative evidence of existence such as payment from customer near year end for hire. (Existence assertion)

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– Check the physical condition of the vehicle to ensure that repairs and renewal expenditure is not being understated.(Existence of repair expenditure)

– Agree details to purchase invoice or similar document for evidence of ownership. (Ownership assertion)

– Test the calculation of depreciation in the non-current asset register, ensuring that the rates used are those disclosed inthe financial statements. (Valuation and accuracy assertion)

– Review profits and losses generated on sale of vehicles and ensure these are not excessive. If they are check the accuracyof the depreciation rates used as this may indicate over or under charge of depreciation. (Valuation and accuracyassertion).

– Compare sales income to sale of similar vehicles with similar mileage and ensure comparable.

For a sample of disposals during the year (for occurrence assertion)

– Ensure asset has been removed from the non-current asset register

– Check calculation of profit or loss on sale

– Agree receipt on sale to the cash book.

For a sample of vehicles purchased during the year, agree details to purchase invoice and Purchase Day Book (PDB) ensuringdetails recorded in the correct year (Occurrence assertion).

For a sample of vehicle purchases in the PBD, agree details to the non-current asset register (Completeness assertion).

Agree totals in non-current asset register to the financial statements, ensuring vehicles are disclosed separately in the non-current assets note (material item). (Classification and understandability assertion).

Ensure that the accounting policy for depreciation is clearly stated in the financial statements and is the same as last year(Classification and understandability assertion).

4 Memo

From: Chief Internal AuditorTo: Board of ZX Subject: Role of Audit CommitteeDate: June 2005

(a) Areas where the internal audit department can assist the directors with the implementation of good corporate governance inan organisation include:

Board reports

Reviewing reports to the board and reports produced by the board to ensure that they do present a balanced andunderstandable assessment of the company’s position and prospects. The internal audit department will have goodknowledge of the operations of the company as well as access to accounting information. The department can effectively‘audit’ board reports to ensure they are accurate and understandable.

Internal controls

The board need to maintain a sound system of internal control. The internal audit department will be able to review existingcontrols and recommend improvements to ensure this objective is met.

Application of ISA and IASs

The board need to have a policy for applying appropriate International Statements on Auditing (ISA) and InternationalAccounting Standards (IAS) to the organisation. Internal audit will certainly be aware of new auditing standards and will havethe technical expertise (especially where internal audiors are professionally qualified) to identify changes required byaccounting standards. Amendments to control systems for new auditing standards and financial accounting systems for newaccounting standards can therefore be recommended.

Communication with exteral auditors

Under corporate governance regulations, communications with external auditors will normally be via the audit committee,although the board must maintain an appropriate relationship with the external auditors. However, internal and externalauditors can also work together to ensure that the internal control system is sufficient; possibly by external audit delegatingwork to internal audit, and each auditor reviewing the work of the other auditor. The board will therefore receive reports fromboth sets of auditors which will be accurate because they have been properly checked.

Communication to the board

The internal auditor can also check that appropriate information is provided to the board from the external auditor. ISA 260Communications of audit matters with those charged with governance provides a list of matters which should becommunicated to the board and the internal auditor can work with the external auditor to ensure that this information isprovided.

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(b) The advantages of an audit committee include:

Public confidence

Providing increasing public confidence in the creditability and objectivity of published financial information. This will beparticularly important for ZX if listing arrangements go ahead. While an internal audit department is not normally necessaryfor incorporated companies, the provision of that department will provide additional confidence in the accuracy of the financialstatements and hopefully make ZX an attractive investment.

Financial reporting

Supports the directors in fulfilling their financial reporting obligations. The directors have to prepare financial statements forZX. The committee can assist by checking the financial statements to ensure that they comply with appropriate reportingrequirements. This is especially important where the board do not have detailed knowledge of accounting requirements.

Communication

Enhancing the role of ZX’s external auditors by providing an appropriate channel of communication. Use of the auditcommittee will enable the external auditor to discuss issues with the financial statements with the internal auditor, prior toproviding a final summary of key points to the board.

‘Friend’ of the Board

The audit committee may also act as a ‘critical friend’ to the board by monitoring the work of the board and providing helpfulguidance, where corporate governance requirements do not appear to be being met. The audit committee should havedetailed knowledge of corporate governance as part of its monitoring function of the company and can share this with theboard who may not have the time to obtain detailed information.

