AUDIT FRAMEWORK AND REGULATION

1 ASSURANCE ENGAGEMENTS

Key answer tips

This question is testing your understanding of the basic purpose of an audit, and also that you understand the differences between an audit and other types of assurance engagement. This could also be tested in question 2, the 10 mark question.

(a) The external auditor as a verifier of financial informationUsers of financial information generally require this information to be as objective as possible. In most businesses financial information is produced by the management of the business, who are unlikely to have the objectivity required by the shareholders and other users, i.e. the view shown by the information is that which is suited to management rather than to anybody else.Hence the need for an auditor, the expert who will examine the financial information produced by management and who will form and express an opinion on the truth and fairness of that information. Thus credibility is lent to the financial information and greater reliance can be placed on it than without the work of the auditor.However, this credibility and reliance will be lost if the auditor is not independent of the management of the business. If the auditor is to some degree under the control of management, then a situation arises whereby users have cause to question his objectivity. There is little doubt that as far as an auditor is concerned, independence may be equated with objectivity and when one of these is lost, the other also disappears.It is important to understand that the audit does not guarantee that the accounts are free of error or fraud, but that the overall picture presented by the accounts is a fair one.There are many outside parties who use the financial statements as a basis for allowing credit or investment in a company. Banks, trade creditors, potential investors and employees all have an interest in the state of the company’s financial affairs. The independent audit requirement fulfils the need to ensure that those financial statements are objective, free from manipulation and relevant to the needs of the users.

(b) An audit – provides a high level of assurance but as noted above it is not a guarantee. As a result of tests on internal control and balances, the auditors can provide positive assurance in their report about the truth and fairness of the financial statements.The auditor’s assurance is limited because:(i) auditors do not test every item, therefore sampling risk exists, the risk that

although the items tested in the sample are correct there are material errors in the population

(ii) however good the client’s system there are inherent deficiencies, e.g. the risk of human error or the risk of collusion

(iii) most audit evidence is persuasive rather than conclusive e.g. relating to provisions.

A review engagement – may be performed on internal control systems or financial statements. A review of financial statements consists primarily of analytical procedures and enquiries. Detailed testing of balances in the financial statements is not performed and hence only moderate assurance can be provided. The subsequent report gives a form of negative assurance that ‘nothing has come to the auditor’s attention which would

indicate the financial statements do not give a true and fair view.’

2 LEE KEY CO

Key answer tips

This question combines legal, practical and ethical aspects of an auditor’s relationship with a growing client. It requires students to demonstrate the ability to discuss the possible problems arising from such a relationship and also to explain some of the typical requirements on resignation and dismissal.

(a) Provision of non-audit services

The duties to be undertaken by a professional firm on behalf of its clients should be clearly set out in a letter of engagement. This serves as written confirmation of the agreement between the parties and serves to avoid misunderstanding.

If it is agreed between an auditor and his client that the auditor will provide services in addition to the statutory audit function then this is generally acceptable. The auditors must, nevertheless, take care not to perform executive functions or to take executive decisions. These are duties of management and Tickit and Hopit must take care not to drift across the borderline of what is proper.

In the case of privately owned or unlisted companies it is frequently necessary to provide a much fuller service than would be appropriate for a publicly owned or listed company and this may include participation in the preparation of accounting records. Tickit and Hopit must, however, take particular care to ensure that the client accepts full responsibility for such records and that objectivity in carrying out the audit is not impaired.

One way in which Tickit and Hopit may attempt to retain their objectivity is by employing the idea known as the ‘Chinese Wall’ whereby different staff are used on each type of work so that information on accountancy work is not given to audit staff. In practice this is likely to prove difficult to implement for the small audit firm and small clients.

The area of systems and control advice is particularly fraught with difficulties. An auditor should regularly point out deficiencies in his clients’ systems and recommend improvements in their internal control by sending an annual memorandum on internal control in which deficiencies and strengths in the system would be discussed. The implementation of new systems is, however, very much an executive function and as such falls outside the scope of services which should normally be undertaken. The auditor firm may act in a consultative capacity in reviewing systems, both computer-based and manual, especially with regard to internal control aspects. As far as computer systems are concerned the introduction of proper controls is so important that auditors may wish to give advice at the development stage, but, on the whole, auditors should avoid going beyond the giving of advice.

The overall theme of this discussion is the need for Tickit and Hopit to retain their independence and objectivity. Their prime function is to undertake an independent examination of their client’s financial statements and to report thereon. In order to fulfil this role in a satisfactory manner they must be, and be seen to be, independent. An undue involvement with accountancy or systems work may impair their ability to take a truly objective view.

(b) Continuing to act as the auditors of Lee Key Co

A significant ethical problem has arisen for Tickit and Hopit following the growth of their client. It is undesirable that a practice should derive too great a part of its professional income from one client. It is recommended by the statement on independence issued by the accounting bodies that the recurring fees paid by one client should not exceed 15% of the gross fees of a practice. As the fee from Lee Key Co is now approximately 20% of the gross fee income, Tickit and Hopit should consider resigning as auditors to the company. The 15% limit is a guideline only and is not to be regarded as more than indicative of the point at which independence might be threatened. However, 20% is considerably above this limit and independence might indeed be in danger. The provision is designed to ensure that auditors do not become too dependent on one client for their income with the result they may be subjected to pressures from the client which they could find difficult to resist.

It may be, however, that the total fee as a percentage of income can be reduced if Tickit and Hopit give up some of the non-audit work involved. In particular, if Lee Key changes in the future from a Private to a Public Company, user group expectations of both the company and its accounting systems and of the auditor’s role will change. It is accepted that an audit firm should not participate in the preparation of the accounting records of a public company client save in exceptional circumstances.

Thus, if Lee Key obtains a quotation on the Stock Market, Tickit and Hopit should withdraw from providing accountancy services as soon as practical and advise their client that they will require the directors to provide draft financial statements for audit.

