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Interim Assessment KAPLAN PUBLISHING Page 1 of 8 ACCA INTERIM ASSESSMENT Advanced Audit and Assurance JUNE 2009 QUESTION PAPER Do not open this paper until instructed by the supervisor This question paper must not be removed from the examination hall Time allowed Reading time: 15 minutes Writing time: 3 hours Answer ALL questions Kaplan Publishing/Kaplan Financial

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Interim Assessment

KAPLAN PUBLISHING Page 1 of 8

ACCA INTERIM ASSESSMENT

Advanced Audit and Assurance

JUNE 2009

QUESTION PAPER

Do not open this paper until instructed by the supervisor This question paper must not be removed from the examination hall

Time allowed Reading time: 15 minutes Writing time: 3 hours Answer ALL questions

Kaplan Publishing/Kaplan Financial

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ACCA P7 (INT) Advanced Audit and Assurance

© Kaplan Financial Limited, 2008 All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

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Interim Assessment

Answer ALL questions QUESTION 1 You have recently been appointed to audit manager at Gilbert LLP, a medium sized firm of chartered certified accountants, where you began as a trainee seven years ago. Your first assignment in your new role is the audit of Moonstone Co, a client of Gilbert LLP for the last five years, for the year ending 30 November 2008. Moonstone are specialists in the quarrying of aggregate materials for use in the various building trades. Their turnover for the year ended 30 November 2008 was $31.5mn (2007: $37.3mn); profit before tax was $2.4mn (2007: $3.2mn); and total assets were $23.0mn (2007: $22.1mn). On 1 December 2007 Moonstone were granted a five year licence by a local council to quarry gravel at a remote site in the Peak District. The gravel is being sold exclusively for use in the construction of a new motorway, the M99, which is due to open in the winter of 2011. Although the licence did not cost Moonstone anything the directors have capitalised the licence on the balance sheet at an estimated fair value of $750k. They argue that the licence is an asset because they control it and it will produce economic benefits over a number of years. The licence was granted with one concession: that Moonstone converts the quarry into a lake and nature reserve at the end of the licence period. In the spirit of prudence the directors are providing $75k a year to cover the total estimated cost of restoration works. Due to high unemployment after the closure of a large car plant local government has awarded Moonstone a $200k grant to recruit and train a local workforce and to employ them for the duration of the project. According to a note on the previous year’s audit file the FD, Trevor Cramphorn, does not want to record the grant in ‘turnover’ because this does not accurately reflect the activity of the business. He proposes instead to record the $200k in ‘other income’ in the 2008 accounts. In order to facilitate this new project Moonstone have purchased some new digging machinery, at a cost of $1,000,000, and some new vehicles to transport the aggregate, at a cost of $250,000. Both are to be depreciated on a straight line basis over their estimated useful lives, which have been assessed as ten years, at which point the directors feel assets of this nature would be scrapped. During a recent telephone conversation with Mr Cramphorn you discovered that the new vehicles will be redeployed at the end of the M99 project. However, it is considered likely that the digging machinery will be surplus to requirements and sold off when digging is complete for a quarter of their original value. As part of your initial planning for the assignment you have done some research on the internet and have found two interesting articles. The first article, from June 2008, relates to a fatal accident at one of Moonstone’s quarries involving an explosives engineer, a faulty light bulb and a poorly placed detonator next to a lavatory flush handle. The second article relates to environmental protests at the Peak District site following the discovery, and consequent relocation of, a rare species of ground nesting bird called the Lesser Spotted Warbling Turtle Dove. The latter appears to have attracted quite a lot of attention as it appeared multiple times on your search. A more recent article suggested that the environmentalists are planning a legal case to close the site down. In response to the articles you held a conversation with the Managing Director, Mr Alfie Moon. He stated that a provision of $100k has been recorded. This is the amount Moonstone offered the engineer’s widow as a goodwill gesture. Apparently she refused the money, threatening

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instead to sue Moonstone for millions. Mr Moon laughed this off as ridiculous given that the accident was solely the engineer’s fault for not following the company’s operating manual. He also added that there is no concern over the environmentalists’ law suit because Moonstone consulted the local council and various experts from the local zoo about the best way to safely relocate the Turtle Doves. He added that Moonstone was “a caring company” and that they do “everything possible to ensure that the local wildlife is affected as little as possible.” It was a little difficult to hear the rest of Mr Moon’s response due to a detonation in the background drowning out the MD’s voice. Required: (a) Using the information provided, prepare a briefing memo that identifies and explains

the audit risks to be addressed at the planning meeting for the final audit of Moonstone Co for the year ended 30 November 2008.

Two professional marks are available for part (a). (14 marks)

(b) Describe the principle audit work to be performed in respect of the useful economic life of the licence. (6 marks)

Currently, in the UK, companies with turnover below £5.6 million are exempt from statutory year-end audit. It has been suggested that for those small companies an independent review might replace the annual audit. Required: (c) Set out the arguments for and against proposals to exempt smaller companies from

statutory audit and to introduce an independent professional review for certain companies. (15 marks)

(Total: 35 marks)