The disadvantages of an audit committee include:

Lack of understanding of function

As the directors in ZX do not have much knowledge of corporate governance, they may see the additional involvement of theaudit committee as a threat to their authority or taking away some of their responsibilities. This memo has hopefully outlinedthe advantages of an audit committee in supporting the work of the directors, removing this as a problem.

Role of non-executive directors

As the audit committee will be made up mainly from non-executive directors, the board may see this as a means of decreasingtheir power and possibly letting other people run the company. Again, the audit committee must be seen as fulfilling asupporting role for the main board. It will utilise the special knowledge of account production and internal controls from theexternal auditor and business non-executives to provide appropriate review of information being given to the board.

Cost

The audit committee will increase the expenditure of the company as the non-executive directors will require someremuneration due to their additional responsibilities. While this cannot be avoided, the benefits of the committee in terms ofproviding assistance to the board and raising the profile of ZX ready for possible listing must not be forgotten.

5 (a) Preparation of financial statements

The directors are normally required to prepare the financial statements of the company using the appropriate law of theircountry and in accordance with the International Accounting Standards (IASs). The auditors are normally required to checkor audit those financial statements, again in accordance with the legislation of their country and the International Statementson Auditing.

Fraud and error

The directors are responsible for preventing and detecting fraud and error in the financial statements, no matter howimmaterial this may be. Auditors are responsible for ensuring that the financial statements show a true and fair view; in otherwords that the financial statements are materially correct. Auditors are not required to detect immaterial fraud or error.

Disclosure

The directors must ensure that there is adequate disclosure of all matters required by statute or IASs in the financialstatements. The auditor will check that disclosure provisions have been complied with, and where certain disclosures havenot been made (e.g. ISA 550 regarding related party transactions) provide this information in the audit report.

Going concern

The directors are responsible for ensuring that the company will continue in operational existence for the foreseeable future,and report to the members in the published financial statements if this is unlikely to be the case. The auditor will check theaccuracy of the directors’ workings and assumptions and if these are considered incorrect or inappropriate, then the auditreport may be modified or qualified to bring the situation to the attention of the members of the company.

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(b) The basis of opinion paragraph may not meet the requirements of ISA 700 for the following reasons:

The use of the term Auditing Standards is not clear, because the report does not state which auditing standards have beenused. This provides uncertainty regarding the actual standard of work performed.

The assessment of estimates and judgements made by the directors normally relates to significant amounts only, rather thanall of those estimates and judgements. The use of the word all implies that the audit was more thorough than it probablywas. Replacing the word all with the word significant will show that there was some limit to the audit testing and that thiswas probably focused on material amounts only.

Stating that time was a factor in obtaining information and explanations for the audit is not correct as this implies some factorwhich could have been avoided and that the audit may therefore be incomplete. The auditor has to plan the audit carefullyand ensure that all the information and explanations considered necessary are obtained to form an opinion, not simply stopwork when time runs out.

The auditor does not confirm that the financial statements are free from material misstatement as this implies a degree ofaccuracy that the auditor simply cannot provide. Making the statement could also leave the auditor liable to claims frommembers or third parties should errors be found in the financial statements later. Rather than make such a categoricalstatement, the auditor provides reasonable assurance that the financial statements are free from material misstatement, whichclearly implies that audit techniques are limited.

The disclaimer regarding errors appears to be useful in that it limits the auditor’s liability. However, it does not belong in thebasis of opinion paragraph as it appears to severely limit the basis of the auditor’s opinion to stating that the directors areresponsible for all errors. Directors’ responsibilities are also clearly outlined in another section of the report, and this statementalso appears to extend those responsibilities making the audit report overall less clear. This could also imply that the auditorhas done little or no work.

As the auditor is not required to audit the whole of the annual report of a company, it is inappropriate to refer to disclosurein that report when checking overall adequacy of presentation. Adequacy of presentation can only be confirmed regardingitems actually audited, which is basically the financial statements.

(c) A positive assurance report means that the auditor has carried out sufficient work to be able to state that financial informationis free from material error.

A negative assurance report means that nothing has come to the attention of the audit, which indicates the financialinformation being reported on has errors in it. However, the extent of the work carried out is normally less, which means thatless reliance can be placed on this report.

