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F8 AUDIT AND ASSURANCE
6/14/2012 AA

F8 AUDIT AND ASSURANCE

AUDIT PLANNING
All audits start by: Planning Understanding

After that the auditor can assess the risk of material misstatements and responded to that risk. We will see later how the risk of material misstatements can be broken down, but for example if you are dealing with a relatively new company with an experienced staff with high value, with portable inventory and many cash transactions. You will probably see that the risk of material misstatements is relatively high. If the auditors concluded that is the case then you have to arrange your audit to try and reduce the risk of material misstatements finding its way to the financial statements. The audit approach then divides: Left hand branch. Here, the auditor has reason to expect that there are effective internal controls operating. If there are effective internal controls then the auditor puts a lot of reliance on employees of the company checking on one another of reconciliations and comparisons being performed. So the chances of errors getting through into the financial statements are relatively remote. Therefore rather than test the high volume of transactions auditors tend to test the effectiveness of controls. Right hand branch. If the auditors do not expect there to be effective internal controls then the only way the auditors will be able to get assurance that the financial statements are free of material misstatement will be to carry out what are known as substantive tests which means very high volume testing.

Of course one can start off going down the left hand part of this diagram expecting there to be internal controls and then once the test being finding those internal controls are not operating satisfactory which case one will have to change ones approach and go down across the right hand part of the diagram and carry out full substantial tests almost certainly a report. Management will be written to with an outline of why the controls are ineffective or are operating unsatisfactorily. Hopefully managerial will take action so that in the following year the problems are less. After all the detailed testing either of the transactions themselves or of the controls there is an overall review of the financial statements as a whole, taken as a whole, do we think they show a true and fair view, and finally the auditors report can be issued.

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AUDIT PLANNING Audit planning is very important noted in the basis of opinion paragraph in the audit report where thy auditors state that they planned and performed their audit.

These are the reasons why planning is important: If u doesnt plan it you wont carry out effectively. You would know something is obvious is when the year-end is, how many branches or factories a company has, how many staff members you may need to conduct the audit. You have to think both of a general strategy in a detailed approach. For Example, in some very large companies auditors do not visit all the branches every year. They may visit only a quarter of the branches one year, another quarter the next year and so on. They have to decide whether not to attend and inventory stock take. They may have to decide whether not opinions from other experts are required. For Example, on the adequacy of the companys pension scheme.

The planning objectives are: To give appropriate attention to important areas. Is there a high inventory? Is there a high volume of cash transactions? Are debtors particularly significant? To identify potential problems. For Example, if the company has recently changed its computerized accounting system there may well have been problems at the switch-over time and staff may indeed still be inexperienced. To carry out the work expeditiously that really means reasonably quickly and efficiently. To ensure that the right numbers of staff are present with the right skills. We have to timetable them in so that work for this client and other clients can be accommodated. To coordinate, if necessary, with other parties. For example, the internal audit department of the company. To facilities review. The work performed in an audit is subjected to many reviews. The audit staff member in-charge of the audit first of all reviews them. All of this has to be timetabled and time must also be left to clear the review points, for example, if additional work is required.

UNDERSTANDING THE ENTITY Pretty much inseparable from the planning process is the process of gaining an understanding of the entity. This includes:

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Nature of the entity. We have to understand the nature of the entity. For example, we simple have to understand what it does, is it in a financial sector, the retail sector, the manufacturing sector, this may seem trivial and it may help you to think of a new audit client. You can often tell very little from the name of the client. You have to go and find out about the entity itself. Particular regulations. Banks, insurance companies, and may other operations in the financial sector are subject to regulation and sometimes the auditor has to ensure that these regulations have been adhered to. Accounting policies. We need to understand what the entitys accounting policies are; different entities have different ways of valuing inventories perhaps. If you are a building company you may have different accounting policies with regard to taking profits and long-term contracts. Objectives and strategies. The auditors must gain an understanding of the entitys, objectives, and strategies. The entitys management defines objectives and strategies are devised to try and achieve those objectives. Nature of business risks. Business risk can arise from circumstances which mean that the objectives and strategies may not be achieved. Business risk is broader than the risk of material misstatement of the financial statements. Most business risks will eventually have financial consequences and therefore an effect on the financial statements is important for the auditors. Therefore to understand what the businesses objectives and strategies are. Internal controls. The auditor has to gain an understanding of the entities internal controls operate. The management of some companies has a very high regard for careful control, for careful recording, and for attention to detail. Other management teams may have less regard for this. For example, it may be for more interesting in making a sale which is of course important, but are not so interested in perhaps recording that sale correctly. They will see some aspects of internal control as been in nuisance. How does management identify business risks? It is important for management to identify business risks. Management has a real expertise of the business sector and if they cant identify business risks it can be relatively difficult for the auditor to ensure that all business risks have been covered. Financial performance. Finally, the auditors should obtain an understanding of the measurement and review of the entitys financial performance. Performance measures and the review indicate to the auditor aspects of the entitys performance that management and others considered be important. Obtaining an understanding of the entitys performance measures assist the auditor in considering whether such pressures result in management actions that may have increased the risks of material misstatements.

