Advanced Auditing & Assurance August 2023 Past paper
Guaranteed
95.5% Pass Rate
CPA Advanced Leval Advanvced Auditing and Assurance May 2017 Suggested solutions
Advanvced Auditing and Assurance
Revision Kit
QUESTION 1(a)
Q
You are the audit manager responsible for the audit of Tamasha Ltd. for the year ended 30 June 2016. The audit fieldwork has been completed and the general manager in charge of finance is seeking to finalize the financial statements.
You are reviewing the audit file and the financial statements and have noted the following issues:
1. An investment held at the year end has since declined by Sh. 1 250,000 in market value.
2. A tangible asset with a net book value ofSh.800,000 was sold on 29 June 2016. The final selling price was contingent on a valuer's report which was not received until 15 July 2016. As a result of this report, the profit recorded on this sale should be reduced by Sh.300,000.
3. A number of minor control points were noted and reported to management by way of a formal management letter,
4. Trade payables include a balance of Sh.700,000 owing to the parent company of Tamasha Ltd. The parent company has assured the general manager that it will not seek repayment of the amount for two years from the date the audit report is signed. The general manager will confirm this in the letter of representation.
5. A legal case which was ongoing at the year end has Just been concluded. The case is disclosed and a provision of Sh.350,000 included in the draft financial statements. The outcome of the case was that Tamasha Ltd. should pay damages amounting to Sh. 1 ,450,000 to the other party.
The draft financial statements, which do not contain any adjustments and some relevant disclosures relating to the above matters, show the following:
Turnover
Profit before tax
Net current liabilities Net assets
Sh."000" 34,500 2,900 (1 ,400) 2,100
Required :
For each of the issues noted from your review, summarise the potential implications on the audit report. Treat each issue independently.
A
Solution
➧ Investment - According to IAS 10 "Events after the Reporting Period," the decline in the investment's market value is considered a non-adjusting subsequent event. It should be disclosed in the financial statements.
Failure to disclose this impairment of Sh. 1,250,000 could result in an adverse opinion being issued by the auditor.
➧ Tangible asset - This event qualifies as an adjusting event in line with IAS 10. As it represents 10% of the profit before tax, the financial statements should be adjusted accordingly. Failure to make this adjustment would lead to a qualified opinion being issued by the auditor.
➧ Internal control points - Minor internal control issues were identified and communicated to management through a formal management letter. If management does not address these recommendations, and it could have potential implications for the company's future, the auditor may qualify the audit report.
➧ Inter-company payable balance - Although this issue itself may not directly impact the audit report, the auditor should directly confirm the inter-company payable balance with the parent company. Failure to disclose related party transactions appropriately could result in a qualified opinion or an adverse opinion due to disagreement.
➧ Legal case - The legal case outcome should be treated as an adjusting event following IAS 10. If the financial statements are not adjusted to reflect the damages awarded (Sh. 1,400,000), an adverse opinion should be issued since this misstatement constitutes 48.26% of the profit before tax.
Q
Explain the overall audit opinion that you would express taking into consideration that no further adjustments or disclosures were made for the Issues noted
A
Solution
➢ Qualified opinion is appropriate due to material misstatements in the financial statements.
➢ The decline in investment market value needs to be disclosed as a non-adjusting subsequent event in accordance with IAS 10.
➢ The tangible asset sale adjustment, representing 10% of the profit before tax, requires adjustment and disclosure in line with IAS 10.
➢ Minor internal control points were noted and communicated to management, and if not addressed, may impact the audit report.
➢ The inter-company payable balance issue may not impact the audit report directly, but appropriate disclosure and confirmation are necessary.
➢ The legal case outcome, as an adjusting event, requires financial statement adjustments and proper disclosure following IAS 10.
➢ The going concern assumption requires careful evaluation given the company's net current liabilities and continuous losses.
➢ Economic conditions and industry-specific factors may further affect the going concern assessment.
Summary
A qualified opinion is warranted due to various material misstatements and uncertainties in the financial statements, requiring proper adjustments, disclosures, and considerations related to going concern.
Q
Describe one other significant audit issue likely to arise from the above information,
A
Solution
➦ One significant audit issue likely to arise from the above information is the assessment of going concern.
