Audit exam revision tutorials and questions PDF

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Week 1 Tutorial 1Part 1 In the context of auditing, explain what the following terms mean: - a) ISA (International Standard on Auditing) b) FRC (Financial Reporting Council) c) IFAC (International Federation of Accountants) d) IAASB (International Auditing and Assurance Standards Board) Which of the...

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Week 1 Tutorial 1 Part 1 1. In the context of auditing, explain what the following terms mean: a) b) c) d)

ISA (International Standard on Auditing) FRC (Financial Reporting Council) IFAC (International Federation of Accountants) IAASB (International Auditing and Assurance Standards Board)

2. Which of the following statements is correct in relation to external statutory audits? a) External audits give absolute assurance that the financial statements are free from all material misstatement b) External audits give limited assurance that the financial statements are free from material misstatement c) External audits give reasonable assurance that the financial statements are free from material misstatement Notes: It is not possible to give absolute assurance given the inherent limitations of audit. 3. Is the following statement regarding stewardship true or false? Directors are stewards of the investment made by shareholders in a company. 4. The objective of an audit of financial statements is to enable the auditor to express an opinion on whether the financial statements are prepared, in all material accordance with an identified financial reporting framework. 5. Link the correct definition to each term Accountable (f) Steward (d) Agent (b)

True (c) Fair (e) Materiality (a)

a) An expression of the relative significance or importance of a particular matter in the context of the financial statements as a whole. b) A person employed to provide a particular service.

c) Factual and conforming with reality. In conformity with relevant standards and law correctly extracted from accounting records. d) A person employed to manage other people’s property. e) Free from discrimination and bias and in compliance with expected standards and rules. Reflecting the commercial substance of underlying transactions. f) Being required or expected to justify actions and decisions.

6. In the case of most general frameworks, what are the two forms of an auditor expressing an opinion that the financial statements are a good reflection? a. “are presented fairly, in all material respects” b. “give a true and fair view”

7. In order to give a true and fair opinion of a company’s financial statements, the auditor must obtain reasonable assurance that the financial statements are free from material misstatement, whether due to fraud or error. 8. In the context of an audit, briefly explain what is meant by the following terms: a) Professional Judgement b) Professional skepticism Professional judgment – The application of relevant training, knowledge and experience, within the context provided by auditing, accounting and ethical standards, in making informed decisions about the courses of action that are appropriate in the circumstances of the audit engagement. Professional skepticism – An attitude that includes a questioning mind, being alert to conditions which may indicate possible misstatement due to error or fraud, and a critical assessment of audit evidence.

9. The ISAs (UK) require that the auditor exercise professional judgment and maintain professional skepticism throughout which different stages of the audit engagement?

Planning; performance; identification and assessment of risks and material misstatements (assessing the entity); obtaining evidence; formation of an opinion Notes:  Identify and assess risks of material misstatement, whether due to fraud or error, based on an understanding of the entity and its environment, including the entity’s internal control. 

Obtain sufficient appropriate audit evidence about whether material misstatements exist, through designing and implementing appropriate responses to the assessed risks.



Form an opinion on the financial statements based on conclusions drawn from the audit evidence obtained.

10. List up to 7 limitations of an audit, you will be given 1 point for each. 

Not objective; entails judgment



Not all items are audited



Limitations inherent in accounting system



Non-routine transactions



Time lag for issuance of audit report



Audit evidence – may give indication of ‘probability’, not certainty

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Structure of profession and concerns with independence.

11. What are the 7 postulates of auditing formulated by Flint (1988)? 1. The primary condition for an audit is that there is a relationship of accountability. 2. The subject matter accountability is too much remote, too complex, and/or too great significance for the discharge of the duty to be demonstrated without the process of audit. 3. Essential distinguishing characteristics of audit are the independence of its status and its freedom from investigatory and reporting constraints. 4. The subject matter of audit, for example conduct, performance or achievement or record of events or state of affairs, or a statement or facts relating to any of these, is susceptible to verification by evidence. 5. Standards of accountability, for example of conduct, performance, achievement and quality of information, can be set for those who are accountable; actual conduct, performance, achievement, quality and so on can be measured and compared with these standards by reference to known criteria; and the process of measurement and comparison requires skill and the exercise of judgement. 6. The meaning, significance and intention of financial and other statements and data which are audited are sufficiently clear that the credibility which is

given thereto as a result of audit can be clearly expressed and communicated. 7. An audit produces an economic or social benefit.

