Question 1: Multiple Choice Questions
Problem Statement: In determining the level of materiality for an audit what should not be considered-
a) Prior years' errors.
b) The auditor remuneration.
c) Adjusted interim financial statement.
d) Prior year financial statements.
e) All the above
Solution:
The correct answer is (b) The auditor remuneration. Materiality is determined based on the financial statements and the needs of the users. Factors such as prior years' errors, adjusted interim financial statements, and prior year financial statements are all relevant in assessing materiality. The auditor's fee, however, has no bearing on the financial statements and should not be considered in the determination of materiality.
Problem Statement: Which of the following statement is most closely associated with analytical procedure applied at substantive stage?
a) It helps to study relationship among balance sheet accounts.
b) It helps to discover material misstatements in the financial statements.
c) It helps to identify possible oversights.
d) It helps to accumulate evidence supporting the validity of a specific account balance
e) None of the above
Solution:
The correct answer is (d) It helps to accumulate evidence supporting the validity of a specific account balance. At the substantive stage of an audit, analytical procedures are used to corroborate evidence from other sources and to test the validity of account balances. This is done by comparing the account balance to a reasonable expectation developed by the auditor. The other options are more closely associated with the planning stage of an audit.
Problem Statement: Professional skepticism requires that the auditor assume that management is-
a) reasonably honest.
b) neither honest nor dishonest.
c) not necessarily honest.
d) dishonest unless proved otherwise.
e) None of the above
Solution:
The correct answer is (b) neither honest nor dishonest. Professional skepticism is an attitude that includes a questioning mind and a critical assessment of audit evidence. It requires the auditor to be alert to evidence that contradicts the financial statements and to not assume that management is either honest or dishonest. The auditor should maintain a neutral stance and seek sufficient and appropriate audit evidence to form an opinion.
Problem Statement: An auditor who accepts an audit but does not possess the industry expertise of the business entity should-
a) engage experts.
b) obtain knowledge of matters that relate to the nature of entity business.
c) inform management about it.
d) take help of other auditors.
e) None of the above
Solution:
The correct answer is (b) obtain knowledge of matters that relate to the nature of entity business. While engaging experts or taking help from other auditors may be options, the auditor's primary responsibility is to first acquire the necessary knowledge and understanding of the client's business and industry to be able to perform the audit effectively. This is a fundamental requirement of professional competence as per the Code of Ethics for Professional Accountants.
Problem Statement: When a transaction has not been recorded in the books of account either wholly or partially such errors are called as-
a) Error of commission
b) Error of omission.
c) Compensating error.
d) Error of principle.
e) None of the above
Solution:
The correct answer is (b) Error of omission. An error of omission occurs when a transaction is completely or partially omitted from the books of accounts. An error of commission is an incorrect recording of a transaction, a compensating error is when an error is offset by another error, and an error of principle is when a transaction is recorded in violation of an accounting principle.
Problem Statement: Verification of the value of assets, liabilities, the balance of reserves, provision and the amount of profit earned or loss suffered a firm is called-
a) Continuous audit.
b) Balance sheet audit.
c) Interim audit.
d) Partial audit.
e) None of the above
Solution:
The correct answer is (b) Balance sheet audit. A balance sheet audit is an audit of the financial position of a company at a specific date. It involves the verification of all the items on the balance sheet, such as assets, liabilities, and equity, to ensure that they are fairly stated. The other types of audits are either based on the timing or scope of the audit, not the type of accounts being audited.
Problem Statement: Which BSA standard deals with the responsibilities of auditors regarding fraud in an audit of financial statements?
a) SA-200
b) BSA-240
c) BSA-315
d) BSA-240A
e) All the above
Solution:
The correct answer is (b) BSA-240. Bangladesh Standard on Auditing (BSA) 240, "The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements," deals with the auditor's responsibilities to consider fraud in an audit. It requires the auditor to identify and assess the risks of material misstatement due to fraud and to respond appropriately to those risks. SA-200 deals with the overall objectives of the auditor, while BSA-315 deals with identifying and assessing risks of material misstatement.
Problem Statement: What is a potential liability that auditors might face?
a) Breach of confidentiality
b) Lack of attention to audit procedures
c) Non-compliance with tax regulations
d) Failure to identify a minor error
e) None of above
Solution:
The correct answer is (a) Breach of confidentiality. Auditors have a professional and legal obligation to maintain the confidentiality of client information. A breach of this duty can lead to legal action, disciplinary proceedings by professional bodies, and damage to the auditor's reputation. Lack of attention to audit procedures and non-compliance with tax regulations are also liabilities, but a breach of confidentiality is a direct legal liability that auditors can face.