The auditors should still continue to use a memorandum on internal control to advise the client, among other things, of control deficiencies, and may advise on systems to eliminate any deficiencies. They should still not, however, undertake executive duties.

If Tickit and Hopit feel that they have the resources to undertake the audit of a public company and if the gross fee income from the client remains at less than 10% of the practice total fee income, it may be acceptable for them to continue. The desirability of them continuing to act as auditor will have to be kept under constant review as the situation develops.

(c) Resignation procedures

In many countries, e.g. the UK, legislation requires for auditors who resigned during the year to undertake the following:

(i) Deposit written notice of resignation at the company’s registered office specifying the date of resignation.

(ii) Include with the notice of resignation a statement that there are no circumstances connected with the resignation which should be brought to the notice of members, or, alternatively, a statement of any such circumstances.

(d) Company actions following auditor resignation

Legislation normally requires that the company should undertake the following on receipt of the auditors’ resignation:

(i) Send a copy of the notice of resignation to the regulatory authorities.

(ii) If a statement of circumstances in connection with the resignation is received, a copy should be sent to every person entitled to receive copies of the annual accounts.

3 MANLY

Key answer tips

This question reinforces the importance of being aware of current problems and developments in auditing. The theme underlying the question is that of auditor independence – the preservation of which is seen to be critical to the credibility of the audit process.

Rotation of auditors has regularly been suggested as a means of improving auditor independence – preventing the auditor becoming too closely involved with the client. You need to be aware of the arguments for and against rotation – they have been voiced regularly in the UK and elsewhere in recent months, particularly as the UK government has been reported as considering the introduction of a rotation requirement.

(a) Removal from office

(i) Removal by management

The financial statements being reported on represent a statement of accountability by management and directors to those on whose behalf they exercise their function, that is the shareholders, in the case of an incorporated business. The ability of management to control the appointment of auditors threatens to undermine the independence of the audit. They can effectively evade an unsatisfactory auditor’s report by dismissing the auditor. Even where the right to appoint (and remove) auditors is in the hands of shareholders or members, management are often able to influence the exercise of that function.

There are a number of safeguards available to auditors to minimise the extent of the problem.

– Not accepting appointment where there is reason to suspect management might seek to dismiss the auditor to evade an unsatisfactory report.

– Communicating with predecessor auditors to ascertain if such reasons lie behind the proposed change of auditor.

– Adhering strictly to professional independence rules to ensure an ability to withstand management threats of removal from office in an attempt to dissuade auditors from modifying their report.

– Taking full advantage of whatever statutory protection exists against removal from office such as a right to communicate with shareholders where a change in appointment is proposed by management.

– Adhering to professional rules relating to providing advice to non-audit clients, which might put undue pressure on their auditor. The other firm in this question appears to be acting in breach of this rule.

(ii) Audit committee

Public companies have many shareholders few of whom take an active interest in its affairs. If they disagreed with the directors’ proposed change of auditors they would probably sell their shares rather than vote against the resolution. For this reason, companies are encouraged to appoint a number of non-executive directors who are not also involved in the management of the company, and for such directors to constitute themselves as an audit committee. As a sub committee of the board they are entrusted with matters concerning the audit. As non-executives they are less likely to be critical of auditors who prevent the company from presenting over optimistic financial statements. Existence of an audit committee, therefore, protects auditors against removal from office by management whom they displease.

(b) Provision of other services

(i) The Rules of Professional Conduct provide for the following:

– An auditor should not provide accountancy services to listed or public interest company audit clients except of a purely mechanical nature such as drafting the statutory financial statements, or in an emergency situation.

– Where accountancy services are provided to other company audit clients, the client should accept full responsibility for the records, the assistance should not extend to management decision making and a full audit must also be undertaken.

– In the provision of other services, care must be exercised that the service is limited to providing advice and not the exercise of management functions. This applies particularly in providing executive recruitment services. The service should be limited to identifying a short-list and not to making the final selection.

– Other services should not include the making of specialist valuations, which are to be incorporated in the audited financial statements.

– The provision of non-audit services should not constitute recurring work which brings total fees received from that audit client to more than 15% of the firm’s gross fee revenues or 10% if the client is a listed or public interest company. The reasons for this are evident from the engagement partner’s reluctance to qualify the opinion for fear of angering the management and losing the audit. Although not over the limit, fees from the provision of non- audit services are, nevertheless, high. The engagement partner’s concern is unprofessional and it would be hoped that professional accountants would be more objective. Nevertheless, it illustrates concerns that would arise in the minds of users of financial statements if it is seen that the auditors are generating substantial fee income from providing non-audit services to the companies they audit.

(ii) Prohibition of non-audit service provision

The Rules of Professional Conduct state that, in principle, there is no objection to providing non-audit services to audit clients. However, it is also claimed that the provision of such services impairs auditor independence. The alleged scenario is as follows:

– As auditors, the firm is appointed by and is responsible to the members of the company.

– In providing other services, the firm is appointed by and is responsible to the management.

– Because of the advantages of dealing with just one firm of accountants, the management tends to prefer to use the audit firm to provide these other services.

– If the firm loses the audit, they are likely to lose revenues from the provision of other services. This is clearly the case here and the audit partner’s judgement is strongly influenced by the potential loss of revenue.

– The auditors recognise the ability of the management to influence auditor appointment. Where auditors receive revenues from providing non-audit services, as in the case of Manly, it is alleged that management may exploit this fact in order to put pressure on the auditors.

– Other services often attract higher fees than audit services. Firms may seek to secure audit appointments primarily as a means of obtaining contracts for the provision of more rewarding other services.

– For these reasons, it is argued, firms should be forbidden to provide non- audit services to audit clients.