The advantages of providing negative assurance include:

– The user of the financial information receives some comfort that the information is correct, even though that assuranceis less than positive assurance.

– The report adds some credibility to the financial information because it has been reviewed by a professional accountant.

– For the preparer, the report will be more cost effective than obtaining a full positive assurance report.

6 (a) (i) Analytical Procedures consist of evaluations of financial information made by a study of plausible relationships amongboth financial and non-financial data.

Inquiry means to seek relevant information from sources, both financial and non-financial, either inside or outside thecompany being audited. Evidence may be obtained orally or in writing.

Inspection is the physical review or examination of records, documents and tangible assets. It may include examinationof records for evidence of controls in the form of a compliance test.

Observation involves looking at a process or procedure as it is being performed to ensure that the process actually worksas documented.

Re-calculation means the checking of the mathematical accuracy of documents or records.

(ii) Analytical Procedures.Review of sales income year on year to try to identify whether income has been under-stated, possibly by cash beingtaken prior to banking. There is no control over the opening of post so cash could be withdrawn by one assistant, andthe deficit made up by a fraud on customers.

InquiryObtain statements from suppliers to check the completeness of liabilities at the end of the year. As there is no controlover purchases, invoices could have been mis-placed resulting in a lower purchases and suppliers figure.

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InspectionThe assets of the company, namely cuddly toys in inventory at the end of the year, can be inspected to ensure allinventory is recorded and that the toys are saleable in their current condition.

ObservationProcedures such as the opening of cash and recording of customer orders can be observed to ensure that theadministrator is recording all orders in the sales day book and cash books.

Re-calculationChecking additions in the cash book to confirm that the total amount of cash recorded is accurate and can be includedin the sales figure (cash receipts normally equal sales because there are no receivables).

(b) Analytical procedures

This method of collecting evidence will be useful in BearsWorld because it will help to identify unusual changes in incomeand expenditure. As BearsWorld is a relatively small company, monitoring gross profit will show relatively small changes insales margin or purchasing costs. Decisions by Mr Kyto to amend margins can therefore be traced into the actual sales made.

However, the technique may be limited in its application because it will not detect errors or omissions made consistently yearon year. If either assistant is defrauding the company (for example by removing cash) each year, then analytical procedureswill not detect this.

Inquiry

Inquiry evidence will be very useful in the audit of BearsWorld, especially where this is derived from third parties. Third partyevidence is generally more reliable than client originated evidence as there is a decreased likelihood of bias. Suppliers cantherefore be verified using supplier statement reconciliations. A review of any customer complaints file (if these letters arekept) will also help to identify any orders that have not been despatched.

External inquiry evidence will be less useful in the audit of sales and receivables because goods are paid for prior to despatch– there are no receivables. Internal evidence will be available from Mr Kyto and the assistant; however the lack of segregationof duties means that this will not be so reliable.

Inspection

Inspection of documents within BearsWorld will be useful, particularly regarding checking whether expenses are bona fide.All purchase invoices, for example, should be addressed to BearsWorld and relate to purchases expected from that companye.g. cuddly toys for resale, office expenses etc.

Inspection of documents can take a long time; however, given the poor internal control system within BearsWorld, the auditormay have no choice but to use this method of gathering evidence.

The fact that an invoice is addressed to the company does not confirm completeness of recording so inspection of the cashbook for unusual payments verified by checking the purchase invoice will also be required. Additional substantive testingwould also be required due to poor controls.

Observation

Observation may be useful because it will show how the assistants check documents. However, no information is providedon any internal controls within BearsWorld so simply viewing how documents are checked without any evidence of checkinghas limited benefit.

Observation tests will be of limited usefulness because the assistants may act differently when an auditor is present. The sameproblem will apply to any observation checking carried out by Mr Kyto.

Re-calculation

Re-calculation evidence is very useful for checking additions on invoices, balancing of control accounts etc. This means thatthe arithmetical accuracy of the books and records in BearsWorld can be confirmed.

The main weakness of re-calculation checking is that calculations can only be carried out on figures that have been recorded.If there are any omissions then checks cannot be carried out.

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Part 2 Examination – Paper 2.6(INT)Audit and Internal Review (International Stream) June 2005 Marking Scheme

Marks1 New client with going concern problems

(a) Allows candidates to demonstrate their knowledge of audit risk – one of the key concepts for auditors. While not necessarily difficult, the candidate must remember the three constituent parts of audit risk as these are not given in the question.

