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AUDIT PRACTICE & ASSURANCE SERVICES

PROFESSIONAL 2 EXAMINATION - AUGUST 2013

NOTES:
SECTION A: Answer Question 1, and
SECTION B: Answer any two from Questions 2, 3 and 4.
(Should you provide answers to more questions than required in Section B, you must draw a clearly
distinguishable line through the answer not to be marked. Otherwise, only the first two answers provided will be
marked.)

Time Allowed
3.5 hours, plus 20 minutes to read the paper.

Examination Format
This is an open book examination. Hard copy material may be consulted during this examination,
subject to the limitations advised on the Institute’s website.

Reading Format
During the reading time you may write notes on the examination paper, but you may not commence
writing in your answer booklet.

Marks
Marks for each question are shown. A mark of 50 or more is required to achieve a pass in this paper.

Answers
Start your answer to each question on a new page.

You are reminded to pay particular attention to your communication skills, and care must be taken
regarding the format and literacy of the solutions. The marking system will take into account the content
of your answers and the extent to which answers are supported with relevant legislation, case law or
examples, where appropriate.

Answer Booklets
List on the cover of each answer booklet, in the space provided, the number of each question
attempted. Additional instructions are shown on the front cover of each answer booklet.

The Institute of Certified Public Accountants in Ireland, 17 Harcourt Street, Dublin 2.


THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

AUDIT PRACTICE & ASSURANCE SERVICES


PROFESSIONAL 2 EXAMINATION - AUGUST 2013

Time allowed: 3.5 hours plus 20 minutes to read the paper.


Section A: Answer Question 1 and
Section B: Answer any two from Questions 2, 3 and 4.

Section A: Question 1 is compulsory.

1. You, Clint Westward, are an audit senior with Daffy and Duffy Certified Public Accountants and Registered
Auditors (Daffy and Duffy). Matt Kennington, the audit partner with Daffy and Duffy, and you recently
attended a meeting with the managing director of a client, Plaza Property Partners Ltd.

You are aware that Plaza Property Partners Ltd. was incorporated in 1999, having previously existed as a
partnership. The company was set up by Jim Young, who has been managing director since incorporation. The
audit was offered to Daffy and Duffy after a competitive tender process and was accepted following approval by
Daffy and Duffy’s quality control partner. The other key member of the board is Katie Harrison(KH), a qualified
accountant, who is the finance director. She has been with the business since it operated as a partnership back
in the 1990s.

On 30 July 2013, you took the following minutes:


Minutes of meeting between Matt Kennington(MK) and Jim Young(JY).
Re: Audit of Plaza Property Partners Ltd, year ended 30 September 2013.
MK introduced himself and asked for a brief history of the business. JY explained that in the seven or so years
following incorporation the company, in common with many in the industry, had expanded rapidly. Its niche area
was in the construction of “retail plazas” (i.e. shopping centres) which it planned to rent out and then manage. It
had developed grandiose strategic plans, divided into several phases. The completion of phase one came towards
the end of 2006 when the company had finished the building and fitting out of the six plazas. The management
realised that the economy was slowing down in 2007 and deferred plans to commence phase two which was to
be the development of a further 10 plazas. As the economy deteriorated throughout 2007/08, the company ceased
all construction activity and began a programme of ruthless cost cutting.

All but 200 of the 1,200 construction workers were laid off in 2007/08 and the remaining 200 (who had been kept
on to work on repairs and maintenance and the making of slight alterations to the design of the shopping centres
in accordance with the requests of tenants) were made redundant in October 2012. In all cases, only statutory
redundancy was paid. Fifty or so workers still make their living by working exclusively or almost exclusively for
Plaza Property Partners Ltd doing repair work etc. but they are now retained on a “contract for service” basis only.

Virtually all of the units in each of the six plazas were fully occupied when first opened in 2006. All of the tenants
signed tenancy agreements which included “upward-only” rent review clauses. Each shopping centre has an
“anchor tenant” which accounts for between 40% and 70% of the space and the rent. There can be up to 50 other
tenants in each centre, varying greatly in size and significance.

To date, all of the anchor tenants have adhered to their contracts and none are in arrears of rent. In the case of
“Plaza 6” the original tenancy agreement was for 9 years from November 2005 and the anchor tenants have
indicated they are unlikely to renew the tenancy on the same terms and conditions in November 2014. JY
expressed the hope that “we wouldn’t worry too much about this since nothing will happen on it in the year under
review or even the year following that”. He admits though, that without an anchor tenant in each plaza, the
remaining shops would hardly survive.

Throughout the six plazas, the performance of the other tenants has been “patchy”. The company has been very
reluctant to sanction rent reductions for fear of setting a precedent and, as a result, some tenancies have
collapsed. It has allowed a couple of other tenants to go into “controlled arrears” of rent meaning that they do not
pay now but acknowledge in a formal way that they have a liability to do so when conditions improve. This is

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usually done to avoid having a major part of the centre unoccupied and unsightly.

