Planning and risk assessment

201 to 214

83- and 185-page number

203 Hart

a) Explain the benefits of audit planning

- Helping the auditor to devote appropriate attention to important areas of the audit
- Helping the auditor to identify and resolve potential problems in a timely basis
- Helping the auditor to properly organize and manage the so that the audit engagement is
performed in an effective and efficient way
- Assisting in the selection of audit team members with appropriate levels of capabilities and
competence to respond to the anticipated risk and assignment of proper work to them
- Assisting , where applicable, in coordination of work done by experts

B audit risk and auditors’ response

Note: new audit client means increased detection risk

Audit risk Auditors response

New audit client Morph Co should ensure that it has suitably
Hart Co is a new client for Morph Co experienced audit team members assigned to the
As the audit team is not familiar with the audit and the adequate time is allowed for team
accounting policies, transactions and balances of to obtain an understanding of the company and
Hart Co, there will be increased detection risk on the risk material misstatement, including a detail
the audit team briefing to cover the key areas of risk.
There is less assurance about the opening Increased audit procedures should be performed
balances as the Morph Co did not perform the over opening balances
audit last year.
Director’s bonus The audit team should be aware of the risk of
Directors are paid bonus on a percentage of manipulation and should assign more
profit before tax for the year. experienced members to significant areas and
There is a risk that the directors will try to judgmental areas.
overstate the profit, and therefore their bonuses The team needs to maintain professional
by increasing the revenue recorded and skepticism and be alert on the increase risk of
decreasing the expenses. This is a particular risk manipulation. Increased testing should be
relating to the judgmental areas such as performed relating to the adjusting journal
provisions and estimates. entries

Revenue recognition They should discuss with the management the

Customer pays 25% deposit on signing the criteria for determining whether performance
contract, with the balance payable when the obligations have been satisfied and the
control of the playground is transferred treatments of deposit received to ensure it is
The deposit should not be recognized as income appropriate and consistent with the relevant
but should be recognized as deferred income standards
within current liabilities until the performance During the final audit, the audit team should take
obligation, as per the contract, has been increased testing over the cut off revenue and
obligated. the completeness of the deferred income
There is a risk that the revenue has been
overstated and the current liabilities has been
understated if the deposit has been treated as
revenue
WIP The team should assess which inventory counts
The audit team will only attend the WIP counts at to attend, most likely to be those with the most
the 16 sites material WIP balances or which are assessed as
WIP is a material balance and the valuation of having the greatest risk of material misstatement
WIP is a judgmental area. As the audit team is not
attending all the sites, detection risk is increased
as the team will not be able to obtain evidence
relating to WIP.
Warranty Provision
Hart Co offers warranty at no extra cost, which The audit team should discuss with management
guarantees that the about the basis of calculation of the provision
playgrounds will function as expected for a and compare this to the industry averages and
period of three years. It has been calculated as level of post year end claim, if there is any. In
2% of revenue. While previous year it was particular they should discuss the rationale
based on 6% of revenue despite having no behind reducing the level of provision this year
significant
difference in construction techniques or the level
of claims in the year
Under IAS 37 Provisions, Contingent liabilities,
Contingent assets this should be recognized as
the warranty provision. Calculating the warranty
provision requires judgment as it is an uncertain
amount.
There is a risk that the warranty provision could
be understated, leading to the understated
expenses and liabilities
Research and Development
From the incurred expenditure of 1.8 million The audit team should obtain a breakdown of the
regarding the research and development, 0.6 research expenditure recognized in the
million has been written off in the statement of statement of profit or loss and the development
profit or loss and 1.2 million has been costs capitalized and review the supporting
assigned as the development expenditure documentation to determine whether they have
IAS 38 Intangible assets have strict criteria as to been properly classified
which costs can be capitalized as development
expenditure. There is a risk that the requirements
of this standard have not been applied correctly.
If research costs have been incorrectly classified
as the development expenditure, then there is a
risk that the intangible assets could be overstated
 and research expenses understated.
PPE
Hart Co placed an order for $2.4m of machinery, Review the non-current asset register to
paying $1 m in advance. The machinery was due determine whether the 1 million has been
to be received in July 20X5 but will now be capitalized. Discuss the correct accounting
delivered post year end treatment with management to confirm the
Only asset physically exist at the year-end should amount paid in advance is recognized as the
be capitalized as property, plant and equipment. prepayment and if incorrectly recognized review
The 1 million advance paid should be treated as the journal entries
the prepayment
If the deposit of 1 million paid in advance has
been capitalized as the PPE, then the PPE would
be overstated and the prepayment would be
understated
Right issues They should recalculate the split of the shares
Hard made right issues in the year. Right issues between share premium and the share capital
are non-standard transaction and there is an and agree this to the journal entry to record the
increased risk that the issues have not been right issues
treated correctly. The audit team should also agree that the
The right issues have been issued at a premium disclosures are adequate and consistent with
and therefore requires to be split into its shares accounting standards and legislation
capital and share premium elements
There is a risk that the split between the share
capital and the share medium has not been
accounted properly and these balances are
misstated. There is also risk that the right issues
have not been disclosed correctly according to
the accounting standards and the local
legislation.
Payroll function
Hart Co’s payroll function is outsourced to an Discuss with management any changes to the
external service organisation. extent of the records maintained at the Hart Co
The detection risk arises as to whether sufficient since the prior year audit and any monitoring of
and appropriate evidence is available at Hart Co controls which has been undertaken by Hart Co
to confirm the completeness and accuracy of management over payroll
controls over the payroll cycle and liabilities at Consideration should be given to contacting the
the year end auditor of the chaz co, to confirm the levels of
control in the place. A type 1 and type 2 records
should be requested.

