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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

Labor law

Environmental Protection law etc.

Responsibilities of Management and Auditors

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.
As with fraud, the auditor is 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
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 auditors existing understanding of the entitys 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 entitys 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 entitys license to operate (non compliance
may doubt going concern) that may have a fundamental affect on operations of
the entity.

3. The following procedures may indicate the instances of non compliance such as:
Reading minutes
Enquiring from the companys 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.

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
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 auditors 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 charges d with governance, unless they themselves are


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

Impact of non-compliance on the auditors 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 auditors 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.
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

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

Factors indicating money laundering:

Transactions routed through several jurisdiction.
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
The three stages of the money laundering process


Layering.; and


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 clients sources of funds
5. The clients business and economic purposes.
In the UK, the basic requirements are for accountants to keep records of clients identity
and to report suspicions of money laundering to the Serious Organized Crime Agency
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
5. Maintain records of identification, and any transactions undertaken for or with the
6. Report suspicions of money laundering to SOCA.
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 clients
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.

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
Describe FOUR measures that assist in preventing professional accountants from
being used for money laundering purposes.
(8 marks)
1) Accountants (firms and individuals) working in a country that criminalises money
laundering are required to comply with anti-money laundering legislation and failure to
do so can lead to severe penalties. Guidance is needed because:

legal requirements are onerous;

money laundering is widely defined; and

accountants may otherwise be used, unwittingly, to launder criminal funds

2) Further guidance is needed to explain the interaction between accountants

responsibilities to report money laundering offences and other reporting responsibilities,
for example:
reporting to regulators;
auditors reports on financial statements (ISA 700);
reports to those charged with governance (ISA 260);
reporting misconduct by members of the same body
3) Professional accountants are required to communicate with each other when there is
a change in professional appointment (i.e. professional etiquette). Additional ethical
guidance is needed on how to respond to a clearance letter where a report of
suspicion has been made (or is being contemplated) in respect of the client in question.

4) Accountants need ethical guidance on matters where there is conflict between legal
responsibilities and professional responsibilities. In particular, professional
accountants are bound by a duty of confidentiality to their clients. Guidance is needed
to explain:
How statutory provisions give protection against criminal action for members in
respect of their confidentiality requirements.
When client confidentiality over-ride provisions are available.
1) Appointing a compliance officer having a suitable level of seniority and experience
The compliance officer being made responsible for:
receiving and assessing money laundering reports from colleagues
making reports to the relevant agency
ensuring that individuals are adequately trained
2) Providing an employee training programme on:
relevant legislation (e.g. the main money laundering offences);
ethical guidance (e.g. ACCAs Guidance for Accountants); and
the firms procedures to forestall and prevent money laundering
3) Performing customer due diligence. Firms should verify the identity of their
customers, when:
establishing business relations;
carrying out occasional transactions (e.g. above a designated threshold);
there is a suspicion of money laundering or terrorist financing; or
there is doubt about the reliability or adequacy of previously obtained
customer identification data
4) Maintaining all client identification records together with a record of all
transactions, in a full audit trail form.


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
The fundamental principles

Members should strive to be objective in all professional


and business judgments.

Professional behavior

Members should desist from any act that can bring


Members have the responsibility to maintain up-to-date


out their work.


Members should be straight forward and honest in


Auditors should not disclose clients information to a

disrepute to the accounting profession.

knowledge that will enable them to competently carry

their professional dealings.

third party 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


This threat arise as a result of the auditor becoming unduly


This threat arise when the auditor comes under intimidation by

Self interest

This arise when personal interest of the auditor conflicts with that of

to defend the interest of its client before a third party.

sympathetic towards its client as a result of long association
dominant individual or aggressive atmosphere at the clients
the client

Self review

This threat arise when the auditor have to review or audit the work
that he help to carry out.


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 clients management
Seek legal advice
Inform the auditors 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.
Possible safeguards:
Audit firm should ensure that members doing the valuation work are not part of the audit
Auditor should obtain managements acknowledgement that it is responsible for the result
of the valuation
Audit work done for the client should be reviewed by an independent accountant

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.
Possible safeguards:
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 clients 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 auditors fee depends on the outcome of uncertain future event.
IESBA code of ethics outrightly 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 get 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.
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. Recruitment of staffs is managements responsibility. Offering of this
service will amount to making management decision. 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.

Possible safeguards:
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
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:
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.

Possible safeguards:
The firm should ensure the seconded staffs do not take on management role or take any
managements decision.
Seconded staffs should not be included in the audit team to the client
Audit work performed should be reviewed by an independent accountant

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:


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. Durans staffs were very supportive throughout and paid for
evening meals that were brought in so that the audit team could work with
minimum disruption.


Durans 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
weeks salary. The bonus was processed through Depeches payroll, in the
same way as overtime payments, and recharged to Duran as part of audit


One of the points initially drafted for possible inclusion in the report to the
companys audit committee concerned the illegal dumping of drums,

containing used machine oil, on nearby wasteland. Notes of discussions

between the audit manager and Frankie show that it is the companys
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.

(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.

(5 marks)

(15 marks)



Depeches objectivity may be threatened, or appear to be

threatened, by acceptance of goods, services or hospitality from
Duran, unless the value of any benefit is modest.

The audit staffs have already accepted the hospitality. Their

objectivity should not have been impaired provided that the meals
were appropriate to the normal courtesies of social life.

However, undue hospitality is likely to be regarded as a corrupt

practice, which could be indicative of fraudulent activities having

taken place.

As the staff needed to work late to meet the deadlines, an

alternative to Duran buying in the refreshments would have been
for the audit team to make their own arrangement and for Duran to
have been re-charged the expense.


Financial reward

The bonus was not accepted in respect of the audit managers

involvement. Therefore there is no obvious threat to his

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 teams 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 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.


Client/auditor integrity

Frankie Sharkeys apparent disregard for environmental

legislation should have been taken into account when making a
risk assessment of Durans control environment. It may cast doubt
on his integrity.

The audit of Duran should have been carried out with due regard to:
ISA 250 Consideration of Laws and Regulations in an Audit
of Financial Statements; and
ISA 260 Communications of Audit Matters With Those
Charged With Governance.

if the illegal dumping became apparent during the audit but was not
known at the planning stage, consideration should have been given
the frequency of the illegal act, how long it has been going
on and what measures, if any, had been taken to conceal it
from the auditors;
the potential financial consequences (e.g. fines, penalties,
enforced discontinuation of operations and litigation);
whether the potential consequences require disclosure;
whether risk assessments made at the planning stage need
now to be revised;
the validity of management representation

Matters to be communicated to those charged with corporate

governance (i.e. the audit committee) include:
the potential effect on the financial statements of any
significant risks and exposures, such as pending litigation,
that are required to be disclosed in the financial statements
(this could arise from the illegal dumping); and
other matters warranting the attention of those charged with
governance, such as questions regarding management

It is of potential concern that the matters have not been included in

the final report unless the engagement partner knows, for example,
that the matter has already been brought to the audit committees
attention (e.g. in an internal auditors report).

Available safeguards

The firms guidance on receiving hospitality should be reviewed

and amended as necessary. It may be that on-going hospitality is
refused, if construable as excessive.

Review of the engagement partners decision to accept the bonus

on behalf of the staff. For example, whether the firms quality
assurance policies and procedures required him to consult with
other partners.

Audit staff and the client should be advised that the bonus was a
one-off and not to be repeated.

Senior staff (the two qualified seniors and two supervisors) should
not be assigned to the audit for the year to 31 December 2009.

Involving a second partner to review the conduct of the audit and

advise staff involved of any concerns they have about their
independence from Duran and the integrity of Durans

If the engagement partner has been involved in the audit for a

number of years (say seven), it may be time to rotate the

Discuss issues of independence with Durans audit committee and

obtain written confirmation that they are aware of the potential
threats posed by public interest, fees, hospitality, etc and that they
are satisfied that the firms safeguards are adequate.

Advice whether or not the audit of Duran should continue

The Duran audit should be retained only if a partner of Depeche
unconnected with Duran independently reviews the safeguards available and
considers them to be adequate.
Alternatively: If the safeguards available are not adequate to maintain
independence, Depeche should withdraw from the audit.

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
Clients 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.
Auditors 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 auditors 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

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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
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

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Ways of reducing auditors 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

Auditors liability (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 auditors liabilities:
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

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Ways of reducing auditors 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 auditors 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
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.

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The storekeepers 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 storekeepers 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 Turnals purchase system was recorded and
tested for the first time during last years 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.


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)


Discuss why the following audit procedures may have failed to detect the above fraud:


evaluation of the prescribed system of controls;

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tests of controls on the authorisation of new suppliers;


analytical procedures.

(10 marks)

Discuss the bases on which Turnals believe they have a claim against their auditors and

the likelihood of its success. (5 marks)

(20 marks)

Regulations and practices that avoid conflicts of interest

Undue dependence on an audit client

It is recommended that the recurring fees from a single client or group of

connected clients should not exceed 15% of the gross practice income
(10% for public companies).

The provision of non-audit work will increase the amount of the fees from
this client. However it is debatable whether the consultancy is a recurring
fee. If it is not it would be disregarded. In any event it is unlikely that the
15% figure would be exceeded (although the question gives no guidance
on this).

