ACCA

Paper P7
Advanced Audit and Assurance

Mock Exam

Commentary, marking scheme and

suggested solutions
Commentary
Tutor guidance on improving performance on the exam paper.

1 Ridley's Bank
This question deals mainly with audit risks present in the first year of auditing a high street bank and how
these risks can be addressed – success comes from identifying those areas where the auditor's opinion
may not be straightforward and explaining what the auditor does to manage this uncertainty in each case.
It also requires you to think specifically about the financial statement risks presented by the recently-
developed online banking facility as well as the IT controls you would expect to find in operation, plus the
auditor's duties with regards to money laundering – your ability to regurgitate theory is not the only test
here though as tact and clarity are required to avoid offending the partner!

2 Murray
To answer this question well, some time spent planning would be very advisable prior to launching into
your answer. In part (a), remember to consider practical aspects as well as ethical issues and keep in
mind the mark allocation – you need to make at least six well explained points to achieve the maximum
potential marks available, and you should be able to generate these from the clues in the question
scenario. In part (b), consider materiality when addressing the issues, and make good use of the
information that's been provided to you in the question scenario. Your financial reporting knowledge
needs to be strong here and there are ten marks available so again, try to make ten well explained points.
Hopefully, part (c) should be fairly straightforward on management letters.

3 Visean
For part (a) remember that matters will cover the issues of risk, materiality and accounting treatment.
There is also a heavy emphasis on accounting knowledge. Make sure you deal with all aspects of the
information. There is often more than one accounting problem in each part of the question. For part (b) it
is essential that you make your points as specific as possible. Generalities will score few marks. It would
also be possible to present your answer in a two column format. In this case if you choose to do so you
need to take care as there is not always a corresponding piece of evidence for each matter raised.

4 RH Manufacturing
This question deals with audit fees and considers how clients see the cost of the audit as well as what
professional services firms can do to try and reduce friction between them. We must remember the
professional and ethical aspects associated with commercial activity however, so the last part focuses on
your ability to critique a statement made about the current economic climate. Good answers will require a
blend of theory, application and current awareness of the auditing profession – a blend the examiner has
pointed out as vital for success.

5 Topper
This question deals with auditors' reports. Section (a) of the question starts with basic knowledge of the
auditor's report but then challenges you into a discussion as to whether standard auditors' reports are
sufficient. To score well you must come up with some advantages, disadvantages and have a conclusion.
Section (b) tests detailed knowledge of the type of audit opinion which should be expressed in a series of
questions. Candidates frequently struggle with the various modifications of the auditor's report, so if you
did too then you should use this as a vital learning exercise.

2
Section A

1 Ridley's Bank
Marking scheme
Marks
(a) For identification and full explanation of each audit risk 1½ each
(only ½ mark if risks are not explained)

For fully describing the procedures required to address each type of audit risk 1½ each
(only ½ mark if procedures are not explained)
Max 16

(b) Misstatement of software planning 1

Development costs and related amortisation 2
Website operational costs 1
Misstatement of Domain name cost accounting 1
IT controls
General controls (any two – 1 mark each) 2
Application controls (any two – 1 mark each) 2
Max 8

(c) Appoint MLRO 1

Implement internal reporting and monitoring procedures 1
Train staff in legislation and auditor obligations on recognising money 2
laundering cases and avoiding tipping off potential fraudsters
Establish internal procedures to forestall and prevent money laundering 1
Verify the identity of new clients and maintain evidence of identification and 1
all client transactions
Report suspicions to relevant national authority (eg SOCA in the UK) 1
7
Professional marks 4
35

Suggested solution
(a) The audit risks and the procedures required to address them are set out below:
 The bank is listed and intends to list further shares or loans – this is an inherent risk as it
may lead to manipulating the financial statements for short term gain by directors.
Procedure – Take steps to identify areas which are more subjective or subject to
management discretion and prioritise review as part of the audit.

 The bank has recently expanded operations to overseas countries which exposes it to
specific business, market and foreign exchange rate risks.
Procedure – Review the performance and position of these overseas units against
expectations. Discuss with management the issues encountered in the retail market in
each territory and review procedures for hedging foreign exchange risk on transactions
and balances such as overdrafts.

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  The online banking facility has encountered some security problems in the past year,
indicating increased risk of controls not being effective, so balances may be misstated or
fraud may have occurred.
Procedure – Discuss the nature and extent of the security issues and assess whether
these issues have since been addressed or not by testing account balances generated
by the system.
 Home loan values may be difficult to quantify leading to potential misstatement of
liabilities.
Procedure – Discuss likely levels of default and asset security with management.
 Although the bank has a well-resourced internal audit department which may serve to
reduce control risk and create efficiencies in the audit process, it is still an unknown
quantity to our firm.
Procedure – Evaluate the quality of the outputs and status of the internal audit
department and establish whether any reliance can be placed on their work.
 Money laundering issues related to a bank's customer may indicate a lack of effective
controls or legal compliance in this area. It may also mean that the bank has been
involved in money laundering. Both of these issues will affect our ability to deliver an
effective opinion.
Procedure – Discuss with management the exact nature of the bank's involvement (if this
has not already been done on client acceptance) and ascertain whether the controls in this
area have been improved.
 This is the first year of the audit of Ridley's Bank and so there is increased risk of
misstatements not being identified by the auditor due to the following:
– Overall lack of familiarity with the client;
– Opening balances may be misstated; and
– Materiality levels may be inappropriate (performance materiality may be too high
for certain assets and liabilities for example).

