Questions and Answers Master Class

Client confidentiality underpins the relationship between Chartered Certified Accountants in practice and their clients. It is a core element of ACCA's Code of Ethics.

Required:

(a) Explain the circumstances in which external auditors are permitted or required to disclose information relating to their clients to third parties without the knowledge or consent of the client. (4 marks)

(b) A waste disposal company has breached tax regulations, environmental regulations and health and safety regulations. The auditor has been approached by the tax authorities, the government body supervising the award of licences to such companies and a trade union representative. All of them have asked the auditor to provide them with information about the company. The auditor has also been approached by the police. They are investigating a suspected fraud perpetrated by the managing director of the company and they wish to ask the auditor certain questions about him. Describe how the auditor should respond to these types of request. (6 marks)

Solution:

(a) Disclosure without consent: Auditors are required to disclose information when it is required by law (e.g., for legal proceedings or to report money laundering) or when there is a professional duty or right to disclose (e.g., for a quality review by ACCA or a regulatory inquiry).

(b) Responding to requests: The auditor must not disclose information without the client's consent unless a statutory duty requires it. The auditor should seek legal advice in all these cases. For non-statutory requests (e.g., from the trade union), the auditor should not disclose information without the client's permission.

You are a manager in the audit firm of JT & Co and this is your first time you have worked on one of the firm's established clients, Pink Co. The main activity of Pink Co is providing investment advice to individuals regarding saving for retirement, purchase of shares and securities and investing in tax efficient savings schemes. Pink Co is a listed company regulated by the relevant financial services authority. You have been asked to start the audit planning for Pink Co, by Mrs Goodall, a partner in JT & Co. Mrs Goodall has been the engagement partner for Pink Co, for the previous seven years and so has a sound knowledge of the client. Mrs Goodall has informed you that she would like her son Simon to be part of the audit team this year; Simon is currently studying for his first set of papers for his ACCA qualification. Mrs Goodall also informs you that the audit senior, received investment advice from Pink Co during the year and intends to do the same next year. In an initial meeting with the finance director of Pink Co, you learn that the audit team will not be entertained on Pink Co's yacht this year as this could appear to be an an attempt to influence the audit opinion. Instead, the audit team has been invited to a day at the horse races costing less than two fifths of the expense of using the yacht. JT & Co has done some consulting work previously and the invoice is still outstanding.

Required: Identify and explain the threats to independence in relation to the audit of Pink Co by JT & Co. For each threat, recommend how the threat can be managed. Prepare your answer using two columns headed Ethical threat and Possible safeguard respectively (10 marks)

Solution:

Ethical threat	Possible safeguard
Familiarity: Mrs Goodall has been the engagement partner for seven years. This long association threatens her objectivity.	Mrs Goodall must be rotated off the engagement team for a cooling-off period of five years.
Self-interest/Familiarity: Mrs Goodall's son, Simon, is on the audit team. This family relationship could compromise objectivity.	Simon should not be part of any audit team where his mother is the partner.
Self-interest: The audit senior received investment advice from the client, which could create a self-interest threat.	The audit senior should be removed from the engagement team.
Self-interest/Intimidation: The offer of a day at the horse races constitutes a gift/hospitality. Accepting this could compromise objectivity.	The offer must be declined unless its value is trivial and inconsequential.
Self-interest: An outstanding consulting invoice creates a fee dependency threat, which could be perceived as a loan.	Payment must be requested immediately. No further work should be performed until the fees are paid.

Tribe Co sells bathrooms from 15 retail outlets. Sales are made to individuals, with income being in the form of cash and debit cards. All items purchased are delivered to the customer using Tribe Co's own delivery vans as most bathrooms are too big for individuals to transport in their own motor vehicles. The directors of Tribe Co indicate that the company has had a difficult year, but are pleased to present some acceptable results to the members. The statement of profit or loss for the last two financial years are shown below:

Statement of profit or loss	31 July 20X5 ($000)	31 July 20X4 ($000)
Revenue	11,223	9,546
Cost of sales	(5,280)	(6,380)
Gross profit	5,943	3,166
Operating expenses
Administration	(1,853)	(1,980)
Selling and distribution	(1,472)	(1,034)
Interest payable	(152)	(158)
Investment income	218
Profit before tax	2,684	(6)

Required:

(a) With reference to ISA 520 Analytical Procedures explain: (i) what is meant by the term 'analytical procedures' (1 mark), (ii) the different types of analytical procedures available to the auditor (3 marks), and (iii) the situations in the audit when analytical procedures are used (3 marks).

