Answers

Applied Skills, AA
Audit and Assurance (AA) March/June 2021 Sample Answers

Section B

Castle Courier Co

(a) Methods for documenting internal control systems

Method Explanation Disadvantage

Narrative notes Narrative notes consist of a written They may prove to be time-consuming and
description of the internal control system. cumbersome if the internal control system is
They detail what occurs in the system at complex.
each stage including related controls which
It may make it more difficult to identify if any
operate at each stage.
internal controls are missing in narrative notes.
Internal control Internal control questionnaires contain a Internal controls may be overstated if the
questionnaires list of questions for each major transaction client is aware that the auditor is looking for a
cycle. They use questions designed to assess particular answer.
whether internal controls exist.
Unusual controls may not be included on a
standard questionnaire and hence may not be
identified.

(b) Key controls and tests of control

Key control Test of control

All staff members are issued with a sequentially numbered For a sample of key cards and data recorded in the
key card. Sequence checks and checks on the data recorded clocking‑in system, carry out a sequence check to identify if
are carried out by the human resources (HR) supervisor. there are any gaps in the sequence.
This ensures that payroll records are complete, that Review details of checks carried out by the HR supervisor
employees are paid for hours worked and that all hours are to identify any gaps in the sequence and check they have
recorded. evidenced their review by way of signature.
The clocking-in process is monitored by a camera on entry For a sample of weeks, review the log of the recordings to
to the distribution centre and video footage is reviewed by identify who reviewed that week’s footage to ensure it has
HR every week. been reviewed by a member of the HR department.
This will prevent staff members fraudulently clocking-in for Review the log for any gaps in the review process and discuss
other employees and hence employees will only be paid for these findings with HR.
actual hours worked.
The payroll clerk confirms the transfer of hours and For a sample of months, review the calculations of gross
calculations has been done accurately by recalculating, for to net pay for evidence that the calculations have been
a sample of employees, their gross to net pay. This check is performed. Confirm the signature of the payroll supervisor
also reviewed by the payroll supervisor who evidences their as evidence that they have reviewed the report. For any
review. anomalies, enquire of the reasons and what action was taken
to resolve the issue.
This reduces the risk that errors occur in the automated
transfer and calculations during the payroll processing. For a sample of months, reperform the gross to net pay
Any errors would be identified on a timely basis to prevent calculations and compare to the payroll system and the
salaries being over or under paid. calculations prepared by the payroll clerk. Discuss any
discrepancies with the payroll supervisor.
The payroll system is password-protected and the payroll Attempt to login to the payroll system using a password
manager changes the password on a monthly basis using a which should be out of date. Confirm that the system has
random password generator. rejected access.
This reduces the risk of fraud by preventing unauthorised
changes being made to the standing data and unauthorised
access to sensitive payroll information.
Each month, the finance director carries out a payroll control For a sample of months, review the control account
account reconciliation and investigates any differences. reconciliations and make enquiries of the finance director of
any errors on the control account, how they arose and what
This will ensure the payroll expense and employment tax
action was taken to ensure they do not arise in the future.
liability is accurate and is not misstated in the year-end
financial statements. Reperform a sample of control account reconciliations and
compare results with those prepared by the finance director.
Discuss any discrepancies with the finance director.

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 Key control Test of control
The amount due to the tax authority is calculated by the Review a sample of calculations of the monthly employment
payroll supervisor who then passes it to the financial tax liability for evidence of review by the financial controller
controller for review. confirming the calculation is correct and that payment can be
made.
This ensures that the amount paid to the tax authority is
correct. It also creates segregation of duties between the
payroll supervisor calculating the liability and the financial
controller reviewing the calculation which reduces the risk of
error.