Part 2 – Case Study Julie has decided to set up a business selling fruit and veg. She wakes up early every morning and heads down to the local market, where she stocks up on fruit and veg and then sets up a stall in a busy parking area where she sells the produce from. For the first 12 months everything goes really well. Every day she completely sells out of the stock she is able to purchase from the market and is making a decent level of income from the business. However, Julie is of the opinion that she would comfortably be able to expand the business and sell more fruit and veg, if she was able to transport more stock from the market to the parking area where she sets up he stall. In addition, she is also aware of several other locations that would make good spots to set up additional stalls if she were able to be in two places at once. She is considering the possibility of buying a van and employing at least one additional member of staff to sell fruit and veg for her at the other locations. Julie needs more money to be able to achieve this and has decided to speak with her friend, Mr Smith, to see if he would like to invest in the business, with the goal of expanding. Mr Smith can see the potential in Julie’s business and is interested in investing, but has made it clear that he wants nothing to do with the management of the business. In addition, he does not want to be held liable for any debts that the business may incur if it fails. He therefor suggests to Julie that she should set up a limited company. He will own the majority of the shares and be entitled to dividends. Julie will be managing director and be paid a salary for her work. Despite his optimism, Mr Smith is a little worried about his lack of knowledge in the fruit and veg business and due to not being directly involved with the company is trying to find out more about the benefits of external audits as a method of assurance. Required 1. Briefly discuss the need for external audit engagements and explain to Mr Smith, in relation to the case study the concepts of Accountability, Stewardship and Agency. 2. Advise Mr Smith on some of the possible benefits and limitations of external audits. Solutions Question 1 The assurance that Mr Smith is seeking can be given through an independent audit or review of the financial statements. In particular, an audit can provide Mr Smith with the two things he requires, a knowledgeable review of the company’s business and of the accounts and also an impartial view. Due to the fact that Julia is receiving a salary for work, it is less likely that she will be concerned should profits begin to fall.

Also other people may also want to view the company accounts in the future:  Other potential creditors  Taxation authorities  General public, if the business begins to grow  Employees of the business As Mr Smith is the main shareholder in the business, with a controlling stake, Julia is effectively a steward and agent of Mr Smith. She is providing the service of managing the organisation and therefore has the responsibility of maximising the shareholders wealth. This also comes under the concept of stewardship as Julia is responsible for the stewardship of Mr Smith’s property (i.e. his investment in the company). Furthermore, as director of the company, Julia is accountable for her shareholders investments and is required to justify actions and decisions that she takes regarding the business to Mr Smith. Shareholders expect a return on their investment and as a director of the company Julia is in the position to effect that return. Question 2 Benefits 

    

An audit provides assurance to shareholders (if they are not directors closely involved in the business) that the figures in the accounts show a true and fair view Enhance the degree of confidence of intended users in the financial statements. An audit helps to identify weaknesses in the accounting systems An audit helps reduce the scope for fraud and poor accounting An audit will enhance the credibility and reliability of the figures being submitted. An audit adds credibility to published information for employees, customers, suppliers, investors and tax authorities

This is not a complete list of the benefits. Limitations Note: Auditors can never clarify that the accounts are correct. They can only express an opinion 1. Auditing is not objective, judgements have to be made  Audit opinion  Risk Assessment – What do we test  How much do we test  Are the errors representative/material 2. Not all items in the financial statements are tested  What do we sample  Sampling risk 3. Limitations in accounting and control systems  Non-routine transactions  Human error

Possibility of collusion and fraud – managers know the company, easy to hide?  Cost/benefit trade-off  Possibility of controls override 4. Audit report has inherent limitations  Standard format can be limiting  The layman may not understand the jargon 5. Audit report issued a long time after the balance sheet date  Up-to-date position and historic may be different 6. Audit evidence sometimes indicates what is possible, not certain  Estimates  Judgements  Intentions 

Week 1 Tutorial Questions

Question 1 You are given the following scenarios to consider from the point of view of the auditor. Identify the nature of any threats to auditor independence and state what the auditor should do. (i)

The audit manager in charge of the audit assignment of Andrew plc holds 1,000 £1 ordinary shares in the company (total shares in issue – 100,000). The audit partner holds no shares.

(ii)

An audit partner of a firm of Certified Accountants is a personal friend of the chief accountant of James Ltd. The chief accountant is not a director of the company and the audit partner is not responsible for the James Limited audit work.

(iii)

The audit fee receivable from Janet plc is £100,000. The total fee income of the Audit Firm is £700,000.

(iv)

The audit senior in charge of the audit of Margot Bank plc has a personal loan from the bank of £2,000 on which she is currently paying 7% interest.

(v)

Mrs Toffee has been the audit engagement partner of Huge plc has for five years. There is also an independent partner and an ethics partner assigned to this client.

(vi)

Asset Holdings Ltd has asked their auditors to undertake an engagement that will involve revaluing material fixed assets from their historical cost to their current market value.

(vii)

At the end of the final audit there is an ‘audit night out’. The audit team and the client staff meet up for a meal at the local pizza restaurant and to go out after the meal for more socialising if they want. The three course meal, including all drinks and alcohol, is paid for by the audit partners or client directors in alternate years. The audit partner and client directors do not attend. The final audit lasted 6 weeks and the interim audit lasted 2 weeks.