Loss of independence

This is a more likely problem area. It could be caused by the auditor

relying on information that has been produced or in some way influenced

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by staff of the audit firm. Generally this can occur in areas such as the
preparation of the accounts (accounting services), or acting as a tax
advisor. In this particular situation, the auditor may be more willing to
accept the system of controls as being reliable because it has been
devised, in part at least, by staff of the audit firm.

In an attempt to create independence audit practices usually require nonaudit work to be performed by staff that are not involved in the audit. Also
the audit and non- audit work should be supervised by different partners
within the firm. As a further precaution the audit partner and senior audit staff
should be periodically rotated. Staff of the audit firm should never make executive
decisions or become involved in the management of a client no matter what
capacity they are acting in.


Ultimately independence and objectivity are a state of mind and cannot be

ensured by sole reliance on the observation of rules and regulations.

Failure to detect the fraud


Evaluation of system of controls

In considering a specific transaction cycle (e.g. purchases), the main

controls that prevent fraud and error are authorisation procedures and
segregation of duties. These would ensure no one person, without
collusion, is able to perpetrate a fraud.

As part of their work on the control system, the auditor would ascertain
and evaluate the system of internal control at the business level (not
within the scope of the question) and at the transaction level. There is a
potential area of conflict here as the audit firm has had a part in the design
of the accounting systems. Therefore it is possible that the auditor would
be reluctant to criticise any weakness in the prescribed system.

In addition, it is a requirement of the auditing standards (ISA 315) that not

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only is the business and its environment understood, but also its internal
control. It was only last year that, for the purchase system, this appears to
have been fully carried out. In previous years this understanding had not
been obtained as a substantive approach was used (i.e. control
effectiveness was not tested). ISA 315 makes it very clear that internal
control must be understood regardless of the audit approach.

As part of their understanding the business, the auditor should ascertain

and verify if segregation of duties is present and implemented within the
system. The fact that Mr Jones covered for the storekeeper during their
holidays, should have alerted the auditors to a potential breakdown in
segregation of duties and the higher risk of fraud this indicated.

In addition, as Mr Jones was responsible for raising purchase

requisitions and initiating the approval of new suppliers, the auditors
should have been placed on guard over the potential for fraud given his
role when the storekeeper went on holiday. This should have triggered
specific testing during the holiday period.

As the total of the fraud at Turnals over the two year period was $50,000
individual transactions within this total are likely to have been small and
infrequent as they only occurred during the storekeepers holidays. It is
unlikely therefore that a fraudulent requisition would be selected at


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. This would be evidenced by the appropriate
signatures appearing on a specific form: Whether this check would have
specifically detected the fictitious supplier is doubtful as only a sample of
new suppliers would have been chosen by the auditor.

Also, the auditor cannot really ensure that the Managing Director takes the
authorisation process seriously, unless this becomes clear from
discussions with the Managing Director and the auditors assessment of
the managements attitude, awareness and actions as part of their

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assessment of the control environment. An indicator of this as a potential

problem area is the fact that no contact was made with the previous
employers of Mr Jones.

It is possible for the company and the auditor to employ a detailed check
on suppliers, for example by making enquiries about prospective suppliers
with credit reference agencies, trade directories and other validating
sources. However this approach is more usual for customers and, perhaps
wrongly, is often considered too expensive and unnecessary for suppliers.

Supplier statement reconciliation may, again, not have detected this

fraud as the purchase turnover is not material.


Analytical procedures

Analytical procedures may indicate problems or inconsistencies. The

errors created by this fraud would affect the gross profit percentage and
inventory levels.
However the size of the fraud probably does not represent an abnormal
movement in either of these areas and would not arouse the auditors

To detect the fraud, the auditor would need to carry out specific
procedures on purchases made during the holiday period of the
storekeeper. Any review based on value or volume of purchases in those
periods would not detect the fraud because of its small size. It would be
necessary to have identified the fictitious supplier through the fact that
purchases were only made from that supplier during the holiday periods.


Bases for a negligence claim, and chance of success

Turnals have suffered a loss due to the fraudulent activity of an employee.
There are two possible reasons why the directors of Turnals may believe
they have a claim against Garner & Co:


In the capacity of auditors

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The auditors have a duty of care to the company. The Caparo case
clearly stated that the company can sue the auditors for damages due to

However there is the argument that the directors have the primary duty
of safeguarding the companys assets. It was the Managing Director who
was casual about approving new suppliers and this was the main cause
of the fraud.

Auditors design their tests to have a reasonable expectation of detecting

a material fraud. This does not appear to be a material fraud.

But, the auditors have not followed the requirements of ISA 315. They
have not fully understood the entitys internal control and may not have
sufficiently assessed the risk of fraud (ISA 240) to enable them to
appropriately plan their audit.

In addition, they did not report to management any weaknesses within the
system. It is clear from the scenario that weaknesses did exist (e.g. use of
Mr Jones to cover during holiday periods, the lax approach of the
Managing Director to authorising new suppliers, the failure to obtain
references from previous employers).


In the capacity of acting as consultants to Turnals

This area of negligence is unusual and uncertain. The case of Arenson v

Casson, Beckman Rutley and Co, although different in nature to this
situation, did establish that auditors acting in a non-audit capacity can be
liable for negligence

The implication in the question is that the system design has a weakness
and Garner & Co were instrumental in both its design and as auditors, its
testing. Prima facie there is a case to answer.

In these circumstances it would be necessary to look at the terms of the

contract for the non-audit services to see if there were any disclaimers of
liability by Garner & Co. Overall it remains the directors who are primarily
responsible for the system of internal controls.

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The design of the internal control system should have specified that during
the holiday periods of the storekeeper a deputy, other than Mr Jones,
should be appointed and a more rigorous suppliers authentication
procedure should have been undertaken.

These weaknesses should have been noted by the auditors and

communicated to management.

Auditing standards do not appear to have been followed.

The probable immateriality of the fraud and the lack of responsibility

shown by the directors, would usually constitute insufficient evidence to
find Garner & Co guilty of negligence as auditors.

However, given that they did not fully apply auditing standards in the
planning of their audit and in informing management of the weaknesses
within the system, they could (at least) be held jointly liable with the

As consultants their position is more open to a negligence claim being

successful, but this would largely depend on the terms of engagement
contract as consultants.

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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

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:

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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 invites 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
A typical tender of an audit firm usually have the following contents:
The level of expertise the firm can boast of in the industry
Previous experience in terms of similar companies audited by the firm
Width of coverage in terms of national and international presence
The propose audit fee and the basis of calculation

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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
permission from client before making any contact with the incumbent auditor. In the

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event that the company refuses to grant this permission, the nomination should be
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

Question AGNESAL

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)

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.
Agnesals 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).

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You have summarised 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:

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.

Artur is currently assigned to three other jobs and is working from Signets office. He last

visited Agnesals 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).

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).

Agnesals 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.

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

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

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comment that it is to be dealt with when all other information for inclusion in the companys
annual report is available.
Identify and comment on the implications of these findings for Signets quality control policies
and procedures.(18 marks)


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.

Direction (i.e. informing assistants about their responsibilities and the

nature, timing and extent of audit procedures they are to perform) may be
communicated through:

briefing meetings and on-the-job oral instruction;

the overall audit plan and audit programs;
audit manuals and checklists; and
time budgets.

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Supervisory responsibilities include monitoring the progress of the audit

to ensure that assistants are competent, understand their tasks and are
carrying them out as directed. Supervisors must also address accounting
and auditing issues arising during the audit (e.g. by modifying the overall
audit plan and audit program).

The work of assistants must be reviewed to assess whether:

it is in accordance with the audit program;

it is adequately documented;
significant matters have been resolved;
objectives have been achieved;
conclusions are appropriate (i.e. consistent with results).

Documentation which needs to be reviewed on a timely basis includes:

the overall audit plan (including risk assessments);

the audit program (and modifications thereto);
results from tests of control/substantive procedures and
conclusions drawn;

financial statements, proposed audit adjustments and the

proposed audit opinion.
An independent review (i.e. by personnel not otherwise involved in the
audit), to assess the quality of audit work (before the issue of an audit
report) should be undertaken for listed and other public interest or high
risk audit clients.


Implications of findings for QC policies and procedures

Analytical procedures

Applying analytical procedures at the planning stage, to assist in understanding

the business and in identifying areas of potential risk, is an auditing standard and
therefore mandatory. Analytical procedures should have been performed (e.g.
comparing the draft accounts to 30 September 2008 with prior year financial
Audit staff may have insufficient knowledge of the highly specialised service
industry in which this new client operates to assess risks. In particular, Agnesal may
be exposed to risks resulting in unrecorded liabilities (both actual and contingent) if
claims are made against the company in respect of outbreaks of contamination

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(e.g. CJD, BSE, foot and mouth, listeria, etc).

The audit has been inadequately planned and audit work has commenced before
the audit plan has been reviewed by the audit supervisor. The audit may not be
carried out effectively and efficiently.

