F-Suggested Answer

Audit & Assurance

CAP II, June 2013
Roll No.

Maximum Marks - 100

Total No. of Questions- 7

Total No. of Printed Pages- 2

Time Allowed - 3 Hours

Marks
Attempt all the questions.
1. As an auditor, give your opinions with reasons on the following cases:

(4
5=20)

a) During the course of audit of a limited company, the auditor detected that the
managing director had committed a fraud involving a loss to the company. And
the managing director has also fully compensated the loss as committed by him
to the company immediately after the detection of fraud.
b) On the basis of approval accounting policy, Bee Limited has revalued its
property and charged Rs. 5 crores revaluation loss in profit and loss account in
2067/68 whereas transferred Rs. 10 crores the revaluation gain to revaluation
reserve in 2068/69.
c) A company wants to adjust the bank balance on the balance sheet date by
reversing the entry for a cheque issued in the normal course of business and
cancelled after the year end but before the finalization of accounts. The cheque
was returned on the ground that the signature differs.
d) Richak & Associates, a chartered accountant firm, was appointed as an auditor
of a company on 15 Aswin 2069 for the year 2068/69 where Ram Lal, one of
the partners of the audit firm, was holding 5% shares of the company since
2065. But Ram Lal sold all his shares of the company on 30 Aswin 2069. It was
further noted that the audit report was signed by another partner of the firm on
15 Falgun 2069 only.
Answer:
a) The detection of a fraud committed by the Managing Director involving a loss to the
company is a serious matter irrespective of the fact that the Managing Director has fully
compensated the company before the end of the fiscal year. In this context, NSA-240 on
the Auditor responsibility to consider fraud and error in an audit of financial statements
enumerates responsibilities of the auditor in case fraud and error to exist while
conducting the audit. It requires, first of all that auditor should consider the implications
of the circumstances on the true and fair view which the financial statements ought to
convey and secondly, where the significant fraud has occurred, that auditor should
consider the necessary for a disclosure of fraud in the financial statements and if adequate
disclosure is not made, the necessity for a suitable disclosure in his report.
NSA 240 further defined the duties of the auditor to communicate these matters to the
appropriate level of management on a timely basis, and consider the need to report such
matters to those charged with governance in such case.
When the auditor has obtained evidence that fraud exists or may exist, it is important that the
matter be brought to the attention of an appropriate level of management. This is so even if

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the matter might be considered inconsequential (for example, a minor defalcation by an
employee at a low level in the entitys organization). The determination of which level of
management is the appropriate one is also affected in these circumstances by the likelihood
of collusion or the involvement of a member of management. If the auditor has determined
that the misstatement is, or may be, the result of fraud, and either has determined that the
effect could be material to the financial statements or has been unable to evaluate whether the
effect is material, the auditor: (a) discusses the matter and the approach to further
investigation with an appropriate level of management that is at least one level above those
involved, and with management at the highest level; and (b) if appropriate, suggests that
management consult with legal counsel.

b) NAS 6 paras 39, 40 and 41 are related with the treatment of revaluation of fixed assets. As per
this para, if an assets carrying amount is increased as a result of a revaluation, the increase shall
be credited directly to equity under the heading of revaluation surplus. However, it reverses a
revaluation decrease of the same asset previously recognized in profit or loss.
If an assets carrying amount is decreased as a result of a revaluation, the decrease shall be
recognized in profit or loss. However, the decrease shall be debited directly to equity under
heading of revaluation surplus to the extent of any credit balance existing in the revaluation
surplus in respect of that asset.
The revaluation surplus included in equity in respect of an item of property, plant and equipment
may be transferred directly to retained earnings when the asset is derecognized. This may involve
transferring the whole of the surplus when the asset is retired or disposed of. However, some of
the surplus may be transferred as the asset is used by an entity. In such a case, the amount of the
surplus transferred would be the difference between depreciation based on the revalued carrying
amount of the asset and depreciation based on the assets original cost. Transfers from revaluation
surplus to retained earnings are not made through profit or loss.

