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Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial statements
are materially misstated. It is a function of the risk of material misstatement (inherent risk and control risk)
and detection risk.
Inherent risk is the susceptibility of an assertion to a misstatement that could be material individually or
when aggregated with other misstatements, independently of any related internal controls. In other words,
inherent risk is the risk that items will be materially misstatement due to their specific characteristics (for
example, the fact that they are accounting estimates or the significant one-off transactions).
Control risk is the risk that a material misstatement, which could occur in an assertion and which could be
material (individually or when aggregated with other misstatements) will not be prevented or detected and
corrected on a timely basis by the entity's internal control.
Detection risk is the risk that the procedures performed by the auditor to reduce audit risk to an acceptably
low level will not detect a misstatement which exists and could be material, either individually or when
aggregated with other misstatements. This is the one component of audit risk that auditors have a control
over. Sampling risk and non-sampling risk are components of detection risk.
(b)
Audit risk
Auditors response
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Auditors response
(c)
Financial reporting framework: are the financial statements to be prepared in accordance with IFRS?
Availability of internal audit work: does Minty have an internal audit department? Can internal audit
work be relied upon?
Use of service organisations: have any service organisations been used in a way that affects the
financial statements?
Effect of information technology on audit procedures: what CAATs can be carried out and how will
these affect our audit procedures?
Availability of client personnel and data: when is management available and how does the audit team
access documentation?
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Entity's timetable for reporting: when do the financial statements need to be signed off?
Organisation of meetings with management to discuss audit issues
Organisation of audit team meetings and timing of the review of work papers
Any expected communications with third parties
Significant factors, preliminary engagement activities and knowledge gained from other audits
Determination of materiality: this includes the determination of performance materiality for specific
accounts and balances
Areas identified with higher risk of material misstatement: this includes the areas of audit risk
identified above
The location of the 15 warehouses and identification of the inventory counts the audit team should
attend.
(d)
Substantive procedures
(i)
(ii)
(iii)
Agree items in the schedule to invoices to ascertain that items have been correctly classified
Agree items on the schedule to the non-current assets register and statement of profit or loss,
respectively
Enquire of the finance director the rationale for releasing the allowance
Review the aged receivables listing to identify old outstanding receivables balances, and
discuss the likelihood of payment with the credit controller
Review board meeting minutes for evidence of doubts concerning the recovery of any
receivable balances
Based on the above procedures, calculate the potential level of unrecoverable receivables and
assess whether this is material. Discuss the adjustment with management
Damaged inventory
Attend the inventory count. Inspect the damaged goods and agree the quantity to the schedule
Discuss with management the companys plans for the damaged goods whether they are to
be scrapped or whether any net realisable value can still be assigned to them
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Obtain the sales invoices for any damaged goods sold post year-end to assess the net
realisable value
Determine the cost of the inventory by obtaining supporting documentation with regards to
the raw material, labour and attributed overhead costs.
Quantify the level of adjustment required to value the damaged inventory at the lower of cost
and net realisable value and discuss with management
Question 2
(a)
(i)
Tests of control
Testing of controls means obtaining sufficient appropriate audit evidence about the operating
effectiveness of the controls in preventing or detecting and correcting material misstatements.
Examples of tests of control in relation to wages and salaries include:
(ii)
Observe whether there is segregation of duties between the HR and payroll departments
Observe and test the existence of authorisation access controls to payroll data (ie by using
test data)
Review a sample of timesheets for overtime pay for evidence of authorisation by a responsible
official.
Substantive procedures
Substantive procedures are audit procedures designed to detect material misstatements at the
assertion level. Substantive procedures comprise:
(i)
(ii)
Tests of details (of classes of transactions, account balances, and disclosures); and
Substantive analytical procedures.
(b)
Carry out a sample recalculation of gross pay to net pay and agree to the payroll records
Perform a proof in total for the expected total payroll costs and statutory deductions, taking
into account joiners, leavers and changes in salary levels
For a sample of joiners and leavers, agree the HR records to payroll to ensure that their pay
relates to the correct period worked.
Reliability is influenced by the source and nature of the evidence. The following factors or generalisations
usually apply.
Audit evidence is more reliable when it is obtained from independent sources outside the entity.
Audit evidence that is generated internally is more reliable when the related controls imposed by the
entity are effective.
Audit evidence obtained directly by the auditor (for example, observation of the application of a
control) is more reliable than audit evidence obtained indirectly or by inference (for example, inquiry
about the application of a control).
Documentary evidence is more reliable, whether paper, electronic or other medium (for example, a
written record of a meeting is more reliable than a subsequent oral representation of the matters
discussed).
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Reviewing the financial statements to determine whether they are prepared in accordance with
national statutory requirements.
Reviewing the disclosures in the financial statements to determine whether they comply with
accounting standards, properly disclosed, consistently applied and appropriate to the entity.
Reviewing the financial statements to determine whether they are consistent with their knowledge of
the entity's business and with the results of other audit procedures.