Supervisors assignments
The senior has performed work on tangible non-current assets which is a less
material (18% of total assets) audit area than trade receivables (57% of total assets)
which has been assigned to an audit trainee. Tangible non-current assets also
appear to be a lower risk audit areas than trade receivables because the carrying
amount of tangible non-current assets is comparable with the prior year ($1.1m
at both year ends), whereas trade receivables have more than doubled (from
$1.6m to $3.5m). This corroborates the implications of (1).
The audit is being inadequately supervised as work has been delegated
inappropriately. It appears that the firm does not have sufficient audit staff with
relevant competencies to meet its supervisory needs.
Direct confirmation
It is usual for direct confirmation of accounts receivable to be obtained where
accounts receivable are material and it is reasonable to expect customers to
respond. However, it is already more than 2 months after the end of the reporting
period and, although trade receivables are clearly material (57% of total assets),
an alternative approach may be more efficient (and cost effective). For example,
monitoring of after-date cash will pr ovide evidence about the collectability of
accounts receivable (as well as corroborate their existence).
This may be a further consequence of the audit having been inadequately planned.
Alternatively, monitoring of the audit may be inadequate. For example, if the audit
trainee did not understand the alternative approach but mechanically followed
circularisation procedures.
Depending on the reporting deadline, there may still be time to perform a
circularisation. However, consideration should be given to circularising the most

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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
Although $2,500 is very immaterial, the clients management may well expect the
auditor to count it, albeit routinely, to confirm that it has not been misappropriated.
Monitoring of the trainee may have been inadequate. For example, Gavin may
not have understood the need to count the cash immediately the request was made
of the client . However, the behaviour of Gavin also needs to be investigated in that
he failed to report back to the audit senior on a timely basis and allowed himself to
be unsupervised.
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.
Although it is not practical to document every matter, details should have been
recorded to support Carlas decision to change the timing of a planned
procedure. (Carlas decision appears justified as it is inappropriate to perform a
cash count when the client is ready for it). Also, if some irregularity is discovered
by the client at a later date (e.g. if Jules is found to be borrowing the cash),
documentation must support why this was not detected sooner by the auditor.
Inventory is almost as immaterial as the cash in (4) from an auditing perspective,
being less than 2.5% of total assets (2007 2.1%). Although it therefore seems
appropriate that a trainee should be auditing it, the audit approach appears highly
inefficient. Such in-depth testing (of controls and details) on an immaterial area
provides further evidence that the audit has been inadequately planned.
Again, it may be due to a lack of monitoring of a mechanical approach being
adopted by a trainee.
This also demonstrates a lack of knowledge and understanding about Agnesals
business the company has no stock-in-trade, only consumables used in the supply
of services.

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Report to Society
The audit senior appears to have assumed that this is other information to be
included in a document containing audited financial statements To be dealt with
presumably means to be read with a view to identifying significant misstatements
or inconsistencies. However, Agnesal may be intending to publish it as an
entirely separate report and require an assurance service (other than audit) such as
an independent verification statement on performance standards.
As the preceding analysis casts doubts on Signets ability to deliver a quality audit
to Agnesal, it seems highly unlikely that Signet has the resources and expertise
necessary to provide such assurance services.

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
companys 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
boards 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.

Identify and comment on the issues raised as they affect your decision to gain the


(10 marks)

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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(15 marks)


Issues raised
Identity of caller
Mr Stone may be a major shareholder in Valda or otherwise control the voting. He
may be an officer (e.g. the managing or finance director). His interest(s) in the
companies concerned should be ascertained to establish:

his authority to commission the proposed review;

his interest in the outcome of the decision to purchase; and

whether this is a related party transaction. Richard Stone could own RS Office


Valdas auditors
The companys auditors might expect to be approached to undertake this
assignment. If approached, they may have declined due to lack of resources or
even expertise. If not approached, the reasons must be established. The auditors
should be notified of the special work requested as a matter of professional
courtesy. A new computer installation will concern the auditors and they would
expect to be involved.

Future business
There may be an opportunity to gain the audit of Valda or additional non-recurring
work. In particular, the companys rapid expansion may result in the current auditors
being outgrown.

As for all professional work, it should be carried out with a proper regard for the

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technical and professional standards expected. It is unlikely that the level of care
and skill expected can be met within a restricted timescale. A few days is
unlikely to be feasible for the work proposed and conclusions cannot be drawn
until the fieldwork is completed. If the purchase cannot be deferred beyond next
month it may not be possible to accept the work.
Access to information
Restricted access to information and explanations, which limits the scope of the
proposed review, may prevent conclusions being drawn. It may be necessary to
discuss sensitive issues including proposed business expansion, technical
obsolescence of products, product development, etc. Also, the current auditors
permission should be sought to review their management letter.
Presumably the findings of the review will be reported, possibly to Mr Stone rather
than the board. Any opinions must be commensurate with the scope of the review
performed. In particular, the report will not recommend the boards decision.

Nature of review
The companys flowcharts and documents may not be up to date. The
reviews could require some element of verification (e.g. using walk-through
checks). Alternatively, it may be assumed that the flowcharts and documents are
reliable and accurate. In this case, managements responsibility for the information
provided must be made absolutely clear in any report.

Decision to purchase
The decision to purchase, or not, will be taken by the board. Matters significant
to the boards decision, which may not be included in Mr Stones proposals, could

cost and availability of software support;

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alternative methods of financing the acquisition;

capacity to meet future needs if growth continues at current rate;

Mr Stones commission or other interest, if any; and

the potential impact on the conduct and cost of the annual audit.

The assignment cannot be accepted if fees are contingent on the outcome. Fees will
be based on time spent and the level of skill of staff involved.

Resources available
The assignment will require at least one member of staff with relevant systems and
computer knowledge and experience. Some knowledge of the industry will be useful.
Such a person may not be available, at such short notice, without disturbing the
services provided to existing clients. For this reason alone, the assignment could be



Telephone Valda and enquire as to the status of Mr Stone.

If appropriate, telephone the existing client (with whom Mr Stone
is acquainted) and ascertain their relationship. Decline
nomination if a conflict of interest could arise.
Undertake company searches of Valda and RS Office Equipment to

current auditors;

Mr Stones interests as director/shareholder.

Call or write to Mr Stone:

declining work if there are obvious barriers at this stage; or

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arranging a meeting at Valdas premises.

Meet at Valdas premises to discuss the unresolved issues concerning

acceptance of the assignment.
Advise Mr Stone of the need to notify and liaise with Valdas auditors.
Obtain the systems flowcharts/documentation and consider whether the
level of detail provided is consistent with the review required.
Agree a provisional timetable to accommodate the needs of Mr Stone, the
review work, board decision and suppliers delivery/installation.
Agree the basis on which fees will be charged and the account rendered paid.
Write to the existing auditors:
advising them of the assignment being undertaken;
requesting a copy of the latest management letter, if relevant
Draft an appropriate letter of engagement.

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Audit planning
Proper planning is required in audit to avoid performing negligent audit. Overall audit plan
includes consideration of the following:
Knowledge of clients business
Understanding of accounting policies of client and reporting framework
Assessment of risk and materiality
Consideration of nature, timing and extent of procedures to perform in gathering
Co-ordination, direction, supervision and review
Knowledge of the business
The followings are the aspect of the clients business which the auditor must understand:
Understand nature of the industry and its regulatory framework
Nature of the entity. This includes knowledge of the corporate structure, organization
structure, managements objectives and philosophy, capital structure and the
composition of the board of directors
Nature of business. This includes knowledge of products, market, suppliers and
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

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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

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
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

Audit approach
Risk-based approach
In this approach, the auditors assess the risks associated with the clients business,
transactions and systems and direct their testing to risky areas. The extent of detailed testing
depends on the outcomes of risk assessment.

Audit risk
Audit risk is the risk that the auditor may give an inappropriate opinion.
Components of audit risk

Audit risk= inherent risk x control risk x detection risk

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Inherent risk- is the susceptibility of an account balance to misstatement. It is a risk which

remains until the causative agent 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
If both control risk and inherent risks are low, the overall audit risk will be low. The auditor will
perform less substantive testing
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 as this is the only component of the audit risk
the auditor can control. To do this, the auditor will need to test more details
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.
Its time consuming

Business risk or Top down Approach to Audit

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

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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 managements 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 save auditors time and add 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
Age of plants

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Risk management
The following are the ways of dealing with risks:
Accept risk
Reduce risk. E.g.
Improved internal control
Staff training
Avoid unacceptable risk
Transfer risk, e.g. using insurance

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
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.

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 statement 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.

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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 companys 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 cause 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

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 operate 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
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

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If the company operate 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
The following areas of financial statements are highly susceptible to manipulation:
Inventory. Valuation may be wrong, in which case IAS 2 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
Leased assets. Assets may be wrongly classified and the lease obligation may be
wrongly calculated as against the treatment laid out in IAS 17.

