AUDIT AND ASSURANCE

AUDIT AND ASSURANCE

2020/21

QUESTION 1

A) MATTERS OTHER THAN INDEPENDENCE RELATING TO CREDIBILITY OF AN AUDITOR

The quality of an audit is significantly dependent on the credibility of an auditor. Credibility refers to the trust that is put in the auditor that he will audit the required business fairly with absolute adherence to the ethics. An auditor’s credibility is chiefly defined by his independence, integrity and objectivity. Ningrum and Wedari (2017) provide that objectivity is the trait of auditor under which he performs the audit without any pressure or conflict of interest. The better auditor’s objectivity, the better are audit results. Further, the authors also provide that an auditor’s integrity also adds on to his credibility. Integrity includes an honest and responsible behaviour from the auditor which he maintains by being right and fair even in the absence of any rules. Decisions made based on integrity are trusted since they are based on courage, responsibility and sincerity.

To ensure that such aspects are adhered to by the auditor to maintain his credibility, the Financial Reporting Council (FRC) has provided ethical standards and keep on revising them time to time so that fairness and accuracy are maintained in the profession. As per the principles set by FRC concerning integrity and objectivity of an auditor, the auditor and his related staff are required to behave with adherence to the said traits while all the professional and related activities. The audit firm is needed to establish an ethical culture so that the auditors get accustomed to following the said principle. Application of confidential policies and procedures regarding whistleblowing is also of great assistance (FRC, 2019).

B) INDEPENDENCE OF AUDITOR AND PRINCIPLES INVOLVED

Independence of an auditor is significantly important for fair conduct of the audit. Here independence of an auditor is referred to independence in all the contexts like financial independence, ethical independence, etc. Apart from the ethical standards provided by the FRC, ISA (UK) 200 “Overall objectives of the independent auditor and the conduct of an audit following international standards on auditing” also sets principles for auditor’s independence (FRC, 2020).

i) The audit manager assigned with the audit of Andrew Co. owns 1% shares of the said company. The auditor is required to be financially independent of his client. However, such portion of shareholding is small and the partner holds no shares, the audit can be performed independently if the auditor does not extend his interest more in the company.

ii) The audit fees receivable from Janet Co. is £100,000 which is a significant portion of auditor’s total income. This influences his independence as the auditor has a key interest in the client’s company.

iii) The auditor of Margot Bank Co. has availed a personal loan from the bank. This reduces his credibility as he has a personal interest in the bank.

iv) Harry Co. has tendered for a contract with Jean Co. for the supply of material. Both the companies are audited by the same auditor. Jean Co. is advised to carefully overview all the aspects of the tender as the contract will cause a conflict of interest and this will reduce the independence of the auditor as when the companies will have a significant interest in each other, the auditor will also tend to have such shared interest as both the companies are his client. Jean Co. is advised to not enter the contract as it will harm the auditor’s independence.

C) CONCEPT OF OBJECTIVITY

i) External Auditors: The external auditors are appointed and reappointed with strict rules to ensure the enhancement of objectivity during the audit. The external auditors are strictly forbidden from the performance of any non-audit services as it threatens the objectivity of the auditor. The objectivity is also threatened by the introduction of auditor’s interest in the organisation being audited and thus, the same should be avoided to maintain the credibility (Albaqali and Kukreja, 2017).

ii) Internal Auditors who are members of ACCA: ACCA mandates the internal auditors to be objective while conducting an audit. It presents that the internal auditor must ensure his work to be in a suitable hierarchy in the organisation. He should not get involved in other managerial responsibilities as it would lead to threats to the objectivity by the way of conflicts and influences. He should also keep on disclosing his interests in the organisation from time to time so that timely steps can be taken to reduce any risks and conflicts that might hinder his responsibilities (ACCA, 2018).

iii) Threats and safeguards to objectivity:

Scenario 1: The auditor firm has been auditing the Bakers Co. for 17 years and is significantly earning from such client. The client has approached the auditor for some non-audit services which will pay him better. However, such provision of service will endanger the objectivity of the auditor since there will be a conflict of interest. Further, it will also disable the auditor to perform the audit in the next year (www.parliament.uk, 2019). To safeguard its objectivity, the auditor can decline the client from providing such consultancy services or can provide such services but ensure a cooling-off period after the completion of such services.