Procedures – Ensure that a thorough planning process takes place to gather full
information on the client. On the assumption that Ridley's Bank was audited by another
auditor before we were appointed, using ISA 510 Initial audit engagements – opening
balances, we should review their work to establish their competence and independence
before reviewing the most recent set of financial statements and the audit report for any
information relevant to opening balances.
We should also observe ISA 320 Materiality in planning and performing an audit to
ensure that the amounts we use for planning materiality are appropriate and that the
criteria adopted for establishing non-financial materiality levels (including performance
materiality on such issues as outstanding loans and related party transactions) are
appropriate.
(b) The financial statement risks with regards to the online banking facility include:
 Website development costs – Those costs that satisfy the condition of IAS 38 Intangible
assets should be capitalised and amortised over the life of the website. All planning costs
should have been treated like research costs and expensed through the statement of profit
or loss in the year they were realised. All website development costs should have been
capitalised and amortised over the useful life of the website (which the standard says
should be 'short').
 Domain name cost – the cost of obtaining the domain name should be treated in the
same way as permission to use a licence – capitalised and amortised.

4
 The IT controls I would expect to find in operation are:
 General controls: These should focus on the prevention of access to the bank's records
from unauthorised persons/hackers (via firewalls) and access controls, so as to ensure
only those authorised have access to the website (through passwords, security checks,
etc).
 Application controls: Input and output controls should be in operation here –
reasonableness triggers should exist to ensure that customers' transactions are input
correctly (such as limits on amounts to be transferred or paid out, queried by the system)
and that they are prompted regularly to confirm that they wish to proceed. Items that
appear outside the reasonable range should be checked on an exception basis.
(c) From: A Manager
To: Fred Hester
Given the sensitivity of this issue, I would suggest starting with a fairly open stance to reassure
the Senior Independent Director that we will not be 'dropping the ball' here, especially as this is
our first year as auditors, but that our duties on money laundering extend beyond the terms of
each individual engagement.
The auditor's money laundering duties in the UK come from the Proceeds of Crime Act 2002 and
can be summarised as follows:
 We must appoint a Money Laundering Reporting Officer (MLRO) whose job it is to
design and implement internal reporting and monitoring procedures
 The MLRO will then train staff in the relevant money laundering legislation, such as how
to recognise cases of money laundering and the action they should take (including
avoiding tipping off potential fraudsters before they can be apprehended)
 We must also establish internal procedures to forestall and prevent money laundering
that may affect the audit office, so we will have to verify the identity of new clients and
maintain all evidence of identification and all client transactions
 We must also report suspicions to the relevant national authority (this is the National
Crime Agency or NCA in the UK) however, it is an offence to tip off fraudsters so care
must be taken in how this reporting is done
 Ridley's Bank will understandably be concerned about the adverse publicity from their
customer who was involved in money laundering last year, and we can help to make them
aware of the issues they face to try and avoid any recurrences
 However, we still have our own duty to uphold the law and while we must be seen to be
supporting the bank in theirs as well (it's likely that as a financial services provider, the
bank's own regulator will have informed them of their responsibilities too) we must be
careful not to overstep the boundaries of independence here – I recommend that our
response stresses that our duty is to the law not to them.

5
2 Murray
Marking scheme
Marks
(a) Matters to be considered
Generally ½ mark each relevant matter identified
+ up to 1 mark for explanation Max 8
Ideas
 Competence/experience
 Objectivity impairment
 Resources/timescale
 Any imposed limitation
 Audit fee constraint
 Materiality
 Group audit
 Permission to communicate
 Future opportunities
(b) Effect of acquisition on planning next year's consolidated financial statement audit
Generally 1 mark each point contributing to an explanation to a maximum of 3
marks each effect Max 10
 Group structure
 Preliminary materiality assessment
 Goodwill acquired
 Reliance on experts (brand/fair values)
 IFRS 3 – completeness of net assets acquired
 Impairment of intangibles
 Liabilities – actual and contingent
 Group (related party) transactions and balances
 Component auditors – group instructions
 Accounting policies
 Timetable
(c) Criteria
Generally ½ – 1½ marks each suitable criterion Max 7
Ideas
 Timeliness
 Clarity, constructiveness, concision ('3 Cs')
 Illustrative examples
 Factual accuracy
 Tiered structure
 Staff/management responses
 Client's perspective
 Professional tone
25

