Answers

Part 2 Examination – Paper 2.6(INT)

Audit and Internal Review (International Stream) December 2002 Answers

1 External auditor objectivity

(a) Why external auditor objectivity may be, or appear to be, threatened
(i) Undue dependence
If the auditor depends, or relies on a particular client or group of connected clients because the firm takes a large part
of its fee income from the client, the auditor may be less likely to challenge accounting policies or disclosures proposed
by the client, for fear of upsetting them. This typically happens when the firm is small, but the client is large.
Where the firm feels that an audit qualification may be necessary, it may be reluctant to issue it for fear of losing the
client and the fee income. This applies regardless of whether the fee income is audit fee income or income for other
work.
The issue is important because if the auditor does not issue a qualified audit report where appropriate, the firm may be
sued for negligence. Where a large client is involved, the firm’s professional indemnity insurance may not cover the
claim.
(ii) Financial interest
Where a partner or member of staff in a firm (or the firm itself) holds shares in a client, they have an interest in the
client’s performance. If the client performs well, the value of the shares may rise. A qualified audit report is not usually
associated with good performance and the firm may therefore be reluctant to issue one where appropriate. This is
important for the reasons noted above.
Even if there is no question of a qualified audit report, there may be a temptation to help the client present the results
in the best possible light, instead of presenting a balanced view.
There is also a financial interest where partners, staff or the firm make loans to, or guarantee the borrowings of the client
or vice versa. Significantly overdue fees of amounts that are significant to either auditor or client are akin to loans.

(iii) Family or other close personal or business relationships

Where there are family or other close personal or business relationships between client and audit firm, the individuals
concerned may try to influence the firm in its dealings with the client in order to protect the family or personal
relationship, or the mutual business interest.
If, for example, an audit partner is married to the finance director of a client, it is less likely that the client will receive a
qualified audit report than it would be if the relationship did not exist. This is important in any case but more so where
the effect of a qualified (or modified) audit report is likely to result in, say, withdrawal or non-renewal of banking facilities
which might result in the business ceasing to be a going concern. If the firm does not issue a modified audit report in
such circumstances, the firm may be exposed to claims of negligence by the bank.
If there are close business relationships between client and auditor, both parties have an interest in each other’s
performance and there is therefore a double pressure to present the results in the best possible light and not to issue a
qualified audit report.

(iv) Other services

Many audit firms provide their audit clients with services other than audit services. It is very common for auditors in the
UK to provide their very small audit clients with accountancy services, for example.
Other services that can be provided include tax, management consulting, IT and human resources advice. Some firms
not only provide consulting advice, but also perform IT and other functions for some of their clients.
There are two threats to objectivity where other services are provided. Firstly, the firm may find that it is reporting on a
system that the firm itself has set up or advised on, or reporting on information that the firm itself has prepared. This
means that it is reporting on its own work and it may be difficult to be objective in such circumstances. Secondly, the
fee income from other services may well exceed the fee income from the audit and the client may pressure the firm to
give an unqualified audit report by threatening to take the other services to another firm if a qualified report is given.

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(b) Requirements
Most of the following are requirements of ACCA’s Rules of Professional Conduct.
(i) Undue dependence
1. A firm should put in place additional safeguards where the recurring fee income from one client or group exceeds
15% of the gross practice income (10% for clients listed on a stock exchange or where the public interest is
involved). Additional safeguards include supplementary reviews and the rotation of the engagement partner and
senior staff.
2. There are exceptions where a practice is being set up or run down. The rules are also applied to members practising
part-time.
3. A review mechanism should be triggered within the firm where the gross fee income exceeds 10% (5%) of gross
practice income.
4. More generally, there is a requirement for firms to carry professional indemnity insurance to cover professional
negligence claims and ACCA monitors practising firms to ensure that they are complying with, amongst other
things, the independence requirements. Firms are also required to keep up with changes in independence
requirements as a condition of being permitted to practice.
(ii) Financial interest
1. No partner in a firm, or any member of staff working on a particular audit, or any person closely connected with
them, should hold any shares in an audit client.
2. There are exceptions where collective investments are held by third parties, where the individual concerned has no
control over the composition of investments.
3. Where such shares or interests are acquired through marriage or inheritance, for example, the shares should be
disposed of at the earliest possible opportunity, provided that the disposal does not involve insider trading. Where
shares are held by the auditor because the company’s constitution requires it, the minimum level should be held
and the votes attaching to the shares should not be exercised.
4. There are some exceptions for transactions on normal commercial terms with money lending institutions – a normal
mortgage from a bank, for example.
5. Firms, their partners and staff should not make loans to, or guarantee the borrowings of, any audit client, or vice
versa.
(iii) Family or other close personal or business relationships
1. An officer (such as a director) or employee of an audit client, or a partner or employee of such a person, is
prohibited from accepting appointment as auditor of that client. Problems can also arise if an officer or senior
employee of an audit client is closely connected with a partner or senior staff member responsible for the conduct
of the audit (or anyone closely connected with them).
2. Closely connected persons generally include minor children and spouses. In this case, adult children and their
spouses, siblings, and any other relative to whom regular financial assistance is given (or who is otherwise indebted
to the partner or employee) are also included.
3. A member should not personally take part in the audit where he or she has been an officer or employee of a
company within the two years prior to the commencement of the first day of the period reported on.