(c) Deficiencies and recommendations

Control deficiency Control recommendation

Department managers are required to approve all employees’ Employees should receive written confirmation when their
holiday forms, however, this does not always occur. holiday has been approved and should be informed that they
will not be able to take holiday without this notification.
This could result in employees taking unauthorised leave
which could lead to operational difficulties if there are Any payments for unused holiday should be authorised by
shortages of staff at critical periods. In addition, payments department managers prior to payment.
for untaken holiday may be made in error as holiday records
may be incorrect.
The financial controller prepares the bank transfers for the Once the bank transfer has been prepared by the financial
payroll and also authorises these to be paid. controller, it should be passed to the finance director to
be reviewed and authorised for payment. The review and
This lack of segregation of duties increases the risk of
authorisation should be evidenced by the finance director.
fraud/error as the financial controller could pay themselves
or certain employees more than they are due without this
being detected.
The payroll clerk amends the payroll and an edit report of The payroll supervisor or a member of the finance team
changes is produced but this report is not reviewed. should review all edit reports and agree changes made to the
details on the joiner/leavers forms. Any discrepancies should
As the edit report is not checked, errors made by the payroll
be investigated promptly and the payroll system updated for
clerk when updating the system will not be identified
any errors or omissions.
promptly. This may result in new employees not being paid
at all, errors being made in payments to new employees The payroll supervisor should evidence their review on the
or leavers being paid after they have left the company. edit report with their signature.
This would lead to loss of employee goodwill and errors in
accounting records for wages and salaries.
It could also result in an increased risk of fraud as fictitious
employees could be added by the payroll clerk.
The HR department is responsible for processing joiners and All staff appointments, including temporary staff, should only
leavers, but due to staff illness, the operations manager has be processed by the HR department to ensure that correct
processed temporary new drivers and notified payroll. procedures are followed.
The operations manager may not carry out all the required If it is not possible for the HR department to carry out all of
procedures for processing temporary new drivers as the the detailed processing due to staff shortages, a member
manager may not be using appropriate documentation. of the HR team should review the leaver/joiner form and
authorise it before it is sent to the payroll department.
This could result in temporary employees not being set up in
the payroll records correctly, resulting in the late payment of The payroll department should be notified not to accept any
wages, incorrect statutory deductions being calculated and new joiner information unless approved by a member of HR.
incomplete payroll records.
Only overtime in excess of five hours per week needs All overtime, including that below five hours, should be
authorisation by the operations manager. authorised by a responsible official before being processed in
the payroll. This authorisation should be evidenced by way of
This means that employees could claim to have worked
signature.
up to five hours overtime without authorisation resulting in
payments being made to employees for hours not worked
and additional payroll costs.
Where cash wages are paid, the driver is only required to All drivers collecting cash pay packets should provide a form
provide their name to collect their pay packet. of identification to the finance staff member before the pay
packet is handed to them. The driver should also be required
Payment of wages without proof of identity or signature
to sign for their pay packet.
increases the risk that wages could be paid to incorrect
employees either in error or due to fraud resulting in a loss
of cash.

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 Control deficiency Control recommendation
The operations manager decides on the bonus to be paid Approved bonus parameters should be established by the
to delivery drivers each quarter and there are no approved board. All bonuses should be determined by a senior official,
parameters for the bonus levels. such as the sales director, in line with these parameters,
who should communicate the bonus in writing to the payroll
Without approved parameters, the operations manager may
department.
award excessive bonuses or pay additional sums to friends
and family members resulting in additional payroll costs.
Delivery drivers must take breaks throughout the day which The company should monitor the activity of the delivery
are not monitored. drivers through electronic means, for example, by using
tracking devices attached to their vehicles to ensure that the
Drivers could take longer breaks than those authorised
prescribed breaks are taken by the employees.
resulting in payments being made to employees for time
not worked. Conversely, if drivers do not take the required Data should be downloaded and reviewed by a responsible
breaks, they may be in breach of law and regulations which official on a regular basis.
require drivers to take regular breaks, hence the company is
at risk of fines.