Scenario 2: The potential internal auditor, Peter, of Murphy Manufacturing Co. is currently serving as an employee involved in setting control systems of purchase department and he does not share a healthy relationship with his immediate supervisor. If Peter goes further with becoming an internal auditor, objectivity would be endangered because of familiarity, bias and previous experiences in the organisation and this can adversely impact the quality of audit. To safeguard this, any other external individual can be considered instead of Peter to maintain the objectivity of the audit.

QUESTION 2: JOHN AND JANE CO.

A) PROCEDURES TO BE UNDERTAKEN IN RESPECT OF UNCORRECTED INVENTORY MISSTATEMENT

John and Jane Co. (John and Jane) is in the business of computer hardware. The business had been flourishing during its previous years but now several discrepancies have arrived before it. The business’ financial year ended on 30 April 2014. At the end of the said year, John and Jane came to know from a customer that the product provided by it to a customer failed to perform appropriately, making the customer lose significant revenue. The customer has also informed of taking legal action against them. They evaluated the informed issue after year-end and found that other products in work-in-progress were also carrying similar issues which mean that the inventory value is required to be written down. The finance director believes that such identification can be recorded in the accounts the next year as the evaluation was also made the next year.

The Financial Reporting Council (FRC) (2016) of the UK provides in the ISA 560 “Subsequent Events” as such events which take place after the date of preparation of financial statements of the business but before the date of auditors’ report or such facts which are known to the auditor after the date of auditor’s report. The events which happen between the date of financial statements and date of auditors’ report are required by the auditor to find sufficient and appropriate audit evidence that such events are required to be adjusted in the financial statements or to be disclosed. In the given situation as well, it is a subsequent event that the inventory is required to be written down and it is evident from the information as received from the customer that the product was not performing well. The auditor must apply appropriate audit procedures so that empirical audit evidence can be found regarding the subsequent event and the given auditing standard can be applied.

B) POTENTIAL INDICATORS THAT JOHN AND JANE CO. IS NOT A GOING CONCERN

The ISA (UK) 570 “Going Concern” provides it as the responsibility of the management of the business to appraise business’ potential of continuing as a going concern and of the auditor to obtain sufficient and appropriate evidence that the business is a going concern and the financial statements are produced while undertaking this basis and there is no significant uncertainty prevailing regarding this fact. A business is a going concern until there is an intention of the management of liquidating the business or ceasing the operations or has no realistic option other than this (Croner-i, 2019). The going concern principle comes to end when certain factors arise in a business influencing it severely. Such factors have arisen in the business of John and Jane Co. as well. Those are:

• Decline in market share due to extreme competition.

• The shift of large customers to the competitor's business.

• The shift of specialist developers of the product to the competitor's business.

• New employees were not skilled and knowledgeable enough to fill the void of the previous employees.

• The key supplier supplying specialised electrical equipment ceased his business operations.

• The shareholders refused to finance the business further.

All the above factors are the indicators which reflect that existence of Jane and John Co.’s business is endangered as these factors represent hurdles before the basic operations of the business. The business is in a crucial situation facing several financial and non-financial threats (Kumor and Poniatowska, 2017) and thus, the going concern is questionable.

C) AUDIT PROCEDURES TO BE PERFORMED TO ASSESS IF JOHN AND JANE CO. IS A GOING CONCERN

The management of John and Jane Co. is required to evaluate the going concern trait of the business and prepare the financial statements based on the same. The auditor of the company is responsible to perform audit procedures to collect sufficient and appropriate audit evidence regarding any major discrepancies related to the going concern concept of the business and suitability of the concept and its use by the management in the preparation of the final accounts (Croner-i, 2019). While applying the audit procedures to obtain evidence, if the auditor finds that the John and Jane Co.’s business is doubtful of operating shortly as a going concern, then it is required to apply additional audit procedures for collecting higher quality and quantity of evidence. The auditor will focus on material uncertainty more.

