ACCA

Audit & Assurance (AA)

Part I + Part II - Test

Solution

Time allowed 90 minutes

Full name:

1
Section A (2 marks per question)

The following scenario relates to questions 1 - 5

You are an audit manager in Swift & Co responsible for the audit of Kingfisher Co, a retail company
planning to list on a stock exchange within the next six months. The board of directors currently
comprises the chair, chief executive, three executive directors and three non-executive directors. Details
of the three non-executive directors is given below.

Teri Toucan

Teri was an employee of Kingfisher until retire six years ago. On retirement, Teri became a non-executive
director. Teri currently receives a pension from Kingfisher Co and a fixed salary for being a non-executive
director. Teri does not own shares in Kingfisher Co.

Pat Parrot

Pat was an employee until 10 years ago and was also a shareholder in Kingfisher Co as part of Pat's
remuneration package included share options which had been exercised. Pat became a non-executive
director three an a half years ago and on appointment, Pat left the company's pension scheme and sold
all shares in Kingfisher Co.

Linda Lorikeet

Linda is an independent non-executive director of Kingfisher Co. Lina has been a member of the board
for 8 years and has extensive retail experience from previous employments.

Proposed changes

Kingfisher Co's management has been advised by the audit engagement partner about the need for
compliance with corporate governance principles once the company is listed. The board of director has
identified two more potential independent non-executive directors to join Kingfisher Co. Once more
directors are appointed, Kingfisher Co plans to establish an audit committee and a remuneration
committee.

The two potential directors are:

Frances Finch

Frances is currently the finance director of a listed multi-national banking company and is a non-executive
director and audit committee member for another company. Frances is agreeable to being a non-
executive director for Kingfisher Co and to be paid a fixed fee which is not related to profits. Frances is
being considered for the role of board chair as the current chair is due to retire in six months' time.

Mica Macaw

Mica, the sister of Kingfisher Co's chief executive, is currently a finance director of a small retail company,
which does not compete with Kingfisher Co. Mica has expressed an interest in a role at Kingfisher Co
provided a contract with a minimum three-year term is offered.

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Section A (2 marks per question)

1 Which of the following recommendations is NOT required to be implemented by Kingfisher

Co to bring the company in line with corporate governance best practice?

A More independent non-executive directors must be appointed to ensure at least half of

the board are independent
B The board must appoint a workforce representative
C Linda will need to be replaced as an independent non-executive director next year
D The board chair must be appointed from within the company to ensure they have
sufficient knowledge of the company

2 In respect of Frances Finch, which of the following statements is TRUE?

A Frances could become board chair and sit on the audit committee as the person with
recent and relevant financial expertise
B Frances could sit on the remuneration committee but must not be the committee chair
C If Frances accepts the role of board chair, remuneration should be related to company
performance to align the interests of the chair and the company
D Frances cannot become board chair for Kingfisher Co whilst holding directorships at
two other companies

3 In respect of Teri Toucan, which of the following will compromise independence?

A Teri receives a pension from Kingfisher Co

B Teri does not own shares in Kingfisher Co
C Teri receives a fixed salary from Kingfisher Co
D Teri was an employee of Kingfisher Co six years ago

4 Which of the follow are advantages of appointing Mica Macaw as a non-executive director of
Kingfisher Co?

1 Mica has close links to Kingfisher Co’s chief executive.

2 Mica’s experience in retail will facilitate understanding of the issues faced by Kingfisher Co.
3 Mica’s financial experience will be useful if appointed to the audit committee.
4 Mica wishes to commit to a three-year contract

A 1, 3 and 4 only
B 2 and 3 only
C 1, 2 and 4 only
D 1, 2, 3 and 4

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Section A (2 marks per question)

5 Which TWO of the following correctly explain corporate governance guidelines in respect of
succession and evaluation of directors?

A A succession plan should be maintained for the board chair and chief executive
B The annual report should explain the work of the nomination committee including the
process for making appointments
C Performance of the board chair, the board, the individual executive and non-executive
directors and each committee must be evaluated annually
D All members of the nomination committee must be independent non-executive directors

The following scenario relates to questions 6 - 10

You are an audit manager in Miranda & Co and you are planning the audit of Milberry Co which
manufactures luxury handbags and other fashion accessories. Milberry Co has been an audit client of
your firm for four years.