(iv) Other services

1. A firm should not participate in the preparation of the accounting records of a company listed on a stock exchange
or a public interest company except in relation to the finalisation of the statutory accounts (assistance of a
mechanical nature) or in an emergency situation.
2. Where a firm does provide such assistance to a smaller firm, care should be taken not to take on management
functions, to ensure that the client accepts responsibility for the accounting records, and to ensure that adequate
audit tests are performed and properly recorded.
3. A firm may advertise for and interview prospective staff for a client and produce a short list and recommendations,
but the client must make the final decision.
4. A firm should not audit a client’s financial statements which include the product of specialist valuations performed
by the firm (such as the valuation of intangible assets or pension funds).
5. Where a firm provides other services to audit clients, it is important that the audit team should be entirely
independent of the team providing the other service. One method of achieving this is by setting up internal
structures whereby the two teams do not communicate with one another.

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2 Internal controls

(a) Key procedures

(i) Documentation of accounting and internal control systems
Auditors document accounting and internal control systems in order to evaluate them for their adequacy as a basis for
the preparation of the financial statements and to make a preliminary risk assessment of internal controls.
In very simple systems with few internal controls where auditors do not intend to perform tests of internal controls, it is
not necessary to document the internal control system in detail. It is always necessary, however, to have sufficient
knowledge of the business to perform an effective audit.
For large entities, where the client has already documented the system, it is not necessary for the auditors to repeat the
process if they can satisfy themselves that the client’s documentation is adequate.
(ii) Walk through tests
The purpose of walk-through tests is for the auditors to establish that their recording of the accounting and internal
control system is adequate.
Auditors trace a number of transactions from source to destination in the system, and vice versa. For example, customer
orders can be traced from the initial documentation recording the order, through to the related entries in the daybooks
and ledgers.
It is common for walk-through tests to be performed at the same time as tests of controls, where auditors are reasonably
confident that systems are recorded adequately.
(iii) Audit sampling
Auditors perform tests of controls and substantive testing on a sample basis in order to form conclusions on the
populations from which the samples are drawn.
It is not possible in anything but the very smallest of entities to take any other approach, as testing 100% of a population
may be impractical, not cost effective and not accurate because populations are too large and because of human error.
Samples can be selected in a number of ways – either statistically or on the basis of auditor judgement. In all cases, the
sample selected must be representative of the population as a whole.
(iv) Testing internal controls
Auditors test internal controls in order to establish whether they are operating effectively throughout the period under
review. If controls are operating effectively, auditors can reduce the level of substantive testing on transactions and
balances that would otherwise be required.
In testing internal controls, auditors are checking to ensure that the stated control has been applied. For example,
auditors may check that there is a grid stamp on a sales invoice with various signatures inside it that show that the
invoice has been approved by the credit controller, that it has been checked for arithmetical accuracy, that the price has
been checked, and that it has been posted to the sales ledger. The signatures provide audit evidence that the control
has been applied.
Auditors are not checking to ensure that the invoice is, in fact, correct. This would be a substantive test. Nevertheless,
it is possible to perform tests of control and substantive tests on the same document at the same time.
(v) Dealing with deviations from the application of control procedures
Where it appears that an internal control procedure has not been applied, it is necessary to form an opinion as to
whether the deviation from the application of the procedure is an isolated incident, or whether the deviation represents
a systematic breakdown in the application of the control procedure. This is usually achieved by selecting a further
sample for testing.
If it cannot be shown that the non-application of the procedure is isolated (i.e. there are no further instances in which
the control has failed), it is necessary either to find a compensating control that can be tested, or to abandon testing of
controls and to take a wholly substantive approach. Where there is a breakdown in internal controls it is also necessary
to reassess the auditor’s preliminary risk assessment. Abandoning tests of control may place strains on the budget for
the audit and auditors should always consider the possibility of compensating controls before abandoning tests of
controls.

