ADVANCED AUDITING & ASSURANCE MAY 2021 - CPA SOLUTION|REVISION KITS|KASNEB

QUESTION 1(a)

Q International Standard on Auditing (ISA) 220 (Quality Control for an Audit of Financial Statements) requires that for audits of financial statements of listed entities, and for those other audit engagements if any. for which the firm has determined that an engagement quality control review is required, the engagement partner shall:
Determine that an engagement quality control reviewer has been appointed. Discuss significant matters arising during the audit engagement, including those identified during the audit control review, with the engagement quality control reviewer.
In addition, the standard requires that the engagement quality control reviewer shall perform an objective evaluation of the significant judgements made by the engagement team and the conclusions reached in formulating the auditor's report.

Required:

In the context of the above provisions and making reference to any other relevant provisions of ISA 220, discuss the key issues that the engagement quality control reviewer should consider during the evaluation of the significant judgements made by the engagement team, with particular reference to listed entities.

A

Solution

➦ The engagement quality control reviewer plays a crucial role in enhancing the quality of the audit of financial statements, particularly for listed entities. When evaluating the significant judgments made by the engagement team, the reviewer should consider the following key issues, with reference to relevant provisions of ISA 220:

➧ Materiality Assessments: The engagement quality control reviewer should evaluate whether the engagement team has appropriately assessed materiality for the audit. This includes considering the quantitative and qualitative aspects of materiality, its impact on the overall audit strategy, and the relevance of the materiality thresholds applied to specific account balances and disclosures.

➧ Accounting Estimates: For listed entities, the audit often involves complex accounting estimates, such as fair value measurements, impairment assessments, and provisions. The reviewer should scrutinize how the engagement team assessed the reasonableness of these estimates, the appropriateness of assumptions used, and whether the estimates comply with relevant accounting standards.

➧ Risk Assessment: The reviewer should evaluate the engagement team's risk assessment process, including how they identified and responded to significant risks of material misstatement. This involves assessing whether the team adequately understood the entity's business and its environment, and whether the responses to identified risks were appropriate and effective.

➧ Auditor's Responses to Identified Risks: For listed entities, the engagement quality control reviewer should ensure that the engagement team's responses to identified risks are comprehensive and well-documented. This includes considering whether the team gathered sufficient audit evidence to support their risk responses and whether they performed substantive procedures that effectively address the identified risks.

➧ Use of Specialists: When listed entities involve specialists in the audit process (e.g., valuation experts), the reviewer should assess whether the engagement team appropriately evaluated the work of specialists, including the reliability of their data and the relevance of their findings to the audit conclusions.

➧ Group Audits: For listed entities that are part of a group, the engagement quality control reviewer should pay special attention to the coordination and communication between component auditors. This involves evaluating whether the group audit procedures were adequately designed and executed and whether there was proper coordination of work to address group-wide risks.

➧ Going Concern Assessment: The reviewer should evaluate the engagement team's assessment of the entity's ability to continue as a going concern. For listed entities, this assessment is of utmost importance due to the impact on investors' decisions. The reviewer should ensure that the team's evaluation is well-documented, considering all available information and supporting evidence.

➧ Communication with Those Charged with Governance: The engagement quality control reviewer should assess whether the engagement team appropriately communicated significant audit findings and issues to those charged with governance. For listed entities, effective communication is essential to maintain transparency and trust with stakeholders.

➧ Compliance with Ethical Requirements: The reviewer should verify that the engagement team complied with relevant ethical requirements, including independence considerations, and that there were no conflicts of interest or breaches of professional ethics.

➧ Use of Technology and Data Analytics: For listed entities, the application of technology and data analytics in the audit process can be significant. The reviewer should evaluate whether the engagement team effectively used relevant tools and technologies to enhance audit efficiency and effectiveness.

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QUESTION 1(b)

Q The auditor needs to have a sufficient understanding of the entity and its environment to enable idendification of the events, transactions and practices that may result in a risk of material misstatement regarding related parties and transactions with such parties. While the existence of related parties and transactions between such parties are considered ordinary features of business, the auditor needs to be aware of them:

Required:

(i) Evaluate the reasons why during the course of an audit the auditor needs to be aware of the existence of related parties.
(ii) Describe the audit procedures that should be carried out to identify the existence of transactions with related parties.

A

Solution

(i) Reasons for the Auditor to be Aware of the Existence of Related Parties:

➧ Risk of Material Misstatement: Related party transactions can present a risk of material misstatement in the financial statements. Due to the close relationship between the parties involved, there is a higher likelihood of biased or non-arm's length transactions that may not be recorded accurately in the financial statements.

➧ Disclosure Requirements: Many accounting standards require companies to disclose related party transactions in their financial statements. As an auditor, being aware of related parties helps ensure that the company complies with disclosure requirements, providing users of the financial statements with complete and transparent information.

➧ Potential Fraud and Abuse: Related party transactions could be used to manipulate financial results or engage in fraudulent activities, such as revenue recognition schemes or asset misappropriation. The auditor needs to be vigilant in identifying such potential fraud risks.

➧ Impact on Financial Performance: Transactions with related parties can significantly impact the financial performance and position of the entity. By understanding these transactions, the auditor can assess their appropriateness and impact on the financial statements' overall accuracy.

➧ Conflict of Interest: Related party transactions may involve conflicts of interest between management and the company, leading to decisions that may not be in the best interest of the shareholders. The auditor needs to be aware of such situations to evaluate the fairness of these transactions.