From a review of the correspondence file, you note that the audit engagement partner and the finance
director have known each other socially for many years and in fact went on holiday together last summer
with their families. As a result of this friendship, the partner has not yet spoken to client about the fee for
last year's audit, 20% of which is still outstanding.

The financial controller of Milberry Co was appointed two months ago. Prior to this appointment the
financial controller was an audit senior at Miranda & Co and was a member of the audit team for Milberry
Co.

Employees of Milberry Co are entitled to purchase handbags at a discount of 40% and during the
planning meeting with the finance director, you and your audit team are offered the same level of staff
discount.

The finance director has asked if your firm will prepare the company's tax return and provide tax advice to
minimize the amount of tax payable.

6 Select which threat to objectivity is created by the information obtained from the review of
the correspondence file.

The partner and the finance director have

Advocacy Familiarity Self-interest
known each other socially for many years

40% of the fee for last year’s audit is still

Advocacy Familiarity Self-interest
outstanding

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Section A (2 marks per question)

7 Which is the MOST appropriate response to the outstanding fees from Milberry Co?

A The auditor should resign from the client

B The auditor should report the client to the ACCA
C The auditor can continue working for the client but should ensure that the audit firm’s
credit control department are informed of the outstanding fees
D The auditor’s report for this year should not be issued until the fees have been paid

8 Which of the following statements in respect of the relationship between the new financial
controller and the audit firm are TRUE?
A The audit approach should be revised to ensure procedures and items to be tested
are not predictable
B The audit team should comprise people who know the audit senior as this will make
the audit run more smoothly and increase efficiency
C The firm must resign as auditor as the threat to objectivity is too significant to
safeguard
D The audit senior should not be allowed to be the financial controller and should resign

9 Which is the MOST appropriate response with respect to the discount offered by Milberry
Co to the audit team?
A The discount may be accepted as it is the same as that offered to the client’s
employees
B The discount should be rejected as it is unlikely to be a trivial monetary amount
C The discount should be rejected as gifts or hospitality are not acceptable per the
ACCA Code of Ethics and Conduct
D Audit manager approval must be obtained before the discount is accepted

10 Select the option which correctly identified whether or not a self-review threat is likely to
arise in relation to the tax services requested

Tax return Tax advice

A Yes Yes
B No No
C Yes No
D No Yes

9
Section A (2 marks per question)

The following scenario relates to questions 11 - 15

It is 1 July 20X5. You are planning the audit of Veryan Co for the year ending 31 July 20X5. Veryan Co is
a new audit client which operates in the oil & gas exploration industry. Companies wishing to operate in
this industry require a license which is valid for 20 years. Licensing authorities take into account public
health and safety, protection of the environment and protection of biological resources when granting
licenses. Veryan Co’s activities are geographically spread across three continents in 35 locations.

Veryan Co has been in existence for 30 years and has grown its revenue at an average of 12% per
annum. This is in line with the industry average. During your planning meeting with the finance director
you were informed that the forecast profit before tax for this financial year is $9.5 million (20X4: $6 million)
based on revenues of $124 million (20X4: $100 million).

You have completed the audit strategy and the risk assessment section identifies the following as areas of
significant risk of material misstatement:

 Overstatement of receivables due to long outstanding debts

 Misstatement of intangible assets (licenses) due to incorrect amortization
 Overstatement of tangible non-current assets in one of the exploration areas due to damage caused by a
recent hurricane
 Overstatement of inventory due to the inherent difficulty of establishing the quantity of oil and gas reserves

11 Which of the following is the LEAST significant audit risk to be considered when planning
the audit of Veryan Co?
A Non-compliance with laws and regulations
B Understatement of trade payables
C Adequacy of provisions and contingent liabilities
D Foreign currency transactions

12 Which TWO of the following are appropriate responses to address the increased detection
risk due to Veryan Co being a new audit client?
A Extended controls testing should be performed
B Obtain an understanding of Veryan Co
C Consideration should be given to relying on the work of an independent expert
D Reduce reliance on tests of controls
E Contract the previous auditor to request working papers

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Section B (20 marks)

13 Which of the following is the LEAST appropriate materiality level to be used in the audit of
Veryan Co?
A $1.5 million
B $1.0 million
C $750,000
D $475,000

