Advanced Audit and Assurance Paper p7 Updated

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ADVANCED AUDIT AND

ASSURANCE PAPER P7
NOTE ON ACCA PAPER P7
TESLEEM ADELODUN (ACCA)
+2348039399907, teshocki@gmail.com
2018/19
Tesleem Adelodun (ACCA) +2348039399907 teshocki@gmail.com

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TABLE OF CONTENT
CONSIDERATION OF LAWS AND REGULATIONS IN AUDIT 3
MONEY LAUNDRY 6
PROFESSIONAL CODES OF ETHICS 11
FRAUD AND ERROR 20
PROFESSIONAL LIABILITY 21
QUALITY CONTROL 27
ADVERTISEMENT OF AUDIT SERVICES 28
TENDERING 28
ETHICS OF APPOINTMENT 39
AUDIT OF FINANCIAL STATEMENTS 40
REVISION OF ACCOUNTING STANDARDS 56
GROUP AUDIT ISSUES 129
AUDIT REPORT 141
OTHER ASSIGNMENTS 154
FORENSIC AUDITING 160

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CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL

STATEMENTS ISA 250
Non compliance
Non-compliance refers to acts of omission or commission by the entity, either intentional
or unintentional which are contrary to the prevailing laws or regulations.
Companies are subject to many laws and regulations for example:
 Company law
 Employment law
 Income tax law
 Labour law
 Environmental Protection law etc.
Responsibilities of Management and Auditors regarding laws and regulation

Management
Management is responsible for the prevention, detection and correction of non-
compliance with laws and regulations.
The following policies and procedures may be implemented by the management in order
to prevent and detect non-compliance with laws and regulations:
1. Maintain a register of significant laws with which the entity has to comply.
2. Engage legal advisors to assist in monitoring legal requirement.
3. Institute and operate appropriate system of internal controls.
4. Develop, publicize and follow a code of conduct.
Auditor
As with fraud, the auditors are not, and cannot be held responsible for preventing non-
compliance but they should aim to be aware of those that could materially affect the
Financial Statements. There is unavoidable risk that some material misstatements in the
financial statements go undetected even though the audit is properly planned and
performed.

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Audit Procedures to identify non-compliance with laws and regulations
1. The auditor should obtain general understanding of the laws and regulations
affecting the entity, which includes procedures such as:
 Use the auditor’s existing understanding of the entity’s industry, regulatory and
other external factors.
 Enquire of management as to the laws and regulations that may be expected
to have a material effect on the operations of the entity.
 Enquire of management concerning the entity’s policies and procedures
regarding compliance with laws and regulations.
 Enquire of management the policies or procedures adopted for identifying,
evaluating and accounting for litigation claims.
2. The auditor should obtain sufficient appropriate audit evidence of compliance with
other laws and regulations such as entity’s license to operate (non-compliance
may doubt going concern) that may have a fundamental effect on operations of
the entity.
3. The following procedures may indicate the instances of non-compliance such as:
 Reading minutes
 Enquiring from the company’s and external legal advisors.
 Performing substantive tests of details of classes of transactions, accounts
balances and disclosures.
4. The auditor should obtain written representation from management and those
charge with governance that they have informed auditor about all known and
suspected non-compliance.

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Audit procedures when non-compliance is identified:

In such a case the auditor shall obtain:
1. An understanding of the nature of the act and the circumstances in which it has
occurred.
2. Further information to evaluate the possible effect on the financial statements.
When evaluating the possible effect on the financial statements the auditor should
consider the following:
 Potential financial consequence such as fines and penalties.

 Whether potential financial consequence require disclosure
 Impact on the auditor’s report.
When non-compliance is identified the auditor should:
 Reassess the risk.

 Reassess the validity of written representation.
 Take independent legal advice.
In exceptional cases the auditor may consider whether withdrawal from the engagement
is necessary.
Reporting of identified or suspected non-compliance
 Communicate to those charged with governance, unless they themselves are
involved.
 If management and those charged with governance are involved consider
reporting to next level of authority like audit committee.
 Where no higher authority exists, or if the auditor believes that the communication
may not be acted upon or is unsure as to the person to whom to report, the
auditor shall consider the need to obtain legal advice

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Impact of non-compliance on the auditor’s report
 When non-compliance is material and not adequately disclosed in the financial

statement the auditor shall express qualified opinion or adverse opinion.
 When the auditor is precluded by the management and those charged with
governance from obtaining sufficient appropriated audit evidence than the auditor
should express a qualified opinion or disclaim an opinion on the basis of limitation
of scope.
Reporting non-compliance to regulatory authority

If the auditor is precluded by management or those charged with governance from
obtaining sufficient appropriate audit evidence to evaluate whether non-compliance that
may be material to the financial statements has, or is likely to have, occurred, the auditor
shall express a qualified opinion or disclaim an opinion on the financial statements on the
basis of a limitation on the scope.
Consideration of withdrawal from the Engagement
The auditor may conclude that withdrawal from the engagement is necessary when the
entity does not take the remedial action that the auditor considers necessary in the
circumstances, even though the noncompliance is not material to the financial
statements. Non-compliance with regulation cast doubt on the integrity of the
management
MONEY LAUNDERING
Money laundering is the process by which criminals attempt to conceal the true origin
and ownership of the proceeds of their criminal activity. In order to be able to spend
money openly, criminals will seek to ensure that there is no direct link between the
proceeds of their crime and the actual illegal activities.

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Factors indicating money laundering:
 Transactions routed through several jurisdictions.

 High level of secrecy over transactions.
 Excessive use of wire transfers
 High value deposits or withdrawals not characteristics of the type of account
 A pattern that after a deposit, the same amount is wired to another financial
institution.
The three stages of the money laundering process
 Placement;
 Layering.; and
 Integration
Anti-money laundering procedures

The firm must gather know your client information (KYC) to assist in spotting suspicious
transactions. This includes:
1. Who the client is

2. Who controls it
3. The nature of the client
4. The client’s sources of funds
5. The client’s business and economic purposes.
In the UK, the basic requirements are for accountants to keep records of client’s identity
and to report suspicions of money laundering to the Serious Organized Crime Agency
(SOCA).

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Elements of basic money laundering program
1. Appoint Money Laundering Reporting Officer (MLRO).

2. Train the individuals to ensure that they are aware of relevant legislation, know
how to deal with potential money laundering, how to report suspicions to MLRO.
3. Establish internal procedures such as know your client and client acceptance
procedures to prevent money laundering.
4. Verify the identity of new and existing clients and maintain evidence of
identification.
5. Maintain records of identification, and any transactions undertaken for or with the
client.
6. Report suspicions of money laundering to SOCA.
Note:
1. Concealing and tipping off (MLRO or any individual discloses something that
might prejudice any investigation) is itself a criminal offence.
2. The obligation to report money laundering act does not depend on the amount
involved or the seriousness of the offence.
The need for ethical guidance on money laundering

This is needed because there is a clear conflict between the following two situations:
1. The accountants’ professional duty of confidentiality in relation to client’s

business, and
2. The duty to report suspicions of money laundering to the appropriate authorities
as required by law.
Professional accountants are not in breach of their professional duty of confidentiality if

they report in good faith their knowledge or suspicions of money laundering to the
appropriate authority.
Disclosure without reasonable grounds would possibly lead to the accountants being
sued for breach of confidence.
The auditor is advised to always seek legal clarification as regards money laundry
disclosure.

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Question
A) Comment on the need for ethical guidance for accountants on money laundering.
(4 marks)
B) The Financial Action Task Force on Money Laundering (FATF) recommends
preventative measures to be taken by independent legal professionals and accountants
(including sole practitioners, partners and employed professionals within professional
firms).
Required:
Describe FOUR measures that assist in preventing professional accountants from
being used for money laundering purposes.
(8 marks)
Answers
Part A
1) In a jurisdiction where money laundry constitutes criminal offence, accountants
need guidance on the correct interpretation of the laws relating to money laundry. This
is because accountants are not lawyers and may lack technical understanding of the
money laundry laws.
2) Further guidance is needed to explain the interaction between accountant’s
responsibilities to report money laundering offences according to the law and auditor’s
responsibility to report to those charged with governance.
3) If he resigns from an engagement as a result of money laundry suspicion, auditor

needs guidance is responding to the clearance letter regarding any necessary
disclosures.
4) Where there is conflict between the legal responsibility and professional
responsibility as regards disclosure of information, accountants need guidance on
which of the responsibilities overrides another.
Part B
1) Audit firm should appoint a compliance officer with suitable level of seniority and
experience
The compliance officer will be responsible for:
 receiving and assessing money laundering reports from colleagues
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 making reports to the relevant agency
2) The audit firm should ensure there is adequate training of its staff regarding:
 relevant money laundering legislation

 ethical and professional guidance relating to the responsibilities of
accountants regarding money laundry
 how to report money laundry suspicions.
3) Firms should Perform customer due diligence before accepting an engagement.

Firms should verify the following:
 the ownership structure of the client

 the identities of the major shareholders
 the identities of the directors
 the nature of transactions of the client
4) The firm should maintain adequate records of the client including details of its
transactions.

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PROFESSIONAL CODES OF ETHICS AND BEHAVIOR

ACCA members are expected to carry out their work with due skill and care while giving proper
regards to technical and professional standards.
Auditors are not only required to be ethical but they must be seen to be ethical. It is on this note
that ACCA publishes rules of professional conduct which all members and students must adhere
to.
The fundamental principles (OPPIC)

Members should strive to be objective in all professional and
Objectivity
business judgments.
Members should desist from any act that can bring disrepute to
Professional behavior
the accounting profession.
Members have the responsibility to maintain up-to-date
Professional
knowledge that will enable them to competently carry out their
competence work.
Members should be straightforward and honest in their
Integrity
professional dealings.
Auditors should not disclose client’s information to a third party
Confidentiality
without due permission from the client.
Threats to the fundamental principles (AFISS) - These are situations that make auditor not
to adhere to the fundamental ethical codes.
This is a situation where the auditor finds himself in a position he has
Advocacy
to defend or promote the interest of its client before a third party.
This threat arises as a result of the auditor becoming unduly
Familiarity
sympathetic towards its client as a result of long association
This threat arises when the auditor comes under intimidation by
Intimidation
dominant individual or aggressive atmosphere at the clients
This arises when personal interest of the auditor conflicts with that of
Self interest
the client
This threat arises when the auditor has to review or audit the work
Self-review
that he helps to carry out.

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SPECIFIC SITUATIONS THAT THREATEN ADHERENCE TO THE FUNDAMENTAL CODES

Gift and hospitality
This may create self-interest and familiarity threat. The IESBA code of ethics states that when a
firm or a member of the assurance team accepts gift and hospitality, unless the value is clearly
insignificant, the threat to independence cannot be reduced to acceptable level by applying
appropriate safeguards, so the firm or team member should decline the gift and hospitality.
Possible safeguards:
 Inform the client’s management

 Seek legal advice
 Inform the auditor’s professional body to seek for advice
Audit firm carrying out actuarial service for clients

Going by IESBA code of ethics, provision of actuarial service and other valuation services may
give rise to self-review threat.
If the service involves evaluating matters that are material to the financial statement and the
valuation involves a high degree of subjectivity, the threat to objectivity and independence cannot
be reduced to an acceptable level by applying appropriate safeguards. The service should
therefore not be provided, or the audit firm should withdraw from the engagement if it wants to
carry out the service.
 Audit firm should ensure that members doing the valuation work are not part of the audit
team
 Auditor should obtain management’s acknowledgement that it is responsible for the result
of the valuation
 Audit work done for the client should be reviewed by an independent accountant

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Audit firm offering internal audit services to client

Offering of this service may result in self-review threats to objectivity. To reduce the threat to an
acceptable level, the firm should ensure that management is ultimately responsible for the control
and management of internal audit.
 The client should acknowledge that it is responsible for establishing and monitoring the
system of internal controls
 The scope of work to be done should be set by the client’s management
 The audit firm should ensure that members responsible for the internal audit service are
not part of the assurance team.
Contingent fee
This is a situation whereby the auditor’s fee depends on the outcome of uncertain future event.
IESBA code of ethics out rightly prohibit contingent fee for audit engagement. It creates self-
interest threat to objectivity. No level of safeguards will be adequate in this regards, contingent
fee arrangement should be rejected by audit firm.
Long association with audit client
This may lead to familiarity threat. The auditor may not see anything wrong in what the client is
doing now because it has always got things right in the past. This makes the auditor to lose his
professional skepticism as a result of the close relationship. It may equally lead to self-interest
threat because the auditor does not want to lose a source of income.
Safeguard
For listed clients, the IESBA code requires the key audit partner to be rotated after 7 years and
should not be involve in the audit for 2 years.
Recruitment of staff on behalf of audit clients
Provision of this service is not prohibited by the IESBA code. It could however lead to the
following threats:
 Self-interest threat. This is because the firm will want to protect its fee income from the
recruitment. The firm may compromise quality in order to earn its own fee
 Self-review threat. If the staff recruited is responsible for the financial statement, this will
amount to the firm auditing its own work.
 Familiarity threat. The interaction made during the process of interview will create
familiarity with the staff. The firm may be less critical of the work of such employee based
on the impression created by the employees during the interview.

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 Management threat. Recruitment of staffs is management’s responsibility. Offering of this

service will amount to making management decision and auditors are not allowed to be
acting in management’s capacity
 Request management to acknowledge that it is responsible for the recruitment of staff

 The firm should only make recommendation, the selection should be made by the
management
 The fee charged should be disclosed to the audit committee
Temporary staff assignment

This is a situation whereby staffs of audit firm are temporarily assigned to work in a client. This
arrangement will lead to the following threats to objectivity and independence:
 Management threat. Depending on the seniority of staff and the position they are
assigned to work, the assigned staffs may be making management decision. In no way
should auditor be making management decision. It will lead to self-review threat because
the auditor will be part of the system he set out to audit.
 Self-review threat. The seconded staffs will be auditing the work they help to prepare and
may never want to fault their own work. The other staffs of the firm on the audit team may
not want to fault the work prepared by their colleagues.
 Familiarity threat. The seconded staffs will be familiar to the members of the audit team
and as a result the team may not be performed the audit with required level of
professional skepticism.
 Self-interest threat. According to the IESBA code; if a partner or employee of the firm
serves as director or officer of an audit client, the self-interest threats created would be so
significant that not safeguards could reduce the threats to an acceptable level.
 The firm should ensure the seconded staffs do not take on management role or take any
management’s decision.
 Seconded staffs should not be included in the audit team to the client
 Audit work performed should be reviewed by an independent accountant

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Financial interest in an audit client
Auditors are not allowed to have financial interest in audit client as the following threats as it
could lead to self-interest threat to objectivity. This threat is so enormous that it may not be
surmounted by safeguards in place.
Safeguards
The auditor should dispose of the investment in order to continue with the audit. If the auditor
is interested in keeping his investments in the client, the he must resign as the auditor.
Preparing financial statement for audit client
Auditors are prohibited from preparing financial statements for public entities (listed clients).
However, auditors may prepare financial statements for non-listed entities provided adequate
safeguards are in place to mitigate the effect of the threats. Offering this service will lead to
the following threats:
 Self-review threats: auditor will be reviewing his own work if the financial statements
being audited are prepared by him
 Self-interest threat: the fees charged for the service constitute self-interest threat. The
fee charged for this service may increase the percentage of total fees from the client
to more than 15% of income of the auditor.
Safeguards
 Use of separate engagement team. The team that prepares the financial
statement should not audit it.
 Review of the work done by an independent accountant.
Representing the interest of clients before a third party
In representing the interest of clients before a third party leads to ethical threats as the auditor
may lose his objectivity:
 Advocacy threat: This is as the auditor found himself in a position defending the position
of clients
 self-review threat will also emanate if the matter which is the subject of the investigation
will have an impact on the financial statements.

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Significance of The Threat depends on the following factors

 The extent to which the outcome of matter would impact the financial statement
 Whether the matter over which the auditor is defending the client was prepared by him.
The IESBA code states that where a taxation service involves acting as an advocate for an
audit client before a public tribunal or court in the resolution of a tax matter and the amount
involved in material to the financial statements, the advocacy threats created would be so
significant that no safeguards could reduce it to acceptable level.
Question DEPECHE
You are a manager in Depeche, a firm of Chartered Certified Accountants. You have
specific responsibility for undertaking annual reviews of existing clients and advising
whether an engagement can be properly continued. The following matters arose in
connection with the audit of Duran, a company listed on a stock exchange, for the
year to 31 December 2008:
(1) The audit team included a manager, two supervisors, two qualified seniors
and six trainees. The final audit, which lasted approximately five weeks, was
very time-pressured and the team worked late into the night towards the end
of the audit. Duran’s staffs were very supportive throughout and paid for
evening meals that were brought in so that the audit team could work with
minimum disruption.
(2) Duran’s chief finance officer, Frankie Sharkey, was so impressed with the
commitment of the audit staff that he asked that Depeche pay them all a
bonus through an increase in the audit fee. In April 2009, Depeche paid all
the members of the team below manager status a bonus amounting to a
week’s salary. The bonus was processed through Depeche’s payroll, in the
same way as overtime payments, and recharged to Duran as part of audit
expenses.
(3) One of the points initially drafted for possible inclusion in the report to the
company’s audit committee concerned the illegal dumping of drums,
containing used machine oil, on nearby wasteland. Notes of discussions
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between the audit manager and Frankie show that it is the company’s
unwritten policy to disregard the local environmental regulations and risk
incurring the fines, which are only small, as it would be costly to use the
nearest licensed disposal unit. The matter is not referred to in the final report.
Required:
(a) Comment on the ethical and other professional issues raised by each of the
above matters. (10 marks)
(b)Discuss the appropriateness of available safeguards and advise whether or not
Depeche should continue as the auditor to Duran.
(15 marks)
Answers
Part A
(1) Hospitality-client paying for evening meals

■ Hospitality is prohibited for audit client unless it is clearly insignificant
■ Depeche will have to determine if the meal is significant to pose a threat to
the objectivity of its staff. While the meal may not be significant to the audit
seniors, it may have serious significance on the objectivity of the juniors.
■ Depeche is unlikely to be seen as objective given that it has accepted the
hospitality. Instead, Depeche could have made arrangement for its own
meal knowing the team could work late.
(2) Financial reward
■ The bonus was not accepted in respect of the audit manager’s
involvement. Therefore, there is no obvious threat to his objectivity.
■ The bonus may be perceived to be a reward (or “bribe”) for having not
detected or reported on a matter and acceptance of it may cast doubt on the
audit team’s integrity.
■ The increase in audit fee as a result of the bonus should be included in the
amount disclosed in the note to the financial statements as auditors’
remuneration.
■ If the audit team had any expectation that a bonus might be awarded to
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them, it is likely that there will be a perception that their objectivity could
have been impaired.
■ That the bonus was not accepted at the manager level suggests that this
was considered to be a threat to objectivity. This consideration and the
decision to accept the bonus for other staff should have been
documented.
(3) Illegal dumping of drums
Frankie Sharkey’s intentional dumping of drums shows that management
of the company has no regard for environmental regulation. This cast
doubt on the integrity of the management. Depeche will have to re-
examine the validity of previous representation made by the management
to determine the extent of reliance that can be placed on such
representation.
Depeche should evaluate the financial implication of the breach and
determine if provision or disclosure is required in the financial statement.
The illegal dumping with the financial implication should be communicated
to those charged with governance. The fact that management intentionally
breaches environmental regulation should be equally communicated.
PART B
Available safeguards
■ The audit staff that collected the bonus should be removed from
the audit team.
■ The partner’s decision to accept the bonus should be investigated
by other partners in the firm.
■ To prevent future ambiguity, the firm should have a system in place
to determine the significance of hospitality
■ Audit work already performed should be reviewed by a partner who
was not part of the audit.
■ The gift of the hospitality should be disclosed to the audit
committee. Potential threat to the auditor’s independence and
available safeguards should equally be disclosed to the committee.
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Advice whether or not the audit of Duran should continue

If Depeche consider the available safeguards to be adequate, the engagement
should be retained, otherwise Depeche may have to withdraw from the audit

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FRAUD AND ERROR

Fraud involves the use of deception to obtain an unjust or illegal financial advantage and
intentional misrepresentation by management, employees or a third party. Fraud may be
categorized as below:
 Fraudulent financial reporting, which involves the following:

Falsification or alteration of accounting records
Misrepresentation of transactions
Intentional misapplication of accounting standards
Omitting the effect of transactions
 Misappropriation of assets or theft
Detection and prevention of fraud

Management responsibilities
Client’s management and those charged with governance are primarily responsible for the
detection and prevention of fraud. The management of the client is responsible for establishing
strong system of internal controls to be able to detect and prevent fraud.
Auditor’s responsibility
Auditor is not primarily responsible for detecting fraud. Rather ISA 240 requires auditor to be
aware, when planning and performing their audit, that fraud may have taken place. Auditor is
only responsible for detecting fraud to the extent that it is material to the financial statements.
On discovering fraud by auditor, ISA 240 the auditor’s responsibility relating to fraud in an audit
of financial statements prescribes the following:
 Auditor should communicate the discovered fraud to management as soon as

discovered or suspected
 If the discovered fraud involves management, the auditor must communicate the matter
to those charged with governance
 The auditor should consider if he has statutory duty to report the fraud to a regulatory
and enforcement authorities
 The auditor should consider the effect of the fraud on the audit opinion
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ERROR
Error is an unintentional mistake. Auditors have the following duties regarding detection and
reporting of error:
 The auditor has the responsibility of discovering material errors

 The auditor should assess whether immaterial errors discovered during the audit are
material in aggregate
 The records of all errors discovered by the auditor should be communicated to the
management as soon as possible
 Auditor should request the discovered errors be corrected by management
 The aggregate of uncorrected misstatement that were determined by management not
to be material, both individually and in aggregate to the financial statements should be
communicated to those charged with governance by the auditor
PROFESSIONAL LIABILITY (EXTERNAL AUDIT)

Auditors have a duty of care to the body of the shareholders (not to individual shareholder) and
may be found liable to them if the auditor was negligent.
Generally, auditors do not owe a duty of care to third parties and cannot be liable to them. For
auditor to be held liable to a 3rd party, the followings must be established:
 There was duty of care at the time of the audit owed by the auditor to the 3rd party
 The duty of care was breached by performing negligent audit by the auditor
 The 3rd party has suffered a loss as a result of the breach
Ways of reducing auditor’s liabilities:
 The audit firm may operate as a limited liability company

 The audit firm may use insurance to limit exposure to claims from third party
 The firm may operate as a limited liability partnership
 Use of liability limitation CAP
 Use of disclaimer in the audit report
 Performing the audit according to international standards

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Auditor’s liability with respect to Non audit assignment

The auditor will only be liable to the following persons:
 Persons with whom proximity can be established
 The direct beneficiaries of the information in the report
 Persons who can reasonably be foreseen to rely on the report
Ways to reduce auditor’s liabilities (Non audit assignment):
 The report should contain a statement that management is responsible for the
underlying information
 The auditor should clearly state in the report that it is only the intended recipient that can
rely on the report
 Liability cap may be included in the engagement letter
 The assignment should be strictly performed according to the terms of engagement
 Use of liability disclaimer paragraph
Ways of reducing auditor’s exposure to litigation
 Firm should develop a robust client acceptance procedure. This should ensure that only
client with manageable level of risk is accepted.
 Firms should follow quality control procedures as contained in ISQC 1. This will reduce
the risk of performing negligent audit.
 Auditors should work to the terms of the engagement.
 Signing of limited liability agreement with client. The disadvantage of this is that the
auditor may not be conscious of quality anymore, knowing that arrangement exist to limit
his liability, and leading to poor quality audit. This may reduce the overall value placed
on the auditor’s opinion.
Question T U R N A L S
Turnals is an unlisted manufacturing company with 120 employees, projected sales of $12
million, and estimated profit before tax of $1.5 million. During the current year the
directors’ attention had been brought to a recently discovered fraud perpetrated by Mr.
Jones, the purchasing manager: He had set up a fictitious business that had invoiced
Turnals for goods that had never been supplied. The fraud had been going on for over two

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years. Mr. Jones was immediately suspended from all duties and the police informed. During
their investigation, Mr. Jones admitted to the police that he had perpetrated a similar fraud at
his previous employers, who had not informed the police. When Mr. Jones had been
employed, no reference had been sought from his previous employers.
Mr Jones had responsibility for obtaining competitive quotes, checking and initially
approving new suppliers. Final approval was authorised by the Managing Director but in
practice this was a formality. Mr. Jones also raised most of the purchase requisitions based
on information supplied by the storekeeper and approved any requisitions made by other
members of staff.
The storekeeper’s responsibility was to match each delivery note to a copy of the purchase
requisition before the goods were taken into inventory. The two documents were then
sent to Mr. Jones who matched them with the purchase invoice before passing the invoice
to the payables ledger cashier for payment. When the storekeeper was on holiday the
system of internal control specified that a deputy should perform the delivery note
matching procedure. In practice this had always been done by Mr. Jones.
The fraud took place during the storekeeper’s holidays (4 weeks each year). It was
discovered when the cashier had to query one of the fraudulent invoices with the
storekeeper because Mr. Jones was absent on company business.
Subsequent investigation revealed that approximately $50,000 had been misappropriated by
Mr. Jones.
Garner & Co has been the auditor of Turnals for many years. The firm has 12 partners
and 60 audit staff. The internal control over Turnal’s purchase system was recorded and
tested for the first time during last year’s interim audit. In previous years a fully substantive
approach to purchases had been applied and no review of the internal controls over the
purchase system had ever been carried out.
No comments were made to management by the auditors on their findings from the interim
work on the purchase system.
Garner & Co had also acted as management and systems design consultants during the
implementation of Turnals’ purchase system at the beginning of last year. As a result the
directors believe that Garner & Co should be liable for the losses suffered by Turnals as
they employed the audit firm in a dual capacity.

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Required:
(a) Describe the regulations and other audit practices that are designed to avoid conflicts of
interest in the provision of non-audit services to an audit client. (5 marks)
(b) Discuss why the following audit procedures may have failed to detect the above fraud:
(i) evaluation of the prescribed system of controls;
(ii) tests of controls on the authorisation of new suppliers;
(iii) analytical procedures.
(10 marks)
(c) Discuss the bases on which Turnals believe they have a claim against their auditors and
the likelihood of its success. (5 marks)
(20 marks)
Answers
(a) Regulations and practices that avoid conflicts of interest

■ It is recommended that the recurring fees from a single client should not
exceed 15% of the gross practice income. If the fee from a single client is
too high, it will cause self-interest threat to objectivity.
■ Auditors are prohibited from having direct financial interest in an audit
client. When auditors have financial interest in a client, the interest of the
auditor becomes conflicting with that of the client. This situation will lead
to the auditor protecting his own interest against the interest of the client
■ Auditors are required to strictly adhere to the IESBA codes of ethics in their
audit practice. Where there is perceived threat to auditor’s adherence to
the codes, he is required to consider the adequacy of safeguards. Where
the auditor considers the safeguards inadequate, such service may need to
be declined.
■ It is prohibited for audit firm to prepare financial statement for its listed
clients unless in times of emergency. Provision of this service may make
the auditor lose his objectivity. Where auditors are allowed to carry out
this service, adequate safeguards must be put in place.

