KC-04 Practice Revision Kit PDF

PRACTICE & REVISION KIT
CA SRI LANKA CURRICULUM 2015
First edition 2015

ISBN 9781 4727 1068 0
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2015
ii
Contents
Page
Question Index
iv
Introduction
How to use this Practice & Revision Kit
vi
Exam techniques
viii
Action verbs
Questions
Answers
63
Contents
iii
Question index
Title
Marks
allocated
Time
allocated
(Minutes)
Page
Question
Answer
Section 1
1
Mahmood
25
45
63
David
25
45
66
Anne
25
45
70
Poodle
25
45
74
Lychee
25
45
77
Axis & Co
25
45
79
Willow
25
45
10
81
Colombo
25
45
12
84
Banana
25
45
16
87
10 Retriever
25
45
17
91
11 Dragon Group
25
45
19
96
12 Lapwing
25
45
20
100
13 Baltimore
25
45
22
103
14 Apricot
25
45
25
109
15 Beech
25
45
26
112
16 Seatown
25
45
28
115
17 WWW
25
45
29
117
18 VV
25
45
31
120
Section 2
iv
Daily Newspapers
50
90
33
124
Farama 1
50
90
40
131
Farama 2
50
90
47
138
Aybe 1
50
90
50
145
Aybe 2
50
90
57
149
KC1 Corporate Financial Reporting
Introduction
Welcome to this first edition Practice & Revision Kit for the Institute of Chartered
Accountants of Sri Lanka professional examinations for curriculum 2015.
One of the key criteria for achieving exam success is question practice. There is
generally a direct correlation between candidates who revise all topics and practise
exam questions and those who are successful in their real exams. This Practice &
Revision Kit gives you ample opportunity for such practice in the run up to your
exams.
The Practice & Revision Kit is structured to follow the modules of the Study Text, and
comprises banks of non-complex mini scenario and simple functional scenario
questions as appropriate. Suggested solutions to all questions are supplied.
We welcome your feedback. If you have any comments about this Practice &
Revision Kit, or would like to suggest areas for improvement, please email
learningdevelopment@casrilanka.org.
Good luck in your exams!
BPP LEARNING MEDIA
Introduction

This Practice & Revision Kit comprises banks of practice questions, mostly in the style
that you will encounter in your exam. It is the ideal tool to use during the revision
phase of your studies.
Questions in your exam may test any part of the syllabus so you must revise the
whole syllabus. Selective revision will limit the number of questions you can answer
and hence reduce your chances of passing. It is better to go into the exam knowing a
reasonable amount about most of the syllabus rather than concentrating on a few
topics to the exclusion of the rest. You should at all costs avoid falling into the trap of
question spotting, that is trying to predict what are likely to be popular areas for
questions, and restricting your revision and question practice to those.
Practising as many exam-style questions as possible will be the key to passing this
exam. You must do exam-style questions under timed conditions and ensure you
write full answers to the discussion parts as well as doing the calculations.
Planning your revision
When you begin your course you should make a plan of how you will manage your
studies, taking into account the volume of work that you need to do and your other
commitments, both work and domestic.
In this time, you should go through your notes to ensure that you are happy with all
areas of the syllabus and practise as many questions as you can. You can do this in
different ways, for example:
Revise the subject matter a module at a time and then attempt the questions
relating to that module; or
Revise all the modules and then build an exam out of the questions in this
Practice & Revision Kit.
Using the practice questions

The best approach is to select a question and then allocate to it the appropriate time,
based on the real exam. All the questions in this Practice & Revision Kit have mark
allocations, so you can calculate the amount of time that you should spend on the
question.
Using the suggested solutions
Avoid looking at the answer until you have finished a question. It can be very
tempting to do so, but unless you give the question a proper attempt under exam
conditions you will not know how you would have coped with it in the real exam
scenario.
When you do look at the answer, compare it with your own and give some thought to
why your answer was different, if it was.
vi
If you did not reach the correct answer make sure that you work through the
explanation or workings provided, to see where you went wrong. If you think that
you do not understand the principle involved, go back to your own notes or your
study materials and work through and revise the point again, to ensure that you will
understand it if it occurs in the exam.
Our suggested solutions are comprehensive, but in some discursive questions it may
be that you have made points that are not included in the suggested solution that are
equally valid. In the real exams you should be given credit for such points.
vii
Exam techniques
Using the right techniques in the real exam can make all the difference between
success and failure.
Here are a few pointers:
1.
During the 20-minute reading time at the start, read through the questions and
decide in what order you are going to attempt the exam. You have to write
your answers in the order set out in the question and answer booklet, but you
can attempt the questions in any order that you like.
Some candidates like to attempt the easiest questions first, on the basis that will
enable them to gain the easiest available marks quickly, and build up their
confidence.
If you select a question on a topic area about which you feel confident, and do
that first, you will build up your confidence right at the start, which will help to
calm you if you are nervous and set the tone for the rest of the exam. You should
decide what approach is best for you.
viii
2.
Having established the order that you are going to do the exam, allocate the
time available to the questions and work out at what time you will need to
stop working on one question and move on to the next. When you reach the end
of the allocated time for the question that you are working on, STOP. It is much
easier to gain the straightforward marks for the next question than to spend a
long time working on the previous question in the hope of gaining one or two
final marks.
3.
Read the question. Read it carefully once, and then read it again to ensure that
you have picked everything up. Make sure that you understand what the
question wants you to do, rather than what you might like the question to be
asking you.
4.
Answer all parts of the question. Even if you cannot do all of the calculation
elements, you will still be able to gain marks in the discussion parts.
5.
Dont worry if you think that you have made a mistake in a computational part
of a question. You will not earn the mark for that particular part, but you will
still be able to gain credit for correct application in the later parts of the
question, even if you are using the wrong figure.
6.
When starting to read a question, especially a long case study, read the
requirement first. You will then find yourself considering the requirement as
you read the data in the scenario, helping you to focus on exactly what you have
to do.
7.
Plan your answer before you start to write your response, especially for longer
case studies. This will help you to focus on the requirements of the question and
to avoid irrelevance.
8.
Try to make sure that your answer relates to the specifics of the question
itself. If you are asked to consider the impact of the scenario on someone named
in the question, make sure that you do that, so your answer is as relevant as
possible.
9.
If you finish the exam with time to spare, use the rest of the time to review your
answers and to make sure that you answered every requirement of every
question.
Exam techniques
ix
Action verbs checklist
Knowledge Process
Verb List
Verb Definitions
Tier 1 Remember
Define
Describe exactly the nature, scope or meaning
Recall important
information
Draw
Produce (a picture or diagram)
Identify
Recognise, establish or select after

consideration
List
Write the connected items one below the

other
Relate
To establish logical or causal connections
State
Express something definitely or clearly
Tier 2 Comprehension
Calculate/Compute
Make a mathematical computation
Explain important
information
Discuss
Examine in detail by argument showing

different aspects, for the purpose of arriving at
a conclusion
Explain
Make a clear description in detail revealing

relevant facts
Interpret
Present in understandable terms or to

translate
Recognise
To show validity or otherwise, using

knowledge or contextual experience
Record
Enter relevant entries in detail
Summarise
Give a brief statement of the main points (in

facts or figures)
Knowledge Process
Verb List
Verb Definitions
Tier 3 Application
Apply
Put to practical use
Use knowledge in a setting

other than the one in which
it was learned/solve closeended problems
Assess
Determine the value, nature, ability or quality
Demonstrate
Prove, especially with examples
Graph
Represent by means of a graph
Prepare
Make ready for a particular purpose
Prioritise
Arrange or do in order of importance
Reconcile
Make consistent with another
Solve
To find a solution through calculations and/or

explanations
Analyse
Examine in detail in order to determine the

solution or outcome
Compare
Examine for the purpose of discovering

similarities
Contrast
Examine in order to show unlikeness or

differences
Differentiate
Constitute a difference that distinguishes

something
Outline
Make a summary of significant features
Tier 4 Analysis
Draw relations among ideas
and to compare and
contrast/solve open-ended
problems
Action verbs checklist
xi
Knowledge Process
Verb List
Verb Definitions
Tier 5 Evaluate
Advise
Offer suggestions about the best course of

action in a manner suited to the recipient
Convince
To persuade others to believe something using

evidence and/or argument
Criticise
Form and express a judgment
Evaluate
To determine the significance by careful

appraisal
Recommend
A suggestion or proposal as to the best course

of action
Resolve
Settle or find a solution to a problem or

contentious matter
Validate
Check or prove the accuracy
Compile
Produce by assembling information collected

from various sources
Design
Devise the form or structure according to a

plan
Develop
To disclose, discover, perfect or unfold a plan

or idea
Propose
To form or declare a plan or intention for

consideration or adoption
Formation of judgments and

decisions about the value of
methods, ideas, people or
products
Tier 6 Synthesis
Solve unfamiliar problems
by combining different
aspects to form a unique or
novel solution
xii
Questions
CA Sri Lanka
Questions
Section 1
1 Mahmood
45 mins
Mahmood is a junior employee of Tzo Company (a large, listed company). Tzo is a

processor of food labelled as containing only high quality meat. The company
enjoys the trust and confidence of its customers because of its reputation for high
quality products. One day, when passing through one area of the plant, Mahmood
noticed some inferior meat being mixed with the normal product. He felt this must
be unauthorised so he informed his supervisor, the factory manager, who told
Mahmood that this was in fact a necessary cost reduction measure because
company profits had been declining in recent months. Mahmood later found out
that all stages of the production process, from purchasing to final quality control,
were adapted in order to make the use of the inferior meat possible. The factory
manager told Mahmood that the inferior meat was safe for humans to eat and its
use was not illegal. However, he told Mahmood that if knowledge of the use of this
meat was made public, it would mean that customers might stop buying the
products. Many jobs could be lost, probably including Mahmoods own. The
factory manager ordered Mahmood to say nothing about the inferior meat and to
conduct his job as normal. Mahmood later discovered that the main board of Tzo
was aware of the use of the inferior meat and supported its use in seeking to
reduce costs and maintain profits. In covering up the use of the inferior meat, the
factory produced a fraudulent quality control report to show that the product was
purely based on high quality meat when the company knew that this was not so.
When Mahmood heard this, he was very angry and considered telling an external
source, such as the local newspaper, about what he had seen and about how the
company was being dishonest with its customers.
Required
CA Sri Lanka
(1)
Advise how Mahmood might act, in each case, if he were to adopt either
conventional or post-conventional ethical assumptions according to
Kohlbergs definitions of these terms. Your answer should include an
explanation of these two terms.
(8 marks)
(2)
Recommend an ethical case for Mahmood to take this matter directly to an

external source such as a newspaper.
(8 marks)
(3)
Some jurisdictions have a compulsory regulatory requirement for an

auditor-reviewed external report on the operation and effectiveness of
internal controls (such as s.404 of Sarbanes Oxley).
Questions
Required
Advise how such a requirement may have helped to prevent the undisclosed
use of the inferior meat at Tzo Company.
(9 marks)
(LO 1.4.1, LO 1.4.2 and LO 1.1.1)
2 David
(Total = 25 marks)
45 mins
David is currently serving as a non-executive director on the board of a

nationalised concern, The Electricity Provision Corporation (EPC), in a country in
Asia. David is also a qualified chartered accountant and a member of his countrys
professional accounting body.
EPC operates a number of coal-fired power stations and transmits energy through
a national grid which it controls. The electricity generated is then sold to the
general public by private sector electricity distribution companies.
David is concerned about the ethical implications of a couple of issues that were
discussed at EPC's most recent board meeting which was held yesterday. As a nonexecutive director, he believes he has a particular responsibility to consider
ethical issues carefully.
(i)
A general election campaign has recently begun in this country. The

governing party has indicated that it intends to maintain EPC as a
nationalised industry if it wins the general election, although it will be
seeking efficiency improvements. The opposition party has indicated that it
intends to privatise all industries that are currently nationalised. Early
yesterday morning before the board meeting, EPC's Managing Director was
suddenly asked by senior civil servants in the Ministry of Energy to provide a
major commitment to cost cutting in the next ten days. The Managing
Director is aware that the Minister of Energy will be making a major election
speech in a fortnight's time.
(ii)
A recent United Nations report ranked EPC's home country in the Top 10 of
its worst polluters, as measured by CO2 emissions per head of population.
This report has been seized upon by environmental groups who have called
for a month of action during the general election campaign. They wish to
highlight the environmental damage being caused by the government's
environmental policies and to highlight the need to switch to alternative
technologies such as wind power generation.
In the last few days small groups of protestors have broken through
perimeter fences at two of EPC's power stations and managed to delay
deliveries of coal by chaining themselves across railway tracks. There have
CA Sri Lanka
Questions
been some reports in the press of heavy handed treatment being meted out
by the security firm hired by EPC to deal with the protests. EPC's Managing
Director has dismissed these reports, saying the protestors' solutions are
impractical, they have no rights of access, and that EPC is entitled to take
whatever action is required against the protestors to protect its property
and maintain electricity supplies.
Required
(1)
Using the American Accounting Association model to support your answer,

recommend to David the course of action the board should take in
responding to the civil servants' request for information.
(15 marks)
(2)
Evaluate the factors that EPC's board should consider when dealing with the
current protests by environmental groups using Tucker's model for
decision-making,
(10 marks)
(LO 1.4.2, 1.5.1)
3 Anne
(Total = 25 marks)
45 mins
It was the final day of a two-week-long audit of Van Buren Company, a

longstanding client of Fillmore Pierce Auditors. In the afternoon, Anne, a recently
qualified accountant and member of the audit team, was following an audit trail on
some cash payments when she discovered what she described to the audit
partner, Zachary Lincoln, as an 'irregularity'. A large and material cash payment
had been recorded with no recipient named. The corresponding invoice was
handwritten on a scrap of paper and the signature was illegible.
Zachary, the audit partner, was under pressure to finish the audit that afternoon.
He advised Anne to seek an explanation from Frank Monroe, the client's finance
director. Zachary told her that Van Buren was a longstanding client of Fillmore
Pierce and he would be surprised if there was anything unethical or illegal about
the payment. He said that he had personally been involved in the Van Buren audit
for the last eight years and that it had always been without incident. He also said
that Frank Monroe was an old friend of his from university days and that he was
certain that he wouldn't approve anything unethical or illegal. Zachary said that
Fillmore Pierce had also done some consultancy for Van Buren so it was a very
important client that he didn't want Anne to upset with unwelcome and
uncomfortable questioning.
When Anne sought an explanation from Mr Monroe, she was told that nobody
could remember what the payment was for but that she had to recognise that
'real' audits were sometimes a bit messy and that not all audit trails would end as
she might like them to. He also reminded her that it was the final day and both he
CA Sri Lanka
Questions
and the audit firm were under time pressure to conclude business and get the
audit signed off.
When Anne told Zachary what Frank had said, Zachary agreed not to get the audit
signed off without Anne's support, but warned her that she should be very certain
that the irregularity was worth delaying the signoff for. It was therefore now
Anne's decision whether to extend the audit or have it signed off by the end of
Friday afternoon.
Required
(1)
Advise Anne why 'auditor independence' is necessary in auditor-client

relationships and describe THREE threats to auditor independence in the
case.
(7 marks)
Anne is experiencing some tension due to the conflict between her duties and
responsibilities as an employee of Fillmore Pierce and as a qualified professional
accountant.
Required
(2)
(i)
Advise Anne on her duties and responsibilities in the two roles of

employee and professional accountant.
(5 marks)
(ii)
Evaluate the ethical tensions between these roles that Anne is now
experiencing.
(4 marks)
(3)
Recommend how absolutist (dogmatic) and relativist (pragmatic) ethical

assumptions would affect the outcome of Anne's decision.
(5 marks)
(4)
Evaluate Annes ethical dilemma from Kolhbergs conventional and preconventional moral development perspectives.
(4 marks)
(LO 1.1.1, 1.7.1, 1.4.2, 1.4.1)
4 Poodle
(Total = 25 marks)
45 mins
You are the manager responsible for the audit of the Poodle Group (the Group)
and you are completing the audit of the consolidated financial statements for the
year ended 31 March 20X3. The draft consolidated financial statements recognise
revenue of $18 million (20X2 $17 million), profit before tax of $2 million (20X2
$3 million) and total assets of $58 million (20X2 $59 million). Your firm audits all
of the components of the Group, apart from an overseas subsidiary, Toy Co, which
is audited by a small local firm of accountants and auditors.
The audit senior has left a file note for your attention. You are aware that the
Group's annual report and financial statements are due to be released next week,
CA Sri Lanka
Questions
and the Group is very reluctant to make any adjustments in respect of the matters
described.
(1)
Toy Co
The component auditors of Toy Co, the overseas subsidiary, have been
instructed to provide the Group audit team with details of a court case which
is ongoing. An ex-employee is suing Toy Co for unfair dismissal and has
claimed $500,000 damages against the company. To comply with local
legislation, Toy Co's individual financial statements are prepared using a
local financial reporting framework. Under that local financial reporting
framework, a provision is only recognised if a cash outflow is virtually
certain to arise. The component auditors obtained verbal confirmation from
Toy Co's legal advisors that the damages are probable, but not virtually
certain to be paid, and no provision has been recognised in either the
individual or consolidated financial statements. No other audit evidence has
been obtained by the component auditors.
(9 marks)
(2)
Trade receivables
On 1 June 20X3, a notice was received from administrators dealing with the
winding up of Terrier Co, following its insolvency. The notice stated that the
company should be in a position to pay approximately 10% of the amounts
owed to its trade payables. Poodle Co, the parent company of the Group,
includes a balance of $1.6 million owed by Terrier Co in its trade receivables.
(8 marks)
(3)
Chairman's statement
The draft chairman's statement, to be included in the Group's annual report,
was received yesterday. The chairman comments on the performance of the
Group, stating that he is pleased that revenue has increased by 20% in the
year.
(8 marks)
Required
In respect of each of the matters described:
(i)
Evaluate the implications for the completion of the Group audit, explaining
any adjustments that may be necessary to the consolidated financial
statements, and recommending any further procedures necessary; and
(ii)
Advise the audit senior on the impact on the Group audit report if these
adjustments are not made.
Note. The split of the mark allocation is shown above against each of the parts.
(LO 4.3.1, 4.4.1, 4.4.2, 4.7.1, 4.8.1)
CA Sri Lanka
(Total = 25 marks)
Questions
5 Lychee
(1)
45 mins
You are the manager responsible for the audit of Lychee Co, a manufacturing
company with a year ended 30 September 20X9. The audit work has been
completed and reviewed and you are due to issue the auditor's report in
three days. The draft audit opinion is unmodified. The financial statements
show revenue for the year ended 30 September 20X9 of $15 million, net
profit of $3 million, and total assets at the yearend are $80 million.
The finance director of Lychee Co telephoned you this morning to tell you
about the announcement yesterday, of a significant restructuring of Lychee
Co, which will take place over the next six months. The restructuring will
involve the closure of a factory, and its relocation to another part of the
country. There will be some redundancies and the estimated cost of closure
is $250,000. The financial statements have not been amended in respect of
this matter.
Required
In respect of the announcement of the restructuring:
(2)
(i)
Comment on the financial reporting implications, and advise the

further audit procedures to be performed; and
(7 marks)
(ii)
Recommend the actions to be taken by the auditor if the financial

statements are not amended
(6 marks)
The finance director is aware that there is guidance for auditors relating to
audit reports in SLAuS 706 Emphasis of Matter Paragraphs and Other Matter
Paragraphs in the Independent Auditor's Report. The finance director has
asked for your assistance in this matter.
Required
(i)
Compile an 'Emphasis of Matter paragraph' and explain, providing

examples, the use of such a paragraph.
(6 marks)
(ii)
Compile an 'Other Matter paragraph' and explain, providing examples,

the use of such a paragraph.
(6 marks)
Note. You are not required to produce draft paragraphs.
(LO 4.3.1, 4.4.1, 4.4.2, 4.5.1)
(Total = 25 marks)
CA Sri Lanka
Questions
6 Axis & Co
45 mins
You are the manager responsible for four audit clients of Axis & Co, a firm of
Chartered Certified Accountants. The year end in each case is 30 June 20X8.
You are currently reviewing the audit working paper files and the audit seniors'
recommendations for the auditor's reports. Details are as follows.
(1)
Lorenze Co has changed its accounting policy for goodwill during the year
from amortisation over its estimated useful life to annual impairment testing.
No disclosure of this change has been given in the financial statements. The
carrying amount of goodwill in the statement of financial position as at
30 June 20X8 is the same as at 30 June 20X7 as management's impairment
test shows that it is not impaired.
The audit senior has concluded that a qualification is not required but
suggests that attention can be drawn to the change by way of an emphasis of
matter paragraph.
(6 marks)
(2)
The directors' report of Abrupt Co states that investment property rental

forms a major part of revenue. However, a note to the financial statements
shows that property rental represents only 1.6% of total revenue for the
year. The audit senior is satisfied that the revenue figures are correct.
The audit senior has noted that an unmodified opinion should be given as
the audit opinion does not extend to the directors' report.
(4 marks)
(3)
Audit work on the after-date bank transactions of Jingle Co has identified a

transfer of cash from Bell Co. The audit senior assigned to the audit of Jingle
has documented that Jingle's finance director explained that Bell commenced
trading on 7 July 20X8, after being set up as a wholly-owned foreign
subsidiary of Jingle.
The audit senior has noted that although no other evidence has been
obtained an unmodified opinion is appropriate because the matter does not
impact on the current year's financial statements.
(5 marks)
Required
For each situation, recommend the suitability or otherwise of the audit senior's
proposals for the auditor's reports. Where you disagree, recommend what audit
modification (if any) should be given instead.
Note. The mark allocation is shown against each of the three issues.
(4)
CA Sri Lanka
You are responsible for answering technical queries from other managers
and partners of your firm. An audit partner left the following note on your
desk this morning.
Questions
(i)
'I am about to draft the audit report for my client, Sycamore Co. I am
going on holiday tomorrow and want to have the audit report signed
and dated before I leave. The only thing outstanding is the written
representation from management I have verbally confirmed the
contents with the finance director who agreed to send the
representations to the audit manager within the next few days. I
presume this is acceptable?'
(5 marks)
(ii)
'We are auditing Sycamore Co for the first time. The prior period
financial statements were audited by another firm. We are aware that
the auditor's report on the prior period was qualified due to a material
misstatement of trade receivables. We have obtained sufficient
appropriate evidence that the matter giving rise to the misstatement
has been resolved and I am happy to issue an unmodified opinion. But
should I refer to the prior year modification in this year's auditor's
report?'
(5 marks)
Required
Advise on the audit partner's comments.
Note. The split of the mark allocation is shown within the question.
(LO 4.5.1, 4.7.1, 4.4.1, 4.4.2, 4.3.1, 4.3.2, 4.6.1)
7 Willow
(Total = 25 marks)
45 mins
Willow Pvt Ltd (Willow) is a print supplier to businesses, printing catalogues,

leaflets, training manuals and stationery to order. It specialises in using 100%
recycled paper in its printing, a fact which is promoted heavily in its advertising.
You are a senior audit manager in Bark & Co, and you have just been placed in
charge of the audit of Willow Co. The audit for the year ended 31 August 20X1 is
nearing completion, and you are reviewing a summary of outstanding issues:
Summary of issues for manager's attention, prepared by audit senior
Materiality has been determined as follows.
Rs. 800,000 for assets and liabilities

Rs. 250,000 for income and expenses
Issues related to audit work performed:

(i)
Audit work on inventory

Audit procedures performed at the inventory count indicated that printed
inventory items with a value of Rs. 130,000 were potentially obsolete. These
items were mainly out of date training manuals. The finance director, Cherry
10
CA Sri Lanka
Questions
Laurel, has not written off this inventory as she argues that the paper on
which the items are printed can be recycled and used again in future printing
orders. However, the items appear not to be recyclable as they are coated in
plastic. The junior who performed the audit work on inventory has
requested a written representation from management to confirm that the
items can be recycled and no further procedures relevant to these items
have been performed.
(ii)
Audit work on provisions

Willow is involved in a court case with a competitor, Aspen Pvt Ltd (Aspen),
which alleges that a design used in Willow's printed material copies one of
Aspen's designs which are protected under copyright. Our evidence obtained
is a verbal confirmation from Willow's lawyers that a claim of Rs. 125,000
has been made against Willow, which is probable to be paid. Cherry Laurel
has not made a provision, arguing that it is immaterial. Cherry refused our
request to ask the lawyers to confirm their opinion on the matter in writing,
saying it is not worth bothering the lawyers again on such a trivial matter.
(iii) Audit work on current assets

Willow made a loan of Rs. 6,000 to Cherry Laurel, the finance director, on 30
June 20X1. The amount is recognised as a current asset. The loan carries an
interest rate of 4% which we have confirmed to be the market rate for shortterm loans and we have concluded that the loan is an arm's length
transaction. Cherry has provided written confirmation that she intends to
repay the loan by 31 March 20X2. The only other audit work performed was
to agree the cash payment to the cash book. Details of the loan made to
Cherry have not been separately disclosed in the financial statements.
Other issues for your attention:
Property revaluations
Willow currently adopts an accounting policy of recognising properties at cost.
During the audit of non-current assets Willow's property manager said that the
company is considering a change of accounting policy so that properties would be
recognised at fair value from 1 January 20X2.
Non-current asset register
The audit of non-current assets was delayed by a week. We had asked for the noncurrent asset register reconciliation to be completed by the client prior to
commencement of our audit procedures on non-current assets, but it seems that
the person responsible for the reconciliation went on holiday having forgotten to
prepare the reconciliation. This happened on last year's audit as well, and the
issue was discussed with the audit committee at that time.
CA Sri Lanka
11
Questions
Procurement procedures
We found during our testing of trade payables that an approved supplier list is not
maintained, and invoices received are not always matched back to goods received
notes. This was mentioned to the procurement manager, who said that suppliers
are switched fairly often, depending on which supplier is the cheapest, so it would
be difficult to maintain an up-to-date approved supplier list.
Financial controller
Mia Fern, Willows financial controller, owns a holiday home overseas. It appears
that she offered the audit team free use of the holiday home for three weeks after
the audit, as a reward for the team's hard work. She also bought lunch for the
audit team on most days.
Required
(1)
Evaluate the audit implications of the three issues related to the audit work
raised by the audit senior. You should consider the sufficiency of evidence
obtained, any necessary adjustments to the financial statements and the
impact on the audit report if any necessary adjustments are not made.
(18 marks)
(2)
Advise on the matters, other than the three issues related to the audit work
raised by the audit senior, which should be brought to the attention of
Willows audit committee.
(7 marks)
(LO 4.1.1, 4.2.1, 4.3.1, 4.4.1, 1.3.1)
(Total = 25 marks)
8 Colombo
45 mins
You are a manager in Sambora & Co, responsible for the audit of the Colombo
Group (the Group), which is listed. The Group's main activity is steel
manufacturing and it comprises a parent company and five subsidiaries. Sambora
& Co currently audits all components of the Group.
You are working on the audit of the Group's financial statements for the year
ended 30 June 20X2.
At the planning stage, materiality was initially determined to be Rs. 900,000, and
was calculated based on the assumption that the Colombo Group is a high risk
client due to its listed status. During the audit, a number of issues arose which
meant that it was necessary to revise the materiality level for the financial
statements as a whole. The revised level of materiality is now determined to be Rs.
700,000. One of the audit juniors was unsure as to why the materiality level had
been revised.
12
CA Sri Lanka
Questions
The audit senior has provided you with the draft consolidated financial statements
and accompanying notes which summarise the key audit findings and some
background information.
The Group's draft consolidated financial statements, with notes referenced to key
audit findings, are shown below.
DRAFT CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER
COMPREHENSIVE INCOME
30 June 20X2 30 June 20X1
Notes
Draft
Actual
Rs'000
Rs'000
1
98,795
103,100
Revenue
(75,250)
(74,560)
Cost of sales
23,545
28,540
Gross profit
2
(14,900)
(17,500)
Operating expenses
8,645
11,040
Operating profit
1,010
900
Share of profit of associate
(380)
(340)
Finance costs
9,275
11,600
Profit before tax
(3,200)
(3,500)
Taxation
6,075
8,100
Profit for the year
Other comprehensive income/expense for
the year, net of tax:
3
800
Gains on property revaluation

4
(1,100)
Actuarial losses on defined
(200)
benefit plan
(300)
(200)
Other comprehensive
income/expense
7,900
5,775
Total comprehensive income for
the year
Notes. Key audit findings Statement of profit or loss and other
comprehensive income
CA Sri Lanka
Revenue has been stable for all components of the Group with the exception
of one subsidiary, Galle Plc, which has recognised a 25% decrease in
revenue.
Operating expenses for the year to June 20X2 is shown net of a profit on a
property disposal of Rs. 2 million. Our evidence includes agreeing the cash
receipts to bank statement and sale documentation, and we have confirmed
that the property has been removed from the non-current asset register.
13
Questions
The property revaluation relates to the Group's head office. The audit team
have not obtained evidence on the revaluation, as the gain was immaterial
based on the initial calculation of materiality.
The actuarial loss is attributed to an unexpected stock market crash. The

Group's pension plan is managed by Axle Plc a firm of independent fund
managers who maintain the necessary accounting records relating to the
plan. Axle Plc has supplied written representation as to the value of the
defined benefit plan's assets and liabilities at 30 June 20X2. No other audit
work has been performed other than to agree the figure from the financial
statements to supporting documentation supplied by Axle Plc.
DRAFT CONSOLIDATED STATEMENT OF FINANCIAL POSITION

30 June
30 June
20X2
20X1
Notes
Draft
Actual
Rs'000
Rs'000
ASSETS
Non-current assets
81,800
76,300
Property, plant and equipment
5
5,350
5,350
Goodwill
6
4,230
4,230
Investment in associate
7
7,800
Assets classified as held for sale

99,180
85,880
Current assets
8,600
8,000
Inventory
8,540
7,800
Receivables
2,100
2,420
Cash and cash equivalents
19,240
18,220
118,420
104,100
Total assets
EQUITY AND LIABILITIES
Equity
12,500
12,500
Share capital
3,300
2,500
Revaluation reserve
33,600
29,400
Retained earnings
8
4,350
4,000
Non-controlling interest
53,750
48,400
Total equity
Non-current liabilities
10,820
9,250
Defined benefit pension plan
9
43,000
35,000
Long-term borrowings
1,950
1,350
Deferred tax
55,770
45,600
Total non-current liabilities
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CA Sri Lanka
Questions
Notes
Current liabilities
Trade and other payables
Provisions
Total current liabilities
Total liabilities
Total equity and liabilities
30 June
20X2
Draft
Rs'000
30 June
20X1
Actual
Rs'000
6,200
2,700
8,900
64,670
118,420
7,300
2,800
10,100
55,700
104,100
Notes. Key audit findings Statement of financial position

