PROFESSIONAL LEVEL AND STAGE EXAMINATION

Monday 9 December 2013

(2½ hours)

AUDIT AND ASSURANCE

This paper consists of SIX short-form questions (20 marks) and THREE written test
questions (80 marks).

1. Ensure your candidate details are on the front of your answer booklet.

2. Answer each question in black ball point pen only.

Short-form Questions (1 – 6)

3. Answer the short-form questions in note form only. Complete sentences are not
required.

4. Answers to each short-form question must begin on a new page and must be submitted
in numerical order.

Written Test Questions (7 – 9)

5. Answers to each written test question must begin on a new page and must be clearly
numbered. Use both sides of the paper in your answer booklet.

6. The examiner will take account of the way in which answers are presented.

IMPORTANT

Question papers contain confidential You MUST enter your candidate number in this
information and must NOT be removed box.
from the examination hall.

DO NOT TURN OVER UNTIL YOU

ARE INSTRUCTED TO BEGIN WORK

Copyright © ICAEW 2013. All rights reserved. Page 1 of 9

1. Jane Harp is the engagement partner responsible for the external audit of Oboe plc (Oboe), a
listed company. Jane is due to be rotated off the audit team as she has been the
engagement partner for the last five years. However, following the unexpected resignation of
Oboe’s finance director, the audit committee has requested that Jane continues as
engagement partner.

State, with reasons, how Jane’s firm should respond to the audit committee’s request.
(3 marks)

2. You are the audit manager responsible for the external audit of Gong Ltd (Gong). During your
annual performance review, John Bell, the engagement partner, set you a target of selling
£100,000 of non-audit services to Gong during the year ending 31 December 2014. He
proposed that if this target was met, a bonus payment of 20% of your salary would be made
and that your progression within the firm would be accelerated.

Identify and explain the threat to your objectivity presented by John’s proposal and state, with
reasons, whether or not it is appropriate. (3 marks)

3. Cornet LLP (Cornet) is a large UK external audit firm that also has an office in Poland. Cornet
has recently transferred some external audit work relating to UK clients, that for many years
has been performed in the UK, to the office in Poland. This audit work comprises obtaining
external confirmations and the audit of ledger balances for those UK clients whose systems
allow the work to be performed remotely in Poland.

State how Cornet could effectively manage the risks to audit quality associated with the work
performed by Cornet’s office in Poland. (3 marks)

4. Your firm is the group external auditor of Timpani plc (Timpani) a company based in the UK
with large subsidiary companies operating in Bahrain, Singapore and Cyprus. Each
subsidiary is audited by a different firm of auditors. You are planning the group audit for the
year ending 31 January 2014 and are currently drafting an email to inform the subsidiaries’
auditors of your firm’s requirements for their work.

List three items to be included in the email that are relevant to the subsidiaries’ auditors when
planning their own audit work and for each item state the reason why it should be included.
(3 marks)

5. External auditors are required to communicate significant deficiencies in internal controls

identified during the audit to those charged with governance.

Identify and explain the attributes that such communications should have in order to be
effective. (4 marks)

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6. Your firm is the external auditor of Banjo Ltd (Banjo), a publisher of a weekly magazine,
whose year end is 31 October 2013. On 26 November 2013 Triangle Ltd (Triangle)
commenced legal proceedings against Banjo for libel, following a series of articles that
appeared in the magazine in September and October 2013. Triangle claims the articles have
damaged its reputation leading to a fall in income. The directors of Banjo dispute the claim. If
the claim is successful, the damages are likely to be material to the financial statements of
Banjo for the year ended 31 October 2013 which are due to be approved on 20 December
2013.

List the audit procedures that you should undertake in respect of the legal claim by Triangle.
(4 marks)

QUESTION 6 COMPLETES THE SHORT-FORM QUESTIONS

WRITTEN TEST QUESTIONS (7 – 9) FOLLOW

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7. Your firm is the external auditor of High Street Electrical plc (HSE), a listed company, for the
year ending 31 December 2013. The company’s principal activity is the retailing of electrical
household goods to the general public through a number of leased stores and online through
the company’s website. Goods are distributed from an old warehouse owned by HSE and
located in a residential area.