The profession, on the other hand, argues that quarantining audit from the provision of non-audit services denies companies the right to select their professional advisers. It also imposes costs in that the audit, necessarily, will become more expensive as will the provision of non-audit services as the firm providing the services will not have the benefit of knowledge of the company gained through the audit. As professionals, it is argued, accountants will not allow their judgement to be influenced by such considerations and the situation illustrated in the question is an unlikely one. Moreover, there is bound to be overlap between audit and non-audit services such as advice on internal control and related matters contained in the management letter.

(c) Rotation

Rotation is the term given to limiting the number of years an individual or a firm is associated with the audit of a particular client.

Professional ethics recommend that audit staff should not spend too many years associated with the same group of clients. The benefit of understanding of the clients’ business is outweighed by the possible loss of professional scepticism. In this case the audit partner has known Manly’s chief financial officer for too long to be able to entertain ideas that he may not be trustworthy.

At a further level it is argued that audit firms should only serve a fixed term of office. The benefits of securing non-audit work from clients are substantially reduced if the term of office as auditor is limited to say seven years. Similarly, efforts to maintain good relations with management possibly to the extent of condoning questionable financial statements would no longer serve a useful purpose.

The argument against rotation of audit firms is that it imposes additional costs and risks. It is the first year as auditor that is most costly and also the year the auditor is at greatest risk of failing to detect misstatement through unfamiliarity with the client. Rotation of audit firms is statutorily required in some countries.

4 OTHER ENGAGEMENTS

Key answer tips

Concentrate on the difference in assurance given by each engagement, and from that explain the work to be done. It’s only 10 marks so don’t spend too long talking about audit.

(1) Engagement to perform a statutory audit

Our procedures are designed to allow us to express a high degree of assurance as to whether or not the financial statements give a true and fair view. Our assurance is not absolute because of the fact that we audit items on a test basis, the fact that many of the items in the accounts are estimates, and the fact that however good the controls in the client’s accounting system there is always the possibility of collusion which might lead to material fraud.

We therefore need to gain reasonable assurance as to whether the accounts are free of material misstatement. This will be expressed as positive assurance in our audit report, that is ‘in our opinion, the financial statements give a true and fair view’.

The work we do on the audit would in the main consist of consideration of the accounting systems and tests of detail of the balances in the accounts as well as consideration of the accounting policies the client has used and the estimates the directors have made.

(2) Engagement to review the financial statements

In a review engagement we need to perform work to enable us to obtain a moderate degree of assurance as to whether the financial statements give a true and fair view. This is expressed as negative assurance, for example ‘nothing has come to our attention that causes us to believe the financial statements do not give a true and fair view’.

This is a lower degree of assurance than an audit. We do not perform an audit and therefore do less extensive work than we would perform in an audit.

Our work will primarily consist of analytical review, discussions with the management about any unusual items, and agreeing the financial statements to the underlying accounting records.

(3) Engagement to compile financial statements

For this engagement, we are acting rather as accountants than auditors. As such, unlike an audit, we give no assurance as to the accuracy of the information, although this does not mean that we perform our work any less diligently than we do our audit work.

It is the statutory duty of the directors to prepare the accounts and their responsibility is not reduced by the fact that our firm prepares the accounts on their behalf.

Our work would consist of collecting, classifying and summarising information from the accounting records and producing financial statements that meet the requirements of statute and accounting standards. We would not verify the accuracy of the accounting records as part of this process, so we would still need to audit the accounts in the normal way during the audit.

INTERNAL AUDIT

5 EXTERNAL AND INTERNAL AUDITORS

Key answer tips

A straightforward question. Make sure you only talk about the planning stage in part (a). In part (b), because the question is not specific, you can talk about the advantages to the client and the advantages to your firm

(a) Four important criteria in assessing work of internal audit are generally recognised:

(i) Organisational status. The internal audit department’s status in the organisation and the effect this has on its ability to be objective. If the client is a listed company, it may have an audit committee. If it does, ideally the internal audit department should report to them (or be able to report to them). In practice, it is probable that much of the work of the internal audit department will be controlled by the Financial Director. However, there should be some input from the Board (and audit committee, if it exists) to ensure that all important aspects of the company’s operations are covered by the internal auditors. As stated earlier, the internal audit department should have the right to report to the audit committee, and the audit committee should review copies of reports by the internal auditors. Also, the internal auditors should be free to communicate with the external auditors. The independence of the internal audit department is important, and I will consider whether it has adequate independence both in terms of the work it carries out and the reports it makes.

(ii) Scope of function. I will check what action is taken by the company as a result of the internal auditors’ work. Action should be taken by the company when the internal auditors detect significant deficiencies in the accounting systems or errors in processing transactions. The internal auditors should re-test the systems to check that the problems have been corrected. The internal auditors’ working papers showing deficiencies and errors and subsequent correction will provide me with evidence of whether action is taken following adverse reports by the internal auditors.

(iii) Technical competence. I will check the qualifications and experience of the internal auditors. If the internal auditors have appropriate qualifications (e.g. a member of the ACCA) their work is likely to be more reliable than if they are unqualified. Experience in auditing is important. They could have qualified with a firm of professional accountants and have performed audits of private and public companies, or they may have experience of internal audit in other companies. They should attend courses to keep up to date and learn about new developments. Unqualified staff should be studying for the exams of a professional body. I will check these matters by discussing them with the head of the internal audit department and obtaining appropriate evidence.

(iv) Due professional care. The work of the internal auditors should be properly planned, supervised, reviewed and documented. I will scrutinise the working papers of the internal auditors. I will check the work they have carried out is appropriate and that the conclusions they reach are consistent with the results of the tests they have carried out. I will assess the work programme of the internal audit department and check it provides adequate coverage of the company’s operations and that it is carried out at an appropriate frequency. For instance, checks should be carried out when new accounting systems are installed, and tests should be re-performed at a later date when serious errors or deficiencies in controls are found. There should be appropriate audit manuals for the internal audit staff.