Considering the impact on the financial statements of the aggregate of uncorrected misstatements
identified during the audit; if the impact is material, discuss the need for adjustment with
management.
Performing analytical procedures to corroborate the conclusions drawn during detailed testing.
Reviewing the audit work papers to assess whether the audit evidence obtained is sufficient and
appropriate.
Question 3
(a)
Simple to record
No training required to document and understand; easily understood by all members of the internal
audit team
Disadvantages
Flowcharts are graphical illustrations of the physical flow of information through the sales and despatch
system.
Advantages
Information is prepared in standard form, so it is easy to follow. Deficiencies in internal control can
also be quickly identified
Ensures that the system is recorded in its entirety; any loose ends are easily identified
Disadvantages
While appropriate for standard systems, unusual transactions cannot be captured without the use of
additional narrative
Questionnaires comprise a list of standard questions. Internal control questionnaires (ICQs) determine
whether desirable controls are present, while internal control evaluation questionnaires (ICEQs) assess
whether specific errors (or frauds) are possible at each stage of the sales and despatch cycle.
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If drafted thoroughly, they can ensure that all controls are considered
Quick and easy to prepare
Easy to use and control
ICEQs are effective in identifying internal control deficiencies
Disadvantages
Questionnaires are only as good as their author: drafted vaguely, the questions could be
misunderstood, and if questions are incomplete, important controls could be missed.
Gives the false impression that all controls are of equal weight; in reality, certain controls may be
more fundamental than others.
Control objectives
Occurrence and existence
To ensure that one person is not responsible for taking orders, recording sales and receiving payment.
To ensure that recorded sales transactions represent goods provided.
To ensure that goods are only supplied to customers with good credit ratings.
To ensure that goods are provided at authorised prices and on authorised terms.
To ensure that customers are encouraged to pay promptly.
Completeness
Accuracy
To ensure that all sales and adjustments are correctly journalised, summarised and posted to the
correct accounts.
Cut-off
Classification
Control deficiencies
Deficiencies
Recommendations
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Recommendations
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Question 4
(a)
Ensure the firm is professionally qualified to act: Salt & Pepper will need to consider whether
it could be disqualified to audit Cinnamon on legal or ethical grounds. This includes evaluating
any threats to auditor independence and ensuring that the engagement is compliant both with
the ACCAs Code of Ethics and Conduct and with local legislation.
(2)
Ensure existing resources are adequate: Salt & Pepper will need to ensure that it has the
staff and technical expertise required to perform the audit competently within the timescale
agreed.
(3)
Obtain references: Salt & Pepper will need to verify the identity, reputation and integrity of
Cinnamons directors. If necessary, references should be obtained for the directors.
(4)
Consider the associated risk: Based on the knowledge obtained about Cinnamons business
and its directors, Salt & Pepper will need to determine the level of risk associated with the
audit engagement. It will need to assess whether the level of risk is acceptable to the firm, and
whether the proposed audit fee is appropriate in the light of the associated risk.
(5)
Communicate with the predecessor auditors: Salt & Pepper should enquire about
Cinnamons reason for not reappointing its previous auditor. It should obtain permission from
Cinnamons directors to contact the outgoing auditor, and then communicate with the
outgoing auditor to confirm whether there have been any actions by the client which would on
ethical grounds preclude Salt & Pepper from accepting the engagement. The outgoing auditor
will also require the directors permission to respond to Salt & Peppers request.
If the directors refuse to allow Salt & Pepper to communicate with the outgoing auditor, or
withholds permission for the outgoing auditor to respond, Salt & Pepper should not accept
the audit engagement.
(ii)
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Obtain agreement from Cinnamons management that it acknowledges and understands its
responsibilities for the following:
Preparing the financial statements in accordance with the applicable financial reporting
framework
Providing Salt & Pepper with access to all information of which management is aware
that is relevant to the preparation of the financial statements, with additional
information that the auditor may request, and with unrestricted access to entity staff
from whom the auditor determines it necessary to obtain audit evidence
(b)
It has determined that the financial reporting framework to be applied is not acceptable.
Management's agreement referred to above has not been obtained.
Management's responsibilities
Identification of the applicable financial reporting framework for the preparation of the financial
statements
Reference to the expected form and content of any reports to be issued by the auditor and a
statement that there may be circumstances in which a report may differ from its expected form and
content.
In addition to the above, an audit engagement letter may also make reference to the following matters:
Elaboration of scope of audit, including reference to legislation, regulations, ISAs, ethical and other
pronouncements
The fact that due to the inherent limitations of an audit and those of internal control, there is an
unavoidable risk that some material misstatements may not be detected, even though the audit is
properly planned and performed in accordance with ISAs
Agreement of management to provide draft financial statements and other information in time to
allow auditor to complete the audit in accordance with proposed timetable
Agreement of management to inform auditor of facts that may affect the financial statements, of
which management may become aware from the date of the auditor's report to the date of issue of
the financial statements
Request for management to acknowledge receipt of the letter and agree to the terms outlined in it
(Note: Only two matters were required, but we have listed additional possible answers for your
reference.)