(d) Substantive procedures on payroll expense

– Cast a sample of payroll records to confirm completeness and accuracy and agree the total wages and salaries expense per the
payroll system to the trial balance.
– Recalculate the gross and net pay figures for a sample of employees and agree to the payroll records.
– For a sample of wage payments, agree the total net pay per the payroll records to the bank transfer listing and to the cash book.
– Perform a proof in total of wages and salaries, incorporating joiners and leavers and the pay increase/bonuses. Compare this
to the actual wages and salaries expense in the financial statements and investigate any significant differences.
– Compare the total payroll figure this year to the prior year, identify any significant differences and discuss with management.
– Review monthly payroll charges, compare this to the prior year and budgets and discuss any significant differences with
management.
– Calculate overtime costs as a percentage of total wages. Compare this to the prior year and discuss any significant differences
with management.
– Agree a sample of individual wages and salaries per the payroll to personnel records and records of hours worked per the
clocking-in system.
– Reperform the calculation of statutory deductions and agree to supporting documentation to confirm whether correct deductions
for this year have been made in the payroll.
– Select a sample of joiners and leavers, agree their start/leaving date to supporting documentation, recalculate their first/last
salary to ensure it is accurate.
– Recalculate holiday pay for a sample of employees and agree to holiday records and daily rate applied.
– Select a sample of employees from HR records and agree salaries per HR records to the payroll records to confirm the accuracy
of the payroll expense.
– Agree the payroll control account reconciliation to accounting records and investigate any differences.

Corley Appliances Co

(a) Preconditions required for an audit

Auditors should only accept a new audit engagement or continue an existing audit engagement if the preconditions for an audit are
present.
ISA 210 Agreeing the Terms of Audit Engagements requires the auditor to:
– Determine whether the financial reporting framework to be applied in the preparation of the financial statements is acceptable
(for example IFRS® Standards). In considering this, the auditor should have assessed the nature of the entity, the nature and
purpose of the financial statements and whether law or regulation prescribes the applicable reporting framework.
– Obtain the agreement of management that it acknowledges and understands its responsibilities for the following:
o preparing the financial statements in accordance with the applicable financial reporting framework;
o internal control necessary for the preparation of the financial statements to be free from material misstatement whether
due to fraud or error; and
o providing the auditor with access to information relevant for the audit and access to staff within the entity to obtain audit
evidence.

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(b) Audit risks and auditor’s responses

Audit risk Auditor’s response

The company has a returns policy allowing a customer Enquire with the finance director how the returns policy has
to return goods within 28 days of purchase if they are been applied at the year end and whether the provisions in
dissatisfied with the product. IFRS 15 have been reflected.
IFRS® 15 Revenue from Contracts with Customers requires Review the assumptions underpinning the refund liability for
that revenue should only be recognised to the extent that reasonableness and whether they meet the historic 5% value
goods will not be returned. The company should recognise a of returns.
refund liability for goods which are expected to be returned.
Compare the level of post year-end returns to the refund
If the company has not correctly accounted for the refund liability and discuss any significant differences with
liability, revenue will be overstated and the refund liability management.
understated.
The company provides a six-month warranty on its products Review the calculation of the warranty provision and assess
which require defects to be repaired at Corley Appliances its reasonableness in light of the value of claims received in
Co’s own cost. The directors have reduced this provision the period.
during the year on the grounds they feel the products they
Review the assumptions underpinning the warranty provision
sell are built to a high standard.
for reasonableness.
The company does not manufacture the goods (they only
Review the level of claims made under warranty post year
sell them) and therefore this is not a reasonable reason for
end to assess the reasonableness of the reduced provision.
reduction, hence if the company has reduced the warranty
provision excessively at the year end, liabilities and expenses
may be understated.
The company purchases their goods from its main supplier Discuss with management the point at which inventory is
in Asia and has responsibility for goods at the point of recorded and review the contract with the supplier to verify
dispatch, the goods are in transit for up to one month. the requirements in place.
At the year end, there is a risk that the cut-off of purchases Review the controls the company has in place to ensure that
may not be accurate as they may not correctly recognise the inventory is recorded from the point of dispatch.
goods from the point of dispatch. There is also a risk that
The audit team should undertake detailed cut-off testing
inventory and trade payables are understated at the year
of purchases of goods at the year end and the sample of
end.
shipping documentation immediately before and after the
year end relating to goods from its main supplier in Asia
should be increased to ensure that cut-off is complete and
accurate.
The company’s central warehouse and all 20 branches will The audit team should assess which of the inventory counts
be carrying out an inventory count at the year-end date of they will attend. This should include the count for the central
31 August. warehouse and a sample of branches which contain the
most material balances of inventory and those which have
It is unlikely that the auditor will be able to attend all sites
historically had exceptions reported during the inventory
which increases detection risk. It may not be possible to
count.
gain sufficient appropriate audit evidence over the inventory
counting controls and completeness and existence of For those not visited, the auditor will need to review the level
inventory for those sites which are not visited. of exceptions noted during the count and discuss any issues
which arose during the count with management.
Over the last six months, the receivables collection period Review and test the controls surrounding the way in which
has increased from 42 days to 55 days and the allowance the finance director assesses the recoverability of receivables
for receivables will be at the same level as the prior year. balances and other credit control processes to ensure that
they are operating effectively.
Some receivables may not be recoverable and if an
additional allowance for receivables is not included in the Perform extended post year-end cash receipts testing and
financial statements, receivables will be overstated and the a review of the aged receivables ledger in order to assess
allowance for receivables understated. valuation and the need for an increased allowance for
irrecoverable receivables.
Discuss with the finance director whether an additional
allowance for receivables will be required against balances
older than the company’s credit terms.