Describe substantive procedures the auditor should perform to obtain sufficient and

appropriate audit evidence in relation to Hart Co’s directors’ bonuses.

 - Obtain a schedule of director’s bonus and cast the schedule to ensure its accuracy. Agree the
amount to that of financial statements
- Review the schedule of current liabilities and confirm that the bonus accrual is included as the
year end liability
- Agree the individual bonus to the post year end payroll records
- Compare the profit before tax used in the bonus calculation to the final profit before tax to
confirm where any adjustment is required to the bonus paid and discuss any differences with
the management
- Agree the amounts paid to the director to the board minutes and contracts to ensure that the
amounts included in the financial statements are fully accrued and disclosed
- Obtain a written representation from the management confirming the completeness of the
director’s remuneration as well as the bonus
- Review the disclosures regarding the bonus paid to the director and assess whether these are in
compliance with the accounting standards and the local legislation

Explain the safeguards which Morph & Co should implement to ensure that this
conflict of interest is appropriately managed.

- Both hart co and its competitors should be notified that Morph co would be acting as auditors
for each company and consent should be obtained from the management of each company
- Morph co should consider one or both the clients to seek additional independent advice
- Morph Co should ensure that it appoints separate engagement teams, with different
engagement partner and team members to each client; once an employee has worked on the
audit, such as hart co, they should be prevented from being on the audit of the competitor
company for a period of time
- Adequate procedures should be in place within the firm to prevent access to information for
example strict physical separation of both teams and confidential and secure data filing
- Morph Co should consider use of confidentiality agreements by the all the members of the audit
engagement team of Hart Co and the competitor
- Work performed should be reviewed by an appropriate reviewer who is not involved in the
audit to assess whether key judgment and conclusions are appropriate
- Regular monitoring of the above safeguards should be undertaken by a senior member of
Morph Co not involved in either of the audit

204

Explain the PURPOSE of an audit engagement letter and list FOUR items which should

be included in an audit engagement letter.

Purpose of an engagement letter is that it outlines the responsibilities of both the audit firm and the
client. It’s purpose is to

- Minimize the risk of misunderstanding between the auditor and the client
- Confirm acceptance of engagement
- Forms the basis of contract by outlining the terms and conditions of the engagement

Items to be included in the engagement letter

The objective and scope of audit

The responsibilities of the auditor

Responsibilities of management

Identification of the financial reporting framework used in the preparation of the financial statements

The fact that the material misstatement may be discovered

The expectation that management will provide written representation

Any obligations to provide audit paper to third parties

Explain WHY the following factors should have been considered by Orange & Co prior
to accepting Scarlet Co as a new audit client
Pre‐acceptance factors Explanation Explanation

