PROFESSIONAL STAGE APPLICATION EXAMINATION

TUESDAY 6 DECEMBER 2011

(2 hours)

AUDIT AND ASSURANCE

This paper consists of SIX short-form questions (20 marks) and THREE written test questions
(80 marks).
1.

Ensure your candidate details are on the front of your answer booklet.

2.

Answer each question in black ball point pen only.

Short-form Questions (1 6)
3.

Answer the short-form questions in note form only. Complete sentences are not required.

4.

Answers to each short-form question must begin on a new page and must be submitted
in numerical order.

Written Test Questions (7 9)

5.

Answers to each written test question must begin on a new page and must be clearly
numbered. Use both sides of the paper in your answer booklet.

6.

The examiner will take account of the way in which answers are presented.

IMPORTANT
Question papers contain confidential
information and must NOT be removed
from the examination hall

Place your label here. If you do not have a label

you MUST enter your candidate number in this
box

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN WORK

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Page 1 of 6

1.

Medlar Ltd (Medlar), an external audit client of your firm, is seeking to increase its overdraft
facility. The companys bank requires the audited financial statements for the year ended
30 November 2011 to be available prior to agreeing the new facility. Medlars finance director
has requested that your firm completes its audit by 31 January 2012 and that a member of
your firm assists with the preparation of the financial statements in order to meet this deadline.
Explain what is meant by a management threat in the context of the scenario above and state
how your firm should mitigate this threat.
(4 marks)

2.

Your firm, which has 25 offices throughout the UK, is planning to open a new UK office in
the town of Milton Keynes. The managing director of Robinia plc (Robinia), a property
company with numerous properties throughout the UK, has suggested that your firm leases
one of Robinias vacant properties in Milton Keynes at the market rate. Your firm is the
external auditor of Robinia.
State with reasons, whether it is appropriate for your firm to lease this property from Robinia.
(3 marks)

3.

Your firm has been the external auditor of Pharma plc (Pharma) for a number of years.
Pharma, a company operating in the pharmaceutical sector, has recently listed on the
London Stock Exchange. Consequently, the audit work undertaken by your firm will be
subjected to an engagement quality control review.
Set out the attributes required of the individual who is appointed to undertake the
engagement quality control review.

4.

(3 marks)

External audit firms are required to consider the integrity of key management before
accepting an engagement with a new client.
Outline the procedures to be undertaken by an audit firm to assess the integrity of key
management of a prospective client. For each procedure, explain how it assists with the
assessment of the integrity of management.
(4 marks)

5.

You have been asked by a partner in your firm to assist with the preparation of a tender for
the external audit of Petro plc (Petro), a multi-national company operating in the oil and gas
sector. The partner has asked you to prepare the section of the tender document that sets
out the basis of the calculation of the audit fee.
Identify the factors that will affect the basis of the calculation of the audit fee to be included in
the tender document to be submitted to Petro.
(2 marks)

6.

During the course of the external audit of Palmatum Ltd (Palmatum), it was discovered that
on several occasions throughout the year employees had not followed company policy of
obtaining quotes from three different suppliers prior to placing an order for property, plant
and equipment.
Prepare notes, in readiness for drafting the audit firms report to the management of
Palmatum, which outline the possible consequences of this significant internal control
deficiency and provide recommendations to remedy the deficiency.
(4 marks)
QUESTION 6 COMPLETES THE SHORT-FORM QUESTIONS
WRITTEN TEST QUESTIONS (7 9) FOLLOW

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Page 2 of 6

7.