One mark each for explaining the following. Allow 0·5 where explanation incomplete. Audit Risk 1Inherent Risk 1Control Risk 1Detection Risk 1

–––Maximum marks 4

–––

(b) (i) Provides a scenario from which a number of audit risks can be identified. The nature of the scenario, that is broad information about the audit, informs the candidate that the risks are at the inherent, controlor detection level, and not detailed risks affecting account balances. The answer should therefore reflect this level of detail.

Candidates must also clearly show application of knowledge to the scenario. Lists of risks are not required – identification of specific risks with explanation of their relevance are required e.g. a general Internet risk is security – this was not identified as an issue in the scenario.

1 mark per pointAllow for alternative formats where these are presented.Overtrading (Expanding rapidly turnover, New product lines, Cash reserves Credits/liquidation)Internet trading (Different products, Naïve directors, New systems, Higher returns, Inventory obsolescence)Control environment (Overall weak, Extent of errors not known, Directors attitude, Lack of skill Fin Accountant, Material error FS)Bank loan (Additional finance, Audit disclaimer, Liquidation)First year of audit (Audit report expectations, Unreliable accounting systems, Time needed – resistdirector pressure)Other relevant points.

–––Maximum marks 10

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(ii) Allows candidates to show their knowledge of going concern reviews. However, the focus of the answer should still be on Parker where possible so issues such as possible lack of forecasts (lack of director control) can be mentioned in the answer.

Key points 1 for each pointFinancial position of company – budgets etc. 2Bank letter 1Bank correspondence 1Enquiries with directors 2Management accounts 1Letter of representation 1Final decision going concern 1Board minutes – review after year end 1Other good relevant points 1

–––Maximum marks 6

–––Total 20

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Marks2 Letter of representation

(a) Allows candidates to demonstrate their knowledge of representation letters – regarding their purpose, not simply a list of the contents.

Representations – one mark per relevant pointForm of evidence 1Reason one – directors confirm accounts 1Reason two – material matters crucial to audit 1Matters of judgment or opinion 1Still obtain other evidence – this is corroboratory 1

–––Maximum marks 5

–––

(b) Provides a scenario which is used to show whether or not a representation letter point is required, and if so the format of that point. This section allows the candidate to apply knowledge of representation letters.

One mark per relevant pointLion’s Roar.Lack of supporting evidence 1Amount material 1Claim not justified and reason 1Treatment in financial statements (alternative provide allow) 1Draft paragraph for representation letter – maximum of 2DepreciationHave sufficient evidence 1Examples of evidence and effect on depreciation charge (1 mark each) 1Example of evidence 2 1Matter not therefore crucial 1Auditor must provide audit evidence to support ‘feelings’ 1

–––Maximum marks 10

–––

(c) Allows candidates to demonstrate their knowledge of procedures for obtaining a representation letter, and the actions that are necessary should that procedure break down.

Key points 1 for each pointMeet with directors 1Possible amendments to letter 1Issue – potential qualification 1Reason for qualification 1Issue – reliance on subsequent representation letter 1Could resign if situation serious enough 1

–––Maximum marks 5

–––Total 20

–––

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Marks3 Sales testing

(a) The question deliberately focuses on one part of the testing of sales income – namely completeness. The system within TT is typical of many ‘modern’ sales systems in that there is a lack of input documentation, and then possible loss of audit trail through the computer. Use of test data may assist the auditor, but this does not overcome the issue of initial loss of telephone order.

The e-mail system is provided to show that audit evidence can be made available, although the filing system for this is not appropriate. However, audit tests can be designed here.

Many other standard tests are not required because they do not relate to the completeness of sales income. The candidate is therefore required to be discriminatory in their listing of audit tests.

Audit tests on completeness and accuracy of sales incomeWatch for tests being combined – be generous where two tests are given in same pointNormally award 1 mark per point.Discussion with booking clerk 1Internal controls on hiring of staff 1Enter orders into VMS 1E-mail orders to VMS 1Customer complaints files 1LMS details to invoice files 1Invoice details agree to standard rental charges 1Casting invoices 1Casting N/L and agree to FS 1Other relevant tests e.g. receivables for accuracy of sales 1

–––Maximum marks 10

–––

(b) Non-current asset testingThis question is designed to test candidate’s knowledge of the audit of non-current assets, as well as to provide a balance to the more difficult part (a). Candidates are informed of the key details of non-current assets in the scenario (non-current asset register, material balance etc.) and from this should be able to provide a clear list of tests.