5
The goodwill relates to each of the subsidiaries in the Group. Management

has confirmed in writing that goodwill is stated correctly, and our other
audit procedure was to arithmetically check the impairment review
conducted by management.
The associate is a 30% holding in Moratuwa Plc, purchased to provide

investment income. The audit team have not obtained evidence regarding
the associate as there is no movement in the amount recognised in the
statement of financial position.
The assets held for sale relate to a trading division of one of the subsidiaries,
which represents one third of that subsidiary's net assets. The sale of the
division was announced in May 20X2, and is expected to be complete by
31 December 20X2. Audit evidence obtained includes a review of the sales
agreement and confirmation from the buyer, obtained in July 20X2, that the
sale will take place.
Two of the Group's subsidiaries are partly owned by shareholders external

to the Group.
A loan of Rs. 8 million was taken out in October 20X1, carrying an interest
rate of 2%, payable annually in arrears. The terms of the loan have been
confirmed to documentation provided by the bank.
Required
(1)
Advise the audit junior as to why there may be a need to reassess

materiality as the audit progresses.
(5 marks)
(2)
Evaluate whether the key audit findings indicate a risk of misstatement and
the adequacy of audit evidence obtained.
(20 marks)
(LO 4.1.2, 3.2.1, 4.1.1)
CA Sri Lanka
(Total = 25 marks)
15
Questions
9 Banana
45 mins
You are a manager in Grape & Co. You have been temporarily assigned as audit
manager to the audit of Banana Pvt Ltd (Banana), because the engagement
manager has been taken ill. The final audit of Banana for the year ended
30 September 20X9 is nearing completion, and you are now reviewing the audit
files and discussing the audit with the junior members of the audit team. Banana
designs and manufactures equipment such as cranes and scaffolding, which are
used in the construction industry. The equipment usually follows a standard
design, but sometimes Banana designs specific items for customers according to
contractually agreed specifications. The draft financial statements show revenue
of Rs. 12.5 million, net profit of Rs. 400,000, and total assets of Rs. 78 million.
The following information has come to your attention during your review of the
audit files.
During the year, a new range of manufacturing plant was introduced to the
factories operated by Banana. All factory employees received training from an
external training firm on how to safely operate the machinery, at a total cost of
Rs. 500,000. The training costs have been capitalised into the cost of the new
machinery, as the finance director argues that the training is necessary in order
for the machinery to generate an economic benefit. After the year end, Cherry Pvt
Ltd (Cherry), a major customer with whom Banana has several significant
contracts, announced its insolvency, and that procedures to shut down the
company had commenced. The administrators of Cherry have suggested that the
company may be able to pay approximately 25% of the amounts owed to its trade
payables (creditors). A trade receivable of Rs. 300,000 is recognised on Banana's
statement of financial position in respect of this customer.
In addition, one of the junior members of the audit team voiced concerns over how
the audit had been managed. The junior said the following:
'I have only worked on two audits prior to being assigned the audit team of
Banana. I was expecting to attend a meeting at the start of the audit, where the
partner and other senior members of the audit team discussed the audit, but no
meeting was held. In addition, the audit manager has been away on holiday for
three weeks, and left a senior in charge. However, the senior was busy with other
assignments, so was not always available.
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CA Sri Lanka
Questions
'I was given the task of auditing the goodwill which arose on an acquisition made
during the year. I also worked on the audit of inventory, and attended the
inventory count, which was quite complicated, as Banana has a lot of work-inprogress. I tried to be as useful as possible during the count, and helped the
client's staff count some of the raw materials. As I had been to the inventory count,
I was asked by the audit senior to challenge the finance director regarding the
adequacy of the provision against inventory, which the senior felt was
significantly understated.
'Lastly, we found that we were running out of time to complete our audit
procedures. The audit senior advised that we should reduce the sample sizes used
in our tests as a way of saving time. He also suggested that if we picked an item as
part of our sample for which it would be time consuming to find the relevant
evidence, then we should pick a different item which would be quicker to audit.'
Required
(1)
(2)
Evaluate the matters to be considered and the audit evidence you should
expect to find during your file review in respect of:
(i)
The training costs that have been capitalised into the cost of the new
machinery
(ii)
The trade receivable recognised in relation to Cherry
(15 marks)
Evaluate the juniors concerns regarding the management of the audit of

Banana.
(10 marks)
(LO 4.1.1, 5.2.2)
10 Retriever
(Total = 25 marks)
45 mins
Kennel & Co is the external audit provider for the Retriever Group (the Group), a
manufacturer of mobile phones and laptop computers. The Group obtained a stock
exchange listing in July 20X2. The audit of the consolidated financial statements
for the year ended 28 February 20X3 is nearing completion.
You are a manager in the audit department of Kennel & Co, responsible for
conducting engagement quality control reviews on listed audit clients. You have
discussed the Group audit with some of the junior members of the audit team, one
of whom made the following comments about how it was planned and carried out:
'The audit has been quite time-pressured. The audit manager told the juniors not
to perform some of the planned audit procedures on items such as directors'
emoluments and share capital as they are considered to be low risk. He also
instructed us not to use the firm's statistical sampling methods in selecting trade
CA Sri Lanka
17
Questions
receivables balances for testing, as it would be quicker to pick the sample based
on our own judgement.
'Two of the juniors were given the tasks of auditing trade payables and going
concern. The audit manager asked us to review each other's work as it would be
good training for us, and he didn't have time to review everything.
'I was discussing the Group's tax position with the financial controller, when she
said that she was struggling to calculate the deferred tax asset that should be
recognised. The deferred tax asset has arisen because several of the Group's
subsidiaries have been loss-making this year, creating unutilised tax losses. As I
had just studied deferred tax at college I did the calculation of the Group's
deferred tax position for her. The audit manager said this saved time as we now
would not have to audit the deferred tax figure.
'The financial controller also asked for my advice as to how the tax losses could be
utilised by the Group in the future. I provided her with some tax planning
recommendations, for which she was very grateful.'
In addition, the audit committee of the Group has contacted Kennel & Co to discuss
an incident that took place on 1 June 20X3. On that date, there was a burglary at
the Group's warehouse where inventory is stored prior to despatch to customers.
CCTV filmed the thieves loading a lorry belonging to the Group with boxes
containing finished goods. The last inventory count took place on 30 April 20X3.
The Group has insurance cover in place and Kennel & Co's internal audit service
has been asked to undertake a special investigation in order to determine the
amount to be claimed in respect of the burglary. The insurance covers the cost of
assets lost as a result of thefts.
It is thought that the amount of the claim will be immaterial to the Group's
financial statements, and there is no ethical threat in Kennel & Co's internal audit
services providing the services requested.
Required
(1)
Evaluate the quality control, ethical and other professional matters arising
in respect of the planning and performance of the group audit. (14 marks)
(2)
Advise on the matters to be considered and the steps to be taken in planning

the internal audit special investigation.
(7 marks)
(3)
Recommend the procedures to be performed in determining the amount of

the claim.
(4 marks)
(LO 1.8.1, 4.1.1, 5.2.5, 5.1.2)
18
(Total 25 marks)
CA Sri Lanka
Questions
11
Dragon Group
45 mins
You are a newly-qualified audit supervisor in Unicorn & Co, a global firm of
Chartered Certified Accountants, with offices in over 150 countries across the
world. You work in a department within the firm which specialises in the audit of
retail companies.
Unicorn & Co has been invited to tender for the Dragon Group audit (including the
audit of all subsidiaries). The Dragon Group is a large group of companies
operating in the furniture retail trade. The group has expanded rapidly in the last
three years, by acquiring several subsidiaries each year. The management of the
parent company, Dragon Plc, has decided to put the audit of the group and all
subsidiaries out to tender, as the current audit firm is not seeking re-election. The
financial year end of the Dragon Group is 30 September 20X9. A senior partner in
your department has recently held a meeting with the group finance director, in
which the current group structure, recent acquisitions and the groups plans for
future expansion were discussed. The partner has produced the following notes of
this meeting.
Meeting notes Dragon Group
Group structure
The parent company owns 20 subsidiaries, all of which are wholly owned. Half of
the subsidiaries are located in this country, and half overseas. Most of the foreign
subsidiaries report under the same financial reporting framework as Dragon Plc,
but several prepare financial statements using local accounting rules.
Acquisitions during the year
Two companies were purchased in March 20X9, both located in this country:
CA Sri Lanka
Mermaid Pvt Ltd, a company which operates 20 furniture retail outlets. The
audit opinion expressed by the incumbent auditor on the financial
statements for the year ended 30 September 20X8 was modified by a
material misstatement over the non-disclosure of a contingent liability. The
contingent liability relates to a court case which is still ongoing.
Minotaur Plc, a large company, whose operations are distribution and

warehousing. This represents a diversification away from retail, and it is
hoped that the Dragon Group will benefit from significant economies of scale
as a result of the acquisition.
19
Questions
Other matters
The acquisitive strategy of the group over the last few years has led to significant
growth. Group revenue has increased by 25% in the last three years, and is
predicted to increase by a further 35% in the next four years as the acquisition of
more subsidiaries is planned. The Dragon Group has raised finance for the
acquisitions in the past by becoming listed on the stock exchanges of three
different countries. A new listing on a foreign stock exchange is planned for
January 20Y0. For this reason, management would like the group audit completed
by 31 December 20X9.
At the meeting the finance director of Dragon requested whether, if Unicorn & Co
were appointed as auditors, a certain audit senior, Kia Nelson, could be assigned
to the audit team. On further investigation it transpires that Kia Nelson is the
sister of Dragons financial controller.
Required
(1)
Recommend the principal matters to be included in the firms tender

document to provide the audit service to the Dragon Group.
(12 marks)
(2)
Evaluate the matters that should be considered before accepting the audit
engagement, in the event of Unicorn & Co being successful in the tender.
(8 marks)
(3)
Evaluate the ethical and other professional issues raised in respect of the
finance directors request for Kia Nelson to be included in the audit team.
(5 marks)
(LO 5.1.1, 1.8.1)
12 Lapwing
(Total = 25 marks)
45 mins
You are a manager in Lapwing & Co. One of your audit clients is Hawk Plc (Hawk)
which operates commercial real estate properties typically comprising several
floors of retail units and leisure facilities such as cinemas and health clubs, which
are rented out to provide rental income.
Your firm has just been approached to provide an additional engagement for
Hawk, to review and provide a report on the company's business plan, including
forecast financial statements for the 12-month period to 31 May 20X3. Hawk is in
the process of negotiating a new bank loan of Rs. 30 million and the report on the
business plan is at the request of the bank. It is anticipated that the loan would be
advanced in August 20X2 and would carry an interest rate of 4%. The report
would be provided by your firm's business advisory department.
20
CA Sri Lanka
Questions
Extracts from the forecast financial statements included in the business plan are
given below.
STATEMENT OF PROFIT OR LOSS (EXTRACT)
Notes
Revenue
Operating expenses
Operating profit
Profit on disposal of Beak Retail
Finance costs
Profit before tax
FORECAST
12 months to
31 May 20X3
Rs'000
25,000
(16,550)
8,450
4,720
(2,650)
10,520
UNAUDITED
12 months to
31 May 20X2
Rs'000
20,600
(14,420)
6,180
(1,690)
4,490
Notes
FORECAST
31 May 20X3
Rs'000
UNAUDITED
31 May 20X2
Rs'000
330,150
293,000
500
3,600
2,250
6,350
336,500
450
3,300
3,750
7,500
300,500
105,000
93,400
198,400
100,000
92,600
192,600
82,500
50,000
52,500
50,000
5,600
138,100
336,500
5,400
107,900
300,500
STATEMENT OF FINANCIAL POSITION
Assets
Non-current assets
Current assets
Inventory
Receivables
Total assets
Equity and liabilities
Equity
Share capital
Retained earnings
Total equity
Deferred tax
Current liabilities
Trade payables
Total liabilities
CA Sri Lanka
21
Questions
Notes
1
Beak Retail is a retail park which is underperforming. Its sale is currently

being negotiated, and is expected to take place in September 20X2.
Hawk Plc is planning to invest the cash raised from the bank loan in a new
retail and leisure park which is being developed jointly with another
company, Kestrel Plc.
Required
(1)
Evaluate the matters that should be considered in agreeing the terms of the
engagement to provide a report on Hawks business plan.
(7 marks)
(2)
Recommend the procedures that should be performed in order to examine

and report on the forecast financial statements of Hawk for the year to 31
May 20X3.
(13 marks)
(3)
Advise on the ethical issues which are relevant when providing other
services to an audit client.
(5 marks)
(LO 5.1.1, 5.1.2, 1.9.1)
13 Baltimore
(Total = 25 marks)
45 mins
You are a manager in the business advisory department of Goleen & Co. Your firm
has been approached to provide assurance to Baltimore Plc (Baltimore), a
company which is not an audit client of your firm, on a potential acquisition. You
have been given the following information.
Baltimore is a book publisher specialising in publishing textbooks and academic
journals. In the last few years the market has changed significantly, with the
majority of customers purchasing books from online sellers. This has led to a
reduction in profits, and the company has recognised that it needs to diversify its
product range in order to survive. As a result of this, Baltimore has decided to
offer a subscription-based website to customers, which would provide the
customer with access to its full range of textbooks and journals online.
On investigating how to set up this website, Baltimore found that it lacked
sufficient knowledge and resources to develop this themselves and began to look
for another company which had the necessary skills, with a view to acquiring the
company. It has identified Mizzen Pvt Ltd (Mizzen) as a potential acquisition, and
has approached the bank for a loan which will be used to finance the acquisition if
it goes ahead.
Baltimore has not previously acquired another company.
22
CA Sri Lanka
Questions
Background information on Mizzen

Mizzen was established four years ago by two university graduates, Vic Sandhu
and Lou Lien, who secured funds from a venture capitalist company, BizGrow, to
set up the company. Vic and Lou created a new type of website interface which has
proven extremely popular, and which led to the company growing rapidly and
building a good reputation. They continue to innovate and have won awards for
website design. Vic and Lou have a minority shareholding in Mizzen.
Mizzen employs 50 people and operates from premises owned by BizGrow, for
which a nominal rent of Rs. 1,000 is paid annually. The company uses few assets
other than computer equipment and fixtures and fittings. The biggest expense is
wages and salaries and due to increased demand for website development,
freelance specialists have been used in the last six months. According to the most
recent audited financial statements, Mizzen has a bank balance of Rs. 500,000.
The company has three revenue streams:
(i)
Developing and maintaining websites for corporate customers. Mizzen

charges a one-off fee to its customers for the initial development of a website
and for maintaining the website for two years. The amount of this fee
depends on the size and complexity of the website and averages at
Rs. 10,000 per website. The customer can then choose to pay another one-off
fee, averaging Rs. 2,000, for Mizzen to provide maintenance for a further five
years.
(ii)
Mizzen has also developed a subscription-based website on which it

provides access to technical material for computer specialists. Customers
pay an annual fee of Rs. 250 which gives them unlimited access to the
website. This accounts for approximately 30% of Mizzen's total revenue.
(iii) The company has built up several customer databases which are made
available, for a fee, to other companies for marketing purposes. This is the
smallest revenue stream, accounting for approximately 20% of Mizzen's
total revenue.
CA Sri Lanka
23
Questions
Extracts from audited financial statements

STATEMENT OF PROFIT OR LOSS AND OTHER COMPREHENSIVE INCOME
Revenue
Operating expenses
Operating profit/(loss)
Finance costs
Profit/(loss) before tax
Tax expense
Profit/(loss) for the year
Year ended Year ended Year ended Year ended

30
30
30
30
September September September September
20X3
20X2
20X1
20X0
Rs'000
Rs'000
Rs'000
Rs'000
4,268
3,450
2,150
500
(2,118)
(2,010)
(1,290)
(1,000)
2,150
1,440
860
(500)
(250)
(250)
(250)
1,900
1,190
610
(500)
(475)
(300)
(140)
890
470
(500)
1,425
There were no items of other comprehensive income recognised in any year.

On a separate matter, Goleen & Co is considering expanding the range of services
offered by its business advisory department. Ingrid Sharapova, a senior manager,
has suggested that the firm could offer a recruitment advisory service to audit
clients, specialising in the recruitment of finance professionals. Goleen & Co would
charge a fee for this service based on the salary of the employee recruited. Ingrid
Sharapova worked as a recruitment consultant for a year before deciding to train
as an accountant.
Required
(1)
Advise on the matters which you would focus on in your due diligence
review and recommend the additional information which you will need to
perform your work.
(17 marks)
(2)
Advise on the type of conclusion which would be issued for a due diligence
report in comparison to an audit report.
(3 marks)
(3)
Evaluate the ethical and practice management implications of the proposal

by Goleen & Co to offer recruitment advisory services.
(5 marks)
(LO 5.1.2, 1.10.1)
24
(Total = 25 marks)
CA Sri Lanka
Questions
14 Apricot
45 mins
Your audit client, Apricot Plc, is intending to purchase a new warehouse at a cost
of Rs. 500,000. One of the directors of the company, Pik Choi, has agreed to make
the necessary finance available through a director's loan to the company. This
arrangement has been approved by the other directors, and the cash will be
provided on 30 March 20X0, one day before the purchase is due to be completed.
Pik's financial advisor has asked to see a cash flow projection of Apricot Plc for the
next three months. Your firm has been asked to provide an assurance report to
Pik's financial advisor on this prospective financial information.
The cash flow forecast is shown below.
Operating cash receipts:

Cash sales
Receipts from credit sales
Operating cash payments:
Purchases of inventory
Salaries
Overheads
Other cash flows:
Dividend payment
Purchase of new licence
Fixtures for new warehouse
Loan receipt
Payment for warehouse
Cash flow for the month
Opening cash
Closing cash
January
20X0
Rs'000
February 20X0
Rs'000
March
20X0
Rs'000
125
580
135
600
140
625
(410)
(100)
(175)
(425)
(100)
(175)
(425)
(100)
(175)
(80)
(35)
(60)
500
(500)
(15)
100
85
(45)
85
40
5
40
45
The following information is relevant.
CA Sri Lanka
Apricot Plc is a wholesaler of catering equipment and frozen food. Its

customers are mostly restaurant chains and fast food outlets.
Customers who pay in cash receive a 10% discount. Analysis has been
provided showing that for sales made on credit, 20% of customers pay in the
month of the sale, 60% pay after 45 days, 10% after 65 days, 5% after 90
days, and the remainder are bad debts.
Apricot Plc pays for all purchases within 30 days in order to take advantage
of a 12% discount from suppliers.
25
Questions
Overheads are mainly property rentals, utility bills, insurance premiums and
general office expenses.
Apricot Plc needs to have a health and safety licence as it sells food. Each
licence is valid for one year and is issued once an inspection has taken place.
A profit forecast has also been prepared for the year ending
31 December 20X0 to help with internal planning and budgeting.
During this year, Apricot Plc established a pension plan for its directors, and this
year end the company will be recognising a pension deficit on the statement of
financial position for the first time, in accordance with LKAS 19 Employee benefits.
The finance director of Apricot Plc has contacted the audit engagement partner,
asking if your firm can provide a valuation service in respect of the amount
recognised.
Required
(1)
Recommend the procedures that should be performed on the cash flow

forecast for the three months ending 31 March 20X0 in order to provide an
assurance report as requested by Apricot Co.
(10 marks)
(2)
Advise on the main contents of the report that will be issued on the
prospective financial information.
(5 marks)
(3)
Evaluate the professional accountants liability for reporting on prospective

financial information and the measures that the professional accountant
might take to reduce that liability.
(5 marks)
(4)
Evaluate the ethical and professional issues raised in respect of the request
regarding the provision of a valuation service.
(5 marks)
(LO 5.1.2, 5.1.3, 1.9.1)
15 Beech
(Total = 25 marks)
45 mins
You are a manager in the audit department of Beech & Co, responsible for the
audits of Fir Plc (Fir), Spruce Plc (Spruce), Pine Plc (Pine) and Oak Plc (Oak). Each
company has a financial year ended 31 July 20X1, and the audits of all companies
are nearing completion. The following issues have arisen in relation to the audit of
accounting estimates and fair values.
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Questions
(1)
Fir Plc
Fir is a company involved in energy production. It owns several nuclear
power stations, which have a remaining estimated useful life of 20 years. Fir
intends to decommission the power stations at the end of their useful life
and the statement of financial position at 31 July 20X1 recognises a material
provision in respect of decommissioning costs of Rs. 97 million (20X0
Rs. 110 million). A brief note to the financial statements discloses the
opening and closing value of the provision but no other information is
provided.
Required
Evaluate the matters that should be considered, and the audit evidence you
should expect to find in your file review in respect of the decommissioning
provision.
(8 marks)
(2)
Spruce Plc
Spruce is also involved in energy production. It has a trading division which
manages a portfolio of complex financial instruments such as derivatives.
The portfolio is material to the financial statements. Due to the specialist
nature of these financial instruments, an auditor's expert was engaged to
assist in obtaining sufficient appropriate audit evidence relating to the fair
value of the financial instruments. The objectivity, capabilities and
competence of the expert were confirmed prior to their engagement.
Required
Advise of the procedures that should be performed in evaluating the
adequacy of the auditor's expert's work.
(5 marks)
(3)
Pine Plc
Pine operates a warehousing and distribution service, and owns 120
properties. During the year ended 31 July 20X1, management changed its
estimate of the useful life of all properties, extending the life on average by
ten years. The financial statements contain a retrospective adjustment,
which increases opening non-current assets and equity by a material
amount. Information in respect of the change in estimate has not been
disclosed in the notes to the financial statements.
Required
Advise of the potential implications for the auditor's report of the
accounting treatment of the change in accounting estimates.
(5 marks)
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27
Questions
(4)
Poppy Plc
Poppy Plc, is a manufacturing company. In the last year, several investment
properties have been purchased to utilise surplus funds and to provide
rental income. The properties have been revalued at the year end in
accordance with LKAS 40 Investment property, they are recognised on the
statement of financial position at a fair value of Rs. 8 million, and the total
assets of Poppy are Rs. 160 million at 31 July 20X1. An external valuer has
been used to provide the fair value for each property.
Required
Propose the principal audit procedures to be performed on the valuation of
the investment properties.
(7 marks)
Note. Assume it is 5 December 20X1.
(LO 4.1.1, 3.4.1)
16 Seatown
(Total = 25 marks)
45 mins
Seatown is located on the coast. The towns main industry is tourism with an
emphasis on family holidays and consequently the cleanliness of the towns
beaches is a major factor in the towns success.
The town council, which is the local government authority, has a cleaning
department that is responsible for keeping the beaches clean and tidy. Early every
morning, after the tide has gone out, the beaches are swept, using equipment that
is towed behind tractors. This equipment skims the top layer of sand and runs it
through a filter to remove any litter, before returning the cleaned sand to the
beach. Most of the litter is paper and plastic packaging which tourists have
discarded, but the litter can include glass bottles and aluminium cans.
To try to prevent litter being left on the beach the town council also places bins on
the beaches above the high water mark. Litter bins need to be emptied regularly,
otherwise holidaymakers pile their rubbish beside the bins and that leads to litter
being spread by the wind or by seabirds scavenging for food scraps.
The cost of cleaning the beaches is a major expense for the town council. The
management team of the town council has asked the internal audit department to
investigate whether the town is getting good 'value for money' from this
expenditure. The head of internal audit has sought clarification from the town
managers on whether the audit should focus on the economy and efficiency of the
cleaning operations or their effectiveness. Economy and efficiency audits generally
focus on whether cost can be reduced for the same level of service and
effectiveness audits ask whether better service can be achieved for the same cost.
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Questions
Required
(1)
Advise, giving reasons, the matters that the town councils internal audit
department should study in order to evaluate the economy and efficiency of
the beach cleaning activities.
Your answer should include advice on how to obtain the necessary data and
information.
(12 marks)
(2)
Recommend, giving reasons, the matters that the town councils internal
audit department should study in order to evaluate the effectiveness of the
beach cleaning activities.
Your answer should include advice on how to obtain the necessary data and
information.
(13 marks)
(LO 2.6.1, 2.6.2, 2.7.1)
17 WWW
(Total = 25 marks)
45 mins
WWW is an international company based in Europe which trades principally in

Asia and Europe. In its published Code of Ethics WWW has committed itself to
'being a company that will trade fairly and sustainably'. WWW has been following
an expansion strategy which has led to the following three situations occurring.
Situation 1
At a recent presentation to investment analysts and financial journalists, WWWs
Chief Executive Officer (CEO) gave a very optimistic forecast for the companys
future, suggesting that revenue would double over the next three years and profits
and dividends would increase by 50%.
However, the CEO had prepared his forecast in a hurry and had not had it
confirmed by anybody else within WWW. He did not mention that WWW's home
Government was considering taking legal action against WWW for underpayment
of excise duties and had made a claim for large damages. If this claim was to be
successful it would materially affect WWWs profit in the next year (20X3).
Situation 2
In connection with the legal case in 1, WWW's home Government had obtained a
court order that all documents relating to WWWs export trade should be made
available to the Government's lawyers.
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29
Questions
However, many of the documents covered by the court order were the subject of
confidentiality agreements between WWW and various entrepreneurs. These
documents included details of patents and processes with a high commercial value
and if knowledge of these became public it would destroy some of WWWs
competitive advantage.
Situation 3
This situation, which is unconnected to Situations 1 and 2, has also occurred.
WWW has a joint venture agreement with a company, ZZZ. Under the terms of the
joint venture agreement each company has to make regular returns of financial
performance to the other. ZZZ is always late in making its returns, which are
usually incomplete and contain many errors. ZZZ's accounting staff are very
reluctant to co-operate with WWWs accounting staff and the working relationship
between the two companies is poor.
WWWs financial controller has been involved in a review of the joint venture with
ZZZ. Due to the many problems that ZZZ has caused him and his staff he has
advised discontinuing the joint venture.
Required
(1)
Advise, giving your reasons, whether each of the three situations is in

conflict with CASLs Code of Ethics.
(i) Situation 1
(ii) Situation 2
(iii) Situation 3
(2)
Inform WWW of the stages of a procedure it could use to resolve ethical

conflicts.
(10 marks)
(LO 1.4.2 1.6.1 1.7.1, 1.4.1, 1.5.1)
30
(5 marks)
(5 marks)
(5 marks)
(Total = 25 marks)
CA Sri Lanka
Questions
18 VV
45 mins
VV is a quoted company. Its board comprises an equal number of both executive

and non-executive directors. The company has a remuneration committee,
comprised entirely of non-executives.
A major institutional investor in VV has written to the chair of the remuneration
committee to raise some concerns about the manner in which the performance of
VVs executive directors is controlled and rewarded.
At present, each of the executive directors receives a fairly substantial fixed
annual salary combined with options granted under an executive share option
scheme ('ESOS'). The ESOS is designed in order to align the directors interests
with those of the shareholders:
The remuneration committee reviews each directors performance during

the financial year and grants a number of share options in accordance with
performance.
The options are issued 'at the money' (that is, the exercise price is the same
as the market price) so that the directors have an incentive to increase the
share price.
The options can only be exercised on a specified date that falls three years
after their issue.
If a director leaves the company then any outstanding options will lapse
without compensation.
The institutional investor has expressed concern about the ESOS arrangement
because of the underlying financial implications of the scheme. VV first introduced
ESOSs in order to motivate the executive directors to act in the shareholders
interests. If the directors work towards maximising VVs share price then the
options will provide higher returns if they are in the money when they come due
for exercise. In addition, VVs directors are much less likely to reject positive net
present value investment opportunities if they hold options. Normally the
directors are more risk averse than the shareholders when it comes to project
appraisal, but holding options makes risk-taking more appealing.
The institutional investor is concerned that the options may have encouraged
dysfunctional behaviour by the directors, although it is difficult to be certain that
that has arisen because of the limited information that is available to the
shareholders.
The institutional investor has suggested that the executive directors should be
rewarded with a simpler scheme, such as an annual profit-related bonus. At
present, it is unclear whether the reward system in place provides the executive
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31
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directors with meaningful feedback on their performance. As a shareholder, the

investor wishes to see a clearer link between the directors performance and their
remuneration.
Required
(1)
(2)
(i)
Explain why the introduction of ESOSs could motivate VVs executive

directors to accept positive net present value (NPV) projects.
(9 marks)
(ii)
Explain how an ESOS scheme could affect the actions taken by the
directors (other than the project appraisal decision).
(8 marks)
Evaluate the advantages and disadvantages of rewarding executive

directors by paying a bonus based on a simple and transparent measure
such as profit.
(8 marks)
(LO 1.1.1, 1.2.1)
32
(Total = 25 marks)
CA Sri Lanka
Questions
Section 2
1 Daily Newspapers
90 mins
Preseen case study

Introduction
Daily plc is a newspaper publisher, with print and online media channels. It is
based in Hong Kong and is listed on the Hong Kong Stock Exchange. Daily has
three operating divisions which are managed from Hong Kong (HK). These are the
Newspapers Division, the Web Division and the Advertising Division.
Newspapers Division
The Newspapers Division publishes three daily newspapers and one Sunday
newspaper in HK. The Division has three offices and two printing sites. Between
them the three offices edit the three daily newspapers and the Sunday newspaper.
The Newspaper Division has two subsidiary publishing companies, FR and N,
which cover regions within Asia. Printing for all the Division's publications, except
those produced by FR and N, is undertaken at the two printing sites. FR and N
have their own printing sites.
Web Division
The Web Division maintains and develops 200 websites which it owns. Some of
these websites are much more popular in terms of the number of 'hits' they
receive than others. Web material is an increasing part of Daily plc's business. In
the last ten years, the Web Division has developed an online version of all the
newspapers produced by the Newspapers Division.
Advertising Division
The sale of advertising space is undertaken for the whole of Daily plc by the
Advertising Division. Therefore, advertisements which appear in the print media
and on the web pages produced by the Newspapers Division (including that
produced by FR and N) and the Web Division respectively are all handled by the
Advertising Division.
Group Headquarters
In addition to the three operating divisions, Daily plc also has a head office, based
in HK, which is the group's corporate headquarters where the Board of Directors
is located. The main role of Daily plc's headquarters is to develop and administer
its policies and procedures as well as to deal with its group corporate affairs.
CA Sri Lanka
33
Questions
Mission statement
Daily plc's mission is 'to be the best news media organisation in Asia, providing
quality reporting and information on Asian and world-wide events'.
Strategic objectives
Four main strategic objectives were established ten years ago by Daily plc's Board
of Directors. These are to:
1
Meet the needs of readers for reliable and well informed news.
Expand the geographical spread of Daily plc's output to reach as many

potential newspaper and website readers as possible.
Publish some newspapers which help meet the needs of native English
speakers who live in countries which do not have English as their first
language.
Increase advertising income so that the group moves towards offering as

many news titles as possible free of charge to the public.
Additional information on each of Daily plc's divisions

