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  • 10 Marks

AAA – L3 – Q47 – Financial instruments

Discuss challenges in auditing financial instruments and matters for planning the audit of Tap Co’s forward exchange contracts.

You are the manager in Dee Kay Company, a firm of Chartered Accountants. You have just attended a monthly meeting of audit partners and managers at which client-related matters were discussed. Information relating to one client which were discussed at the meeting is given below.
Tap Co
Tap Co is a clothing manufacturer, which has recently expanded its operations overseas. To manage exposure to cash flows denominated in foreign currencies, the company has set up a treasury management function, which is responsible for entering into hedge transactions such as forward exchange contracts. These transactions are likely to be material to the financial statements. The audit partner is about to commence planning the audit for the year ending 31 July 2014.
Required:
Discuss why the audit of financial instruments is particularly challenging, and explain the matters to be considered in planning the audit of Tap Co’s forward exchange contracts.

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  • 10 Marks

AAA – L3 – Q46 – Internal audit

Assess the need for an internal audit function at Adepa Ltd, considering its growth and technology adoption.

Adepa Ltd, a fruit processing company, has been in operation for many years. It has managed to grow the business over the years and now has eight branches, four in rural areas and four in urban towns, in addition to the head office. The management and those charged with governance are looking forward to the company adopting the latest technology in production – Advanced Technology Manufacturing (ATM) and marketing and sales through the internet.
During the last audit of the financial statements of the company, the Managing Director suggested to the Senior Partner an assessment of the need for an internal audit function in the company. You were the audit manager who led the engagement team to do the audit. The Senior Partner has therefore asked you to carry out the assignment to assess the need for an internal audit in Adepa Ltd.
Required:
Draft a report to the Senior Partner on the assessment of the need for an internal audit function for Adepa Ltd., highlighting the factors to be considered in such assessment.

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  • 30 Marks

AAA – L3 – Q45 – Forensic auditing

Investigate Accra Engineering Co's losses, focusing on inventory valuation, material consumption, and potential fraud.

You have been asked to carry out an investigation by the management of Dominic Co. One of the company’s subsidiaries, Accra Engineering Co, has been making losses for the past year. Dominic’s management is concerned about the accuracy of Accra Engineering’s most recent quarter’s management accounts.
The summarised statements of profit or loss for the last three quarters are as follows:

Quarter to 30 June 20X8 31 March 20X8 31 December 20X7
C000 C000 C000
Revenue 429 334 343
Opening inventory 180 163 203
Materials 318 235 240
Direct wages 62 54 74
560 452 517
Less: Closing inventory (162) (180) (163)
Cost of sales 398 272 354
Gross profit 31 62 (11)
Less: Overheads (63) (75) (82)
Net loss (32) (13) (93)
Gross profit (%) 7.2% 18.6% (3.2)%
Materials (% of revenue) 74.1% 70.0% 70.0%
Labour (% of revenue) 14.5% 16.2% 21.6%

Dominic’s management board believes that the high material consumption as a percentage of revenue for the quarter to 30 June 20X8 is due to one or more of the following factors:
(1) under-counting or under-valuation of closing inventory;
(2) excessive consumption or wastage of materials;
(3) material being stolen by employees or other individuals.

Accra Engineering has a small number of large customers and manufactures its products to each customer’s specification. The selling price of the product is determined by:
(1) estimating the cost of materials;
(2) estimating the labour cost;
(3) adding a mark-up to cover overheads and provide a normal profit.

The estimated costs are not compared with actual costs. Although it is possible to analyse purchase invoices for materials between customers’ orders this analysis has not been done.
A physical inventory count is carried out at the end of each quarter. Items of inventory are entered on inventory sheets and valued manually. The company does not maintain perpetual inventory records and a full physical count is to be carried out at the financial year end, 30 September 20X8.
The direct labour cost included in the inventory valuation is small and should be assumed to be constant at the end of each quarter. Historically, the cost of materials consumed has been about 70% of revenue.
The management accounts to 31 March 20X8 are to be assumed to be correct.
Required
(a) Define ‘forensic auditing’ and describe its application to fraud investigations. (5 marks)
(b) Identify and describe the matters that you should consider and the procedures you should carry out in order to plan an investigation of Accra Engineering Co’s losses. (10 marks)
(c) (i) Explain the matters you should consider to determine whether closing inventory at 30 June 20X8 is undervalued; and                (ii) Describe the tests you should plan to perform to quantify the amount of any undervaluation.
(d) (i) Identify and explain the possible reasons for the apparent high materials consumption in the quarter ended 30 June 20X8; and (ii) Describe the tests you should plan to perform to determine whether materials consumption, as shown in the management accounts, is correct.