Your firm has recently been appointed as the external auditor of Fitco Ltd (Fitco) for the year
ended 30 November 2011. The previous auditors were not re-appointed because the directors,
who are also the shareholders, believe that your firm has more appropriate expertise to assist
with their plans to expand the business. The expansion plans involve the acquisition of small
companies in the same industry sector and the directors would like your firm to undertake due
diligence investigations into possible acquisitions of target companies, identified by the
directors, over the next five years. The due diligence investigations will involve, amongst other
procedures, a review of the financial statements of the target companies. Your firm has a
number of clients operating in the same industry sector.
The directors have concluded that the companys present capital structure will hinder the
growth of the business and have decided to seek a listing on the London Stock Exchange in
two years time. The finance and managing directors have held preliminary discussions with
stockbrokers, lawyers and investment banks. They have been advised, in preparation for the
listing, to appoint non-executive directors to the board. The directors have suggested that a
partner from your firm joins the board as a non-executive director. The appointment would
require the partner to attend monthly board meetings and participate in approving strategy and
acquisitions whilst continuing as a partner in your firm.
Fitcos principal activity is the design and assembly of a range of healthcare and fitness
measuring devices that includes products such as blood pressure monitors, body fat monitors
and step counters. All products are designed by Fitcos in-house design team and are
assembled from bought-in components from suppliers based in the UK and overseas. All
products are sold with a 12 month warranty and the company includes a provision for such
warranties in the financial statements. The provision is based on the finance directors
assessment of future claims with reference to past experience.
The company operates a perpetual inventory system for components and finished products,
which is checked by periodic counting throughout the year by Fitco employees. As a result, the
company does not undertake a full inventory count at the year end. The inventory system is
fully integrated with the cost accounting system. The cost accounting system records the cost
of components, labour and production overheads for each finished product. Finished products
are assembled to a standard specification produced by the in-house design team.
Each week, the inventory system generates an inventory valuation listing and an aged
inventory report. The inventory valuation listing includes the cost and quantity on hand for
each component and finished product and also the current selling price of each finished
product. The aged inventory report details the length of time each component and finished
product has been held by the company.
During the planning meeting, the engagement partner informed you of the following:

Due to a design fault in a recently launched blood pressure monitor, Fitco has recalled this
product. The companys records indicate that 5,000 of these monitors have been sold and
that to date 60% have been returned.

During the year, Fitco experienced quality and delivery problems with components
purchased from one of its major suppliers, Comp Ltd (Comp). Comp supplied components
for the fitness range of products. As a result, Fitco terminated its contract with Comp and
has switched to a new supplier which is more reliable but charges higher prices for the
components. On 5 December 2011, Fitco received a letter from Comps lawyers informing
it that Comp is suing Fitco for breach of contract.

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Page 3 of 6

The engagement partner has also provided you with the following extracts from the financial
statements for the years ended 30 November:
2011 (draft)
000

2010 (audited)
000

96,400
54,800

89,100
49,900

Statement of financial position

Current assets
Inventory

8,400

7,200

Current liabilities
Trade payables
Provision for warranties

5,700
964

5,600
891

Income statement
Revenue
Purchases

The engagement partner has asked you to consider the following areas of key audit risk:
(1)
(2)
(3)
(4)

opening balances
inventory
trade payables
provision for warranties

Requirements
(a)

Explain the self-interest and self-review threats arising from the provision of due
diligence services to Fitco and outline how your firm should respond to those threats.
(8 marks)

(b)

State, with reasons, how your firm should respond to the directors request for a
partner in your firm to join the board of Fitco as a non-executive director.
(3 marks)

(c)

Justify why the items listed in (1) to (4) above have been identified as key areas of
audit risk and, for each item, describe the procedures that should be included in the
audit plan in order to address those risks.
Note: You should present your answer in a two-columnar format using the headings
(i)
(ii)

(d)

Justification; and
Procedures to address each risk.