Newspapers Division
FR is wholly owned and was acquired four years ago. Its financial statements
are translated into HK dollars and consolidated into Daily plc's group accounts
and included within the Newspaper Division's results for internal reporting
purposes.
Shortly after it was acquired by Daily plc, FR launched a pan-Asian weekly
newspaper. This newspaper, which is written in English, is produced in the FR
region and then distributed throughout Asia. Daily plc's board thought that this
newspaper would become very popular because it provides a snapshot of the
week's news, focused particularly on Asian issues but viewed from an
expatriates perspective. Sales have, however, been disappointing.
N, which publishes local newspapers in its region, is also treated as part of the
Newspapers Division. Daily plc acquired 80% of its equity in 20X0. At that time,
Daily plc's board thought that the region was a growing market for newspapers.
The subsidiary has proved to be profitable mainly because local production
costs are lower than those in HK relative to the selling prices.
The Newspapers Division's journalists incur a high level of expenses in order to
carry out their duties. The overall level of expenses claimed by the journalists
has been ignored by Daily plc in previous years because it has been viewed as a
necessary cost of running the business. However, these expenses have risen
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Questions
significantly in recent years and have attracted the attention of Daily plc's
internal audit department.
There has been significant capital investment in the Newspapers Division since
20X9/X0. The long-term borrowings of the company include HK$83 million of
loan capital which is due for repayment on 1 April.
Web Division
The web versions of the newspapers are shorter versions of the printed ones.
There is currently no charge for access to the web versions of the newspapers.
Revenues are generated from sales by the Advertising Division of advertising
space on the web pages. Some of the websites permit comments from the public
to be posted on them and they have proved to be very popular. The Web
Division is undertaking a review of all its costs, particularly those relating to
energy, employees and website development.
Advertising Division
The Advertising Division remits advertising revenue to both the Newspapers
and Web Divisions after deducting its own commission. In addition, the
Advertising Division offers an advertising service to corporate clients. Such
services include television and radio advertising and poster campaigns on bill
boards. Advertisements are also placed in newspapers and magazines which are
not produced by Daily plc, if the client so wishes. An increasing element of the
work undertaken by the Advertising Division is in providing pop-up
advertisements on websites.
The Board of Directors and group shareholding
Daily plc's Board of Directors comprises six executive directors and six nonexecutive directors, one of whom is the Non-executive Chairman. The executive
directors are the Chief Executive, and the Directors of Strategy, Corporate
Affairs, Finance, Human Resources and Business Development. There are
divisional managing directors for each of the three divisions who are not board
members but report directly to the Chief Executive.
Some board members feel that the newspapers market is declining because
fewer people can make time to read printed publications. Some of the nonexecutive directors think that many people are more likely to watch a television
news channel than read a newspaper.
Editorial policy
Daily plc's board applies a policy of editorial freedom provided that the
published material is within the law and is accurate. The editors of each of the
publications printed in HK and FR and of the websites have complete autonomy
CA Sri Lanka
35
Questions
over what is published. They are also responsible for adhering to regulatory
constraints and voluntary industry codes of practice relating to articles and
photographs which might be considered offensive by some readers.
There is less scrutiny of the accuracy of the reporting in N's home country than
in other countries. The country has become politically unstable in the last two
years. Much of this unrest is fuelled by the public distaste for the perceived
blatant corruption and bribery which is endemic within the country's
Government and business community. It is well known that journalists have
accepted bribes to present only the Government's version of events, rather than
a balanced view. There is also widespread plagiarism of published material by
the country's newspapers and copyright laws are simply ignored.
Corporate Social Responsibility
A policy is in place throughout Daily plc in order to eliminate bribery and
corruption among staff especially those who have front line responsibility for
obtaining business. This policy was established 15 years ago. All new employees
are made aware of the policy and other staff policies and procedures during
their induction. The Director of Human Resources has confidence in the
procedures applied by his staff at induction and is proud that no action has ever
been brought against an employee of Daily plc for breach of the bribery and
corruption policy.
Daily plc is trying to reduce its carbon footprint and is in the process of
developing policies to limit its energy consumption, reduce the mileage
travelled by its staff and source environmentally friendly supplies of paper for
its printing presses.
Unseen case material
The following information relates to Daily plc.
Web site
Daily plc publishes a Sunday newspaper that is popular throughout the UK. The
newspaper has recently launched an online version which can be downloaded by
subscribers who pay a monthly fee that is slightly less expensive than buying the
printed version of the newspaper. There are approximately 80,000 subscribers to
this service.
The online version of the newspaper allows subscribers to post comments
concerning any of the articles published in the most recent version of the
newspaper. This has been a popular facility that readers appear to value. There
has been an average of 15,000 posts per week since the posting facility was
introduced.
36
CA Sri Lanka
Questions
Subscribers must log in using their user names and passwords before they can
make a post. Daily plc does not edit such posts because it would be prohibitively
expensive to do so. Instead, Daily plc relies on software that scans each draft post
for offensive language and any post that does not trigger that software appears in
a text box underneath the article and can be read by all subscribers.
Subscribers to the online version of this newspaper must register using a credit
card in order to obtain a subscription. They have to tick a box onscreen to
acknowledge that they have read and agreed to Daily plcs terms and conditions,
which include the following.
Subscribers accept Daily plc is not responsible for any offensive or incorrect
comments posted on the site.
Subscribers agree that any posts they place on the site will be honest, accurate
and not intended to cause any harm or offence. Authors agree that all
responsibility for comments they post remains with the author not Daily plc.
The copyright to all posts to the site belongs to Daily plc and nobody is
permitted to copy, print or publish them for any purpose without first
seeking Daily plcs permission.
Last month a post was made underneath an article about J, a famous pop singer,
who endorses a range of vegetarian meals. The posts author claimed to have seen
J eating a meat dish in a restaurant. The post was read and copied by a journalist
from a rival newspaper. The journalist sought reactions from J and the
manufacturer of the vegetarian meals and published the story on the front page of
the Monday edition of the rival newspaper under the headline 'Famous vegetarian
eats principles'. The article was careful to state that the only foundation for the
story is the post to Daily plcs site.
Js lawyers have contacted Daily plc to inform the company that the vegetarian
meals manufacturer has cancelled Js advertising contract. J is seeking
compensation from Daily plc for the loss of these earnings and also for the damage
to her reputation. Daily plc has rejected the claim on the grounds that it had taken
all reasonable steps to prevent any harm to Js reputation when it drafted its terms
and conditions. The offending post was removed from the site as soon as it was
drawn to Daily plcs attention.
Expenses audit
Daily plcs directors receive monthly management accounts which show major
categories of income and expenditure. The level of journalists expenses has been
growing dramatically. The Board of Directors has insisted that the internal audit
department carry out regular reviews of the journalists expenses starting as soon
as possible.
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37
Questions
The directors also asked the Head of Internal Audit to investigate immediately the
increase in journalists expenses. The investigation revealed no evidence of fraud
but did uncover a culture in which job-related expenses were being incurred with
no regard to the cost. For example, if a journalist wished to conduct an interview
outside of a contacts office for the sake of privacy, it had become accepted that the
interview would be conducted in an expensive restaurant. Journalists make their
own travel arrangements: this was considered to be necessary in order to avoid
slowing down work on a breaking story. It had become common practice for all
rail journeys to be booked first class and all flights to be taken in business class
even though that cost a great deal more than standard or economy class travel.
Overnight stays tended to be booked in five star hotels.
Journalists had also claimed for items of equipment ranging from mobile phones
and laptops to expensive televisions and office furniture for home offices. They
usually bought the latest and most expensive technology and justified it on the
basis that it would make news gathering more efficient.
Expense claims must be submitted on official claim forms with receipts attached.
Each claim must be signed by the journalists editor before the accounts
department will process it. Editors told the Head of Internal Audit that journalists
attitudes had changed over the past four or five years and that they were making
ever more substantial claims. Editors did not wish to risk demotivating journalists
by restricting expenses and so spending had tended to escalate.
Daily plc has a formal policy on expenses, with guidance on the maximum costs
that can be incurred for entertaining or travel without seeking specific approval.
The investigation found that no one in the company has paid any attention to that
policy.
Wood pulp
Paper is manufactured from wood pulp. Wood pulp is a commodity that is traded
around the world at prices set in USD. That means that Daily plc is quite heavily
exposed to fluctuations in the USD exchange rate against HK$ because paper is one
of the companys biggest expenses.
Daily plcs board reviews its policies on currency risk on a regular basis. It has called
for a discussion of three possible methods of managing the companys exposure:
Switch to a HK supplier
There are three or four HK-based paper manufacturers with which Daily plc
could do business. Daily plc buys paper in such large quantities that the
Production Director believes that it will be possible to negotiate a contract
under which the manufacturer will offer a price set in HK$ that will be fixed
for, say, three years.
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Invest in USD
Daily plc has a small cash reserve that it can increase by borrowing a
substantial amount in HK$. If the resulting balance is deposited in a USD bank
account then the interest received will go some way to compensating for the
increased cost of borrowing. If the USD strengthens then the deposit will
appreciate in value and that will compensate for the additional cost of paper.
Take the risk

Daily plc can accept that the price of paper will fluctuate as the GBP
fluctuates against the USD. If the movement in the exchange rate is either
small or short-lived then Daily plcs profits will be depressed or enhanced
slightly. If the USD appreciates significantly then the additional cost may
require the cover price of newspapers to increase.
Required
(1)
(2)
(i)
Evaluate the risks to Daily plc associated with allowing subscribers to

post comments and views on the newspaper website. Using a risk grid,
decide on the level and frequency of risk being faced.
(10 marks)
(ii)
Recommend, stating reasons, appropriate controls that might be put

in place in future to minimise the risks to Daily plc associated with
malicious and inaccurate posts.
(5 marks)
(i)
Evaluate how a enterprise risk management system would operate at

Daily plc. Your answer should include the definition of enterprise risk
management, its role in the current business operating environment,
and the importance of a robust risk framework to Daily plc. (10 marks)
(ii)
Explain the difficulties that could arise from the boards directive that
the internal audit department should carry out regular reviews of
journalists expenses. Include in your discussion the role of the internal
auditor and a chief risk officer within the enterprise management
system structure.
(7 marks)
(iii) Explain THREE weaknesses in the control environment which are

preventing risk being effectively embedded within the organisational
culture at Daily plc.
(5 marks)
(3)
Discuss the THREE stated possible methods of managing Daily plcs

exposure to movements of the USD against the GBP. Your answer should
include an evaluation of the costs and risks associated with each of the three
methods.
(13 marks)
(LO 2.5.1, 2.3.1, 2.1.1, 2.1.2, 2.1.3, 2.2.1, 2.6.1, 2.2.2, 2.4.1)
CA Sri Lanka
(Total = 50 marks)
39
Questions
2 Farama 1
90 mins
Note. This Preseen applies to Questions 2 and 3.

Preseen case study
Introduction
F plc is a food manufacturer based in Farama. It generates its revenue from three
divisions named the Meals, Snacks and Desserts divisions. Each division
specialises in the production of different types of food and operates from its own
factory located on three different sites in Farama. F plcs head office is located in a
remote part of Farama and is about equidistant from each of the companys three
divisions.
Currently, F plc has a total employment establishment of about 10,000 full-time
equivalent employees, about 97% of whom are employed in its three divisions. It
is constantly running with about 700 full-time vacancies, mostly in the Desserts
Division. This vacancy factor in the Desserts Division impedes its productivity.
The company was founded over 150 years ago by an entrepreneurial farmer who
saw the opportunity to expand his farming business by vertically integrating into
food production. Instead of selling his crops on the open market, he established a
mill and produced flour. From this, it was a natural progression to diversify into
producing other crops which were then processed into different ingredients for
food products.
The company grew steadily the divisionalised and de-centralised structure was
established. Prior to this, the company managed its factories directly from its head
office.
The environment in which F plc trades is dynamic, particularly with regard to the
growth of legislation relating to food hygiene and production methods. F plc now
exports many of its products as well as obtaining ingredients from foreign
producers, which means that F plc must observe legislative requirements and food
standard protocols in different countries.
Mission statement
F plcs mission statement is as follows.
'F plc is committed to continually seek ways to increase its return to investors by
expanding its share of both its domestic and overseas markets. It will achieve this
by sourcing high quality ingredients, using efficient processes and maintaining the
highest standards of hygiene in its production methods and paying fair prices for
the goods and services it uses.'
40
CA Sri Lanka
Questions
Strategic aims
The strategic aims are set in order to enable F plc to meet the obligations
contained in its mission statement.
F plc aims to:
(a)
Increase profitability of each of its divisions through increased market share

in both domestic and overseas markets
(b)
Source high quality ingredients to enhance product attractiveness
(c)
Ensure that its factories adhere to the highest standards of food hygiene
which guarantee the quality of its products
(d)
Strive to be at the forefront in food manufacturing techniques by being

innovative and increasing efficiency of production with least waste.
Corporate Social Responsibility

F plc takes Corporate Social Responsibility (CSR) seriously. The post of
Environmental Effects Manager was created two years ago and a qualified
environmental scientist was appointed to it. The Environmental Effects Manager
reports directly to the Director of Operations. The role of the Environmental
Effects Manager is to develop initiatives to reduce environmental impacts, capture
data on the environmental effects of divisional and head office operations and
report to the Board of Directors on the progress towards the achievement of F
plcs CSR targets. An extract from F plcs internal CSR report for 2010 is shown in
Appendix 1. F plc does not publish its CSR report externally.
Last year, F plc received criticism in the national press for exploiting some of its
suppliers in Africa by paying low prices for ingredients. This resulted in an
extensive public relations campaign by F plc to counter these accusations. It
established a programme to channel funds to support farmers in Africa via
payments made through African government agencies. The programme, which is
managed through F plcs head office, received initial financing from F plc itself and
is now widening its remit to draw funding from other sources including public
funding.
Competition within the industry
F plc is one of the largest food production companies in Farama. The products in
the industry have varying product life cycles. Competition is intense and there is a
high failure rate for new products. Usually, new products require significant
marketing support particularly if a new brand is being established.
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41
Questions
Organisational culture within each division

Different cultures have emerged within each division.
Meals Division
In the Meals Division, each function operates with little direct interference from
the Divisional Board members. The approach is to allow each function to operate
with as little control as possible being exercised by the Divisional Board.
Snacks Division
In the Snacks Division, the emphasis of the Divisional Board is on product research
and development and marketing. The Snacks Divisional Board expects its
divisional marketing staff to undertake market research into customer tastes and
preferences and then for products which satisfy these to be developed by its
divisional research staff.
Desserts Division
In the Desserts Division, the finance function is the dominant force. It is clear that
within the Desserts Division, the Divisional General Manager, a food technologist
by profession, and the Divisional Accountant, formerly an auditor with a local
government authority, maintain strict control over the operation of the division.
Further details relating to the three divisions are as follows.
Meals Division
The Meals division is located in the South of Farama. It specialises in
manufacturing frozen meals, which are designed to be easy for consumers to
quickly heat up and serve. The meals are sold to supermarkets and other retail
outlets. Some are manufactured under F plcs own brand and others are
manufactured under supermarkets own labels. The division is also increasing its
sales to welfare organisations which support elderly and infirm people. These
organisations purchase simple frozen meals in bulk which they then heat up to
provide a hot meal each day to those people in their care.
One of the Meals Divisions most profitable products is a steak pie that is flavoured
with special gravy that was developed by one of F plcs founding family members
in the early part of the 20th Century. F plcs competitors cannot copy this gravy
because the ingredients have to be combined in a very precise manner and then
cooked in a particular way. The recipe for this gravy is known only to F plcs
Director of Operations and the manager of the pie factory.
Two of the Meals Divisions products are currently subject to investigation by the
Food Standards Authority of another country. Please see Appendix 1 under the
heading Food labelling for more information on this.
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Snacks Division
The Snacks Division, located in the East of Farama, mainly manufactures
confectionery such as packet savouries and chocolate bars. Its main customers are
supermarkets and retail shops. It has a growing overseas market and last year
earned 19% of its revenue from export sales. Many of its products are F plcs own
brands, although, similarly with the Meals Division, it supplies products to
supermarkets under their own label.
Desserts Division
The Desserts Division is located in the North of Farama where road, rail and air
links are not well developed. This has resulted in high transportation costs for
goods into and out of the factory.
The Divisions sales increase in the periods which lead up to national and
international festive periods. The Division is constantly researching new markets
in an effort to increase its foreign earnings. Revenue from exports represented
23% of the Divisions total revenue last year.
Inventory control and IT systems
There have been a number of problems across all three divisions in respect of
inventory control. Poor inventory control has led to high levels of wastage and
obsolete inventory being carried. This has been particularly problematic in
respect of perishable ingredients. In the case of the Desserts Division, the
Divisional Accountant has estimated that 5% of the Divisions potential revenue
has been lost as a result of not being able to satisfy customer orders on time, due
to poor inventory control.
Internal audit
Until now, F plcs Internal Audit function, which is based at Head Office, has
tended to concentrate its efforts on reviewing activities in the Meals and Snacks
divisions as they each produce lower revenues and net operating profits in
absolute terms compared with the Desserts division. The Internal Audit functions
approach of applying a 'light touch' to the Desserts Division is also in recognition
of the influence exerted by the Divisional Finance function over the Divisions
operational activities.
Strategic development
The Board of Directors is now midway through its strategic planning cycle and is
considering how the company should move forward. There is a proposal to build
and operate a factory in West Africa to reduce air kilometres being flown in
supplying the Meals Division with fresh vegetables. It is intended that the African
factory will freeze the vegetables and then transport them to the Meals Divisions
factory in England by refrigerated ship.
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43
Questions
APPENDIX 1
Extracts from F plcs internal Corporate Social Responsibility report
This report was produced by the Environmental Effects Manager and presented to
the Board of F plc in January 20X1.
Fair trading
In accordance with its mission statement, F plc is committed to paying a fair price
for the ingredients it uses in its products, particularly to farmers in the less
developed economies of the world.
Food labelling
Legal requirements demand accuracy in food labelling, in respect of ingredients,
product description and cooking instructions in many countries. F plc employs a
Compliance Manager to ensure that relevant labelling laws in each country, with
which the company trades, are adhered to. A target is set for F plc to justify 100%
of its claims in food labelling. Two products manufactured in the Meals Division
are currently undergoing investigations by the Food Standards Authority of a
European country following allegations that the labelling is inaccurate.
Transportation
Following adverse press coverage relating to the high number of kilometres
travelled when importing and exporting goods from and to overseas countries, F
plc introduced a target that its use of air travel should be reduced by 10% in 20X0
compared with the amount used in the previous year.
African factory
F plcs Meals Division also produces frozen vegetables. Fresh vegetables are
purchased from farmers in West Africa because the climate there enables
vegetables to be grown throughout the year.
Fresh vegetables are flown to the United Kingdom within 24 hours of being
harvested. The vegetables are perishable and therefore must be processed and
frozen within hours of arriving in the UK. After they have been frozen the
vegetables are packaged and stored ready for sale.
F plcs board has decided to build a factory in West Africa to process the
vegetables. Fresh vegetables will be delivered to the factory, where they will be
processed and packaged in the same way as they are in the UK factory. The
packaged vegetables will then be transported in refrigerated shipping containers
to the UK and will be ready for immediate sale.
The board of F plc believes that building a factory in West Africa will demonstrate
a commitment to sound corporate social responsibility. The factory will create
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jobs in the West African country and so more of the wealth created by its farmers
will circulate in the local economy. Furthermore, environmentalists will have
fewer objections to shipping than air freighting.
There will be no significant difference in the total cost of manufacturing and
transporting the finished product compared to the present arrangements.
Staffing
The factory will be highly mechanised and therefore most of the labour will be
unskilled. Manual workers are needed to move vegetables and finished products.
The staffing plan prepared by the Director of Operations shows that the unskilled
labour will be recruited locally in West Africa.
However, there are some posts that require staff with considerable education and
training. For example, the UK factory currently employs several qualified food
technicians who have university degrees. They are responsible for testing batches
of vegetables when they arrive to ensure that they are suitable for freezing. This
work is very important because factors such as the water content and acidity of a
batch of vegetables can affect the quality of the final product. There is also a
significant number of skilled supervisors who are responsible for quality control,
health and safety and other tasks.
The staffing plan shows that the skilled posts will initially be filled by sending staff
from the UK factory to West Africa. It is proposed that the staff will work for four
weeks in West Africa and then be flown home for two weeks of leave before being
flown back to West Africa for another four weeks. The Director of Operations has
planned for this pattern to continue for the first two years. During this period F plc
will work with local West African colleges to develop intensive courses on food
technology, management and other skills to provide a local pool of skilled labour
with the required qualifications.
F plc has already determined that there are local colleges that teach relevant
subjects and so there is the basis of an educational programme. It would not be
particularly expensive for F plc to sponsor courses at these colleges so that they
could develop their course content to ensure that Fs requirements are met in
terms of both syllabus coverage and rigorous assessment.
At the end of the two year transitional period, the UK staff will either be
transferred to other posts in the UK or they will be made redundant.
When the proposal to transfer production was announced the UK skilled staff
were unhappy with the planned arrangements. Many of them have said that they
will not work in West Africa because the proposed work patterns are too
disruptive to family life and that F plc will either have to find them suitable
alternative employment in the UK or make them redundant.
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Information systems
Inventory management is very important for the success and profitability of
producing frozen vegetables. Frozen vegetables can be stored for a very long time
but it is expensive to do so and therefore inventory levels are closely monitored
and managed through the Meals Divisions information system. Sometimes major
customers are offered substantial discounts in order to clear inventory and
thereby reduce holding costs.
The inventory management system will need to be adapted significantly when
production is transferred to West Africa because additional data will have to be
collected at the West African factory and also when finished goods are loaded onto
ships in refrigerated shipping containers.
Finance
F plc has the choice of two ways to fund the investment needed for the factory in
West Africa:
The company has banked with a UK commercial bank for many years and the
bank has offered to grant a loan denominated in GBP. The loan would be
secured against F plcs UK assets.
The government of the West African country has also offered to make a loan
for the same amount, but denominated in the local currency. The loan would
be secured against the West African factory.
Risk evaluation
F plc has a policy of conducting all formal risk evaluations in accordance with a
Risk Management Cycle. The first four stages of the cycle are:
Set goals
Identify risk areas
Understand and assess scale of risk
Develop risk response strategy
Required
(1)
46
F plcs directors are concerned about the risks to F plcs reputation arising
from moving production to West Africa.
(i)
Evaluate the FOUR possible risks to F plcs reputation described above

using the Risk Management Cycle.
(8 marks)
(ii)
Recommend appropriate actions to manage those risks.
(8 marks)
CA Sri Lanka
Questions
(2)
Advise the board of F plc on the control procedures that should be

established over the development and running of the food technology
courses that will be provided by the West African colleges for F plc.
Your answer should consider the following areas.
Governance
Staffing
Support facilities
Course content
(10 marks)
(3)
Advise the board on the controls necessary during the development and
implementation of the changes to the inventory management system.
(12 marks)
(4)
Evaluate both the currency and the non-currency risks associated with each
of the two loan packages for the financing of the West African factory.
(12 marks)
(LO 2.3.1, 2.4.1, 1.2.1, 2.2.1)
3 Farama 2
(Total = 50 marks)
90 mins

Meals Division
The sale of pre-packaged oven-ready meals to charities and government-funded
organisations generates 15% of the revenue of the Meals Division. The Division
produces a range of frozen meals that are designed to meet the nutritional
requirements of elderly and infirm people. The meals are packaged so that they
can be cooked in bulk in catering ovens before being delivered as ready to eat
meals to the homes of the elderly and infirm.
The Meals Division sells a large quantity of these meals and enjoys significant
economies of scale. Consequently, even though the selling price of these meals is
much lower than any other products, this is a very profitable business segment.
Unfortunately, the Meals Division suffered a significant setback in February 20X1.
A charity that works with elderly people received complaints that several cases of
severe food poisoning had occurred. Eight of the victims were so ill that they had
to be admitted to hospital for emergency treatment. Samples of the frozen meals
remaining in the charitys freezer, all of which had been supplied by the Meals
Division, were sent to an independent laboratory for analysis. It was discovered
that they were contaminated by bacteria that can cause severe abdominal illness.
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47
Questions
The Meals Division conducted its own analysis of the meals purchased by the
charity. The presence of the bacteria was confirmed, but it was found to be a
common organism that is present in almost all meat. If the charity had cooked the
frozen meals in accordance with the instructions printed on the packaging then
the bacteria would have been killed and the consumers would not have been
harmed in any way. Furthermore, the contamination was only very slight. A
healthy person who ate a meal containing small quantities of these bacteria would
not become ill because of the bodys immune system.
This case has been reported widely in newspapers and on television. F plcs
directors have asked for an analysis of the risks to the companys reputation. The
Meals Divisions management team has recommended that F plcs defence should
be based on the following two arguments:
All meat products contain these bacteria. Those manufactured by F plc

contain a lower concentration than the industry average and comply with all
relevant hygiene regulations.
The frozen meals supplied by the Meals Division should not have caused any
harm unless they had been prepared negligently by the charity. The charity
should be blamed for the food poisoning and not F plc.
Secret recipe
One of F plcs most popular and profitable products is a steak pie that is flavoured
with a special gravy that was developed by one of F plcs founding family
members. The gravy is manufactured using a very specific mixture of herbs and
spices. F plcs competitors cannot copy this mixture because the ingredients have
to be combined in a very precise manner and then cooked in a particular way.
The recipe for this herb and spice mix is known only to F plcs Director of
Operations and the manager of the pie factory. There is no written record
anywhere. The factory manager has worked for F plc for more than 30 years and he
is a trusted member of staff. Twice a year, the director and the manager of the pie
factory close part of the factory to all other staff and the two of them make sufficient
quantity of the mix to last for the next six months.
The factory manager was recently offered a job by one of F plcs largest rivals. The
job would double the factory managers salary and he would be guaranteed the
opportunity to retire on full pay within two years of taking up the post. He
declined this offer and informed the Director of Operations that he received this
approach.
The chief executive of F plc is concerned that a competitor could have acquired the
factory managers knowledge of the recipe in such an easy and inexpensive
manner. He is also concerned that F plc does not have a record, other than the
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memories of two senior members of staff. He has asked for recommendations on

the most appropriate way to secure this knowledge.
Internal audit
The external auditor has noted concerns expressed by the management
accountant in the Desserts Division concerning weaknesses in the IT system
associated with inventory and the relative lack of attention paid to the division by
the internal audit department. The partner in charge of the external audit has held
a meeting with the finance director and has requested that the internal audit
department investigates the concerns voiced by the management accountant.
The head of internal audit has responded that it is inappropriate for the divisional
management accountant to comment on the allocation of internal audit resources
and that the external auditor should offer to cooperate more fully with internal
audit before making such requests.
F plc currency risks
Most of F plcs sales are to customers in Farama. F plc imports many of the
ingredients that it uses from a variety of countries. The vast majority of F plcs
foreign suppliers insist on invoicing F plc in their own currency and it has proved
impossible to insist on paying for imported ingredients in Farama dollars (F$).
The board of F plc has always refused to devote any attention to the currency risks
associated with importing. It has always absorbed minor fluctuations by taking a
slightly larger or smaller profit on sales. Larger fluctuations have been passed on
to customers in the form of increased or decreased selling prices. Certain
members of the board have always argued that F plcs competitors are subject to
the same currency risks and so the market will always be forced to accept the
impact of currency movements, in which case there is very little point in taking
active steps to manage currency risks.
Required
(1)
(2)
CA Sri Lanka
(i)
Evaluate the risks arising from the outbreak of food poisoning to F

plcs reputation in terms of their likelihood and impact of occurrence.
(8 marks)
(ii)
Advise the directors of F plc on the suitability of the two arguments

proposed by the managers of the Meals Division for defending the
companys reputation.
(8 marks)
(i)
Advise the board on the implications of the secret recipe being

obtained by a competitor.
(4 marks)
(ii)
Recommend, stating reasons, suitable precautions for preventing the

recipe from being obtained by a competitor.
(6 marks)
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Questions
(3)
(4)
(i)
Evaluate the head of internal audits statement that the divisional

management accountant should not comment on the allocation of
internal audit resources.
(6 marks)
(ii)
Discuss the validity of the head of internal audits assertion that the
external auditor should be prepared to cooperate with the internal
audit department.
(6 marks)
Evaluate the views of certain board members concerning there being no

need to manage F plcs currency risks.
(12 marks)
(LO 2.3.1, 2.4.1, 1.2.1, 2.6.1, 2.7.1)
4 Aybe 1
(Total = 50 marks)
90 mins
Note. This Preseen applies to Questions 4 and 5.

Preseen case study
Background
Aybe, located in Country C, was formed by the merger of two companies in 20W1.
It is a listed company which manufactures, markets and distributes a large range
of components throughout Europe and the United States of America. Aybe
employs approximately 700 people at its three factories in Eastern Europe and
supplies products to over 05 million customers in 20 countries. Aybe holds stocks
of about 100,000 different electronic components.
Aybe is regarded within its industry as being a well-established business.
Company Ay had operated successfully for nearly 17 years before its merger with
Company Be. Company Ay can therefore trace its history back for 25 years which
is a long time in the fast moving electronic component business.
The company is organised into three divisions, the Domestic Electronic
Components division (DEC), the Industrial Electronic Components division (IEC)
and the Specialist Components division (SC). The Domestic and Industrial
Electronic Components divisions supply standard electronic components for
domestic and industrial use whereas the Specialist Components division supplies
components which are often unique and made to specific customer requirements.
Each of the three divisions has its own factory in Country C.
Composition of the Board of Directors
The Board of Directors has three executive directors, the Company Secretary and
five non-executive directors. The Chairman is one of the five independent nonexecutive directors. The executive directors are the Chief Executive, Finance
Director and Director of Operations. There is also an Audit Committee, a
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Remuneration Committee and a Nominations Committee. All three committees are

made up entirely of the non-executive directors.
Organisational structure
Aybe is organised along traditional functional/unitary lines. The Board considers
continuity to be a very important value. The present structure was established by
Company Ay nearly 20 years ago and continued after the merger with Company
Be. Many of Aybe's competitors have carried out structural reorganisations since
then. In 20X7, Aybe commissioned a review of its organisational structure from a
human resource consultancy. The consultants suggested alternative structures
which they thought Aybe could employ to its advantage. However, Aybe's Board
felt that continuity was more important and no change to the organisational
structure took place.
Product and service delivery
Customers are increasingly seeking assistance from their component suppliers
with the design of their products and the associated manufacturing and assembly
processes. Aybe's Board views this as a growth area. The Board has recognised
that Aybe needs to develop web-based services and tools which can be accessed
by customers. The traditional method of listing the company's range of
components in a catalogue is becoming less effective because customers are
increasingly seeking specially designed custom made components as the
electronics industry becomes more sophisticated.
Financial objectives of Aybe
The Board has generally taken a cautious approach to providing strategic
direction for the company. Most board members feel that this has been
appropriate because the company was unprofitable for the three year period after
the merger and needed to be turned around. Also, most board members think a
cautious approach has been justified given the constrained economic
circumstances which have affected Aybe's markets since 20X7. While
shareholders have been disappointed with Aybe's performance over the last five
years, they have remained loyal and supported the Board in its attempts to move
the company into profit. The institutional shareholders however are now looking
for increased growth and profitability.
The Board has set the following financial objectives which it considers reflect the
caution for which Aybe is well known:
(i)
(ii)
CA Sri Lanka
Dividend payout to remain at 50% of profit for the year;

No further equity shares to be issued over the next five years in order to
avoid diluting earnings per share.
51
Questions
Capital budget overspends

Aybe has an internal audit department. The Chief Internal Auditor, who leads this
department, reports directly to the Finance Director. Investigation by the Internal
Audit department has revealed that managers with responsibility for capital
expenditure have often paid little attention to expenditure authorisation levels
approved by the Board. They have justified overspending on the grounds that the
original budgets were inadequate and in order not to jeopardise the capital
projects, the overspends were necessary.
An example of this was the building of an extension to the main factory at the DEC
division that was completed in 20X8 at a final cost of nearly C$3 million which was
almost 50% over budget. The capital budget for the extension was set at the outset
and the capital investment appraisal showed a positive net present value. It
subsequently became apparent that the site clearance costs and on-going
construction expenditure were under-estimated. These estimates were provided
by a qualified quantity surveyor who was a contractor to Aybe. The estimates
supplied by the quantity surveyor were accurately included in Aybe's capital
investment appraisal system which was performed on a spreadsheet. However, no
regular checks were carried out to compare the phased budgeted expenditure
with actual costs incurred. It came as a surprise to the Board when the Finance
Director finally produced the capital expenditure project report which showed the
cost of the extension was nearly 50% overspent.
Strategic development
Aybe applies a traditional rational model in carrying out its strategic planning
process. This encompasses an annual exercise to review the previous plan,
creation of a revenue and capital budget for the next five years and instruction to
managers within Aybe to maintain their expenditure within the budget limits
approved by the Board.
Debates have taken place within the Board regarding the strategic direction in
which Aybe should move. Most board members are generally satisfied that Aybe
has been turned around over the last five years and were pleased that the
company increased its profit in 20X8 even though the global economy slowed
down. Aybe benefited from a number of long-term contractual arrangements with
customers throughout 20X8 which were agreed in previous years. However, many
of these are not being renewed due to the current economic climate.
The Board stated in its annual report, published in March 20X8, that the overall
strategic aim of the company is to:
'Achieve growth and increase shareholder returns by continuing to produce and
distribute high quality electronic components and develop our international
presence through expansion into new overseas markets.'
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Aybe's Chief Executive said in the annual report that the strategic aim is clear and
straightforward. He said 'Aybe will strive to maintain its share of the electronic
development, operational, maintenance and repair markets in which it is engaged.
This is despite the global economic difficulties which Aybe, along with its
competitors, has faced since 20X7. Aybe will continue to apply the highest ethical
standards in its business activities.'
In order to facilitate the achievement of the strategic aim, Aybe's Board has
established the following strategic goals:
1.
Enhance the provision of products and services which are demanded by

customers
2.
Invest in engineering and web-based support for customers
3.
Maintain the search for environmentally friendly products
4.
Pursue options for expansion into new overseas markets
The Board has also stated that Aybe is a responsible corporate organisation and
recognises the social and environmental effects of its operational activities.
Concern over the rate of growth
Aybe's recently appointed Director of Operations and one of its Non-Executive
Directors have privately expressed their concern to the Chief Executive at what
they perceive to be the very slow growth of the company. While they accept that
shareholder expectations should not be raised too high, they feel that the Board is
not providing sufficient impetus to move the company forward. They fear that the
results for the year ended 31 December 20X9 will be worse than for 20X8. They
think that Aybe should be much more ambitious and fear that the institutional
shareholders in particular, will not remain patient if Aybe does not create stronger
earnings growth than has previously been achieved.
Development approaches
The Board has discussed different ways of expanding overseas in order to meet
the overall strategic aim. It has, in the past, been reluctant to move from the
current approach of exporting components. However the Director of Operations
has now begun preparing a plan for the IEC division to open up a trading company
in Asia. The DEC division is also exploring various options on how to establish
operations in Africa. The two main options are a wholly-owned subsidiary or a
joint venture.
The Aybe group's draft consolidated financial statements for the year ended 31
December 20X9 with comparative figures are shown below:
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53
Questions
DRAFT CONSOLIDATED STATEMENT OF PROFIT OR LOSS AND OTHER