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(b) Failure to detect the fraud

(i) Evaluation of system of controls
Auditors are required to ascertain and test the system of internal control like
the purchase system in this case. This has not been done in the previous
audits. The auditor may have discovered the weakness in the purchase
system but unwilling to report it because it is responsible for the design
Mr. Jones was responsible for raising purchase requisition and also
approves new suppliers. This is obvious weakness in the purchase system
which exposes the company to fraud.
The amount involved is likely to be immaterial and the fraud is not frequently
perpetrated. Thus, the fraudulent invoices may escape the test of the auditor
(ii) Tests of control on the system for authorising new suppliers

■ The auditor would test on a sample basis that new suppliers are initially
approved by the purchasing manager and then authorised by the
Managing Director the fictitious suppliers may not have been detected
because the auditor would have carried out his test on a sample basis.
There is tendency that the fictitious suppliers were not selected among the
samples to be tested.
■ The managing director does not take the authorisation serious. He may as
a result approve the fictitious suppliers. This is a weakness in the control
environment which the test on the system may not have detected.
(iii) Analytical procedures
Analytical procedure would have indicated inconsistency in the movement
of gross profit percentages and inventory levels. However, the small size
of the amount involved would not give a significant inconsistency to attract
the attention of the auditor.

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(c) Bases for a negligence claim, and chance of success

The success of the negligent claim against Garner & co will be discussed in
the following two capacities:
(i) In the capacity of auditors
Arguments in favour of the directors making successful claim
The auditors have a duty of care to the company. This duty of care
appeared to have been breached by performing a negligent audit. The
audit has been negligently performed because the auditors did not follow
the requirements of ISA 315. They have not fully understood the entity’s
internal control and may not have sufficiently assessed the risk of fraud
(ISA 240) to enable them to appropriately plan their audit. In addition, the
company has suffered a loss.
Arguments against successful claim
The directors have the primary duty of safeguarding the company’s
assets. The fraud was successful as a result of the Managing Director
not taking approval serious.
Auditors design their tests with the expectation of detecting a material
fraud. The amount involved does not appear to be a material.
(ii) In the capacity of acting as consultants to Turnals
The auditors were contracted for the design of the system. The system has
been shown to have weakness that lead to fraud. This may mean that the
directors a strong case against the auditors. However, it would be
necessary to look at the contract terms to see if there is disclaimer.

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QUALITY CONTROL (ISQC 1)

The importance of having good quality control procedures in place is to ensure quality of audit
work is maintained and to ensure the auditor complies with his duty of professional competence
and behavior. Lack of quality audit work will generally bring the audit profession to disrepute and
increase litigation risk against the auditor.
Quality control at firm level
 Management of the firm should establish internal culture that promotes quality.
 A staff with appropriate level of authority should be appointed as the quality control
manager. This person will ensure quality is maintained within the firm
 Firm should ensure it has sufficient staff with required competence and capabilities
 Firm should maintain a robust recruitment process
 Continuous training of staff
Quality control on individual assignment
 The engagement partner should ensure that the team is appropriately qualified and
experienced. staff assignment should be based on competence and capabilities
 All assignments should be adequately directed, supervised and reviewed
 Acceptance or continuance of client relationship should be carefully evaluated
 Engagement partner should ensure that audit evidence is sufficient and appropriate to
support the audit opinion.
 All work should be properly planned and documented

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ADVERTISEMENT OF AUDIT AND OTHER ASSURANCE SERVICES BY

AUDITORS
Advertising is not prohibited for audit firm. However, the content of the advertisement or the
medium used should not bring accounting profession to disrepute. The following principles on
advertising should be followed:
 Adverts should not discredit the service offers by other members

 The adverts should be truthful and honest
 The use of ACCA logo is not allowed to be used in such a manner that portray the firm
as being part of ACCA
 If a fee is included in the advertisement, the basis of calculation should also be included
 Unsubstantiated claims should be avoided
AUDIT FEES
Audit fee constitute expense and companies may perceive it to be too high. The auditor must
therefore ensure that they can provide a quality audit for the price charged.
Auditors may use any suitable method to calculate fees, but the basis upon which the fee is
calculated should reflect the level of work done. Contingent fee arrangement is however
specifically prohibited by the IESBA code.
TENDERING FOR NEW CLIENT

When companies want to appoint auditors, they normally invite tender for their audit work. This
will give them the opportunity to obtain a competitive rate. The tender give opportunities to each
audit firm to showcase what they have in their fold to give them competitive hedge against
others.
A typical tender of an audit firm usually has the following contents:

 The level of expertise the firm can boast of in the industry. It is important to draw the
attention of the potential client to your area of expertise.
 Previous experience in terms of similar companies audited by the firm.
 Extent of coverage in terms of national and international presence.
 Discussion of proposed audit fee and the basis of calculation.

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 Identify the client’s requirements and state how your firm intends to meet them.
 Explanation of your audit methodology and show to client how this will address client’s
requirements.
 Discussion of other services offered by the firm that could be of interest to the potential
 client.
Lowballing
This is a situation where firms charge less than market rate for an audit. This practice is
common when firms are tendering for new clients.
While Lowballing is not considered ethically wrong, the firm must ensure the following conditions
are strictly upheld:
 The auditors must ensure they carry out an audit of required quality as dictated by
international standards of auditing
 The auditors must ensure that the low audit fee does not create a situation where their
independence will be compromised.
ETHICS OF APPOINTMENT
Ethics of appointment is divided into two phase, procedures to follow before accepting a
nomination and procedures to follow after accepting nomination.
Procedures before accepting nomination
 The firm must ensure that it is completely independent of the client.

 The firm should assess the integrity of the directors of the company, where the integrity
of the directors or the company is questionable, the nomination should be rejected
 The firm should ensure it has adequate resources in terms of staff strength, expertise
and availability of time to perform the audit
 The firm must ensure that there is no any conflict of interest with the potential client
 The firm must ensure it is professionally qualified to act for the potential client
 Communicate with the incumbent auditor to learn of the reason for the change of auditor
and some other issues the new auditor should be aware of. The firm must seek for

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permission from client before making any contact with the incumbent auditor. In the
event that the company refuses to grant this permission, the nomination should be
rejected.
Procedures after accepting nomination
 The firm should ensure that the removal of the outgoing auditor is legally done
 The new auditor should request for a copy of the resolution passed at the general
meeting to confirm the validity of his appointment
 The auditor should draft letter of engagement to be submitted to the directors of the
company
Question AGNESAL
(a) “Quality control policies and procedures should be implemented at both the level of the
audit firm and on individual audits.” ISA 220 “Quality Control for Audit Work”
Describe the nature and explain the purpose of quality control procedures appropriate to the
individual audit. (7 marks)
(b) You are the manager responsible for the quality of the audits of new clients of Signet, a
firm of Chartered Certified Accountants. You are visiting the audit team at the head office of
Agnesal Co. The audit team comprises Artur Bois (audit supervisor), Carla Davini (audit senior)
and Errol Flyte and Gavin Holst (trainees). The company provides food hygiene services which
include the evaluation of risks of contamination, carrying out bacteriological tests and providing
advice on health regulations and waste disposal.
Agnesal’s principal customers include food processing companies, wholesale fresh food
markets (meat, fish and dairy products) and bottling plants. The draft accounts for the year
ended 30 September 2008 show turnover $19.8 million (2007 $13.8 million) and total assets
$6.1 million (2007 $4.2 million).
You have summarized the findings of your visit and review of the audit working papers relating
to the audit of the financial statements for the year to 30 September 2008 as follows:
(1) Against the analytical procedures section of the audit planning checklist, Carla has
written “not applicable – new client”. The audit planning checklist has not been signed off as
having been reviewed by Artur.

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(2) Artur is currently assigned to three other jobs and is working from Signet’s office. He last
visited Agnesal’s office when the final audit commenced two weeks ago. In the meantime, Carla
has completed the audit of tangible non-current assets (including property and service
equipment) which amount to $1.1 million as at 30 September 2008 (2007 $1.1 million).
(3) Errol has just finished sending out the requests for confirmation of accounts receivable
balances as at 30 September 2008 when trade accounts receivable amounted to $3.5 million
(2007 $1.6 million).
(4) Agnesal’s purchase clerk, Jules Java, keeps $2,500 cash to meet sundry expenses. The
audit program shows that counting it is ‘outstanding’. Carla has explained that when Gavin was
sent to count it he reported back, two hours later, that he had not done it because it had not
been convenient for Jules. Gavin had, instead, been explaining to Errol how to extract samples
using value-weighted selection. Although Jules had later announced that he was ready to have
his cash counted, Carla decided to postpone it until later in the audit. This is not documented in
the audit working papers.
(5) Errol has been assigned to the audit of inventory (comprising consumable supplies)
which amounts to $150,000 (2007 $90,000). Signet was not appointed as auditor until after the
year-end physical count. Errol has therefore carried out tests of controls over purchases and
issues to confirm the ‘roll-back’ of a sample of current quantities to quantities as at the year-end
count.
(6) Agnesal has drafted its first ‘Report to Society’ which contains health, safety and
environmental performance data for the year to 30 September 2008. Carla has filed it with the
comment that it is ‘to be dealt with when all other information for inclusion in the company’s
annual report is available’.
Required:
Identify and comment on the implications of these findings for Signet’s quality control policies
and procedures. (18 marks)

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Answers
(a) QC procedures
Quality controls are the policies and procedures adopted by a firm to provide
reasonable assurance that all audits done by a firm are being carried out in
accordance with the objective and general principles governing an audit (ISA 220).
Individual audit level
 Work delegated to assistants should be directed, supervised and

reviewed to ensure the audit is conducted in compliance with ISAs.
 Assistants should be professionally competent to perform the work
delegated to them with due care.
 Audit Supervisors must address accounting and auditing issues arising
during the audit
 The work of assistants must be adequately reviewed to assess whether it
conforms to the audit program and objectives.
 An independent review of audit work performed should be carried out to
assess the quality of audit work.
(b) Implications of findings for QC policies and procedures

Analytical procedures
It is mandatory to perform analytical procedures at the planning stage of the audit.
This will enable the auditor understands then risk characteristics of the audit. The
fact that analytical was not performed is an indication that the audit was not properly
planned.
Another point that indicates inadequate planning was the fact that the audit had
already began before the audit supervisor review the audit plan.
Supervisor’s assignments
The audit senior should have been assigned to the audit of trade receivables. This is
because receivable is more material than tangible non-current asset. Also, analytical
procedures showed that receivable is riskier than tangible non-current asset. The percentage
change in tangible non-current asset was 0% from 2007 to 2008 while it was 119% for
receivables.

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The above points mean that assignment of staff has not been properly done. There
is indication that the firm may not have enough manpower to execute the audit
assignment.
Direct confirmation
Depending on the reporting deadline, there may still be time to perform a
circularisation. However, consideration should be given to circularising the most
recent month end balances (i.e. November) rather than the year end balances
(which customers may be unable or reluctant to confirm retrospectively).
Cash count
Gavin ought to know that the cashier should not have dictated when the cash should
be counted. He should have reported the request of the cashier to audit senior. The
shift of the counting date should also have been documented. Though the amount is
not material, but the trainee did not act properly in that situation.
The trainees do not appear to have been given appropriate direction. Gavin
may not be sufficiently competent to be explaining sample selection methods to
another trainee. A more senior staff should be doing this. This indicates that trainees
are not properly monitored.
Inventory
Given the nature of the service offered by the client, one would expect the auditor to
know that inventory would be immaterial. The company has no stock-in-trade, only
consumables used in the supply of services. The extensive work carried on the
inventory by the trainee may not be needed. Though, slightly material to total asset
at 2.1%, it is not material to the revenue. This shows that the auditor lacks
knowledge of the client’s business which is essential to performing a quality audit.
Report to Society
The assumption that the ‘report to society’ is meant to be other information that
need to just be reviewed for misstatement or inconsistencies may be wrong. There
may be a reporting requirement for Agnesal to publish a verifiable ‘report to society’
in which case it will be treated as other assurance service separated from the
external audit. Should this be the case, the auditor will have to have a separate

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negotiation with the client and must also assess if it has enough knowledge to
handle such assignment.
Question VALDA
As manager responsible for prospective new audit clients you have received a
telephone call from an acquaintance of a client. The caller, Richard Stone, has
asked for your assistance concerning Valda Co, a supplier of electrical alarm
equipment. Business has boomed over the last two years due to reported
increasing crime rates. Turnover has nearly doubled and the company is very
profitable.
Mr Stone asks you for an estimate of the cost of a “cheap and cheerful” review
of the company’s accounting systems and internal controls and of a new computer
installation. The new computer is to be supplied next month, by R S Office
Equipment, subject to board approval. He suggests that you could spend a few
days looking at the systems’ flowcharts and documentation. He wants you to tell
him anything else that could be significant to the board’s decision to adopt his
proposals.
Although you are keen to gain the business, you inform him that you will write after
giving the matter further consideration.
Required:
(a) Identify and comment on the issues raised as they affect your decision to gain
the business. (10 marks)
(b) State what procedures you would adopt to clarify and agree the basis on which
your firm would undertake this work. (5 marks)

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Answers
(a) Issues raised

Identity of caller
The identity of the caller need to be ascertained .it is important to know his position in
the company. The firm needs to ascertain if Mr Richard Stone is a related party to
Valda. Also, there is need to know the reason why Valda’s auditor is not approached
for such service.
Deadline
Adequate time frame must be agreed to avoid offering poor quality service. Mr
Stone’s suggestion of spending few days on the system flowchart and documentation
may be inadequate.
Access to information
The auditor needs to ensure that there will be unrestricted access to information. The
firm may need to obtain permission from Valda’s auditor to access the management
letter.
Fees
Fees to be charged need to be commensurate with the level of work to be performed.
Also, the fees should not be contingent in nature.
Level of assurance
If high level of assurance is to be provided, merely looking at the system flowchart
and documentation may not be enough. The opinions given in the report should be
commensurate with the level of work performed.
Future business
Acceptance of the engagement may create opportunity to gain more work from
Valda in the future.
Decision to purchase
The following information may influence the board’s decision regarding the
acceptance of Mr Stone’s proposals:
 Availability of better alternatives.

 Cost effectiveness of the new system.
 The impact on the external audit in terms of audit cost.
 Availability of software support should there be any need to change or
upgrade the software in the future.

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Availability of resources
The firm needs to ensure there are enough resources to perform the engagement.
Unavailability of skilled professionals may be the reason why Valda’s auditor is not
engaged for the service.
(b) Procedures
 We would review the system’ flowchart and available documentations to determine
whether the information is detailed enough for the engagement.
 We would agree the basis on which the fees will be charged with the client.
 We would agree timetable with the client taking cognizance of the applicable
deadline
 We would discuss with Mr Stone on the need to contact the current auditor of Valda
 We would search Valda’s website or its audited report to confirm if Mr stone is a
director or a major shareholder
 We would draft the engagement letter

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INTERNAL AUDIT
Internal audit is the function in an organization that ensures that the system in operation runs
smoothly. Specifically, the internal audit ensures there is compliance with the system of internal
control of the organization. In addition, it ensures there is compliance with the regulatory laws
that affect the operations of the entity.
Advantages of internal audit

 Discovery of errors thereby improving the integrity of financial reporting.
 Reduces incidence of frauds.
 Ensures the staff work towards achievement of company’s strategy.
Issues with internal audit

 Internal audit Personnel may not be appropriately qualified.
 Internal audit Personnel are recruited by management and therefore are not
independent. This makes internal audit report not accepted by the shareholders.
Outsourcing of internal audit

This refers to contracting of internal audit function to experienced and independent external
providers
Impact of outsourcing of internal audit on external audit

 The external auditor may be prevented from having easy access to information of the
client. This is important as the external auditor need to test the system of internal
controls to determine the audit strategy.
 It may lead to improved internal control as the external are likely to be expert and
independent. This would improve the reliance external auditor places on the work of
internal auditors which may reduce the audit fee charged as less work would be
performed.
 External providers are going to be more objective as they are independent. This would
improve the reliance that external auditor place on the work of internal audit. As a result,
audit evidence may be readily available which reduces audit work and costs.
 Improved internal control. Since internal audit is carried out by an independent expert,
the internal control would be strengthened which reduce the risk of material

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misstatement and as a result reduces the substantives procedures of the external

auditor. As a result of reduced audit work, the audit fee charged is also reduced.
Matters to consider by external auditors in relying on the work of internal audit
According to ISA 610 Using the work of internal Auditors, the external auditors may decide to
use the work of internal auditor. However, he must ensure this practice is allowed by the local
regulations as it is not permitted in some jurisdiction. Quality control of the internal audit work
must meet the standard required by the external auditor before reliance can be placed.
The following must be considered before the external auditor can rely on the work of internal
auditors
 Objectivity of the internal audit function.
 Technical competence of the internal audit function.
 Whether there is smooth communication with the internal audit.
 Whether the work was properly supervised, reviewed and documented.
 Whether sufficient and appropriate evidence exist.
AUDIT COMMITTEE
This committee comprise of non-executive directors set up to improve the risk management
process of the entity and also review the financial statements.
Function of audit committee

 Recommend the appointment of the external auditor to the board.
 Negotiate the external audit fee.
 Review the risk management of the entity.
 Review the financial statements of the entity.
 Check the integrity of the entity’s financial reporting system.
 Review the effectiveness of the internal control systems.
 Ensure the effectiveness of internal audit.

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Advantages of audit committee

 Increase the credibility of the financial reporting process.
 Improve the control environment.
 Provide external expertise to the system.
 It increases public confidence on the financial reporting of the entity.
 It provides alternative channel of communication to external and internal auditors.
Disadvantage of having audit committee

 Increase of entity’s expenses.
 Recruitment of members with required knowledge may prove difficult.

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AUDIT OF FINANCIAL STATEMENTS
Audit planning
Proper planning is required in audit of financial statements to avoid performing negligent audit.
Overall audit plan includes consideration of the following:
 Knowledge of client’s business. How do you audit a business you know nothing about?
 Understanding of accounting policies of client and reporting framework. If you lack
knowledge of the reporting framework, how can you spot deviation from it?
 Assessment of risk and materiality.
 Consideration of nature, timing and extent of procedures to perform in gathering
evidences.
 Co-ordination, direction, supervision and review
Knowledge of the business

The followings are the aspect of the client’s business which the auditor must understand:
 Understanding nature of the industry and its regulatory framework

 Nature of the entity. This includes knowledge of the corporate structure, organization
structure, management’s objectives and philosophy, capital structure and the
composition of the board of directors
 Nature of business. This includes knowledge of products, market, suppliers and
operation
 Financial reporting framework
 Business risk. This is the risk that the company may not achieve its objectives. Business
risk is a good indicator of going concern problem
 Internal control. Assessment of the internal control will determine the audit strategy to be
adopted
 Performance measurement. The auditor need to understand key performance ratios
used to assess the performance of the entity. Management may deliberately manipulate
the financial statements to obtain a better assessment

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Procedures to gain business understanding
 Discuss with regulatory agencies to gain knowledge of the industry regulations

 Discuss with internal audit personnel and review the internal control manual to obtain
knowledge of the internal control system in operation
 Observe internal control activities to assess the effectiveness of the internal control
system
 Perform analytical procedure on the entries in the financial statements to assess risk of
material misstatement
 Discuss with management to gain knowledge of the corporate structure
 Read industry related publications to gain knowledge about the industry
 Inspect documentations to obtain knowledge of ownership structure
Difference between Audit strategy and Audit plan

Audit strategy sets the overall scope, timing and direction of the audit. The suitability of an audit
strategy depends on the risk characteristics of the audit. In other words, the strategy to be
adopted for a particular audit depends on the result of risk assessment carried out by the
auditor.
Audit plan details the specific procedures that need to be carried out in order to implement the
strategy and complete the audit. It details the step-by-procedures needed to gather evidences
for the completion of the audit.
AUDIT APPROACH
Audit approach refers to the strategy adopted by an auditor to carry out an audit
Types of audit approach
 The substantive procedure approach. This approach is otherwise known as direct

verification approach. It focuses on testing large volumes of transactions and account
balances. The approach is suitable when the financial reporting system of the entity is
weak. It is highly laborious as significant number of transactions will be tested.
 Balance sheet approach. This approach directs substantive procedures on the statement
of financial position. The assumption in this approach is that if all the assertions in the
statement of financial position are tested, the figures of profit/loss reported will not be
materially misstated.

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 System based approach. This approach prioritizes testing and validation of client’s
system of internal controls. Substantive procedures will be directed to areas where there
is established weaknesses in internal controls. For areas where the internal controls are
established to be strong, less substantive testing will be carried out.
 Risk-based approach. In this approach, the auditors assess the risks associated with the
client’s business, transactions and systems and direct their testing to risky areas. The
extent of detailed testing depends on the outcomes of risk assessment. ISA 315,
Identifying and Assessing the Risks of Material Misstatement Through Understanding
the Entity and its Environment (Redrafted) compels auditors to adopt a risk-based
approach to audits. Auditors are required to carry out risk assessments of material
misstatements at the financial statement and assertion levels, based on an appropriate
understanding of the entity and its environment, including internal controls
Advantage of risk-based strategy

This approach ensures that the greatest audit effort is directed at the riskiest areas, so that the
chance of detecting misstatement is enhanced and less time is devoted to less risky areas.
Disadvantage of risk-based strategy
 It lays too much emphasis on test of details. This may make the auditor overlook other
important issues like frauds and going concern problem.
 It’s time consuming

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Business risk or Top down Approach to Audit

This is the same as risk-based approach explained above. This approach starts by considering
the business and its objectives and works down to the financial statements, instead of working
up from the financial statements. The auditor will establish what the business risks are and then
relate these to how they could cause material misstatement in the financial statements.
The auditor gains an understanding of management’s business strategy, business processes,
key performance indicators and associated risks and controls; he then compares his
assessment of these factors with the position reflected in the financial statement.
This approach saves auditor’s time and adds more value to the client.
Components of business risks
Environmental risks
 Increase in competition
 Adverse weather condition
Financial risks
 Cost of maintenance
 Cost of any inputs
 Increase lease obligations
 Customer dissatisfaction lead to reputational damage and loss of revenue
 Foreign exchange risk may reduce company income
 Tax complications may lead to paying more tax e.g. wrong tax computation may to
paying fines
Compliance risks
 Right or license to operate

 Health and safety
Operational risks
 Aged plants
 Safety issues

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Relationship between business risk and financial statement risk

Financial statement risks include both inherent and control risk. Financial statement risk is
generally the risk that the assertions in the financial statements may not be correct.
Business risk on the other hand is the risk that the business may not achieve its objectives. For
example, any factors capable of eroding the profit of an organization constitute business risk.
Any factors that threaten the going concern of an organization equally constitute business risk.
The presence of business risks makes the financial statement susceptible to manipulation. This
is because business risk put management under pressure. Management would likely want to
hide the effect of the business risk from the shareholders. This would make management to
manipulate the financial statements.
Specific examples of business and financial statement risks

Highly geared company
A highly geared company is faced with financial risk. This is because of the huge financial
commitment involved. Interest payments reduce the company’s profit, and as such, it constitutes
a business risk. This may equally lead to going concern problem because some of the assets of
the company may have been used as collateral to secure the loan. Inability to meet interest
obligation or loan repayment will lead to the seizure of such assets. This causes operational
problem and could eventually lead to the company going out of business. The financial
statement risk here is possible understatement of liabilities or non-disclosure of going concern
problem.
A business that requires a license to operate
The business risk here is non-renewal of the license as a result of not meeting the attached
conditions. If the license is not renewed, the business will become inoperative. The associated
financial statement risk is non-disclosure of going concern problem in the financial statements.
A company Listed on multi exchange
A company listed on multiple stock exchanges is inherently risky to audit because the reporting
requirement on each exchange differs
Company that operates in multiple location
Presence in multiple locations increases control risk in that the entity system of control may not
cover all location. It equally increases detection risk in that the auditors need to attend and
obtain information from various locations.

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Risks particular to a retail business
 Transactions tend to be high volume, low value transactions

 Transactions are often carried out in cash
 Trade receivables are likely to be immaterial and therefore low risk
 It is difficult to establish completeness of income
 The risk of theft is very high
Industry specific risk

Some companies operate in industries that make use of complex assets that are difficult to
value. This constitutes inherent risk
Hints on answering questions on business and financial statement risk

When you are provided with extracts of financial statements and ask to highlight business and
financial statement risks, perform analytical procedures for the followings:
 Movement in revenue
 Movement in finance cost
 Movement in profit margin
The percentage increment or decrement of the following pair of items should ideally be fairly the
same. Compare the percentage changes in the items and explain any variance with possible
misstatement.
 Percentage change in sales revenue versus percentage change in cost of sale

 Percentage change in sales revenue versus percentage change in material expenses
 Percentage change in sales revenue versus percentage change in trade receivables
 Percentage change in trade payables versus percentage change in material expenses
If the company operates overseas branch, the following risks should be identified
 Foreign exchange risk

 Tax complication as a result of the company not understanding the foreign tax system.
When customers are dissatisfied for whatever reasons, the following risks are possible
 Reputational damage which may lead to brand impairment

 Drops in revenue which may lead to going concern problem

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The following areas of financial statements are highly susceptible to manipulation:
 Inventory. Valuation may be wrong, in which case IAS 2 inventory is not followed
 Contingent liabilities/provisions. Contingent liabilities may not be disclosed where
required. Provision may be understated or not made at all. Theses translate to not
complying with the provision of IAS 37
 Intangible assets. Intangible assets may be overstated or wrongly classified as against
the provision of IAS 38. Impairment review may not be carried out in compliance with the
requirement of IAS 36. Of particular importance in this regard is the treatment of website
costs. It is only the expenditure in the development phase that may be capitalized.
Expenditure incurred before and after the development phase is to be expensed in the
period.
 Leased assets. Assets may be wrongly classified and the lease obligation may be
wrongly calculated as against the treatment laid out in IFRS 16.
Audit risk and its components

Audit risk is the risk that the auditor may give an inappropriate opinion. This can be caused a
mixed of factors as explained in the section below.
Audit risk= inherent risk x control risk x detection risk
Inherent risk- is the susceptibility of an account balance to misstatement. It is a risk which

remains until the causative agent or situation is removed.
Control risk- is the risk that the system of control put in place by the management will fail to
detect material misstatement.
Detection risk- is the risk that the procedures performed by the auditor will fail to detect
material misstatements
If both control risk and inherent risks are low, the overall audit risk will be low. The auditor will
perform less substantive testing

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If both control risk and inherent risks are high, the auditor needs to reduce the overall audit risk
by keeping the detection risk as low as possible giving that it is the only component of the audit
risk the auditor can control over. To do this, the auditor will need to test more details
Analytical procedures
Analytical procedures consist of the analysis of significant ratios and trends including the
resulting investigations of fluctuations and relationships that are inconsistent with other relevant
information or which deviate from predictable amounts.
Auditor must apply analytical procedures at the planning and review stage of the audit. In
addition it may be used as substantive procedures to obtain audit evidence
According to international standard of auditing, analytical procedures include:
 The consideration of comparisons with:

Similar information for prior periods
Anticipated results of the entity, from budgets or forecasts
Predictions prepared by the auditors
Industry information
 Those between elements of financial information that are expected to conform to a
predicted pattern based on the entity’s experience, such as the relationship of gross
profit to sales
 Those between financial information and relevant non-financial information, such as the
relationship of payroll costs to number of employees
Analytical procedures at the planning stage of audit

Auditors must apply analytical procedures at the planning stage to assist in understanding the
business and in identifying areas of potential risk.
The followings are the possible sources of information about the client:
 Interim financial information

 Budgets
 Management accounts
 Non-financial information
 Bank and cash records
 Sales tax returns

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 Board minutes
 Discussions or correspondence with the client at the year end
 Industry information
The Importance of Analytical Procedures at The Planning Stage of Audit: ISA 520 Analytical
Procedures
 Enable the auditor to obtain understanding of the company being audited.
 It helps the auditor identify possible risk and respond appropriately and timely.
 ISA: 315, identifying and assessing the risk of material misstatement through
understanding the entity and environment makes it a requirement for auditor to perform
analytical procedures at the planning stage of the audit to identify and assess the risk of
material misstatement at the financial statement and assertion levels.
 Through analytical procedure, the auditor may become aware of unusual transactions in
the financial statement which call for investigations.
 Through examination of ratios, the auditor may become aware of situations that indicate
risk of misstatement.
Limitation of analytical procedures at planning stage
 Figures used are likely to be in draft form: - subsequent adjustment to these figures will
invalidate analytical procedures performed.
 Information will not cover the entire accounting period e.g. seasonal variation may distort
information making analytical procedures misleading.
 Information may not be prepared on the same basis as the previous year.
 Information may not be available before the year-end accounts are produced.
Reasons for performing analytical procedures during risk assessment
 To develop business understanding at the planning stage of the audit e.g. profit margin
may be compared with industry trend
 To identify key audit risk so as to allow the auditor direct work to key risky areas and
reduce chance of unnecessary work
Analytical procedures on Statement of profit or loss
 Review trends in the following

Revenue
Gross profit

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Net profit
 Compare actual revenue and profits for like 3 years with projected revenue and profit.
 Compare actual and budgeted figured on the following expenses
Staff cost
Training cost
Property cost
 Calculate and make comparison of the following ratios
Return on capital employed
Earnings per share
Gross and Net profit margin
Analytical procedures on Statement of financial position

Calculate and make companions of following ratios:
 Account receivable collection period

 Account payable collection period
 Current (liquidity) ration
Analytical procedures as substantive procedures

ISA 520 Analytical procedures states that auditors must decide whether using available
analytical procedures as substantive procedures will be effective and efficient in reducing
detection risk for specific financial statement assertions.
The followings are the factors which the auditor should consider when using analytical
procedures as substantive procedures:
 Availability of information
 Reliability of the information
 Relevance of the available information
 Source of the information. Information from independent sources are generally more
reliable than internal sources
 Comparability of the information available

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Use of Analytical Procedures as a Substantive Tests during Fieldwork to provide sufficient

Appropriate Audit Evidence
 Proof in total test can be used to assess the reasonableness of items in the statement of
comprehensive income such as depreciation, wages and salary change.
 For depreciation and amortization, the expected change for the year can be calculated
by applying the depreciation policy for each class of asset to the opening balance and
factoring in the acquisitions and disposal in the year.
 For wages and salaries, the average numbers of employees can be taken and multiplied
by the average salary for the year to get an estimate of the salary charge for the year-
any pay rise should be factored into the calculation.
 Comparisons of current year figures to prior year figures can be made for immaterial
items to form an assessment about the reasonableness of the figure. Comparison can
also be made with budget figures for the year.
 Accounting ratios can be used as analytical procedures to provide audit evidence. The
ratios can be calculated for prior periods and for comparable companies.
Extent to which reliance can be placed on analytical procedure as audit evidence
 Materiality of the item involved. Analytical procedure would be used for those items that
are not material to the financial statements. It is not suitable to use only analytical
procedure on items that are material.
 The accuracy with which the expected results of analytical procedures can be predicted
 Analytical procedure can be used to proof in total for specific items in the accounts e.g.
depreciation, staff costs
 Analytical procedures are more suited to large volume transactions. The auditor needs
to test if the controls are effective to determine the extent of reliability
MATERIALITY IN PLANNING AND PERFORMING AN AUDIT – ISA 320

An item is material if its omission or misstatement could influence the economic
decision of user of the financial statements.
An item might be material due to:
1. Nature
2. Value
3. Impact.

