Backers Notes

December 2014June 2015 Edition
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REVISION QUESTION BANK
ACCA
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Paper P7 | ADVANCED AUDIT AND
ASSURANCE
(INTERNATIONAL)
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ACCA
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ADVANCED AUDIT AND ASSURANCE

(INTERNATIONAL)
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REVISION QUESTION BANK
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For Examinations to June 2015
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Acknowledgement
Past ACCA examination questions are the copyright of the Association of Chartered Certified
Accountants and have been reproduced by kind permission.
(ii) 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.
REVISION QUESTION BANK ADVANCED AUDIT AND ASSURANCE (P7)
CONTENTS
Question Page Answer Marks Date worked
The current exam format is indicated by the June 2013 and December 2013 Examinations
(see page (v)). Questions with different mark allocations and those that are not identified as
ACCA are provided for further revision question practice on certain syllabus area.
REGULATORY ENVIRONMENT
1 Flight Investment 1 1001 20
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MONEY LAUNDERING
2 Banana Co (ACCA D09 adapted) 1 1004 35
3 Dedza & Co (ACCA J07 Pilot Paper) 3 1011 20
CODES OF ETHICS FOR PROFESSIONAL ACCOUNTANTS

4 Kloser (ACCA D02) 3 1014 15
5
6
7
9
10
11
Carter & Co (ACCA J10)
Neeson & Co (ACCA D10)
PROFESSIONAL RESPONSIBILITY AND LIABILITY

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Becker & Co (ACCA D08 adapted)
Rapid Travel Co (ACCA J98)

Negligent actions (ACCA J00)
Blod Co (ACCA J08 adapted)
Grimes Co (ACCA J10)
4
5
6
7
8
8
9
1016
1021
1023
1027
1030
1032
1034
35
20
20
20
20
20
20
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QUALITY CONTROL
12 Guidance on quality control 10 1037 20
PROFESSIONAL APPOINTMENTS
13 Sepia (ACCA D03) 11 1041 15
14 Wexford (ACCA J11 adapted) 11 1044 25
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BUSINESS RISK
15 Champers (ACCA J09 adapted) 12 1047 35
16 Jolie Co (ACCA D10 adapted) 14 1053 35
PLANNING, MATERIALITY AND RISK

17 Shire Oil (ACCA D05 adapted) 16 1058 35
18 Island Co (ACCA D07 adapted) 17 1063 35
19 Bluebell (ACCA D08 adapted) 19 1069 35
20 Oak (ACCA D11 adapted) 22 1075 35
EVALUATION AND REVIEW

21 Seymour Co (ACCA D06) 24 1081 20
22 Lamont Co (ACCA J07) 25 1085 20
23 Clooney Co (ACCA D10) 26 1088 20
2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. (iii)
ADVANCED AUDIT AND ASSURANCE (P7) REVISION QUESTION BANK
AUDIT OF FINANCIAL STATEMENTS

24 Ozac (ACCA D99) 27 1091 15
25 Pulp Co (ACCA J08) 27 1093 20
26 Robster Co (ACCA J09) 28 1096 20
27 Beech & Co (ACCA D11 adapted) 29 1100 20
GROUP AUDITS
28 Murray Co (ACCA J07) 30 1103 25
29 Rosie Co (ACCA J08 adapted) 31 1107 35
30 Nassau Group (ACCA J11 adapted) 33 1113 20
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ASSURANCE SERVICES
31 Value for money 34 1116 20
32 Sci-Tech Co (ACCA J07 adapted) 35 1118 35
33 Eastwood Co (ACCA D10 adapted) 37 1123 35
34
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Bradrye City Council
REVIEWS AND RELATED SERVICES
35 Plaza Co (ACCA J05 adapted)
PROSPECTIVE FINANCIAL INFORMATION

36 Cusiter Co (ACCA J07)
39
40
41
1128
1131
1135
20
25
25
FORENSIC AUDITS
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37 Crocus (ACCA D08 adapted) 42 1139 25
38 Chestnut (ACCA D11 adapted) 43 1143 20
39 Efex Engineering (ACCA J07 Pilot Paper adapted) 44 1146 35
OUTSOURCING
40 RBG (ACCA D06) 46 1152 20
41 Mac Co (ACCA J10 adapted) 47 1156 25
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AUDITORS REPORTS
42 Bertie Co (ACCA D07) 48 1159 20
43 Pluto Co (ACCA J09 adapted) 49 1162 20
44 Willis and Moore (ACCA D10) 50 1165 20
45 Yew (ACCA D11 adapted) 51 1167 20
CURRENT ISSUES AND DEVELOPMENTS

46 Serious fraud 52 1170 15
47 Greater limitations 52 1172 20
48 Audit risk alert 53 1175 20
49 Corporate business risk (ACCA D00) 53 1176 15
50 IFAC (ACCA J06) 54 1177 15
51 Practices (ACCA D06) 54 1181 15
(iv) 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.
RECENT EXAMS
June 2012
1 CS Group (adapted) 55 1185 35
2 Hawk Co (adapted) 57 1191 35
3 Lark & Co 60 1197 15
4 Raven & Co 61 1199 15
5 Snipe Co 62 1202 15
December 2012
1 Grohl Co (adapted) 63 1204 35
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2 Jovi Group (adapted) 65 1209 25
3 Weller & Co 68 1213 16
4 Beck & Co 69 1216 16
5 Dylan Co 70 1218 16
June 2013
1
2
3
4
5
1
2
Parker Co
Retriever Group
Setter Stores Co
Groom & Co
Poodle Group
December 2013
Stow Group
Baltimore Co
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74
75
76
77
78
80
1222
1228
1232
1235
1237
1241
1248
35
25
20
20
20
35
25
3 Dasset Co 81 1252 20
4 Chester & Co 82 1255 20
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5 Burford Co 83 1258 20
Note: References to the IESBA (International Ethics Standards Board for Accountants) Code of Ethics
and the IFAC Code of Ethics relate to the same document, the IESBA being an independent standard
setting body established by the IFAC.
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2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. (v)
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(vi) 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.
Question 1 FLIGHT INVESTMENT
Arnie Row, managing director of Flight Investment, has contacted you, as his auditor, for advice
regarding the establishment of an audit committee. The company operates a group of investment and
property management companies with interests overseas and has a small internal audit department.
Some companies are audited by other firms and some by other offices of your own firm. The board of
Flight Investment comprises Arnie Row, the heads of three departments of the main activities
undertaken by the group (property, investment and marketing) and a non-executive director (Arnies
brother-in-law, Dan Ackroyd) who rarely attends. Arnie himself is the driving force behind the
business. When the idea of an audit committee was raised by an insurance company with a significant
shareholding in Flight Investment, Arnie, with his usual enthusiasm, was keen that he should head the
committee but was not too sure of its role. He has turned to you for guidance.
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Required:
Draft for inclusion in a letter to Mr Row:
(a) an explanation of the purposes of an audit committee; (7 marks)
(b)
(c)
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suggestions for the composition of the committee and its responsibilities in relation to
Flight Investment and its subsidiaries; and (10 marks)
a description of the relationship you would envisage between your audit firm and the
audit committee.
Question 2 BANANA CO
(3 marks)
(20 marks)
You are a manager in Grape & Co, a firm of Chartered Certified Accountants. You have been
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temporarily assigned as audit manager to the audit of Banana Co, because the engagement manager has
been taken ill. The final audit of Banana Co for the year ended 30 September 2014 is nearing
completion, and you are now reviewing the audit files and discussing the audit with the junior members
of the audit team. Banana Co 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 Co designs specific items for customers according to contractually agreed
specifications. The draft financial statements show revenue of $125 million, net profit of $400,000,
and total assets of $78 million.
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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 Co. All factory employees received training from an external training firm on how to safely
operate the machinery, at a total cost of $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 Co, a major customer with whom Banana Co has several significant
contracts, announced its insolvency, and that procedures to shut down the company had commenced.
The administrators of Cherry Co have suggested that the company may be able to pay approximately
25% of the amounts owed to its trade payables. A trade receivable of $300,000 is recognised on
Banana Cos 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:
2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved. 1
I have only worked on two audits prior to being assigned to the audit team of Banana Co. 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.
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 Co has a lot of work-in-progress. I tried to be as useful as possible during the count, and helped
the clients 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.
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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:
(a)
(i)
(ii)
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In respect of the specific information provided:
Comment on the matters to be considered, and explain the audit evidence you should
expect to find during your file review in respect of:
The training costs that have been capitalised into the cost of the new
machinery; and
The trade receivable recognised in relation to Cherry Co. (12 marks)
(b) Evaluate the audit juniors concerns regarding the management of the audit of Banana
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Co. (9 marks)
(c) There are specific regulatory obligations imposed on accountants and auditors in relation to
detecting and reporting money laundering activities. You have been asked to provide a
training session to the new audit juniors on auditors responsibilities in relation to money
laundering.
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Required:
Prepare briefing notes to be used at your training session in which you:
(i) Explain the term money laundering. Illustrate your explanation with
examples of money laundering offences, including those which could be
committed by the accountant; and
(ii) Explain the policies and procedures that a firm of Chartered Certified
Accountants should establish in order to meet its responsibilities in relation to
money laundering. (10 marks)
Professional marks will be awarded in part (c) for the format of the answer, and the quality of
the explanations provided. (4 marks)
(35 marks)
2 2014DeVry/BeckerEducationalDevelopmentCorp.Allrightsreserved.
Question 3 DEDZA & CO
(a) Comment on the need for ethical guidance for accountants on money laundering.
(5 marks)
(b) You are senior manager in Dedza & Co, a firm of Chartered Certified Accountants. Recently,
you have been assigned specific responsibility for undertaking annual reviews of existing
clients. The following situations have arisen in connection with three clients:
(i) Dedza was appointed auditor and tax advisor to Kora Co last year and has recently
issued an unmodified opinion on the financial statements for the year ended 31
March 2006. To your surprise, the tax authority has just launched an investigation
into the affairs of Kora on suspicion of underdeclaring income. (7 marks)
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(ii) The chief executive of Xalam Co, an exporter of specialist equipment, has asked for
advice on the accounting treatment and disclosure of payments being made for
security consultancy services. The payments, which aim to ensure that
consignments are not impounded in the destination country of a major customer,
may be material to the financial statements for the year ending 31 December 2006.
(iii)
Required:
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Xalam does not treat these payments as tax deductible. (4 marks)
Your firm has provided financial advice to the Pholey family for many years and
this has sometimes involved your firm in carrying out transactions on their behalf.
The eldest son, Esau, is to take up a position as a senior government official to a
foreign country next month. (4 marks)
Identify and comment on the ethical and other professional issues raised by each of these
matters and state what action, if any, Dedza & Co should now take. (15 marks)
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Note: The mark allocation is shown against each of the three situations.
(20 marks)
Question 4 KLOSER
You are an audit manager of Kloser, a firm of Chartered Certified Accountants. You are assigning staff
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to the final audit of Isthmus, a company listed on a stock exchange, for the year to 31 December 2014.
You are aware of the following matters:
(1) Isthmus has recently issued a profits warning. The company has announced that the
significant synergies expected from the acquisition of Vanaka, a former competitor company,
have not materialised. Moreover, it has emerged that certain of Vanakas assets are
significantly impaired. Your firms corporate finance department, assisted by two audit
trainees, carried out due diligence work on behalf of Isthmus before the purchase of Vanaka
was completed in December 2013.
(2) Mercedes, the assistant manager assigned to the interim audit of Isthmus, has since inherited
5,000 $1 shares in Isthmus. Mercedes has told you that she has no intention of selling the
shares until the share price recovers from the fall to $195 which followed the profit warning.
(3) Anthony, an audit senior, has been assigned to the audits of Isthmus since joining the firm
nearly three years ago. He has confided to you that his father owned 1,001 shares in Isthmus
but sold them only days before the profits warning at a share price of $795. You are assured
that Anthony did not previously know that his father had the shares.
Required:
Comment on the ethical and other professional issues raised by the above matters and their
implications, if any, for staffing the final audit of Isthmus for the year to 31 December 2014.
(15 marks)
Question 5 BECKER & CO
You are a senior manager in Becker & Co, a firm of Chartered Certified Accountants offering audit and
assurance services mainly to large, privately owned companies. The firm has suffered from increased
competition, due to two new firms of accountants setting up in the same town. Several audit clients
have moved to the new firms, leading to loss of revenue, and an over staffed audit department. Bob
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McEnroe, one of the partners of Becker & Co, has asked you to consider how the firm could react to
this situation. Several possibilities have been raised for your consideration:
(1) Murray Co, a manufacturer of electronic equipment, is one of Becker & Cos audit clients.
You are aware that the company has recently designed a new product, which market research
indicates is likely to be very successful. The development of the product has been a huge
(2)
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drain on cash resources. The managing director of Murray Co has written to the audit
engagement partner to see if Becker & Co would be interested in making an investment in the
new product. It has been suggested that Becker & Co could provide finance for the
completion of the development and the marketing of the product. The finance would be in the
form of convertible debentures. Alternatively, a joint venture company in which control is
shared between Murray Co and Becker & Co could be established to manufacture, market and
distribute the new product.
Becker & Co is considering expanding the provision of non-audit services. Ingrid Sharapova,
a senior manager in Becker & Co, has suggested that the firm could offer a recruitment
advisory service to clients, specialising in the recruitment of finance professionals. Becker &
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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.
(3) Several audit clients are experiencing staff shortages, and it has been suggested that
temporary staff assignments could be offered. It is envisaged that a number of audit managers
or seniors could be seconded to clients for periods not exceeding six months, after which time
they would return to Becker & Co.
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Required:
Identify and explain the ethical and practice management implications in respect of:
(a) A business arrangement with Murray Co. (7 marks)
(b) A recruitment service offered to clients. (7 marks)
(c) Temporary staff assignments. (6 marks)
(d) Murrays management has informed you that it is developing a strategy for global expansion.
As well as acquiring companies (both listed and unlisted) in key locations, it plans to seek
listings in four or five strategic financial centres.
Required:
(i) Define transnational audit and explain its relevance to the audit of the
Murray Group. (3 marks)
(ii) Discuss TWO features of a transnational audit that may contribute to a high
level of audit risk in such an engagement. (4 marks)
(32 marks)
Question 6 CARTER & CO
You are a manager in the audit department of Carter & Co, and you are dealing with several ethical and
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professional matters raised at recent management meetings, all of which relate to audit clients of your
firm.
(1). Fernwood Co has a year ending 30 June 2014. During this year, the company established a
pension plan for its employees, and this year end the company will be recognising for the first
time a pension deficit on the statement of financial position, in accordance with IAS 19
(2)
(3)
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Employee Benefits. The finance director of Fernwood Co has contacted the audit engagement
partner, asking if your firm can provide a valuation service in respect of the amount
recognised.
The finance director of Hall Co has requested that a certain audit senior, Kia Nelson, be
assigned to the audit team. This senior has not previously been assigned to the audit of Hall
Co. On further investigation it transpired that Kia Nelson is the sister of Hall Cos financial
controller.
Collier Co has until recently kept important documents such as title deeds and insurance
certificates in a safe at its head office. However, following a number of thefts from the head
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office the directors have asked if the documents could be held securely at Carter & Cos
premises. The partners of Carter & Co are considering offering a custodial service to all
clients, some of whom may want to deposit tangible assets such as paintings purchased as
investments for safekeeping. The fee charged for this service would depend on the value of
item deposited as well as the length of the safekeeping arrangement.
(4) Several audit clients have requested that Carter & Co provide technical training on financial
reporting and tax issues. This is not a service that the firm wishes to provide, and it has
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referred the audit clients to a training firm, Gates Co, which is paying a referral fee to Carter
& Co for each audit client which is referred.
Required:
Identify and evaluate the ethical and other professional issues raised, in respect of:
(a) Fernwood Co; (6 marks)

(b) Hall Co; (6 marks)
(c) Collier Co; (5 marks)
(d) Gates Co. (3 marks)
(20 marks)
Question 7 NEESON & CO
(a) You are a manager in Neeson & Co, a firm of Chartered Certified Accountants, with three
offices and 12 partners. About one third of the firms clients are audit clients, the remainder
are clients for whom Neeson & Co performs tax, accounting and business advisory services.
The firm is considering how to generate more revenue, and you have been asked to evaluate
two suggestions made by the firms business development manager.
(i) An advertisement could be placed in national newspapers to attract new clients.

The draft advertisement has been given to you for review:
Neeson & Co is the largest and most professional accountancy and audit
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provider in the country. We offer a range of services in addition to audit, which
are guaranteed to improve your business efficiency and save you tax.
If you are unhappy with your auditors, we can offer a second opinion on the
report that has been given.
Introductory offer: for all new clients we offer a 25% discount when both audit
(ii)
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and tax services are provided. Our rates are approved by ACCA.
A new partner with experience in the banking sector has joined Neeson & Co. It
has been suggested that the partner could specialise in offering a corporate finance
service to clients. In particular, the partner could advise clients on raising debt
finance, and would negotiate with the clients bank or other provider of finance on
behalf of the client. The fee charged for this service would be contingent on the
(8 marks)
client obtaining the finance with a borrowing cost below market rate. (5 marks)
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Required:
Evaluate each of the suggestions made above, commenting on the ethical and
professional issues raised.
Note: the mark allocation is shown against each of the issues.

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(b) You have set up an internal discussion board, on which current issues are debated by
employees and partners of Neeson & Co. One posting to the board concerned the compulsory
rotation of audit firms, whereby it has been suggested in the press that after a pre-determined
period, an audit firm must resign from office, to be replaced by a new audit provider.
Required:
(i) Explain the ethical threats created by a long association with an audit client.
(3 marks)
(ii) Evaluate the advantages and disadvantages of compulsory audit firm rotation.
(4 marks)
(20 marks)
Question 8 RAPID TRAVEL CO
You have been the auditors of Rapid Travel Co since its incorporation five years ago. The company
was formed by two brothers, Jon and Soko Dallio, who each own 50% of the share capital.
The company initially acquired an inexpensive fleet of old buses and coaches in one city and, by the
use of competitive predatory pricing, managed to undercut its competitors fares to the point that they
went out of business leaving Rapid Travel with a local monopoly. The success of this tactic was such
that the company expanded its operations in a similar manner over its five year life to become a
national bus and coach operator.
As the company became more profitable it gradually improved its fleet by acquiring more modern (but
not new) vehicles less than ten year finance leases. These vehicles are depreciated over the lease term.
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Despite this, a majority of its fleet is still more than eight years old.
The company has a network of maintenance workshops throughout the country in which it repairs and
maintains all of its vehicles, and also undertakes some external work. During the current year the
companys vehicles appeared to be suffering an abnormally high level of breakdowns and mechanical
failures, some of which have led to accidents. One such accident, caused by suspected brake failure,
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led to the deaths of several passengers and the driver. It is still being investigated by the authorities.
Approximately six months ago a previous employee (a driver) of Rapid Travel, who was dismissed for
a persistent failure to maintain scheduled timetables, contacted you, as auditors. He made allegations
concerning Rapid Travels improper conduct in respect of encouraging excess driver hours and
malpractice in the maintenance workshops. Recently similar reports concerning Rapid Travel have
been published in the press as a result of disclosures by an ex-employee. It is not known if it is the
same employee that contacted the auditors.
All drivers of public service vehicles have strict maximum hours that they are permitted to drive before
taking compulsory rest and sleep breaks. Also all public service vehicles require a certificate showing
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they have passed a thorough independent annual safety check.
The ex-employee claimed that routes cannot be completed in the scheduled times without exceeding
speed limits. He also alleged that there have been occasions where vehicles that have failed the safety
check, due mainly to unsafe braking, have been substituted with a near identical vehicle that has
temporarily been given the identity of the failed vehicle for the re-test.
Three months before the year end the company was successful in a bid to acquire the right to operate
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some previously state-run nursing homes. The fee paid was $25 million. This represented more than
25% of Rapid Travels gross assets. It has been shown in the statement of financial position as an
intangible asset. You acted as advisors to Rapid Travel in respect of the bid.
Required:
(a) Describe the main areas and factors that you would consider in your assessment of the
inherent risk in the audit of Rapid Travel Co. (4 marks)
(b) Explain the extent to which auditors are responsible for ensuring a client complies with
the laws and regulations relating to the clients industry. (6 marks)
(c) Describe the audit work you would undertake to satisfy yourself that that you have
discharged your responsibilities in relation to (b) above for Rapid Travel Co, and
explain the significance you would attach to the information provided by the dismissed
employee and by press reports. (5 marks)
(d) Shortly after Rapid Travels year end it became involved in negotiations with Adapt, a public
listed company, which wished to acquire Rapid Travel. As auditors you were invited by your
client to attend the finalisation meeting at the specific request of Adapt. During the meeting
the negotiator for Adapt asks you if the financial statements for the last financial year still
showed a true and fair view. Your reply was that, based on the information you had
available, they did show a true and fair view.
Two months later your practice received a claim for damages from Adapt, the substance of
which was that the value of the leased vehicles was overstated due to an excessive write off
period which had resulted in under-depreciation; and, based on regulated tariffs applicable to
the nursing homes, the business could not be run at a profit so the related intangible asset was
worthless.
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Your firm is covered by professional indemnity insurance. The legal representatives of the
insurance company have taken over the defence of the law suit and advised you that they
intend to settle with Adapt out of court.
Required:
Discuss the advantages and disadvantages of audit liability claims being settled out of
court.
Question 9 NEGLIGENT ACTIONS

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The accounting profession has called for a less severe liability for negligent actions. It can be argued
that the reason why the profession wants a change in its liability is to protect its own interests.
Alternatively it may be that the profession has a legitimate case for reform based upon its concern for
the public interest.
(20 marks)
Required:
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(a) Discuss the accountability of auditors for their negligent actions. (8 marks)
(b) Discuss the current implications for the audit profession of a system of determining the
legal liability of the auditor, which has been historically decided by the courts of law.
(12 marks)
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(20 marks)
Question 10 BLOD CO
You are the manager responsible for the audit of Blod Co, a listed company, for the year ended 31
March 2014. Your firm was appointed as auditors of Blod Co in September 2013. The audit work has
been completed, and you are reviewing the working papers in order to draft a report to those charged
with governance. The statement of financial position shows total assets of $78 million (2013 $66
million). The main business activity of Blod Co is the manufacture of farm machinery.
During the audit of property, plant and equipment it was discovered that controls over capital
expenditure transactions had deteriorated during the year. Authorisation had not been gained for the
purchase of office equipment with a cost of $225,000. No material errors in the financial statements
were revealed by audit procedures performed on property, plant and equipment.
An internally generated brand name has been included in the statement of financial position at a fair
value of $10 million. Audit working papers show that the matter was discussed with the financial
controller, who stated that the $10 million represents the present value of future cash flows estimated to
be generated by the brand name. The member of the audit team who completed the work programme
on intangible assets has noted that this treatment appears to be in breach of IAS 38 Intangible Assets,
and that the management refuses to derecognise the asset.
Problems were experienced in the audit of inventories. Due to an oversight by the internal auditors of
Blod Co, the external audit team did not receive a copy of inventory counting procedures prior to
attending the count. This caused a delay at the beginning of the inventory count, when the audit team
had to quickly familiarise themselves with the procedures. In addition, on the final audit, when the
audit senior requested documentation to support the final inventory valuation, it took two weeks for the
information to be received because the accountant who had prepared the schedules had mislaid them.
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Required:
(a) (i) Identify the main purpose of including findings from the audit (management
letter points) in a report to those charged with governance.
(3 marks)
(b)
(ii)
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From the information provided above, recommend the matters which should
be included as findings from the audit in your report to those charged with
governance, and explain the reason for their inclusion. (7 marks)
The finance director of Blod Co, Uma Thorton, has requested that your firm type the financial
statements in the form to be presented to shareholders at the forthcoming company general
meeting.
Required:
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Discuss the ethical issues raised by the request for your firm to type the financial
statements of Blod Co. (4 marks)
(c) Uma has also commented that the previous auditors did not use a liability disclaimer in their
audit report, and would like more information about the use of liability disclaimer paragraphs.
In the context of a standard unmodified audit report, describe the content of a liability
disclaimer paragraph, and discuss the main arguments for and against the use of a
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liability disclaimer paragraph. (6 marks)
(20 marks)
Question 11 GRIMES CO
(a) You are the partner responsible for the audit of Grimes Co, for the year ended 30 April 2014.
The final audit has been completed and you have asked the audit manager to draft the audit
report. The manager is aware that there is guidance for auditors relating to audit reports in
ISA 706 Emphasis of Matter Paragraphs and Other Matter Paragraphs in the Independent
Auditors Report. The manager has asked for your assistance in this matter.
Required:
(i) Define an Emphasis of Matter paragraph and explain, providing examples,

the use of such a paragraph; (6 marks)
(ii) Define an Other Matter paragraph and explain, providing examples, the use
of such a paragraph.
Note: You are not required to produce draft paragraphs. (4 marks)
(b) You are also responsible for providing direction to more junior members of the audit
department of your firm on technical matters. Several recent recruits have asked for guidance
in the area of auditors liability. They are keen to understand how an audit firm can reduce its
exposure to claims of negligence. They have also heard that in some countries, it is possible
to restrict liability by making a liability limitation agreement with an audit client.
Required:
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(i) Explain FOUR methods that may be used by an audit firm to reduce exposure
to litigation claims; (4 marks)
(ii) Assess the potential implications for the profession, of audit firms signing a
liability limitation agreement with their audit clients. (6 marks)
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Question 12 GUIDANCE ON QUALITY CONTROL
You are responsible for quality control in your firm of Certified Accountants. The firm has three
offices and 15 partners. The partner in charge of your audit firm believes quality control is important,
and she has asked you to provide guidance on quality control under the following headings:
(a) The importance of quality in audit work