COMPREHENSIVE INCOME
31 Dec 20X9 31 Dec 20X8
Draft
Actual
C$'000
C$'000
275,000
243,100
Revenue
(175,250)
(154,500)
Cost of sales
99,750
88,600
Gross profit
(89,900)
(81,500)
Operating expenses
9,850
7,100
Operating profit
Share of profit of equity accounted
450
investments
(2,300)
(2,000)
Finance costs
8,000
5,100
Profit before tax
(3,200)
(2,850)
Taxation
4,800
2,250
Profit for the year
Other comprehensive income/expense for
the year, net of tax:
2,300
Gains on property revaluation
2,300
Other comprehensive
income/expense
2,250
7,100
Total comprehensive income for
the year
DRAFT CONSOLIDATED STATEMENT OF FINANCIAL POSITION
31 Dec 20X9 31 Dec 20X8
Draft
Actual
C$'000
C$'000
ASSETS
Non-current assets
197,500
179,780
8,750
8,750
Goodwill
13,500
Investment in joint venture

219,750
188,530
Current assets
18,500
17,700
Inventory
12,500
12,800
Receivables
3,600
5,570
36,070
34,600
254,350
224,600
Total assets
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Questions
31 Dec 20X9
Draft
C$'000
EQUITY AND LIABILITIES
Equity
Share capital
Revaluation reserve
Retained earnings
Total equity
Total non-current liabilities
Current liabilities
Trade and other payables
Provisions
Total current liabilities
Total liabilities
31 Dec 20X8
Actual
C$'000
110,000
13,500
33,700
18,500
175,700
110,000
13,500
29,400
17,000
169,900
51,950
51,950
35,350
35,600
10,800
15,900
26,700
78,650
254,350
9,300
9,800
19,100
54,700
224,600

New market opportunity
Two years ago IEC, a division of Aybe, established a special parts department
("SPD") to undertake the manufacture of customised components, such as a
microprocessor that has been programmed with a specific set of instructions
supplied by the customer. SPD can also make complex parts and assemblies. For
example, a customer might require a circuit board for a computer or a control panel.
Making such an assembly involves overlaying a plastic sheet with copper tracks to
carry electrical current and signals and attaching components and connectors.
SPD does not generate a large proportion of Aybe's revenue, but it has been very
profitable since it began two years ago because SPD can charge high profit
margins. SPD employs 18 highly skilled technicians who work in a sophisticated
electronics workshop.
Almost all of the work undertaken by SPD is 'jobbing work' ie for very small
quantities, sometimes only a single unit. This is because SPD's customers often build
prototypes of products that they plan to test before committing themselves to fullscale production. If the prototype is successful and the customer then requires
larger quantities of the component SPD directs them to Aybe's IEC division. IEC has
a highly automated electronics factory and consequently uses mainly semi-skilled
employees. IEC's equipment can mass-produce almost anything that SPD's
workshop can design. However because of the very high set-up costs associated
with each new order, IEC needs the order to be for a significant volume.
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SPD has been approached by Q, a specialist manufacturer of extremely expensive

high performance cars. Q is in the process of developing a new car that will be one
of the fastest in the world. The car will be designed to be driven on public roads,
but the owners of such cars often take them to private race tracks where they can
be driven at very high speeds.
Q has designed an electronics system to enable an average driver to drive the car
safely at high speed. The system will monitor the engine, brakes and steering and
will compensate for errors that could cause a crash. The system will, for example,
sense that the car is about to skid and will compensate for that. The electronics
system will be based on a circuit board that Q wishes to have built by SPD.
Building Q's circuit board will pose a number of challenges for SPD. The circuit
board will be subject to a great deal of vibration when the car is driven at speed.
The cars are expected to last for a very long time and so there could be problems if
the circuit boards deteriorate with age. The circuit board will be installed in an
inaccessible part of the car where it will be difficult to inspect or maintain.
Many of the components on the board will be manufactured by SPD, but some
crucial components will be supplied by a third party that has already been
selected by Q.
Q is prepared to order a large number of circuit boards but only if they are hand
built by SPD. That is partly because the cars will not be built in sufficient volume
to make it possible for IEC to mass-produce the boards and partly because Q
wishes to be able to update and modify the design of the circuit boards in
response to feedback from owners. SPD's Production Manager believes that the Q
contract will create sufficient work to keep four technicians almost fully occupied.
SPD will have to recruit and train additional staff in order to service this contract.
Post-completion audit
The members of Aybe's Audit Committee are very concerned about the Chief
Internal Auditor's report on the capital budget overspends (see preseen case
study). The Audit Committee is keen to introduce a system of post-completion
evaluations as a matter of priority.
For the sake of clarity, the Audit Committee wishes to adopt the following
definition of post-completion evaluations:
Objective and independent appraisal of the measure of success of a capital
expenditure project in progressing the business as planned. It should cover the
implementation of the project from authorisation to commissioning and its
technical and commercial performance after commissioning. The information
provided is also used by management as feedback which aids the
implementation and control of future risk projects.
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The Head of the Audit Committee has asked the Chief Internal Auditor to consider
the matter and to brief the Audit Committee on the following matters:
The approach that the internal audit department would take to the planning
and execution of post-completion evaluations. For example, how will
projects be selected for investigation and what aspects will be examined?
What difficulties does the Chief Internal Auditor envisage in conducting

these post-completion evaluations?
The Audit Committee has informed the main board of its intention to commission
post-completion evaluations. The Chief Executive is worried that some managers
might be reluctant to propose projects if they know that such actions could be
subjected to an audit.
Required
(1)
(2)
(i)
Evaluate FOUR significant risks associated with accepting the order

from Q.
(12 marks)
(ii)
Recommend, with reasons, an appropriate response to each of the

risks identified in (a)(i) above.
(12 marks)
(i)
Recommend an appropriate approach to the selection and

investigation of projects for evaluation by the internal audit
department.
(16 marks)
Discuss the possibility that the introduction of evaluations by internal
audit will deter capital investment.
(10 marks)
(ii)
(LO 2.31, 2.4.1, 2.6.2, 2.7.1, 3.5.1)
5 Aybe 2
(Total = 50 marks)
90 mins

DEC: New factory under joint venture arrangement
Following Aybe's desire to expand overseas, DEC looked at establishing a
subsidiary in a central African country. This factory was actually developed as a
joint venture with a government-owned joint venture partner. All new foreign
companies entering the African country are required to establish joint ventures in
this way. This stipulation means that the African government effectively dictates
the terms of the investment to the foreign investor. This has meant restrictions on
payments per year, the remittance of profits, and operations.
The African joint venture manufactures products to be sold within that country
and for export to neighbouring countries. The products manufactured in the
African factory use components and raw materials that are purchased directly
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from DEC (in Aybe's home country). Payments for the components and raw
materials will be made to DEC in the currency of the African country but DEC's
accountant is concerned about the high level of inflation in the African country
and the consequent impact on future receipts. He is particularly worried because
it has been stated that the African joint venture arrangement will only make three
payments each year for components and materials and therefore each payment
will be for a high value. The share of profits from the joint venture will be remitted
to DEC on request and in accordance with any exchange control regulations of the
African country.
DEC has just received payment for all of the shipments to the African factory to
date (as stated earlier, the African joint venture arrangement will in future only
make three payments each year). The accountant has noticed that the amount
remitted was in excess of the invoice value of the goods sent to the factory. Initial
investigations show that the prices were inflated on the invoices by a manager in
DEC at the headquarters in Aybe who was attempting to increase his profit-related
bonus.
The joint venture has just started selling its output within its home country but
sales volumes are low. Export sales to other African countries have not yet
commenced and forecasts for future export sales have yet to be produced. The
product range offered by the African joint venture is similar to DEC's European
range.
The information systems within the African joint venture are not fully developed.
The priority was to set up control systems for inventory and production. These
systems became operational within the last month. Consequently the sales staff in
the joint venture is already benefiting from knowledge of inventory levels and are
able to provide accurate information to customers about product availability.
However due to over-optimistic initial sales forecasts, significant levels of
inventory have accumulated. The African sales staff are concerned that the
shortfall in sales is having an adverse impact on their bonuses because they are
not meeting their targets.
African sales staff are reluctant to offer discounts to promote sales and reduce the
excessive inventory. Their bonuses, which make up the majority of their
remuneration packages, are based on average profit per unit sold and sales
volumes.
This information system problem referred to above is not the only issue affecting
DEC's information systems in recent years. Another factory extension previously
referred to under "Capital budget overspends" was 50% overspent party due to
lack of regular checks of budget to actual costs.
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DEC: New service

The DEC Division in Europe and its African joint venture have started to offer a
new service in response to pressure from environmental campaigners. Up to five
years ago, many of the components sold by DEC contained toxic materials. Recent
legislation in Europe and the African country requires components to be recycled
in specific ways to minimise any environmental damage. DEC has told customers
that when they purchase new components they can give the old components to
DEC and then the company will recycle them in accordance with the new
legislation.
This service has provided some good publicity for DEC and has featured in its
recent social and environmental report. However, a review of DEC's recycling
procedures by Internal Audit Department identified that many components,
including some that contain toxic materials, are simply thrown away by DEC staff
rather than being recycled.
The joint venture has been set up in an African country where the financial
reporting framework is based on International Financial Reporting Standards. The
joint venture prepares its financial statements to 31 March each year and these
will be audited by a firm of auditors based in the same country as the joint venture
and which has no relation to the auditors of the Aybe group. The group
engagement team has set planning materiality at 0.5% of revenue.
The draft statement of profit or loss of the joint venture, retranslated into the
functional currency of the Aybe group, is shown below:
STATEMENT OF PROFIT OR LOSS
Revenue
Cost of sales
Gross profit
Operating expenses
Operating profit
Finance costs
Profit before tax
31 March
20Y0
C$'000
43,700
(27,420)
16,280
(12,600)
3,680
(1,750)
1,930
Required
(1)
CA Sri Lanka
(i)
Explain how the risk appetite of the group would have influenced the
decision to establish new operations in Africa.
(5 marks)
(ii)
Identify and evaluate FIVE risks affecting DEC's new joint venture in
Africa.
(10 marks)
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Questions
(2)
(3)
(i)
Discuss the implications of establishing a joint venture within Africa

on the planning of the audit of the consolidated financial statements of
the group for the year ended 31 December 20X9.
(7 marks)
(ii)
Evaluate the potential risks of material misstatement which affect the

audit of the financial statements of the African joint venture. (8 marks)
(i)
Discuss the methods DEC and the African joint venture could use to
mitigate the foreign exchange risk when trading with other foreign
countries.
(5 marks)
(ii)
Evaluate the ethical behaviour associated with throwing toxic

materials to the environment and its potential consequences.
(5 marks)
(4)
Discuss the safeguards that should exist within any company to prevent the
unethical manipulation of transactions. (You should refer to examples from
DEC in your answer.)
(10 marks)
(LO 2.1.3, 2.4.1, 3.1.1, 3.2.1, 1.4.1, 1.4.2, 2,4,1, 1.5.1, 3.4.1, 3.5.1) (Total = 50 marks)
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Section 1
1 Mahmood
(1)
Conventional ethical behaviour

Kohlbergs three stages of ethical development are the pre-conventional, the
conventional and the post-conventional. Each of these has its own likely
ethical response. The conventional ethical response is to believe that the
ethical right is to comply in full with whatever regulations apply or
whatever orders are given in the context they are operating in. It assumes
that the highest ethical position is to be in compliance with whatever rules,
regulations or requirements are applicable at the time. So the individuals
focus is on positioning themselves so as to maximise his or her ability to
comply. This might involve learning how to adopt compliant behaviour,
learning about compliance requirements and familiarisation with the
cultural norms which apply. For Mahmood, it is clear in the case that he has
been ordered by his manager to say nothing and to conduct his job as
normal. A conventional ethical position would not reflect beyond this. His
instructions are clear and he would see virtue in obedience to this
instruction. The fact that he is a part of an organisational hierarchy and that
those in a supervisory position over him have imposed a rule for him to
comply with, is sufficient for him.
Post-conventional ethical behaviour.
To adopt a post-conventional ethical response is to see a higher ethical duty
despite whatever laws, regulations, norms or instructions apply at any given
time. What Kohlberg referred to as universal principles are essentially
subjective, meaning that each person can have his or her view of what those
are. But in each case, a post-conventional actor will consider the ethical
right not in line with current regulations (which can change over time) but
with his or her higher principles, perhaps those concerning concepts such as
justice, fairness, compassion, decency, etc.
For Mahmood, post-conventional behaviour might involve him questioning
the morality of the decision to include inferior meat in the companys
products in the interests of what he sees as the greater good. He may come
to the view, for example, that honesty and truthfulness to customers is a
higher or universal principle, even though the board of Tzo Company
appears to have decided to introduce the inferior meat into its
premium meat product. In such a situation, he could maintain, but
suppress, his beliefs for the sake of keeping his job, or he could act upon his
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belief. Because he has had no satisfaction from his manager at Tzo, he might
believe it ethically right to inform an external source, such as a
newspaper, as he is considering. Post-conventional behaviour is often costly
to the actor and if Mahmood were to become a whistleblower in this case, he
may well lose his own job and cause others to lose theirs.
(2)
Ethical case
In recognising that it would be very costly on a personal level for Mahmood
to act as a whistleblower in this case, there is a strong ethical argument that
he should do so.
The company is acting in a concerted manner to deceive customers by
selling food which is not what they believe it to be. As an employee of the
company, Mahmood is taking part in a value adding process which results in
a product which is not what the customer thinks they are purchasing. It may
be that the inferior meat, even if safe to eat for the majority, is unsuitable for
some diets or which may offend some consumers personal or cultural
beliefs. In a trades-description sense, this deceit is a breach of customers
trust. It may cause offence to some and possibly even illness in others if they
purchased a product unaware of the inferior nature of the contents.
Because the board of Tzo Company is complicit in the decision, he is
unlikely to get any change of mind from anyone in the company. So the only
way to highlight the deceit is to go outside the company. Were he to adopt
the normal grievance procedure by observing the chain of command in the
company, the involvement of the board of Tzo Company in the use of inferior
meat would make it unlikely he would get a sympathetic hearing. In fact by
raising the issue internally, he might risk his own safety or the comfort of his
position at work. So going to a newspaper may be the only way he can
reasonably expect to see the problem addressed.
The division is falsifying quality control reports and therefore
intentionally misleading whoever it is who receives these perhaps a food
standards agency, a regulator or similar. This control is presumably intended
to ensure that the companys main output is of a high quality as stated, and
that the quality assurance measures are met for the product. The falsification
of the report means that normal quality procedures are being systematically
subverted and this is a very serious matter. Again, the fact that the board of
directors has sanctioned this makes it unlikely that Mahmood would receive
a sympathetic hearing, thus making the case for going directly to the
newspaper.
It is in the public interest to highlight a situation in which a company is
mislabelling food, deceiving customers and shareholders, and requiring its
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employees to take part in the deceit and remain quiet about it. This is not
how business should behave and it could serve to erode societys trust in
business in general. Employees have an ethical right to work for a company
which is not structurally deceitful and were such a situation to persist, it
could undermine managementemployee relations and open the company
up to legal and reputational damage. Inasmuch as such a situation is
probably likely to be disclosed eventually, a quicker rather than protracted
conclusion is preferable.
(3)
IC report and preventing the fraud

External reports on the effectiveness of internal controls are intended to
convey the robustness of a companys internal controls to an external
audience (usually the shareholders). As with other reports, however, the
company must make preparations and institute systems to gather the
information to report on. This in itself is capable of controlling behaviour
and constraining the professional and ethical behaviour of management.
With any report required by regulation, the board must take control of the
process and acknowledge its responsibility for the companys system of, in
this case, internal controls. This means that it would be unable to knowingly
circumvent or undermine the internal controls put in place to control the
quality of meat in the factory. The regulatory nature of this requirement
would also make it an offence to make a false disclosure, meaning that the
directors could be held personally liable for any untruths in the report. So
although the use of the inferior meat itself may not be illegal as indicated by
the factory manager, making an untrue statement on an internal control
report over the use of that meat would be an offence.
Any reporting (including one on internal controls) creates greater
accountability because stakeholders can hold to account those making
those statements. In this case, any stakeholder can then point to what was
said in the report and hold the board to account for its performance against
any given statement. This includes employees such as Mahmood and
consumers concerned with product quality. So if Tzo explained the internal
controls behind the production of its high quality meat products, it could
then be held accountable for any breach in the controls underpinning that
quality.
The need to report on internal controls would make it almost impossible to
use the inferior meat without disclosing the fact of its use, because the
penalty for intentionally including misleading or false statements in the
report would be high (regardless of whether Tzo is based in a rules or a
principles-based jurisdiction). It might then be faced with the choice of
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continuing to use the meat and admitting it, or discontinuing its use in order
to report on internal controls supporting the claimed high quality of its
products. Either way, continuing to use inferior meat in a concealed way
would be very difficult.
A report on the effectiveness of internal controls (such as Sarbanes Oxley
s.404) typically requires the inclusion of a statement on the processes used
by the directors to assess the effectiveness of internal controls. This includes
the disclosure of any material internal control weaknesses or any
significant problems which the company encountered in its internal controls
over the period under review. The value of the report as a means of
reassuring investors is to use this statement to demonstrate the robustness
of the processes. An unconvincing disclosure on this would potentially
undermine investor confidence.
Because the report is subject to an auditors review (or full audit in some
jurisdictions), the auditors can demand evidence of any statement on the
report and follow any claim made back along the relevant audit trail. It is a
serious and often easily detectable offence to deceive an auditor or to make a
knowingly false statement in an audited or auditor-reviewed report. Such a
deceit (of the auditors) would result in an immediate loss of confidence in
management on the part of the auditors and, in consequence, also on the
part of shareholders and regulators
2 David
(1)
What are the facts of the case?

The facts are that the civil servants have made what is an apparently
legitimate request for information. However the circumstances suggest that
if the board supplies this information, it may be used by the governing party
to support its bid for re-election.
What are the ethical issues in the case?
Independence. The main ethical issue is independence. The corporation
exists to serve the interests of the country as a whole and should not be
seen to be supporting one political party, even if the board believes that
party's policies are best for EPC. The fact that the request has come via the
civil servants will not be a defence, since the civil servants also have a
(possibly stronger) duty of independence.
Obedience. The board also however owes a duty of obedience to the
Ministry of Energy, which is its employer, and has a right to make legitimate
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business requests. Confidentiality may also be an issue, that the board may
be instructed to treat the request and its response as confidential.
What are the norms, principles and values related to the case?
Objectives. The board must act in accordance with the corporation's
objectives, which will be to supply electricity as economically and
efficiently as possible. The board is entitled to consider whether major
cost-cutting may increase the risk of the electricity supply failing.
Governance. As EPC is a nationalised entity, the directors are expected to
act in accordance with the wishes of the properly elected government,
since the democratic process confers legitimacy upon the government's
wishes. This means accepting major changes such as privatisation if they
wish to remain on the board, also accepting other obligations such as
keeping certain information confidential if necessary.
Independence. The duty of independence means that the board cannot
actively intervene in the political process, an issue of most relevance
during a general election campaign.
Transparency. Ultimately also the board owes a duty of transparency
about its policies to the public and consumers, as they are primary
stakeholders. However the duty of transparency is not normally regarded
as absolute; strategic business discussions may legitimately be kept
confidential in the short-term for various reasons.
What are the alternative courses of actions for the board?
Supply the information on the grounds that the board is not empowered
to refuse a legitimate request from the Ministry of Energy.
Supply the information provided that the board receives prior assurance,
certainly from the civil servants and preferably from the Minister of Energy,
that the information will not be used for political purposes during the
election campaign.
Refuse to supply the information on the grounds that the board must be
seen to be neutral when its future is a significant issue in the election
campaign.
Refuse to supply the information on the grounds that it cannot be
expected to make a major commitment to cost reduction instantly;
review and discussion of possible options will be required and this will take
time.
What is the best course of action that is consistent with the norms,
principles and values?
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The board seems to have legitimate business reasons for asking for more
time to consider cost reductions. It is also entitled to be sensitive to
independence issues and seek assurances before it supplies any
information that could help the governing party.
What are the consequences of each course of action?
If the information is supplied and then kept confidential, the board's
independence is unlikely to be questioned, although a hastily drawn up
plan may later be criticised for business reasons. If detailed information is
not supplied until the board has had the chance to consider its plans
carefully, the decisions are more likely to be in accordance with the
corporation's objectives.
If the board supplies the information and it is used for political
purposes, then the board's independence will be questioned. If the
opposition party then wins the election, some or all of the board may well be
replaced and EPC may suffer disruption to board decision-making and
monitoring. Similarly if the board refuses, the current government takes
offence and wins the election, the board may also be replaced.
What is the decision?
The board may feel able to supply some indications of how it might cut
costs. It should refuse to supply detailed information until it has had time
to consider future planning carefully, even if this means the information is
not available until after polling day. Before it supplies any information it
should seek guarantees from the governing party that it will not use the
information to forward its political platform. It should not reveal the request
has been made unless the information is used for political purposes and the
board therefore needs to demonstrate that it has acted independently.
(2)
The stages of Tucker's five question model are in the decision:

Profitable
Although the nationalised corporation will be a non-profit making body, it
has the duty to control its costs. The costs of combating the protestors will
include:
The costs of security
The costs of taking action to counter the bad publicity that may be a
consequence of the treatment of the protestors
The costs of legal action brought by the protestors as a result of the

actions of the security guards
The other issue however is whether there is any alternative to incurring

these costs. If the protestors are determined to protest, the alternative may
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be disruption to the country's power supply, which is likely to be regarded as

being much more important.
Legal
The legality of the security guards' action depends upon local legislation, in
particular the rights to protest, to protect property and use reasonable
force. There is also the issue of how far EPC will be held responsible for the
actions of its agent, the security firm. Because of the issues of poor publicity
and also the costs described above, EPC's board should be wary if it appears
that excessive force may be being used, since this is likely to be a legally grey
area.
Fair
The pressure groups may claim that they have a legitimate right to protest.
Their case may be weakened by the fact that they can currently take political
action in the general election campaign, although perhaps they might argue
that none of the major parties fairly represents their views. However even if
the board was to accept that the pressure groups are legitimate
stakeholders, it also has a duty to consumers, who are undoubtedly also
legitimate stakeholders, to preserve the continuity of electricity supplies.
These include consumers whose livelihoods and indeed lives may be
threatened by power cuts (hospital patients for example).
Right
The main ethical issues are whether it is right for the pressure group to take
potentially life-threatening action in order to advance a cause that has
fundamental long-term consequences (action against global warming). From
EPC's point of view the ethical issue is whether force should be used against
the pressure group if its actions are life-threatening; if it can be, how much
force would be right; ultimately would it be legitimate to take action that
might jeopardise the lives of the protestors.
Sustainable
Because of the general election campaign and a possible change of
government, the board cannot be expected at present to make long-term
decisions about switching to a more environmentally friendly method of
electricity generation. However if the managing director's attitude is
typical of the board, then the viewpoint is not sustainable; continued use of
coal will mean supplies are eventually exhausted and there is strong
scientific evidence that the emissions are having adverse climatic effects.
Many countries are investigating alternative sources of power. Whatever the
result of the general election, EPC's board has a duty to ask the new
government to review energy policies.
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3 Anne
(1)
Necessity for independence

Reliability of financial information
Corporate governance reports have highlighted reliability of financial
information as a key aspect of corporate governance. Shareholders and
other stakeholders need a trustworthy record of directors' stewardship to
be able to take decisions about the company. Assurance provided by
independent auditors is a key quality control on the reliability of
information.
Credibility of financial information
An unqualified report by independent external auditors on the accounts
should give them more credibility, enhancing the appeal of the company to
investors. It should represent the views of independent experts, who are not
motivated by personal interests to give a favourable opinion on the annual
report.
Value for money of audit work
Audit fees should be set on the basis of charging for the work necessary to
gain sufficient audit assurance. A lack of independence here seems to
mean important audit work may not be done, and thus the shareholders are
not receiving value for the audit fees.
Threats to professional standards
A lack of independence may lead to a failure to fulfil professional
requirements to obtain enough evidence to form the basis of an audit
opinion, here to obtain details of a questionable material item. Failure by
auditors to do this undermines the credibility of the accountancy
profession and the standards it enforces.
Threats to independence
Familiarity with client
Zachary Lincoln has been partner in charge of the audit for longer than the
period recommended by most governance reports (between five and
seven years). His familiarity appears to have influenced his judgement,
leading him to make the dubious assumption that because there has been no
problem on this audit in the past, there cannot be a problem now.
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Personal friendship self interest

Zachary Lincoln appears to be allowing his personal friendship with Frank
Monroe to bias his judgement on whether to investigate the questionable
payment. There is a self interest threat involved in Zachary's wish to
maintain the friendship, and also a lack of objectivity.
Non-audit services self interest
Governance codes identify provision of non-audit services as a potentially
significant threat to auditor independence. This scenario illustrates why; a
qualified opinion on Van Buren's accounts may mean that the company
stops using Fillmore Pierce to provide consultancy services. Thus it is clearly
in Fillmore Pierce's self interest to give an unqualified audit report, and
therefore it seems doubtful that the firm is truly independent.
(2)
(i)
Obedience
As an employee Anne owes the duty of obedience to her managers,
and should comply with reasonable orders provided they do not
breach her professional duties.
As a professional accountant Anne should comply with the technical
and ethical standards established by her professional body, even if
these conflict with what she is being required to do in the workplace.
Interests of employer and profession
As an employee, Anne has a responsibility to promote the interests of
her employer. These include the commercial, fee-earning, interests,
making efforts to obtain new work and keep existing clients happy.
As a professional accountant, Anne has a responsibility to maintain the
good name of her accountancy body. This includes acting honestly and
objectively, and not allowing herself to be associated with misleading
information or a misleading report.
Obligations of employment and membership
As an employee, Anne owes a general duty to 'fit in', be part of a team
and behave in ways that are in accordance with the organisational
culture of her employer.
As a member of a professional accounting body, Anne owes the duty to
act in accordance with the norms of that body, including its stress on
professional behaviour.
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(ii)
Acting non-commercially
The main tension between the roles that Anne is experiencing is that if
she acts in accordance with professional standards, and pursues a full
explanation for the payment, she will not be acting in her employer's
commercial interests. The audit will go on longer than budgeted,
meaning that the assignment is less profitable. She also risks
upsetting the client and putting future income at risk.
Anne's own interests
There is also the issue of whether Anne should take into account her
own interests and if so how she should do this. She may feel that in
order to make her life easier as an employee of Fillmore Pierce, she
should allow the report to be signed. Against this is the possibility of
suffering disciplinary action by her professional body if she allows
the audit report to be signed, and it later turns out to be misleading.
(3)
Absolutist assumptions
Definition
Absolutist dogmatic assumptions are based on the idea that there are rules
which should be followed in all circumstances, whatever the
consequences. This means that if an individual is facing an ethical dilemma,
there should be a 'right' solution to that dilemma.
Van Buren situation
Absolutist assumptions would indicate that an audit provides
independent assurance on a business. Because of this, all material audit
queries need to be resolved if an unqualified audit report is to be given.
Conclusion using absolutist assumptions
Resolving the query is the right course of action to take and thus should be
pursued, even if it means a longer audit and problems with the client.
Relativist assumptions
Definition
A relativist position would be that there are a variety of ethical beliefs and
practices, and that the ethics that are most appropriate in a given situation
will depend on the conditions at that time. A pragmatic consequentialist
position would consider the consequences of the various options available,
and choose the option that on balance produced the greatest benefits or
the least degree of harm. This may be benefits or lack of harm in general, or
it may be defined more narrowly to mean benefits or lack of harm to
Fillmore Pierce or even just to Anne herself (which would be egoism).
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Van Buren situation