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 Audit risk Auditor’s response
The payables ledger supervisor was dismissed in June 20X5 Discuss with the finance director the details of the fraud
due to a fraud. The value of this fraud has been recognised perpetrated by the payables ledger supervisor and what
as an expense in the draft statement of profit or loss. procedures have been adopted to date to identify any further
adjustments which are needed in the financial statements.
If additional frauds committed by the payables ledger
In addition, discuss with the finance director what additional
supervisor are not discovered, this could result in expenses
controls have been put in place to prevent any similar frauds.
being understated and payables being overstated. Control
risk is also increased if the fraud has gone undetected for a The audit team should undertake additional substantive
period of time. procedures over the payables balance, particularly the
fictitious supplier set up on the payables ledger to ensure this
has been removed.
In addition, the team should maintain professional scepticism
and be alert to the risk of further fraud.
Since the dismissal of the payables ledger supervisor, Review the unprocessed invoices file at the year end to
purchase invoices have yet to be logged onto the payables identify any invoices which relate to the supply of pre
ledger. year‑end goods and ensure they have been properly accrued
for in the year-end financial statements and recognised as a
There is a risk that the purchases and trade payables
liability.
balance at the year end will be understated if these invoices
are not logged onto the payables ledger before it is closed Discuss with the finance director the approach to be adopted
down for the year or accrued for. to resolve the issue of unprocessed purchase invoices.
The company purchased and installed a new dispatch Discuss the accounting treatment with the finance director
system. The costs which have been capitalised include staff and request that the training costs are written off to profit
training costs ($0·1m). or loss to ensure treatment is in accordance with IAS 16. If
adjusted, review the journal entry for accuracy.
As per IAS® 16 Property, Plant and Equipment, the cost of
an asset includes its purchase price and directly attributable
costs only. IAS 16 does not allow staff training costs to be
capitalised as part of the cost of a non-current asset, as
these costs are not directly related to the cost of bringing the
asset to its working condition.
The training costs should be charged to profit or loss.
Therefore property, plant and equipment (PPE) and profits
are overstated.
The company breached the terms of its overdraft facility Discuss with the finance director the availability of alternative
in June 20X5 and the bank will only confirm the decision financing if the bank is unwilling to continue to support the
whether, or not, to continue to support the business in company and review the adequacy of any going concern
November 20X5, which is after the auditor’s report will be disclosures in the financial statements.
signed. The company is dependent on the overdraft facility.
The audit team should undertake detailed going concern
If the bank refuses to continue to support the company, testing, in particular, reviewing the impact of a non-renewal
there may be doubts as to the company’s ability to of the overdraft facility.
continue as a going concern. The uncertainties may not be
adequately disclosed in the financial statements.