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QUESTION 2 You have been the auditors of Rapid Travel since its incorporation five years ago. Rapid Travel is a private limited liability company that was formed by two sisters, Christine and Stephanie Hulme, who each own 50% of the share capital and are the company’s only directors. The company initially acquired an inexpensive fleet of old buses and coaches in one city and, by the use of competitive predatory pricing, managed to undercut its competitors’ fares to the point that they went out of business, leaving Rapid Travel with the local monopoly. The success of this tactic was such that the company expanded its operations in a similar manner over its five-year life to become a national bus and coach operator. As the company became more profitable, it gradually improved its fleet by acquiring more modern (but not new) vehicles under ten-year finance leases. These vehicles are depreciated over the lease term. Despite this, a majority of its fleet is still more than eight years old. The company has a network of maintenance workshops throughout the country in which it repairs and maintains all of its vehicles, and also undertakes some external work. During the current year, the company’s vehicles appeared to be suffering an abnormally high level of breakdowns and mechanical failures, some of which have led to accidents. One such accident, caused by suspected brake failure, led to the deaths of several passengers and the driver. It is still being investigated by the authorities. Approximately six months ago, a previous employee (a driver) of Rapid Travel, who was dismissed for a persistent failure to maintain scheduled timetables, contacted you, as auditors. He made allegations concerning Rapid Travel’s improper conduct in respect of encouraging ‘excess’ driver hours and malpractice in the maintenance workshops. Recently, similar reports concerning Rapid Travel have been published in the press as a result of disclosures by an ex-employee. It is not known if it is the same employee who contacted the auditors. All drivers of public service vehicles have strict maximum hours that they are permitted to drive before taking compulsory rest and sleep breaks. Also, all public service vehicles require a certificate showing they have passed a thorough independent annual safety check. The ex-employee claimed that routes cannot be completed in the scheduled times without exceeding speed limits. He also alleged that there have been occasions where vehicles that have failed the safety check, due mainly to unsafe braking, have been substituted with a near identical vehicle that has temporarily been given the ‘identity’ of the ‘failed’ vehicle for the re-test. Three months before the year-end, the company was successful in a bid to acquire the right to operate some previously state-run nursing homes. The fee paid was $25 million. This represented more than 25% of Rapid Travel’s gross assets. It has been shown in the balance sheet as an intangible asset. You acted as advisors to the company in respect of the bid.

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Required: (a) You have been asked to write a briefing memo to the engagement team for use at the

upcoming year-end audit planning meeting that identifies and explains the inherent risks faced by Rapid Travel.

Two professional marks are available for part (a). (11 marks)

(b) Explain the extent to which auditors are responsible for ensuring a client complies with the laws and regulations relating to the client’s industry. (6 marks)

(c) Describe the audit work you would undertake to satisfy yourself that you have

discharged your responsibilities in relation to (b) above for Rapid Travel, and explain the significance you would attach to the information provided by the dismissed employee and by press reports. (6 marks)

(d) ISA 600 (Revised and Redrafted) The Audit of Group Financial Statements is likely to

substantially increase the formal requirements in the area of group audits.

(i) Outline the significant issues that are being addressed in the IAASB’s project on group audits;

(ii) Explain the need for a first time group auditor to analyse the group structure;

and (iii) Critically discuss the likely effectiveness of standard questionnaires sent to

other auditors as a means of obtaining information required. (12 marks)

(Total: 35 marks)

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QUESTION 3 You are an audit manager in Bartolome, a firm of Chartered Certified Accountants. You have specific responsibility for undertaking annual reviews of existing clients and advising whether an engagement can be properly continued. The following matters have arisen in connection with recent assignments: (a) Leon Dormido is the senior in charge of the audit of the financial statements of

Moreno Co for the year ending 31 October 2008, which is currently approaching completion. Moreno’s Chief Executive Officer, James Bay, has just sent you an e-mail to advise you that Leon has been short-listed for the position of Finance Director. You were not previously aware that Leon had applied for the position. (5 marks)

(b) Chatam Inc is a long-standing client. One of its subsidiaries, Ayora, has made losses

for several years. At your firm’s request, Chatam’s management has made a written representation that goodwill arising on the acquisition of Ayora is not impaired. Your firm’s auditors’ report on the consolidated financial statements of Chatam for the year ended 30 June 2008 is unmodified. Your firm’s auditors’ report on the financial statements of Ayora is similarly unmodified. Chatam’s Chief Executive, Charles Barrington, is due to retire in 2009 when his share options mature. (6 marks)

(c) An audit client, Pinzon Inc, is threatening to sue your firm in respect of audit fees

charged for the year ended 31 December 2007. Pinzon is alleging that Bartolome billed the full rate on air fares for audit staff when substantial discounts had been obtained by Bartolome. (4 marks)

Required: Comment on the ethical and other professional issues raised by each of the above matters and their implications, if any, for the continuation of each assignment. Note: The mark allocation is shown against each of the three issues. (Total: 15 marks)

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QUESTION 4 (a) ISA 701 Modifications to The Independent Auditor’s Report includes ‘suggested

wording of modifying phrases for use when issuing modified reports’.

Required: Explain and distinguish between each of the following terms: (i) ‘qualified opinion’; (ii) ‘disclaimer of opinion’; (iii) ‘emphasis of matter paragraph’. (6 marks)

(b) You are the audit manager of Mouse Co, a private company that retails sports equipment. The draft financial statements for the year ended 31 December 2008 show revenue $21.1 million (2006 – $20.9 million), profit before taxation of $0.9 million (2007 – $1.1 million) and total assets of $15.4 million (2007 – $11.7 million).

You are currently reviewing two matters that have been left for your attention on Mouse’s audit working paper file for the year ended 31 December 2008: (i) Mouse’s management board decided to revalue properties for the year ended

31 December 2008 that had previously all been measured at depreciated cost. At the balance sheet date three properties had been revalued by a total of $1 million. Another nine properties have since been revalued by $2.7 million. The remaining three properties are expected to be revalued later in 2009. (5 marks)

(ii) On 1 April 2008 Mouse introduced a 10-year warranty on all sales of its entire

range of golf equipment. Sales of golf equipment for the year ended 31 December 2008 totalled $9.1 million. The notes to the financial statements disclose the following:

‘Since 1 April 2008, the company’s range of golf equipment is guaranteed to be free from defects in materials and workmanship under normal use within a 10-year guarantee period. No provision has been recognised as the amount of the obligation cannot be measured with sufficient reliability.’ (4 marks)

Your auditor’s report on the financial statements for the year ended 31 December 2007 was unmodified. Required: Identify and comment on the implications of these two matters for your auditor’s report on the financial statements of Mouse Co for the year ended 31 December 2008. NOTE: The mark allocation is shown against each of the matters above.

(Total: 15 marks)

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Interim Assessment

ACCA

Paper P7 (INT)

Advanced Audit and Assurance June 2009

Interim Assessment – Answers

To gain maximum benefit, do not refer to these answers until you have completed the interim assessment questions and submitted them for marking.

KAPLAN PUBLISHING Page 1 of 23

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© Kaplan Financial Limited, 2008 All rights reserved. No part of this examination may be reproduced or transmitted in any form or by any means, electronic or mechanical, including photocopying, recording, or by any information storage and retrieval system, without prior permission from Kaplan Publishing.