(b) The advantages of having the external audit firm perform the internal audit work will include:(i) The new internal auditors should be skilled in carrying out audit work, so the

learning time for the staff should be short compared with setting up an internal audit department within the company.

(ii) The audit procedures and standards should be consistent with those of the external auditor. Thus, the external audit staff should be able to use more of the internal auditor’s work in coming to their audit opinion. This should reduce the cost of the external audit.

(iii) The audit firm may be able to provide staff with a wider range of skills than the client may be able to recruit as employees. For instance, the audit firm may be able to provide specialists in computer auditing, where it would not be economical to have a computer audit specialist as an employee.

The disadvantages of the external audit firm performing the internal audit work will include:(i) There may be problems with who is in charge of the internal audit staff. The

internal audit staff will be employees of the external audit firm. The client company will probably have less control over the internal audit staff, and this may create problems over the work they do and the reports they make.

(ii) Owing to the ACCA’s Rules of Professional Conduct, the internal auditors may be restricted in the work they do. For instance, they may be prevented from preparing the financial statements and making management decisions. Thus, they may not be able to decide the form and controls for a whole accounting system.

(iii) The internal audit staff will be skilled at performing work similar to the external auditors, but they may have limited skills and experience of other work carried out by internal auditors (e.g. advising on the purchase of a business).

(iv) Using the external audit firm to perform internal audit work is likely to be more expensive than the company employing its own internal audit staff, as the external audit firm will want to cover its costs and make a profit on the work.

(v) There may be problems with the internal audit staff changing from time to time.The external audit firm will probably want to provide the maximum staff to theclient when the audit firm are less busy and fewer staff when they are busy. Having different staff at different times will require the new staff to learn about the client’s business. This learning time is likely to be greater than if the client employed its own staff.

(vi) The requirement of the external audit function to have to perform external audits (when it is busy) may mean that the client does not have sufficient internal audit staff during periods when it wants them (e.g. at the year end for counts and to help in preparation of the annual financial statements).

6 EASTFIELD DISTRIBUTORS

Key answer tips

The question focuses on a client company outsourcing its internal audit function to the external auditors. Make sure that you focus your answer on the specific requirements of each part of the question – these could usefully be reflected as main headings in your answer plan:

Part (a) ethical guidance on the preservation of independence of the external auditor

Part (b) the advantages and disadvantages of outsourcing from the point of view of the client

Part (c) the advantages and disadvantages of outsourcing from the point of view of the auditfirm.

You should then be looking to list and explain as many points as possible under each of the above headings.

However, the examiner’s answer below is more comprehensive than you can produce in exam time – use it as a learning aid – you should ask yourself whether you identified a reasonable number of relevant points.

(a) Ensuring independent status

The matters I will consider and the action I will take to ensure the provision of an internal audit service does not conflict with my duties and the independence requirements of my firm being external auditor to the company include:

(i) As Eastfield Distributors is a listed company, my fees from the external audit, the internal audit and other work I perform for Eastfield Distributors should not exceed 10% of the practice income.

(ii) As Eastfield Distributors is a listed company, my audit firm should not prepare the annual financial statements (except in emergency situations). This requirement will apply to my firm’s work as internal auditors.

(iii) It is desirable that there should be some independence between the internal and external audit functions within the audit firm. Thus, it is desirable that different audit staff should carry out internal audit work from those who undertake the statutory external audit. Internal audit staff should report to a different partner from the engagement partner for the external audit. If the internal audit and external audit staff report to the same engagement partner the audit firm may be criticised for a lack of independence.

(iv) The internal audit staff should be careful not to assume the role of management when carrying out their work, as this would contravene the ACCA’s Rules of Professional Conduct. This may create problems, as the internal auditors may be asked to design the company’s accounting systems in order to provide adequate controls. This problem may be reduced by requiring the company’s directors to confirm any recommendations by the internal auditors. The company’s chief financial officer or chief accountant will be an important person to be involved in this type of decision, as he/she will have the skills to make a responsible decision.

(v) There may be problems about who the internal audit staff are responsible to. On a day to day basis, they will probably report to the chief financial officer but they should have the right to report to the board of directors. For the internal auditors to be truly independent of the external auditors, they should not report to partners in the audit firm. However this is impractical and unrealistic. It is impractical, as the internal auditors will be employees of the audit firm and their promotion will be determined by the audit firm. Thus, the audit firm will have to be able to assess the quality of each employee’s work. It is unrealistic, as external auditors use the work of internal auditors in coming to their audit opinion. Thus, the external audit staff will have to review the work of the internal auditors, and the internal auditors may be asked to carry out certain work to assist the external audit staff.

There will need to be some agreement with the client about the extent to which the company and the external audit firm control the internal auditors’ work. This should be included in the engagement letter.

(vi) There will have to be a decision about which members of the audit staff should perform this internal audit service. The staff should have a range of skills and range from junior to qualified staff. I will have to consider whether the staff should always work for the audit client, or whether different staff should be employed at different times. More staff may be provided for the internal audit service when the external audit work-load is low, and fewer staff when the external audit department is busy. It is important that the internal audit staff are competent, as otherwise this could adversely affect Eastfield Distributors’ opinion of the audit firm. This will create the risk that Eastfield Distributors will want to change the external auditor with the consequent risk to the external auditor’s independence.

(vii) There will have to be an agreement about how much should be charged for the internal audit service, and the services which will be provided. The charge will probably be based on the number of hours worked by staff at Eastfield Distributors and their level of experience.

(viii) Other considerations will be similar to those for my audit firm being external auditor of Eastfield Distributors. These will include:

– staff undertaking the internal audit work should not own shares in Eastfield Distributors or have close family or other personal relationships with the directors or senior employees of Eastfield Distributors

– there should be an agreement over payment of charges for the internal audit work. If Eastfield Distributors is slow at paying these charges, it could adversely affect the independence of my audit firm

– the internal audit staff will have to be careful in accepting goods, services and hospitality from Eastfield Distributors. Any benefit from these items should be modest. For instance, staff purchasing goods from the client should receive them at no more favourable rates than employees of Eastfield Distributors, and they should be only for personal use.

