THE UNIVERSITY OF THE SOUTH PACIFIC SCHOOL OF ACCOUNTING AND FINANCE AF 304 - AUDITING (Semester 2 - 2009) FINAL EXAM (Time allowed: 3hours + 10 min extra reading time) (50% Weighting towards Final Grades & Minimum mark of 40% in the Final Exam) INSTRUCTIONS FOR CANDIDATES: * THERE ARE 4 QUESTIONS IN THIS EXAM PAPER - ATTEMPT ALL QUESTIONS. = SHOW ALL CALCULATIONS. "YOU MAY USE SILENT, NON-PROGRAMMABLE CALCULATOR. QUESTION "DESCRIPTION MARK | SUGGESTED | ALLOCATION | 1 | Multiple choice 25 2 Audit planning/testing 25 3 | Audit sampling _ 25 S 4 Audit review & reporting 25_ 45 MINUTES TOTAL 100 3 HOURSQuestion 4 Multiple Choice - General [25 marks] Circle the BEST answer for each of the following multiple-choice items. Each multiple-choice question is each worth one (1) mark. Auditing plays a vital role in business, government and our economy. Which of the following bodies does not require an annual audit? a. all public and large proprietary companies. b. small proprietary companies. c. ‘not-for-profit’ organisations, including educational institutions, d. commonwealth government departments and statutory authorities, Recent corporate and audit failures have led to a wide-ranging reform agenda attempting to have the profession refocus on basics - the public interest, redefining audit relationships and fundamental audit methods. This refocus has been called the: a. conformance role of auditing. b. enhancing role of auditing, c. convergence role of auditing. d. none of the above. Which of the following is true regarding auditor’s responsibility for detecting fraud? a, auditors are required to detect all fraud during an audit b. auditors must be reasonably cautious and careful and investigate anything suspicious. c. auditors are not required to detect possible fraud. d._ auditors are not able to investigate fraud. Accepting a gift with the possibility of it subsequently being made public is a form of what type of threat? a. self-interest. b. self-review. familiaity, d,_ intimidation, Independence is the cornerstone of the auditing profession. Which of the following is self-review threat? a, a guarantee from an officer of an assurance client. b. performing services for an assurance client that directly affects the subject matter of the assurance engagement. c. long association of a senior member of an assurance team client. d, pressure to reduce inappropriately the extent of work performed in order to reduce fees. the assuranceWhich case laid down the fundamental auditing principles of the ‘watchdog’ role and the notion of taking reasonable skill and care? a, Kingston Cotton Mill b, London and General Bank. ¢. Pacific Acceptance. d. AWA. Which of the following is not an inherent limitation of an audit? a. time lapse between the balance date and the presentation of the audit report. b. audit testing of selective samples. c. forming professional judgements in highly specialised areas. 4. a means of improving controls and operations, Audit committees are perceived to strengthen the independence of auditors. Which of the following is not an objective of an audit committee? a, ensuring that the entity operates in the best interests of the shareholders. iprove the credibility and objectivity of the accountability process including, financial reporting. ©. assist the board of directors to discharge its responsibility to exercise due care, diligence and skill. 4. facilitate the maintenance of the independence of the external auditor. $.294 of the Corporations Act requires a Directors’ Declaration, Which of the following is not an inclusion in that declaration? a. that the financial statements and notes comply with accounting standards. b. that the financial statements and notes are correct and accurate. c. that the financial statements and notes comply with the Corporations Act. 4. that there are reasonable grounds to believe that the company will be able to pay its debts as and when they fall due. When the auditor concludes that there is substantial doubt about the entity's ability to continue as a going concern for a reasonable period of time, and this fact adequately disclosed in the notes to the financial statements, the audit report should express: a