Using relativist assumptions would mean that Anne needs to assess the
consequences of pursuing this point. The relativist viewpoint would take
into account the argument that not all audit trails can end neatly. It would
also consider the other circumstances surrounding the audit, including
previous experience of the client and personal knowledge of Frank
Monroe. That said, the relativist view would also consider the possible
adverse consequences to the reputation of Anne and Fillmore Pierce if
the firm gives an unqualified report when it later turns out it should not have
done.
Conclusion using relativist assumptions
The decision using relativist assumptions therefore requires the weighing up
of different possible consequences. Because of this, the outcome of the
decision cannot be predicted easily.
(4)
Conventional viewpoint
Kohlberg identified the conventional viewpoint as one of the levels of moral
reasoning. Using this perspective, individuals judge ethical decisions in
terms of what is expected of them in terms of the norms of society or
organisation. In this example Anne would take into account what would be
considered good practice in the industry and the relevant accounting body
and auditing rules. She would also consider society's viewpoint as expressed
in the law; would signing-off on the audit be expected of them by the law? Is
there a potential that this is fraud and therefore illegal? Another viewpoint
would be whether members of society outside of the accounting and
auditing professions would approve of signing off on the audit.
Pre-conventional viewpoint
The pre-conventional reasoning viewpoint sees reasoning in terms of the
rewards or punishments that will result from a particular act. The factors
influencing the decision would be whether Fillemore Pierce and Van Buren
Company would suffer a legal penalty through the actions/or lack of actions
Anne would take, whether Fillemore Pierce would lose business by not
signing off on the business (as Zachery indicates) or would it lose business
in the future by signing off on potential fraud?
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4 Poodle
(1)
Implications
The value of the claim is material to the group financial statements, at 25%
of group profit before tax (= $0.5m $2m).
The treatment in Toy Co's individual financial statements appears correct in
line with the local financial reporting framework. However, these financial
statements must be restated in accordance with IFRS for consolidation into
the group accounts.
According to IFRS, a provision should be recognised. This is because there is
a probable outflow of resources which can be measured reliably. The
omission of the provision means that the financial statements are materially
misstated.
Procedures
Verbal evidence is not sufficient for the group audit, and Toy Co's legal
advisors should be asked to provide a written statement that, in their
opinion, it is probable that damages will have to be paid.
As this is a material matter which could result in a qualified auditor's
opinion, further evidence surrounding the claim should be obtained. The
claim itself should therefore be reviewed, along with any board minutes
discussing the claim.
Report
The Group should be asked to adjust the group financial statements for the
claim, and it should be explained to them that if the adjustment is not made
then a qualified opinion will be expressed.
The Group's reluctance to make changes, taken together with the impending
deadline for releasing the financial statements, represents a significant
intimidation threat to the auditor's independence. This may call into
question the integrity of the management and the reliability of its written
representations.
If the financial statements are not adjusted then the auditor will express a
qualified 'except for' opinion on the grounds that the financial statements
are materially misstated.
The misstatement is not pervasive as it appears to be confined to one
specific area of the financial statements, so an adverse opinion is not
necessary.
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The auditor's report should include a paragraph headed 'Basis for Qualified
Opinion' immediately before the Opinion paragraph, in which the reasons for
the qualification are described.
(2)
Implications
The trade receivable is material to the group financial statements, at 2.8% of
total assets and 80% of profit before tax.
SLAuS 560 Subsequent Events requires the auditor to consider evidence
obtained after the year end and before the issuance of the auditor's report.
The notice constitutes evidence that the receivable is impaired at the year
end; the insolvency of Terrier is therefore an adjusting event.
The receivable is impaired by $1.44m (= $1.6 Mn 90%), which should be
recognised as follows.
Dr
Operating expenses
$1.44 Mn
Cr
Trade receivables
$1.44 Mn
Procedures
A copy of the notice from Terrier's administrators should be obtained to
confirm that the company is insolvent and that 10% of the debt will be
received.
Obtain written confirmation from the administrators regarding the expected
timing of the payment.
Bank receipts post-year end should be reviewed for evidence of the payment
being received. However, given when the notice was received and the tight
deadline for the auditor's report, it is not likely that amount will have been
received.
Report
If the financial statements are not adjusted, then the auditor's opinion will be
qualified 'except for' in relation to this issue.
Aggregate effect on financial statements
The overall effect of the provision and the impaired receivable is to reduce
net profit by $1.94 Mn, which would reduce profit before tax to just $60,000.
It could reasonably be argued that this is a pervasive misstatement, as it
affects multiple areas of the financial statements and is highly material to
profit before tax.
In this case, an adverse auditor's opinion should be expressed.
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The auditor's report should include a paragraph headed 'Basis for Adverse
Opinion' immediately before the Opinion paragraph, in which the reasons for
the adverse opinion are described.
(3)
Implications
The chairman's statement is other information, which SLAuSs require the
auditor to read. The auditor is looking for material inconsistencies with the
audited financial statements, which may undermine the credibility of the
financial statements and the auditor's report.
The chairman's claim that revenue has risen by 20% is materially
inconsistent with the financial statements, which indicate a rise of 5.9%.
Procedures
SLAuS require the auditor first to determine which of the chairman's
statement and the financial statements needs to be amended.
It will be necessary to review the audit evidence obtained on revenue to
ensure that it is sufficient and appropriate.
Explanation should be obtained from the chairman of how his figure of 20%
was arrived at, as it is possible that this will shed further light on the real
figure for revenue. If no further information comes to light and the
chairman's statement is incorrect, then he should be asked to amend it.
Report
If management refuses to amend the other information then the auditor's
report must be modified to include an Other Matter paragraph. This would
not affect the auditor's opinion, which would be unmodified in this respect
(although it may be modified in other respects, as discussed in parts (1) and
(2)).
This paragraph should be presented immediately after the opinion
paragraph, and should describe the material inconsistency clearly.
The matter should be communicated to those charged with governance. It
may be necessary for the auditor to speak at a shareholders' meeting in
order to explain the reasons for including the Other Matter paragraph in the
report.
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5 Lychee
(1)
(i)
The restructuring does not relate to conditions at the reporting date, so

under LKAS 10 this is not an adjusting event. LKAS 10 requires that this
event be disclosed in the financial statements, usually by way of a note
explaining the event and its financial effect.
Audit procedures would include:
(ii)
Verifying that management have included a note disclosing this

event in the financial statements, and that it is drafted in line with
LKAS 10
Agreeing the estimated cost of the closure to underlying

calculations and supporting documentation, such as staff
employment contracts
Reviewing the announcement for details, and agree these details

to the disclosures made in the financial statements
Reviewing board minutes for details of the plan and to verify that
it has been approved by the board
Discussing the reasons for the plan with management and

consider whether it is consistent with the auditor's knowledge of
the business
If the financial statements are not amended then they are not in
accordance with LKAS 10. Considering the materiality of the cost of
closure:
Based on revenue:
$250,000
= 1.67%
$15m
Based on profit:
$250,000
= 8.3%
$3m
Based on assets:
$250,000
= <1%
$80m
The cost of closure is material to the statement of profit or loss, so nondisclosure of this event is a material misstatement. In line with SLAuS
705 Modifications to the Opinion in the Independent Auditor's Report,
the auditor should express a qualified 'except for' opinion, as the
misstatement is material but not so pervasive as to render the
statement of profit or loss meaningless.
The auditor's report should contain a paragraph discussing the reasons
for the modified opinion, in which the auditor would explain the nature
of the costs not disclosed, state the financial effect of the costs and state
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that this is in breach of LKAS 10. It would also be helpful for the auditor
to state that this does not affect profit for the year, but is a disclosure
only.
(2)
(i)
An Emphasis of Matter (EoM) paragraph is a paragraph in the auditor's

report that is appropriately presented or disclosed, but which is so
important that special emphasis is needed for users.
An EoM is different from a modification to the auditor's opinion. An
EoM paragraph does not modify the opinion; indeed, it should state
clearly that this is the case. An auditor should only include an EoM if
s/he has sufficient appropriate audit evidence that the matter is not
materially misstated.
The EoM should provide a clear reference to the matter, and to where
the appropriate disclosures and other information can be found in the
financial statements.
Examples of when an EoM may be used include:
(ii)
An uncertainty relating to the future outcome of exceptional

litigation
Early application of a new accounting standard that has a

pervasive effect on the financial statements
A major catastrophe that has had a significant effect on the

entity's financial position
Significant going concern issues
An Other Matter (OM) paragraph has in common with the EoM the fact
that it does not modify the auditor's opinion. However, whereas the
EoM refers to a matter within the financial statements, an OM refers to
information that is rightly not present in the financial statements, but
which is so important for users' understanding of them that it needs to
be highlighted in the auditor's report.
Examples of situations include:
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Law, regulation or generally accepted practice may require or

permit the auditor to elaborate on matters that provide further
explanation of the auditor's responsibilities or report.
The auditor may be reporting on more than one set of financial

statements (eg a set of statements prepared under national
reporting framework, and a set of statements prepared under
International Financial Reporting Standards).
Any restrictions on the distribution of the auditor's report
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The OM is thus a means for the auditor to communicate with users, and
should state explicitly that the matter referred to is not required to be
included in the financial statements.
6 Axis & Co
(1)
Lorenze Co
The company has changed its accounting policy for goodwill during the year
and failed to disclose this in the financial statements. In accordance with
LKAS 8 Accounting policies, changes in accounting estimates and errors, the
change in policy should be disclosed in the accounts.
An unmodified opinion on the financial statements with the inclusion of an
emphasis of matter paragraph is therefore not suitable as the opinion should
be modified on the grounds of a misstatement regarding disclosure
depending on the materiality of the issue, the modification would either be
qualified ('except for') (if material) or adverse (if pervasive).
(2)
Abrupt Co
Although the auditors are not required to provide an opinion on other

information in documents containing financial statements, they are required
to read the other information and consider its consistency with the accounts
in accordance with SLAuS 720 The auditor's responsibility in relation to other
information in documents containing audited financial statements.
There is a material inconsistency between the financial statements and what
is stated in the directors' report. It is the directors' report that contains the
misstatement. If the directors refuse amend their report so that it is
consistent with the accounts, then although an unmodified opinion on the
financial statements can be issued, an Other Matter paragraph should be
included in the report to highlight this inconsistency.
(3)
Jingle Co
A wholly-owned subsidiary of Jingle has commenced trading on 7 July 20X8,

subsequent to Jingle's year end. It is not clear whether the company was
incorporated prior to 30 June 20X8.
The auditors should obtain more information about Bell. It should be possible to
obtain details about its registration from the companies' registry. If this
information is unavailable, this would represent an inability to obtain
sufficient appropriate audit evidence in respect of which the auditors would
have to qualify their auditor's opinion in respect of it.
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If the company was incorporated after 30 June 20X8, it requires disclosure in

the financial statements as a non-adjusting event after the end of the
reporting period. If these disclosures are not made, the auditors would have
to qualify the auditor's opinion for 20X8 due to a misstatement regarding the
disclosure. However, assuming the subsidiary was accounted for correctly in
the 20X9 financial statements, the 20X9 auditor's report would be
unaffected.
If the company was incorporated before 30 June 20X8 then the subsidiary
needs to be consolidated in Jingle's financial statements and the relevant
disclosures have to be made. If this is not the case, then the auditor's opinion
for 20X8 would have to be qualified over a misstatement in respect of the
accounting treatment of the subsidiary Bell. This would also result in the
20X9 auditor's opinion having to be qualified over the same issue if it was
not corrected, as the problem would affect the comparative financial
information in the following year.
(4)
(i)
SLAuS 700 Forming an opinion and reporting on financial statements

requires that the audit report only be signed once sufficient
appropriate audit evidence has been obtained on financial statements.
Written representations from management are audit evidence, so
logically there is not sufficient appropriate audit evidence until these
are received.
It is therefore not appropriate to sign the report and date it before
these are received.
(ii)
It is not generally appropriate to refer to third parties in an auditor's

report, as this may give the impression that someone other than the
auditor is responsible for the report.
However, SLAuS 710 Comparative information corresponding figures
and comparative financial statements permits reference to be made to a
predecessor auditor's report; this is the auditor's own choice.
This reference should be made in an Other Matter paragraph, included
directly after the Opinion paragraph, which states that the financial
statements for the prior period were audited by a predecessor auditor,
states what opinion was expressed, and the date of their report.
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7 Willow
(1)
Matters raised by audit senior
(i)
Inventory
This area is not material to net assets or to income and expenses, but
could become so in combination with any other immaterial
misstatements detected. Unless this is the case, there would be no
effect on the audit report.
LKAS 2 Inventories requires inventory to be measured at the lower of
cost and net realisable value (NRV). If the NRV is zero, then an expense
of Rs. 130,000 will be incurred, reducing both and assets by the same
amount.
SLAuS 580 Written representations states that a written representation
is not of itself sufficient appropriate audit evidence. Therefore further
evidence must be obtained.
The assertion that must be tested here is that NRV is not less than Rs.
130,000. The finance director's claim that the inventory can be
recycled would therefore need to be supported by evidence that the
NRV of this recycled inventory would not be less than Rs. 130,000.
Further procedures include:
(ii)
Making enquiries from an operations director to ascertain

whether or not the materials could be recycled.
Obtaining documentary evidence of the costs of recycling

together with the potential selling price of recycled materials.
Reviewing invoices raised after the period end for evidence that
the materials have in fact been recycled and sold on.
Provisions
This area is not material to net assets or to income and expenses, but
could become so in combination with any other immaterial
misstatements detected.
LKAS 37 Provisions, contingent liabilities and contingent assets requires
that a provision be recognised where it is probable that there would be
an outflow of resources embodying economic benefits, as is the case
here. If this adjustment is not made then liabilities and expenses are
both understated. There is also unlikely to be adequate disclosure of
the circumstances surrounding the case.
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When combined with the inventory misstatement, the result is a total

misstatement of Rs. 255,000, which is material to income and
expenses. If neither adjustment is made then the audit opinion is
qualified.
The verbal confirmation that the case will probably be paid is not
sufficient, and written confirmation from the lawyers is required. The
finance director's refusal to provide this evidence may constitute a
limitation on the scope of the audit if the evidence cannot be obtained
elsewhere, and throws into question management's integrity. This
should trigger a re-assessment of any written representations from
management relied on elsewhere in the audit, for example in relation
to inventory.
Review correspondence with lawyers for evidence regarding the

outcome of the legal claim.
Review board minutes for evidence about the claim.
(iii) Current assets

A loan to a director is material by nature, irrespective of its monetary
value. In line with LKAS 24 Related party disclosures Cherry is key
management personnel and thus a related party. The financial
statements must therefore disclose the loan principal amount, the
amount outstanding at the year end, together with the terms of the
loan including details of any security offered.
As the loan is not disclosed in the financial statements, there is a
material misstatement in respect of LKAS 24. If no adjustment is made
then the audit opinion is qualified.
It is possible that the interest payment has not been made or accrued
for. If not, then interest of 4% Rs. 6,000 = Rs. 40 should be accrued
(the adjustment is immaterial).
(2)
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Review the written terms of the loan to confirm the interest rate
and any other conditions.
Review list of accruals to see whether interest has been accrued.
Property
A move from recognising properties at cost to at fair value would be
acceptable in line with LKAS 16 Property, plant and equipment, as long as it
is applied across an entire class of assets. The committee should be aware of
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the benefits and drawbacks of such a change. Benefits include more relevant
information on the values of properties, and quicker recognition of fair value
gains in the financial statements. But the drawbacks include the need to
remeasure fair value at each period end. It may also be necessary to employ
an external expert to estimate fair values, which could be costly.
Asset register
The delay in receiving the non-current asset register would have impaired
audit efficiency, and potentially resulted in greater audit costs and therefore
fees.
The fact that the issue was discussed with the committee last year but then
recurred, suggests some sort of controls failure; either the last year's
discussion was not acted upon by the committee, or at some other point. In
both cases the reason for this needs to be ascertained.
The fact the financial controller has been on holiday at the start of the audit
for two years running is not just unhelpful, but may be a cause for concern eg
indicative of fraudulent behaviour.
Procurement
No explanation is actually given for why invoices are not matched to goods
received notes; there is no reason why this cannot be done if suppliers are
changed frequently, for example. Without this control, it is possible that
invoices are paid without goods ever being received. There is also a risk of
fraud if this is done intentionally, either delivering goods to another address
or using dummy invoices. The committee should seek to improve controls in
this area as a matter of some urgency.
Frequently switching suppliers is not itself a problem, but again this would
not seem to totally preclude maintaining a list of approved suppliers it only
means that such a list would be a long one. If totally new suppliers really are
being used so frequently, then there may be issues with quality rather than
price.
There are a number of ethical issues here. First, the offer of three weeks' use
of her holiday home needs to be considered in light of the CA Sri Lanka Code
of Ethics requirements on gifts and hospitality. In this case the value of the
offer is likely to mean that no safeguards could prevent the auditors'
independence being impaired, so the offer should be declined. If the team
considers that Mia Fern intends to influence the outcome of the audit by
making the offer, then this casts doubt on her integrity. The audit committee
should be notified of this situation.
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The gifts of lunches are unlikely to impair independence as they are likely to
be of an insignificant monetary value. Provided that this is the case, they may
be accepted.
8 Colombo
(1)
Revising materiality
Auditors must reassess materiality if they become aware of new information

that would have resulted in a different materiality level being set at the
planning stage.
Planning materiality is likely to have been based on draft financial
statements, but during the course of the audit it could become clear that the
final financial statements will be substantially different. For example, the
carrying amount of assets held at fair value could be much lower than
originally expected, which would affect the amounts in the statement of
financial position. In that case, the auditor would need to set materiality
again, on the basis of the actual results and position.
Alternatively, something could happen during the audit, eg the client could
decide to dispose of a subsidiary. This could change the appropriate
materiality level, as well as performance materiality. The auditor should take
this into account and revise materiality.
(2)
Statement of profit or loss and other comprehensive income

Galle revenue
Galle's 25% drop in revenue indicates that goodwill relating to this

subsidiary may be impaired. There is a risk that this goodwill has not been
impaired when it should have been.
Property disposal
At Rs. 2 Mn, the property disposal is material.

The option to repurchase the property in five years' time points to the
possibility that this could not be a genuine sale, but a finance arrangement
whose economic substance is that of a secured loan. In this case the audit
evidence obtained is inadequate, and further evidence needs to be obtained
to determine the substance of the transaction.
If this is indeed a secured loan (in substance), then the asset will be
recognised in the statement of financial position, and the cash receipt will be
recognised as a loan (liability). Finance costs will be accrued over the period
of the loan five years.
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If this is the case, then profit has been materially overstated, and liabilities
understated.
Property revaluation
The gain of Rs. 800,000 was just below initial materiality of Rs. 900,000, but
above the current materiality level of Rs. 700,000. Audit procedures must
now be performed in this area, as it is possible that there could be a material
misstatement here.
Actuarial loss
The actuarial losses are material, at Rs. 1.1 Mn, as is the defined benefit
liability of Rs. 10.82 Mn.
Axle Plc is a service organisation, and SLAuS 402 Audit considerations
relating to an entity using a service organisation requires the auditor to
obtain an understanding of this organisation. This can be obtained:
From the Group itself, we should gain an understanding of how Axle Plc
arrives at its valuation, its systems and its controls.
By obtaining a report from the auditor of Axle Plc (the service auditor),
which contains an opinion on the description of Axle Plc's systems and
controls.
This has not been done, and we have no information about how the plan
assets and liabilities were valued, or how reliable their valuation might be.
The audit team must therefore obtain this information before the service
organisation's representation can be relied upon.
Goodwill impairment
There is an indicator that goodwill relating to the Galle subsidiary is

impaired, but this does not appear to have been considered by the audit
team. Audit procedures must be performed on the assumptions used by
management in conducting this review. The reasons why the 25% fall in
revenue has not resulted in impairment must be specifically addressed.
Associate
The statement of profit or loss includes Rs. 1.01 Mn share of profit of

associate. The figure in the statement of financial position should include (at
a minimum) the amount brought forward, plus any profit attributable, less
any dividends received. It is thus highly unlikely that this figure would not
have changed since last year.
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Trading division held for sale
The division held for sale is part of a subsidiary. Therefore, some of the
goodwill relating to this subsidiary may need to be reclassified as part of the
disposal group of assets held for sale. Although it is possible that no goodwill
will need to be reclassified, evidence needs to be obtained that this is the
case.
The statement of financial position contains one line within assets for 'assets
classified as held for sale'. This disclosure is incorrect: the assets held for
sale should be a separate section within 'assets'.
It appears that this Rs. 7.8 Mn could be a net figure, which again is incorrect
there should also be a separate section within 'liabilities' showing the
liabilities from the disposal group. Audit procedures should be performed to
ascertain whether this in fact a net figure, in order to get the classification
right.
Although there are assets held for sale from a trading division, the statement
or profit or loss shows no discontinued operations. SLFRS 5 Non-current
Assets Held for Sale and Discontinued Operations requires the post-tax profit
or loss of discontinued operations to be shown as a single line. This appears
to be a material misstatement, and audit procedures should be performed to
determine whether it is or not whether there are any discontinued
operations.
There is no disclosure in relation to the non-controlling interest in the

statement of profit or loss and other comprehensive income. Both profit for
the year and total comprehensive income attributable to the non-controlling
interest should be disclosed.
New loan
Finance costs should be included of Rs. 8 Mn 2% 9 / 12 = Rs. 120,000.

However, finance costs have only risen by Rs. 40,000. No loans appear to
have been paid off during the year, as long-term borrowings have increased
by exactly the Rs. 8 Mn received for the new loan. Therefore, finance costs
appear to be understated.
The amount is not material in itself, but should be accumulated together
with any other misstatements that are discovered as they could become
material in aggregate.
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9 Banana
(1)
(i)
Matters to consider
Materiality
Materiality on revenue:
Rs. 500,000
= 4%
Rs. 12.5 Mn
Materiality on net profit:
Rs.500,000
= 125%
Rs.400,000
Materiality on total assets:
Rs. 500,000
= <1%
Rs. 78 Mn
The training costs are not material to the statement of financial

position. They would, however, be material to revenue and profit if
they were reclassified as expenses, turning a profit into a loss.
Accounting treatment
The training costs are currently recognised as non-current assets. This

is not in accordance with LKAS 16 Property, plant and equipment, which
states that the costs of training staff should always be treated as an
expense, as they do not meet the definition of an asset, which requires
that the entity has control of the asset. This is very unlikely to be the
case with training costs, as the staff will probably have the right to
leave the company, meaning that Banana would not receive any
subsequent economic benefit from having trained them.
The training costs should be treated as an expense in the statement of
profit or loss.
Audit opinion
If Banana does not amend its financial statements, the audit opinion
will be modified due to a material misstatement. This would probably
be an 'except for' qualification as the misstatement is material but not
pervasive.
Evidence
The file should contain:
CA Sri Lanka
A review of the nature of the expenses themselves to verify that

they are classified correctly and that they are in fact training
costs.
Testing of entries selected according to sampling procedures

detailed in the audit plan to supporting documentation, such as
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purchase invoices, and agreement of payment of related payables

to the cashbook and to bank statements.
Evidence that a sample (selected according to audit plan) of

entries are included in the accounts in the correct period.
Testing for completeness and that all invoices that should have been
accrued for were in fact accrued for.
(ii)
Matters to consider
Materiality for whole receivable
Rs. 30,000
= 2.4%
Rs. 12.5 Mn
Rs. 300,000
= 75%
Rs. 400,000
Materiality on total assets:
Rs. 300,000
= <1%
Rs. 78 Mn
The receivable is not material to the statement of financial position. It

would, however, be material to the statement of profit or loss if an
impairment loss were recognised in relation to it.
Accounting treatment
LKAS 39 Financial Instruments: Recognition and Measurement requires

receivables to be recognised at fair value. The fair value of the Cherry
receivable is the 25% that the administrators suggest it may be able to
pay, ie Rs. 75,000. Rs. 225,000 should therefore be recognised as an
impairment loss in the statement of profit or loss.
Calculating materiality for the impairment loss:
Rs. 225,000
= 1.8%
Rs. 12.5 Mn
Rs. 225,000
= 56%
Rs. 400,000
This is clearly material to profit for the year.

Inventory
As Cherry is a customer, it is possible that Banana is holding inventory

or work in progress that was ordered by Cherry. Grape & Co needs to
ascertain whether this is the case, and if so whether the inventory can
in fact be sold. If it cannot be, then it may be impaired and should be
written down, recognising the loss in profit for the year.
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Audit opinion
If Banana does not amend its financial statements, the audit opinion
will be modified due to a material misstatement. This would probably
be an 'except for' qualification as the misstatement is material but not
pervasive.
If the misstatement in respect of the receivable is taken together with
the misstatement in respect of the training costs, the overall result may
be that Grape & Co judges the statement of profit or loss to be rendered
meaningless (pervasive effect). In this case it would issue an adverse
audit opinion.
Audit evidence
(2)
External documentation confirming the insolvency of Cherry and

the possible repayment of only 25% of the receivable.
Confirmation from the administrator of the 25% to be paid,

including an indication of when this is likely to happen.
Agreement of the amount owed from the receivables listing to the

ledger.
Review of inventory documentation, and evidence of enquiries

made of management, regarding the value and the potential
recoverability of any inventory relating to contracts with Cherry.
Calculations regarding the amount to be recognised as an

impairment loss.
Selection of engagement staff
The fact that the junior had only worked on two audits before this is not a
problem. However, it is important that they be given work appropriate to
their level of skill and experience. This does not appear to have happened
here, as detailed below.
No audit planning meeting
The audit planning meeting, led by the partner, is a crucial part of the audit.
It is the best way of giving the team an understanding of the client, and
should discuss both the overall strategy and the detailed audit plan, perhaps
going into difficulties that have been experienced in previous years and
which could come up again. The discussion should focus on what individual
members of the team need to do. This is particularly important for less
experienced and junior members of the team.
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Audit manager away
The manager should not have given the senior responsibility for the audit
while they were away on holiday for three weeks. It is important that an
audit is properly supervised, and it may have been more appropriate for
another manager to take responsibility for the audit.
Senior busy
Not only is there a question mark over whether they have the experience to
manage the audit, but the senior is also busy with other assignments and
thus unable to devote sufficient time to this one. It is very important that
someone is available to supervise junior members of the audit team. This is
not happening here.
It is also possible that the lack of attention paid by both the manager and the
senior has led to the misstatements in respect of the trading costs and trade
receivables not being picked up by the audit team.
Junior auditing goodwill and inventory
Goodwill is a complex accounting area to audit, and should not be given to a

junior to do. The same can be said of inventory and in particular work-inprogress. A junior is very unlikely to have developed the judgement needed
to audit these areas. This seems to be the case here, as shown by the junior's
error at the inventory-take (see below).
Inventory-take
The junior helped the client's staff to count raw materials at the inventorytake, when they should instead have been observing that the client's staff
were counting them correctly and in accordance with the count procedures.
This would seem to imply that the junior had not been properly briefed on
their responsibilities at the inventory-take, as this is a relatively basic error.
It is likely that more audit evidence will be needed to be done on inventory
as a result of this error.
Junior asked to challenge FD
It is not appropriate for a junior to be asked to challenge a client's finance

director regarding an accounting issue that they are unlikely to understand
fully. This should have been done by either the audit manager or the partner,
as they would be in a position to understand the technical issues involved,
and would carry sufficient authority with the client to make the challenge
effective.
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Running out of time to complete procedures
Pressure of time is an important contributor to audit risk. Audit time

budgets should allow staff enough time to complete the audit to the required
quality. It is also possible that the lack of supervision of the audit team's
work has led to the audit being conducted inefficiently, with inadequate
monitoring of progress and discussion of issues as they arise.
Reduction of sample sizes
It is clearly unacceptable to reduce sample sizes as a way of saving time. The

sample sizes detailed in the audit plan should have been designed to gather
sufficient appropriate audit evidence. Reducing the sample size beneath this
point increases detection risk, and the risk of the auditor giving the wrong
opinion.
Basis of sample selection
Selecting a sample on the basis of the ease of finding evidence for an item, is
not an appropriate basis. Indeed, this might actively increase detection risk
as it means by definition that those items for which evidence is not readily
available, or might not even exist, are not tested.
Conclusion
The failures above suggests that this engagement has not been adequately
supervised, and that the audit work performed is inadequate in some areas.
A detailed review should be performed so that any other shortcomings can
be addressed.
Doubt is also cast over the sufficiency of the firm's quality control
procedures. This matter should be referred to the relevant partner for
consideration.
10 Retriever
(1)
The Group obtained a listing during the year which means that its financial
statements will be the subject of particular scrutiny. This raises the overall
risk level of this assignment, which means it should be subject to especially
stringent quality control. This does not appear to have been the case.
Engagement quality control review
The fact that there is an engagement quality control review taking place is an
encouraging sign, as it summons the prospect of some of the more egregious
failings of quality control being made good before the auditor's report is
signed.
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Time pressure
The existence of time pressure points to poor planning. The purpose of the
audit plan is not only to direct audit work to appropriate areas of the
financial statements, but also to decide on the resources and deadlines
necessary to complete the audit satisfactorily.
Time pressure increases detection risk. Procedures are likely to be rushed,
resulting in a lack of professional scepticism and misstatements going
undetected. This seems to be what has happened here.
Directors' emoluments
The audit manager described these as low risk, but they are material by
nature. Not only are they related party transactions, they carry a high risk of
manipulation as directors may attempt to conceal their remuneration from
shareholders and other users of the financial statements.
There will also be additional reporting requirements as this is a listed group,
which only increases the risk to the auditor.
Even if they were low risk, planned audit procedures would still need to be
performed. The fact they are high risk only heightens this necessity.
Share capital
If the group were not listed, then share capital might be low risk. However,
the fact it obtained a listing during the year means that share capital could
have changed significantly. This is a highly visible area, and is therefore high
risk.
Sampling method
SLAuS 530 Audit Sampling does allow samples to be selected haphazardly,

which is effectively the exercise of judgement which the manager appears to
be advocating. However, several points can be made against the manager's
advocacy of judgmental sampling.
Firstly, the audit plan prescribes statistical sampling. It is possible to deviate
from the audit plan, but only if this would provide better evidence. Yet this is
not the manager's stated argument, so the suggestion should not have been
made.
Secondly, haphazard sampling requires the exercise of judgement which
juniors are unlikely to possess in view of the fact that their firm usually
samples statistically. There is a risk that juniors will not understand how to
select samples in this way, and will simply select eg large balances.
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Thirdly, the manager's claim that haphazard sampling is quicker is

manifestly false. When done properly, haphazard sampling requires the
exercise of judgement and this takes time. Statistical sampling is much
quicker to implement as it is relatively mechanical.
In fact the manager's suggestion that this would save time amounts to an
incitement to the juniors to select the samples without due care, perhaps
only picking the items that are close to hand. This is a serious breach of the
CA Sri Lanka Code of Ethics.
Trade payables
It is acceptable for juniors to be involved in the audit of trade payables,

however the suggestion appears to be that one junior has been made
responsible for the whole of trade payables on a listed company audit. This is
clearly unacceptable, as the junior would possess neither the skills nor the
time to perform the work to a satisfactory standard.
Going concern
Going concern is a difficult area to audit as it usually involves making

judgements about a business's future prospects, which requires substantial
experience. Juniors are very unlikely be able to do this and so should not
have been assigned going concern.
A more senior member of the audit team should have been assigned going
concern, such as the audit manager or partner.
Taken together with trade payables, this reveals a disturbing failure of
direction on the audit, which is a key aspect of quality control.
Review
It may well be good training for juniors to review each other's work, but this
is no substitute for proper supervision and monitoring by more senior
members of the audit team. Being at the same level, juniors are unlikely to be
able to spot any errors or invalid conclusions drawn, so the reviews are
likely to be of little use. Moreover, the juniors are likely to be very familiar
with each other and may be unwilling to criticise each other's work. The
work should have been reviewed by the audit manager.
The financial controller of a listed company should be able to calculate

deferred tax, so the fact that she could not raises issues about the Group's
internal controls. The audit team should therefore revisit the risk
assessment done at the audit planning, as deficient internal controls may
mean that more substantive testing will be required.
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The junior should not have been discussing the tax position with the
financial controller in the first place. Given that the time on the audit is so
short, what time there is would be better allocated to performing audit
procedures. This points to a lack of supervision, and also to a need for
further training for the audit junior.
Deferred tax asset
This is a good example of the principle of professional competence and due

care, which the junior appears to have breached. Although the junior has
studied deferred tax in college, they lack the experience to know that in
practice the recognition of deferred tax assets is rare. Given that the Group's
subsidiaries have been suffering losses it is not certain that any such asset
will be recoverable; making the judgement over the asset's recoverability
requires experience that the junior does not yet possess.
The key ethical issue here is that the auditor must not provide accounting
services such as this to listed clients. The self-review threat so created
whereby the firm would then be auditing accounts that it has itself prepared
would be deemed by the Code to be insurmountable in this instance.
The audit manager said that this would save time and that the figure would
not need to be audited. This is wrong. Now that the junior has calculated the
figure it will need to be carefully reviewed and re-performed, and discussed
with the management of the Group. The audit manager's suggestion is
indicative of a lack of due care.
Tax planning
The audit junior should not be providing tax planning recommendations.

