AnswersApplied Skills, AA ‘Audit and Assurance (AA) Section B Daley Co September/December 2022 Sample Answers (2) Five components of a system of internal control Component of internal control Control environment Ently's risk assessment process Entiy’s process to monitor the system of internal control Information system and ‘communication Control activities Description “The control environment includes the governance and management functions and the aitues, awareness and actions of those charge with governance and management ‘concerning the entiy’s system of internal control and its importance in the entity. The control ‘environment ses the tone of an organisation, influencing the contol consciousness of Its People and provides the overall foundation forthe operation of other components, “The control environment encompasses many elements, such as how management's responsibilities ae caried out (such as creating and maintaining the entiy’s culture and {demonstrating management's commitment to integrity and ethical values); how thase ‘charged with goverance demonstrate independence ftom management and exercise ‘oversight ofthe entity's system of internal control; how the entity assigns authority and responsibilty in pursuit offs objectives; how the entity attracts, develops and retains ‘competent individuals in alignment with its objectives; and howe the entity holds individuals accountable fo thet responsibitias in pursult ofthe entity's system of internal contol The entity's risk assessment process Is an iterative process for identifying and analysing risks to achieve the entity’ objectives and forms the basis for determining the risks to be ‘managed. For financial reporting purposes, the entity's risk assessment process includes how management identifies business risks relevant tothe preparation of financial staterents In accordance with the entiy’s applicable financial reporting tamework. It estimates their significance, assesses the lkelnood oftheir occurrence, and decides upon actions to respond to and manage them and the results thereat. Monitoring of controls isa continual process to assess the effectiveness of internal control performance over time: It involves assessing the effectiveness of controls and taking necessary remedial actions on 2 timely basis. Management accomplishes the monitoring ‘of controls through ongoing activities, separate evaluations, or a combination of the two. Ongoing monitoring activities are often built into the normal recurring activites of an entity and include regular management and supervisory activities. “The information system relevant to the preparation of the financial statements consists of the activities, policies and records designed and established to inate, record, process, and report entity transactions (as well as events and conditions) and to maintain accountability forthe related assets, labile, and equity Communication which involves providing an understanding of individual roles and responsibilities may be through policy and accounting and financial reporting manuals. It may be made electronically, orally ot through management actions. Control activites include controts which are designed to ensure proper application of policies inal te components of the entiy’s system of intemal contol and include both direct and indirect contols. Control activities include Information processing controls and general IT ‘controls and may be manual or automated in nature. They have various objectives and are applied at various organisational and functional levels. ‘They may include authorisation and approvals, reconciliations, verifications, physical or logical contols andjor segregation of duties.(©) Internal control deficiencies, controls and test of controls Control deficiency ‘Atthe end of each week, the key card system transfers the hours worked to the payroll system. As the system is automated, no checks are performed As there ate no checks performed on the transfer of hours worked from the ey card system to the payroll system, ‘errors and overpayments could be made resulting in a loss of employee goodwil ‘The paytoll clerk reperforms payrall calculations and amends the payroll data if there are any errors. The edit report of the amendments is not reviewed, ‘The payroll clerk could make errors when making the amendments or could fraudulently revise payroll data to inflate the pay of fiends or family. This could result in incorrect payments being made to employees and incorrect deductions being made resulting in loss of employee goodwill and misstated payroll expenses. The internal audit (IA) department undertakes physical veiication of assets each year. AS inthe prior years, | will only complete the comparison at one factory and one warehouse in the year ta 30 September 20X5. Daley Co has ten factories, ten warenouses and ‘a head office. Therefore, on ths basts, it will take over ten years to physically verify all 21 sites Inthe non-current assets register is not physically verified on a regular basis, mere Is an increased rsk of assets being misappropriated as there is no check thatthe assets still exist in their correct locaton. in addition, obsolete ‘assets may not be identified on a timely bass During the year, the company’s ‘accounting policy was changed by the financial controller so that tems of a capital nature are