JY continued to talk about a new innovation that has come to the fore in the last 12 months. Both MK and myself
were unaware of this so I kept a verbatim note of what he said. “Recently, we have stumbled into the “pop-up
shop” market. Basically, we have been approached by a number of individuals separately to set up a counter
kiosk selling some specific item or range of items with a connected theme, or doing a promotion. Typically, it might
be Christmas stuff (cards, trees, holly etc.) or something related to an event in the immediate area e.g. hats and
flags for football matches. Typically, a pop-up shop will last for between one day and six weeks and we get paid
in full in cash up front. We check that nothing illegal is being offered for sale; that nothing will detract from sales
in our regular shops; but otherwise we find it best not to ask too many questions. Sometimes, we don’t understand
what these traders are doing. They are happy to pay in cash for fairly inconspicuous corners and I can’t see how
some of them make money. But they pay us; they are no trouble; so why should we worry?”

MK asked about accounting and control systems. JY replied that at its peak the company had 20 people employed
in the accounting function. He went on “Basically, over the years they have all left except for Don Hastings(DH),
the financial controller. He does everything himself now; he has a personal assistant, but no accounting staff as
such. He is always complaining that he is too busy even to take a holiday. I know things are tough for him – he
has three children in college but I tell him there are thousands of construction workers out there who would love
to be so busy they couldn’t take a holiday!”

MK asks for an assessment of the current financial position. JY replies that Plaza Property Partners Ltd has been
incredibly lucky to have minimal unused retail space and no unused land banks. He continued “Gearing is high at
about 75%, but all loans are being serviced in full and none have been renegotiated. We exceeded our overdraft
limit only twice during the year and only by trivial amounts. Operating profits are healthy; expenses minimised
and those who remain are making a living. It’s a lot better than most of our peers”.

“We had loads of trouble with the previous auditors. They wanted us to make “impairment charges” against our
property values. All our property is, and will remain, in our financial statements at historical cost. The previous
auditors were trying to argue that we ought to have written about €50million off property values. That would have
wiped us off the map. In the end their report said that our financial statements didn’t show a true and fair view.
That didn’t do us any harm but neither did it do them any good!”

MK enquired as to whether there were any anticipated developments in the business which he should know about.
JY made reference to KH’s plans to retire from full-time work in the business. MK asked how JY was going to
replace her. JY commented that he was hoping to persuade her to stay on as she deals with the financial side,
he’d be lost without her. MK tried to discover how firm her retirement plans were, but JY was not forthcoming.

Addendum:
After the meeting, Matt asked me to ring Katie to discuss her plans. She confirmed that she does plan to retire.
She informed me that she plans to emigrate to the US and is not keen to change her mind. She asked about the
possibility of Daffy and Duffy assisting in the recruitment process of her replacement as she does not feel that JY
has the technical ability to recruit someone in her absense, and has not accepted her intentions enough to recruit
somebody in advance of her retirement. She said that she has even wondered about the possibility of someone
being seconded to the company from Daffy and Duffy to cover her position after she has left and before a
replacement is found.

Page 2
REQUIREMENT:

In the light of the information on pages 1 and 2, prepare briefing notes for the full engagement meeting which is due to
take place before the commencement of the audit in which you:

(a) Analyse the business risks facing the client at the current date. (6 marks)

(b) Evaluate the risks arising from the current configuration of the accounting and control systems. (5 marks)

(c) Evaluate the possible audit approaches to be used in the audit of Plaza Property Partners Ltd, and justify the most
appropriate approach in the circumstances.
(6 marks)

(d) Appraise the particular problems that arise for Daffy and Duffy, the auditors, from the existence of the “pop-up”
shops.
(6 marks)

(e) Assess critically the audit tests which should be conducted on the redundancy payments made during the year
under review.
(6 marks)

(f) Evaluate the threats to independence (as specified in the CPA Ireland code of ethics) which are most significant
in this case and justify the safeguards which should be implemented to mitigate against those risks.
(10 marks)

(g) Analyse what appears to be the most significant breaches of GAAP (Generally Accepted Accounting Practice)
committed by Plaza Property Partners Ltd and consider the impact they are likely to have on the Audit Report.
(8 marks)

Format & Presentation (3 marks)

[Total: 50 Marks]

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SECTION B - ANSWER TWO QUESTIONS ONLY
2. For many years, auditors debated the merits or otherwise of auditing small companies. That debate was effectively
brought to an end in Ireland by the enactment of S32 of Companies Act, 1999 which exempted most companies
with turnover and net assets totals below certain specified levels. Although the levels have changed on several
occasions since, the principle has remained intact.

