Peony Co has an internal audit (IA) department which undertakes controls testing across the network of stores.

Each
store is visited at least once every 18 months. The audit manager has discussed with the finance director that the
external audit team may rely on the controls testing which is undertaken by IA.
During the meeting, the finance director provided some forecast financial information. Revenue for the year is
expected
to increase by 3% as compared to 20X8; the gross margin is expected to increase from 56% to 60%; and the
operating
margin is predicted to decrease from 21% to 18%.
Peony Co values inventory in line with industry practice, which is to use selling price less average profit margin.
The
directors consider this to be a close approximation to cost.

The company does not undertake a full year-end inventory count and instead undertakes monthly perpetual
inventory counts, each of which covers one-twelfth of all lines in stores and the warehouses. As part of the interim
audit which was completed in January, an audit junior attended a perpetual inventory count at one of the warehouses
and noted that there were a large number of exceptions where the inventory records showed a higher quantity than
the physical inventory which was present in the warehouse. When discussing these exceptions with the financial
controller, thea udit junior was informed that this had been a recurring issue.

During the year, IA performed a review of the non-current assets physically present in around one-third of the
company’s stores. A number of assets which had not been fully depreciated were identified as obsolete by this
review.

The company launched a significant TV advertising campaign in January 20X9 in order to increase revenue. The
directors have indicated that at the year end a current asset of $0·7m will be recognised, as they believe that the
advertisements will help to boost future sales in the next 12 months. The last advertisement will be shown on TV in
early May 20X9.

Peony Co decided to outsource its payroll function to an external service organisation. This service organisation
handles all elements of the payroll cycle and sends monthly reports to Peony Co which detail wages and salaries and
statutory obligations. Peony Co maintained its own payroll records until 31 December 20X8, at which point the
records were transferred to the service organisation.

Peony Co is planning to expand the company by opening three new stores during July 20X9 and in order to finance
this, in March 20X9 the company obtained a $3m bank loan. This is repayable in arrears over five years in quarterly
instalments.

In preparation for the expansion, the company is looking to streamline operations in the warehouses and is planning
to make approximately 60 employees redundant after the year end. No decision has been made as to when this will
be announced, but it is likely to be in May 20X9.
Risk Rsponse
The External Audit team may place realiance on The External Audit team must meet the Internal
the reports of Internal Audit Department. audit, read their reports and revies their files of
If realiance is placed on irrelevant and poorly store visit to asseertaint the nature of the work
performed testing than the external audit team undertaken
may form an incorrect conclusion on the strength
of internal control a t Peony co.
This could result in them performing insufficient
substantive testing which will increase the
detection risk
As per finance director the the gross profit margn The classification of cost of sales and operating
is expected to increase from56% to 60%, and the expense must be compared with those of last
operating profit margin is expected to Decrease year and any inconsistanices identified must be
from 21% to 18%.
There is a risk that the cost directly attributable
to sales might be classified and accounted as
administration or operating expense which could
under state the cost of sales and overstate the
operating expenses
Peony company values it inventory using selling
price minus average profit margin.
IAS 2 inventories allows to value inventory lower
of cost and net realisable value (NRV) unless it is
close approximation to cost. If this is not the
case, this will result in under and overvaluation of
inventory.
During the year, IA performed a review of the non-
current assets physically present in around one-third of
the company’s stores. A number of assets which had
not been fully depreciated were identified as obsolete
by this review.
During a review of IA on one third of the
company stores, a number of assets which were
not fully depreciated were identified as obsolete.
This is an indication that the depreciation policy
of the company is not properly applied or the
policy its self is not appropriate
This could result in the overstatement of asset
and understating depreciation
Peoncy Company has included a sum of 0.7m as
non-current asset, amount is sepent on TV
advertising and there is no basis for this to be
included in Non-currents assets.
Classifiying an expense as asset will overstate
assets and profit.
During the year peony Co has outsourced its
payroll department to an external service
provider. Detection risk may arise that whether
sufficient approporiate evidence are available to
confirm the accuracy and completeness of
controls over the payroll cycle and liabilities at
the year end.
Peony Company has obtained a $3m loan in order
investigated
Testing should be undertaken to confirm the cost
and NRV of the inventory.
On sample bases test that few items of the
inventory to confirm that the current valuation
method is the close approximation to cost.
Discuss the depreciation policy with the finance
director and assess its reasonableness. Enquire
the finance director that whether an obsolete
asset have been identified and written off, review
the adjustment for completeness.
The recognistion must be dissucussed with the
finance director and must be asked for
reasonable ground to justify this by. Request the
management about the supporting documents
which prove the probable inflow of the economic
benefits which will flow in the future.
Review the documentation which will prove that
the expenditure was incuured before 31 May
2009.
Request management to remove the current
asset form Balance Sheet and charge it to profit
or loss to be expensed out
Disscuss with management the availability of
records since Janayry 2009 and monitoing
controls undertaken by management over the
payroll.
Consideration must be given to contacting the
auditor of the service organisation to confirm the
controls in place, requesting them to provide
Type 1 and Type 2 Reports.
Reperform the calculation and confirm the
 to expand its operations.
The finance department need to disclose the loan
adequately and allocate the loan between
current and noncurrent liabilities correctly. If this
is not so there will be a misclassification of
liabilities.
During
classification between current and non current
liabilities, ascertain the total of $3m is actually
received by Peony Company.
In addition the disclosure of the loan must be
review to confirm to ensure compliance the
relevant accounting standard.