qualified opinion due to the uncertainty. the standard unqualified opinion. an unqualified opinion, with an emphasis of matter paragraph. an adverse opinion. pegs In the opinion paragraph of the standard audit report, the phrase “in our opinion,” really expresses what about the financial statements being presented reasonably and without bias or distortion: a. “we certify b. “Wwe guarantee. c. “we are certain d. “we are satisfied...”12, Which of the following is not an ethical consideration for the auditor in deciding to accept an audit engagement? a, ensure their scheduling process allows completion on time, b. evaluate circumstances that would compromise independence. ¢. assessing competence to perform the audit, d. determine their ability to use due care in performing the audit Setting materiality levels, assessing audit risk and its components and obtaining an understanding of the internal control structure are all part of which audit stage? a. client evaluation, b. audit planning, ¢. conducting the audit. 4. issuing the audit report. Which of the following would be considered an audit adjusting entry? a. a significant amount of inventory was found which had not been included in the accounts and subsequently was by the auditors. b. payroll owing for the last five days of the financial year was recorded by management. c. the accounts receivable balance is debited by the auditors to separately show istomer accounts with credit balances relating to customer advances. d. depreciation on the office equipment was recorded by. For a given assertion, the relationship between the level of detection risk (DR) and assessed control risk (CR) and inherent risk (IR) is shown correctly in which of the following, where + means increase, - means decrease: a. +DRif+CR and HR. b. HDR if-CR and -IR. c. +DR if +CR and -IR. d. +DR if-CR and +R. ‘The auditor has determined that there is a preponderance of persuasive evidence for each financial statement assertion that is material, and therefore a reasonable basis for their opinion. Which of the following would not be a possible opinion that the auditor could issue? a. an unqualified opinion. b. an ‘except for’ opinion, c. an adverse opinion. dan inability to form an opinion. Flowcharts should depict all of the following except: a. all operations performed in processing the class of transactions. b. the method of processing. the extent of segregation of duties. 4d. audit procedures conducted.20. 21 Afier performing additional tests of controls, the auditor reassesses control risk from the initial planning level of slightly below maximum to moderate. The auditor should now: a, decrease the level of detection risk, and decrease substantive testing. b. increase the level of detection risk, and increase substantive testing ¢. increase planned substantive testing. d._ increase the level of detection risk, and decrease substantive testing. A test of an asset for overstatement provides corresponding evidence on: Expense Revenue Liability a. Overstatement Overstatement Understatement b. Understatement Overstatement Overstatement c. Understatement Understatement Understatement d, Overstatement Overstatement Overstatement Which of the following is an advantage of PPS sampling over variable sampling? a. itis more suitable for detecting errors of understatement. b. individually material items are automatically selected. ¢. as expected error increases, sample size will be smaller than that required by variable sampling. d. all of the above. Which of the following models expresses the general relationship of risks associated with the auditor’s evaluation of control risk (CR), inherent risk (IR), and audit risk (AR) that would lead the auditor to conclude that additional substantive tests of details of an account balance are not necessary cig cR AR a 20% 40% 10% bd. 20% 60% 5% ©. 10% 70% 4.5% d 30% 40% 55% ing evidence concerning the cash balance, the auditor performs the following procedures: Scan client-prepared bank reconciliations and verify the ‘mathematical accuracy of the reconciliation. In this case, itis likely that: detection risk is set at moderate to high. detection risk is set at low to very low. control risk is set at slightly below maximum to maximum. control risk is set at moderate to high. nese23. 