ATC

paper 2.6
Part 2

Audit and
Internal Review

Monitoring Test 1F Answers

& Marking Scheme

MT2.6Z011F-A

The model answers to the questions are longer

and more detailed than would be expected from a
candidate in the examination. However, the model
answer may not include all valid points mentioned
by students – credit will be given to students
mentioning such points.

The model answer may be used as guide to the form

and standard of answer students should aim to
achieve.

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1 STAR RECORDS

(a) (i) Additional information

Tutorial note: Q said “list” rather than describe – so bullet points should be concise.

The company’s constitution (eg Memorandum and Articles of Association).

Organisation structure, key personnel and their previous experience in the record
industry.

Terms of engagement (including any additional services) as documented in the

engagement letter.

Draft contract agreements with artists/bands.

Names of artists/bands and titles of their singles and albums.

The company’s bankers and legal advisors.

Customer base.

Terms of “sale or return” agreements with major customers (eg Virgin).

Nature of the accounting and internal controls systems (eg manual or computerised).

Any management accounts prepared to date (including any forecasts prepared to

obtain loan finance).

How royalties are accounted for.

Directors’ plans for signing up new artists/bands.

Basis of calculating production cost of records (eg hire of studio, equipment,

backing vocals, reproduction costs, etc).

Nature of promotional costs (eg advertising, videos, entertaining).

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(a) (ii) Key dates

Financial year end/balance sheet date (eg 31 December 2001).

Reporting deadline for issue of financial statements and Annual General Meeting.

Interim visit(s) to obtain additional information, document the accounting and

internal control system (and perform tests of controls if appropriate).

Attendance at physical inventory count (of records, tapes, CDs etc and promotional
material) – most likely to be at balance sheet date.

Draft financial statements to be ready for audit.

Supporting schedules and analyses to be prepared by client for audit purposes.

Manager and partner review dates.

“Audit clearance” meeting with directors/approval of financial statements.

(b) Potential risks of misstatement Why cause for concern

Promotion and advertising

Expenditure may be understated and
assets overstated if such expenditure is
imprudently carried forward.
Inventories
This is likely to be the most material item of
expenditure in the financial statements, as
promotion is the company’s main activity.
Costs should only be carried forward to the
extent that it is probable that they will be
recovered against future revenues.
Much of this expenditure is likely to represent
“entertaining”. Due to the uncertainty of this
resulting in future revenue, it may be prudent to
expense it in the period in which it is incurred.

Inventories may be materially overstated
if inadequate provision is made to write
them down to net realisable value
(NRV) per IAS 2.
Inventory held on sale or return at retail
outlets at the balance sheet date should
be included in year end inventory.
NRV of records no longer in the charts and
returns by retail stores may be $nil.
The accuracy of returns from retail outlets will
need to be verified to confirm cutoff between
inventory/receivables/sales.