17 You are an audit senior of Loganberry & Co and are planning the audit of Blackberry Co for the year
ending 31 March

20X8. The company is a manufacturer of portable music players and your audit manager has already had
a planning meeting with the finance director. Forecast revenue is $68·6m and profit before tax is $4·2m.

She has provided you with the following notes of the meeting:

Planning meeting notes

Inventory is valued at the lower of cost and net realisable value. Cost is made up of the purchase price of
raw materials and costs of conversion, including labour, production and general overheads. Inventory is
held in three warehouses across the country. The company plans to conduct full inventory counts at the
warehouses on 2, 3 and 4 April, and any necessary adjustments will be made to reflect post year-end
movements of inventory. The internal audit team will attend the counts.

During the year, Blackberry Co paid $1·1m to purchase a patent which allows the company the exclusive
right for three years to customise their portable music players to gain a competitive advantage in their
industry. The $1·1m has been expensed in the current year statement of profit or loss. In order to
finance this purchase, Blackberry Co raised $1·2m through issuing shares at a premium.

In November 20X7, it was discovered that a significant teeming and lading fraud had been carried out by
four members of the sales ledger department who had colluded. They had stolen funds from wholesale
customer receipts and then to cover this, they allocated later customer receipts against the older
receivables. These employees were all reported to the police and subsequently dismissed. As a result of
the vacancies in the sales ledger department, Blackberry Co decided to outsource its sales ledger
processing to an external service organisation. This service organisation handles all elements of the sales
ledger cycle, including sales invoicing and chasing of receivables balances and sends monthly reports to
Blackberry Co detailing the sales and receivable amounts. Blackberry Co ran its own sales ledger until 31
January 20X8, at which point the records were transferred to the service organisation.

In December 20X7, the financial accountant of Blackberry Co was dismissed. He had been employed by
the company for nine years, and he has threatened to sue the company for unfair dismissal. As a result
of this dismissal, and until his replacement commences work in April, the financial accountant’s
responsibilities have been adequately allocated to other members of the finance department. However,
for this period no supplier statement reconciliations or purchase ledger control account reconciliations
have been performed.

In January 20X7, a receivable balance of $0·9m was written off by Blackberry Co as it was deemed
irrecoverable as the customer had declared itself bankrupt. In February 20X8, the liquidators handling
the bankruptcy of the company publicly announced that it was likely that most of its creditors would
receive a pay-out of 40% of the balance owed. Asa result, Blackberry Co has included a current asset of
$360,000 within the statement of financial position and other income in the statement of profit or loss.

Required:

(a) Describe Loganberry & Co’s responsibilities in relation to the prevention and detection of fraud and
error.