REQUIREMENT:

(a) Critically evaluate the decision to exempt companies from audit based on size alone. (7 marks)

(b) Discuss the suggestion that since there is, by definition, no public interest in the accounts of a private limited
company, there is no reason to subject such companies to audit and nobody but auditors would lose out if they
were so exempted.
(8 marks)

(c) You are Raphael O’Brien, the managing partner in O’Brien & Co. Certified Public Accountants and Registered
Auditors. Your firm has recently entered into a strategic partnership with Antrim & Co., a Northern Ireland based
firm of registered auditors. You arrive at work one day to find the following e-mail in your inbox from Martin Antrim
of Antrim & Co.

Raphael,
As you may be aware we act as auditors and tax consultants to the ABC Group, a substantial UK-based entity.
Our tax department has been working on a tax planning scheme for the group over the past 18 months or so. (By
the way, don’t worry – they assure me that this is a minor variant on a fairly standard tax planning arrangement,
and comes nowhere near what might be termed “aggressive tax planning”). Anyway, as part of the scheme, about
10 months ago they set up a company in the Republic of Ireland, called Bandana Co. This is a company limited
by guarantee, not having a share capital. The arrangements for the tax planning scheme got partly derailed due
to unforeseen circumstances which have now been sorted out. However it does mean that Bandana Co. has been
sitting there in a dormant state for nearly a year. I am most anxious that there be no regulatory or legal infractions
on our part so I would like you to tell me if this company needs an audit; and, if so, what exactly should be done
during the audit. We are anxious to do whatever is necessary but, in the circumstances, no more than is
necessary. Since the client is bound to ask you might also let me know the rationale behind whatever it is
necessary for us to do.

See you at the golf next week.


Regards,
Martin.

REQUIREMENT:
Draft a suitable reply to Martin’s e-mail. (10 marks)

[Total: 25 Marks]

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3.
Each of the following statements is an extract from different “letters of representation” to which ISA 580 Written
Representations applies:

1) “Certain representations in this letter are limited to matters that are material”.

2) “No frauds involving management or employees who have significant roles in internal control, or other frauds that
could have a material effect on the financial statements have occurred during the year under audit”.

3) “Based on assessment we conclude that the company has maintained an effective financial control over financial
reporting as of 22 March 2013”.

4) “We have prepared a description and evaluation of certain contingencies to which our legal advisors have devoted
substantial attention on our behalf in the form of legal representation”.

5) “There are no significant deficiencies, including material weaknesses, in the design or operation of internal
controls that could adversely affect our ability to record, process, summarise, and report financial data”.

6) “Summarised below are important actions taken in response to comments provided by you in the management
letter [letter of control weakness] dated 22 March 2013, based on your prior audit”.

7) “Our assessment of internal control over financial reporting provides us with absolute assurance that no material
misstatements will occur and be undetected by our internal control”.

8) “We have made available to you all financial records and related data”.

REQUIREMENT:
Evaluate the extent to which is it appropriate to include each of the above statements in a letter of representation. Detail
the representations that should be wholly excluded or, where appropriate, suggest a more suitable alternative wording
and justify your rationale.
[Total: 25 Marks]

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4.
(a) How should a member of the Institute of Certified Public Accountants in Ireland respond to a request to provide
a “second opinion” on a professional matter. Justify your answer.
(5 marks)

(b) Evaluate the role of ‘support letters’ (also called ‘comfort letters’) as evidence in the audit of financial statements,
especially in the context of consolidated financial statements.
(5 marks)

(c) Discuss the problems international auditors might face when auditing companies in some developing countries.
(5 marks)

(d) Extrasport plc recently expanded its overseas operations by entering into an agreement on 1 May, 2013 with the
government of Ruritania. The intention was to gain market share for its goods in that part of the world. A new
company called Lankasport was set up with a share capital of €50 million owned equally by Extrasport plc and
the Ruritanian government. The agreement stipulated that Extrasport plc would provide finance, equipment (sold
at cost to Lankasport), and expertise; the government would provide premises, materials, and labour, and would
help to create a market for the goods.

The company has been incorporated for an initial five-year period and will operate under a special government
scheme to help regenerate a part of the country which suffered badly in a civil war that ended a few years ago.
After the five-year period, the agreement states that either party can insist that the business be wound up or its
terms can be renegotiated. In the event of a wind-up after five years or, if the business is not viable, the
government has a priority in the repayment of its share of the original capital. In that event, Extrasport plc will
receive no more than a refund of its original capital investment.

The board of Lankasport consists of equal numbers of directors from Extrasport and from the Ruritanian
government. The Chair, who has a casting vote, is rotated annually between the two sides. In the first year
Extrasport will nominate one of its directors to act as Chair. On that basis, the Financial Controller of Extrasport
has decided to treat Lankasport as a subsidiary of Extrasport in the consolidated financial statements.

You are the audit partner reviewing the audit file. You find the following note from the audit senior on the report to
partner file:

Treatment of Lankasport as a subsidiary


The financial controller’s treatment appears reasonable given the facts so an unqualified opinion is appropriate.
However, given the nature and complexity of this investment, I suggest that we add the following “emphasis of
matter” paragraph to our audit report.