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There is an inverse relationship between the risk and the materiality. The higher the risk
the lower the materiality level and vice versa. When materiality level is set at lower level
then the auditor will have to verify more transactions.
Materiality is set at two levels:
1. Overall financial statements level. (Overall materiality)

2. For each account balance appearing in the financial statement (Performance
materiality).
Performance materiality is set at much lower level than the overall materiality so that
small misstatements in aggregate should not cross the overall materiality level.
Following are the benchmarks for the materiality:
Profit after tax 5%-10%
Revenue 0.5%-1%
Total assets 1%-2%
The following factors may affect the identification of an appropriate benchmark:
1. Elements of financial statements (assets, liabilities, equity, revenue, expenses)

2. Whether there are items on which users tend to focus.
3. Relative volatility of benchmarks.
Gathering evidences
Students will be required to suggest audit procedures for specific matters raised in an
examination scenario. To be able to do this, students need strong knowledge of
accounting standards. Students must first identify the accounting issues in the questions
before prescribing procedures.
Using the Work of an auditor’s expert ISA 620

Professional audit staffs are highly trained and educated, but their experience and
training is limited to accountancy and auditing matters. In certain situations, it would
therefore be necessary to employ someone else with different expert knowledge to gain
sufficient and appropriate audit evidence.

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Examples of situation where expert’s opinion is required:
1. Valuation of certain types of assets for example land and building, plant and
machinery.
2. Determination of quantities or physical conditions of assets.
3. Determination of amounts using specialized techniques for example pensions
accounting.
4. The measurements of work completed and work in progress on contracts.
5. Legal opinion.
Competence and objectivity of the auditor’s expert

This involves considering:
1. The expert’s professional certification or licensing by or membership of an
appropriate professional body.
2. The expert’s experience and reputation in the relevant field.
The risk that the expert’s objectivity is impaired increases when the expert is:
1. Employed by the entity.
2. Related in some other manner to the entity, for example by being financially
dependent upon or having an investment in the entity.
The scope of work of the auditor’s expert

The auditor shall agree in writing when appropriate on the nature, scope and objectives
of that expert’s work. Such agreement/instruction should cover the following factors:
1. The objective and scope of the expert’s work.

2. A general outline as to the specific matters the expert’s report to cover.
3. The intended use of the expert’s work.
4. The extent of the expert’s access to appropriate records and files.
5. Clarification of the expert’s relationship with the entity.
6. Confidentiality of the entity’s information.

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Assessing the work of the auditor’s expert

This requires the consideration of:
1. The source data used.
2. The assumptions and methods used.
3. When the expert carried out the work.
4. The reasons for any change in assumptions and methods if any.
5. The results of the expert’s work in the light of the auditor’s overall knowledge of
the business and the results of other audit procedures.
Reference to an auditor’s expert in the audit report

The auditor shall not refer the work in an auditor’s report unless required by law or
regulation. The reason is that such a reference may be misunderstood and interpreted
as a qualification of the audit opinion or division of responsibility neither of which are
appropriate.
Question RAVENSHEAD CONSTRUCTION

You are carrying out the audit of Ravenshead Construction Inc. The company’s business
includes large civil engineering contracts – the construction of buildings and roads. It also owns
investment properties which are let to third parties – these comprise offices and industrial
buildings.
During the year ended 30 April 2009 the company received a substantial claim for damages
from Netherfield Manufacturing Inc for faults in a building it had constructed – this claim includes
the cost of repair and damages, as the customer alleges that the building cannot be used
because of the faults, so alternative accommodation has had to be found. The company has
obtained advice on the likely outcome of this claim from a local solicitor.
In the year-end accounts the investment properties have been revalued by an independent
valuer and the construction contract has been valued by an employee of the company who is a
qualified valuer.
Required:
Describe the matters you would consider and the other evidence you would obtain to enable
you to assess the reliability of the work of specialists in the following cases:

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(a) Legal advice obtained from the local solicitor on the outcome of the claim by Netherfield
Manufacturing; (6 marks)
(b) Valuation of the investment properties by the independent valuer; (7 marks)
(c) Valuation of the construction contract by the internal valuer. (7 marks)
(20 marks)
Answers
(a) Solicitors advice
 Enquire into the background of the local solicitor and establish that he/she has no
connection with the company or with the officers of the company.
 The auditor should investigate the experience of the solicitor – ideally he should be a
specialist at this type of litigation.
 Compare the previous opinion given by the solicitor against the actual outcome to
determine accuracy of his opinion.
 The reputation of the solicitor should also be considered and his/her track record in the
past in advising the company should also be taken into account.
 The information supplied for the solicitor and the correspondence with the solicitor
should be inspected.
(b) Independent valuer of investment properties

 The independence of the valuer should be considered. He/she should have no
connection with the company or with any officer or director of the company. The
requirements of IAS 40 in this regard should be noted.
 The qualification of the valuer should be noted. Membership of the/a national institute for
surveyors is a recognised qualification for this purpose.
 The terms of reference given to the independent valuer should be noted. There may be
important reservations with regard to how the valuation is conducted. This may obviously
affect the quality of the valuer’s opinion.
 The basis used for valuation must be reasonable and generally acceptable. Investment
properties are valued on the basis of the future income that they generate. The
calculations for the valuation should be examined and verified by the auditor. This will
involve communicating with the experts and establishing sight of his working papers.

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The auditor should also consider the valuation of other investment properties in a similar
area with those contained within the portfolio of his client.
(c) Internal valuation of construction contract

 The value of the construction contract and the degree of monetary precision which would
be acceptable for its valuation.
 The basis of valuation should comply with IAS 11 and should be consistent with previous
years.
 The accounting records for the contract should be reliable and should be capable of
substantiation.
 The past record of the valuer should be considered; there should be other construction
contracts which have been completed in the past.
 The auditor should also examine the estimate of cost of completion and estimated
contract revenue. The estimates of cost completion should allow for remedial costs and
for cost escalation in the price of materials. Any fixed price contract is likely to be
exceedingly risky. The auditor should check the calculation of attributable profit and
establish that all adjusting events after the reporting period have been taken into
accounts in the valuation of the contract. Where a loss is foreseen provision should be
made in full as per IAS 11.

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ACCOUNTING STARDARDS REVISED

Presentation, (IAS 1)
This standard requires management to make assessment of an entity’s ability to
continue as a going concern. Should there be any indication of material uncertainties
regarding the ability of the entity to continue as a going concern IAS 1 requires
adequate disclosures.
Audit issue or risk regarding going concern problem
 Management may use inappropriate basis of preparing the financial statements

 Assets and liabilities may be misclassified as noncurrent when they should be classified
as current in a situation where the entity will be liquidating its assets.
 There may be inadequate disclosure in the account regarding the going concern
uncertainty
ISA 570 summarizes the main responsibilities of both management and auditor regarding going
concern. The going concern assumption is a fundamental principle. Readers of the financial
statements would assume the entity is viable unless it is clearly stated otherwise
Responsibilities of management
 Management should assess the entity’s ability to continue as a going concern

 Management should use the correct basis of presentation e.g. where the entity is no
more a going concern, alternative basis of presentation should be adopted E.g. break-up
basis.
 Adequate disclosure should be made in the notes to the account regarding any
uncertainty in the going concern of the entity.
Responsibilities of Auditor
 The auditor should obtain sufficient, appropriate evidence about the appropriateness of
management’s use of the going concern assumption in preparing the financial
statement.
 Based on the evidence collected, the auditor should conclude whether there is a material
uncertainty about the entity’s ability to continue as a going concern.
 Auditor should determine the implication on the auditor’s report. If there is material
uncertainty on the entity’s ability to continue as a going concern and this has been duly

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disclosed by the management, there will be no need to qualify the auditor’s opinion,
otherwise qualified opinion will need to be issued.
 The auditor shall remain alert throughout the audit for audit evidence of events or
condition that may cast significant doubt on the entity’s ability to continue as a going
concern
Note: The auditor shall cover the same period as management in the evaluation of
management’s assessment of going concern
The following range of indicators may be used by both the auditor and the management in
making assessment of going concern:
Financial indicators
Analytically compare key financial ratios. Any adverse movement could indicate going
concern problem e.g. drop in profit margin, decrease in interest cover, decrease in current
ratio.
Operating indicators
The following factors could indicate going concern problem
 Inability to obtain finance to fund operation or invest in new projects

 Emergence of a successful competitor
 Inability to renew operating license
 Loss making, this is because losses deplete owners’ capital and reserves
 High gearing. Interest payment commitment reduces earnings and causes liquidity
problem. It may equally create operational problem if there is charge on the entity’s
assets.
 Reliance on overdraft facilities. This is an unsuitable source of long term funding. It
is not sustainable on long term and it usually carries high interest rate.
 Unusual increase in inventory level or insufficient inventory level.
 Selling of non-current assets in order to raise capital for the business. This will
create further operational problem.
 Over-trading. This may come in the form of too rapid expansion. It may lead to poor
working capital management if the entity does not get enough cash to settle its
current liabilities e.g. inability to pay salaries or suppliers.
 Loss of key customer and key staff
 Impairment of assets
 Debts going bad

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Note: any of the above points constitutes matters to be considered regarding going concern
problem when asked by the examiner
Audit procedures on going concern

If the auditor becomes aware of factor of uncertainty casting significant doubt on the entity’s
ability to continue as a going concern, the auditor must carry out further procedure to obtain
sufficient evidence. The following specific procedures may be helpful:
 The auditor should evaluate management’s future plan to sustain the entity’s going
concern. E.g. management’s plan for the expansion of its business or invest in new
projects.
 The auditor should consider the availability and sufficiency of finance available to fund
any future business expansion or new projects.
 The auditor should obtain direct confirmation from the entity’s bank on its readiness to
provide the needed finance for the entity.
 The auditor should assess the viability of management’s plan e.g. by assessing the
market research report.
 The auditor should evaluate management’s cash flow forecast to determine if the
underlying assumptions are reasonable
 Auditor should obtain written representations from management regarding its plan for
future and the feasibility of the plan.
Note: these are general procedure; students should make sure that the procedures they
prescribe are tailored to the fact of the scenario given in an examination
Implication of going concern on audit opinion

The followings are implications of going concern issues on the auditor’s report:
 Where the auditor considers that there is significant level of concern about the ability of
the entity to continue but do not disagree with management’s use of the going concern
assumption in preparing the financial statements, an unqualified opinion will be issued
provided it is adequately disclosed in the notes to the account. The auditor’s report
would include a going concern uncertainty paragraph to draw readers’ attention to the
note.

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 If the use of the going concern is appropriate but there is material uncertainty on the
going concern and required disclosures are inadequate the auditor would issue a
qualified or adverse opinion depending on the pervasiveness of the uncertainty to
financial statements.
 If the auditor disagrees with the basis of preparation, an adverse opinion will be issued
because it is pervasive to the financial statements.
 Where the accounts have been prepared on an alternative basis, e.g. break up basis,
and the disclosure to this effect is considered not adequate, the auditor’s report would
need to be modified on the ground of inadequate disclosure
 If there is clear indication that the entity will be liquidating its assets and there is no
adequate disclosure, regardless of the basis of preparation of the financial statements,
an adverse audit opinion should be expressed. The use of the “except for” qualification
or disclaimer of opinion would be grossly inappropriate in this situation.
Client with going concern problem applying for a loan: - Audit implication
 If the client is unable to obtain the loan, the financial statement must contain disclosures
regarding the material uncertainty over going concern. The auditor’s report should
contain a going concern uncertainty paragraph discussing the uncertainty and referring
to the note.
 If the financial statements do not contain the disclosures, the auditor’s opinion would
need to be either qualified or adverse
Audit Procedures in respect of an entity with going concern problem applying for bank loan
to fund a project
Obtain & review the forecasts and projections and assess if the assumptions
used reflect business reality.
Obtain written representation confirming from management that the assumptions
used in the forecasts and projections are considered achievable.
Obtain & review the terms of the loan to see if the client can make the
repayments required.
Consider the sufficiency of the loan requested to cover the costs of the intended
project.

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Review the repayment history with the client’s bankers to form an opinion as to
whether the client has any history of defaulting on payments.
Obtain confirmation from the banker of their intention to provide the finance.
Discuss with management, to ascertain if any alternative providers of finance is
considered.
Obtain a written representation from management stating management’s opinion
as to whether necessary finance is likely to be obtained.
IAS 2 Inventories
IAS 2 requires that inventory should be valued at the lower of cost and net realizable value.
The method used in allocating costs to inventory needs to be selected with a view to providing
the fairest possible approximation to the expenditure actually incurred in bringing the inventory
to its present location.
Notes:
 It is permitted to value inventory at market price at year end only if the rate of turnover
and fluctuations in the market price is very high, but this is a departure from IAS 2 and
as such needs to be adequately explained and justified in the financial statement.
 LIFO is not acceptable method of valuing inventory under IAS 2.
 Base inventory valuation is not acceptable.
 Selling price less gross profit margin is an acceptable method of approximating to cost of
inventory
Inventory valuation- matters to consider for audit
 Cut-off. Inventory will be undervalued or overvalued if cut-off has not been appropriately
applied.
 Counting. Inventory will be undervalued if not all inventory items have been included in
count.
 Inventory will be undervalued or overvalued if the valuation methods are incorrect

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Audit Procedures to carryout
 Obtain inventory counting instructions in place and review to make an assessment of

their adequacy.
 Perform analytical procedures, any unexpected result should be discussed with
appropriate staff
 Discuss scrap and wastage policy with the concerned staffs.
 Examine details of scrap and discuss reasonability of figures with appropriate staff
 Agree cost to purchase invoice to confirm valuation
 Check sales invoices immediately after the year end and compare to the cost of
inventory to confirm the net realizable value is not lower.
 Test cut-off is correct by tracing the last goods delivery notes and dispatch notes to the
invoices.
 Recast additions on inventory sheets to verify accuracy.
IFRS 5 Discontinued Operation

A division will be a discontinued operation if it is an independent business division which can be
distinguished operationally and for financial reporting purposes. It must constitute a separate
line of business
Disposal group: the assets of a discontinued operation are a disposal group per IFRS 5.
IFRS 5 requires that a disposal group is recognized as held for sale where the assets are
available for sale in their present condition, the sale is highly probable and the sale should be
expected to take place within 12 months.
According to IFRS 5:
 The assets in disposal group should be measured at the lower of their carrying amount
and the fair value less cost to sale.
 The assets should not be depreciated.
 The assets should be presented separately in the statement of financial position.

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Disclosure Requirement on the closure of a Business Segment

In order to be separately disclosed:
 The discontinued operations should be a component that is separately identifiable from

the rest of the business.
 The disposal should be as a result of a single coordinated effort to dispose a major line
of business.
If products are different from the products of the continued operations, then it is arguable that a
component has been closed as part of a single coordinated plan to dispose of a separate major
line of business. In this case, there should be separate disclosure in the financial statements.
If the discontinued operations are not separately identifiable either by products or geographical
location, there is no need to make separate disclosure.
Audit Risks associated with IFRS 5
 Lack of commitment to discontinue the operation

 The component being disposed may not be separately identifiable from the rest of the
business
 There may be inadequate disclosure regarding the disposal in the note to account
 Wrong value may be used to recognise assets in the disposal group
 Discontinue operations may not be separately recognized in the profit or loss statement
 Assets held for sale may be wrongly depreciated
Audit procedures regarding disposal group:
 Review board minutes for evidence that the sale is certain

 Assess any announcement made regarding the sale
 Confirm that results of the discontinued operation are presented separately in the
statement of profit or loss as per the requirement of IFRS 5
 Confirm that the disposal group is presented as assets held for sale in the statement of
financial position.
 Obtain evidence of the estimated fair value, possibly by engaging an auditor’s expert.
 Inspect any correspondence with potential buyers to confirm management is actively
looking for buyers

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SETTER STORES
the year ended 31 January 2013. The draft financial statements of Setter Store recognise total
assets of $300 million, revenue of $620 million and profit before tax of $47.5 million.
Setter Stores Co owns a number of properties which have been classified as assets held for
sale in the statement of financial position. The notes to the financial statements state that the
properties are all due to be sold within one year. On classification as held for sale, in October
2012, the properties were re-measured from carrying value of $26 million to fair value less cost
to sell of $24 million, which is the amount recognised in the statement of financial position at the
year end.
Required:
Comment on the matters to be considered, and explain the audit evidence you should
expect to find during your file review in respect of each of the issues described above.
Solution
Matter to consider
Materiality:
Fair value of the asset: 24/300*100 = 8% is material to the statement of financial position.
Impairment:
(26-24)/620*100% = 0.3% is not material to the statement of profit or loss
(26-24)/47.5*100% = 4.2% is not material to the statement of profit or loss
For asset to be classified to be classified as held for sale, the following conditions, according to
IFRS 5 must be met.
 The asset is available for immediate sale
 There is management commitment to dispose the asset
The asset must be recognized at the lower of its carrying value and the fair value less costs to
sale. If this has not been done, the value of the asset may be misstated.
IFRS 5 does not permit the depreciation of assets held for sale. There is need to confirm that
the assets classified as held for sale were not depreciated.
There is need to consider if adequate disclosures have been made in the account regarding the
assets classified as held for sale. Information such as the following should be disclosed:
 The description of the assets
 Circumstances surrounding the sale of the assets

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 The details of the impairment and the amount recognized in the account
Audit Evidence
 A copy of board minute at which the disposal of the asset was discussed and
authorization granted to ascertain management’s commitment to the sale.
 A copy of minutes of meetings held with any prospective buyer to ascertain effort of
management in finding buyer for the assets.
 Copies of correspondences with prospective buyers of the assets.
 Written representation by management that the assets will be sold within stated period to
confirm commitment.
 A copy of depreciation schedule to confirm that the assets held for sale were not
depreciated.
 Copy of valuation report used to determine the fair value of the assets
IAS 8 Accounting policies, change in accounting estimates and error
Prior period (retrospective) adjustment is required where:

 There is a change of accounting policy in the current year
 An error is discovered in the prior period
IAS 8 states that a company should only change its accounting policy towards an item if
required to do so by an accounting standard or if the change in policy would give a more reliable
and relevant reflection of the substance of the transaction
In a case where for example there is prior year overvaluation of inventory, comparative figures
should be restated in the financial statements and adjustments should be made to the opening
balances of reserves for the effect. The effect should equally be adequately disclosed in the
notes to the account e.g. the prior year profit might have been wrongly calculated because of
the wrong valuation of the inventory. This will have a cumulative effect on the retained earnings.
There should be no specific reference to the corresponding figure in the auditor’s report merely
because they have been restated (ISA 710). However, if the corresponding amounts have not
been properly restated or appropriate disclosures have not been made, the report should be
modified with respect to the corresponding figures.

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Audit procedures for change in policy and error
 Compare prior year accounting policies with the current policies to determine if there is
any change in accounting policies.
 If there is any change in policy, auditor should ensure effect of the change is applied
retrospectively to comply with the requirement of IAS 8
 The auditor should recalculate any restated figure in statement of changes in equity due
to prior period error.
 The auditor should ensure adequate disclosure is made in the notes to the account
regarding any change in accounting policies and error.
IAS 8 requires prospective adjustment where is change in accounting estimate. The followings
give situation of change in accounting estimate:
 Change in useful life of an asset

 Change in parameters used in provision for warranty costs as a result of getting more
realistic information
 Account receivables (estimated net of bad debts and interest)
 Change in estimate for inventory value (at lower of cost and NRV)
 Goodwill (recognized net of impairment which depends on many external factors)
 Contingent liabilities (estimated based on existing information which is subject to
changes)
 Pension obligations
Audit procedures on accounting estimates
 Auditor should familiarize himself with the way management assess and make estimates
in the financial statements
 Auditors should obtain understanding of the relevant accounting framework to be able to
assess the validity and correctness of the estimate made by managements
 Auditor should enquire from management if there is any change in accounting estimate
in the current period and assess the justification for the change
 Auditor should obtain management representation that estimates made are valid

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IFRS 9 Financial instrument

An entity should recognise a financial asset or liability in the statement of financial position when
it becomes a party to the contractual provisions of the financial instrument.
Financial asset:
According IFRS 9, the business model for holding an asset will determine if the asset should be
recognized at amortise cost, fair value through other comprehensive income (FVOCI), or the fair
value through profit or loss (FVPL). Financial assets should be initially measured at fair value.
Financial asset measured at amortised cost

A financial asset must be measured at amortised cost if both of the following conditions are met:
 The asset is held to collect contractual cash flows
 The contractual terms of the financial asset give rise on specified dates to cash flows
that are solely payments of principal and interest on the principal amount outstanding.
Financial asset that meets the above conditions is first recognized at fair value and
subsequently at amortised cost.
Financial asset measured at fair value through other comprehensive income (FVOCI)
Financial assets are measured at FVOCI if the following conditions are met:
 The objective of holding the asset is to collect contractual cash flows and selling the
assets
 The asset’s contractual cash flows represent solely payments of principal and interest
The following applies to financial assets in this category:
 Assets are initially and subsequently recognized at fair value.

 Movement in the carrying amount should be taken to other comprehensive income.
 Impairment gain or loss is recognized in the profit or loss.
 Foreign exchange gain or loss should be recognized in the profit or loss
 When the assets are derocognised, the associated cumulative gain or loss in the OCI
should be transferred to profit or loss.

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Financial assets measured at fair value through profit or loss (FVPL)
Financial asset that does not meet the condition for amortised costs and FVOCI should be
measure at fair value through profit or loss. Financial assets in this category should be initially
and subsequently measured at fair value. All changes in fair value should be recognized in the
profit or loss.
Equity instrument
Equity instruments held for trading should be measured at fair value according to IFRS 9. Any
change in fair value should be recognized in the profit or loss. Any gain or loss that crystalize at
measurement should be taken to statement of profit or loss. If an equity instrument is not held
for trading, entity can make an irrevocable election to classify the equity instrument as fair value
through other comprehensive income and it must be subjected to fair value measurement at
each year end.
Note
 Once an election is made regarding equity instrument, all fair value changes excluding
dividend should be recognized in other comprehensive income
 No reclassification from OCI to profit or loss can be made. Movement within equity is
however allowed
note the following

 Financial assets should be initially measured at fair value which in most cases is the
price paid.
 If the financial asset is classified as fair value through profit or loss, transaction costs
should not be added to initial carrying amount.
Financial liabilities
Financial liabilities are measured at amortised cost unless:
 The financial liability is held for trading and is therefore required to be measured at
FVTPL. This includes derivatives that are not part of a hedging arrangement
 The entity elects to measure the financial liability at fair value through profit or loss.
IFRS 9 gives option for some liabilities, which would normally be measured at amortised
cost to be measured at FVTPL if, in doing this would eliminate or reduces an accounting
mismatch.

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IFRS 9 splits gains and losses on financial liabilities designated at FVTPL into two as follows:
 Amount of change in fair value attributable to changes in credit risk of the liabilities. This
should be presented in other comprehensive income. Gain or losses recognized
comprehensive income cannot be subsequently transferred to profit or loss.
 Other gain and losses to be recognized in the profit or loss
IFRS 7: Financial Instrument disclosure

Increase in receivable days may indicate over statement of receivables. when there’s increase
in receivable days, the situation may require disclosure according to IFRS 7 may not be done.
IAS 32 financial instruments: Presentation

Financial instruments are classified into financial assets, financial liabilities and equity
instruments. It’s important to distinguish between liability and equity instrument as clearly shown
below:
Is there an obligation to deliver cash or other financial assets?
YES NO
FINANCIAL LIABILITY EQUITY
Going by the above, preference share is to be classified as liability while ordinary share is equity
According to IAS 32, an equity instrument is:
 A non-derivative that includes no contractual obligation to deliver a variable number of
own equity instruments, or
 A derivative that will be settled only by the issuer exchanging a fixed amount of cash or
another financial asset for a fixed amount of its own equity instruments.