(4 marks)

(b) Describe EIGHT audit risks and explain the auditor’s response to each risk in planning the audit of

Blackberry Co.

Note: Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.

(16 marks)

Risk
Balckberry Company values its inventory at lower
of cost and Net realaisbale value.
IAS 2 Inventory states that in the valuation of
goods or services those costs be taken into
account which bring the inventory into present
condition which includes material, labour,
production overheads. But Blackberry also
included the general overheads which might
consist of administration overheads which does
not meet the criteria of the relevant accounting
standard (IAS 2). If these overheads are included
in the value of inventory there is a risk that the
value of inventory will be overstated.
Response
Discuss with management about the nature of
general overheads. If general overheads are
included in inventory valuation, request the
management to remove it.
Obtain the supporting documents of general
overhead and observe if any of the general
overheads consist production overheads, which is
valid to be included in costing the inventory.

As the inventory is held in multiple warehouses,

there is continues movements of inventory The auditor must attend the inventory count,
among the ware houses, this may result in over held after the year end, and note the goods
and understating of the inventory. received and despatched post year end ,in order
If the movements are adjusted for, the inventory to agree to the reconciliation.
count may not meet the numbers in the company
list, due to possible weak control over
warehouse, this also will result in the inventory
overstatement.
The inventory might be obsolete or damaged, in
this case the inventory may have no value, this
could also result in inventory overstatement.
Blackberry Co. has paid $1.1m to obtain a patent
which a an useful life of three years. The patent
must be capitalised in accordance with IAS 38
Intangible asset in statement of Financial Position
and must be amortised over its useful life of
three years.
If the cost the patent is expense out it shows the
failure of the company to comply with IAS 38 and
will result in understatement of asset and
overstatement of expenses
During the year Blackberry has raised new
finances by issue new shares at a premium. This
need to be accounted for correctly with adequate
disclosure made and the equity finance need to
be allocated correctly between share capital and
share premium.
If this is not done than the account may be
misstated due to the lack of disclosure or share
capital or share premium may be misstated.
In November 20X7, it was discovered that a
significant teeming and lading fraud had been
carried out by four members of the sales ledger
department who had colluded. They had stolen
funds from wholesale customer receipts and then
to cover this, they allocated later customer
receipts against the older receivables.
In Novemeber 2007, it was discovered that a
significant teeming and lading fraud had been
carried out by four members of the sales ledger
department.
There is a risk that the full impact of fraud have
not been quantified, and any additional
fraudulent transaction would need to be written
During the final audit the year end inventory
adjustment must be reviewed in detail and
agreed to supporting documentation obtained
during inventory count for all adjusting items.
The audit team should increase the inventory cut
off date testing at the year end and at the date of
count.
The audit team will need to obtain supporting
documents in order to confirm that the patent
acquired actually cost 1.1m and check with the
contract to ensure the right of use for three
years.
Disscuss with management for the reason of
expensing out the patent and request them to
treat the patent correctly.
Review the correct journal entry for capitalising
the patent and recalculate the amortisation for
the period in order to ensure accuracy and
compliance with relevant accouting standard
The audit team must ensure that proceeds of
$1.2m have been received and split between
share capital and share premium. In addition
disclosure for this finance must be reviewed in
detail to ensure compliance with relevant
accounting standard.
Discuss with finance director what procedures
the have adopted to full identify and quantify the
impact of teeming and lading fraud. In addition
discuss with finance director what controls have
been put in place to identify any similar fraud.
Review the receivable listing to identify any
unusual posting to the receivebale balances as
this could be further evidence of fraudulent
transactions.
In addition the team should maintain their
professional scepticism and be alert to any risk of
further fraud and errors
off in the statement of Profit or Loss. If these
transaction have not been uncovered the
financial statement could be misstated.
In addition individual receivable balances may be
under/over stated as customer payment receipt
have been miss allocated to other customers.
During the year Blackberry Co has outsourced the
sales ledger processing department to an
external service organisation. There is a high
detection risk as that sufficient approporiate
evidence are available with Blackberry to confirm
the accuracy and completeness of controls over
the sales and receivable balances
The sales ledger is transferred to service
organisation from 1 Feb 2008, if any errors
occurred during the transfer process this could
result in over/understatement of sales or
receiables.
In December 2007 Blackberry Co dismissed it
financial accountant and he is threatened to sue
the company for unfair dismissal.
If it is probable that Blackberry will make a
payment to the financial accountant for unfair
dismissal, a provision is required.
It the payment is possible rather than probable a
contingent liability disclosure will be necessary.
If Blackberry co has not done so there is risk over
the completeness of any provision and
contingent liabilities.
No supplier statement or purchase ledger control
account reconciliation have been performed in
the period from Decemebr 2007 till the year end.
This is key control which is overridden and as
such there is an increased risk of errors and might
result in the over/undersatetment of purchase
and payable balances
The Amount of 0.9m written off after the
customer declared itself bankrupt. The liquidator
Discuss with management the extent of records
maintained by the management from the start of
February and any monitoring controls
undertaken by the management over sales and
receivables.
Consideration should be given to contacting
service provide auditor to confirm the level of
controls in place.
Discuss with management the transfer process
undertaken and any controls put in place to
ensure the completeness and accuracy of data.
Where possible under take the test of controls to
confirm the effectiveness of transfer controls.
In Addition perform substantive testing of the
transfer of information from old to new system
The audit team must request a confirmation from
the company’s lawyer of the existance and
likelihood of success of any claim from the
former financial accountant.
After confirmation with the lawyer, request
management to comply with IAS 37.
The audit team should increase their testing on
trade payables at the year end including
performing supplier statement reconciliations
with a particular focus on completeness of trade
payables.
Request from Management
 of the customer publicly announced that the
creditor of the customer can receive 40% of their
receivable balance. Therefore Blackbeey Co has
included $360,000 in current asset in Satement of
financial postion and other income in the profit
and loss.
As the announcement has made publicly to all
creditors, no notification has been addressed to
the Blackberry company, this will represent a
possible contingent asset. As per IAS 37 this
should be recognised until the payment is
virtually certain, otherwise this will overstate
profit and current asset.