25. ‘The performance of cash cut-off tests provides evidence primarily for whi the following assertions? Existence or Rights and Accuracy or occurrence Completeness obligations __ valuation. Disclosure ce = b. ¥ = c. * * ae * An auditor observes inventory held by the client and notes that some of the inventory appears to be old, but in good condition. Which of the following conclusions is justified by the audit procedure? 1. The older inventory is obsolete. Tl. The inventory is owned by the company IIL, Inventory needs to be reduced to current market value. a. Lonly. b. Honly c. 1& Mlonly. d. None of the above If the application of accounting policies in compliance with statutory and other requirements does not result in a fair presentation in accordance with the accounting standards the auditor shoul a. express an unqualified opinion in accordance with statutory and other requirements and a qualified opinion in accordance with the accounting standards. b. express an unqualified opinion in accordance with statutory and other requirements and an unqualified opinion in accordance with the accounting, standards. ©. express a qualified opinion in accordance with statutory and other requirements and a qualified opinion in accordance with the accounting standards. . express a qualified opinion in accordance with statutory and other requirements and an unqualified opinion in accordance with the accounting standards.Question 2 Audit Planning/Te: Part Theory [5 marks [25 marks] (The audit risk standards outline the circumstances undertake testing of controls. Identify two of these Which the auditor is required to ircumstances? [2 marks] Distinguish between the types of testing that the auditor would undertake in testing the existence of internal control versus the effectiveness and continuity of internal control. [3 marks} Part B: Audit Planning 12 marks| Lagoon International Pty Limited Consider each of the following situations, which are independent of each other: a) Your audit plan for sales places substantial reliance on the system of internal control and the use of analytical review. Your testing of the internal control system for sales has found a significant number of instances where clients’ credit ratings have not been checked and abnormally large discounts have been given. The sales manager states that these changes have been the result of difficulties in maintaining past sales levels. b) You are carrying out the annual audit of a tractor retailer. You are aware of significant problems in the rural industry over the past six months and little improvement is in sight. ©) Since the last audit your client has introduced a new management compensation scheme with the result that top managers’ salaries are closely tied to the company’s” profitability. 4) Management informs you that during the year the internal auditors discovered that a substantial amount of stock had disappeared from a small branch of your client. A number of local managers have subsequently resigned although there were no prosecutions. The loss equalled 1% of the company’s operating profit.©) Since your last audit the client has introduced a new computer information system for inventory to replace the manual system. Management has indicated that the big advantage of the new system over the old one is that it provides information on inventory levels and gross margins for both produet line and geographical area. 1) A new competitor of your client entered the market two months before year end and, since that time, selling prices have fallen significantly. Your inquiries have revealed that the industry expects heavy discounting to continue for the whole of next year. 2) The organization has introduced an internal audit department in the second quarter of the year. The section consists of three staff. The chief Internal Auditor is a former “Big 6” audit manager with 10 years experience in the profession. He has no internal audit experience. He reports direct to the Managing Director Since joining the firm he has spent most of his time examining the internal control systems of the company. He is assisted by