only capitalised if they exceed $20,000. While it can be normal practice for a threshold toe set for capitalisation, this represents a significant change to.an accounting policy which does ‘not appear to have been discusses of ‘approved at board level. This threshold is too high, as overtime this wil resut in a significant amount of costs which should be capitalised being writen Oto te statement of prof or loss ‘and understated property, plant and equipment. Control recommendation The transfer of hours worked from the key card system to the payroll should be checked by a senior official in the payroll department and this ‘check snould be evidenced by way ot signature, “The exit report should be reviewed ‘on a weekly basls by a senior oficial from the payroll department before the payroll i finalised and any payments ‘made, Any unusual amendments should be Investigated. This review should be evidenced likely by way cof signature) and the results of any investigations should be recorded. ‘The boatd should seta policy to ensure ‘comparisons must be carried out more frequently for example, every two years). A should review its programme Of visits to assess if addtional resources could be devoted to ensure that all 21 sites are vised In a shorter period, This ‘would ensure that physical verification cof all assets could be completed more reguiatly. During visits, any assets which cannot 'be lecated should be investigated fully to Identiy where they could be. If hey ‘cannot be located, then they should be written off ‘Significant changes to an accounting policy should be discussed and ‘approved at board level. A record of any decisions should be included in the board minutes. ‘The capitalisation limit should be reduced to a mote appropriate limit ‘such as $1,000 so that assets and profitability ate more accurately reported Test of control Review a sample of weeks transferred from the key card system to the payroll system for evidence that they have been checked by a senior official prior to the payfoll being finalised Fora sample of weekly edit reports, confirm that these have been signed as reviewed by a senior ofcial from the payroll department. For a sample cof amendments, agree to record of Investigation and confitm appropriate action taken, Review the board minutes for evidence of new policy set by the board regarding frequency of IA visits. Review IA programme to assess whether visits are In ine with new policy, Review records from physical verification Visits by A to ensure comparisons have been performed and any unigentiied and obsolete assets have been written off folowing approval by the board or a responsible official Review board minutes for evidence that changes to accounting policies have been discussed and approved, Discuss with the fnance director the capitalisation limit and fora sample of capita items over $1,000, agree that they have been correctly capitalised in the statement of financial position© Control deticiency The finance director authorises the ‘monthly supplier payments isting, but only views the total amount of payments to be made. Without looking atthe detail of the ‘payments ist, as well as supporting ‘documentation, there isa risk that suppliers could be being paid an incortect amount, or that sums are being paid to fictitious supplies. ‘There is no requitement for receipts for sundry purchases paid for aut of petty cash tobe retumed to the finance department This could result in sundry purchases being made which are for non-business related items or the cash could be being ‘misappropriated The company maintains four bank ‘accounts but only the main cutrent ‘account Is reconciled on a monthly ‘bass, withthe other three bank accounts being reconciled quarterly If all bank accounts are not reconciled (on a monthly basis, errors or fraud may ‘not be spotted on a timely basis Control recommendation ‘The finance director should review the whole payments list prior to authorising {As part ofthis, the finance director should agree the amounts to be paid to supporting documentation, as wall as ‘eviewing the supplier names to identity ‘any duplicates or any unfamiliar ‘names. This should be evidenced by signing the supplier payments listing, ‘A patty cash book should be ‘maintained so that the amount ‘borrowed, date and employee name is recorded together with details of the sundry purchase made Inaction to returning exoess cash ‘back fo the finance department, ‘employees should also be required to ‘rompity return a receipt for sundry purchases, The petty cash book should ten be updated to record the excess ‘cash and the receipt. ‘A member of the nance department should reconcile the petty cash on a Weekly basis and if any receipts are ‘missing, they should be investigated {urther with the employees who made the petty cash purchases during that week. The reconciliations shoula be reviewed by a responsible ofcal who should evidence their review. All bank accounts should be reconciled feach month and any reconciling items (on the bank reconcilaton statements Should be investigated and conrected, where necessary. The reconciliations should be reviewed by a responsible Official who should evidence their review. ‘Substantive procedures over the bank balances — Obtain a bank confirmation letter from Daley Co's bank fr allo its bank accounts, Test of