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SUMMARY

WHY PLAN (ISA-300) Enables the audit to be carried out in an effective and timely manner. To reduce audit risk. To determine the audit approach. To decide how much audit work. To facilitate review.

Matters to consider when planning an audit ISA 300 suggests

Knowledge of the business. Understanding accounting and internal control systems. Risk and materiality. Nature, extent and timing of procedures. Coordination, direction, supervision and review. Other matters.

In the exam you might use the mnemonic MARE Materiality Accounting treatment problems more likely where there is Complexity Estimation Judgment Risk Evidence practical problems

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Contents of the audit strategy memorandum Q29 Tempest 20 marks Characteristics of the business what does the business do Nature of assignment - what work is to be done is it and Audit?? Key dates interim and final audit dates, deadlines for the AGM Budget Overall audit approach test of control and substantive assess the systems to decide reliance Overall materiality Risk areas and important figures Specific areas of audit work (because of issues) Client assistance IA, documentation etc

INTERIM AND FINAL AUDIT INTERIM AUDIT MEANING It is voluntary. Conducted in between two final audits (during an accounting period) Errors and frauds are discovered at an early stage. Books and records of clients are always up to date. Reduces workload for final audit. Audited figures may be altered. Not relevant for small entities. High cost. FINAL AUDIT Done after the end of the accounting period

ADVANTAGES

Allocation of work to staff becomes easier. Costs are lower. No duplication of work

DISADVANTAGES

Delay in presentation of final accounts and completion of work May overlook some detailed aspects

Contents of the audit planning memorandum Risk assessment. Audit approach (see below). Sampling. Planned audit procedures. Key audit risks.

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JUNE 2009 QUESTION 1

Background information B-Star is a theme park based on a popular series of childrens books. Customers pay a fixed fee to enter the park, where they can participate in a variety of activities such as riding roller-coasters, playing on slides and purchasing themed souvenirs from gift shops. The park is open all year and has been in operation for the last seven years. It is located in a country which has very little rainfall the park is open-air so poor weather such as rain results in a significant fall in the number of customers for that day (normally by 50%). During the last seven years there have been on average 30 days each year with rain. B-Star is now very successful; customer numbers are increasing at approximately 15% each year. Ticket sales Customers purchase tickets to enter the theme park from ticket offices located outside the park. Tickets are only valid on the day of purchase. Adults and children are charged the same price for admission to the park. Tickets are preprinted and stored in each ticket office. Tickets are purchased using either cash or credit cards. Each ticket has a number comprising of two elements two digits relating to the ticket office followed by six digits to identify the ticket. The last six digits are in ascending sequential order. Cash sales 1. 2. 3. 4. 5. All ticket sales are recorded on a computer showing the amount of each sale and the number of tickets issued. This information is transferred electronically to the accounts office. Cash is collected regularly from each ticket office by two security guards. The cash is then counted by two accounts clerks and banked on a daily basis. The total cash from each ticket office is agreed to the sales information that has been transferred from each office. Total cash received is then recorded in the cash book, and then the general ledger.

Credit card sales 1. Payments by credit cards are authorized online as the customers purchase their tickets. 2. Computers in each ticket office record the sales information which is transferred electronically to the accounts office. 3. Credit card sales are recorded for each credit card company in a receivables ledger. 4. When payment is received from the credit card companies, the accounts clerks agree the total sales values to the amounts received from the credit card companies, less the commission payable to those companies. The receivables ledger is updated with the payments received. You are now commencing the planning of the annual audit of B-Star. The date is 3 June 2009 and B-Stars year end is 30 June 2009.