(b) As part of your risk assessment procedures for Tribe Co, identify and provide a possible explanation for unusual changes in the statement of profit or loss. (8 marks)

Solution:

(a) Analytical procedures:

(i) Analytical procedures are evaluations of financial information by studying plausible relationships among financial and non-financial data, and investigating unusual fluctuations.

(ii) Types include comparing current year data to prior periods, comparing actual results to budgets/forecasts, and comparing company ratios to industry data.

(iii) They are used at the planning stage for risk assessment, as substantive procedures to detect misstatements, and at the final review stage to form an overall conclusion.

(b) Unusual changes:

• Revenue increase: The 17% increase is inconsistent with the directors' comments about a difficult year, potentially indicating revenue overstatement.
• Cost of sales decrease: An unusual 17% fall while revenue increased could be due to incorrect inventory valuation or suppliers.
• Gross profit: The GP% increased significantly from 33% to 53%. This requires investigation into the fall in cost of sales.
• Selling and distribution expenses: The 42% increase is not in line with the 17% revenue increase. This could be due to misclassification of expenses or rising transport costs.

You are an audit senior in Staple and Co and you are commencing the planning of the audit of Smoothbrush Paints Co (Smoothbrush) for the year ending 31 August 20X5. Smoothbrush is a paint manufacturer and has been trading for over 50 years. It operates from one central site which includes the production facility, warehouse and administration offices. Smoothbrush sells all of its goods to large home improvement stores, with 60% being to one large chain store Homewares. The company has a one-year contract to be the sole supplier of paint to Homewares. It secured the contract through significantly reducing prices and offering a four-month credit period, the company's normal credit period is one month. Goods in/purchases: In recent years, Smoothbrush has reduced the level of goods directly manufactured and instead started to import paint from South Asia. Approximately 60% is imported and 40% manufactured. Within the production facility is a large amount of old plant and equipment that is now redundant and has minimal scrap value. Purchase orders for overseas paint are made six months in advance and goods can be in transit for up to two months. Smoothbrush accounts for the inventory when it receives the goods. To avoid the disruption of a year-end inventory count, Smoothbrush has this year introduced a continuous/perpetual inventory counting system. The warehouse has been divided into 12 areas and these are each to be counted once over the year. At the year-end it is proposed that the inventory will be based on the underlying records. Traditionally Smoothbrush has maintained an inventory allowance based on 1% of the inventory value, but management feels that as inventory is being reviewed more regularly it no longer needs this allowance. Finance Director: In May 20X5 Smoothbrush had a dispute with its finance director (FD) who immediately left the company. The directors have temporarily asked the financial controller to take over the role while they recruit a permanent replacement. The former FD has notified Smoothbrush of intention to sue for unfair dismissal. The directors are not proposing to make any provision or disclosure for this, as they are confident the claim has no merit.

Required:

(a) Explain the audit risks identified at the planning stage of the audit of Smoothbrush Paints Co. (8 marks)

(b) Discuss the importance of assessing risks at the planning stage of an audit. (6 marks)

(c) Describe THREE substantive procedures the auditor of Smoothbrush Paints Co should perform at the year-end in confirming each of the following: (i) The valuation of inventory, and (ii) The completeness of provisions or contingent liabilities. (6 marks)

Solution:

(a) Audit risks:

• Inventory valuation: Smoothbrush's reduced prices to Homewares and old plant and equipment could mean inventory is overvalued.
• Receivables: The four-month credit period for Homewares increases the risk of irrecoverable debts.
• Perpetual inventory system: A new, untested system poses a risk to the accuracy and completeness of inventory records.
• FD dispute: The company's refusal to provide for the FD's legal claim could lead to an understatement of liabilities.
• Cut-off: The long transit times for imported paint increase the risk of cut-off errors for purchases and inventory.