– internal audit staff should not accept loans from Eastfield Distributors.

(ix) An engagement letter should be agreed with Eastfield Distributors for the internal audit work, which includes most of the matters listed above. It may be appropriate to have a trial period after which Eastfield Distributors will decide whether the service should continue. Following this, both parties should agree a new engagement letter which seeks to overcome any problems and includes important matters which were omitted from the original engagement letter.

(b) The advantages and disadvantages to Eastfield Distributors of providing an internal audit service

The advantages to Eastfield Distributors of having the external audit firm perform the internal audit work will include:

(i) The new internal auditors should be skilled in carrying out audit work, so the learning time for the staff should be short compared with setting up an internal audit department within the company.

(ii) The audit procedures and standards should be consistent with those of the external audit. Thus, the external audit staff should be able to use more of the internal auditor’s work in coming to their audit opinion. This should reduce the cost of the external audit.

(iii) The audit firm may be able to provide staff with a wider range of skills than Eastfield Distributors may be able to recruit as employees. For instance, the audit firm may be able to provide specialists in computer auditing, where it would not be economical to have a computer audit specialist as an employee.

The disadvantages of the external audit firm performing the internal audit work will include:

(i) There may be problems with who is in charge of the internal audit staff. The internal audit staff will be employees of the external audit firm. The client company will probably have less control over the internal audit staff, and this may create problems over the work they do and the reports they make.

(ii) Because of the ACCA’s Rules of Professional Conduct, the internal auditors may be restricted in the work they do. For instance, as Eastfield Distributors is a listed company, they will be prevented from preparing the financial statements and there could be limitations on them making management decisions. Thus, they may not be able to decide the form and controls for a whole accounting system.

(iii) The internal audit staff will be skilled at performing work similar to the external auditors, but they may have limited skills and experience of other work carried out by internal auditors (e.g. advising on the purchase of a business).

(iv) Using the external audit firm to perform internal audit work is likely to be more expensive than the company employing its own internal audit staff, as the external audit firm will want to cover its costs and make a profit on the work.

(v) There may be problems with the internal audit staff changing from time to time.The external audit firm will probably want to provide the maximum staff to Eastfield Distributors when the audit firm are less busy and fewer staff when they are busy. Having different staff at different times will require the new staff to learn about Eastfield Distributors’ business. This learning time is likely to be greater than if Eastfield Distributors employed its own staff.

(vi) The requirement of the external audit firm to have to perform external audits (when it is busy) may mean that Eastfield Distributors does not have sufficient internal audit staff during periods when it wants them (e.g. at the year end for inventory counts and to help in preparation of the annual financial statements).

(c) The advantages and disadvantages to the audit firm of providing an internal audit service

The advantages to the external audit firm are frequently similar to the disadvantages to the audit client. However some advantages can apply to both the audit firm and the client. The advantages can be summarised:

(i) By having the internal auditors as part of the audit firm’s staff, their audit procedures should be the same and the confidence of the audit firm in their work will probably be greater than if the internal auditors were employees of the client company. Thus, the external auditor will probably be able to achieve a greater reduction in the external audit work compared with if the internal audit work is being carried out by employees of the client company.

(ii) The service will provide additional income and profits to the audit firm. It may provide a wider experience to the audit staff, but there may be problems with obtaining the appropriate work experience for staff to become members of the ACCA.

(iii) It may be possible to use the internal audit work to fill in periods when there is little external audit work. For instance, in the UK, there is little audit work from July to early September so more staff could be employed in internal audit work during this period.

The disadvantages to the audit firm in providing an internal audit service include:

(i) The firm must be careful that the professional rules on independence are not contravened. It may be difficult to ensure that none of the staff employed on internal audit work are part of the external audit team. It may be very difficult to ensure the rules of professional independence are complied with at all times, as the internal auditors may be required to make executive decisions or be involved in the preparation of the annual financial statements.

(ii) If a dispute arises with the client over the internal audit work, this is likely to affect the audit firm’s relationship with the client. Because of this, there may be implications on the external audit. For instance, if the audit firm is dismissed as internal auditor of Eastfield Distributors, it may be dismissed as external auditor as well.

7 ZX COMPANY

Key answer tips

The role of internal audit in risk management and corporate governance is an important area of the syllabus, so you must be fully prepared for a question such as part (a) here.

Part (b) is standard bookwork. You should aim to explain at least five advantages and five disadvantages to earn the 10 marks available.

From: Chief Internal AuditorTo: Board of ZXSubject: Role of Audit CommitteeDate: June 20X5(a) Areas where the internal audit department can assist the directors with the

implementation of good corporate governance in an organisation include:Board reportsReviewing reports to the board and reports produced by the board to ensure that they do present a balanced and understandable assessment of the company’s position and prospects. The internal audit department will have good knowledge of the operations of the company as well as access to accounting information. The department can effectively ‘audit’ board reports to ensure they are accurate and understandable.Internal controlsThe board need to maintain a sound system of internal control. The internal audit department will be able to review existing controls and recommend improvements to ensure this objective is met.Application of ISAs and IASsThe board need to have a policy for applying appropriate International Standards on Auditing (ISA) and International Accounting Standards (IAS) to the organisation. Internal audit will certainly be aware of new auditing standards and will have the technical expertise (especially where internal auditors are professionally qualified) to identify changes required by accounting standards. Amendments to control systems for new auditing standards and financial accounting systems for new accounting standards can therefore be recommended.Communication with external auditorsUnder corporate governance regulations, communications with external auditors will normally be via the audit committee, although the board must maintain an appropriate relationship with the external auditors. However, internal and external auditors can also work together to ensure that the internal control system is sufficient; possibly by external audit delegating work to internal audit, and each auditor reviewing the work of the other auditor. The board will therefore receive reports from both sets of auditors which will be accurate because they have been properly checked.Communication to the boardThe internal auditor can also check that appropriate information is provided to the board from the external auditor. ISA 260 Communication of Audit Matters with those charged with Governance provides a list of matters which should be communicated to the board

and the internal auditor can work with the external auditor to ensure that this information is provided.