Hence in a given case, the revaluation profit of Rs 5 crores is to be credited to profit or

loss account of the year 2068/69, the amount equivalent to revaluation loss which was
charged to profit or loss account in earlier years and Rs 5 crores is to be credited to equity
directly (i.e. revaluation reserve). So, the accounting treatment on revaluation of property,
plant and equipment provided by the company for the year 2068/69 is not in accordance
with the requirement of NAS.
c) According to the NAS-05 Events After the Balance Sheet Date, assets and liabilities
should be adjusted for significant events occurring after the balance sheet date that
provide additional evidence to assess estimation of amounts relating to conditions
existing at the balance sheet date. Since the phenomenon of difference in signature
existed on the balance sheet due (though known afterwards); the reversal of the entry
can be made as on the balance sheet date if the amount is material.
d) A person or a firm in which such person has substantial shareholding of the company or a
shareholder holding one percent or more of the paid up capital of the company or his/her
close relative is not qualified for appointment as an auditor as per section 112(1) of the
Companies Act. So, in the present case since Ram Lal, a partner of Richak & Associates,
holds 5% shares of the company, Richak & Associates is disqualified from appointment
as an auditor as on 15 Asoj 2069. But Ram Lal disposes all his shares after appointment
of his firm as an auditor and audit report is signed after his disposal of shares. Despite
this fact as per section 112(4) of the Companies Act since the appointment of auditor is in
contravention of the provisions of the Companies Act, the audit cannot be considered as
valid.
2. Answer the following:
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a) As an auditor of a small business, how can you assure the internal control
system of that company?

b) How would you safeguard your client against the payment for fictitious
purchases?
7
Answer:
a) Internal control is a set of internally generated policies and procedures adopted by the
management of an enterprise which is pre requisitive for an organizations efficient and
effective performance. It is thus a primary responsibility of every management to create
and maintained adequate system of internal control appropriate to the size and nature of
the business entity.
The system of internal control as the process designed, implemented and maintained by
those charged with governance, management and other personnel to provide reasonable
assurance about the achievement of an entitys objectives with regard to reliability of
financial reporting, effectiveness & efficiency of operations, safeguarding of assets and
compliance with applicable laws & regulations.
The auditor needs to obtain the same degree of assurance in order to given an unqualified
opinion on the financial statements of both small & large entities. However many
controls which would be relevant to large entities are not practical in small business. For
example, in a small business, accounting procedure may be performed by a few persons.
Small business is characterized by the lower number of employees, minimum investment
of capital, small capacity of production, difficulty to segregate the owner and the
management and there is less use of technology. It means the business is producing the
product (if it is a manufacturing industry) manually using very less mechanical tools and
traditional tools.
Like, another characteristic is the simplicity and local products designed to cover up the
local environment. It is highly labour intensive and less machine oriented in nature. Also
the business is dependent with the skill labour instead of installing high value of machine.
Those persons may have both operating and custodial responsibilities and segregation of
function may be missing or severely limited.
Inadequate segregation of duties, may in some cases, is offset by supervisory controls
exercised by the owner. The supervisory function by the owner becomes possible because
of the fact that he has direct personal knowledge of the business and involvement in the
business transactions.
In circumstances where segregation of duties is limited and the evidence of supervisory
controls is lacking the evidence necessary to support the auditors opinion on the financial
information may have to be obtained largely through substantive procedure.
b) The auditor has to be very cautious while verifying the purchases that no payments have
been made for the fictitious purchases. For this purpose, he may have to take the
following actions:
i) He should examine first the internal control system in connection with purchases and
satisfy himself with regard to its effectiveness.
ii) He should ensure that before passing the invoices for payment, they are checked with
the original order, with goods received book and the stock records.
iii) He should inspect the invoices and see that the authorities responsible for passing them
for payment have duly checked them and initialed.
iv) He should test check the invoices to see that dates given in the invoices are for the
period concerned and they have been addressed in the name of the client.
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v)
vi)
vii)
viii)

He should also compare a number of invoices with the records in the goods received
book and stock records.
He can make physical verification of the goods purchased, if a part of it is still in the
stock.
He should also compare the suppliers statement with the suppliers account.
Postings in the various suppliers accounts should also be checked and compared with
the statement received from them.