Here are some of the reasons why:
➧ Net Current Liabilities: The financial statements show net current liabilities of Sh. (1,400,000). Negative net current liabilities suggest that the company's current liabilities exceed its current assets. This raises doubts about the company's ability to meet its short-term obligations as they become due, which is a key indicator for assessing the going concern assumption.
➧ Continuous Losses: The company's net assets are reported as Sh. 2,100,000. The fact that the company has a net asset position does not necessarily guarantee going concern, especially if the company has been consistently incurring losses over several years. The auditor needs to assess whether there are any indications that the losses will continue, affecting the company's ability to remain in business.
➧ Legal Case Outcome: The legal case's outcome, where Tamasha Ltd. is required to pay damages of Sh. 1,450,000, poses a significant financial burden on the company. The ability to pay this amount could impact the company's liquidity and viability, raising concerns about its ability to continue as a going concern.
➧ Uncertain Recovery of Impaired Investment: The decline in the market value of an investment by Sh. 1,250,000 could indicate underlying financial difficulties in the company. The auditors need to assess the recoverability of the investment and evaluate whether any other similar investments are at risk, affecting the company's financial stability.
➧ Contingent Liability from Tangible Asset Sale: The adjustment to the profit on the tangible asset sale based on the valuer's report, reducing the profit by Sh. 300,000, may imply that the company is facing uncertainties in its business operations. Such uncertainties can have implications on the company's cash flow and ability to meet obligations.
➧ Trade Payable from Parent Company: The significant trade payable of Sh. 700,000 owed to the parent company, even with an assurance of a two-year repayment period, raises questions about the company's financial dependency on its parent. This financial arrangement could have implications on Tamasha Ltd.'s liquidity and ability to operate independently.
Q
Outline further audit work you would perform arising from the potential audit issue identified in (c) above.
A
Solution
➧ Analyze Management's Going Concern Assessment: Review the management's assessment of the company's ability to continue as a going concern. Evaluate the key assumptions, projections, and plans used by management to support their conclusion.
➧ Review Financial Projections and Budgets: Obtain and analyze the company's financial projections and budgets for the foreseeable future. Assess the reasonableness of assumptions used in these projections, considering historical performance, industry trends, and economic conditions.
➧ Evaluate Debt Covenants and Credit Agreements: Review the terms of the company's debt agreements and credit facilities. Identify any potential breaches or restrictions that may impact the company's ability to meet its obligations.
➧ Assess Liquidity and Cash Flow: Evaluate the company's liquidity position and projected cash flows. Consider the availability of cash reserves, credit lines, and short-term borrowing capacity to meet upcoming obligations.
➧ Review Contingent Liabilities: Identify and review any other potential contingent liabilities that may affect the going concern assumption. This includes potential legal claims, warranties, or environmental obligations.
➧ Discuss with Management and the Board: Hold discussions with management and the board of directors regarding their plans and actions to address the net current liabilities and continuous losses. Inquire about any additional funding or strategic initiatives being undertaken to support the company's financial position.
➧ Obtain Updated Financial Information: Obtain subsequent financial information and events occurring after the year-end to assess any material changes that may impact the going concern assessment.
➧ Assess External Factors: Consider the impact of external factors such as industry-specific challenges, economic conditions, and changes in market dynamics on the company's financial position and viability.
➧ Obtain Legal Confirmations: Obtain legal confirmations regarding any ongoing or potential legal claims that may impact the company's financial position and ability to continue as a going concern.
➧ Evaluate Management Representations: Obtain written representations from management regarding their assessment of the company's ability to continue as a going concern. Request explicit confirmation of any plans or commitments to address financial challenges.
➧ Consult with Experts: Consult with industry experts, if necessary, to gain insights into the company's position and prospects in light of market conditions and industry-specific challenges.
Q
Pona Hospital is a referral hospital fully owned by the Government. Two years ago, on recommendation by the hospital's internal audit department, the management reviewed all aspects of hospital operations and implemented a number of measures aimed at improving overall "value for money" for the users of the facility.