(20 marks)
(b) Training of staff

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(c) Monitoring the performance of staff and providing additional training
(d) Reviews of audit work:
(i) by staff and the audit engagement partner before the auditors report is signed;
(ii) a cold review of audit work.
The partner has explained that a cold review is carried out periodically on a sample of audits after the
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auditors report is signed, to check the quality of the firms audit work.
Required:
Draft, for inclusion in a memorandum to the senior partner of your audit firm on quality control,
guidance which covers the four topics listed in (a) to (d) above.
(20 marks)
Question 13 SEPIA
You are an audit manager in Sepia, a firm of Chartered Certified Accountants. Your specific
responsibilities include advising the senior audit partner on the acceptance of new assignments. The
following matters have arisen in connection with three prospective client companies:
(a) Your firm has been nominated to act as auditor to Squid Co. You have been waiting for a
response to your letter of professional enquiry to Squids auditor, Krill & Co, for several
weeks. Your recent attempts to call the current engagement partner, Anton Fargues, in Krill
& Co have been met with the response from Antons personal assistant that Mr Fargues is
not available. (5 marks)
(b) Sepia has been approached by the management of Hatchet, a company listed on a recognised
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stock exchange, to advise on a take-over bid which they propose to make. The target
company, Vitronella, is an audit client of your firm. However, Hatchet is not. (5 marks)
(c) A former colleague in Sepia, Edwin Stenuit, is now employed by another audit firm, Keratin.
Sepia and Keratin and three other firms have recently tendered for the audit of Benthos Co.
Benthos is expected to announce the successful firm next week. Yesterday, at a social
Required:
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gathering, Edwin confided to you that Keratin lowballed on their tender for the audit as
they expect to be able to provide Benthos with lucrative other services. (5 marks)
Comment on the professional issues raised by each of the above matters and the steps, if any, that
Sepia should now take.
Note: The mark allocation is shown against each of the three issues.
(15 marks)
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Question 14 WEXFORD
(a) Your firm, Rendell & Co, has been approached by Wexford Co to provide the annual audit.
Wexford Co operates a chain of bookshops across the country. The shops sell stationery such
as diaries and calendars, as well as new books. The financial year will end on 31 July and this
will be the first year that an audit is required, as previously the company was exempt from
audit due to its small size.
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The potential audit engagement partner, Wendy Kwan, recently attended a meeting with Ravi
Shah, managing director of Wexford Co regarding the audit appointment. In this meeting,
Ravi made the following comments:
Wexford Co is a small, owner-managed business. I run the company, along with my sister,
Rita, and we employ a part-qualified accountant to do the bookkeeping and prepare the annual
accounts. The accountant prepares management accounts at the end of every quarter, but Rita
and I rarely do more than quickly review the sales figures. We understand that due to the
companys size, we now need to have the accounts audited. It would make sense if your firm
could prepare the accounts and do the audit at the same time. We dont want a cash flow
statement prepared, as it is not required for tax purposes, and would not be used by us.
Next year we are planning to acquire another company, one of our competitors, which I
believe is an existing audit client of your firm. For this reason, we require that your audit
procedures do not include reading the minutes of board meetings, as we have been discussing
some confidential matters regarding this potential acquisition.
Required:
Identify and explain the professional and ethical matters that should be considered in
deciding whether to accept the appointment as auditor of Wexford Co. (10 marks)
(b) Wexford Cos financial statements for the prior year ended 31 July included the following
balances:
Profit before tax $50,000

Inventory $25,000
Total assets $350,000
The inventory comprised stocks of books, diaries, calendars and greetings cards.
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Required:
In relation to opening balances where the financial statements for the prior period were
not audited:
(c)
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Explain the audit procedures required by ISA 510 Initial Audit Engagements
Opening Balances and recommend the specific audit procedures to be applied to
Wexford Cos opening balance of inventory. (8 marks)
Rendell & Co is suffering from declining revenue, and as a result of this, another audit
manager has been asked to consider how to improve the firms profitability. In a
conversation with you this morning he mentioned the following:
We really need to make our audits more efficient. I think we should fix materiality at the
planning stage at the maximum possible materiality level for all audits, as this would reduce
the work we need to do.
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I also think we can cut the firms overheads by reducing our spending on training. We spend
a lot on expensive training courses for junior members of the audit team, and on Continuing
Professional Development for our qualified members of staff.
We could also guarantee our clients that all audits will be completed quicker than last year.
Reducing the time spent on each assignment will improve the firms efficiency and enable us
to take on more audit clients.
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Required:
Comment on the practice management and quality control issues raised by the audit
managers suggestions to improve the audit firms profitability. (7 marks)
(25 marks)
Question 15 CHAMPERS CO
Champers Co operates a large number of restaurants throughout the country, which are operated under
four well-known brand names. The companys strategy is to offer a variety of different dining
experiences in restaurants situated in city centres and residential areas, with the objective of maximising
market share in a competitive business environment. You are a senior audit manager in Carter & Co, a
firm of Chartered Certified Accountants, and you are planning the audit of the financial statements of
Champers Co for the year ended 31 May 2014. Extracts from the draft integrated report are shown
below:
Key financial information
31 May 2014 31 May 2013

Draft Actual
$m $m
Company revenue 1,500 1,350
Revenue is derived from four branded restaurant chains:
Happy Monkeys family bistros 800 660
Quick-bite outlets 375 400
City Sizzler grills 300 290
Green George cafs 25
Company profit before tax 135 155
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Company total assets 4,200 3,350
Company cash at bank 116 350
Business segments
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The Happy Monkeys chain of restaurants provides family-friendly dining in an informal setting. Most
of the restaurants are located in residential areas. Each restaurant has a large childrens play area
containing climbing frames and slides, and offers a crche facility, where parents may leave their
children for up to two hours. Recently there has been some media criticism of the quality of the child
care offered in one crche, because a child had fallen from a climbing frame and was slightly injured.
One of the Happy Monkeys restaurants was closed in December 2013 for three weeks following a
health and safety inspection which revealed some significant breaches in hygiene standards in the
kitchen.
The Quick-bite chain offers fast-food. The restaurants are located next to busy roads, in shopping
centres, and at railway stations and airports. Champers Co has launched a significant marketing
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campaign to support the Quick-bite brand name. The draft statement of comprehensive income for the
year ended 31 May 2014 includes an expense of $150 million in relation to the advertising and
marketing of this brand. In January 2014 the company started to provide nutritional information on its
menus in the Quick-bite restaurants, following pressure from the government for all restaurants to
disclose more about the ingredients of their food. 50% of the revenue for this business segment is
derived from the sale of chuckle boxes self-contained childrens meals which contain a small toy.
The City Sizzler grills offer a more sophisticated dining experience. The emphasis is on high quality
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food served in luxurious surroundings. There are currently 250 City Sizzler grills, and Champers Co is
planning to expand this to 500 by May 2015. The grills are all situated in prime city centre locations
and are completely refurbished every two years.
The Green George caf chain is a recent addition to the range of restaurants. There are only 30
restaurants in the chain, mostly located in affluent residential areas. The restaurants offer eco-friendly
food, guaranteed to be free from artificial flavourings and colourings, and to have been produced in an
environmentally sustainable manner. All of the 30 restaurants have been newly constructed by
Champers Co, and are capitalised at $210 million. This includes all directly attributable costs, and
borrowing costs capitalised relating to loans taken out to finance the acquisition of the sites and
construction of the restaurants. Champers Co is planning to double the number of Green George cafs
operating within the next twelve months.
Laws and regulations
Two new regulations were issued by the government recently which will impact on Champers Co. The
regulations come into effect from September 2014.
(i) Minimum wage regulation has increased the minimum wage by 15%. One third of Champers
Cos employees earn the minimum wage.
(ii) Advertising regulations now forbid the advertising of food in a manner specifically aimed at
children.
Three audit juniors are joining your team for the forthcoming audit of Champers Co, and you have
asked them to read through the permanent file to familiarise themselves with the client. One of the
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juniors has told you that he appreciates that auditors need to have a thorough understanding of the
business of their client, but he does not know what aspects of the clients business this relates to, or
how the understanding is developed.
Required:
(a)
you:
(i)
(ii)
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Prepare briefing notes to be used at a planning meeting with your audit team, in which
identify and explain the aspects of a clients business which should be

considered in order to gain an understanding of the company and its operating
environment; and
recommend the procedures an auditor should perform in order to gain
business understanding. (4 marks)
(6 marks)
Professional marks will be awarded in part (a) for the clarity, format and presentation
of the briefing notes. (4 marks)
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(b) Using the information provided, evaluate the business risks facing Champers Co.
(12 marks)
(c) Describe the principal audit procedures to be performed in respect of:
(i) the amount capitalised in relation to the construction of the new Green George
cafs; and (5 marks)
(ii) the amount recognised as an expense for the advertising of the Quick-bite
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brand. (4 marks)
(35 marks)
Question 16 JOLIE CO
Jolie Co is a large company, operating in the retail industry, with a year ended 30 November 2014.
You are a manager in Jen & Co, responsible for the audit of Jolie Co, and you have recently attended a
planning meeting with Mo Pitt, the finance director of the company. As this is the first year that your
firm will be acting as auditor for Jolie Co, you need to gain an understanding of the business risks
facing the new client. Notes from your meeting are as follows:
Jolie Co sells clothing, with a strategy of selling high fashion items under the JLC brand name. New
ranges of clothes are introduced to stores every eight weeks. The company relies on a team of highly
skilled designers to develop new fashion ranges. The designers must be able to anticipate and quickly
respond to changes in consumer preferences. There is a high staff turnover in the design team.
Most sales are made in-store, but there is also a very popular catalogue, from which customers can
place an order on-line, or over the phone. The company has recently upgraded the computer system
and improved the website, at significant cost, in order to integrate the website sales directly into the
general ledger, and to provide an easier interface for customers to use when ordering and entering their
credit card details. The new on-line sales system has allowed overseas sales for the first time.
The system for phone ordering has recently been outsourced. The contract for outsourcing went out to
tender and Jolie Co awarded the contract to the company offering the least cost. The company
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providing the service uses an overseas phone call centre where staff costs are very low.
Jolie Co has recently joined the Ethical Trading Initiative. This is a fair-trade initiative, which means
that any products bearing the JLC brand name must have been produced in a manner which is clean and
safe for employees, and minimises the environmental impact of the manufacturing process. A
significant advertising campaign promoting Jolie Cos involvement with this initiative has recently
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taken place. The JLC brand name was purchased a number of years ago and is recognised at cost as an
intangible asset, which is not amortised. The brand represents 12% of the total assets recognised on the
statement of financial position.
The company owns numerous distribution centres, some of which operate close to residential areas. A
licence to operate the distribution centres is issued by each local government authority in which a centre
is located. One of the conditions of the licence is that deliveries must only take place between 8 am and
6 pm. The authority also monitors the noise level of each centre, and can revoke the operating licence
if a certain noise limit is breached. Two licences were revoked for a period of three months during the
year.
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To help your business understanding, Mo Pitt has e-mailed to you extracts from the draft statement of
comprehensive income, and the relevant comparative figures, which are shown below.
Extract from draft statement of comprehensive income
Year ending 30 November 2014 Draft 2013 Actual

$m $m
Revenue:
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Retail outlets 1,030 1,140

Phone and on-line sales 425 395

Total revenue 1,455 1,535

Operating profit 245 275
Finance costs (25) (22)

Profit before tax 220 253

Additional information:
Number of stores 210 208
Average revenue per store $4905 million $577
million
Number of phone orders 680,000 790,000
Number of on-line orders 1,020,000 526,667
Average spend per order $250 $300
Required:
(a) Prepare briefing notes to be used at a planning meeting with your audit team, in which
you evaluate the business risks facing Jolie Co to be considered when planning the final
audit for the year ended 30 November 2014. (15 marks)
Professional marks will be awarded in part (a) for the format of the answer and the
clarity of the evaluation. (4 marks)
(b) Using the information provided, identify and explain FIVE financial statement risks.
(10 marks)
(c) Recommend the principal audit procedures to be performed in respect of the valuation
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of the JLC brand name. (6 marks)
(35 marks)
Question 17 SHIRE OIL CO
Revenue
Profit before tax
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Shire Oil Co (Shire), a listed company, is primarily an oil producer with interests in the North Sea,
West Africa and South Asia. Shires latest interim report shows:
30 June
2014
Unaudited
$000
22,000
5,500
30 June
2013
Unaudited
$000
18,300
4,200
31 December
2013
Audited
$000
37,500
7,500
Total assets 95,900 92,300 88,400
Earnings per share (basic) $182 $207 $353
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In April 2014, the company was awarded a new five-year licence, by the central government, to explore
for oil in a remote region. The licence was granted at no cost to Shire. However, Shires management
has decided to recognise the licence at an estimated fair value of $3 million.
The most significant of Shires tangible non-current assets are its 17 oil rigs (2013 15). Each rig is
composed of numerous items including a platform, buildings thereon and drilling equipment. The
useful life of each platform is assessed annually on factors such as weather conditions and the period
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over which it is estimated that oil will be extracted. Platforms are depreciated on a straight line basis
over 15 to 40 years.
A provision for the present value of the expected cost of decommissioning an oil rig is recognised in
full at the commencement of oil production. One of the rigs in South Asia sustained severe cyclone
damage in October 2014. Shires management believes the rig is beyond economic recovery and that
there will be no alternative but to abandon it where it is. This suggestion has brought angry protests
from conservationists.
In July 2014, Shire entered into an agreement to share in the future economic benefits of an extensive
oil pipeline.
You are the manager responsible for the audit of Shire. Last year your firm modified its auditors
report due to a lack of evidence to support managements schedule of proven and probable oil reserves
to be recoverable from known reserves.
Required:
(a) Using the information provided, identify and explain the audit risks to be addressed
when planning the final audit of Shire Oil Co for the year ending 31 December 2014.
(12 marks)
(b) Describe the principal audit work to be performed in respect of the useful lives of Shire
Oil Cos rig platforms. (6 marks)
(c) You have just been advised of managements intention to publish Shire Oil Cos first
integrated report for 2014 that will contain the financial statements for the year ending 31
December 2014. Extracts from the integrated report will include the following provided on
the companys website during 2014:
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Shire Oil Co sponsors national school sports championships and the Shire Ward at the
national teaching hospital. The companys vision is to continue its investment in health and
safety and the environment.
Our health and safety, security and environmental policies are of the highest standard in the
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energy sector. We aim to operate under principles of no-harm to people and the environment.
Shire Oil Cos main contribution to sustainable development comes from providing extra
energy in a cleaner and more socially responsible way. This means improving the
environmental and social performance of our operations. Regrettably, five employees lost
their lives at work during the year.
Required:
(i) Describe the responsibility of those charged with governance for the integrated
report. (6 marks)
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(ii) Suggest performance indicators that could reflect the extent to which Shire Oil
Cos social and environmental responsibilities as discussed in the integrated
report are being met, and the evidence that should be available to provide
assurance on their accuracy. (7 marks)
Professional marks will be awarded in part (c) for the presentation and clarity of your answer.
(4 marks)
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(35 marks)
Question 18 ISLAND CO
You are the manager responsible for the audit of Island Co, a manufacturer of machinery used in the
coal extraction industry. Your firm was appointed as auditor to Island Co for the first time in June 2014
and you are currently planning the audit of the financial statements for the year ended 30 November
2014.
Island Co designs, constructs and installs machinery for five key customers. Payment is due in three
instalments: 50% is due when the order is confirmed (stage one), 25% on delivery of the machinery
(stage two), and 25% on successful installation in the customers coal mine (stage three). Generally it
takes six months from the order being finalised until the final installation.
Kate Shannon (CEO) owns 60% of the shares in Island Co. She also owns 55% of Pacific Co, which
leases a head office to Island Co.
(a) You have just received the following e-mail from the engagement partner of Island Co:
To: Audit Manager

From: Adrian Brown, Engagement partner, Island Co
Subject: Planning for 30th November 2014 year end audit
I have just met with Karen Shannon, the CEO of Island Co, and note below the key matters
raised in our discussions that you should take into consideration when planning the year end
audit:
The draft financial statements show revenue of $125 million (2013 $103 million),
profit before tax of $56 million (2013 $51 million) and total assets of $95 million
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(2013 $90 million).
At 30 November, there is an amount outstanding of $285 million from Jacks Mine Co.
The amount is a disputed stage three payment. Jacks Mine Co is refusing to pay until
the machinery, which was installed in August 2014, is running at 100% efficiency.
One customer, Sawyer Co, communicated in November 2014, via its lawyers with

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Island Co, claiming damages for injuries suffered by a drilling machine operator whose
arm was severely injured when a machine malfunctioned. Kate has told me that the
claim is being ignored as it is generally known that Sawyer Co has a poor health and
safety record, and thus the accident was their fault. Two orders which were placed by
Sawyer Co in October 2014 have been cancelled.
Following the physical inventory count on 17 November (that we observed and
concluded that the process was reliable) work in progress was valued at $85 million as
at 30 November 2014. The chief engineer estimated the stage of completion of each
machine at that date.
One of the major components included in the coal extracting machinery is now being
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sourced from overseas. The new supplier, Locke Co, is located in Spain and invoices
Island Co in euros. There is a trade payable of $15 million owing to Locke Co
recorded within current liabilities.
All machines are supplied carrying a one year warranty. A warranty provision is
recognised in the statement of financial position at $25 million (2013 $24 million).
Kate estimates the cost of repairing defective machinery reported by customers, and this
estimate forms the basis of the provision.
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Kate is considering selling some of her shares in Island Co in late January 2009, and
would like the audit to be finished by that time.
Based on the information that you have and my notes above, please can you prepare
planning briefing notes for our meeting next week that:
(i) Identify and explain the principal audit risks, and any other matters to be considered, for
the final audit of Island Co; and (14 marks)
(ii) Explain the principal audit procedures you believe should be performed during the final
audit in respect of the estimated warranty provision. (5 marks)
Many thanks for your input on this. I look forward to receiving the briefing notes prior to
our meeting.
Adrian Brown
Required
Respond to the partners e-mail. (19 marks)
Note: the split of the mark allocation is shown within the partners email.
Professional marks will be awarded in part (a) for the presentation and clarity of your
answer. (4 marks)
(b) Quality control provides the environment within which audits are conducted.
Required
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(i) Identify and describe FOUR quality control procedures that are applicable to the
individual audit engagement; and (8 marks)
(ii) Discuss TWO problems that may be faced in implementing quality control
procedures in a small firm of Chartered Certified Accountants, and recommend
how these problems may be overcome. (4 marks)
Question 19 BLUEBELL
PL (35 marks)
Bluebell Co operates a chain of 95 luxury hotels. This years results show a return to profitability for
the company, following several years of losses. Hotel trade journals show that on average, revenue in
the industry has increased by around 20% this year. Despite improved profitability, Bluebell Co has
poor liquidity, and is currently trying to secure further long-term finance.
You have been the manager responsible for the audit of Bluebell Co for the last four years. Extracts
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from the draft financial statements for the year ended 30 November 2014 are shown below:
Extracts from the Statement of Comprehensive Income 2014 2013

$m $m
Revenue (note 1) 890 713
Operating expenses (note 2) (835) (690)
Other operating income (note 3) 135 10
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Operating profit 190 33
Finance charges (45) (43)

Profit/(loss) before tax 145 (10)

Note 1: Revenue recognition
Revenue comprises sales of hotel rooms, conference and meeting rooms. Revenue is
recognised when a room is occupied. A 20% deposit is taken when the room is booked.
Note 2: Significant items included in operating expenses:
2014 2013
$m $m
Share-based payment expense (i) 138
Damaged property repair expenses (ii) 100
(i) In June 2014 Bluebell Co granted 50 million share options to executives and
employees of the company. The cost of the share option scheme is being
recognised over the three year vesting period of the scheme. It is currently assumed
that all of the options will vest and the expense is calculated on that basis. Bluebell
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Co operates in a tax jurisdiction in which no deferred tax consequences arise from
share-based payment schemes.
(ii) In September 2014, three hotels situated near a major river were severely damaged
by a flood. All of the hotels, which were constructed by Bluebell Co only two years
ago, need extensive repairs and refurbishment at an estimated cost of $100 million,
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which has been provided in full. All of the buildings are insured for damage caused
by flooding.
Note 3: Other operating income includes:
Profit on property disposal (iii)

2014
$m
125
2013
$m
10
(iii) Eight properties were sold in March 2014 to Daffodil Fund Enterprises (DFE).
Bluebell Co entered into a management contract with DFE and is continuing to
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operate the eight hotels under a 15 year agreement. Under the terms of the
management contract, Bluebell Co receives an annual financial return based on the
profit made by the eight hotels. At the end of the contract, Bluebell Co has the
option to repurchase the hotels, and it is likely that the option will be exercised.
Extracts from the Statement of Financial Position 2014 2013

$m $m
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Property, plant and equipment (note 4) 1,265 1,135

Deferred tax asset (note 5) 285 335
Deferred tax liability (note 6) (735) (638)
Total assets 2,870 2,230
Note 4: Property, Plant and Equipment (extract)
On 31 October 2014 all of Bluebell Cos owned hotels were revalued. A revaluation gain of
$250 million has been recognised in the statement of changes in equity and in the statement of
financial position.
Note 5: Deferred Tax Asset (extract)
The deferred tax asset represents unutilised tax losses which accumulated in the loss making
periods 20102013 inclusive. Bluebell Co is confident that future taxable trading profits will
be generated in order for the tax losses to be utilised.
Answer 1 FLIGHT INVESTMENT
(a) Purposes of an audit committee
The basis for establishing an audit committee primarily concerns corporate governance (i.e.
the ethical corporate behaviour of directors or others charged with governance in the creation
of wealth for all stakeholders). Such committees have been mandatory for domestic
companies listed on the New York Stock Exchange for many years and are also a requirement
of the London Stock Exchange for UK listed companies.
An audit committee is the sub-committee of the board, established by the board, which
provides an independent oversight of the organisations systems of internal control and
financial reporting process. This separate committee:
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enables the board to delegate a thorough and detailed review of audit matters;
enables non-executive directors to contribute an independent judgement and play a

positive role in an area for which they are particularly fitted;

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offers the external auditors a direct link with non-executive directors.
Taking, for example, the UK Corporate Governance Code, the main role and responsibilities
of the committee members must be set out in written terms of reference and include:
monitoring the integrity of the financial statements (and any formal announcements
relating to the companys financial performance) and reviewing significant financial
reporting judgements contained therein;
reviewing internal financial controls and internal control and risk management
systems (unless reviewed by a separate risk committee of independent directors or
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by the board itself);
monitoring and review of the effectiveness of the internal audit function or, if there
is no internal audit, consideration (annually) of the need for internal audit and
making that recommendation to the board;
recommending that the board put certain matters to the shareholders for their
approval in general meeting (e.g. regarding the appointment, re-appointment,
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removal and remuneration of the external auditor);
reviewing and monitoring the external auditors independence and objectivity and
the effectiveness of the audit process, taking into consideration relevant UK
professional and regulatory requirements;
developing and implementing policy on the engagement of the external auditor to

supply non-audit services, taking into account ethical guidance for the provision of
non-audit services by the external audit firm;
reporting to the board any matters for action or improvement including

recommendations on the steps to be taken;
reviewing arrangements by which staff may, in confidence, raise concerns about

possible improprieties in matters of financial reporting or other matters and ensuring
that arrangements are in place for independent investigation of such matters and for
appropriate follow-up action.
(b) Composition of the committee
Since the primary purpose of an audit committee is to carry out an independent review its
members should be independent of the companys main executives.
In a large company there should be a minimum of three members. All must be independent,
non-executive directors. At the present time Flight Investments has only one non-executive,
Mr Ackroyd. As his relationship with the executive (brother-in-law) will mean that he will
not be perceived to be independent, three new non-executive directors must be appointed.
At least one of these must be experienced in financial accounting (i.e. IFRS) and the others
should have sufficient business experience to be of appropriate assistance to the firm.
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(c) Specific responsibilities with internal audit and external auditors
Internal audit
Approve the appointment or termination of the head of internal audit.