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Interim Assessment

ANSWER 1 (a) PLANNING MEMORANDUM

To: A. Partner From: M. Anager Date: 30 January 2009 Subject: Planning for audit of Moonstone Ltd for the year ended 30 November

2008

The audit risks associated with the audit of Moonstone Ltd for the year ended 30 November 2008 are discussed below. Materiality Preliminary materiality has been assessed according to the following thresholds, which are based upon the draft accounts for the year ended 30 November 2008:

Turnover ½ – 1% $158k – $315k Profit before tax 5 – 10% $120k – $240k Total assets 1 – 2% $230k – $460k

Industry/environment Moonstone’s business supplies the building trade, an industry sensitive to economic change. It is possible that the fall in turnover and profits experienced by the company is due to a downturn in the building trade. Although there is no indication that Moonstone are facing difficulty there is a risk that, given a sustained period of economic decline and a slowdown in the building trade, Moonstone may not be a going concern and that the financial statements may need to be prepared on a break up basis. Licence There is a risk that the intangible licence assets are overstated on the balance sheet. At $750k the asset is material to the balance sheet. The grant of a licence may be valued at either cost or fair value according to IAS 20. However, it states in the case that the directors have estimated the fair value, which is inherently risky. The licence may be unique (i.e. for a period of five years in a national park) and in the absence of an active market it appears unlikely that an estimate of fair value can be justified. Even if the fair value can be estimated there is a risk that the amortisation of the licence is incorrect. As per IAS 38 the intangible should be amortised over its useful life. In this case the useful life is only four years, not the full five years granted. This is because the project is due to complete in winter 2011 and the gravel quarried at the site is exclusively for this project. If amortised over five years the annual charge will be $150k pa, whereas over four years it would be $188k. The difference is not material to either assets or profits.

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Restoration There is an audit risk that provisions are overstated and that intangible assets are understated. The annual provision for restoration is not material to the accounts. However, annual provisioning is contrary to IAS 37. An estimate of the full cost of restoration should have been made at the outset and included in the cost of the licence on the balance sheet. Presumably the full cost will be (4 x $75k) $300k, which should be discounted to a present value. Using an estimated rate of 7% the appropriate discount factor would be 0.763. This would provide an additional intangible asset of $230k. The failure to capitalise this would lead to a material error in the accounts. The additional cost would also require amortisation over the four year useful life of the licence. This would lead to additional amortisation of $58k per annum. Whilst this is not material on its own it may be in conjunction with other adjustments proposed to the annual amortisation charge. Government grant There is an audit risk that other income is overstated and that deferred income liabilities are understated. As per IAS 20 the grant should not be recognised in income until all the conditions for receipt have been satisfied. The grant should be held on the balance sheet as deferred income and released to the income statement to match the costs incurred meeting the recruitment/training goal. According to the case Trevor Cramphorn has recorded all $200k in this year’s income statement. It is likely that the grant has some condition relating to the retention of local employee’s for the duration of the project. In this instance it would be prudent to release $50k per annum to the income statement to match the four year life of the project. In this case the $150k reduction of income and the consequent recognition of deferred liabilities would be material to the accounts. New non-current assets There is a risk that non-current assets are overstated on the balance sheet. As per IAS 16 the new machinery and vehicles should be depreciated over their useful economic lives. According to IAS 16 this is the period over which they will provide benefit to the reporting entity. So, whilst the machinery may have a total life of 10 years, the useful life to Moonstone is only four years because after this period they will be sold. Moonstone should depreciate these assets down to their residual value ($250k) by 30 November 2011. This would require an annual depreciation charge of $188k, not the $100k currently being applied. Whilst this is not material to the accounts it will lead to a cumulative error that would become material in the next accounting period. However, it is likely that this adjustment in combination with the other proposed increases in amortisation will be material to the 2008 accounts.

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Provision for staff fatality There is a risk that provisions are understated. As per IAS 37 Moonstone should provide for all foreseeable costs that meet the following criteria: • Present obligation as a result of a past event; • Probable outflow of economic benefit; and • Reliable measurement of the amount.

Whilst Mr Moon finds the widow’s response laughable there is a real possibility that she will pursue legal compensation for her husband’s death. In this case it is likely that Moonstone will incur significant fines or penalties. At this point it is impossible to estimate the amount to provide. It would be necessary to contact the company’s solicitors. However, it should be reviewed as part of audit testing. If the criteria are not met then there is almost certainly a case for recording a contingent liability in the notes to the accounts. Provisions due to environmental protests Again there is a risk that provisions are understated. As per IAS 37 Moonstone should perhaps make a provision for any legal costs they incur challenging the environmentalists case to close the site down. It is unclear whether such costs would be material to the accounts. In addition to this there is a direct threat to the continuance of the M99 project. If this is shut down Moonstone would lose significant amounts of turnover and be left with large amounts of new plant and equipment that has no use elsewhere in the business. If this were to happen there would be serious implications to the going concern status of Moonstone and, once again, it must be ascertained whether the accounts should be prepared on a break up basis. Other issues There is some concern over the accounting controls within Moonstone. The FD, Trevor Cramphorn, appears to have a limited knowledge of the requirements of accounting standards and the MD, Alfie Moon, appears too eager to overlook certain issues that could have significant financial consequences. The evidence regarding the number of potential errors already identified suggests that control risk (and therefore audit risk) is high. There has been a change to the senior members of the audit team. This could lead to increased audit risk as there will be a reduction in knowledge of the client. This will necessitate more detailed – and possibly more frequent – reviews.

