Paper 6(Y)

Audit Framework
(International Stream)

MODULE C – CERTIFICATE STAGE

JUNE 2001

QUESTION PAPER

Time allowed 3 hours

This paper is divided into two sections

Section A ALL THREE questions are compulsory

and MUST be answered

Section B TWO questions ONLY to be answered

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

1 Bardwell is a privately owned incorporated business that operates a garage which repairs and services motor vehicles.
Most customers are required to pay by cash or cheque on collecting their vehicle. Credit accounts are available to
business customers. These customers sign the invoice on collection of the vehicle and their business is billed monthly.
Separate series of prenumbered invoices are drawn up by the foreman for cash sales and for credit sales. All customer
accounts are maintained by the receptionist. His duties include the following:

Cash sales
Collect cash or cheques from customers on collecting their vehicle.
At the end of the day, check the numerical sequence of cash sales invoices, add the sales total and agree the total
to the amount of cash and cheques received.
Record the total cash sales in the cash receipts book.

Credit sales
Obtain the customer’s signature on the copy invoice of business account customers.
Enter the invoices in numerical sequence in the sales journal and post the customer’s account in the accounts
receivable ledger.
Send monthly statements to credit account customers and follow up overdue accounts.
List the balances on the accounts receivable ledger at the end of the month and reconcile the total with the control
account in the general ledger.
Write off uncollectible balances to bad debts.

Cash receipts
Open the mail, extract cheques from credit account customers, record them in the cash receipts book and post the
accounts receivable ledger.
Make up the day’s banking of cash (and cheques) from both cash and credit sales, prepare the deposit slip and
bank the cash (and cheques).
All other accounting duties are the responsibility of two further accounts clerks and all are subject to supervision by the
garage manager.
Required:
(a) (i) Explain why the functions assigned to the receptionist result in an inadequate segregation of duties. Your
explanation should identify misstatements that could occur and indicate how those duties could be
reassigned to other staff members; (8 marks)

(ii) Identify other control procedures you would consider necessary to ensure the completeness of the
recorded cash receipts and accounts receivable. (4 marks)

(b) As a member of the audit staff of the company’s external auditors, you visit the garage and make a count of cash
on hand. You subsequently compare details of unbanked cash receipts that you counted with the entry in the cash
receipts book for that date. Although the total in the cash receipts book is the same, the amount of banknotes and
coins is less and there is a cheque from a business customer that you did not record.
Required:
(i) Explain the procedures to be followed in making a cash count for audit purposes; (4 marks)
(ii) Explain the irregularity that the discrepancy between the cash count and cash receipts book might lead
you to suspect, and describe how you would investigate the discrepancy. (4 marks)
(20 marks)

2
2 ISA 500 Audit Evidence provides a framework for evaluating the role of evidence in forming an opinion. Amongst other
matters it:
(a) describes the objectives of audit evidence as being either to test controls or provide substantive evidence. Tests of
controls are further analysed into tests of design and tests of operation. Substantive procedures are classified as
tests of details of transactions, tests of details of balances and analytical procedures;
(b) identifies financial statement assertions to which evidence relates; and
(c) discusses the reliability of different kinds of evidence.
The following procedures appear in the accounts payable audit program for Gordon, a listed company.
(1) Select a sample of purchase transactions recorded in the purchase journal during the year and vouch them to
suppliers’ invoices.
(2) Observe the goods received clerk accepting delivery of goods.
(3) Check the numerical continuity of a sequence of goods received notes and trace them to suppliers’ invoices and to
the entry in the purchase journal.
(4) Select a sample of purchase invoices and see that they have been initialled as being agreed to the goods received
note and to the purchase order.
(5) Consider the reasonableness of the relationship between the year-end accounts payable balance and the total of
credit purchases during the year.
(6) Add the list of creditors’ balances and agree the total to the control account in the general ledger.
(7) Enquire into the procedures used to ensure the reliability of cut-off.