(c) Professional scepticism and examples where professional scepticism should be applied
Professional scepticism is defined in ISA 200 Overall Objectives of the Independent Auditor and the Conduct of an Audit in
Accordance with International Standards on Auditing as an attitude which includes a questioning mind, being alert to conditions
which may indicate possible misstatement due to fraud or error, and a critical assessment of audit evidence.
Examples where the auditor should apply professional scepticism for Corley Appliances Co are as follows:
Revenue recognition
ISA 240 The Auditor’s Responsibilities Relating to Fraud in an Audit of Financial Statements contains a rebuttable presumption that
fraud in relation to revenue is high risk and hence the auditor must apply professional scepticism to Corley Appliances Co’s revenue
recognition policies, especially in relation to the company’s returns policy which due to the judgement involved may be used as a
way to manipulate revenue.
Warranty provision
Accounting for warranty provisions will include an element of estimation based on previous experiences of the costs incurred by the
company to repair defective goods. The auditor should maintain professional scepticism keeping in mind that warranty provisions
may include management bias to either deliberately over or understate the provision. Management has reduced the warranty
provision in the year on the grounds they feel the goods they sell are built to a high standard. As the company is not involved in the
manufacturing of the goods they sell, it may be unreasonable to reduce the warranty provision on this basis.

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 Fraud
As a fraud has been committed during the year, the auditor must maintain professional scepticism recognising the fact that internal
controls may be weak, hence allowing for employee manipulation of such internal control deficiencies. The auditor must also
consider the possibility that other frauds may have taken place during the year through management override of the entity’s internal
controls.
Bank overdraft
The company is reliant on its bank overdraft due to the significant levels of expenditure which it has incurred during the year on the
new dispatch system. Management may want to deliberately overstate profit and understate liabilities so that the bank renews the
overdraft facility.
Receivables valuation
The receivables collection period has been increasing over the past six months, but the finance director does not envisage that
an increase in the allowance for receivables is required. The auditor must apply professional scepticism in considering whether
management’s assessment of recoverability is reasonable, as any increase in the allowance will reduce profits.

Purrfect Co

(a) Inventory of Vego Dog

– Obtain and cast the inventory listing of Vego Dog products and agree the total cost of $2·4m to inventory records.
– Agree the quantity of Vego Dog products shown as held at the year end to the year-end inventory count records.
– Request a breakdown of the cost calculation of each unit of this product and discuss with management how the standard cost
was derived.
– Recalculate the cost calculations to confirm that the quantity multiplied by the standard cost is $2·4m.
– For a sample of finished goods items, obtain standard cost cards and agree:
− raw material costs to recent purchase invoices;
− labour costs to time sheets or wage records;
− overheads allocated to invoices and that they are of a production nature.
– Compare sales prices over time to establish if the price has been reduced because of falling demand to determine whether an
allowance is required.
– Compare actual sales units per month to budgeted sales per month from before and after the year end to establish how much
lower actual sales are than expected and discuss with management.
– Select a sample of items included in inventory of Vego Dog and review post year-end sales invoices to ascertain if net realisable
value (NRV) is above cost or if an adjustment is required.

(b) Receivable due from Ellah Co

– Review correspondence with Ellah Co to establish if there was a discussion about payment difficulties and whether Ellah Co
intends to fully settle the outstanding amount.
– Review the age of the outstanding debt with Ellah Co and discuss the circumstances with the credit controller to establish if it
has exceeded the agreed credit terms and consider if an allowance is required.
– Review post year-end receipts from Ellah Co to establish how much of the debt was recovered by the audit completion date
and to assess how much of the year-end balance remains outstanding.
– Inspect board minutes to identify whether there are any significant concerns in relation to payments by Ellah Co.
– Discuss with management of Purrfect Co why no allowance has been made in respect of this debt and assess the justification.