➧ Regulatory Compliance: For some industries or jurisdictions, there may be specific regulations or laws regarding related party transactions that the company must adhere to. The auditor needs to verify compliance with these regulations.

(ii) Audit Procedures to Identify the Existence of Transactions with Related Parties:

➧ Inquiry and Review of Related Party Disclosures: The auditor should inquire with management and review the financial statements and notes to identify related party disclosures. These disclosures often provide a list of related parties and the nature and extent of transactions with them.

➧ Review of Corporate Structure: The auditor should review the company's organizational structure and ownership to identify entities or individuals that may be related parties.

➧ Review of Board Minutes and Governance Documents: Board minutes and governance documents may contain information about significant related party transactions. The auditor should review these documents to identify any potential related party issues.

➧ Analytical Procedures: Analytical procedures can be used to identify transactions that appear unusual or disproportionate compared to the company's past performance or industry norms. Such transactions might indicate related party involvement.

➧ Requesting Confirmations: The auditor may request confirmations from management or third parties to verify the existence of related party transactions and the terms of those transactions.

➧ Inquiry with Management and Key Personnel: The auditor should interview management and key personnel to obtain information about any transactions with related parties not yet disclosed.

➧ Review of Contracts and Agreements: The auditor should review significant contracts and agreements to identify related party involvement, ensuring that the terms are consistent with arm's length transactions.

➧ Comparison with Industry Benchmarks: The auditor can compare the company's related party transactions with industry benchmarks to identify any significant deviations.

➧ Data Analytics: The use of data analytics can help identify patterns or anomalies in financial transactions that may indicate related party involvement.

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QUESTION 2(a)

Q In an engagement to examine prospective financial information, the auditor should obtain sufficient and appropriate evidence as to whether management's best-estimate assumptions on which the prospective financial information is based are not unreasonable and, in the case of hypothetical assumptions, such assumptions are consistent with the purpose of the information

Required:

In the context of the above statement:

(i) Explore the difference between a "forecast" and a "projection" with reference to prospective financial information.
(ii) Explain the matters you would consider before accepting an engagement to examine prospective financial intòrmation.
(iii) Describe in detail the key areas of focus during the actual audit of prospective financial information

A

Solution

(i) Difference between a "Forecast" and a "Projection" with Reference to Prospective Financial Information:

➧ Forecast:

A forecast is a prospective financial statement that presents an entity's expected financial results based on management's best-estimate assumptions about future events and circumstances. It reflects the entity's expectations of future performance, assuming that events will unfold as anticipated. Forecasts are typically based on a realistic and reasonable set of assumptions and are often used for budgeting, operational planning, and decision-making purposes.

➧ Projection:

A projection is a prospective financial statement that presents an entity's expected financial results based on hypothetical assumptions. Unlike a forecast, a projection allows for the exploration of various scenarios, including hypothetical or "what-if" assumptions. Projections are not necessarily based on management's best-estimate assumptions and may involve more speculative or exploratory assumptions about the future.

Summary

The key difference between a forecast and a projection lies in the level of certainty and the nature of the assumptions used. Forecasts are based on management's best-estimate assumptions, and there is a higher level of confidence in their achievability. In contrast, projections involve a wider range of assumptions, some of which may be hypothetical, and their achievement is less certain.

(ii) Matters to Consider before Accepting an Engagement to Examine Prospective Financial Information:

➧ Professional Competence and Expertise: The auditor should assess whether they have the necessary skills, knowledge, and experience to perform the examination effectively. They need to ensure that they are proficient in examining prospective financial information and can apply the appropriate auditing and assurance procedures.

➧ Independence and Objectivity: The auditor should evaluate their independence and objectivity regarding the entity. Independence is critical to maintain the auditor's impartiality and credibility in providing assurance on the prospective financial information.

➧ Understanding of the Engagement Scope: The auditor needs to have a clear understanding of the scope and objectives of the engagement. They should agree with management on the terms of engagement, the nature of the prospective financial information, and the intended use of the examination report.

➧ Review of Assumptions: Before accepting the engagement, the auditor should critically review the assumptions used in the prospective financial information. They should assess whether these assumptions are reasonable, consistent with the entity's historical performance and industry norms, and properly documented.

➧ Evaluation of Limitations: The auditor should consider any inherent limitations related to examining prospective financial information. Unlike historical financial statements, prospective financial information involves inherent uncertainties, and the auditor needs to communicate these limitations clearly to stakeholders.

➧ Legal and Ethical Considerations: The auditor should ensure that the engagement complies with relevant legal and ethical requirements. They need to be aware of any specific regulations or standards governing the examination of prospective financial information.

(iii) Key Areas of Focus during the Actual Audit of Prospective Financial Information:

➧ Evaluation of Assumptions: The auditor should critically evaluate the assumptions used by management in preparing the prospective financial information. This involves assessing the reasonableness of these assumptions and considering their sensitivity to changes in underlying variables.

➧ Examination of Supporting Data: The auditor should verify the accuracy and completeness of the data used to develop the prospective financial information. This may involve examining market research, economic forecasts, and other relevant data sources.

➧ Compliance with Applicable Standards: The auditor needs to ensure that the preparation and presentation of the prospective financial information comply with applicable standards, guidelines, or regulatory requirements.

➧ Consistency with Purpose: For projections, the auditor should assess whether the hypothetical assumptions used are consistent with the purpose of the information and the intended use by stakeholders.

