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Audit and Internal

(International Stream)




Time allowed 3 hours

This paper is divided into two sections

Section A ALL THREE questions are compulsory and MUST

be answered

Section B TWO questions ONLY to be answered

Section A - ALL THREE questions are compulsory and MUST be attempted

1 You have been presented with the following draft financial information about Hivex, a very successful company that
develops and licences specialist computer software and hardware. Its non-current assets mainly consist of property,
computer hardware and investments, and there have been additions to these during the year. The company is
experiencing increasing competition from rival companies, most of which specialise in hardware or software, but not
both. There is pressure to advertise and to cut prices.

You are the audit manager. You are planning the audit and are conducting a preliminary analytical review and
associated risk analysis for this client for the year ended 31 May 2003. You have been provided with a summarised
draft income statement which has been produced very quickly and certain accounting ratios and percentages. You
have been informed that the company accounts for research and development costs in accordance with IAS 38
Intangible Assets.

Year ended 31 May
2003 2002
$¶000 $¶000
Revenue 15,206 13,524
Cost of sales 3,009 3,007
Gross Profit 12,197 10,517
Distribution costs 3,006 1,996
Administrative expenses 994 1,768
Selling expenses 3,002 274
± -- ---
Profit from operations 5,195 6,479
Net interest receivable 995 395
± -- ---
Profit before tax 6,190 6,874
Income tax expense 3,104 1,452
± -- ---
Net profit 3,086 5,422
Retained profits 1,617 3,983
Dividends paid $1,469,000 $1,439,000
Accounting ratios and percentages
Earnings per share 0·43 1·04
Performance ratios include the following:
Gross margin 0·80 0·78
Expenses as a percentage of revenue:
Distribution costs 0·20 0·15
Administrative expenses 0·07 0·13
Selling expenses 0·20 0·02
Operating profit 0·34 0·48

(a) Using the information above, comment briefly on the performance of the company for the two years.
(8 marks)
(b) Use your answer to part (a) to identify the areas that are subject to increased audit risk and describe the
further audit work you would perform in response to those risks. (12 marks)
(20 marks)

2 Some organisations conduct inventory counts once a year and external auditors attend those counts. Other
organisations have perpetual systems (i.e they conduct continuous inventory counting) and do not conduct a year-
end count.
(a) Explain why year-end inventory counting is important to the auditors of organisations that do not have
perpetual inventory systems. (4 marks)
(b) Describe audit procedures you would perform in order to rely on a perpetual inventory system in a large,
dispersed organisation. (4 marks)
(c) Snu is a family-owned company which retails beds, mattresses and other bedroom furniture items. The
company¶s year-end is 31 December 2003. The only full inventory count takes place at the year-end. The
company maintains up-to-date computerised inventory records.
Where the company delivers goods to customers, a deposit is taken from the customer and customers are
invoiced for the balance after the delivery. Some goods that are in stock at the year-end have already been paid for in
full - customers who collect goods themselves pay by cash or credit card.
Staff at the company¶s warehouse and shop will conduct the year-end count. The shop and warehouse are open
seven days a week except for two important public holidays during the year, one of which is 1 January. The
company is very busy in the week prior to the inventory count but the shops will close at 15.00 hours on
31 December and staff will work until 17.00 hours to prepare the inventory for counting. The company has a
high turnover of staff. The following inventory counting instructions have been provided to staff at Snu.
(i) The inventory count will take place on 1 January 2004 commencing at 09.00 hours. No movement of
inventory will take place on that day.
(ii) The count will be supervised by Mr Sneg, the inventory controller. All staff will be provided with pre-printed,
pre-numbered inventory counting sheets that are produced by the computerised system. Mr Sneg will ensure
that all sheets are issued, and that all are collected at the end of the count.
(iii) Counters will work on their own, because there are insufficient staff for them to work in pairs, but they will
be supervised by Mr Sneg and Mrs Zapad, an experienced shop manager who will make checks on the work
performed by counters. Staff will count inventory with which they are most familiar in order to ensure that
the count is completed as quickly and efficiently as possible.
(iv) Any inventory that is known to be old, slow-moving or already sold will be highlighted on the sheets. Staff
are required to highlight any inventory that appears to be soiled or damaged.
(v) All inventory items counted will have a piece of paper attached to them that will show that they have been
(vi) All inventory that has been delivered to customers but that has not yet been paid for in full will be added
back to the inventory quantities by Mr Sneg.
Describe the weaknesses in Snu¶s inventory counting instructions and explain why these weaknesses are
difficult to overcome. (12 marks)
(20 marks)