control ‘A sample of payment listings should be reviewed to verify thatthe finance director has agreed the amounts payable te supporting documentation prior tothe bank transfer being made. ‘A sample of pety cash transactions trom the record book should be reviewed ‘to ensure all cash issued has been accounted for and receipts provided for expenses. AA sample of reconciliations should also be reviewed to ensure these are approved. Review a sample of bank reconciliation statements for all bank accounts to ensure they are being completed and reviewed on monthly basis, — Agree all accounts tisted on the bank confirmation letter to Daley Co's bank reconciliations and twial balance to ensure completeness of bank balances. = Obtain the year-end bank reconciliations and cast to ensure mathematical accuracy. — Agree the balance per cash book on the yearend bank reconciliation statements to the cash Dookftral balance/inancial statements. — __Aaree the balance per the bank reconciliations tothe year-end bank confirmation letter and bank statements. — Trace all outstanding lodgements/éepesits to the pre year-end cash book, post year-end bank statement and also to the ppaying-in book pre year end = Trace all unpresented cheques through to the pre year-end cash book and post yearend bank statements. For any unusual amounts or delays, oblain explanations from management — Examine any old unpresentad cheques to assess if they need to be written back to the payables ledger as they ate no longer vali, — Examine the bank confimation letter for dtals of any security provided by the company ot any legal right of set-off as this may requite disclosure — Review the cash book and bank statements for any Unusual tems oF large transfers around the year end as this may be evidence of window dressing.(@) Corporate governance deficiencies and recommendations Deficiency During the year, the Chair resigned and Fred Johnson, who ts curently the chief executive, took over the role. It Fred Johnson fs both the Chair and chief executive, he will have unfettered power of decision making and will effectively be responsible for running the company and the board, ‘The Chair recently wrote to all shareholders to inform them that any questions or comments they may have could only be ‘aged at the company’s annual ganoral meoting (AGM) Restricting shareholders to only raising concems at the AGM will not ensure regular effective engagement withthe owners of the company. This could resuft in the board making decisions which are not inline with the wishes of major shareholders ‘Non-executive droctors remuneration is based on pre-tax ‘profit targets agreed by the board atthe start ofthe year. Non-executive directors’ remuneration should not be based on pre-determined profit targets as their pay should not be based on Now the company performs as this Would reduce ther independence, ‘The company curently does not have an audit committee as the board views the internal contol environment as very effective The lack of an audit committee means there is no oversight in the company to enable the directors to discharge thelr responsibilities for accountability appropriately and there will ‘ot be @ means of the company maintaining its independent relationship with the extemal auditors. Magpie Co (2) Engagement letter purpose and matters to be included Recommendation Fred Johnson should resign as the Chair and only carry out the role of chief executive. An independent non-executive should be appointed to fil the Chair's role. The Chair of Daley Co should take steps to encourage regular effective engagement with major shareholders in addition to the AGM. This could be in the form of regular meetings and ‘would aim to seek shareholders’ views on the company’s ‘eoverance and performance against strategy. Daley Co should pay tho non-executive directors an annual {ee for thelr services tothe company and this fee should be Unrelated to the company’s financial performance, but rather based on time committed and responsibilities ofthe ole, ‘The company should consider appointing an audit committee ‘as quickly as possible. The audit committee should be ‘comprised of at least three non-executive directors and one of ‘ese non-executive directors should have recent and relevant financial expertise, The committe as a whole should have appropriate competence inthe industry “The audit engagement letter outlines the nature ofthe contract between the audit frm and the auelt client. Its purpose fs to minimise the risk of any misunderstanding of the tetms of the engagement between the auditor and the client and it confi acceptance of the engagement. The purpose of the engagement letter Is 10 also set out the terms and conditions of the engagement and the responsibilities of the auditor and management, ‘Matters which should be included in the engagement letter include: ~The objective and scope ofthe aualt; ~The auattor's responsibilities; — Management’ responsibites; — _Identicaton of te applicable tiancial reporting framework forthe preparation ofthe financial statements; ~ Expected form and content of any reports to be ssuad by the auditor and a statement that there may be circumstances in which {report may difer from its expected form and content; — Elaboration ofthe scope of the audit wit reference to legislation; ~The form of any