You are an audit supervisor of Earl & Co and are planning the audit of Darjeeling Co for the year ending 30 September
20X8. The company develops and manufactures specialist paint products and has been a client of your firm for
several years. The audit manager has attended a planning meeting with the finance director and has provided you
with the following notes of the meeting and financial statement extracts. You have been asked by the audit manager to
undertake preliminary analytical procedures using the financial statement extracts.

Planning meeting notes

During the year Darjeeling Co has spent $0·9m, which is included within intangible assets, on the development of new
product lines, some of which are in the early stages of their development cycle. Additionally, as the company is looking
to expand production, during the year it purchased and installed a new manufacturing line. All costs, incurred in the
purchase and installation of that asset, have been included within property, plant and equipment. These capitalised
costs include the purchase price of $2·2m, installation costs of $0·4m and a five-year servicing and maintenance plan
costing $0·5m. In order to finance the development projects and the new manufacturing line, the company borrowed
$4m from the bank which is to be repaid in instalments over eight years and has an interest rate of 5%. Developing
new products and expanding production is important as the company intends to undertake a stock exchange listing in
the next 12 months.
The company started a number of initiatives during the year in order to boost revenue. It offered extended credit terms
to its customers on the condition that their sales order quantities were increased. In addition, Darjeeling Co made an
announcement in October 20X7 of its ‘price promise’: that it would match the prices of any competitor for similar
products purchased. Customers who are able to prove that they could purchase the products cheaper elsewhere are
asked to claim the difference from Darjeeling Co, within one month of the date of purchase of goods, via its website.
The company intends to include a refund liability of $0·25m, which is based on the monthly level of claims to date, in
the draft financial statements.
The finance director informed the audit manager that a problem arose in June 20X8 in relation to the mixing of
materials within the production process for one particular product line. A number of these faulty paint products had
already been sold and the issue was identified following a number of complaints from customers about the paint
consistency being incorrect. As a precaution, further sales have been stopped and a product recall has been initiated
for any of these specific paint products sold since June. Management is investigating whether the paint consistency of
the faulty products can be rectified and subsequently sold.