The outgoing auditor’s response the auditor should consider the outgoing auditor response to
assess whether there are any ethical or professional reason why the firm should not accept the
engagement
Management integrity if the management lack integrity, then there is higher risk of fraud
and intidimation. If there are serious concerns regarding this then the management should not accept
the audit engagement
Pre‐conditions for an audit Preconditions are :
- Preparing the financial statement in accordance to the financial reporting framework
- Internal controls necessary for the preparation free to be from material misstatement
- Providing the auditors with access to information relevant for the audit and access to staff
within the entity to obtain audit evidence
Independence and objectivity they should consider whether there are any risk to the auditor’s
independence and objectivity and whether they can be reduced to an acceptable low level by applying
appropriate safeguards. If such threats are present and cannot be sufficiently mitigated then they should
not accept the engagement
Resources available at the time of the audit Orange Co must have adequate resources and relevant
experience at the time when the audit of Scarlet Co is likely to be carried out. All audit staff deployed to
the audit of Scarlet Co must be capable of carrying out the audit in relevance to the International
Standards on Auditing. If adequate resources are not available then the audit firm should not accept the
audit engagement

Describe substantive procedures the auditor should perform to obtain sufficient and
appropriate audit evidence in respect of the redundancy costs.

- Review the board minutes for evidence of the decision to discontinue the chemical prior to the
year end
- Review the supporting documentation to confirm the decision to discontinue the brand was
notified to the four staffs prior to the year end
- Obtain the details of redundancy calculated by employee and cast the schedule and agree to the
financial statements or trial balance
- Recalculate the redundancy provision to confirm completeness and agree the components of
the cost to the supporting documentation such as employee contracts
- Obtain a written representations from the management confirming the completeness of the
cost
- Agree the redundancy made in July 20X5 to the payroll or cash books and compare these to the
provisions in the financial statements
- Review the financial statement disclosures to verify they are in compliance with the IAS 37
Provisions, Contingent Assets, Contingent Liabilities

Audit Risk Auditor’s response

New client Orange and Co should ensure that it has

Orange Co is a new audit client of the Scarlet Co. deployed suitably experienced team for the
The audit engagement team will be unfamiliar engagement. In addition, sufficient time should
with the accounting policies, transactions and be allocated so the team members can
balances of the client, hence there will be familiarize themselves to the client, document its
increased risk on the audit system and controls and understand the risks of
In addition, there is less assurance regarding the material misstatement
opening balances as Orange and Co did not
perform last year’s audit.
Temporary financial accountant Discuss with management the technical
The company’s financial accountant was competency and experience of the temporary
suddenly taken ill in July and a temporary financial accountant. In addition, the audit
financial accountant was hired for the time being engagement should ensure that increased
There is an increased risk of errors in the financial substantive procedures are undertaken on the
statement as the temporary financial accountant material areas of the financial statements due to
might not be familiar with the company’s reduce audit risk particularly to those requiring
activities and errors/omissions might go judgment
unnoticed
Manipulation
The year-end financial statements have to be The audit engagement team should maintain
prepared by September 20X5 in order to secure a professional skepticism throughout the course of
bank finance and management wish to report audit. Detailed cut off testing on the areas such
strong results as revenue, inventory and payables should be
This increases the risk that the directors might performed to ensure that the cut off has been
manipulate the financial statements to secure correctly applied and extensive substantive
the bank finance by overstating the profits and procedures should be performed on estimates
understating the liabilities and judgments to ensure accuracy
Machinery
The company has purchased a specialized Discuss the accounting treatment with the
machine and staff members had to be trained in directors and request that an adjustment is made
the machine uses at the cost of 15000 which has to ensure appropriate treatment of training cost.
been capitalized as the part of the cost of Obtain a breakdown of remaining capitalized cost
machine. and agree the supporting documentation to
IAS 16 prohibits the staff training costs to be ensure they meet the recognition criteria in IAS
capitalized therefore the profits of plant property 16
and equipment will be overstated and the
expenses understated if the training costs are not
written off in statement of profit or loss
Inventory cut off
The delivery time of three weeks from the Discuss with management the point at which the
international supplier is likely to result in goods in inventory is recorded and review the contract
transit at the year end. The company has advised with the supplier to verify the requirement in
that the contract with supplier means the Scarlet place.
Co will be responsible for the goods since the Review the controls of the company to record
time of dispatch and therefore the inventory the inventory from the moment of dispatch
should be recorded when the products are sent
by the supplier
There is a risk that the inventory is recorded on
dispatch and the liabilities will be understated at
the yea end
Receivables valuation
The preliminary analytical review indicates that Extend post year end cash receipts testing and
the receivable collection period has increased perform a review of old aged receivable listing to
from 38 days to 52 days due to customers taking assess the valuation of receivables. Discuss with
longer time to pay the management regarding the adequacy of
There is a risk that some receivable might not be allowance for receivables
recoverable and an allowance for receivable is
required. Hence receivables might be overstated
and the allowance for the receivables
understated.
Redundancy provision
On 29 May 20X5, the directors announced that a
brand was being discontinued resulting in four Obtain the calculation of redundancy payments
 members of staff being made redundant. The and agree that a provision has been included as
costs of redundancy are being included in the the liability in the year end financial statement.
July 20X5 payroll run. Agree the redundancy payments have been paid
As there is a present obligation for which the cost post end
can be measured reliably and which will result in
the outflow of the funds, IAS 37 Provisions,
Contingent Assets and Contingent Liabilities
would require the provision to be recognized in
the financial statements. If the provision is not
recognized the profit will be overstated and the
liabilities/provisions will be understated
Return of the faulty goods
A customer has returned 12000 worth of faulty Inspect a copy of credit note and insure that the
goods but a credit note has not been issued yet adjustment to the revenue and receivables have
As this sale occurred pre year end there is a risk been recorded pre-year end
that the receivables and revenue are overstated
and the credit note is not correctly recorded to
the prior to the year end
Payment runs
The company’s suppliers have been paid on 1 Request that the bank reconciliation is amended
June 20X5 and the payment has been included as to remove the supplier payment at the year end
an unpresented item in the year end bank as these should be accounted in the 31 May 20X6
reconciliation. financial statements
This is possible evidence of window dressing Review the journal entries correcting the
which results in understated payables and bank payables and the bank balances at the year end
balances.