Problem Statement: According to auditing standards, what should auditors primarily consider when assessing the risk of material misstatement due to fraud?
a) The possibility of management override of controls
b) The history of the company's financial performance
c) The amount of internal control documentation
d) The complexity of the financial reporting framework
e) All the above
Solution:
The correct answer is (a) The possibility of management override of controls. Management is in a unique position to perpetrate fraud because of its ability to override controls that are otherwise operating effectively. Therefore, according to BSA 240, the auditor's primary consideration when assessing fraud risk is the possibility of management override of controls.
Problem Statement: During an information system audit, what is the primary concern?
a) Compliance with marketing regulations
b) Security and integrity of data
c) Efficiency of production processes
d) Accuracy of financial statements
e) None of the above
Solution:
The correct answer is (b) Security and integrity of data. An information system audit, or IT audit, focuses on the controls over the information technology infrastructure and the data that it processes. The primary concern is to ensure that the data is secure, reliable, and not subject to unauthorized access or modification. While an IT audit can support the accuracy of financial statements, it is not its primary focus.
Question 2: Modified True/False
Problem Statement: IT audit primarily focuses on assessing the effectiveness of internal controls over financial reporting related to information technology systems.
Solution:
True. The statement is correct. An IT audit, in the context of a financial audit, is primarily concerned with assessing the effectiveness of the controls over the financial reporting process that are embedded within the information technology systems. This includes controls over data input, processing, and output to ensure the accuracy and integrity of the financial statements.
Problem Statement: Auditors should avoid situations that create conflicts of interest, such as having financial interests in the company being audited.
Solution:
True. The statement is correct. Auditors have a professional and ethical obligation to maintain their independence and objectivity. Having a financial interest in an audit client creates a self-interest threat, which can compromise the auditor's independence. The Code of Ethics for Professional Accountants requires auditors to identify, evaluate, and address such threats.
Problem Statement: The auditor's primary responsibility is to detect fraud during the audit engagement.
Solution:
False. The auditor's primary responsibility is to obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error. The detection of fraud is an important part of the audit, but it is not the primary responsibility. The primary responsibility for the prevention and detection of fraud and error rests with management and those charged with governance.
Problem Statement: The scope and objectives of a special audit are determined solely by the organization being audited.
Solution:
False. The scope and objectives of a special audit are determined by the specific needs of the party requesting the audit, which may be management, the board of directors, or a regulatory body. The organization being audited does not have the sole authority to determine the scope and objectives of a special audit.
Problem Statement: Public sector audits are conducted by government agencies and independent auditors appointed by the government.
Solution:
True. The statement is correct. Public sector audits are conducted by government audit institutions, such as the Office of the Comptroller and Auditor General, as well as by private audit firms that are appointed by the government. The audits are conducted to ensure that public funds are used efficiently and effectively and that the financial statements are reliable.
Question 3: Matching
Problem Statement: Match the items of column A with the most suitable items of column B. Match only one item of column A with one item of column B. Write your answer on the answer script. Follow the example given below in proving your answer.
| Column A | Column B |
|---|---|
| 1. The most difficult type of misstatement to detect fraud is based on | (a) weakness of internal control that could have a material effect on financial statement. |
| 2. Professional skepticism requires that the auditor assume that management is | (b) May be test of transactions, test of balance and analytical Procedures |
| 3. The least persuasive type of audit evidence example is- | (c) The relevant information may not be available |
| 4. In an audit of financial statements, substantive tests are audit procedures that | (d) neither honest nor dishonest |
| 5. The limitations of analytical procedures in planning are: | (e) Carbon copies of sales invoices inspected by the auditor |
| (f) Will increase proportionately when the auditor decreases the assessed level of control risk | |
| (g) omission of a sales transaction from being recorded. | |
| (h) Bank statements obtained from the client | |
| (i) the restatement of sales. |
Solution:
The correct matches are as follows:
- 1. The most difficult type of misstatement to detect fraud is based on -> (i) the restatement of sales. Fraudulent financial reporting, such as the restatement of sales, is often difficult to detect because it is typically perpetrated by management who have the ability to override internal controls.