(b) The advantages of an audit committee include:

Public confidence

Providing increased public confidence in the credibility and objectivity of published financial information. This will be particularly important for ZX if listing arrangements go ahead. While an internal audit department is not normally necessary for incorporated companies, the provision of that department will provide additional confidence in the accuracy of the financial statements and hopefully make ZX an attractive investment.

Financial reporting

Supports the directors in fulfilling their financial reporting obligations. The directors have to prepare financial statements for ZX. The committee can assist by checking the financial statements to ensure that they comply with appropriate reporting requirements. This is especially important where the board do not have detailed knowledge of accounting requirements.

Communication

Enhancing the role of ZX’s external auditors by providing an appropriate channel of communication. Use of the audit committee will enable the external auditor to discuss issues with the financial statements with the internal auditor, prior to providing a final summary of key points to the board.

‘Friend’ of the Board

The audit committee may also act as a ‘critical friend’ to the board by monitoring the work of the board and providing helpful guidance, where corporate governance requirements do not appear to be being met. The audit committee should have detailed knowledge of corporate governance as part of its monitoring function of the company and can share this with the board who may not have the time to obtain detailed information.

The disadvantages of an audit committee include:

Lack of understanding of function

As the directors in ZX do not have much knowledge of corporate governance, they may see the additional involvement of the audit committee as a threat to their authority or taking away some of their responsibilities. This memo has hopefully outlined the advantages of an audit committee in supporting the work of the directors, removing this as a problem.

Role of non-executive directors

As the audit committee will be made up mainly from non-executive directors, the board may see this as a means of decreasing their power and possibly letting other people run the company. Again, the audit committee must be seen as fulfilling a supporting role for the main board. It will utilise the special knowledge of accounts production and internal controls from the external auditor and business non-executives to provide appropriate review of information being given to the board.

Cost

The audit committee will increase the expenditure of the company as the non-executive directors will require some remuneration due to their additional responsibilities. While this cannot be avoided, the benefits of the committee in terms of providing assistance to the board and raising the profile of ZX ready for possible listing must not be forgotten.

PLANNING AND RISK ASSESSMENT

8 PHONES ANYWHERE

Key answer tips

This question is testing your ability to apply your auditing knowledge in two mainstream areas – risk assessment and professional ethics.

The key to producing a good answer to part (a) is an understanding of the main features of the business of the company. The business appears to be fairly specialised and technical – do not let this put you off. The examiner ‘feeds’ you with relevant business details and is simply inviting you to think about the main areas of risk exposure involved.

In dealing with part (b), there are many aspects of professional ethics that could be mentioned. In the time available in an exam, it is probably necessary to prioritise – dealing more fully with the major points (technical competence and fee levels perhaps) and mentioning others more briefly.

In part (c) the examiner is likely to be looking for the arguments which support your decision, rather the decision itself – justify your answer to this type of question.

(a) Audit risks

There appear to be considerable risks associated with undertaking the audit. In particular, Phones Anywhere appears to have a very high inherent risk. Looking at the matters in (a) to (k) in the question:

(i) The low coverage of the country will be a disincentive to new subscribers. Initially, subscribers will only be those who operate in the town with a population of 1,000,000. The service will not be available when the subscribers are outside that town. I will have to consider whether the company has the financial resources to develop to towns with a population of 250,000 in the next year and its planned developments to 20X7. The company’s plans for extending the network do not appear to be realistic, as many mobile phones are used on motorways and trunk roads. Motorways will not be covered until 20X7, and coverage of other roads is not mentioned. These plans are likely to be a serious disincentive to new subscribers joining the system, when competitors cover most of the country.

(ii) The central computer is pivotal to the organisation, as it relays the calls and calculates the bills for subscribers. We need to consider if this computer and its software be reliable. The consequences of a break-down of the computer will be very serious. Ideally, there should be more than one computer running the system, and the system should be able to continue if one of the computers fails.

(iii) The capacity of the main computer needs to be considered. With the planned expansion, it is probable that it will run out of capacity in the near future. This raises questions such as is it possible to expand the capacity of the computer? Has the cost of upgrading the computer been included in future forecasts? Will the current software be able to process a large increase in subscribers, or will it have to be re-written (at substantial cost)?

(iv) Is it reasonable to amortise the cost of the relay stations and main computer over six years? Six years may be realistic for the ‘buildings’ part of capital expenditure, but it may be too long for electronic components including the main computer and transmitters.

(v) Is the discount paid to retailers for the purchase of the phones recoverable? The question says it is capitalised and amortised over four years. Do subscribers remain connected to a single operator for as long as four years (if many change in less than four years, this amortisation period is too long), and are subscribers likely to change their phones within four years (to update to a more advanced model)?

(vi) Paying the executive directors a bonus based on the number of subscribers of the system could encourage them to obtain as many subscribers as possible (by offering discounted prices) rather than charging a realistic price which will ensure the long term future of the company. However, the executive directors should be concerned with the long term future of the company, as this will ensure they continue to be paid (rather than have to find a new job when the company fails).

(vii) In view of the planned high borrowings, and future trading losses, there is a very serious risk the company may not be a going concern. This increases the risk of my firm being sued for negligence. Also, Phones Anywhere will put severe pressure on me to give a completely unmodified audit report. This pressure will increase because my audit firm is small and Phones Anywhere is a relatively large and rapidly growing company.