Required Comment on each situation in the context of the independence of the auditor, showing clearly the principles involved. (Adapted from an ACCA question) (i)

The shares may be small percentage of total shares but a high percentage of the manager’s wealth. ES Section 2 states:

“The firm, each of the firm’s key audit partners and each of the firm’s directly involved covered persons for any engagement, and any persons closely associated with the firm or any such partner or covered person, shall not hold”:

(a) hold any material financial interest(other than an indirect financial interest held through a diversified collective investment scheme) in, or engage in any transaction in, any financial instrument of any entity relevant to an engagement in the areaofactivity22in which they (or in the case of a person closely associated, the area of activity in which the firm, key audit partner or covered person with whom they are closely associated) are involved relating to engagements; or (b) hold any financial interest, other than an indirect financial interest held through a diversified collective investment scheme, in: (i) (ii) (iii)

any entity relevant to an engagement for which they are a directly involved covered person; or an entity which is an affiliate of such an entity; or any other entity otherwise related to such an entity in circumstances where holding such a financial interest may cause, or may be generally perceived as causing, a conflict of interest; or, if a person holds such a financial interest, 3they shall be excluded from any role by virtue of which they would be a covered person for any such engagement.

The holding constitutes a threat to auditor objectivity and independence (self interest threat). Para 2.5 - 2.11 basically state that the holding should be disposed of or reduced to a level that is no longer material, or the manager should not retain a position of influence in the audit. If the person in question was a partner, then the holding should be disposed of or the firm does not accept the engagement. (ii)

OK probably since partner is not involved in audit. But see ES Section 2 (2.62)– i.e The firm shall establish policies and procedures that require:

(a) partners and professional staff members to report to the firm any persons closely associated with them, any close family, and other personal relationships, where any of those persons is involved with an entity relevant to an engagement of the firm, where the partner or professional staff member considers that the relationship might create a threat to integrity or objectivity or may compromise independence;

(b) the relevant engagement partners to be notified promptly of any information reported by partners and other professional staff members as required by paragraph (a). The engagement partner shall: (a) assess the threats to integrity and objectivity and evaluate whether independence would be compromised, on the basis of the information reported to the firm by partners and other professional staff members as required by paragraph 2.62; (b) apply appropriate safeguards to eliminate any threats or to reduce them to a level where independence would not be compromised; and (c) where there are unresolved matters or the need for clarification, consult with the Ethics Partner/Function. (iii)

14.3% - is Janet plc listed? If so it looks too high since limit would be 10%. Even if unlisted it is to be viewed with care – it’s below the 15% but above the level (10%) where regular review of propriety is appropriate – see ES Section 4 (4.23 -4.31)

“Where it is expected that the total fees for services receivable from a public interest entity or other listed entity and its subsidiaries relevant to a recurring engagement by the firm46 will regularly exceed 10% of the annual fee income of the firm47 or, where profits are not shared on a firm wide basis, of the part of the firm by reference to which the engagement partner’s profit share is calculated, the firm shall not act as the provider of the engagement for that entity and shall either resign or not stand for reappointment, as appropriate” This 10% rule (or 15% for non-listed companies) applies where fee income is derived from audit only or audit and non-audit services. Also: see 4.15 – 4.21 for note on Non-audit services: 4.20: Where substantial fees are regularly generated from the provision of nonaudit / additional services and the fees for non-audit / additional services are greater than the annual fees for recurring engagements for an entity, the engagement partner has regard to the possibility that there may be perceived to be a loss of independence resulting from the expected or actual level of fees for nonaudit / additional services. The engagement partner determines whether there is any risk that there will be an actual loss of integrity, objectivity or independence by the firm or covered persons. In making that assessment, the engagement partner considers matters such as whether the non-audit / additional services were:  

audit related services; provided on a contingent fee basis;

   

(iv)

consistent with the services undertaken and fees received on a consistent basis in previous years; in the case of a group, disproportionate in relation to any individual group entity; unusual in size but unlikely to recur; and/or of such a size and nature that an objective, reasonable and informed third party would be concerned at the effect that such services would have on the integrity, objectivity and independence of the firm or covered persons. This constitutes a financial relationship relating to loans and guarantees (ES Section 2 – 2.22 – 2.26). Seems to be (approximately) normal commercial terms. (Loan from a bank is not the same thing as a loan from a client whose normal business does not involve making loans.) ES Section 2 (2.22):

Covered persons and persons closely associated with them shall not accept a loan from, or have their borrowings guaranteed by, the entity relevant to the engagement, or the affiliates of such an entity, unless: (a) the entity is a bank or similar deposit taking institution; and (b) the loan or guarantee is made in the ordinary course of business on normal business terms; and (c) the loan or guarantee is not material to the entity. ES Section 2.20 Where firms, covered persons or persons closely associated with them: (a) accept a loan or a guarantee of their borrowings from an entity relevant to the engagement; or (b) make a loan to or guarantee the borrowings of an entity relevant to the engagement, a self-interest threat and an intimidation threat to integrity or objectivity can be created and independence may be compromised. In these situations, set out in paragraphs 2.21, 2.22 and 2.23, no safeguards can eliminate these threats or reduce them to a level where independence is not compromisedand accepting and making loans in those circumstances is therefore precluded.

(v)

Reference to ES Section 3 – Long association with client. There are more stringent rotation rules relating to the audit engagement partner of a listed company compared to a non-listed ...