Your audit firm has been requested to perform a review Of the following measures which have been implemented so far:
1. Pona Hospital has one centralised purchasing department where all purchase requisitions for medical supplies are forwarded. Upon receipt, the procuring team will research on the lowest price from suppliers and a purchase order is raised. This is then forwarded to the purchasing manager who authorises all orders. The small purchasing team receives in excess of 200 requisition forms per day.
2. The human resource department has experienced difficulties in recruiting suitably trained staff. Overtime rates have been increased to incentivize permanent staff performing extra duties due to staffing gaps. This has been popular and reliance on expensive temporary staff has been reduced. Monitoring of staff hours had been difficult. However, the hospital has implemented time card procedures for clocking in and out. The hours clocked are used to calculate payments.
3. The hospital has invested heavily in new surgical equipment. Although the surgical equipment are very expensive, more surgeries can be performed and patient recovery rates are now faster. However, there is a shortage of appropriately trained medical staff and the equipment is underutilized. A capital expenditure committee has been established, made up of senior managers, to authorize future procurement of any significant capital expenditure items,
Required:
(i) Analyse four strengths within Pona Hospital's internal control environment.
(ii) For each of the strengths analysed in (a)(i) above, recommend further improvements in order to provide best value for money.
A
Solution
(i) Analyze four strengths within Pona Hospital's internal control environment:
➧ Centralized Purchasing Department: The existence of a centralized purchasing department is a strength as it helps ensure consistency in procurement practices and enables bulk buying, potentially leading to cost savings.
➧ Purchase Order Authorization: Having the purchasing manager authorize all purchase orders provides a control mechanism to prevent unauthorized purchases and helps ensure adherence to budgetary limits.
➧ Time Card Procedures: Implementing time card procedures for staff clocking in and out is a positive step to monitor and control staff hours. It helps in accurately calculating payments and reduces the risk of payroll fraud or errors.
➧ Capital Expenditure Committee: Establishing a capital expenditure committee comprised of senior managers is a strength as it adds a layer of oversight and control over significant capital expenditures. This helps ensure that investments in new equipment or facilities are carefully evaluated and approved by appropriate stakeholders.
(ii) Recommendations for further improvements to provide best value for money:
➧ Centralized Purchasing Efficiency: To enhance the value for money, the hospital can explore options to improve the efficiency of the centralized purchasing department. This may involve investing in technology solutions, such as e-procurement systems, to streamline the procurement process and facilitate real-time price comparisons from suppliers. Additionally, conducting periodic supplier evaluations and negotiating long-term contracts with reliable suppliers could lead to further cost savings.
➧ Staff Recruitment and Training: While increasing overtime rates has reduced reliance on expensive temporary staff, the hospital should continue efforts to attract and retain suitably trained permanent staff. This may involve collaborating with educational institutions to offer training programs or providing incentives for professional development. Investing in staff training can lead to higher efficiency and improved patient care.
➧ Surgical Equipment Utilization: To maximize the return on investment in surgical equipment, the hospital should focus on addressing the shortage of appropriately trained medical staff. This could include offering specialized training programs for existing staff or hiring trained professionals from other institutions. Additionally, the hospital could explore options for sharing resources with nearby facilities to optimize equipment usage and minimize underutilization.
➧ Capital Expenditure Analysis: While the capital expenditure committee provides oversight, the hospital can enhance the value for money by conducting thorough cost-benefit analyses for significant capital expenditures. The committee should consider factors such as expected patient demand, potential revenue generation, and long-term maintenance costs. This analysis will help ensure that investments align with the hospital's strategic goals and provide the best value for money in the long run.
Q
Your firm has been invited by Mr. Abdalla Juma. the Managing Director of Msingi Bora Ltd., to accept appointment as auditors of the company. You establish that the present firm of auditors will not be reappointed when their term of office expires as Msingi Bora Ltd. is dissatisfied with their services.
Mr. Juma has further requested that:
l. An employee of your firm assumes responsibility of preparing monthly management accounts on tight deadlines, The continuation of the overdraft facility by the company's banker is dependent on the receipt of these accounts by the bank within ten days of each month end.
2. The audit partner in your firm attends the monthly board meetings, mainly to explain the management accounts to the other directors.