➧ Disclosure and Presentation: The auditor should review the disclosure and presentation of the prospective financial information to ensure that it is clear, understandable, and does not contain any misleading information.

➧ Communication with Management: Throughout the audit process, the auditor should maintain open communication with management to address any concerns, seek clarifications, and ensure that all relevant information is available.

➧ Reporting: The final step is to issue an examination report on the prospective financial information. The report should communicate the auditor's findings, conclusions, and any material observations in a clear and concise manner.

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QUESTION 2(b)

Q Nyota Ltd. intends to invite tenders for provision of external audit services following the expiry of the contract of the current auditor. The company has approached you, as an independent audit consultant to advise on the general guidelines to be followed to ensure the best auditor is engaged.

Required:

From your professional background, advise the company on some of the key guidelines to observe in the tender for audit services.

A

Solution

As an independent audit consultant, I advise Nyota Ltd. to follow these key guidelines to ensure the best auditor is engaged during the tender process for audit services:

➧ Define Clear Scope of Services: Clearly define the scope of audit services required by Nyota Ltd. Provide detailed information on the financial reporting requirements, specific areas of focus, and any additional value-added services expected from the auditor.

➧ Seek Audit Firms with Relevant Experience: Look for audit firms with significant experience in auditing companies similar to Nyota Ltd. in terms of size, industry, and complexity. A firm with relevant experience is more likely to understand the company's operations and risks, leading to a more effective and efficient audit.

➧ Evaluate Audit Firm Reputation: Conduct background checks on the reputation and track record of the audit firms under consideration. Review client feedback, references, and any reported disciplinary actions or litigation to ensure the firms have a history of providing quality audit services.

➧ Consider Industry Knowledge: Select an audit firm with a deep understanding of Nyota Ltd.'s industry. This will enable the auditor to stay updated with industry-specific regulations, accounting practices, and emerging trends that may impact the company's financial statements.

➧ Assess Auditor Independence: Ensure that the selected audit firm maintains independence and objectivity throughout the engagement. Confirm that there are no conflicts of interest that could compromise the auditor's independence.

➧ Review Audit Team Composition: Evaluate the qualifications and expertise of the audit team members who will be assigned to the engagement. Consider the experience, certifications, and industry knowledge of the engagement partner, manager, and staff who will be working on Nyota Ltd.'s audit.

➧ Request Proposal and Engagement Letter: Ask shortlisted audit firms to submit detailed proposals outlining their approach to the audit, the audit team's qualifications, timelines, and fees. Review the engagement letter carefully to ensure that it covers all essential terms and conditions of the audit engagement.

➧ Assess Quality Control Measures: Inquire about the audit firm's quality control procedures and processes for ensuring the accuracy and reliability of their audit work. A firm with robust quality control measures is more likely to deliver a high-quality audit.

➧ Evaluate Technology and Data Analytics Capabilities: Consider audit firms that leverage technology and data analytics tools to enhance the efficiency and effectiveness of the audit process. Advanced audit tools can provide valuable insights and improve audit outcomes.

➧ Cost-Effectiveness: While quality is paramount, also consider the cost of the audit services. Compare the proposed fees with the expected benefits and value provided by the audit firm to ensure cost-effectiveness.

➧ Conduct Interviews and Presentations: Arrange interviews or presentations with shortlisted audit firms to gauge their understanding of Nyota Ltd.'s business and their commitment to delivering high-quality audit services.

➧ Obtain Management Input: Involve Nyota Ltd.'s management in the decision-making process to understand their expectations and preferences. This will ensure alignment between the company's needs and the selected auditor's capabilities.

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QUESTION 3(a)

Q You are the auditor of Majiwa Electronics, a small family owned entity involved in selling electronic items.

During your upcoming audit planning meetings, one of the matters to be discussed is whether the auditor will perform analytical procedures.

Required:

(i) Describe the steps involved in conducting analytical procedures.
(ii) Analyse the criteria used to assess whether substantive analytical procedures might be used.

A

Solution

(i) Steps Involved in Conducting Analytical Procedures:

➧ Identify the Objectives: Define the objectives of the analytical procedures, such as assessing the overall reasonableness of financial information, identifying potential risks of material misstatement, or evaluating financial performance trends.

➧ Obtain Industry Knowledge: Gain a thorough understanding of the industry in which Majiwa Electronics operates. This will help the auditor identify relevant benchmarks and industry-specific factors that may impact the company's financial performance.

➧ Select Data and Develop Expectations: Choose relevant financial and non-financial data to develop the expectations against which the actual financial results will be compared. The auditor can use historical financial information, industry data, budgeted financials, and other sources to create expectations.

➧ Perform Data Analysis: Analyze the selected data using various statistical and data analysis techniques. This may include trend analysis, ratio analysis, regression analysis, or other mathematical methods to identify unusual fluctuations or patterns.

➧ Assess the Results: Compare the actual financial results with the expectations developed in step 3. Assess any significant variances and investigate the reasons behind them. This step helps the auditor identify potential risks and areas requiring further examination.

➧ Investigate Significant Variances: For significant variances, the auditor should inquire with management to understand the reasons for the discrepancies. Additional audit procedures may be required if explanations provided by management are not satisfactory.

➧ Document the Analytical Procedures: Record the procedures performed, the data used, the expectations developed, and the results obtained. Proper documentation is essential for audit evidence and to support the conclusions drawn.