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  • 30 Marks

AAA – L3 – Q44 – Group audits

Identify risks, audit planning effects, support letters, and horizontal groups' impact for Kwei Co's group audit.

You are an audit manager in Rita & Co, a firm of Chartered Accountants. One of your audit clients Kwei Co provides satellite broadcasting services in a rapidly growing market.
In February 20X8 Kwei purchased Thunder Co, a competitor group of companies. Significant revenue, cost and capital expenditure synergies are expected as the operations of Kwei and Thunder are being combined into one group of companies. The following financial and operating information consolidates the results of the enlarged Kwei group:

| | Year end 31 December | | | | 20X8 (Est.) | 20X7 (Actual) | | | $m | $m | | Revenue | 6,827 | 4,404 | | Cost of sales | (3,109) | (1,991) | | Distribution costs and administrative expenses | (2,866) | (1,700) | | Research and development costs | (25) | (22) | | Depreciation and amortisation | (927) | (661) | | Interest expense | (266) | (202) | | Loss before taxation | (366) | (172) | | Customers | 14.9m | 7.6m | | Average revenue per customer (ARPC) | 458 | 579 |

In November 20X8 Kwei purchased Storm Co, a large cable communications provider in India, where your firm has no representation. The financial statements of Storm for the year ending 31 December 20X8 will continue to be audited by a local firm of Chartered Accountants. Storm’s activities have not been reflected in the above estimated results of the group. Kwei is committed to introducing its corporate image in India.
In order to sustain growth, significant costs are expected to be incurred as operations are expanded, networks upgraded and new products and services introduced.
Required
(a) Identify and describe the principal business risks for the Kwei group.
(b) Explain what effect the acquisitions will have on the planning of Rita & Co’s audit of the consolidated financial statements of Kwei Co for the year ending 31 December 20X8.
(c) Explain the role of ‘support letters’ (often called ‘comfort letters’) as evidence in the audit of financial statements.
(d) Discuss how ‘horizontal groups’ (i.e. non-consolidated entities under common control) affect the scope of an audit and the audit work undertaken.

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  • 25 Marks

AAA – L3 – Q43 – Internal audit and outsourcing

Explain risks, controls, further work, and financial statement impact for YUM Supermarkets' issues.

YUM Supermarkets (YUM) has 200 stores throughout Ghana, with around a further 20 stores across Africa. YUM have been trying to compete with the large out of town supermarkets for the last five years but have recently taken the decision to move into the smaller stores in towns. Their aim is to be specialist in the type of value for money ‘quality’ products that cannot normally be obtained in local shops. YUM has also moved into sales via the internet. They receive orders through the internet and arrange for the closest local store to distribute the shopping to the customer.
You have been assigned to the audit of YUM this year. You have obtained the following information:
(1) The internet sales service has proved very successful with a 100% increase in revenue on last year. However, there have been complaints about the quality of deliveries and that customers are failing to receive all items ordered.
(2) There have been interruptions to the internet sales service caused by the higher than expected levels of revenue. There have also been concerns over the confidentiality and security of information accessed via the internet.
(3) Problems have arisen with two of the new sites selected by YUM for expansion.
In respect of Site A, there has been substantial local opposition accompanied by environmental concerns over potential contamination of the site.
In respect of Site B, planning permission has not yet been obtained and has been deferred due to an alternative application in the locality by a major competitor. This looks likely to delay planning decisions for a significant period of time.
(4) YUM acquired Ripe Supermarkets last year as part of their business strategy. Initially, the decision was taken to continue to operate Ripe separately and integrate the stores on a phased basis over a two year period. This would involve rebranding Ripe, investing and upgrading stores and ensuring the same quality of staff as YUM. Ripe managers were retained to continue managing stores and to ensure continuity. As the integration has commenced, a number of problems have now become apparent with Ripe operations. These include the following:

  • Ripe employees have not been receiving the legal minimum wage.
  • No records have been maintained of the number of hours worked by employees, although anecdotal evidence has been received that in some areas they have been regularly working 60 hour weeks.
  • There are three ongoing complaints for unfair dismissal.
  • Staff retention has been a major difficulty.
  • Investigations are underway by the authorities over allegations of false labelling of sales items.
  • An investigation is underway over the sale of meat products in one store that appear to have resulted in a local outbreak of food poisoning. The most likely cause for this outbreak is the poor refrigeration and maintenance of the products and sales beyond ‘sell by’ dates. Some local press comment has already arisen.
    Required
    Explain the risks facing YUM Supermarkets in respect of the above, the controls you would expect to operate in the scenario, the further work you would undertake and the potential impact on the financial statements and the audit.