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These are tests carried out to obtain audit evidence to detect material misstatement in the
financial statements.
Types of substantive procedures are:
Analytical procedures
Test of details
Substantive tests carried out to obtain evidence on financial statement assertions are described
Audit objective

Right and obligations






Typical audit test

(a) Review of post balance sheet items
(b) Cut off
(c) Analytical review
(d) Confirmations
(e) Reconciliations to control account
(f) Sequence checks
(g) Review of reciprocal populations
(a) Checking invoices for proof that item
belongs to the company
(b) Confirmations with third parties
(a) Checking to invoices
(b) Recalculation
(c) Confirming accounting policy consistent
and reasonable
(d) Review of post balance sheet payments
and invoices
(a) Physical verification
(b) Third party confirmations
(c) Cut off testing
(a) Inspection of supporting documentation
(b) Confirmation from directors that
transactions relate to business
(c) Inspection of items purchased
(a) Re-calculation of correct amounts
(b) Third party confirmations
(c) Expert valuation
(d) Analytical review
Check compliance with law and accounting

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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 entitys 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
Management accounts
Non-financial information

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Bank and cash records

Sales tax returns
Board minutes
Discussions or correspondence with the client at the year end
Industry information
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 Comprehensive Income
Review trends in the following
Gross profit
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

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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
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.

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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 yearany 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 analytical procedure
on items that are material.
The accuracy with which the expected results of analytical procedures can be predicted
Analytical procedure can be use 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 need to
test if the controls are effective to determine the extent of reliability

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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.
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
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 bench marks for the materiality:
Profit before tax


Profit after tax




Total assets


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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 auditors expert ISA 620

Professionals audit staff are highly trained and educated, but their experience and
training is limited to accountancy and auditing matters. In certain situations it will
therefore be necessary to employ someone else with different expert knowledge to gain
sufficient and appropriate audit evidence.
Examples of situation where experts opinion is required:
1. Valuation of certain types of assets for example land and building, plant and
2. Determination of quantities or physical conditions of assets.
3. Determination of amounts using specialized techniques for example pensions
4. The measurements of work completed and work in progress on contracts.

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5. Legal opinion.
Competence and objectivity of the auditors expert
This involves considering:
1. The experts professional certification or licensing by or membership of an
appropriate professional body.
2. The experts experience and reputation in the relevant field.
The risk that the experts 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 auditors expert
The auditor shall agree in writing when appropriate on the nature, scope and objectives
of that experts work. Such agreement/instruction should cover the following factors:
1. The objective and scope of the experts work.
2. A general outline as to the specific matters the experts report to cover.
3. The intended use of the experts work.
4. The extent of the experts access to appropriate records and files.
5. Clarification of the experts relationship with the entity.
6. Confidentiality of the entitys information.

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Assessing the work of the auditors 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.
5. The results of the experts work in the light of the auditors overall knowledge of
the business and the results of other audit procedures.

Reference to an auditors expert in the audit report

The auditor shall not refer the work in an auditors 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


You are carrying out the audit of Ravenshead Construction Inc. The companys 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
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

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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.
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:

Legal advice obtained from the local solicitor on the outcome of the claim by Netherfield


(6 marks)


Valuation of the investment properties by the independent valuer; (7 marks)


Valuation of the construction contract by the internal valuer.

(7 marks)

(20 marks)


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.
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.

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The information supplied for the solicitor and the correspondence with the solicitor
should be inspected; any opinions given by the solicitor should be from him in writing
and should not be merely the transcripts of conversation. The opinion of any learned
counsel briefed by solicitor is also relevant in this area. Lastly the materiality of the
amount of the claim should be considered and the solicitors opinion should be read
carefully. The solicitor may only give a very pessimistic estimate of the likely outcome of
the case. This should be considered in the light of any precedence and will obviously be
relevant in examining the accounting treatment of the item in the financial statements.


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 valuers 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.
The auditor should also consider the valuation of other investment properties in a similar
area with those contained within the portfolio of his client.

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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
The accounting records for the contract should be reliable and should be capable of
The past record of the valuer should be considered; there should be other construction
contracts which have been completed in the past and the valuation basis should have
been capable of validation with the benefit of hindsight.
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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This standard requires management to make assessment of an entitys 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
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 entitys 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
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
managements use of the going concern assumption in preparing the financial

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Based on the evidence collected, the auditor should conclude whether there is a material
uncertainty about the entitys ability to continue as a going concern.
Auditor should determine the implication on the auditors report. If there is material
uncertainty on the entitys ability to continue as a going concern and this has been duly
disclosed by the management, there will be no need to qualify the auditors 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 entitys ability to continue as a going
NOTE: The auditor shall cover the same period as management in the evaluation of
managements 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 entitys
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.

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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 do 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
Note: any of the above points constitute matters to be consider 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 entitys
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 managements future plan to sustain the entitys going
concern. E.g. managements plan for the expansion of its business or invest in new

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 entitys bank on its readiness to
provide the needed finance for the entity.
The auditor should assess the viability of managements plan e.g. by assessing the
market research report.
The auditor should evaluate managements 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.

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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 the implications of going concern issues on the auditors report:
Where the auditor consider that there is significant level of concern about the ability of
the entity to continue but do not disagree with managements 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 auditors report
would include an emphasis of matter paragraph to draw readers attention to the note.
If the use of the going concern is appropriate but there is material uncertainty on the

going concern, if required disclosures are inadequate the auditor would issue a qualified
or adverse opinion depending on the pervasiveness of the uncertainty to financial
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 auditors 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.

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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 auditors report should
contain an emphasis of matter paragraph discussing the uncertainty and referring to the
If the financial statements do not contain the disclosures, the auditors 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
Consider the sufficiency of the loan requested to cover the costs of the intended
Review the repayment history with the clients 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 financial is
Obtain a written representation from management stating managements opinion as
to whether necessary finance is likely to be obtained.

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Requires that inventory should be valued at the lower of cost and net realizable value.
The method used in allocating costs to inventory need 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.
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 explain 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 valuation- matters to consider for audit

Cut-off. Inventory will be undervalued or overvalued if cut-off has not been appropriately
Counting. Inventory will be undervalued if not all inventory items have been included in
Inventory will be undervalued or overvalued if the valuation methods are incorrect
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

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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
Recast additions on inventory sheets to verify accuracy.

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.
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.

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Obtain evidence of the estimated fair value, possibly by engaging an auditors expert.
Inspect any correspondence with potential buyers to confirm management is actively
looking for buyers
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.

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 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

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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 auditors 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 the
modified with respect to the corresponding figures.

Audit procedures
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.

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:
Financial assets should be initially measured at fair value
A financial asset must be measured at amortised cost if both of the following conditions are met:
The asset is held within a business model whose objective is to hold assets in order to
collect contractual cash flows; and

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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.
Any asset which is not measured at amortised cost must be measured at fair value
Financial liabilities
Financial liabilities are measured at amortised cost unless held for trading
Matters to consider for audit
Materiality of the assets should be first determined
Classification may not be correct.
Assets shown at fair value may be subjective
Disclosure may not be made
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
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.
Agree purchase price to documentation

Events after reporting period (subsequent events)

A subsequent event is any event occurring after the date of the financial of the financial
statement being audited.
Material non-adjusting events must be disclosed in the note- explaining the event and its
financial implication.

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Auditors 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
According to ISA 560, subsequent events divide into three periods:
Events occurring between date of the financial statement and the date of auditors 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 auditors 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

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The auditor should seek for a legal advice

The auditor should consider resigning from the engagement.

Events discovered after the financial statements are issued

Auditors have no obligations to perform procedures after the financial statements have been
If the auditor becomes aware of a situation that if he had known at the date of the financial
statement would have cause 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 managements revision of the financial statements, the auditor should carry out further
procedures as follows:
Carry out further procedures on the amendments made
Ensure management have taken necessary measure to prevent reliance on the
previously issued financial statements
Issue new auditors report

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
Review the details of the announcement made on the restructuring and agree the details
to the disclosures made in the financial statements.

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Review boards 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
Analytical review of sale against budget
Board minute regarding any decision taken

Note: Increase in tax rate merely announced is a non-adjusting event

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.

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

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Agreement of tax rate to tax legislation

Schedule of Non-current asset in tax calculations agreed to Non-current Asset
Minutes of directors meetings confirming detail of any major additions in Non-current
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.

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
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 nonactive markets.
Using the entitys own assumptions about market exit value.

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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.

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.
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 auditors expert.

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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
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
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.
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

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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 procedures regarding tangible assets:
Take a sample of assets from the asset register and trace to physical location to confirm
Take a sample of assets from physical location and trace to assets register to confirm
Inspect purchase invoices to confirm the cost of assets and the dates on the invoice
should confirm the cut-off is proper.
Recalculate the depreciation
Check consistency of the depreciation policy by comparing the current rate with prior
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
Audit concern in respect of dismantling cost:
Provision may not have been created
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

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Principal Audit work 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 managements expert report
Review the managements 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
Ensure the basis of capitalization agrees with IAS 16
Discuss with management on the consideration of possible impairment

A lease is a finance lease if it transfers the majority of the risks and rewards relating to the
ownership of the asset to the lessee. If this is not, it is an operating lease.
Finance lease:
At the start of the lease, the lessee should recognize the leased asset as a non-current asset,
valued at the lower of:
Fair value of the asset, and
The present value of the minimum lease payments
The asset should be depreciated over the shorter of:
The period of the lease, and
The useful life of the asset

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Each year, the lease payment is divided into two as follows:

Finance charge
Partial repayment of the lease obligation
Both the depreciation and finance charge should be accounted for as period charges in the
statement of profit or loss.
Operating lease
Lease payment under operating lease is treated as rental expense in the statement of profit or
The asset should not be recognized in the statement of financial position of the lessee. Also, the
leased asset should not be depreciated.