This is a non-audit service, which the junior is providing free of charge and
without the required professional skills. There is a self-review threat here
because the tax balances calculated on the basis of the junior's advice would
be included in the audited financial statements. There is a danger that the
junior has been taking management decisions. It would usually be possible
for a tax planning service to be provided to a listed client, but the auditor
would have to put in place safeguards such as separate engagement teams
which clearly do not exist here.
There is a risk that the firm may be the subject of litigation as well as
reputational damage if the client relies on wrong advice given by the junior.
Steps should therefore be taken to inform the Group of the situation and to
prevent it from relying on this advice.
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(2)
It would be helpful to arrange a meeting with Group management in order to

help obtain an understanding of the theft and the circumstances around it,
and to clarify matters in relation to the engagement.
The objective should be specified precisely, and clarification may be needed
regarding whether quantification is to be made of the amount to be claimed
from the insurer, or of the amount of the loss.
It should be clarified whether the Group wants us to investigate the crime
itself and to identify the perpetrator, as this would be a radically different
type of investigation which may be outside the scope of Kennel & Co's
professional competence.
Clarification should be sought on whether the Group has already made any
calculations of the amount to be claimed, in which case it may simply want
us to audit its calculation. Alternatively it may want us to calculate the loss
ourselves from scratch. This would have an effect on fees, which should also
be discussed at the meeting.
Kennel & Co appears likely to have sufficient resources to conduct the
investigation as it has an internal audit services department. It should,
however, be determined whether the firm has the requisite staff available for
this assignment.
It will be necessary to discuss timings with the Group, and in particular any
planned deadlines for submission of the insurance claim. Any such deadlines
should allow enough time for the work to be completed without sacrificing
quality. This will in turn affect the consideration of whether sufficient
staffing resources are available at the right times.
It must be confirmed that the assurance team will have full access to any
information required to conduct the investigation.
The Group should have reported the theft to the police, and it may be helpful
to obtain a copy of any police reports available. It should be established
whether the perpetrator(s) have been caught, and if so, whether they are
likely to be prosecuted. Kennel & Co should bear in mind that there is a
possibility that the Group might ask it to act as an expert witness if there
were a court case, in which case there may be an advocacy threat to the
firm's independence.
It is possible that the perpetrator(s) have been caught and that some of the
assets have been recovered. This should be ascertained, and any recovered
assets excluded from the calculation of the loss. It is also possible that these
assets may have been damaged, in which case this should be taken into
account.
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From the circumstances described it is possible that the thieves may have
been Group employees. This information should be obtained from
management.
Finally, the output of the investigation should be confirmed. The Group may
require a report to the insurance company for example, or alternatively a
report addressed to itself but which it can use for the purposes of the
insurance claim. It should be clarified that the report would not be
distributable to any other parties.
(3)
Procedures
Watch the CCTV to determine the quantity of goods stolen, eg how

many boxes loaded onto lorry.
If possible determine if the boxes contain mobile phones or laptops.
Inspect boxes of goods in the warehouse to determine how many

finished goods are in each.
Agree cost of an individual phone and laptop to accounting records, eg

cost cards.
Perform inventory count on boxes of goods in the warehouse and

reconcile to latest inventory movements.
Discuss the case with police to establish if any goods have been
recovered and if this is likely to happen.
Obtain details of stolen lorry, eg licence plate, and agree the lorry to
non-current asset register.
Review the insurance policy to confirm that assets lost as a result of

thefts are covered and to confirm that the date of the theft falls within
the period insured.
Determine by inspecting the insurance policy whether there are any

restrictions in the case of thefts perpetrated by Group employees, as
this may affect the amount that can be claimed.
11 Dragon Group
(1)
Matters to include in the tender document

Fees
The proposed fee should be included, along with an explanation of how it is

calculated. This would include details of the charge-out rates of the staff
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likely to be used on the audit, along with estimates of the amount of time the
audit would be likely to take.
Dragon Group's needs and how Unicorn & Co could meet them
(i)
An explanation of the need for each subsidiary (as well as Dragon Plc)
to have its own individual audit, and for the consolidated financial
statements then to be audited too.
That Unicorn & Co is a large firm and would be capable of auditing a
large group such as this.
(ii)
The Dragon Group may also need some non-audit services (see below).
That Unicorn & Co can provide a variety of non-audit services, should
they be required.
(iii) Several subsidiaries prepare accounts under local accounting rules, so

the auditor of these
That Unicorn & Co is a global firm with offices in over 150 countries. It
would well placed to audit under local accounting rules, and to audit
their consolidation into the group accounts.
(iv) The Dragon Group operates in the furniture retail trade.
That Unicorn & Co has a specialist retail department and therefore has
the experience to audit the group efficiently.
Proposed audit approach
This section should include a description of the methodology to be used in

the audit. For instance:
(i) How the firm would acquire knowledge of the business
(ii) Methods used in planning and risk assessment
(iii) Procedures used to gather audit evidence
Brief outline of Unicorn & Co
A short history of the firm, including a description of its organisational

structure, the services it can offer and the locations in which it operates.
Other services
A description of any other services Unicorn & Co can offer, such as offering
advice in relation to the proposed stock exchange listing. Careful
consideration should be given to ethical requirements relating to
independence when offering other services to a potential audit client.
Key staff
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Details of the proposed engagement partner and of his experience that is

relevant to this audit. Details should also be given of the approximate size
and composition of the audit team, together with a description of the
relevant experience of key members of that team.
Communication with management
An outline of the various communications will be made to management over

the course of the audit. This may include information on the way in which
these reports could add value to the Dragon Group's business, for instance
the production of a written report on the effectiveness of internal control
procedures.
Timing
Details should be provided of the timeframe envisaged for the various

aspects of the audit. This might include details of when the subsidiaries
would be audited, when the consolidation process would be audited, and an
estimate of by when the group audit opinion could be completed.
Conclusion
This is a large, transnational group, carrying a high level of risk. Unicorn &
Co should take on the audit only once it is sure that it is able to do so, and is
assured of a fee that adequately compensates it for the level of risk involved
in undertaking the audit.
(2)
Matters to consider before accepting engagement

Size of Dragon Group
The Dragon Group is large and expanding group of companies, and would
therefore require a high level of resources to audit. Unicorn & Co must
consider whether it has sufficient staff available to audit a growing group of
this size.
Overseas subsidiaries
Half of the subsidiaries are located overseas. Unicorn & Co has a large
number of overseas offices which could perform some or all of the overseas
audits. However, these offices may not all have specialist retail audit
departments, so consideration needs to be given to whether there is enough
experienced staff to carry out the audit.
If some of the overseas audit work needs to be done by auditors outside of
Unicorn & Co, then this work would need to be evaluated in order to express
an opinion on the group financial statements.
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Relevant expertise
As Unicorn & Co has a department specialising in retail audits, it is likely that

it will have sufficient expertise in this country.
As a large auditing firm, it is also likely that Unicorn & Co will have staff
sufficiently experienced in auditing the consolidation process to audit the
consolidation of the Dragon Group's results.
Time pressure
The group's year end is 30 September 20X9, and management wants the audit
completed by 31 December 20X9. This represents a tight deadline, given that
the audit involves a large number of subsidiaries located in several different
countries and reporting under a number of different accounting rules. The
fact that this would be the first year that Unicorn & Co would have audited
the group also makes the deadline tight. There is also a possibility that
management do not fully understand what is required for an audit.
Planned listing
Management are planning a new listing on a foreign stock exchange. This

will increase the risk of management manipulation of the accounts, as
management may under pressure to report favourable results. Audit risk is
also increased by the fact that as a result of the listing, the financial
statements will be subject to heavy scrutiny by regulators.
Previous auditor
Unicorn & Co should consider the reason for the group seeking to change its
auditor, as this might affect the decision to accept the engagement. On the
face of it, it appears likely that the quickly-growing group has outgrown its
previous auditors, but Unicorn & Co should still seek to obtain the reason for
the change from the previous auditors.
Mermaid Pvt Ltd
Mermaid Pvt Ltd's previous auditors expressed a qualified audit opinion.

Unicorn & Co should gather information about the related contingent
liability, part of which would involve contacting the previous auditors.
Management's refusal to disclose the contingent liability may indicate a lack
of integrity on their part, which would increase audit risk. Consideration
then needs to be given to whether any future non-disclosure would be
material to the group financial statements.
Minotaur Plc
Minotaur Plc operates in a different business area from the rest of the group,
so Unicorn & Co must consider whether it has staff available with the
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appropriate level of expertise. This difficulty should be straightforward for a

firm of Unicorn & Co's size to overcome.
(3)
Ethical and professional issues
There are a number of possible threats to Unicorn & Co's independence here:
Familiarity: Kia may fail to exercise professional scepticism.
Intimidation: the financial controller may be able to intimidate and

influence Kia's work.
Self-interest: Kia may have an interest in not causing problems for her
relative, and may be unwilling to challenge them if required to do so.
To assess the severity of the threat, the degree of influence held by the family
member and by Kia must be considered. As financial controller and audit
senior respectively, both would have some influence over the financial
statements. It would therefore be unlikely that Kia would be able to be
assigned to this audit engagement.
Furthermore, allocation of staff to audit teams should be the decision of
Unicorn & Co alone. Staff should be allocated on the basis of their experience
and skills. There is a risk of the audit team possessing an inappropriate mix
of experience and skills for this audit if Unicorn & Co were not able to select
the audit team, which may impair audit quality. It is therefore crucial that
Unicorn & Co exercise a free choice over the composition of the audit team.
12 Lapwing
(1)
The terms of the engagement to report on the business plan should be

agreed in an engagement letter for this assurance engagement. The following
matters should be considered.
Intended use of the business plan
It should be confirmed that the report will be provided to the bank, as this
may establish Lapwing & Co as potentially liable to the bank.
Distribution of report
Clarification should be sought over whether the report will be distributed to

any other parties. It may be necessary for the report to include a liability
disclaimer.
Elements of business plan covered
The engagement is to report on the business plan, but clarification is needed

about whether this means the business plan as a whole, or merely the
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forecast financial statements included in it. This will affect the extent of
Lapwing & Co's possible liability, and the extent of procedures required.
Nature of assumptions
It should be clarified whether the plan's assumptions are best estimates or

hypothetical. If the assumptions are clearly unrealistic, then SLSAE 3400 The
examination of prospective financial information states that the auditor
should not accept the engagement.
Period covered
The forecast financial statements are for 12 months. It should be clarified

that this is the only period on which assurance is to be provided.
Clarification is also needed over whether the other elements of the business
plan refer to only this period.
Fees and practical matters
The level of fees should be confirmed, together with billing arrangements.

Practical matters to confirm include the timing of the report, which will
enable Lapwing & Co to ensure that it has adequate resources (eg staff)
available to perform the engagement.
Form of report
The planned form of the report should be agreed in advance in order to

avoid any misunderstandings. The report would use a negative form of
words to provide limited assurance.
Respective responsibilities
It should be confirmed that management is responsible for preparing the

business plan, and for providing the auditor with all relevant information.
(2)
CA Sri Lanka
General procedures
Re-perform calculations to check arithmetical accuracy.
Agree unaudited figures for period to May 20X2 to management

accounts to assess their reliability.
Confirm that accounting policies applied consistently between the

periods and audited financial statements.
Assess accuracy of past forecasts by comparison with actual figures.
Consider reasonableness of trends in light of auditor's understanding

of Hawk.
Review correspondence with bank about negotiated terms of the loan,

and confirm major terms and interest rate directly with bank.
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Statement of profit or loss
Discuss 21.4% increase in revenue with management, and consider if

reasonable.
Operating margin rises from 30% to 33.8%. Ask for explanation from
management and consider if reasonable.
Discuss sale of Beak Retail, including likelihood of sale and any likely
terms. Review board minutes for details about the sale.
Recalculate profit on disposal, and agree proceeds to any draft legal

documentation.
Consider reasonableness of finance costs. New loan should add Rs. 1

Mn (Rs. 30 Mn 4% 10 / 12), but finance costs are up by only Rs.
960,000 need to ascertain the reason for this.
Statement of financial position
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Non-current assets are up Rs. 37.15 Mn, but the loan which financed
this investment was only for Rs. 30 Mn. Enquire about other possible
sources of finance used for this increase.
Review reconciliation of movement in non-current assets, confirming

that Beak Retail assets are derecognised.
Confirm that any assets relating to the joint venture with Kestrel are
accounted for in line with SLFRS 11 Joint arrangements.
Discuss the planned Rs. 5 Mn increase in equity (is this to help finance
the increase in assets?). Discuss what form this will take (ie rights
issue, or at full market price).
Agree the increase in non-current assets to capital expenditure

budgets.
Agree cash figure at May 20X2 to bank reconciliation and statement.
Receivables days are predicted to fall from 58 days (3,300 / 20,600

365) to 53 days (3,600 / 25,000 365), improving the company's cash
position. The reasons for this should be discussed with management,
and considered for reasonableness.
Payables days are predicted to fall from 137 days (5,400 / 14,420
365) to 124 days (5,600 / 16,550 365), worsening the company's
cash position. The reasons for this should be discussed with
management, and considered for reasonableness.
Agree the increase in long-term borrowings to documentation obtained

for the new loan
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(3)
Discuss the deferred tax provision, and establish why there has been
no movement (which is unexpected, given the capital expenditure).
Discuss the movement on retained earnings, which have risen only by

Rs. 0.8 Mn, in spite of a profit before tax of Rs. 10.52 Mn. It may be that
a dividend is planned.
Ethical issues
The key issue with the provision of other services is that independence of
the auditor may be impaired as a result. In principle, CA Sri Lanka Code does
not prohibit the provision of other services. However, the fundamental
principles apply to all professional assignments. Therefore the audit firm
must assess the threats to which it is exposed in performing the engagement
and consider whether safeguards are necessary. In this instance appropriate
courses of action would include:
Ensuring that the review is performed by staff other than those

involved in the audit eg stag in a business advisory department.
Obtaining a second partner review of the audit opinion.
13 Baltimore
(1)
Equity owners
It is crucial to determine the identity of Mizzen's majority shareholder. It

appears likely that this is Bizgrow, but further information is needed.
This is important because if Bizgrow does own the shares then it is with
Bizgrow that Baltimore would need to negotiate the purchase of Mizzen. If
Bizgrow does not want to sell its shares then Mizzen cannot be bought.
However, it is unclear how Baltimore came to identify Mizzen as an
acquisition target in the first place, and it is possible that Bizgrow may have
had something to do with this.
Funding
It is noted that Vic and Lou secured funds from Bizgrow. The nature of any
agreement that was made needs to be ascertained, as it is possible that
Mizzen may owe Bizgrow a substantial amount of money. This would be
material to any decision Baltimore might make about the acquisition.
The precise nature of the ongoing relationship between Mizzen and Bizgrow
is unclear. It is possible that Bizgrow is involved with Mizzen at an
operational level. Any agreements between the two parties should be
obtained and scrutinised.
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Examination of the statement of profit or loss reveals a finance cost of

Rs. 250,000 which appears to be fixed. It is unlikely that this is interest on a
loan because loan interest would change as the balance is repaid. It is
therefore possible that this is a management charge from Bizgrow, which
would be indicative of ongoing involvement. We would need to understand
the nature of any liabilities Mizzen may have in relation to this charge.
Reputation
Mizzen's good reputation, and its having won awards for website design, is
key evidence for its expertise in this area. This should be verified to external
evidence. Customer satisfaction could be gauged by obtaining the results of
any customer satisfaction surveys that may have been conducted.
Vic and Lou
Vic and Lou appear to be crucial to the success of Mizzen, so Baltimore

would want them to be involved in future. It is not certain, however, that
they would want to be involved with Baltimore and its website, and they
may wish to concentrate on their own more innovative work. The
acquisition would be much less attractive to Baltimore were they to leave.
Vic and Lou's intentions post-acquisition should be determined. It may be
possible to structure any future deal in such a way that Vic and Lou would be
required to continue working at Mizzen for a set period after the acquisition.
Staff
Mizzen is a business with few tangible assets, which relies heavily on the
expertise of its employees, who may leave after any acquisition particularly
if Vic and Lou were to leave. It would make little sense to acquire Mizzen for
its staff, only to find that they leave on acquisition.
An organisational structure should be obtained in order to identify
management and key personnel within Mizzen.
It is also possible that Baltimore may wish to restructure Mizzen after
acquisition. In this case it is likely that redundancy payments would need to
be made to staff members losing their jobs. The amount of any possible
liability in this eventuality should be estimated as part of the review.
Freelancers
Mizzen has been using freelancers recently, which may result in a drop in the
quality of work done by comparison with established staff. This should be
investigated as it may affect Mizzen's ostensibly impeccable reputation.
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Intangible assets
Mizzen has few assets, but is likely to have important intangible assets which
would form part of any goodwill paid on acquisition. Vic and Lou have
developed new website interfaces, and it should be determined whether any
resulting intellectual property belongs to them personally or to Mizzen.
Valuing these assets is likely to be difficult.
Customer databases should also be valued, which again is likely to be
difficult owing to the absence of any active market for assets of this kind.
Premises
It is apparent that the Rs. 1,000 nominal rent paid to Bizgrow would increase
after the acquisition, so it should be determined what an equivalent market
rent might be for the premises. Alternatively, the premises may no longer be
available, in which case the rent should be ascertained for premises meeting
Mizzen's needs. It may be possible for Mizzen to operate from Baltimore's
premises, in which case any opportunity costs should be considered.
Tangible assets
Mizzen's tangible assets need to be valued, and it should be determined

whether they are owned or held under lease, as it is possible that Mizzen
may be liable for any future lease payments.
Revenue recognition
The first revenue stream should be split into two components, with the
revenue relating to maintenance being recognised as deferred income and
spread over the contract period. There is a risk that revenue is recognised
too early, inflating Mizzen's profit in the short term.
Relevance of revenue
Baltimore needs Mizzen to develop a website for it, and it should be asked
whether Baltimore might be better off simply paying Mizzen Rs. 10,000 to
develop a website rather than acquiring the whole company.
It is clear that Mizzen would have the expertise to do this because it operates
its own subscription-based website. It should therefore be able to create
something of a similar nature for Baltimore.
The third revenue stream in particular does not appear relevant to
Baltimore, and it should be considered how this revenue stream would be
managed after the acquisition.
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Revenue increase
Revenue rose 23.7% from 20X2 to 20X3, which is an impressive increase

although it is lower than the 60.4% increase from 20X1 to 20X2. The
question is whether such a growth rate might feasibly be achieved in the
future. It will therefore be necessary to scrutinise Mizzen's forecasts and
plans for future growth.
Operating expenses
Operating expenses in 20X2 were 58.3% of revenue, but only 49.6% in 20X3.
This is unusual, and may be indicative of efficiencies being achieved as
Mizzen grows. It does not, however, tally with the fact that freelancers have
been used this year, which would be expected to increase operating
expenses in relation to revenue.
A detailed review needs to be performed on operating expenses to ensure
that expenses are complete and are recorded accurately.
Cash
Mizzen's cash position should be confirmed to its bank statement. Although

the company is not lacking cash, from its statements of profit or loss one
would expect it to be in a better cash position than it is in. It is possible that
cash has been paid out in dividends to shareholders.
Further information
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Copy of Mizzen's register of shareholders, to determine the identity of

the majority shareholder.
Copy of any agreement between Bizgrow and Vic and Lou, to help
understand their ongoing relationship as well as Bizgrow's planned
exit route.
Agreements of any loans received by Mizzen.
Full audited financial statements of Mizzen.
Details of awards won for website design, including press reports,

trade journals, for evidence of Mizzen's good reputation.
Details of any customer satisfaction surveys conducted by Mizzen.
Copies of contracts with Vic and Lou.
Copy of organisational structure.
Copies of contracts with key employees containing details of any

redundancy payments that might be due in the future, along with other
employee benefits and entitlements that are due to them.
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(2)
List of freelance designers used by Mizzen, together with copies of

contracts.
Details of any copyrights or patents owned by Vic and Lou or Mizzen.
Copy of rental agreement with Bizgrow, to be scrutinised for details of

possible rental payments after acquisition.
Details of tangible non-current assets owned or operated by Mizzen.
Copies of any lease agreements for non-current assets such as

computers or fixtures and fittings.
Copies of projected financial information for the next year.
Detailed management accounts, including breakdown of operating

expenses to ascertain reasons for rising operating margin.
Details of any dividend payments made over the last three years.
Due diligence can be a review engagement, and as such provides only limited
assurance. Some due diligence can be undertaken as an agreed-upon
procedures engagement in which case no assurance is provided only
factual findings are reported. By contrast an external auditor's report gives
reasonable assurance, which is a higher level of assurance. This is because
review engagements and agreed-upon procedures engagements involve
obtaining less evidence than is required for an external auditor's report, and
conducting procedures which are less thorough.
The conclusion of a review report is expressed negatively, and would begin
with the wording, 'Based on our review, nothing has come to our attention...'.
In an agreed-upon procedures report, there would be a statement that the
procedures performed do not constitute either an audit or a review and so
no assurance is expressed.
The conclusion of an external auditor's report is phrased positively, and may
state that the financial statements do in fact 'present fairly', or 'give a true
and fair view of', the entity's financial position, performance and cash flows.
(3)
Professional and ethical issues
Providing a recruitment service to a client is not specifically prohibited by

the CA Sri Lanka Code. However, the Code does say certain threats to
independence could be created. These are examined below.
Self-interest threat
Goleen & Co are considering the provision of recruitment services to audit

clients, earning fees based on a percentage of the salary of the person
recruited. This creates a financial self-interest threat to independence. The
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firm may be tempted to recommend an individual to a client in order to earn

a fee, and not consider whether that individual is suited to the role.
Familiarity threat
The provision of recruitment services will create a familiarity threat. During

audits, Goleen & Co will have to assess the work of individuals they helped
recruit. The firm may be or may be perceived to be less likely to criticise or
challenge such individuals because this could discredit their recruitment
services.
Self-review threat
A self-review threat occurs where an audit firm makes management

decisions for an audit client. Goleen & Co could be seen to be making such
decisions by providing recruitment services to audit clients. The firm could
review candidates' CVs and recommend individuals to interview but the final
decision of who to recruit should always rest with the client.
This threat is increased with the seniority of the individual being recruited,
for example if Goleen & Co were to advise on a new finance director. The
threat could be reduced by only providing services for the recruitment of
junior staff members.
Demand for services
Goleen & Co would need to carry out market research to ensure that there is
a demand for recruitment services before embarking on any new business
venture.
Training costs
The firm should also consider whether it has the time and resources to enter
into a new area of business. Ingrid Sharapova only worked in recruitment for
a year and seems to be the only employee with any experience. She may
require further training in order to recruit finance professionals and update
her skills.
An additional member of staff at Goleen & Co will also require some training
so the recruitment business can be kept running whilst Ingrid is away or on
sick leave.
If successful, the recruitment business may prove too much for Ingrid to
handle alone and the firm will have to either train or hire additional staff to
assist her.
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Damage to reputation
Goleen & Co's reputation could be damaged if the quality of recruitment

services is low. This risk can be reduced by setting up the recruitment
services as a separate company.
14 Apricot
(1)
General procedures
(i)
Check that the forecast casts.
(ii)
Check that the opening cash balance agrees to bank reconciliations and
statements.
(iii) Enquire as to who prepared the forecast, and verify that they are
competent to do so (evidence eg by being a chartered certified
accountant).
Operating cash receipts
(i)
Enquire as to the basis for the forecast rise in both cash and credit sales
receipts.
(ii)
Perform analytical procedures on historical information to confirm

reasonableness of forecast revenues, taking into account knowledge of
the business.
(iii) Confirm split between cash and credit sales to past trends and to
knowledge of the business.
(iv) Recalculate cash receipts from credit sales from revenue figures in
profit forecast and ageing structure of receivables.
(v)
Verify that the 10% discount for cash payment has been taken into
account when calculating cash received from cash sales.
(vi) Enquire as to who Apricot's major customers are and confirm that they
are to continue trading with Apricot, eg that none are going into
administration.
Operating cash payments
(i)
Confirm that forecast is prepared on the assumption that all purchases

are paid for within 30 days.
(ii)
Confirm that 12% supplier discount is received from suppliers'

invoices, supplier statements, etc.
(iii) Confirm that forecast is prepared on the assumption of receiving the

12% supplier discount.
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(iv) Verify the accuracy of the statement that suppliers are paid within 30
days by reviewing aged payables analyses for historical information.
(v)
Agree the salary payments to payroll information.
(vi) Review the overheads to ensure that non-cash items such as

depreciation are not included.
(vii) Enquire as to the reason for no outflows for taxation (eg Corporation
Tax, Sales tax).
Other cash flows
(i)
Agree the cost of the licence to supporting information from the health
and safety authority, and confirm the cost of Rs. 35,000.
(ii)
Enquire as to the likelihood of actually receiving the licence whether

the inspection will be passed. For example: if the inspection has
already taken place, ask what the result was; if it has not taken place,
consider the use of a health & safety expert.
(iii) Agree the fixtures outflow of Rs. 60,000 to underlying information, eg

to supplier quotations.
(iv) Confirm that the fixtures outflow will take place during March this
seems unlikely given that the premises will only be bought on 30
March. This may cast doubt over the reliability of other information in
the forecast.
(v)
(2)
Agree the Rs. 500,000 to be paid for the premises to documentation

and verify that it is complete.
In accordance with the requirements of SLSAE 3400, the report should

contain the following:
(i)
Title and addressee
(ii)
Identification of the prospective financial information (PFI) being

reported on
(iii) A reference to the purpose of the PFI, which in this case is to provide
assurance to Pik Choi's financial advisor regarding Apricots cash flow
forecast
(iv) A statement of negative assurance as to whether the assumptions
provide a reasonable basis for the prospective financial information
(v)
110
An opinion as to whether the prospective financial information is

properly prepared on the basis of the assumptions and is presented in
accordance with the relevant financial reporting framework
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(vi) Date of the report, auditor's address and signature

(3)
The accountant's liability for reporting on PFI
A report on PFI can only provide negative assurance because of its subjective
nature as it is based on assumptions of future results.
To determine whether the firm is liable, the criteria generally applied are
that the firm is liable to persons with whom there is proximity only or whose
relationship approaches privity and to persons of a limited group for whose
benefit the information was supplied or who knew that the recipient was
going to receive the information and to persons who can reasonably be
foreseen to rely on the information.
To reduce the liability, the accountant must ensure that the report contains
sufficient caveats as to the achievability of the forecasts. The report should
also refer to the fact that the engagement was undertaken in accordance
with SLSAE 3400 The examination of prospective financial information (or
relevant national standards or practices applicable to the examination of
PFI).
The report should include a statement that it is the management who is
responsible for the prospective financial information, including the
assumptions on which it is based, not the assurance firm.
Another important point to include is that the information is for restricted
use, so it should include who it has been prepared for and who is entitled to
rely on it. Reference should also be made to the fact that the engagement to
review the PFI was undertaken in accordance with the terms of the
engagement.
The terms of the engagement should include an appropriate liability cap. In
some cases, it may be possible to obtain indemnity from the client in respect
of claims from third parties.
(4)
Ethical and professional issues
The issue is whether there is a self-review threat, as the valuation of the

amount recognised would be recognised in the financial statements. The CA
Sri Lanka Code states that where the valuation service relates to a material
amount in the financial statements, and the valuation involves a significant
degree of subjectivity, the self-review threat created could not be reduced to
an acceptable level. If this is the case, the firm must choose between
providing the audit and providing the valuation service.
The firm therefore needs to assess the materiality of the figure, and the
degree of subjectivity involved. If it considers that safeguards could reduce
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the threat to an acceptable level, then it can go ahead with both the audit and
the valuation service. Safeguards may include:
Using separate personnel for the valuation service and the audit
Performing a second partner review
Confirming that the client understands the valuation method and the
assumptions used
There is a further question over whether an audit firm would be likely to

possess the requisite competence to provide such a valuation service.
Professional competence and due care is a fundamental ethical principle,
which in this context would mean that the firm should only do work which it
is professionally qualified to do. The firm would therefore have to ensure
that it could perform the work competently.
15 Beech
(1)
Fir Plc
Matters to consider
LKAS 16 Property, plant and equipment requires that where there is an

obligation to dismantle an asset, then the costs of doing so should be
provided for, and included in the cost of the asset. The question here is
whether an obligation exists in accordance with LKAS 37 Provisions,
contingent assets and contingent liabilities. It is not sufficient for Fir merely to
'intend' to incur the costs, rather; there must be a legal or constructive
obligation as a result of a past event. If there is no such obligation, then no
provision should be recognised.
The provision should be for the present value of the future outflow of
economic benefits. Measuring a provision for costs to be incurred in 20years' time is inherently risky. For example, the cost to be incurred may only
be an estimate; the remaining useful life of the power stations is definitely
just an estimate; the selection of a discount rate to calculate the present
value involves judgement and is therefore not certain.
The provision has decreased in value since last year, which is unusual as
provisions normally increase over time as the present value is built up. This
could mean that circumstances have changed, or may signal new
measurement assumptions being made. It may also be a sign of profitsmoothing, as earnings have effectively been shifted from last year's
statement of profit or loss into this year's. The reasons for this need to be
investigated.
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The note to the financial statements does not conform to LKAS 37's
requirement to provide narrative information, including disclosure of the
reasons for making the provision together with any uncertainties in relation
to them. The notes should also analyse the movement in the year. Unless this
is remedied then this is a material misstatement which may lead to a
qualified audit opinion.
Audit evidence
(2)
Review of evidence that there is an obligation to dismantle, eg from

regulatory authorities.
Review of management's calculations used to measure the provision,

considering their consistency with other audit evidence obtained (eg
that the remaining life of the assets is 20 years).
Review of documentation supporting management's assumptions (eg

to support the estimated cost of decommissioning).
Discussion with management about reasons for the fall in the

provision, and evaluation of these reasons (eg regarding SLFRS,
knowledge of the entity).
Spruce Plc
The expert should have been provided with clear written instructions
covering the objectives of the work and any specific issues to address. The
first procedure would therefore be assessing whether the work done meets
these objectives, whether it has been performed in accordance with any
standards specified, and that it is consistent with the applicable financial
reporting framework.
The expert's work should be reviewed to confirm that the correct source
data was used, and that it relates to the right financial instruments in the
right period. Any assumptions made by the expert should be compared with
eg similar assumptions used by management in preparing the financial
statements.
Any evidence contained in the report should be reviewed for consistency
with our understanding of the entity and with other audit evidence obtained.
Evidence used by the expert should be agreed to supporting documentation,
and any calculations contained in the work should be reperformed, eg fair
value movements.
The appropriateness of any models used by the expert should be evaluated.
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(3)
Pine Plc
LKAS 8 Accounting policies, changes in accounting estimates and errors

requires a change in accounting estimate to be accounted for prospectively,
not retrospectively as has been done here; retrospective accounting should
only be used for a change in accounting policy.
There should be no change to opening assets or equity; these are therefore
materially misstated here (overstatement). The extension of the properties'
useful life would probably decrease the depreciation expense, resulting in an
overstatement of profit. Also it is not clear why all of the properties' useful
lives have been extended; LKAS 16 requires that the useful life is the period
over which an asset is expected to be used. There is a risk that the useful
lives used are not appropriate, and that the financial statements are
materially misstated.
LKAS 8 requires disclosure of the nature and amount of the change in
estimate; as this has not been done, there is a material misstatement in
respect of LKAS 8's disclosure requirements.
The matter should be discussed with management, who should be asked to
amend the financial statements. If satisfactory amendments are not made
then the auditor's report will contain a qualified opinion. This will be 'except
for' a material misstatement, as the amount is material but not pervasive.
The opinion paragraph in the auditor's report is headed 'Qualified opinion'.
Immediately before this is a paragraph headed 'Basis for qualified opinion',
which describes the matter giving rise to the qualification and quantifies the
effects of the misstatement.
(4)
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Poppy Plc
Inspection of the written instructions given to the valuer by Poppy

which should include the objectives and scope of the work, the
intended use of the valuer's work and the extent of the valuer's access
to records and files.
Consideration of the assumptions and methods used by the valuer to

ensure they are reasonable based on other audit evidence and the
auditor's previous knowledge of Poppy.
An evaluation of the method used to measure fair value to ensure

consistency with LKAS 40.
Examination of the valuation report to ensure each property has been

valued consistently and that the date of valuation is reasonably close to
Poppy's year end.
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Physical inspection of the valuation properties to ensure their

condition is in line with the valuation report.
Inspection of purchase documentation for the investment properties to

ensure that any revaluations made in the year of purchase are
reasonable and not significantly different from the purchase price.
A review of subsequent events for additional evidence on the valuation

of the investment properties.
Written representations from management concerning the

reasonableness of any stated assumptions in determining fair value.
Evaluate the appropriateness of that expert's work as audit evidence

for the relevant assertion.
16 Seatown
(1)
Economy
Costs of labour
Controlling labour costs will be an important element of economy. The

council needs to break labour costs down for sweeping the sands and
emptying the bins. To judge whether the costs are being limited sufficiently,
the council will need to compare actual costs with benchmarks. These
include comparing actual costs with budget, with costs of previous
years, with comparable costs for the other areas of the councils activities
and costs incurred by other councils responsible for beaches. The councils
management will need to investigate fluctuations from any of the expected
benchmarks.
The councils management accounting data should provide most of the
information required, assuming that a proper system of budgeting is in
place. It should be possible to obtain labour cost information from other
councils.
Costs of machinery
Similar comparisons for labour costs should be made for machinery costs
such as vehicle running costs. The analysis made will need to take into
account the cost drivers such as the number of tractors and the number of
vehicle miles covered.
As well as management accounting cost information and budgets,
details of vehicle miles covered will also need to be maintained.
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Efficiency
Efficient use of labour and machines
The council needs to find out how resources are being used. It needs to know
how much time is being spent sweeping the sands and how frequently
bins are being emptied. The actual frequency of emptying bins should be
compared with the standards the council set, to review whether bins are
being emptied more frequently than required or whether the schedule for
emptying bins is unrealistic.
It would also be helpful to have more detail about how much time is being
spent on different areas. Some beaches may be more problematic to clean
because of obstacles such as rocks. The time and costs spent on these
beaches could be reduced by limiting access to them to popular times of the
year. To judge efficiency fairly though, the council will also need to take into
account the area of different beaches and the number of litter bins.
Employees will need to maintain detailed records of the time spent on
each beach and when they empty the litter bins. It will also be important
to keep the permanent data, the areas covered by cleaning and the number
of litter bins, up-to-date.
(2)
Quantity of refuse collected
The council will need to ascertain how much refuse has been collected. Again
it will be helpful if the refuse collected from sweeping can be recorded
separately from the refuse collected from bins, in order to judge both
activities fairly. When quantities are reviewed over time, it will be useful to
see how much the litter generated is proportionate to the number of
visitors. The Council should also try to identify whether other seasonal
variations have a significant influence (visitors being less likely to
consume food and hence drop food litter during the autumn and winter, and
also fewer refreshment kiosks being open during these seasons). The council
will need to assess whether more staff resources are needed at the busiest
times of the year to keep the litter under control.
Records kept will therefore need to include the quantity of litter disposed of
each week. There are various ways in which the number of visitors can be
estimated, including number of users of tourist information centres, car
park records and estimates based on physical space occupied by each
beach user.
Quantity of refuse not collected
As well as assessing how much litter has been collected, the council needs to
have an idea of whether all litter has been collected from the beach (or
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how long litter remains on the beach before it is collected). Complaints or

feedback from beach users will give indications. Management also needs to
consider whether litter bins have been emptied frequently enough to
avoid overflowing. It should be possible to compare records of how
frequently litter bins have been emptied compared with the standards set
by the council. Management should investigate if bins are being emptied less
frequently than required by standards.
The council should maintain records of complaints it has received about
litter, ratings made by external parties and other indications of problems,
for example adverse media comment or injuries caused by litter left on the
beach. The council should also try to collect feedback systematically
throughout the year from visitors, for example through issuing
questionnaires in tourist information centres.
Spot checks of beaches after sweeping and of bins, particularly during the
busiest seasons of the year, by internal audit will also provide evidence of
whether litter is being collected thoroughly and promptly. Spot checks of
beaches will need to distinguish between different types of litter. Larger
items, or items that could cause injury, will be of most concern. This will also
help determine whether the standard frequency for emptying bins is
appropriate and whether the frequency should vary at different times of the
year.
17 WWW
(1)
Situation 1
Integrity This situation could be in conflict with the fundamental principle
of integrity.
CASLs Code of Ethics highlights that the principle of integrity requires

accountants to be honest, straightforward and truthful in all business
relationships. The principle of integrity also implies that accountants should
not be associated with any information which they believe contains a
materially false or misleading statement, or which is misleading by
omissions.
Contain a materially false or misleading statement The CEO has
presented a very optimistic forecast for WWWs profits, but this could be
misleading if the governments claim for damages against the company is
successful.
Omits information where such omission would be misleading
Although the governments claim for damages would materially affect
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WWWs profit for 20X3 if it were successful, the CEO did not mention the
claim in his presentation to the analysts and journalists. This omission is
therefore misleading, because it prevents his audience from being aware
that WWWs profit for 20X3 might be materially lower than the figure given
in the forecast.
Tutorial Note:
The principle of integrity also requires professional accountants to

disassociate themselves from statements or information which have been
furnished recklessly.
Contain statements or information furnished recklessly The CEO
prepared his forecast in a hurry, and did not check the figures with anyone
else in WWW. Given that WWW is an international company, the CEO could
be seen as reckless for presenting a forecast without asking anybody else in
the company to confirm it. Such actions suggest the CEO has perfect
knowledge of the company and its prospects, but that seems very unlikely.
Advice:
The CEOs forecast and presentation demonstrate the characteristics of

communications which conflict with the principle of integrity. The CEO has
not been honest in his dealings with the analysts and the journalists, and
therefore Situation 1 represents a conflict with the principle of integrity.
Situation 2
Confidentiality The principle which could be jeopardised here is
confidentiality. The Code requires accountants and firms to refrain from
disclosing, outside a firm, confidential information which has been acquired
as a result of business relationships with that firm.
Many of the documents which the Governments lawyers have requested

contain confidential information, which suggests there could be a conflict
with the principle of confidentiality if they are handed over.
Exception: Legal proceedings However, the Code makes an exception to
the principle of confidentiality in the context of legal proceedings. In others
words, the principle of confidentiality is not breached if confidential
information is disclosed when it is required in the course of legal
proceedings.
This is the case in Situation 2. WWW has been required to produce the
documents as a result of the court order obtained by the Government.
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Advice:
Although the documents contain confidential information, Situation 2 does

not represent a conflict with the Code.
Situation 3
Objectivity The principle which could be at stake in this situation is
objectivity.
The principle of objectivity requires accountants not to allow bias, conflict of

interest, or the undue influence of others to override their professional or
business judgements.
Reasons for financial controllers decision - The financial controllers
advice about discontinuing the joint venture appears to have been driven by
the poor working relationship between the accounting staff in the two
companies, and the problems which ZZZ has caused the financial controller
and his staff.
By contrast, the financial controller does not appear to have considered the
profitability of the joint venture, or the commercial benefits to WWW of
continuing with it.
Conflict - In this respect, it appears that financial controllers decision has
been biased as a result of the problems which he and his staff have
encountered in working with ZZZ.
Advice:
This situation represents a conflict with the Code, and specifically with the
principle of objectivity.
(2)
WWW could use the following stages for resolving ethical conflicts:
Establish the all relevant facts and information
Identify the ethical issues which are involved, and identify the
fundamental ethical principles related to the matter in question. These
principles should be identified in WWWs published Code of Ethics, but
alternatively WWW could refer to a Code published by a professional body
such as CASL or IFAC (in its Code of Ethics).
Follow procedures Where possible, WWW should follow its internal
procedures when enquiring into the ethical conflict.
Identify potential courses of action WWW should investigate possible
courses of action which it could use to resolve the conflict, and should
consider the potential consequences of each possible course of action.
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The following questions could be relevant here:
Can the conflict be resolved?
What are the consequences if the conflict is not resolved?
What stakeholders are affected by the conflict, or will be affected if it is

not resolved?
Consultation In order to help answer these questions, WWW needs to

consult all the stakeholders who are affected by the conflict.
Resolution Once WWW has established all the relevant facts, and
considered the consequences of each possible course of action, it should then
determine the appropriate course of action to resolve the conflict.
External advice If WWW is not able to resolve the matter internally, it
may need to seek external advice, either from its legal advisors, or from a
relevant professional body (such as CASL).
Compromise However, it is important for WWW to recognise that, in some
ethical conflicts, there may not be a way of resolving the conflict which is
entirely wholly acceptable to all stakeholders. The resolution is likely to
involving trading off the interests of one stakeholder group against those of
another. Therefore, it is almost inevitable that there will need to be a degree
of compromise in resolving the conflict.
18 VV
(1)
(i)
How ESOSs (Executive Share Option Schemes) work