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 (b) Internal controls
(i) Receipt, processing and recording
1. All orders taken should be recorded on a pre-numbered multi-part document generated by the computer. One part
might be a copy for the customer, one might form the invoice, one might be for the despatch department and one
might be retained for accounts receivable ledger purposes. Manual or computer systems should perform checks on
the completeness of the sequence of pre-numbered documents at various stages. Any documents unaccounted for
should be traced and investigated.
2. The computer system should apply the credit limits set by the credit controller and the system should reject any
orders that exceed customer credit limits at the point at which the order is taken, so that the customer can be
advised. Any override of credit limits should be authorised by the credit controller.
3. From time to time, there should be an independent check to ensure that the credit limits within the system are
being properly calculated and properly applied to individual transactions. Similar considerations apply to prices
maintained within the system.
4. The computer system should also reject any order for which there are no flowers available so that orders cannot
be taken for flowers that cannot be delivered.
5. All invoices should be posted to the sales daybook, the accounts receivable ledger and the accounts receivable
control account automatically by the system and the accounts receivable ledger and the accounts receivable control
account should be reconciled each month in order for sales and receivables records to be kept up to date.
6. There should be controls in place to deal with credit notes and other discrepancies involving the price, type or
quality of flowers delivered in order to maintain the accuracy of records and customer goodwill.
(ii) Collection of cash
1. At the end of each period, the system should produce a list of overdue receivables. There should be procedures for
chasing these customers and for putting a ‘stop’ on accounts where amounts are significant in order to control bad
debts.
2. When bank transfers are received from customers, they should be input into the system and matched with
individual transactions and controls should ensure that the correct amounts are allocated to the correct customers
and transactions.
3. An exception report should be produced for any unallocated bank transfers. Exceptions should be promptly
investigated. This will ensure that receivables information is accurate and up to date and that customers are not
chased for amounts that have been paid.
4. A bank reconciliation should be performed on a monthly basis in order to ensure that the company’s cash records
are complete, accurate and up to date.

3 Audit of payables, accruals and provisions

(a) Company A

(i) 10-year bank loan and bank overdraft

1. Authorisation for the loan and overdraft should be checked to the minutes of a board or other relevant meeting.
2. The details of contracts with the bank and any relevant correspondence should be examined. Any covenants
restricting the use of securities held against the loans should be examined and the client’s compliance with the
covenant checked. If covenants have not been complied with, the implications for the company and the financial
statements should be considered.
3. The response to the year-end bank confirmation should be examined. It should provide details of the amounts
outstanding and the amounts paid and payable during the year in terms of both interest (loan and overdraft) and
capital (loan only). In both cases, details of any security held for the loan and overdraft should be requested.
4. Analytical procedures should be applied to the interest paid in the income statement, and to the interest and capital
paid and outstanding at the period-end for the loan.
5. The bank reconciliation should be checked to ensure that the overdraft has been properly reconciled to the records,
and that there are no old or significant outstanding amounts that need to be adjusted for.
6. The amount payable at the year-end should include amounts payable in one year, which should be included in
current payables, and amounts payable in over one year. The notes to the financial statements should also disclose
amounts payable in over five years.
7. The auditors should ensure that appropriate disclosures are made in the notes to the accounts in accordance with
legislation and International Financial Reporting Standards. In particular, where assets are held as security, this
should be disclosed in the notes relating to the assets.