(ii) Criteria Used to Assess Whether Substantive Analytical Procedures Might be Used:

➧ Materiality: The auditor should consider the materiality level for the audit engagement. If the account balances or financial transactions are significant, substantive analytical procedures become more relevant in providing assurance over the financial statements.

➧ Availability of Reliable Data: Substantive analytical procedures rely on accurate and reliable financial data. If the necessary data is not available or if the data is unreliable, it may not be appropriate to use substantive analytical procedures.

➧ Predictability of Data: The data selected for analytical procedures should be reasonably predictable. If there are significant fluctuations or unpredictable trends, substantive analytical procedures may not be suitable for those areas.

➧ Precision of Expectations: The expectations developed for analytical procedures should be precise and capable of detecting material misstatements. If the auditor cannot develop precise expectations, substantive analytical procedures may not be effective.

➧ Risk Assessment: The auditor should consider the assessed risks of material misstatement when deciding whether to use substantive analytical procedures. If there are higher inherent or control risks in certain areas, substantive testing may be more appropriate.

➧ Industry and Company Specifics: The auditor should consider the industry in which Majiwa Electronics operates and the specific characteristics of the company. Certain industries may have more predictable financial patterns, making substantive analytical procedures more effective.

➧ Effectiveness of Other Audit Procedures: The auditor should evaluate the effectiveness of other planned audit procedures in addressing specific risks. If other audit procedures can provide sufficient assurance, the need for substantive analytical procedures may be reduced.

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QUESTION 3(b)

Q You are the auditor of Wazee Pensioners, which is registered as a charity to provide support for retired employees of a church with branches all over the country. The charity receives funds from overseas donors which are invested in fixed interest securities and shares in listed companies.

The trustees manage the charity and a full time administrator keeps the accounting and other records. A draft summarised income and expenditure account for the year ended 30 September 2020 and an extract from the statement of financial position as at 30 September 2020 are given below together with the audited figures for the year ended 30 September 2019.

Income and expenditure account for the year ended 30 September:
Income Fixed interest investments Shares in listed companie Expenditure Payments to pensioners Administration costs Audit and accountancy Sundry expenses Net (deficit) for the year	2020 Sh."000" 44,200 123,900 168,100 141,300 21,600 4,700 2,800 170,400 (2,300)	2019 Sh."OOO" 41,900 123,500 165,400 144,300 20,500 4,500 2,600 171,900 (6,500)
Extracts from the statement of financial position as at 30 September:
Cost of investments Fixed interesl investments Shares in listed companies	2020 Sh."OOO" 511,200 1,445,600 1,956,800	2019 Sh."OOO" 511,200 1,262,700 1,773,900

The following additional information has been provided:

During the year ended 30 September 2020, some shares were sold at a profit of Sh.182,900,000 and the proceeds were re-invested in shares of other companies.
There were no purchases or sales of fixed interest investments in the year ended 30 September 2020. In the year ended 30 September 2019, some, of the fixed interest investments were sold and others purchased using the proceeds of sale.
The charity is managed by voluntary trustees from the church who meet four times a year, and the administrator who is a priest in the church keeps the minutes of the meetings
The trustees receive applications for payments to pensioners and approve them if they are suitable and there is sufficient income from investments
As the auditor of the charity, you prepare the financial statements from the accounting records kept by the administrator and audit those financial statements, Your audit report is addressed to the trustees of the charity.

Required:

(i) Describe the audit work you would carry out to verify that payments to pensioners are made to authorised pensioners and that the pensioners exist.
(ii) Explain the important matters which you would consider in confirming the ownership of fixed interest investments and shares in listed companies.

A

Solution

(i) Audit work to verify payments to pensioners:

➧ Reviewing Pensioner Records: The auditor would examine the pensioner records to verify the accuracy and completeness of the information. For example, the auditor would check whether the names, addresses, and pension amounts match the records provided in the financial statements.

➧ Confirmation Letters: The auditor would send confirmation letters to a sample of pensioners, requesting them to confirm the amount of pension they received during the year. The responses received would be compared with the records maintained by the charity to ensure the existence and accuracy of the payments.

➧ Vouching Payments: The auditor would select a sample of pension payments made during the year and trace them back to supporting documents, such as bank statements and payment vouchers. This would verify that the payments were properly authorized and supported by appropriate documentation.

➧ Bank Reconciliation: The auditor would perform a bank reconciliation to ensure that all pension payments are recorded in the bank statement and that there are no unidentified transactions related to pension payments.

➧ Physical Verification: For a sample of pensioners, the auditor may perform physical verification. This could involve visiting pensioners in person to verify their identity and existence. Alternatively, the auditor may contact them through telephone or video calls.

➧ Approval Process: The auditor would review the process followed by the trustees in approving applications for pension payments. The objective is to assess whether the decisions were made in accordance with the charity's policies and whether there was sufficient income from investments to cover the pension payments.

➧ Reviewing Internal Controls: The auditor would assess the internal controls surrounding pension payments to identify any weaknesses that could lead to errors or fraud. This would include evaluating the segregation of duties, authorization procedures, and documentation processes.

(ii) Important matters to consider in confirming ownership of fixed interest investments and shares in listed companies:

➧ Custody and Confirmation: The auditor would seek confirmation of the ownership of fixed interest investments and shares directly from the custodian or financial institutions. This would involve obtaining a statement from the custodian providing details of the investments held on behalf of the charity.