203

Benefits of audit planning

- Helping the auditor to devote appropriate attention to important areas of the audit
- Helping the auditor to identify and resolve potential problems on a timely basis
- Helps the auditor to organize and manage the audit engagement so that it is performed in an
effective and efficient manner
- Assisting in the selection of suitable team member for the engagement who have appropriate
level of capabilities and competence to respond to anticipated risks and the proper assignment
of work to them
- Assisting, where applicable, in coordination of work done by experts

C
 - Review the financial statement disclosure to ensure that they are in accordance to the local
legislation
- Agree the amounts paid to the director as bonus to the board minutes and the contracts to
ensure they are included in the current year’s financial statement fully accrued and disclosed
- Obtain a schedule of director’s bonus and cast the schedule to ensure accuracy. Agree the
amount to that disclosed in the financial statements
- Confirm the bonus paid to the directors by reviewing the post year end cash book and the bank
statements
- Obtain a written representation from the management ensuring the completeness of the
director’s remuneration including bonus
- Recalculate the bonus payments and agree the criteria to the supporting documentation and
the percentage rates to be paid to the director’s service contracts
- Agree the individual bonus payment to the post year end payroll records

- Both Hart Co and the competitor should be notified that the Morph Co will be auditing each of
the company and should get consent from each of the both clients
- Morph co should consider advising one or both the clients to seek additional independence
advice
- Adequate procedures should be in place to prevent the access of information like physical
separation of the both teams and confidential and secure data filing
- Morph Co should consider using the confidentiality agreement signed by the team members of
the Hart Co and competitor
- The work done by the engagement team of both the company should be reviewed by an
independent reviewer who is not associated to either of the audit
- Morph Co should assign different audit engagement team including audit engagement partner
and team member; and once an employee has worked for one company, for instance, Hart Co
then they shouldn’t be allowed to work in the audit of its competitor for some time
- Regular monitoring of the application of the above-mentioned safeguards by a senior member
of Morph Co who is not engaged in either audit

201

Peach

Audit risks Auditor’s response

New accounting systems
A new accounting system was introduced on May The audit team should undertake detailed testing
31st, post implementations hasn’t been done. to ensure that all the balances have been
There’s a chance that the opening balances might accurately transferred from the old accounting
be misstated and the risk of data being lost if not system. The team should also perform a
properly transferred from the old system. If the walkthrough to document the new system and
new system is not working properly there is a test the control in place
chance of the accounting treatments being
misstated.
Development costs
Peach co has been developing a new product and The audit team should discuss with the
it has been capitalised for 0.8 million for the management the accounting policies applied and
current financial year procedure to determine the nature of the
IAS 38 Intangible Assets requires research expenses
expenditure to be expensed in the statement of The audit team should review the cost capitalised
profit or loss and the development costs to be and the supporting documentation to determine
capitalized only if it satisfies the strict criteria the nature of the costs. Then the development
There is a risk that the research expenditure has costs identified should then be agreed to the
been incorrectly capitalized as development cost criteria of development costs as stated in the IAS
which results in overstatement of intangible 38
assets and understatement of research expenses
in the statement of profit or loss
Inventory Valuation
Peach Co hold inventory of 227,000 which they The audit team should discuss with management
cannot sell in the home market but can be sold to about their belief that the items could be sold
international customer by incurring additional and review the documentation and contract with
costs international customers to determine the
There is a risk that the net realisable value is less inventory being sold and selling price of the
than the cost hence the inventory might be inventory
overstated and the cost of sales might be The audit team should also review the contracts
understated to determine the NRV and discuss with the
management if they need any write down