(b) Importance of risk assessment: A proper risk assessment ensures the auditor focuses on key areas, performs an efficient audit, allocates the right resources, and ultimately reduces the risk of an inappropriate audit opinion.

(c) Substantive procedures:

(i) Valuation of inventory:

• Review post-year-end sales invoices to check if NRV is above cost.
• Obtain cost sheets for manufactured goods and agree costs to invoices.
• Review aged inventory reports for slow-moving goods and discuss with management.

(ii) Completeness of provisions:

• Discuss the dispute with the former FD with management and review legal correspondence.
• Review board minutes for discussions of the claim.
• Obtain a written representation from the directors confirming their view on the claim.

Stone Holidays is an independent travel agency. It takes commission on holidays sold to customers through its chain of high street shops. Staff are partly paid on a commission basis. Well-established tour operators run the holidays that Stone Holidays sells. The networked reservations system through which holidays are booked, and the computerised accounting system, are both well-established systems used by many independent travel agencies. Payments by customers, including deposits, are accepted in cash and by debit and credit card. Stone Holidays is legally required to pay an amount of money (based on its total sales for the year) into a central fund maintained to compensate customers if the agency should cease operations.

Required:

(a) Explain how the internal audit function helps an entity deal with the risk of fraud and error. (5 marks)

(b) Explain the responsibilities of external auditors in respect of the risk of fraud and error in an audit of financial statements. (5 marks)

(c) Describe the nature of the risks to which Stone Holidays is subject arising from fraud and error. (5 marks)

Solution:

(a) Internal audit and fraud/error: Internal audit helps management by reviewing systems and controls to ensure they effectively manage fraud and error risks. They can also investigate serious cases and make recommendations for improvement.

(b) External auditors' responsibilities: External auditors must consider fraud risks, maintain professional skepticism, and perform procedures to identify material misstatements caused by fraud or error. They are required to test journal entries, review estimates for bias, and identify unusual transactions.

(c) Risks for Stone Holidays:

• Cash payments: The acceptance of cash creates a high risk of misappropriation of assets by staff.
• Commission-based pay: Staff may enter false transactions to inflate their commission, leading to fraudulent financial reporting.
• IT systems: Despite being well-established, systems are vulnerable to manipulation by staff who understand them.
• Central fund: Senior management might falsify sales figures to reduce the amount payable to the central fund, resulting in fraudulent financial reporting.

You are the partner responsible for quality control within your firm. You are reviewing the findings from a recent post-issuance (cold) review performed by your firm's compliance department. The following issues were identified: Client A: A review of working papers found that some working papers had not been signed off by the team member who completed the work. Some working papers were not dated and some did not have a signature confirming they had been reviewed. Client B: A mandatory procedure included in the audit plan which required a written representation letter to be obtained, had not been completed. A comment had been added by the audit manager stating that there were no issues requiring a written representation from management. Client C: An audit test over purchases required a sample of 30 invoices to be tested. 27 had been tested and found to be recorded accurately and completely. Three invoices could not be found. No further invoices were identified for testing and a conclusion was drawn based on the 27 items tested. Client D: The audit of a material provision was performed by the audit junior as the audit manager was too busy finishing off work for the previous audit client on which they had been working. Client E: The planning section of the file has not been completed. The audit procedures performed were copied over from the previous year's file and the same approach and sample sizes have been used for this year's audit.

Required: Describe the quality control issues arising from each of the findings. (10 marks)

Solution:

• Client A: Lack of sign-offs and dates on working papers makes it difficult to identify who performed the work and when, compromising the audit trail and quality control.
• Client B: Failing to obtain a written representation is a breach of ISA 580, meaning the auditor has not obtained sufficient appropriate evidence.
• Client C: The sample size was not completed, meaning sufficient evidence was not obtained. The missing invoices should have been investigated further.
• Client D: The audit of a high-risk area (a material provision) was assigned to an inexperienced junior, which is a breach of the quality control principle of assigning appropriate personnel.
• Client E: Copying the prior year's plan without performing a new risk assessment is a breach of ISA 300, compromising the effectiveness and efficiency of the audit.