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Ensure that the internal auditor has direct access to the board chairman and to the
Audit Committee and is accountable to the Audit Committee.
Review and assess the annual internal audit work plan, ensuring that it covers all
group companies.
Receive a report on the results of the internal auditors work on a periodic basis
including reports all group companies and locations visited.
Review and monitor group and local managements responsiveness to the internal
auditors findings and recommendations.
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Meet with the head of internal audit at least once a year without the presence of
management.
Monitor and assess the role and effectiveness of the internal audit function in the
overall context of the groups and individual companies risk management systems.
External audit
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Approve the terms of engagement and the remuneration to be paid in respect of

audit services provided for all of the auditors of the group.
Ensure that all external auditors (group and other auditors) are independent of the
group and group companies, for example:
discussion with the auditors;

review of their policies and processes to maintain independence; and
compliance with appropriate ethical guidelines.
At the start of each annual audit cycle, ensure that appropriate plans are in place for
the group audit (e.g. the overall strategy, risk assessment, materiality, resources,
work plans and group accounting instructions).
Review and discuss, with the group auditors, the findings of their work, for
example:
the outcome of the audit of each subsidiary;

major issues arising during the audit (resolved and unresolved);
key accounting and audit judgements;
levels of error identified during the audit; and
why certain errors remain unchanged.
Review with the group auditors the draft financial statements of each subsidiary
company, with particular attention to significant elements, for example:
compliance with legislation;
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compliance with the applicable financial reporting framework (e.g. IFRS);
disclosure of all items and accounting policies;
large or unusual items;
foreign currency translation;
valuations of properties and investments;
consistency of treatment of like items within the group; and
PLall other financial information included in the annual report.
Review the audit representation letters (before signing by management).
Review the management letters and monitor managements actions taken on its
recommendations.
Consider any modifications made by the group and subsidiary auditors in their
reports and in particular the impact of any subsidiary qualification on the group
auditors report.
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Consider the planning of subsequent audits, with particular reference to:
timing;
use of internal auditors;
use of computer-assisted auditing techniques; and
location visits by rotation.
Make recommendations to the main board on the appointment and remuneration of

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all auditors; the desirability or otherwise of having several firms of auditors should
be considered regularly.
Assess the effectiveness of the audit process for the group and for each subsidiary.
Consider, for example:
whether the agreed audit plan was adhered to and, where changes were
made, understand the reasons for such changes (including changes in
perceived audit risks and the work undertaken address those risks);
the robustness and perceptiveness of the group auditors in handling the

key accounting and audit judgements identified, in responding to
questions from the audit committees, and in commenting, where
appropriate, on the systems of internal control;
feedback obtained about the conduct of the audit from the key people
involved (e.g. finance directors and the head of internal audit).
The audit committee should develop and recommend to the board the companys
policy in relation to the provision of non-audit services by the auditor. The audit
committees objective should be to ensure that the provision of such services does
not impair the external auditors independence or objectivity. In this context, the
audit committee should consider:
whether the skills and experience of the audit firm make it a suitable
supplier of the non-audit service;
whether there are safeguards in place to ensure that there is no threat to

objectivity and independence in the conduct of the audit resulting from the
provision of such services by the external auditor;
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the nature of the non-audit services, the related fee levels and the fee
levels individually and in aggregate relative to the audit fee; and the
criteria which govern the compensation of the individuals performing the
audit.
Tutorial note: It is a higher level skill to be able to distinguish between the requirements of
(d)
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parts (a) and (c) without repeating detail between the two parts.
Relationship between the audit firm and audit committee
Establishing an audit committee should not impair the relationship between the audit firm and
the company. Rather, it should be enhanced by the forum for discussion of important issues
which it provides.
Although the audit committee must report on the work of the auditors, this should not prevent
it from working with them. By discussion of the issues as they arise in regular meetings, the
work of both the internal and external auditors should become more effective.
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From the perspectives of shareholders and those whose money is invested in Flight
Investments, an audit committee provides an extra tier of independence which will further
enhance the credibility of the audited financial statements.
Answer 2 BANANA CO
(a) File review

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(i) Training costs
Matters to consider
Materiality the relevant materiality calculations are:
Based on revenue: 500,000/125 million 100 = 4%

Based on net profit: 500,000/400,000 100 = 125%
Based on total assets: 500,000/78 million 100 = <1%
Based on the above, the training costs are immaterial to the statement of financial position,
but material to the statement of comprehensive income and therefore to revenue and profit. It
is important to note that any adjustment made to recognise the costs as an expense will have
the effect of turning the profit of $400,000 currently recognised into a loss of $100,000.
Accounting treatment
The finance directors argument is based on the idea that the training costs are directly related
to the assets concerned and therefore should be capitalised. IAS 16 Property, Plant and
Equipment does not permit the capitalisation of these costs as they are operating costs rather
than costs directly attributable to the item of plant. The concept behind this is that assets
should only be recognised if they are controlled by the entity. It is unlikely that Banana can
exercise control over the skills of its staff which have been developed by the training
programme, as staff may decide to leave employment with the company. Further, IAS 38
Intangible Assets also argues against the recognition of training costs as an intangible asset.
Therefore there are no grounds for recognising the training costs as a non-current asset and
the $500,000 cost of the training programme should be expensed to profit or loss.
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Audit opinion
If the financial statements are not amended, the audit opinion should be modified due to a
disagreement in accounting treatment. This would most likely be a qualified except for
opinion due to the material nature of the disagreement.
Evidence

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A schedule detailing the major categories of expenses which make up the total
$500,000 costs of the training programme.
Agreement of a sample of the costs per the schedule to supporting documentation

such as invoices provided from the external training firm.
Agreement of a sample of the costs to the cash book and/or the bank statement.
Confirmation that the training programme was completed before the year end (i.e.
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that none of the $500,000 represents a prepayment of costs).
Confirmation that the $500,000 is the total and that no further invoices received
after the year end for training carried out before the year end should have been
accrued.
Clarification that Banana does not exercise specific control over the skills of its
staff, by a review of standard terms of employment.
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Confirmation that the amount spent on the training programme agrees to an

authorised budget or an approved expenditure programme relating to the new
machinery and that the amount incurred is in line with expectations.
(ii) Trade receivable
Matters to consider
Materiality the relevant calculations for the total value of the trade receivable are as
follows:

Based on total assets: 300,000/78 million 100 = <1%
Therefore the total receivable is not material to the statement of financial position; however, it
is material to the profit and loss account and therefore to profit for the year, which is relevant
given that it appears that an impairment loss should be recognised in respect of this amount.
Accounting treatment
IAS 39 Financial Instruments: Recognition and Measurement requires that impaired trade
receivables are recognised at fair value, which is the present value of estimated cash inflows.
According to the information provided by Cherrys administrators, it is likely that 25% of the
amount outstanding will be paid. It seems, therefore, that 75% of the $300,000 trade
receivable is irrecoverable and so an impairment loss of $225,000 should be recognised. This
is material to the statement of profit or loss as follows:
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The potential expense to be recognised is highly material to net profit.
A further issue is that there may be inventory relating to Cherry in current assets. As Banana
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has several contracts with Cherry there may be raw materials purchased specifically for use in
a contract agreed with Cherry or items of work-in-progress. As Cherry is in insolvency, all
activity on such contracts will cease with immediate effect. Any such inventory should be
reviewed to see if it can be re-allocated to different contracts or back into general inventory.
If not, the inventory should be written down to the lower of cost and fair value less costs to
sell, with the associated loss recognised in profit or loss for the year.
Audit opinion
If the impairment loss on the trade receivable is not recognised the audit opinion should be
modified due to a disagreement in accounting treatment. This would most likely be a
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qualified except for opinion due to the material nature of the disagreement.
Looking at the two issues together, it appears that with the adjustments needed for the training
costs and the impairment of the receivable, the statement of profit or loss should show a loss
for the year of $325,000 (400 500 225). If the adjustments are not made the auditor may
be of the opinion that the statement of comprehensive income is rendered meaningless. This
may results in an adverse opinion stating that the financial statements are not fairly presented.
SA
Tutorial note: Credit will be awarded for discussion of going concern issues arising from the
loss of a major customer.
Audit evidence
The initial correspondence from the administrators of Cherry confirming that the
company is insolvent and that only 25% of amounts outstanding is likely to be paid.
A written confirmation from the administrators of Cherry stating the amount that is
likely to be paid and an anticipated payment date.
Agreement of the amount owed by Cherry to the receivables ledger and to written
confirmation from the administrator.
Recalculations of the impairment losses.
A review of inventory documentation for the value of inventory relating to contracts

with Cherry.
(b) Evaluation of the management of the audit of Banana
The comments made by the junior indicate that the audit has not been properly planned or
supervised. Both ISQC1 Quality Control for Firms that Perform Audits and Reviews of
Historical Financial Information and Other Assurance and Related Services Engagements
and ISA 220 Quality Control for Audits of Historical Financial Information provide guidance
in this area. There are many indicators of poor quality control which are evaluated below.
No audit planning meeting at the start of the audit
A meeting is important as this is where the audit partner should direct the audit assignment by
explaining to the members of the audit team their responsibilities, the nature of the clients
business and significant risk or fraud indicators identified, and the detailed approach to the
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audit.
If no meeting is held at the start of the audit, then it is unlikely that members of the audit team
will understand the audit strategy, the objectives of the work they have been asked to perform
or how tasks have been allocated amongst members of the team.
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The audit partner should lead the meeting, as it is his responsibility to ensure that the audit is
directed, supervised and performed in accordance with professional and regulatory standards.
Audit manager and supervisor are not always available
All audit assignments should be properly supervised. In the absence of a manager and
supervisor, the more junior members of the audit team will not be able to resolve problems
which arise. The longer there is a lack of supervision, the more problems will accumulate.
Without supervision, the audit plan may not be properly followed and inappropriate
modifications may be made to audit programmes.
M
Junior was given the tasks of auditing goodwill and inventory
It seems that audit work has not been properly delegated amongst members of the audit team.
An inexperienced audit junior should not be given relatively complex procedures to perform.
Both goodwill and work-in-progress can be challenging to audit and involve the use of
judgement (e.g. the evaluation of the stage of completion of work-in-progress) and it is
unlikely that a junior who has only been on two audits will have enough knowledge and
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experience to fully understand the complexities of the accounting and audit issues involved.
Tasks associated with goodwill and work-in-progress should be allocated to a more

experienced member of the team, leaving more straightforward tasks for the junior.
Junior helped with inventory count procedures
The junior did not understand the objectives of the inventory count. Test counts should have
been performed by the junior, in order to gather audit evidence for the completeness and
existence of inventory items, but members of the audit team should not help out the clients
staff with counting. Instead, the junior should have observed the clients staff and assessed
whether the count was being performed in accordance with count instructions.
Junior was asked to challenge the finance director
It is inappropriate for an inexperienced junior to challenge a senior member of clients

management. Contentious issues should be discussed with the client by the audit manager or
partner, as they have a more appropriate level of authority and will be in a better position to
explain why the provision is considered to be inadequate. This is an inappropriate delegation
of tasks within the audit team.
Inadequate time to complete necessary audit procedures
It seems that either not enough time has been allowed to complete the necessary audit
procedures or that, in the absence of much direction and supervision, the audit procedures
have been performed inefficiently.
E
One of the key aspects of supervision is to keep track on the progress of the audit
engagement. The audit plan should initially determine appropriate timescales and deadlines;
if it transpires that more time is needed, this should be discussed with the client.
Modification to planned audit procedures
PL
The audit procedures have been changed in response to lack of time. It is not acceptable to
cut corners by reducing sample sizes or changing the items selected for the sample.
Modifications should be discussed by senior members of the audit team and should only
occur for genuine reasons. The danger is that reduced sample sizes or changing the items
selected for testing will not provide sufficient, reliable audit evidence as the sample selected
may no longer be representative of the population as a whole.
Conclusion
M
Poor quality control means that this audit engagement has not had appropriate direction and
supervision. The evidence gathered may be inappropriate and inadequate for the purposes of
issuing an audit opinion. This could result in an incorrect opinion being issued. A detailed
hot and cold review should be performed to determine if any areas need extra audit work
performed and to consider what measures the firm should take to improve its quality control
monitoring procedures.
(c) Briefing notes to be used at training session

SA
Subject: Money laundering policies and procedures
(i) Introduction
In recent years accountants and auditors have become subject to anti-money laundering
regulations. This is largely due to the work of the inter-governmental body the Financial Task
Force on Money-Laundering (FATF).
A firm of Chartered Certified Accountants must establish sound policies and procedures to
ensure that the firm meets its responsibilities under the relevant regulation in which the firm is
operating. It is important that all members of an audit engagement team are aware of the
regulations, the firms policies and procedures and their own responsibilities regarding money
laundering activities.
Definition of money laundering
Money laundering is a process by which criminals attempt to conceal the true origin and
ownership of the proceeds of criminal activities. It is a way in which money earned from
criminal activities (dirty money) is transferred and transformed so it appears to have come
from a legitimate source (clean money). Money laundering includes a wide range of
potential crimes including possessing, dealing with, or concealing the proceeds of crime.
Illustrations
Money laundering activities could include:
Acquiring, using or possessing the proceeds of criminal activities such as drug
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trafficking and terrorist activities, or retaining control over the proceeds of tax
evasion.
Benefits obtained through bribery or corruption.
Inciting, aiding, counselling or concealing such activities.

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The three stages of the money laundering process are placement, layering and integration:
Placement is putting money into financial products or instruments, including life

policies, pension arrangements, unit trusts, travellers cheques and bank deposits.
Layering is creating a series of transactions so that the original source of funds is

obscured and difficult to trace.
Integration is converting the proceeds of money laundering into a legitimate form.

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For accountants there are specific ways that they could commit offences relating to money
laundering. These could include:
Handling the proceeds of criminal activity, or advising on the use of such proceeds.
Failure to report knowledge or suspicion of money laundering activities to the

appropriate authority.
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Making a disclosure which is likely to prejudice an investigation into money

laundering (known as tipping off).
Failure to comply with the specific regulatory requirements in relation to money

laundering in the jurisdiction in which the accountant is operating.
(ii) Policies and procedures
Appointment of a Money Laundering Reporting Officer (MLRO)
The MLRO is a nominated officer who is responsible for receiving and evaluating reports of
suspected money laundering from colleagues, deciding whether further enquiry is required
and, if necessary, making reports to the appropriate external body. The MLRO should have
an appropriate level of seniority and experience and would usually be a senior partner.
Customer identification procedures
This is often referred to as customer due diligence or know your client procedures. The
point of these procedures is to ensure that the firm knows the identity of clients (whether the
client is an individual or an entity) and has obtained evidence of that identity. For an
individual, typical evidence of identity would be a passport or driving licence and evidence of
home address (e.g. a utility bill). For an entity, evidence may include a certificate of
incorporation.
The identification process for an entity would also involve identification of key management
personnel and those people in control of the entity, and an assessment as to whether any
connected individuals are politically exposed people.
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Enhanced record keeping
Records must be kept of clients identity, the firms business relationship with them and
details of transactions with the client. All records should be kept for five years after the end
of the business relationship or completion of the transactions. Internal and external reports
made in connection to money laundering should also be securely kept for five years.
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Communication and training
All relevant employees should receive training so that they are aware of the main provisions
of money laundering regulations and know how to recognise and deal with activities which
may be money laundering.
The training programme should be offered to all members of the firm with an involvement in
audit engagements. Training should also be provided on the firms internal policies and
procedures with relation to money laundering. In particular, all staff should be aware of
appropriate lines of communication and who they should report suspicions of money
laundering activities to. Training should be considered for all staff, including support staff
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who do not carry out an advisory role.
Internal controls, risk assessment, management and monitoring
The firm should establish systems and controls to effectively manage the risk that the firm is
exposed to in terms of money laundering activities. This could include:
Client screening procedures to minimise the risk of taking on a new client with a
high risk of money laundering activities;
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Systems and controls to ensure that training is attended and understood by all
relevant employees;
Systems that allow periodic testing that the firms policies and procedures comply
with legislative and regulatory requirements.
All of the above contribute to the acceptance and following of firm-wide practices by all
relevant individuals and can be seen as quality control measures.
Conclusion
It can be seen that the firm needs to have in place appropriate measures to ensure that
complex anti-money laundering regulation is adhered to. It is the responsibility of all relevant
staff to be alert for suspicious activities and to understand their own responsibility to report
the activity. Failing to do so places the individual and the firm at risk of a breach of
regulation.
Answer 3 DEDZA & CO
(a) Need for ethical guidance
Accountants (firms and individuals) working in a country that criminalises money

laundering are required to comply with anti-money laundering legislation and
failure to do so can lead to severe penalties. Guidance is needed because:
legal requirements are onerous;

money laundering is widely defined; and
accountants may otherwise be used, unwittingly, to launder criminal funds.
Accountants need ethical guidance on matters where there is conflict between legal
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responsibilities and professional responsibilities. In particular, professional
accountants are bound by a duty of confidentiality to their clients. Guidance is
needed to explain:
how statutory provisions give protection against criminal action for

members in respect of their confidentiality requirements;
PLwhen client confidentiality over-ride provisions are available.
Further guidance is needed to explain the interaction between accountants

responsibilities to report money laundering offences and other reporting
responsibilities, for example:

reporting to regulators;
auditors reports on financial statements (ISA 700);
reports to those charged with governance (ISA 260);
reporting misconduct by members of the same body.
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Professional accountants are required to communicate with each other when there is
a change in professional appointment (i.e. professional etiquette). Additional
ethical guidance is needed on how to respond to a clearance letter where a report
of suspicion has been made (or is being contemplated) in respect of the client in
question.
Tutorial note: Although the term professional clearance is widely used, remember that
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there is no clearance that the incumbent accountant can give or withhold.
Ethical guidance is needed to make accountants working in countries that do not

criminalise money laundering aware of how anti-money laundering legislation may
nevertheless affect them. Such accountants may commit an offence if, for example,
they conduct limited assignments or have meetings in a country having anti-money
laundering legislation (e.g. UK, Ireland, Singapore, Australia and the United States).
(b) Annual reviews of existing clients
(i) Tax investigation
Kora is a relatively new client. Before accepting the assignment(s) Dedza should
have carried out customer due diligence (CDD). Dedza should therefore have a
sufficient knowledge and understanding of Kora to be aware of any suspicions that
the tax authority might have.
As the investigation has come as a surprise it is possible that, for example:
the tax authorities suspicions are unfounded;

Dedza has failed to recognise suspicious circumstances.
Tutorial note: In either case, Dedza should now review relevant procedures.
Dedza should review any communication from the predecessor auditor obtained in
response to its professional inquiry (for any professional reasons why the
appointment should not be accepted).
A quality control for new audits is that the audit opinion should be subject to a
second partner review before it is issued. It should be considered now whether or
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not such a review took place. If it did, then it should be sufficiently well
documented to evidence that the review was thorough and not a mere formality.
Criminal property includes the proceeds of tax evasion. If Kora is found to be guilty
of under-declaring income that is a money laundering offence.

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Dedzas reputational risk will be increased if implicated because it knew (or ought
to have known) about Koras activities. (Dedza may also be liable if found to have
been negligent in failing to detect any material misstatement arising in the 31 March
2006 financial statements.)
Koras audit working paper files and tax returns should be reviewed for any
suspicion of fraud being committed by Kora or error overlooked by Dedza. Tax
advisory work should have been undertaken and/or reviewed by a manager/partner
not involved in the audit work.
As tax advisor, Dedza could soon be making disclosures of misstatements to the tax
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authorities on behalf of Kora. Dedza should encourage Kora to make necessary
disclosure voluntarily.
If Dedza finds reasonable grounds to know or suspect that potential disclosures to

the tax authorities relate to criminal conduct, then a suspicious transaction report
(STR) should be made to the financial intelligence unit (FIU) also.
Tutorial note: Though not the main issue credit will be awarded for other ethical issues such
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as the potential self-interest/ self-review threat arising from the provision of other services.
(ii) Advice on payments
As compared with (i) there is no obvious tax issue. Xalam is not overstating
expenditure for tax purposes.
Dedza should consider its knowledge of import duties, etc in the destination country
before recommending a course of action to Xalam.
The payments being made for security consultancy services may amount to a bribe.
Corruption and bribery (and extortion) are designated categories of money
laundering offence under The Forty Recommendations of the Financial Action Task
Force on Money Laundering (FATF).
If this is a bribe:
Xalam clearly benefits from the payments as it receives income from the contract
with the major customer. This is criminal property and possession of it is a money
laundering offence
Dedza should consider the seriousness of the disclosure made by the chief executive
in the context of domestic law.
Dedza may be guilty of a money laundering offence if the matter is not reported. If
a report to the FIU is considered necessary Dedza should encourage Xalam to make
voluntary disclosure. If Xalam does not, Dedza will not be in breach of client
confidentiality for reporting knowledge of a suspicious transaction.
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Tutorial note: Making a report takes precedence over client confidentiality.
(iii) Financial advisor
Customer due diligence (CDD) and record-keeping measures apply to designated

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non-financial businesses and professions (such as Dedza) who prepare for or carry
out certain transactions on behalf of their clients.
Esau is a politically exposed person (PEP i.e. an individual who is to be

entrusted with prominent public functions in a foreign country).
Dedzas business relationships with Pholey therefore involve reputational risks

similar to those with Esau. In addition to performing normal due diligence measures
Dedza should:
have risk management systems to have determined that Esau is a PEP;

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obtain senior partner approval for maintaining business relationships with
such customers;
take reasonable measures to establish the source of wealth and source of

funds;
conduct enhanced ongoing monitoring of the business relationship.

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Dedza can choose to decline to act for Pholey and/or Esau (if asked).
If the business relationship is to be continued senior partner approval should be

obtained for any transactions carried out on Pholeys behalf in future.
Tutorial note: The Pholey family is not described as an audit client therefore no familiarity
threat arises in relation to an audit (the family may not have any involvement in entities
requiring an audit).
Answer 4 KLOSER
Tutorial note: This answer is expressed in the terms used in IESBAs Code of Ethics for Professional
Accountants. However, an answer expressed in terms of the ACCAs Code of Ethics and Conduct
is equally acceptable. Remember that there is more to ethics than independence (e.g. competence,
confidentiality) and more to professional issues than ethics (e.g. quality control and risk
assessments).
(1) Profits warning
Ethical and professional issues
The profit warning increases the inherent risk of this assignment. As more work
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may be needed than for the prior year (e.g. on Vanakas impaired assets), additional
staff may need to be assigned to the audit.
An advocacy threat may occur if a dispute (potential legal action) arises between
Isthmus and Kloser. For example, if the due diligence work should have recognised
the significant impairments.

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Kloser should undertake a review of the due diligence work and audit for the year-
ended 31 December 2013 to ensure there were no findings which should have
alerted them to the problems in Vanaka which precipitated the profit warning.
A self-review threat may arise in that the prior year-end audit, which followed the
purchase, may have lacked objectivity. For example, the involvement of the
corporate finance department in due diligence may have resulted in less audit work
being carried out on Vanakas assets and operating results than would otherwise
have been performed.
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If Kloser was negligent in undertaking the due diligence work (e.g. because assets
were impaired at the time of acquisition and/or the assumptions underlying the
expected synergies were unrealistic or hypothetical), to whom will Kloser be liable?
To whom was the due diligence work reported? (Isthmus, Isthmuss shareholders,
providers of finance for the acquisition?)
Tutorial note: To illustrate that these model answers are not exhaustive consider, for
example, that credit was given to candidates who argued that the trainees involvement in the
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audit would be beneficial (to Kloser and/or Isthmus).
Implications for staffing
As a safeguard for the provision of the other service (due diligence) the audit personnel
seconded to the corporate finance department should not have participated in the audit for the
year ended 31 December 2014. Any such bar should continue.
If the secondees are involved in the audit, appropriate safeguards would include not assigning
them to the audit areas most closely associated with due diligence and close monitoring and
review of their work.
More senior or experienced staff should be assigned to the audit (than would have been
necessary had the profit warning not been issued).
(2) Shares inherited
A self-interest threat has arisen as Mercedes has a direct financial interest in

Isthmus (i.e. she controls the shares). In particular, in wishing the share price to
increase Mercedes might be in a position to overlook unrecorded liabilities and
losses discovered during the conduct of the audit (say).
Even though Mercedes may have independence of mind and be known to act with
the utmost integrity, she cannot have independence in appearance.
This inadvertent violation (i.e. through inheritance) of an independence principle
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does not impair the independence of Kloser or the audit team providing:
Klosers established policies and procedures have resulted in Mercedes

having reported promptly her inheritance of the shares;
Kloser promptly advises Mercedes that the shares should be disposed of;

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the disposal occurs at the earliest practical date, or she is removed.
Mercedes does not intend to dispose of the shares quickly as she is waiting for the
share price to recover.
It is unlikely that Kloser would consider offering her adequate compensation for an
earlier disposal (the loss in share value since the fall being 5,000 ($795 $195)
= $30,000).
Although IESBAs independence statement requires Mercedes removal from the

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audit team, Kloser may require stricter safeguards and prohibit all professional staff
from holding direct financial interests. Mercedes may therefore be asked to choose
either to stay with the firm or dispose of the shares at the earliest practical date.
If any work has been done by Mercedes on the audit of Isthmus since she inherited
the shares (e.g. in reviewing interim audit work or planning the year-end or final
audit visits) that work should be re-reviewed by another professional accountant.
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This threat is so significant that Mercedes should be removed from the audit team unless she
disposes of the shares before she undertakes any further tasks relating to the audit of Isthmus.
(3) Dealing in shares
A self-interest threat would have arisen only if Anthony had known that a close
family member (a parent) had shares in Isthmus (but he did not). A self-interest
threat cannot now arise as his father has disposed of the shares.
Providing Anthony did not knowingly prompt his father to sell the shares, he has
not committed a criminal act (e.g. of insider dealing).
Tutorial note: If he committed such an act he should be instantly dismissed by the firm and
any professional body under which he is registered (e.g. ACCA) notified for disciplinary
action.
However, if he in some way communicated (e.g. in a careless remark) something

that prompted his father to sell the shares, he may be in breach of his duty of
confidentiality. This should be investigated and appropriate action taken (e.g. he
may be cautioned or given a written warning).
If he unknowingly gave his father price sensitive information, then his father may
be guilty of insider dealing (or similar) for having acted on it.
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Unless there is any reason to suppose that Anthony has acted improperly (e.g. if he has
delayed disclosing the matter) there is no reason why he should not continue his position in
the audit team.
However, if his father were to come under suspicion of insider dealing then Anthony should
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be withdrawn from this assignment.
Overall
Given the high profile attaching to this listed client it would be timely to have all members
assigned to the audit team renew their written declarations of independence and
confidentiality.
Answer 5 BECKER & CO
(a) Joint business arrangement

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The business opportunity of Murray could be lucrative if the market research is to be
believed.
However, IESBAs Code of Ethics for Professional Accountants states that a mutual business
arrangement is likely to give rise to self-interest and intimidation threats to independence and
objectivity. The audit firm must be and be seen to be independent of the audit client, which
clearly cannot be the case if the audit firm and the client are seen to be working together for a
mutual financial gain.
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In the scenario, two options are available:
(1) provision of finance by Becker & Co;

(2) establishing a joint venture.
(1) Provision of finance
Becker & Co could provide the audit client with finance to complete the development and
take the product to market. There is a general prohibition on audit firms providing finance to
their audit clients. This would create a clear financial self-interest threat as the audit firm
would be receiving a return on investment from a client. The Code states that if a firm makes
a loan (or guarantees a loan) to a client, the self-interest threat created would be so significant
that no safeguard could reduce the threat to an acceptable level.
The provision of finance using convertible debentures raises a further ethical problem; if the
debentures are ultimately converted to equity the audit firm would then hold equity shares in
an audit client. This is a severe financial self-interest; safeguards are unlikely to be available
to reduce the risk to an acceptable level.
The finance should not be advanced to Murray while the company remains an audit client of
Becker & Co.
(2) Establishing a joint venture
This would be perceived as a significant mutual business interest as Becker & Co and Murray
would be investing together, sharing control and sharing a return on investment in the form of
dividends. IESBAs Code of Ethics states that unless the relationship between the two parties
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is clearly insignificant, the financial interest is immaterial and the audit firm is unable to
exercise significant influence, then no safeguards could reduce the threat to an acceptable
level. In this case Becker & Co may not enter into the joint venture arrangement while
Murray is still an audit client.
The audit practice may consider that investing in the new electronic product is a commercial
from Murray.
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strategy that it wishes to pursue, either through loan finance or using a joint venture
arrangement. In this case the firm should resign as auditor with immediate effect in order to
eliminate any ethical problem with the business arrangement. The partners should carefully
consider if the potential return on investment will more than compensate for the lost audit fee
The partners should also reflect on whether they want to diversify to such an extent this
investment is unlikely to be in an area where any of the audit partners have much knowledge
or expertise. A thorough commercial evaluation and business risk analysis must be performed
on the new product to ensure that it is a sound business decision for the firm to invest.
The audit partners should also consider how much time they would need to spend on this
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business development if they decided to resign as auditors and proceed with the investment.
Such a new and important project could mean that they take their focus off the key business
(i.e. the audit practice). They should consider if it would be better to spend their time trying
to compete effectively with the two new firms of accountants; trying to retain key clients and
to attract new accounting and audit clients rather than diversify into something completely
different.
(b) Recruitment service