Required:
Describe the matters that you would consider in deciding whether to accept the above appointment as auditor and to provide the additional services as requested
A
Solution
➦ When deciding whether to accept the appointment as auditor and provide the additional services as requested by Mr. Abdalla Juma, the Managing Director of Msingi Bora Ltd., the audit firm should consider the following matters:
➧ Independence and Objectivity: The audit firm must assess whether providing the additional services would compromise the independence and objectivity required to perform an unbiased and impartial audit. Being involved in preparing management accounts and attending board meetings may raise concerns about independence and potential conflicts of interest.
➧ Ethical Considerations: The audit firm should evaluate whether providing additional services aligns with the firm's ethical principles and professional standards. Ethical guidelines may restrict auditors from assuming management responsibilities or being too closely involved in the financial reporting process.
➧ Expertise and Competence: The audit firm needs to assess whether it has the necessary expertise and competence to prepare monthly management accounts accurately and on tight deadlines. This includes considering whether the firm has experienced professionals capable of understanding and presenting financial information to the board effectively.
➧ Impact on Audit Quality: Providing additional services could divert resources and attention away from the core audit engagement. The audit firm must carefully evaluate whether it can still perform a high-quality audit while taking on these extra responsibilities.
➧ Potential Conflicts of Interest: The audit firm should identify any potential conflicts of interest that may arise due to the additional roles and responsibilities assumed. Conflicts of interest could jeopardize the firm's ability to provide independent and objective opinions on the financial statements.
➧ Regulatory and Professional Standards: The audit firm needs to review the relevant regulatory requirements and professional standards to ensure compliance with any restrictions or limitations on providing additional services to audit clients.
➧ Impact on Audit Fees: The additional services requested by Mr. Juma may impact the audit fees. The audit firm should evaluate whether the fees for the audit and additional services are reasonable and reflect the scope and complexity of the work involved.
➧ Communication with Current Auditors: Before accepting the appointment, the audit firm should communicate with the current auditors to understand the reasons for their non-reappointment and assess whether there are any significant issues or concerns related to the company's financial reporting or internal control systems.
➧ Terms of Engagement: The audit firm should establish clear terms of engagement with the company, outlining the scope of services provided, responsibilities, deliverables, and any limitations or restrictions related to the additional services.
➧ Consultation with Professional Bodies: If needed, the audit firm may seek guidance and advice from professional bodies or regulators regarding the appropriateness of providing additional services and maintaining independence.
Q
Periodically, there arises debate within and outside the accountancy profession on the independence of auditors. One suggestion floated to improve auditor independence is to have compulsory rotation of audit firms after a pre-determined period.
Required:
(i) Discuss four ethical threats created by a long association with an audit client.
(ii) Evaluate three advantages and three disadvantages of compulsory rotation of audit firms,
A
Solution
(i) Ethical threats created by a long association with an audit client:
➧ Familiarity Threat: Over time, auditors may become too familiar with the client's operations, personnel, and accounting systems. This familiarity can lead to complacency and reduced professional skepticism, making it easier to overlook potential errors or irregularities in the financial statements.
➧ Self-Interest Threat: A long-term association with an audit client can create self-interest threats. Auditors may develop a financial interest in maintaining the client relationship, as the loss of a major client could significantly impact the audit firm's revenue and profitability.
➧ Advocacy Threat: As auditors build long-term relationships with the client, there is a risk of becoming advocates for the client's interests rather than maintaining objectivity and independence. This can compromise the auditor's ability to provide unbiased opinions on the client's financial statements.
➧ Intimidation Threat: Over time, auditors may feel pressured to maintain the client relationship, leading to an intimidation threat. This threat can arise from the fear of losing the client or facing negative repercussions from the client for delivering unfavorable audit findings.
➧ Self-review threat: This threat exists when the auditor is auditing his own work or work that is done by others in the same firm.As the audit firm reviews its own work, independence and objectivity may be compromised, and there is a risk of bias in reporting issues related to the non-audit services provided.
(ii) Advantages and disadvantages of compulsory rotation of audit firms:
Advantages:
➧ Increased Independence: Mandatory rotation can help enhance auditor independence by reducing the familiarity and self-interest threats associated with long-term client relationships. New auditors are less likely to be influenced by client pressures and are more likely to apply professional skepticism.