Due to difficult trading conditions, the directors of HSE have recently approved a three-
year strategic plan for 2014 to 2016 which sets out how HSE’s operations will be
restructured in order to remain competitive. Funding for the restructuring will be provided
by proceeds from the disposal of the warehouse, existing cash reserves and a bank loan.
The directors are negotiating with the company's bank to provide the loan and have
prepared cash flow forecasts for the three years ending 31 December 2016 in support of
the request for funding. The company's bank requires the cash flow forecasts to be
examined and reported on by independent accountants and the directors have requested
that your firm performs this examination.

The key elements of the three-year strategic plan are:

 unprofitable stores located in retail parks will be closed over the next three years
when each store’s lease expires. HSE expects that approximately 50% of the staff
will accept alternative positions within HSE and the remaining 50% will be made
redundant on the date of closure.

 agreement has been reached with the administrators of an unconnected company,

Victory Videos Ltd, to transfer the leases of twenty stores, in prime locations, to
HSE. These stores will be refurbished and act as display stores where customers
can see the products before ordering either in-store or through the company’s
website.

 the company’s website will be re-launched and an IT director recruited to manage

the sub-contractors to be engaged in this work. The IT director will also have
responsibility for the replacement of the management information and financial
reporting systems.

 the warehouse will be sold to a property developer and HSE is currently applying for
planning permission to change the use of the land from commercial to residential. A
new larger purpose-built warehousing facility will be leased. Rent on this facility is
payable quarterly in advance but the landlord has agreed a rent-free period for the
first six months.

 as an increase in sales volume is forecast, further investment will be made in

vehicles to be used for distribution.

HSE does not currently have an internal audit function. However, in accordance with the
UK Corporate Governance Code, HSE’s audit committee has considered the need for an
internal audit function and has recommended the introduction of such a function during
the year ending 31 December 2014.

In addition to the external audit and the examination of the cash flow forecast the
directors have asked your firm to:

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(1) Advise on the acquisition of the new management information and financial
reporting systems. The directors wish to purchase off-the-shelf packages but are
overwhelmed by the choice of the systems available.

(2) Provide a forensic specialist from your firm to assist HSE in an investigation of
substantial inventory losses. Preliminary investigations by HSE’s directors have
highlighted the theft of inventory by two former employees as a possible cause. The
directors want your firm to help quantify the inventory loss and to act as an expert
witness in any resulting legal proceedings against the employees.

(3) Advise on the remuneration package for the IT director.

Requirements

(a) (i) Identify the matters to be included in your firm’s engagement letter for the
examination of the cash flow forecasts in respect of:

 management’s responsibilities;
 the purpose and scope of your firm’s work; and
 limiting your firm’s liability.

(ii) Explain why these matters should be included. (8 marks)

(b) From the information provided in the scenario, identify the key receipts and payments
that you would expect to be included in the cash flow forecasts prepared by the
directors of HSE. For each receipt and payment, identify the specific matters you would
consider when reviewing the reasonableness of the assumptions underlying that receipt
or payment. (11 marks)

(c) Identify and explain the principal threats to independence and objectivity which may
arise from the provision of the non-audit services listed (1) to (3) above and state how
your firm should respond to each threat. (12 marks)

(d) Assuming the board of directors accepts the audit committee’s recommendation:

(i) Outline three procedures that might be performed by HSE’s internal audit function
during visits to the stores.

(ii) Outline the effect on your firm’s approach to the external audit of HSE for the year
ending 31 December 2014, if your firm decides to rely on the work of HSE’s
internal audit function. (6 marks)

(37 marks)

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8. Your firm is the external auditor of Graphite plc (Graphite) for the year ended
30 November 2013. The principal activity of the company is the manufacture and installation
of mining equipment. Graphite operates from two freehold sites in Cardiff and Newcastle.
Trading conditions are difficult and revenue in previous years has increased by less than 2%
per annum.

You are the audit manager and the engagement partner has asked you to consider the
following key areas of audit risk:

(1) Revenue
(2) Work in progress
(3) Trade receivables
(4) Freehold premises

All work performed by the company is carried out under short term fixed-price contracts for
mining companies located throughout Europe and all customers are invoiced in Sterling.
Graphite’s employees design the equipment to customers’ specifications and buy in
components from suppliers in mainland Europe and install the machinery. Overseas
suppliers invoice Graphite in Euro.

The contract price is negotiated and agreed with the customer before commencement of any
work by Graphite. The terms of payment require an initial payment of 40% of the contract
value prior to the commencement of any work and the balance following the successful
installation of the equipment. It is company policy to recognise revenue once the customer
confirms successful installation of the equipment. Graphite’s terms of trade require payment
within 30 days of invoice date for both initial payments and final instalments. One customer,
Durcoal Ltd, is withholding its final instalment of £1,835,000 as it claims that the equipment is
not operating efficiently.