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IESBAs Code of Ethics for Professional Accountants does not prohibit firms from offering a
recruitment service to client companies. However several ethical problems could arise if the
service were offered. The severity of these problems would depend on the exact nature of the
service provided and the role of the person recruited into the clients organisation.
Specific ethical threats could include:
Self-interest clearly the motive for Becker & Co to offer this service is to generate
income from audit clients, thereby creating a financial self-interest threat. The
amount received for the recruitment service depends on the magnitude of the salary
of the person employed. The more senior the person recruited, the higher his salary
is likely to be, and the higher the fee to be paid to Becker & Co.
In addition, the firm could be tempted to advise positively on the recruitment of an

individual merely to receive the relevant recruitment fee, without properly
considering the suitability of the person for the role.
Familiarity when performing the audit, the auditors may be less likely to criticise
or challenge the work performed by a person they helped to recruit, as any
significant problems discovered may make the recruitment appear ill-advised.
Management involvement there is also a threat that the audit firm could be
perceived to be making management decisions by selecting employees. The firm
could offer services such as reviewing the professional qualifications of a number of
applicants and providing advice on the applicants suitability for the post. In
addition the firm could draw up a shortlist of candidates for interview, using criteria
specified by the client. However in all cases, the final decision as to whom to hire
must be made by the client, as the audit firm should not make, or be perceived to be
making, management decisions.
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The threats discussed above would increase in significance if the recruitee took on a role in
key management pertaining to the finance function, such as finance director or financial
controller. The threats would be less severe if the audit firm advised on the recruitment of a
junior member of the clients finance function.
If these threats could not be reduced to a level less than clearly insignificant, then the
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recruitment service should not be offered.
Commercial evaluation
The firm should consider whether there is likely to be much demand for the potential service
before developing such a resource. Some form of market research is essential.
Offering this type of service represents a significant departure from normal audit services.
The firm should consider whether there is sufficient knowledge and expertise to offer a
recruitment service. Ingrid Sharapova seems to have some experience but her skills may be
out of date and not specifically relevant to the recruitment of finance professionals. It may be
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that considerable training and possibly the attainment of a new professional qualification
relevant to recruitment may be necessary for a credible service to be offered to clients.
If the recruitment service proved successful Ingrid could be faced with too much work (as she
is the only person with relevant experience and has no one to delegate to). If the firm decides
to offer this service, then one other person should receive appropriate training (to cover for
Ingrids holidays and any sick leave and provide someone for Ingrid to delegate to). The
financial cost of such training should be considered.
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Finally, Becker & Co should consider the potential damage to the firms reputation if the
service offered is not of a high quality. If the partners decide to pursue this business
opportunity, they may wish to consider setting it up as a separate entity, so that if the business
fails or its reputation is questioned, the damage to Becker & Co would be minimised.
(c) Temporary staff assignments
Lending staff on a temporary basis to an audit client will create the following ethical threats:
Management involvement assuming that the manager or senior is seconded to the

finance function of the audit client, it is likely that the individual would be in some
way involved in decision making in relation to the accounting systems, management
accounts or financial statements.
Self-review on returning to the audit firm a seconded individual could be a

member of the audit team for the client to which he was seconded. This would
create a self- review threat as he would be unlikely to criticise his own work
performed or decisions made. Even if the individual was not assigned to the client
where he performed a temporary assignment, the audit team assigned may tend to
over rely on areas worked on by a colleague during the period of his temporary
assignment.
Familiarity if the individual is working at the client at any time during the audit,
there will be a familiarity threat; audit team members will be unlikely to sufficiently
challenge the work performed by the seconded individual (and professional
scepticism may be lacking).
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In addition, due to the over-staffing problem of Becker & Co, the seconded individuals may
feel that if they were not on the secondment, they could be made redundant. This may cause
them to act in such a way as not to jeopardise the secondment, even if the action were not in
the best interests of the firm.
The threats discussed above are increased where a senior person likely to make significant

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decisions is involved with the temporary assignment, as in this case where audit managers or
seniors will be the subjects of the proposed secondment.
In practice, assistance can be provided to clients, especially in emergency situations, but only
on the understanding that the firms personnel will not be involved with:
making management decisions;

approving or signing agreements or similar documents; and
having the authority to enter into commitments on behalf of the company.
In addition, the individual seconded to a client should not then be involved in any way with
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the audit of that client when he returns to the audit firm. This may be a difficult area, as
presumably the client would prefer that such an individual has knowledge and experience of
the business (i.e. a member of the audit team) and, most likely in this scenario, is the audit
manager. If this were the case the manager would then have to be reassigned to a different
client, causing internal problems for the audit firm. This problem is likely to outweigh any
benefits, financial or otherwise, to Becker & Co.
If the temporary staff assignment were to a non-finance department of the client then the
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threats would be reduced.
If Becker & Co decides to go ahead with the secondment programme, the firm must ensure
that the staff are suitably experienced and qualified to carry out the work given to them by the
client. There could be a risk to the reputation of Becker & Co if the seconded staff are not
competent or do not perform as well as expected by the client.
One advantage of a secondment is that the individual concerned can benefit from exposure to
a different type of work and work environment. This will provide some valuable insights into
accounting within a business and the individual may bring some new skills and ideas back
into the audit firm.
However, the staff seconded could be offered a permanent position at the client. This would
lead to the loss of key members of staff and be detrimental for Becker & Co in the long run.
The other benefit for the audit firm is that a programme of secondments will ease the problem
of an over-staffed audit department and should have cash flow benefits.
Tutorial note: In answering this question it is relevant to briefly mention corporate

governance implications (e.g. the client may not be able to accept the services offered by the
auditor for ethical, particularly objectivity, reasons).
(d) Transnational audit
(i) Definition and relevance
Definition: A transnational audit means an audit of financial statements which are or may be
relied upon outside the audited entitys home jurisdiction for the purpose of significant
lending, investment or regulatory decisions.
Relevance: The Murray Group will be listed on the stock exchange of several countries. This
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means that the group will be subject to the regulations of all stock exchanges on which it is
listed and so bound by listing rules outside of its home jurisdiction. The group will also
contain many foreign subsidiaries, meaning that it operates in a global business and financial
environment.
(ii) Features
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Application of auditing standards
Although many countries of the world have adopted International Standards on Auditing
(ISAs), not all have done so, choosing instead to use locally developed auditing regulations.
In addition, some countries use modified versions of ISAs. This means that in a transnational
audit, some components of the group financial statements will have been audited using a
different auditing framework, resulting in inconsistent audit processes within the group and
potentially reducing the quality of the audit as a whole.
Regulation and oversight of auditors

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Similar to the previous comments on the use of ISAs, across the world there are many
different ways in which the activities of auditors are regulated and monitored. In some
countries the audit profession is self-regulatory, whereas in other countries a more legislative
approach is used. This also can affect the quality of audit work in a transnational situation.
Financial reporting framework

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Some countries use International Financial Reporting Standards, whereas some use locally
developed accounting standards. Within a transnational group it is likely that adjustments,
reconciliations or restatements may be required in order to comply with the requirements of
the jurisdictions relevant to the group financial statements (i.e. the jurisdiction of the parent
company in most cases). Such reconciliations can be complex and require a high level of
technical expertise of the preparer and the auditor.
Corporate governance requirements and consequent control risk
In some countries there are very prescriptive corporate governance requirements, which the
auditor must consider as part of the audit process. In this case the auditor may need to carry
out extra work over and above local requirements in order to ensure group wide compliance
with the requirements of the jurisdictions relevant to the financial statements. However, in
some countries there is very little corporate governance regulation at all and controls are
likely to be weaker than in other components of the group. Control risk is therefore likely to
differ between the various subsidiaries making up the group.
Tutorial note: Only two features are required to be discussed.
Answer 6 CARTER & CO
(a) Fernwood Co
The provision of a valuation service is an example of providing a non-audit service. The key
issue is that if an audit firm provides a valuation service for an item which will be included in
the financial statements, a self-review threat arises. The self-review threat exists because the
audit firm will be auditing a balance on which they have themselves placed a valuation.
The significance of the risk depends on the level of materiality of the item in the financial
statements. According to IFACs Code of Ethics for Professional Accountants (the Code), if
the valuation service involves the valuation of matters material to the financial statements,
and the valuation involves a significant degree of subjectivity, the self-review threat created
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could not be reduced to an acceptable level by the application of any safeguards. If this were
the case, the audit firm should not provide the valuation service. Alternatively, if the
valuation service were provided, the firm should resign from providing the audit service.
Carter & Co must assess the degree of risk in valuing Fernwoods pension liability. If the
amount is immaterial to the financial statements, or does not involve a significant degree of

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subjectivity, the valuation service can be provided, as long as safeguards are put in place, for
example:
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.
The valuation of the pension balance recognised is likely to involve many judgments and
assumptions, and so is likely to be a subjective exercise. It is, therefore, most likely that
Carter & Co will assess the situation as creating a significant self-review threat which
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safeguards cannot reduce to an acceptable level, in which case the valuation service should
not be provided as well as carrying out the audit.
If Carter & Co were to provide the valuation service, either because the self-review threat is
assessed as low, or if they were to resign as auditor, then the firm should carefully consider
whether it possesses sufficient skills and expertise to perform the valuation. This is a
specialist area, and the firm would have to ensure that it could perform the work competently.
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(b) Hall Co
Allocation of staff to an audit team should be the decision of the audit firm, and should not be
influenced by the wishes of the client. This point should be made clear to the finance director
of Hall.
Staff should be allocated to an audit team based on the needs of the audit. The team should
comprise staff with a mix of skills, experience and technical knowledge as appropriate to the
size and complexity of the audit, as well as logistical issues such as location and deadlines.
Introducing an audit senior with no previous experience of the client may lead to ineffective
leadership of the team, and could jeopardise the quality of the audit.
On the other hand, working on a new audit client will provide Kia with more experience and
broaden her knowledge and expertise.
A further issue is that Kia is a relative of the financial controller of Hall. A family or personal
relationship between a member of the audit team, and an officer or employee of the audit
client can create threats to objectivity. The threats that arise are as follows:
Familiarity Kia may fail to approach the audit with professional scepticism;
Intimidation the financial controller may be able to exert influence on Kia, for
example, influence her conclusions on work performed;
Self-interest Kia may be unwilling to challenge the financial controller about

accounting matters for fear of causing problems for her relative.
The degree of threat depends on the level of seniority of the close family member. Where
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they are in a position to exert direct and significant influence over the financial statements
then the threat is significant. In this case, Kias relative is the financial controller, so is
clearly in an influential position. Kia herself is also in a position of some influence over the
audit, as she would take the position of audit senior, therefore responsible for the day-to-day
supervision and direction of the junior members of the audit team.
(c) Collier Co PL
The most appropriate course of action would be that Kia is not assigned to the audit of Hall,
and the reasons for this should be explained to the client.
Usually documents such as title deeds or insurance certificates are held by the audit client or
their legal advisors, but sometimes the service is provided by the accountant.
The Code states that before agreeing to provide custodial services the audit firm must ensure
that there is no legal restriction on holding assets (documents or tangible assets). A self-
interest threat could be created as the firm receives a financial benefit from the fee charged for
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the service. There could also be a perception of a close relationship between the audit firm
and the client, if one is holding documents on behalf of the other.
Appropriate safeguards to be used in the provision of a custodial service could include:
Keeping the assets physically separate from the firms assets;
Keep orderly documentation regarding the assets and be ready to account for them
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to the client when requested;
Establishing strict controls over the physical access to the assets; and
Comply with all relevant laws and regulations in respect of holding the assets.
Confidentiality is also a key issue the firm must ensure that documentation is only ever
given to the client who has entrusted it to the firm. The reasons for this should be explained
to the client.
In addition Carter & Co should be vigilant in respect of money laundering regulations. The
tangible assets could be purchased using the proceeds of crime and as such the firm in custody
of such assets would be deemed to be involved with money laundering. The firm would have
to be careful to ascertain the true origin of the assets in its custody.
A further issue is whether Carter & Co has sufficient security to offer such a service.
Employment of extra security methods such as alarm systems, CCTV, security personnel
could be costly, and might outweigh the revenue to be derived from offering the service.
In order to maximise the revenue from this source of income, Carter & Co could be tempted
to concentrate on holding high value assets, as these would attract the highest fees. This
would compound the security issues discussed above, especially the cost of extra insurance.
If there were ever a problem such as documents held in custody being lost or damaged, or
assets being stolen, then Carter & Co would face major reputational risk. This risk, along
with the extra costs discussed above, may outweigh the relatively small revenue stream that
the custodial service would provide.
(d) Gates Co
Referral fees are not prohibited by the Code. However, a self-interest threat can arise, as the
audit firm gains a financial benefit for each audit client referred to Gates. The referrals and
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payments to Carter & Co can continue, provided that safeguards are put in place. Safeguards
could include:
Disclosing to the audit clients that a referral fee arrangement exists, and the details
of the arrangement;

arrangement;
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Receiving confirmation from the audit clients that they are aware of the referral
Receiving confirmation from all employees of Carter & Co that they have no
interest in Gates.
Carter & Co may also wish to consider the quality of the training provided by Gates. Any
problems with the training provided could cause damage to the reputation of Carter & Co.
Answer 7 NEESON & CO

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(a) Ethical and professional issues
(i) Draft advertisement
Advertising is not prohibited by IFACs Code of Ethics for Professional Accountants or by

ACCAs Code of Ethics and Conduct. However, the Code states that a professional
accountant in public practice should not bring the profession into disrepute when marketing
professional services. The professional accountant in public practice should be honest and
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truthful when advertising services and should not:
Make exaggerated claims for services offered, qualifications possessed or

experience gained;
Be misleading, either directly or by implication; or
Make disparaging references or unsubstantiated comparisons to the work of another.
In addition to consideration of the above, firms of accountants should also ensure that any
advertisements comply with local regulations, such as Advertising Standards Regulations.
Neeson & Cos advertisement begins by claiming that the firm is the largest in the country.
The firm has only three offices and 12 partners, and it may be misleading to claim that the
firm is the largest in the country. It is also claimed that Neeson & Co is the most
professional firm. This claim is impossible to substantiate, and could be misleading, as
members of the public may be led to believe that the firm can demonstrate that it is better
than its competitors.
The advertisement claims that the firms services guarantee improved business efficiency.
This cannot be guaranteed, so the advertisement is not honest in this respect. In addition,
there is a guarantee that the firm will save tax for the client. This also cannot be guaranteed,
as each individual client will have different tax issues, and it will only be on detailed
investigation of the exact tax affairs of the individual client that tax planning methods leading
to savings could be suggested.
In addition, the claims increase the risk that the firm is exposed to litigation claims, as clients
that engage Neeson & Co and do not see improvements in business efficiency or reduction in
tax may take action against the firm on the grounds of false claims being made in the
advertisement.
Second opinions are not prohibited, but it is unusual for clients to seek a second opinion, and
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extremely uncommon to advertise this service. The advertisement implies that Neeson & Co
can offer a better audit opinion than other firms, which is unprofessional and lacking in
integrity. The advertisement could also imply that it is common practice for a second opinion
to be sought, which is not the case, and is misleading to the public.
Offering an introductory fee would not in itself be prohibited. However, fees should be
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calculated based on the time that would need to be devoted to an assignment to ensure a
quality service was provided. Offering a fee 25% lower than the current auditor is effectively
lowballing. Cutting fees by 25% could result in poor quality work being conducted.
It is also unwise for the firm to offer a reduction in fee when both audit and tax services are
provided, as the provision of a non-audit service such as tax planning can create a threat to
objectivity of self-review and advocacy, which means that both services cannot be offered to
the client without the use of safeguards to reduce the threat to an acceptable level.
The advertisement claims that the firms rates are approved by ACCA. This is a false claim,
as ACCA does not monitor or approve the rates charged by firms for their services. The
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statement implies that ACCA endorses the firms activities, and takes advantage of using
ACCA as a brand, which is unprofessional. This could lead to disciplinary action against
the firm or individual partners by ACCA.
(ii) Corporate finance service
Although the new partner has experience in the banking sector, and therefore appears to be
competent to provide this corporate finance service, there are several problems raised by the
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suggested service.
The first problem is that by negotiating finance arrangements on behalf of an audit client,
Neeson & Co is exposed to an advocacy and self-review threat to objectivity. This threat
occurs when the audit firm takes a position on behalf of the client, and promotes the clients
interests to a third party. The audit firm could be perceived as taking on a management role,
thus compromising independence.
The significance of any threat to objectivity should be evaluated and safeguards applied when
necessary to eliminate the threat or reduce it to an acceptable level. Examples of such
safeguards include:
Ensuring that the new partner is not involved in the audit of any clients for which he
has provided a corporate finance service; or
Using a professional who was not involved in providing the corporate finance
service to advise the audit team on the service and review the accounting treatment,
and any financial statement treatment.
The second issue is the contingent fee. A contingent fee arises where the audit firm receives a
fee which is dependent on a certain outcome, in this case the outcome being securing finance
at a favourable cost of borrowing.
Contingent fees are not allowed for audit engagements, according to IFACs Code because of
the self-interest threat to objectivity created. The Code argues that for an audit engagement,
no safeguards could reduce the threats to an acceptable level.
For non-assurance work performed for an audit client, contingent fees may still create such a
significant self-interest threat that safeguards could not reduce the threat to an acceptable
level. This would be the case where the contingent fee is material to the provider of the
service, or the fee is related to a matter which is material to the financial statements. It is
usually inappropriate to accept a contingent fee for non-assurance work that is carried out for
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an audit client. Neeson & Co should not offer the finance negotiation service to audit clients
for these reasons unless the fee received is clearly immaterial to the firm, and the matter is
immaterial in the context of the clients financial statements.
However, contingent fees could be used for corporate finance services offered to Neeson &
Cos non-audit clients. A self-interest threat may still arise, and the firm should consider the

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significance of any threat by reference to the nature of the engagement, the range of possible
fees and the basis for determining the fee.
If Neeson & Co goes ahead with offering this service to non-audit clients, safeguards should
be considered, such as:
An advance written agreement with the client as to the basis of remuneration.
Ensuring that the partner providing the corporate finance service is not involved
with other work for the same client.
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(b) Compulsory rotation of audit firms
(i) Ethical threats created by long association
It is not uncommon for firms to act as auditor for a client for a number of years. However, the
Code argues that using the same senior personnel on an assurance engagement over a long
period of time may create a familiarity and self-interest threat. The significance of the threat
will depend upon factors such as:
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The length of time that the individual has been a member of the assurance team;
The role of the individual on the assurance team;
The structure of the firm;
The nature of the assurance engagement;
Whether the clients management team has changed; and
Whether the nature, complexity of the clients accounting and reporting issues have
changed.
The problem of long association is that a familiarity threat to objectivity is created. The
senior personnel risk losing their professional scepticism, and may cease to challenge the
client on significant matters. A close relationship will be built up between the senior audit
personnel and senior members of the clients management team, so the auditors become too
sympathetic to the interests of the client.
The Code requires that for public interest clients, the key audit partner should be rotated after
a pre-determined period of seven years, as a means to safeguard against the familiarity threat.
After such time, the key audit partner shall not be a member of the engagement team or be a
key audit partner for the client for two years. During that period, the individual shall not
participate in the audit of the entity, provide quality control for the engagement, consult with
the engagement team or the client regarding technical or industry-specific issues, transactions
or events or otherwise directly influence the outcome of the engagement.
(ii) Evaluation of advantages and disadvantages
The main argument in favour of compulsory rotation of audit firms is that it should work to
eliminate the familiarity threat. By not only rotating the key partner, but the entire audit firm,
it is argued that the auditors independence is not compromised, and that this adds credibility
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to auditors reports and to the profession as a whole.
It can also be argued that clients would benefit from a fresh pair of eyes after a number of
years. A new audit firm can offer different insights from a fresh point of view.
However, there are significant disadvantages to compulsory rotation of the audit firm. Firstly,
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from the audit firms perspective, there will be a loss of fee income when forced to resign as
auditor. Also, the firm may be unwilling to make investments that may increase the quality or
efficiency of a particular audit (for example, investing in bespoke audit software for a client),
as the rewards would only be in the short-term.
Audit effectiveness depends upon the audit firms accumulated knowledge of, and long-term
experience with, the clients operations and financial reporting issues. Compulsory rotation
undermines this accumulation of knowledge and experience. Audit problems are more likely
to occur when the audit firm lacks this base. In the first few years auditors will know less
about the client company and its management, and will be in a weaker position in making
judgements about reporting issues. This severely detracts from the quality of the audit, and
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creates higher levels of risk exposure for the firm.
Compulsory rotation of audit firms increases audit costs and creates significant practical
problems. With each rotation, a new audit team must be brought up to speed on the clients
operations and reporting issues, involving significant management time. Systems will need to
be documented and evaluated. The increase in costs is likely to be passed onto the client in
the form of a higher audit fee.
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Finally, from the clients perspective, as well as facing increased audit fees and a potential
loss of audit quality, the periodic rotation of audit provider could be disruptive to the
business.
On balance, it would seem that the disadvantages to both the audit firm and the client would
outweigh the perceived benefits of compulsory rotation. The best safeguard to reduce
familiarity threat is partner rotation, which allows the audit firm to continue in office, but
avoids close relationships being built up.
Answer 8 RAPID TRAVEL CO
(a) Inherent risk assessment
The main areas and factors that should be considered include:
The rapid expansion of the business. It may be that the company is under-
capitalised and may be overtrading leading to high gearing and poor liquidity;
Many businesses with such rapid growth and a successful profit record are often the
targets of takeover bids. This increases the inherent risk of the financial statements
being manipulated to improve the offer terms of airy bidder (e.g. the apparent
under-depreciation);
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The company has only two shareholders and directors and there appears to be no
other form of corporate governance such as an audit committee. It is likely that the
companys internal controls are weak and could easily be overridden by the two
dominant directors;

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The business may have a high level of cash sales (bus and coach fares) which at the
point of receipt is likely to be under the control of the driver with no internal check.
This point may be mitigated by controls such as the pre-selling of seats, issuing of
prepaid travel passes, ticket inspectors and a statistical analysis of ticket sales;
The business operates in a highly-regulated area where public safety is of major

importance. Breaches of safety regulations may have serious consequences for the
continuity of the business;
The company is investing in an area (operating nursing homes) where it has little
experience and this represents a huge investment for this company.
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(b) Responsibility for compliance with laws and regulations
ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements says that
during the planning and performance of an audit the auditor should be aware that non-
compliance by the company with laws and regulations may have a material effect on the
financial statements. During the planning stage the auditor should obtain a general
understanding of the legal and regulatory framework applicable to the clients industry,
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particularly those regulations that may have a fundamental effect on the future operation of
the company.
It must also be said that such responsibility can only relate to material non-compliance with
serious breaches of laws and regulation. Auditors cannot be expected to be aware of all laws
and regulations relating to a particular business, although they should be fully aware of
matters relating to the form and content of published financial statements. Responsibility for
compliance (and detection of non-compliance) with financial, non-financial and detailed
industry specific laws and regulations rests with the management and employees of the
company.
(c) Audit work to discharge responsibilities
ISA 250 says that auditors should perform procedures to help them to identify instances of
non-compliance with laws and regulations. It specifically mentions:
inquiring of management for assurances of compliance;

inspecting correspondence with relevant licensing or regulatory authorities; and
obtaining evidence regarding compliance with those regulations that are generally
recognised as having the potential to cause a material effect on the financial
statements.
Rapid Travel operates in an industry which in most parts of the world is heavily regulated,
mainly in terms of ensuring the safety of passengers. The aspects of the industry which the
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auditors should have researched and be aware of are:
Drivers hours, speed restrictions most countries have strict (but differing)
regulation over how long drivers are permitted to work. There are generally
statutory methods of monitoring this such as the maintenance of drivers logs and
tamper proof machines that can measure the periods and speeds at which vehicles

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have been driven. The presence of this type of monitoring together with any other
relevant methods should be verified and tested by the auditor. An independent
transport consultant should be asked for an opinion on whether the schedule
timetables are achievable in normal operating conditions.
Annual safety checks although these are conducted by independent, government-

approved garages and workshops, events suggest that such tests are not fool proof.
Once alerted to the possibility of manipulation of these tests the auditors should
seek assurances from management, in the form of written representations, that such
events did not take place. The auditor should attempt to obtain further evidence to
corroborate or refute the malpractice. This may involve asking for suspect vehicles
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to be re-inspected.
Serious or persistent breaches of any of the above regulations can have a fundamental effect
on the business and its financial statements. It is highly likely that the authorities can and
would put serious offenders out of business by refusing operating licences. The fatal accident
and related press reports would mean that public awareness would be high and public interest
and safety would be paramount in the investigation.
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Information provided by dismissed employees should be treated with caution, but it should
not be ignored. It may be that the ex-employee is bearing a grudge against the company. The
press reports may corroborate the employees information, but it may also be that they are
actually from the same person. It is unlikely the newspaper will reveal its source of
information. There is however other evidence that supports the ex-employees claims, the
high level of breakdowns and the authorities investigation into the fatal accident. The
auditor should discreetly ask current employees if they are aware of similar pressures or
events of malpractice and possibly talk to trade associations or trade unions for further
information.
Another possible area where the company may be in breach of regulations is in its pricing
policy. In many countries it is illegal to deliberately undercut competitors prices if these are
being subsidised from more profitable areas of the business, particularly where the purpose of
this is to put competitors out of business so that prices can then be increased from a
monopolistic position. Again it is likely that this tactic may be investigated by the
appropriate authorities.
(d) Out-of-court settlement
Advantages
They avoid escalating legal costs. In some cases it is estimated that these can be
more than the damages and it is not always certain that even a successful defence
will recover the legal costs.
They may also avoid costs relating to audit staff time preparing for court cases.
The alleged damaged parties are often willing to settle for a lesser amount than
claimed in the action. This is due to the fact that they too may be taking risks in
terms of their defence costs and the possibility of having to pay the auditors costs if
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they lose. Even a successful decision (for the client) may not lead to the award of
the full amount of damages claimed.
When cases are adversely decided against the auditor it undoubtedly diminishes the
reputation of the auditor and leads to related adverse publicity in the financial press.
It may also lead to an investigation of the auditors by their regulatory body.
Disadvantages
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The auditor is deprived of the opportunity to defend himself in a court of law as the
insurance company effectively takes over the defence and settlement of the case.
This cannot be a good development. Where the auditor is not insured this is
unlikely as it is compulsory in most audit regulatory systems or the insurance is
insufficient to cover the claim, the above would not apply and the auditor would
then be in a position to contest the claim if he so wished.
The development in some countries of the no-win; no-fee basis of remunerating