Matters to consider for audit include:

Classification whether leases have been correctly classified as finance or operating
lease according to IAS 17 leases.
Whether calculation of finance charge using the actuarial method has been done
Note: For lease of land and building, according to IAS 17 leases, only the buildings element of
the lease can be capitalized as land is always an operating lease. The risk here is that both land
and building may be wrongly capitalized.
Audit Evidence in respect of lease amount recognized:
Copy of clients workings in relation to the amount recognized as finance lease charge.
Recalculation of the present value of the minimum lease payment and compare to fair
Recalculation of finance charges.
Agreement of interest rates used in calculation to lease agreement.
Recalculation of depreciation charges applied to the assets

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Verify that land element is classified as operating lease and there is no non-current
asset recognized in respect of land.
The discount rate used in the above calculation should be agreed as appropriate.
Recalculation of operating lease expenses on a straight line basis over the lease term

Sale and lease back transaction

If the transaction results in a finance lease, any associated profit or loss should not be
immediately recognized. The profit/loss should instead be deferred and amortised in the
financial statement of the seller over the term of the lease.
If the transaction results in operating lease, the associated profit/loss should be recognized
immediately. In a case where the transaction does not occur at fair value, one of following
treatments applies:
If the sales price is above the fair value, the excess of the price over the fair value
should be deferred and amortised over the lease term to match the lease payments.
If the sale price is below the fair value, any profit/loss should be recognized immediately

Sale should only be recognized when risk and benefit associated with goods have been
transferred to the buyer.
Deposits made when the customer is yet to enjoy the service is treated of deferred income and
shown as liability on the statement of financial position.
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

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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

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
Audit implications regarding IAS 20
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.

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.
Revision of the terms and condition attached from the grant document to determine the
consequence of any breach on terms.

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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.

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
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
Not making provision when it is required
Contingent liability may not be disclosed

Audit procedures:
Discuss with management on the need to make provision
Discuss with management the suitability of the method used to arrive at the provision

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Assess the reasonability of managements method of making the provision

Review notes to the account to assess the adequacy of disclosures
Inspect Correspondence with the other parties involved
obtain direct confirmation from companys lawyer
analytically compare currents year provision with that of prior years, obtain explanation
for any unexpected result
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

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:

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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 companys commitment to complete the project.
Inspect results of the entitys market research to assess future marketability of the
Assess the capitalized cost to be sure they meet the recognizing criteria
Obtain direct confirmation from the entitys bank to confirm availability of finance to
complete the asset
Obtain written managements 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

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
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

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Audit Procedure for Capitalized cost

Agree cost to invoice- a sample of costs capitalized should be agreed to supporting
documents, labour costs should be agreed to payroll and material cost should be agreed
to purchase invoice
Agree finance cost to loan contracts - interest rate should be agreed to finance
agreements, recalculation of the finance charge should be carried out.
Agree classification between revenue and capital expenditure.
Check that staff training cost is not capitalized.
Review list of items capitalized to ensure all are capital in nature

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

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.

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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

Earnings per share

IAS 33 requires disclosure of earning per share figure. Both basics EPS and diluted EPS should
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 auditors
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

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Share based payment

The model used to assess the fair value of the share options must comply with IFRS 2 share
based payment.
Fair value must be measured at the grant date in order to calculate expense otherwise the
financial statements will be inaccurate.
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.

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Business combination
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.
There is risk that goodwill has not been calculated correctly. The fair value of subsidiarys
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 risks this
is not done. Inventories may as a result contain unrealized profit thereby overstating revenues,
expenses, assets and liabilities.
Principal Audit Procedure in Respect of Non-Controlling Investment
Determine the percentage of shareholding acquired using purchase documentation.
Confirm that percentage shareholding is between 20 and 50% of equity shares.
Obtain list of directors of the companies to confirm whether the company has appointed
director(s) to the boards.
Discuss with the directors of the company the level of involvement in policy decision made at
the companies.
Obtain a written representation detailing the nature of involvement and influence exerted over
the companies.

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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 auditors report issued by the outgoing auditors which
referred to inadequate internal controls in Abacus Leanings 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 Leanings sales revenues have doubled
each year and lease receivables now represent over 80% of the companys 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
Although the terms and conditions of the leases vary considerably all of them had been treated
by Abacus Leasing as finance leases.
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

Describe the procedures an audit firm should undertake before accepting a potentially

high risk audit such as that of Abacus Leasing.


(5 marks)

Describe the factors in relation to the audit of Abacus Leasing that would affect your

assessment of risk.

(7 marks)

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Describe the audit work that you would undertake to determine the correct accounting

treatment and disclosure of:


the leases;


the bad debts allowance in respect of lease receivables.

(8 marks)



Procedures before accepting a high risk audit client

It should be apparent to a prospective auditor that the audit of Abacus Leasing is a high risk
audit and therefore the quality control procedures to be adopted before tendering for such an
audit would include:
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 auditors willingness to tender. In
particular, details of the reason for their resignation would be relevant.
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.
A commercial assessment must be made. The prospective client appears to have weak
controls and several high risk areas. This may entail a large amount of audit time making
the audit fee expensive. The financial position of the client may not be sound and there
may be a serious risk of non-payment of the audit fee. The risk of an incorrect audit
opinion being given increases the possibility of legal action against the auditor as well as
the possibility of bad publicity and implications for future insurance indemnity premiums.

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Assessment of risk

The following factors would need to be considered in assessing the level of risk in Abacus
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.
The domination by the managing director.
The company is a new company with little history and the growth of the company is
There may be an element of overtrading causing the company to be over borrowed,
highly geared and experiencing liquidity problems.
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.
The nature of the products, building equipment, can have high associated risks. There is
frequent theft of this type of equipment and as the equipment is often abused in its use it
may not last the length of the lease, making default more likely.
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.

Audit work



The principal aim is to determine whether a tease falls to be treated as a finance lease or an
operating lease. IAS 17 Leases says that a finance lease occurs when substantially all the risks
and rewards of ownership are transferred to the lessee. This is deemed to occur where:
ownership is transferred to the lessee at the end of the lease;
the lessee has an option to purchase the asset at a bargain price; or

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the present value of the minimum lease-payments amounts to more than, or

substantially all of, the fair value of the asset.
As a result of this the auditor must perform the following work:
Obtain and inspect copies of all different types of lease agreements.
Determine the fair value of the asset. In practical terms this will be the purchase price,
but it would be net of any trade or large quantity discounts and any grant assistance for
the purchase. The auditor must identify the specific asset being leased in the
agreements and determine its original cost by tracing the purchase invoice and the
payment made. If any grants have been received by Abacus Leasing during the year the
documentation relating to them must be inspected to determine which assets had grant
aid and how much this was.
The minimum lease payments (MLP) should be readily determinable from the
agreement. The auditor would then calculate the present value of the MLP using an
appropriate discount rate. The discount rate should be confirmed by management and
the auditor would use his experience of similar agreements and market interest rates to
confirm the appropriateness of the rate.

The results of the above tests should determine whether the agreement is a finance lease or an
operating lease (as per the definition above). If it is a finance lease the outstanding net
investment in the finance lease should be shown in receivables. The rental income should be
allocated partly to finance charges and credited to profit or loss with the balance being treated
as a repayment of the lease receivable. If it is an operating lease the assets should be shown
under non-current assets and depreciated over their estimated lives, with the rental income
credited to profit or loss.

If a lease has been incorrectly classified there may not be a material error in the total value of
the assets in the statement of financial position. However the presentation of the statement of
financial position would be incorrect.

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Bad debts allowance

The work the auditor would do to confirm the estimate of the bad debts allowance is:
Confirm the gross lease receivables by the tests above and, using an appropriate
sample, perform a positive circularisation of lease receivables.
The auditor should focus his attention on recent lease receivables as these are likely to
be of greater value and at more risk of non-payment. Leased receivables differ from
normal trade receivables in that they are not receivable within a short period of time.
The auditor should check to see if any receivables contain overdue instalments: Such
receivables are more likely to be bad. Some of the lessees may be in dispute and the
payments have been stopped. This should be investigated by the auditor:

The auditor should review the companys 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.
The above tests should give the auditor a basis for estimating the total allowance required for
bad debts. From the information in the question this is likely to be a high figure due to the credit
standing of some of the customers and the sales policy encouraged by the bonus scheme.
Lease receivables again differ from most normal trade receivables in that Abacus Leasing
retains ownership of the related assets. Where an agreement is in default such assets could be
repossessed by the company.
If Abacus Leasing has reduced the total allowance by an estimate of the recoverable amount of
leased assets the auditor must do farther work. The auditor should try to obtain proof of the
physical existence of the assets to confirm they are still in the possession of the lessee and-to
determine their condition. This may be very difficult in practice. The auditor would then form an
opinion of the recoverable amount of the assets. This would either be an estimate of their net
selling price or their fair value if leased to another builder. The value to be used would be

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dependent upon the intention of management and the auditor agreeing with its appropriateness.