Under the additional procedures, the auditor will request the business' management to assess its potential of carrying on as a going concern, if it has not done the same. It will also evaluate if the management has any significant plans which can improve the condition. The auditor will also check if John and Jane Co. have any forecasts prepared regarding the cash flow. If so, then reliability of such forecast assumptions used to prepare it will also be evaluated. Any additional information or fact if generated after the management performs its assessment will also be checked. The management and/or those charged with governance will also be requested to provide written plans and their feasibility (FRC, 2019).

D) IMPACT ON AUDITOR’S REPORT IF THE COMPANY IS A GOING CONCERN BUT SUBJECT TO A MATERIAL UNCERTAINTY

While evaluating the going concern trait of a business, material uncertainty is significantly assessed by the auditor. Existence of material uncertainty will provide evidence to the auditor to claim the business as incapable of existing in near future. Even if such uncertainty is not found and auditor reflects the business as a going concern in his report, this will not guarantee that the business cannot get dissolved soon. While auditing, if the auditor finds that John and Jane Co. is a going concern but the same is subject to a material uncertainty, then it will examine if the financial statements disclose such conditions because of which going-concern of the business can be doubted and also disclose that due to such doubts, the realisation of assets and discharge of liabilities can get hampered in the normal course of business. The auditor will reveal so in his report so that the users of the report can make an understanding of the business’ ability to continue operations in the future (FRC, 2016).

QUESTION 3: PETER COLA CO.

A) AUDIT RISK AND ITS COMPONENTS

As per Han et al. (2016), audit risk can be understood as the risk of an inappropriate opinion by the auditor in his report after completion of an audit when the financial statements audited are materially misstated. Such misstatement can be either due to fraud or error or both. Audit risk is a function of detection risk and material misstatement. As per ISA (UK) 315 “Identifying and Assessing the Risks of Material Misstatement”, provided by FRC (2020), audit risk is comprised of three types of risks, i.e. inherent risk, control risk and detection risk.

Figure: Relationship between audit risk, inherent risk, control risk and detection risk.

Source: Sardasht and Rashedi, 2018.

INHERENT RISK: Inherent risk is the risk carried on by the transactions of a business due to the nature of the business' structure or industry where it functions. The inherent risk factors are crucially studied by the auditor mainly in account balances and their disclosures, important classes of transactions and assertions related to them. Inherent risk is mainly driven by systematic risk and such risk cannot be controlled. Higher inherent risk is an indicator that the account balance or class of transaction or the disclosures are likely to be materially misstated, while lower inherent risk indicates the opposite (FRC, 2020).

CONTROL RISK: Control risk refers to the risk carried on by the internal controls prevailing in the business. The auditor performs audit procedures to understand the internal controls implemented in the organisation so that he can assess if such controls are adequate, in place and efficient enough. These controls are designed, implemented and maintained by the management of the organisation. If the auditor finds the controls to be inadequate or inefficient, the control risk is high and if the controls or adequate and efficient, then such risk is low. No matter how efficient these controls are, they can reduce the risk of material misstatement but cannot eliminate it because of the inherent limitations of such controls (FRC, 2020).

DETECTION RISK: Detection risk is the risk of failure of detecting the existing misstatement which might be or might not be material. Determination of detection risk significantly influences the audit results. Determining the detection risk involves professional judgment and experience of the auditor. The level of inherent risks and control risks significantly impact the auditor’s judgment of detection risk (Sardasht and Rashedi, 2018).

B) IDENTIFYING AUDIT RISKS AND AUDITOR'S RESPONSE TO SUCH RISKS

After reading the minutes of the planning meeting, the auditor will plan the audit following ISA (UK) 300 "Planning an Audit of Financial Statements” and ISA (UK) 320 “Materiality in Planning and Performing an Audit” so that audit can be planned in a manner that all the risks are addressed since the estimation of audit risk is a part of planning a successful audit. Here are the audit risks existing in the audit of Peter Cola Co. and auditor’s response to it while planning the audit:

• A significant amount has been invested in the production process of cola and other fizzy drinks which involved an expenditure of £5 million on the update, repair and replacement of production machinery. Such amount is significant and based on professional judgment, carries risks. Such risks can be related to material misstatement. The auditor will plan the nature, extent and timing of assessing the transaction and need of basic and further audit procedure following ISA (UK) 320 (FRC, 2016).