one new graduate and another person who has two years of internal audit experience and is presently in his third year part-time of a commerce degree. hh) There were neither major disposals nor additions to fixed assets during the period. ‘xed assets are not material and consist mainly of furniture and fittings Required Assume you ate responsible for constructing an audit plan in each of the situations discussed above. In each case describe how the situation posed would affect your audit plan, Include reference to the nature and /or extent of audi evidence to be collected. [1 % marks each] [Total = 12 marks]Part C: Audit Testing [8 marks) ‘You are the audit manager in charge of the 31 December audit of Pacific-« large private company oper audi Chow Pty Ltd, a ig in the boutique food and beverages market. The is now nearing completion and you are preparing a schedule of adjustments to discuss with the client. The schedule of adjustmen icludes the following: Adjustment Required L Dr Cr [Balances affected 3000 $000 Explanation zi te T. Obsolescence expense 300 Store of dried goods in Darwin warehouse Inventory 300 | destroyed by vermin 2, Inerest expense 600 Interest not recorded on borrowings Borrowings wo 3. Income tax expense 00 Underprovision for tax for year ending S0/GIXT Provision for tax 400 | client disagrees with treatment of claimed deductions for tax year ended 20X1. | 4 Depreciation expense 1000 Record additional depreciation expense on “Accumulated depreciation TO00 | catering equipment. Discussions indicate it will be scrapped next year. Client believes it has high scrap value; review of publications in this area suggests this is unlike Materiality for the audit has been set at $1 600 000. Required: a) Which of the above items, if any, do you believe require adjustment? Explain. b) Your partner had originally set a preliminary materi [4 marks} ity level for the audit of Pacifie-Chow Pty Ltd at $3000000. After your review of inherent risk your partner has lowered this materiality level to $1600000. Outline how the new lower materiality level will affect the nature and extent of audit procedures planned, [4 marks}Question 3 Audit Sampling 225 marks] Part A: Sampling Theory 10 marks} (Discuss and explain the risks that are associated with compliance and substantive tests, [5 marks] Discuss the benefits to the auditor from using statistical sampling, [5 marks] Part B: Sampling Techniques [15 marks| You are in the process of evaluating the internal control system of your client, Kris Company, and you desire to perform a compliance test of controls that the client has indicated are in effect in the accounts payable area, The specific control in which you are interested relates to the matching of the purchase order, receiving report, and vendor invoice, prior to approving the invoice for payment, You are told that the 3 documents are compared, cancelled, and approved for payment by the accounts payable supervisor. After performing this operation, the supervisor indicates that the invoice is approved for payment, initials the invoice, staples the 3 documents together and forwards them for processing. After processing the documents are filed together in voucher number order. Each year, the voucher number begins at 0001. The last voucher number assigned during the current year is 8178. You define an error as being either (1) any approved invoice that does not agree in amount with the other 2 documents, (2) cases in which any of the 3 documents is missing, or (3) any paid invoice that does not bear the initials of the supervisor. In the past you have found an error rate in this population of approximately 3% and you expect this condition in the current year. If you found evidence that the error rate exceeded 6%, however, you would conclude that this control feature was ineffective, Because of the importance you place on this control, you decide to use a 90% reliability level. Required: a) Determine the sample size appropriate in this case if the auditor uses estimation sampling for attributes. [3 marks] b) Discuss the procedures you would use in selecting the sample. [3 marks} ©) What would you conclude if, in examining the items in the sample, 3 