➧ Fresh Perspective: Rotating audit firms provides a fresh perspective on the client's financial statements and internal controls. New auditors can bring different insights and approaches, which may lead to the identification of previously unnoticed issues or risks.
➧ Enhanced Competition and Quality: Regular rotation encourages more audit firms to compete for audit engagements. This increased competition can lead to improved audit quality as firms strive to demonstrate their expertise and credibility to potential clients.
Disadvantages:
➧ Transition Costs: Compulsory rotation can lead to increased costs for the client during the transition to a new audit firm. This may include additional time and resources required for the new auditor to familiarize themselves with the client's operations and systems.
➧ Loss of Industry Expertise: Long-term audit relationships allow auditors to develop in-depth knowledge of the client's industry, business processes, and specific risks. Mandatory rotation may result in the loss of this specialized expertise, potentially affecting the audit quality.
➧ Reduced Audit Effectiveness: Frequent rotation may limit the ability of auditors to gain a deep understanding of the client's business, operations, and unique risks. This could reduce the effectiveness of audit procedures and the auditor's ability to detect material misstatements.
Q
You are a newly appointed auditor of Shida Ltd. You have recently ascertained the following about your new client:
l . The company has two major customers and a few small-sized customers.
2. The company recently purchased a very large and complex computer system as part of its automation process, The administration staff do not have adequate competence to run the system properly.
3. The Chief Executive Officer of the company, Albert Amingi, has a dominating personality and is overbearing on his subordinates.
4. The company has no formal management accounting system. The new computer system is supposed to remedy this gap.
Required:
Justifying your answer, suggest an appropriate audit strategy for the first audit of Shida Ltd,
A
Solution
➧ Risk Assessment: Conduct a thorough risk assessment to identify and understand the key risks affecting the company's financial statements. Given the few major customers, it is essential to assess the credit risk associated with these customers, as their financial stability may impact the company's revenue significantly.
➧ Computer System Audit: Due to the recent purchase of a large and complex computer system, it is crucial to focus on the effectiveness of internal controls over IT systems. Given the lack of competence in using the system, there is an increased risk of errors and potential fraud. Plan to perform extensive IT controls testing to ensure data integrity, confidentiality, and system reliability.
➧ Evaluation of CEO's Influence: Given the dominating personality of the CEO, there may be a risk of management override of internal controls and potential unethical practices. Consider reviewing significant accounting estimates and management judgments carefully to assess whether they are reasonable and free from bias.
➧ Management Accounting System Review: As there is no formal management accounting system, conduct a detailed review of the new computer system's implementation and effectiveness in addressing the management accounting gap. Ensure that the system captures relevant financial and operational information accurately for decision-making.
➧ Sample Testing of Small Customers: For small-sized customers, consider applying sampling techniques to verify the accuracy of sales and accounts receivable balances. This will help assess the creditworthiness and collectability of receivables from these customers.
➧ Communication and Coordination: Given the complex computer system and lack of formal management accounting, establish open communication and coordination with management throughout the audit process. Understand management's plans for implementing the new system and how they intend to address any identified control weaknesses.
➧ Training and Competence: Provide recommendations for training administration staff on how to effectively use the computer system. Address any concerns related to the lack of competence to ensure proper system operation and data accuracy.
➧ Audit Evidence: Gather sufficient and appropriate audit evidence to support the financial statement assertions. Given the risks associated with significant customers, complex IT systems, and lack of formal management accounting, perform detailed testing to obtain reliable evidence.
➧ Continuous Monitoring: Develop a plan for continuous monitoring and evaluation of key risk areas, especially during the early stages of the audit engagement. Regular updates will enable the audit team to adapt the audit approach as necessary.
Q
Kenya Construction Ltd. (KCL), a company involved in construction of residential houses for sale, has sued their outgoing general manager over matters of financial impropriety. Kelly Limited, which owns 70% of the shares in KCL is also a complainant against the general manager of KCL on the basis that Sh.60 million advanced by the company to KCL was not refunded. The High Court has ordered the lawyers representing the parties in the above case to liaise with their clients and appoint an independent auditor who would scrutinize the documents submitted by the general manager as ordered by the Court, Thereafter, the independent auditor is to file a report to the Court.