Emphasis of matter – investment in Lankasport


In forming our opinion, which is not qualified, we have considered the treatment of the investment in Lankasport,
details of which can be found in Note 22 to the financial statements. We concur with the financial controller’s view
that as Extrasport plc has a casting vote on the board of Lankasport, it has control of the entity and it is justifiable
to treat the entity as a subsidiary.

Opinion
In our opinion, the financial statements give a true and fair view....

REQUIREMENT:
Critically analyse the audit senior’s proposed audit report, including an asessment of both the opinion itself and the
format of the report.
(10 marks)

[Total: 25 Marks]

END OF PAPER

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SUGGESTED SOLUTIONS
THE INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS IN IRELAND

AUDIT PRACTICE & ASSURANCE SERVICES


PROFESSIONAL 2 EXAMINATION - AUGUST 2013

SOLUTION 1
To: Audit Partner
From: Audit Senior
Re: Briefing Notes in respect of the audit of Property Partners Ltd. y.e. 30-09-2013
Date: August 30th 2013.

(a) Business risks are often divided into operating, financial and compliance risks. Property Partners Ltd. would
appear to suffer from the following risks.

a. Operating risks: The company relies (albeit indirectly) on the retail market. The retail market is hard-hit
in the current recession and we are told that some tenancies have already failed. If conditions do not
improve there is a risk of more tenancies failing resulting in a loss of revenue but also resulting in a
possible “snowball” effect as more shops in the centres close down the centres become more
depopulated and unattractive thus accelerating the decline. The situation in relation to the anchor tenant
in Plaza 6 gives grave cause for concern in this regard.

b. Financial risk: Gearing is high (at 75%) and costs have already been cut ruthlessly. There would appear
to be little scope for further cost cutting and little prospect of sufficient profitability to enable gearing to
be reduced. Ultimately, we may need to consider restructuring debts. Also, we exceeded our overdraft
limit twice during the year even if by small amounts.

c. Compliance risk: We would appear to have several risks in this regard such as a risk of Revenue Audit
in relation to the “employees” retained on a “contract for service” basis. There would appear also to be
a need to examine more closely the activities of the “pop-up shop” operators in case illegal activities
are being carried out on our premises.

(b) The main problem in relation to accounting and control systems would appear to be lack of segregation of
duties and possibly also lack of management supervision. Don Hastings does everything himself and there
appears to be no effective check on his work so his work may be liable to fraud or error. He also appears to
be extremely busy which increases the risk of error. He also has no peers in the company in the accounting
sense so presumably takes a lot of highly judgemental decisions himself. Thus, we can say that control risk
is high.

(c) It would appear that we will need to apply a risk based approach combined with analytical review and
extensive substantive testing in this audit. The infrastructure does not appear to be present in the company
to allow for a good system of controls (see solution to (b) above). This means that testing controls is unlikely
to be an effective or efficient approach. Assessing risk will be very important both at the entity level and at
the assertion level. The risk assessment at the assertion level will help determine the extent of the testing in
relating to each assertion. For example, it is obvious that there will be problems with the valuation assertion
in relation to property.

(d) The existence of the “pop-up” shops gives rise to various risks. There is, for example, the risk that the traders
are not what they seem and may be carrying out some kind of illegal or at least disreputable activity on the
client’s premises. This could result in reputational damage and even have adverse legal consequences for
our client. Secondly, their propensity to pay in cash increases control risk as there is a risk of misappropriation
or non-recording of cash received. Thirdly, since these “pop-up” shops arise on an ad hoc basis income from
them is unpredictable and may not be susceptible to analytical review in any coherent way. All of this depends
on the materiality of the income stream from this revenue source.

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(e) The procedures are as follows:

a. Establish exactly which employees were on the payroll as on 1st July 2012.
b. Compare list to current payroll.
c. Ascertain which of missing employees were made redundant.
d. Re-perform the redundancy pay calculations and make sure they are correct and ensure that employees
have received their statutory and contractual entitlement (if any).
e. Verify that the figures used in the redundancy pay calculations are correct (e.g. final salary, length of
service etc.)
f. Agree payments on redundancy payment schedule to cash book.
g. Check correspondence files for evidence of any disputes or challenges.
h. Pay particular attention to any redundancy paid to ex staff members (if any) who are still retained on a
contract-for-service basis. Consider the implications of any queries that may have been raised by
Revenue or other authorities in this regard.

Following these tests should give us sufficient and appropriate evidence in relation to the assertions of
measurement/valuation and existence of the redundancy payments. The quality of the evidence will be
commensurate with the level of control risk associated with the assertions in respect of these transactions and
balances.