14 Select whether the following statements are consistent or not consistent with the
movement in revenue.

Cut-off of revenue is an audit risk Consistent Not consistent

Completeness of revenue is an audit risk Consistent Not consistent

Occurrence of revenue is an audit risk Consistent Not consistent

15 Match the audit risks given in the scenario with the MOST appropriate response the
auditor of Veryan Co should take.

Audit risk Auditor’s response

1. Receivables A. Physically inspect a sample of exploration areas

2. Non-current assets B. Contact a sample of customers to confirm the year-

end balance
3. Intangible assets (licenses)
C. Ask management to adjust the financial statements

D. Inspect the license agreement

E. Review correspondence with customers

F. Calculate the expected amortization

G. Review the results of management’s impairment

test

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Section B (20 marks)

16 AQUAMARINE

It is July 20X5. You are an audit supervisor of Amethyst & Co and are currently planning the
audit of your client, Aquamarine Co which manufactures elevators. Its year end is 31 July
20X5 and the forecast profit before tax is $15.2 million.
The company undertakes continuous production in its factory, therefore at the year end it is
anticipated that work in progress will be approximately $950,000. In order to improve the
manufacturing process, Aquamarine Co placed an order in April for $720,000 of new plant and
machinery; one third of this order was received in May with the remainder expected to be
delivered by the supplier in late July or early August.
Included within intangible assets is a patent recognized at a cost of $1.3 million which was
purchased at the beginning of the year. The patent gives Aquamarine Co the exclusive right to
manufacture specialized elevator equipment for five years. In order to finance this purchase,
Aquamarine Co borrowed $1.2 million from the bank which is repayable over five years.
In January 20X5 Aquamarine Co outsourced its payroll processing to an external service
organization, Coral Payrolls Co (Coral). Coral handles all elements of the payroll cycle and
sends monthly report to Aquamarine Co detailing the payroll costs. Aquamarine Co ran its own
payroll until 31 December 20X4, at which point the records were transferred over Coral.
The company has a policy of revaluing land and buildings and the finance director has
announced that all land and buildings will be revalued at the year end.
During a review of the management accounts for the month of May 20X5, you have noticed
that receivables have increased significantly on the previous year end and against May 20X4.
The finance director has informed you that the company is planning to make approximately 65
employees redundant after the year end. No decision has been made as to when this will be
announced, but it is likely to be prior to the year end.

Required:

a. Define audit risk and the components of audit risk (4 marks)

b. Describe EIGHT audit risks, and explain the auditor’s response to each risk, in
planning the audit of Aquamarine Co. (16 marks)

Audit risk Auditor’s response

9
Section B (20 marks)

a. Define audit risk and the components of audit risk

o Audit risk is the risk that the auditor expresses an inappropriate audit opinion when the financial
statements are materially misstated.

o Audit risk is a function of two main components: The risk of material misstatement and detection
risk.

o Risk of material misstatement is made up of a further two components, inherent risk and control
risk.

o Inherent risk is the susceptibility of an assertion about a class of transaction, account balance or
disclosure to a misstatement which could be material, either individually or when aggregated with
other misstatements, before consideration of any related controls.

o Control risk is the risk that a misstatement which could occur in an assertion about a class of
transaction, account balance or disclosure and which could be material, either individually or when
aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely
basis by the entity’s controls.

o 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 which could be material, either
individually or when aggregated with other misstatements. Detection risk is affected by sampling
and non-sampling risk.

b. Audit risks and auditor’s responses

10
Section B (20 marks)

Audit risk Auditor’s response

1. Work-in-progress
 Aquamarine Co undertakes continuous  The auditor should discuss with the
production and the work in progress management the process they will
balance at year end is likely to be undertake to assess the cut-off point for
material. As production will not cease, work in progress at the year end. This
the exact cut-off of the work in process should be reviewed by the auditor
progress will need to be assessed. while attending the year-end inventory
 If the cut-off is not correctly count.
calculated, the inventory valuation may  In addition, consideration should be given as
be under or overstated. to whether an independent expert is
required to value the work in progress. If
so, this will need to be arranged with consent
from management and in time for the year-
end count.

2. Property, plant and equipment

 Aquamarine Co has ordered $720,000  Discuss with management as to whether
of plant and machinery, two-thirds of the remaining plant and machinery ordered
which may not have been received by have arrived; if so, physically verify a
the year end. sample of these assets to ensure existence
 Only assets which physically exist at and ensure only appropriate assets are
the year end should be included in recorded in the non-current asset register at
property, plant and equipment. If items the year end.
not yet delivered have been  Determine if the asset received is available
capitalized, PPE will be overstated. for use at the year end by physical
 Consideration will also need to be observation and if so, if depreciation has
given to depreciation and when this commenced at an appropriate point.
should commence. If depreciation is
not appropriately charged when the
asset is available for use, this may
result in assets and profit being over or
understated.