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 (ii) Expense accruals
1. If accruals are material to the financial statements, more evidence will be required than if they are not. If accruals
are not material, analytical procedures may be sufficient audit evidence.
2. A schedule of accruals should be obtained and checked for arithmetical accuracy. Individual accruals should be
reviewed by comparison with prior periods and budgets and any significant variations investigated, particularly if
accruals have been made in previous periods but have not been made in the current period.
3. The amounts paid after the period-end should be checked to the bank statement and the calculation of a sample
of amounts payable should be checked for accuracy, by reference to subsequent invoices.
4. If any accruals are payable more than one year after the balance sheet date, an appropriate split should be made
in the balance sheet.
(iii) Trade payables and purchase accruals
1. The nature and extent of testing will depend on the quality of controls over trade payables, as evidenced by interim
testing of internal controls. Evidence in relation to the completeness of trade payables and accruals is important,
but not always easy to obtain.
2. The auditors should form an opinion as to whether direct confirmation of trade payables is likely to provide valuable
audit evidence by discussion with the client.
3. It is sometimes possible to rely on supplier statement reconciliations instead of direct confirmation, but this depends
on the availability of supplier statements. Where supplier statement reconciliations are performed, it is important
to be aware of the possibility of forged or altered statements – originals rather than copies should be examined.
Some combination of supplier statement reconciliations and direct confirmation is often used.
4. If a decision to obtain direct confirmation of trade payables is taken, the client’s co-operation is required in
authorising the requests and in helping the auditors sort out any differences between the balances recorded by the
company and those recorded by suppliers.
5. Particular care should be taken if there are material balances for which there are no supplier statements or no
response to a request for confirmation. Consideration should be given to telephoning the supplier in this case.
6. Analytical procedures should be applied to the ageing and level of trade payables by comparison with prior periods.
Variations should be investigated and substantiated, with particular attention being paid to old outstanding
amounts.
7. A representative sample of individual trade payables should be traced back through the system from the schedules
supporting the financial statements to the ledgers, daybooks and source documentation to ensure that the amounts
recorded are accurate. The size of the sample will depend on the auditor’s assessment of risk in this area.
8. A schedule of purchase accruals should be obtained and checked for arithmetical accuracy and completeness by
comparison with prior periods and invoices received after the period-end. As with trade payables generally, there
is a risk of unrecorded items.
9. Both trade payables and purchase accruals should be tested for the accuracy of cut-off by reference to invoices and
inventory records for an appropriate period each side of the period-end.
10. A review of correspondence with trade creditors should be performed and any legal department should be
requested to provide details of disputes with creditors.
11. If any trade payables are payable more than one year after the balance sheet date, an appropriate split should be
made in the balance sheet.
(b) Company B
(i) Provisions for manufacturing warranty claims are heavily dependent on the judgement of directors. The auditors should
establish how the directors have arrived at the provision and assess it for reasonableness in the light of previous
provisions and claims. More work will be required if there has been a significant discrepancy between provisions and
claims in the past and more work will be required if the company does not have significant experience in dealing with
this type of warranty claim.
(ii) IAS 37 ‘Provisions, Contingent Liabilities and Contingent Assets’ states that a provision is a liability of uncertain timing
or amount which should only be recognised when there is a present obligation, as a result of a past event, and where
it is probable that an outflow of resources will be required to settle the obligation, the amount of which can be reliably
estimated. It would appear that the warranty claim fits this description.
(iii) Such warranties are often underwritten by insurance and any arrangements with the insurance company should be
checked in detail so that the substance of the transaction can be reflected in the financial statements.
(iv) Auditors should check the calculation of the provision for arithmetical accuracy and to ensure that it is calculated in
accordance with the method determined by directors. This can be achieved by reviewing the level of claims and
payments both before and after the period-end.

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 (v) If there has been a change in the method of calculating the provision, the auditors should ensure that it is reasonable
in the light of evidence available and that it is properly disclosed, if material. If there has been a change in the product
mix to which the warranty applies, this should also be considered, particularly if there are new, relatively untried
products which carry a higher risk of claims in the first few years.
(vi) If any previous provisions have been released in the current period because of over-provisions in previous periods, the
auditors should ensure that the amount released is reasonable, and is properly disclosed in the income statement as
appropriate. ‘Soft’ provisions such as these can be manipulated by the client and particular care therefore needs to be
taken.
(vii) A review of correspondence with customers should be performed and any legal department should be requested to
provide details of disputes with customers relating to claims.