Required:
For each procedure (2) to (7) inclusive:
(a) identify its principal objective; (3 marks)
(b) explain its objective in terms of the account balance or transaction class involved and the financial statement
assertion(s) to which the evidence principally relates; (8 marks)
(c) discuss the reliability of the evidence obtained. (9 marks)
(20 marks)

For your guidance an answer to the first procedure would be:

Test (a) Objective (b) Assertion(s) (c) Reliability

1 Substantive To verify the occurrence of
test of details purchase transactions by
of purchase ensuring that each recorded
transactions purchase is supported by
evidence of being invoiced
by the supplier.
Suppliers’ invoices are reasonably
reliable being third party documents
providing the copy examined is the
original and has not been altered.

You may find it convenient to turn your answer book sideways in answering this question.

3 [P.T.O.
3 Two important communications between the auditors and the management or Board of Directors of the client entity are
commonly referred to as the Letter of Representation and the Management Report (or Letter of Weaknesses). Both
communications are referred to in ISA 210 Terms of Audit Engagements. The letter of representation is, additionally, the
subject of ISA 580 Management Representations and the management report is referred to in ISA 400 Risk
Assesments and Internal Control.

Required:
(a) Letter of representation:
(i) Explain the purpose of the letter of representation and the extent to which it constitutes sufficient
appropriate audit evidence; (5 marks)
(ii) Describe three matters you might find in a letter of representation (other than the acknowledgement by
management of its responsibility for the financial statements); (3 marks)
(iii) Explain the effect, on the audit, if management refuse to make one or more of the representations
requested. (3 marks)

(b) Management report:

(i) Describe the procedures associated with the communication of control weaknesses to management
relating to:
– timing of the communication;
– method of communication;
– level of management to which communication should be made. (4 marks)
(ii) Discuss the extent of the auditors’ responsibility for detecting and reporting internal control weaknesses.
(5 marks)

(20 marks)

4
Section B – TWO questions ONLY to be attempted

4 (a) As the senior in charge of the audit of Killara, a listed company, you are planning appropriate sample sizes for tests
specified in the audit program. In accordance with the guidance provided in ISA 530 Audit Sampling and other
Selective Testing Procedures, you have identified the relevant factors to be taken into consideration in the following
tests of control and substantive tests of details.
Tests of control
Test 1 Purchase Invoices
Select a sample of purchase invoices and see that they are initialled by the accounts payable clerk as having been
checked with the goods received note.
Test 2 Sales Invoices
Select a sample of sales invoices and see that a second clerk has initialled them for checking prices against the
approved price list.
Sample size factor Test 1 Test 2
Purchase invoices Sales invoices
Population of invoices processed in the year 6,000 20,000
Preliminary assessment of control risk low at 30% moderate at 60%
Tolerable deviation rate 2% 5%
Expected deviation rate based on last year’s audit 0·1% 3%

Substantive tests of detail

Test 3 Inventory
Test pricing of inventory items against costing records.
Test 4 Accounts receivable
Test the ageing of balances in the aged listing of accounts receivable balances.
Sample size factor Test 3 Test 4
Inventory Accounts receivable
Combined assessment of inherent and control risk moderate at 50% low at 20%
Tolerable error as percentage of recorded balance 2% 0·5%
Expected error rate based on last year’s audit 2% 0%

Required:
(i) For each pair of tests, discuss the effect of each of the factors referred to in the tables above on relative sample
size. (12 marks)
(ii) When subsequently performed, the sample tests of control indicated a deviation rate of 2·1% for test 1 and a
deviation rate of 0·5% for test 2.
Comment on the implications of these results on the assessment of control risk. (4 marks)