3 [P.T.O.
3 Your firm is the external auditor to two companies. One is a hotel, Tourex, the other is a food wholesaler, Pudco, that
supplies the hotel. Both companies have the same year-end. Just before that year-end, a large number of guests
became ill at a wedding reception at the hotel, possibly as a result of food poisoning.
The guests have taken legal action against the hotel and the hotel has taken action against the food wholesaler.
Neither the hotel nor the food wholesaler have admitted liability. The hotel is negotiating out-of court settlements with the ill
guests, the food wholesaler is negotiating an out-of-court settlement with the hotel. At the balance sheet date, the public
health authorities have not completed their investigations.
Lawyers for both the hotel and the food wholesaler say informally that negotiations are µgoing well¶ but refuse to
confirm this in writing. The amounts involved are material to the financial statements of both companies.
(a) Describe how ACCA¶s Rules of Professional Conduct apply to this situation and explain how the external
auditors should manage this conflict of interest. (6 marks)
(b) Outline the main requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets and apply
them to this case. (7 marks)
(c) Assuming that your firm continues with the audit of both companies, for each company describe the
difficulties you foresee in obtaining sufficient audit evidence for potential provisions, contingent liabilities and
contingent assets, and describe how this could affect your audit reports on their financial statements.
(7 marks)
(20 marks)

Section B - TWO questions ONLY to be attempted

4 Your firm is the newly appointed external auditor to a large company that sells, maintains and leases office equipment
and furniture to its customers and you have been asked to co-operate with internal audit to keep total audit costs
down. The company wants the external auditors to rely on some of the work already performed by internal audit.
The internal auditors provide the following services to the company:
(i) a cyclical audit of the operation of internal controls in the company¶s major functions (operations, finance,
customer support and information services);
(ii) a review of the structure of internal controls in each major function every four years;
(iii) an annual review of the effectiveness of measures put in place by management to minimise the major risks facing
the company.
During the current year, the company has gone through a major internal restructuring in its information services
function and the internal auditors have been closely involved in the preparation of plans for restructuring, and in the
related post-implementation review.
(a) Explain the extent to which your firm will seek to rely on the work of the internal auditors in each of the areas
noted above. (6 marks)
(b) Describe the information your firm will seek from the internal auditors in order for you to determine the extent
of your reliance. (6 marks)
(c) Describe the circumstances in which it would not be possible to rely on the work of the internal auditors.
(4 marks)
(d) Explain why it will be necessary for your firm to perform its own work in certain audit areas in addition to
relying on the work performed by internal audit. (4 marks)
(20 marks)

5 [P.T.O.
5 Reports produced by internal auditors are different from audit reports produced by external auditors performing audits
under International Standards on Auditing. The reports are produced for different purposes, and are directed at
different users. They differ substantially in both form and content.
Internal audit reports often comprise the following:
(i) A cover page;
(ii) Executive summary;
(iii) The main report contents;
(iv) Appendices.
(a) List and briefly describe the general categories of information that you would expect to find in an internal
audit report under each of the four headings above. (4 marks)
(b) List the main contents of most external audit reports. (4 marks)
NB: You are not required to reproduce a full external audit report.
(c) Explain why the contents of external audit reports prepared under International Standards on Auditing and
internal audit reports are different. (4 marks)
(d) Some reports produced by internal auditors are similar to the report to management (management letter) on
internal controls and other matters that are produced by external auditors during the course of the audit. The
steps taken by internal and external auditors in drafting, issuing and following up such reports are also similar.
Describe the common characteristics of the steps taken by internal and external auditors in producing reports to
management. (8 marks)
(20 marks)

6 (a) Internal controls over non-current assets are designed to ensure the orderly and efficient running of the business,
adherence to management policies, safeguarding of assets, the prevention of fraud and error and the
completeness and accuracy of the accounting records.
List the internal controls that a small printing company with office equipment, motor vehicles and plant and
machinery should have in place to achieve the objectives described above. (10 marks)
(b) Audit sampling is a technique for drawing conclusions about the characteristics of a population by testing a
sample drawn therefrom. Internal and external auditors use it for both tests of controls, and substantive testing.
Describe the following:
(i) Judgement sampling and statistical sampling;
(ii) A representative sample;
(iii) Tolerable error;
(iv) Two different methods of selecting a representative sample; (v) The
extrapolation of errors.
NB: Parts (i) - (v) carry equal marks. (10 marks)
(20 marks)

End of Question Paper