CAF 08: Audit and Assurance

Suggested Solution – Term Test # 1

Answer # 1
(a)
Company A:
Materiality = Rs. 864 million* 5% = Rs. 43.2 million(01 mark).

Company B:
Materiality = Rs. 571 million* 1% = Rs. 5.71 million(01 mark).

(b)
Company A - Reasons for selection of Profit before Tax as Benchmark:
1. Company A is a profitable entity(01 mark).
2. Company A has consistent financial results(01 mark).
3. Company A is substantially financed by Shareholders (with 90% equity financing) (01 mark).
Therefore, appropriate benchmark is Profit before tax in this case(0.5 mark).

Company A - Reasons for selection of Net Assets as Benchmark:

1. Company B is a loss-making entity(01 mark).
2. Company B has volatile financial results (with sudden fluctuations) (01 mark).
3. Company B is substantially financed by Creditors (with 85% debt financing)(01 mark).
Therefore, appropriate benchmark is Net Assets in this case(0.5 mark).

(c)
How Performance Materiality can be calculated for Company A:
Determination of performance materiality is not a mathematical calculation. It involves the exercise of
professional judgment(01 mark) and is affected by:
• misstatements identified in previous periods(0.5 mark); and
• expected misstatements in current periods(0.5 mark).

Marking Plan:

(a) 01 mark for calculating materiality of each company 2.0 marks

(b) 01 mark for each reason for selecting the appropriate benchmark 7.0 marks
(c) Discussion on how to calculate the performance materiality 2.0 marks

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 CAF 08: Audit and Assurance
Suggested Solution – Term Test # 1
Answer # 2
Risk
Risk Factor: Significant investment in
Plant & Machinery:
There is a risk of misclassification between
capital and revenue expenditure.
Risk Factor: Inventory is located at
various locations:
It will be difficult for auditor to verify
existence and completeness of inventory.
Risk Factor: New accounting system has
been launched:
There is a risk that opening balances have
not been transferred accurately and
completely into new accounting system.
Risk Factor: Company pays additional
bonus on achievement of sales goals:
Sales may be overstated due to recording of
fake sales or next year's sales recorded in
current year.
Risk Factor: There is stock of old and
defective goods returned by customers:
Stock may not have been recorded at lower
of cost and NRV. Further, sales return may
not have been appropriately recorded.
Marking Plan:
• 01 mark for identification and discussion of each risk factor.
• 0.5 mark for each Key Audit procedure to address the issue identified.
Response
• Compare actual expenditure on Plant and Machinery
with budget. Investigate unusual fluctuation.
• Select a sample of cost incurred, and check with
supporting documents to ensure expense has been
properly classified.
• Select a sample of locations to be physically
inspected by auditor. Conduct simultaneous stock
checking for selected locations.
• For locations not selected for stock-count, compare
inventory level with previous periods. Obtain
working papers of internal auditors, if relevant.
• Auditor shall inspect system notes of new
accounting system and shall test control over its
implementation.
• Auditor shall compare the balances of new system
with old system to identify issues in processing of
accounting system.
• Discuss reasons for the increase in revenue with
management.
• Perform cut-off test
• Select a sample of significant revenue recorded and
check their supporting documentation.
• Check any returns after the year end.
• Send confirmation letters to major debtors.
• Obtain and inspect aged inventory report and
review for evidence of slow-moving/obsolete
inventory.
• Inquire client about calculation of NRV of
inventory (particularly of defective inventory), and
check reasonableness of the basis of calculations
(e.g subsequent sale price of inventory).
• Ensure sale has been reversed for all returned
items.
4.0 marks
4.0 marks
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 CAF 08: Audit and Assurance
Suggested Solution – Term Test # 1

Answer # 3

Sr. # Business Risk Audit Risk

1. Competition is increasing in the
market due to entry of new players,
and expansion of operations by
existing competitors.
Needs and preferences of consumers
are continuously changing.
2. Expired material may be used in
production process, resulting in
harm to consumers.
3. AL has to import its raw material for
new products, therefore it is exposed
to foreign currency risk because of
the fluctuation in exchange rates.
4. New ERP system may not be
correctly implemented, and staff may
not be properly trained.
5. Due to bank loan, AL will now have
to manage its debt load and all the
terms and conditions of that loan.
As revenue from existing products is
decreasing, AL's equipment will need to be
tested for impairment and its inventory will
need to be written down to NRV.
There may be undisclosed penalties from food
authorities.
A contingent liability may arise and not
disclosed relating to any legal action taken by
consumers harmed from use of expired
material.
There is a risk that trade payables may not be
translated using the correct exchange rate.
Exchange gain/loss may not be calculated
correctly.
There may be error/omission in transferring of
amounts from old system to new system.
New system may incorrectly process
transactions.
In order to meet bank's covenants, APL may
overstate its revenue or understate its expenses
to depict a better picture to its lenders.