(b) During the year the company introduced a new, fully integrated computer system. The new system required a
fundamental reorganisation of the management of information technology in the organisation. As a result, you will
have to reappraise the effectiveness of general controls over computer processing.
Required:
In your evaluation of the effectiveness of general controls, describe the control objectives you will be concerned
with in the following categories:
– organisational controls;
– systems development and maintenance controls;
– access controls;
– other controls. (4 marks)
NB Candidates should note that they are not required to describe procedures necessary to achieve the control
objectives.
(20 marks)
5 [P.T.O.
5 During a seminar on fraud and compliance with laws and regulations, with particular reference to the implications of:
ISA 240 Fraud and Error
ISA 250 Consideration of Law and Regulations in an Audit of Financial Statements,
participants were invited to offer experiences for consideration by the seminar. Amongst the experiences considered
were the following.

(a) During the audit of a listed company, confirmation of investments held by the company’s bank revealed that a
number of share certificates were missing. The value of the shares was not material to the company but the matter
was investigated because of suspicions of further irregularities. On enquiry, the chief financial officer to the
company provided the auditors with a copy of a letter from a different bank stating that they held the certificates for
safekeeping. Enquiry of that bank revealed the letter to be a forgery. The chief financial officer admitted to using his
authority to transfer the shares into his own name as security on a personal loan. (6 marks)

(b) The directors’ minutes of a large company indicated that a recently launched product had failed a safety test and
was not in compliance with official safety requirements. The company decided to remove evidence of the failure
from the test records so that the failure would not be discovered by government inspectors. The chief financial
officer refused to make provision for the consequences of the product’s failure. The breach of the regulations, he
argued, was purely technical with no bearing on the safety of the product. (6 marks)

(c) A small publishing company paid royalties to authors at an agreed percentage of sales revenue for each title.
Recomputation, by the auditors, of royalties payable, indicated a substantial underpayment on a regular basis. The
chief financial officer claimed that any underpayment was an error. However, she added, authors had the right to
appoint a representative to check payments. Since they failed to do so the company had no further liability.
(5 marks)

(d) Scrutinising the unclaimed wages book of a medium sized business it was apparent that the same employee
regularly failed to collect her pay. The book showed that the wages were always collected on her behalf by the
department supervisor. The total amount was not material so further investigation by the auditors was considered
unnecessary. (3 marks)
Required:
For each situation, comment on the implications for the audit and discuss further actions the auditors should take.
(20 marks)

6
6 As part of the process of planning the external audit of Five Dock, a public listed company, for the year ending
31 October 2001, you have reviewed the minutes of meetings of the Board of Directors for the year to date. You have
identified the following items likely to have a bearing on the assessment of audit risk and the design of audit procedures
when drawing up the audit plan.
(1) On the recommendation of its non-executive Chairman, Five Dock has invested a substantial amount in the shares
of Burwood, a private company, of which the Chairman is chief executive and major shareholder.
(2) Development project 21A is behind schedule. Unexpected problems have emerged which will substantially
increase the cost of the development and the production cost of the new product. $120,000 of development cost
was recognised as an asset in the balance sheet last year. A further $50,000 has been spent this year. The original
budget was $130,000.
(3) In order to encourage performance, a bonus scheme has been introduced for senior management. In total, 25% of
the company’s reported profits before tax in excess of the previous period’s profits will be set aside to provide for
bonuses. No bonus will be paid if profits do not exceed the previous period.
(4) An internal audit department has been established.
(5) In order to finance investment in new projects Five Dock has taken out a substantial bank loan. The loan
agreement states that the company’s gearing ratio (the proportion of loan capital to equity capital) must not exceed
30%. Last year’s financial statements had a gearing ratio of 20% and the latest monthly management accounts
show a gearing ratio of 25%.
Required:
For each of the items (1) to (5) above:
(a) explain how it might affect the assessment of inherent or control risk. (8 marks)
(b) consider how it might affect the design of audit procedures specific to that item. (12 marks)
(20 marks)
Assume each item is potentially material. Consider each item separately.

End of Question Paper