3. Give your comments on the following:

(3
5=15)

a) The chief executive officer of a client company has returned your draft
representation letter stating that the directors fail to see why such a letter is
necessary and declaiming to issue the letter.
b) The management of Shri Ram Pvt. Ltd. argued that auditor has not carried out the
work properly citing reason that certain fraud and error were revealed after
issuing audit report, whereas audit report was silent on such fraud & error.
c) Mr. Raj, a fellow member of the Institute of Chartered Accountants of Nepal,
working as manager of Rahul & Associates, a chartered accountant firm, signed
the audit report of Om Ltd. on behalf of Rahul & Associates.
Answer:
a) NSA 580 has defined the management representations while conducting the audit. The
auditor should obtain written representations from management on matters material to the
financial statements when other sufficient appropriate audit evidence cannot reasonably be
expected to exist. The possibility of misunderstandings between the auditor and management
is reduced when oral representations are confirmed by management in writing. Matters which
might be included in a letter from management or in a confirmatory letter to management are
contained in the example of a management representation letter in the Appendix to this NSA.
8. Written representations requested from management may be limited to matters that are
considered either individually or collectively material to the financial statements. Regarding
certain items it may be necessary to inform management of the auditors understanding of
materiality.
If management refuses to provide a representation that the auditor considers necessary, this
constitutes a scope limitation and the auditor should express a qualified opinion or a
disclaimer of opinion. In such circumstances, the auditor would evaluate any reliance placed
on other representations made by management during the course of the audit and consider if
the other implications of the refusal may have any additional effect on the auditors report.

b) Nepal Standards on Auditing (NSA) 240 on The Auditor's Responsibility to Consider

Fraud and Error in an Audit of Financial Statements deals the matter on auditor
responsibility. NSA 01 has defined the objective of an audit of financial statements and
as per this standard, the auditor should express an opinion whether the financial
statements are prepared, in all material respects, in accordance with an identified
financial reporting framework or relevant practices. An audit conducted in accordance
with NSAs or relevant practices is designed to provide reasonable assurance that the
financial statements taken as a whole are free from material misstatement, whether
caused by fraud or error. The fact that an audit is carried out may act as a deterrent, but
the auditor is not and cannot be held responsible for detection of fraud and error.
The management connotation on charge to auditor will be tenable only if the auditor fails
to carry out his duty under following parameters:
i) Using professional skepticism for understanding the risk of material misstatements
resulting from the errors and frauds in financial statements.
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ii) Audit preliminaries for gaining knowledge about any susceptibility of misstatements
arising from fraud; Audit planning with audit team, audit enquiry of management;
discussion with charge of corporate governance; identification of fraud risk
factors etc.
iii) Audit Response when fraud risk factors are identified to be present-Considering
modifying substantive procedures to reduce detection risk.
iv) Circumstances indicative of presence of misstatement resulting from fraud,
identification of misstatement.
v) Determining the effect of misstatement in financial statements, tagging it with fraud,
documentation, communication and reporting.
vi) Awareness of auditors responsibility in addition with the responsibility of that charge
of governance.
c) Signature on Audit Report: Section 116 of the Companies Act, 2063 requires that only a
person appointed as the auditor of the company or where a firm is so appointed, the
member who has been authorized by a decision of the partners of such institution, may
sign the auditors report or sign or authenticate any other document of the company
required by law to be signed or authenticated by the auditor. Therefore, Mr. Raj, a fellow
member of the Institute and a manager of M/s Ram & Associates., Chartered
Accountants, cannot sign on behalf of the firm in view of the specific requirements of the
Companies Act, 2063.
(3
5=15)

4. Answer the following:

a) Under what circumstances an independent auditor can issue comfort letter to
his/her client?
b) District Education Office has appointed you as an auditor for some community
schools of Humla District. What special points do you consider while doing
audit of such schools? Explain.
c) Write down ten areas where different accounting policies are applied on
accounting the financial transactions based on the nature of entities.
Answer:

a) A letter from independent auditor including in a preliminary prospectus stating that,

while a full audit has not undertaken, the auditor has done a review sufficient to assure
that financial statement information in the preliminary prospectus is correctly prepared to
the best of the auditor knowledge. The auditor in effort states that, had a full audit been
done, they are comfortable that the audited financial statements would not be materially
different from the ones presented in the preliminary prospectus.
Before or during a new issue, a statement by an auditor stating that, while a full audit has
not been done, a review of the issue's prospectus has revealed nothing inaccurate or
misleading. The comfort letter also states that the auditor is confident that a full audit
would not uncover anything unusual that would negatively affect the issue.
In other word, a letter is given to organizations or persons of interest by external auditors
regarding statutory audits, statements and reports used in a prospectus. The comfort letter
will be attached to the preliminary statements as assurance that it will not be materially
different from the final version.
b) Audit of Education Institutions i.e. Community Schools of Humla District:
The special steps involved in their audit are the following:

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Examine the Education Act and Education Rules in these cases as these are the
Community Schools which are under the control of the District Education Office and
note all the provisions affecting accounts. .
Read through the minutes of the meeting of the School Management Committee, noting
resolutions affecting account to see that these have been duly complied with, specially the
decisions as regards the operation of bank account and sanctioning of expenditure.
Check names entered in the Students Fee Register for each month or term, with the
respective Class Registers, showing names of student on rolls and test amount of fees and
extra charged; and verify that there operates a system of internal check which ensures that
demands against the student are properly raised.
Check fees received by comparing counterfoils or receipts granted with entries in the
Cash Book and tracing the collections in the Fee Register to confirm that the revenue
from this source has been duly accounted for.
Total up the various columns of the Fees Register for each month or term to ascertain that
fees paid in advance have been carried forward and that the arrears that are irrecoverable
have been written off under the sanction of an appropriate authority.
Check admissions fees with admissions slips signed by the head of the institution and
confirm that the amount has been credited to a Capital Fund, unless the School
Management Committee has taken a decision to the contrary.
See the free studentship and concessions have been granted by a person authorized to do
so, having regard to the Rules prepared by the Management Committee.
Confirm that fines for late payment or absence, etc. have been either collected or remitted
under proper authority.
Confirm that hostel dues were recovered before student's accounts were closed and their
deposits of caution money refunded.
Verify rental income from landed property with the rent rolls, etc.
Verify any government or local authority grant with the memo of grant. If any expense
has been disallowed for purposes for grant, ascertain the reasons thereof.
Report any old heavy arrears on account of fees, dormitory rents, etc. to the Management
Committee.
Confirm that caution moneys and other deposits paid by students on admission, have
been shown as liability in the balance sheet and not transferred to revenue, unless they are
not refundable.
See that the investments representing endowment funds for prizes are kept separate and
any income in excess of the prizes has been accumulated and inappropriate securities.
Check the distribution of scholarship to the students and ensure the same with the receipts
of the students.
Check the distribution sheet of textbooks, payroll of the PCF teachers with the number of
students.

c) Various Nepal Accounting Standards (NAS) are issued by the Accounting Standard
Board of Nepal which are mandatory in nature and few are recommendatory as well. For
prudent accounting practices; application of NAS should be made on accounting of
financial transactions. Some areas where accounting policies suggested by NAS are:
i) Method of depreciation, depletion and amortization-Straight Line Method, Written
Down Value method.
ii) Accounting Concept: Historical cost convention is to be defined.
iii) Fluctuation of foreign currency and its treatment should be defined.
iv) Valuation of inventories FIFO, LIFO, weighted average etc.
v) Treatment of goodwill write off, retain.
vi) Valuation of investment at cost, market or net realizable value etc.
vii) Treatment of retirement benefits-Actuarial, funded through trust, insurance policy etc.
viii) Recognition of Revenue either on mercantile or accrual basis is defined.
ix) Revaluation of fixed assets and writeoff of fixed assets having certain value say Rs.
1,000 or less.
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x) Treatment of contingent liabilities.
5. Comment on the following situations/statements.