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Equity settle transactions

When a transaction will be settled in the entity’s own shares, classification depends on whether
the number of shares to be issued is fixed or variable. Note the following scenarios:
 A transaction that involves delivery of another entity’s share is a financial liability
 A transaction to deliver variable number of entity’s own share is a financial liability
 A transaction to deliver fixed amount of entity’s own share is an equity instrument
Compound financial instruments

A compound financial instrument has both debt and equity components combined. An example
of this is convertible bond. The issuer has the liability to settle the loan by payment in cash and
a call option (to the holder) to deliver some quantity of ordinary shares. The difference between
the fair value of the compound instrument and the fair value of the liability component gives the
equity component.
The debt component should be presented as financial liability while the equity component
should be presented as equity.
Matters to consider for audit

 Materiality of the assets should be first determined.
 Competence of the auditor in valuing financial instruments
 Complex accounting involved.
 Gain or loss on hedging instruments may not be recognized in the profit or loss
statement
 Classification and presentation may not be correct.
 Assets shown at fair value may be subjective.
 Disclosure may not be made or inadequate according to IFRS 7 Financial instruments
Disclosure.
 Amount recognized in the statement of profit or loss as a result of movement in fair value
may not be in accordance with IFRS 9.
 Complex financial instruments like convertible debts may not be split between debt and
equity component in line with IAS 32. This would lead to under/overstatement of
liabilities and finance costs.

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NOTE
If the auditor is unable to obtain adequate evidence on material financial instruments, he should
consider impact of this on his audit opinion. In a situation where the client is unwilling to bear the
costs of obtaining valuation for the financial instruments, auditor should determine whether this
constitute imposed limitation.
Risks of material misstatements relating to financial instruments
 Management lack of relevant technical knowledge to determine the correct value of the
financial instruments.
 Management lack of knowledge of the relevant financial reporting framework.
 Management’s lack of adequate internal controls over activities relating to financial
instruments
Business risks relating to financial instruments
 Credit risk. The other party to the contract may default thereby creating financial loss on
the part of the company
 Liquidity risk. The financial instruments may become unmarketable thereby making it
difficult to realize expected cash inflows from the financial instruments
 Market risk. Fluctuations in the market price of the instruments may create financial loss
Use of management expert by client

In a situation where management engaged a third party to obtain valuation of its fianancial
instruments, auditor should consider the followings:
 Methodology used by the expert 3rd party

 Reputation of the 3rd party expert
 Objectivity of the 3rd party expert
 Independence of the 3rd party expert
Audit Evidence
 Agreement of the fair value to year end market price

 Recalculation of total gain or loss recognized as a result of movement in the fair value.
 Review of disclosure in the notes.
 A copy of the purchase document

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 A copy of valuation report from management’s expert

 Agree purchase price to documentation
Audit procedures
 Review disclosures made to ensure adequacy
 Review assumptions used in the valuation for reasonableness
 Evaluate whether value obtained is reasonable by comparing with auditor’s own
estimate or other third party source
 Obtain management representation that it’s assumptions are valid
 Engage the service of auditor’s expert to confirm reasonableness of management’s
value
REVENUE: 98 MILLION
PROFIT: 15 MILLION
TOTAL ASSET: 134 MILLION
a small treasury management function was established to manage the company’s foreign
currency transactions, which include forward exchange currency contracts. The treasury
management function also deals with short-term investments. In January 2015, cash of $8
million was invested in a portfolio of equity shares held in listed companies, which is to be held
in the short term as a speculative investment. The shares are recognized as a financial asset at
cost of $8 million in the draft statement of financial position. The fair value of the shares at 31
May 2015 is $6 million.
Required:
a) Evaluate the audit risks to be considered in planning the audit of Ted Co.
b) Recommend the principal audit procedures to be performed in the audit of The portfolio
of short-term investments.
Solution
 Transactions may not re-translated to the functional currency at the date the transaction
occurred which may lead to either understatement or overstatement of the amount
involved.
 Payable and receivable figures may not be re-translated at year end closing rate which
may lead to over/under statement of assets and liabilities.

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 Inadequate disclosure of risks associated with the financial instruments (forward

contracts)
 Difficulty in determining the fair value of the derivative at the year-end may give rise to
detection risk as the auditor may lack knowledge to assess reasonableness of the fair
value asserted by management.
 Management may lack required knowledge of hedge accounting giving this is a complex
area of accounting
 The decision to recognize the equity purchase at cost in the draft account appeared to
be wrong as IFRS 9 financial instrument is not followed in this regard. Investment held
for speculative purpose should be recognized at fair value through profit or loss. Thus,
the account has been over-stated by $2 million. This is a material amount to the financial
statement at 13% of the profit
 The treasury department of the company may lack adequate knowledge of the
accounting for hedge instrument which constitute an inherent risk to the audit of ted co.
IFRS 15, revenue from contract from customer

According to IFRS 15 Revenue from contracts with customer revenue should only be
recognized when control is passed to the buyer. In determining the timing of revenue
recognition; attention should be given to the following:
 When control over the physical asset is passed to the customer.

 When legal title over the item is passed.
 When the customer accepts the significant risks and reward incidental to the ownership
of item.
NOTE:
Advance payment received when the recognizing criteria of IFRS15 are yet to be treated as
deferred income. An equal liability should also be recognized against the deferred income.
According to IFRS 15, the following five steps should be applied in order to recognize revenue:
Identifying the contract

Identifying the performance obligation within the contract
Determination of transaction price

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Allocation of transaction price to the performance obligation

Matching revenue to the performance obligation or spreading the revenue across the
period of the obligation.
To understand the above five steps better, let us consider a simple scenario below:
A company agreed to supply a machine free in order to earn a servicing contract of three years.
The total price of the three years servicing contract is $5000. If the machine was not supplied
free, the following price applies:
Machine: $2,500
Servicing: $1,000 per each year of servicing ($3,000 for three years)
Step 1: Identify the Contract-Agreement to supply the machine and to service the machine for
three years.
Step 2: identify the performance obligation-the performance obligation includes the supply of
machine and servicing of the machine for three years
Step 3: Determination of transaction price-transaction is $5000
Step 4: Allocation of transaction price:
Supply of machine- $5000 X 2500/5500= $2,272.7
Servicing of machine- $5000 X 3000/5500=$2,727.3
Step 5: Matching revenue to the performance of obligation
Revenue relating to the supply of machines should be recognized in the current accounting
period provided the following conditions are met:
The risks and rewards incidental to the ownership of the machine has been transferred
to the client.
Control of the machine has been transferred to the customer. Control can be evident
through the transfer of legal title to the goods in the form of invoice or receipts or other
legal documents as the case may be.
Note: sales should not be recognized when the performance obligation is yet to be met
The revenue relating to the servicing cost should be recognized to the extent of the performance
of the obligation i.e. the $2,727.3 should be spread across the three years recognizing
$2,727.3/3 per year of servicing.

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AUDIT RISKS RELATING TO THE ABOVE TRANSACTION

Overstatement of sales
The whole contract price may be recognized in sales revenue. This would make the sales figure
to be overstated.
Overstatement of receivable
It is not allowed to recognize a receivable against an obligation that is yet to be performed. This
would lead to the receivable being overstated.
Understatement of liability
If cash was received for an obligation yet to be performed, then, there is need to create equal
amount of liability to the cash (deferred income). If this this is not done, there is an
understatement of liability in the financial statement.
SITUATION WHERE THE RISKS AND REWARDS HAVE BEEN TRANSFERRED BUT THE
SELLER RETAINS THE GOOD IN HIS OWN PREMISE BASED ON THE AGREEMENT WITH
THE BUYER
Sales will be recognized in this case if the risks and rewards have been transferred provided
there is no agreement to the contrary. Should there be a clause in the sales agreement which
make the seller responsible for the theft or damage of the goods then the risks and rewards still
remain with the seller which means no sales was made. If there is fees charged by the seller for
keeping the goods in its own premises, this represents a separate sales of service which should
be recognized as the obligation is performed taking cognizance of cut-off.
Audit risks
Over-statement of revenue: if there are clauses in the sales agreement which indicate that the
seller is responsible damage or theft of the goods, then, no sales should be recognized.
Recognition of sales in this case is against the dictate of IFRS 15.
Understatement of inventory: the goods that should have been accounted for under inventory
would have been wrongly recognized as sales leading to understatement of inventory.
Audit procedure
The auditor should evaluate the sales contract documentation to determine whether risk and
rewards has been transferred to the buyer.

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Consignment Inventory
This refers to inventory held by one party but legally owned by another party. Items should be
accounted for according to the substance of the transaction rather than legal form. Consignment
inventory should never be recognized as a sale. It is otherwise known as agency sale
Note: if the agent never exercises his legal right to return the goods before payment the
commercial reality is that the consignment is a purchase from the date of delivery.
Audit procedures
The auditor should examine the terms of the sale in order to establish whether:
 The buyer has the legal right to return the goods.

 The seller has the legal right to cancel the sale and order the return of the goods
CONTRACTS THAT SPAN THROUGH MORE THAN ONE ACCOUNTING PERIOD

(CONSTRUCTION CONTRACTS)
In this kind of contract, performance obligation is satisfied overtime. According to IFRS 15,
revenue should be recognized to the extent of the obligation that has been satisfied.
The extent (percentage) of obligation satisfied can be measured using;
Output method: calculated as (work certified to date)/ (total contract price) X 100%
Input method: calculated as (cost incurred to date)/ (total cost) X 100%
The total cost includes any incremental cost of obtaining the contract and those that can be
recovered through the contract.
Note: Any cost that cannot be recovered through the contract should be recorgnised as expense
in the period in which it is incurred. Example of these costs is rectification cost on mistake made
by the contractor.
Audit risk
Overstatement of revenue: revenue would be overstated if the whole contract price is
recorgnised in a single accounting period instead of spreading over the entire contract period.
Wrongly calculated percentage of completion constitute risk of misstatement: this could lead to
either over or under-statement of profit.
Irrecoverable costs recorgnised may be wrongly recognized as part of total cost: Irrecoverable
costs like rectification cost should be recorgnised in the period it is incurred and should not be
spread. This would lead to understatement of cost and overstatement of profit

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Audit procedures
 Review the contract documentation to ascertain the contract price.

 Review the contract documentation to establish terms of the contract.
 Review the expert report to obtain evidence on the correctness of the percentage
completed.
 Review the correspondences with the client to obtain evidence of contract renegotiation.
 Review the correspondences with the client to establish recoverability of any rectification
cost.
Onerous Contract
This is a contract which is expected to generate overall loss i.e. total contract revenue minus
total contract price = loss
According IFRS 15, the whole loss should be recognised immediately (both loss to date and
loss be incurred in the future). Then, provision should be created against the loss to be incurred
in the future.
Audit Risk
Over-statement of profit: the whole loss should be recorgnised in the period it is determined the
contract would generate overall loss.
Under-statement of liability: loss relating to the future period should be provided for in the
liability section of the statement of financial position
Audit procedures
Recalculate the overall loss to establish the amount
Discuss with management on the need to recognise the whole loss in the period
Contract with unknown outcome

In this case, the level of obligation satisfied cannot be reasonable determined. According to
IFRS 15, revenue should be recognised to the extent of cost incurred. This implies that revenue
= costs incurred. In essence, no profit is recognised.

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AMOUNT TO BE RECOGNISED IN THE STATEMENT OF FINANCIAL POSITION

REGARDING LONG TERM CONTRACT
Current asset
contract work in progress; this represent amount by which contract cost to date exceed the
contract cost recognised in statement of profit or loss as cost of sales
Trade receivables; this represent the amount by which contract revenue recognised in the
statement of profit or loss exceeds the cash received from the contract.
Current liability
Deferred income; this represent the amount by which the cash received is more than the
revenue recognized in the statement of profit or loss.
Current provision; the provision recognized against the loss to be incurred on onerous contract.
Non-current asset
PPE used for the contract is recognized at carrying amount minus accumulated depreciation.
AUDIT PROCEDURES RELATING TO CONSTRUCTION CONTRACTS
Total contract cost should be agreed to the contract agreement (documentation).

Total contract price should be agreed to contract documentation.
Review the element that make up the total contract cost to ensure no irrecoverable cost
is included.
Review costs recognized in the accounting period and ensure any irrecoverable costs
(rectification costs) incurred in the period has been included.
Agree cost incurred to date to invoice to ensure accuracy.
Recalculate the depreciation on the PPE used in the contract to ensure the carrying
amounts of PPE are correctly valued.
Agree the cash received to bank statement to ensure contract’s current asset or liability
is correctly valued.

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Question
TED CO
REVENUE: 98 MILLION
PROFIT: 15 MILLION
TOTAL ASSET: 134 MILLION
Computer games are largely sold by Ted co through retail outlets, but approximately 25% of
Ted Co’s revenue is generated through sales made on the company’s website. In some
countries Ted Co’s products are distributed under licenses which give the license holder the
exclusive right to sell the products in that country. The cost of each license to the distributor
depends on the estimated sales in the country to which it relates, and licenses last for an
average of five years. The income which Ted Co receives from the sale of a license is deferred
over the period of the license. At 31 May 2015 the total amount of deferred income recognised
in Ted Co’s statement of financial position is $18 million.
Required:
Evaluate the audit risks to be considered in planning the audit of Ted Co.
Solution
Detection Risk: the auditor may not understand how the website functions which would limit his
ability to obtain sufficient evidence to ascertain the assertions on sales made through the
website. At 25% of the total revenue, the sales though the website is material to the statement
of profit or loss. In addition, it may be particularly difficult for the auditor to carry out control test
over the sales made through the website as this may require the use of software which the
auditor may not understand.
High risk of fraud: Website sales is susceptible to fraudulent order. Fraudulent order made
through websites may be captured in the revenue which cause it to be overstated.
Issues related to revenue recognition stated below constitute audit risk:
 The system may not properly apply cuff-off which means revenue may be wrongly
recognized. This may lead to overstatement or understatement of the revenue
 The treatment of income from license may be out of tune with the requirement of IFRS
15 revenue from contracts with customers. If the risks and rewards associated to the
license has been transferred to the purchaser, the Ted co must recognize all the
revenue in the year license was sold. In this case, deferring the income would have
understated Ted co’s revenue. If, however management of Ted co still retain control over

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the usage of the license through its involvement in the operation of the license, then, the
risk and rewards would not have been transferred. This means the revenue should be
spread over the period of the license to comply with IFRS 15 revenue from contracts
with customers. The risk here is that period of recognition may not be correct which may
either understate or overstate revenue.
Further questions:
Describe audit procedures regarding the revenue from the sales of license and State expected
audit evidences
IAS 10 Events after reporting period & subsequent events for auditor
A subsequent event is any event occurring after the date of the financial statement being
audited. It can either be classified as adjusting event or non-adjusting event according to IAS 10
Adjusting events
An event after the reporting period that provides further evidence of conditions that existed at
the end of the reporting period, including an event that indicates that the going concern
assumption in relation to the whole or part of the enterprise is not appropriate. An entity must
adjust the amount recognized in the financial statements to reflect the new information
discovered after year end.
Examples of adjusting events
 Going concern issue that arose after the year end

 Fraud discovered after the year end which indicate that the closing cash of other assets
are incorrect
 Sales of inventory at a value below cost of purchase after year end which gives
indication that closing inventory was impaired
 Inability of a customer to pay outstanding debt which existed at year end. This indicates
that the year-end receivable was impaired.
 Indication that an asset was impaired at reporting date
 Settlement of a court case that confirm existence of obligation at reporting date

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Non-adjusting events
An event after the reporting period that is indicative of a condition that arose after the end of the
reporting period. An entity shall not adjust the amount recognized in its financial statements in
respect of the non-adjusting events discovered after year end. However, the entity is required to
make adequate disclosure of the non-adjusting event in its financial statements if it is material.
The nature of the event and an estimate of its financial effect should be disclosed.
Examples of non-adjusting events
 Disposal or acquisition of major subsidiary after the year end

 Disposal of assets after year end
 Destruction of a major production plant or asset after year end
 Plan to discontinue major line of business initiated after the year end
 Major restructuring announced after year end
 Change in tax rate announced after year end
 Major litigation arising as a result of events that occur after year end.
Material non-adjusting events must be disclosed in the note- explaining the event and its
financial implication.
Auditor’s concern
The auditor needs to consider whether the events have been properly accounted for in
accordance with the requirements of IAS 10 Events after the reporting date
Audit risk with IAS 10
 Lack of disclosure or inadequate disclosure of non-adjusting events

 Non adjustment of necessary adjustments required for adjusting events as required by
IAS 10
Audit procedure to get evidence of subsequent events
 Discuss with management on the need to make adjustments for adjusting events
 Review any adjustments made in the financial statements to ensure adequacy

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 Review disclosure made in respect of non-adjusting events to ensure IAS 10 complied

with.
 For a sample of sales invoices immediately after the year end, compare invoice value
with purchase cost to get evidence of impairment.
 Review correspondences with client lawyer to get further information on pending cases
at year end.
 Enquire from management of any out-of-court settlement being negotiated
Audit procedures for restructuring cost discovered after the year end (Non-adjusting event)
 Verify that management has included a note disclosing this event in the financial
statements as required by IAS 10
 Agree the estimated cost of the restructuring to related calculations and supporting
documentation
 Review the details of the announcement made on the restructuring and agree the details
to the disclosures made in the financial statements.
 Review board’s minutes for details of the plan and verify that it has been approved by
the board
A fall in demand after year end is an adjusting event. This is because:
 It provides evidence about the valuation of the brand at the reporting date (the brand as
an intangible asset may be overvalued).
 The net realizable value of inventory may be less than cost
 The value of the brand may be impaired
Audit Evidence regarding fall in demand after year end
 Analytically review of sale against budget

 Board minute regarding any decision taken

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According to ISA 560, subsequent events (For auditors)

According to ISA 560, subsequent events divide into three periods as explained below:
Events occurring between date of the financial statement and the date of auditor’s report
In this period:
 The auditor has an active duty to perform procedures to identify any subsequent events.
 The auditor should perform procedures to identify events that might require adjustment
or disclosure in the year-end financial statements.
 The auditor should consider the impact on the audit reports and whether modification is
necessary to the audit report
Events occurring after the date of auditor’s report but before the financial statements are issued.
In this period:
 The auditor has a passive duty

 The auditor does not have a duty to search for evidence of events after reporting period.
If the auditor becomes aware of information which might have led him to give a different
audit opinion, he should disclose the matter to the directors. In addition, the following
actions should be taken by the auditor:
 The auditor should request that management amend the account to allow for the
subsequent event
 The auditor should review any amendment made by management
 The auditor should re-issue the audit report.
In the event that management fails to make adjustment to the account regarding the
subsequent event, the auditor should take the following steps:
 The auditor should take necessary step to prevent reliance on the report
 The auditor should speak about the event at the general meeting of members
 The auditor should seek for a legal advice
 The auditor should consider resigning from the engagement.

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Events discovered after the financial statements are issued

Auditors have no obligations to perform procedures after the financial statements have been
issued.
If the auditor becomes aware of a situation that if he had known at the date of the financial
statement would have caused the auditor to give alternative audit opinion, the auditor should
carry out the following procedures:
 Discuss the matter with management

 Discuss the need to amend the financial statements with management
On management’s revision of the financial statements, the auditor should carry out further
procedures as follows:
 Carry out further procedures on the amendments made

 Ensure management has taken necessary measure to prevent reliance on the previously
issued financial statements
 Issue new auditor’s report
Deferred tax
IAS 12 Requires that deferred tax is calculated at a rate of tax that is substantively enacted and
expected to apply to the period when the deferred tax is to be settled, it must have been passed
into law, not merely suggested or announced.
A deferred tax asset arising as a result of unused tax credit should only be recognized if and
only if, it is probable that there would be sufficient future taxable profit against which the tax
credit could be utilized. If the deferred tax asset can no longer be utilized, it should be written
off.
Audit concern
Check that the increase or decrease in provision will not be material to profit in order to explain
the implication for the audit
Audit Evidence to sought
 A copy of all the calculations made in relation to the tax balance

 Agreement of tax rate to tax legislation

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 Schedule of Non-current asset in tax calculations agreed to Non-Current Asset

registrar/ledger
 Minutes of directors’ meetings confirming detail of any major additions in Non-current
asset
Audit Procedures in Respect of Recoverability of Deferred Tax Assets.
 Check the arithmetical accuracy of deferred tax and corporate tax computations.
 Agree the figures used to any tax correspondence and financial statements.
 Obtain profitability forecasts and ensure there are enough forecast taxable profits for the
losses to be offset against.
 Evaluate the reasonableness of the assumptions used in the profitability forecast.
 Assess the length of time it will take to generate enough profits to offset the tax losses
and judge whether recognition of the asset should be restricted.
Implication of revaluation on deferred tax

Revaluation leads to temporary difference between carrying amount and tax base of the
revalued asset. Deferred tax should be recognised on the revaluation of property, plant and
Equipment. Deferred tax arising on the revaluation should be recorded in other comprehensive
income. This is because the situation that give rise to the deferred tax occur in other
comprehensive income
Audit concern
Deferred tax arising from revaluation may be wrongly recognized in the profit or loss statement
in which case the operating profit or loss will be overstated. Also, the treatment would go
against IAS 1 presentation.

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Related Party (IAS 24)

A related party is a person or entity that is related to the entity that is preparing its financial
statements.
(a) A person or a close member of that person’s family is related to a reporting entity if that
person:
(i) has control or joint control of the reporting entity;
(ii) has significant influence over the reporting entity; or
(iii) is a member of the key management personnel of the reporting entity or of a parent of the
reporting entity.
(b) An entity is related to a reporting entity if any of the following conditions applies:
(i) The entity and the reporting entity are members of the same group (which means that each
parent, subsidiary and fellow subsidiary is related to the others).
(ii) One entity is an associate or joint venture of the other entity (or an associate or joint venture
of a member of a group of which the other entity is a member).
(iii) Both entities are joint ventures of the same third party.
(iv) One entity is a joint venture of a third entity and the other entity is an associate of the third
entity.
(v) The entity is a post-employment benefit plan for the benefit of employees of either the
reporting entity or an entity related to the reporting entity. If the reporting entity is itself such a
plan, the sponsoring employers are also related to the reporting entity.
(vi) The entity is controlled or jointly controlled by a person identified in (a).
(vii) A person identified in (a)(i) has significant influence over the entity or is a member
A related party transaction is a transfer of resources, services or obligations between a reporting

entity and a related party
Why related party transaction difficult to identify
 Identification of related party transactions is unlikely to be captured by the internal
control system as the transactions may not have occurred in normal course of business.
 Management may not be aware of all related transactions.
 Related transactions may be intentionally concealed to commit fraud by management
Audit risks relating to related party transactions

 Likelihood of fraud which may cause material misstatement in the financial statements.
 Risks of disclosures not made or inadequate in line with IAS 24.

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 Risks of going concern problem emanating from related party transactions
Auditor’s objectives regarding related party transactions

Auditor need to develop understanding of related party transactions to be able to:
 Assess risks factors regarding related party transactions and relationships.
 Conclude whether the financial statements have been affected by related party
transactions and relationships.
 Obtain sufficient and appropriate audit evidence to be able to conclude whether related
party transactions and relationships have been appropriately identified, accounted and
adequately disclosed in line with IAS 24, related party transaction
Audit procedures on related party transactions

 Auditor should plan and perform the audit with high level of professional skepticism.
 Enquire of management if the company enter into any transactions with an identified
related party.
 Obtain management representation that all related party transactions have been
disclosed.
 Inspect the financial statement of the related party to confirm that the amount due is
recognized as either payable or receivable.
IFRS 11 – Joint Arrangements

The objective of this standard is to establish guidelines for financial reporting by entities that
have interest in a joint arrangement. The following definitions (as per IFRS 11) are key to
understanding this standard.
Joint arrangement: An arrangement of which two or more parties have joint control
Joint control: The contractually agreed sharing of control of an arrangement, which exists only
when decisions about the relevant activities require the unanimous consent of the parties
sharing control.
Joint operation: A joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement

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Joint venture: A joint arrangement whereby the parties that have joint control of the arrangement
have rights to the net assets of the arrangement
Types of joint arrangements

joint operation is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the assets, and obligations for the liabilities, relating to the
arrangement. Those parties are called joint operators. [IFRS 11:15]
A joint venture is a joint arrangement whereby the parties that have joint control of the
arrangement have rights to the net assets of the arrangement. Those parties are called joint
venturers. [IFRS 11:16]
Accounting for joint arrangement depends on the classification as explained below:
Joint operation: the following should be recognized in the financial statements of joint operator
according to relevant accounting standards
 its assets, including its share of any assets held jointly;

 its liabilities, including its share of any liabilities incurred jointly;
 its revenue from the sale of its share of the output of the joint operation;
 its share of the revenue from the sale of the output by the joint operation; and
 its expenses, including its share of any expenses incurred jointly.
Joint venture: A joint venturer recognises its interest in a joint venture as an investment and
shall account for that investment using the equity method in accordance with IAS 28
Investments in Associates and Joint Ventures unless the entity is exempted from applying the
equity method as specified in that standard. [IFRS 11:24]
Notes:
 if a party with interest in joint venture lacks joint control, then, its interest should be
accounted for as ordinary investment under IFRS 9 unless it has significant influence
over the joint venture, in which case it accounts for it in accordance with IAS 28.
 Interest in in a joint venture is determined solely on existing ownership interest. Possible
exercise of potential voting rights is not considered in establishing joint control.
 In most cases, a separate legal entity with joint control is classified as joint venture
 If the company does not have the power to appoint an equal number of board members
in order to make joint decisions, then the investment cannot be treated as joint venture.

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Principal Audit Procedure on IFRS 11: Joint Venture
 Review joint operating agreement to establish percentage of contribution required from

joint operators
 Assess the contribution made by the client to the joint operation to confirm it is in line
with agreement
 Obtain lists of assets contributed to the joint operation and confirm they are recognized
in the asset register of the client
 Recalculate the revenue from the joint operation using agreed percentage to confirm
correctness
 Review the contractual terms of the arrangement to ensure proper classification as joint
operation
Principal Audit Procedure on IFRS 11: Joint Venture
 Read the minutes of the board meetings to confirm the approval of the investment and
understand the structure of the investment.
 Review the minutes of meetings between the two companies involved in the joint venture
to establish that control is equally between them.
 Review the list of directors of the joint venture company to establish the companies are
equally represented on the board.
 Review the legal document from the joint venture to establish number of shares
purchased and assessed if this amount to joint control.
 Read legal document to establish how profit is shared.
 Read legal document to establish voting right attached to shares.

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IFRS 13 Fair value measurement

The fair value of an asset or a liability is the price that would be received to sell an asset or paid
to transfer a liability in an orderly transaction between market participants at the measurement
date.
According to IFRS 13 fair value measurement entity should follow the following hierarchy in
order to determine the fair value of an asset:
 Quoted prices in an active market for identical assets or liability that the reporting entity
can assess at the measurement date.
 Quoted price for similar asset in active markets or for identical or similar assets in non-
active markets.
 Using the entity’s own assumptions about market exit value.
Audit Risk associated with IFRS13

In a situation where the market is illiquid, it will be difficult to apply fair value because of
unavailability of information. This constitutes area of great audit risk.
Audit risks associated with the application of IFRS 13 will be grouped as follows:
INHERENT RISK
 Measurements of fair value are subjective in nature because they generally involve
making estimates based on a number of assumptions, management may not be
sufficiently experienced or skilled to make these assumptions
 Deliberate manipulation by management in order to obtain a favorable figure for fair
value in the financial statement making them inherently more difficult to audit
 The estimates of fair value involve complex calculations making them inherently difficult
as the likelihood of an error is higher in complex calculations.
CONTROL RISK
Making estimate for fair value is likely to fall outside the system of controls set up by the entity to
deal with regular transactions since they are likely to take place once in a year.
DETECTION RISK
There is risk that the audit team may lack the knowledge to make assessment of the fair value
measurement and may rely too heavily on the work of auditor’s expert.