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Suggested solution
(a) Matters to consider before accepting the audit of Di Rollo
Resources
Ross should consider whether it has sufficient resources available to carry out the audit of Di
Rollo, given also that the company is based in South America.
Experience and technical competence
Ross should consider whether its staff are adequately experienced and technically competent
to undertake the audit of Di Rollo, given that it is a foreign subsidiary based in South America, so
will be subject to different rules and legislation.
Fee income
The audit firm should consider whether taking on the audit of the whole of the enlarged Murray
group will mean it places undue dependence on this audit in terms of fees charged. According
to the ethical guidance, gross fee income should not exceed 15% of the firm's total fees from one
client.
Restriction on audit fee
The management of Murray has indicated that the audit fee for the group should not exceed 120%
of the fee for the preceding year. There is a risk that the profitability of the audit engagement will
be compromised if the audit firm cannot deliver to this target (possibly creating a self-interest
threat in the early years of the engagement) plus there is some pressure on Ross & Co to manage
costs that some might consider borders on intimidation.
Materiality
Ross & Co should consider whether Di Rollo is material to the Murray group. The fair value of Di
Rollo's non-current assets at acquisition represents nearly 15% of the non-current assets in
Murray's consolidated financial statements at 31 March 20X8, so this is likely to be seen as a
material component.
Reputation
The company is being sued by its former Chief Executive following his dismissal due to allegations
of contravening Di Rollo's policy on environmentally-friendly waste disposal. Ross should consider
whether it wishes to be associated with the company, given the adverse publicity this is likely to
generate and the possible money laundering implications of not observing laws and regulations
(not least the risk of tipping-off the client).
Objectivity
The audit firm must also consider whether its objectivity would be impaired by taking on the audit
of the Di Rollo and the group audit. This might occur if it was providing other services, in which
case appropriate safeguards would need to be implemented so that objectivity was not
compromised.
Predecessor auditor
Ross should contact the predecessor auditor of Di Rollo to establish why the company is
seeking new auditors and whether there are any reasons why Ross should not accept the audit of
Di Rollo. If the company does not give Ross permission to contact the predecessor auditors
then Ross should not accept the audit.
Group audit
If Ross does not accept the audit of Di Rollo, the parent company may seek an alternative auditor
which may make the audit of the group financial statements more complex.

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(b) Effect of the acquisition on the planning of Murray's consolidated accounts
Resources
Ross & Co must ensure that it has adequate audit resources and expertise in place so that it
can carry out the audit of Di Rollo as well as the audit of Murray and the group accounts.
Use of other auditors
As Di Rollo is based in South America, Ross may choose to use another audit firm based in
South America to undertake the audit of Di Rollo. In this case, it would have to ensure the other
auditors are sent the required information to carry out the audit of Di Rollo as per ISA 600
Special considerations – Audits of group financial statements (including the work of
component auditors). The timetable for preparing and auditing the group accounts must also be
agreed with client management so that all the parties concerned are clear on the key dates and
all the information that is required.
Predecessor auditors of Di Rollo
The auditors may need to arrange to meet the predecessor auditors of Di Rollo to discuss any
issues that may have arisen during their audit of the previous financial year. Ross may also like to
see the previous year's audit file so that these can be reviewed to identify any potential issues.
Materiality
As a result of the acquisition, planning materiality for the group will be higher than previously. In
addition, the materiality of each component should be recalculated as there may now be some
entities that will no longer be material to the group.
Assets of Di Rollo
Assets of $2,373,000 including goodwill were acquired in Di Rollo and make up over 10% of the
post acquisition assets of the Murray group at 31 March 20X8. The acquired company's assets are
therefore material to the group and so the auditors should incorporate into the audit plan a visit to
South America.
Related parties
The auditors must ensure that special consideration is paid to the group structure in order to
eliminate any inter-company balances and transactions on consolidation of the accounts. Any
transfer pricing policies used to distort the financial statements should be identified as well.
Accounting policies
Di Rollo may have accounting policies which are not consistent with those of the consolidated
group. The auditors will have to pay attention to this area as they would have to calculate the effect
of any non-compliance with a group policy that would need to be adjusted on consolidation.
Dismissal of Di Rollo's Chief Executive
As the former Chief Executive has been dismissed, and is suing the company for six months'
salary and damages, the accounts may require disclosure of a contingent liability if the case is
not finalised before the financial statements are authorised for issue.
Possible impairment of brand name and goodwill
As a result of bad publicity for contravention of Di Rollo's policy on waste disposal, the auditors
must consider whether the brand name and goodwill acquired have suffered any impairment.
Consolidation of Di Rollo
As a result of the acquisition early in the financial year, the assets and liabilities of Di Rollo must be
combined into the group accounts and the goodwill capitalised. Special consideration must be
directed to goodwill, the $600,000 fair value of the brand name and the plant and equipment
to ensure that the amounts are reasonable. The fair value adjustment of $419,000 to the plant
and equipment seems particularly high given that the carrying amount is only $95,000.

8
 Goodwill is approximately 50% of the cash consideration paid for Di Rollo and care should be
taken that it does not include items that should be classified as assets elsewhere.
(c) Criteria to assess effectiveness of report to management
The report to management points should be fully and thoroughly explained in terms of the
control deficiencies identified, their implications and the recommendations to mitigate them (all
in line with ISA 265 Communicating deficiencies in internal control to those charged with
governance). Vague points would not have much impact and would be open to questioning, so
the recommendations made to mitigate control deficiencies should be sensible and specific to
the client.
The report to management should be issued on a timely basis as soon as possible after the end
of the audit. This means issuing one at the conclusion of the interim audit as well as the final
audit. This ensures that control deficiencies identified are acknowledged and addressed as soon
as possible.
The report to management could be set out in a tiered fashion – more significant deficiencies
being addressed first. More minor issues could be presented in an appendix at the end of the
letter.
The report to management should be set out in such a way that it allows for management to
respond to the points made. It should include suggestions for actions for management to take.
The implications of the deficiencies identified should be from the point of view of the client and
not the auditor. This ensures that the report to management has more impact and provides added
value at the end of the audit assignment.