Risk
During the year Darjeeling Co has spent $0·9m, which is
included within intangible assets, on the development of new
product lines, some of which are in the early stages of their
development cycle.
Because the product lines are in the initial stage of
Response
Obtain a break down of the expenditure and verify
that the cost relates to the development of the new
product line. Review the expenditure documentation
and determine whether the cost relates to
 development, The expenditures raised may the not meet the development or research expenditure.
criteria of IAS 38. The $0.9m spent might wrongly be Discuss the accounting treatment with finance
classified as development expenditure though it may be
director and ensure that the cost is an accordance
research expenditure which do not be capitalised as asset
rather than expense. This will cause the overstatement of with IAS 38.
asset and profit.

Review the purchase documentatioan to confirm the

During the year Darjeeling company purchased and cost actually relates to the service and miantainance.
installed new manufacturing line.
According to IAS 16 the all the costs directly Discuss with finance director the correct treatment of
attributable to an asset including purchase and service and maintenance cost in accordance with IAS
installation cost must be included in the cost of the 16
asset.
Capitalising service and maintainance cost in the cost
of an asset shows a failure of compliance with IAS 16
which will result in the overstatement of asset and
understatement of expense.
The service and maitainance cost cover a period of
forthcoming five years. This should be charged to the
profit or loss on the proportion of the service period
therefore $0.5m must be divided on 5 years and which
result 0.1m in each year.
In order to finance the development projects and the new Obtain the loan contract from the management and
manufacturing line, the company borrowed confirm the loan amount, number of instalments, the
$4m from the bank which is to be repaid in instalments over
interest rate and check it with the bank statements
eight years and has an interest rate of 5%.
that the money is received.
To finance the development project the company has Verify that the loan is correctly classified between
obtained a loan of $4m from the bank which will be repaid in current and non-current liabilities and adequate
eaight years the interest rate the loan is 5%. disclosure has been made to ensure compliance with
relevant accounting standard.
The journal entry for the loan might not be properly Dissuss with management the collateral security which
passed to accounts, and may not be split between is been placed with the bank in exchange of loan,
current and non-current liabilities which will cause check that whether there is a disclosure of collateral
misclassification of liabilities asset.
The company has offered extended credit terms
to its customers on the condition that their sales order
quantities were increased.
There is a risk that customers who customers who did
not meet the sales increase condition might have
claimed the offer and use the privilege of the offer.
However those customers whose purchase
performance have the condtion of the offer may not
use the privilege of the offer.

You are an audit supervisor of Cupid & Co, planning the final audit of a new client, Prancer Construction Co, for the
year ending 30 September 20X7. The company specialises in property construction and providing ongoing annual
maintenance services for properties previously constructed. Forecast profit before tax is $13·8m and total assets are
expected to be $22·3m, both of which are higher than for the year ended 30 September 20X6.
You are required to produce the audit strategy document. The audit manager has met with Prancer Construction Co’s
finance director and has provided you with the following notes, a copy of the August management accounts and the
prior year financial statements.
Meeting notes

The prior year financial statements recognise work in progress of $1·8m, which was comprised of property construction
in progress as well as ongoing maintenance services for finished properties. The August 20X7 management accounts
recognise $2·1m inventory of completed properties compared to a balance of $1·4m in September 20X6. A full
year-end inventory count will be undertaken on 30 September at all of the 11 building sites where construction is in
progress. There is not sufficient audit team resource to attend all inventory counts.

In line with industry practice, Prancer Construction Co offers its customers a five-year building warranty, which covers
any construction defects. Customers are not required to pay any additional fees to obtain the warranty. The finance
director anticipates this provision will be lower than last year as the company has improved its building practices and
therefore the quality of the finished properties.

Customers who wish to purchase a property are required to place an order and pay a 5% non-refundable deposit prior
to the completion of the building. When the building is complete, customers pay a further 92·5%, with the final 2·5%
due to be paid six months later. The finance director has informed you that although an allowance for receivables has
historically been maintained, it is anticipated that this can be significantly reduced.