 Accountancy Tuition Centre (Overseas Courses) Ltd 2001 3

Revenue recognition
Record sales may be overstated in
respect of “sale or return” sales to
certain retail outlets.
Royalties receivable
Royalties receivable will be a material
source of income and may be misstated
(eg due to “cutoff” error).
Royalties payable
Royalties payable will be a material
item of expenditure. If underpaid,
unrecorded liabilities will arise. Any
overpayments will have to be detected
before they can be recovered.
Going concern
Assets may be overstated (and liabilities
understated) if the going concern basis
is not appropriate.
Tutorial note: It is important not to labour just one or two issues (eg going concern) at the expense of
dealing with the specific risks of misstatement in revenue, expenditure (royalties and advertising) and
inventory.
1
Tutorial note: For example, Performing Rights Society, Mechanical Copyright Protection Society
 Accountancy Tuition Centre (Overseas Courses) Ltd 2001
The accounting policy for recognition of record
sales income should be prudent. For example, if
it is customary for the retail stores to make
returns, revenue should not be recognised until
sales have been made.
Star Records will rely on periodic statements
from various societies1 to determine royalties
due. The year end accrual (an accounting
estimate) may be misstated because the
statements do not coincide with Star Record’s
year end and are received months in arrears.
Artists will receive a proportion of the
performing and copyright royalties which Star
Records receives. Each artist/band will have its
own contractual rights to royalties and hence
errors in calculations could arise. (However,
royalties payable on record sales will be
relatively straightforward.)
As a rapidly expanding new company, there is a
risk that the company may overtrade/lose control
over its cash flow.
Due to the unpredictability of the level of activity
of operations in the music industry, it is likely
that Star Records did not forecast (and hence
arrange finance for) instant success.
The company’s continuing success may be
dependent on its managing directors staying with
the company.
Current success is based on a currently
fashionable sound which may, just as quickly,
become unfashionable.
4
2 SLIPPER
(a) Weaknesses
Segregation of duties
One individual has authority for placing
orders, receiving GRNs, approving accounts
payable ledger output and determining
payments to suppliers.
Exception reports and accounts payable
printouts are not independently reviewed by
the accounts department.
Lack of order documentation
Goods are ordered by telephone with
subsequent fax confirmation.
Updating of inventory records
Weekly inventory file update uses details of
order quantities rather than goods physically
received.
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(b) Consequences
Financial loss may result due to payments
being made in error (eg for goods and
services not received or overcharged).
Systematic errors (for example) may not be
detected. Any over-payments arising as a
result may not be recovered.
A fax confirmation is unlikely to be a
reliable source document for subsequent
checking of deliveries and invoices.
Disputes may arise with suppliers over
quantity or price of goods ordered if fax
quality is poor.
Inventory record quantities do not show
physical inventory and are not adequate for
management or accounting purposes. In
particular, goods ordered may not actually
be received or alternatives substituted.
5
(c) Recommendations
Greater segregation of duties is required in the
purchasing department (eg an accounts payable
ledger controller could determine payment for
subsequent authorisation by a senior member of
the accounts department).
All exception reports and accounts payable
printouts should go to the accounts department
for review and correction prior to re-input.
All orders should be documented on a pre-
numbered 3-part company order. The top copy
for the supplier, part 2 to the warehouse and part
3 to accounts department.
The inventory file should be updated using GRN
information. The accuracy of the inventory
ledger quantities should be confirmed (eg by
periodic physical inspection and discrepancies
investigated).
Goods received procedures
Goods receipts are accepted without
reference to the authorised order to check
quantity and quality of goods.
Suppliers’ invoices
Suppliers’ invoices are amended prior to
processing.
No purchase invoice register (or day book)
is apparently maintained.
New ledger accounts
New payable ledger accounts are set up
without authorisation.
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Financial loss may arise due to:
− goods of inferior quality being
received;
− acceptance of goods not ordered.
Disputes may arise with suppliers if, for
example, credit notes are not sought by
recognised procedure.
If purchase invoices are lost/ processing
delayed:
− purchases and accounts payable may be
understated at year-end;
− disputes may arise over subsequent
non-payment.
Financial loss may arise if, for example
− cash purchase invoice (ie already paid);
− supplier’s terms are unfavourable.
6
On receipt of goods, the warehouseman should
check to the copy order the description, quantity
and quality of goods. Any shortages or
discrepancies should be recorded on the
supplier’s delivery note and promptly notified to
accounts.
Disputed invoices should be notified to suppliers
and separately filed awaiting revised
invoices/credit notes.
Purchase invoices should be logged or registered
and given a sequential number so that the total
liability to a supplier may be accurately determined.
New accounts should be authorised by a director
before purchases are ordered.
Suppliers payment procedure
Cheque signatories do not refer to the
accounts payable ledger or source
documentation.
The directors signing the cheque do so
without reference to the accounts payable
ledger or source documentation.
Suppliers’ statement reconciliations
There are no reconciliations of suppliers’
statements with the accounts payable ledger
balances.
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Working capital may not be managed to best
effect, eg:
− discount opportunities may be
foregone; and
− supplier goodwill may be lost if credit
terms are over-extended.
Errors and omissions could go undetected
resulting in:
− overpayments to suppliers;
− misstatement at the year-end (cutoff
error).
7
The directors should authorise payment of
suppliers by reviewing supporting
documentation:
− authorised order;
− GRN; and
− approved invoices;
before signing cheques.
Suppliers’ statements should be compared to
accounts payable and reconciliations produced
monthly. The reconciliations should be
independently reviewed to ensure that
discrepancies are resolved.
3 RUFF

Tutorial note: Part (a) is not client-specific, so the requirement is potentially wider than if it was asked
in the context of the scenario in (b).

(a) Matters to be considered in the audit of depreciation

The client’s procedures for determining the depreciation charge should be identified
and evaluated. In particular:

− depreciation should be allocated on a systematic basis over useful lives;

− the useful economic lives of the various classes of non-current assets must
be finite and reviewed periodically;

− the estimates of residual values must be reasonably accurate and

consistently determined.

The treatment of disposals must be appropriate and consistently applied.

Accumulated depreciation brought forward in the current year should agree with
that carried forward in the previous year.

Calculations should be checked for numerical accuracy.

The accounting policy should be consistent with previous years and comply with
IAS 16 Property, Plant and Equipment and IAS 4 Depreciation Accounting.