9
SECTION B

3 Visean
Marking scheme
Marks
Matters to be considered Evidence to be sought
(a) Brands
Broadly speaking, 1 mark per well 1 mark per well explained source of Max 8
explained point evidence
Issues should address risks, Evidence should explain what it is, where
materiality and accounting treatment it has come from and why it is required
Specific mention of accounting
standards does not score marks, but
demonstration of suitable knowledge
on how to account for an issue
scores marks (IAS 36 and 38 content
capped at 1 mark for each standard)

(b) Discontinued operation

As above for each point As above for each point Max 7
IFRS 5 content capped at 3 marks
IAS 37 content capped at 1 mark

(c) Cash flow statement

As above for each point As above for each point Max 5
IAS 7 content capped at 1 mark
20

Suggested solution
(a) Brands
Matters
(i) Risk
The key risk is that the Ulexite brand has suffered an impairment as a result of the poor
advertising campaign.
(ii) Materiality
The cost of purchased brands represent 3.2% of total assets and 32.2% of profit before
tax. Amortisation represents approximately 3.2% of profit before tax. Net book value would
be a more appropriate figure to use, however based on the information available it would
appear that brands overall are material to the accounts.
The key issue, however, is whether any adjustment required as a result of any impairment
to the Ulexite brand would be material. Assuming materiality based on 5% of profit before
tax any write down in excess of approximately $92,000 would be material.
(iii) Accounting treatment
– Whether the recognition of brands is in accordance with IAS 38. Purchased
brands including Ulexite are capitalised. Self-created brands are expensed. This
satisfies the basic requirements of the accounting standard.

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 – The extent to which management believe the Ulexite brand to have suffered
an impairment. In accordance with IAS 36 an impairment occurs where the
recoverable amount of the asset falls below the carrying amount. This is normally
the result of a change in circumstances, in this case the fall in sales due to the
advertising campaign.
– The amount of any impairment. This will depend on the recoverable amount of
the asset which is the higher of the fair value less costs to sell (not selling price), if
known, and value in use. The way in which management have calculated net
realisable value and value in use will need to be considered.
(It may be difficult to calculate the fair value of the brand, unless there is a binding
sale agreement to sell the asset. Value in use should be more straightforward. It is
likely that each brand will be treated as an income generating unit as it should be
possible to identify the income streams which it generates ie sales independently of
those generated by other brands.)
– Valuation of inventories of Ulexite products. Information obtained in July 20X8
regarding the fall in sales of Ulexite products represents an adjusting subsequent
event as it provides information about the value of the inventory at the year-end
date. This information suggests that the net realisable value of this inventory has
fallen below cost in which case an allowance would be required.
– Valuation of other brands. The effect of the bad publicity could have a knock-on
effect on other brands and products. Customer confidence and goodwill may have
been lost in which case other brands may have suffered an impairment and
other lines of inventory may require allowances.
– Proposed action to be taken by management. This might include:
 The possibility of suing the advertising company responsible for the
campaign. If it is probable that Visean will win the case a contingent gain
would be disclosed.
 Future plans for Ulexite, for example whether it might be sold or discontinued
or alternatively any plans to counteract the bad publicity.
– Period over which brands are amortised. Currently this is over ten years on a
straight line basis. In a business which is subject to fashion and the unpredictable
tastes of the general public the useful economic life of the assets may need to
be reduced.
Evidence
(i) Cost of Ulexite brand at 30 June 20X8 agreed to prior year working papers
(ii) Accumulated amortisation on Ulexite brand agreed to prior year working papers and
current year's amortisation charge
(iii) Schedule showing the basis for any impairment write down of the Ulexite brand.
Assuming this is based on value in use this would be cash flow projections over the
remaining useful life of the brand. This period would not be expected to exceed five years.
(iv) Analytical review of after-date sales and inventory turnover by fragrance (in comparison
to budget). This will show the extent to which the publicity campaign has affected the sales
of Ulexite or otherwise and the impact this may be having on other fragrances
(v) Records and analysis of sales returns after the year-end
(vi) Results of review of the cash book and after-date invoices to identify any expenses
incurred in order to rectify the damage caused eg advertisement with apology, new
advertising campaign
(vii) The initial advert and any press/media comment to gauge the scale of the impact and the
strength of feeling