errors were found? [4 marks} d) If 5 errors were found in the sample, what would your conclusions be? What would be the effect on your audit? [5 marks} 10Question 4 Audit Review & Reporting [25 marks] Part A: Theory 6 marks} You are the audit manager of'a new client. Management of the new client has prepared its accounts in accordance with generally accepted accounting principles but you believe that the overall view presented by this financial report is not true and fair. Required: Briefly outline your partner the approach that should be taken in these circumstances. [6 marks} Part B: Audit Completion 10 marks} Assume that an auditor is expressing an opinion on Rose Ltd’s financial report for the year ended 30 September 20X3, that field work was completed on 21 October 20X3, and that the audit opinion to accompany the financial report is now being prepared. In each item a ‘subsequent event’ is described. This event was disclosed to the auditor either in connection with the review of subsequent events or after the completion of field work. a) A large account receivable from Chan Industries (material to financial report presentation) was considered fully collectible at 30 September 20X3, Chan suffered a plant explosion on 25 October 20X3. Since Chan was uninsured, itis unlikely that the account will be paid, b) The court ruled in favour of the company on 25 October 20X3 concerning deductions claimed on the 20X1 and 20X2 tax returns. Rose Ltd had provided in accrued taxes payable for the full amount of the potential disallowances. The Commissioner of Taxation will not appeal the court’s ruling. c) Rose Ltd’s manufacturing division, whose assets constituted 75% of Rose Ltd’s total assets at 30 September 20X3, was sold on I November 20X3. The new owner assumed the indebtedness associated with this property. 4) On 15 October 20X3, a major investment advisor issued a pessimistic report on Rose Lid’s long-term prospects. The market price for Rose Ltd’s ordinary shares subsequently declined by 50%, ©) Atits 5 October 20X3 meeting Rose Ltd’s board of directors voted to double the advertising budget for the coming year and authorised a change in advertising agencies. Required: You are to indicate in each case the required disclosure of this event in the financial report, Each of the 5 cases is independent and is to be considered separately. [2n/each] [Total = 10 marks}Part Audit Reporting arks) You are an audit manager for C.K. Chartered Accountants and are currently finalising your 30 June 2010 audits. Company A Company A is a listed company with 3 subsidiaries, Company B, Company C and Company D. Another firm D.K, Chartered Accountants act as the auditors of Company D and have qualified their audit report on the basis that continued financial support from ‘Company A is required for Company D to continue as a going concern, In auditing Company A and the economic entity, you are satisfied that the going concern basis of preparing the financial report is appropriate. In addition, you are satisfied that the carrying value in Company A’s financial report of the investment in Company D of $200 is not stated above its recoverable amount. The company and the economic entity made profits for the year. Company H The audit of Company H was extremely difficult as the client did not maintain appropriate books and records during the year. Although the statutory registers were maintained, the accounting records were not updated for the first 9 months of the year as the company was without an accountant during this period. An accountant was employed in April 2010 and she tried to reconstruct records ftom the details of receipts and payments available. The accountant has been unable to reconcile the bank account and you are not satisfied that all transactions which occurred during the year are reflected in the financial report. The operating loss recorded by Company H in the current year is $22 190. Company G Company G, a property developer, holds freehold property purchased for development and resale which is classified as inventories. This property, as disclosed in the financial report at Note 10, has been valued at cost, which is $5 000 000. In your audit you found that