All direct costs relating to each contract are recorded in the company’s job costing system
which is integrated with the purchases and payroll systems. The finance director uses the
cost records to calculate the value of work in progress for the monthly management accounts
and the year-end financial statements. For the valuation of work in progress a percentage is
added to direct costs to cover production overheads. The percentage is determined by taking
attributable overheads in the management accounts as a percentage of direct costs in the
management accounts. Provision is made for contract losses where appropriate. The prior
year audit identified a number of weaknesses in the job costing system.

The company’s freehold premises in Cardiff were valued by an external valuer in October
2013. The premises are currently included in the accounting records at cost less
accumulated depreciation which is lower than the valuation figure. The directors wish to
recognise the new valuation in the financial statements for the year ended
30 November 2013.

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The engagement partner has provided you with the following extracts from the financial
statements:

Income statement for the year ended 30 November

2013 2012
(draft) (audited)
£’000 £’000
Revenue 51,260 47,560
Cost of sales 30,760 30,440
Gross profit 20,500 17,120

Statement of financial position as at 30 November

2013 2012
(draft) (audited)
£’000 £’000
Current assets
Work in progress 7,500 6,305
Trade receivables 6,620 3,450

Requirement

Justify why the items listed (1) to (4) in the scenario have been identified as key areas of
audit risk and, for each item, describe the procedures that should be included in the audit
plan in order to address those risks. (23 marks)

Note: You should present your answer in a two-column format using the headings:

(i) Justification; and

(ii) Procedures to address the risk.

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9a. Your firm has recently been appointed as the external auditor of Toledo Ltd (Toledo) a
company which owns and manages a large portfolio of residential properties from which it
receives rental income. The company has non-current assets comprising properties,
vehicles, grounds maintenance machinery, office equipment and high value tools used for
property repairs.

During the external audit for the year ended 31 October 2013, you identified the following
deficiencies in internal control to be reported to the management of Toledo:

(1) References and signed lease contracts were not obtained for new tenants on a number
of occasions throughout the year.

(2) Comparison of the non-current asset register with physical assets has not been
undertaken in the last four years. Company policy stipulates that an annual asset
verification exercise must be performed.

(3) Monthly bank reconciliations prepared by the assistant accountant are not reviewed by
a responsible official.

Requirement

Draft points for inclusion in your firm’s report to the management of Toledo. For each internal
control deficiency identified, you should outline the possible consequence(s) of the deficiency
and provide recommendation(s) to remedy each deficiency. (10 marks)

Note: You should present your answer in a two-column format using the headings:

(i) Consequences; and

(ii) Recommendations

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9b. Described below are situations which have arisen at two unrelated external audit clients of
your firm. The year end in each case is 31 October 2013.

Herald Ltd (Herald)

Herald maintains continuous inventory records and consequently the company does not
perform a physical count at the year end. On 1 November 2013, a fire in the office at Herald’s
warehouse destroyed the company’s inventory records and records of goods inwards and
outwards. The physical inventory was not damaged. There were no satisfactory audit
procedures which could be performed to verify the inventory figure at the year end. The
company has estimated the value of inventory on 31 October 2013 to be £250,000 and
included this amount in the year-end financial statements.

Herald’s total assets as at 31 October 2013 are £8,350,000 and profit before tax for the year
then ended is £1,370,000.

Acclaim plc (Acclaim)

Acclaim is a company which searches for and excavates minerals and is involved in the
development of two sites in Wales where mineral reserves have been identified. Planning
permission for the mining infrastructure has not yet been obtained and the technology
needed to extract the minerals is unproven because of difficult geological conditions. The
directors have prepared cash flow forecasts that show that Acclaim can continue to operate
without the need for additional funding for one year from the proposed date of approval of the
financial statements. Continued operations can be achieved by deferring expenditure as
necessary, but additional funding will be required after one year. The directors are confident
that all of the uncertainties can be resolved and have prepared the financial statements on a
going concern basis. They have included a note to the financial statements which fully
discloses the situation. The engagement partner is satisfied that the note includes all the
necessary information for the users of the financial statements to understand the situation.

Requirement

For each of the situations outlined above, state whether or not you would modify the audit
opinion. Give reasons for your conclusions and describe the modifications, if any, to each
audit report. (10 marks)

(20 marks)

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