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Salt & Pepper guarantees that its audits will not last
longer than two weeks.
10
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Question 5
(a)
(i)
(ii)
Reviewing the prior year financial statements and the auditor's report (if they have been
published) for evidence regarding the opening balances, including disclosures
Determining whether the prior period's closing balances have been correctly brought forward
or restated
Determining whether the opening balances reflect the application of appropriate accounting
policies
Where the prior period's financial statements were audited, reviewing the predecessor
auditor's working papers
Evaluating whether audit procedures performed in the current period provide evidence
relevant to opening balances
(b)
The independent expert who has undertaken work on raw material inventory quantities is an auditor's
expert. ISA 620 Using the Work of an Auditors Expert requires the auditor to evaluate whether their expert
has the necessary competence, capabilities and objectivity before relying on the expert's work.
Evaluating the expert's competence will involve obtaining information about the expert's qualifications and
professional memberships.
It will be relevant to obtain the expert's client portfolio, to understand whether it has performed similar
services to comparable companies in the past. Other teams within our firm may previously have worked with
the expert. If this is the case, a discussion with these team members will help to provide an understanding of
the expert's level of technical competence and professional reputation.
We may wish to have a discussion with the expert in order to understand the scope of the work done on the
raw material quantities, and the methodology used. The audit team will need to evaluate the adequacy of the
work carried out by the expert, including the relevance and reasonableness of the assumptions and methods
used and its consistency with other audit evidence (for example, records from previous inventory counts).
The relevance, completeness and accuracy of any source data used should also be assessed.
In order to evaluate the expert's work, the audit team members will need to have a sufficient understanding
of the audit of inventory quantities, so we must ensure that we have staff with the appropriate experience
and knowledge on the team.
The expert's independence must also be assessed. We need to make enquiries of Paprika's management
and the expert regarding any interests and relationships that could create a threat to independence (for
example, whether a high proportion of the expert's income derives from its work for Paprika). If the expert's
independence is impaired, its work should not be relied upon and it may be necessary for the audit team to
use another, independent, expert to confirm the raw material inventory quantities.
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11
12
'Our responsibility is to express an opinion on all pages of the financial statements': The auditor is
only required to express an opinion on the statement of financial position, statement of profit or loss
and comprehensive income, statement of cash flows, summary of significant accounting policies,
and other information contained within the notes to the financial statements.
'We conducted our audit in accordance with most of the International Standards on Auditing': The
auditor is required to comply with all of the ISAs. This fact must be stated in the auditor's report.
'The standards require that we [...] plan and perform the audit to obtain maximum assurance as to
whether the financial statements are free from all misstatements': The auditor does not aim to obtain
assurance that the financial statements are free from all misstatements, but only gives reasonable
assurance that the financial statements are free from material misstatements. It is not practical for
the auditor to test every single transaction and account balance. Instead, the level of the audit
procedures carried out, and the sample size tested, depends upon the auditor's assessment of audit
risk and consequently, materiality.
'We have a responsibility to prevent and detect fraud and error and to prepare the financial
statements in accordance with the International Financial Reporting Standards': Preventing and
detecting fraud and error, and the preparation of the financial statements, are the responsibilities of
the entity's management. The auditor's responsibility is to detect material misstatements, whether
caused by fraud or error, and to express an opinion on the truth and fairness of the financial
statements.
'The procedures selected depend on the availability and experience of the audit team members': The
auditor is required to perform the necessary audit procedures to obtain sufficient and appropriate
audit evidence. The audit team must be staffed adequately with appropriately experienced team
members to ensure that the necessary audit procedures are performed.
'We express an opinion on the effectiveness of these internal controls': The auditor's report provides
an opinion on the truth and fairness of the financial statements, but does not express an opinion on
the effectiveness of internal controls. Any deficiencies identified by Brown & Co during the course of
the audit will be reported to Paprika's management.
'We did not evaluate the overall presentation of the financial statements as this is management's
responsibility': Although it is management's responsibility to prepare the financial statements, the
auditor is required to review the overall presentation to determine whether it is in accordance with
applicable accounting standards and consistent with the audit evidence obtained.
'We considered the reasonableness of any new accounting estimates': All accounting estimates must
be considered by the auditor, whether they are brought forward or new. Accounting estimates carried
forward from year to year, such as allowances and provisions, may need to be adjusted or reversed.
'We did not review the appropriateness of accounting policies as these are the same as last year':
Accounting policies must be reviewed in each accounting period. A change in accounting policies
may become necessary as a result of new accounting standards, or as the company's circumstances
change.
'We relied on the work undertaken by an independent expert': As stated previously, no reference
should be made to independent experts in the auditor's report. Regardless of any reliance on the
work of external experts, the responsibility for the audit opinion remains with the auditor. This
statement may be interpreted as the auditor passing on responsibility for the account to the expert.
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