Disclosure should include:

− depreciation methods;
− useful lives or depreciation rates used;
− total depreciation allocated for the period;
− the gross amount of depreciable assets and the related accumulated
depreciation;
− any change in residual values, useful lives or depreciation method having
a material effect on the accounting estimate (ie depreciation).

 Accountancy Tuition Centre (Overseas Courses) Ltd 2001 8

(b) Sources of evidence

Management

The consideration which management gives to estimating useful economic lives, eg:

whether there is a blanket policy or consideration is on an asset by asset basis;

the replacement policy used for assets. (Are assets being replaced before the end of
their useful lives, or being used when fully depreciated?)

These points will be confirmed, for example, by examining profits/losses on sales of non-
current assets.

Management’s procedures for monitoring changes in estimated useful lives resulting from
damage, obsolescence or accelerated wear and tear.

Client’s records

Comparison of annual hire charges with cost. High annual recovery of cost possibly suggests
that an asset is being used heavily over a short time.

Examination of hiring records to see whether seasonal usage needs to be taken into account
and whether aged assets are less popular with hirers.

Analytical procedures on depreciation comparing with previous years and policy rates.

Review of maintenance records to determine whether any assets are uneconomic and should
be sold or scrapped.

The evidence from clients records is largely based on analytical procedures. To make it
sufficient evidence the auditor needs to:

− assess the reliability of the records from which the information is taken; and
− obtain corroborative evidence from management or external sources for any
deviations from expected results.

External

Evidence from outside Ruff may be persuasive as to the appropriateness of useful lives. This
may be gained by examination of records and statistics or by direct communication. For
example:

− hire industry statistics may indicate appropriate useful lives and hire charges for
specific types of asset;
− examination of accounting policies of similar organisations;
− review of correspondence with customers paying special attention to complaints and
the need for repairs. (To what extent do these increase with the age of the hired asset?)

Direct communication

With experts – possibly hire industry experts in the accountancy profession, and engineers.
Possible examination of equipment by experts to determine the remaining useful life of the
assets.

 Accountancy Tuition Centre (Overseas Courses) Ltd 2001 9

 Marking scheme

For most questions the marking scheme suggests you award 1 mark a point. However, the mark you
award for each point will depend on its relevance and the depth of the student’s discussion. So, a brief
point may be worth 1/2 mark or less while a point with a longer and deeper discussion could be worth 2
marks.
Also, marks are not allocated to specific points, as the student may mention a valid point which is not
given in the model answer – obviously the student should be given credit for the point.
Many questions require the students to include a range of points in their answer, so an answer which
concentrates on one (or a few) points should normally be given a lower mark than one which considers
a range of points.
Finally, in awarding the mark to each part of the question you should consider whether the stand of the
student’s answer is above or below a pass grade. If it is of pass standard it should be awarded a mark of
50% or more, and it should be awarded less than 50% if it does not achieve a pass standard. When you
have completed marking a question you should consider whether the total mark is fair. If you decide
the total mark is not a proper reflection of the standard of the student’s answer, you should review the
student’s answer and adjust marks, where appropriate, so that the total mark awarded is fair.

Marks Marks
Question 1

(a) (i) Additional information

Generally ½ mark a point up to a maximum 5
Ideas:

documentation for PAF, explanations (oral),

details, analyses (written), etc

(a) (ii) Key dates

Generally 1 mark each up to a maximum of 3

(b) Potential risks

Generally 1 mark a risk + 1 mark a reason up to a maximum of 12

Risk areas SPECIFIC to Star Records:

− – promotion + advertising
expenses
− – inventories
− – royalties receivable/also
payable
− – revenue recognition
− – going concern

____

20
____

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 Marks Marks
Question 2

For each internal control weakness comprising:

(a) specific weakness; ½ 4 max

(b) consequence explaining risk; and 1 8 max
(c) appropriate recommendation (ie practical) 1 8 max

Areas of system – segregation of duties

– ordering
– inventory updating
– goods received
– suppliers’ invoices
– credit payments

Risk areas – incomplete

– inaccurate
– invalid

Recommendations – select controls from control

environment + PAC-A-
MAC (mnemonic for
control procedure
identified in ISA 400)

Presentation – appropriate format (eg three columns) 1

– professionalism of writing and persuasiveness 1 2
____ ____

max 20
____

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 Marks Marks
Question 3

(a) Matters
Generally ½ mark each matter identified and comment thereon
up to a maximum 4
Ideas:

(CAVe) – completeness
– accuracy (eg of disclosure)
– validity (eg comparability worth prior year)

(b) Sources of evidence

Generally ½ mark each source identified and comment thereon
up to a maximum of 2 each source 6

Ideas:

– internal/external
– oral/written
– auditor-generated

____

10
____

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