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IAS 16 Non-current asset

According to IASB framework, an asset is a resource controlled by an entity as a result of past
events and from which future economic benefits are expected to flow to the entity.
For an asset to be recognized in the financial statement, it must be probable that the economic
benefit associated with the asset will flow to the entity and the cost can be measured reliably.
Initial recognition
Recognized Asset should be initially measured at cost. The cost of an asset includes the
followings:
 Purchase price minus any trade discount

 Directly attributable cost. This includes:
Cost of bringing the asset to its location in its workable condition
Cost of testing the asset (pre-production test)
 Initial estimate of the costs of dismantling and removing the asset and restoring the site
on which it is located.
Measurement subsequent to initial recognition

After the initial recognition, an entity may adopt any of the following recognition models:
 Cost model. This refers to the cost of asset minus the accumulated depreciation
 Revaluation model. This refers to the fair value of the asset minus subsequent
accumulated depreciation and impairment losses. The revaluation model can only be
used if the fair value of the asset can be measured reliably.
NOTE
IAS 16: Requires that each part of an item of PPE with a cost which is significant compared to
the total cost of the item must be depreciated separately. Failure to follow IAS 16 in this regard
could lead to misstatement of the book value of the asset and depreciation expenses.
IAS 16 Property, plant & equipment requires all assets in the same class to be revalued. The
standard also requires disclosure of the revaluation policy of the entity.

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According to IAS 16:
 assets should be recognized at cost and depreciated over their useful Economic lives.
 If asset is revalued, the excess of the revalued amount over the carrying amount should
go to revaluation reserve in the equity
 If revalued asset is disposed, the balance on the revaluation reserve should be
recognized as income in the statement of changes in equity and should not be
recognized as current profit
Audit risks relating to IAS 16
Cost of assets not correctly calculated (only directly attributable costs of bringing the
asset to its useable condition should be added net of any trade discount)
Trade discount is not removed from recognised cost which over-state the value of asset
Use of wrong depreciation rate which does not reflect consumption pattern
Revaluation gain may be wrongly recognised as realized profit which over-state the
profit
Depreciation of revalued asset is not adjusted to new useful life revealed after
revaluation
Newly acquired assets may be omitted from the asset register which lead to
understatement of assets and depreciation
Assets disposed during the period are not removed from the asset register which lead to
over-depreciation and over statement of asset in the financial statement. Over-
depreciation leads to understatement of profits
Training costs may be wrongly capitalized. Training costs, according to IAS 16 should
be expensed as it does not meet recognition criteria.
Audit procedures regarding PLANT PROPERTY AND EQUIPMENTS
 Take a sample of assets from the asset register and trace to physical location to confirm
existence
 Take a sample of assets from physical location and trace to assets register to confirm
completeness.
 Inspect purchase invoices to confirm the cost of assets and the dates on the invoice
should confirm the cut-off is proper.

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 Recalculate the depreciation to confirm valuation of assets

 Check consistency of the depreciation policy by comparing the current rate with prior
years.
 Check to confirm any disposed asset has been removed from the asset register and
ledger properly updated
Dismantling costs
Dismantling costs should be capitalized as non-current assets, and a provision created against
them.
Audit risks in respect of dismantling cost:
 Provision may not have been created which understate liabilities

 Asset and Liabilities might have been understated
 The provisions may not have been measured correctly according to IAS
37,provisions,contigent liabilities and contingent assets
Note: Account should be taken care of the effect of discounting if it is material to the account,
and should be included in the statement of profit or loss to represent the unwinding of the
discount.
Audit procedures in respect of the carrying amount of Plant, Property and equipment (PPE)
under construction
 Verify cost of the PPE by reviewing the contract with the contractor
 Agree cost of the PPE to invoice
 Inspect the asset at year end to assess the stage of completion. Use this to confirm the
reasonableness of the management’s expert report
 Review the management’s expert report concerning stage of completion at the end of
reporting period and estimate cost of completion
 Agree finance cost to the terms of the finance contract and payment made
 Recalculate capitalized amount to ensure accuracy
 Review the basis of capitalization to ensures it agrees with IAS 16
 Discuss with management on the consideration of possible impairment

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IAS 23 Borrowing Cost

Borrowing Cost
Borrowing costs are ‘interest and other costs that an entity incurs in connection with the
borrowing of funds. It includes exchange differences arising from foreign currency borrowings to
the extent that they are regarded as an adjustment to interest costs.
as an adjustment to interest costs.
Qualifying Asset
A qualifying asset is one which takes a substantial period of time before being made available to
use or dispose. For assets that meet this definition, borrowing cost would be capitalized. Assets
that are ready for their intended use or sale are not qualifying assets
Audit risks
 Interest costs on asset that is ready for its intended use may be wrongly capitalized. This
would over state asset and under state expenses or over state profits
 Interest costs on a non-qualifying assets may be wrongly capitalized
Audit evidence
 A copy of loan agreement to establish interest rate

 Copies of invoices showing expenses incurred on the qualifying assets
 Copy of schedule showing recalculation of interest costs capitalised
Audit procedures
 Inspect copy of the loan agreement to confirm the interest rate used is correct
 Confirm interest payment to cashbook and bank statement
 Physically inspect the asset for existence and to confirm it is still under construction
 Recalculate the capitalised borrowing costs to confirm its correctness

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IFRS 16 Leases
Classification and recognition of leased asset
A leasee must recognize a right-to-use an asset and record a corresponding lease liability for all
leases of more than 12 months provided the asset is not of low value (below $5,000).
Interest on the lease liability should be recognized as a finance charge in the statement of profit
or loss.
Depreciation
Leased asset should be depreciated over the shorter of the lease term and the useful life of the
asset.
Presentation and disclosure

The lease liability should be separated into current and non-current liabilities. The following
disclosures should be made:
 Total amount outstanding on the lease
 An analysis showing timing of the cash outflows relating to the leased asset
Audit risks
 Non-lease component of the lease may be wrongly recognized as part of the lease
 Right of use asset may be wrongly estimated
 Use of wrong discount rate in calculating present value of lease payments
 Wrong classification of lease liabilities between current and non-current
Audit Evidences
 Copy of the note Confirming that adequate disclosure was made in the account
 Copy of schedule showing how lease obligation and write of se asset were derived
 A copy of the lease agreement to assess the terms and condition and also confirm the
period of the lease
 Copy of recalculation carried out on the finance charge relating to the leased asset
 Copy of the bank statement and cashbook showing lease payment

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Audit procedures
 Recalculate the depreciation charge to confirm accuracy
 Assess the lease contract agreement to confirm the lease term
 Confirm lease payments to the bank statements and cashbook
 Assess adequacy of information disclosed about the leased asset as required by IFRS
16
 Recalculate interest on lease liability to confirm accuracy
 Physically inspect the leased asset to confirm existence
Sale and Lease back

According to IFRS 16 leases, sales and lease back transaction depends on whether control of
the assets was transferred or retained by the seller. Where substantially the asset’s remaining
benefits was not passed to the buyer, it means the seller still retains control of the asset and
must continue to recognize and depreciate it.
Example
Adder Group (Adapted)
In December 2014, a leisure centre complex was sold for proceeds equivalent to its fair value of
$35 million, the related assets have been derecognised from the Group statement of financial
position, and a profit on disposal of $8 million is included in the Group statement of profit or loss
for the year. The remaining useful life of the leisure centre complex was 21 years at the date of
disposal. Adder Group is leasing back the leisure centre complex to use in its ongoing
operations, paying rentals annually in arrears. At the end of the 20-year lease arrangement, the
Group has the option to repurchase the leisure centre complex for its market value at that time.
The Group’s draft consolidated financial statements recognise total assets of $150 million, and
profit before tax of $20 million for the year ended 31 March 2015.
Required:
In respect of the issues described above:
Comment on the matters to be considered, and explain the audit evidence you
should expect to find in your review of the audit working papers.

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Solution
Materiality
Sales proceed 35M
Profit (8M)
Carrying amount 27M
27/150*100= 18% of the group’s total recognized asset. This means that the deionized asset is
material to the group’s statement of financial position.
8/20*100 = 40% of the group’s profit recognized. This means that the profit wrongly recognized
is material to the group’s profit and loss statement.
Given that Adder group will be using the asset for majority of its useful life (20 years), it must
continue to recognize and depreciate the asset since control was not passed to the buyer. The
following corrections would be required:
 As the asset was not depreciated for the remaining four months in the year, $0.45 million
should be debited to profit or loss statement (27/20*4/12 = 0.45M).
 As the group’s asset was understated by the carrying amount of the derecognized asset,
it is necessary that $26.55 million is recognized as asset (27-0.45)
 Liability of the group has been understated by $35 million being the proceeds of the
disposal. There is need to record a liability equal in amount to the cash of $35M
collected.
 In substance, the transaction is a secured loan and there is need to recognize finance
charge spread throughout the 20 years.
If the above adjustments are not made, the auditor’s opinion will be modified as the
company would have disobey
Evidence Required of the auditor
 Review of the agreement signed by the two parties to confirm that Adder group
retains control of the asset through continue use
 Evidence of physical inspection of the asset to confirm that Adder group continue to
use it for business purpose
 Confirmation of the $35 M in the bank statement and cash book
 Confirmation of the fair value of the asset through review of expert’s report
 Minutes of board meeting to confirm sale of the asset and the amount

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 Copies of insurance documents to establish that Adder group is responsible for the
insurance
 Recalculation of the depreciation charge
 Recalculation of the finance charge
 Discussion with management on the need to recognize finance charge
 Copies of re-drafted financial statements to confirm adequate adjustment was carried
out
SETTER STORES
A sale and leaseback arrangement involving a large property complex was entered into on 31
January 2013. The property complex is a large warehousing facility, which was sold for $37
million, its fair value at the date of the disposal. The facility had a carrying value at that date of
$27 million. The only accounting entry recognised in respect of the proceeds raised was to
record the cash received and recognise a noncurrent liability classified as ‘Lease obligations’.
The lease term is for 8 years, while the remaining useful life of the property complex was 20
years. The present value of the annual lease payments is $16 million.
Solution
Materiality:
Carrying value of asset sold: 27/300*100 = 9% material to the statement of financial position
Fair value of assets: 37/300*100 = 12.3% material to the statement of financial position
Right-of-use of asset: 16/37*27 = 11.68. net overstatement of asset = (27-11.68)/300*100 =
5.1% material to the statement of financial position.
According to IFRS 16 leases, if the buyer owns substantial benefits of the asset, sale would
have been made and the asset should be derecognized by the seller. However, in this case
right-of-use of asset should be recognized on plant property and equipment. Also depreciation
should be calculated on the right-of-use of asset over 8 years.

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The present value of the annual payments which in this case is $16 million should be
recognized as liability. Interest should be calculated on this liability and recognized in the profit
or loss statement.
Since sales has taken place, profit or loss should be calculated and recognized in the profit or
loss statement as: (27-11.7)/27*(37-27) = $5.7 million.
The asset of the company was overstated by $27 million while it was understated by $11.7
million to give net overstatement of 27-11.7 = $15.3 million. This is a material amount as
calculated above and should be adjusted for. The auditor should consider modifying his opinion
should the company failed to make necessary adjustment
Audit Evidence
 A copy of the lease agreement signed by both parties to ascertain the terms
 Copy of valuation report to confirm the fair value of the property
 Copy of auditor’s expert report to confirm the fair value of the property
 Recalculation of the present value of the lease payments to confirm arithmetic accuracy
 Agreement of cash of $37 million received to bank statement and cash book to confirm
receipt.
 Copy of draft account to confirm the necessary adjustment have been made
 Physical inspection of the property to ascertain setter stores co is actually using it.
 Copies of correspondences with the buyer to establish if there are any changes in the
terms of the contract.
IAS 19, Employee benefit

Employee benefits include all forms of payments given by an entity to employees in exchange
for services rendered or for the termination of employment. Employee benefit can either be
short term or long term.
Short term benefits include basic salary, bonus and other short term benefits. In accounting for
short term benefits, we debit the profit or loss statement and credit cash (or credit liability if the
benefit is yet to be settled with cash).
Long term benefit includes payment with shares which is dealt with by IFRS2, share based
payment and pension payments.

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A pension payment refers to the money that would be paid to employees at the end of their
employment contract. There are two types of pension plan considered by IAS19 the defined
contribution and defined benefit plan.
DEFINED CONTRIBUTION PLAN

Defined contribution scheme means the money put into trustee in each month is defined or
fixed. The entity pays fixed contributions into a fund and does not have an obligation to pay
further contributions if the fund does not hold sufficient assets. When the employee has
rendered the service, the entity will debit the profit or loss statement and credit cash (or credit
liability if cash is yet to be paid).
Audit risks relating to defined contribution plan
Correct amount of pension expense may not be recognized in the profit or loss
statement by the entity which will lead to overstatement of profit.
Employees who have cease to be employee may not have been removed from the
scheme which may lead to over-provision of pension expenses and thus overstate
liability and understate profit.
The defined pension contribution may be misclassified as defined contribution plan
which may leads to wrong presentation in the financial statements.
Audit procedures relating to defined contribution plan
Analytically compare the pension expense recognized in the profit or loss statement for
the current year with prior year to expose any unexpected fluctuation.
Review the terms of the pension contract to ensure proper classification.
Inspect the pension contract documentation to determine the amount of the contribution
required from the entity.
Obtain the number of employees in the scheme and recalculate the pension expense to
ensure the amount recognized is correct.
Obtain list of employees who have cease to be employee and ensure that they have
been removed from the scheme.

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DEFINED BENEFIT PLAN

These are post-employment plans other than defined contribution plans. In this plan, the final
benefit is defined at the time of signing the contract. But the monetary value of the benefit
cannot be precisely determined at the time of signing the contract because of the time value of
money.
Disclosures requires in the financial statements

Assets
Opening balance X1
Return on asset (disc rate x X1) X Debit asset : Credit income
Contribution into asset X Debit asset : credit Cash
Benefit paid (X) Credit asset : debit liability
Expected closing amount XX1
Re-measurement component (XX2-XX1) xx Recognize in other comprehensive income
Fair value of asset at year end (actuarial) XX2
Liability
Opening balance X1
Finance cost (discount Rate x X1) X Debit P & L : Credit Liability
Service cost X Debit P & L : Credit Liability
Benefit paid (X) Debit Liability : Credit Asset
Expected closing balance XX1
Re-measurement component (XX2-XX1) xx Recognized in other comprehensive income
Fair value of liability at year end XX2
Audit risks relating to defined benefit plan
Use of wrong discount rate to calculate return on pension asset which lead to overstating
of assets
The effect of Past service costs may be ignored which lead to understating of liabilities

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New employees joining the scheme may be wrongly omitted from calculation of liabilities
which understate the liabilities.
The auditor may lack knowledge of estimating the fairs values of pension asset and
liabilities which increases the detection risks
Auditor may have to depends on the knowledge of experts because of the complex
actuarial calculation involved in the deriving the fair values of pension asset and
liabilities which increase the detection risks
Benefit paid may not be removed from the pension asset and liability thereby overstating
both assets and liabilities
Re-measurement components may be wrongly recognised in the operating profit instead
of recognizing it in the other comprehensive income thereby overstating the operating
profit
IAS 20 Government Grant

IAS 20 Accounting for Government Grants and disclosure of Government Assistance requires
that the Grant income is matched to the cost it is intended to compensate for. The standard
requires that a grant is recognized as income over the period necessary to match the grant
received with related cost it is meant to ameliorate.
Audit risks
Just as we systematically allocate the cost of a non-current asset over the useful life in line with
the matching concept, IAS 20 requires that Govt. grant should be recognized as deferred
income in the statement of financial position. There is risk that this may not be done leading to
liabilities being understated and profit being overstated.
IAS 20 requires that a grant is recognized only when there is Reasonable assurance that the
company will meet the condition attached to the grant. Where there is doubt over this, a
provision should be recognised in line with IAS 37. There is risk that this will not be done
thereby understating liabilities and overstating profits.

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Audit Procedures on the receipt of Government Grant
 Obtain the grant document and review the terms to verify the amount of grant.
 Determine the period the grant covered by reviewing the grant document to ensure the
grant income is correctly spread.
 Revision of the terms and condition attached from the grant document to determine the
consequence of any breach on terms.
 Review correspondences with relevant government agencies to determine if there has
been any breach of terms.
 Obtain representation from management that the condition of the grant will be met.
IAS 21 Effects of Changes in Foreign Exchange Rates

Presentation currency- is the currency in which the financial statements are presented
Functional currency- is the currency of the primary economic environment in which the entity
operates. It is the currency in which the entity normally generates and spends cash, and that in
which transactions are normally denominated. All transactions in currencies other than the
functional currency are treated as transactions in foreign currencies
Monetary and non-monetary items

Monetary items- Items that will be received in a fixed or determinable amount of cash or Items
that will be paid out in a fixed or determinable amount of cash. It includes the followings:
 Cash
 Cash equivalents
 Debt securities
 Account receivables
 Account payables
 Loan notes payables
 Lease payables
 Accruals
 Deferred tax

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Non-monetary items- Items that will not be received in a fixed or determinable amount of cash.
Also described as items that will not be paid out in a fixed or determinable amount of cash. It
includes the followings:
 Inventory
 Prepaid expenses
 Equity securities
 Investment properties
 Property, plant and equipment
 Intangible assets
 Deferred income
 Government grant
Treatments of monetary and non-monetary items

 Monetary items should be re-translated at the year-end using the closing rate.
 Non-monetary items measured at historical cost should be reported using the exchange
rate at the date of the transaction.
 Non-monetary items carried at fair value should be reported at the rate that existed when
the fair values were determined.
Recording transactios and subsequent measurements

Foreign currency transactions should initially be recorded at the spot rate of exchange at the
date of the transaction
Exchange gain and losses

 Exchange differences arising on monetary items are reported in profit or loss in the
period
 Exchange differences arising on monetary items that form part of the reporting entity’s
net investment in a foreign operation are recognised in the group financial statements,
within a separate component of equity. They are reclassified to profit or loss on disposal
of the net investment
 If gain or loss on revaluation of non-monetary item is recognized in profit or loss, any
foreign exchange gain or loss element is also recognised in profit or loss
 If gain or loss on revaluation of non-monetary item is recognized in equity, any foreign
exchange gain or loss element is also recognised in other comprehensive income

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Audit risks
Companies that transact across borders are likely to be transacting in in foreign currencies. The
audit of such companies have the following risks to look out for:
 Transactions may not be re-translated to the functional currency at the date the
transaction occurred which may lead to either understatement or overstatement of the
amount involved.
 Monetary items like payable and receivable figures may not be re-translated at year end
closing rate which may lead to over/under statement of assets and liabilities
 Non-monetary items may be wrongly translated at closing rate instead of transaction
date
 Recognition of exchange gain or loss on non-monetary items may not be consistent with
recognition of gain or loss on the item
Audit procedures
 Review sample of transactions conducted in foreign currency and confirm they are
translated using spot exchange rate at the date of transactions
 Enquire from management how it obtains currency exchange rate and confir its
authenticity
 Recalculate translated transactions using appropriate rate and check it conforms with
management’s figures
 Review draft financial statements to confirm that monetary items are retranslated using
closing rate
 Confirm that closing exchange rate used is in conformity with prevailing official exchange
rate

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IAS 37 Provisions and Contingencies

IAS 37 requires that a company set up a provision where there is a present obligation as a
result of past event from which it is probable that a transfer of economic benefit will be required
to settle the obligation and reliable estimate can be made.
In a situation where the future payment is only possible but not probable, no provision is
required but there should be adequate disclosure in the notes to the account. This is called
contingent liability.
Examples of cases where provision may be required include:
 Warranty cost on products already sold

 Legal case brought against the company, the outcome of which may turn out
unfavourable
 Breach of law and regulation which may likely lead to fines and compensation
 Obligation to decommission a site after use
Audit risks here include:
 Not making adequate provision leading to understatement of liabilities and

overstatement of profits
 Not making provision when it is required leading to understatement of liabilities and
overstatement of profits
 Contingent liability may not be disclosed
Audit procedures:
 Discuss with management on the need to make provision

 Discuss with management on the suitability of the method used to arrive at the provision
 Assess the reasonability of management’s method of making the provision
 Review notes to the account to assess the adequacy of disclosures
 Inspect Correspondence with the other parties involved to assess the likelihood of any
claim being successful
 obtain direct confirmation from company’s lawyer to assess the probability of any
pending claim being successful
 analytically compare current’s year provision with that of prior years, obtain explanation
for any unexpected result

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Note the following specific cases:
 No provision should be made in respect of future spending on a damaged property that

has adequate insurance cover.
 No provision should be made for an intention to incur expenses in the future. Mere
intention does not create present obligation from past event.
 No provision is required for expected future changes in tax rate. This does not create
present obligation as a result of past event because the tax rate will be applicable in the
year of the change
Note: A provision for restructuring costs (e.g. the closure of a business segment) should only
be recognized if a formal plan had been in place and there has been a public announcement
regarding the plan. If these conditions are not satisfied, the plan should only be disclosed in the
note to the account as a non-adjusting event in line with IAS 10 Events after reporting period
IAS 38 Intangible asset

Intangible assets are business resources that have no physical form, items that cannot be seen
nor touched but capable of been used to generate economic benefits.
Research and development cost

Research cost should be written off as an expense as they are incurred.
Development costs may qualify for recognition as intangible assets provided the following
criteria are met:
 There is technical feasibility of completing the intangible asset

 There is management commitment to complete the intangible asset
 The entity has the ability to use or sell it
 It is probable the asset will generate future economic benefits
 The expenditure attributable to the intangible asset can be measured reliably
Audit procedure in respect of research and development cost
 Inspect Board Minutes to assess company’s commitment to complete the project.

 Inspect results of the entity’s market research to assess future marketability of the
product.
 Assess the capitalized cost to be sure they meet the recognizing criteria

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 Obtain direct confirmation from the entity’s bank to confirm availability of finance to
complete the asset
 Obtain written management’s representation to confirm commitment.
 Assess the result of any test carried out on the asset to confirm the technical feasibility
of the asset
 Agree period of capitalization correct by reference to date of completion of the capital
project to be sure capitalization is in line with IAS 38
 Agree finance cost to loan contracts - interest rate should be agreed to finance
agreements, recalculation of the finance charge should be carried out.
Purchased intangible assets

The following recognition criteria must be met before an intangible asset can be recognized in
the financial statements:
 it must be probable that the company will gain future economic benefit attributable to the
asset
 The cost of the asset must be capable of being measured reliably.
If an item does not meet both the definition of intangible asset and recognition criteria given
above, the expenditure on such item should be recognized as expense in the period. IAS 38
Intangible Assets requires that amortization method should reflect the pattern of benefits. If the
pattern of benefit cannot be reliably determined, straight method should be adopted.
Audit risk with intangible assets
 The asset may be wrongly amortized when the asset is yet to be ready for operation in
the manner intended by management.
 Inappropriate estimation of useful life would lead to understatement or overstatement of
profit & carrying amount of the intangible assets.
 If there is an indication of impairment, management is required to compare the
recoverable and the carrying amount to ascertain if there is impairment.
 Before an asset can be recognized an intangible asset, the entity must have gained
control over the use of the asset. I.e. the risk and reward must have been transferred to
the entity.

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Audit Procedure for Capitalized cost
 Agree classification between revenue and capital expenditure.

 Check that staff training cost is not capitalized.
 Obtain a written representation from management to confirm that there is no indication of
impairment regarding the intangible assets.
 Review the cash flow forecasts prepared by management to confirm the intangible
assets are capable of generating profit.
 Review any contract of sales generated from the intangible assets to confirm the
amortization started at the appropriate time.
 Confirm that the intangible asset was brought to use in the year the amortization begins
 Recalculate the amortization charge to ensure it is correctly calculated.
 Obtain any agreement in respect of the intangible assets to establish the useful years.
 Agree costs to cash book and bank statement to establish correctness of amount
capitalised
The following specific cases should be noted:
 Intangible asset (e.g. operating license) granted at no cost can be recognized at its fair
value if the fair value can be correctly measured.
 If there is a legal or constructive obligation to dismantle an asset after its useful life,
provision should be made and should be included in the cost of the asset.
 Internally generated goodwill should not be recognised

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SETTER STORES
The statement of financial position includes an intangible asset of $15 million, which is the cost
of a distribution licence acquired on 1 September 2012. The licence gives Setter Stores Co the
exclusive right to distribute a popular branded soft drink in its stores for a period of five years.
Solution
Matter to consider
Materiality
15/300*100 = 5% material to the statement of financial position.
An intangible asset can only be recognized in the financial statement according to IAS 38 if the
following conditions are met:
 It is probable that future economic benefit associated with the intangible asset will flow to
the organization. It is important for management of setter store to prove that the
economic benefit will be derived from the distribution license.
 The cost of intangible asset can be reliably measured.
The cost of the distribution license should be amortised over its useful life of 5 years.
Amortisaton should start from 1 September 2012. This means amortization should be charged
for 5 months to the year ended 31 January 203 as 15/5*5/12 = $1.25 million. This means asset
has been overstated as $15 million was recognized in the financial statement instead of 13.75
(15-1.25). however, this amount is not material to the statement of financial position at 0.4% of
total asset and 2.6% of the profit after tax.
Audit Evidence
 A copy of the purchase document to confirm the cost and the 5 year term of the license
 Confirmation of the amount paid in the bank statement and cashbook.
 Copy of sales forecast to confirm the future economic benefit of the license
 Minutes of meeting with management regarding the necessary changes needed in the
account regarding amortization of the license.

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Impairment
Impairment refers to a fall in the value of an asset. An asset is impaired when the recoverable
amount of such asset is less than its carrying amount.
If an asset is impaired, the value of the asset as recognized in the financial statement should be
reduced by the value of the impairment. The amount of the impairment should be debited to the
statement of profit or loss to reduce the profit.
Indicators of impairment
 Fall in market value of the asset.

 Technological change that may restrict the use of the asset by the entity.
 Evidence of obsolescence or physical damage of the asset
Specific procedures on impairment
 Assess whether an impairment review has been undertaken by management

 Review the impairment test carried out by the directors
 Obtain written representation that the estimate of the useful life is valid
 Review board minutes for any major decision regarding the intangible asset
 Assess the present value of future cash flows associated with the asset and compare
with carrying value.
 Inspect board minutes to see any evidence of change in operation plan that may render
some asset obsolete

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IAS 33 Earnings per share

IAS 33 requires disclosure of earning per share figure. Both basics EPS and diluted EPS should
be disclosed. Non-disclosure will always amount to a material misstatement. This is because
the earnings per share figure are material by nature.
If there is Non-disclosure of the earnings per share figure in the financial statement, the
auditor’s report will need to be modified.
Audit procedures
 Recalculate both the basic and diluted EPS figures

 Ensure adequate disclosure of the EPS figures in the financial statement
 Recalculate any prior year adjustment of EPS figures and access adequate disclosure to
this effect in the current year financial statements
IAS 41 Agriculture
Agricultural activity – This involves the management of the transformation of a biological asset
for sale into agricultural produce or another biological asset.
Biological asset – This includes living animal or plant.
Agricultural produce – This includes harvested produce of the entity’s biological assets.
Biological transformation – This involves the process of growth, degeneration, production, and
procreation that cause an increase in the value or quantity of the biological asset.
Recognition
Biological assets or agricultural produce are recognised when the following conditions are met:
Entity controls the asset as a result of a past event.

It is probable that future economic benefit will flow to the entity.
Fair value or cost of the asset can be measurement reliably.
Initial measurements of biological assets

Biological asset should initially be recognised at fair value less estimated point-of-sale costs
except where fair value cannot be reliably estimated. In a situation where there is no reliable
measurement of fair value, biological assets are stated at cost.