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lawyers is leading to a general proliferation of litigation (not just in auditing). Often
lawyers acting against auditors are expecting out-of-court settlements because they
know that otherwise the auditors face expensive legal defence costs.
Although out-of-court settlements do not necessarily mean the auditors were

guilty of the alleged negligence, many observers will infer at least some blame on
the auditors and thus they may receive adverse publicity similar to had they lost the
case in a court of law.
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A likely consequence of the settlement is that the auditors insurance company may
consider the practice to be a higher risk and indemnity premiums will rise
accordingly. A further effect of outof-court settlements (even for audit firms that
have not been involved in litigation) is that premiums in general will rise to
incorporate the perceived risk of such settlements. In many cases it may be that,
given the chance, the Courts would have found in favour of the auditors. Thus all
audit firms may inadvertently be insuring for risks that do not have a real
foundation.
Case law is very much a part of a legal and regulatory system. Neither statute nor
auditing standards can cover all possibilities that may arise and some aspects of
professional life (e.g. audit liability) are dynamic; they do not stand still. In the past
case law has helped the profession to gauge the changing standards that are
expected of it. If cases do not go to law the profession as a whole is weaker for this
lack of guidance and interpretation from the courts.
Answer 9 NEGLIGENT ACTIONS
(a) Accountability of auditors
Auditors can be held accountable for negligent actions in several ways, for example:
by their membership of a designated professional body;

via a lawsuit;
through quality control mechanisms; and
to society.
Professional body membership
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Auditors have an ethical responsibility to their clients as a member of a designated
professional body. This membership is subject to the regulations of that body and the auditor
acting in accordance with accepted professional standards of behaviour. Thus auditors have a
responsibility to act in a non-negligent manner to their clients and also to their profession.
The status of the profession is dependent upon the actions of its members and members who
act in a negligent manner are accountable to that profession.
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A formal complaint can be made about the members actions to the professional body which
can lead to disciplinary action against the member. This action can in turn lead to expulsion
from the profession. Thus the professional body is protecting client companies from
negligent auditors. This disciplinary procedure is very important as it is often triggered
sooner than a court action and its sanctions are quite dramatic as it can result in the auditor
losing his livelihood.
Law suits
Auditors can be held liable for negligent actions via a law suit seeking damages for their
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negligent work. This procedure not only can result in a loss of capital for the auditor but also
a loss in revenue because of the loss of reputation, which naturally follows a law suit. The
difficulty often is proving negligence and the fact that the audit work is not of an acceptable
standard. Often cases are settled out of court in order to save money. The action brought
against the auditor may be criminal or civil depending on the nature of the negligent action
and the country concerned.
Quality control
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Auditor accountability is increased by the internal quality control mechanisms which are
designed to control individual partners. Audit firms have joint and several liability for the
most part and partners have a responsibility to other members and partners of the firm.
Partners are subject to peer review and quality control procedures, which review their actions.
There is a specific standard of behaviour and competence which is required by the body of
partners and the actions of individual partners are scrutinised to ensure conformity with these
standards of behaviour. Partners need to guard against pressures which may compromise
audit quality and result in court actions being brought against the auditor. Any partner found
guilty of negligent actions will be censured by the internal mechanisms of the firm.
Accountability to society
Society will not tolerate or accept a regulatory body if it does not discipline its members for
negligent actions. A firm of auditors found guilty of negligence will suffer because of the
effect that this verdict will have on the reputation and image of the audit firm.
(b) Determining legal liability
If the legal liability is determined by the courts then the amount of the damages paid is also
determined by the courts. Accordingly, the auditing profession feel that it is often the victim
of law suits simply because it has deep pockets. Potential litigants feel that the auditors
have substantial assets from which parties affected by auditor negligence may be
compensated by the courts. Additionally, as most audit firms are partnerships, the partners
may have joint and several liability and thus are targeted by potential litigants even though the
auditors may not be wholly responsible for a corporate collapse or a failure to detect fraud or
mismanagement.
It seems that the number and size of law suits and claims against auditors are rising and a
significant proportion of the income from auditors is being spent on meeting liability costs in
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the form of insurance premiums and uninsured settlements. The audit firms feel that the size
and frequency of the claims made in court could potentially jeopardise their operations,
profitability and existence. Insurance companies are making it harder for firms to obtain
insurance cover and thus audit firms are carrying higher risks. There is a possibility of an
audit firm failing because of the law relating to auditor negligence with the resultant
consequences for employment, competition and the image of the profession.
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However, one of the major problems relating to auditor liability arises where liability is
determined by the courts. Certainly following cases such as Caparo and Al Saudi Banque,
individual shareholders and creditors will find it difficult to sue the auditor in the UK. Many
would argue that such a position is untenable and that shareholders should be allowed to bring
class actions against negligent auditors.
However, in the case of Royal Bank of Scotland v Bannerman Johnstone Maclay (2002) the
judge found in favour of the Royal Bank of Scotland who had sued the auditors to reclaim a
lost loan which it had offered based on a set of audited financial statements. In this case the
judge said that a disclaimer within the audit report would have made it impossible to infer that
the auditors had assumed a duty of care to the bank. Because of this ruling, the ICAEW
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(Institute of Chartered Accountants in England and Wales) issued guidance on the use of
appropriate wording within UK audit reports. Such wording is optional and even if used,
each case brought against auditors would still be considered on the individual circumstances.
In Australia the situation is far less clear. Some courts have applied the Caparo ruling and
others have not. In R Lowe Lippman Figdor and Frank v AGC (Advances) Ltd (1992) the
Supreme Court of Victoria followed Caparo. However, other courts (e.g. in New South
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Wales in the case of Columbia Coffee and Tea Pty Ltd v Churchill (1992)) have adopted a
different approach. In New Zealand, the Court of Appeal has indicated that it will not be
following the Caparo decision. In the U.K., the courts recognise a prima facie duty of care
for auditors to third parties and then restrict it if it is just and equitable to do so, following the
rule on Anns v Merton London Borough Council (1978). However, a common theme
emerges in all countries that determine legal liability by the use of the courts. They
essentially seek to decide whether it is just and equitable that a duty of care should be
imposed in the particular circumstances of the case. Thus the facts of the case determine the
result. It is often difficult to determine an auditors liability in a given case which leads to
uncertainty.
Tutorial note: Students are not required to have a detailed knowledge of case law.
However, as for any answer to a discussion question, students will be given credit for relevant
answer points which draw on their wider reading of current issues.
Different audit clients expose auditors to different degrees of risk and it can be argued that
auditors will chose the less risky clients. Thus clients in innovative sectors, or those clients
who carry out complex financial transactions, may find it difficult to attract an auditor
because of the possibility of a negligence claim. Faced with the prospect of losing such
clients, auditors have developed sophisticated client screening and acceptance procedures and
often reject risky clients. Thus this could be an argument for reforming the liability of the
auditor and capping that liability. This would reduce the need for client acceptance systems
and self-insurance schemes which are normally the preserve of the global firms of
accountants.
It can be argued that reform of audit liability could improve the functioning of the capital
markets, helping with investment decisions and corporate governance. Audit reports could be
more informative rather than standardised through fear of litigation. Professional judgement
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may be exercised more appropriately rather than through fear of a law suit. However, the
effects of a reform on capital markets would be difficult to quantify.
Answer 10 BLOD CO
(a) Findings from audit
(i) Purpose
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A report to those charged with governance is produced to communicate matters relating to the
external audit to those who are ultimately responsible for the financial statements. ISA 260
Communication with Those Charged with Governance requires the auditor to communicate
many matters, including independence and other ethical issues, the audit approach and scope,
the details of management representations and the audit findings (commonly referred to as
management letter points). By communicating these matters, the auditor is confident that
there is written documentation outlining all significant matters raised during the audit process
and that such matters have been formally notified to the highest level of management. The
report should ensure that management fully understands the scope and results of the audit
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service and that this service is likely to provide constructive comments to help management to
fulfil its duties in relation to the financial statements and accounting systems and controls
more effectively. The report should also include, where relevant, any actions that
management has indicated will be taken in response to recommendations made by the
auditors.
(ii) Control weakness

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Capital expenditure
SA 260 contains guidance on the type of issues that should be communicated. One of the
matters identified is a control weakness in the capital expenditure transaction cycle. The
assets for which no authorisation was obtained amount to 03% of total assets (225,000/78
million 100%), which is clearly immaterial. However, regardless of materiality, the auditor
should ensure that the weakness is brought to the attention of the management, with a clear
indication of the implication of the weakness and a recommendation for its elimination.
The auditor is providing information to help those charged with governance improve the
internal systems and controls and ultimately reduce business risk. In this case there is a high
risk of fraud, as the lack of authorisation for purchase of office equipment could allow
expenditure on assets not used for bona fide business purposes.
Accounting treatment of brand

Audit procedures have revealed a breach of IAS 38 Intangible Assets, in which internally
generated brand names are specifically prohibited from being recognised. Blod has
recognised an internally generated brand name which is material to the statement of financial
position as it represents 128% of total assets (10/78 100%). The statement of financial
position therefore contains a material misstatement.
The report to those charged with governance should clearly explain the rules on recognition of
internally generated brand names, to ensure that the management has all relevant technical
facts available. In the report the auditors should request that the financial statements be
corrected and explain that, if the brand is not derecognised, the audit opinion will be qualified
on the grounds of a material disagreement (i.e. an except for opinion). Once the breach of
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IAS 38 is made clear the matter can be discussed to decide whether to amend the financial
statements and thereby avoid a qualified audit opinion.
Audit inefficiencies
Documentation relating to inventories was not always made readily available to the auditors.
This seems to be due to poor administration by the client rather than a deliberate attempt to
(b)
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conceal information. The report should contain a brief description of the problems
encountered by the audit team. The management should be made aware that significant delay
to the receipt of necessary paperwork can cause inefficiencies in the audit process. This may
seem a relatively trivial issue, but it could lead to an increase in audit fee. Management
should react to these comments by ensuring as far as possible that all requested
documentation is made available to the auditors in a timely fashion.
Typing financial statements
It is not uncommon for audit firms to word process and typeset the financial statements of
their clients, especially where the client is a relatively small entity, which may lack the
resources and skills to perform this task. It is not prohibited by ethical standards.
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However, there could be a perceived threat to independence, with risk magnified in the case
of Blod, which is a listed company. The auditors could be perceived to be involved with the
preparation of the financial statements of a listed client company, which is prohibited by
ethical standards. IESBAs Code of Ethics for Professional Accountants states that for a
listed client, the audit firm should not be involved with the preparation of financial
statements, which would create a self-review threat so severe that safeguards could not reduce
the threat to an acceptable level. Although the typing of financial statements itself is not
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prohibited by ethical guidance, the risk is that providing such a service could be perceived to
be an element of the preparation of the financial statements.
It is possible that during the process of typing the financial statements, decisions and
judgments would be made. This could be perceived as making management decisions in
relation to the financial statements, a clear breach of independence.
Therefore to eliminate any risk exposure, the prudent decision would be not to type the
financial statements, ensuring that Blod appreciates the ethical problems that this would
cause.
Tutorial note: This area is not specifically covered by ethical guides; different audit firms
may have different views on whether it is acceptable to provide typing services for the
financial statements of their clients. Credit will be awarded for sensible discussion of the
issues raised bearing in mind other options for the audit firm. For example, it could be
argued that it is acceptable to offer the typing service provided that it is performed by people
independent of the audit team and that the matter has been discussed with the audit committee
or those charged with governance.
(c) Liability disclaimer
In the UK it has become increasingly common for audit firms to include a disclaimer
paragraph in the auditors report. However, it is not a requirement of auditing standards and
individual audit firms need to assess the advantages and disadvantages of the use of a
disclaimer paragraph.
The wording is used to state the fact that the auditors report is intended solely for the use of
the companys members as a body and that no responsibility is accepted or assumed to
anyone other than the company and the companys members as a body.
The main perceived advantage is that the disclaimer should help to reduce the exposure of the
audit firm to liability claims from anyone other than the company or the companys body of
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shareholders. The disclaimer makes it clear that the audit firm reports only to those who
appointed the firm (i.e. the members of the company) and this may make it more difficult for
the audit firm to be sued by a third party.
It is also argued that the use of a disclaimer could help to bridge the expectation gap by
providing a clearer indication of the responsibility of the auditor.
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In this way the audit firm can manage its risk exposure in an increasingly litigious
environment. High profile legal cases against audit firms (e.g. the Bannerman case in
Scotland) illustrate that an audit firms duty of care can extend beyond the company and its
shareholders and that audit firms should consider how to protect themselves against liability
claims.
Tutorial note: It is appropriate here to quote recent cases such as the Bannerman case to
illustrate the reason why audit firms face increased potential exposure to claims from third
parties. However, knowledge of specific legal cases is not required to gain full marks for this
requirement.
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However, it can be argued that a disclaimer does not necessarily work to protect an audit firm.
Each legal case has individual circumstances and although a disclaimer might protect the
audit firm in one situation it may not offer any protection where the facts of the case are
different.
In addition, it is often argued that if an audit firm conducts an audit using full due care and
diligence, there is no need for a disclaimer, as a high quality audit would be very unlikely to
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lead to any claims against the audit firm. Consequently, it could be argued that the use of
disclaimers as a means to limit liability could permit low quality audits to be performed, the
auditors being confident that legal cases against them are restricted due to the presence of a
disclaimer within the audit report.
Answer 11 GRIMES CO
(a) ISA 706
(i) Emphasis of Matter
The Emphasis of Matter (EOM) paragraph is a paragraph included in the auditors report that
refers to a matter appropriately presented or disclosed within the financial statements that, in
the auditors judgement, is of such importance that it is fundamental to the users
understanding of the financial statements. ISA 706 states that the paragraph must only be
used provided the auditor has sufficient appropriate audit evidence that the matter is not
materially misstated in the financial statements. Such a paragraph should refer only to
information presented or disclosed in the financial statements.
The paragraph is therefore used to highlight a fundamental issue to the users of the financial
statements. It does not relate to a disagreement or a limitation in scope, and therefore is not in
any way a qualification of the audit opinion. The EOM paragraph should clearly state that the
auditors opinion is not modified in respect of the matter emphasised.
The EOM paragraph should include a clear reference to the matter being emphasised, and to
where relevant disclosures that fully describe the matter can be found in the financial
statements.
Examples are provided in ISA 706 of the potential situations in which an EOM paragraph
may be used:
An uncertainty relating to the future outcome of exceptional litigation or regulatory
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action;
Early application (where permitted) of a new accounting standard that has a

pervasive effect on the financial statements in advance of its effective date;
A major catastrophe that has had, or continues to have, a significant effect on the
(ii) Other Matter

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entitys financial position;
Significant going concern issues.
The Other Matter paragraph should be included in the auditors report to refer to a matter
other than those presented or disclosed in the financial statements that, in the auditors
judgement, is relevant to users understanding of the audit, the auditors responsibilities, or
the auditors report.
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Examples of such matters could include:
Law, regulation or generally accepted practice may require or permit the auditor to
elaborate on matters that provide further explanation of the auditors responsibilities
or report.
The auditor may be reporting on more than one set of financial statements (e.g. a set
of statements prepared under national reporting framework, and a set of statements
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prepared under International Financial Reporting Standards).
Any restrictions on the distribution of the auditors report.
The paragraph is therefore used as means by which the auditor can communicate a matter to
the users of the financial statements. The content of the paragraph should clearly reflect that
the matter is not required to be presented or disclosed in the financial statements.
For both EOM and Other Matter paragraphs, there should be communication with those
charged with governance, who should be made aware of the nature of any specific items that
the auditor intends to highlight.
(b) Auditors liability
(i) Methods to reduce exposure to litigation claims
All audit firms want to avoid litigation, due to the bad publicity that is likely to follow, the
financial consequences, and the potential collapse of the audit firm. There are several ways
that an audit firm can reduce its exposure to claims.
Client acceptance procedures
Firms should carefully assess the risk associated with potential audit clients. Screening
procedures should be used to identify matters that create potential exposure for the audit firm.
For example, it would be unwise to take on a new client with significant going concern
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problems. The issue is that a client should only be accepted if the associated risk can be
managed to an acceptably low level given the skills and resources of the audit firm.
Proper use of engagement letters
The engagement letter should be used to clearly state the responsibilities of the auditor, and of
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management. As it forms a contract between the audit firm and the client, it should be
updated on an annual basis, with care being taken to ensure the client is fully aware of any
changes in the scope of the audit, or the reporting responsibilities of the audit firm.
Performance and documentation of audit work
Audit firms should ensure that professional standards are maintained, and that International
Standards on Auditing (ISAs) are adhered to. It is crucial that full documentation is
maintained for all aspects of the audit, including planning, evaluation of evidence, and
consideration of ethical issues. A claim of negligence is unlikely to be successful if the audit
firm has documentary evidence that ISAs have been followed.
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Quality control
Firms must ensure they have implemented firm-wide quality control procedures, as well as
procedures applicable to the individual audit engagement. Quality control acts as an internal
control for the audit firm, helping to ensure that ISAs and internal audit methods have been
followed at all times.
SA
External consultations
Firms should make use of external specialists when the need arises, for example obtaining
legal advice where appropriate, to ensure that the auditors actions are acceptable within the
legal and regulatory framework.
Disclaimers
In recent years it has become common in some jurisdictions for audit firms to include a
disclaimer paragraph in the audit report. This is an attempt to restrict the duty of care of the
audit firm to the shareholders of the company, thereby attempting to restrict legal liability to
that class of shareholders. Disclaimers, however, may not always be effective.
Tutorial note: This answer covers more than the required number of points. Credit would be
awarded for discussions of other, relevant means of limiting exposure to liability, such as the
need for adequate Professional Indemnity Insurance (PII).
(ii) Potential implications of liability limitation agreements
A liability limitation agreement is a contractual limitation of the auditors liability to a

company. There are several possible implications for the audit profession as follows:
Audit quality
One of the main arguments against the use of such agreements is that audit quality could
suffer as a result. The argument is that auditors could become less concerned with the quality
of their work, in the knowledge that if there was a claim against them, the financial
consequences are limited.
Value of the audit opinion
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As a consequence of the point above, many argue that users of the financial statements will
place less reliance on the audit opinion, resulting in less credible financial statements.
Pressure on audit fees
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It is considered that firms may be under pressure from clients to reduce their audit fees. This
is a response to the fact that if the audit firm has reduced its risk exposure, then the fee for
providing the audit service should be reduced.
Competition in the audit market
The ability to set a cap on auditors liability could distort the audit market. Bigger audit firms
may have the ability to set a high cap, which creates a disadvantage to smaller audit firms.
However, it can be argued that the ability to set a cap actually helps the audit market, by
protecting firms and making collapse less likely, and can promote competition between the
larger firms.
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Answer 12 GUIDANCE ON QUALITY CONTROL
(a) Importance of quality control
Quality control is important in audit work for a number of reasons but principally to reduce
the risk of audit failure.
SA
Under the IFAC, quality control is currently considered at three levels the member
organisation, the professional firm and the assignment.
Statement of Membership Obligations 1 (SMO 1) Quality Assurance deals with the

procedures required at the level of member organisations (e.g. the ACCA) and
includes the need for a mandatory quality assurance programme in monitoring
member partners and firms.
International Standard on Quality Control (ISQC 1) requires all firms to have

procedures in place to provide reasonable assurance that the firm and its personnel
comply with professional standards, regulatory and legal requirements.
ISA 220 Quality Control for an Audit of Financial Statements deals with the quality
control standards required to be implemented on individual assignments.
SMO 1 is external to the individual firm and requires monitoring of the audit firm by the
member body. In some jurisdictions, this may mean monitoring by an independent body (e.g.
the UK Financial Reporting Council monitors auditors of listed companies). Such monitoring
provides specific assurance to external bodies and interested parties of the level and quality of
audit work carried out by professional firms (e.g. the stock exchange and Government).
For the individual firm (applying ISQC 1 and ISA 220) conducting high quality audits
reduces the risk of audit failure and the auditor being sued for negligence.
Audit failure occurs when an unmodified auditors report is given and subsequently material
errors or fraud are found in the financial statements, or, less commonly, a modified auditors
report is issued, but subsequently no material errors or fraud are found in the financial
statements.
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Audit failure can result in the audit firm being sued for negligence. Also, it is likely to result
in a deterioration in the relationship with the client and possibly the loss of the audit. Adverse
publicity from a negligence claim can result in losing other clients and not gaining new
clients.
dealt with.
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If the procedures (as required by ISQC 1 and ISA 220) over the firms procedures for
conducting audits are appropriately applied, the manager and partner can be more confident
that the audit work has been carried out satisfactorily and that any material errors within the
financial statements will have (within the inherent limitations of an audit) been detected and
High quality audit work will minimise the occasions when review of audit work reveals
weaknesses in the audit approach audit work (the review process itself being an element of
quality control). These weaknesses will require additional time spent by audit staff (usually
of a senior level) which will increase the cost of the audit. High quality audit work should
increase the efficiency of the audit and thus reduce costs.
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However, it should be appreciated that to a certain extent, auditing is a balance between audit
risk and the cost of carrying out an audit. So there has to be a balance between the time spent
on the audit and the risk that material errors and fraud are not detected. Nevertheless, if a
high quality audit means spending more time on significant audit areas (particularly those
of a high risk) and spending little time on low risk areas this increased efficiency should
reduce overall audit risk (for a fixed time in carrying out an audit).
SA
High quality audit work will ensure there are good records of audit work so that these can be
produced in a court of law, if required.
Finally, high quality work will give confidence to the client of the standard of service
provided. Client satisfaction is important as the audit should have provided an accurate
assessment of the quality of the companys financial systems; it should ensure the audit is
retained and could attract new audits (though recommendations by the audit client).
(b) Training of staff
Training of staff is important to ensure that they have the highest level of competence in the
work they carry out.
If the staff are unqualified, they should undertake the exams of a professional accounting
body. Depending on the qualifications and ability of the staff, this could include a technician
qualification or the full ACCA qualification. Staff may be given time off to study and take
the professional examinations. Their performance should be monitored. This could be
through reports from their tutors, or by the audit firm carrying out tuition sessions and
assessed tests.
Action should be taken where the employees performance is unsatisfactory.
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In addition, the firm should train staff in the companys auditing procedures. There should be
progressive courses for staff studying for the professional accounting exams. This will start
by explaining the firms basic audit procedures then cover more advanced procedures and
finally include managing staff and the audit.
(c)
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For new employees, who are professionally qualified, there must be a progression of post
qualification courses. (Continuing professional education is a mandatory requirement for all
members of the IFAC.) Not only will such courses cover internal matters, personal and
managerial skills, they must also include courses on new relevant legislation (e.g. company
financial reporting legislation) and International Financial Reporting Standards and
International Standards on Auditing.
Monitoring staff performance and providing additional training
The performance of each employee should be assessed. This should be carried out more
frequently than annually. Ideally, it should be at the end of each audit assignment provided
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the assignment is not too short (e.g. less than one week). The senior in charge of the audit
should assess each member of his audit team and the manager should assess the senior in
charge of the audit.
A number of factors should be included in the rating. These could include:
technical ability;
organising ability;
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initiative;
quality of working papers; and
relations with the client.
The member of staff should be rated on each factor, using a rating system like A to E
with A being excellent, C being satisfactory and E being unsatisfactory. The
performance of each member of the audit team should be discussed with them as part of the
closedown procedures of the audit. Where a weakness is continuing, additional training (e.g.
classroom tutorials, in additional to the standard training programme, or closer supervision
and training on-the-job should be organised).
In addition, there should be a feedback system which reports problems in audits, which are
found during reviews of audit work. These problems may be reported to individual members
of staff. Also, the system may report them to all staff when the problem is either frequent, or
important (either in a training session or a staff newsletter).
For staff who have problems passing the professional accounting exams, there may be advice
on examination technique (e.g. allocating the correct time to answer each question) and the
member of staff may be allocated work in the area where his exam performance is poor (e.g.
audit work if their exam performance in the auditing exams is poor).
(d) Reviews of audit work
(i) By staff and the audit engagement partner before the auditors report is signed
Tutorial note: The review flow is senior reviews juniors; manager reviews senior; partner
reviews manager; quality control review procedures (hot review, cold review) deal with the
review of the partner.
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The senior in charge of the audit should review the work of the audit team juniors and
assistants. The seniors work (including the review of the assistants carried out by the senior)
will be reviewed by the manager of the audit. Finally the managers work and the whole audit
process will be reviewed by the audit engagement partner.
The amount of review at each stage will depend on the competence of the staff at each stage.
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For example, where the senior is experienced and the audit is not high risk, the manager will
fully review any audit work carried out by the senior and carry out an overview of the seniors
review procedures of the assistants. This will include ensuring all necessary completion
procedures (e.g. analytical review, subsequent events, going concern), checklists (e.g. senior
and manager completion, IFRS, etc) and summaries for the partner have been completed (e.g.
details of contentious issues, adjusted and unadjusted errors, draft weakness letters, draft
representation letters, draft audit report).
The rationale of ensuring a competent manager and senior are in charge of an audit is that the
engagement partner will not have to spend (expensive) time reviewing the detail of the
working papers. In this situation, the manager and senior will have prepared a completion
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memorandum (sometimes referred to as Partner Review Notes, Matters for the Attention of
the Partner or similar) which covers each stage of the audit. This document should explain
the figures in the financial statements and the audit work which has been carried out
(including the conclusions of the audit work). Problems encountered in the audit should be
noted. The audit engagement partner can review this memorandum and discuss the audit with
the manager and senior in charge. Where problems are highlighted, the partner may refer to
the detailed audit working papers (drill down).
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After the partner is satisfied that the audit meets the standards required by the firm and ISA,
he will discuss any contentious and other issues with management.
Based on this work the audit engagement partner will decide whether an unmodified auditors
report can be given. When there are problems in the audit which might lead to a
modification, another audit partner (who is independent of the audit) should be consulted to
carry out a hot review. This review aims to ensure that the working papers support the
decision of the engagement partner and that the audit has been carried out in accordance with
ISA 220 and other relevant audit regulations.
Before issuing a modified auditors report, the audit engagement partner should discuss the
matter with the client. Then, the client will be given the opportunity to amend the financial
statements and avoid an audit modification.
The firm should also identify those clients it considers high risk (e.g. listed companies,
public interest clients, major clients of each partner, specialist audits (e.g. banks)) and carry
out hot reviews on all such clients regardless of the original opinion of the engagement
partner.
The detail of how outstanding issues were resolved should be feedback to all audit staff (not
just the audit team). This may be done directly to the audit team (with regular bulletins or
training days for other staff) to ensure that when similar problems are encountered, the audit
team will have a good idea about how to deal with them.
Tutorial note: When giving such feedback to other staff, care must be taken to ensure that
particular clients cannot be directly recognised. If they could be recognised, this would be a
breach of client confidentiality.
(ii) Cold reviews
A cold review involves looking at the audit working papers (some time after completion of
the audit and signing of the audit report) and interviewing the manager and partner in charge
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of the audit to determine if ISQC 1, ISA 220 and the firms audit regulations and
methodology have been followed and correctly applied.
These reviews are normally carried out annually (or more frequently if a significant number
of problems are highlighted) by independent auditors (usually at a senior manager or partner
level) on a risk based sample of audits (i.e. high risk audits, listed audits, largest audits,
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specialist audits) plus a random selection of other audits.
As the firm has three offices, the review teams should be drawn from managers and partners
from offices not undertaking the assignments selected for review. Alternatively, the office
could engage the services of an external provider of quality control reviews (e.g. a training
and technical support consortium).
A written report should be prepared for each audit studied which assesses the quality of the
audit and reports any significant weaknesses. There should be a final report which notes the
quality of the audits of the office and reports common and significant weaknesses. These
weaknesses should be reported to staff so that they can be avoided in future audits.
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Additional training (and/or modification to current training courses) should be carried out
where considered necessary.
Tutorial note: The cold review procedure is often incorporated into a general quality control
review that covers all aspects of ISQC 1 (e.g. independence procedures, recruitment, training,
disciplinary procedures, etc).
Answer 13 SEPIA
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(a) Professional enquiry
Professional issues raised
Krill has a professional duty of confidentiality to its client, Squid. If Krills lack of response
is due to Squid not having given them permission to respond, Sepia should not accept the
appointment. However, in this case, Anton Fargues should have:
notified Squids management of the communication received from Sepia; and