The opportunity has arisen for your firm to seek appointment as auditors of Sunshine Stores, a
supermarket chain of twenty stores which operates a sophisticated computerised inventory
control and re-ordering system. You learn that Sunshine Stores has also invited four of your
competitors to produce a written presentation, the standard of which is crucial to progressing to
the next stage when the company will select two firms to make an oral presentation.
Sunshine Stores has a centralised purchasing system and individual stores transmit electronic
point of sale (EPOS) information each night to the head office for processing the following day.
All other accounting functions are also carried out centrally with the exception of casual wages
and petty cash expenditure. Each days takings are banked daily to one single bank account.
Sunshine Stores is particularly anxious to establish the ability of your auditing procedures to
deal with the business risks and has asked you to set out, as part of your presentation, your
approach concerning:

audit risk (that is, the degree of risk of misstatement through errors or irregularities) and

how your procedures would seek to address it in the business of Sunshine Stores;

materiality, and how this might be applied;


sampling, and the extent to which it might be appropriate to use this technique; and


analytical procedures and its contribution to the efficiency of your audit process.

You understand the need for Sunshine Stores to have a high level of confidence in your firms
approach to highly computerised clients, and you have the task of drafting the sections of your
firms written presentation to demonstrate how your procedures would be likely to apply to this

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Draft the sections of the written presentation to Sunshine Stores which deal with these four
aspects of the audit approach and the inter-relationships, if any, between them.
(15 marks)


Audit risk

Audit risk, defined as the degree of risk of material mis-statement through errors and
irregularities, is a fundamental determinant of the sufficiency of audit evidence. It is ascertained
the overall financial statement level (e.g. the knowledge that accounts are likely to be
used partly to defend a takeover bid would be considered to increase audit risk); and
at the individual account level (e.g. in many organisations, the sales/receivables/cash
cycle would be considered to have higher audit risk than, say, executive salaries).
Our approach involves assessing audit risk at both levels under the two headings of inherent (or
business) risk, and control risk. Inherent risk arises due to the nature of the companys
operations and industry within which it operates, and control risk is the risk that the accounting
and internal control system will fail to prevent or detect any errors or irregularities that do occur.
In the particular context of Sunshine Stores, inherent risk can be identified in the following
the large volumes of cash handled;
the likelihood of shoplifting (shrinkage);
the problems arising from shelf lives for foodstuffs; and
at the time of writing, the losses arising from excess inventory of eggs and poultry.
Control risk is minimised by a comprehensive system of internal controls, especially where a
well constituted system of internal audit is involved. In the particular context of Sunshine Stores,

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the centralisation of the majority of the accounting functions together with the use of EPOS
techniques for inventory recording will make a valuable contribution to minimising control risk.
The detailed assessment of audit risk is made by using the techniques of interviews and
completion of internal control questionnaires (ICQs). Inherent risk is assessed primarily by
discussion with senior staff coupled with our prior knowledge of operations in the retail sector
(we have a number of clients in this area). Control risk is assessed by obtaining a thorough
understanding and evaluation of the internal control system assisted by the use of pre- prepared
ICQs. Based on our judgement as to the likelihood of errors and irregularities arising due to
inherent risk, and the extent to which such eventualities are likely to be prevented or detected
by the internal control system, we assign numerical values to these elements based on a well
recognised model of audit risk, which leads us to the design of samples and sample size


Materiality is a concept fundamental to the auditor, the user of accounts and the preparer of
those accounts. To the preparer, the concept is applied in deciding on the applicability of IASs
(IASs are to be applied to all items which are material in determining the value of
assets/liabilities or the determination of profit/loss). To the auditor the concept is applied when
determining the areas of the financial statements to which especial effort should be devoted and
ultimately in adjudicating whether a true and fair view is shown. It is also relevant in designing
sampling plans. Finally, the user of accounts is concerned with the concept, since it is likely that
a material error, omission or mis-statement would have caused him to act differently had he
known the true position.
In the context of our audit approach to the financial statements of Sunshine Stores, materiality
will be assessed by the exercise of professional judgement. Our overall concern is that the
needs of users must be met, and thus materiality measures based on the critical points (e.g.
the amount that would change profit to loss, or net current assets to net current liabilities) would
be relevant. Furthermore, measures based on percentages of major elements of the accounts

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(e.g. 1% of turnover, 5% of net assets) would be borne in mind. Based upon such
considerations, a numerical measure of acceptable monetary error is established.
Having set such a measure, we are not rigidly constrained by it. For instance, the nature of an
omission or mis-statement may, whilst being immaterial in amount, nevertheless be viewed as
critical to the ability of the user to reach an informed and justified conclusion. In a similar
manner, the trend demonstrated in financial results may, on occasions, suggest that smaller
monetary amounts be viewed as material.
Finally, we would be pleased to advise you on what we view as material in any particular
context so as to assist you in applying IASs and devoting appropriate effort to the determination
of amounts appearing in your accounts.

Audit sampling

Audit sampling can be described as the application of an audit procedure(s) to less than 100%
of an accounting population in order to draw an inference, based on the sample, about the
population from which it was drawn. Two particular factors make it an appropriate technique for
use in many modern audits, and especially the audit of Sunshine Stores.
First, the sheer volume of transactions in most modern businesses make it an essential
technique to enable the audit to be completed in a reasonable time and at a realistic fee.
Secondly, and particularly in the case of Sunshine Stores, the homogenous nature of
transactions (many transactions of broadly similar size and nature) means that entirely
justifiable conclusions about a population can be made by examining a relatively small, though
representative, sample. Thus we would intend to make extensive use of the technique in the
audit of much of your business, most notably in the audit of the transactions cycle, year-end
liabilities, inventory valuations and shop fittings.
In certain areas of your financial statements, the use of sampling would not be appropriate. For
instance the audit of freehold/leasehold premises and directors emoluments would most likely
be subjected to 100% checking, as would any other area that was small in terms of number of
items but large in value, or of statutory importance. In a similar manner, those areas of high

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audit risk (whether inherent or arising from weaker internal control) would be subject to a greater
degree of testing. And finally, those areas identified as being highly material would be subjected
to a greater degree of testing.
Our firm makes use of two techniques of sampling judgement sampling and statistical
sampling. It is most likely that we will make extensive use of the latter method, especially since
our approach integrates numerical measures of audit risk and materiality, to ensure a high level
of confidence derived from the overall audit.

Analytical procedures

Analytical procedures involve the systematic analysis of past results, budgets, trends, financial
and non-financial data and variations from predicted patterns in order to provide an efficient
approach to an audit. The efficiency is realised:
in the planning of the audit since the method should serve to direct effort to critical
areas and/or those which do not conform to predictions; and
in the evidence collection stage where a degree of reliance can be placed on the results
of satisfactory substantive analytical procedures.
Analytical procedures are also very relevant in the final review of financial statements where it
both serves as corroborative evidence to that gathered by other techniques and supports the
review for fairness and credibility.
Our approach involves the use of manual techniques of comparison, and on occasion we make
use of sophisticated statistical techniques such as multiple regression analysis to determine
patterns and trends and project these to the current and future accounting periods. It is likely
that, in the case of a new client, the method is used in the first audit only at the planning and
overall review stages, since the amount of reliance placed on SAPs is necessarily limited when
we have little personal experience of the major features and account relationships to build upon.
However, we would seek at the earliest opportunity to build up a profile of past trading patterns
to use as a basis in later years in order to place greater reliance on this technique. We will thus
be able to future years to further reduce the time spent on traditional audit testing.

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Inter-relationship between techniques

Our overall audit approach is designed to ensure that sufficient audit evidence is obtained to
enable us to form our opinion as to the truth and fairness of financial statements in the most
efficient manner possible. To this end the various elements of approach and the particular
techniques of risk assessment, materiality and sampling (and on occasion, analytical
procedures) are integrated via well recognised and tested models. It should be clear that such
relationships exist, and our approach specifically links the elements to ensure that, in total, we
achieve a high level of confidence in our opinion. Where inherent risk is high, though control risk
is low, audit risk is medium and thus sample sizes will be manageable. Highly material areas will
dictate larger sample sizes than immaterial areas, and those in which analytical procedures
showed no unexpected variations will correspondingly have smaller sample sizes (although
perhaps not in the first year of a new audit). When the opportunity exists (as appears at this
stage to be the case in the audit of Sunshine Stores) to make use of the EDP system to extract
samples in an expeditious manner, the greatest efficiencies are realised.

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:

One of the companys largest customers, Bramley, notified Sellers of its intentions to go

into liquidation with an outstanding debt of $260,000. Sellers directors consider that the current
allowance for bad debts will cover any potential loss.

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.

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A fire at the companys 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

Half of the sales force was made redundant and a provision has been made for

redundancy payments amounting to $400,000.

For EACH of the four events:

Explain the effect, if any, on the financial statements

(8 marks)


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)


Bad debt $260,000


Effect on financial statements

As Bramley is one of Sellers largest customers, the outstanding balance is presumably

material to trade receivables.
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 Sellerss accounting policy.
However, an adjustment would not required if the amount of the specific allowance required was
found to be immaterial (e.g. if the balance at the end of the reporting period was considerably
less than $260,000 and/or the liquidator considered that a reasonable dividend would be paid
to creditors).