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 (viii) Board minutes noting any future plans for Ulexite, for example a plan to discontinue it
(ix) Correspondence with legal advisors in respect of any claim which might be made against
the advertising company
(x) Industry information regarding average product lives and analysis of Visean's sales
trends to assess the useful economic life of the brands.
(b) Discontinued operation
Matters
(i) Risk
There is a risk that results relating to the factory are disclosed incorrectly ie
continuing/discontinuing. There is also a risk that costs surrounding the closure are
inappropriately provided for.
(ii) Materiality
Although the results of the factory are not specifically provided the disclosure (or not) of
this information as a discontinued activity is likely to have a material effect on the
accounts.
The provisions represent 68.3% of the profit before tax and are therefore material to the
accounts.
(iii) Accounting treatment
– Whether the plans to discontinue medical consumables constitute a discontinued
operation. This depends on whether:
 It meets the criteria to be classified as 'held for sale' under IFRS 5
 Represents a separate major line of business
 Is part of a single co-ordinated plan to dispose of a separate major line of
business
– Assuming the plans do constitute a discontinued operation, are disclosures
adequate? As a minimum, the statement of comprehensive income should show
as a single figure post-tax profit or loss of the discontinued operation and the post-
tax gain or loss on re-measurement of assets classified as 'held for sale' or on
disposal
– An analysis of the above figures should be provided showing:
 Revenue, expenses and pre-tax profit or loss
 Income tax expense
 Gain or loss recognised on the measurement to fair value less costs to sell or
on the disposal of the assets
 Net cash flows by category
– Whether related assets need to be classified as 'held for sale', such as the
factory. These would be disclosed in aggregate as a separate line item within
current assets. This will depend on whether the following criteria are met:
 Available for immediate sale in their present condition
 Management are committed to the plan to sell
 An active programme to locate a buyer has been initiated
 Assets are being actively marketed for sale at a reasonable price
 They are expected to be sold within one year of classification
 It is unlikely that significant changes will be made to the plan.

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 – Whether any assets 'held for sale' have been valued correctly. Non-current
assets should be valued at the lower of their carrying amount and fair value less
costs to sell.
– Whether provisions for redundancy costs and the unexpired lease term
should be recognised. In accordance with IAS 37 a provision should only be
recognised if a constructive obligation exists. The company does seem to have a
detailed and formal plan and by making the announcement in June is likely to have
raised a valid expectation that the restructuring will occur.
– Whether the costs provided for are allowed. A restructuring provision should
include only those costs directly arising from the restructuring and not
associated with ongoing activities. The redundancy costs (excluding any
retraining or relocation of continuing staff) and obligations under the onerous
contract appear to meet those criteria.
– The impact on Visean's relationship with hospitals. Visean may lose the
hospitals completely as a customer if they no longer supply medical consumables.
The extent of the impact will depend on the nature and amount of any other sales.
Visean may be liable to penalties if the cessation of supply constitutes a breach of
contract.
Evidence
(i) Board minutes approving the closure of the factory and the decision to discontinue the
medical consumables range
(ii) Copy of the announcement made to the press/employees/customers
(iii) Segmental analysis to support the contention that medical consumables represent an
identifiable market
(iv) Schedule/accounts showing disclosure of the medical consumables operation as
discontinued and assets as 'held for sale'
(v) Details of the values attributed to assets 'held for sale' and the basis on which those
valuations have been made
(vi) Ledger accounts/budgets and prior year accounts for comparison with separate
disclosure in the current period
(vii) Documentation supporting a detailed and formal plan for closure
(viii) Schedule showing the calculation of the provisions including a breakdown of the nature
of the costs (eg redundancy or training) and any assumptions made
(ix) Employment contracts for agreement of redundancy terms
(x) Factory lease and any correspondence with the lessor for confirmation of the penalty for
surrendering the lease
(xi) Sales agreements for plant and equipment entered into post year-end to determine
impairment of assets
(xii) Contracts with hospitals and other suppliers to determine the extent of any other penalty
clauses

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(c) Statement of cash flows
Matters
(i) Accounting treatment
Whether Visean can report net cash flows from operating activities using the indirect
method.
Under IAS 7 operating cash flows can be shown either under the direct method or the
indirect method. Although the direct method is encouraged by IAS 7 it is not a requirement.
Visean can adopt either method therefore and the change from one method to the other
does not contravene IAS 7.
(ii) Whether the comparative figures should have been restated
These figures are used for comparison purposes and as such they need to be prepared on
a consistent basis with the current year's figures. In accordance with IAS 8, where a
change in policy is made should be applied retrospectively. The auditor has a
responsibility under ISA 710 Comparative information to ensure that if comparatives
have been adjusted this is properly disclosed. Provided this is the case, the treatment is
acceptable.
(iii) Potential impact on the auditor's report
Although they form part of the financial statements the auditor does not specifically
express an opinion on the comparatives. Even though in this case they have been
restated, provided that this has been done correctly and disclosed adequately, no
reference would be made to this in the audit report.
Evidence
(i) Agreement of figures in revised comparative cash flow to previous years financial
statements. (Even though the presentation of cash flows from operating activities will have
changed, ultimately the final result should be the same.)
(ii) Schedule of cash received from customers agreed to receivables ledger control account
(iii) Schedule of cash paid to suppliers agreed to payables ledger control account
(iv) Schedule of payments to employees agreed to payroll control account
(v) Analysis of any other cash payments.