➧ Physical Certificates: If the charity holds physical share certificates, the auditor would physically inspect and verify them to ensure that they are held in the name of the charity.

➧ Investment Income: The auditor would reconcile the investment income reported in the income and expenditure account with the income generated by the fixed interest investments and shares. This includes verifying interest income and dividends received from the investments.

➧ Purchase and Sale Transactions: The auditor would examine the supporting documents for any purchase or sale transactions of investments during the year. This is to ensure that the investments were acquired and disposed of in accordance with the charity's policies and that any gains or losses were appropriately accounted for.

➧ Reinvestment of Proceeds: The auditor would verify the reinvestment of the proceeds from the sale of shares (Sh.182,900,000) in shares of other companies. This would involve examining the relevant transaction documents to ensure proper recording and disclosure.

➧ Valuation and Disclosure: The auditor would assess the valuation of investments and ensure that they are disclosed appropriately in the financial statements. This may involve obtaining expert opinions on the valuation of certain investments.

➧ Compliance with Regulations: The auditor would verify whether the charity's investments comply with any legal or regulatory restrictions regarding the types of investments a charity is allowed to hold.

➧ Reviewing Investment Policy: The auditor would review the investment policy of the charity to ensure that it aligns with the trustees' objectives and that the investment decisions are consistent with the policy.

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QUESTION 3(c)

Q Outline the importance of the concept of "materiality" as applied in the audit of financial statements.

A

Solution

➦ The concept of "materiality" is of paramount importance in the audit of financial statements. Materiality refers to the significance or importance of an item or information in the financial statements that could influence the decisions of users. It is a fundamental concept in auditing and has a profound impact on the auditor's procedures, judgments, and reporting. Here are the key reasons why materiality is crucial in the audit process:

➧ Risk Assessment: Materiality plays a vital role in the auditor's risk assessment process. By setting materiality thresholds, the auditor can focus on areas of the financial statements that are more likely to contain misstatements that could have a significant impact on users' decisions. It helps the auditor allocate audit resources efficiently to areas with higher inherent risks.

➧ Planning and Performance of Audit Procedures: Materiality guides the auditor in planning and performing audit procedures. It helps determine the nature, extent, and timing of audit tests. More rigorous and detailed procedures are applied to items or accounts that are considered material, while less significant items may undergo less detailed testing.

➧ Evaluation of Misstatements: Materiality assists the auditor in evaluating misstatements identified during the audit. It helps differentiate between immaterial misstatements that may not warrant adjustment and material misstatements that require correction in the financial statements.

➧ Auditor's Judgment: Materiality involves professional judgment on the part of the auditor. It requires considering both quantitative factors, such as financial significance, and qualitative factors, such as the nature and impact of misstatements. The auditor exercises professional judgment in assessing materiality, which influences the overall conduct of the audit.

➧ Communication with Management and Those Charged with Governance: The concept of materiality provides a basis for communicating significant audit findings to management and those charged with governance. It enables the auditor to discuss and report on matters that are of significance and may affect their decision-making.

➧ Audit Reporting: Materiality affects the content of the auditor's report. If material misstatements are identified and corrected, the auditor may modify the audit opinion to reflect the impact of these corrections on the financial statements. The level of materiality also influences the content of the auditor's communication on internal control deficiencies.

➧ Compliance with Professional Standards: Materiality is a fundamental concept embedded in auditing standards, such as the International Standards on Auditing (ISAs). Compliance with materiality requirements ensures that auditors follow standardized approaches to assess and report on financial statement audits consistently.

➧ Stakeholder Confidence: Stakeholders, including investors, lenders, and regulators, rely on audited financial statements to make informed decisions. The application of materiality ensures that the auditor focuses on reporting matters that are likely to be relevant and influential to these stakeholders.

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QUESTION 4(a)

Q You are the auditor of Tambaa Mattresses Ltd., a company involved in bulk production of mattresses for sale to individual consumers, The company's year end is 31 December 2020.

Assume further that the following information has juSt been availed to you before the audit report is signed:

"The springs in a new type of mattress have been found to be defective making the mattresses unsafe for use. There have been no sales of this type of mattress. It was due to be marketed in the next four weeks, The company's insurers estimate that inventory to the value of Sh.75 million has been affected. The insurers also estimate that the mattresses were now only worth Sh.22.5 milhon, No claim can be made against the supplier of the springs as the supplier is in liquidation with no prospect of any amounts being paid to third parties. The insurers will not pay Tambaa Mattresses Ltd. the reduction in value of the inventory as the company was under insured. All of this inventory was in the finished goods store at the end of the year and movements of invenlory have been recorded post year-end"

Required:

With reference to applicable International Standards on Auditing:

(i) Determine whether the above event is an adjusting or non-adjusting event.
(ii) Discuss the auditors' responsibility and the audit procedures and actions that should be carried out in the above scenario.

A

Solution

(i) Classification of the event:

Based on the information provided, the event of the defective springs in the new type of mattress is an adjusting event.