written to Sepia to decline to give information and state his reasons.
Krill should not have simply failed to respond.
Krill may have suspicions of some unlawful act (e.g. defrauding the taxation authority), but
no proof, which they do not wish to convey to Sepia in a written communication. However,
Krill has had the opportunity of oral discussion with Sepia to convey a matter which may
provide grounds for the nomination being declined by Sepia.
Steps by Sepia
Obtain written representation from Squids management that Krill & Co has been
given Squids written permission to respond to Sepias communication.
Send a further letter to Krill by a recorded delivery service (i.e. requiring a

signature) which states that if a reply is not received in the next seven days (say)
Sepia will assume that there are no matters of which they should be aware and so
proceed to accept the appointment. (Advise also that unless a response is received,
a written complaint will be made to the relevant professional body.)
Make a written complaint to the disciplinary committee of the professional body of

which Anton Fargues is a member so that his unprofessional conduct can be
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investigated.
(b) Take-over bid
Sepia has a professional duty of confidentiality to its existing audit client,

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Vitronella.
Vitronella may ask Sepia to give corporate finance advice on Hatchets take-over
bid which would be incidental to the audit relationship. Providing Sepia can
maintain and demonstrate integrity and objectivity throughout, there would be no
objection to Sepia providing such an additional service, to advance the existing
clients case.
It is often in a companys best interests to have financial advice provided by its

auditors and there is nothing ethically improper in this. So it seems unusual that
Hatchet should have approached Sepia, rather than the current auditors.
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ACCAs Code of Ethics and Conduct considers that it would not be improper for an
audit firm to audit two parties (even if the take-over is contested) and that to cease
to act could damage the clients interests. However, the situation is different here in
that Sepia is not Hatchets auditor.
Sepia should take all reasonable steps to avoid conflicts of interest arising from new
engagements and the possession of confidential information. Sepia cannot therefore
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resign from Vitronella in order to undertake the advisory role for Hatchet. (A
relationship which has ended only in the last two years is still likely to constitute a
conflict.)
Steps by Sepia
As it is clear that a material conflict of interest exists, Sepia should decline to act as
adviser to Hatchet.
Advise Vitronellas management that Hatchets approach has been declined.
(c) Lowballing
Lowballing is a practice in which auditors compete for clients by reducing their fees for
statutory audits. Lower audit fees are compensated by the auditor carrying out more lucrative
non-audit work (e.g. consultancy and tax advice).
The fact that Keratin has quoted a lower fee than the other tendering firms (if that is the case)
is not improper providing that the prospective client, Benthos, is not misled about:
the precise range of services that the quoted fee is intended to cover; and
the likely level of fees for any other work undertaken.
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Although an admission to lowballing Setting the early price in an arrangement at a low
amount to secure business with the intent later to raise the price may sound improper, it does
not breach current ethical guidance providing Benthos understands the situation. So, for
example, Keratin could offer Benthos a free first-year audit, providing Benthos appreciates
what the cost of future audits would be.
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The risk is, that if the non-audit work does not materialise, Keratin may be under pressure to
cut corners or resort to irregular practices (e.g. the falsification of audit working papers) in
order to keep within budget. If a situation of negligence (say) were then to arise, Keratin
could be found guilty of incompetence.
As the provision of other services is under scrutiny and becoming increasingly restricted this
risk is likely to be high. For example, non-audit services which are prohibited in the US
include bookkeeping, financial information systems design and implementation, valuation
services, actuarial services, internal audit (outsourced), human resource services for executive
positions, investment and legal services.
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Keratin may not be just lowballing on the first year audit fee, but in the longer term; perhaps
indicating that future increases might only be in line with inflation. In this case if, rather than
comprise the quality of the audit, Keratin were to substantially increase Benthos audit fees, a
fee dispute could arise. In this event Benthos could refuse to pay the higher fee. It might be
difficult then for Keratin to take the matter to arbitration if Benthos was misled.
Edwin is likely to be in breach of a duty of confidentiality to his employer.

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Steps by Sepia
There are no steps which Sepia can take to prevent Benthos from awarding the
tender to whichever firm it chooses.
If Keratin is successful in being awarded the tender, Sepia should consider its own
policy on pricing in future competitive tendering situations.
Sepia could report Edwin to ACCA for misconduct (breach of duty of

confidentiality to employer).
Answer 14 WEXFORD
(a) Initial audit engagement
The prior year financial statements have not been audited and have been prepared by a part-
qualified accountant. This leads to a risk of misstatement in the opening balances. If the
audit engagement is accepted, procedures should be planned to ensure that the opening
balances have been brought forward correctly and reflect the application of appropriate
accounting policies.
Lack of internal controls
The small size of the company and the fact that there is only one person preparing
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management information relating to the accounts would indicate that internal controls are
likely to be weak. For example, there is limited scope for segregation of duties or for
authorisation and approval controls. Additionally it seems that Ravi and Rita do not exercise
a managerial control over the financial reporting process, as they do not perform a detailed
review of the accounts. The lack of internal control procedures may not necessarily mean an
increased risk of fraud or error but the auditor should assess the suitability of the systems in
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place for each specific clients purposes when establishing a clients risk profile.
Preparation of financial statements
The audit firm has been approached to prepare the financial statements as well as provide the
audit service. Providing an audit client with bookkeeping or accounting services, including
the preparation of the financial statements, provides a self-review threat to objectivity and
independence when the firm subsequently audits the financial statements. According to
IFACs Code of Ethics for Professional Accountants, for an audit client which is not a public
interest client, such as Wexford, it is acceptable to provide the bookkeeping or accounting
service if appropriate safeguards can reduce the threat to an acceptable level (e.g. if the
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service were provided by individuals who are not part of the audit team). The audit firm must
therefore consider if it has sufficient resources to enable this safeguard to be put into place.
The bookkeeping service provided should be of a routine and mechanical nature, to avoid the
auditor making judgements about the amounts included in the financial statements. For
example, the client should pre-approve journal entries made to the trial balance.
Small businesses may have the problem of very informal accounting systems and
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completeness of records may be a specific audit risk as the auditors may find it impossible to
be sure that they have been given full information.
Statement of cash flows
The client has suggested that a statement of cash flows should not be prepared. This indicates
the lack of knowledge and experience that the directors have with regard to financial reporting
matters. The fundamental principle of IAS 7 Statement of Cash Flows is that all entities that
prepare financial statements in conformity with IFRS are required to present a statement of
cash flows. One of the preconditions for an audit referred to in ISA 210 Agreeing the Terms
of Audit Engagements that should be present is that management acknowledges and
understands its responsibility for the preparation of the financial statements. The matter
should be discussed with Ravi and Rita and only when they have accepted their responsibility
for the preparation of the statement of cash flows should the engagement be accepted.
Conflict of interest
The audit firm already provides the audit service to a competitor of Wexford, leading to a
potential conflict of interest if the audit engagement were accepted. The Code identifies a
conflict of interest in providing the audit service to competing entities as a potential threat to
objectivity. The significance of the threat should be evaluated and appropriate safeguards
considered (e.g. disclosing the conflict to all relevant parties, requesting the consent of the
two entities involved and the use of separate engagement teams (Chinese Walls)). Other
relevant procedures could include the use of confidentiality agreements signed by partners
and staff of both audit engagements and procedures to limit access to information.
Potential limitation on scope
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Ravi states that he does not want to allow the auditor access to the board minutes, as they
contain confidential information. The auditor has the right of access to all information that is
relevant to the preparation of the financial statements and ISA 210 requires the auditor to
obtain the agreement of management to provide such information as one of the preconditions
affecting audit engagement acceptance. The matter should be discussed with Ravi and Rita.
It may be that they are unaware that the auditor should have unrestricted access to company
(b)
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books and records, including the minutes of meetings. They may also be unaware of the
auditors principle of confidentiality. Once these matters have been discussed, the client
should be happy to allow access to the board minutes. If, however, there remains a potential
limitation on the scope of the auditors work, the audit engagement should not be accepted.
Opening balances
ISA 510 requires certain audit procedures to be carried out in an initial engagement where the
prior year financial statements were not audited.
Firstly, the auditor is required to read the most recent financial statements for information
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relevant to opening balances, including disclosures.
Then the auditor needs to obtain sufficient appropriate evidence about whether the opening
balances contain misstatements that materially affect the current years financial statements.
This evidence is obtained by firstly determining whether the prior periods closing balances
have been correctly brought forward.
The auditor also needs to determine whether the opening balances reflect the application of
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appropriate accounting policies.
Depending on the nature of the opening balances, specific audit procedures are performed to
gain specific evidence on those opening balances. Additional procedures would be required if
it appears that the opening balances contain misstatements that could materially affect the
current periods financial statements.
Finally, the auditor needs to obtain sufficient appropriate evidence about whether the
accounting policies reflected in the opening balances have been consistently applied in the
current periods financial statements and that any changes in accounting policies have been
accounted for and disclosed in accordance with IAS 8 Accounting Policies, Changes in
Accounting Estimates and Errors.
Opening balance of inventory specific audit procedures
Inspection of records of any inventory counts held at the prior period year end to
confirm the quantity of items held in inventory agrees to accounting records.
Observation of an inventory count at the current period year end and reconciliation
of closing inventory quantities back to opening inventory quantities.
Analytical procedures on gross profit margins, comparing the opening and closing
gross profit margins year on year for the various types of items held in inventory.
Verifying the sales value in the current financial year of items held in inventory at
the end of the prior year and comparing the sales value with cost. This should
provide evidence that inventory is correctly valued at the lower of cost and net
realisable value.
Inspection of management accounts for evidence of any inventory items written off
in the current financial period this is important for inventory of calendars and
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diaries which are likely to be obsolete.
Discussion with management regarding any slow moving items of inventory which
were included in opening inventory.
Analytical procedures (e.g. inventory turnover calculations to highlight slow
(b)
Materiality
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moving inventory from the opening balance).
Practice management and quality control issues
Setting materiality at the maximum possible level would reduce the work conducted on an
audit by reducing sample sizes. Raising the materiality threshold means that more balances
and transactions would be considered immaterial when compared to the threshold.
While materiality is recognised to be a judgemental matter, setting materiality at a high level

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may mean that some balances and transactions are ignored despite them containing a specific
risk of material misstatement. This increases detection risk and impairs the quality of the
audit. Materiality should be judged based on the specific circumstances of each client as is
affected by factors such as misstatements identified in previous years audits, the results of
risk assessment procedures and the regulatory environment in which the client operates.
Using the maximum materiality level possible will simply not be appropriate in all audits.
ISA 320 Materiality in Planning and Performing an Audit requires that materiality should be
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revised if necessary as the audit progresses. Fixing materiality at the planning stage is
contrary to the ISA and could increase detection risk if insufficient audit work is performed
on matters deemed to be immaterial when planning the audit.
Training
Many firms consider reducing the amount they spend on training as a response to difficult
economic conditions. However, any prolonged reduction in training for all members of the
audit department will have a long-term detrimental effect on audit quality.
ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements,
and Other Assurance and Related Services Engagements requires an audit firm to establish
policies and procedures designed to promote an internal culture recognising that quality is
essential in performing engagements. Part of creating this internal culture includes training
staff appropriately.
Training is essential in order for auditors to be kept up-to-date with developments in the
profession. For example, ISAE 3000 (Revised) Assurance Engagements Other than Audits or
Reviews of Historical Financial Information was published in December 2013. Without the
necessary training there is a risk that not all of the requirements will be met for assurance
reports dated on or after 15 December 2015 (when the ISAE becomes effective).
Additionally, qualified members will need to verify that they have met Continuing
Professional Development requirements, for which training on new developments in auditing
will be essential.
Quicker audits
It is unprofessional to make a guarantee to clients that audits will be performed in a shorter

time than previously. The audit firm cannot know how long an audit will take until they have
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completed the planning of that audit. The clients circumstances may have changed since the
previous year, or there may be special considerations in this years audit which mean that the
audit will take longer than previously.
Trying to complete the audit as quickly as possible will have an implication for the quality of
the work performed. Short-cuts may be taken which reduce the appropriateness or sufficiency
Answer 15 CHAMPERS CO
(a) Briefing notes
(i)
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of evidence obtained, leading to increased audit risk.
In summary, the audit managers suggestions are not appropriate, as each would impair the
short-term and long-term quality of audit work carried out by the firm.
Gaining an understanding of the company and operating environment
Briefing notes
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To: Audit Juniors
From: Audit manager
Subject: Understanding a clients business and environment
Introduction
Gaining an understanding of the clients business and the environment in which it operates is
a crucial part of the audit planning process. ISA 315 Identifying and Assessing the Risks of
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Material Misstatement through Understanding the Entity and Its Environment provides
guidance on this matter. The auditor must have a thorough understanding of many aspects of
the clients business and environment in order to be able to assess risk, decide on an
appropriate audit strategy and design and perform effective audit procedures.
Aspects to be considered
ISA 315 states that there are five main aspects of the clients business and environment which
the auditor should understand.
(1) Industry, regulatory and other external factors, including the applicable
financial reporting framework
This means having an understanding of the industry in which the company operates including
the level of competition, the nature of the relationships with suppliers and customers and the
level of technology used in the industry. The industry may have specific laws and regulations
which affect the business. The auditor should also consider wider economic factors such as
the level and volatility of interest rates and exchange rates and their potential effect on the
client.
These issues are important because of their potential effects on the financial statements and on
the planning of the audit. For example, if a client operates in a highly-regulated industry, it
may be worth considering the inclusion in the audit team of a person with specific experience
or knowledge of those regulations. Regulations include the financial reporting framework, for
example, whether the company uses local or international financial reporting standards.
(2) Nature of the entity and its accounting policies
This includes having an understanding of the legal structure of the company (and group where
relevant), the ownership and governance structure and the main sources of finance used by the
company. Complex ownership structures with multiple subsidiaries and/or locations may
increase the risk of material misstatement. Understanding the nature of the company also
includes an understanding of the accounting policies selected and applied to the financial
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statements. The auditor must consider whether the accounting policies applied are consistent
with the applicable financial reporting framework.
(3) Objectives and strategies and related business risks
The management of the company should define the objectives of the business, which are the
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overall plans for the company. Strategies are the operational approaches by which
management intend to meet the defined objectives. For example, an objective could be to
maximise market share and the strategy to achieve this could be to launch a new brand or
product every year. Business risks are factors which could stop the company achieving its
stated objectives, for example, launching a product for which there is limited demand. Most
business risks will eventually have financial consequences and thus affect the financial
statements. This is why auditors perform a business risk assessment as part of their planning
procedures.
(4) Measurement and review of the entitys financial performance

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Here the auditor is looking to gain an understanding of the performance measures which
management and others consider to be of importance. Performance measures can create
pressure on management to take action to improve the financial statements through deliberate
misstatement. For example, a bonus payable to the management based on revenue growth
could create pressure for revenue to be overstated. Thus the auditor must gain an
understanding of the companys financial and non-financial key performance indicators,
targets, budgets and segmental information.
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(5) Internal control
The auditor must gain knowledge of internal control in order to consider how different aspects
of internal control could affect the audit. Internal control includes the control environment,
the entitys risk assessment procedures, information systems, control activities and the
monitoring of controls. Put simply, the evaluation of the strength or weakness of internal
control is a crucial consideration in the assessment of audit risk and so has a significant effect
on the audit strategy. The design and implementation of controls should be considered as part
of gaining an understanding. The auditor should also understand whether controls are manual
or automated. ISA 315 contains a great deal of detailed guidance on the understanding of
controls, which these briefing notes do not cover.
(ii) Procedures used to gain understanding
(1) Inquiries of management and others within the company
A discussion with management is often the starting point in gaining understanding. A

meeting is usually held with management to talk about all of the aspects of the company and
its environment referred to in the first part of the briefing notes. However, inquiries can also
be made of others, who may be able to provide a different perspective or provide specific
insights into certain matters. For example, internal auditors would be able to comment
specifically on internal controls.
(2) Analytical procedures
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Auditors perform analytical procedures at the planning stage in order to identify unusual
transactions or events and to understand the main trends reflected in the financial statements
for the year. This will enable the auditor, for example, to see if the company has experienced
a growth or decline in revenue or profits in the year, which when reviewed in the context of
industry or economic trends, may indicate a risk of material misstatement. Analytical
procedures should be performed in accordance with ISA 520 Analytical Procedures.
(3) Observation
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Observation may help to support inquiries of management and others and could involve, for
example, physical observation of the internal control operations and visits to premises such as
factories, warehouses and head office.
(4) Inspection
Inspection may support inquiries made of management and others. It could include, for
example, an inspection of business plans, internal control manuals, reports made by
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management (e.g. interim financial statements), the minutes of board meetings, and the
companys website and brochures.
Conclusion
Auditors must make sure that they have gained and documented an understanding of five
main aspects of the clients business and the environment in which it operates. A variety of
procedures can be used for this. Without a thorough knowledge of the business and its
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environment, an auditor would be unable to effectively assess the risk of material

misstatement in the financial statements and therefore could not plan the audit to minimise
audit risk.
(b) Business risks
Health and safety regulations
Champers operates in a highly-regulated industry and the risk of non-compliance with various
laws and regulations is high. The industry has strict health and safety regulations which must
be complied with and there will be regular health and safety inspections to ensure that
regulations are being adhered to. One of the Happy Monkeys restaurants failed a health and
safety inspection during the year. This could lead to bad publicity and damage to the brand
name. As the Happy Monkeys business segment contributes the highest proportion of
revenue to the company, damage to this brand name could be significant for the company. In
addition, damage to one brand name could be easily transferred to the other brand names used
by Champers.
Child play areas
There was an incident during the year where a child was injured at a Happy Monkeys
restaurant. This could have significant repercussions for the company. It is essential that the
play areas are perceived as a safe environment in which children can be placed by their
parents. If this is not the case, then visits to these restaurants will fall in number, leading to
loss of revenue and cash inflows. The Happy Monkeys business segment contributes 53% to
total revenue (2013 49%), so any loss of revenue from this brand could have a major effect
on the performance of the company as a whole. Any bad publicity surrounding this incident
could cause major damage to the Happy Monkeys brand.
In addition, this incident could provoke action by regulatory bodies, such as an investigation
into health and safety procedures at all Happy Monkeys child care facilities. Any breaches in
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regulation could result in the facility and possibly the associated restaurant being shut down.
As discussed above, damage to any one of the brand names could easily transfer across to the
other brand names used by Champers.
As a result of the accident, the company may have to spend a significant amount on the play
areas to bring them in line with the required health and safety standards. Funds may have to
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be diverted from other projects (e.g. the advertising campaign for the Quick-bite brand, or the
development of new Green George cafs).
Quick-bite chain revenue reduction
Revenue from the Quick-bite business segment has fallen by 6%. This is significant given
that the business segment contributes 25% to total revenue in 2014 (2013 30%). The
reduction in demand is likely to be linked to the increased awareness of the importance of
healthy eating. Champers has responded to this issue by publishing nutritional information,
but new business strategies will need to be put in place to avert further any decline in revenue.
Perhaps the company should consider carrying healthier product lines to attract any customers
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it has lost. These new product lines could be part of the advertising campaign for the brand.
Expenditure on advertising to support the Quick-bite brand name is material at 10% of the
total revenue of the company and the expenditure amounts to 40% of the revenue generated
by the Quick-bite business segment. Given the companys relatively poor cash position at the
year end, this level of expenditure is unlikely to be sustainable. This is a competitive market
with a huge number of suppliers, so brand awareness in important, but supporting the brand
name using expensive advertising techniques could prove to be prohibitively expensive.
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Further problems lie ahead for the Quick-bite brand, as new regulations will prohibit the
advertising of food to children from September 2014. Half of the revenue of Quick-bite is
derived from the sale of chuckle boxes to children. The advertising ban will detrimentally
affect a significant revenue and cash flow stream for the company. Champers needs to
consider the development of alternative menus and consider how to support the brand name
given the restriction imposed by the government.
Expansion plans City Sizzler grills
Champers has ambitious plans to dramatically increase the number of City Sizzler restaurants
from 250 to 500 within the next 12 months. It may be that the expansion plans are unrealistic
and that a different strategy should be used in order to expand the company. The risk is that
the company could begin to expand the City Sizzler chain but then run out of cash and be
unable to complete the expansion. The risk is increased by the fact that the grills are located
in prime city centre locations, which will be expensive to acquire.
The company may need to borrow significantly to carry out this expansion. It is essential that
a realistic business plan is prepared to assess if the expansion is financially viable. Given the
scale of the expansion plans in relation to both the City Sizzler and the Green George chains,
it is likely that the company will struggle to raise all of the necessary finance.
The on-going refurbishment costs are also a potential problem. If Champers does not have
the cash to spend on refurbishing the restaurants every two years, then customers with high
expectations regarding luxury surroundings are likely to switch their preference to other
chains of restaurants. In addition, the closure of the restaurants during the refurbishment
every two years would lead to a loss of revenue. Possibly the period between refurbishments
should be extended to reduce future costs and prevent the loss of revenue on such a frequent
basis.
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Expansion plans Green George cafs
To compound the problems discussed above, there are plans to open another 30 Green George
cafs during the year. The cafs are located in affluent areas, so the site acquisition costs are
likely to be expensive.
Green George cafs

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It would seem that Champers is trying to expand two business segments at the same time,
which would be feasible given sufficient finance being raised, but it may be wise for the
company to focus on the expansion of one business segment at a time.
A new business segment has been launched during the year and further expansion of the
brand is planned.
One particular risk with this business segment is the guarantee that the produce is chemical-
free and that it has been produced in a sustainable way. Champers will have to be extremely
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vigilant in monitoring the supply chain of ingredients. Any perceived breaches of these
claims with associated bad publicity could totally destroy the integrity of the brand name.
Profit before tax has fallen by 13%
Despite an overall increase in revenue of 11%, profits have fallen by 13%. This may indicate
poor cost control by the company, or it could be that some one-off expenses (for example, set
up costs for the new Green George cafs) during this year have caused a distorting effect in
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the financial statements. In either case, the management of Champers should consider how
costs are managed and monitored.
This is especially important given the increase in minimum wage which is going to come into
force a few months after the year end. The regulation will have the effect of increasing
operating expenses and thus causing a further reduction in profits.
Reduction in cash
The cash position is now only one third of the amount as at last year end. If this trend were to
continue, Champers will run out of cash within the next financial year. The company has
increased revenue during the year, so it seems that poor cash management techniques are
being used for such a reduction in the cash balance to have occurred. Possibly the company is
overtrading attention is being focused on maximising revenue with little attention being
paid to working capital and cash management.
The cash flow problem is a priority and should be addressed immediately if the company is to
successfully expand in the way that management plans.
Cash based business
Restaurants in general, and especially fast food outlets such as the Quick-bite branches, tend
to be cash based businesses. This can lead to a high risk of fraud, as cash can easily be
misappropriated by staff when dealing with cash sales.
Internal structure
The company is already facing financial problems namely the fall in profit and a reduction
in cash. Yet there are ambitious plans for significant growth which will rely on funds being
available. These problems will become worse as the expansion proceeds unless high calibre
management and employees can be put into place as soon as possible. The company should
review its internal structure and the skills and experience of key management personnel
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before proceeding with expansion plans. It seems that management is planning large scale
expansion at a time when the company is facing regulatory pressures, which may not be an
appropriate prioritisation of, and reaction to, the issues facing the company at this time.
Tutorial note: Credit will be awarded for other relevant business risks discussed in the
answer to this requirement, for example, the competitive nature of the industry.
(c)