4 Confirmations
(a) Management representations
Evidence
(i) Auditors obtain written representations from management on material matters where other sufficient appropriate audit
evidence cannot reasonably be expected to exist. ISA 580 ‘Management Representations’ deals with this subject.
(ii) Such matters might include confirmation that all related party transactions have been disclosed in the financial
statements and confirmation of all matters that rely principally on the exercise of judgement by directors – such as ‘soft’
provisions. The letter also usually includes confirmation that all matters occurring since the balance sheet date that
should be brought to the attention of auditors have been brought to their attention, and that all of the accounting records
have been made available to the auditors.
(iii) Management representations should not conflict with other audit evidence. If they do, the matter should be investigated
and resolved.
Practical difficulties
(iv) In practice, it is not always easy to obtain a signed management representation letter. The letter should be addressed
from the client to the auditor, but it can take the form of a letter from the auditor to management that is acknowledged
by management, or signed minutes of a board or similar meeting.
(v) If management refuse to provide representations, this may be grounds for a qualification of the audit report on the basis
of a limitation in the scope of the audit. However, this is an extreme step and auditors will always discuss with directors
alternative wordings that will be acceptable to them before considering qualification of the audit report. There may be
genuine uncertainty on the part of management as to the reasonableness of the representations that auditors request
them to make.
Alternative evidence
(vi) Unfortunately, because of the content of these letters, there is very little alternative evidence; that is why the letter is
requested in the first place.
(vii) Auditors need to think carefully about the content of the letter if management refuses to sign altogether, and consider
whether there is alternative evidence, whether the matters are truly material and whether an audit qualification is
needed. Auditors can exert some pressure on management to sign by making this threat, in practice.
(b) Direct confirmation of receivables
Evidence
(i) Auditors often seek direct confirmation of receivables to ensure that the amounts stated in the entity’s accounts
receivable ledger are not overstated. Confirmation also provides evidence in relation to certain frauds and the quality of
internal controls.
(ii) Confirmation that an amount is owed is not confirmation that the amount will be paid and auditors need additional
evidence on the recoverability of receivables.
(iii) There are two types of confirmation, positive and negative. In the former case, the customer is requested to reply in any
case, and the auditor can either insert the balance to be confirmed or the customer can be requested to do so. In the
latter case, a reply is only requested if the customer disagrees. This method is only suitable where receivables are well-
controlled.
Practical difficulties
(iv) The response rate to requests for confirmations is not always satisfactory and repeated requests may be necessary. It is
not uncommon for replies to be inaccurate, especially where the amount stated is too low.
(v) Where the customer is requested to insert the balance, the reconciliation can sometimes be very difficult, even with the
help of the client, and the customer’s assistance may be needed.

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 Alternative evidence
(vi) Where no reply is received it is important that alternative evidence is obtained on the same balance (and not to test
another balance). Where there is a discrepancy between the client’s records and the customer’s records, the matter
should be investigated and resolved.
(vii) Sometimes, the customer can provide a reconciliation, particularly if the matter only relates to timing differences. On
other occasions there may be a dispute and a provision may be necessary.
(viii) Alternative evidence for receivables includes payment of the amount after the period-end, a review of contracts and
signed delivery notes, and analytical procedures on the ageing of receivables.

(c) Confirmation of inventory held by third parties

Evidence
(i) It is often not possible for auditors to confirm inventory held by third parties by attendance at an inventory count and
therefore the only evidence available is confirmation from the third party.
(ii) It is particularly important to ensure that the confirmation is genuine because of the possibility of fraudulent collusion
between the third party and the client to inflate inventory and profit figures.
(iii) The reliability of service from the third party and the quality of documentation and correspondence are all taken account
of as part of the auditor’s risk assessment in this area.
Practical difficulties
(iv) Both the quality and quantity of inventory held should be confirmed. It is common for third parties to use different
descriptions or units of measurement in their records to those used by the client and it is necessary to reconcile these
items.
(v) It may be possible for the auditor of the third party to provide some evidence in relation to the amounts held.
Alternative evidence
(vi) If the inventory held by the third party is likely to be material, the auditor must consider the possibility of visiting the
third party and attending the inventory count.
(vii) The auditor may review and test the controls over the movement of inventory to and from the third party and the related
records, in order to reduce the level of substantive evidence needed at the period-end.
(viii) Records that show ‘negative’ inventory (more ‘outs’ than ‘ins’) at either the client or the third party may be indicative of
misclassifications, for example.