The main issues being raised between Kelly Limited and KCL are as follows:
All the houses planned to be constructed and sold were actually constructed and sold.
All the buyers had paid KCL all monies due.
The general manager kept changing contractors and the terms of contract for personal gain.
The general manager engaged in excessive overseas travels for personal errands using company resources.
The general manager did not maintain proper books of account and did not retain all business vouchers as expected.
The general manager did not file VAT, PAY E, corporate tax and social security returns as expected thereby exposing the company to fines and penalties. Failure to file returns was aimed at concealing the general manager's malfeasance.
Although all houses were sold, KCL still owed Kelly Limited Sh.60 million and had a bank overdraft of Sh.80 million secured against some of the houses already disposed of.
The present cost was grossly overstated through unexplained and unsupported expenditure. The general manager violated all known principles of good project governance regarding execution, supervision and handing over of a project.
Required:
Assuming you have been appointed the forensic auditor in the above case
Describe how you would deal with each of the issues numbered 1 to 8 above.
A
Solution
All the houses planned to be constructed and sold were actually constructed and sold:
➫ To verify this claim, I would conduct a physical inspection of the construction sites and compare the number of completed houses against the original plans. Additionally, I would review sales records, contracts, and financial statements to ensure that each constructed house was indeed sold.
All the buyers had paid KCL all monies due:
➫ I would review the sales records, bank statements, and any other relevant financial documents to cross-check the payments received from buyers against the expected amounts based on the sales agreements. This would help confirm whether all buyers paid KCL in full.
The general manager kept changing contractors and the terms of the contract for personal gain:
➫ To investigate this issue, I would review all contracts and invoices related to the construction projects. I would look for any patterns of irregularities, sudden changes in contractors, or evidence of kickbacks or personal gains made by the general manager in relation to these changes.
The general manager engaged in excessive overseas travels for personal errands using company resources:
➫ I would examine travel records, expense reports, and any other relevant documents to determine the purpose of the overseas trips made by the general manager. If these trips were indeed for personal errands, I would quantify the expenses incurred by the company and assess whether they were justified.
The general manager did not maintain proper books of account and did not retain all business vouchers as expected:
➫ As a forensic auditor, I would inspect the company's accounting records and check for any missing or incomplete documentation, including business vouchers, receipts, and invoices. I would also assess the overall quality and accuracy of the financial records maintained by KCL.
The general manager did not file VAT, PAYE, corporate tax, and social security returns as expected, thereby exposing the company to fines and penalties:
➫ To investigate this claim, I would review the tax filings and correspondences with relevant tax authorities. I would also verify whether KCL incurred any fines or penalties due to non-compliance with tax regulations and assess the impact of such non-compliance on the company's financial position.
Although all houses were sold, KCL still owed Kelly Limited Sh.60 million and had a bank overdraft of Sh.80 million secured against some of the houses already disposed of:
➫ To address this issue, I would closely examine the financial statements, loan agreements, and bank records of KCL. I would determine the reasons behind the outstanding debt to Kelly Limited and assess the accuracy and legitimacy of the bank overdraft taken by KCL against the houses sold.
The present cost was grossly overstated through unexplained and unsupported expenditure. The general manager violated all known principles of good project governance regarding execution, supervision, and handing over of a project:
➫ To investigate this matter, I would conduct a thorough review of all project-related expenditures and costs incurred by KCL. I would compare the expenses with industry standards and benchmarks to identify any discrepancies or signs of mismanagement. Additionally, I would assess whether the general manager's actions violated any applicable project governance guidelines.
Q
Explain how you would ensure that you are effective in the provision of valuable evidence to the Court
A
Solution
➧ Independence and Objectivity: As a forensic auditor, I would maintain strict independence and objectivity throughout the investigation to ensure that my findings are unbiased and credible.
➧ Document Preservation: I would ensure that all relevant documents and evidence are properly preserved, securely stored, and protected from any tampering or alteration.
➧ Thorough Investigation: I would conduct a comprehensive and systematic investigation, considering all available evidence and conducting interviews with relevant parties to gather crucial information.
➧ Expertise and Methodology: I would apply appropriate forensic auditing techniques and methodologies to analyze financial data, detect fraud, and uncover any financial irregularities effectively.