other communication of results of the audit engagement; — The requitement forthe aucitor to communicate key auait matters in accordance with ISA 701 Communicating Key Auatt (Matters in the Independent Auoltor’s Report — The fact that some material misstatements may not be detected, — Arrangements regarding the planning and performance of the audit, including the composition ofthe audit team; ~The expectation that management will provide wlten representations; — The expectation that management will provide aocess to all information relevant to or afecting the financial statements ~The basis on which fees are computed and any billing arangements; — A request for management to acknowledge receipt of the audit engagement leer and to agree to the tems ofthe engagement;o © — Arrangements concerning the involvement of intemal auitors and other staff ofthe entity — Any obligations to provide audit working papers to other partes; — Any restriction on the auditor's ability and — Arrangements ta make availabe draft nancial statements and any other information. Ratios 20%5 20x8 Operating profit margin 0-40/22.0 = 1.8% 1-2726:0 = 4.6% Payables payment period 19/109 x 365 = 64 days 32/1405 x 365 = Bl cays ‘Audit risks and auditor's response Audit risk ‘Auditor's response Magpie Co Is a new cent for Crow & Co. AS the audit team are not familar with the accounting policies, transactions and balances of Magpie Co, there will be an increased detection risk on the audit There is also less assurance over opening balances as Crow 4 Co did not perform the aucit last year During the year, the company has spent $0-75m on ‘efurbishing its stores. This expenditure has been recognised {as property, plant and equipment in the statement of financial position. There Is a risk that some items of revenue expenditure may hhaye been capitalise in contravention of IAS” 16 Propexty Pant and Equipment (PPE) which woukd mean that PPE is ‘overstated and expenses are understated, During the year, a sales system was installed but it was not felt necessary to run the old and the new system in parallel (Opening balances from the old system may not have been ltansferred correctly. In addition, further ertors could have arisen If there are issues with the operation of the new system, AS a result, sales and recelvables may be misstated, Daily cash takings reports sent to head office show an inereasing number of cash shortages at each store when comparing the contents ofthe cash registrs to the reports. These differences have not been investigated or reconciled a they ate only small amounts. This i arisk that these discrepancies ate the result of fraud ‘ang several small cash shortages coukt become materia when aggregated. In addition, an increase in contol isk arises when Internal controls detect a problem but it is being ignored ‘There has been an increase in corporate customer accounts hich ate overdue for payment, but no inerease has been ‘made to the allowance for receivables in the financial statements. In addition, the receivables collection period has inereased from 101 days to 149 days. ‘There is a risk that some of the customers may not pay and thatthe receivables balances are nat recoverable. This would ‘result in receivables being overstated and the allowance for ‘receivables being understated ‘Crow & Co should ensure it has a suitably experienced team ‘assigned to the audit. In addition, adequate time should be allocated for team members to obtain an understanding of Magpie Ca and the risks of material misstatement including a ‘etalled team briefing to cover the key areas of isk. Increased auait procedures should be performed over opening balances, ‘Obtain a schedule of casts which have been capitalised as part of the refurbishment programme. Review supporting ‘documentation such as invoices to establish that they are cepital in nature. ‘The auditor should fully document and test the new accounting system. In addition, they should also perform ‘substantive tests over the opening balances to ensure they hhave been cortectly transfered from the old system. Discuss with the finance director whether any issues have arisen since the new sales system has been in operation, which may give rise to a misstatement in the financial statements. Discuss with the directors whether these cash shortages may be indicative of fraud. The audit team must also apply professional scepticism ‘throughout the audit recognising that fraud may have arisen 28. a result of the cash shortages. Extended substantive procedures over the cash sales cycle should also be carried ut, Discuss with the credit controller the likelihood of recovering the overdue balances and catty out extended post yeat-2nd ‘cash receipts testing to identity ifthe overdue balances have been propery cleared after the reporting dato, Discuss with the finance director the need to increase the allowance for receivables in respect of other customers who may be unlikely to settle their debts.Auait risk The payables ledger clerk has carried out supplier statement reconciliations and a number of supplier statements indicate 2 higher balance fs owing by the company than is shown on the payables ledget. The differences have been included 35, ‘econeiling items on the supplier statement reconeliavions ‘ather than being investigated. In addition, the payables payment