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Required: (a) List and explain the purpose of the main sections of an audit strategy document and for each section, provide an example relevant to B-Star. (8 marks)

SOLUTION SECTION OF DOCUMENT Characteristics of engagement PURPOSE This section of audit strategy identifies the key characteristics of the client which helps the auditor to develop basic knowledge about the client (number of locations, financial reporting framework, etc) This section of audit strategy identifies the types of communication the auditor needs to have with the client management, component auditor and team members This section of audit strategy identifies the significant areas of client which includes significant changes in business, high risky areas, quality of internal controls, etc. This section of audit strategy identifies the time and work allocation among team members normally in high risky areas. EXAMPLE FROM B-STAR Use of IT (ticket sales are recorded on computer)

Reporting objectives

N/A

Significant factors

1. Cash sales 2. Reasonable control procedures in place

Nature, timing and extent of resources

Senior audit staff will be allocated to the audit of cash sale (risky areas identified above)

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RISK
The sources of risk International standard on auditing 315, states that the auditor should: Obtain an understanding of the entity and its environment sufficient to identify and assess the risk of a material misstatement in the financial statements. The total risk of material misstatement can be split into two: Business risks. Audit risks.

Business risks result from significant conditions, events, circumstance, actions or inactions that could adversely affect the entities ability to achieve its objectives and execute its strategies. The business risks can itself be split into: Financial risk Operational risk, and Compliance risk.

Financial risks, for example, could arise because of high borrowings and a rise in interest rates. This will put to business under severe pressure and could increase the risk of material misstatement, perhaps with regards to going concern problems. Operational risks could arise from operational errors. The products are made incorrectly, that there might be warranty claims, that there is a loss of reputations or indeed the products simply become old-fashioned and an insufficient investing has been made historical in research and development to have new products coming online. Compliance risks arises from a failure to comply with regulations, this can mean that the business has got large penalties or fines to pay or it may result in the business been prevented from continuing to trade. The auditor does not have a responsibility to identify or assess all business risks, but an understanding of business risks increases a likelihood of identifying risks of material misstatement. Other than potential implications for going concern assumptions, business risk is not something to worry about at the F8 stage.

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AUDIT RISK The second component of total risk is the audit risk, and that is a risk that the auditor gives an inappropriate opinion on the financial statements. For example, the audit report states the financial statement show a true and fair view when in fact they contain a material misstatement. Audit risk comprises two elements: The risk that the financial statements actually contained the material misstatement. The risk that the auditors have failed to detect it. This is detection risk.

In turn, we can ask why the financial statements might contain a material misstatement and that depends on two other risks: The risk that the error occurs in the first place, that is inherent risk The risk that the clients own procedures dont pick up and correct that error that is known as control risk.

Therefore, for an inappropriate opinion to have been expressed:

The error has to occured

The client's procedures and staff must not have picked that up and corrected it

The auditors must have failed to detect it

The material error reaches the published financial statements

The audit risk equation The risks found of an audit can be expressed as an equation. This equation is saying that the audit risk depends on inherent risks, the control risks, and the detections risk. AR = IR x CR x DR

Dont look upon it too mathematically. What it is saying is auditors will want the audit risk to be low: they dont want to make an error in their audit opinion. If you want the audit risk being low then the terms on the right hand side of the equation, or at least some of them, have to be low.

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If both inherent risk and control risks are high then the only way you will get the audit risk low is to be very sure that your detections risk is low. This means you would have to do an enormous amount of work. If, however, the inherent risk and control risks are low themselves, in other words that there is only a small chance the error occurs in the first place and the client systems and staff are very good, then you can achieve a relatively low audit risk even with a relatively high detections risk. In other words the auditor doesnt have to do quite so much work. In the short-term the auditors cannot control the inherent risk and the control risks; those are givens in an audit. The auditor must respond by varying the amount of work which is actually performed.

The detections risk itself depends on two components: Sampling risk Non-sampling risk.

Sampling risk arises because, in most audits, auditors only look at a very small proportional of transactions and documents. There is always a risk that they happen to look at all the documents and transactions which are correct and dont find any which are incorrect. That can just be bad luck in sampling and could lead the auditor to do too little work. Sampling risk can be reduced by examining larger samples. Non-sampling risk arises from reasons other than sampling. For example, if the staff and the audit were inappropriately qualified then there is a high risk because they wouldnt properly understand what was going on or detect the regularities in the financial statements. Nonsampling risk can be reduced by batter planning of the audit, and ensuring that audit staff are better trained, have appropriate skills and that their work is well-supervised and reviewed. Examples of three types of risk Lets look at the three types of risks in a little bit more detail.