(viii) As an alternative to the company not being a going concern, there is the risk that other investors may purchase more shares in the company (to provide additional equity finance) or purchase the company outright from the existing directors (or the administrator/liquidator). If this occurs, recent financial statements will be subject to close scrutiny. The standard of audit work will have to be high, and the problems mentioned above (e.g. complex computer systems and depreciation rates which may be inaccurate) could lead to undetected material errors in the financial statements. Thus, there is a high risk that legal action for negligence could be taken against my audit firm following a take-over or purchase of shares.

(ix) Flotation of the company on the London Stock Exchange is a further risk.Immediately prior to the flotation, the audit work carried out by my firm will besubject to close scrutiny. So, I will have to be very careful in my work which would increase the cost of the audit and reduce its profitability. Also, when the company becomes quoted on the London Stock Exchange, it is probable I will be replaced as auditor, as my firm will be ‘too small’. Almost all of the companies quoted on the London Stock Exchange are audited by one of the ‘Big 4’ firms.

(x) This is a high technology industry. The technology or customer requirements may change, which could make parts of the equipment obsolete. Alternatively, it could be expensive to modify the equipment or software to meet the demands of subscribers. Is the company currently providing a similar range of facilities to other mobile phone companies? If its service is not as comprehensive as other mobile phone companies, it may not be successful in breaking into the market.

(xi) This appears to be a very competitive industry. Are the competitors profitable, or are they making losses to keep prices low to prevent other companies entering the market? Establishing Phones Anywhere as a major company in the market will probably require large expenditure on advertising and offering new subscribers a service at a lower price than competitors. Both of these factors will tend to make Phones Anywhere unprofitable (as note (j) in the question suggests).

(xii) I will have to consider the reputation of the three major shareholders and the executive directors. If they have been directors of companies which have failed, or been involved in financial or other wrongdoings, this will increase the inherent risk. The reputation of the financial director and the quality of the accounting records are other factors which will have to be considered.

(b) Professional and ethical matters

(i) The size of the audit fee. The Association of Chartered Certified Accountants’ (ACCA) rules of professional conduct say the fees for audit and other recurring work paid by one client should not normally exceed 15% of the gross practice income (and 10% for listed and other public interest companies). If the planned audit fee is over 15% of the current practice income I should not accept the audit. However, the rate of expansion of Phones Anywhere will probably be much greater than the increase in income of my practice, so the 15% rule may become a problem in the next few years. When Phones Anywhere becomes a listed company in 20X5, the audit fee from Phones Anywhere must be less than 10% of the fees of the practice. It seems probable that this limit of 10% will be exceeded. In practice, it is undesirable for the audit fee to approach 15% of the practice income, as reliance on such a large audit fee could be seen to affect my firm’s independence.

(ii) My audit firm may be able to audit Phones Anywhere at its current size. However, when the system covers all towns with a population of over 250,000, on occasions audit work will probably have to cover all areas of the country, and it is most unlikely that my audit firm will have sufficient staff to perform this work.

(iii) Whether my firm is technically competent to perform the audit, and whether the size of the firm being audited is too large for the experience of my practice. Mobile telephone companies are very complex and have specialised accounting procedures, both in terms of the accounting system and the ways matters are treated in the financial statements (e.g. the advance payment of $200 given towards the purchase of phones purchased by new subscribers).

My firm will probably not have experience in auditing the computerised accounting system which controls calls and generates bills for subscribers. This requires specialised computer auditing techniques. Also, my firm will be unfamiliar with many of the accounting treatments for non-current assets and they will probably not be able to decide whether the lives given to non-current assets are reasonable. This lack of experience will probably mean that the audit will be too high a risk for my audit firm (i.e. my firm’s inexperience will mean that a satisfactory audit cannot be carried out, so there will be a high risk of material misstatements in the financial statements, which increases the risk of litigation being brought against me).

(iv) I will have to consider whether I have adequate professional indemnity insurance (PII) cover. This is unlikely in view of the size of Phones Anywhere, so there will be an increased cost of obtaining more PII cover. The insurance company may refuse to increase my firm’s PII cover, because they perceive this is a high risk audit which is exacerbated by the small size of my firm.

Other matters I will have to consider will include ensuring:

(i) partners of my audit firm have no family or personal relationships with the directors of Phones Anywhere. These relationships also apply to any staff involved in the audit. Ideally, no member of my firm should have relationships with the directors of Phones Anywhere.

(ii) no-one in the audit firm should own shares or any investments in Phones Anywhere

(iii) no-one in the audit firm should be a beneficiary or trustee of a trust which holds shares in Phones Anywhere. The ACCA’s rules of professional conduct do allow employees of the audit firm to be a beneficiary of shares in an audit client, but that employee must not be employed on the audit of that client. For trustees, the trust should hold less than 10% of the shares of the company, and the value of the shares should be less than 10% of the total assets of the trust.

(iv) employees and partners of the audit firm must not vote on the appointment, removal or remuneration of a firm which is an audit client

(v) the audit firm should not make a loan to or accept a loan from an audit client (exceptions to this rule apply where the audit client is a bank or other financial institution which does not appear to apply in this case).

The audit fee has been considered earlier in this section. However, the audit fee should be sufficient for my firm to perform the audit to a satisfactory standard. Thus, it would not be acceptable to offer a very low fee (often called ‘lowballing’) in order to obtain the audit, as this would impose pressure on the time allowed to carry out the audit. This could lead to inadequate audit work being carried out which would increase the risk that material misstatements in the financial statements may not be detected.

Other matters covered by the ACCA’s Rules of Professional Conduct include:

(i) When my audit firm is asked to accept the audit appointment, I must ask the client’s permission to communicate with the existing auditor. If this permission is refused, my audit firm should decline to accept appointment as auditor.

(ii) My audit firm should write to the existing auditor requesting all the information which ought to be made available to decide whether or not to accept the audit appointment.