Reasons for classification as an adjusting event:

The event is considered an adjusting event because it provides evidence of conditions that existed at the balance sheet date (31 December 2020). Specifically:

➢ The company identified that the springs in the new type of mattress were defective before the year-end.
➢ The company did not make any sales of this type of mattress before the year-end.
➢ The impact on inventory value was assessed by the company's insurers and resulted in an estimated reduction in value of Sh. 75 million.
➢ The inventory value was determined to be Sh. 22.5 million at the balance sheet date due to the defect.
➢ Since the conditions existed at the balance sheet date and affected the financial position of the company, the event qualifies as an adjusting event. As a result, the financial statements for the year ended 31 December 2020 need to be adjusted to reflect the decrease in the value of inventory due to the defective springs issue. The adjustment would involve reducing the value of the affected inventory by Sh. 52.5 million (Sh. 75 million - Sh. 22.5 million).

As an adjusting event, the impact of the defective springs issue should be recognized in the financial statements for the year ended 31 December 2020, and appropriate adjustments should be made to reflect the reduced value of inventory in the finished goods store. The auditor's responsibility is to verify the accuracy of the adjustment and ensure that the financial statements are fairly presented in accordance with the relevant accounting standards.

(ii) Auditor's responsibility and audit procedures in the given scenario:

In the scenario of the defective springs issue impacting Tambaa Mattresses Ltd., the auditor's responsibility is to perform a thorough audit to assess the implications on the financial statements and ensure compliance with the relevant accounting standards. The following are the audit procedures and actions that should be carried out:

➧ Understanding the Event: The auditor should obtain a detailed understanding of the defective springs issue, including its nature, extent, and financial impact. This would involve discussions with management, reviewing relevant documents, and communicating with the company's insurers.

➧ Assessing Materiality: The auditor should determine the materiality of the defective springs issue to assess its significance on the financial statements. Materiality helps the auditor in planning the audit procedures and evaluating the overall fairness of the financial statements.

➧ Reviewing Insurance Claims: The auditor should review the insurance claim documents and correspondence with the insurers to verify the claimed amount of Sh. 75 million and understand the reasons for the denial of the claim.

➧ Confirmation with Insurers: The auditor should consider obtaining written confirmation from the insurers about the estimated reduction in value of the inventory (Sh. 22.5 million) and the reasons for not paying the claim due to underinsurance.

➧ Reviewing Inventory Records: The auditor should review the inventory records to assess the accuracy of the inventory amount reported in the financial statements and identify any potential discrepancies.

➧ Subsequent Events Review: The auditor should perform a review of subsequent events up to the date of the audit report. This would involve assessing any subsequent developments related to the defective springs issue and its impact on the financial statements.

➧ Physical Inventory Count: The auditor should consider conducting a physical inventory count at the end of the year to verify the existence and condition of the inventory. This is especially important given the material impact of the defective springs issue on inventory value.

➧ Evaluating Internal Controls: The auditor should assess the effectiveness of internal controls related to inventory management, insurance claims, and financial reporting. This would help identify any weaknesses that could lead to misstatements in the financial statements.

➧ Management Representations: The auditor should obtain written representations from management regarding the defective springs issue, insurance claims, and the impact on inventory.

➧ Adjusting Journal Entry: If the defective springs issue is considered an adjusting event, the auditor should propose an adjusting journal entry to record the reduction in the value of inventory (Sh. 52.5 million) in the financial statements for the year ended 31 December 2020.

➧ Disclosures: If the event is considered a non-adjusting event, the auditor should ensure that appropriate disclosures are made in the financial statements, as required by the accounting standards.

➧ Emphasis of Matter or Other Matter Paragraph: Depending on the materiality of the event, the auditor may consider including an "Emphasis of Matter" or "Other Matter" paragraph in the audit report to draw users' attention to the defective springs issue and its impact on the financial statements.

➧ Communication with Governance: The auditor should communicate the findings and implications of the defective springs issue to the company's governance, such as the board of directors or the audit committee.

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QUESTION 4(b)

Q The Board of Directors of Jaribu Ltd. are considering a proposal from the Chief Internal Auditor to establish an audit committee. The committee would consist of one executive director, the Chief Internal Auditor as well as three new appointees. One appointee would have a non mexecutive seat on the Board of Directors.

Required:

Argue the case for the establishment of the Audit Committee by jaribu Ltd.

A

Solution

Establishing an Audit Committee is a prudent and beneficial step for Jaribu Ltd. for several reasons:

➧ Independence and Objectivity: An Audit Committee comprising external appointees, one non-executive director, and the Chief Internal Auditor would bring independence and objectivity to the company's internal control and risk management processes. External appointees, who are not involved in day-to-day operations, can provide unbiased insights and challenge management decisions, ensuring a more robust and credible internal audit function.

➧ Enhancing Corporate Governance: An Audit Committee plays a crucial role in strengthening corporate governance practices. It acts as a link between the Board of Directors and internal/external auditors, overseeing the integrity of financial reporting, risk management, and compliance with relevant laws and regulations. This helps to build investor confidence, attract potential investors, and protect the interests of shareholders.

➧ Risk Management and Internal Controls: With an Audit Committee in place, Jaribu Ltd. can better identify and address potential risks and weaknesses in internal controls. The committee can review the effectiveness of the internal audit function, risk management processes, and ensure that management takes appropriate actions to mitigate risks.

➧ Fraud Prevention and Detection: An independent Audit Committee is instrumental in mitigating the risk of fraud and irregularities within the company. It ensures that proper anti-fraud controls are in place, investigates any suspected fraudulent activities, and reinforces a strong ethical culture within the organization.