ESOSs are designed to provide incentives for directors to manage a
company in a way that ensures its share price increases. If the share
price exceeds the option exercise price at the date the options can be
exercised, then directors can buy shares at less than market price. They
can either then realise an immediate capital gain or retain the shares in
the hope that share prices will increase further. Directors will only face
an upside risk, because if the share price is less than the exercise price
when the option expires, they will not suffer any losses.
Agency
An ESOS is a way of aligning shareholder and manager goals.
Shareholder goals are often focused around share price, whereas
management will often focus on maximising their remuneration and
benefits. It should overcome the agency problem of having different
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owners and managers (directors), as the managers would enjoy the

benefits of ownership.
Impact on risk-taking
Efficient investors should have a diversified portfolio. They should
therefore be most concerned about the link between the risk and
return of the investments the company makes. However directors may
be more risk-averse than investors, as they are in VV. They may be
excessively concerned with the downside risk of projects, fearing that
they will be blamed if a project fails and they will lose their jobs. They
may evaluate projects at higher implicit rates of return than
shareholders, leading them to reject projects that shareholders would
regard as acceptable. They may not therefore invest in projects that
offer an acceptable combination of risk and return for shareholders. An
ESOS is designed to overcome this problem, by making directors
remuneration dependent on the returns of projects and hence
encouraging them to take into account the risk-return relationship.
(ii)
Share price rises

The options will only become valuable if share prices rise. In an
efficient stock market, the market value of a companys shares should
be determined by the long-term value of the investments it makes.
Therefore investing in projects with positive net present values should
mean that the companys market value should increase. This should in
turn mean that the value of share options should rise.
Long-term nature
The options cannot be exercised until 3 years after the date that they
are offered. This will mean that directors have to be concerned with
longer-term growth, rather than just focusing on the results for the
next year.
Exercise on specific date
Requiring options to be exercised on a specific date will mean that
directors have to ensure share price increases are sustained, to
guarantee increases in share prices. However directors may have an
opportunity to manipulate results and hence share prices around
the date of exercise. There is also the issue that different directors will
have options that mature at different times. This may cause
disagreement amongst the directors, for example directors who have a
lot of options coming up in the near future may fight plans that could
cause a short-term fall in the share price.
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Options lapsing on departures

Options lapsing on directors leaving the company will deter directors
from departing suddenly and hence losing potentially significant
rewards. This will help with long-term board succession planning, as
the nomination committee will not need to allow for a significant
possibility of directors leaving without warning.
(2)
Advantages of profit-related bonuses

Link with performance
Paying a bonus based on performance means that part of directors
remuneration packages are based on what they have achieved during the
year. Profitability figures provide a simple measure of feedback on
performance. Directors can be held to account if they have failed to reach
target profitability. Bonuses can vary year-by-year if performance varies.
They can be used flexibly to encourage and reward performance that is not
taken into account in long-term incentive schemes, but is still important.
Bonuses contrast with rewarding directors solely by salaries, as salary levels
are not determined by actual performance.
Clarity of disclosure
Readers of the accounts may find it easier to understand profit-based
bonuses than the rewards conferred by share-based schemes. Directors
motives may be clearer. The amount of information disclosed about
complex schemes may make their nature and scale difficult to understand.
Limitation of profit-related bonuses
The size of bonuses can be restricted to whatever limit is considered
desirable by shareholders. Under an ESOS, where the directors rewards
depends on the difference between share price and exercise price, the
maximum reward directors can earn is not limited by the company.
Disadvantages of profit-related bonuses
Manipulation of measures
Directors can use questionable accounting policies to distort profit. This
issue would become less significant if a range of different measures was used
to determine performance, so that manipulation of individual measures
would have less impact. However it would then be more difficult to decide
how important each measure used should be and whether the relative
importance of each should vary by individual director. A scheme based on
multiple measures might also be more difficult for shareholders to
understand.
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Encouragement of short-term outlook

Cash bonuses encourage directors to focus on annual, short-term,
performance. This may mean their decision-making is distorted from the
viewpoint of shareholders. Directors may choose shorter-term projects with
quick gains, rather than projects that offer shareholders the best
combination of risk and return over the longer-term.
Publicity
Large bonuses may be more likely to attract adverse publicity because they
are more visible. They may be particularly unpopular in a poor economic
climate when they are based on profits that have increased because of
cutbacks in staff.
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Section 2
1 Daily Newspapers
(1)
(i)
Reliability
Dailys reputation for producing reliable news may be threatened by
allowing subscribers to post on its site. What subscribers post will
not be subject to the same checks that a story in Dailys newspapers
would be subject. Subscribers may be more inclined to post doubtful
material on Dailys website than on personal blogs, because of the
wider readership it will have. If what is posted is untrue, Daily will
suffer by association, particularly if it is publicly known that Daily does
not carry out checks on the contents of its site. This may affect not just
the reputation of the Sunday newspaper, but all publications within
Dailys group.
Values
The brand values Daily promotes of quality reporting and information
may be undermined by comments on the website that some find
offensive, even though the comments are legal. Comments may not be
of high quality. The views may be based on dubious sources of evidence
or they may be badly written. However there are upsides to allowing
controversial comments to be posted. Some newspapers promote their
comment facility as encouraging free speech with views that do not
reflect the position of the papers being allowed.
Libel
Daily may be subject to the risk of damages for libel. Daily may become
liable once the post is made on the site. As posts are not validated in
advance, in theory subscribers could post very serious libels. Daily will
remain liable even if it subsequently removes the post, although this
may mitigate damages. Those libelled are more likely to sue Daily
rather than the person who posted the libel, because they will reckon
that Daily has greater financial resources. They may also be more
inclined to sue Daily in order to deter Daily from publicising further
libels.
Advertising and readership
Some advertisers may not be willing to associate with a site with
doubtful material. Some readers may stop accessing it if they find
the content offensive. Equally, however, if Dailys site is known to
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contain strong content, it may increase the number of readers who

access it.
Competitive advantage
Competitors may publicise problems that Daily has, in order to
persuade readers to switch to their papers. For example fans of pop
singer J may be angry about the comments made about her and may
stop buying Dailys papers as a result.
Conclusion on level and frequency of risk
Referring to the risk grid, likelihood of this occurring is 4-5 (as it has
occurred) and the consequences are likely to be moderate to major (3
or 4). This places the scores between 12 and 20 which places the
range almost entirely in the High Risk category. This means it should
not be tolerated and need senior management attention to ensure they
are controlled and managed immediately.
(ii)
Selective monitoring of stories

Although Daily considers that editing all posts would be prohibitively
expensive, it may be that it has to monitor posts on particularly
controversial stories where there is a very high risk of seriously
offensive or inaccurate posts being made. Daily would face massive
damages if celebrities were falsely accused on such a story. Possibly
Daily could introduce a time delay, so that posts do not go straight on
to the site live, allowing Daily the scope to block them.
Tightening terms and conditions
Daily should continue to insist that subscribers agree to terms and
conditions. As part of this, Daily should also require subscribers to
agree to take responsibility not only for anything that they post but
also anything posted from their log-in account. This will prevent
subscribers from claiming that they are not accountable as someone
else has used their account.
Monitoring of users
Daily must have full contact details for all subscribers. Daily must make
it clear that it will close the account of anyone who is found to post
offensive or libellous content. It should block anyone from using the
same email address to open a new account. It should also trace the
user back to the credit card details they have supplied and prevent
anyone with that credit card number from opening a new account.
Daily may also seek compensation from subscribers whose malicious
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or reckless posts have resulted in bad publicity or other damage for

Daily.
Reporting of doubtful material
Daily can attach a facility to all posts, allowing readers of the post to
report the post if they believe that the post contravenes Dailys rules.
The post can then be removed automatically until Dailys staff have
checked it. The problem with this facility is that it may be used
excessively, with readers reporting content with which they disagree.
Access controls
Daily could tighten controls over the security of accounts, to ensure
that they cannot be accessed by illegitimate users. Daily should not
allow the software to remember passwords so that users do not
have to enter them. Daily should require passwords to be changed
after a certain length of time. Passwords should consist of a
combination of numbers and upper and lower case letters to make
them less easy to guess. Users should only be allowed to enter
incorrect passwords a certain number of times before access to the
account is halted and the user has to re-register.
Publicity
Daily can make it clear on its website and when it is challenged that it
requires subscribers to adhere to rules that prohibit inaccurate or
offensive comment and that it will take appropriate action against
subscribers who contravene its rules. It could also make clear that it
will remove any content that contravenes its rules as soon as it is
identified.
(2)
(i)
Definition of ERM and how it operates in global business environment

Enterprise risk management is a process, effected by an entity's
board of directors, management and other personnel, applied in
strategy setting and across the enterprise, designed to identify
potential events that may affect the entity and manage risks to be
within its risk appetite, to provide reasonable assurance regarding the
achievement of entity objectives.
Internal control is a process effected by an entitys board of directors,
management and other personnel designed to provide reasonable
assurance regarding the achievement of objectives in the following
categories:
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Effectiveness and efficiency of operations

Reliability of reporting
Compliance with laws and regulations' COSO
Although COSOs guidance is non-mandatory, it has been influential

because it provides frameworks against which risk management and
internal control systems can be assessed and improved. Corporate
scandals, arising in companies where risk management and internal
control were deficient, and attempts to regulate corporate behaviour as
a result of these scandals have resulted in an environment where
guidance on best practice in risk management and internal control
has been particularly welcome.
Importance of robust framework
A robust risk framework includes a strong control environment and a
strong emphasis must be placed on the importance of risk management
and internal controls. This includes management style and corporate
culture and values.
Management style is particularly important at Daily because issues
such as expense claims are not closely regulated by rules. Therefore
the onus is on management to be prepared to set fair boundaries and to
stand up to staff, to say specific expenditure is not acceptable. If
management does not do this, there is a risk of an anything goes
corporate culture.
At the same time managers cannot be completely inflexible and have to
make allowances for the story and the contacts being established.
If, for example, the paper is seeking the views of a top businessman, it
may be necessary to entertain him at an expensive restaurant.
However a manager might question other contacts being taken there,
on the grounds that it is not necessary to obtain the story.
(ii)
Problems with staff being audited

Staff and managers may be very resentful at being audited, feeling that
the expenditure is necessary to do their job. Internal auditors may be
drawn into a lot of lengthy and heated discussions and the audit may
not therefore be carried out efficiently. Internal audit may be able to
reduce this problem by allowing staff to explain the reasons for their
expenditure, but may still face a lack of co-operation from staff. It is
the role of the internal audit team to build team co-operation and trust.
The appointment of a chief risk officer creates a strong sense to staff
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that risk management is being taken seriously from the board level
down to the newsroom floor.
Stifling of initiative
Auditor visits together with tougher attitudes from management may
result in expenditure being reduced. However the system could
become too bureaucratic. If rules about approving expenditure in
advance are enforced and policed by internal auditors, opportunities
may be lost if approval cannot be obtained quickly. Staff may become
fearful of incurring expenditure which may later be challenged and
therefore miss the chance to pursue a good story.
Auditor judgements
Internal auditors may find it difficult to make judgements about what
expenditure is unacceptable or doubtful, because of lack of effective
guidelines and limitations on the evidence. The expense claims they
review, for example, may show that a claim for meals in an expensive
restaurant is supported by valid documentation (that the journalist and
contact did go there) but not why that restaurant was chosen (whether
it was valid for the journalist to incur that expenditure). Auditors may
also have problems judging whether the explanation given for certain
expenditure justifies its level. For example, buying the latest
equipment may make journalists more efficient but does it justify the
amount of expenditure made?
Diversion away from other activities
Although the increase in expenses is legitimately a matter of concern,
Daily may be facing more significant risks in other areas. If internal
audit resources are limited, auditors may spend too much time on
expenses and not enough on other areas. Possibly a one-off drive to
bring journalists expenses under control may result in a reduction to
more acceptable levels and mean that there is less need for regular
internal auditor review.
(iii) Confusion over standards
Journalists may have been unclear as to what expenses they could
claim. The policies that are in place have never been effectively
enforced. Instead if journalists expense claims have always been
allowed, they may have assumed that in practice it will be fine to incur
whatever expenses are necessary to obtain a good story and
management will ignore any questionable expenses. Possibly also they
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have regarded the generous hotel and travel arrangements as a perk of

their job.
Weaknesses in local management
Journalists views on what constitute acceptable expenses have been
unchallenged by local management. Local management acknowledge
that journalists attitudes have changed, but managers have done
nothing to curb journalists increased expectations. Instead editors
top priority has been keeping journalists happy. Editors may be
motivated in this by a feeling that they will primarily judged by the
quality of stories in their newspapers, and it is worth paying greater
expenses to gain better stories and keep good journalists loyal.
Weaknesses in central management
The increase in expenses claimed has been apparent to Dailys central
management for some time. However no action has been taken to
enforce the rule book or budgets. The internal audit work being
planned is belated. It also appears that central management has not
given any support to editors who may have tried to enforce a tighter
expenses policy. The delay will make it more difficult to enforce a
stricter policy.
(3)
Switch to UK supplier
Costs
Costs of raw materials
The paper may be more expensive that it would be if Daily continued to use
its current supplier, who is relatively cheap. As, however, there are three or
four suppliers in competition for Dailys business, Daily may be able to
negotiate a good deal.
Pricing of deal
The fixed price deal will however have an additional cost element built into
it. The supplier will be aware that it will be bearing risks of adverse price
movements and not be able to pass these on to Daily for the period of the
deal. The pricing will therefore include a premium to compensate the
supplier for this risk.
Risks
Exchange risk
Dealing with a HK supplier removes an element of exchange risk for Daily.
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Commodity price risk

The fixed price deal will also remove uncertainty surrounding
commodity price movements and make cost budgeting by Daily more
straightforward. However Daily will not be able to benefit from
favourable price movements.
Reliability of supplier
The supplier Daily chooses may be less reliable than the supplier that Daily
has previously used. The level of product quality may be lower than its
current supplier provides. If the fixed price deal with Daily is a particularly
large one and the suppliers costs significantly increase, this may threaten
the suppliers viability.
Invest in US$
Costs
Costs of loan
As well as the interest that it has to pay, Daily will incur other costs if it takes
out a loan and makes an investment. It may incur set-up costs for both
accounts and also costs for transferring the money to the USA.
Rate of interest received
The interest received on the US bank account will not completely exceed the
increased cost of borrowing. There will therefore be an opportunity cost of
the return foregone through tying up the money in the bank account rather
than making an investment with a better return. Holding a large amount in a
hedging account may appear to investors to be a poor use of funds.
Risks
Translation risk
The arrangement will decrease translation risk by matching the interest on
the US bank account with the costs of supply.
Economic risk
Daily will be still be subject to economic risk if it continues to use the
Scandinavian supplier and its competitors have dealt with exchange risks in
other, more effective, ways and hence have lower costs. It can reduce
economic risk by using the monies in the US$ investment account to pay
for the paper, but a lower balance in the investment account may mean that
Daily receives a lower rate of interest. Longer-term hedging by this
method will eventually exhaust the money in the investment account.
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Take the risk

Costs
Costs of supply
The costs of the paper may be lower over the three year period than if Daily
enters a fixed price deal on less favourable terms.
Costs of changing supplier
Daily will not incur the costs of establishing a relationship with a new
supplier.
Risks
Exchange risk
Daily may suffer losses through adverse movements in the US$. However
it will also benefit from favourable movements in the US$.
Commodity price increase
Daily could also be exposed to increases in the cost of paper, although
again there is an upside risk that paper costs will fall.
Risks of price increase
If Daily has to increase its cover price as a result of adverse movements in
the exchange rate, the impact on demand for its papers will depend on the
price elasticity. If competitors are facing similar supply pressures, the
impact on Daily may be limited if competitors have to put their prices up as
well. However price increases may also have the effect of reducing overall
the number of customers who pay for newspapers. More customers may
obtain news from free papers, free websites or television news programmes.
2 Farama 1
(1)
(i)
Risks
The main risks F faces relate to its revenues, its costs, its
environmental performance and its reputation.
Set goals
The board has made the investment in order to enhance Fs social
responsibility performance. A clear upside risk is that the factory will
reduce Fs use of air travel. F needs to implement new measures, as the
steps it has taken so far were insufficient to meet its targets in 20X0.
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The investment in the factory is also intended to enhance profitability

and efficiency. However this has the downside risk of threatening Fs
reputation because of the possibility of redundancies in Farama.
Identify risk areas
If Fs reputation as an eco-friendly company improves as a result of the
investment, it could have the upside risk of increased sales to
environmentally-concerned consumers. There could also be a
decreased risk of criticism from environmental groups because F is
less reliant on air travel. However there is also an increased risk of
criticism from environmental groups because F will be selling fruit
and vegetables out of season.
F is also at risk of being criticised for taking jobs away from its main
market and relocating them to a lower-wage economy.
Understand and assess scale of risk
Given current environmental concerns, F is at risk of suffering bad
publicity from environmental groups for operating an unsustainable
business model that is reliant on selling vegetables out of season.
They may ignore the reduction in air travel, particularly if F still fails to
publish its annual environmental report externally. Whether these
criticisms translate into significantly reduced sales to consumers is
questionable.
F may also be particularly at risk of being criticised for exploiting
labour in Africa because of the previous bad publicity about its
treatment of its African suppliers. This may be more likely to result in a
consumer boycott and reduced sales, particularly when combined
with the adverse publicity about the redundancies.
Develop risk response strategy
Fs board appears to be well aware of the need for a strategy to
manage its environmental impact, as demonstrated by the
appointment of the Environmental Effects Manager.
It my now need to consider the need for a strategy of publicity
campaigns for its CSR policies. Generating this publicity should not
cost very much. F may however face a risk of increased costs,
depending on the actions that are required to justify the publicity.
(ii)
Publicity strategy
F needs to implement a clear publicity strategy that explains clearly its
CSR objectives. F should stress publicly that the reasons for
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establishing the factory in West Africa are to act in a more socially

responsible manner by reducing air travel. It should also publicise
the jobs it is creating and the college courses that are going to be
established, to demonstrate that it is investing in the African economy.
Its CSR stance will be enhanced by greater transparency, including
publication of its environmental report within its annual report.
Informing domestic staff
F needs to keep its domestic staff informed of what is happening
because of the uncertainty over their jobs. In particular it needs to
communicate well with the skilled staff who are unhappy about the
possibility of working in Africa. It also needs to have a strategy for
retaining skilled staff whose expertise F particularly needs. This could
include greater financial incentives and limiting the period the staff
spend on the 4 weeks-2 weeks regime. F should also make every effort
to find alternative employment for domestic staff whose jobs will
disappear as a result of the switch to Africa, by giving them preference
when internal vacancies are advertised.
Employment conditions in Africa
F may be able to limit the criticism of exploiting labour in Africa by
paying labour of all classes more than the local market rate. It should
also ensure that other labour conditions, such as hours of work, are
generous compared with those offered by other local employers.
Healthy products
To counter the bad publicity from selling out-of-season vegetables, F
should advertise the health benefits of these products. It should
also stress the environmental advantages of freezing the goods where
they are harvested.
(2)
Governance
F needs to obtain evidence that colleges management is committed to
supporting and promoting the courses. This includes a strategy of
publicising the courses and a guarantee that courses will not be cancelled
because of low numbers and other reasons.
F also needs to establish what arrangements management has in place for
monitoring the quality of courses. This includes review of tutor teaching
and of the quality of courses notes and support facilities. The colleges
should seek feedback from students, as well as responding appropriately to
feedback from F itself.
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Staffing
F should obtain evidence from colleges that they will be using tutors with
relevant qualifications and experience in the subjects in the programme.
The tutors should be undertaking continuous professional education.
F should establish what contingency arrangements colleges have if staff go
absent or leave suddenly.
F should also confirm with colleges what the staff-student ratio will be on
courses and also how much teaching staff are expected to do. F would want
to ensure that staff have sufficient contact and support time with
students.
Support facilities
F should find out what colleges have in terms of libraries and IT facilities. F
should assess whether these are adequate to support the planned course
programme.
F should ascertain whether libraries have purchased up-to-date copies of
textbooks, and whether colleges plan to upgrade IT facilities.
Course content
The syllabus needs to be clearly defined by the college and publicised to
students. The syllabus should include clear learning objectives that are
related to the requirements that F has. This should be supported by a
detailed learning guide that enables students to understand what they are
expected to know. The course material that students are given should be
clearly linked to the syllabus.
The exams students sit during the course should fairly and appropriately
test the knowledge and skills that students have. Fs staff should be involved
in the oversight of the exams. The quality of exams should be verified by
independent external examiners, who should be academics also with
industry experience that is relevant for Fs needs.
Placements at the factory or a sandwich structure should be built into the
course design for all students, to enable them to experience the practical
application of what they are studying. This would also enable F to assess
whether students have sufficient knowledge and application skills, and
feedback shortcomings to the colleges.
(3)
Resource planning
The development of the new system needs to be timetabled carefully, with
deadlines that match Fs requirements as the factory opens. Delays and
consequent problems with inventory management could be expensive.
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F will also need to ensure that staff with sufficient IT expertise are used to
design the systems, write the software, and be involved in the testing
process.
Analysis
F should ensure that the new system is based on an analysis of the
information F will need in the future, taking into account the views of
management, the accounts team and operational staff. The analysis should
include assessment of the training and documentation that will be required
for the new system.
The analysis should also take into account the problems F has had with its
inventory control and information technology. As well as being influenced by
the new requirements, will the systems changes attempt to remedy the other
current problems with inventory management?
Design and specification
The system design will need to specify the inputs and outputs required for
the system and incorporate the new basis for inventory management. It will
need to make clear what changes are needed from the old system.
Management and internal audit should review and sign off the specification,
confirming in particular whether it appears to meet the enhanced
information needs of the business.
Testing
The new system should be tested by IT staff and also operational
management and staff based both in Farama and in Africa. These tests need
to obtain evidence that the system will be a sufficient basis for the new
approach to inventory management.
Internal audit should also be involved in the testing process. Internal
auditors should assess whether the system can generate a sufficient audit
trail for their needs. They should also review the results of other tests, and
whether the development process has taken into account problems found.
Training and documentation

Full user documentation should be prepared for the new system. The
documentation should highlight changes from the previous system and
should act as a basis for future changes that are required in the system.
A training programme for all sales and logistics staff that have to use the
system should be timetabled for before the system is implemented. This is
likely to involve Head Office IT staff having to go out to Africa for a period to
train local staff.
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Implementation
A direct changeover to the new system would be risky for F given its
previous IT problems, but may be the only practical solution. Parallel
running of the old and revised system would be difficult because the two
systems do not completely match.
F should conduct a post-implementation review, focusing on the number
of errors found and whether managers and staff find the information the
revised system produces to be for sufficient for their needs. This review may
form the basis of a more limited subsequent update of the system.
(4)
Farama loan risks

Currency risks
Impact of matching
The interest payments will be in F$, matching the revenues in F$ earned
from food sales. This will avoid the currency risks arising from the interest
payments being in a foreign currency.
Operating risks
F will however be vulnerable to currency risk on the operating payments it
makes in the local currency, such as staff wages. If the West African currency
strengthens, these costs will become more expensive.
Non-currency risks
Borrowing limits
At 31 December 20X0 F was close to the limit of its revolving credit facility.
Taking out the loan to build the African factory may come close to exhausting
the facility and mean that there is a risk that loan finance will not be
available for profitable opportunities in Farama.
Lack of collateral
F may also face a risk that its Farama borrowing opportunities will be
restricted by the reduction in available collateral resulting from the
pledging of Farama assets to secure the loan for the factory.
Realisation of security
If the factory is appropriated or destroyed, F will be at risk of having to
realise the Farama assets on which the loan is secured to repay the loan.
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Foreign loan
Currency risks
Exchange risks and interest rate
If the currency of the West African country strengthens against the F$, the
interest payments in that currency will become more expensive, as well as
the operating expenses (discussed above).
Translation risk
The loan from the government will have to be translated in Fs annual
accounts at the year-end exchange rate. However the cost of the factory will
be translated at the exchange rate on the date of the expenditure on the
factory. If the currency of the West African country strengthens against the ,
the cost of the factory will no longer be fully offset against the loan. There
will be a translation loss shown in the accounts, which may concern
shareholders.
Non-currency risks
Change in loan terms
A change in government or a change in the policy of the current government
may result in higher interest costs if the government can charge interest at
a floating rate. However the risk of this happening may be limited if the
government feels that it would threaten Fs servicing of the loan.
Collateral
The pledging of the factory in Africa is unlikely to concern Farama
lenders. Therefore F will face a low risk that its Farama borrowing
opportunities will be limited by pledging the factory to the government.
Appropriation of factory
The risk of appropriation of the factory by the current or a future
government may be decreased by the loan that F has with the government.
Appropriation would put the repayment of the loan in jeopardy. The
government may also be less likely to misappropriate the factory if it
threatens local jobs and the local economy.
Interference by government
Again F may only face a low risk of excessive government intervention in
other ways (through burdensome regulation) if the government fears it will
mean F pulling out of the country and the loan being jeopardised.
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3 Farama 2
(1)
(i)
Adverse press coverage

Likelihood
F has already suffered adverse press coverage even if no legal and
regulatory action is ultimately taken against it. The fact that a number
of elderly people have been taken seriously ill makes the story
much more newsworthy.
Impact
If papers run frequent food scare stories, older stories may be
forgotten quite quickly by most of the public. However the fact that
elderly people were taken ill may particularly damage F as it is trying
to increase its sales to welfare organisations for the elderly. These
organisations have a duty to keep track of potential problems and
reduce risks where possible, and so sales to this sector may be affected
for longer.
Government investigation
Likelihood
The Farama Food Standards Authority will certainly complete its
investigation into the two food products, because of the possible
threat to health. F may also face the threat that the investigation is
extended to other products if it reveals widespread problems in the
Meals Division.
Impact
F will probably suffer a threat to its reputation for as long as the
investigation takes place. The uncertain situation may damage sales.
If F does not stop selling the products, it could also develop a
reputation for being unethical, putting Profits ahead of people. An
adverse verdict may well cause a collapse in the sales for these
products. If F is exonerated, this is unlikely to receive the same amount
of coverage.
Legal action
Likelihood
F may be liable to legal action by those who have become ill from
eating the meals. The likelihood of this risk will be related to the
results of the investigation by the Farama Food Standards
Authority. If the authority exonerates F, then legal action is unlikely to
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succeed. The risk may also be limited if those who suffered ill-health do
not have the financial resources to bring a civil action.
Impact
If F settles with claimants before the case comes to court, it could suffer
bad publicity for having acknowledged liability for poor practices. If
legal action does come to court however, the threat to reputation
may be longer-lasting. Press coverage may keep the story fresh in the
minds of the public. Even if F is cleared, evidence in the court case
could still damage its reputation.
Loss of sales
Likelihood
As well as affecting sales of the two products, F may suffer a threat to
sales of any of other products, even if there is no evidence that they
could threaten customers health. The likelihood of this occurring may
depend on the attachment the public has to other products and
whether they can easily be substituted.
Impact
The impact on sales is potentially large, as it may affect any of Fs
products. The public is unlikely to be concerned about which division
of F manufactured the products.
(ii)
All products contain these bacteria

