Paper 2.

6(INT)
Audit and Internal
Review
(International Stream)

PART 2

TUESDAY 14 JUNE 2005

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A ALL THREE questions are compulsory and MUST

be answered

Section B TWO questions ONLY to be answered

Do not open this paper until instructed by the supervisor

This question paper must not be removed from the examination

hall

The Association of Chartered Certified Accountants

Section A – ALL THREE questions are compulsory and MUST be attempted

1 (a) Explain the term ‘audit risk’. (4 marks)

(b) You are the audit manager for Parker, a limited liability company which sells books, CDs, DVDs and similar items
via two divisions: mail order and on-line ordering on the Internet. Parker is a new audit client. You are
commencing the planning of the audit for the year-ended 31 May 2005. An initial meeting with the directors has
provided the information below.
The company’s turnover is in excess of $85 million with net profits of $4 million. All profits are currently earned
in the mail order division, although the Internet division is expected to return a small net profit next year. Turnover
is growing at the rate of 20% p.a. Net profit has remained almost the same for the last four years.
In the next year, the directors plan to expand the range of goods sold through the Internet division to include toys,
garden furniture and fashion clothes. The directors believe that when one product has been sold on the Internet,
then any other product can be as well.
The accounting system to record sales by the mail order division is relatively old. It relies on extensive manual
input to transfer orders received in the post onto Parker’s computer systems. Recently errors have been known
to occur, in the input of orders, and in the invoicing of goods following despatch. The directors maintain that the
accounting system produces materially correct figures and they cannot waste time in identifying relatively minor
errors. The company accountant, who is not qualified and was appointed because he is a personal friend of the
directors, agrees with this view.
The directors estimate that their expansion plans will require a bank loan of approximately $30 million, partly to
finance the enhanced web site but also to provide working capital to increase inventory levels. A meeting with
the bank has been scheduled for three months after the year end. The directors expect an unmodified auditor’s
report to be signed prior to this time.

Required:
(i) Identify and describe THE MATTERS that give rise to audit risks associated with Parker. (10 marks)

(ii) Explain the enquiries you will make, and the audit procedures you will perform to assist you in making
a decision regarding the going concern status of Parker in reaching your audit opinion on the financial
statements. (6 marks)

(20 marks)

2
2 (a) Explain the purpose of a management representation letter. (5 marks)

(b) You are the manager in charge of the audit of Crighton-Ward, a public limited liability company which
manufactures specialist cars and other motor vehicles for use in films. Audited turnover is $140 million with
profit before tax of $7·5 million.
All audit work up to, but not including, the obtaining of management representations has been completed. A
review of the audit file has disclosed the following outstanding points:
Lion’s Roar
The company is facing a potential legal claim from the Lion’s Roar company in respect of a defective vehicle that
was supplied for one of their films. Lion’s Roar maintains that the vehicle was not built strongly enough while
the directors of Crighton-Ward argue that the specification was not sufficiently detailed. Dropping a vehicle
50 metres into a river and expecting it to continue to remain in working condition would be unusual, but this is
what Lion’s Roar expected. Solicitors are unable to determine liability at the present time. A claim for $4 million
being the cost of a replacement vehicle and lost production time has been received by Crighton-Ward from Lion’s
Roar. The director’s opinion is that the claim is not justified.
Depreciation
Depreciation of specialist production equipment has been included in the financial statements at the amount of
10% pa based on reducing balance. However the treatment is consistent with prior accounting periods (which
received an unmodified auditor’s report) and other companies in the same industry and sales of old equipment
show negligible profit or loss on sale. The audit senior, who is new to the audit, feels that depreciation is being
undercharged in the financial statements.

Required:
For each of the above matters:
(i) discuss whether or not a paragraph is required in the representation letter; and
(ii) if appropriate, draft the paragraph for inclusion in the representation letter. (10 marks)

(c) A suggested format for the letter of representation has been sent by the auditors to the directors of Crighton-Ward.
The directors have stated that they will not sign the letter of representation this year on the grounds that they
believe the additional evidence that it provides is not required by the auditor.

Required:
Discuss the actions the auditor may take as a result of the decision made by the directors not to sign the
letter of representation. (5 marks)

(20 marks)