Training costs
The staffs were trained regarding the site The audit team should discuss with management
preparation for the new site for the machinery the accounting treatment applied and request
and its testing which has been included in the the relevant staff cost to be included in the cost
wages and salary expenses the period of the PPE.
IAS 16 Property Plant and Equipment directly
states that any direct cost used to bring the
machinery into its intended condition is
capitalised in the financial statements as the cost
of the asset. The site production and the testing
are included in those.
It appears that incorrect accounting treatment
has been applied in case of the staff costs, where
the cost of the asset has been understated and
the salary and wages have been overstated.
Extension of useful life
The directors have extended the useful life of the
machinery despite the fact that the machinery
has been disposed at a significant loss The audit teams should discuss the rationale
Under IAS 16 Asset lives should be reviewed behind increasing the asset lives and reduction of
annually and if it does genuinely has assets life the depreciation
increased then the decrease of depreciation is The revised useful life of assets should be
reasonable. However, the fact that the machinery compared to how often the asset gets replaced
were sold at a significant loss does not support and the loss or gain on its disposal as it provides
the decision to increase the life evidence of the useful life of the assets
As such, it appears that the plant and machinery
has been overstated and the depreciation
expense has been understated
Fraudulent purchases
It has been discovered that there was fraudulent The audit team should discuss how the fraud was
purchase of non-current assets for the personal detected and corrected. They must understand
use. the controls in place to prevent the fraud from
Since the reconciliation of the physical assets to occurring in the future
the non-current assets register is still ongoing and
isn’t going to be complete by the year end there
is a risk of the non-current assets being
overstated as they simply may include the
personal non-current assets purchased
Control risk has also increased if the fraud was
ongoing for a lot of the time
Legal Claim
Peach Co’s previous supplier has sued the The audit team should the correspondence with
company for the breach of contract claiming they management’s lawyer to understand the
didn’t have the right to exit the agreement early. likelihood of the supplier winning the case the
The claim hasn’t been settled but the legal team amount of the payments to be made to them.
of peach Co believe that they will have to pay
around 0.3 million
As it appears the Peach Co would have to pay to
settle the claim , the provision is required to
comply with IAS 37 Provisions, Contingent Assets
and Contingent Liabilities
There is a risk of understatement of the
Provisions for this claim
New bank loan
Peach Co has just secured a new bank loan in the The audit team should undertake a review of the
year repayable over three years loan agreement to confirm the details and
There’s a risk that the loan hasn’t been correctly reperform the calculation to confirm that the
allocated between current and non-current loan has been correctly classified into current and
liabilities which would give rise to classification non-current liabilities
error and the liabilities being misstated. The finance costs should be recalculated and
In addition, the finance cost is paid in arrear and agreed to the arrears schedule
may not have been correctly accrued at the year
end resulting in understated accruals and finance
costs
B

Describe Apricot & Co’s responsibilities in relation to the prevention and detection

of fraud and error

- Apricot and Co must conduct the audit in accordance with the IAS 240 The Auditor’s
responsibilities relating to fraud in audit and provide reasonable assurance that the financial
statements taken as a whole are free from material misstatement either due to fraud or error
- Apricot and Co is required to identify and assess the risks of material misstatement of the
financial statement due to fraud
- Apricot and Co need to acquire audit evidence regarding the risk of material misstatement due
to fraud through designing and implementing appropriate responses
- Apricot Co should respond appropriately to fraud or suspected fraud identified during the audit
- Apricot Co should report any fraud or suspected fraud to the appropriate parties
- While obtaining reasonable assurance, Apricot and co are required to maintain professional
scepticism throughout the audit, considering the potential override of controls by the
management and recognising the fact that the audit procedures which are effective in detecting
error might not be effective in detecting fraud.