Inherent risk is the risk that there is a misstatement that could be material, if there were no
related internal controls which could identify and trap that misstatement. Inherent risks can be increased by complex transactions which are difficult to understand, inexperience staff, a cashbased business (because cash is usually more difficult to record that bank transfers) a pressure to perform which may mean that some staff members who have optimistic view of sales and costs, and short reporting deadlines.

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Control risk is the risk that material misstatement, having occurred, will not be prevented,
detected, or corrected by internal control system. The three elements which effects which affect control risk are the control environment (that is really the status that the internal control system has in the organization), the design of the internal control system itself, and finally how well and consistently the internal control system operates.

Detections risk is the failure of the auditor to detect the material misstatement in the
financial statements. This will be increased if the auditor was relatively inexperienced, if it was a new client, if there was a lot of time and fee pressure, if planning was poor so the entity was poorly understood, and if the auditor was straying into an industry where they had little previous experience or expertise.

WHERE THE AUDIT RISK CAN BE FOUND Audit risk has to be reduced to an acceptable amount of both the Financial statement level Assertion levels.

Dealing first with the assertion level, essentially any single figure which appears in the financial statements is making an assertion is saying something about its size, its accuracy, its valuation. There are some figures, for example, directors emoluments which in the overall scheme of thing may not be terribly material, but which by law are required to be disclosed accurately and relatively a material misstatement would mean that the accounts are not showing a true and fair view. Dealing with the financial statement level, all the figures appearing in the financial statements could be true, but overall the financial statements could still not how a true and fair view. For example, liquidity issues could be concealed or in some way the overall effect of the accounts is to be misleading. To get a higher assurance at the assertion levels audit procedures must be designed and performed in line with the assessed risks of material misstatement. For example, if you are worried about debtors valuations you have to do a lot more work verifying the debtors are recoverable. Perhaps you could try to wait for several months after year end to see which customers actually pay. At a financial statement level just to doing more work as such is probably insufficient. You need more experienced and batter staff. Misstatements at the financial statement level are potentially more subtle and require a higher level of skill to detect.

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SUMMARY BUSINESS RISK Risk inherent to the business Of interest to the auditor as business risk may cause material misstatements in the financial statements Broken down into a) Financial risk b) Operational risk c) Compliance risk

AUDIT RISK

AR = IR x CR x DR Definitions are in the open book glossary of terms. Audit risk Inherent risk Control risk Detection risk

Risk is determined at the planning stage as it affects the nature, extent and timing of work to be done.

Materiality ISA 320 Information is material if its misstatement or omission would influence the decision of users of the financial statements. This can result from size or nature.

Qualitative considerations Effect on use e.g. descriptions of accounting policies should not be misleading. Some items are capable of precise determination e.g. cash, share capital. Directors transactions must be accurate.

Quantitative considerations Auditor must use their judgment Some rules of thumb: - 1% revenue 1 2% gross assets 5 10% profit before tax

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JUNE 2010 QUESTION 2 (B) ISA 320 Materiality in Planning and Performing an Audit provides guidance on the concept of materiality in planning and performing an audit. Required: Define materiality and determine how the level of materiality is assessed. (5 marks)

SOLUTION Materiality is defined as follows: Misstatements, including omissions, are considered to be material if they, individually or in the aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. In assessing the level of materiality there are a number of areas that should be considered. Firstly the auditor must consider both the amount (quantity) and the nature (quality) of any misstatements, or a combination of both. The quantity of the misstatement refers to the relative size of it and the quality refers to an amount that might be low in value but due to its prominence could influence the users decision, for example, directors transactions. In assessing materiality the auditor must consider that a number of errors each with a low value may when aggregated amount to a material misstatement. The assessment of what is material is ultimately a matter of the auditors professional judgment, and it is affected by the auditors perception of the financial information needs of users of the financial statements. In calculating materiality the auditor should also consider setting the performance materiality level. This is the amount set by the auditor, it is below materiality, and is used for particular transactions, account balances and disclosures. As per ISA 320 materiality is often calculated using benchmarks such as 5% of profit before tax or 1% of gross revenue. These values are useful as a starting point for assessing materiality.