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4 RH Manufacturing
Marking scheme
Marks
(a) Objections about the cost of the statutory audit:
Audit regarded by some companies as a commodity and priced accordingly
Audit may not be perceived as value for money unlike other consultancy
Disconnect between statutory requirement and any benefits obtained
RH Manufacturing – private company so agency solution is not an issue
Listed companies – some agency protection but costs money with no choice
and little liability on auditors
Lenders/HMRC etc. may want audited F/S but do not pay for them
1 mark for each well-explained point Max 6

(b) Auditors can help the clients keep the audit fee low by:
Cooperating with the company's internal audit department
[Independence issues of providing both internal and external audit?]
Advising the client to improve its internal control systems
Explaining the fee structure to the client (expectations gap?)
Highlighting the areas to the client where the auditor adds value
Advising companies to simplify their structures
Advising clients to use one audit firm
1 mark for each well-explained point Max 7

(c) Critical discussion of finding audit work however and wherever:

Ethical issues – competence
Ethical issues – self-review
Ethical issues – familiarity
RH Manufacturing – 'lowballing' in theory and practice
Anti-competitive nature of statement
Homogeneous commodity? Reputation issues
Contradiction of fees and quality
Conclusion – what do clients want?
Up to 1½ marks for each well-explained point – critical nature suggests that
candidates focus on the flaws in this statement so answers should reflect
this. Marks should be capped at 5 if no mention of RH Manufacturing.
Max 7
Total 20

Tutorial note: It is worth pointing out that given the topical and discursive nature of this question,
candidates' answers may vary quite considerably from these solutions but still address the key issues of
fee-setting and the trade-off between professional duty and commercial awareness.

Suggested solution
(a) The likely reasons for such objections on the part of the client may start with the perception that
the audit is treated as a commodity and priced on the basis of it being bought and sold in a
market, regardless of its value to the client or society due to it being a legal requirement. This
is further reinforced by the perception that value for money (VfM) is questioned when compared
with other services, such as management consultancy.
This sense of disconnection between the statutory requirement and the benefit obtained is
bound to generate resentment among companies whose profits are being squeezed already by
the harsh trading environment.

15
 Commentators often state the benefits of audits as a form of reassurance to shareholders who
struggle with the lack of visibility of their directors (also known as the agency problem). For
companies like RH Manufacturing however, as the company is run and owned by the same
family, this is not an argument that will carry much weight. Similarly, although other public listed
companies have many shareholders who can use the audit as a form of control over their
agents, the inflexible approach and limited liability attached to the auditors' work makes the
fees still seem unfair.
It seems as though the only parties to really benefit from the audit are third parties such as
lenders and the tax authorities (HMRC in the UK) as they stipulate the requirement for an
external audit (and even who should do it, such as a 'Big 4 Firm' in the case of some restrictive
covenants placed on companies by their banks) and yet it is still the company who has to pay for
the audit fee.
All these factors lead to companies feeling frustrated with the costs of the audit and may go some
way towards understanding why they may seek an audit at minimal cost.
(b) Taking the points raised in part (a) into account, there are things that the auditor can do to try and
help keep the audit fee at a level deemed acceptable by the client. Cooperating with the
company's internal audit department (if one exists) as much as is possible is a good starting
point to try and avoid unnecessary duplication in areas such as testing internal controls.
This raises an issue that has become more prevalent in recent years, that of the same firm
providing both internal and external audit services. A significant proportion of listed
companies have been shown to be making use of such arrangements (referred to as 'extended
audit'). While companies are frequently able to make significant savings on their previous audit
fees by taking this approach, concern has understandably been expressed over independence
due to potential self-review threats (although such claims have so far been rejected quite
vigorously by the members of the audit profession concerned).
While question marks remain over the professional issues surrounding closer working with
internal auditors, advising the client to improve its internal control systems so as to enable
greater reliance on internal control systems, and thus reducing expensive substantive
procedures is a far more straightforward suggestion for reducing the fee burden.
Sometimes, the fee level may not be the issue and instead, the client may not feel it is getting
what it agreed to pay for. This is a perennial problem for auditors, so explaining the fee
structure to the client so that there is no misunderstanding (in line with ISA 210 Agreeing the
terms of audit engagements) may be a quick win for the auditor in managing such expectations.
Similarly, highlighting those areas to the client where the auditor adds value might help make the
fee seem more acceptable. Auditing standards such ISA 260 Communication with those
charged with governance and ISA 265 Communicating deficiencies in internal control to
those charged with governance and management include measures to improve valuable
feedback from the audit process and hence remove the perception that the audit is simply a
necessary evil. The recent introduction of extended auditor reporting, in which auditors report
on key matters considered in the audit but not previously communicated, attempts to make use of
information already obtained by auditors which can add value to users of the auditor's report.
The auditor can also suggest to the client that they adopt some organisational changes to
reduce the likely cost burden of the statutory audit. Advising companies to simplify their
structures to keep the audit fee low rather than simply to avoid tax is one idea. Advising clients
to use one audit firm for all components and therefore maximise any efficiencies is another.
After experiencing financial reporting problems, Royal Dutch Petroleum Company and Shell
Transport and Trading decided to adopt one corporate and listing entity under the name Royal
Dutch Shell, removing among other things the need for two separate audits in the Netherlands
and the UK.