(d) Reports provided by auditors of service organisations

Evidence
(i) Where an entity has out-sourced a significant element of its accounting function to a third party, as is increasingly
common, the auditor may be forced to assess control risk as high in that area unless he can perform tests of control.
(ii) In testing controls, it may be appropriate for auditors to obtain a letter from the auditors of the service organisation. Such
letters confirm either the suitablility of the design of the system, or the suitability of the design of the system and its
operating effectiveness.
(iii) Only where the latter type of report is obtained can the auditors reduce their assessment of control risk and perform
reduced substantive testing. The auditors should also consider the competence and experience of the service
organisation’s auditors.
Practical difficulties and alternative evidence
(iv) The alternative is to visit the service organisation in order to perform tests of controls, although this may be impracticable
because it might be located on the other side of the world, for example. It may also be costly because it will be necessary
for the auditors to obtain a working knowledge of the third party’s system before it can be tested. Such systems can be
complex.
(v) Auditors have no right to visit the third party or test controls there; if it is considered absolutely essential to do this, the
client may have to bring pressure on the third party to permit it.
(vi) In practice, a client that has out-sourced a significant element of its accounting (or other) functions to a third party may
well have made arrangements in respect of auditors as part of the contractual arrangements with the third party.

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5 Inventories
(a) Importance of inventory
(i) Inventories are important to the financial statements because the inventory figure, particularly for manufacturing
companies, may be material to the balance sheet and income statement, both in the current year and as a comparative
figure.
(ii) Inventories may be high risk if they are valuable, and/or easily portable. The valuation of inventories is a matter requiring
the exercise of judgement, which means that inventories are sometimes used to manipulate the appearance of both the
income statement and the balance sheet.
(iii) In the income statement, there is a direct relationship between the inventory figure and the profit for the period. If closing
inventories are overstated, profits will be overstated.
(iv) Many key accounting and performance ratios are calculated using the inventory figure. These include inventory turnover,
inventory days, the current ratio and working capital ratios. Many companies use these ratios for internal purposes and
many third parties, such as investment analysts, also use these figures to assess performance.
(v) Poor inventory control will be reflected in inventory figures at the period-end. For many companies, excess inventory is
a sign of serious problems.
(vi) Some significant cases of litigation against auditors have involved the alleged overstatement of inventories in financial
statements of companies where the auditors have issued an unqualified audit report before the company has been taken
over.
(vii) There is sometimes relatively little audit evidence for the inventory figure, particularly for small companies and it is
therefore important for auditors to scrutinise the evidence available carefully and consider the scope for misstatement or
deliberate manipulation of the inventory figure.

(b) Cost and net realisable value

(i) IAS 2 requires that cost comprises all costs of purchase, costs of conversion and other costs incurred in bringing the
inventories to their present location and condition.
(ii) Costs of purchase include the purchase price, import duties and other taxes, transport, handling and other costs directly
attributable to the acquisition of finished goods, materials and services. Trade discounts, rebates and similar items are
deducted.
(iii) Costs of conversion include costs directly related to units of production such as direct labour. They also include a
systematic allocation of fixed and variable production overheads that are incurred in converting materials to finished
goods.
(iv) Fixed production overheads are indirect costs of production that remain relatively constant regardless of the volume of
production such as depreciation, the maintenance of factory buildings and equipment and the cost of factory
management and administration. The allocation of fixed overheads is based on a normal level of production.
(v) Variable production overheads vary directly, or nearly directly, with the volume of production and include indirect
materials and labour. The allocation of variable overheads is based on actual levels of production.
(vi) Other costs might include the costs of designing products for specific customers and borrowing costs, which may be
included in certain circumstances.
(vii) Costs not included are storage costs, unless these are necessary to the production process prior to completion, general
administrative overheads and selling costs.
(viii) Net realisable value is the estimated selling price in the ordinary course of business, less the estimated costs of
completion and the estimated costs necessary to make the sale, such as advertising costs.