DECEMBER 2009 QUESTION 1 (a) Explain the importance of audit planning and state TWO matters that would be included in an audit plan. (6 marks)

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SOLUTION Audit planning is addressed by ISA 300 (Redrafted) Planning an Audit of Financial Statements. The standard notes that an audit plan will be developed after the overall audit strategy has been established and then states that adequate planning benefits the audit of financial statements in several ways, including the following: Helping the auditor to devote appropriate attention to important areas of the audit. Helping the auditor identify and resolve potential problems on a timely basis. Helping the auditor properly organize and manage the audit engagement so that it is performed in an effective and efficient manner. Assisting in the selection of engagement team members with appropriate levels of capabilities and competence to respond to anticipated risks and the proper assignment of work to them. Facilitating the direction and supervision of engagement team members and the review of their work. Assisting, where applicable, in coordination of work done by experts. The following are examples of matters that would be included in the audit plan: (1) A description of the nature, timing and extent of planned risk assessment procedures sufficient to assess the risks of material misstatement. (2) This would include assessment of inherent risk and control risk at both the entity and assertion level. An important element of the plan would be the understanding and assessment of the control environment of the organization. (3) A description of the nature, timing and extent of planned further procedures at the assertion level for each material class of transactions, account balance, and disclosure. (4)This would include an explanation of the decision Whether to test the operating effectiveness of controls (an important decision is whether reliance is to be placed on controls). On the nature, timing and extent of planned substantive procedures (this would depend on the decision as to the level of control risk).

(5) Audit procedures required to be carried out for the engagement in order to comply with ISAs, for example, the use of external confirmations to obtain sufficient appropriate evidence at the assertion level.

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JUNE 2010 QUESTION 1 Introduction and client background You are an audit senior in Staple and Co and you are commencing the planning of the audit of Smoothbrush Paints Co for the year ending 31 August 2010. Smoothbrush Paints Co is a paint manufacturer and has been trading for over 50 years; it operates from one central site, which includes the production facility, warehouse and administration offices. Smoothbrush sells all of its goods to large home improvement stores, with 60% being to one large chain store Homewares. The company has a one year contract to be the sole supplier of paint to Homewares. It secured the contract through significantly reducing prices and offering a fourmonth credit period, the companys normal credit period is one month. Goods in/purchases In recent years, Smoothbrush has reduced the level of goods directly manufactured and instead started to import paint from South Asia. Approximately 60% is imported and 40% manufactured. Within the production facility is a large amount of old plant and equipment that is now redundant and has minimal scrap value. Purchase orders for overseas paint are made six months in advance and goods can be in transit for up to two months. Smoothbrush accounts for the inventory when it receives the goods. To avoid the disruption of a year-end inventory count, Smoothbrush has this year introduced a continuous/perpetual inventory counting system. The warehouse has been divided into 12 areas and these are each to be counted once over the year. The counting team includes a member of the internal audit department and a warehouse staff member. The following procedures have been adopted; 1. The team prints the inventory quantities and descriptions from the system and these records are then compared to the inventory physically present. 2. Any discrepancies in relation to quantities are noted on the inventory sheets, including any items not listed on the sheets but present in the warehouse area. 3. Any damaged or old items are noted and they are removed from the inventory sheets. 4. The sheets are then passed to the finance department for adjustments to be made to the records when the count has finished. 5. During the counts there will continue to be inventory movements with goods arriving and leaving the warehouse. At the year-end it is proposed that the inventory will be based on the underlying records. Traditionally Smoothbrush has maintained an inventory provision based on 1% of the inventory value, but management feels that as inventory is being reviewed more regularly it no longer needs this provision. Finance Director In May 2010 Smoothbrush had a dispute with its finance director (FD) and he immediately left the company. The company has temporarily asked the financial controller to take over the role while they recruit a permanent replacement. The old FD has notified Smoothbrush that he intends to sue for unfair dismissal. The company is not proposing to make any provision or disclosures for this, as they are confident the claim has no merit.

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Required: (a) Identify and explain the audit risks identified at the planning stage of the audit of Smoothbrush Paints Co. (10 marks)

IDENTIFICATION OF RISK Smoothbrush supplies 60% of its goods to Homewares at a significantly reduced selling price, hence inventory may be overvalued.

Recoverability of receivable balances as credit period extended

Valuation of plant and equipment.

