Auditing and Contemporary Issues, June 2014, Solutions Version A

SECTION A SOLUTIONS

Please note that this document provides relevant extracts from the course text book, in order
to indicate the depth and accuracy of technical detail required. Candidates are expected to
shape the relevant material to the context provided in the question. Application to the context
is particularly important in A1 and A2 but is also relevant to other questions. For full credit
candidates must show knowledge and the ability to apply that knowledge.

Question A1

Engagement letter ( Ch 5 section 5.9)

Once the audit work has been offered to the audit firm, a detailed document of agreement
must be prepared. This is called the Engagement Letter and sets out the work which the
auditor will carry out, together with the level of co-operation expected from the client
company and its staff. The agreement of the conditions of the audit is in the best interests of
both the auditor and the client company. It helps to avoid subsequent misunderstandings
and also serves to reduce the expectations gap by making the client companys
management more aware of the audit process. [The answer should also reflect some
knowledge of ISA 210.

Independence [Ch 1 section 1.9]

The external auditor provides reasonable assurance from an independent source that they
present a true and fair view. We are responsible to the shareholders, not to the directors.
Independence must be shown in determining the audit strategy, carrying out the audit and
communicating the result. These three aspects are referred to as programming
independence, investigative independence and reporting independence.

To preserve the integrity of the audit report, we carry out a thorough investigation. We must
be free to plan their investigation in a manner that we deem appropriate. Our programming
independence may be impaired if we are asked to take a low fee or are expected to work
within unreasonable deadlines to complete the audit. Our investigative independence may
be compromised if we are unable to gain all the explanations and information necessary for
the audit. Our reporting independence is impaired if any person tries to restrict us in
expressing our opinion.

Our independent attitude is supported by the regulatory framework to support that

independence. Our appointment, conditions for removal, and access to information, all help
reassure shareholders of the impartiality of our work.

Internal control (Ch 5 section 5.5)

The essential features of internal controls are: organisation controls, segregation of duties,
controls over physical assets, authorisation and approval of documents; arithmetical and
accounting controls.

In your system you allowed the purchases officer to authorise the transaction (establishing
the suppliers account) and to control an asset (cash paid to suppliers). This broke the
principle of separation of duties. The person authorising the supplier should be a different
person, ideally the purchasing supervisor. The internal audit department should make
periodic tests of supplier payments against supplier records, or even phone and talk to them.

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Auditing and Contemporary Issues, June 2014, Solutions Version A

You also allowed the purchases officer to have access to the computer records. This again
broke the principle of separation of duties. A person who controls an asset should not also
have unrestricted access to the records. Computer access should be password protected
and any alterations, such as changing a suppliers record, should be authorised only by the
purchasing manager. The internal audit department should use analytical review (trend
analysis and ratio analysis) to check that supplier payments appear reasonable in relation to
another measure of activity such as purchases or cost of sales.

Internal audit (section 6.3)

The relationship between the external auditor and the internal auditor (section 6.3)

The external auditor should consider the activities of internal audit and their effect, if any, on
external audit procedures. The external auditor should obtain sufficient understanding of
internal audit to help plan the external audit. The external auditor should perform preliminary
assessment of the internal audit function. Where external auditors use internal audit work to
reduce the extent of the audit procedure, they should evaluate that work first.

Internal audit means a monitoring activity established by management and directors for the
review of the accounting and internal control systems as a service to the entity. It examines,
evaluates and reports to management on the adequacy and effectiveness of components of
the accounting and internal control systems. The external auditors have sole responsibility
for the audit opinion

The external auditors have sole responsibility for the audit opinion expressed and for
determining the nature, timing and extent of external audit procedures. All judgments
relating to the audit of the financial statements are those of the external auditors. We can
not reduce that responsibility by any use made of internal audit work. However, internal
audit work may provide us with audit evidence.

In particular the external auditor is mainly concerned with establishing whether the financial
statements are free from material misstatement. The internal auditors place less emphasis
on materiality. Nevertheless we share some similar objectives. Also the existence of the
audit committee monitoring the work of the internal audit department helps give us
assurance about the quality of controls within the organisation.