3 [P.T.O.
3 You are the external auditor of Tracey Transporters, a public limited company (TT). The company’s year end is
31 March. You have been the auditor since the company was formed 24 years ago to take advantage of the increase
in goods being transported by road. Many companies needed to transport their products but did not always have
sufficient vehicles to move them. TT therefore purchased ten vehicles and hired these to haulage companies for
amounts of time ranging from three days to six months.
The business has grown in size and profitability and now has over 550 vehicles on hire to many different companies.
At any one time, between five and 20 vehicles are located at the company premises where they are being repaired;
the rest could be anywhere on the extensive road network of the country it operates in. Full details of all vehicles are
maintained in a non-current asset register.
Bookings for hire of vehicles are received either over the telephone or via e-mail in TT’s offices. A booking clerk checks
the customer’s credit status on the receivables ledger and then the availability of vehicles using the Vehicle
Management System (VMS) software on TT’s computer network. E-mails are filed electronically by customer name in
the e-mail programme used by TT. If the customer’s credit rating is acceptable and a vehicle is available, the booking
is entered into the VMS and confirmed to the customer using the telephone or e-mail. Booking information is then
transferred within the network from the VMS to the receivables ledger programme, where a sales invoice is raised.
Standard rental amounts are allocated to each booking depending on the amount of time the vehicle is being hired
for. Hard copy invoices are sent in the post for telephone orders or via e-mail for e-mail orders.
The main class of asset on TT’s balance sheet is the vehicles. The net book value of the vehicles is $6 million out of
total shareholders’ funds of $15 million as at 31 March 2005.

Required:
(a) List and explain the reason for the audit tests you should perform to check the completeness and accuracy
of the sales figure in TT’s financial statements. (10 marks)

(b) List and describe the audit work you should perform on the balance sheet figure for vehicles in TT’s financial
statements for the year ended 31 March 2005. (10 marks)

(20 marks)

4
Section B – TWO questions ONLY to be attempted

4 You are a recently qualified Chartered Certified Accountant in charge of the internal audit department of ZX, a rapidly
expanding company. Turnover has increased by about 20% p.a. for the last five years, to the current level of
$50 million. Net profits are also high, with an acceptable return being provided for the four shareholders.
The internal audit department was established last year to assist the board of directors in their control of the company
and to prepare for a possible listing on the stock exchange. The Managing Director is keen to follow the principles of
good corporate governance with respect to internal audit. However, he is also aware that the other board members
do not have complete knowledge of corporate governance or detailed knowledge of International Auditing Standards.

Required:
Write a memo to the board of ZX that:
(a) Explains how the internal audit department can assist the board of directors in fulfilling their obligations
under the principles of good corporate governance. (10 marks)

(b) Explains the advantages and disadvantages to ZX of an audit committee. (10 marks)

(20 marks)

5 [P.T.O.
5 You are the audit manager of Hood Enterprises a limited liability company. The company’s annual turnover is
over $10 million.

Required:
(a) Compare the responsibilities of the directors and auditors regarding the published financial statements of
Hood Enterprises. (6 marks)

(b) An extract from the draft audit report produced by an audit junior is given below:
Basis of Opinion
‘We conducted our audit in accordance with Auditing Standards. An audit includes examination, on a test basis,
of evidence relevant to the amounts and disclosures in the financial statements. It also includes an assessment
of all the estimates and judgements made by the directors in the preparation of the financial statements, and of
whether the accounting policies are appropriate to the company’s circumstances, consistently applied and
adequately disclosed.
‘We planned and performed our audit so as to obtain as much information and explanation as possible given the
time available for the audit. We confirm that the financial statements are free from material misstatement,
whether caused by fraud or other irregularity or error. The directors however are wholly responsible for the
accuracy of the financial statements and no liability for errors can be accepted by the auditor. In forming our
opinion we also evaluated the overall adequacy of the presentation of information in the company’s annual
report.’

Required:
Identify and explain the errors in the above extract.
NOTE you are not required to redraft the report. (10 marks)

(c) The directors of Hood Enterprises have prepared a cash flow forecast for submission to the bank. They have
asked you as the auditor to provide a negative assurance report on this forecast.

Required:
Briefly explain the difference between positive and negative assurance, outlining the advantages to the
directors of providing negative assurance on their cash flow forecast. (4 marks)

(20 marks)

6
6 You are the auditor of BearsWorld, a limited liability company which manufactures and sells small cuddly toys by mail
order. The company is managed by Mr Kyto and two assistants. Mr Kyto authorises important transactions such as
wages and large orders, one assistant maintains the payables ledger and orders inventory and pays suppliers, and the
other assistant receives customer orders and despatches cuddly toys. Due to other business commitments Mr Kyto
only visits the office once per week.
At any time, about 100 different types of cuddly toys are available for sale. All sales are made cash with order – there
are no receivables. Customers pay using credit cards and occasionally by sending cash. Turnover is over
$5·2 million.
You are planning the audit of BearsWorld and are considering using some of the procedures for gathering audit
evidence recommended by ISA500 as follows:
(i) Analytical Procedures
(ii) Inquiry
(iii) Inspection
(iv) Observation
(v) Re-calculation

Required:
(a) For EACH of the above procedures:
(i) Explain its use in gathering audit evidence. (5 marks)
(ii) Describe one example for the audit of BearsWorld. (5 marks)

(b) Discuss the suitability of each procedure for BearsWorld, explaining the limitations of each. (10 marks)

(20 marks)

End of Question Paper