Information from management accounts:

Prancer Construction Co’s prior year financial statements and August 20X7 management accounts contain a material
overdraft balance. The finance director has confirmed that there are minimum profit and net assets covenants attached
to the overdraft.

A review of the management accounts shows the payables period was 56 days for August 20X7, compared to 87 days
for September 20X6. The finance director anticipates that the September 20X7 payables days will be even lower than
those in August 20X7.
Required:
(a) Describe the process Cupid & Co should have undertaken to assess whether the PRECONDITIONS for an audit
were present when accepting the audit of Prancer Construction Co. (3 marks)
(b) Identify THREE main areas, other than audit risks, which should be included within the audit strategy
document for Prancer Construction Co, and for each area provide an example relevant to the audit.
(3 marks)
(c) Using all the information provided describe SEVEN audit risks, and explain the auditor’s response to each risk,
in planning the audit of Prancer Construction Co.
Note: Prepare your answer using two columns headed Audit risk and Auditor’s response respectively.
(14 marks)

Risk
As Prancer Co is a new client of Cupid and Co., the audit
team is nit familiar with accounting policies, transactions
and balance s of the client, there will be an increased
detection risk.
Response
The audit team must comprise more experienced members
and sufficient time must be allocated to the team in order to
obtain the understanding of the client and to cover the risk
of material misstatement and other key risks.

Prancer Co is likely to have a material level of work in

progrees at the year end, being construction work in progress
and ongoing maintenance services, as pancer construction
company has annual contracts for many of the buildings
constructed.
The Level of work in progress need to be assessed at the
year end, assessing the percentage completion for partially
constructed building is quite subjective and the team should
consider if they required expertise to undertake this If the
percentage completed is not calculated correctly the
 inventory at the year end may be overs/under stated
prior year financial statements recognise work in progress of
$1·8m, which was comprised of property construction in
progress as well as ongoing maintenance services for finished
properties.

The August 20X7 management accounts recognise $2·1m

inventory of completed properties compared to a balance of
$1·4m in September 20X6. A full year-end inventory count
will be undertaken on 30 September at all of the 11 building
sites where construction is in progress. There is not sufficient
audit team resource to attend all inventory counts.

You are an audit senior of Scarlet & Co and are in the process of reviewing the systems testing completed on the
payroll cycle of Bronze Industries Co (Bronze), as well as preparing the audit programmes for the final audit.
Bronze operate several chemical processing factories across the country, it manufactures 24 hours a day, seven days
a week and employees work a standard shift of eight hours and are paid for hours worked at an hourly rate. Factory
employees are paid weekly, with approximately 80% being paid by bank transfer and 20% in cash; the different
payment methods are due to employee preferences and Bronze has no plans to change these methods. The
administration and sales teams are paid monthly by bank transfer.

Factory staff are each issued a sequentially numbered clock card which details their employee number and name.
Employees swipe their cards at the beginning and end of the eight-hour shift and this process is not supervised.
During the shift employees are entitled to a 30-minute paid break and employees do not need to clock out to access
the dining area. Clock card data links into the payroll system, which automatically calculates gross and net pay along
with any statutory deductions. The payroll supervisor for each payment run checks on a sample basis some of these
calculations to ensure the system is operating effectively.
Bronze has a human resources department which is responsible for setting up new permanent employees and leavers.
Appointments of temporary staff are made by factory production supervisors. Occasionally overtime is required of
factory staff, usually to fill gaps caused by staff holidays. Overtime reports which detail the amount of overtime worked
are sent out quarterly by the payroll department to production supervisors for their review.
To encourage staff to attend work on time for all shifts Bronze pays a discretionary bonus every six months to factory
staff; the production supervisors determine the amounts to be paid. This is communicated in writing by the production
supervisors to the payroll department and the bonus is input by a clerk into the system.
For employees paid by bank transfer, the payroll manager reviews the list of the payments and agrees to the payroll
records prior to authorising the bank payment. If any changes are required, the payroll manager amends the records.
For employees paid in cash, the pay packets are prepared in the payroll department and a clerk distributes them to
employees; as she knows most of these individuals she does not require proof of identity.

Control Deficiency Recommendation Test of Control