3. Patent
 A patent has been purchased for $1.3  The audit team will need to agree the
million and is recognized at cost in the purchase price to supporting
financial statements. documentation and to confirm the useful
 The patent exclusive rights for the next life is five years.
five years. In accordance with IAS 38  The amortization charge should be
Intangible Assets, this should be calculated and management informed that
amortized over its five-year life. an adjustment is required in order to
 Management has not correctly ensure that intangible asset is
accounted for the patent as no appropriately valued at the year end.
amortization has been charged.
Intangible assets and profits are
overstated.

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Section B (20 marks)

4. Bank loan
 The company has borrowed $1.2 million  During the audit, the team would need to
from the bank via a five-year loan. confirm that the $1.2 million loan finance
 This loan needs to be correctly split was received.
between current and non-current  In addition, the split between current and
liabilities. non-current liabilities and the disclosures
 There is a risk of incorrect disclosure for this loan should be reviewed in detail to
if the loan is not correctly split between ensure compliance with relevant accounting
current and non-current liabilities. standards.
 Details of security should be agreed to the
bank confirmation letter.

5. Finance costs
 As the level of debt has increased,  The finance costs should be recalculated
there should be additional finance and any increase agreed to the loan
costs. documentation for confirmation of interest
 There is a risk that this has been rates.
omitted from the statement of profit or  Interest payments should be agreed to the
loss. Finance costs may be bank ledger account and bank statements
understated and profit overstated. to confirm the amount was paid and is not
therefore a year-end payable.

6. Outsourced payroll function

 During the year Aquamarine Co  Discuss with management the extent of
outsources its payroll processing to an records maintained at Aquamarine Co and
external service organization. any monitoring of controls undertaken by
 The audit team will need to verify management over the payroll charge.
controls at the third party.  Consideration should be given to contacting
 A detection risk arises as to whether the service organization’s auditor to
sufficient and appropriate evidence is confirm the level of controls in place; a type
available at Aquamarine Co to confirm 1 or type 2 report could be requested.
the completeness and accuracy of
controls over payroll. If not, another
auditor may be required to undertake
testing at the services organization.

7. Data transfer
 The payroll processing transferred to  Discuss with management about the
Coral Payrolls Co in January 20X5. transfer process undertaken and any
 Errors may have occurred during the controls put in place to ensure the
transfer process; completeness and accuracy of the data.
 There is a risk that the payroll charge  Where possible, undertake tests of controls
and related employment tax liabilities to confirm the effectiveness of the transfer
are under/ overstated. controls.
 In addition, perform substantive testing on
the transfer of information from the old to
the new system.

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Section B (20 marks)

8. Revaluation of land and buildings

 The land and buildings are to be  Discuss with management the process
revalued at the year end. It is likely that adopted for undertaking the valuation,
the revaluation surplus/ deficit will be including whether the whole class of assets
material; was revalued and if the valuation was
 The revaluation needs to be carried out undertaken by an expert. This process should
and recorded in accordance with IAS 16 be reviewed for compliance with IAS 16.
Property, Plant and Equipment.
 Non-current assets may be incorrectly
valued.

9. Valuation of receivables
 Receivables at the end of May 20X5 are  Discuss with management the reasons for
considerably higher than the prior the increase in receivables and
year; management’s process for identifying
 The receivables may not be recoverable potential irrecoverable debt. Test controls
and allowance for credit losses may surrounding management’s credit control
not have been made. processes.
 There is a risk that receivables may be  Extended post-year-end cash receipts
overvalued as they are not recoverable. testing and a review of the aged list of
individual customer balances to be performed
to assess valuation. Also consider the
adequacy of any allowance for credit
losses/ receivables.

10. Redundancy provision

 Aquamarine Co is planning to make  Discuss with management the status of the
approximately 65 employees redundancy announcement; if before the year
redundant after the year end. end, review supporting documentation to
 The timing of this announcement has confirm the timing. In addition, review the
not been confirmed; if it is announced basis of and recalculate the redundancy
to the staff before the year end, then provision.
under IAS 37 Provisions, Contingent
Liabilities and Contingent Assets a
redundancy provision will be required
at the year end.
 Failure to provide will result in an
understatement of provisions and
expenses.

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