60% paints are imported from South Asia

Redundant plant and equipment

Inherent risk is higher due to the changes in the finance department

EXPLANATION OF RISK Per IAS 2 Inventories, inventory should be stated at the lower of cost and net realizable value (NRV). Therefore, as selling prices are much lower for goods sold to Homewares, there is a risk that the NRV of some inventory items may be lower than cost and hence that inventory could be overvalued. Smoothbrush has extended its credit terms to Homewares from one month to four months. Hence there is an increased risk as balances outstanding become older, that they may become irrecoverable. The production facility has a large amount of unused plant and equipment. As per IAS 16 Property, Plant and Equipment and IAS 36 Impairment of Assets, this plant and equipment should be stated at the lower of its carrying value and recoverable amount, which may be at scrap value depending on its age and condition. This situation might result in an inappropriate recognition of exchange gain/loss. Smoothbrush will need to identify appropriate amount of exchange gain/loss resulting from fluctuation in exchange rates. However, the management might be interested in showing a picture of exchange gains to support profitability of Smoothbrush. The situation might result in an inappropriate value at which the redundant plant needs to be recorded if the financial statements of Smoothbrush Co. Redundant plants need to be recorded at a lower of recoverable amount or value in use. There is a risk that management is not applying the policy accurately thus affecting the value of plant in financial statements The financial controller has been appointed as temporary FD and this lack of experience could result in an increased risk of errors arising in the financial statements. In addition the

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previous FD is not available to help the finance or audit team. The companys finance director (FD) has left and is intending to sue Smoothbrush for unfair dismissal. However, the company does not intend to make any provision/disclosures for sums due to the FD. Under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, if there is a present obligation, a probable outflow of resources to settle the obligation and a reliable estimate can be made of the obligation then a provision should be recognized. If the obligation is only possible, or if there is a present obligation but it is not recognized as there is not a probable outflow of resources, or the amount of the obligation cannot be measured with sufficient reliability then a contingent liability should be disclosed, unless the likelihood of payment is remote

Provisions/contingent liability disclosures may not be complete

JUNE 2008 QUESTION 3 Zak Co sells garden sheds and furniture from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Zaks own delivery vans; most sheds are too big for individuals to transport in their own motor vehicles. The directors of Zak indicate that the company has had a difficult year, but are pleased to present some acceptable results to the members. The income statements for the last two financial years are shown below:

Income statement
31ST MARCH 2008 REVENUE 7482 31ST MARCH 2007 6364

COST OF SALES

(3520)

(4253)

GROSS PROFIT

3962

2111

OPERATING EXPENSES

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ADMINISTRATION (1235) (1320)

SELLING AND DISTRIBUTION INTEREST PAYABLE

(981)

(689)

(101)

(105)

INVESTMENT INCOME PROFIT/(LOSS) BEFORE TAX

145

1790

(3)

Financial statement extract Cash and bank 253 (950)

Required: (b) As part of your risk assessment procedures for Zak Co, identify and provide a possible explanation for unusual changes in the income statement. (9 marks) SOLUTION Net profit Overall, Zaks result has changed from a net loss to a net profit. Given that sales have only increased by 17% and those expenses, at least administration expenses, appear low, then there is the possibility that expenditure may be understated. Sales increase 17% According to the directors, Zak has had a difficult year. Reasons for the increase in sales income must be ascertained as the change does not conform to the directors comments. It is possible that the industry as a whole, has been growing allowing Zak to produce this good result. Cost of sales fall 17%

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A fall in cost of sales is unusual given that sales have increased significantly. This may have been caused by an incorrect inventory valuation and the use of different (cheaper) suppliers which may cause problems with faulty goods in the next year. Gross profit (GP) increase 88% This is a significant increase with the GP% changing from 33% last year to 53% in 2008. Identifying reasons for this change will need to focus initially on the change in sales and cost of sales. Administration fall 6% A fall is unusual given that sales are increasing and so an increase in administration to support those sales would be expected. Expenditure may be understated, or there has been a decrease in the number of administration staff. Selling and distribution increase 42% This increase does not appear to be in line with the increase in sales selling and distribution would be expected to increase in line with sales. There may be a misallocation of expenses from administration or the age of Zaks delivery vans is increasing resulting in additional service costs. Interest payable small fall Given that Zak has a considerable cash surplus this year, continuing to pay interest is surprising. The amount may be overstated reasons for lack of fall in interest payment e.g. loans that cannot be repaid early, must be determined. Investment income new this year This is expected given cash surplus on the year, although the amount is still very high indicating possible errors in the amount or other income generating assets not disclosed on the balance sheet extract.