in the current market the net realisable value of the property is $3 500 000. Although material, the client does not consider that the value of the property should be written down as future development will result in the property being worth more than the current book value. The write-down would have no tax effect. The financial report audited, including the Directors’ Declaration, spans pages 5 to 38. The company made a profit for the year. Company G has other assets of $25 000 000 and liabilities of $7 000 000. Required: Discuss the type of audit opinion that you intend to issue for each of the above companies for the year ending 30 June 2010. [3 marks each] [Total = 9 marks} THE ENDQuestion 1 Multiple Choice - General [25 marks] Circle the BEST answer for each of the following multiple-choice items. (PLEASE ATTACH THIS WITH YOUR ANSWER BOOKLET) 1 ala 2 3. 4. 5. 6. a 8. 9. alo] olalaiala 10. 1. 12. aQalaia 13. 14. 15. 16. 17. 18. 19. 20. 21. 22. alalalalalalalalalalala 23. 24, DL > > lel > > >) >) >) >) >) >) > el > > >) >) pl >) > >) >) >) > Bess oo vjolvlojol op vis/elyjgle vlojvigi/y ala1.39 1.00 8g 2.70 244 5.33 3.93 32 6.69 5.11 4 8.00 6.28 5.43 9.28 7.43 6.49 10.54 7.56 11.78 8.63 13.00 9.68 14.21 10.74 15.41 11.79 16.60 15. 12.84 17.79 16 13.89 18.96 17.86 14.93 20.13 19.00 15.97 21.30 20.13 17.02 22.46 21.26 48.06 23.61 22.39 19.10 24.76 23.51 20.14 25.91 24.63 24.18 27.05 25.74 22,22 Expansion factors for expected errors Sy Petal 3.00 475 6.30 7.76 9.16 10.52 Bea RoI 4.58 1.44 1.36 13 1.28Bc ari Pe a 0.00% 14940) 99(0) 74(0) 59(0) 490) 42(0) 360) 92/0) 2940) 19(0) 14(0) 025 236(1) 187(1) 117(1) 93(1) Jaq) 66(1) $8(1). St(1) 46¢1) 3001) 22(1) 080 = 197(1) 117(1) @a(1) 78(1) 86(1) 58(1) sit) 48(1) 30(1) 22(1) 075 = 208(2) 117(1) 93(1) a(t) 66(1) 58(1) S1(t) 46(1) 30(1) 22(1) 4.00 es 156(2) 9(1) 78(1) 66(1) 58(1) sit) 46(1) 30(1) 22(1) 125 - 156(2) 124(2) 78(1) 86(1) S(t) S1(1) 48(1) 30(1) 2201) 50 - 192(3) 424(2) 10812) 66(1) 58(1) S1(1) 48(1) 30(1) 2211) 227(4) 153(3) 10312) 88(2) 7(2) S1{1) 46(1) 30(1) 22(1) = 481(4) 127(8) 88(2) 77(2) 68(2) 46(1) 30(1) 22(1) 2.25 = 208(5) 12713) 88(2) 77(2) 68(2) 6112) 30(1) 22(1) 260 _ 8 - — 1904) 109(3) 77(2) 682) 61(2) 30(1) 2211) 278 734g) 10918) 95(8) 6812) 6112) 30(1) 221) 300 : - [ — 195(6) 129(4) 95(3) 84(3) 61(2) 30(1) zal) 3.26 a = 148(5) 142(4) 84(8) 6112) 30(1) 22(1) 350 oe — = 167(6) 112(4) 8403) 76(3) 40(2) 2211) 3.75 a - - 185(7) 429(5) 100(4) 76(3) 40(2) 22(1) aye 4.00 oe ~ = 148(6) 100(4) 89(4) 40(2) 22(1) a ee sl Bee 158(8) 116(6) 40(2) 30(2) ee (with number of 6.00 ad bel ce a a ea = 179(11) 50(3) 30(2) expected errors — parentheses) 7.00 ae === 888) 3718) Sour: Av - - Sampling Guide Note: This table assumes a large population. For a discussion of the effect of population on No 1, ARF, sample size, see Audit Sampling Guide, AICPA, 1983, Chapter 2. 1983, 0 90. \ iWSE 0.00% 114(0) 76(0) 57(0) 45(0) 38(0) 32(0) 28(0) 25(0) 22(0) 15(0) 18(0) 028 aga(t) 1291) 96(1) 77(4) 641) 85(1) 48(1) 42(1) 981) 25(1) 18(1) 0.50 194(1) 1291) 96(1) 77(1) 84(1) 85(1) 48(1) 42(1) 38(1) 25(1) 78(1) 0.75 265(2) 129(1) get) 77(1) 641) 58(1) 481) 42(1) 38(t) 25(1) 181) +00 = 176(2) 961) 77(1) 64(1) salt) 48(1) 428) 38(1) 25(1) 121) qos 22t{a) 13042) 7(1) aC) 85(1) 481) 42(1) 38(1)25(1) vain) 450 = = 132(2) 105(2) sat) ssi) 48(1) 42(1) 38(1) 28(1) 18") 178 — = 166(3) 105(2) 88(2) 55(1) 481) 4241) 381) 25(%) 721) 2.00 - 498(4) 192(3) 88(2) 75(2) 48(1) 42(1) 38(1) 25(1) 18(1) 2.25 eS yas) ee) Toe), 6a), 201) A 25(1) 18(1) 2.50 18868) 1013) 75(2) 85(2) 58(2) 38(1) 25(t) 18(1) 278 - = 209(6) 132(4) 94(3) 85(2) 25(1) 18(1) 3.00 - =. 15218) 94(3) 65(2) 58(2) 521) 25(1) 7a) 3.25 . - 453(5) 113(4) 82(3) §8(2) 52(1) 28(1) 3.50 - . - 494(7) 113(4) 82(3) 73(4) 52(2) 1) 18(1) Table 9.4 Statistical sample sizes for 73(3) 52(2) 25(1) 18(1) compienes OO - . 73(3) 65(8) 25(1) 18(1) testing: 19% sk - i per at = - - - - = 160(8) 115(6) 78(4) 34(2) 18(1) 6.00 oo Se - — 482(11) 116(7) 4313) 25(2) Source: Audit 7.00 ee 7 = 199(14) 524) 25(2) Samping Guide — No 1, BAR Note: This table assumes a large population. For a discussion af the effect of population on 1288, 1 sample size, see Auait Sampling Guide, AICPA, 1983, Chapter 2 16