➧ Clarity and Accuracy: The evidence and findings presented to the Court would be clear, well-documented, and supported by appropriate calculations, analysis, and explanations.
➧ Adherence to Legal and Ethical Standards: I would ensure that all the forensic audit procedures comply with relevant legal and ethical standards, maintaining confidentiality and professionalism.
➧ Expert Witness Testimony: If required, I would be prepared to provide expert witness testimony in court to explain the findings and answer any relevant questions related to the case.
➧ Collaboration with Legal Teams: I would maintain open communication and collaboration with the lawyers representing the parties involved, providing them with the necessary information and insights to support their arguments effectively.
"The role of statutory auditors is often misunderstood. In particular, there is confusion over the auditor's responsibilities in respect to fraud and the nature of the assurance provided by an audit. Furthermore, following a number of corporate collapses and the revelation of fraud perpetrated by management, it is the auditors who may be sued for large sums of money. This trend is threatening the future of the auditing profession. The majority of auditors would prefer the current legislation to be changed to enable auditors agree on a contractual cap on liability (that is. a limit on the monetary amount which the auditors could pay out in damages)".
Required:
Compare and contrast the responsibilities of auditors and directors of a company in relation to the prevention and detection of fraud.
A
Solution
➦ Auditors and directors of a company have distinct roles and responsibilities when it comes to the prevention and detection of fraud. Below is a comparison and contrast of their respective responsibilities:
Responsibilities of Auditors in relation to the prevention and detection of fraud:
➧ Independent Review: Auditors are external professionals appointed by shareholders to conduct an independent review of a company's financial statements and internal controls. Their primary role is to express an opinion on the fairness and accuracy of the financial statements.
➧ Fraud Detection: While auditors are responsible for detecting material misstatements due to fraud, they are not expected to provide absolute assurance in uncovering all instances of fraud. Their focus is on detecting significant fraud risks and evaluating the adequacy of internal controls to mitigate those risks.
➧ Professional Skepticism: Auditors are required to maintain a skeptical mindset throughout the audit process. They should actively search for any red flags or indications of potential fraud, especially when there are unusual transactions or inconsistencies in financial data.
➧ Reporting: If auditors discover evidence of fraud during the course of their audit, they are obligated to report their findings to management and, in certain cases, to regulatory authorities. They should also assess the impact of the fraud on the financial statements and the related disclosures.
➧ Compliance with Auditing Standards: Auditors must adhere to established auditing standards, which provide guidance on how to approach fraud risk assessments, design audit procedures, and report on their findings.
Responsibilities of Directors in relation to the prevention and detection of fraud:
➧ Oversight and Governance: The board of directors is responsible for providing oversight and governance of the company's operations, including the establishment of a strong control environment to prevent and detect fraud.
➧ Internal Controls: Directors are responsible for ensuring that the company has robust internal control systems in place to minimize the risk of fraud. This includes implementing segregation of duties, regular monitoring, and periodic risk assessments.
➧ Code of Conduct and Ethics: Directors are expected to set and enforce a code of conduct and ethics that promotes integrity and ethical behavior throughout the organization. This includes zero tolerance for fraud and misconduct.
➧ Risk Management: Directors should actively participate in identifying and assessing the company's fraud risks. They should also be informed about the measures taken to mitigate these risks and monitor their effectiveness.
➧ Whistleblower Mechanism: Directors must ensure that there is an effective whistleblower mechanism in place to encourage employees and stakeholders to report any suspected fraudulent activities without fear of retaliation.
Summary
Auditors and directors have complementary roles in preventing and detecting fraud. Auditors provide an independent and objective assessment of the company's financial statements and internal controls, while directors are responsible for establishing a strong control environment, promoting ethical behavior, and actively overseeing the company's risk management efforts. Collaboration between auditors and directors is crucial to effectively address fraud risks and maintain the integrity of the company's financial reporting.
Q
Explain why the statutory audit cannot provide absolute assurance that the financial statements are free from misstatement whether caused by fraud, error or other irregularity.