(f) The following table shows the most significant threats to independence and safeguards:

Threat Safeguard
Self-Review Threat: In this type of operation, it is We must be careful to separate out our role as
likely that we will be asked to work on the preparation accounts preparer and auditor. Preferably, we should
(or at least presentation) of the financial statements. have different teams involved and “Chinese walls”
between them.

Self-Interest Threat: Our fee income from this client We must be careful not to let our financial interest in
is likely to be substantial. our fee income impair our impartiality in relation to the
client. A Quality Control Review could be useful in this
regard.

Intimidation Threat: There is a more than a hint of We need solid, independent reviewing of this client’s
intimidation in the client’s comments about the file and we must be prepared to modify the Audit
previous auditors. Report if that is necessary in spite of threats from the
client.

Management Threat: There is a possibility that we We may assist with finding a replacement for Katie
could make management decisions in respect of this but the final decision is clearly for the management of
client in relation to accounts preparation (see above) Property Partners Ltd.
or in relation to choosing Katie’s replacement.

(g) One issue that could be problematic is the rents in “controlled arrears”. The client is likely to want to record
these as simple receivables due within one year. However, there must be considerable doubt that they will
be received within one year or, indeed, that they will ever be received. The other obvious issue is in relation
to the impairment charges on the property. As investment properties, these should be valued at open market
value per IAS 40. Previously, the management had refused to do this and the predecessor auditors had
clearly thought this was a pervasive matter and thus that the financial statements did not show a true and fair
view. On the assumption that neither the economic conditions nor the attitude of management has changed
since, it is hard to see a different outcome this year. We will also need to consider going concern issues in
formulating our report.

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MARKING SCHEME

SOLUTION 1
(a) Operation Risk 2
Financial Risk 2
Compliance Risk 2
Identification and brief application of each needed; other suitable classifications such as External v. Internal
risk would be equally acceptable
Maximum for part (a) 6

(b) Lack of segregation of duties 2


Possible absence of management controls 2
Dealing in cash 1
Other 1
Maximum for part (b)) 5

(c) Risk Based Approach essential 2


Use of Analytical Review 1
Mainly substantive testing 2
Need to consider going concern 1
Testing controls unlikely to be suitable 1
Assertion level v. Financial statement level 2
Other 1
Maximum for part (c) 6

(d) Activities being carried out in the shops could affect us as landlords 2
Tendency to pay in cash increases control risk 2
Could have a distorting effect on analytical procedures and/or are income stream
is inherently unpredictable 2
Mention of materiality 1
Maximum for part (d) 6

(e) One point for any six of the seven points detailed in the solution;
or for any other meritorious points made by candidates (1 x 6) 6
Maximum for part (e) 6

(f) Self-Review Threat and safeguard 3


Self-Interest Threat and safeguard 3
Intimidation Threat and safeguard 3
Management Threat and safeguard 3
Maximum marks for part (f) 10

(g) Property valuation 2


Controlled arrears of rent 2
Redundancy payments 2
Potential effect on Audit Report 3
Maximum marks for part (g) 8

Maximum marks for layout and presentation 3

Total maximum for question 50

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SOLUTION 2
(a) Once the decision in principle is made that not all companies require an audit the next question becomes
“which companies should be excluded?” The main argument for excluding small companies is that an audit
is an undue burden on small companies and is thus a disproportionate expense. The costs of smaller company
audits may be higher for two reasons. Firstly, because the auditor incurs fixed costs associated with any audit
and these fall harder on smaller companies. Secondly, auditors are less likely to be able to use cost saving
techniques such as Computer Assisted Audit Techniques when auditing smaller companies.

Another way of deciding which companies to exclude would be to look at the “public interest” argument. On
this basis it could be argued that there is no real public interest in the audit of private entities and that thus
all non-public companies should be exempt from audit. This approach is taken in some countries. The
argument against approach is that some of the largest companies in the country are, in fact, private but it is
not burdensome or unreasonable to subject these multi-million euro businesses to a financial audit and,
furthermore, there is a considerable public interest in their results. It should also be noted that size alone is
not the only criteria used in Ireland to exclude companies from audit. The full list of conditions are as follows:

• The company must be a company to which the Companies (Amendment) Act 1986 applies i.e. a Private
Limited Company;
• The amount of turnover of the company must not exceed €8.8 million;
• The balance sheet total of the company is less than €4.4 million at the end of its financial year;
• The average number of employees must not exceed 50;
• The company must not be a parent company or a subsidiary company;
• The company must not come within one of 19 classes of companies listed in the Second Schedule to
the 1999 Act;
• The company’s annual return, to which the accounts for the financial year in question are attached, must
be furnished to the CRO in compliance with section 127 Companies Act 1963. This means that the
return must be delivered to the CRO not later than 28 days after the company’s annual return date, or
where the return has been made up to an earlier date, within 28 days of that earlier date. i.e.it must not
be late in the current year;
• Furthermore, where an annual return to which accounts for the immediately preceding financial year
was delivered to the CRO, that return must also have been filed on time. i.e. it must not be late in the
previous year;
• The year in question must be the current year – section 32 provides that the directors must be of the
opinion that the company “will satisfy” the conditions – use of the future tense precludes the decision
being taken in respect of a year that has already ended.
• A company which satisfies the revised exemption threshold levels in a current financial year, the year
in respect of which the audit exemption is being claimed, must also have satisfied those revised
threshold levels in the preceding financial year.