(c) Audit evidence

(i) The costs of purchase for a furniture manufacturing company will include purchase costs such as the cost of timber,
metals, fabrics, fillings and adhesives.
(ii) These costs can be checked on a sample basis from the inventory records through to the daybooks, ledgers and purchase
invoices, ensuring that the correct amounts have been recorded in the correct period.
(iii) The variable production overheads will include direct labour costs (including tax and social insurance costs), the cost of
power for factory machinery, the cost of small tools and similar items that are directly related to the level of production.
(iv) Direct labour costs can be checked to payroll records, production records, timesheets or clock cards, and payment
records, including entries in the bank statements. It is likely that the cost of power for machinery will have to be
allocated, but if this is not possible it may be necessary to include such costs in fixed overheads. In either case, the cost
can be traced to utility invoices and accruals. The costs of small tools can be checked in the same way as purchase
invoices, ensuring that capital items are not included in the revenue accounts and vice versa.

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 (v) Fixed production overheads will include depreciation of machinery, the cost of heat and light in the factory, factory
administration overheads and storage space for work in progress. It is important to establish that the factory is operating
at a normal level of activity. If it is not, it is not appropriate to include overheads on the basis of an abnormal level of
activity.
(vi) Depreciation can be checked to asset registers. It is important that auditors examine both the accuracy of calculations,
and the reasonableness of the depreciation rates applied as costs may be inappropriately included as assets, otherwise.
Factory administration may include the wages and salaries of those administering the factory payroll for example, and
the costs of the offices in which such staff work. It may be necessary to split such costs out from general administration
overheads that should not be included. The attributable payroll and overhead costs can be checked in the same way as
for direct factory costs.
(vii) Analytical procedures can also be performed on all of the costs noted above and compared with prior periods and
budgets, as well as production levels, profits and factory capacity where they vary directly with production or sales.
Analytical procedures on gross margins will also provide audit comfort on costs.
(viii) Cut-off tests may include checks between inventory records, the inventory itself, and purchase and sales records for a
period just before and just after the period-end. It may also be necessary to examine provisions for goods despatched
or received but not invoiced before the period-end.
(ix) The net realisable value of finished goods will only be relevant if it is likely to be lower than cost, i.e. if furniture is to be
sold at a loss. Auditors should review inventory counting results and inventory records for old or slow-moving inventory
and form an opinion, in discussion with directors, as to whether any such inventories need to be reduced to net
realisable value.
(x) Evidence from post year-end sales or contracts is a good source of evidence in relation to net realisable value. If these
are not available, it is important to review the entity’s previous experience of having to sell furniture below cost. Current
market conditions are relevant as is the existence of a high level of inventories, which may indicate problems.

6 Risks
(a) Transfer, reduce or accept
(i) Contaminated foodstuffs – market share and profit margins
The business would reduce the risk relating to contaminated foodstuffs by having good quality control procedures in
place, by adhering to quality control standards such as ISO 9000, and by commissioning independent audits of the
production process. The business might also try and transfer the risk by means of insurance against the consequential
losses.
The business would reduce the risk of the loss of market share or profit margins by monitoring the activities of
competitors carefully, by monitoring production costs and techniques, and by maintaining an appropriate level of
advertising expenditure and other methods of promoting brand loyalty.
(ii) Non-availability of a basic element of production – injuries to employees or damage to property
It may be necessary to accept these risks as some insurance policies exclude liability caused by events such as ‘acts of
God’ and there is likely to be little cover for a significant world shortage of basic commodities such as sugar.
The business would reduce the risk relating to sugar by maintaining a variety of suppliers. In relation to earthquake, it
would implement normal health and safety procedures to prevent injuries to employees and would maintain the
buildings properly. It would attempt to transfer the risk of any damages payable to employees and the costs of repairing
property by means of insurance.
(iii) Minor damage to property
The business is likely to accept this risk or to transfer it by means of insurance.
Low impact, low likelihood risks are sometimes not viewed as risks at all. They are included for the sake of completeness
in the analysis to ensure that risks have not been ignored as a result of misclassification.
(iv) Drivers involved in vehicle accidents – production employees may be ill.
The business is likely to reduce the risk by maintaining its vehicles and training its drivers, and to transfer it by insuring
against the cost of repairs and lost time. Alternatively, it might require drivers to buy their own vehicles and maintain
them, but permit drivers to claim expenses. Another possibility is a fleet management program dealing with all matters
relating to vehicles, including providing alternative vehicles whilst others are being repaired.
The risk of production employees being ill is likely to be accepted as the cost of transferring it by insurance may not be
worthwhile. The business may reduce it by providing a good working environment, free or subsidised health insurance,
and incentives for good attendance records. It would also plan for a certain level of absences by production employees.