- 2. Professional skepticism requires that the auditor assume that management is -> (d) neither honest nor dishonest. This is the core tenet of professional skepticism as per auditing standards.
- 3. The least persuasive type of audit evidence example is- -> (e) Carbon copies of sales invoices inspected by the auditor. Evidence is more persuasive when it is obtained from an independent source, so a carbon copy of a sales invoice, which is an internal document, is less persuasive than a bank statement or a third-party confirmation.
- 4. In an audit of financial statements, substantive tests are audit procedures that -> (b) May be test of transactions, test of balance and analytical Procedures. Substantive procedures are performed to detect material misstatements in the financial statements. They include tests of details of transactions, tests of details of balances, and analytical procedures.
- 5. The limitations of analytical procedures in planning are: -> (c) The relevant information may not be available. Analytical procedures rely on the availability of reliable data, which may not always be available, especially during the planning stage of an audit.
Question 4: Auditor's Responsibility for Fraud and Audit Risks
Problem Statement: State KPMG's responsibilities in relation to the prevention and detection of fraud and error.
Solution:
The auditor's responsibilities for fraud and error are governed by BSA 240, "The Auditor's Responsibilities Relating to Fraud in an Audit of Financial Statements." The auditor's primary responsibility is to obtain reasonable assurance that the financial statements as a whole are free from material misstatement, whether caused by fraud or error. The auditor is not responsible for the prevention of fraud and error; that is the responsibility of management and those charged with governance.
The auditor's responsibilities include:
- **Professional Skepticism:** The auditor must maintain professional skepticism throughout the audit and not assume that management is either honest or dishonest.
- **Risk Assessment:** The auditor must identify and assess the risks of material misstatement due to fraud.
- **Response to Risk:** The auditor must design and implement appropriate audit procedures to respond to the assessed risks of material misstatement due to fraud.
- **Communication:** The auditor must communicate any identified fraud or error to management and those charged with governance on a timely basis.
Problem Statement: Describe EIGHT audit risks, and explain the auditor's response to each risk, in planning the audit of Sycamore Science Co.
Solution:
Here are eight audit risks for Sycamore Science Co and the corresponding auditor's responses:
| Audit risk | Auditor's response |
|---|---|
| The profit on disposal of plant and equipment may be misstated as management could have manipulated the carrying amount of the disposed assets. | Verify the disposal proceeds to the sales documentation. Trace the carrying amount to the non-current asset register and recalculate the profit or loss on disposal. |
| The new finance director's inexperience in the pharmaceutical industry could lead to a lack of understanding of the business and its risks, which could result in errors in the financial statements. | Increase the level of professional skepticism and perform more extensive substantive procedures. Consider the need for an audit expert with pharmaceutical industry knowledge. |
| The fraudulent expenses claimed by the previous finance director could indicate a weak control environment. The new finance director's surprise at the fraud indicates a potential control weakness. | Increase the sample size for testing expenses and review all expenses for the period of the fraud. Perform a review of the company's internal control environment and assess its effectiveness. |
| The \$1.8 million spent on developing new products may not meet the criteria for capitalization, which could lead to a material misstatement. | Obtain a detailed breakdown of the development costs. Verify that the costs meet the criteria for capitalization as per IAS 38, "Intangible Assets," and that they are correctly amortized over the useful life of the assets. |
| The loan covenants with the bank, such as the minimum profit targets, could put pressure on management to manipulate financial statements to meet the targets. This creates a risk of material misstatement. | Obtain the loan agreement and review the covenants. Discuss with management their plans to meet the targets. Perform extensive substantive procedures on the revenue and expenses to ensure they are not manipulated. |
| The significant number of sales returns after the year-end could indicate that the revenue for the year is overstated. This is a subsequent event that needs to be considered. | Perform subsequent events procedures as per BSA 560. Trace the sales returns to the sales records and ensure that the revenue for the goods returned is reversed and that an adequate provision is made. |
| The outsourcing of the payroll function to an external service organization could lead to a risk of misstatement in the payroll expenses if the controls at the service organization are weak. | Obtain and review the SOC report of the service organization. If a SOC report is not available, perform alternative audit procedures to obtain sufficient appropriate audit evidence about the payroll expenses. |
| The poor control over inventory movements during the count could lead to a misstatement of the inventory balance. | Perform additional audit procedures on the inventory count, such as re-performing the count or performing a detailed review of the inventory records. |
Question 5: Receivables & Going Concern
Problem Statement: Describe the procedures the auditor should perform to resolve the exceptions noted for each customer during the positive receivable circularsation for Triggerfish Co.