(22 marks)

Explain why the legal claim by Comp should be considered by your firm in respect of the
audit of the financial statements for the year ended 30 November 2011 and describe the
audit procedures to be undertaken in respect of this matter.
(7 marks)
(40 marks)

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Page 4 of 6

8. Gourmet Ltd (Gourmet), a client of your firm, is a fast-food chain, operating outlets in and

around London selling ethically-sourced healthy food and drink to eat in or take away. The
company opened its first outlet six years ago and, following its phenomenal success, it has
opened ten additional outlets. The directors wish to continue the companys expansion by
opening two outlets outside London and introducing a delivery service.
The directors of Gourmet have been negotiating with the company's bankers in order to
increase borrowings. In support of the request for funding, the directors have prepared profit
and cash flow forecasts for the three years ending 31 December 2014, on the basis of
assumptions they have made about the future operations of the business. The company's
bankers require this information to be examined and reported on by independent accountants.
The directors have requested that your firm undertakes this examination.
In respect of the new outlets, the directors have identified two potential properties outside
London. The properties are leasehold premises which will require extensive refurbishment to
bring them up to the high standard of existing outlets.
The delivery service, for which a charge will be made, will only be available from the central
London outlets and, if successful, will be extended to other outlets at a later date. This will
require the acquisition of vehicles which the directors plan to purchase outright. The vehicles
will be painted with the companys logo in order to raise the profile of the delivery service.
The majority of the ingredients used in the preparation of the food and the packaging are
bought centrally on credit terms. Fruit and vegetables are purchased locally by the chef at
each outlet and paid for at the time of purchase. All ingredients are sourced from within the UK
to reduce the companys carbon footprint and all packaging used in the take-away business is
made from recycled material. In addition, all employees are paid above the average wage for
the industry sector and are entitled to a bonus based on the level of profit achieved by the
company as a whole.
Requirements

(a)

From the information provided in the scenario, identify the key receipts and payments
that you would expect to be included in the cash flow forecasts prepared by the directors
of Gourmet. For each receipt and payment, identify the specific matters you would
consider when reviewing the reasonableness of the assumptions in forecasting that
receipt or payment.
(10 marks)

(b)

Explain the role of written representations in the examination of and reporting on forecast
information.
(3 marks)

(c)

Describe the differences between the conclusion expressed in an assurance report

on forecast information and the opinion expressed in an audit report on financial
statements. Give reasons for these differences.
(7 marks)
(20 marks)

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Page 5 of 6

9.

Described below are situations which have arisen at three unrelated external audit clients of
your firm. The year end in each case is 30 September 2011.
Southerndown plc (Southerndown)
The directors of Southerndown have prepared cash flow forecasts and other information
needed for the assessment of the appropriateness of the going concern basis of preparation of
the financial statements for the year ended 30 September 2011. The forecasts indicate that the
company has sufficient resources to continue trading for the period ending 30 September 2012
but additional funding will be required after that date. The directors believe that this can be
achieved by an issue of shares which is planned for June 2012. The engagement partner is
satisfied that the assumptions on which the forecasts are based are reasonable. The directors
have included a note in the financial statements which fully explains the situation to the
engagement partners satisfaction.
Belfry Ltd (Belfry)
The statement of financial position as at September 2011 includes 2 million of cash and cash
equivalents, which is held on deposit in an overseas bank account. An earthquake has
severely disrupted the commercial and banking systems in the overseas country in which the
bank account is located and you have been unable to obtain direct confirmation of the balance
at 30 September 2011. Belfry has no borrowings and has positive cash flow.
The total assets of Belfry at 30 September 2011 are 30.5 million and the profit before tax for
the year ended 30 September 2011 is 10.2 million.
Turnberry plc (Turnberry)
In March 2011 Turnberry paid 120,000 for consultancy services to Valderama Ltd, a company
in which the managing director of Turnberry has a controlling interest. The managing director
refuses to disclose details of this transaction in the notes to the financial statements because
of its sensitive nature.
The total assets of Turnberry at 30 September 2011 are 48 million and the profit before tax
for the year ended 30 September 2011 is 8 million.
Requirements
(a)

For each of the three situations outlined above, state whether you would modify the
audit opinion. Give reasons for your conclusions and describe the modification(s), if
any, to each audit report.
(14 marks)

(b)

Describe the possible consequences for your firm if an inappropriate audit opinion on
financial statements is issued and outline the quality control procedures your firm
should implement to reduce the risk of issuing an inappropriate audit opinion. (6 marks)
(20 marks)

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