(3
5=15)

a) Siddhi & Co., a chartered accountant firm is appointed a fund manager of an

INGO situated in Nepal. The INGO has then transferred money in the current
account of Siddhi & Co. for the operation of project activities. Opine on the act
of Siddhi & Co. for:
i) transferring certain money to saving bank account and
ii) charging/ drawing fee due from the client.
b) RB Associates, a firm of chartered accountants has two partners, R and B. The
firm is already holding audit of 130 companies including audit of 90 NGOs. The
firm is offered the audit of Labour Welfare Association.
c) CA. Khari Adhikari heads the internal audit department of Tee limited. The
external audit firm decided to rely on the internal auditors work relevant for
external audit because of the professional competency of the chief of internal
audit of Tee Limited. Later it was found that the external auditor had conducted
audit procedures himself instead of relying on internal auditors work; however
claimed that he should not be made responsible for inappropriate audit opinion
because he had relied on the work of qualified internal auditor.
Answer:
a) Section 12 of the Code of Ethics of the Institute of the Chartered Accountants of Nepal
permits keeping clients money for using on legal activities on behalf of client and which
is also permitted by the ToR and the agreement with the client.
i)
The act of transferring clients money in saving bank account for reasonable
time is valid only when it seems likely that the clients monies remain on
current account for a significant period of time and Siddhi & Co. have taken
prior concurrence of the client.
ii)
Siddhi & Co., can charge/draw fees due from a clients monies provided that
client, after being notified of the amount of such fees, has agreed to such
withdrawal.
b) As per the notification issued by the ICAN :
i) In case of partnership firms of auditor, the ceiling on audit is hundred entities per
partner of the firm.
ii) The maximum number of audits of the public company registered under Company Act
is 15 and number of audits of other entities is 85 per partner.
iii) The firm can taken maximum of two hundred audits (100 2), but the number of
Audits of NGOs should not exceed 90. There are two partners R and B.
iv) The firm is holding 90 audits of NGOs at present.
v) The firm can, therefore, accept audit of Labour Welfare Association assuming that
Labour Welfare Association is registered under the Association Registration Act, 2034.
c) The role of internal auditing is determined by management, and its objectives differ from
those of the external auditor who is appointed to report independently on the financial
statements. The internal audit functions objectives vary according to managements
requirements. The external auditors primary concern is whether the financial statements are
free from material misstatements. Nevertheless some of the means of achieving their
respective objectives are often similar and thus certain aspects of internal auditing may be
useful in determining the nature, timing and extent of external audit procedures. Internal
auditing is part of the entity. Irrespective of the degree of autonomy and objectivity of
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internal auditing, it cannot achieve the same degree of independence as required of the
external auditor when expressing an opinion on the financial statements. The external auditor
has sole responsibility for the audit opinion expressed, and that responsibility is not reduced
by any use made of internal auditing. All judgments relating to the audit of the financial
statements are those of the external auditor.

The external auditor has sole responsibility for the audit opinion expressed, and that
responsibility is not reduced by any use made of internal auditing. All judgments relating
to the audit of the financial statements are those of the external auditor. Hence the
external audit firm in the given situation cannot be relieved of its duty to express opinion
on the financial statements by relying on the work of internal auditor.
(4
2.5=10)

6. Write short notes on the following:

a) Detection risk
b) Audit strategy
c) Features of government audit
d) Tolerable error
Answer:

a) Detection risk: Detection risk is the risk that the auditor will not detect a misstatement
that exists in an assertion that could be material, either individually or when aggregated
with other misstatements. Detection risk is a function of the effectiveness of an audit
procedure and of its application by the auditor. Detection risk cannot be reduced to zero
because the auditor usually does not examine all of a class of transactions, account
balance, or disclosure and because of other factors. Such other factors include the
possibility that an auditor might select an inappropriate audit procedure, misapply an
appropriate audit procedure, or misinterpret the audit results. These other factors
ordinarily can be addressed through adequate planning, proper assignment of personnel to
the engagement team, the application of professional skepticism, and supervision and
review of the audit work performed.
b) Audit Strategy
Audit planning is the process of gathering information and design audit strategies. The
main output of audit planning is a tailored audit approach supported by appropriate
administrative arrangements.
Audit strategy is concerned with designing optimized audit approaches that seeks to
achieve the necessary audit assurance at the lowest cost within the constraints of the
information available. Audit procedures should be relevant to the important assertions,
and as cost effective as possible to perform.
Audit strategy generally involves the following steps:
i)
Obtaining knowledge of clients business,
ii)
Performing analytical procedures at initial stage,
iii)
Evaluating inherent risks,
iv)
Evaluating internal control system for strategy purpose and
v)
Formulating the strategy.
The auditor should also develop the strategy by considering the results of gathering or
updating information about the client, and making preliminary judgment about
materiality, inherent risk and control effectiveness.