The existence of these provisions would suggest that companies should not be excluded from audit based
on size alone.

The full list is reproduced here for information only. Candidates in the examination would not have been
expected or required to reproduce it in full.

(b) It is imortant to recognise the many benefits audits provide other than just fulfilling a statutory obligation.
Some examples of these are listed below:

• An independant review of the effectiveness of the company’s systems and controls


• A check on the accounting records.
• Adding to the integrity of the financial information being used by the directors and owners of the
company.
• Assuring the reliability and enhancing credibility of financial statements when raising finance or applying
for credit from suppliers.
• Giving the auditors an opportunity to provide business and financial advice as a result of the detailed
examination of the systems and procedures (management letters).
• Acting as a deterrent to, and possibly protecting from, the risk of fraud, money laundering and other
illegal activities.
• Satisfying requirements of certain existing loan contracts or overdraft agreements that may require the
company to present audited accounts each year.
• Reducing the risk of error in the information used to compile tax returns.

Page 10
It could, of course, be argued that whilst these benefits may be real enough they could be achieved outside
of the context of statutory audit. Accountants could, if necessary, be employed to provide assurance on a firm’s
internal controls separately from a statutory audit. Equally, it could be argued that little reliance is placed on
an audit by third parties. Why, for example, do banks habitually seek personal guarantees from directors or
do the Revenue carry out their own revenue audits?

In relation to the point about auditors losing out it should be noted that the professional bodies providing the
auditing services in Ireland have generally been in favour of the recent increases in the audit exemption
thresholds and have not sought to oppose them. Also, the bringing into line of the definition of “small company”
and the audit exemption threshold has been welcomed by most practitioners.

(c) Martin,

I have just received your query about the audit requirements of Bandana Co. the Irish registered company
limited by guarantee. The bad news is that the requirements are fairly extensive especially considering that
this company has never done anything!

The most important points to make are that there is no audit exemption in the Republic of Ireland for
companies limited by guarantee so an audit is required, and, as you are aware, once an audit is required the
International Auditing Standards need to be applied in full as we consider appropriate in each case. Even if
you think that this is “overkill” (and I would think that it is) it is what the law requires.
I would suggest that, at a minimum, we need to do the following:

1. Complete our client acceptance checklist and obtain a signed Letter of Engagement.
2. Hold an audit planning meeting (over the phone or via Skype might well suffice in the circumstances)
and document it.
3. Convene an engagement team meeting – again this will be minimal since it will probably just be one
staff member and the engagement partner
4. Complete an audit planning memo. We need to consider (at the very least) ISA 240, ISA 250, ISA 320
(if any transactions), ISA 315 (if any activity), ISA 501 (e.g. we made need to do a Bank Confirmation
letter if the company ever had a bank account), ISA 550/600 (considering its relationship to other group
entities) and, of course ISA 700 or the extant equivalent for ROI companies.
5. We will also need to complete a Financial Statement disclosure checklist and an audit
findings/completion checklist and/or letter for client.
6. An audit completion meeting will also need to be held.
7. Written Representations should be obtained from management (ISA 560).
8. Lastly, we will need to draft an Audit Report.

See you next week.


Kind Regards,
Richard.

MARKING SCHEME

SOLUTION 2
(a) Reasons for using size alone as a criteria
Fixed cost element, absence of cost saving possibilities 3
Other reasons
Public interest minimal; absence of reliance by 3rd parties 3
Other reasons currently in law 2
Other relevant comments 2
Maximum for part (a) 7

(b) One mark for each of the nine bullet points given in solution or other relevant points (1 X 9) 9
Possibility of achieving similar ends apart from statutory audit 3
Maximum for part (b)) 8

(c) Description of company limited by guarantee 1


Not audit exempt with reasons 2
Each of the eight steps mentioned or other relevant steps (1 X 8) 8
General comments on the merits/usefulness of the regulations 2
Other relevant comments 2
Maximum for part (c) 10
Total maximum for question 25
Page 11
SOLUTION 3

1) It is inappropriate for the LOR (Letter of Representation) to include this limitation. Auditors would not normally
require representations on matters that are considered immaterial. However, it is for the auditor (not the client)
to decide what constitutes materiality. Moreover, sometimes representations are sought from management
that particular financial statement balances are, indeed, immaterial e.g. warranty provisions.