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(b) External auditor use of internal auditor work
(i) The external auditor may review the work performed by internal auditors because financial statement risk may be viewed
as just one part of the overall risk to the business.
(ii) The performance of the risk assessment itself is indicative of good overall management controls.
(iii) The external auditor, with the permission of management and the co-operation of the chief internal auditor, would review
the work performed by the department with a view to ensuring that it appears to be complete, and that classifications
are appropriate.
(iv) It is important to bear in mind that what is low risk or low impact to one entity may be high risk and high impact to
another.
(v) The external auditor will pay particular attention to those risks identified that are either high risk, or high impact. Such
risks may have a material impact on the financial statements.
(vi) The external auditor will then assess how the business has dealt with those risks (by transferring, reducing or accepting
them) and include that risk assessment in his or her own assessment of risk for the financial statements as a whole,
and for particular account areas. This will then affect the nature and extent of audit testing.
(vii) For example, if the risk of contamination to foodstuffs in the production process is not properly managed, there is more
likelihood that a provision may be required at the period-end and there may even be a risk that the business may not
be a going concern if the business is in breach of health and safety regulations.

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Part 2 Examination – Paper 2.6(INT)
Audit and Internal Review (International Stream) December 2002 Marking Scheme

Marks
1 External auditor objectivity
(a) Why external auditor objectivity may be, or appear to be, threatened
Up to 1 mark per point to a maximum of 12
subject to a maximum of 3 for each of the four categories

(b) Requirements
Up to 1 mark per point to a maximum of 8
subject to a maximum of 2 for each of the four categories ____
Total 20

2 Internal controls
(a) Key procedures
Up to 1 mark per point to a maximum of 10
subject to a maximum of 2 for each of the five categories

(b) Internal controls

(i) Receipt, processing and recording
Up to 1 mark per point to a maximum of 6
(ii) Collection of cash
Up to 1 mark per point to a maximum of 4
____
Total 20

3 Audit of payables, accruals and provisions

(a) Company A
(i) 10-year bank loan and bank overdraft
Up to 1 mark per point to a maximum of 5
(ii) Expense accruals
Up to 1 mark per point to a maximum of 4
(iii) Trade payables and purchase accruals
Up to 1 mark per point to a maximum of 6

(b) Company B
Up to 1·5 marks per point to a maximum of 5
____
Total 20

4 Confirmations
(a) Management representations
Up to 1 mark per point to a maximum of 5

(b) Direct confirmation of receivables

Up to 1 mark per point to a maximum of 6

(c) Confirmation of inventory held by third parties

Up to 1 mark per point to a maximum of 5

(d) Reports provided by auditors of service organisations

Up to 1 mark per point to a maximum of 4
____
Total 20

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 Marks
5 Inventories
(a) Importance of inventory
Up to 1 mark per point to a maximum of 5

(b) Cost and net realisable value

Up to 1 mark per point to a maximum of 6
(but only provided that NRV is dealt with in addition to cost)

(c) Audit evidence

Up to 1 mark per point to a maximum of 9
____
Total 20

6 Risks
(a) Transfer, reduce or accept
For each item (i) – (iv)
Up to 1 mark per point to a maximum of 3 per item subject to a total of 12
Some flexibility of mark allocation is acceptable but all areas must have been
addressed in order to obtain maximum marks

(b) External auditor use of internal auditor work

Up to 2 marks per point to a maximum of 8
____
Total 20

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