period has decreased from 81 days to 64 days. There is a risk that cut-off is incorrect, resulting in trade payables, cost of sales and expenses being understate. Inventory of $0-Lm has been noted as being damaged due {o containing contaminated soll In adaiton, the inventory ‘holding period has increased from 2B days to 54 days ‘meaning the company is retaining inventory longer than the prior year IAS 2 Inventors requires inventory to be valued atthe lower of cast and net realisable value, Ifthe cantaminated soil cannot be remedied and the damaged inventory of $0-1m is ‘ot written down to its net realtsable value (NVR), inventory will be overstated and cost of sales will be understated. In addition, ifthe inventory holding period suggests further inventory may need writing down to NRY, inventory will be overstated and cost of sales will be understate, Last year's management report highlighted a number ot significant deficiencies in the company’s payroll cycle Iv these deficiencies have not been addressed by ‘management, the controls over the payroll may stil contain deficiencies leading to an increased risk of misstatement. \Wages and salaries expense and the year-end employment ‘ax ecorual may be misstated, The company’s operating prof margin has reduced from 4°6% to 1-8% and gioss profit margin has increased from 44% to 50%. ‘Tete Is a classitication risk tat costs may have been ‘omitted from costs of sales or some lect costs have been included in overhead expenses incorrectly, meaning cost of sales Is understated and opetating costs overstated. Pacific Co (2) Substantive procedures for trade payables and accruals ‘Auditors response Review the supplier statement reconciliations and discuss withthe payables edger clerk why they have been included as reconciling items on the supplier statement reconciliation rather than investigate. Perform a review of afterdate purchase invoices to determine Hany relate to me cutrent yea. If any do relate tothe current ‘year, agree them tothe accruals isting. Discuss with the finance director whether the damaged Inventory will be writen down to I's net realsable valve and ‘age this write down tothe final inventory valuation. Discuss with the dlectors why the inventory holding period has ineroased and whether further inventory may need to be written down to net reaisable value. Perform review of post year-end sales invoices to determine the price at which these items have been sold and carpare to Inventory valuation Discuss with the alrectors whether the recommendations made by the audit fm in respect of the payroll cycle have been implemented and carry out tests of controls to assess ‘whether they ate operating effectively. Hf the recommendations have not been implemented or there are no controls in place, adopta fully substantive approach {to address the completeness and accuracy of the wages ‘and salaries expense and completeness of the year-end. ‘employment tax accrual Review the nature of a sample of operating expenses during the year to identify it any tect costs have been incorrectly Classited as overniead expenditure. ‘Compare the classifeation of costs between cost of sales anc ‘operating expenses and compare with the prior year to ensure Consistency and Investigate any significant dierences, Increase cut-off testing of purchases and accruals to verity that ‘sts are included in the cortect period, — Calculate the payables payment period for Pacific Co, compare to prior years and investigate any significant ciferences, in particular any decrease this year due to the inclusion of the payment un on 1 June. — Compare the total trade payables, or significant supplier balances, and good received not invoiced (GRNI) accrual against the prior year and investigate any significant aierences. = Compare the list of accruals this year to the prior year to identify any missing items or unusual fluctuations and discuss with ‘management — Discuss with management the process they have undertaken to quantify the misstatement of trade payables due to the payment run and consider the materiality of the error in isolation as well as with other misstatements found, — Review the Journal entry processed to correct the misstatement of trade payables due to the payment tun to ensure all erors have been included. — Selecta sample of purchase invoices received around the year end. Ascertain, through reviewing goods received notes (GRINS), ifthe goods were received pre of post year end. If post yearend, then confi that they have been excluded from the ledger = Review after-date payments; if they relate to the current year, then follow through to the payables ledger or GRNI accrual to ensure they are recorded in the corect period.o c) @ — _Reperfoim a sample of supplier statement reconciliations and agiee these to te payables ledger balances. Investigate ary reconciling items. — Select a sample of trade payables balances and perform a trade payables’ clrcularisation, Follow up ary non-tesponses and ‘any reconciling items between the balance confirmed and tne trade payables’ balance. — Select a sample of GRNs hefore the year end and after the year end and follow through to inclusion ofthe lability in the corect period's payables balance to ensure correct cut-of. ‘Substantive procedures for provision for legal claims — _Enquie withthe ditecors or