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(b) Principle audit work

Useful economic life of licence • Inspect licence agreement to confirm that it is a five year licence and to

confirm that the licence begins in December 2007; • Inspect any contracts with the construction company building the motorway to

confirm the length that supplies will be required, i.e. until 2011; • Inspect any available press reports regarding the new motorway to confirm

that the proposed opening date is 2011; • Inspect company forecasts to ensure Moonstone forecasts profitable trade for

the full period of the contract until 2011; • Analytically review actual sales and profits since December 2007 in

comparison to forecasts for the year to 30 November 2008 to ensure forecasts are a reasonable assessment of potential future profits;

• Enquire of directors about the nature of the forecasts and how they arrived at any forecast sales and costs relating to the M99 project;

• Review assumptions underpinning the forecasts to ensure that they are consistent with Gilbert LLP’s understanding of the business and currently achieved margins;

• Inspect and re-compute any impairment reviews conducted by management regarding the intangible licence asset at 30 November 2008;

• Enquire of directors about the length of time that Moonstone will be required to provide aggregate to the motorway contract. Whilst the M99 will open in winter 2011 the requirements for building materials may end some months before this deadline;

• Inspect board minutes to identify any key issues that have arisen during and since the financial year that may have an impact upon the length of the project, and hence the UEL of the licence intangible.

• Re-compute useful economic life based upon Gilbert LLP’s understanding of the life of the contract;

(c) Audit exemption

The main arguments in favour of increasing the audit exemption limit can be summarised as follows: • Reduction of the costs of compliance imposed on smaller companies, which

in turn may encourage unincorporated businesses to incorporate. • The granting of choice to smaller companies. Those companies whose

stakeholders make substantial use of the financial statements may continue having a full audit performed to maintain the credibility of the financial statements; those who make little use of the statements (e.g. proprietary companies largely financed by the owner/ directors) may choose to dispense with a full audit.

• In any event, it is becoming increasingly common for lenders and other interested parties to place more reliance on information which is not covered by the scope of the statutory audit, for example cash flow projections, personal guarantees of directors, etc. This trend reduces the importance of the role of a full audit for many smaller companies.

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• The use of an independent professional review will provide a greater level of assurance (moderate assurance) that the financial statements are free from material mis-statement, than that given by a full audit and at a lower cost to the company.

• An independent professional review should ensure that appropriate accounting standards have been applied.

• If users require a full audit (or other assurance service), they can request one which is specific to their needs.

• In setting the audit threshold, a distinction should be made (as discussed in the Company Law Review in the UK) between ‘public interest’ companies and others.

• It is consistent with developments in many countries (e.g. a number of EU countries) to exempt from audit those companies classified under the size criteria as small companies.

Arguments against increasing the audit exemption limit include the following:

• Financial statements will lose a degree of credibility if no independent check is performed at all or if an independent review with a narrower scope replaces a full statutory audit.

• Scope for the manipulation of financial statements will be increased for those companies or their directors who may feel inclined to undergo manipulation.

• It is undoubtedly the case that some stakeholders place heavy reliance on audited financial statements when making decisions. The loss of the assurance currently provided by a full audit may have significant repercussions on the decision-making processes of a variety of stakeholders, including, for example, banks when considering lending decisions and tax authorities when levying corporate income and other tax charges.

• Overall, the quality of financial reporting may suffer since auditors police compliance with statute law and accounting standards. This service is widely relied upon by smaller companies, who tend to find it difficult to apply the more complex aspects of, say, IASs and may leave much of the more technical aspects of their financial reporting to their auditors.

• Companies not subject to a full audit are losing more than a simple ‘verification process’. Modern auditing will often identify weaknesses in controls and systems, and suggest suitable improvements. Many auditors now take a ‘value-added’ approach to their audits, aiming to provide client companies with practical business advice. This broader aspect of the role of the auditor may be lost to smaller companies – who may need it most – if the audit exemption threshold is increased.

Note: the above answer makes no reference to the loss of fee income to accounting firms as a result of increasing the exemption limit. The current view is that smaller accountancy practices earn a relatively small proportion of total fees from pure audit work – more significant amounts being generated from accounting, tax and general advice and compliance work.

MARKING SCHEME

(a) Audit risks Generally ½ mark each risk identified and up to 1½ marks for a thorough discussion Ideas • Materiality (max 1½ marks) • Industry decline (and going concern risk)

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MARKING SCHEME – continued

• Licence: - Fair value estimate - UEL

• Restoration provision • Grant deferred income • Non-current assets UEL • Provision for staff fatality • Provision for protests • Other issues (max 1 mark) Up to 2 marks for presentation of briefing notes and clarity of explanation 14 marks

(b) Principle audit work on UEL of licence Generally 1 mark per explained procedure (1/2 mark for just listing procedure) • Inspect licence • Inspect supply contracts • Inspect press reports • Inspect forecasts • Analytically review forecasts to actual • Enquiry of directors re. forecasts • Review assumptions • Inspect/re-compute impairment reviews • Enquire about forecast dates of supply • Inspect board minutes • Re-compute UEL 6 marks

(c) Audit exemption Generally 1–1½ marks for each well explained argument Argument for increasing exemption limit Ideas • Reduction in costs of compliance • More choice • Lenders reliance on other reports • IPR would give moderate assurance if acceptable • Specific audit could be requested • Public interest • Greater consistency with other countries Argument against increasing exemption limit Ideas • FSs will lose credibility • Increase risk of management manipulation of figures • Stakeholder reliance • Reduction in quality of financial reporting • Added value of audit 15 marks

TOTAL FOR QUESTION 1 35 MARKS

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Interim Assessment

ANSWER 2 (a) PLANNING MEMORANDUM

To: Mrs Partner From: Snr. Manager Date: 13 Jan 2009 Subject: Planning for year-end audit of Rapid Travel

The inherent risks of Rapid Travel are discussed below. Expansion The rapid expansion of the business could lead to overtrading. In such circumstances companies (usually relatively new ones) try to grow too quickly and are unable to secure long term funding on their limited asset bases. This usually leads to short term, high risk funding being used and significant increases in working capital assets. Overall this could lead to high gearing and poor liquidity. Such rapid growth is often accompanied by takeover bids. Whilst this itself is not a risk it offers the temptation to manipulate the accounts to present the profits of the business in the best possible light. The aim would be to improve any potential bid, which is usually based upon a multiple of profits. This is relatively easy to achieve, for example; by extending the useful lives of assets and reducing depreciation charges. Pricing Predatory pricing strategies mean that Rapid have to set low initial prices. Whilst this has proved successful in the short term it can backfire as a long term strategy. For example; Rapid may find it difficult to consequently increase prices and in times of rapidly inflating wages or fuel prices this could significantly damage margins. Finance leases Acquiring assets on finance lease increase the complexity of accounting valuations and disclosures. In particular it must be assessed whether the leases constitute operating or finance leases. This strategy therefore significantly increases the risk of non-compliance with accounting standards, namely IAS 17. Old vehicles The chosen strategy of acquiring old vehicles increases the risk of breakdown and repair costs. Perhaps more significantly this strategy is also partly to blame for the accident and consequent legal claims. Rapid have continued with this acquisition policy and it is therefore possible that further accidents could happen in the future. Control/dominant management The company only has two shareholders, who are also the sole directors. There appears to be no other form of corporate governance, such as an audit committee. This increases the risk of management override and further increases the possibility of accounts manipulation. This indicates a weak control environment.