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No allowance should be made, in the financial statements under review, in respect of any sales
made to Bramley after the reporting period. However, if material, such transactions may be
disclosed (as non-adjusting events after the reporting period).

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
The make-up of Bramleys account balance in Sellerss 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).
Reservation of title clauses (if any) on sales invoices which may give Sellers the right to
repossess goods sold to Bramley.

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Legal claim $90,000


Effect on financial statements

If settlement of the claim is probable (e.g. because the former sales directors action is
likely to succeed or an out of court settlement is envisaged) a prudent estimate of the
full amount of the liability (including legal costs) should be provided in the financial
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). However, as
the amount involved ($90,000) makes this the smallest of the events (in financial terms)
it may not be considered sufficiently material to warrant or require disclosure.

Matters to consider
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. For example, if
Sellers did not follow specified procedures for dismissal, the sales director may
have good grounds for his claim (even though Sellers may be justified in
dismissing him).
Whether the company intends to contest or counter the claim or negotiate an outof- court settlement.

Audit evidence
The service agreement, to ascertain whether actions of the former sales director
were sacking offences.
Board minutes discussing how Sellers is planning to proceed (e.g. by offering an
out-of-court settlement).

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Legal correspondence to assess the most likely outcome and amounts involved
(including legal costs).
Former directors personnel records including dismissal notice etc.
Post year-end cash book payments to the former director, if any.


Inventory loss ($1,800,000)


Effect on financial statements

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).
However, the matter should be fully disclosed in a note to the financial statements as
the amounts involved are very material. Even if there is no financial loss in respect of
the inventory destroyed (e.g. because it is fully insured), some disruption to trading is
likely (with consequent reduction in next years reported profit).
As non-disclosure would affect the ability of users to make proper evaluations and
decisions, the financial statements should disclose:
that there was a fire on [date];
that $1.8m of inventory included in the statement of financial position was
the financial effect (e.g. amount of any uninsured loss).

Matters to consider
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.

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Whether orders or customer goodwill been lost due to delays in despatching

goods to customers.
Whether the cause of the fire was accidental or arson is suspected (in which
case the insurers may not pay up).
Audit evidence
Insurance policy to confirm the extent to which loss of inventory, trade and
warehouse fixtures and fittings were covered and on what basis (e.g.
replacement cost, historic cost or some depreciated amount).
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.

Redundancy payments $400,000


Effect on financial statements

Assuming that the sales force is more than a handful of employees, making half of it
redundant is likely to be material. It may be appropriate to disclose the redundancy
expense separately to explain the performance of Sellers (IAS 1). If the redundancies
relate to the closure of a business segment, separate disclosure under discontinued
operations would be required (IFRS 5).
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. That a
provision has been recognised means that the obligation existed at the year end
(IAS37). The provision should include all related tax, social security and pension
contributions (less any statutory recoveries).

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Matters to consider
Whether further similar redundancies are likely in the foreseeable future.
The reason(s) for the redundancies (e.g. rationalisation 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.
Sales order books to establish the impact, if any, on sales levels in the wake of

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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
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.

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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.
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

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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
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
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 auditors 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 groups financial
statements, the group auditor should review the component auditors 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 components
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 auditors 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.

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The group auditor should evaluate the effect of any uncorrected misstatements on the
groups financial statements
After reviewing the components auditors 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.

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
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.

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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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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.

Describe the audit procedures which you would carry out before placing reliance upon

the work of the auditors of Loopy.


(7 marks)

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

(7 marks)

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

(6 marks)

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.


(25 marks)

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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
companys 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 and this will determine the nature of the procedures to be carried out by the group auditor.
Further an assessment of the risk inherent in the audit of Loopy will be made. This will involve a
review 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
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
It is unlikely that the group auditor will have dealings with the component auditors prior to taking
over the audit of Cuckoo. Therefore, the above items can best be dealt with by a meeting of the
auditors. If this is not possible, then a questionnaire may be sent to the component auditors,
covering the above areas. The questionnaire will cover such areas as the nature of the interim
audit, the audit of non-current and current assets, liabilities, profit and loss account and the

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areas which required audit judgement. The audit procedures used by the component auditors
will be reviewed also in this questionnaire.
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 auditors report on
Loopys financial statements.


Accounting policies for inventories



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 is necessary to depart from IAS 2 and apply alternative accounting
practices. The financial statements are 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 companys 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.

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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


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 comprehensive income and statement of financial
position under existing accounting conventions. The presentation in the statement of financial
position takes the form of reserve accounting with the base inventory write-down presumably
being charged against retained earnings without being shown in profit or loss. It is a practice
which would be discouraged by the auditor but because the amount is immaterial, the error may
be summarised along with other errors found in order to ascertain the collective materiality of
those items. Alternatively, because the item can be adjusted easily on consolidation, the
financial statements of Snoopy may be adjusted.

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.
The most practical method of valuing year end inventory is to record inventory at selling price
and convert it to cost by removing the mark-up.

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It is important that Fooey Retail plc keeps a record of the mark-up on each product and those
items which have been marked down otherwise the calculation of original cost will be
inaccurate. IAS 2 says that this method is acceptable only if it can be demonstrated that the
method gives a reasonable approximation to actual cost.

Overheads in inventory valuations

Problems arise under IAS 2 with regard to how overheads are to be incorporated into inventory
valuation. 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.
Thus it can be seen that the allocation of costs to inventory will vary from organisation to
organisation and the accounting policy of valuing inventories at cost is fraught with difficulty. It
leads to a situation where companies may ostensibly have the same accounting policy but the
overhead cost allocation may be quite different.
Another problem is that IAS 2 requires overheads to be included in inventory on the basis of a
companys 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.

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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
The directors of Cuckoo Group appear to have adopted the latter viewpoint as the information to
be given to users has little interpretational value. Hence the bullion inventories, retail goods and
the trading inventories should be suitably described.
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. Examples of this are set out below:
Raw materials Purchase cost on a first in, first out basis
Work in progress and finished goods Cost of direct materials and labour plus attributable
overheads based on a normal level of activity
Retail inventoriesCost is computed by deducting the gross profit margin from the selling value
of inventory for the different product lines
Bullion inventoriesAssets in bullion and other metals are stated at year-end market values in
the statement of financial position.

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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
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.


List and briefly describe the audit work you would perform to check that inter-company

balances agree; state why inter-company balances should agree and the consequences of them
not agreeing. (7 marks)

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)

List and briefly describe the audit work you would perform to verify that the work carried

out by other audit firms, who are auditors of subsidiaries of the group, is satisfactory.



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:


the size of the subsidiary whether it is small or large;


if the auditors report on the subsidiarys accounts is qualified;


if the subsidiary is a banking company.

(5 marks)

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Inter-company balances

A group company will have the following types of inter-company balances:

A sales ledger balance. This will be represented by a corresponding purchase ledger
balance in the supplier company books.
A purchase ledger balance this will be a sales ledger balance in the receiver company
Short-term general ledger debit balances in respect of dividends receivable or loans.
Long-term general ledger debit balances which are effectively investments in group
companies and are shown as part of non current asset investments.
Short-term general ledger credit balances which are loans or advances repayable within
twelve months and long term non ledger credit balances which are loans repayable after
twelve months.
There should be an agreed procedure laid down by the group accountants department for the
following matters:
Goods in transit Some companies follow the convention that the supplier companys
record is the definite record; therefore the consignee should make an accrual to agree
the inter-company balance.
Cash in transit A convention which is often adopted is that the paying companys
record is the definitive record and agreement should be made on that basis.
There should be a timetable laid down for the agreement of inter group balances and for
the publication of a return to head office so that inter-company balances are clearly

General ledger balances described above should be confirmed in writing at the yearend and if necessary validated by reference to an auditors certificate. There should be

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no setting off of inter-company balances. The individual balances should be capable of

being eliminated on consolidation. It is important that all inter-company balances agree.
Failure to agree inter-company balances may result in double counting with the result
that either profits or net assets could be over stated. If this is done to any material extent
the group financial statements may not give a true and fair view.


Profit in inventory

Inter-company profit from inventory must be eliminated in group accounts as this is effectively
unrealised profit in the context of the group. In order to eliminate inter-company profit from
inventory the group accounting procedures should be so designed so as to identify year-end
inventory balances which are the result of inter-group trading. If the group follows a policy of
trading at arms length these amounts of inventory will be stated at cost and there will obviously
be an element of unrealised profit in the context of the group. The procedure adopted by
companies to reduce this inventory to true cost would include the following:
Identification of inventory which is part of inter-group trading by a suitable analysis of
inventory balances in a supporting schedule.
The auditors, who wish to check the provision for unrealised profit, 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 or the individual
subsidiary accountant to eliminate the profit should be validated by reference to the data
on transfer pricing and inter-group trading. The volume of inter-company inventory
should be reviewed from one year to the next and any significant variations investigated.
The inter-company inventory thus reduced to true cost should be traced to the final
inventory summary to verify that it has been included. Lastly the auditor should verify
that the provision for inter-company profit is appropriately increased or reduced in order

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to provide the correct closing balance that is necessary to reduce inter-group inventories
to a figure of cost.