inspect relevant supporting documentation to confi ita present obligation exists at the yearend — Discuss with directors how the mislabelling of ingredients is alleged to have occurred and whether itis likely that any other customers have been affected, — Discuss the claim with management and review the intemal vest gation report in order to gain an insight into the cteumstances \which led to the mislabelin, — Inspect board minutes to ascertain whether payment is probable. — Inspect post year-end bank statements to identify whether any payments have been made in respect of the claim. — Review correspondence with Paci Co's lawyers or with the client's permission, contact the lawyers and obtain confirmation regarding the claim to assess whether a provision should be recognised and whether the amount of the provision is material — Review correspondence or discuss with lawyers the likelihood and amount of other potential future claims, — Ifevidence indicates that it's only possibie that the claim will be successful, inspect the financial statement for contingent liability disclosures to ensure compliance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Obtain a written representation trom management confirming thei view that they have an obligation atthe year end in respect ofthe claim and that its appropriate to include a provision ‘Substantive analytical procedures for revenue — Compare the overal evel of revenue against prior years and discuss the reasons for the 9-4% increase with management and aggee to supporting documentation. — Compare the overall level of revenue against the budget fo the year and investigate any significant fluctuations, — Obtain a schedule of sales for the year disaggregated Into the elght main product tines and compare this to tne prior year breakdown and budget to understand what impact the new products have had on revenue, For any unusual movements, alscuss with management. — Obtain a schedule of sales forthe year analysed for the existing 13 stores. Compare this to the prior year and discuss any Unusual mavementy/significant fluctuations with management. = Perform a proof in total calculation for revenue. The prior year revenue forthe eight main product lines should be taken and {an adjustment should be made for sales from the new product lines and forthe new store for approximately rine months. Ths ‘expectation should be compared to actual revenue and whether this equates to 9-4% growth over the por yeat. Any significant fluctuations should be investigated, — Calculate the gross profit margin for Pacific Co and compare this to the pror year and investigate any significant fluctuations. Auditor's report ‘The financial statements contain a provision for legal claims of $0°Sm, however, audit work has identified that the provision should bbe $0:2m. Hence the provision is understated and profits overstated by $0-3m. The argument that the provision is a reasonable estimate is not vad. The etror of $0°3m represents 7-3% of profit before tax (0-3nv4-1m) and hence is a material matter Ifthe finance director refuses to inctease the provision, the audit opinion wil be modified due to material misstatement, AS provisions are understated and the error is material but not pervasive, a qualified opinion would be necessary AA basis for qualified opinion paragraph would be needed subsequent to the opinion paragraph and would explain the matetal ‘misstatement in relation fo the understated provision for the legal claims and the effect on the financial statements. The opinion Daragraoh would be qualified ‘except forApplied Skills, AA ‘Audit and Assurance (AA) Section B Daley Co (2) Five components of a system of internal control 11 mark per well-explained point Restricted to (©) Internal control deficiencies, controls and test of controls No checks of data Edit report not reviewed PPE physical verficaion Change to capex policy Finance director only reviews payment total No receipts for oety cash Quarterly bank reconciliations ‘Maximum 5 issues, 3 marks each (©) Substantive procedures over the bank balances 11 mark per wel-explained point Restricted to (@) Corporate governance deficiencies and recommendations CEO fs ais0 Chair Shareholder engagement Remuneration of non-executive directors ‘No auait commitee ‘Maximum 3 Issues, 2 marks each “Total marks ‘Magpie Co (2) Engagement letter purpose and matters to be included | mark per well-explaned point Restricted to (©) Ratios Operating profit margin Payables payment petiog (©) Audit risks and auditor's response New client PPE exp New sales system Cash shortages Receivables valuation ‘Supplier statement reconciliations Inventory valuation Prior year management report Operating profit and gross profit margins ‘Max 7 issues, 2 marks each “Total marks. September/December 2022 Sample Marking Scheme Marks avaliable Marks awarded * [Slelsrors rsiPacific Co (2) Substantive procedures for trade payables and accruals | mark per well-described procedure Restricted to (©) Substantive procedures for provision for legal claims 11 mark per wel-described procedure Restricted to (©) Substantive analytical procedures for revenue | mark per well-described procedure Restricted to (@) Auditor's report Discussion of issue Materialty calc Type of modification Impact on report Total marks Marks avaliable Marks awarded ISlelemwee12