• The number of warehouses of Peter Cola Co. has also increased to 15 now. Some are owned and the rest are rented. There is a risk of expropriation here. The auditor will plan physical verification of all the warehouses and attending the inventory count at the year-end and will cross-check with the third party holding the inventory for rent.

• There is an introduction of new accounting general ledger with which the old and new systems are to run simultaneously for two months. This carries a significant risk of fraud and error and the auditor will plan to understand and check both the systems thoroughly to reduce audit risk.

• A new product is being intended to launch whose development cost £4·5 million. The auditor will plan to check out the truthfulness of the expenditure.

• The opening allowance of £1·5 million was released with the introduction of new credit controller for collecting the receivables. The auditor will plan to check if such release is veracious and per the governing rules.

• The damaged inventory costing £1 million is lying unadjusted. The auditor will plan to verify the amount and condition of the inventory while planning to estimate the audit risk.

• The company's management is due to be paid an annual bonus based on year-end total assets' value. The auditor will pay special attention to the assets’ valuation and computation of the bonus to be paid to the eligible employees.

C) IDENTIFYING AREAS OTHER THAN AUDIT RISKS TO BE INCLUDED IN THE AUDIT STRATEGY

Under ISA (UK) 300 "Planning an Audit of Financial Statements”, the auditor of Peter Cola Co. will include the following as well in its audit strategy:

• Deployment of resources: The auditor will plan involvement of resources (human resources here) like experienced team members and experts while auditing the significant aspects of Peter Cola Co., namely inspection of repaired machinery, valuation of assets, etc., so that audit can be effectively performed.

• Audit coverage: The auditor will include the scope up to which the audit is required to be performed. It will include the number and locations of entities included under Peter Cola Co. like its warehouses, branches, chain stores, etc.

D) DIFFERENCE BETWEEN INTERIM AUDIT AND FINAL AUDIT

Interim audit: As discussed by Camilleri (2017), the interim audit is a preliminary audit performed before the final audit of an organisation by the auditors to prepare a strong base for the final audit. This saves efforts of the auditors during the final audit and helps them perform the final audit more efficiently and accurately as they develop an understanding of the organisation during the audit. It is a must requirement for the listed and large organisations’ audit.

Final audit: A final audit is an audit that takes place after the year ends. This audit focuses mainly on the financial statements prepared for the business for the year. It is an annual audit which gets easier and more valuable to be performed when an interim audit is carried on by the auditor to support the final audit.

E) PROCEDURES TO BE PERFORMED DURING THE INTERIM AUDIT AND ITS IMPACT OF FINAL AUDIT

The procedures of an interim audit differ from business to business depending on the circumstances and different aspects of the audit. Whatever procedures are applied during the interim audit, assist in the final audit. A general interim audit is carried on as follows:

Figure: Interim audit procedure

Source: Wall Street Mojo, 2021.

While carrying out the interim audit of Peter Cola Co., the auditor will perform the following procedures (Wall Street Mojo, 2021):

• The auditor will focus on developing an understanding of the industry in which the company is operating. It will identify the basic operations required to be carried on in such business along with the hierarchy, fundamental norms and other crucial aspects.

• The auditor will gather information regarding those charged with governance, key managerial persons, significant decision-makers and vital external identities associated with the business.

• The auditor will also interact with the management and internal audit team of Peter Cola Co.

• The auditor will obtain a management representation letter to ensure the fairness of the information provided to it.

• The auditor will ensure the application of auditing standards and document the audit as performed to support the report provided at the end of such an audit.

Impact of interim audit procedures on the final audit: Performing the above procedures during the interim audit will significantly help the auditor in knowing the organisation thoroughly and thus, it would be able to carry out a more effective final audit. It would not have to waste its time and efforts in enquiring the hierarchy and with the help of working papers of interim audit, the final audit of Peter Cola Co. would get easy and smooth.

REFERENCES

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