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The initial assessment of the quality and complexity of the clients system will affect the
amount of the information the auditor needs to gather. Sometimes, on a new engagement,
the appropriate strategy may be oblivious from a limited amount of investigation work.
c) Features of Government Audit
Citizen of the country are more concern on issues concerning public accountability, including the
misuse of public funds, evaluation of the effectiveness and outcomes of government programs,
information disclosure based on the right-to-know, and requests for disclosure of government
financial data through financial statements. To meet these challenges, each government has one
Supreme Audit Institution that is responsible for the public auditing whereas Financial
Comptroller General is responsible to maintain public accounting.
Supreme Audit Institution in Nepal is called the office of the Auditor General (OAGN) who
conduct public audit of the government budget and expenditure. Regarding the aim of auditing,
public audits are carried out as comprehensive audits that include financial auditing and
performance auditing or value-for-money (VFM) auditing.
The aim of audit of government auditing has some audit areas that are completely different from
those concerning the auditing of corporate accounts. In government auditing, the scope of
financial auditing includes audit areas other than the audit of accounts, and performance auditing
includes the evaluation of economy, efficiency, and effectiveness. OAGN also performs the audit
of regularity and propriety.
Government auditing was initially conducted as compliance audits, which means accurate
account auditing or financial auditing. Subsequently, government organizations were required to
provide effective public services by efficient management in the performance of their trusteeship
obligations, which in turn necessitated performance auditing.
As a feature of performance auditing, the Auditing Standards of the International Organization of
Supreme Audit Institutions (INTOSAI) point out that performance audits should not concentrate
solely on criticism of the past but should be constructive.

d) Tolerable error: Tolerable error is the maximum error that that the auditor would be
willing to accept and still concludes that the result from the sample has achieved the audit
objective. Tolerable error is considered during the planning stage and for substantive
procedures related to the auditor judgment about materiality. The smaller the tolerable
error, the greater the sample size will needs be.
In test of control, the tolerable error is the maximum rate of deviation from a prescribed
control by control procedure that at the auditor would be willing to accept, based on the
preliminary assessment of control risk. In substantive procedure, tolerable error is the
maximum monetary error in an account balance or a class of transactions that the auditor
would be willing accept, so that when the result of all audit procedure are reasonable
assurance, that the financial statement are not materially mis-stated.
7. Distinguish between :
a) Computerized and manual accounting system
b) Test checking and routine checking

(2
5=10)

Answer:
a) Distinction between computerized and Manual Accounting System:
i) Faster and efficient in processing of information in computerized system and no such
faster and efficient in processing of information in manual system
ii) Automatic generation of accounting documents like invoices, cheques and statement of
account which manual system cannot produce.
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iii) With the larger reductions in the cost of hardware and software and availability of userfriendly accounting software package, it is relatively cheaper like maintaining a manual
accounting system;
iv) More timely information can be produced than manual system
v) No more manual processing of the data- all automatically posted to the various
ledgers/accounts and many types of useful reports can be automatically generated for
management to make decisions where as such reports cannot generated on manual system
vi) Power failure, computer viruses and hackers are the inherent problems of using
computerized systems, such risk not remain in manual system
vii) Once data been input into the system, automatically the output are obtained hence the
data being input needs to be validated for accuracy and completeness, we should not
forget concept of GIGO (Garbage In(Input) Garbage out ( Output) where validation in
manual system can be checked on inception
viii) Accounting system not properly set up to meet the requirement of the business due to
badly programmed or inappropriate software or hardware or personnel problems can
caused more havoc , where manual system does not have such problem.
ix) Danger of computer fraud if proper level of control and security whether internal and
external are not properly been instituted, where manual system does not have such
problem.
b) Test checking and routine checking can be distinguished on the basis of following points:
i) Concept: Test checking involves selecting a few transactions on the basis of auditors
judgment and examining them. But routine checking involves checking of books and
records.
ii) Object: The main object of test checking is to form an opinion on the financial statements
on the basis of examination of selected sample. While the main object of routine
checking is ensuring arithmetical accuracy of the entries in the original books and ledgers
and posting to correct ledgers accounts.
iii) Relationship: Routine checks may be performed on the basis of test checking.

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