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Cash The business will have a high level of cash sales (bus and coach fares) which at the point of receipt is likely to be under the control of the driver with no internal check. This point may be mitigated by controls such as the pre-selling of seats, issuing of prepaid travel passes, ticket inspectors, and a statistical analysis of ticket sales. However, as with all cash transactions there is increased risk of fraud. Laws and regulations The business is in a highly-regulated area where public safety is of major importance. Breaches of safety regulations may have serious consequences for the continuity of the business. This is apparent given the accident in the year. In the worst case scenario, failure to implement relevant safety precautions could lead to the closure of Rapid Travel. Employment law is also relevant, particularly where drivers are working multiple shifts throughout the day and night. It appears as though there is some discontent amongst employees. This could indicate that Rapid is not fulfilling its legal obligations, which could in turn lead to fines and penalties or employee de-motivation. Repair costs Public transport is subject to a high level of vandalism and, as such, sufficient resources need to be made available for refurbishment. Failure to do so could lead to customer dissatisfaction and lost revenue. Diversification The company is investing in an area (nursing homes) where it has little experience, and this represents a huge investment for this company. It does not appear as though the directors have any knowledge of this industry, which could prove disastrous, given the scale of the investment. The expansion also increases reporting requirements, such as consolidated group accounts and segmental reporting.

(b) According to ISA 250 it is the directors' responsibility to:

• Ensure compliance with relevant laws and regulations; and • Establish effective controls to prevent and detect non-compliance. However, the auditor must form an opinion as to whether the financial statements are properly prepared and free from material misstatement. Non-compliance by the client with laws and regulations may have a material effect on the financial statements. In particular non-compliance could lead to: • Fines and penalties; • Closure of the business (particularly health and safety); • Loss of reputation (and hence loss of custom – going concern).

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The auditor must ensure that all material provisions and contingent liabilities are adequately made/disclosed and that the accounts are prepared on the appropriate going concern or break up basis. Therefore the auditor must: • Obtain sufficient evidence regarding compliance with laws and regulations

that determine the form and content of the financial statements (such as IFRS’ and the Companies Act)

• Plan and perform the audit in such a way to gather evidence to identify whether the client is compliant with laws and regulations; and

• Consider non-compliance when seeking management representations. In order to achieve these aims the auditor should obtain a general understanding of the legal and regulatory environment of the client’s industry to assist with planning and audit test design. During audit fieldwork the auditor should review any correspondence with licensing or regulatory authorities, including the results of health/fire safety inspections. The auditor must also enquire of directors whether they have received notice of, or are aware of, any breach of laws and regulations. Written confirmation must be received to support these enquiries.

It must also be said that such responsibility can only relate to material non-compliance with serious breaches of laws and regulations. Auditors cannot be expected to be aware of all laws and regulations relating to a particular business, although they should be fully aware of matters relating to the form and content of published financial statements. The task of compliance and detection of non-compliance with financial, non-financial and detailed industry-specific laws and regulations rests with the management and employees of the company.

(c) Rapid Travel operates in an industry that in most parts of the world is heavily

regulated. The main regulation will surround working hours, speed restrictions and safety checks. In order to gain a general understanding of the regulations the auditor can perform general research (perhaps over the internet) and can discuss more specific regulations with management of Rapid Travel. The auditor could then perform the following tests to gather evidence to support compliance:

Working hours • Inspect payroll/HR summaries for overtime; • Inspect driver’s log books, if maintained; • Inspect employee contracts to establish standard working hours. • Enquire of a transport consultant whether scheduled timetables may be

achieved under ‘normal’ operating conditions. Speed restrictions • Inspect records from machines that record vehicle’s speed (mandatory for

lorries and buses in most European countries) • Inspect correspondence with legal authorities regarding speeding fines and

cautions.

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Safety checks • Inspect results of independent garage safety checks. Where faults are

identified request copies of repair schedules/invoices for repairs. At very least enquire of management how and when necessary repairs were conducted.

• Given the possible manipulation of these tests obtain written representations from management that such avoidance of safety laws has not taken place and that all necessary steps to repair vehicles have been taken.

• The auditor should attempt to obtain further evidence to corroborate or refute the malpractice. This may involve asking for suspect vehicles to be re-inspected.

Information provided by dismissed employees should be treated with caution, but it should not be ignored. It may be that the ex-employee is bearing a grudge against the company. The press reports may corroborate the employee’s information, but it may also be that they are actually from the same person. It is unlikely the newspaper will reveal its source of information. There is, however, other evidence that supports the ex-employee’s claims – the high level of breakdowns and the authorities’ investigation into the fatal accident. However, the auditor should review the claims of the ex-employee and the press and seek corroborative evidence. Perhaps the auditor could discreetly ask current employees if they are aware of similar pressures or events of malpractice, and possibly talk to trade associations or trade unions for further information. The auditor must also review all correspondence with the company legal advisors and with relevant regulatory authorities to identify if any non-compliance has been reported. Another possible area where the company may be in breach of regulations is in their pricing policy. In many countries, it is illegal to deliberately undercut competitors’ prices if these are being subsidised from more profitable areas of the business, particularly where the purpose of this is to put competitors out of business so that prices can then be increased from a monopolistic position. Again, it is likely that this tactic may be investigated by the appropriate authorities.