16
 In summary, there are plenty of ways that the 21st Century auditor can make the fee more
acceptable to the client, but overall, a sound working relationship based on constructive
dialogue is a good start.
(c) 'In the 21st Century, audit firms are just like any other business and have to find work
however and wherever they can.'
This statement opens up a debate that is at the very heart of being a professional – how do you
find the right balance between professional duty and commercial success? The suggestion
made by the statement is that we should make money regardless of the professional duty placed
upon us – there are certainly three issues that are raised by this:
1. It would be unethical for us to tender for an engagement that we are not technically
competent to perform, as it reflects badly on us in the long run (unlike emergency surgery,
where incompetence is identified very quickly);
2. From the discussion in part (b) above, there would appear to be a business case for
providing both internal and external audit services to the same client (a case that
satisfies both the client and the auditor) but the fact remains that the self-review threat is
still something that could affect audit independence (which shareholders and other
stakeholders may have concerns about); and
3. It would adversely affect our independence if we were to ignore the guidance on rotation
put forward to counter the threat of familiarity with our clients.
So the fundamental ethical principles have something to say in this debate – what about the
market? Taking RH Manufacturing as a case in point, the implication is that the prospective
auditor should submit a tender at a price that satisfies the client regardless of whether it covers
the true cost of the audit – the practice of setting fees at such a level is referred to as 'lowballing'
and while not unethical, it does raise questions about the quality of an audit where the fees do
not cover the necessary costs for delivering an opinion.
Competition is a tricky subject in the audit profession, as it raises the issue of value for money
which assumes that all firms can be compared on a like-for-like basis, where the amount of
'utility per $' is the common principle used for comparison. However, while competition is
supposed to focus on all factors, inevitably cost will be considered in times of financial austerity
and the simple facts of commercial life dictate that, while large professional services firms may
have sprawling overheads to cover, they can often under-cut the smaller firms meaning that
competition is not on a level playing field and quality is again ignored.
This can have dangerous implications if the profession promotes a market where auditors are
chosen simply on the basis of commercial criteria alone, as it may risk devaluing our services to
such an extent that they are viewed as just another homogeneous commodity (Tutorial note: to
some extent, audit is generic – reforming audits to be more than just a 'health-check' however is a
debate for another day) open to basic supply and demand economics. Supermarkets are very
open about selling products at competitive prices, some at levels below cost to tempt the
shopper into the marketplace for other more lucrative products. This 'loss-leading' approach is
fine for groceries, but we have seen the same thing in the audit profession before – Arthur
Andersen losing money on the Enron and WorldCom audits simply to secure more lucrative
consultancy work – and that can only be a bad thing for a profession already with question marks
over its reputation.
Perhaps the secret for professional services firms is to find a way of differentiating themselves
when the audit is so regulated and the outcome is in such a standard format so as to avoid
charges of simply selling on price alone. We face a curious contradiction that in order to create
a better impression of quality, we have to increase our fees and 'market' our services at the
luxury end of the market, where value rises along with price. This 'designer' approach to audit
creates a unique brand but can back-fire as the fees charged may be too high to attract clients.
So, it seems clients hold the key to commercial success then – fees should follow the 'Goldilocks'
approach of 'not too high, not too low' – but engagements should be agreed with clients so the
process is also considered, rather than just the input (fees) and the output (the auditor's report).

17
5 Topper
Marking scheme
Marks
(a) Standardised auditor's report:
– Easy to follow/familiar
– Common language
– Ensure all items mentioned/expectation gap
– Inflexible
– Won't read same as last year
– Conclusion
Credit should be given for all sensible arguments
1 mark should be awarded for a clearly explained point
(half marks may be awarded) Max 6

(b) (1) Mouse

– No opinion given on Chairman's statement
– ISA 720 (need to consider effect of material inconsistencies)
– 0.4% not the same as major = material inconsistency
– Reworded/resolved – unmodified, no comment
– Not resolved – unmodified but refer to in Other Information
section
Generally 1 mark per developed point to a maximum of 4 marks Max 4

(2) Rocky
– Duty to check disclosure in accordance with ISA 550
– IAS 24 requires disclosures re: key management personnel
– Materiality zero for sensitive areas such as directors
– Not disclosed = qualified 'except for'
– Material misstatement over inadequate disclosure
– Detail included in explanatory paragraph
– Conclusion
Specific use of ISA 550 and IAS 24 content scores 1 mark each
(no marks for just mentioning names of standards)
Generally 1 mark per developed point to a maximum of 4 marks
(half marks may be awarded) Max 4

(3) Mighty
Subsidiary acquired with the intention to sell has exemption from 1
IFRS 10 and consolidation
Provided it satisfies the conditions of IFRS 5 1
Under IFRS 5 asset should be classified under Current assets 1
If IFRS 5 is satisfied, then no modification is required 1
BUT Any form of control leads to consolidation surely? Further
discussion with client suggested? 1
Negative Goodwill per IFRS 3 should be rechecked for occurrence 1
If confirmed, should be credited directly to SoPL 1
Modification is required – opinion should be qualified on grounds 1
of material misstatement
Specific knowledge of reporting standards scores ½ mark each
Max 6