DECEMBER 2008 QUESTION 4 (a) Explain the term audit risk and the three elements of risk that contribute to total audit risk. (4 marks) The EuKaRe charity was established in 1960. The charitys aim is to provide support to children from disadvantaged backgrounds who wish to take part in sports such as tennis, badminton and football. EuKaRe has a detailed constitution which explains how the charitys income can be spent. The constitution also notes that administration expenditure cannot exceed 10% of income in any year. The charitys income is derived wholly from voluntary donations. Sources of donations include: (1) Cash collected by volunteers asking the public for donations in shopping areas,

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(2) Cheques sent to the charitys head office, (3) Donations from generous individuals. Some of these donations have specific clauses attached to them indicating that the initial amount donated (capital) cannot be spent and that the income (interest) from the donation must be spent on specific activities, for example, provision of sports equipment. The rules regarding the taxation of charities in the country EuKaRe is based are complicated, with only certain expenditure being allowable for taxation purposes and donations of capital being treated as income in some situations. Required: (b) Identify areas of inherent risk in the EuKaRe charity and explain the effect of each of these risks on the audit approach. (12 marks)

SOLUTION
(a) Audit risk

Audit risk is the risk that an auditor gives an inappropriate opinion on the financial statements being audited. Inherent risk is the susceptibility of an assertion to a misstatement that could be material individually or when aggregated with misstatements, assuming that there are no related controls. The risk of such misstatement is greater for some assertions and related classes of transactions, account balances, and disclosures than for others. Control risk is the risk that a material error could occur in an assertion that could be material, individually or when aggregated with other misstatements, will not be prevented or detected on a timely basis by the companys internal control systems. Detection risk is the risk that the auditors procedures will not detect a misstatement that exists in an assertion that could be material, individually or when aggregated with other misstatements. (b) AREA OF INHERENT RISK Income is from voluntary donations only. There is a risk that donations will fall, especially where donors own income is limited by the credit crunch etc. EFFECT ON AUDIT APPROACH It is difficult to estimate that income in the future will be sufficient to meet the expenditure of the charity. Audit of the going concern concept (as in ensuring that the charity can still operate) will therefore be quite difficult Careful review of expenditure will be necessary to ensure that expenditure is not ultra vires the objectives of the charity. The auditor will need to review the constitution of the EuKaRe charity carefully in this respect. The auditor will need to ensure that staff,

Funds can only be spent in accordance with the aims of the charity. There is a risk that funds are spent outside the aims of the charity.

Taxation rules relevant to charities. There is a

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risk that the rules will be broken due to lack of correct analysis of income/expenditure. Requirement to report expenditure in accordance with the constitution administration expenditure can be no more than 10% of total income. Risks here include income being overstated to allow expenditure to be overstated. Completeness of income where there are no controls to ensure income is complete for example sales invoices are not raised to obtain donations and donations could be stolen by staff. Donations to charity for specific activities for example provision of sports equipment. There is a risk that donations are not spent in accordance with donors instructions DECMBER 2010 QUESTION 3 (c) You are the audit senior of White & Co and are planning the audit of Redsmith Co for the year ended 30 September 2010. The company produces printers and has been a client of your firm for two years; your audit manager has already had a planning meeting with the finance director. He has provided you with the following notes of his meeting and financial statement extracts. Redsmiths management was disappointed with the 2009 results and so in 2010 undertook a number of strategies to improve the trading results. This included the introduction of a generous sales-related bonus scheme for their salesmen and a high profile advertising campaign. In addition, as market conditions are difficult for their customers, they have extended the credit period given to them. The finance director of Redsmith has reviewed the inventory valuation policy and has included additional overheads incurred this year as he considers them to be production related. He is happy with the 2010 results and feels that they are a good reflection of the improved trading levels. familiar with the taxation rules affecting the charity, is on the audit team. The trustees may attempt to hide excessive expenditure on administration under other expense headings. As the auditor has to report on the accuracy of income and expenditure then audit procedures must focus on the accuracy of recording of expenditure. Audit tests are unlikely to be effective to meet the assertion of completeness. The audit report may need to be modified and qualified to explain the lack of evidence stating that completeness of income cannot be confirmed. Documentation for any donation will need to be obtained and then expenditure agreed to the terms of the documentation. Any discrepancies will have to be reported to management.