Ethical threats Safeguards

Apricot Co has suggested that they go away for a As it is unlikely that the weekend gate away is of
weekend gateway instead of meal at the start of trivial value, the audit team should politely
the audit this year at Peach Co’s expense decline. The normal meal at the start of the audit
This might impose self interest threat and is acceptable if the audit team pay for themselves
familiarity threat
The acceptance of goods and services unless
trivial and inconsequential is not permitted as
this might make the audit staff less likely to
challenge the management’s assumption and
explanation
Alan Edward has also suggested that the current Apricot and Co should not agree the proposed
year audit fee is renegotiated to be based basis of fee and should communicate with the
on a percentage of Peach Co’s net profit for the Peach and Co that the audit fee needs to reflect
year the level of work and the experience of the team
This is contingent fee and gives rise to self to gain reasonable assurance
interest threat
If the audit fee is based on the net profit then the
audit team might feel incentivized to allow
incorrect accounting treatments to overstate the
profit

Substantive expenditures regarding the capitalization of development costs

 - Obtain a schedule of capitalised cost within intangible assets and cast it to the closing balances
of the trial balance, general ledger and the financial statement
- Select a sample of capitalised cost and agree it to invoices, payroll records or other source of
documentation to ensure the amount is accurate and relate to the project
- Review the breakdown of nature of cost capitalised to identify if any research costs have been
incorrectly included. If so, remove these, and request the management to remove those and
include them in statement of profit or loss
- Review the market research to ensure that there is a market for the new process and that selling
price is high enough to make a profit
- Review the feasibility report as of November 20X4 and discuss with the management regarding
their view of the feasibility of the new production line at that date
- Recalculate the amortisation charge and confirm that it covers the period for May to August
20X5
- Review the disclosures for intangible assets in the draft financial statement and ensure that they
are in compliance to the IAS 38 Intangible Assets
- Review cash flow forecast of Peach Co to assess if they have enough resources to complete the
project

202

Corley Appliances

a) Describe the preconditions required for an audit

IAS 210 Agreeing the terms of the audit engagement Requires an auditor to:
- Determine whether the financial reporting framework to be applied in the preparation of
financial statements are acceptable.
In considering this the auditor should have assessed the nature of the entity, nature and the
purpose of the financial statements and whether law or legislation prescribes the applicable
reporting framework
- Obtain the agreement of the management that it acknowledges and understand its
responsibilities of the following.
A) Preparing the financial statement in accordance with the applicable financial reporting
framework
B) Internal Control necessary for the preparation of financial statements to be free from material
misstatement either due to fraud or error
C) Providing the auditor with the access to information relevant to the audit and access to staff
within entity to obtain audit evidence.

B)

Audit risk Auditor’s response

Inventory Count The audit team should assess which of the
The company’s central warehouse and its central inventory count they will attend. The audit team
branches will be conducting year end inventory needs to choose the central warehouse and the
count on 31 August 20X5 branches which have most material balances of
It is unlikely that the audit engagement team inventory and has historically had exceptions
would be able to attend the inventory count in generated during the inventory count.
the central warehouse and all its branches which
increases detection risk. It may not be possible to
gain sufficient audit evidence regarding the
inventory counting controls and completeness
and existence of the inventory of those sites
which were not visited.
Refund liability
Customers can return the goods if they are not Review the assumptions underpinning the refund
satisfied with the product within the 28 days of liability for reasonableness and whether they
purchase. meet historic 5% customer return goods.
IRS 15 Revenue from Contracts with Customers Compare the level of post year end good returns
requires that the revenue should be recognised to the refund liability and discuss the differences
only to the extent that goods will not be with the management
returned. The company should recognise refund
liability for goods which are expected to be
returned.
If the company hasn’t correctly accounted for the
refund liability, the revenue will be overstated
and the refund liability will be understated.