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Subsequent measurements of biological assets

Biological asset should be subsequently measured at fair value less estimated point-of-sale
costs except where fair value cannot be estimated reliably. If there is no reliable measurement
of fair value, biological assets are stated at cost less accumulated depreciation and
accumulated impairment losses.
Measurement of agricultural produce

Produce harvested from biological assets is measured at fair value less costs to sell at the point
of harvest. After produce has been harvested, it becomes an item of inventory (IAS 2) which
means IAS 41 ceases to apply. The initial measurement will be taken as the cost at the date
when applying IAS 2 Inventory.
Fair Value Gains and Losses to Be Recognised in the Profit or Loss Statement
The gain or loss on initial recognition of biological asset which is the difference between the
opening value and the closing value at the year-end is included in profit or loss in the period in
which it arises. Subsequent change in fair value is included in profit or loss in the period it
arises.
The gain or loss on initial recognition of agricultural produce is included in profit or loss in the
period in which it arises.
Audit risks
 Fair value used may be wrongly estimated which may overstate assets or profit.
Getting fair value may be particularly difficult in situation where the asset is not
traded on established market.
 Wrong application of IAS 41 to non-agricultural assets (see section below).
 Risk of making inadequate disclosure
Assets outside the scope of IAS 41

Land related to agricultural activity (IAS 16 Property, Plant and Equipment and IAS 40
Investment Property are applicable).
Intangible assets related to agricultural activity (IAS 38 Intangible Assets is applicable).
Bearer plants related to agricultural activity (IAS 16 Property, Plant and Equipment is applicable)

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Government grants relating to biological assets

If a government grant relating to a biological asset is measured at its cost less accumulated
depreciation or accumulated impairment losses, it will be accounted for under IAS 20
Accounting for Government Grants.
If a government grant relates to biological assets and it is measured at fair value less costs to
sell, it will be accounted for under IAS 41 Agriculture depending on if it is conditional or
unconditional
Unconditional government grant
An unconditional government grant related to a biological asset measured at fair value less
estimated point-of-sale costs is recognised as income when, and only when, the government
grant becomes receivable.
Conditional government grant
A conditional government grant, including a situation where a government grant requires an
entity not to engage in specified agricultural activity, is recognised as income only when the
conditions of the grant are met. If the situation is such that the entity is entitled to part of the
grant after meeting part of the condition, then part of the grant relating to the condition satisfied
should be recognised as income.
IAS 40 Investment Property

Investment property is property (land or a building or part of a building or both) held (by the
owner or by the lessee under a finance lease) to earn rentals or for capital appreciation or both.
Investment property includes the following:
Land held for long-term capital appreciation.

Land held for a currently undetermined future use. This should be regarded as held for
capital appreciation
Building leased out under an operating lease.
Vacant building held to be leased out under an operating lease.
Property that is being constructed or developed for future use as investment property.

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Investment property excludes the following:
Property held for use in the production or supply of goods or services or for
administrative purposes (IAS 16 Property, Plant and Equipment applies).
Property held for sale in the ordinary course of business or in the process of construction
or development for such sale (IAS 2 Inventories applies).
Property being constructed or developed on behalf of third parties (IAS 11 Construction
Contracts applies).
Owner-occupied property (IAS 16 applies).
Property leased to another entity under a finance lease (IAS 17 applies).
Recognition
Investment property should be recognised as an asset when it is probable that the future
economic benefits that are associated with the property will flow to the entity, and the cost of the
property can be reliably measured.
Initial measurement
Investment property is initially measured at cost, including transaction costs. Such cost should
not include the following:
Start-up costs.
Abnormal waste or initial operating losses incurred before the investment property
achieves the planned level of occupancy.
Subsequent measurement
An entity can choose between the fair value and the cost model. The accounting policy choice
must be applied to all investment property. Change of policy is permitted only if this results in a
more appropriate presentation. IAS 40 notes that this is highly unlikely for a change from a fair
value model to a cost model.
Fair value model

Investment properties are measured at fair value, which is the price that would be received to
sell the investment property in an orderly transaction between market participants at the
measurement date. Gains or losses arising from changes in the fair value of investment
property should be recognized in the statement of profit or loss for the period in which it arises

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Cost model
Under this model, investment property is measured in accordance with requirements set out for
that model in IAS 16, plant property and equipment (cost less accumulated depreciation and
less accumulated impairment losses).
Partial own use
If the owner uses part of the property for its own use, and part to earn rentals or for capital
appreciation, and the portions can be sold or leased out separately, they are accounted for
separately. Therefore, the part that is rented out is investment property. If the portions cannot be
sold or leased out separately, the property is investment property only if the owner-occupied
portion is insignificant
Inter-company rentals
Property rented to a parent, subsidiary, or fellow subsidiary is not investment property in
consolidated financial statements that include both the lessor and the lessee, because the
property is owner-occupied from the perspective of the group. Such property will be investment
property in the separate financial statements of the lessor, if the definition of investment
property is otherwise met.
Audit risks relating to investment properties

Use of wrong fair value which may lead to over or understatement of assets and profits.
Recognition of owner occupied property as investments property leading to under or
overstatement of profit.
Use of wrong depreciation rate
Non removal of disposed investment properties from the financial statement
Inclusion of pre-acquisition costs in the value of investment property
Revaluation gain or loss may be recognized in comprehensive income instead of profit
or loss statement
Audit procedures
 Physically inspect the investment properties to ensure existence

 Agree costs of the investments properties to bank statements or cashbook
 For investment property carried at cost models, recalculate the depreciation charge

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 Discuss with management the purpose for which the asset is held and decide if it meet
definition of investment property according to IAS 40
 Review the criteria used by the entity to classify asset as investment property to
determine if it conforms to IAS 40 investment property
 For investment properties recognized at fair value, discuss with management how fair
was determined and assess for reasonability
 Obtain list of disposed investment properties and trace to the ledger to be sure they
have been derecognized
 Obtain list of newly acquired investment properties and trace to the ledger to be sure
they are all captured
IFRS 2 Share based payment
Types of share based payments
 Equity-settled share based payment- one in which the entity receives goods or services
as consideration for equity instruments of the entity. It includes shares or share options.
 Cash-settled share based payment- one in which the entity receives goods or services
by incurring a liability to the supplier that is based on the price (or value) of the entity’s
shares or other equity instruments of the entity.
 Transactions in which the entity receives goods or services and either the entity or the
supplier of those goods or services have a choice of settling the transaction in cash (or
other assets) or equity instruments.
Recognitions under IFRS 2 share based payments

Debit entries
 Recognise the goods or services received or acquired in a share-based payment

transaction when the goods are obtained or as the services are received.
 When the goods or services received or acquired do not qualify for recognition as
assets, recognise an expense.
Credit entries
 Recognise an increase in equity for an equity-settled share-based payment transaction

 Recognise a liability for a cash-settled share-based payment transaction.

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Measurements under IFRS 2 share based payments

Equity-settled share based payments
Transactions with employees
 Measure at the fair value of the equity instruments granted at grant date.
 The fair value is never re-measured.
 The grant date fair value is recognised over the vesting period.
 The fair value will be charged to profit or loss equally over the vesting period, with
adjustments made at each accounting date to reflect the best estimate of the number of
options that will eventually vest
 Shareholders’ equity will be increased by an amount equal to the charge in profit or loss
 If employees decide not to exercise their options, no adjustment is made to profit or loss
Transactions with non-employees
 Measure at the fair value of the goods or services received at the date the entity obtains
the goods or receives the service.
 If the fair value of the goods or services received cannot be estimated reliably,
measure by reference to the fair value of the equity instruments granted.
Cash-settled share based payments
 Measure the liability at the fair value at grant date

 Re-measure the fair value of the liability at each reporting date and at the date of
settlement, with any changes in fair value recognised in profit or loss for the period.
 Liability is recognised over the vesting period.
Share-based payment transactions where there is a choice of settlement
 If the counterparty has the right to choose whether a share-based payment transaction is
settled in cash or by issuing equity instruments, the entity has granted a compound
instrument (a cash-settled component and an equity–settled component).
 If the entity has the choice of whether to settle in cash or by issuing equity instruments,
the entity shall determine whether it has a present obligation to settle in cash and
account for the transaction as cash-settled or if no such obligation exists, account for the
transaction as equity-settled.

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Impact of conditions on measuring share-based payments

Award with vesting market condition only
The entity should recognises an expense irrespective of whether the market condition is
satisfied, if all vesting conditions are satisfied. The rationale behind this is that the market
conditions have already been taken into account when fair valuing the shares.
Non-market vesting conditions and service vesting conditions

If the vesting or performance conditions are based on non-market conditions, for example, the
growth in profit or earnings per share, then it will have to be taken into account in estimating the
fair value of the option at the grant date
Award with non-vesting condition only

The entity should recognises an expense irrespective of whether the non-vesting condition is
satisfied. Example of a non-vesting condition is when an employee is entitled to an award on the
grant date and is not required to provide any future services to the entity. Another examples of
non-vesting conditions include a non-compete clause. The ‘non-compete’ clause is a non-
vesting condition, because the entity does not receive any services.
Disclosure requirements
The following disclosures are required by IFRS 2
 Information about the share-based payment transactions that existed during the period
 Information on how the fair value of the goods or services received, or the fair value of
the equity instruments which have been granted during the period, was determined
 Information on expenses which have arisen from share-based payment transactions, on
the entity’s profit or loss in the period
Audit risks
Use of wrongly calculated fair value leading to over or understatement of liabilities.

In case of employee share based payment, leavers may not be removed from the
scheme thereby overstating liabilities.
In case of employee share based payment new employees joining the scheme may not
be accounted for thereby understating liabilities.
Use of unrealistic estimates by management

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Inadequate disclosures may be made in the account
Principal Audit Procedure in Respect of Share Based Payment.
 Review contractual documentation for the share-based payment scheme and agree the
following to the management calculation of the expense:
 Number of employees in scheme
 Number of options per employee
 Length of vesting period
 Grant date of the share options
 Any performance condition attached to options
 Re-perform the management calculation of the share-based payment expense, ensuring
fair value is spread correctly over the vesting period.
 Agree fair value of the options to a specialist report calculating the fair value.
 Compare methods used for estimates with prior years to ensure consistency
 Assess whether the specialist report is reliable and objective.
 Check that the fair value is calculated at the grant date.
 Discuss the reasonableness of the percentage staff turnover assumption with human
resources department.
 Obtain written representations from management confirming that the assumptions used
in measuring the expense are reasonable and that there are no share-based payment
schemes in existence that have not been disclosed to the auditors.
 Recalculate the fair value calculated by using the model adopted by management

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Business combination
IFRS 10 Consolidated Financial Statements

This standard outlines the requirements for the preparation and presentation of consolidated
financial statements, requiring the parent entities to consolidate the subsidiaries it controls.
Changes in parent’s ownership interest in a subsidiary which does not result in the parent losing
control of the subsidiary should be treated as equity transactions.
The different between the amount by which the non-controlling interest are adjusted and the fair
value of the consideration paid or received is recognized directly in equity and attributed to the
owners of the parent.
IFRS 12
Disclosure of interest in other entities requires disclosure relating to the consequence of
changes in a group’s ownership interest in a subsidiary which does not result in a loss of
control.
IFRS 3 Business Combinations

this standard outlines the process to use in accounting when a parent company obtains control
of a business (e.g. an acquisition or merger).
The following points should be noted as they present source of audit risks:
IFRS 3 requires the recognition of contingent liabilities on the acquisition date at fair value if
they
are reliably measurable, irrespective of whether the obligations are probable. The audit risk here
is that contingent liabilities may not be captured by the parent entity which in this case
understate the liabilities of the company
IFRS 3 does not allow for the recognition of contingent assets. The audit risk here is that
contingent assets is wrongly recognized thereby overstating assets
Acquisition-related costs are not included as part of the consideration transferred, but rather
expensed as incurred example of this costs include advisory, legal, accounting, valuation, other
professional or consulting fees and administrative costs. The audit risk here is that these costs
will be recognized as consideration used in calculating the Goodwill leading to overstatement of
assets.

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If the parent company is expected to incur restricting costs post-consolidation but there is no
present obligation, no liabilities would be recognized at the date of acquisition. The audit risk
here is that restructuring costs without present obligation would be recognized thereby
overstating liabilities.
Acquisition of asset or group of assets may not be termed as business acquisition under
business combination as there must be an identifiable process acquired which should lead to
production of outputs.
Audit risk associated with consolidation process

Subsidiaries Acquired Mid-Year
There is risk that its results have not been consolidated from the correct date leading to the
group profits being overstated.
Goodwill
There is risk that goodwill has not been calculated correctly. The fair value of subsidiary’s
assets and liabilities may not have been estimated reliably.
Accounting polices across the group may not be the same
When a subsidiary does not prepare accounts in line with IFRS the accounts of the subsidiary
should be restated to be in line with group accounting policies.
Intra-group trading
Intra-group transactions must be eliminated during the consolidation process. There is risk this
is not done. Inventories may as a result contain unrealized profit thereby overstating revenues,
expenses, assets and liabilities.
Fair value of Non-controlling interest
If the subsidiary is a listed on stock exchange, it may be easy to get the fair value of NCI
otherwise, IFRS 13 should be strictly applied adhered to ascribe fair value to the NCI. There is
risk that IFRS 13 is not used to arrive at the fair value of NCI which may overstate or understate
the assets.
Audit Evidence regarding Business combination
 Copy of due diligence report to confirm fair value of assets acquired.
 Confirmation of approval for the purchase of the subsidiary by reviewing the minutes of
 board of directors.
 Agreement of money paid to the bank statement or cashbook.
 Confirmation of the number of shares acquired by reviewing the purchase
documentation.

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 Discussion with management on how fair value of assets was arrived at.
 Agreement of management’s method in deriving fair value with IFRS 13.
 Discussion with management on the need to test goodwill for impairment.
 Recalculation of any additional depreciation due to adjustment of assets to fair value.
Principal Audit Procedure in Respect of Non-Controlling Investment

 Determine the percentage of shareholding acquired using purchase documentation to
establish the applicable standard.
 Confirm that percentage shareholding is between 20 and 50% of equity shares to
establish there is no control.
 Obtain list of directors of the companies to confirm whether the company has appointed
director(s) to the boards to establish the investment does not amount to control.
 Discuss with the directors of the company the level of involvement in policy decision
made at the companies to establish they don’t mount control.
 Obtain a written representation detailing the nature of involvement and influence exerted
over the companies.
Question ABACUS LEASING

Your firm has been approached by the managing director of Abacus Leasing to tender for the
audit. The company is a small non-listed incorporated enterprise. The previous auditors have
resigned after a loss of confidence in them by the board of Abacus Leasing. This concerned the
disapproval by the board of a qualified auditor’s report issued by the outgoing auditors which
referred to inadequate internal controls in Abacus Leaning’s systems.
The company leases equipment to building contractors, many of whom have insufficient cash
resources to purchase the equipment outright. Some lessees have been refused credit
elsewhere. Since formation three years ago Abacus Leasing’s sales revenues have doubled
each year and lease receivables now represent over 80% of the company’s gross assets. The
company is now experiencing difficulty in collecting a substantial amount of overdue lease rental
payments. The company has no formal system for approval of new customers or any laid down
procedures for repossession of assets where the terms of the lease agreements have been
broken.
Although the terms and conditions of the leases vary considerably all of them had been treated
by Abacus Leasing as finance leases.

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The company is managed by a Board of three directors with a dominant managing director who
owns 93% of the share capital. The directors and senior management are largely remunerated
by a “performance bonus” based on new sales. The company does not have an audit
committee.
Required:
(a) Describe the procedures an audit firm should undertake before accepting a potentially
high risk audit such as that of Abacus Leasing. (5 marks)
(b) Describe the factors in relation to the audit of Abacus Leasing that would affect your
assessment of risk. (7 marks)
(c) Describe the audit work that you would undertake to determine the correct accounting
treatment and disclosure of:
(i) The leases;
(ii) The bad debts allowance in respect of lease receivables. (8 marks)
Answers
(a) Procedures before accepting a high risk audit client
 A request to communicate with the previous auditor. A refusal of this would inevitably
lead to a refusal by the auditor to tender.
 The previous auditor should be asked if there are any circumstances of which they are
aware that would have a bearing on the prospective auditor’s willingness to tender.
 A visit to the firm to make a preliminary assessment of the audit risk with particular
attention being focused on the system of controls and activities of the company.
 We need to conduct assessment on the ability of the client to pay the audit fee. The
financial position of the client may not be sound and there may be a serious risk of non-
payment of the audit fee.
(b) Assessment of risk
 The suspicious circumstances in which the previous auditors resigned, particularly the
reasons for the audit qualification. It would appear that there are poor internal controls at
Abacus Leasing, and further, it seems management are reluctant to improve them.

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 The domination by the managing director.

 The company is a new’ company with little history and the growth of the company is
spectacular.
 There may be an element of overtrading causing the company to be over borrowed,
highly geared and experiencing liquidity problems. The company may be faced with a
significant going concern uncertainty which may not be disclosed
 The bonus incentive for management may have caused high risk sales (leases) to have
been made, or the sales revenue figure may have been falsified.
 There is high risk of theft given the nature of equipment making to assets to be
overstated
 The high proportion of assets in the form of lease receivables which appear to be difficult
to collect and the lack of a formal system of collection.
(c) Audit work

(i) Audit work in respect of leases
 Obtain and inspect copies of all different types of lease agreements to ensure
classification is correct.
 Enquire on how management determines the fair value of the leased asset and
determine it is reasonable using auditor’s knowledge of the business.
 The auditor should review the costs of asset recognised to ensure they are stated net of
any trade discounts
 The auditor should reconcile the original cost of the leased asset with the purchase
invoice and the payment made.
 The auditor should recalculate minimum lease payments using an appropriate discount
rate.
 The discount rate used in calculating the minimum lease payment should be compared
with market interest rates to confirm the appropriateness of the rate.
(ii) Audit procedures in respect bad debts allowance
 The auditor should perform circularization of lease receivables on sample basis.

 The auditor should check to see if any receivables contain overdue installments as such
receivables are more likely to be bad.
 The auditor should discuss the need to write off overdue receivables with the
management

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 The auditor should review the company’s procedures for recovery of receivables which
have breached the terms of the agreements. As these procedures are known to be weak
further tests of detail (substantive procedures) should be performed to confirm the value
of the lease receivables.
Question SELLERS
You are planning the final audit of the financial statements of Sellers, a manufacturing company.
The following events occurred shortly after the end of the reporting period:
(1) One of the company’s largest customers, Bramley, notified Sellers of its intentions to go
into liquidation with an outstanding debt of $260,000. Seller’s directors consider that the current
allowance for bad debts will cover any potential loss.
(2) A writ was issued against Sellers by a former sales director who is claiming $90,000 for
breach of his service agreement following his dismissal during the year under review. No
provision has been recognised in respect of this claim.
(3) A fire at the company’s warehouse destroyed all inventory held there. This inventory is
valued at the lower of cost and net realisable value amounting to $1,800,000 in the financial
statements.
(4) Half of the sales force was made redundant and a provision has been made for
redundancy payments amounting to $400,000.
Required:
For EACH of the four events:
(i) Explain the effect, if any, on the financial statements (8 marks)
(ii) State the matters you would consider and the audit evidence you would obtain to be able
to draw a reasonable conclusion on which to base the audit opinion. (12 marks)
(20 marks)
Answers
(1) Bad debt – $260,000
(i) Effect on financial statements
As Bramley is one of Sellers “largest customers”, the outstanding balance is presumably
material to trade receivables.

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Specific allowance, calculated on a prudent basis, should be made against the amount due from
Bramley at the end of the reporting period. The year-end general allowance should be
recalculated in accordance with Sellers’s accounting policy.
(ii) Matters to consider
 Steps being taken by Sellers to find new customers to lessen the impact of the loss of
this major customer (which may otherwise have implications for the appropriateness of
the going concern assumption).
 Whether any goods have been manufactured to specific orders for Bramley. Such goods
should be separately identified in year-end inventory as their net realisable value may be
less than costs if an alternative customer cannot be found.
 The steps which have been (are being) taken to recover the amount due (e.g. attending
the creditors meeting arranged by the liquidator).
Audit evidence
 A copy of Bramley’s account balance in Sellers’s receivables ledger (i.e. year- end
balance and post year-end transactions).
 After-date (post year-end) cash receipts from Bramley.
 Correspondence with the liquidator to establish the amount of debt (if any) most likely to
be recovered.
 Insurance policy documents (if Sellers is insured against such losses).
(2) Legal claim – $90,000

If settlement of the claim is probable, a reliable estimate of the full amount of the liability
should be provided for in the financial statements.
If the outcome is less certain, any part of the contingent loss which is not provided for
should be disclosed by way of a note to the financial statements (IAS 37).
 The reason(s) for which the former sales director was dismissed. If he was guilty
of wrongdoing or misconduct he may be the one in breach of contract.
 The nature of the alleged breach of the service agreement.
 Materiality of the amount of the claim to the financial statements

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 Whether the company intends to contest or counter the claim or negotiate an out-
of- court settlement.
Audit evidence
 A copy of the employment contract, to ascertain whether actions of the company

amount to breach of terms.
 Board minutes discussing how Sellers is planning to proceed (e.g. by offering an
out-of-court settlement).
 Legal correspondence to assess the most likely outcome and amounts involved
(including legal costs).
 Former director’s personnel records including dismissal notice etc.
 Post year-end cash book payments to the former director, if any.
(3) Inventory loss ($1,800,000)

The destruction of warehouse inventory was not a condition existing at the end of the
reporting period and therefore is a non-adjusting event (IAS 10 “Events After the
Reporting Period”). No adjustment is required to the financial statements (unless, for
example, the loss was uninsured and Sellers is no longer a going concern).
Given that amount involved is likely to be material, the following should be disclosed in
the financial statements:
 that there was a fire on [date];

 that $1.8m of inventory included in the statement of financial position was
destroyed;
 The financial effect (e.g. amount of any uninsured loss).
 To what extent have inventories have been replaced since the fire.
 To what extent the manufacturing processes were disrupted (if at all) by the loss
of raw materials.
 Whether orders or customer goodwill been lost due to delays in dispatching
goods to customers.

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 Whether the loss is adequately covered by insurance
Audit evidence
 Insurance policy to confirm the extent to which loss of inventory, is covered and
on what basis (e.g. replacement cost or historic cost).
 Correspondence with insurers/loss adjusters to ascertain whether the claim will
be settled in full.
 Sales order books to identify any significant loss of customer goodwill.
 Cash book payments to suppliers for “emergency” purchases of raw materials.
 Any cash book receipt of insurance monies.
(4) Redundancy payments – $400,000

If the decision to make personnel redundant was made after the reporting period, the
matter is a non-adjusting event (IAS 10) which should be disclosed if material. The fact
that a provision has been recognised means that the obligation existed at the year-end
(IAS37).
 Whether further similar redundancies are likely in the foreseeable future.

 The reason(s) for the redundancies (e.g. re-organisation of operations or closure
of a business segment).
Audit Evidence
 Schedule showing the make-up of the provision for agreement to payroll and
personnel records.
 Post year-end cash book payments to confirm amounts originally provided.
 Redundancy notices/board minutes to confirm the date on which the decision
was made.

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Group audit issues
Responsibility of being appointed as Group Auditor
 Communicate clearly with the component auditors about the scope and timing of their
work on financial information related to components and their findings
 To obtain sufficient appropriate evidence regarding the financial information of the
components and the consolidation process
 To express an opinion whether the group financial statement are prepared, in all material
respects, in accordance with the applicable financial reporting framework
 If the engagement partner concludes that it will not be possible to obtain sufficient
appropriate evidence due to restriction imposed by group management and that the
possible effect of this will result in a disclaimer of opinion, then they must not accept the
engagement.
Group Auditor has to obtain Understanding of:
 The group structure.

 The components.
 Group-wide controls.
 The consolidation process.
 The risk of material misstatement in the component and group financial statement.
If an acquisition is in planning made
 Business understanding should be obtained for the new component.

 Liaising with new component auditor should be considered.
If a disposal is made by the group
 The auditors need to audit the disposal transaction.

 The group auditor has to determine the type of work to be performed on the financial
information of the components, whether performed by the group team or another auditor.
Significant components
If significant risk of material misstatement of the group account has been identified in a
component that is audited by another auditor, the group auditor shall evaluate the
appropriateness of further audit procedures performed in response to the assessment.

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If the component it not considered significant then the group auditor shall simply performed
analytical procedures at group level.
ISA 600 co-operation between auditors in respect of group audit
The group Engagement team has the right to require from auditors of subsidiaries the
information and explanations they require, and to require the group management to obtain the
necessary information and explanations from subsidiary. if The degree of corporation is limited
by factors such as the component auditor not being subject to the requirement of ISA,s, but of
different national practice. ISA 600 states that the group auditor should not accept a group audit
if there are restriction on his communication with component auditors.
Factors to be considered by the group auditor in relying on the work of component auditor
Ethics: the group auditor should consider whether the component auditor complies with
required ethical requirements. The component auditor should be subjected to the same ethical
requirements as the group auditors irrespective of the local regulations applicable.
Professional competence: The group auditor should check whether the component auditor
understand IAS and must make sure the work performed by the component auditor is in
conformity with international standards. He must make sure the component auditor understand
IFRS and have sufficient resources and skills to perform the required work.
Procedures that should be performed to determine the extent of reliance to be placed on the
work of component auditor:
 Obtain and review the ethical code adopted by the auditor

 Obtain statement from the auditor that it has adhered to the ethical code
 Enquire from the auditor if it is a member of an auditing regulatory body, and the
professional qualification issued by the body
 Obtain confirmation from the professional body which the auditor belong to
 Discuss the audit methodology used by the auditor and compared to international
standards
 Review the quality control policies and procedures used by the auditor at firm level and
those applied to the audit engagement.
 Request the result of monitoring visits conducted by the regulatory authority under which
the auditor operates

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Audit procedures to carry out as part of the planning and evaluation of the work of the
component auditors
 The group auditor should review the component auditor’s working papers to determine
the adequacy of work performed by component auditor.
 The group auditors is responsible for setting the materiality level for the group financial
statements as a whole, and for components which are individually significant, this would
be set at a lower level than the materiality level of the group as whole. The component
auditor will then perform a full audit based on the component materiality level.
 Depending on whether the component is significant or not to the group’s financial
statements, the group auditor should review the component auditor’s overall audit
strategy and audit plans and perform risk assessment procedures to identify and assess
risks of material misstatement at the component level.
 The group auditor should discuss with the component auditor on the component’s
business activities that are significant to the group, and the susceptibility of the
component to material misstatement of the financial statement due to fraud or error.
 The group auditor should review the component auditor’s documentation of identified
significant risks of material misstatement.
 The group auditor should review a questionnaire completed by the component auditor
highlighting key issues identified during the audit.
 The group auditor should evaluate the effect of any uncorrected misstatements on the
group’s financial statements
 After reviewing the component’s auditor’s work, the group auditor should determine
whether any additional procedures are necessary to gather audit evidence.
Support or comfort letter

The parent and subsidiaries are seen to be a single entity, so if the group as a whole is a going
concern then this is sufficient. When a subsidiary is not a going concern, auditor may request a
support letter from the directors of the parent company. This letter represents documentary
evidence and is normally approved by the parent company board. If there is a limitation on the
time for which the support is to be provided, other evidence may be required that the subsidiary
will be able to continue as a going concern.
The auditor will need to ensure that the parent company is in a position to provide the support
which it is claiming to give in the comfort letter. The auditor should confirm this promise by
reviewing the group statement of cashflows for availability of needed finance.