(iii) My audit firm should consider the reply from the existing auditor. If adverse comments are made by the existing auditor, I will have to consider whether to accept the audit appointment.

(iv) If the existing auditor does not reply to my firm’s letter, a further letter should be sent giving notice (e.g. seven days) that if no reply is received in that time, it is understood that there are no professional or other reasons preventing my firm from accepting the audit appointment.

(v) Before finally accepting the audit, my firm should prepare a letter of engagement and ask the directors of Phones Anywhere to sign it.

(c) Accepting or declining the client

From the discussion above, my firm should not offer itself nor accept the appointment as auditor of Phones Anywhere. The main reasons for this decision are:

(i) Phones Anywhere appears to be too large a company for my firm to audit, and it is likely to grow faster than my audit firm. The audit fee will probably exceed the ACCA’s limit of 15% of the practice income, and if this is not exceeded now, it is likely to be exceeded in the next few years.

(ii) Phones Anywhere is a specialised company with complex computer systems. It is probable my firm will not have the skills to perform this work.

(iii) The accounting conventions for Phones Anywhere will probably be unfamiliar to my firm, particularly the treatment of the $200 given to new subscribers to purchase the phones and the lives of the non-current assets. I will probably not have the skills to consider whether these treatments are satisfactory, and this could lead to me not detecting material misstatements in the financial statements.

(iv) Phones Anywhere appears to be undercapitalised. Currently, leverage is 20% but this will increase substantially with expansion of the network and losses in early years of trading. Thus, there is a serious risk that Phones Anywhere will fail or be taken over, which could result in my firm being sued for negligence.

(v) The large size of Phones Anywhere and the small size of my audit firm could compromise the independence of my firm. Third parties (including shareholders) will perceive my firm is not independent (on the relative size criteria), and Phones Anywhere could bring severe pressure on my firm which would be hard to resist(i.e. they will ask for an unmodified audit report to be given when I should either give a modified opinion or an emphasis of matter paragraph which mentions going concern problems).

(vi) The potential listing of the company on the London Stock Exchange increases the audit risk, as there will be greater scrutiny of the financial statements prior to listing, which could highlight problems in the financial statements.

(vii) Finally, because of the large size of Phones Anywhere and the large audit fee, Phones Anywhere may attempt to ‘squeeze’ the audit fee. I may have to accept this reduced audit fee (as I would be reluctant to lose such a large audit fee) and this could result in a reduction in the time to perform the audit and thus increase the risk of me not detecting material misstatements in the financial statements.

Note: Candidates will be given credit for valid points which are not included in this answer.

9 GRINDSBROOK CLOTHING

Key answer tips

This question covers two key aspects of auditing – professional ethics relating to the acceptance of an audit engagement and risk assessment.

Part (a) requires you to identify a number of standard factors, which need to be considered before an audit engagement is accepted – key points to make would cover technical competence, resource availability and independence.

(a) Ethical issues concerning acceptance of appointment

Factors to be taken into account in deciding whether to accept the assignment:

(i) The fact that I have considerable experience in this area is a good reason to accept the assignment – my skills and experience and my qualification may be valuable to the company.

(ii) However, I have a continuing duty of confidentiality to my previous employer and I must not disclose any information relating to my previous employer to my sister.

(iii) The fact that I am related to the company’s owners will mean that my view may not be sufficiently independent or objective, even though there may be no formal requirement for me to be independent. I may be influenced by my sister and there are some disagreements among family members.

(iv) It will be important for all of the family involved in the management of the company to agree to my taking on this assignment if it is to be effective.

(v) I also need to consider my existing client commitments, I may be too busy to perform this assignment effectively. I need to consider on what basis I will charge the company for my services.

(b) Risks and actions to deal with them

(i) External risks

1 The main business risk facing the company is competition from new entrants– the company’s market share is declining. This share may decline further if the company does not have an Internet presence and does not extend its marketing activities.

Dealing with the risk

Marketing is essential to any retail business and even if the company’s products are high quality, it will not be possible to sell them if they are not properly marketed. The company should, for example, seek advice on setting up a web-site and should consider employing a full-time marketing professional.

2 A further risk relates to the different views of family members – the business appears to be prevented from growing because of the attitude of the managing director.

Dealing with the risk

It would be helpful if the family could be persuaded to agree on objectives and to develop a plan to achieve them. If the business is to be passed on to junior members of the family, it would be better for them to be involved in this process, including those individuals who are not currently involved in the business.

(ii) Financial risks

The company may not be optimally funded, it is not very profitable and sales revenue is growing slowly. This is related to the fact that the company is a family- owned company that is structured according to family relationships.

Dealing with the risk

Additional investment could be obtained from family members to expand the business, and additional bank financing could be used for the same objective. The long-term bank loan in particular might be increased.

The company may wish to retain the family structure of management. However, it may be in the best interests of both the family and the company in the long term for plans to be made to pass more control to junior members of the family.

This will enable them to gain appropriate experience of the responsibilities involved in running the business.

(iii) Operational risks

The company does not source its supplies effectively, which has an effect on the budgeting process. It may also have an effect on the quality of products. The control and budgeting process is further hampered by the fact that the company has not employed a proper accountant and the fact that the systems are out of date and slow.

Dealing with the risk

The company should consider employing an accountant. This would make it easier to control and monitor costs and profitability. The company should also consider investment in new systems, which would help with receivables and payables management. All of this requires expenditure, but there appears to be scope for increased funding, as noted above.

(iv) Compliance risks

The company’s financial statements are of poor quality and late. There are often penalties for the late filing of financial statements and although these may be relatively small, the costs of correcting errors may be disproportionate to the benefits.

Dealing with the risk

The company should consider employing a professional accountant or ensure that whoever is responsible for preparing the accounts and filing them is doing so consistently and to an acceptable standard.