Reduced warranty provision

It is anticipated that the warranty provision for Review the post year end claims to assess the
the current year will be lower than for the prior reasonableness of the reduced warranty
year as they feel that the products sold by the provision. Also review the assumptions
company are of the higher level. underpinning the warranty provision for
The company does not manufacture the product reasonableness
and only sell them so that is not valid reason to
reduce the warranty provision. This increases the
risk of the expenses and the liability and the
provision being understated.
Goods in transit
The goods are purchased form their supplier in The audit team should take detailed cut-off
Asia and has responsibility for the goods at the testing of the purchased goods at the year end
point of dispatch, the goods are in transit for up and the sample of shipping documentation
to one month immediately before and after the year end should
At the year end, there is a risk that the cut off of be increased to ensure that the cut-off is
the inventory might not be accurate at the year complete and accurate
end if they are recognised at the point of
dispatch. There is also a risk that the inventory
and the trade payables might be understated at
the year end
Allowance for the credit loss
The receivable collection period has increased Perform extended post year end cash receipts
from 55 days from the 42 days of the prior year testing and a review of aged receivable ledger to
and the allowance for the credit losses will be assess the valuation and need for increment of
same as that for the prior year the allowances for the credit loss
Some receivables may not be recoverable and if
an additional allowance for the credit loss is not
created then the receivables will be overstated
and the allowance for the credit losses will be
understated
Payable ledger fraud
The payable ledger supervisor was discovered Obtain the detail of the fraud committed by the
committing fraud by diverting payable funds to payable ledger supervisor from the management
the fictitious supplier. The value of the fraud was and what other procedures have been adopted
recognised as the expense in statement of profit to date to identify any further adjustments which
or loss. are needed in the financial statements.
If any additional fraud committed by the payable
ledger supervisor has gone undetected, it will
result in understated expense and overstated
payables. In addition, if the fraud was not
detected for a long period of time then there will
be increased control risk
Backlog of payables ledger
Since the dismissal of the payable ledger Review the unprocessed files at the year end to
supervisor, the purchase invoices is yet to be identify any invoices which relate to the goods
logged into the payables ledger. brought before the year end and ensure they
There is a risk that the payable and the purchases have been properly accrued for in the financial
for the company will be understated if the statements and recognised as the liability
purchase invoices are logged in to the payable
ledger before the year end or accrued for.
Capitalised training costs
The company purchased and installed a new Discuss the accounting treatment with the
dispatch system. The costs which have been management and request that the staff training
capitalised include the staff training costs of 0.1 costs are expensed in the statement of profit or
million loss to ensure treatment in accordance with IAS
As per IAS 16 Property Plant and Equipment, the 16. If adjusted, review the journal entry for
cost of an asset includes its purchase cost and accuracy.
directly attributable cost. IAS 16 does not allow
staff training costs to be capitalised as the part of
non-current asset, as this cost is not directly
attributable to bringing the asset to its working
condition
Going concern
The company’s overdraft facility has increased
after once the company went over the agreed Discuss with the finance director regarding the
limit of 0.7 million. The bank will only confirm the availability of alternative financing sources and
 decision of whether or not to continue the review the adequacy of any going concern
support the business in November 20X5 after the disclosures in the financial statements.
signing of the auditor’s report.
If the bank refuses to support the company
further, there might be doubt regarding the
company’s going concern. The uncertainties
might not be adequately disclosed in the financial
statement.

Professional scepticism is defined as IAS 200 Overall objectives of Independent Auditor and Conduct of
an Audit in accordance with the International standards on Audit as an attitude with questioning mind,
being alert to possible material misstatement due to fraud or error and a critical assessment of audit
evidence.

205

Harlem Co

Gross profit margin = Gross profit/revenue

Inventory holding period = (Inventory / cost of sales) * 365

Gearing = Debt/ (debt + equity)

Interest cover = (finance costs + profit before tax) / finance costs

B)