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Question A2

(a) In a good system of internal control the auditor expects to observe separation of
authorisation, recording and custody of assets. The significant asset here is the value of
the four depots, comprising land and buildings. Typical controls, with reasons, would be
[two such as the following or similar will suffice for the answer]:

(i) One important control is to ensure that there is legal title to the equipment,
typically found in the invoice from the supplier and in an insurance policy.

(ii) Another important control is to ensure that the equipment is physically secure
and adequately insured. All sales or disposals should be authorised by
someone other than the plant manager. Periodic surveys of security should be
carried out by a senior manager. Safety officer should carry out fire
inspections.

(b) For net book value, four of the following audit tests, or similar:
(i) Check physical state of asset to description on invoice
(ii) Check plant register to physical assets to make sure they exist
(iii) Calculate and compare ratio of fixed assets to turnover
(iv) Check cash records for proceeds of disposals and examine authorisation for
disposal.
For depreciation charge, four of the following tests or similar:
(i) Examine documentation of asset life e.g. inspectors reports, output levels.
(ii) Examine method of calculation for consistency
(iii) Check calculations in fixed asset register and examine asset for appearance of
depreciation.
(iv) Examine maintenance records to ensure machines work regularly.

(c )
The answer should show an understanding of each term (course reading asks
students to read ISA 500 on audit evidence).

An example of corroboration would be the price of the similar equipment as shown in

trade catalogues.

An example of inquiry would be asking the equipment manager about the estimated
life of the equipment.

(Extract from ISA 500, not required for answer)

More assurance is ordinarily obtained from consistent audit evidence obtained from
different sources or of a different nature than from items of audit evidence
considered individually. For example, corroborating information obtained from a
source independent of the entity may increase the assurance the auditor obtains
from audit evidence that is generated internally, such as evidence existing within the
accounting records, minutes of meetings, or a management representation.

Inquiry consists of seeking information of knowledgeable persons, both financial and

non-financial, within the entity or outside the entity. Inquiry is used extensively
throughout the audit in addition to other audit procedures. Inquiries may range from
formal written inquiries to informal oral inquiries. Evaluating responses to inquiries is
an integral part of the inquiry process.

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A3

2 marks each x 6 points well made, or 1 x 12 for briefer remarks.

(a) Audit report Chapter 7 section 7.5.

(b) True and fair Chapter 2 section 2.4

SECTION

B1

Wool Group

Wool plc
Consolidated statement of financial position (balance sheet) at 31 December Year 8

Note 000's 000's

Intangible non-current (fixed) assets: Goodwill (208 - 6) 7 202

Tangible non-current (fixed) assets:
Land 1 862
Other non-current (fixed) assets 2 522
1,586
Inventories (stocks) 210 + 92 302
Receivables (debtors) 115 + 35 150
Cash 10 + 15 25
477

Payables (creditors) 110 + 29 (139)

338
1,924
Non-current liabilities 3 (402)
1,522

Ordinary share capital 110

Share premium account 85
Retained earnings (Profit and loss reserve) 6 1,225
Equity interest 1,420
Non-controlling interest 4 102
1,522

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Working notes (All figures in 000's)

1. Fixed assets: Land

000s
Land in Wool, to be included at net book value 440
Land in Cotton, to be included at fair value (212 + 90) 302
742
Land brought on balance sheet 120
862
Fair value adjustment 90

2: Fixed assets: Other

000s
Other fixed assets of Wool, at net book value 385
Other fixed assets of Cotton - book value 175
560
Fair value adjustment at date of acquisition (100-40) (60)
500
Add back depreciation saved through lower charge 22
522

Production machine has been depreciated by Cotton at 36k for full year or 3k per month. Ten
months = 30k.

Directors of Wool would depreciate 40,000 over 4 years, = 10,000 p.a. or 833 per month, =
8,333 for 10 months. Write down for 10 months to 31 December Year 8 = (40-8)k = 32k nbv
compared with 70k in books of Cotton.