Financial statement extracts for year ended 30 September DRAFT 2010 23.0 (11) 12 (7.5) 4.5 2.1 4.5 ACTUAL 2009 18.0 (10) 8 (4.0) 4 1.6 3.0

Revenue Cost of sales Gross profit Operating expenses PBIT Inventory Receivables

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Cash Trade payables Overdraft Required: Using the information above: (1) Calculate FIVE ratios, for BOTH years, which would assist the audit senior in planning the audit; and (5 marks) (2) From a review of the above information and the ratios calculated, explain the audit risks that arise and describe the appropriate response to these risks. (10 marks) 1.6 0.9 2.3 1.2 -

SOLUTION (c) (1) Ratios to assist the audit supervisor in planning the audit: 2010 12/23 = 52.2% 4.5/23 = 19.6% 2.1/11*365 = 70 days 4.5/23*365 = 71 days 1.6/11*365 = 53 days 6.6/2.5 = 2.6 (6.6-2.1)/2.5 = 1.8 2009 8/18 = 44.4% 4/18 = 22.2% 1.6/10*365 = 58 days 3.0/18*365 = 61 days 1.2/10*365 = 44 days 6.9/1.2 = 5.8 (6.9-1.6)/ 1.2 = 4.4

Gross margin Operating margin Inventory days Receivable days Payable days Current ratio Quick ratio (c) (2)

Audit risk Management was disappointed with 2009 results and hence undertook strategies to improve the 2010 trading results. There is a risk that management might feel under pressure to manipulate the results through the judgments taken or through the use of provisions. A generous sales-related bonus scheme has been introduced in the year; this may lead to sales cut-off errors with employees aiming to maximize their current year bonus. Revenue has grown by 28% in the year however; cost of sales has only increased by 10%. This increase in sales may be due to the bonus scheme and the advertising however,

Response to risk Throughout the audit the team will need to be alert to this risk. They will need to carefully review judgmental decisions and compare treatment against prior years.

Increased sales cut-off testing will be performed along with a review of post year-end sales returns as they may indicate cut-off errors. During the audit a detailed breakdown of sales will be obtained, discussed with management and tested in order to understand the sales increase.

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this does not explain the increase in gross margin. There is a risk that sales may be overstated. Gross margin has increased from 444% to 522%. Operating margin has decreased from 222% to 196%. This movement in gross margin is significant and there is a risk that costs may have been omitted or included in operating expenses rather than cost of sales. There has been a significant increase in operating expenses which may be due to the bonus and the advertising campaign but could be related to the misclassification of costs. The finance director has made a change to the inventory valuation in the year with additional overheads being included. In addition inventory days have increased from 58 to 70 days. There is a risk that inventory is overvalued

The classification of costs between cost of sales and operating expenses will be compared with the prior year to ensure consistency.

Receivable days have increased from 61 to 71 days and management have extended the credit period given to customers. This leads to an increased risk of recoverability of receivables. The current and quick ratios have decreased from 58 to 26 and 44 to 18 respectively. In addition the cash balances have decreased significantly over the year. Although all ratios are above the minimum levels, this is still a significant decrease and along with the increase of sales could be evidence of overtrading which could result in going concern difficulties

The change in the inventory policy will be discussed with management and a review of the additional overheads included performed to ensure that these are of a production nature. Detailed cost and net realizable value testing to be performed and the aged inventory report to be reviewed to assess whether inventory requires writing down. Extended post year-end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation Detailed going concern testing to be performed during the audit and discussed with management to ensure that the going concern basis is reasonable.

JUNE 2011 QUESTION 3 (b) Donald Co operates an airline business. The companys year-end is 31 July 2011. You are the audit senior and you have started planning the audit. Your manager has asked you to have a meeting with the client and to identify any relevant audit risks so that the audit plan can be completed. From your meeting you ascertain the following: In order to expand their flight network, Donald Co will need to acquire more airplanes; they have placed orders for another six planes at an estimated total cost of $20m and the company is not sure whether these planes will be received by the year end. In addition the company has spent an estimated $15m on refurbishing their existing planes. In order to fund the expansion Donald Co

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has applied for a loan of $25m. It has yet to hear from the bank as to whether it will lend them the money. The company receives bookings from travel agents as well as directly via their website. The travel agents are given a 90-day credit period to pay Donald Co, however, due to difficult trading conditions a number of the receivables are struggling to pay. The website was launched in 2010 and has consistently encountered difficulties with customer complaints that tickets have been booked and paid for online but Donald Co has no record of them and hence has sold the seat to another customer. Donald Co used to sell tickets via a large call centre located near to their head office. However, in May they closed it down and made the large workforce redundant. Required: Using the information provided, describe FIVE audit risks and explain the auditors response to each risk in planning the audit of Donald Co. (10 marks)

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