➧ Compliance and Regulatory Oversight: In an ever-changing regulatory environment, having an Audit Committee will help Jaribu Ltd. stay up-to-date with relevant laws and regulations. The committee can monitor compliance with accounting standards, tax laws, and other applicable regulations, reducing the risk of penalties and reputational damage due to non-compliance.

➧ Efficient Board Oversight: By delegating some of the oversight responsibilities to the Audit Committee, the Board of Directors can focus on strategic decision-making and overall governance issues. This distribution of responsibilities improves the efficiency of the Board and allows for better time allocation among directors.

➧ Stakeholder Confidence: The establishment of an Audit Committee signals a commitment to transparency, accountability, and responsible financial management. It enhances the company's reputation and demonstrates to stakeholders, including customers, suppliers, lenders, and regulators, that Jaribu Ltd. is dedicated to upholding high standards of corporate governance.

➧ Long-Term Sustainability: An Audit Committee contributes to the long-term sustainability of the company. It helps identify and address potential risks that could threaten the company's financial stability, thereby safeguarding the interests of employees, shareholders, and other stakeholders in the long run.

Summary

Establishing an Audit Committee is a proactive and strategic move by Jaribu Ltd. It reinforces corporate governance practices, enhances risk management, and improves financial reporting integrity. The presence of external appointees, along with an independent non-executive director, strengthens the committee's objectivity and ensures the company's internal audit and risk management functions are well-aligned with best practices. Overall, an Audit Committee would be an asset in fostering a culture of transparency, accountability, and ethical conduct within the organization, which are crucial elements for sustainable growth and success in today's business environment.

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QUESTION 5(a)

Q You are the audit partner at Utopia Certified Public Accountants operating in country Z. You have been invited to a stakeholders' forum attended by officers from the registrar of companies, the revenue authority, donors, profit making entities, government entities, non-governmental organisations(NGO), professional institutes and ather interested parties. All profit making entities have their financial year end on 31 December and have to file returns (including audited accounts) on or before 31 March of the following year.

Key issues of concern to some of the stakeholders are:

The three period between the year end and filing deadline is too short, limiting entities ability to provide accurate financial stagements.
Auditors sometimes issue disclaimers of opinion, which in their opinion is of no value. It would be better if they declined appointment.
Audit fees are too high and are charged even when businesses are making losses causing unnecessary financial burden on entities.
In an attempt to attract clients, some auditors charge very low fees hence there is need for the institute of accountants to set minimum fees.
Whenever clients are penalised for non-compliance with regulations, the auditor goes scot-free even when the penalties are based on audited accounts. There is need for the auditor to bear part of the penalties.
Some auditors have audited the same clients for too long. There is need for mandatory auditor rotation periods specified by regulators for all clients.

Required:

Evaluate each of the issues raised above and provide an informed opinion, justifying your position with relevant facts and examples.

A

Solution

➧ Short Filing Deadline and Accuracy of Financial Statements:

It is true that a short filing deadline can put pressure on entities to complete their financial statements and audits within a limited time frame. However, it is essential to strike a balance between providing sufficient time for accurate financial reporting and ensuring timely availability of financial information to stakeholders. While the filing deadline may need to be reviewed to consider the complexities of certain businesses, it is crucial for entities to adopt efficient accounting and reporting processes to meet the deadlines. Auditors can play a role in assisting their clients in improving their internal controls and financial reporting systems to meet the filing requirements.

➧ Disclaimers of Opinion and Auditor Appointment:

A disclaimer of opinion is issued when the auditor is unable to obtain sufficient appropriate audit evidence to form an opinion on the financial statements. While disclaimers can be disappointing to stakeholders, they serve an important purpose by highlighting potential deficiencies in the company's financial reporting and internal controls. Instead of declining appointments, auditors should continue to perform their professional duties diligently and communicate any issues or weaknesses to the entity's management and stakeholders. This transparency helps in promoting accountability and enhances the reliability of financial information.

➧ High Audit Fees and Loss-Making Entities:

Audit fees are determined based on the scope and complexity of the audit engagement. It is essential to consider that auditing is a professional service requiring expertise, time, and resources. Even in situations where entities are making losses, auditors must carry out a comprehensive audit to provide reasonable assurance that the financial statements are free from material misstatements, regardless of the financial health of the company. Reducing audit fees significantly for loss-making entities might compromise the quality and rigor of the audit process, undermining the purpose of an audit.

➧ Setting Minimum Audit Fees:

While it is crucial to ensure that audit fees are reasonable and competitive, setting minimum fees could potentially lead to unintended consequences. It may reduce the flexibility for auditors and clients to negotiate fees based on the scope of the engagement, company size, industry complexity, and specific audit risks. Instead, it is more appropriate for regulators to establish guidelines for determining fair and justifiable audit fees to maintain a balance between affordability and the quality of the audit services.

➧ Auditor's Accountability for Penalties:

Auditors are responsible for conducting their audits in accordance with professional standards and guidelines. If the auditor's negligence or failure to adhere to auditing standards leads to misstatements in the financial statements, they can be held accountable through legal and regulatory mechanisms. However, it is essential to establish a clear link between the auditor's actions and the penalties imposed on the client to ensure fairness and avoid any unwarranted liability.

➧ Mandatory Auditor Rotation:

Mandatory auditor rotation can help promote independence and fresh perspectives in the audit process. However, it is essential to consider the size and complexity of the entities and the level of expertise required for the audit engagement. Regulators can consider setting rotation periods based on the entity's size and public interest significance. For example, large public companies may require more frequent rotation compared to smaller private companies.