Audit risks Auditors response

Refund provision
Customers can return the goods within 60 days of Review the assumptions underpinning reduced
the purchase without any penalty, And the return rate to 5% for reasonableness and discuss
finance director is planning to reduce the return with finance director any differences that arise
rate from 10 % to 5% when quantified a 60 days period for returned
IRS 15 Revenue from Contracts with Customers goods to the assumed rate of 5%.
provides that the revenue and cost of sales
should only be accounted for to the extent that
the company foresees the good will not be
returned.
For goods which will be returned, the company
should recognise a refund liability. if after 60
days, the goods are not returned then the liability
is reversed and revenue is recognised.
By reducing the return rate, the cost of sales and
revenue may be overstated and liabilities
understated.
Patent
The company bought a patent last year for 800 K Agree the useful life of 4 years of the intangible
which had a useful life of 4 years. They have the assets to supporting documentation. The
same amount as their carrying amount this year amortisation charge should be calculated and the
too which means they haven’t been amortised appropriate journal adjustment should be done
correctly by discussion with the management
IAS 38 Intangible Assets states that the intangible
assets should be amortised over its useful life. It
does not appear that the management has
correctly accounted for the amortisation
according to the financial statement.
Which means intangible assets and eventually
the profits are overstated
Loss on disposal
Sale of surplus items of plant and machinery Discuss the depreciation policy with manager for
when sold resulted in loss of disposal amounting reasonableness. Recalculate the loss on disposal
160,000 and agree to the supporting documentation.
Significant profit or losses on disposal indicates
that the depreciation policy of plant and
machinery may not be appropriate.
Therefore, depreciation might be understated,
and the profit and plant and machinery
overstated.
Financial controller fraud
The financial controller of the company Discuss with the finance director regarding the
committed fraud on May 20X5 was fired as she details of the fraud perpetrated by the financial
had committed fraudulent transactions against controller and what procedures have been
the company adapted to date to identify any further
If any additional fraud committed by the finance adjustments which are needed in the financial
controller has gone undetected, it will result in statements.
misstatement of profits. In addition, if the fraud
was not detected for a long period of time then
there will be increased control risk. These will
need to be written off to the statement of profit
or loss.
Unfair dismissal claim
The financial controller has sued the company The audit team should discuss with the
under the allegation of the unfair dismissal management and request a confirmation from
It is probable that the Harlem Co will make the company’s lawyer regarding the likelihood
payment to the financial controller and provision and existence of any claim made by financial
created need to comply with IAS 37 Provision, controller
Contingent Assets, Contingent Liabilities. If
payment is possible rather than the probable
then a contingent liability disclosure is necessary
If harlem co fails to create a provision or
disclosures there is a risk of completeness over
the provision or liability disclosure.

Inventory holding period.

Harlem co has had significant production Testing should be undertaken to confirm the cost
problems which have affected the quality of the and the NRV of the affected products in inventory
products. In addition, the inventory holding and that all the inventory on a line by line basis is
period has increased from 34 to 41 days. valued correctly.
Inventory might be overvalued as its NRV may
be well below the cost. If the tyres can be
rectified that means that the cost will be higher
than the NRV
If the tyres cannot be rectified, then the
inventory need to be written down completely.
There is a risk of overstatement of inventory.
Receivable valuation
A significant customer has been granted a 6 Test the post year end cash receipts and review
months payment break and the receivable the aged receivable ledger to assess the valuation
collection period has increased from 38 days to and the need for increase in allowance for credit
61 days. s. An allowance for credit losses or receivables
losses/receivables has historically been
maintained, and it is anticipated that it will
remain at the prior year level.
So there is a risk that the receivable will be
overstated and the allowance for receivable will
be understated if the receivable balance become
irrecoverable and there is not adequate
allowance against receivables

Bonus shares
Harlem co has issued the share this year via Review the board minutes for authorisation and
bonus issues. Share capital of the equity should terms of bonus and review if the transaction has
increase by the value of the shares and the been conducted in line with this approval.
reserves should decrease accordingly. Review the adequacy of bonus issue disclosures
If the company has not accounted for a bonus in financial statements
issue before, there is a risk that it could have
been incorrectly treated with equity being under
or overstated. In addition, legal issues may arise if
the shares have not been issued in accordance
with the company’s statutory constitution.
Additionally, bonus issues require disclosure in
 the financial statements and there is a risk that
these may be incomplete or inaccurate.

In line with ISA 220 (Revised) Quality Management for an Audit of Financial
Statements, describe the audit supervisor’s responsibilities in relation to supervising
and reviewing the audit assistants’ work during the audit of Harlem Co. (4 marks)

Answer

Supervision

During the audit, the supervisor should keep track of the progress of the audit engagement to ensure
that the audit timetable is met and should ensure that the audit manager and partner are kept updated
of progress. The competence and capabilities of individual members of the engagement team should be
considered, including whether they have sufficient time to carry out their work, whether they
understand their instructions and whether the work is being carried out in accordance with the planned
approach to the audit. In addition, part of the supervision process should involve addressing any
significant matters arising during the audit, considering their significance and modifying the planned
approach appropriately. The supervisor would also be responsible for identifying matters for
consultation or consideration by the audit manager or engagement partner of Harlem Co.

Review

The supervisor would be required to review the work completed by the assistants and consider whether
this work has been performed in accordance with professional standards and other regulatory
requirements and if the work performed supports the conclusions reached and has been properly
documented. The supervisor should also consider whether all significant matters have been raised for
partner attention or for further consideration and where appropriate consultations have taken place,
whether appropriate conclusions have been documented.

Valuation of receivables