Public fears
The problem with highlighting the fact that all the products contain
bacteria is that the public may be scared off by the products by this
admission by itself, particularly because of the link between the
bacteria and severe illness. The public may not appreciate the
qualifications about the bacteria being a common organism.
Cooking properly
Emphasising the need to cook the products properly may only act to fix
in the public mind the damaging idea that the products need to be
handled with care. This issue may be made worse by the fact that F
has been investigated for inaccurate labelling, indicating to the public
that they cannot rely on the information on the packaging.
Highlighting concentration in competitors products
If F emphasises that its competitors products have higher
concentrations, the impact could be a fall in demand for all products
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of this type, Fs and its competitors. In addition competitors have an

obvious response, that their products are not under investigation, but
Fs are. Fs competitors could use this as a basis of a positive marketing
campaign, damaging Fs sales, although this might prove to be risky if
the competitors products subsequently suffer the same problems.
Legal defence
If F uses the legal argument that it complies with all relevant hygiene
regulations, this may not impress the public. Many of the public may
believe that F should be concerned with taking effective action to
prevent any threat to health and going beyond hygiene regulations if
necessary.
Conclusion
This argument is not suitable, as it is unlikely to remove public fears
about this type of product.
Negligence by charity
Public fears
A common problem with the other defence is that this argument
further reinforces in consumers minds the harmful nature of the
bacteria.
Passing the blame
Trying to shift the blame onto any user may be counter-productive
for F. Some of the public may take the view that F should not be selling
products containing these bacteria, particularly as many of the
products sold are ultimately for elderly people who are particularly
vulnerable to this bacterium.
Appeal of charity
The damage to reputation may be further enhanced by Fs attempts to
blame the charity. Many of the public are likely to contrast the good
work the charity is doing with Fs aim of maximising profits. They
may believe the charity must be innocent or believe that F should have
liaised more closely with the charity. The public may also dislike F
mounting a publicity campaign against charity workers who cannot
defend themselves.
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Inaccurate instructions
As with the other possible defence, the argument is undermined by the
investigation into inaccurate labelling by F and the belief that the
information it supplies is unreliable.
Conclusion
F may suffer additional damage to its reputation if it uses this
argument and therefore it, too, is unsuitable.
(2)
(i)
Impact if recipe is stolen

If someone who knows the recipe joins a rival and leaks it, it may be
difficult for F to detect that its recipe had been copied. It may not be
obvious from the taste of the product or the labelling. However a
marketing campaign by the rival promoting the new taste of its pies
may be unlikely, since it would draw Fs attention to the possibility that
copying had occurred. In addition the advertising costs may also deter
competitors.
Lifecycle factors
How much impact the secrecy of the recipe has on sales now is
debatable. The pie has been established for many years. Most sales
may well be to consumers who have been eating the pies for a long
time rather than to new customers. If there is an aura around the pie
that helps enhance its sales, this may be due to its traditional taste
rather than the secrecy of the recipe. Competitors may have analysed
the pie legitimately and produced a recipe for their own pies that is
very close to the secret one.
(ii)
Security of tenure
Recording of recipe
The recipe could be held in a secure location and brought out only if
there was no-one left who knew the recipe. This would mean that F had
a fall-back copy to which it could refer. It would also mean that the
recipe did not otherwise need to be written down and become more
vulnerable to theft as a result.
Non-disclosure agreement
The two individuals who know the recipe could be asked to sign a nondisclosure agreement. Although this would not guarantee stopping
them leaking the recipe, knowledge that there might be legal
consequences might be a deterrent.
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Staff issues
One way to stop those who know the recipe leaking it to a rival
company is to ensure that they are content working for F by
rewarding them well. The board therefore needs to monitor the
behaviour of those who know the recipe carefully and investigate any
indications that they are unhappy. Employment legislation means that
F cannot prohibit, for more than a few months, directors or staff joining
a rival company.
(3)
(i)
Allocation of internal audit resources

Ultimately the board or the audit committee should decide on how
internal audit resources should be allocated. They would take into
account the recommendations of the head of internal audit. It is
important that internal audit maintains independence of the
operational departments being audited and does not grant any
requests they make automatically. However the operational
departments are stakeholders of the internal audit function.
Therefore internal auditors should carefully consider any reasonable
requests that they make.
Role of divisional management
However divisional management is entitled, and should be expected, to
raise issues relating to risk management that concern the board. Poor
inventory control caused by problems with the IT systems has been a
significant source of loss for F. It is therefore appropriate for
divisional management, and specifically the divisional management
accountant, to raise the issue and ask if action can be taken.
Investigation by the internal auditors to assess the extent of the
problem would be a logical step to take.
Liaison with external auditor
Fs staff also have a statutory duty to co-operate with the external
auditors and supply the information and explanations that they
request. Co-operation with the external auditors also assists the
efficiency and effectiveness of the external audit process. It appears
that the divisional management accountant is informing the external
auditor of a matter that would interest the external auditor and is
doing so for constructive reasons, to try to resolve the inventory
management problem.
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(ii)
Co-operation between external and internal audit

Auditing and corporate governance best practice envisages cooperation between the internal and external audit functions. The
audit committee should exercise oversight over both functions and
ensure that there is liaison between them. External auditors may be
able to make some use of internal audit work and therefore reduce
their own testing. An unnecessarily antagonistic relationship may
reduce the efficiency of external audit and push up its costs.
Purpose of external audit
However the statutory purpose of an external audit is to provide an
opinion on the truth and fairness financial statements. External
auditors work is directed towards providing this opinion and their
fees are set on that basis. Co-operating with the internal auditors on
review work on IT systems that do not impact on the accuracy of the
financial statements goes beyond the terms of engagement for the
external auditors. Therefore the fees for the work would have to be
negotiated separately.
Monitoring of internal audit
External auditors should also be careful about co-operating with
internal auditors, as external auditors have a general duty to maintain
independence of management, since they are reporting to
shareholders. In particular, as part of their work on the audit of the
accounts, the external auditors will assess the controls that impact
upon the reliability of the financial statements. This includes the
internal audit function, with external auditors assessing the staffing,
knowledge and skills of the department, the scope of its work and
how much reliance can be placed on what it has done. As a result of
this review of controls, external auditors may discuss weaknesses in
controls that they have noticed during the audit with management, as a
by-product of the audit. They will not however be involved in dealing
with the weaknesses, which will be supervised by the board and also
involve internal audit.
(4)
Exchange risks
Arguments against hedging
Diversification
F is well-diversified in terms of the countries it uses for supplies and hence
the currencies in which it deals. Currency movements against many
currencies may be more likely to even themselves out. Because many of
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the supplies that F uses come from a number of countries, F could possibly
change its countries of supply as a result of currency movements, although
this could mean F is not able to establish long-term relationships with
suppliers. It may also impact on the quality of supplies, which is one of Fs
major strategic concerns. Changing suppliers may also impact on other
objectives, for example the CSR objective of reduction of air travel.
Costs
The cost of derivatives to manage specific transaction risks may be high. If F
used derivatives regularly, it would probably have to employ costly treasury
expertise. Use of derivatives would mean that F could not take advantage of
favourable currency movements.
Arguments in favour of hedging
Certainty of cash flows
Use of derivatives to manage the risks relating to large transactions with
suppliers would mean that the cash flows for F would be guaranteed. This
would mean budgeting would be more predictable and pricing decisions
would not have to allow for variations in cost.
Competitor reaction
F has assumed that its competitors will react in the same way as it does to
managing currency risk. Its competitors may however take better decisions
when changing their supply policies in the light of currency movements.
Competitors may also be prepared to absorb larger fluctuations in
exchange rates than F before putting prices up. If F increases prices before
its competitors do, it may suffer unpredictable falls in demand as a result.
Price taker
F may in any case not be allowed to pass on currency movements in the
form of price rises. Significant customers, such as large supermarkets, may
be able to insist that F keeps its prices down.
Conclusion
Because of the tight margins under which F operates, the certainty of cash
flows that derivatives on large transactions offer may mean their costs are
acceptable. If F continues not to hedge, the board needs to ensure that F has
a flexible supplier management policy and an effective strategy for
responding to competition.
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4 Aybe 1
(1)
(i)
Liability for crashes

If a car manufactured by Q crashes, then SPD could be held liable for
the failure of the circuit board. If a crash happens, it may be difficult to
tell whether and why a circuit board has failed and it may be difficult
for SPD to prove it was not responsible. This risk is increased by the
functioning of the circuit board being dependent on factors beyond
SPDs control. It includes a component manufactured by Q, a supplier
that SPD has not selected. SPD also has no control over how the circuit
board is fitted in the finished car, or how conscientiously the car is
maintained.
Reputation risk
Even if SPD is not held liable for problems, it may suffer a serious loss
of reputation if cars manufactured by Q have safety problems. Toyotas
problems illustrate that potential problems with car safety will be
widely publicised. However responsibility for the Gulf of Mexico
disaster is allocated, there is no doubt that BP and the other companies
involved have all suffered damage to their reputation. If there are
problems and SPD is blamed by Q or the supplier, this will damage its
reputation even if the allegations are unfounded. The risk to reputation
is enhanced by how the cars are being marketed. SPD could be
criticised for being associated with a car with the appeal that it can
supposedly be driven safely at high speeds, although the speeds may
in fact make it more likely that its components will fail.
Problems with supplier
The component supplier may not deliver on time or its components
may be unreliable, causing delays in the production process. If the
supplier goes out of business, SPD and Q may have difficulty finding a
replacement supplier at short notice. Particularly if there are only a
few suppliers who can manufacture the component, a new supplier
may be able to charge a much greater price, threatening profit
margins on the contract.
Threats to profitability
The contract represents a major commitment of resources for SPD. If Q
goes out of business or changes its supplier, SPD will be left with
surplus staff. Commitment of technicians that are currently employed
to the contract may mean that SPD is forced to turn down more
profitable opportunities because of a lack of resources.
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(ii)
Liability for crashes

SPD could build a failsafe routine into the circuit board. This would
mean that the car could only start if the board was functioning
correctly. SPD should also carry out full and documented quality
testing on the circuit boards. It should either test the components it
purchases from the supplier itself, or insist that the supplier provides
evidence that it has tested the components. The agreement with Q
should make clear that SPD is not liable for circuit board failure caused
by problems with the manufacturing process at Q or inadequate
maintenance. SPD may wish to insure against legal costs if the
premiums are not excessive, and should hopefully be able to do so if it
can satisfy the insurer that it has taken all the steps it can to ensure the
circuit boards operate safely.
Reputation risk
SPD should ask Q to ensure drivers are fully warned about the need to
drive at safe speeds and the threat to the cars safety of driving too fast.
Warnings should be included in sales literature, together with the
explanation that the system is designed to make driving safer if the
car is driven at reasonable speeds. Safety warnings should also be
included in the documents purchasers are supplied with about the car.
The documentation should also include advice to keep the car wellmaintained and have it regularly and thoroughly serviced. New
owners could be asked to sign an agreement that the system cannot
prevent all crashes.
Problems with suppliers
If SPD is able to have input into the contract with the supplier, it should
insist that the contract includes requirements about the quality and
timing of supply, and that the supplier is liable for delays caused by
The contract should also include other
its shortcomings.
requirements imposed on the supplier, for example carrying out
quality checks. Its contract with Q should make clear that SPD is not
liable for delays caused by the supplier. The supplier contract
should include a termination clause that SPD or Q can enforce if the
supplier fails to perform satisfactorily. If problems begin to occur
SPD and Q should consult with a view to finding alternative suppliers
as soon as possible.
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Threats to profitability
SPDs finance department should review Qs accounts and other
evidence of its financial status. It should consider how dependent Qs
future profitability is on the success of this new car, or whether it is
very committed to any other makes. SPD should also try to assess Qs
plans for promoting the car, and whether they are likely to be
successful, particularly as it is an expensive car being marketed at a
time of financial stringency. The contract with Q should include
provisions for Q to pay financial penalties if it terminates the contract
prematurely without good reason or fails to order a certain number of
boards each year. SPD should also plan the staffing of the contract
carefully, focusing particularly on the use of technician time, and trying
to use lower grade staff for basic tasks wherever possible.
(2)
(i)
Selection
Important projects
Any projects above a certain size or which involve particularly high
risks should be audited, because of the potential magnitude of the
consequences if they do go wrong.
Projects that had problems
Projects which have failed to deliver expected benefits, have cost
too much or used too many resources should be selected for
investigation. Here obviously not only the factory building project
would be selected, but the other projects where managers had
overspent and ignored the budgets should be reviewed. If problems are
identified during the course of the project, a post-completion audit
could take place before the project ends, and the feedback result in the
rest of the project being carried out more efficiently.
Projects providing lessons
Internal audit should focus on projects that are likely to recur in future,
to see if they can be done more efficiently next time. Internal audit
should also examine projects which provide indications of how
important aspects of control systems are functioning. With Aybe,
where budgets have been ignored, internal audit should consider how
realistic the budgets were and whether improvements need to be
made to the budget-setting process.
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Coverage of managers and departments

Over time internal audit should review the work of different
managers and departments, to ensure projects over the whole
company are reviewed and managers and departments know that
they could be selected for review.
Investigation procedures
Decision-making process
Internal auditors will wish to look at the key decisions made during
the project. This should be done on the basis of what was known or
what should have been known at the time. For example it may have
been reasonable for managers making decisions about the factory to
rely on the work of the quantity surveyor.
Operation of controls
Internal audit should look for evidence that controls that should have
operated during the project did so. For example internal audit would
normally check that comparisons were regularly being made between
phased budgeted expenditure and actual expenditure, and action
taken if variances were identified.
Reasonableness of expenditure
Internal audit would also look at the reasonableness of expenditure
charged to the project. One reason for high costs might be the charging
of costs to the project that were not associated with it. Internal audit
should compare costs charged against planned expenditure on the
project.
Investigation of variances
Whether variances are identified as part of the control process by
management or by internal audit, internal audit would investigate why
they had occurred. They should investigate a number of projects to see
if patterns emerge, if the same managers or departments are
responsible for over-runs or over-runs occur at the same stage.
They would certainly wish to investigate the budgeting process for
Aybe to see why it was being ignored.
(ii)
Performance management
The chief executives comments are surprising, since they appear to
suggest that management do not have confidence in the way their
performance is appraised generally, which is an issue that the chief
executive should be addressing. Managers should only be judged on
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factors that they can control. However the way they manage risks
should also be part of the appraisal process. It is true that managers
may be accountable for projects that they agreed should proceed but
which turned out to be unprofitable. However the appraisal process
should also identify an unduly cautious approach to risk management,
resulting in a failure to invest in projects that would have been
worthwhile.
Decisions about investment
A further problem with the chief executives comments is that they
imply that responsibility for proposing projects solely rests with
lower management. Corporate governance best practice suggests that
the board should consider major investments itself. Managers
would therefore sometimes be required to proceed on significant
projects selected by the board that might be subject to an audit.
Fairness of audit process
However the auditors are responsible for reassuring managers that
they will be judged fairly. They should obtain feedback from
managers as part of the audit process, although they should assess
managers comments objectively. Auditors conclusions and
recommendations should not be stated in unduly negative terms.
Managers should be given a fair chance to respond to the auditors
findings.
5 Aybe 2
(1)
(i)
Risk appetite of the Aybe Group

Risk appetite refers to the nature and strength of risks that an
organisation is prepared to bear. Aybe appears to be more risk-averse
than risk-seeking. This can be gleaned from a number of factors:
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Aybe is organised in a traditional way which has remained in

place since before the two companies Ay and Be merged in 20W1,
and the current Board has strived to maintain continuity by not
changing the structure of the company post-merger. Despite even
the fact that the companys competitors have reorganised their
structures and the fact that Aybe commissioned a review on
organisational structure in 20X7 which recommended changes,
Aybe has remained the same in terms of how it is structured.
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(ii)
The Board has taken a cautious approach to the strategy of the

company in light of the recent economic downturn and its
unprofitable period after the merger. Its dividend policy remains
the same and it has taken the view to not issue any more equity
shares during the next five years.
However, despite these factors, the company has recognised that

it needs to make changes as it operates in a high tech fast-moving
environment. It has also taken into account the views of its
shareholders, particularly the institutional shareholders who
want to see increased growth and profitability.
To this end, it has made changes to the way its products and
services are offered and has decided to invest in a new overseas
market by establishing a joint venture in an African country
which is offering products within that and neighbouring
countries. This increases risk for Aybe since it currently has no
operations in Africa and does not sell its products to customers
based here. There is therefore no knowledge of trade within
Africa nor of other factors such as the economy, legislation and
regulation and indeed the cultural factors, all of which may be
complex.
Product risks
Possibly the most significant threat to the joint ventures existence is
that its operations are not viable. It appears to have been established
on the basis of sales forecasts that are now appearing to be overoptimistic. Costs have been increased by the failure to predict
demand correctly and hence the need to store excess inventory. If
the joint venture is unviable, it may be difficult to know when to take a
decision to cease operating, and there may be significant termination
costs.
Risks of joint venture partner
Another serious threat to the joint venture's continued existence is
Aybe falling out with its joint venture partner and the agreement
being dissolved. The joint venture would have to cease operations.
Possible causes of disagreement include pricing policy. The partner
may wish to offer discounts to establish a presence in local markets,
even though the joint venture's sales staff wish to maintain prices. It
may be difficult to assess the likelihood of these disagreements when
the contract is signed, as the position on these issues may only become
clear once the joint venture experiences trading difficulties.
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Political risks
The joint venture is also vulnerable to other changes in government
policy. The government may introduce tariffs, tighten exchange
control regulations or restrict payments for supplies as well as
limiting profit remittances, on the grounds that companies are not
charging their joint ventures a fair market rate. It may insist that the
joint venture has to use local suppliers or be managed by local
managers. Although information should be available about the
direction of the policy of the existing government, political risks and
uncertainties could increase if there is a change of government.
Economic risks
The joint venture could be affected by the risks associated with
inflation, including economic instability and a weakening of the local
exchange rate. Government action to combat inflation may also impact
seriously on the joint venture. Rises in interest rates could reduce
expenditure and increases in tax could reduce profits that can be
remitted.
Legal and reputation risks
The joint venture may face legal action and a risk to its reputation if
staff do not recycle components in accordance with stated policy but
throw them away. This risk may be enhanced if the joint venture's
staff are not experienced in handling toxic material. This may result
in costly sanctions being taken against the joint venture and DEC for
failing to dispose of components properly and publishing misleading
information. It may also cast doubt on the other information DEC
publishes.
(2)
(i)
Planning implications of the African joint venture on the group

financial statements
Understanding the entity and its environment
SLAuS 315 Identifying and Assessing the Risks of Material Misstatement

through Understanding the Entity and Its Environment requires the
auditor to understand the entity and its environment, and internal
control.
To understand the African joint venture and its environment, we must
consider any relevant regulatory factors, such as whether it uses the
same financial reporting framework as the group; the nature of the
entity's operations, ownership and governance, and the kinds of
transactions and balances that should be expected in the financial
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statements; and its selection and application of accounting policies, and

whether they are in line with its business and the financial reporting
framework.
Internal control system
To understand the African joint ventures internal controls, we must

consider its accounting systems as well as any other controls relevant
to the audit. Our understanding of these controls must be documented.
This is particularly important here because the auditors will not have
had time to build up knowledge of the entity, and so need to place
special emphasis on this area.
The information systems of the African country are still not up and
running and this will have an impact on the consolidation for the group
financial statements. Errors and inaccuracies may result in the group
financial statements containing misstatements.
Significant component
Another consideration is whether the African joint venture is a

significant component according to SLAuS 600 Special Considerations Audits of Group Financial Statements (Including the Work of Component
Auditors).
The auditors need to decide whether the African joint venture is a
significant component and in order to do so may apply a specific
percentage to a chosen benchmark. This is a matter of audit judgement
in terms of identifying an appropriate benchmark and determining a
percentage to be applied to it.
Given that the figures for the year breach 15% in terms of revenue and
profit before tax, the auditors may consider that the joint venture is
likely to be a significant component and a full audit may therefore be
required under SLAuS 600.
Component auditors
The financial statements of the joint venture will be audited by a local

firm of auditors in the African country in which the joint venture has
been set up. This increases the audit risk for the group financial
statements of Aybe as the group engagement team may not have any
knowledge or experience of the component auditors. SLAus 600 will
require the group engagement team to obtain an understanding of the
component auditor and evaluate the work done on the audit of the
financial statements of the joint venture.
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Financial reporting framework
The financial reporting framework for the African company may be

very different to that used in Aybes home country. This will have
repercussions for the audit of the group financial statements. It will be
necessary to confirm what the financial reporting framework is in the
African country and also to check whether the accounting policies used
are consistent with the rest of the Aybe group. As the country in which
the joint venture operates uses a framework which is based on
International Financial Reporting Standards, this may not be too much
of an issue.
Non-Coterminous year ends
Another issue that may arise is that the joint ventures year end is
different from the rest of the group. The joint venture produces
financial statements to 31 March each year whereas the Aybe group
produces its financial statements to 31 December each year. As there is
a difference, this will impact on the audit and additional procedures
must be performed on the financial information so that the group
financial statements can be prepared correctly.
Treatment of the joint venture
The African operation has been set up as a joint venture with a

government-owned joint venture partner which is a requirement for all
foreign companies wishing to set up in the country.
A joint venture is defined as a joint arrangement where the parties that
have joint control have rights to the net assets. Joint control is
evidenced by a contractually agreed sharing of control and also only
exists when decisions about relevant activities require the unanimous
consent of the parties involved. A joint venture must be accounted for
in the group financial statements using the equity method per LKAS 28
Investments in Associates.
In this case, is there even joint control? The government of the country
in which the joint venture has been established effectively dictates the
terms of the investment to Aybe. This issue increases the audit risk as
the African company may be treated incorrectly in the group financial
statements.
Foreign exchange issues
Since the African companys functional currency is different to that of

Aybes, LKAS 21 The Effects of Changes in Foreign Exchange Rates
requires the African companys financial statements to be translated
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into Aybes own reporting currency before incorporation into the

groups financial statements. There is a risk that the wrong rates are
used, which could over- or understate total assets and profit.
In addition, when the currency exposure of the African joint venture is
hedged, the fair value of forward contracts must be recognised in profit
and loss at the period end, with appropriate specific disclosures made.
This increases the risk of material misstatement at the group level.
Another issue with the African company is that there is very high
inflation. LKAS 29 Financial Reporting in Hyperinflationary Economies
requires the financial statements to be restated in terms of measuring
units current at the end of the period and a gain or loss on the net
monetary position to be included within net income. This issue
increases the audit risk as this may be done incorrectly.
Unrealised profit
The African company purchases the raw materials and components

from DEC in AyBes home country. Where there are downstream
transactions ie sales from a group company to the joint venture, the
group share of unrealised profit must be eliminated. The risk is that
this is not done correctly.
Materiality
The group auditors will need to determine the component materiality

for the African company and assess how material it is to the group
overall.
Disclosure requirements
SLFRS 12 Disclosure of Interests in Other Entities requires disclosure of

specific information relating to the nature and risks associated with a
groups interests in other entities. Disclosures required depend on
whether the interest is material or not and its nature. There is a risk
that these are not included in the group financial statements or
disclosures are not made in accordance with SLFRS 12.
(ii)
Risks of misstatement in audit of individual financial statements of the

African joint venture
Fraud risk
There is a risk of misstatements occurring in the financial statements

as a result of fraud. Sales staff are paid a bonus based on average profit
per unit sold and sales volumes and there is therefore a personal
motive for staff to misstate sales and profit in order to inflate their own
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bonuses and this may lead to overstatements in the statement of profit

or loss and other comprehensive income. Controls within the company
appear to be weak as information systems are still bedding in and this
factor may further increase the risk of fraud being carried out by staff
with authority who have access to system information.
Information systems
There is a risk of misstatements occurring in the financial statements

because the information systems are not fully developed. The systems
may not contain accurate up-to-date information which could feed
through to the financial statements.
Going concern issues
There is a risk that the African company may not be a going concern
and hence that the financial statements at the year-end could be
produced on an incorrect basis. The indicators of going concern issues
include the fact that sales within the country are low and sales to
neighbouring countries have not begun. As a result, inventory has built
up which may not be able to be sold. Another factor which could result
in going concern issues is the potential litigation arising from the
company irresponsibly dumping toxic waste from old components
customers may wish to steer clear of such a company and the probable
adverse publicity resulting from this could cause the company to fail
ultimately.
Toxic waste disposal
It has recently been discovered via internal audit that old components
are not being disposed of in accordance with African legislation. This
could result in fines and penalties being imposed on the company.
Provisions may be required in the financial statements from possible
litigation and as this is a judgemental area, any potential provisions
could be under or overstated.
Valuation of inventory
As a result of low sales within the country and exports not commencing
as yet, inventory has built up. There is a risk that this inventory may
not be able to be sold due to technological obsolescence and therefore
its value may be overstated in the financial statements. Inventory
should be valued at the lower of cost and net realisable value in
accordance with IAS 2 Inventories.
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Related party disclosures
The intra-group transactions between DEC and the African company

fall within the scope of IAS 24 Related Party Disclosures, and must be
disclosed in the individual financial statements of the group companies.
There is a risk that if disclosure is inadequate, a material misstatement
may result in the financial statements.
Restatement of financial statements due to high inflation
The African company operates in a country in which there is very high

inflation. IAS 29 Financial Reporting in Hyperinflationary Economies
requires the financial statements to be restated in terms of measuring
units current at the end of the period and a gain or loss on the net
monetary position to be included within net income. This issue
increases the audit risk as this may be done incorrectly.
(3)
(i)
Risks faced by DEC and its joint venture

The businesses face transaction risk on specific orders from foreign
customers. The joint venture also faces an economic risk of its
currency declining due to inflation and this resulting in sales prices
having to be maintained at high levels.
Payment in DEC's currency
Payments for exports could be made in DEC's currency rather than
that of the African country or the export customers'. This would avoid
the apparently greater risk to receipts of the African joint venture's
exchange rate deteriorating. However export customers may be
reluctant to pay in DEC's currency if they believe they may suffer
adverse currency risk.
Natural hedging
DEC or its joint venture could purchase goods or services from the
countries in which its export customers are located or perhaps
from the export customers themselves. The transactions could net
off and the currency risk would be reduced, as it would only arise on
the difference between receipts and payments in that currency.
However this could mean DEC or its joint venture having to change
their supply arrangements. The terms available may not be as good as
they are currently getting and the quality of supplies may be more
uncertain.
Money market hedges
The joint venture could use a hedge in order to mitigate the risk.
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(ii)
Ethical issues
New legislation in Europe and the African country where the joint
venture is based requires components to be recycled in order to
minimise the damage to the environment. Consequently customers of
DEC have been informed that they can return old components to DEC
for recycling in accordance with the new legislation. Whilst this has had
a positive impact on the company, internal auditors have found that
some staff are not carrying out the recycling to comply with the
legislation but are simply dumping the old components.
The ethical implications of this include a lack of integrity being shown
by DECs management. Integrity means being straightforward and
honest. If the company has made the assertion in its social and
environmental report that it recycles old components in accordance
with legislation but is, in fact, not always doing so, it is not acting with
integrity. Indeed, the Chief Executive of Aybe has stated in the annual
report that Aybe will continue to apply the highest ethical standards in
its business activities. This appears not to be the case.
Furthermore, the company is not acting in the public interest if it is
sometimes throwing old components away. By doing so, it adversely
affects the environment and this is not in the public interest. This
results in the ethical principle of professional behaviour being
breached by the company not always complying with the recent
legislation on the recycling of potentially toxic components.
So we can see that the actions of some staff of DEC will result in both
non-compliance with legislation and non-compliance with CASLs Code
of Ethics.
There are several potential consequences for the company as a result
of this behaviour.
Firstly, there will be a reputational risk for the company and the group.
If the information gets into the public domain, this will have an adverse
effect on the company and the group as a whole. Shareholders and
potential investors may lose confidence in the company and this could
lead existing shareholders selling their shares and a fall in the share
price. Institutional shareholders are already getting restless because
they feel the group is not achieving good rates of growth and this latest
issue may push them to sell.
The whole groups reputation for reliable reporting may be in doubt,
particularly as Aybes Board has stated that it is a responsible
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corporate organisation that recognises the social and environmental

effects of its operations.
Furthermore, if the company is found to be not complying with
legislation, it may be subject to large fines and penalties from the
government. Lawsuits may arise as a result of the dumping of toxic
waste into the environment. From the perspective of the financial
statements, large provisions might be required. From the companys
business risk perspective, fines, penalties and lawsuits could result in
the company failing altogether. The African joint venture is not
achieving high sales yet and the non-compliance with legislation will
impact further on its profits and may result in it not being a going
concern.
DEC supplies standard components to a large number of customers in
several countries worldwide. The dumping of toxic material may result
in those customers going to competitors and this will impact negatively
on the company and the group in terms of its revenues, profits and
share price.
(4)
Control environment
The board should consider whether Aybe's control environment encourages
ethical behaviour. This has various dimensions, including the board being
seen to act ethically. A code of ethics and ethics training should help. It is
also important that unethical behaviour in other areas of the business is not
tolerated. Action should be taken for example to prevent components
containing toxic materials being simply thrown away, as not only is it
dangerous but it means that the social and environmental report is
misleading.
Personnel policies
Recruitment controls can reduce the likelihood of staff who are likely to act
dishonestly being employed. References given by applicants should be
checked with referees, and applicants asked to explain gaps in employment
records as these could indicate a spell in prison. Applicants should also be
asked whether they have been convicted of any offence involving
dishonesty. Aybe's employment handbook should make clear that staff who
are found guilty of unethical behaviour will be subject to disciplinary
action, including the threat of dismissal.
Review of remuneration packages

The board needs to review the performance-related element of
remuneration packages as this appears to be tempting staff to manipulate
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transactions. It also may be resulting in other behaviour that isn't in Aybe's

interests, such as the joint venture's sales staff being unwilling to reduce
prices. To motivate staff, a performance-related element needs to be
maintained but this should be linked to an appraisal of staff behaviour that
includes consideration of whether they have acted ethically. The board
should also attempt to establish conditions for obtaining the element that it
is possible to fulfil by acting honestly.
Accounting controls
Checks built into the system should highlight discrepancies such as the
problems with invoice pricing. Staff at the joint venture should have
compared the order that was submitted with the prices on the inflated
invoice. As well as control systems highlighting problems automatically,
accounting staff also need to be vigilant for suspicious transactions. The
manipulation of the invoices was spotted by the alertness of the accounts
department.
Internal audit
Internal audit work also should act as a further deterrent to fraud, as it
should increase the chances that fraudsters will be discovered. Internal
audit work should concentrate on areas of high risk, such as high value
transactions including the periodic transfer payments. As the African joint
venture has been recently established, and its staff appear to be under
pressure, the risks of problems with its transactions may be high and hence
internal audit may need to concentrate on it.
CA Sri Lanka
159
Answers
160
CA Sri Lanka

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PRACTICE & REVISION KIT

CA SRI LANKA CURRICULUM 2015

First edition 2015

All rights reserved. No part of this publication may be

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How to use this Practice & Revision Kit

KC1 Corporate Financial Reporting

BPP LEARNING MEDIA

How to use this Practice & Revision Kit

Using the practice questions

KC1 Corporate Financial Reporting

How to use this Practice & Revision Kit

KC1 Corporate Financial Reporting

Action verbs checklist

Describe exactly the nature, scope or meaning

Produce (a picture or diagram)

Recognise, establish or select after

Write the connected items one below the

To establish logical or causal connections

Express something definitely or clearly

Make a mathematical computation

Examine in detail by argument showing

Make a clear description in detail revealing

Present in understandable terms or to

To show validity or otherwise, using

Enter relevant entries in detail

Give a brief statement of the main points (in

KC1 Corporate Financial Reporting

Put to practical use

Use knowledge in a setting

Determine the value, nature, ability or quality

Prove, especially with examples

Represent by means of a graph

Make ready for a particular purpose

Arrange or do in order of importance

Make consistent with another

To find a solution through calculations and/or

Examine in detail in order to determine the

Examine for the purpose of discovering

Examine in order to show unlikeness or

Constitute a difference that distinguishes

Make a summary of significant features

Action verbs checklist

Offer suggestions about the best course of

To persuade others to believe something using

Form and express a judgment

To determine the significance by careful

A suggestion or proposal as to the best course

Settle or find a solution to a problem or

Check or prove the accuracy

Produce by assembling information collected

Devise the form or structure according to a

To disclose, discover, perfect or unfold a plan

To form or declare a plan or intention for

Formation of judgments and

KC1 Corporate Financial Reporting

Mahmood is a junior employee of Tzo Company (a large, listed company). Tzo is a

Recommend an ethical case for Mahmood to take this matter directly to an

Some jurisdictions have a compulsory regulatory requirement for an

David is currently serving as a non-executive director on the board of a

A general election campaign has recently begun in this country. The

Using the American Accounting Association model to support your answer,