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Effects of Acquisition of a subsidiary on Audit planning

Always relate your answer to the given scenario in the examination question. However, the
following points may be of immense guidance:
 The revised group structure will need to be ascertained to ensure all relevant entities are
consolidated.
 The issue of component auditor should be discussed. Before reliance can be placed on
the work of the component auditor, Independence and competence of the auditor need
to be assessed.
 Materiality of the new company will need to be assessed in relation to the group as a
whole in order to determine the extent and nature of work to be done.
 The audit plan will need to address the calculation and accounting treatment of goodwill.
Goodwill must be calculated by comparing the cost of the investment with the fair value
of the net assets of the subsidiaries at the acquisition dates.
 The auditor will need to assess the method used by management to obtain the fair value
of net assets acquired.
 Impairment of goodwill should be assessed.
 Information regarding accounting policies of the new subsidiary should be obtained as
this will need to be reconciled so that the consolidation adjustment can be quantified.
 The way in which the group identifies intercompany balances/transactions will need to
be established.
 The audit plan should contain a list of all the companies within the group so that
completeness of intercompany balances can be confirmed.
Business Risks Relating to Acquisition of a subsidiary
 The acquisition may result in the group incurring additional cost.

 Customer and key staffs may be lost.
 Key staff may be lost as a result of the inability to integrate the culture of the company
 In the case of a foreign acquisition the company may not be familiar with local legislation
which is critical to the survival of the business.
 The business is exposed to foreign exchange risk (foreign acquisition)

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Toy Co
2013 2012
REVENUE $18M $17M
PBT $2M $3
TOTAL ASSET $58 $59
YEAR ENDED 31 March 2013.
The component auditors of Toy Co, the overseas subsidiary, have been instructed to provide
the Group audit team with details of a court case which is ongoing. An ex-employee is suing Toy
Co for unfair dismissal and has claimed $500,000 damages against the company. To comply
with local legislation, Toy Co’s individual financial statements are prepared using a local
financial reporting framework. Under that local financial reporting framework, a provision is only
recognised if a cash outflow is virtually certain to arise. The component auditors obtained verbal
confirmation from Toy Co’s legal advisors that the damages are probable, but not virtually
certain to be paid, and no provision has been recognised in either the individual or consolidated
financial statements. No other audit evidence has been obtained by the component. (7 marks)
Required:
In respect of each of the matters described:
(i) Assess the implications for the completion of the Group audit, explaining any
adjustments that may be necessary to the consolidated financial statements, and
recommending any further procedures necessary; and
(ii) Describe the impact on the Group auditor’s report if these adjustments are not made.
Adjustment required
All companies in the group should use the same accounting policies. In line with IAS 37
provisions, contingent liabilities and contingent provision is required when it is probable that
there would be outflow of economic benefit to settle an obligation and this amount can reliably
be measured. In this case, a provision of $ 500,000 should be recognized as current liabilities
and the same amount should be changed against the profit.
Further audit procedures
 Obtain direct confirmation from TOY CO’s legal adviser that it’s probable the claim would
be successful.
 Inspect count documents relating to the claim to establish the $ 500,000.

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 Inspect correspondence between toy co and the ex-employee to establish the possibility
of out-of- court settlement.
Impact on group auditor’s
Given that the amount involved is material to the group’s profit (25% of PBT),
The group audit report will be modified with qualified except for opinion. This would only happen
if sufficient and appropriate has been obtained by the auditor that the amount of the claim is
probable.
Question CUCKOO GROUP

You are currently auditing the consolidated financial statements of the Cuckoo Group and are
scrutinising the accounting policies being used by the group for the valuation of inventories. The
group has three principal subsidiaries which are Loopy, Snoopy and Drake Retail. You are not
currently the auditor of Loopy as Cuckoo only recently acquired this subsidiary company.
Cuckoo, the holding company, carries on business as a dealer in gold bullion and other precious
metals. It purchased the three subsidiaries in order to diversify its activities. It felt that dealing in
commodities was quite risky and wished to spread the operating risk. The following are the
accounting policies proposed by Cuckoo Group regarding the valuation of inventories:
Cuckoo proposes to recognise the bullion and other precious metals in the statement of
financial position at the year-end market values. It does not enter into any contracts for the
forward purchase or sale of precious metals. Cuckoo does not manufacture products from the
precious metals but simply buys and sells the metals on the bullion markets.
Loopy manufactures domestic products such as cutlery, small electrical appliances and
crockery. The inventory is valued at the lower of cost or market valued applied to the total of the
inventory. Cost is determined by using the last in, first out (LIFO) method of inventory valuation.
Overhead costs are allocated on the basis of normal activity and are those incurred in bringing
the inventory to its present location and condition.
Snoopy manufactures similar domestic products to Loopy. The inventory is valued at the lower
of cost and net realisable value for the purpose of the group statement of financial position.
However, inventory is further reduced to its standard value for the purpose of the group profit or
loss. This reduction is not material in the context of the group accounts. Overheads are
allocated on the basis of normal activity levels and the costs incurred in bringing the inventory to
its present location and condition.

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Drake Retail acts as the retail outlet for approximately 60% of the combined output of Loopy and
Snoopy. It values its inventories at the lower of cost and net realisable value. Inventories mainly
consist of goods held for resale. Cost is computed by deducting the gross profit margin from the
selling value of inventory. When computing net realisable value, an allowance is made for any
future mark downs to be made on inventory.
The directors of Cuckoo Group wish the following accounting policy note to be included in the
group financial statements regarding inventory: “Inventories are stated at the lower of cost and
net realisable value and comprise raw materials (including bullion), work in progress and
finished goods.”
Required:
(a) Describe the audit procedures which you would carry out before placing reliance upon
the work of the auditors of Loopy. (7 marks)
(b) Discuss whether you feel that the current accounting policies adopted by Cuckoo and its
three subsidiaries regarding inventory and work in progress are acceptable to you as group
auditor. (7 marks)
(c) Discuss the problems which may arise when determining which overhead costs are to
be incorporated into the inventory valuation of manufacturing companies such as Loopy and
Snoopy. (6 marks)
(d) Discuss whether you feel that the accounting policy note regarding inventory and work in
progress provides adequate information to the users of the group financial statements. (5
marks)
(25 marks)

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Answers
(a) Reliance on the work of component auditors
Reliance will not be placed upon the financial statements of Huey until the audit procedures
carried out by their auditor (the component auditor) have been reviewed by the parent
company’s auditor (the group auditor). Before any approach is made to the auditor of Huey plc,
the directors of Donald plc will be informed of the intention to communicate with the component
auditor. The component auditor is under a statutory duty in this case to co-operate with the
group auditor.
The auditors of Loopy should be informed in advance of the standard and scope of the work
required and any reporting deadlines, and the component auditor should discuss any potential
problems they foresee with the group auditor.
An assessment of the materiality of amounts in the financial statements of Loopy should be
made to determine the nature of the procedures to be carried out by the group auditor.
Furthermore, an assessment of the risk inherent in the audit of Loopy will be made. A meeting
should be schedule with the component auditor to obtain knowledge of the following:
 the previous and current financial statements of Loopy (including analytical procedures);
 the terms of the component auditor’ engagement and any restrictions placed upon their
work;
 the standard of the work of the component auditor and the nature and extent of their
audit examination;
 the independence of the auditor of Loopy
A questionnaire should be used to review the audit procedures used by the component auditors
If Loopy is of material significance a review of the working papers of the component auditor may
be required. This may involve a further visit to the subsidiary company as it is important that the
group auditor is satisfied that the audit has been carried out in accordance with acceptable
auditing standards, and that the component auditor’ audit opinion is reasonable and reliable.
If the auditor is not satisfied with the work carried out, the auditor should arrange for additional
tests to be performed by the auditor of Loopy. Only in exceptional circumstances will the group
auditor perform more tests as the component auditor is responsible for the auditor’s report on
Loopy’s financial statements.
(b) Accounting policies for inventories

(i) Cuckoo

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This practice is quite common place when dealing with commodities. It represents a departure
from the usual valuation rules as inventories are stated at above their cost. IAS 2 “Inventories”
does not deal with this issue and the requirement of the standard to show inventory at the lower
of cost and net realisable value has obviously been dispensed with. It can be argued that in the
case of commodities, it may be necessary to depart from IAS 2 and apply alternative accounting
practices. The financial statements are likely to be more helpful to users if the commodities are
shown at market value and this is generally justified in order to show a true and fair view.
However, it will only be acceptable as a valuation model where the company’s principal activity
is the trading of commodities, the commodities do not alter in character between purchase and
sale, the commodities can be traded on an organised market and the market is sufficiently liquid
to allow the company to realise its inventory close to the valuation price. It would appear
therefore that in the case of Donald plc., the policy is acceptable.
(ii) Loopy
IAS 2 requires that the comparison of cost and net realisable value should be done on an item
by item basis or by groups of similar items. In the case of Huey plc the comparison has been
carried out on a total inventory basis. Thus the group auditor will request the component auditor
to carry out a net realisable value test on an item by item or group basis. Further, the LIFO (last
in, first out) method of inventory valuation is not acceptable by IAS 2 and therefore inventory will
need to be revalued in order to conform with the standard if the financial statements are not to
be qualified. (This is dependent upon the materiality of the amount in the context of the group
accounts.)
(iii) Snoopy
This accounting procedure is effectively showing inventory at base inventory value in profit or
loss and at FIFO (first in, first out) valuation in the statement of financial position. Base inventory
is not an acceptable method of valuing inventory under IAS 2. Inventories should be stated at
the same value in both the statement of profit or loss and statement of financial position under
existing accounting conventions.
(iv) Drake Retail
This company sells high volumes of various small items of inventory. Invariably in this type of
trade, similar mark-ups are applied to groups of inventory items. In this situation, a
disproportionate amount of time can be spent determining the cost of the year-end inventory.

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The most practical method of valuing year-end inventory is to record inventory at selling price
and converts it to cost by removing the mark-up.
IAS 2 says that this method is acceptable only if it can be demonstrated that the method gives a
reasonable approximation to actual cost.
(c) Overheads in inventory valuations
IAS 2 defines costs as “that expenditure which has been incurred in the normal course of
business in bringing the product to its present location and condition”. Certain costs are not
costs of bringing the inventory to its present location and condition. These include storage costs,
selling costs and administrative overheads. However, in certain circumstances it is possible to
argue a case for their inclusion in inventory valuation. For example if firm sales contracts have
been entered into for the sale of inventories, the inclusion of selling costs incurred before
manufacture can be justified under IAS 2. Storage costs may be incurred prior to further
processing and these costs should be included in the cost of production. The standard
recognises that in the case of smaller organisations there may not be a clear distinction of
management functions and that this cost may be allocated to production on fair basis.
Another problem is that IAS 2 requires overheads to be included in inventory on the basis of a
company’s normal level of activity. “Normal” is not defined in the standard but normal level of
activity is established by reference to the budgeted or expected level of activity over several
years. What is “normal” is obviously left open to subjective assessment particularly during the
initial years of a business or in a recession. The standard is unhelpful in this area and the
acceptability of the overhead allocation based on normal activity is effectively left to mutual
agreement between the auditor and the client.
(d) Accounting policy note

IAS 2 states that the accounting policies that have been applied to inventories and work in
progress should be stated and applied consistently from year to year. The degree of detail given
by companies varies considerably. Some companies provide comprehensive and informative
information; others provide very brief statements. Companies need only state that inventories
and work in progress are valued at the lower of cost and net realisable value in groups of similar
items.
Different accounting policies have been used to value the bullion, retail goods and the trading
inventories and these should be detailed in the notes to the accounts. Further it would be useful
to users if the accounting policy relating to a specific category of inventory was set out in some
detail.

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Question BEESTON INDUSTRIES

Your firm is the auditor of Beeston Industries Inc, which has a number of UK subsidiaries (and
no overseas subsidiaries), some of which are audited by other firms of professional
accountants.
You have been asked to consider the work which should be carried out:
 to ensure that inter-company transactions and balances are correctly treated in the
group accounts;
 to check the auditors’ work and the accounts of companies not audited by you.
Required:
(a) Describe the audit work you would perform to verify that inter-company profit in inventory
has been correctly accounted for in the group accounts. (5 marks)
(b) Briefly describe the effect the following would have on your review of the work of the
subsidiaries’ auditors and on your opinion on the group accounts:
(i) The size of the subsidiary – whether it is small or large;
(ii) If the auditor’s report on the subsidiary’s accounts is qualified;
(iii) If the subsidiary is a banking company. (5 marks)
Answers
(a) Profit in inventory
 The auditor should identify inventory which is part of inter-group trading by carrying out
suitable analysis of inventory balances in a supporting schedule.
 The auditor should review the transfer pricing arrangements between the individual
companies by examining the invoices for the items concerned and making enquiries of
the supplier companies of the basis of cost structure.
 The calculations used by the group accountant to eliminate the profit should be validated
by reference to the data on transfer pricing and inter-group trading.
 The inter-company inventory thus reduced to true cost should be traced to the final
inventory summary to verify that it has been included.
 The auditor should verify that the closing balance of inventory is correct by recalculating
the inventory figures and adjusting for the unrealized

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(b) Factors affecting review and opinion

In considering the accounts of a subsidiary audited by another firm the following matters are
relevant.
(i) Materiality
If the subsidiary contributes a large proportion of group turnover, profit before tax and net
assets, the work of the auditor of the subsidiary will be examined in much greater detail.
(ii) Qualified opinion
If the auditor’s report of a subsidiary is qualified the qualification may be significant in the
context of the group. A material and fundamental qualification of a significant subsidiary will
almost certainly involve some form of qualification in the auditor’s report of the group. In a case
where the subsidiary is not material the group the opinion issued by the component auditors
would not need to be reflected in the group auditor’s report.
(iii) Banking subsidiary
If the subsidiary is a bank it will be necessary to make additional disclosures relating to
segmental information under IFRS 8 Operating Segments.

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AUDIT REPORT

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Elements of Auditor’s report

The following elements must be present in an audit report:
Title: The title should clearly indicate that it is the report of the independent auditor
Addressee: the report should be addressed to the legal recipient of the report
Introductory paragraph: this paragraph contains the name of entity being audited, the sets of
financial statements that have been audited, period covered by the audit, and brief statement of
accounting policy.
Section describing management’s responsibility for the financial statements: This section
describes responsibility of management regarding preparation of the financial statements
Section describing Auditor’s responsibility: this section must state that the auditor is
responsible for expressing an opinion based on the audit. This section also gives brief
explanation of Audit and describes the strength of the audit evidence obtained.
Opinion paragraph: for unmodified opinion
Auditor’s signature: the signature of the person signing for the firm and the name of the firm
Date: the report must be duly dated
Auditor’s address: the report should include the address of the auditor
Meaning of unmodified audit report

Unmodified report means:
 The financial accounts of the audited entity give true & fair view.
 The financial accounts of the entity have been prepared in accordance with the
applicable financial reporting framework
Modification of auditor’s report

Circumstance Material but not pervasive Material and pervasive
Financial statements are QUALIFIED OPINION ADVERSE OPINION
materially misstated
Inability to obtain sufficient QUALIFIED OPINION DISCLAIMER OF OPINION
appropriate evidence

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The basis of opinion should be shown immediately above the opinion paragraph. ISA 705
requires them be headed as:
“Basis for Disclaimer of Opinion”
“Basis for adverse opinion”
“Basis for Qualified Opinion”
Notes on ‘Basis of opinion’ paragraph:
 The paragraph should not include argument credited to the directors

 Full name of IAS should be provided in the paragraph e.g. IAS 33 Earnings per share
 The paragraph should be precise
 Where management imposes restriction and the auditor is unable to obtain sufficient
evidence, the paragraph should refer to the relevant accounting standard and should
state that a limitation has been imposed by management in respect of the specified
issue. It should state that management did not allow access to evidence and that the
auditor has been unable to determine whether the accounting treatment of the issue is
correct.
 The paragraph should not contain unprofessional words e.g. abusive words should be
particularly avoided, it should not contain any form of accusation against management
Note on opinion paragraph where there is insufficient audit evidence:

The opinion paragraph should use the specific form of words sets out in ISA 705 and the
statement that the auditor has been unable to obtain sufficient appropriate audit evidence, and
that it is therefore unable to express an opinion

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Management imposed limitation on the scope of audit; matter to consider and action to be taken
by the auditor
 Any significant difficulty encountered should be communicated to those charged with

governance (ISA 260 communication with those charged with governance)
 The auditor should consider whether evidence can be obtained by any alternative
procedures
 The auditor should consider the integrity of the management. Any representation made
by the management on the issue should be reconsidered.
 Where the restriction will lead to modification of opinion, the circumstances surrounding
this should be communicated with the expected wording to be used
 The audit firm should consider withdrawing from the audit engagement to protects its
integrity
KEY AUDIT MATTER

Significant matters which arose during the audit and which must have been discussed with
those charged with governance must be disclosed in the audit report under section named ‘KEY
AUDIT MATTERS’. According to ISA 701 ‘key audit matters’ is defined in as: Those matters
that, in the auditor’s professional judgment, were of most significance in the audit of the financial
statements of the current period. Key audit matters are selected from matters communicated
with those charged with governance.
ISA 701 requires the auditor to consider the followings in determining matters that will be
included in the ‘KEY AUDIT MATTER’ section:
 Areas of high susceptibility to material misstatement.
 Areas of the account that involved significant management judgement.
 How significant events and transactions which took place during the period in
consideration has affected the audit.
Communication requirements of KAM
The following description of KAM is required in the audit report:
 The reason why the particular matter is considered to be key audit matter.
 How the matter was addressed during the audit.

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Material Uncertainty Related to Going Concern

This section will be included in the audit report when there is material uncertainty regarding the
ability of the entity to continue as a going concern. The section will only be needed if
management’s use of the going concern assumption is assessed to be appropriate and
adequate disclosure of the material uncertainty has been made in the financial statements. The
section is basically used to draw readers’ attention to the section of the notes where the material
uncertainty has been adequately disclosed in the financial statement.
Emphasis of matter paragraph (EOM)

This is a paragraph in the auditor’s report that explain matter that is appropriately presented or
disclosed, but which is so important that special emphasis is needed for users of the financial
statements.
Note: emphasis of matter paragraph does not qualify the opinion. Auditor should only include
an EOM if there is sufficient and appropriate audit evidence that the matter is not materially
stated
Examples of situations when EOM can be used:
 An uncertainty relating to the future outcome of an exceptional litigation

 Early application of a new accounting standard that has pervasive effect on the financial
statements
 A major catastrophe that has had a significant effect on the entity’s financial position
Other matter paragraph
This explains information that is rightly not present in the financial statements but which is so
important for user’s understanding of them that it needs to be highlighted in the auditor’s report.
Examples of when other matter paragraph is used:
 When the legislation specifically requires auditor to provide further explanation on

auditor’s responsibilities
 When auditor is reporting on more than one set of financial statements e.g. using both
IFRS and local GAAP

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 When prior period’s financial statements have not been audited at all or audited by
another auditor
Inconsistencies between audited and un-audited information in the annual report

The financial statements are normally published in the annual reports along with other
information like the chairman speech and other financial review by the chief financial officer.
This other information is normally not subjected to audit. Auditors are required to read other
information contained in the annual report to ensure consistency with the audited financial
statements. In a situation where the auditor discovered inconsistencies between audited
financial statements and other information in the annual report, the auditor should assess which
of the two is correct and consider the following actions:
If the other information is correct which means there is misstatement in the financial statements,
the auditor should consider the following actions:
Discuss with management on the need to make necessary adjustment to correct the
misstatements in the financial statements
If management made the changes, the auditor should perform further procedures to
obtain sufficient and appropriate audit evidence that the financial statement is free of
material misstatement
If management refuse to make any adjustment needed to correct the misstatement, the
auditor should consider modifying his opinion accordingly.

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2013 2012
REVENUE $18M $17M
PBT $2M $3
TOTAL ASSET $58 $59
Chairman’s statement
The draft chairman’s statement, to be included in the Group’s annual report, was received
yesterday. The chairman comments on the performance of the Group, stating that he is pleased
that revenue has increased by 20% in the year. (6 Marks)
Required:
In respect of each of the matters described:
(i) Assess the implications for the completion of the Group audit, explaining any
adjustments that may be necessary to the consolidated financial statements, and
recommending any further procedures necessary; and
(ii) Describe the impact on the Group auditor’s report if these adjustments are not made.
OTHER INFORMATION
The auditor is required by ISA 720 read other information published in the annual report to
identify any material inconsistency between audited and non- audited information.
In this case, there is inconsistency between the claim of their chairman (non-audited) and the
audited financial statement. As against the claim of the chairman, the revenue only increased by
5.9%.
The auditor should review audit work performed on revenue which of the information is
materially misstated. If review shows the financial statement to be materially misstated, the
auditor should request management make necessary adjustment. Any adjustment made by
management should be audited by the auditor for adequacy.
In the case where the chairman statement is found to be incorrect, this inconsistency should be
brought to the notice of those changed with government. If management refuses to adjust the
figure, the auditor will include other information section in the audit report. The inconsistency will
be explained in this section. In addition, this should also state his responsibility regarding other
information in the annual report.

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Refusal to make necessary changes by management on cash doubt on the integrity of

management. In this case, the auditor may consider resigning from the engagement. The
auditor can also consider speaking on the inconsistency during the AGM to inform the
shareholders.
Group audit report

The following matters are to be considered by the group auditor if the account of a component is
qualified:
 Materiality of the component to the group financial statements. According to ISA 600, a
component is significant to the group where a chosen benchmark is more than 15% of
the same figure for the group. Possible benchmark includes: profit before tax; total
assets; and sales. Materiality must be determined at both the component and group
level
 The group auditor should consider whether there is sufficient and appropriate audit
evidence to support the qualified opinion
 If the entity is a material component, the group auditor should review the component’s
auditor’s evidence in relation to the qualified opinion
 The group auditor should determine if there is need for further audit evidence.
 If evidence showed that the qualification is inappropriate, the group auditor should
request the component auditor to redraft its auditor’s report.
 The group auditor should consider the impact of the qualification on the group’s audit
report
If the qualification of the component’s report is deemed appropriate by the group auditor, the
following steps should be taken:
 The group auditor should discuss the issue with the group management
 The group auditor should request that the group management ask the component’s
management to adjust its financial statement. If this is done, the auditor will perform
further audit procedure on the adjustment, if the adjustment is adequate, the component
auditor will re-issue its audit report.

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 If the component’s management refuse to correct the material misstatement but the
effect of the misstatement has been corrected in the group financial statements, the
components audit report will remain qualified, but the group’s auditor’s report will not be
qualified
 If there is no adjustment in both the components’ account and the group’s account in
respect of the material misstatement, the group’s audit opinion will be qualified ‘except
for’ because of the material misstatement.
Note: should there be any need to qualify the group’s opinion in respect of a material
misstatement in the account of a component, the work of the component auditor should
never be referred to in the group auditor’s report
QUESTION POODLE GROUP
2013 2012
REVENUE $18M $17M
PBT $2M $3
TOTAL ASSET $58 $59

Terrier co is a subsidiary of Poodle Plc. On 1 June 2013, a notice was received from
administrators dealing with the winding up of Terrier Co, following its insolvency. The notice
stated that the company should be in a position to pay approximately 10% of the amounts owed
to its trade payables. Poodle Co, the parent company of the Group, includes a balance of $1.6
million owed by Terrier Co in its trade receivables.
Questions
Comment on the adjustment required
Comment on the implication on the group audit
Recommend further procedure on the receivable

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SOLUTION
TRADE RECEIVABLES
ADJUSTMENT REQUIRED
Information from the administrator suggest the receivable has been impaired by 90%, i.e. the
recoverable amount of the receivable is (10% x $1.6m) 0.16m.
This means impairment of (1.6m – 0.16) 1.44m should be recognized against the receivable.
Also, 1.44m should be recognized as expense in the statement of profit or loss. This is in line
with IFRS 9 financial instrument and IAS 10 events after reporting period (adjusting event).
IMPLICATION FOR THE COMPLETION OF GROUP AUDIT
If the above adjustment is not made, the group audit report will be modified with qualified except
for opinion. This is because the value of the impairment is material to the group financial
statement (80% of revenue; 72% PBT).
Basis of qualified opinion would be included to employ the reason for the qualification.
FURTHER PROCEDURES REQUIRED
Inspect correspondences between the company and terrier administrator to confirm that 10% of
the receivable will be recovered. Check after year end receipts to establish any amount received
from terrain co.
Re-calculate the impairment amount to ascertain arithmetic accuracy obtain direct confirmation
that the 10 % of the receivable would be received.
Report to those charged with governance
Those charged with governance’ is defined by ISA 260 as the persons who are responsible for
given strategic direction to the entity. Example of this is the board of directors of an entity. The
board is held accountable for whatever happens to the entity.
According to ISA 260, the followings should be reported to those charged with governance:
The auditor responsibilities as regards the audit of the financial statements.

The planned scope and timing of the audit

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Significant matters that arose during the audit

Matters relating to the independence of the auditor
Communicating deficiencies in internal control (ISA 265)
ISA 265 requires the auditor to communicate identified deficiencies in internal control that, in the
auditor's judgement, are of sufficient importance to be brought to the attention by the entity.
In addition to the timely communication of deficiencies to management, ISA 265 requires the
following to be communicated to those charged with governance:
Description of the deficiencies and their possible effects on the financial statements.
The auditor should clearly state that he is not responsible for the design of the
internal control system.
The auditor should state that the reported deficiencies are those discovered in the
course of the audit.
Question THETA
In January 2009, the head office of Theta was damaged by a fire. Many of the company’s
accounting records were destroyed before the audit for the year ended 31 March 2009 took
place. The company’s financial accountant has prepared financial statements for the year ended
31 March 2009 on the basis of estimates and the information he has been able to salvage. You
have completed the audit of these financial statements.
Required:
(a) Draft, for inclusion in the auditor’s report, wording appropriate to Theta. (5 marks)
Note: You are not required to reproduce the auditor’s report in full.
(b) Explain the reasons for your audit opinion. (3 marks)
(c) Explain and distinguish between the following forms of modified report:
(i) Emphasis of matter
(iii) Disclaimer of opinion
(iv) Adverse opinion. (8 marks)

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Answers
Introductory paragraph
We have audited the accompanying financial statements of Theta, which comprise the
statement of financial position as at March 31 2009, and the statement of comprehensive
income, statement of changes in equity and statement of cash flows for the year then ended,
and a summary of significant accounting policies and other explanatory notes.
Auditor’s responsibility
Our responsibility is to express an opinion on these financial statements based on conducting
the audit in accordance with international standards on auditing. Because of the matter
described in the basis for Disclaimer of opinion paragraph, however, we were not able to obtain
sufficient appropriate audit evidence to provide a basis for an audit opinion
Basis for Disclaimer of Opinion

The evidence available to us was limited because many of the company’s accounting records
were destroyed by fire in January 2009. The financial statements therefore include significant
amounts based on estimates. In these circumstances there were no satisfactory audit
procedures that we could adopt to obtain all the information and explanations we consider
necessary.
Disclaimer of Opinion
Because of the significance of the limitation on the evidence available described in the Basis for
Disclaimer of Opinion paragraph, we do not express an opinion on the financial statements.
(b) Reasons for audit opinion
 The fire has resulted in limitations in audit work and evidence necessary to form an
opinion cannot be obtained.
 It is a matter of fact that accounting records adequate for audit purposes have not been
kept and all information and explanations necessary for audit purposes have not been
received.
 The effect of the limitation is so material and pervasive that it is not possible to express
an opinion on the financial statements.
(C) Forms of modified audit opinion
(i) Emphasis of matter

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 An emphasis of matter is clearly distinguishable from other modifications in that it does

not affect the auditor’s opinion.
 An emphasis of matter paragraph highlights a matter affecting the financial statements
which is discussed in note to the financial statements, for example, going concern.
 The paragraph is included after the opinion paragraph

An “except for” opinion is expressed when the auditor cannot express an unqualified opinion but
the effect of the matter (disagreement or limitation on scope) is not so material and pervasive as
to require an adverse opinion or disclaimer of opinion.
(iii) Disclaimer of opinion

An auditor is unable to express (i.e. “disclaims”) an opinion when the effect of a limitation on
scope is so material and pervasive that the auditor has been unable to obtain sufficient
appropriate audit evidence (which may be reasonably expected to be available).
(iv) Adverse opinion

The effect of a disagreement is so material and pervasive that the auditor concludes that a
qualification is not adequate to disclose the misleading or incomplete nature of the financial
statements.
Distinctions
There are three issues which distinguish the form of modified reports
EITHER the matter does not affect the auditor’s opinion as in case (i)) or it does affect the
opinion as in cases (ii), (iii) and (iv)
If the audit opinion is affected, then:
EITHER there is sufficient appropriate evidence on a matter for the auditor to disagree with the
amount, treatment or disclosure in the financial statements as in case (iv));
OR there is insufficient evidence due to scope limitation as in case (iii)).
EITHER the matter is “so material and pervasive’ as in cases (iii) & (iv)
OR not so material and pervasive as in case (ii)) resulting in an “except for” opinion

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Other assignments
Matters to consider before accepting any Non-audit assignment
 Whether any conflict of interest exist

 Whether level of risk involved is manageable
 Independence
 Whether deadlines can be met
 Whether the auditor has the competency level required by the assignment
 Staff availability
 Integrity of clients
The followings should be discussed with management:
 Content of report
 Level of assurance. This will usually take the form of negative assurance as the work will
be less detailed compared to statutory audit. This type of work only relies on analytical
procedure and enquiry in gathering evidences
 Deadlines
 Limitation of liability. Liability to third party should be discussed
 Distribution of report. The use of the report will normally be restricted to the intended
users
 Types of evidence to be sought for
 Engagement letter
 Fess to be charged
Review Engagement
A review engagement is a professional engagement in which the auditor performs procedures
designed to enable the auditor to obtain the moderate level of assurance required to provide a
negative assurance report. Review engagement is an alternative to audit for companies not
required to carry out statutory audit.
In a negative assurance report the auditor states whether anything has come to the auditor’s
attention that causes the auditor to believe that the assertions do not present a true and fair
view, or otherwise comply with the criteria laid down for the engagement.