Reviewing the work of other auditors

The audit work that would be done to verify that the work of the subsidiaries auditors has been
properly carried out would include the following:
An assessment of materiality: The group auditor should establish the materiality of the
individual subsidiary within the group context as a whole. In evaluating materiality he will
add regard to contribution towards profit for tax, net assets and turnover. Those
subsidiaries which are material or if not material which possess risk factors out of
proportion to their size will be subjected to greater audit effort that those which are not
material and do not present any great problem.
Group accounting policies: The group auditor should enquire into group accounting
policies and in particular should review those key accounting policies to ensure that they
are harmonious within the group. The key accounting policies are those on turnover,
inventories, deferred tax, depreciation, common occurrences, leasing. The most usual
way of doing this is to send the component auditors a questionnaire specifically dealing
with accounting policies and on receipt to review the questionnaire to establish that the
policies are harmonised. Where policies are not harmonised it may be necessary for the
group company to harmonise them by means of a consolidating adjustment.
Adequate information: In addition to the questionnaire dealing with accounting policies
the group auditor should ensure that the parent board have made available adequate
information for audit purposes. Adequate information will generally mean:

the full audited accounts;

the audited accounts restated on consolidation pro forma schedules to facilitate

the preparation of consolidated accounts; and

Schedules of all supplementary information required for disclosure or taxation


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This availability of information is exceedingly important in approaching and appraising the work
of the component auditor. When appraising the work of the component auditor the group auditor
will determine the depth of appraisal by reference to materiality or risk factors which were
mentioned earlier. All companies immaterial or otherwise who are audited by other firms will
receive an audit policies and procedures questionnaire from the group auditor.
This policies and procedures questionnaire will seek to examine auditing standards
employed by subsidiary company auditors. They would include consideration of the

The audit strategy and the relying or otherwise on the companies system of
internal trouble.

The procedures used to verify assets (e.g. attendance to physical inventory

counting, verification of bank and cash balances, circularisation of receivables
and verification of research and development).

The procedures used to verify liabilities.

The identification of contingencies and any events after the reporting period.

The management letters sent by the component auditors to the management of

the subsidiary.

The auditors report and the scope of any qualifications. It would be necessary to
consider the scope of the qualifications in the context of the group. A review of
working papers of the subsidiary company auditors will be carried out by the
group auditor where the subsidiary is a material subsidiary or possesses risk
factors out of proportion to its size.


Factors affecting review and opinion

In considering the accounts of a subsidiary audited by another firm the following matters are


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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.

Qualified opinion

If the auditors 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 auditors support of the group. In many
cases where the subsidiary is not material the group context of qualification issued by the
component auditors would not need to be reflected in the group auditors report.

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.

Elements of Auditors report
The following elements must be present in an audit report:
Title: The title should clearly indicates 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 managements responsibility for the financial statements: This section
describe responsibility of management regarding preparation of the financial statements

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Section describing Auditors responsibility: this section must state that the auditor is responsible
for expressing an opinion based on the audit. This section gives brief explanation of Audit and
describes the strength of the audit evidence obtained.
Opinion paragraph: for unmodified opinion
Auditors signature: the signature of the person signing for the firm and the name of the firm
Date: the report must be duly dated
Auditors 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 auditors report

Financial statements are

Material but not pervasive

Material and pervasive





materially misstated
Inability to obtain sufficient
appropriate evidence

The basis of opinion should be shown immediately above the opinion paragraph.ISA 705
requires them be headed as:
Basis for Disclaimer of Opinion, and Disclaimer of Opinion

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Basis for adverse opinion, and Adverse of opinion

Basis for Qualified Opinion, and 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
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
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
Emphasis of matter paragraph (EOM)
This is a paragraph in the auditors 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
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
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
A major catastrophe that has had a significant effect on the entitys financial position
Significant going concern issue

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Other matter paragraph

This explains information that is rightly not present in the financial statements but which is so
important for users understanding of them that it needs to be highlighted in the auditors report.
Examples of when other matter paragraph is used:
When the legislation specifically requires auditor to provide further explanation on
auditors responsibilities
When auditor is reporting on more than one set of financial statements e.g. using both
IFRS and local GAAP
When prior periods financial statements have not been audited at all or audited by
another auditor

Group audit report

The following matters are to be considered by the group auditor if the account of a component is
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 components
auditors 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 auditors report.

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The group auditor should consider the impact of the qualification on the groups audit
If the qualification of the components 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 components
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.
If the components 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 groups auditors report will not be
If there is no adjustment in both the components account and the groups account in
respect of the material misstatement, the groups audit opinion will be qualified except
for because of the material misstatement.
NOTE: should there be any need to qualify the groups 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 auditors report

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Question THETA
In January 2009, the head office of Theta was damaged by a fire. Many of the companys
accounting records were destroyed before the audit for the year ended 31 March 2009 took
place. The companys 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.

Draft, for inclusion in the auditors report, wording appropriate to Theta. (5 marks)

Note: You are not required to reproduce the auditors report in full.

Explain the reasons for your audit opinion. (3 marks)


Explain and distinguish between the following forms of modified report:


Emphasis of matter


Qualified opinion


Disclaimer of opinion


Adverse opinion.

(8 marks)

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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.
Auditors 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 companys 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
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.

Reasons for audit opinion

The fire has resulted in limitations in audit work and evidence necessary to form an
opinion cannot be obtained.

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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
The effect of the limitation is so material and pervasive that it is not possible to express
an opinion on the financial statements.

Forms of modified audit opinion


Emphasis of matter
An emphasis of matter is clearly distinguishable from other modifications in that it does
not affect the auditors 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


Qualified opinion

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.


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).

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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

There are three issues which distinguish the form of modified reports
EITHER the matter does not affect the auditors 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 assignment
Matters to consider before accepting any Non-audit assignment
Whether any conflict of interest exist
Whether level of risk involved is manageable
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 rely on analytical
procedure and enquiry in gathering evidences
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
Types of evidence to be sought for
Engagement letter
Fess to be charged

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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
auditors 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.
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 auditors work.

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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 results of the company over a relevant
time period and report on this in terms of relevancy for the proposed transaction.

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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
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

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Whether existing lease agreement give right of termination to the lessor on

change of ownership

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.
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 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.

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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
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.

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.

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Auditors Responsibilities
In an engagement to examine prospective financial information, the auditor should
obtain sufficient appropriate evidence as to whether
Managements 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
The prospective financial information is properly prepared on the basis of the
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 procedure 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
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

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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
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 cashflow 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.

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Forensic Auditing
Forensic Accounting
This refers to use of accounting, auditing and investigative skills to conduct an
examination into companys 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
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.

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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 clients 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

show up in court proceedings if required

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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

IFACs 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
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.
As in an audit engagement, the investigators 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

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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 competence of the investigation team could severely undermine the
credibility of the evidence presented at court.

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.

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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.

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 companys 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.

Identify and comment on the issues raised as they affect the extent and scope of this


(8 marks)

State the information you would seek and the procedures you would perform in order to

reach an opinion on the companys claim for losses of profits and loss of inventory.
(7 marks)

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Outline the form and content of your report accompanying the claim.

(5 marks)


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 directors best expectation of the most likely results of 6 months
trading after the fire.
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, for example, concerning the level of winter sales in a year in which the housing
market (to which household furniture sales will be related) has been in recession.
The investigation will encompass the raw material inventory valuation, loss of profits calculation
and statement of assumptions.
Managements responsibilities
Managements 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

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established before the assignment can be accepted. It would be equally inappropriate for
opinions in true and fair terms to be required.
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 companys 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 auditors 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.
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.

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Insurance cover, terms and conditions including sums insured and deductibles.

whether raw material inventory is insured for replacement cost or a written down

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 years 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.
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 managements assumptions and policies with those normally adopted for the
preparation of management accounts and annual financial statements. Confirm the
suitability of any significant departures (e.g. if insurance cover is for replacement value
of inventory).

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Agree the clients valuation of all significant raw material inventory to historic or current
purchase invoice data (as appropriate).
Agree the basis of the clients loss of profits calculation to that specified in the insurance
Agree the make-up of costs deducted from lost sales and ensure they are
valid/allowable under the terms of the insurance policy.


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
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

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.

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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 peoples home; each resident will have a bedroom, there will be a communal sittingroom and all meals will be provided in a dining-room. No long-term nursing care will be
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 peoples 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 peoples home.

Identify and comment on the issues you would consider before undertaking such work.

(5 marks)

Describe the factors you should consider in verifying each of the three forecasts.

(15 marks)

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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
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
In planning his work the accountant needs to obtain a good understanding of the
residential home market.


Factors to consider in verifying forecasts


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 solicitors fees, survey fees and stamp duty on
the purchase. The latter cost is unavoidable and maybe a significant part of the cost of
Building and repairs Review of the estimate and comparison to any architects
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.

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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 cashflow forecast.


Profit forecast

The profit forecast will include income and expenditure. The accountant will consider the
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.
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.

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Electricity and gas this will be subjective and based upon the accountants 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, employers liability insurance and
fire insurance. Correspondence with Mr Lawrences underwriter should reveal estimates
for these.
Interest the interest charge should be based upon Mr Lawrences 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.

Cashflow 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 cashflow forecast are consistent with the profit

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