Solution:
The auditor should perform the following procedures to resolve the exceptions noted for each customer:
- **Albacore Co (Nil response):** Send a second and third request for confirmation. If no response is received, perform alternative procedures, such as examining subsequent cash receipts, reviewing sales invoices and shipping documents, and vouching the balance to the underlying sales ledger.
- **Flounder Co (\$24,115 vs. \$18,265):** Inquire of management about the difference in the balance. The difference of \$5,850 could be due to goods in transit or payments made by the customer that have not yet been recorded by the company. Examine the sales invoices and shipping documents to determine the correct balance.
- **Menhaden Co (-\$5,360 vs. \$3,450):** The credit balance could be due to a payment in advance or a sales return. Inquire of management about the nature of the credit balance. Examine the cash receipts and sales return documentation to determine the correct balance.
Problem Statement: Describe substantive procedures the auditor should perform to obtain sufficient and appropriate audit evidence in relation to the allowance for credit losses/receivables in the current year.
Solution:
The auditor should perform the following substantive procedures for the allowance for credit losses:
- **Review of aging report:** Obtain and review the aged receivables listing and discuss any long-outstanding balances with management.
- **Subsequent cash receipts:** Review subsequent cash receipts to determine if any of the outstanding balances have been collected.
- **Customer correspondence:** Review correspondence with customers to identify any disputes or complaints that may suggest that the receivables are not recoverable.
- **Credit controller:** Discuss with the new credit controller the credit policy of the company and the reasons for the increase in receivables.
- **Recalculation:** Recalculate the allowance for credit losses based on the company's historical data and the auditor's own judgment.
Problem Statement: Identify and explain THREE potential indicators that Marlin Co is NOT a going concern.
Solution:
Three potential indicators that Marlin Co is not a going concern are:
- **Late payment to suppliers:** The company has consistently paid its suppliers late, which could indicate a cash flow problem. This has led to some suppliers withdrawing credit terms, which will put further pressure on the company's cash flow.
- **Loss of a key supplier:** The company's main supplier has ceased to trade, which could lead to a disruption in the company's operations and a loss of revenue.
- **Increased overdraft:** The significant increase in the overdraft could indicate that the company is struggling to manage its cash flows. The fact that the overdraft facility is due for renewal next month adds to the uncertainty.
Problem Statement: Describe the audit procedures the auditor should perform in assessing whether or not Marlin Co is a going concern.
Solution:
The auditor should perform the following procedures to assess whether or not Marlin Co is a going concern:
- **Cash flow forecast:** Obtain and review the company's cash flow forecast to assess its ability to meet its financial obligations.
- **Bank confirmation:** Obtain a bank confirmation to verify the terms and conditions of the overdraft facility and the likelihood of its renewal.
- **Subsequent events:** Inquire about any events that occurred after the year-end that may affect the going concern assumption, such as the renewal of the overdraft facility.
- **Supplier correspondence:** Review correspondence with suppliers to assess the impact of the withdrawal of credit terms on the company's operations.
- **Management plans:** Discuss with management their plans to address the going concern problem, such as obtaining a new supplier or a new source of finance.
Question 6: Materiality, True and Fair View & Restructuring
Problem Statement: Discuss what is meant by the concepts of materiality and a true and fair view.
Solution:
Materiality: A misstatement is considered material if it could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements. The auditor considers both the size and nature of the misstatement when assessing its materiality.
True and fair view: The concept of a true and fair view means that the financial statements should be a factual and objective representation of the company's financial position, performance, and cash flows. The auditor's opinion on the financial statements is a statement of whether they present a true and fair view in accordance with the applicable financial reporting framework.
Problem Statement: Explain why there can be difficulties for auditors regarding materiality and true and fair in relation to the three cases above: Jay, Finch and Sparrow, and state how you might modify your auditor's report in each case.
Solution:
Here are the difficulties and the potential modifications to the auditor's report for each case:
- **Jay plc ('Jay'):**
- **Difficulty:** The company has a significant going concern issue. The directors have made a judgment that the company will continue as a going concern, but the outcome is highly uncertain. The auditor must assess whether the disclosure of the uncertainty is adequate and whether the going concern assumption is appropriate.