The audit testing assertions are mentioned in the answer as candidates are likely to structure their answer around these headings.

List of tests at 1 mark per relevant testCast non-current asset register 1Board minute – evidence of authority to purchase 1Physical existence 1Repairs expenditure check 1Evidence of ownership 1Check depreciation calculation 1Check on depreciation – profit / loss on sale 1Check on depreciation – similar vehicles 1Disposals testing 1Agree to Purchase Day Book 1Agree non-current asset register to financial statements 1Financial statements disclosure 1Allow other relevant points 1

–––Maximum marks 10

–––Total 20

–––

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Marks4 Corporate Governance

Corporate governance was highlighted as an important area in the study guide from changes made in 2004. It is therefore appropriate to examine this topic in the context of internal audit at an early opportunity.

(a) Board reports 2Internal control 2Application of ISAs and IASs 2Communication with external auditors 2Communication to the board 2Allow other relevant points 2Risk management 2Communication with external auditors 2Prevent/detect fraud 2

–––Maximum marks 10

–––2

(b) The importance of audit committees was confirmed in the Higgs report and the combined code. This question, while being topical, also allows candidates to apply knowledge in this area to a specific scenario.

One mark for explaining the area and one mark for applying to the situation in ZXAdvantagesPublic confidence 2Financial reporting 2Communication 2Friend of the board 2DisadvantagesLack of understanding of function 2Role of non-executive directors 2Cost 2Allow other relevant points 2

–––Maximum marks 10

–––Total 20

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Marks5 (a) Duties re financial statements

This question allow candidates to show that they understand the difference between the responsibilities ofdirector and auditors.

Allow 1 mark for director responsibilities, and 1 for auditor responsibilities.

Preparation of financial statements 2Fraud and error 2Disclosure 2Going concern 2Similar relevant points – each point 2

–––Maximum marks 6

–––

(b) Auditor’s reportsCandidates will be familiar with the format of auditor’s reports from their studies. This question allows the candidate to demonstrate knowledge of a specific aspect of that report by identifying weaknesses.

Up to 2 marks per relevant point.Use of term International Auditing Standards 2Limitation on use of judgments and estimates 2Time limitation 2FS free from material error 2Directors’ responsibilities 2Reference to annual report 2Allow other relevant points 2

–––Maximum marks 10

–––

(c) Audit reportsCandidates will be aware of the different reports that can be produced by an auditor. This question allows the candidate to demonstrate knowledge of different reports, and specifically the benefits of negative assurance.

One mark per pointMeaning of positive assurance 1Meaning of negative assurance 1Advantages of negative assuranceSome comfort provided 1Credibility 1Cost effective 1Allow other relevant points 1

–––Maximum marks 4

–––Total 20

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Marks6 Types of evidence

Candidates will be familiar with the different types of evidence available from the Auditing Standards. This question requires an explanation of five different types of evidence and then applies this knowledge into a scenario where controls are weak – by implication the auditor will be looking for substantive evidence and this should be borne out in the examples provided in part (a)(ii).

(a) (i) Types of audit evidenceAward one mark for each well explained point. Allow 0·5 for simply stating the appropriate area.Analytical Procedures 1Inquiry 1Inspection 1Observation 1Re-calculation 1

(ii) Examples of evidenceAward one mark for each well explained point. Allow 0·5 for simply mentioning the appropriate test.Analytical Procedures 1Inquiry 1Inspection 1Observation 1Re-calculation 1

–––Maximum marks 10

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Suitability of methods of gathering evidence(b) required candidates to state tests that could be carried out in BearsWorld. Part (b) takes this forward to

actually considering whether each type of testing would be used in BearsWorld. Candidates should be able to identify that some methods of gathering evidence such as inquiry are of more use than others.Note – also allow procedures as if used in BearsWorld by director – question could be read this way.Types of audit evidenceAward one mark for explaining whether each technique is suitable for BearsWorld and one mark for explaining limitations in that techniqueAnalytical Procedures 2Inquiry 2Inspection 2Observation 2Re-calculation 2

–––Maximum marks 10

–––Total 20

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