Net book value of storage unit at date of acquisition was 70k + 30k = 100k

Fair value adjustment = 100k-40k = 60k

Depreciation adjustment required for post-acquisition 10 months = (30,000- 8,333) = 21,670

(round to 22k) added back because the new depreciation is lower.

3. Non-current liabilities

000s
Convertible loan stock 210
Preference shares in subsidiary guaranteed 72
Loan financed land 120
Balance sheet 402

The preference shares issued by the subsidiary in Mar Year 8 are guaranteed by the parent and
therefore, under IAS 32, must be included in liabilities.

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4. Calculation of non-controlling interest at balance sheet date

000s
Share capital acquired 207
Share premium account 31
Fair value adjustment (90 - 60) 30
Accumulated profit to 31 Dec Year 7 193
Profit and loss account at 31 Dec Year 8 = 25 + 22 47
508
20% thereof 102

5. Calculation of pre-acquisition profit in Cotton plc

000s
Profit for the year 25
Add back preference dividend (3% x 72 for10 months) 1.8
26.8
Pre-acquisition 2/12ths = 4.467 Say, 4.5

6. Calculation of post-acquisition profit for the group

000s
Post-acquisition profit in Cotton 26.8-4.5 22.3
Add back depreciation charge 22
44.3
Less preference dividend (1.8)
42.5
Group's share at 80% = 34,000 34
Wool: Profit of the year 80
Impairment of goodwill (6)
Adjusted group profit of the year 108
Reserves of Wool at start of year 1,117
1,225

7. Calculation of goodwill

000s
Share capital acquired 207
Share premium account 31
Fair value adjustment 90 - 60 30
Profit and loss account at 31 December Year 7 193
Pre-acquisition to 28 Feb Year 8 4.5
Total equity investment available 465.5
80% thereof 372
Cash price 580
Goodwill 208

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Auditing and Contemporary Issues, June 2014, Solutions Version A

Question B2

(a) (applying the definitions of section 4.3)

General introduction a financial instrument is a contract that gives rise to a financial asset
of one entity and a financial liability or equity instrument of another entity

(i) Yes: There is a financial asset of the euro deposited and a financial liability in the
banks obligation to repay.
(ii) Yes: There is a financial asset of the invoiced sale, which is valued in money
terms, and there is a financial liability in the customers obligation to pay.
(iii) No. The asset is for delivery of gold bullion (a commodity, not money) and the
liability is to deliver gold bullion.
(iv) No. The asset is for use of the warehouse space and the obligation is to deliver
use of that space.

(b) (based on ch 7)

1. (Exhibit 7.8)

The method to be used here is the net investment (closing rate) method. The fixed assets
are translated at $1.6. The rate at the date of acquisition is not relevant. The amount
reported in the translated balance sheet is $760,000/1.6 = 475,000. The comparative
figure for the previous year will be at the closing rate for that year $840,000/2.5 = 336,000.

2. (See second edition Activity 7.2 and Exhibit 7.4)

The asset was acquired and paid for in dollars. There is no inventory at the end and so we
are not concerned with translating inventory. The loan is recorded at the balance sheet date
as $160,000/1.6 = 100,000. When the loan was taken out the sterling equivalent was
$160,000/2.5 = 64,000. There is an unrealised loss in sterling of 36,000 between 30 June
and 31 December [which would be recorded in half-yearly accounts income statement].

3. (See second edition, section 7.4.3 and Exhibit 7.3)

This is a monetary item. At the balance sheet date it is recorded at $360,000/1.6 =

225,000. One year ago the item was recorded at $360,000/2.5 = 144,000. So there is an
unrealised gain on a monetary item, which will affect the income statement (profit and loss
account).

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Question B3

2 marks each x 6 well written points, or 1 mark each x 12 less detailed but relevant.

(a) Share-based payment is section 3.4 in the module text. Answers

should focus on accounting issues as in 3.4.2..

(b) IASB is covered in section 1.2 in the module text.