Total 20

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Suggested solution
(a) Standardised auditors' reports assist the reader by helping them to follow and understand the
content of the report. In particular the use of common language, with which the user should be
familiar, aids the understanding of the report.
A standardised auditor's report ensures that all necessary areas of content have been included,
for example details of auditor's responsibilities, and information regarding the basis of opinion,
in addition to the actual opinion. This helps to address the problem of the expectation gap.
However, wholly standardised auditors' reports are inflexible and cannot be tailored to specific
circumstances. In most situations this should not cause problems, however unusual
circumstances may warrant the provision of additional information which a standardised
auditor's report cannot incorporate.
ISA 700 Forming an Opinion and Reporting on Financial Statements attempts to overcome this
problem by including tailored elements in the standard unmodified report for listed companies: the
Key Audit Matters (KAMs). These allow the auditor to give additional information on the audit, but
without modifying the report.
Although readers should be aided by standardised auditor's reports the use of a standard report
may result in the user not thoroughly reading the report in the belief they know what it contains
and under the impression that it is the same as in previous years. Readers may therefore
miss a modification or an explanatory paragraph (such as an emphasis of matter paragraph).
The introduction of KAMs, however, means that the auditor’s report is providing useful information
to users, which they are more likely to take the time to read carefully.
To conclude, the advantages arising from the use of standardised auditors' reports seem to
outweigh the limited drawbacks. ISA 700 attempts to walk a line between the two extremes, by
including tailored elements within an otherwise standardised report.
(b) (1) Mouse
The auditor expresses an opinion on the truth and fairness of the financial statements
(ie statement of profit or loss, statement of financial position, statement of cash flows and
associated notes), of which the Chairman's statement is not a part. Therefore the auditor’s
opinion does not cover the other information as such.
Under ISA 720 The auditor's responsibilities relating to other information however,
the auditor must read the other information (the Chairman’s statement). This is because if
there are inconsistencies between the other information and the audited financial
statements (and the auditor’s understanding of the entity) then this suggests that there is a
misstatement somewhere. Either the other information is misstated, or the financial
statements (or auditor’s knowledge) are misstated.
In this case, there is a material inconsistency between the Chairman’s statement and the
financial statements: clearly, 'major' is inconsistent with 0.4% and gives a misleading view
of the state of the company.
The auditor must determine whether it is the Chairman’s statement or the financial
statements which contain the misstatement. If, as the audit senior thinks, it is the
Chairman’s statement then the Chairman should be asked to amend it. If it is the audited
financial statements then further evidence must be obtained, performing further
procedures in line with ISAs.
If the misstatement is corrected, then a standard unmodified auditor’s report will be issued.
If it is the other information that is misstated and this is not corrected, then the auditor
should state in the Other Information section of the auditor’s report that the Chairman’s
statement is misstated. A description of the misstatement would then be given. This
section would be placed after the Basis for Opinion section, and does not affect the
auditor's opinion.

19
 If the misstatement were found to be in the financial statements (after obtaining further
audit evidence), then this is the same as any other material misstatement. A modified
auditor’s opinion would be expressed, the extent of which would have depended on the
circumstances. In this case it is likely to have been material but not pervasive, leading to a
qualified 'except for' opinion.
(2) Rocky
The auditor has a responsibility under ISA 550 Related Parties to ensure that all
transactions with directors, which require disclosure under IAS 24 Related Party
Disclosures, have been adequately disclosed.
Consequently, the details of the loans of $2,000 to Mr Wright and of $15,000 to Mr Oldfield
should be disclosed in the financial statements of Rocky as key management personnel
are related parties under IAS 24. The amounts may be considered immaterial in
quantitative terms, but materiality is reduced to zero when dealing with sensitive
transactions such as directors' transactions.
If these details are not fully disclosed, then it is the auditor's responsibility to detail the
missing information in an explanatory paragraph in the auditor's report. The opinion would
be qualified 'except for' on the grounds of material misstatement or disagreement over
disclosure.
Conclusion
The audit senior's proposal is not suitable. If the necessary disclosures are not made by
the client, the auditor's opinion should be modified ('except for') due to material
misstatement (disagreement) over inadequate disclosure.
(3) Mighty and Minor
The decision not to consolidate a subsidiary on the grounds that only temporary control is
exercised is acceptable under the provisions of IFRS 5 Non-current assets held for sale
provided the conditions of accounting under IFRS 5 are satisfied. The main conditions
include management's commitment to sell the subsidiary within 12 months, the active
search for a buyer, the active marketing of the subsidiary, the sale should be highly
probable and the subsidiary should be available for immediate sale. If all these conditions
are satisfied, then the subsidiary held for sale should be classified under Current Assets.
It could be argued that any form of control indicates a desire to make use of the subsidiary
for more long term purposes than making a profit on immediate resale, so consolidation is
the only option – perhaps discussions with the client to clarify their intentions would be
more appropriate before deciding on the most appropriate form of audit report.
Conclusion
The audit senior's proposal for Minor is incorrect as the accounting treatment seems
reasonable. The auditor's opinion should be unmodified with no additional form of
communication required. However, if discussions with management indicate that this
treatment is not consistent with their plans for Minor, then this may require revision.
Mighty and Merry
Accounting for negative goodwill as a negative asset is unacceptable according to IFRS
3 Business Combinations. Where negative goodwill is calculated, IFRS 3 states that this
calculation should be checked for accuracy. When the amount of negative goodwill is
confirmed, this amount should be credited to the statement of profit or loss as a non-
recurring gain or bargain.

20
Consequently, there appears to be a misstatement over disagreement on the basis of
the accounting treatment of negative goodwill. The matter is likely to be material. If this
matter is not resolved with management, a qualified opinion will be expressed at the
beginning of the auditor’s report.
Conclusion
The audit senior's proposal is correct for Merry: the auditor's opinion should be qualified
on the grounds of material misstatement.

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