(d) (i) Significant issues

Tutorial note: The objective of the IAASB’s project on the audit of group financial statements (‘group audits’) was to deal with special considerations in group audits and, in particular, the involvement of other auditors. The re-exposure of ISA 600 (Revised and Redrafted) in March 2006 (following initial publication of a proposed revised ISA in December 2003 and an exposure draft in March 2005) reflects the significance of the issues that the IAASB has sought to address. Sole vs divided responsibility The IAASB has concluded that the group auditor has sole responsibility for the group audit opinion. Thus the exposure drafts eliminate the distinction between sole and divided responsibility. Therefore no reference to another auditor (e.g. of significant components) should be made in the group auditor’s report. The practice of referring to another auditor may, arguably, be more transparent to users of group financial statements. However, it may also mislead users to believe that the group auditor does not have sole responsibility.

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Definition of group auditor

The group auditor is the auditor who signs the auditor’s report on the group financial statements. The project has sought to clarify whether, for example, an auditor from another office of the group engagement partner’s firm is a member of the group engagement team or an ‘other auditor’. ‘Related’ vs ‘unrelated’ auditors IAASB recognises that the nature, timing and extent of procedures performed by the group auditor, including the review of the other auditor’s audit documentation, are affected by the group auditor’s relationship with the other audit. (For example, if the other auditor operates under the quality control policies and procedures of the group auditor.) However, IAASB acknowledges that a consistent distinction between ‘related’ and ‘unrelated’ auditors cannot be made due to the varying structures of audit firms and their networks. Consequently, the only distinction that is made is between the ‘group’ and ‘other’ auditors.

Acceptance/continuance as group auditor A group auditor should only accept or continue an engagement if sufficient appropriate evidence is expected to be obtained on which to base the group audit opinion. Acceptance and continuance as group auditors therefore requires an assessment of the risk of misstatement in components. IAASB has therefore proposed guidance on the benchmarks that might be used in identifying significant components. Access to information IAASB has concluded that a group audit engagement should be refused (or resigned from) if the group engagement partner concludes that it will not be possible to obtain sufficient appropriate audit evidence, the result of which would be a disclaimer. However, if the group engagement partner is prohibited from refusing or resigning an engagement, the group audit opinion must be disclaimed. Aggregation of components

Sufficient appropriate audit evidence must be obtained in respect of components that are not individually significant (but significant in aggregate). This requires that components be selected for audit procedures (e.g. on specified account balances). Analytical procedures are required to be performed on components that are not selected. IAASB has therefore identified factors to be considered in selecting components that are not individually significant. Responsibilities of other auditors Historically, other auditors, knowing the context in which their work will be used by the group auditor, have been required to cooperate with the group auditor. However, the project did not address guidance for other auditors. Therefore, in providing guidance on the group audit, the IAASB requires the group auditor to obtain an understanding of the requirements for other auditors to cooperate with the group auditor and provide access to relevant documentation.

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(ii) Need to analyse the group structure

A certain amount of analysis of the group structure will be undertaken before an auditor accepts the role of group auditor, particularly if the auditor is not directly responsible for the whole group. An analysis of the group structure is necessary to: • ensure that particular attention is given to the more unusual aspects of

corporate structures (e.g. partnership arrangements that may be a joint venture, components in tax havens, shell companies and horizontal groups);

• arrange access to information relating to all ‘significant’ components (i.e. those representing 20% or more of group assets, liabilities, cash flows, profit or revenue), on a timely basis;

• identify the applicable financial reporting framework for each component and any local statutory reporting requirements;

• plan work to deal with different accounting frameworks/policies applied throughout the group and differences between International Auditing Standards (ISAs) and national standards;

• integrate the group audit process effectively with local statutory audit requirements;

• identify related parties and effectively audit the completeness of disclosures in the group accounts in accordance with IAS 24 Related Party Disclosures.

Any doubts about the group structure will need to be clarified against publicly available information as soon as possible to ensure an effective audit of the relevant components (i.e. subsidiaries, associates and joint ventures). The auditor can then plan the level of assurance required on each component well in advance of the year end. Having established thoroughly the group structure from the outset the auditor will then need only to update the structure for changes year-on-year.

(iii) Likely effectiveness of standard questionnaires

Most group auditors obtain information from other auditors through questionnaires in the form of yes/no requests and/or detailed questions. Standard yes/no questionnaires are widely used because, for example, they:

• can be completed more quickly by someone already familiar with their form

and content; • facilitate summarisation of responses from other auditors by the group

auditor.

However, a standard questionnaire may be less effective than a ‘bespoke’ one in that it is likely to ask unnecessary questions. This may result in the other auditor finding the questions to be ‘not applicable’ and regarding completion of the questionnaire as a form-filling exercise, rather than providing the group auditor with essential information. Nevertheless, there is a danger that questionnaires that are not based on some standard form may overlook or otherwise omit some significant issues and therefore fail to alert the group auditor to a potential risk area.

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Thus a balance needs to be struck between requesting enough information for the group auditor to form their own view without requesting meaningless ‘box-ticking’ questions that do not deal with the issues. Questionnaires that get longer and longer are likely to lose their effectiveness especially if they are to be used in different locations/jurisdictions. Questionnaires will cover a broad range of topics such as qualifications, competence/experience, compliance with ISAs (and ISQC 1), audit findings, subsequent events, etc. Therefore there will be a tendency to length (completeness) rather than quality (relevance). In conclusion, questionnaires should:

• avoid over-use of yes/no questions which may encourage laxity; • not ask for information that has already been provided or which is

unnecessary; and • be adequately tailored.