(c) Contamination – legal claims

– Review customer correspondence to establish the details of the claims and the amounts being claimed.
– Review correspondence with Purrfect Co’s lawyers or, with the client’s permission, contact the lawyers to establish the likely
outcome of the customer claims made to date.
– Discuss with the lawyers the likelihood and amount of potential future claims.
– Inspect board minutes to establish details of the circumstances of the contamination and to ascertain management’s view as
to the likelihood that the existing claims will be successful and the extent of possible future claims.
– Compare levels of returns and claims to date against sales volumes of the product to assess the potential level of future claims.
– Review post-year end payments for damage settlements and compare with any amounts provided at the year end to assess the
reasonableness of the provision.

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 – Obtain written representations from management that there have been no other contamination incidents and no other product
liability claims of which management are aware and for which provision may be required.
– Review the draft financial statements to establish that the legal claims have been appropriately provided for or disclosed in
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

(d) Issue and impact on auditor’s report

According to IAS 37, the possibility of additional claims should be disclosed as a contingent liability as it is possible but not probable
and quantifiable.
As the claims may be significant, this issue represents a matter which is fundamental to users’ understanding of the financial
statements. The impact on the auditor’s report depends on whether this matter is deemed to be adequately disclosed in the financial
statements.
Adequate disclosure
If Purrfect Co adequately discloses the issue, then an unmodified audit opinion should be given but the auditor’s report should include
an emphasis of matter paragraph. This would draw attention to the disclosure in the financial statements by cross-referencing the
user to the note in the financial statements which discloses the possible claims, emphasising that the audit opinion is unmodified.
Inadequate disclosure
If there is no disclosure in the financial statements or the disclosure is considered to be inadequate, then this indicates that the
financial statements are materially misstated. As this lack of adequate disclosure is likely to be material but not pervasive, then a
qualified opinion will be given. A basis for qualified opinion paragraph will be added to the auditor’s report discussing the matter and
the opinion paragraph will be modified to state that ‘except for’ the failure to adequately disclose the matter, the financial statements
give a true and fair view.

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Applied Skills, AA
Audit and Assurance (AA) March/June 2021 Sample Marking Scheme

Section B Marks available Marks awarded

Castle Courier Co

(a) Methods for documenting internal control systems

Narrative notes 2
Internal control questionnaires 2
–––
4
–––

(b) Key controls and tests of control (only 4 required)

Sequence checks on key cards/data 2
HR review of clocking in process 2
Payroll calculations reperformed 2
Password updated monthly 2
Control account reconciliations performed 2
Tax liability calculation reviewed 2
–––
Max 4 issues, 2 marks each 8
–––

(c) Control deficiencies and recommendations (only 6 required)

Holiday requests not authorised 2
FC prepares and authorises bank transfer 2
Edit report not checked 2
Temporary staff not processed by HR 2
Only overtime above five hours authorised 2
Cash wages collected without identification 2
No approved bonus parameters 2
Drivers breaks not monitored 2
–––
Max 6 issues, 2 marks each 12
–––

(d) Substantive procedures for payroll expense

1 mark per well-described procedure
Restricted to 6
–––
Total marks 30
–––

Corley Appliances Co

(a) Preconditions required for an audit

1 mark per well-explained point
Restricted to 3

(b) Audit risks and auditor’s responses (only 7 required)

Refund liability 2
Reduced warranty provision 2
Goods in transit 2
Inventory count attendance 2
Allowance for receivables 2
Fraud 2
Payables ledger backlog 2
Training costs capitalised 2
Renewal of overdraft facility 2
–––
Max 7 issues, 2 marks each 14
–––

(c) Professional scepticism and examples where professional scepticism should be applied
Professional scepticism definition 1
Examples 2
–––
3
–––
Total marks 20
–––

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 Marks available Marks awarded
Purrfect Co

(a) Substantive procedures for inventory of Vego Dog

1 mark per well-described procedure
Restricted to 6

(b) Substantive procedures for receivable due from Ellah Co

1 mark per well-described procedure
Restricted to 4

(c) Substantive procedures for contamination – legal claims

1 mark per well-described procedure
Restricted to 5

(d) Issue and impact on auditor’s report

Discussion of issue 1
Adequate disclosure 2
Inadequate disclosure 2
–––
5
–––
Total marks 20
–––

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