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QUESTION 5(b)

Q Madini Ltd. is a company involved in buying and exportation of minelite, a newly discovered type of mineral. The mineral is mined and purchased when still wet. As the newly appointed auditor for the year ended 30 September 2020. you gather the following from the Managing Director of Madini Ltd.:

It takes about two months by sea to transport the mineral to company the major buyer based in country Z. During transpotation, the mineral loses some weight due to evaporation.
Company X tests the quality of the mineral and pays based on the quality determined, not the invoice generated by Madini Ltd,
Madini Ltd. pays 4% to its home country's revenue authority as export levv based on the invoice to Company X and other buyers.
Of late, Madini Ltd. has experienced heavy losses due to currency fluctuations, inadequate supplies of the mineral and falling prices in the international market. The major shareholder is contemplating closing down the business.

Required:

(i) Explore the key audit risks that the auditor is exposed to in auditing the financial statements of Madini Ltd
(ii) Formulate a realistic audit plan to determine the gross profit of Madini Ltd

A

Solution

(i) Key Audit Risks:

➧ Valuation and Existence of Inventory: The mineral is purchased when wet and experiences weight loss during transportation. As an auditor, you would need to assess the accuracy of the inventory valuation and ensure that the recorded quantities of the mineral are valid. There could be a risk of over or understating the inventory value if the weight loss during transportation is not properly accounted for, or if there are issues with the measurement of wet inventory.

➧ Revenue Recognition: Since Madini Ltd. receives payment based on the quality of the mineral determined by Company X and not the generated invoices, there is a significant risk of misstating revenue. The auditor needs to verify the accuracy of the quality assessment process by Company X and ensure that revenue is recognized in the appropriate accounting period and according to applicable accounting standards.

➧ Export Levy Calculation and Compliance: The payment of 4% export levy to the home country's revenue authority is based on the invoice to Company X and other buyers. There is a risk of miscalculating the export levy or failing to comply with relevant tax regulations. The auditor should verify the accuracy of the export levy calculation and ensure that all necessary taxes are properly accounted for.

➧ Going Concern and Impairment: Madini Ltd. is experiencing heavy losses due to currency fluctuations, inadequate supplies, and falling prices in the international market. The major shareholder is considering closing down the business. As an auditor, you need to assess the company's ability to continue as a going concern. Additionally, there might be a need to test for impairment of assets if there are indicators of potential impairment.

➧ Currency Fluctuations: Currency fluctuations can impact the company's financial statements, particularly with regard to transactions denominated in foreign currencies. There is a risk of misstating financial results if these currency fluctuations are not properly accounted for or disclosed. The auditor needs to review the company's foreign currency transactions and assess the appropriateness of accounting treatments.

➧ Adequacy of Supply Chain: The company's business heavily relies on the availability of the mineral. If there are disruptions or inadequacies in the supply chain, it may affect the company's ability to fulfill contracts and generate revenue. The auditor needs to evaluate the company's supply chain management and its potential impact on financial statements.

➧ Related Party Transactions: As the major shareholder is contemplating closing down the business, there could be related party transactions or potential conflicts of interest that need to be assessed for their appropriateness and compliance with accounting standards and regulations.

➧ Fraud Risk: Given the challenging financial situation and potential closure of the business, there might be an increased risk of fraudulent activities. The auditor needs to be vigilant and perform procedures to detect any indications of fraud or material misstatements.

(ii) Audit Plan for Determining Gross Profit:

To determine the gross profit of Madini Ltd., the following steps should be included in the audit plan:

➧ Understanding the Business and Industry: Gain a thorough understanding of Madini Ltd.'s business operations, including its supply chain, major buyers, transportation process, and the mineral's quality assessment methods.

➧ Assessing Internal Controls: Evaluate the company's internal controls related to inventory management, revenue recognition, and payment of export levies. Identify key control points and perform tests to assess their effectiveness.

➧ Inventory Observation: Physically observe the mineral inventory at the company's premises to verify its existence and condition. Check if the mineral is still wet and assess the weight loss due to evaporation during transportation.

➧ Confirmation with Company X: Request confirmation from Company X about the quality assessment results and the corresponding payments made to Madini Ltd.

➧ Revenue Testing: Test a sample of transactions to ensure that revenue is recognized correctly based on the quality assessment results provided by Company X.

➧ Export Levy Verification: Review the calculations and payments of export levies to the revenue authority to ensure accuracy and compliance.

➧ Going Concern Assessment: Analyze the company's financial position, cash flow projections, and the major shareholder's intentions regarding the business's future to assess the going concern assumption's appropriateness.

➧ Currency Fluctuations Impact: Consider the impact of currency fluctuations on the company's financial statements, particularly on inventory valuation and revenue recognition.

➧ Subsequent Events: Review events occurring after the year-end but before the audit report's issuance that may affect the company's financial position and results of operations.

➧ Professional Skepticism: Maintain a high level of professional skepticism throughout the audit process, especially when evaluating management's representations and assessing the overall financial statement presentation.

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CPA
Advanced Leval
Advanvced Auditing and Assurance May 2021
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Comments on CPA past papers with answers:

Advanced Taxation

Advanced Financial reporting & analysis

Advanced Financial Managemen

Advanced Management Accounting

Advanced Public finance

Comments on:

CPA
Advanced Leval
Advanvced Auditing and Assurance May 2021
Suggested solutions