MARKING SCHEME

(a) Areas and factors in inherent risk assessment Generally 1 mark for matters raised Ideas • Rapid expansion – overtrading • Takeover target/manipulation • Pricing strategy • Finance leasing • Use of old vehicles • Dominant management • Cash fraud • Vandalism/repairs • Diversification • Business is highly regulated – breaches having serious implications Up to 2 marks for presentation of briefing notes and clarity of explanation 11 marks

(b) Client’s compliance with rules, laws and regulations

Generally 1 mark for each matter raised

Ideas

• ISA 250 (½ mark) • Directors responsibility • Auditor responsibility – opinion • Non-compliance may have material impact on FSs • Obtain evidence • General understanding • Correspondence • Written reps • Materiality 6 marks

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MARKING SCHEME – continued

(c) Application to Rapid Travel

Generally 1 mark for each suggestion

Ideas

• General research/enquiries • Payroll/HR • Driver’s log • Consultant • Speed records • Penalty notices • Inspection records • Written representations • Trade union correspondence • Legal correspondence 6 marks

(d) ISA 600 Generally 1 mark for each explained point Ideas (i) Significant issues

• Sole vs divided • Definition of group auditor • Related vs unrelated • Acceptance/continuance • Access to information • Aggregation of components • Responsibilities of other auditors

(ii) Group structure • Unusual corporate structures • Access to information • Applicable FR framework • Related parties

(iii) Standard questionnaire • Types of questionnaire • Advantages • Disadvantages • Need to balance • Conclusion 12 marks

TOTAL FOR QUESTION 2 35 MARKS

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ANSWER 3 (a) Senior audit staff leaving for employment with client

Ethical and professional issues Leon’s independence is in doubt as he is threatened by self-interest. Leon’s objectivity in relation to the audit may be influenced by a desire to please and impress Moreno as a prospective employer. There appears to be a lack of integrity on the part of James and/or Leon.

• Leon should have confided in an appropriately senior manager/ partner of

Bartolome. In not doing so he has compromised the firm by having applied for a position with a client whilst assigned to the client.

• James may lack integrity in having advised Bartolome of the short-listing if he gave an undertaking to Leon not to do so. (Conversely, James may be acting with integrity in advising Bartolome and as a matter of professional courtesy.)

Leon should be removed from the audit assignment immediately regardless of whether or not he is finally appointed by Moreno. Leon should be given an oral warning (assuming this to be a first offence) for failing to adhere to Bartolome’s quality control policies and procedures (requiring disclosure to the firm of any threat of involvement with an audit client). The working papers for all audit work relating to Moreno performed under the supervision of Leon should be reviewed as soon as possible. Communication should be made via human resources about the need to disclose such job applications to audit clients. The ethical importance of this situation must be stressed. Implications for continuation with assignment The assignment can be properly continued with a new senior in charge of the audit of the financial statements for the year ending 31 October 2008. Any planning of the year end and final audit work by Leon should be reviewed, amended as necessary and approved before any further work is undertaken.

(b) Unqualified auditors’ reports

Ethical and professional issues An unmodified opinion means, inter alia, that: • there are no material matters giving rise to disagreement with the auditor; and • the auditors’ report does not include an emphasis of matter paragraph (e.g.

regarding going concern).

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By implication the auditor must have obtained sufficient appropriate evidence that notwithstanding the losses: • the going concern basis is appropriate to Ayora’s financial statements and

any related matters (e.g. parental support) are adequately disclosed therein • goodwill in Chatam’s consolidated financial statements is not materially

impaired.

Management’s written representation (that the goodwill is not impaired) must have been necessary (otherwise it should not have been asked for). This means that Bartolome does not have sufficient other audit evidence. This seems dubious as management should have carried out an impairment test to satisfy themselves that goodwill is not impaired. This test should similarly have satisfied Bartolome. If there is evidence that goodwill is impaired management’s refusal to write it down might be considered a fraud. The matter may cast doubt on the quality of audit evidence obtained in other areas. All other matters on which management representations have been obtained should be reviewed by another audit partner/manager. Charles Barrington is retiring next year and his share options would presumably be worth less if goodwill were written down. His position in this long-standing client suggests a familiarity threat. Bartolome may be threatened by self-interest to accept the representation as sufficient in order to retain the client. Bartolome may be unduly influenced by a combination of factors (familiarity and previous experience) and failing to exercise the necessary degree of professional scepticism. Implications for continuation with assignment There is no reason why the audit should not be continued. However, a change in senior audit staff and audit manager may be overdue. The unmodified auditors’ reports should be subject to a cold review and any quality control issues raised with the staff who conducted the audit.

(c) Threatened legal action

Ethical and professional issues An advocacy threat has arisen as Bartolome and Pinzon are in opposition concerning the fee note for the 2007 audit. If Pinzon’s allegations are true this may cast serious doubt on the integrity of Bartolome. Pinzon should be advised to take its claims first to ACCA’s Disciplinary Committee.

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If Bartolome has indeed charged full air fares when substantial discounts had been obtained this could be due to:

• Bartolome incorrectly believing this to be an acceptable industry practice; or • a billing error/oversight.

In either case Bartolome should issue a credit note, although this may be insufficient to make amends and salvage the auditor-client relationship.

Bartolome may have legitimately claimed for full airfares if this was agreed in its contract (i.e. the terms of engagement) with Pinzon.

Implications for continuation with assignment

Unless the threat of legal action is amicably resolved very quickly (which is perhaps unlikely) Pinzon and Bartolome are in conflict. Bartolome cannot therefore be seen to be independent and so should tender its resignation as auditor for the year ending 31 December 2008 (assuming it was re-appointed and has not already been removed from office).

MARKING GUIDE

Generally 1 mark each point of explanation Ideas

(a) Leon Dormido's application for position of Finance Director • Self interest threat • Integrity • Remove Leon from audit • Warning • Review working papers • New senior 5 marks

(b) Chatam Inc – treatment of goodwill affecting share options • Implication re. evidence • Lack of other evidence • Fraud? • Quality of other representations • Familiarity threat • Self interest threat • Rotation • Cold review 6 marks

(c) Pinzon Inc – professional integrity • Advocacy • Integrity • Possible error? • Credit note • Contract • Resign 4 marks

TOTAL FOR QUESTION 3 15 MARKS

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ANSWER 4 (a) Independent auditor’s report terms

(i) Qualified opinion – A qualified opinion is expressed when the auditor concludes that an unqualified opinion cannot be expressed but that the effect of any disagreement with management, or limitation on scope is not so material and pervasive as to require an adverse opinion or a disclaimer of opinion.

(ii) Disclaimer of opinion – A disclaimer of opinion is expressed when the

possible effect of a limitation on scope is so material and pervasive that the auditor has not been able to obtain sufficient appropriate audit evidence and accordingly is unable to express an opinion on the financial statements.