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Principal audit procedures
(i) Capitalised costs
Obtain a breakdown of the total amount capitalised and agree the total to the general
ledger.
Agree a sample of costs to supporting documentation:
Site acquisition costs to purchase invoice and legal papers/surveyors

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report (if any);
Labour costs to approved payroll records, time sheets, etc;
Materials (such as cement, bricks and fittings) to suppliers invoice.
Compare the amounts capitalised to an approved capital expenditure budget for the
new chain of restaurants and discuss significant variances with an appropriate
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employee, for example the project manager.
Compare the amounts capitalised restaurant to restaurant and discuss as above.
Review any relevant signed contracts (e.g. from building contractors, electricians,
architects, etc) and discuss any significant deviations from the amounts stated in the
contract and the amount capitalised.
Review the list of amounts capitalised to ensure that revenue items have not been
capitalised by mistake (e.g. staff training costs, consumable items such as cutlery
and plates these are operating expenses which should not be capitalised).
For any sites still in construction at the year end, obtain a stage of completion
certificate from the building contractor.
For the capitalised finance cost:
Recalculate the amount, agreeing that the capitalisation period ceases on

completion of the restaurant.
The completion date should be verified by evidence from building

inspectors of the date the building was signed off as complete.
Agree the rate of interest to the terms of finance.
Read the terms of finance to see that the finance was taken out specifically
in relation to the construction of the restaurants.
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Tutorial note: the procedures described above will provide evidence that finance costs have
been capitalised in accordance with IAS 23 Borrowing Costs, which states that finance costs
should be capitalised only up until the point when the asset is ready for its intended use.
(ii) Advertising and marketing expense

expense.
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Discuss the nature of the advertising with the appropriate employee (e.g. brand
manager, marketing director) in order to gain an understanding of the specific type
of advertising campaigns conducted during the year (e.g. TV or radio, magazine or
newspaper advertising). This should help the auditor to form an expectation of the
Review business plans which outline the marketing strategy to be used to support
the brand name (again to develop an understanding).
Perform analytical review comparing current year expense to prior year and budget.
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Inspect advertising and marketing budgets and check for approval of the amount.
Agree a sample of advertising costs to supporting documentation (e.g. invoices for

newspaper or television advertising).
Physically inspect the marketing documents (e.g. newspaper advertisements, flyers).
Review after-date invoices received in connection with advertising to ensure that

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the $150 million expense is complete and that all outstanding amounts have been
accrued for.
Inspect the dates when advertising took place to gain assurance that costs and
benefits have been matched in the correct accounting period. Any costs incurred for
which advertising has not yet taken place should be treated as a prepayment.
Answer 16 JOLIE CO
(a) Briefing notes
Subject: Business risks facing Jolie Co
Introduction
These briefing notes evaluate the business risks facing our firms new audit client, Jolie,
which operates in the retail industry, and has a year ended 30 November 2014.
Ability to produce fashion items
The company is reliant on staff with the skill to produce high fashion clothes ranges, and also
with the ability to respond quickly to changes in fashion. If Jolie fails to attract and retain
skilled designers then the clothing ranges may not be desirable enough to attract customers in
the competitive retail market. The high staff turnover in the design team indicates that Jolie
struggles to maintain consistency in the design team. This could result in deterioration of the
brand name and, ultimately, reduced sales.
There would be a high cost associated with frequently recruiting this would have an impact
on operating margins.
Inventory obsolescence and margins
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There is a high operational risk that product lines will go out of fashion quickly, because new
ranges are introduced so quickly to the stores (every eight weeks), leading to potentially large
volumes of obsolete inventory. These product lines may be marked down to sell at a reduced
margin. The draft results show that operating margins have already reduced from 179% in
2013 to 168% in 2014. Any significant mark down of product lines will cause further
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reductions in margins.
Wide geographical spread of business operations
Jolie operates a large number of stores, many distribution centres, and has an outsourced
function which is located overseas. This type of business model could be hard to control,
increasing the likelihood of inefficiencies, systems deficiencies, and theft of inventories or
cash.
E-commerce volume of sales

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On-line sales now account for $255 million ($250 per order 1,020,000 orders). In the
previous year, on-line sales accounted for $158 million ($300 per order 526,667 orders).
This represents an increase of 614% ((255 158) 158 100%). One of the risks
associated with the on-line sales is the scale of the increase in the volume of transactions,
especially when combined with a new system introduced recently. There is a risk that the
system will be unable to cope with the volume of transactions, leading possibly to unfilled
orders and dissatisfied customers. This would harm the reputation of the company and the
JLC brand.
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The company has recently upgraded its computer system to integrate sales into the general
ledger. A disaster plan should have been put into place, for use in the event of a system
shutdown or failure. The risk is that no plan is in place and the business could lose a
substantial amount of revenue in the event of the system failure.
E-commerce security of systems
It is crucial that the on-line sales system is secure as customers are providing their credit card
details to the site. Any breach of security could result in credit card details being stolen, and
Jolie may be liable for losses suffered by customers if their credit card details were used
fraudulently. There would clearly be severe reputational issues in this case. Additionally, the
system must be secure from virus infiltration, which could cause system failure, interrupted
sales, and loss of customer goodwill.
E-commerce tax and regulatory issues
There are several compliance risks, which arise due to on-line sales. Overseas sales expose
Jolie to potential sales tax complications, such as extra tax to be paid on the export of goods
to abroad, and additional documentation on overseas sales that may be needed to comply with
regulations. Another important regulatory issue is that of data protection. Jolie faces the risk
of non-compliance with any data protection regulation relevant to customers providing
personal details to the on-line sales system.
Jolie is now making sales overseas. If these sales are made in a different currency to Jolies
currency, the business will be exposed to exchange rate fluctuations which will have an
impact on the companys profit margin.
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Tutorial note: Credit will be awarded for other e-commerce related risks, such as the risk of
obsolescence (leading to the need to continually update the website and system), and
associated costs; and the risk of not having enough staff skilled in IT and e-commerce issues.
Outsourcing of phone ordering system
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The fact that Jolie engaged the outsource provider offering the least cost could lead to
business risks. Staff at the call centre may not be properly motivated, due to low wages being
paid, and may fail to provide a quality service to Jolies customers, leading to loss of
customer goodwill. As the call centre is overseas, the staff may have a different first language
to Jolies customers, leading to customer frustration if they are not understood, and incorrect
orders possibly being made. In addition, there may be staff shortages due to the low wage
offered, leading to delay in answering calls and lost sales.
Overseas call centres are not always popular with customers, so Jolie may find that fewer
customers use this method of purchase. However, the on-line system is there as an alternative
for customers, and is proving popular, so this may not be a significant risk for the company.
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The fact that Jolie opted for the lowest cost provider for the phone ordering system could pose
a potential problem in that the provider may not be sustainable in the long term. If the
provider fails to generate sufficient profit or cash, it may shut down, leaving Jolie without a
crucial part of the sales generating system.
Ethical Trading Initiative

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Jolie has aligned itself to an initiative supporting social and environmental well-being,
presumably to promote its corporate social responsibility. The risk associated with this is that
the claims that products have been produced in a responsible way can easily be undermined if
the supply chain is not closely managed and monitored. Such claims are often closely
scrutinised by the public and pressure groups, and any indication that Jolies products have
not been sourced responsibly will lead to loss of customer goodwill and waste of expenditure
on the advertising campaign.
Distribution centres
There is a risk of non-compliance with the operating licence issued by the local government
authority. The authority will monitor the operating hours of the distribution centres, and also
the noise levels created by them. Breaches of the terms of the licence could lead to further
revocations of licences, causing huge operational problems for Jolie if the centres are forced
to close for any period of time. Fines and penalties may also be imposed due to the breach of
the licence.
Financial performance
Total revenue has decreased by $80 million, or 52% (80/1,535 100). Operating profit has also
fallen, by $30 million, or 109% (30/275 100). The information also shows that the average
spend per order has fallen from $300 to $250. These facts may signify cause for concern, but
operating expenses for 2014 are likely to include one-off items, such as the costs of the new
on-line sales system, and the advertising of the fair-trade initiative. The fall in spend per
customer could be a symptom of general economic difficulties. The company has increased
the volume of on-line transactions significantly; so on balance the overall reduction in profit
and margins is unlikely to be a significant risk at this year-end, though if the trend were to
continue it may become a more pressing issue.
Jolies finance costs have increased by $3 million, contributing to a fall in profit before tax of
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13%. The company has sufficient interest cover to mean that this is not an immediate
concern, but the company should ensure that finance costs do not escalate.
Conclusion
Jolie faces a number of operational and compliance risks, the most significant of which relate
(b)
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to the need for constant updating of the product lines and the potential for obsolete inventory.
The new on-line sales system also raises risks in terms of security, systems reliability and the
sheer volume of transactions. Jolie must also carefully manage the risk of non-compliance
with local government authority regulations. The trend in financial performance should be
carefully monitored, as further reductions in revenue and margins could indicate that a change
in business strategy is needed.
Financial statement risks
Valuation of inventory
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High fashion product lines are likely to become out-of-date and obsolete very quickly. Jolie
aims to have new lines in store every eight weeks, so product lines have only a short shelf life.
Per IAS 2 Inventories, inventory should be valued at the lower of cost and net realisable
value, and could be easily overvalued at the year-end if there is not close monitoring of sales
trends, and necessary mark downs to reflect any slow movement of product lines. The
decline in revenue could indicate that the JLC brand is becoming less fashionable, leading to a
higher risk of obsolete product lines.
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Orders made over the phone or by the internet are prone to higher levels of returns than items
purchased in a store, as the customer may find that the item is not the correct size, or they do
not like the item when it arrives. The risk is insufficient provision has been made in the
financial statements for pre year-end sales being returned post year-end.
Completeness/existence of inventory
Jolie has 210 stores and numerous distribution centres. It may be hard to ensure that
inventory counting is accurate in this situation. There may be large quantities of inventory in-
transit at the year-end, which may be missed from counting procedures, meaning that the
inventory quantities are incomplete. Equally, it may be difficult for the auditor to verify the
existence of inventory if it cannot be physically verified due to being in-transit at the year-
end. Inventory could be the subject of fraudulent financial reporting, as it would be relatively
easy for management to inflate quantities of inventory to increase the amount recognised on
the statement of financial position. The clothing items could also be at risk of theft, making
inventory records inaccurate.
Unrecorded revenue
The on-line and phone sales systems could contribute to a risk of misstated revenue figures.
Firstly, the on-line sales system is integrated with the general ledger, so sales made through
the system should automatically be recorded in the accounting system. However, the system
is new, and it is possible that the integration is not functioning as expected. The scenario does
not state whether the phone sales system is integrated, but it is unlikely given that the function
is outsourced, so a similar risk of unrecorded transactions may arise here.
Sales made in store will include a proportion of cash sales. The risk is that the cash could be
misappropriated, and the revenue unrecorded.
Over-capitalisation of IT/website costs
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The on-line sales system has been upgraded at significant cost. There is a risk that costs have
been incorrectly capitalised. SIC 32 Intangible Assets Website Costs states that only costs
relating to the development phase of the project should be capitalised, but costs of planning,
and all costs when the website is operational should be expensed. Software development
costs follow similar accounting principles. Hence there is a risk of overvalued assets and
unrecognised expenses.
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Tutorial note: Equivalent credited would be awarded for reference to IAS 38 as SICs are no
longer examinable in P2.
Overvaluation of the brand name
The JLC brand name is recognised as an intangible asset, which is the correct accounting
treatment for a purchased brand. The risk is that the asset is overvalued, for two reasons.
Firstly, if no amortisation is being charged on the asset, management are assuming that there
is no end to the period in which the brand will generate an economic benefit. This may be
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optimistic, and there is a risk that the brand is overvalued, and operating expenses incomplete
if there is no annual write-off. An intangible asset which is not being amortised should be
subject to an annual impairment review according to IAS 38 Intangible Assets. If no such
review has been conducted, the asset could be overvalued. The falling revenue figures could
indicate that the asset is overvalued.
Secondly, a significant amount has been spent on promoting the brand name during the year.
This amount should be expensed and, if any has been capitalised, the brand is overvalued and
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operating expenses incomplete.
Overvaluation of properties
There are two indications from the scenario that properties may need to be tested for
impairment, and so could be overvalued. The first is the potential for distribution centres
operating licences to be revoked. If this were to occur, the asset would cease to provide
economic benefit, triggering the need for an impairment review. Secondly, the average
revenue per store has fallen. IAS 36 Impairment of Assets suggests that worse economic
performance than expected is an indicator that an asset could be impaired. For these reasons,
both stores and distribution centres have the potential to be overvalued.
Unrecognised provision/undisclosed contingency
The revocation of an operating licence could lead to a fine or penalty being paid to the local
authority. Two licences have been revoked during the year. The risk is that Jolie has not
either provided for any amount payable, or disclosed the existence of a contingent liability in
accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Opening balances and comparative figures
As this is our first year auditing Jolie, extra care should be taken with opening balances and
comparative figures, as they were not audited by our firm. Additional audit procedures will
need to be planned.
Tutorial note: More than the required number of financial statement risks have been
described in the answer above. Credit may be awarded for the discussion of other, relevant
risks to a maximum of five financial statement risks.
(c) Principal audit procedures in respect of the JLC brand
Agree the cost of the brand to supporting documentation provided by management.
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A purchase invoice may not be available depending on the length of time since the
acquisition of the brand name.
Agree the cost of the brand to prior year audited financial statements.
Tutorial note: as this is a first year audit, no marks will be awarded for procedures relating

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to prior year working papers of the audit firm.
Review the monthly income streams generated by the JLC brand, for indication of
any decline in sales.
Review the results of impairment reviews performed by management, establishing

the validity of any assumptions used in the review, such as the discount rate used to
discount future cash flows, and any growth rates used to predict the cash inflows
from revenue.
Perform an independent impairment review on the brand, and compare to

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managements impairment review.
Review the level of planned expenditure on marketing and advertising to support

the brand name, and consider its adequacy to maintain the image of the brand.
Inquire as to the results of any customer satisfaction or marketing surveys, to gain

an understanding as to the public perception of the JLC brand as a high fashion
brand.
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Consider whether non-amortisation of brand names is a generally accepted

accounting practice in the fashion retail industry by reviewing the published
financial statements of competitors.
Discuss with management the reasons why they feel that non-amortisation is a
justifiable accounting treatment.
Answer 17 SHIRE OIL CO
(a) Audit risks
Inherent financial statements level
As Shire is a listed company there will be pressures on its management to meet the
expectations of users, in particular shareholders and analysts, thereby increasing
inherent risk.
The oil industry is exposed to a volatile market (e.g. in futures trading). This
increases going concern (failure) risk.
Shire operates in different regions with exposure to economic instability, currency

devaluation and high inflation. Increased disclosure risk arises as IAS 1
Presentation of Financial Statements requires that key assumptions concerning the
future of such sources of estimation uncertainty be disclosed.
Disclosure risk is increased as Shire is required to comply with the extensive

disclosure requirements of IFRS 8 Operating Segments.
The fall in basic EPS (as compared with the first six months of the previous half
year) may increase management bias to overstate performance in the second half
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year (to 31 December 2014).
Inherent assertion level
The grant of a licence may be valued at either cost or fair value (IAS 20 Accounting
for Government Grants and Disclosure of Government Assistance). However,

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valuation other than at cost ($nil) is inherently risky as fair value has been estimated
by management. The licence may be unique (being for five years in a remote
region) and in the absence of an active market in them or recent transactions for
which prices can be observed it seems unlikely that any estimate of fair value
made by management can be substantiated.
The licence is an intangible asset. If recognised other than at cost it should be

amortised on a straight-line basis over five years (IAS 38 Intangible Assets).
Item replacements (e.g. of drilling equipment) should be recognised as items of

property, plant and equipment (and the replaced items as disposals) in accordance
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with (IAS 16 Property, Plant and Equipment). Constituent items of each rig should
be depreciated over their useful lives.
If management is properly re-assessing the useful life of each rig annually then this
should be reflected in the change, from time to time, of the number of years over
which each rig is depreciated.
Tutorial note: There is a change in estimate not policy. It is not a risk that the
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useful life of a platform is not the same for all rigs.
Although the treatment of decommissioning provisions (Debit Asset; Credit

Provision) appears to be correct (IAS 16 and IAS 37 Provisions, Contingent
Liabilities and Contingent Assets) abandoning the cyclone-damaged rig calls into
question Shires recognition of such provisions. In the absence of a legal or
constructive obligation there is no liability to be provided for.
The abandoned rig may be overstated. Depreciation should cease and the rig tested
for impairment. In particular, the decommissioning provision should be reversed
against the undepreciated balance included in cost (and any difference included in
profit or loss).
Tutorial note: The difference is between depreciation charge and finance cost (on
unwinding of the discount).
Actual and/or contingent liabilities may arise if Shire is exposed to fines/penalties as

a result of abandoning the rig (IAS 37). As the rig was damaged before the year
end, provisions should be made as at 31 December 2014 unless they cannot be
reliably measured (unlikely). (This could include provision for redundancy of rig
workers.)
The oil pipeline is a jointly controlled asset that should be accounted for to reflect
its economic substance (IFRS 11 Joint Arrangement). Shire must recognise its
share of the asset, liabilities and expenditure incurred and any income from the sale
of its share of the oil output (as well as its own liabilities and expenses separately
incurred).
The prior year modification would have been qualified except for. If there is a
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similar lack of evidence in the current year the auditors report should be similarly
qualified. Even if the correct position at 31 December 2014 is determinable, the
audit opinion at that date should be modified in respect of the effect, if any, on the
opening position and comparative information (unless the opening oil reserves
position has since been ascertained and can be corrected with a prior period
adjustment).
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Tutorial note: Modification could not have been an emphasis of matter as there
was a lack of scope. The matter was evidently material but not pervasive.
Tutorial note: Credit will be given for additional answer points relevant to the scenario and
the industry. For example:
Going concern (failure) risk is increased if significant operating licences1 are

withdrawn from oil-producing areas (e.g. as a result of non-compliance with
environmental legislation).
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Research and development2 costs must be expensed unless or until Shire has a legal
right to explore the area in which they are incurred. So, in the remote region, Shire
can only capitalise costs incurred from April. (Risk is asset overstatement.)
Exploration and evaluation assets should be classified as tangible (e.g. rigs) or

intangible (e.g. drilling rights) according to their nature (IFRS 6 Exploration for
and Evaluation of Mineral Resources).
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When the technical feasibility and commercial viability of extracting oil from an
area of interest can be demonstrated, exploration and evaluation assets must be
tested for impairment before reclassification (as tangible/intangible assets).
(b) Principal audit work useful life of rig platforms
Tutorial notes: The platforms are just one item of each rig. Candidates should not be
awarded marks here for the matters to be considered in the assessment of useful lives (since
this is illustrated in the scenario). No marks will be awarded for criticising management for
estimating useful lives on a per platform basis or for audit work on depreciation
charges/carrying amounts unrelated to the determination of useful lives.
1
Withdrawal of the new licence would not create a going concern issue.
2
May also be described as exploration and evaluation costs or discovery and assessment.
Review of managements annual assessment of the useful life of each rig at 31

December 2014 and corroboration of any information that has led to a change in
previous estimates. For example, for the abandoned rig, where useful life has been
assessed to be at an end, obtain:
weather reports;
incident report supported by photographs;
insurance claim, etc.
Consider managements past experience and expertise in estimating useful lives.

For example, if all lives initially assessed as short (c. 15 years) are subsequently
lengthened (or long lives consistently shortened) this would suggest that
management is being over (under) prudent in its initial estimates.
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Review of industry comparatives as published in the annual reports of other oil
producers.
Comparison of actual maintenance costs against budgeted to confirm that the

investment needed in maintenance, to achieve expected life expectancy, is being

made.

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Comparison of actual output (oil extracted) against budgeted. If actual output is less
than budgeted the economic life of the platform may be:
shorter (e.g. because there is less oil to be extracted than originally

surveyed); or
longer (e.g. because the rate of extraction is less than budgeted).
Tutorial note: An increase in actual output can be explained conversely.

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A review of the results of managements impairment testing of each rig (i.e. the
cash-generating unit of which each platform is a part).
Recalculations of cash flow projections (based on reasonable and supportable

assumptions) discounted at a suitable pre-tax rate.
Tutorial note: As the rigs will not have readily determinable net selling prices
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(each one being unique and not available for sale) any impairment will be assessed
by a comparison of value in use against carrying amount.
Review of working papers of geologist/quantity surveyor(s) employed by Shire

supporting estimations of reserves used in the determination of useful lives of rigs.
(c) Integrated reporting
(i) Managements responsibility
The International <IR> Framework clearly places the responsibility for the information
contained in the integrated report with those charged with governance of the organisation.
Those charged with governance must work in collaboration to prepare the report.
A statement from those charged with governance should include:
an acknowledgement of their responsibility to ensure the integrity of the integrated

report;
an acknowledgement that they have applied their collective mind to the preparation and
presentation of the integrated report; and
their opinion or conclusion about whether the integrated report is presented in

accordance with the Framework.
If the integrated report does not include such a comply statement, it should explain:
how those in charge of governance were involved in the preparation and

presentation of the integrated report;
the steps being taken to ensure those in charge of governance will include such a
statement in future reports;
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the time frame in which this will be achieved. This should be no later than the third
integrated report that references the framework.
Tutorial note: These comply or explain requirements are for up to three years of
transition only. Thereafter there should be only compliance.
(ii)