2) The basic thrust of this comment is fine and should be included in the LOR. However, the qualification “who
have a significant role in internal control” to the word employees arguably narrows the representation
unnecessarily. Also, management would probably prefer if the representation said that “no frauds...had come
to the attention of management” rather than “no frauds...have occurred”.

3) There is no problem with this representation although it might be considered excessively bland.

4) The problem with this representation is that it does address the financial statement assertions. It omits to
mention, for example, that the list of contingencies is complete or that their presentation in the financial
statements is in accordance with IAS 37. The representation should be reformulated to include these points.

5) This is a valuable representation from management because it confirms to the auditor that, as far as
management is concerned, control risk is low. If confirmed by tests of control it allows for a systems audit to
be carried out. Of course if control tests do not confirm the representation then it is virtually worthless and calls
into question the veracity of other representations.

6) It is useful to have this response on file so that we may evaluate the response of management to previous
Management Letters (Letters of Control Weakness). Again, we would need to confirm that these actions have
actually taken place.

7) This representation is wholly inappropriate because it is not possible to provide absolute assurance over any
aspect of the financial statements. No matter how good the internal control appears mistakes and/or frauds
are always possible. The representation would be more appropriate if the word “absolute” was replaced
“reasonable”.

8) This representation is acceptable and should be included.

MARKING SCHEME
SOLUTION 3

Up to two marks for sections 3 and 8 above (2 X2) 4

Up to four marks for sections 1 and 7 above (2 X 4) 8

Up to 3.5 marks for the remaining points (3.5 X 4) 14

Other relevant points 4

Total maximum for question 25

Page 12
SOLUTION 4

(a) Second opinion


If an auditor is asked to comment on an issue such as an accounting treatment, or a proposed audit opinion
by someone who is not a client, then it is likely that he is being asked for a second opinion and he should take
care in his answer.

How to respond to the request


The auditor should ask why the opinion has been sought. He should then contact the person's auditor to
obtain any relevant facts relating to the situation. He should then ensure that a copy of his (the second)
opinion is sent to the first auditor, although he will need permission from the entity to do this.

If the auditor is told that the situation is hypothetical, when he gives his opinion, he should be very careful to
point out that the opinion is based on hypothetical facts and does not relate to any specific organisation.

Why such care should be taken


The auditor is at risk of giving an inappropriate opinion if he gives an opinion without being aware of all the
relevant facts.

It is also significant possibility that giving a second opinion will put pressure on the company's auditor (who
gave the first opinion) and may compromise his independence.

An auditor should always, therefore, decline to give a second opinion if the client refuses permission for him
to contact the company's auditor.

(b) Support letters


In the context of group accounts, the parent and subsidiaries are seen to be a single entity, so if the group
as a whole is a going concern then this is sufficient. It is sometimes the case that a subsidiary, when
considered in isolation, does not appear to be a going concern. In such a case the auditor may request a
support letter from the directors of the parent company. This letter states that the intention of the parent is to
continue to support the subsidiary, for example, if problems regarding its viability subsequently arose. (Banks
also often require this type of confirmation.)

This letter represents documentary evidence and is normally approved by the parent company board and
minuted. If there is a limitation on the time for which the support is to be provided other evidence may be
required that the subsidiary will be able to continue after this date.

Auditors also need to be careful that the parent company is actually in a position to provide the guarantees
(legally, financially and otherwise), and also that the guarantee is capable of being legally enforced. For
example, in the case of Kleinwort Benson Ltd. v. Malaysia Mining Corp. Bhd [Ltd.](1989) it was decided
that the words “It is our policy” [to support subsidiary companies] “are simply a statement of fact, not a warranty
or contractual promise. They show moral responsibility on the part of the comfort [support] letter writer, not
legal liability. They do not imply ‘it is our policy now and in the future%’ The context in which a comfort letter
was written is important in determining if it’s legally binding or not”.

(c) Problems of auditing entities from developing countries


There are a number of issues that must be considered when auditing entities from developing countries,
some of which are discussed below.
(i) Accounting methodology. There may be a deficiency of knowledge in certain countries in relation to
International Accounting and Financial Reporting Standards. Depending on the country involved certain
fundamental concepts may appear strange even to professionals in those countries e.g. concepts as
fundamental as property rights vary greatly across the developing world.
(ii) Control risk is likely to be high. Corporate governance procedures may not be very sophisticated or
adhered to. In some counties, there may be a preponderance of cash transactions with consequent
control difficulties.
(iii) Audit methodology. Local officials may not understand the audit methodology used by the audit firm and
particular difficulties may arise when the auditors attempt to obtain sufficient appropriate audit evidence
from third parties such as banks or solicitors, or from the government's officials. Even with full access
to accounting records, lack of co-operation by local officials could hamper the audit.
(iv) Joint practice. At the extreme the audit firm may be forced to set up some kind of joint practice in the
country concerned, or carry out a joint audit with a local firm. If a joint audit is required, division of
responsibilities and how much local auditors can be relied on will need to be considered.