Marking Plan:

• 01 mark for identification and discussion of each business risk. 6.0 marks
• 01 mark for identification and discussion of each Audit risk. 6.0 marks

Answer # 4

Pollen plc (Pollen)

1. Regulatory action pending against company is a significant uncertainty which requires disclosure in
financial statements(01 mark) (not a misstatement if it is adequately disclosed in financial statements).
2. Auditor shall express unmodified opinion on financial statements. (01 mark)
3. Suspension of license casts doubt on entity's ability to continue as going concern as 65% of firm's
annual revenue is lost. (0.5 mark) Auditor shall include a separate section in audit report with heading
"Material uncertainty related to Going Concern"(0.5 mark) to:
• Draw attention to the note in the financial statements that discloses the matters(0.5 mark); and
• State that these events or conditions indicate that a material uncertainty exists that may cast
significant doubt on the entity's ability to continue as a going concern(01 mark) and
• State that auditor's opinion is not modified in respect of the matter. (0.5 mark)

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 CAF 08: Audit and Assurance
Suggested Solution – Term Test # 1

Bloome plc (Bloome)

1. This is a misstatement(0.5 mark) in financial statements because management has not recorded
depreciation which is required by IFRS.
2. Effect is material(0.5 mark) as amount of misstatement 140,000 (£2.8 million/10%)(0.5 mark) is greater
than materiality level determined using rule of thumb 65,000 (1,300,000 5%)(0.5 mark).

3. Auditor shall express qualified opinion on financial statements (as effect is material but not
pervasive) (0.5 mark). Auditor shall also describe nature of misstatement in Basis for Qualified Opinion.
(0.5 mark)

Answer # 5

1. Significant related party transactions indicate risk of material misstatement.

2. Incentive/Pressure on management to achieve financial goals increases risk of fraud.
3. This indicates that Management's integrity is in doubt. Auditor should consider its impact on
engagement acceptance and continuance. There may also exist some undisclosed contingencies or
unrecorded liabilities due to non-compliance with laws and regulations.
4. Does earnings of the company and earnings of the Charles justify his 'extravagant' living standard.

Answer # 6

1. Existence and Completeness of Inventory:

NFL has various restaurants located in all major cities of Pakistan, which makes it difficult for auditor to
verify existence and completeness of inventory simultaneously at year-end on all locations.

2. Exchange Rate Risk:

During the year, NFL has been importing raw material. Due to foreign currency transaction, there may
be errors in conversion of foreign currency into local currency. Further, translation of foreign currency
payables into local currency may not be appropriately recorded.

3. Excessive Cash in Hand:

Significant transactions of NFL are conducted in cash, particularly at weekend. Existence of excessive
cash in hand may cause theft or misappropriation of cash.

4. Valuation of Inventory:
There is a risk of expiry of stock in a food chain restaurant, particularly when 2 of the restaurants are not
segregating expired stock separately. Some obsolete stock may be included at cost in valuation of
inventory.

Further, decrease in demand of product may also cause obsolescence of some inventory items.

5. Non-compliance with laws and regulation:

Expired stock may be harmful to the health of customers. NFL is not segregating expired food from
fresh food. Food authorities may take adverse actions against NFL on inspection which may result in
fines and penalties as well as cancellation of license.

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 CAF 08: Audit and Assurance
Suggested Solution – Term Test # 1

6. Impairment of Property. Plant and Equipment:

Value in use of machinery and equipment has reduced due to decrease in demand of product due to
recession in economy. This may cause impairment loss due to under-utilization of machinery.

7. Risk of fraudulent financial reporting:

Decrease in profits, due to decrease in demand and increase in cost of production, may put pressure on
management to engage in fraudulent financial reporting to show better performance in financial
statements.

Marking Plan:

• 01 mark for identification of each audit risk. 6.0 marks

Answer # 7
1. Arrangement concerning involvement of predecessor auditor (because this is the first year of audit).
2. Arrangement concerning involvement of expert (because client has revalued property, which may
involve use of expert).
3. Reference to the expected form and content of any report to be issued by auditor (because change in
accounting policy from cost to revaluation model may require Key audit matter in report).
4. Expected date of completion of audit (to ensure appropriate deadline is agreed between parties).
5. Timely availability of financial statements, and arrangement regarding interim audit (to meet
deadline).

Marking Plan:

• Up to 01 mark for each matter to be included in the engagement letter 4.0 marks

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