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In review engagement, the auditor primarily uses enquiry and analytical review procedures to
gather evidence. Audit procedures in review engagement do not include inspection,
confirmation or observation procedures as in audit engagement, however, the evidence
gathered must be sufficient to enable the auditor to provide a moderate level of assurance.
Agreed-Upon Procedures
An agreed-upon procedures engagement is one in which a practitioner is engaged by a client to
issue a report of findings based on specific procedures performed on subject matter. The client
engages the practitioner to assist specified parties in evaluating subject matter or an assertion
as a result of a need or needs of the specified parties.
In an agreed-upon procedure engagement, the auditor does not express an opinion or negative
assurance. Instead, the auditor issues a report that details the specific procedures performed
and the results of such procedures. Users of the report assess for themselves the procedures
and findings reported by the auditor and draw their own conclusions from the auditor’s work.
The report is restricted to those parties that have agreed to the procedures to be performed
since others, unaware of the reasons for the procedures, may misinterpret the results.
Examples of situations in which agreed-upon procedures may be used include:
 Licensing, contract and royalty compliance engagements

 Cash balances verification
 Security balances
 Compliance with specified terms of an agreement
Due diligence review

Due diligence review refers to the work commissioned by a client involving enquires into agreed
aspects of the accounts, systems, and activities of the target company in prospective business
purchase.
This assignment mainly requires the auditor to make enquiries and perform analytical
procedures. A lower level of assurance will be provided on the review.
Unlike audit engagement, a financial due diligence review would not only look at the historical
financial performance of a business but also consider the forecast financial performance for the
company under the current business plan and consider the reasonableness of such forecasts. A
financial due diligence review will investigate reasons for the trends observed in operation

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results of the company over a relevant time period and report on this in terms of relevancy for
the proposed transaction.
Due diligence review would typically involve a review of the following areas:
 historical financial results;
 current financial position
 forecast financial results
 working capital requirements
 employee entitlements provisions
 valuation implications
 risks and opportunities
 Taxation implications.
Matters to consider for due diligence assignment

 Whether there are ethical reasons why the work should not be undertaken
 Whether any conflict of interest exist
 Whether the firm has the required level of expertise required
 Reason for making the acquisition
 Deadlines
 Fess
 The scope and extent of work to be performed
Enquiries to be made by auditor
 Whether there are any contingent liabilities

 Whether take over will precipitate any tax liabilities
 Whether there any terms in the contract of employees which entitled them to
compensation in the event of any change in ownership
 Whether any redundancy payment will be required
 Whether any business contract with customers will be terminated on change of
ownership
 Whether existing lease agreement give right of termination to the lessor on change of
ownership

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Prospective Financial Information

According to International standard on Assurance engagements No. 3400 The Examination of
Prospective Financial Information, ‘Prospective financial information’ (PFI) means financial
information based on assumptions about events that may occur in the future and possible
actions by an entity. It is highly subjective in nature and its preparation requires the exercise of
considerable judgment. Prospective financial information can be in the form of forecast, a
projection or a combination of both, for example, a one year forecast plus a five year projection.
Forecast
ISAE 3400 defines a ‘forecast’ as prospective financial information prepared on the basis of
assumptions as to future events which management expects to take place and the actions
management expects to take as of the date the information is prepared (best –estimate
assumptions).
Projection
Projection is defined as prospective financial information prepared on the basis of:
(a) hypothetical assumptions about future events and management actions which are not
necessarily expected to take place, such as when some entities are in a start –up phase or are
considering a major change in the nature of operations, or
(b) A mixture of best-estimate and hypothetical assumptions.
In effect a forecast is an informed opinion on what will happen and a projection is an opinion on
what might happen in certain circumstances. Often a one-year forecast is given together with a
five year projection.
Prospective financial information can include financial statements or one or more elements of
financial statements and may be prepared:
 As an internal management tool, for example, to assist in evaluating a possible capital

investment; or
 For distribution to third parties in, for example:
A prospectus to provide potential investors with information about future
expectations.
An annual report to provide information to shareholders, regulatory bodies and
other interested parties.
A document for the information of lenders which may include, for example, cash
flow forecasts.

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Management Responsibilities regarding PFI

Management is responsible for the preparation and presentation of the prospective financial
information, including the identification and disclosure of the assumptions on which it is based.
The auditor may be asked to examine and report on the prospective financial information to
enhance its credibility whether it is intended for use by third parties or for internal purposes.
Auditor’s Responsibilities
In an engagement to examine prospective financial information, the auditor should obtain
sufficient appropriate evidence as to whether:
 Management’s best-estimate assumptions on which the prospective financial information

is based are not unreasonable and, in the case of hypothetical assumptions, such
assumptions are consistent with the purpose of the information
 The prospective financial information is properly prepared on the basis of the
assumptions
 The prospective financial information is properly presented and all material assumptions
are adequately disclosed, including a clear indication as to whether they are best-
estimate assumptions or hypothetical assumptions
 The prospective financial information is prepared on a consistent basis with historical
financial statements, using appropriate accounting principles.
General procedures on PFI

In performing an examination of prospective financial statements, the auditor should:
 Assess inherent and control risk as well as limit his or her detection risk.
 Consider the sufficiency of external sources and internal sources of information
supporting the underlying assumptions.
 Assess the consistency of the assumptions and the sources from which they are
predicated.
 Assess the consistency of the assumptions themselves.
 Assess the reliability and consistency of the historical financial information used.
 Evaluate the preparation and presentation of the prospective financial statements to
ensure conformity with relevant standards

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 Obtain a client representation letter to confirm that the responsible party acknowledges
its responsibility for the presentation of the prospective financial statements and the
underlying assumptions.
Acceptance of PFI engagement

Before accepting an engagement to examine prospective financial information, the auditor
would consider, among other things:
 The nature of the assumptions, that is, whether they are best –estimate or hypothetical
assumptions
 The period covered by the information
 The intended use of the PFI
 Whether the information will be for general or limited distribution. “General use” means
that the statements will be used by persons not negotiating directly with the responsible
party. “Limited use” refers to situations where the statements are to be used by the
responsible party alone or by the responsible party and those parties negotiating directly
with the responsible party.
 Competence and experience of the preparer
 Level of assurance to be provided
Possible procedures for cash flow forecast

The following procedures, among others may be applicable:
 Make enquiry of the preparer of the forecast and verify that they are competent
 Perform analytical procedures on historical information to confirm reasonableness of the
forecast
 Obtain direct confirmation from major trading partners of the client that they will continue
to deal with the client
 Agree salary payment to payroll
 Discuss sources of cash inflow in the forecast and evaluate the validity of the reasons
obtained
 Obtain a written confirmation from loan provider if any
 Obtain and review the financial statement of loan provider to assess whether it has
sufficient fund available

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 Should there be any claimed subsidy, inspect the application made for the subsidy to
confirm the amount of the subsidy
 In addition to the above, inspect correspondence with the subsidy awarding body to
assess the likelihood of getting the subsidy
 Cast the cash flow forecast
 Agree the opening cash position to cash book and bank statement
Procedures on forecast made in support of loan application
 Review the forecast and assess if the assumptions used reflects business reality.
 Obtain written representation from management confirming that the assumptions in the
forecast are achievable.
 Assess the sufficiency of the loan requested to cover the intended expenditure.
 Discuss any other source of finance being considered by management and assess the
likelihood.
Forensic Auditing
Forensic Accounting
This refers to use of accounting, auditing and investigative skills to conduct an examination into
company’s financial affairs. Forensic accounting refers to the whole process of investigating a
financial matter, including potentially acting as an expert witness if the fraud comes to trial.
Forensic Accounting provides an accounting analysis that is suitable to the court which will form
the basis for discussion, debate and ultimately dispute resolution.
Forensic Accounting includes:
 Reconstructing records accidentally or intentionally destroyed
 Vouching and tracing transactions and validation of supporting documentation
 Analyzing financial results
 Determining the completeness and accuracy of financial reports
Forensic Audit
Forensic auditing refers to the specific procedures carried out in order to produce evidence.
Audit techniques are used to identify and to gather evidence to prove

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Forensic Investigation
The utilization of specialized investigative skills in carrying out an inquiry conducted in such a
manner that the outcome will have application to a court of law.
Matters to consider in forensic assignment
 Whether the firm has staff with sufficient experience

 Scope of work involved
 Whether any independence issue arise
 Reliance to be placed on the report
Procedures to carry out before accepting appointment
 Review staff availability and timings

 Discuss scope with client’s management
 Discuss fees and deadlines
 Draft an engagement letter
Forensic audit and its application to fraud investigation

The objectives of the investigation will include:
 Identifying the type of fraud that has been operating, how long it has been operating for,
and how the fraud has been concealed.
 Identifying the fraudster(s) involved.
 Quantifying the financial loss suffered by the client.
 Gathering evidence to be used in court proceedings.
 Providing advice to prevent the reoccurrence of the fraud.
Steps involved in forensic investigation (fraud case)
 establish the type of fraud that has taken place

 determine for how long the fraud has been operating
 determine how the fraud was conceal
 collect evidence
 produce report

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 show up in court proceedings if required
Forensic investigation being requested by an audit client: ethical consideration

Unless robust safeguards are put in place, the firm should not provide audit and forensic
investigation services to the same client.
A perceived threat to objectivity that may occur includes:
 Advocacy threats. The audit firm may be promoting interest of the client in court as they
are concerned about losing their audit fees
 Self-review. The self-review threat arises because the investigation is likely to
involve the estimation of an amount. If the amount as quantified by the auditor is
material to the financial statement, the auditor will be auditing his own work
Application of ethical principles to a fraud investigation

IFAC’s Code of Ethics for Professional Accountants applies to all ACCA members involved in
professional assignments, including forensic investigations. There are specific considerations in
the application of each of the principles in providing such a service.
Integrity
The forensic investigator is likely to deal frequently with individuals who lack integrity, are
dishonest, and attempt to conceal the true facts from the investigator. It is imperative that the
investigator recognises this, and acts with impeccable integrity throughout the whole
investigation.
Objectivity
As in an audit engagement, the investigator’s objectivity must be beyond question. The report
that is the outcome of the forensic investigation must be perceived as independent, as it forms
part of the legal evidence presented at court. The investigator must adhere to the concept that
the overriding objective of court proceedings is to deal with cases fairly and justly. Any real or
perceived threats to objectivity could undermine the credibility of the evidence provided by the
investigator.
Professional competence and due care
Forensic investigations will involve very specialist skills, which accountants are unlikely to
possess without extensive training.
It is therefore essential that forensic work is only ever undertaken by highly skilled individuals,
under the direction and supervision of an experienced fraud investigator. Any doubt over the

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competence of the investigation team could severely undermine the credibility of the evidence
presented at court.
Confidentiality
Normally accountants should not disclose information without the explicit consent of their client.
However, during legal proceedings arising from a fraud investigation, the court will require the
investigator to reveal information discovered during the investigation. There is an overriding
requirement for the investigator to disclose all of the information deemed necessary by the
court.
Outside of the court, the investigator must ensure faultless confidentiality, especially because
much of the information they have access to will be highly sensitive.
Professional behaviour
Fraud investigations can become a matter of public interest, and much media attention is often
focused on the work of the forensic investigator. A highly professional attitude must be
displayed at all times, in order to avoid damage to the reputation of the firm, and of the
profession. Any lapse in professional behaviour could also undermine the integrity of the
forensic evidence, and of the credibility of the investigator, especially when acting in the
capacity of expert witness.
During legal proceedings, the forensic investigator may be involved in discussions with both
sides in the court case, and here it is essential that a courteous and considerate attitude is
presented to all parties.

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Question FLASHMARK
Flashmark is an audit client of your firm and manufactures household furniture. It has a year end
of 30 June.
On 13 November 2008, a fire destroyed the company’s factory complex, which included the
area used for storing raw materials. The fire was caused by an electrical fault. The factory has
now been rebuilt and the company recommenced trading in May 2009.
The finance director of Flashmark produces monthly management accounts; in these, inventory
and cost of sales are estimated, based on sales figures less assumed margins. At 30
September and 31 March, the company conducts full physical inventory counts for its own
purposes in addition to its year-end count. The results of these counts are compared with the
management accounts for September and March and adjustments are made to reflect the
physical quantities and their appropriate values.
The finance director has contacted your firm to provide a certificate in support of his claim for
losses of profits and loss of inventories arising as a result of the fire.
Required:
(a) Identify and comment on the issues raised as they affect the extent and scope of this
assignment. (8 marks)
(b) State the information you would seek and the procedures you would perform in order to
reach an opinion on the company’s claim for losses of profits and loss of inventory.
(7 marks)
(c) Outline the form and content of your report accompanying the claim. (5 marks)
Answers
(a) Issues raised
Prospective financial information
The financial information on which a certificate is required is for a period (not yet expired) in
respect of which the annual audit has yet to be undertaken. The losses of profits will essentially
be forecasts of the finance director’s best expectation of the most likely results of 6 months
trading after the fire.
Assumptions

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The finance director will have had to make assumptions which reflect his judgment as to the
conditions prevailing during the period of non-trading activity. Some assumptions will be highly
subjective.
Scope
The investigation will encompass the raw material inventory valuation, loss of profits calculation
and statement of assumptions.
Management’s responsibilities
Management’s responsibility for the assumptions and other matters of judgement and opinion
should be confirmed in a letter of engagement.
Report required
Although the finance director has requested a “certificate”, it will not be appropriate for his
claims to be “guaranteed” in any way. The form and content of the report(s) required must be
established before the assignment can be accepted. It would be equally inappropriate for
opinions in “true and fair” terms to be required.
Timescale
As for all professional work, the assignment should be carried out with a proper regard for the
technical and professional standards expected. It is unlikely that the level of skill and care
necessary for forming opinions in these areas can be exercised within a restricted timescale.
Access to information
There should be unrestricted access to all information and explanations necessary to form an
opinion on the company’s claims. It may be necessary to discuss sensitive issues, for example,
relating to the cause of the fire and any police investigation.
Prior year audit
Some relevant information is probably included in the prior year audit working paper file as the
fire is likely to have occurred before the auditor’s report was signed (or even before the field
work was completed). Some verification work may have already been undertaken, for example,
for disclosure of the financial effect of this non-adjusting event after the reporting period.
Current year audit
It may be expeditious to perform certain audit work while undertaking this assignment (e.g. to
avoid having to repeat or extend tests at a later date). In particular, the insurance claim is likely
to constitute a receivable balance at 30 June 2009.

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Engagement letter
All relevant matters concerning responsibilities, scope of work and reporting requirements
should be set out in a letter of engagement which the finance director should acknowledge in
writing before work on the assignment commences.
(b) Information
 Insurance cover, terms and conditions including sums insured and deductibles.
Specifically:
 whether raw material inventory is insured for replacement cost or a written down
value;
 how gross profit is defined (e.g. the amount by which turnover and closing
inventory exceed opening inventory and specified operational expenses)
 Latest amounts declared for consequential loss cover (e.g. based on last year’s audited
financial statements).
 Results of 30 September 2008 (and earlier) inventory counts. The quality as well as the
quantity of slow-moving items should have been noted (at least for last year- end).
 Monthly profits for the 6 months of disruption, the previous 6 months and the
corresponding amounts for the previous year.
 Industry statistics, for example, % increase/decrease of monthly trading compared with
prior year.
Procedures
 Inspect the insurance policy and obtain details of any claims already submitted, for
example, in respect of damage to buildings (which could include cleaning costs which
might otherwise be claimed as consequential loss).
 Compare inventory quantities claimed to have been lost against September inventory
count quantities. Substantiate significant increases, for example, to purchase invoices
dated in the period 1 October to mid-November.
 Compare management’s assumptions and policies with those normally adopted for the
preparation of management accounts and annual financial statements and investigate
any inconsistency

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 Agree the client’s valuation of all significant raw material inventories to historic or current
purchase invoice data (as appropriate).
 Agree the basis of the client’s loss of profits calculation to that specified in the insurance
policy.
 Agree the make-up of costs deducted from lost sales and ensure they are allowable
under the terms of the insurance policy.
(c) Form and content
 Purpose of report and for whom it is prepared (e.g. to the directors of Flashmark).
 The financial information investigated, i.e. the valuation of lost inventory and loss of
profits.
 The date of the event (13 November) and the nature of the disruption, i.e. fire followed
by periods of closure and rebuilding.
 Scope of investigation undertaken, for example, in accordance with the terms of the
letter of engagement and ISA 920 Engagements to Perform Agreed-Upon Procedures
Regarding Financial Information.
 Principal assumptions and judgements relating to the valuations concerning, for
example:
 the net realisable value or replacement cost of inventory:
 the basis of verifying the quality of inventory destroyed
 Summary of results and findings
 Opinions e.g. “assumptions not contradicted”
 Qualification, for example, “except for” all necessary information and explanations
having been received from the client.
Question PETER LAWRENCE

A new client of your practice, Peter Lawrence, has recently been made redundant. He is
considering setting up a residential home for old people as he is aware of an increasing need for
this service with the ageing population. He has seen a large house, which he plans to convert
into an old people’s home; each resident will have a bedroom, there will be a communal sitting-
room and all meals will be provided in a dining-room. No long-term nursing care will be

168 | P a g e
provided. The large house is in a poor state of repair, and will require considerable structural
alterations, and repairs to make it suitable for an old people’s home, and in particular new
furniture and fittings, decoration of the whole house, and specialised equipment.
Mr. Lawrence and his wife propose to work full-time in the business, which he expects to be
available for residents six months after the purchase of the house. Mr. Lawrence has already
obtained some estimates of the conversion costs, and information on the income and expected
running costs of the home.
Mr. Lawrence has received about $30,000 from his redundancy, and expects to receive about
$30,000 from the sale of his house (after repaying his mortgage). The owners of the house he
proposes to buy are asking $50,000 for it, and Mr. Lawrence expects to spend $50,000 on
conversion (i.e. building work, furnishing, decorations and equipment).
Mr. Lawrence has prepared a draft capital expenditure forecast, a profit forecast and a cashflow
forecast which he has asked you to check before he submits them to the bank, in order to obtain
finance for the old people’s home.
Required:
(a) Identify and comment on the issues you would consider before undertaking such work.
(5 marks)
(b) Describe the factors you should consider in verifying each of the three forecasts.
(15 marks)
Answers
(a) Considerations before undertaking work
 Before accepting such an engagement the accountant must ensure that he has sufficient
time, skilled staff and experience to perform the work.
 If he is reasonably confident of the viability and stability of the proposed business and
foresees no limitations imposed on his work by management then he can accept the
engagement.
 An engagement letter should be issued to confirm the nature, responsibilities and scope
of the work. The letter should emphasise that management are responsible for the
forecasts.
 In planning his work the accountant needs to obtain a good understanding of the
residential home market.

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(b) Factors to consider in verifying forecasts
(i) Capital expenditure forecast

The capital expenditure forecast will be split into monthly periods. The accountant would carry
out the following checks to establish that the forecast is reasonable.
 House purchase – Inspection of correspondence between estate agent, solicitors and

Peter Lawrence. Consider estimates of solicitor’s fees, survey fees and stamp duty on
the purchase. The latter cost is unavoidable and maybe a significant part of the cost of
purchase.
 Building and repairs – Review of the estimate and comparison to any architect’s
specifications, for reasonableness. It would be prudent to inspect the house and
examine those areas which are going to be subject to major renovations and repairs.
 Estimates for fixtures, furnishings and equipment – consider the reasonableness of
estimates in the light of any Health Authority guidelines.
 Agree capital expenditure to estimates and price catalogues for specialist equipment,
kitchen appliances and decoration.
 The forecast should also include specialised plumbing for kitchens, bedrooms and
bathrooms which would be required for the type of clientele in the home.
 The accountant would enquire whether Mr. Lawrence intends to purchase any of these
items on Hire Purchase; alternatively whether any of the items are to be leased which
would have a bearing on the cash flow forecast.
(ii) Profit forecast

The profit forecast will include income and expenditure. The accountant will consider the
following:
 Income – The majority of income will arise from room lettings. It will be unlikely that Mr.
Lawrence will have 100% occupancy when the home becomes operational. Therefore it
will be necessary to establish that realistic estimates of income have been obtained.
There should obviously be no income in the period when the home is being renovated.

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The reasonableness of the rate per room should be checked with any Health Authority
guidelines and brochures of homes of a similar type.
 Staff costs – The major item of expenditure will be staff costs. The accountant should
enquire whether the ratio of residents to nursing staff is reasonable and complies with
what the Health Authority regard as desirable. The rates of pay for the staff should be
verified by reference to local newspapers, staff agencies and any other homes of a
similar type.
 Rent and water rates – can be verified by reference to local authority data or from
surveyors correspondence.
 Electricity and gas – this will be subjective and based upon the accountant’s experience
with similar types of business.
 Food – an estimate of the cost of each day's meals per head should be obtained. This
should be reasonable in comparison with similar organisations.
 Telephone – there will be an initial charge for installing the telephone and a reasonable
estimate of expenditure should be made.
 Insurance – this will include public liability insurance, employer’s liability insurance and
fire insurance. Correspondence with Mr. Lawrence’s underwriter should reveal estimates
for these.
 Interest – the interest charge should be based upon Mr. Lawrence’s capital requirements
at the rate applicable to overdrafts of unincorporated businesses.
 Depreciation, advertising etc – verify by reference to the outlays on plant and equipment,
and advertising rates from the local press.
(iii) Cash flow forecast
 Verifying the capital expenditure line in the outgoings part of the forecast with the capital
expenditure forecast.
 Verifying the pattern of cash inflows with the profit and loss account income section.
 Verifying the payment of overheads, telephone, electricity and gas, with the profit and
loss account and establishing that the total paid in the year is broadly equivalent to the
annual charge plus or minus a year-end accrual.
 Verifying that rates are prepaid on the due dates and that the cash forecast makes
provision for taxation.
 Checking that the computations on the cash flow forecast are consistent with the profit
forecast

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SOCIAL AND ENVIRONMENTAL AUDIT

Environmental and social audit involves performing procedures to identify compliance with
environmental regulations and to assess if entity is meeting its social targets. It involves
assessing how well an entity performs in keeping environmental regulations and complying with
its environmental policies. To meet this responsibility, company are expected to:
 Establish target.
 Measure its actual performance compare to target set.
 Report compliance.
Audit procedure
 Obtain a copy of the entity’s environmental policy to establish compliance target.
 Assess whether the likelihood of the entity’s policy in achieving objectives.
 Discuss how the policies were implemented with management.
 Observe implementation of policies.
Impact of social and environmental compliance on external audit

 There is need for auditor to understand any environmental regulations affecting the client
for planning purpose.
 Auditors need to assess the risks of material misstatement as a result of any
noncompliance with environment regulations so as to design appropriate audit
procedure to obtain evidence.
Risk attached to non-compliance with environmental and social regulations
 Bad publicity and boycott by environmentally conscious customers.

 Fines and compensation claims that put the entity under financial risks.
 Withdrawal of operating license as a result of non-compliance.

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ADVANCED AUDIT AND

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CONSIDERATION OF LAWS AND REGULATIONS IN AUDIT 3

PROFESSIONAL CODES OF ETHICS 11

FRAUD AND ERROR 20

ADVERTISEMENT OF AUDIT SERVICES 28

AUDIT OF FINANCIAL STATEMENTS 40

REVISION OF ACCOUNTING STANDARDS 56

GROUP AUDIT ISSUES 129

AUDIT REPORT 141

OTHER ASSIGNMENTS 154

FORENSIC AUDITING 160

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CONSIDERATION OF LAWS AND REGULATIONS IN AN AUDIT OF FINANCIAL

Responsibilities of Management and Auditors regarding laws and regulation

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Audit Procedures to identify non-compliance with laws and regulations

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Audit procedures when non-compliance is identified:

 Potential financial consequence such as fines and penalties.

When non-compliance is identified the auditor should:

 Reassess the risk.

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Impact of non-compliance on the auditor’s report

 When non-compliance is material and not adequately disclosed in the financial

Reporting non-compliance to regulatory authority

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Factors indicating money laundering:

 Transactions routed through several jurisdictions.

The three stages of the money laundering process

Anti-money laundering procedures

1. Who the client is

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Elements of basic money laundering program

1. Appoint Money Laundering Reporting Officer (MLRO).

The need for ethical guidance on money laundering

1. The accountants’ professional duty of confidentiality in relation to client’s

Professional accountants are not in breach of their professional duty of confidentiality if

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3) If he resigns from an engagement as a result of money laundry suspicion, auditor

 making reports to the relevant agency

 relevant money laundering legislation

3) Firms should Perform customer due diligence before accepting an engagement.

 the ownership structure of the client

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PROFESSIONAL CODES OF ETHICS AND BEHAVIOR

The fundamental principles (OPPIC)

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SPECIFIC SITUATIONS THAT THREATEN ADHERENCE TO THE FUNDAMENTAL CODES

 Inform the client’s management

Audit firm carrying out actuarial service for clients

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Audit firm offering internal audit services to client

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 Management threat. Recruitment of staffs is management’s responsibility. Offering of this

 Request management to acknowledge that it is responsible for the recruitment of staff

Temporary staff assignment

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Financial interest in an audit client

Preparing financial statement for audit client

Representing the interest of clients before a third party

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Significance of The Threat depends on the following factors