- **Auditor's Report:** The auditor should issue a standard unmodified opinion with a "Material Uncertainty Related to Going Concern" paragraph to draw attention to the note in the financial statements that discloses the uncertainty.
- **Finch plc ('Finch'):**
- **Difficulty:** The auditor of Finch cannot obtain sufficient appropriate audit evidence about the inventory of Wren. The misstatement is material to the consolidated financial statements (1.5% of pre-tax profit) but not pervasive.
- **Auditor's Report:** The auditor should issue a qualified opinion with a "Basis for Qualified Opinion" section explaining the inability to obtain sufficient appropriate audit evidence about the inventory of Wren.
- **Sparrow Ltd ('Sparrow'):**
- **Difficulty:** The company has made a provision for restructuring costs, but the decision to restructure was made after the year-end. As per IAS 37, "Provisions, Contingent Liabilities, and Contingent Assets," a provision should be made only when there is a present obligation as a result of a past event. The misstatement of Tk. 1.8 million is material (25% of pre-tax profit) but not pervasive.
- **Auditor's Report:** The auditor should issue a qualified opinion with a "Basis for Qualified Opinion" section explaining the misstatement. An adverse opinion would be appropriate if the misstatement was pervasive.
Question 7: Audit Issues & Opinions
Problem Statement: Identify and Evaluate the Issues: Analyze the audit issue identified in XYZ Ltd's financial statement. Discuss how each issue could impact the auditor's opinion.
Solution:
- **Inventory Valuation:** The overvaluation of inventory is a material misstatement. Management's refusal to adjust the financial statements will lead to a modified opinion. The impact on the auditor's opinion depends on whether the misstatement is pervasive or not.
- **Going Concern:** The significant doubts about the company's ability to continue as a going concern are a material uncertainty. The disclosure in the notes is an appropriate response, but the lack of a provision for potential future losses is a misstatement. The auditor's opinion will depend on the adequacy of the disclosure and the nature of the misstatement.
- **Revenue Recognition:** The discrepancy in the timing of revenue recognition is a material misstatement. The auditor's opinion will be modified, and the type of modification will depend on the pervasiveness of the misstatement.
Problem Statement: Determine the Type of Audit Opinion: Recommend the appropriate type of audit opinion (unqualified, qualified, adverse, or disclaimer) that ABC & Co. should issue for XYZ Ltd's, financial statements. Justify your recommendation by referring to relevant auditing standards and principles.
Solution:
The auditor should issue an **adverse opinion**. The issues identified (inventory overvaluation, going concern, and revenue recognition) are not only material but also pervasive to the financial statements as a whole. The cumulative effect of these misstatements is that the financial statements do not present a true and fair view in accordance with the applicable financial reporting framework. The auditor should also include a "Basis for Adverse Opinion" section in their report explaining the reasons for the adverse opinion, as per BSA 705, "Modifications to the Opinion in the Independent Auditor's Report."
Problem Statement: Impact on Stakeholders: Discuss how the recommended audit opinion might influence the decisions of key stakeholders, such as investors, creditors, and management.
Solution:
The adverse opinion would have a significant impact on key stakeholders:
- **Investors:** The adverse opinion would likely lead to a significant decline in the company's stock price, as it would signal that the financial statements are not reliable. Investors would be hesitant to invest in the company.
- **Creditors:** The adverse opinion would make it difficult for the company to obtain new financing or to renew existing credit facilities. Creditors would view the company as high-risk and would likely demand a higher interest rate.
- **Management:** The adverse opinion would be a serious blow to management's credibility. It could lead to a loss of confidence from shareholders and a potential shake-up of the board of directors.
Problem Statement: Ethical Considerations: Consider the ethical implications of issuing the audit report. What ethical responsibilities does the auditor have in this situation, and how should they balance these against pressure from XYZ Ltd's management?
Solution:
The auditor has a professional and ethical responsibility to act with integrity, objectivity, and professional competence and due care. The auditor's primary duty is to the public interest, not to the client's management. The auditor must resist any pressure from management to issue a clean audit report when the financial statements are materially and pervasively misstated. The auditor should document all communications with management and those charged with governance, including the reasons for the adverse opinion, and ensure that the audit report is issued in a timely manner. The auditor's independence is crucial in this situation, and they must not allow any threats to independence, such as intimidation threats, to compromise their professional judgment.