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  • 10 Marks

AAA – L3 – Q42 – Audit Evidence and Materiality

State audit testing procedures, criteria for using internal audit work, and materiality definition with audit stages.

Required
(a) ISA 500 Audit Evidence identifies the different audit procedures that can be performed in order to obtain audit evidence.
Required
State, and briefly explain, five testing procedures that can be performed to obtain audit evidence.
(b) ISA 610 Using the Work of Internal Auditors explains when the work of the internal audit function can be used.
Required
State TWO criteria that the external auditor shall evaluate when assessing whether the work of the internal audit function can be used for the purposes of the audit.
(c) ISA 320 Audit Materiality provides guidance to the auditor on the concept of materiality and its relationship with audit risk.
Required
State a brief definition of materiality and state the two stages of the audit at which the auditor should consider materiality.

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  • 15 Marks

AAA – L3 – Q41 – Internal and External Audit

Explain differences between internal and external audit and discuss outsourcing internal audit to external auditors.

Required
(a) Explain the difference between the internal and external audit functions.
(b) List the advantages and disadvantages of a company outsourcing its internal audit function to its external auditors.

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  • 20 Marks

AAA – L3 – Q40 – Group audits

Planning considerations for Pinnacle Holdings and Viper audits, including group restructuring and disposals.

The following diagram shows the structure of the Pinnacle Holdings group, a listed company with subsidiaries both locally and overseas. All subsidiaries are wholly-owned. All of Pinnacle Holdings’ overseas operations are run via Falcon.
During the year ended 31 December 20X8 the board of Pinnacle Holdings decided to restructure the group and the following events took place:
(1) Robin was sold on 1 August 20X8 to an East African competitor, Hawk. The consideration was in the form of shares in Hawk, such that Falcon now owns 30% of Hawk.
(2) Heron was sold on 30 November 20X8 to Viper. The consideration was C100 million settled in cash.
(3) To stimulate the operations of Viper and Heron, 26% of the Viper group was sold to Innovative Ventures on 1 December 20X8.
You are the audit manager on the Pinnacle Holdings audit. In addition to the main group financial statements, Viper is also required by Innovative Ventures to prepare group financial statements. Your office audits the Pinnacle Holdings group, Viper and Heron. Your Asian associate audits Falcon. Ibis (which is not material to the group) is not audited, and Hawk and Robin are audited by a small East African practice. With the exception of Ibis, all members of the group are components at which audit work will be performed.

Required
(a) Prepare notes for a planning meeting with the engagement partner setting out the significant matters which need to be considered at this stage in respect of the Viper audit.
(b) Prepare notes for a planning meeting with the engagement partner setting out the significant matters which need to be considered at this stage in respect of the Pinnacle Holdings audit.

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  • 30 Marks

AAA – L3 – Q39 – Audit evidence

Audit procedures for Nexu Co's purchases and payables, controls, and use of automated tools.