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Performance indicators
Absolute ($) and relative (%) level of investment in sports sponsorship and funding
to the Shire Ward.
Increasing number of championship events and participating schools/students as
compared with prior year.
Number of medals/trophies sponsored at events and/or number awarded to Shire
sponsored schools/students.
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Number of patients treated (successfully) a week/month. Average bed occupancy
(daily/weekly/monthly and cumulative to date).
Staffing levels (e.g. of volunteers for sports events, Shire Ward staff and the company):
ratio of starters to leavers/staff turnover;
absenteeism (average number of days per person per annum).
Number of:
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breaches of health and safety regulations and environmental regulations;

oil spills;
accidents and employee fatalities;
insurance claims.
Evidence
Tutorial note: There is a wide range of performance indicators and a wide range of possible
sources of audit evidence. As the same evidence may contribute to providing assurance on
more than one measure they are not tabulated here, to avoid duplication. However,
candidates may justifiably adopt a tabular layout. Also note that where measures may be
expressed as evidence (e.g. trophies awarded) marks should be awarded only once.
Actual level of investment ($) compared with budget and budget compared with
prior period.
Tutorial note: Would expect actual to be at least greater than prior year if
performance in these areas (health and safety) has improved.
Physical evidence of favourable increases on prior year, for example:

medals/cups sponsored;
number of beds available.
Increase in favourable press coverage/reports of sponsored events. (Decrease in

adverse press about accidents/fatalities.)
Independent surveys (e.g. by marine conservation organisations, welfare groups,
etc) comparing Shire favourably with other oil producers.
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A reduction in fines paid compared with budget (and prior year).
Reduction in legal fees and claims being settled as evidenced by fee notes and
correspondence files.
Amounts settled on insurance claims and level of insurance cover as compared with
prior period.
Answer 18 ISLAND CO
(a) Planning Briefing Notes
(i)
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Principal Audit Risks
Revenue Recognition timing
Island raises sales invoices in three stages. There is potential for breach of IAS 18 Revenue,
which states that revenue should only be recognised once the seller has the right to receive it,
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in other words the seller has performed its contractual obligations. This right does not
necessarily correspond to amounts falling due for payment in accordance with an invoice
schedule agreed with a customer as part of a contract. Island appears to receive payment from
its customers in advance of performing any obligation, as the stage one invoice is raised when
an order is confirmed (i.e. before any work has actually taken place). This creates the
potential for revenue to be recognised too early, in advance of any performance of contractual
obligation. When a payment is received in advance of performance, a liability should be
recognised equal to the amount received, representing the obligation under the contract.
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Therefore a significant risk is that revenue is overstated and liabilities understated.
Tutorial note: Equivalent guidance is also provided in IAS 11 Construction Contracts and
credit would be given for discussing revenue recognition under IAS 11 as Island is providing
a single substantial asset for a customer under the terms of a contract.
Disputed receivable
The amount owed from Jacks Mine is highly material as it represents 509% of profit before
tax, 23% of revenue, and 3% of total assets. The risk is that the receivable is overstated if no
impairment of the disputed receivable is recognised.
Legal claim
The claim should be investigated seriously by Island. The chief executive officers (CEO)
opinion that the claim will not result in any financial consequence for Island is nave and
flippant. Damages could be awarded against Island if it is found that the machinery is faulty.
The recurring high level of warranty provision implies that machinery faults are fairly
common and therefore the accident could be the result of a defective machine being supplied
to Sawyer. The risk is that no provision is created for the potential damages under IAS 37
Provisions, Contingent Liabilities and Contingent Assets, if the likelihood of paying damages
is considered probable. Alternatively, if the likelihood of damages being paid to Sawyer is
considered a possibility then a disclosure note should be made in the financial statements
describing the nature and possible financial effect of the contingent liability. As discussed
below, the CEO, Kate Shannon, has an incentive not to make a provision or disclose a
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contingent liability due to the planned share sale after the reporting date.
A further risk is that any legal fees associated with the claim have not been accrued within the
financial statements. As the claim has arisen during the year, the expense must be included in
this years income statement, even if the claim is still on-going at the reporting date.
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The fact that the legal claim is effectively being ignored may cast doubts on the overall
integrity of senior management, and on the integrity of the financial statements. Management
representations should be approached with a degree of professional scepticism during the
audit.
Sawyer has cancelled two orders. If the amounts are still outstanding at the reporting date
then it is highly likely that Sawyer will not pay the invoiced amounts, and thus receivables are
overstated. If the stage one payments have already been made, then Sawyer may claim a
refund, in which case a provision should be made to repay the amount, or a contingent
liability disclosed in a note to the financial statements.
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Sawyer is one of only five major customers, and losing this customer could have future going
concern implications for Island if a new source of revenue cannot be found to replace the lost
income stream from Sawyer. If the legal claim becomes public knowledge, and if Island is
found to have supplied faulty machinery, then it will be difficult to attract new customers.
A case of this nature could bring bad publicity to Island, a potential going concern issue if it
results in any of the five key customers terminating orders with Island. The auditors should
plan to extend the going concern work programme to incorporate the issues noted above.
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Inventories
Work in progress is material to the financial statements, representing 89% of total assets.
The inventory count was held two weeks prior to the year end. There is an inherent risk that
the valuation has not been correctly rolled forward to the position at the reporting date.
The key risk is the estimation of the stage of completion of work in progress. This is
subjective, and knowledge appears to be confined to the chief engineer. Inventory could be
overvalued if the machines are assessed to be more complete than they actually are at the year
end. Absorption of labour costs and overheads into each machine is a complex calculation
and must be done consistently with previous years.
It will also be important that consumable inventories not yet utilised on a machine (e.g.
screws, nuts and bolts) are correctly valued and included as inventories of raw materials
within current assets.
Overseas supplier
As the supplier is new, controls may not yet have been established over the recording of
foreign currency transactions. Inherent risk is high as the trade payable should be retranslated
using the year end exchange rate per IAS 21 The Effects of Changes in Foreign Exchange
Rates. If the retranslation is not performed at the year end, the trade payable could be
significantly over or under valued, depending on the movement of the dollar to euro exchange
rate between the purchase date and the year end. The components should remain at historic
cost within inventory valuation and should not be retranslated at the year end.
Warranty provision
The warranty provision is material at 26% of total assets (2013 27%). The provision has
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increased by only $100,000, an increase of 42%, compared to a revenue increase of 214%.
This could indicate an underprovision as the percentage change in revenue would be expected
to be in line with the percentage change in the warranty provision, unless significant
improvements had been made to the quality of machines installed for customers during the
year. This appears unlikely given the legal claim by Sawyer, and the machines installed at
Jacks Mine operating inefficiently. The basis of the estimate could be understated to avoid
Majority shareholder
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charging the increase in the provision as an expense through the income statement. This is of
special concern given that it is the CEO and majority shareholder who estimates the warranty
provision.
Kate Shannon exerts control over Island via a majority shareholding, and by holding the
position of CEO. This greatly increases the inherent risk that the financial statements could
be deliberately misstated (i.e. overvaluation of assets, undervaluation of liabilities) to
overstate profits. The risk is severe at this year end as Kate Shannon is hoping to sell some
Island shares after the year end. As the price that she receives for these shares will be to a
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large extent influenced by the financial position of the company at 30 November 2014, she
has a definite interest in manipulating the financial statements for her own personal benefit.
For example:
Not recognising a provision or contingent liability for the legal claim from Sawyer;
Not providing for the potentially irrecoverable receivable from Jacks Mines;
Not increasing the warranty provision;
Recognising revenue earlier than permitted by IAS 18 Revenue.
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Related party transactions
Kate Shannon controls Island and also controls Pacific. Transactions between the two
companies should be disclosed per IAS 24 Related Party Disclosures. There is risk that not
all transactions have been disclosed, or that a transaction has been disclosed at an
inappropriate value. Details of the lease contract between the two companies should be
disclosed within a note to the financial statements; in particular, any amounts owed from
Island to Pacific at 30 November 2014 should be disclosed.
Other issues
Kate Shannon wants the audit to be completed as soon as possible, which brings
forward the deadline for completion of the audit. The audit team may not have time
to complete all necessary procedures, or there may not be time for adequate reviews
to be carried out on the work performed. Detection risk, and thus audit risk is
increased, and the overall quality of the audit could be jeopardised.
This is especially important given that this is the first year audit and therefore the
audit team will be working with a steep learning curve. Audit procedures may take
longer than originally planned, yet there is little time to extend procedures where
necessary.
Kate Shannon may also exert considerable influence on the members of the audit
team to ensure that the financial statements show the best possible position of Island
in view of her share sale. It is crucial that the audit team members adhere strictly to
ethical guidelines and that independence is beyond question.
Due to the seriousness of the matters noted above, a final matter to be considered at
the planning stage is that a second partner review (Engagement Quality Control
Review) should be considered for this years audit. A suitable independent
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reviewer should be identified, and time planned and budgeted for at the end of the
assignment.
Conclusion
From the range of issues discussed in these briefing notes, it can be seen that the audit of
(ii)
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Island will be a relatively high risk engagement.
Warranty provision
ISA 540 Audit of Accounting Estimates requires that auditors should obtain sufficient audit
evidence as to whether an accounting estimate, such as a warranty provision, is reasonable
given the entitys circumstances, and that disclosure is appropriate. One or a combination of
the following approaches should be used:
Review and test the process used by management to develop the estimate
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Review contracts or orders for the terms of the warranty to gain an understanding of
the obligation of Island.
Review correspondence with customers during the year to gain an understanding of

claims already in progress at the year end.
Perform analytical procedures to compare the level of warranty provision year on

year, and compare actual to budgeted provisions. If possible disaggregate the data,
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for example, compare provision for specific types of machinery or customer by

customer.
Re-calculate the warranty provision.
Agree the percentage applied in the calculation to the stated accounting policy of
Island.
Review board minutes for discussion of on-going warranty claims, and for approval
of the amount provided.
Use management accounts to ascertain normal level of warranty rectification costs

during the year.
Discuss with Kate Shannon the assumptions she used to determine the percentage
used in her calculations.
Consider whether assumptions used are consistent with the auditors understanding
of the business.
Compare prior year provision with actual expenditure on warranty claims in the
accounting period.
Compare the current year provision with prior year and discuss any fluctuation with
Kate Shannon.
Review subsequent events which confirm the estimate made
Review any work carried out post year end on specific faults that have been
provided for. Agree that all costs are included in the year end provision.
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Agree cash expended on rectification work after the reporting date to the cash book.
Agree cash expended on rectification work post year end to suppliers invoices, or
to internal cost ledgers if work carried out by employees of Island.
Read customer correspondence received post year end for any claims received after
(b) Quality control
(i)
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the reporting date.
Individual audit engagement
Tutorial note: ISQC 1 Quality Control for Firms That Perform Audits and Reviews of
Historical Financial Information and Other Assurance and Related Services Engagements
provides guidance on the overall quality control systems that should be implemented by an
audit firm. ISA 220 Quality Control for Audits of Historical Financial Information
specifies the quality control procedures that should be applied by the engagement team in
individual audit assignments.
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Client acceptance procedures
There should be full documentation, and conclusion on, ethical and client acceptance issues in
each audit assignment. The engagement partner should consider whether members of the
audit team have complied with ethical requirements, for example, whether all members of the
team are independent of the client. Additionally, the engagement partner should conclude
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whether all acceptance procedures have been followed, for example, that the audit firm has
considered the integrity of the principal owners and key management of the client. Other
procedures on client acceptance should include:
Obtaining professional clearance from previous auditors;

Consideration of any conflict of interest;
Money laundering (client identification) procedures.
Engagement team
Procedures should be followed to ensure that the engagement team collectively has the skills,
competence and time to perform the audit engagement. The engagement partner should
assess that the audit team, for example:
Has the appropriate level of technical knowledge;

Has experience of audit engagements of a similar nature and complexity;
Has the ability to apply professional judgement;
Understands professional standards, and regulatory and legal requirements.
Direction
The engagement team should be directed by the engagement partner. Procedures such as an
engagement planning meeting should be undertaken to ensure that the team understands:
Their responsibilities;
The objectives of the work they are to perform;
The nature of the clients business;
Risk related issues;
How to deal with any problems that may arise; and
The detailed approach to the performance of the audit.
The planning meeting should be led by the partner and should include all people involved
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with the audit. There should be a discussion of the key issues identified at the planning stage.
Supervision
Supervision should be continuous during the engagement. Any problems that arise during the
audit should be rectified as soon as possible. Attention should be focused on ensuring that
audit engagement.
Review
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members of the audit team are carrying out their work in accordance with the planned
approach to the engagement. Significant matters should be brought to the attention of senior
members of the audit team. Documentation should be made of key decisions made during the
The review process is one of the key quality control procedures. All work performed must be
reviewed by a more senior member of the audit team. Reviewers should consider for example
whether:
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Work has been performed in accordance with professional standards;
The objectives of the procedures performed have been achieved;
Work supports conclusions drawn and is appropriately documented.
The review process itself must be evidenced.
Consultation
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Finally the engagement partner should arrange consultation on difficult or contentious

matters. This is a procedure whereby the matter is discussed with a professional outside the
engagement team, and sometimes outside the audit firm. Consultations must be documented
to show:
The issue on which the consultation was sought; and

The results of the consultation.
(ii) Potential problems and how overcome
Consultation it may not be possible to hold extensive consultations on specialist issues

within a small firm, due to a lack of specialist professionals. There may be a lack of suitably
experienced peers to discuss issues arising on client engagements. Arrangements with other
practices for consultation may be necessary.
Training/Continuing Professional Development (CPD) resources may not be available, and

it is expensive to establish an in-house training function. External training consortia can be
used to provide training/CPD for qualified staff, and training on non-exam related issues for
non-qualified staff.
Review procedures it may not be possible to hold an independent review of an engagement

within the firm due to the small number of senior and experienced auditors. In this case an
external review service may be purchased.
Lack of specialist experience when needed for an engagement; the skills may be bought in,
for example, by seconding staff from another practice. Alternatively if work is too specialised
for the firm, the work could be sub-contracted to another practice.
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Working papers the firm may lack resources to establish an in-house set of audit manuals or
standard working papers. In this case documentation can be provided by external firms or
professional bodies.
Answer 19 BLUEBELL CO
(a) Financial statement risks
Revenue recognition
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Bluebell has an accounting policy of recognising revenue when a room is occupied. The
deposits (and possibly sometimes even full payment) are received when the room is booked.
Revenue will be overstated if it is recognised too early. On receipt of a deposit prior to the
occupation of the room, the revenue should be deferred and disclosed as a liability, per IAS
18 Revenue. Liabilities may therefore be understated and profit overstated.
Further indication of possible overstatement of revenue is shown by Bluebells 24.8%

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increase in revenue compared to the industry average of only 20%.
Share-based payment
The expense could be overstated if the assumption regarding all of the shares vesting is
incorrect. The expense should be calculated by considering whether performance conditions
attached to the share options will be met. It is unlikely that every single employee granted an
option will meet the required performance criteria and therefore a more realistic, lower
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estimate should be made of the expense. The expense should be adjusted each year end to
account for staff turnover. If the expense is overstated due to an incorrect assumption, then
the corresponding credit to equity is also overstated.
In addition, the calculation of the total cost of the share-based payment is complex; if any of
the components of the calculation are incorrect, then the expense will be over or understated.
For example, the fair value used to calculate the expense should be the fair value of the
granted share options calculated at the grant date; the use of fair value at any other date is
incorrect. The model used to calculate fair value (e.g. the Black-Scholes Model) must comply
with IFRS 2 Share-based Payment.
It is also important for the measurement of the expense that it has been calculated based on
the share options being granted midway through the accounting period.
Provisions
The provisions for repairing flood damage should only be recognised if Bluebell has an
obligation to perform the repairs at the year end. There is unlikely to be any legal or
constructive obligation attached to this situation so a provision should not have been
recognised in this accounting period. Operating expenses (and property, plant and equipment
if any portion of the provision relating to refurbishment has been capitalised) and liabilities
are therefore overstated.
Disclosure should be made in a note to the financial statements for any capital commitment
entered into before the year end.
In addition, it is important to consider that the buildings are covered by an insurance policy,
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which will pay out for repair and refurbishment costs to the assets. The fact that Bluebell has
recognised a repair expense of $100 million indicates that either the buildings were not
covered by adequate insurance (a business risk), or that the accounting implication of the
reimbursement has been ignored.
Tutorial note: Credit will be awarded for alternative interpretations as to whether an
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obligation exists at the year end for the property repairs to be carried out.
Impairment of flood damaged properties
The carrying amount of the properties will be overstated if the carrying amount has not been
fully written down to recoverable amount. It is not stated whether or not the damaged
properties have been tested for impairment, but it would seem likely, given the amount of
damage caused by flooding, that some impairment loss should have been recognised this year.
Potential understatement of operating expenses

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A comparison of operating expenses for the two years reveals an unusual trend. The
operating expenses for 2014 include two new items; the share-based payment expense of
$138 million and the repairs of $100 million. Once these have been eliminated to enable a
meaningful comparison to the previous year, the 2014 operating expenses are $597 million
($835 138 100). This is a reduction in operating expenses compared to the prior year of
$93 million i.e. 135% (93/690 100).
Given that revenue has increased by 248% (as discussed above), it would appear likely that
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operating expenses for the current year are understated.
Property disposals
It is correct that profit on asset disposals should be recognised within other operating income,
or alternatively, if material, be disclosed separately in the statement of comprehensive
income. However, it appears that the substance of this transaction is more a financing
arrangement than a genuine sale. Bluebell has retained operational control of the assets and is
still exposed to the risk and the reward associated with the properties, as shown by the
financial return received each year based on the performance of the hotels. In addition, the
option to repurchase in 15 years time indicates that at that time Bluebell will be repaying the
long-term finance secured on the properties sold.
Therefore the assets should remain on the statement of financial position, with the proceeds
received on the sale recognised as a liability. There should be no profit recorded on the
transaction. Currently other operating income is overstated by the profit of $125 million.
Property, plant and equipment is understated by the value of the properties sold and
liabilities understated by the amount of finance raised.
In addition, Bluebell will need to continue to depreciate the properties. Operating expenses
are currently understated due to the lack of depreciation on the disposed properties since the
date of disposal.
Finally, as the sale is in reality a finance arrangement, it is likely that Bluebell should
accrue finance charges. The total finance charge associated with the sale and repurchase
arrangement should be allocated over the period of the finance. It is likely that finance
charges are understated due to the lack of inclusion of finance cost in relation to the sale and
repurchase arrangement.
Property revaluations
Property, plant and equipment is a highly material figure, representing 44% of total assets
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(2013 51%). The revaluation during the year introduces financial statement risk to the
carrying amount of the assets given the subjective nature of establishing the fair value of
properties. As Bluebell is trying to raise finance in order to improve liquidity, there is a
definite incentive for overvaluation of the properties, as this will strengthen the statement of
financial position and make Bluebell more attractive to potential providers of finance.
similarly misstated. PL
Under IAS 12 Income Taxes, a deferred tax provision must be recognised on the revaluation
of a property, with the debit recorded within equity. If the properties have been overvalued in
the financial statements then the corresponding deferred tax liability and equity entry will be
Tutorial note: Note 6 shows a deferred tax entry of $88 million charged to equity during the
year, representing 352% of the $250 million revaluation gain recognised (note 4). Therefore
the financial statement risk is not that the deferred tax has not been recognised, but that its
value will be incorrect if the revaluation itself is misstated.
Deferred tax asset

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IAS 12 states that a deferred tax asset can only be recognised where the recoverability of the
asset can be demonstrated. Unutilised tax losses can be carried forward for offset against
future taxable profits, so Bluebell must demonstrate, using budgets and forecasts, that future
tax profits will be available for the losses to be fully utilised. If this cannot be demonstrated
then the deferred tax asset recognised should be restricted to the level of future profits that can
be measured with reasonable certainty.
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The financial statements currently show a healthy profit before tax of $145 million.
However, when the profit on asset disposal is removed, if adjustments are necessary for the
impaired properties (as discussed above) and if finance costs and depreciation charges need to
be expensed for the sale and repurchase agreement, then it could be that Bluebells
profitability has actually substantially decreased from last year, and is likely to be a loss.
Tutorial note: Credit will be awarded where candidates calculate a new profit before tax
figure based on the adjustments suggested in their answer.
Given this detrimental underlying trend in profitability and the past losses it could be difficult
to demonstrate that the tax losses are recoverable against future profits. In this case the
deferred tax asset is overstated.
Going concern
Given poor liquidity and an underlying trend of falling profits the company could face going
concern problems. Disclosure regarding the availability of long-term finance may be
necessary for the financial statements to show a true and fair view.
(b) (i) Principal audit procedures measurement of share-based payment expense
Obtain management calculation of the expense and agree the following from the
calculation to the contractual terms of the scheme:
Number of employees and executives granted options;

Number of options granted per employee;
The official grant date of the share options;
Vesting period for the scheme;
Required performance conditions attached to the options.
Recalculate the expense and check that the fair value has been correctly spread over
the stated vesting period.
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Agree fair value of share options to specialists report and calculation and evaluate
whether the specialist report is a reliable source of evidence.
Agree that the fair value calculated is at the grant date.

PL
Tutorial note: A specialist such as a chartered financial analyst would commonly be used to
calculate the fair value of non-traded share options at the grant date, using models such as
the Black-Scholes Model.
Obtain and review a forecast of staffing levels or employee turnover rates for the
duration of the vesting period and scrutinise the assumptions used to predict level of
staff turnover.
Discuss previous levels of staff turnover with a representative of the human

resources department and query why 0% staff turnover has been predicted for the
next three years.
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Check the sensitivity of the calculations to a change in the assumptions used in the
valuation, focusing on the assumption of 0% staff turnover.
Obtain written representation from management confirming that the assumptions

used in measuring the expense are reasonable.
Tutorial note: A high degree of scepticism must be used by the auditor when conducting the
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final three procedures due to the management assumption of 0% staff turnover during the
vesting period.
(ii) Principal audit procedures recoverability of deferred tax asset
Obtain a copy of Bluebells current tax computation and deferred tax calculations
and agree figures to any relevant tax correspondence and/or underlying accounting
records.
Develop an independent expectation of the estimate to corroborate the

reasonableness of managements estimate.
Obtain forecasts of profitability and agree that there is sufficient forecast taxable
profit available for the losses to be offset against. Evaluate the assumptions used in
the forecast against business understanding. In particular consider assumptions
regarding the growth rate of taxable profit in light of the underlying detrimental
trend in profit before tax.
Assess the time period it will take to generate sufficient profits to utilise the tax
losses. If it is going to take a number of years to generate such profits, it may be
that the recognition of the asset should be restricted.
Using tax correspondence, verify that there is no restriction on the ability of

Bluebell to carry the losses forward and to use the losses against future taxable
profits.
Tutorial note: in many tax jurisdictions losses can only be carried forward to be utilised
against profits generated from the same trade. Although in the scenario there is no evidence
of such a change in trade, or indeed any kind of restriction on the use of losses, it is still a
valid audit procedure to verify that this is the case.
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(c) Briefing notes Guidance on the establishment of social and environmental Key
Performance Indicators (KPIs) within Bluebell Co
For discussion with Daisy Rosepetal, internal auditor of Bluebell Co
Tutorial note: Note format of answer to obtain professional marks.
Introduction
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Many companies use social and environmental KPIs as a means of establishing performance
targets and measuring actual results against the performance target set. Social KPIs involve
performance relating to employees, customers and the wider community. Environmental
KPIs are focused on the environmental impact of the companys activities.
The following table recommends some KPIs and suggests the evidence that should be
available in relation to each KPI:
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KPI Nature of evidence
Social employees
% female employees, % ethnic minority Personnel files, starters and leavers

employees. documentation.
Staff absentee rates number of days of Payroll records, medical certificates

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absenteeism compared to total labour days supporting sick leave.

per year.
Employee satisfaction/engagement (i.e. Internal audit could prepare a questionnaire

combined) index. or survey of Bluebells staff. Alternatively
summaries of staff appraisal records could
provide evidence.
Monetary value of staff training and Cash book to verify amount. Also
development. documents authorising the training and
outlining the need for the training.
Staff turnover Personnel files, leavers documentation from
payroll records, exit interview records.
Social customers
Customer satisfaction rates % satisfaction Surveys or questionnaires completed by

with service provided, cleanliness of room, customers after staying at a hotel or using a
quality of food, etc. room for an event.
Level of repeat bookings repeat bookings as Customer account details from the sales
% of total bookings. system would indicate multiple bookings.
Bluebell may operate a loyalty reward
scheme to attract multiple bookings this
would provide detailed evidence.
Level of complaints number of customers Management log book of complaints
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who have demanded refunds or have made a received. Sales system could provide
formal written complaint. evidence of refunds via credit notes issued.
Number of customers reporting accidents Accident log book describing the nature of
while on Bluebell premises (this point could the injury, seriousness, whether emergency
also be made in relation to staff). services called.
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Social wider community
Monetary value of any donations made to

local or other charities, could be expressed as
% profit.
Number of times Bluebell has made its hotels
available for use free of charge for local
community or charity events.
Cash book will show value of any donations.
Board minutes should contain evidence of
authorisation.
Register of events Bluebell will have some
kind of diary or timetable indicating date and
reason for use of facilities. Approval by
manager of free use.
Environmental
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% change in water use, electricity use, etc Comparison of utilities costs using suppliers
compared to prior year. bills received. Review of actual to budgeted
consumption of water, electricity, etc.
Monetary amount of investment in or List of preferred suppliers and products.
purchase of environmentally friendly items Observation by internal auditor of products
(e.g. energy efficient light bulbs, recycled used in the hotels.
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paper, water efficient dishwashers).

Quantification of carbon footprint and % Review energy supplier contracts for
change from prior years. evidence that energy used is from renewable
source. Board authorisation of any payments
made for carbon offsetting.
% waste recycled compared to non-recycled. Cash book should show amounts invested in
recycling facilities at each hotel.
Observation of the use of recycling facilities.
Conclusion
The specific KPIs set by Bluebell should reflect the priorities of the company. There is an
extremely wide range of measures that could be used the important thing is to make each
measure quantifiable and to ensure that evidence will be readily available to support the stated
KPI. In the absence of this, the KPIs may lack credibility if disclosed in the future as part of
Bluebells annual report or in any publicly available information.
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PL ABOUT BECKER PROFESSIONAL EDUCATION
Together with ATC International, Becker Professional Education
provides a single destination for candidates and professionals
looking to advance their careers and achieve success in:
Accounting
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International Financial Reporting
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Continuing Professional Education
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For more information on how Becker Professional Education can
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support you in your career, visit www.becker.com.

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This ACCA Revision Question Bank has been reviewed
by ACCA's examining team and includes:
t The most recent ACCA examinations with suggested answers

t Past examination questions, updated where relevant
t
t
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Model answers and suggested solutions
Tutorial notes
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www.becker.com/ACCA | acca@becker.com
2014 DeVry/Becker Educational Development Corp. All rights reserved.

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December 2014June 2015 Edition

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ADVANCED AUDIT AND ASSURANCE

For Examinations to June 2015

Copyright 2014 DeVry/Becker Educational Development Corp. All rights reserved.

Question Page Answer Marks Date worked

CODES OF ETHICS FOR PROFESSIONAL ACCOUNTANTS

PROFESSIONAL RESPONSIBILITY AND LIABILITY

Rapid Travel Co (ACCA J98)

PLANNING, MATERIALITY AND RISK

EVALUATION AND REVIEW

Question Page Answer Marks Date worked

AUDIT OF FINANCIAL STATEMENTS

REVIEWS AND RELATED SERVICES

35 Plaza Co (ACCA J05 adapted)

PROSPECTIVE FINANCIAL INFORMATION

CURRENT ISSUES AND DEVELOPMENTS

Question Page Answer Marks Date worked

Question 1 FLIGHT INVESTMENT

Draft for inclusion in a letter to Mr Row:

(a) an explanation of the purposes of an audit committee; (7 marks)

Prepare briefing notes to be used at your training session in which you:

Question 3 DEDZA & CO

Question 5 BECKER & CO

(a) A business arrangement with Murray Co. (7 marks)

(b) A recruitment service offered to clients. (7 marks)

(c) Temporary staff assignments. (6 marks)

Question 6 CARTER & CO

(a) Fernwood Co; (6 marks)

Question 7 NEESON & CO

(i) An advertisement could be placed in national newspapers to attract new clients.

Note: the mark allocation is shown against each of the issues.

Question 8 RAPID TRAVEL CO

Question 9 NEGLIGENT ACTIONS

liability disclaimer paragraph. (6 marks)

(i) Define an Emphasis of Matter paragraph and explain, providing examples,

Note: You are not required to produce draft paragraphs. (4 marks)

(a) The importance of quality in audit work

(b) Training of staff

Profit before tax $50,000

Key financial information

31 May 2014 31 May 2013

Laws and regulations

identify and explain the aspects of a clients business which should be

Extract from draft statement of comprehensive income

Year ending 30 November 2014 Draft 2013 Actual

Retail outlets 1,030 1,140

Question 17 SHIRE OIL CO

To: Audit Manager

Respond to the partners e-mail. (19 marks)

Extracts from the Statement of Comprehensive Income 2014 2013

Note 1: Revenue recognition

Note 2: Significant items included in operating expenses:

Note 3: Other operating income includes:

Profit on property disposal (iii)

Extracts from the Statement of Financial Position 2014 2013

Property, plant and equipment (note 4) 1,265 1,135

Note 4: Property, Plant and Equipment (extract)

Note 5: Deferred Tax Asset (extract)

Answer 1 FLIGHT INVESTMENT

(a) Purposes of an audit committee

enables non-executive directors to contribute an independent judgement and play a

removal and remuneration of the external auditor);

developing and implementing policy on the engagement of the external auditor to