(iii) Emphasis of matter paragraph – An auditor’s report may be modified by

adding an emphasis of matter paragraph to highlight a matter of significant uncertainty affecting the financial statements that is included in a note to the financial statements that more extensively discusses the matter. Such an emphasis of matter paragraph does not affect the auditor’s opinion. An emphasis of matter paragraph may also be used to report matters other than those affecting the financial statements (e.g. if there is a misstatement of fact in other information included in documents containing audited financial statements).

(iii) is clearly distinguishable from (i) and (ii) because (i) and (ii) affect the opinion paragraph, whereas (iii) does not. (i) and (ii) are distinguishable by the degree of their impact on the financial statements. In (i) the effects of any disagreement or limitation on scope can be identified with an ‘except for …’ opinion. In (ii) the matter is pervasive, that is, affecting the financial statements as a whole. (ii) can only arise in respect of a limitation in scope (i.e. insufficient evidence) that has a pervasive effect. (i) is not pervasive and may also arise from disagreement (i.e. where there is sufficient evidence).

(b) Implications for auditor’s report

(i) Selective revaluation of premises The revaluations are clearly material to the balance sheet as $1 million and $2.7 million represent 6·5% and 17·5% of total assets, respectively (and 24% in total). As the effects of the revaluation on line items in the financial statements are clearly identified (e.g. revalued amount, depreciation, surplus in statement of changes in equity) the matter is not pervasive. The valuations of the nine properties after the year end provide additional evidence of conditions existing at the year end and are therefore adjusting events per IAS 10 Events After the Reporting Period.

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However, IAS 16 Property, Plant and Equipment does not permit the selective revaluation of assets thus the whole class of premises would need to have been revalued for the year to 31 December 2008 to change the measurement basis for this reporting period. The revaluation exercise is incomplete. Unless the remaining three properties are revalued before the auditor’s report on the financial statements for the year ended 31 December 2008 is signed off: (1) the $3.7mn revaluation made so far must be reversed to show all premises at depreciated cost as in previous years; OR (2) the auditor’s report would be qualified ‘except for’ disagreement regarding non-compliance with IAS 16. When it is appropriate to adopt the revaluation model (e.g. next year) the change in accounting policy (from a cost model to a revaluation model) should be accounted for in accordance with IAS 16 (i.e. as a revaluation). Tutorial note: IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors does not apply to the initial application of a policy to revalue assets in accordance with IAS 16. Assuming the revaluation is written back, before giving an unmodified opinion, the auditor should consider why the three properties were not revalued. In particular if there are any indicators of impairment (e.g. physical dilapidation) there should be sufficient evidence on the working paper file to show that the carrying amount of these properties is not materially greater than their recoverable amount (i.e. the higher of value in use and fair value less costs to sell). If there is insufficient evidence to confirm that the three properties are not impaired (e.g. if the auditor was prevented from inspecting the properties) the auditor’s report would be qualified ‘except for’ on grounds of limitation on scope. If there is evidence of material impairment but management fail to write down the carrying amount to recoverable amount the auditor’s report would be qualified ‘except for’ disagreement regarding non-compliance with IAS 36 Impairment of Assets. (ii) 10-year guarantee $9.1 million golf sales amount to 43·1% of revenue and are therefore material. However, the guarantee was only introduced three months into the year, say in respect of $6.8 million (3/4 × 9.1 million) i.e. approximately 32% of revenue. The draft note disclosure could indicate that Mouse’s management believes that Mouse has a legal obligation in respect of the guarantee that is not remote and likely to be material (otherwise no disclosure would have been required).

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A best estimate of the obligation amounting to 5% profit before tax (or more) is likely to be considered material, i.e. $45,000 (or more). Therefore, if it is probable that 0·66% of sales made under guarantee will be returned for refund, this would require a warranty provision that would be material. Tutorial note: The return of 0.66% of sales over a 10-year period may well be probable. Clearly there is a present obligation as a result of a past obligating event for sales made during the nine months to 31 December 2008. Although the likelihood of outflow under the guarantee is likely to be insignificant (even remote) it is probable that some outflow will be needed to settle the class of such obligations. The note in the financial statements is disclosing this matter as a contingent liability. This term encompasses liabilities that do not meet the recognition criteria (e.g. of reliable measurement in accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets). However, it is extremely rare that no reliable estimate can be made (IAS 37) – the use of estimates being essential to the preparation of financial statements. Mouse’s management must make a best estimate of the cost of refunds/repairs under guarantee taking into account, for example: • the proportion of sales during the nine months to 31 December 2008 that

have been returned under guarantee at the reporting date (and in the post reporting date period);

• the average age of golf equipment showing a defect; • the expected cost of a replacement item (as a refund of replacement is more

likely than a repair, say).

If management do not make a provision for the best estimate of the obligation the audit opinion should be qualified ‘except for’ non-compliance with IAS 37 (no provision made). The disclosure made in the note to the financial statements, however detailed, is not a substitute for making the provision. Tutorial note: No marks will be awarded for suggesting that an emphasis of matter of paragraph would be appropriate (drawing attention to the matter more fully explained in the note). Management’s claim that the obligation cannot be measured with sufficient reliability does not give rise to a limitation on scope on the audit. The auditor has sufficient evidence of the non-compliance with IAS 37 and disagrees with it.

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MARKING SCHEME

(a) Audit report terms Generally 1 mark each point of explanation Ideas (ISA 701) • Explanation of each term • Which do and do not effect audit opinion • Pervasive vs material • Limitation (=insufficient evidence) • Disagreement (= sufficient evidence) 6 marks

(b) (i) Selective revaluation of premises Generally 1 mark each point of explanation • Materiality assessed • Not pervasive • Adjusting event (IAS 10) • Non-compliance (IAS 16) • Reversal of revaluation OR • Qualified ‘except for’ disagreement (IAS 16) • Change in accounting policy (next year) • Impairment (IAS 36)

- Insufficient evidence – limitation – except for - Sufficient evidence – disagreement except for 5 marks

(ii) 10 year guarantee Generally 1 mark per explained issue relating to the scenario • Matter is material • Present obligation, probable etc • Not a contingent liability • Best estimate – how determinable • ‘Except for’ disagreement (IAS 37) 4 marks

TOTAL FOR QUESTION 4 15 MARKS

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