Nexu Co assembles mobile telephones in a large factory. Each telephone contains up to 100 different parts, with each part being obtained from one of 50 authorised suppliers.
Like many companies, Nexu’s accounting systems are partly manual and partly computerised. In overview the systems include:
(i) Design software
(ii) A computerised database of suppliers (bespoke system written in-house at Nexu)
(iii) A manual system for recording goods inwards and transferring information to the accounts department
(iv) A computerised payables ledger maintained in the accounts department (purchased off-the-shelf and used with no program amendments)
(v) Online payment to suppliers, also in the accounts department
(vi) A computerised general ledger which is updated by the payables ledger
Mobile telephones are assembled in batches of 10,000 to 50,000 telephones. When a batch is scheduled for production, a list of parts is produced by the design software and sent, electronically, to the ordering department. Staff in the ordering department use this list to place orders with authorised suppliers. Orders can only be sent to suppliers on the suppliers’ database. Orders are sent using electronic data interchange (EDI) and confirmed by each supplier using the same system. The list of parts and orders are retained on the computer in an ‘orders placed’ file, which is kept in date sequence.
Parts are delivered to the goods inwards department at Nexu. All deliveries are checked against the orders placed file before being accepted. A hand-written pre-numbered goods received note (GRN) is raised in the goods inwards department showing details of the goods received with a cross-reference to the date of the order. The top copy of the GRN is sent to the accounts department and the second copy retained in the goods inwards department. The orders placed file is updated with the GRN number to show that the parts have been received.
Paper invoices are sent by all suppliers following dispatch of goods. Invoices are sent to the accounts department, where they are stamped with a unique ascending number. Invoice details are matched to the GRN, which is then attached to the invoice. Invoice details are then entered into the computerised payables ledger. The invoice is signed by the accounts clerk to confirm entry into the payables ledger. Invoices are then retained in a temporary file in number order while awaiting payment.
After 30 days, the payables ledger automatically generates a computerised list of payments to be made, which is sent electronically to the chief accountant. The chief accountant compares this list to the invoices, signs each invoice to indicate approval for payment, and then forwards the electronic payments list to the accounts assistant. The assistant uses online banking to pay the suppliers. The electronic payments list is filed in month order on the computer.

Required
(a) List the substantive audit procedures you should perform to confirm the assertions of completeness, occurrence and cut-off for purchases in the financial statements of Nexu Co. For each procedure, explain the purpose of that procedure.
(b) List the audit procedures you should perform on the trade payables balance in Nexu Co’s financial statements. For each procedure, explain the purpose of that procedure.
(c) Describe the control procedures that should be in place over the standing data on the trade payables master file in Nexu Co’s computer system.
(d) Discuss the extent to which automated tools and techniques might be used in your audit of purchases and payables at Nexu Co.

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  • 20 Marks

AAA – L3 – Q38 – Evaluation and review

Plan audit of Belmont Pharmaceuticals for 31 Dec 20X8, addressing drug development, legal claim, and voucher revenue issues.

Belmont Pharmaceuticals, a public limited liability company, is a pharmaceutical company which concentrates on medical research and the production of new medicines and remedies designed to improve the quality of life, for all ages. You are an audit manager who is planning the audit of Belmont Pharmaceuticals for the year ended 31 December 20X8. Profit before tax for the year ended 31 December 20X8 is C3.46m.
In the course of planning discussions with the finance director of Belmont Pharmaceuticals, he raised the following issues that have affected the financial statements of Belmont Pharmaceuticals for the year:
(a) During the year ended 31 December 20X8, Belmont Pharmaceuticals spent C8m on researching the relationship between two chemicals. As a result of the research, Belmont Pharmaceuticals identified a new drug that discourages the growth of carcinogenic cells in the body. It stimulates the production of antibodies in the white blood cells of the body’s immune system. Substantial progress has been made in the development of the drug and it is hoped that a drug for a cancer antidote may be possible in the foreseeable future. During the year C15 million has been spent on the project to develop this drug, codenamed project ‘Horizon’. The directors of Belmont Pharmaceuticals have capitalised the costs of C15 million as an intangible non-current asset.
(b) On 30 November 20X7, Belmont Pharmaceuticals received notification from its lawyers of a claim from users of a new type of asthma tablet. At 31 December 20X7, neither the likelihood of the success of the claim nor the amount were known and as a result, no provision was made in the financial statements for the year ended 31 December 20X7. As at 31 December 20X8, the case is still in progress, but the lawyers now advise Belmont Pharmaceuticals that the amount of the claim is an estimated C20 million and that the claimants are very likely to be successful in court.
(c) This year, just prior to the year end, Belmont Pharmaceuticals launched a DIY ‘Check the health of your blood’ voucher, marketing it as ‘a perfect choice…the gift of ensuring life longevity’. Belmont Pharmaceuticals will launch the product on a ‘2 for the price of 1’ basis and launch will be timed for Valentine’s Day on 14 February 20X5. Previous schemes on health schemes vouchers have proved immensely popular previously. The directors will issue C5 million vouchers and they expect an 80% take. Accordingly, the directors have included C4 million in revenue in the year to be December 20X8.

Required
For each of the above issues:
(i) Comment on the matters you should consider; and
(ii) State the audit evidence that you should expect to find, in undertaking planning of the audit working papers and financial statements of Belmont Pharmaceuticals.

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