Page 13
(d) Audit report format
The audit senior has wrongfully suggested that the audit firm include an emphasis of matter in the audit report.
This is only used when the auditor needs to highlight a particular matter in the financial statements, for
example, a fundamental uncertainty affecting the financial statements.

Auditors would not draw attention to an accounting policy they agreed with in an explanatory paragraph if there
was sufficient disclosure of the policy, which is implied by the reference to a note. If there was insufficient
disclosure, the auditor would qualify his report on grounds of disagreement.

Accounting treatment
The accountant of Extrasport plc wishes to treat Lankasport as a subsidiary or, more accurately, believes
that it is a quasi subsidiary. Quasi subsidiaries are those investments which, while not falling into the
mainstream definition of a subsidiary undertaking, are in fact controlled by the parent entity to such an extent
that the parent enjoys the same benefits from the relationships with the investments as it would do if the
investments were subsidiary undertakings. The important point is control, which in this situation means the
ability to determine the financial and operating policies of the investment with a view to gaining future economic
benefit. The converse is also true: control means being able to deprive others of the same rights.

Dominant party
In the situation with Lankasport it might at first appear that there is no dominant party in the joint venture. It
is very rare for this to be the case in practice. It is more likely that, once the commercial reality of the situation
is revealed, a dominant party will emerge. The accountant of Extrasport plc obviously believes that Extrasport
plc is the dominant partner, presumably on the grounds that it provides finance, equipment, expertise and that
it also has a casting vote.

As auditor, however, I take the opposite view, namely that the government in Extrasport's home country is the
dominant party, and this view tends to be supported by the following facts.

(i) The casting vote rotates between the two parties, it cannot therefore be seen as an indication of
permanent control. It is not good accounting to treat the investment differently in alternate years.

(ii) Profits are not split 50:50 because the government rakes in extra 'taxes' levied in effect only on
Extrasport plc, plus an extra 'repatriation tax'.

(iii) Extrasport plc's rights are restricted on liquidation/termination to its original capital. The majority of the
benefits accrue to the government.

(iv) Extrasport plc cannot appoint a majority of the Board.

(v) The future plans of Lankasport are determined by the terms of the local government's foreign investment
rules and regeneration scheme.

(vi) Most of the agreement has been imposed upon Extrasport plc with little choice on policy or direction.

Extrasport plc, while not exerting a dominant influence may be able to exercise significant influence over the
financial and operating policies of Lankasport. Further, its interest is more than 20% and is for the long term
(at least five years). This is what is known as a participating interest, which makes the investment either an
associated undertaking or a joint venture. If it is considered an associated company the provisions of IAS 28
(Revised) apply. If it is an a joint venture the provisions of IFRS 11 apply. In either case the provisions of
IFRS 12 need to be considered.

The objective of IFRS 12 is to require the disclosure of information that enables users of financial statements
to evaluate: [IFRS 12:1]

• the nature of, and risks associated with, an entity’s interests in other entities
• the effects of those interests on its financial position, financial performance and cash flows.

Where the disclosures required by IFRS 12, together with the disclosures required by other IFRSs, do not
meet the above objective, an entity is required to disclose whatever additional information is necessary to meet
the objective. [IFRS 12:3]

Page 14
IFRS 12 is required to be applied by an entity that has an interest in any of the following: [IFRS 12:5]

• subsidiaries
• joint arrangements (joint operations or joint ventures)
• associates
• unconsolidated structured entities

Correct audit report format


If the accountant does not agree to change his treatment of Lankasport in line with the above, the auditors
will disagree with the accounting treatment used and, if it is material, which is implied by the auditor drawing
attention to it in the original report, qualify the accounts on these grounds.

This would be a material qualification, not an adverse opinion, as the matter is not pervasive to the accounts.
No explanatory paragraph would be needed, as an explanation of the disagreement would be given in the
opinion paragraph (which would be headed 'Qualified opinion arising from disagreement about accounting
treatment'). The opinion would end 'except for the incorrect treatment of investments, in our opinion the
financial statements give a true and fair view ... '

MARKING SCHEME

SOLUTION 4

(a) Description of second opinion 2


How to respond to request 2
Why we should take care 2
Other relevant points 1
Maximum for part (a) 5

(b) Description of support letters 2


Why they are needed; usefulness as audit evidence 2
Why we need to treat with caution 2
Other 1
Maximum for part (b) 5

(c) Accounting methodology 2


Control risk 1
Audit methodology 2
Ways of dealing with the above 1
Other 1
Maximum for part (c) 5

(d) Incorrect use of emphasis of matter 2


Whether subsidiary or not: any 5 of the six points made in the solution or other valid point 6
Alternative treatments if not a subsidiary 2
Audit Report implications of incorrect treatment 2
Maximum for part (d) 10

Total maximum for question

Page 15