A
Solution
➦ Statutory audits are conducted by external auditors in accordance with established auditing standards and regulations to provide an independent opinion on the fairness and reliability of a company's financial statements. While these audits are designed to provide reasonable assurance that the financial statements are free from material misstatements, they cannot offer absolute assurance for several reasons:
➧ Sampling Nature of Audits: Auditors use sampling techniques to examine a subset of transactions and account balances during the audit process. They do not review every single transaction or record, which means there is always a possibility that material misstatements or errors could exist in the portions not examined.
➧ Inherent Limitations of Accounting: Financial statements are prepared based on accounting estimates, assumptions, and judgments made by the company's management. These estimates may involve a level of subjectivity, and the inherent complexity of certain accounting standards can create opportunities for misinterpretation or errors.
➧ Fraud Risk and Collusion: Fraudulent activities are designed to be concealed, making them challenging to detect through standard audit procedures. Fraud perpetrators may collude or create elaborate schemes to manipulate financial information without leaving easily identifiable traces.
➧ Time and Cost Constraints: Audits have time and cost limitations, as they need to be completed within a reasonable timeframe and budget. These constraints may prevent auditors from conducting an exhaustive investigation into every aspect of the company's operations.
➧ Reliance on Internal Controls: Auditors often rely on the company's internal controls to assess the risk of material misstatement. However, if the internal controls are ineffective or overridden by management, this reliance may not be entirely reliable.
➧ Omissions and Concealment: Misstatements, whether intentional or unintentional, can be omitted or concealed in the financial statements, making them difficult to identify through traditional audit procedures.
➧ Information Asymmetry: Auditors do not have access to all information related to the company. Some information, such as undisclosed related party transactions or off-balance-sheet arrangements, may not be readily available to auditors.
➧ Forward-Looking Nature: Financial statements represent historical information and may not reflect future events or changes that could impact the company's financial position.
Q
Discuss in each case, arguments for and against changing the legislation to allow auditors to agree on a contractual cap on liability in respect to the statutory audit.
A
Solution
Arguments FOR changing legislation to allow auditors to agree on a contractual cap on liability in respect to the statutory audit:
➧ Risk Mitigation: Allowing auditors to agree on a cap on liability could help mitigate the substantial financial risks they face. In cases of corporate collapses or financial fraud, auditors may be held liable for significant damages, even if they followed professional standards diligently. A liability cap could protect auditors from excessive financial burdens.
➧ Attracting More Audit Firms: Implementing a liability cap could attract more audit firms to take on riskier audit engagements, particularly for companies with complex financial structures or in high-risk industries. Increased competition among audit firms may lead to better audit services.
➧ Cost Control: A liability cap could provide auditors with more certainty about potential liability, enabling them to better assess and manage their insurance and risk management costs. This, in turn, might result in cost savings that could be passed on to clients.
➧ Focus on Professional Judgment: Without the fear of unlimited liability, auditors may be more inclined to exercise their professional judgment more effectively and objectively during the audit process. This could lead to a higher-quality audit, benefiting shareholders and other stakeholders.
Arguments AGAINST changing legislation to allow auditors to agree on a contractual cap on liability in respect to the statutory audit:
➧ Reduced Incentive for Diligence: Introducing a liability cap may reduce auditors' motivation to perform thorough audits, as they may feel less accountable for potential negligence or oversight. This could compromise the overall quality of audit work.
➧ Impact on Credibility: A liability cap might raise concerns among stakeholders about auditors' independence and objectivity. There may be skepticism about whether auditors can maintain their impartiality if their financial exposure is limited.
➧ Risk to Investor Confidence: Limiting auditor liability could erode investor confidence in financial reporting and auditing processes. Shareholders and potential investors might perceive it as a weakening of the auditing profession's commitment to accountability.
➧ Unfair Distribution of Risk: A liability cap could shift a significant portion of the financial risk associated with potential audit failures from auditors to shareholders and other stakeholders. This could result in stakeholders bearing the brunt of losses caused by inadequate audits.
➧ Legal Complexity: Implementing a liability cap may introduce legal complexities, such as defining the scope and limits of the cap and determining its enforceability in different jurisdictions. This could lead to disputes and uncertainty in legal proceedings.
➧ Potential for Lower Damages Recovery: A cap on liability might limit the ability of affected parties to recover their losses in cases of significant audit failures, especially if the damages exceed the capped amount.
