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External audit is statutory requirement for companies working in public interest. However, statutory requirements of United Kingdom regarding audit allows exemption to small companies from statutory audit. According to United Kingdom regulations, a company is considered small if following conditions are met. Turnover of company is equal to or below £6.5 million, gross assets of company are equal to or less than £3.26 million and/or total number of employees is equal to or less than 50 employees. In contrast to this, certain businesses are not exempt from statutory audit, such as banking and insurance business, regardless of above criteria. Furthermore, shareholders of small companies, having holding equal to or more than 10%, hold the right to demand external audit of their small company.
In case of small companies having exemption from audit, the directors are required to declare on the face of the financial statements that directors are responsible for proper record keeping and accounting of the company and financial statements presented provide a true and fair view of the company's performance and position.
According to corporate governance rules and regulations, an auditor must be appointed where statutory audit is required. The first auditor of a new company is usually appointed by the directors or by the company members (shareholders) at annual general meeting. Where no auditor is appointed by directors or members of the company, the Secretary of State has the power to appoint an auditor. Moreover, auditors should be appointed annually at annual general meeting. Moreover, corporate governance code requires companies to grant access to the books, records, documents and accounts of the company to appointed auditor. Auditor has the right to receive notice of attendance at any general meeting of the company. In addition, auditor holds the right to be heard at that particular meeting. Moreover, auditor has right to receive written notice of intention of company to propose removal of auditor and call extraordinary general meeting at the time of their removal.
Question 1.1 (b)
An audit is an independent examination of the financial statements with a view to express an opinion on the truth and fairness of the financial statements. Truth and Fairness means that information in the financial statements is free from material misstatements, conform to the reality, not false, unbiased, and comply with the applicable technical, professional and legal standards. Information is material if its omission or misstatement could influence the economic decisions of the users taken on the basis of the financial statements.
Overall objective of an audit is to enable the auditor to express an opinion that whether the financial statements are free from material misstatement whether due to fraud or error. So, it increases the credibility of the financial statements and enhances confidence of users in the financial statements.
An audit conducted in accordance with International Standards on Auditing must have regard to the requirements of ISAs, relevant professional bodies, e.g. ACCA, local legislation and regulations, e.g. Companies Acts, the terms of the audit engagement and reporting requirements.
An audit provides reasonable assurance not an absolute assurance. In order to provide reasonable assurance the auditor needs to obtain sufficient and appropriate audit evidence to be able to draw conclusions on which to base the audit opinion.
International Standards on Review Engagements govern the review engagements while statutory audits are governed by the International Standards on Auditing.
Overall objective of the review engagements is to provide negative/moderate assurance while an audit provides reasonable/positive assurance.
In expressing the negative assurance the auditor clearly states that "nothing has come to our attention that causes us to believe that financial statements are not prepared, in all material aspects, in accordance with the applicable financial reporting framework.
The level of assurance dictates the extent of work required. Therefore, more work is done in an audit than a review engagement. In review engagements evidence is gathered primarily through enquiry of the management and analytical procedures.
Question 1.2 (a)
An auditor needs to comply with some fundamental ethical principles and one of those fundamental principles is 'objectivity'. But there are some sources of threats to compliance with the fundamental principle of objectivity.
When a firm receives a high proportion of its fee income from just one audit client, it gives rise to self-interest threat in that the firm will become dependent on the client, and intimidation threat may also arise in the sense that the client may intimidate the firm by threats of, such as, ending-up the business relations with the audit firm.
Therefore, the Code places a threshold on the single audit fee as a proportion of total fee income of the firm to mitigate the threats of self-interest and intimidation. Placement of the threshold encourages the firms to find more clients so that they do not become dependent on one or few number of audit clients. On the other hand, it also reduces the ability of the clients to intimidate the audit firms because they will be acknowledging that the firm's business is not dependent on a single client. This ensures objectivity in the work of the auditors and ensures delivery of quality audits. In addition, it also ensures the independence in appearance.
Question 1.2 (b)
Determining the appropriate basis for the audit fee will involve a substantial number of estimates.
The first stage of setting the audit fee is therefore to ascertain what will be the extent of work required. The job should then be broken down into its respective parts and it should be established that what aspects of the job would be undertaken by what level of staff.
The second stage involves ascertaining which personnel of the staff will be involved and in what proportions they will be involved, i.e. which personnel will be involved, which work will be done by whom ,number of hours/days required from each member of the team to complete the work, etc.
Once the above estimates are made then the firm's standard charge out rates can be applied to that information, and accordingly a fee can be estimated and set.
An issue of 'Lowballing' may arise through competitive tendering. Lowballing gives rise to a self-interest threat to objectivity. However, this threat can be mitigated through safeguards, such as, complying with all applicable assurance standards, guidelines and quality control procedures, maintaining records, etc.
Guidelines state that it is not improper to secure the work by quoting a lower fee so long as the client has not been misled about the level of work that the fee represents.
Question 2.1 (a)
David Chizande and the colleague auditor at Bonney, Kuteszko & Co are brothers. This relation gives rise to self-interest threat to independence. The colleague auditor may lose professional scepticism and may become too sympathetic to the work of his brother and may not report any issue, if any, in his brother's work. However, in order to assess the significance of the threat each situation should be evaluated individually. Factors to consider are:
The colleague auditor's responsibilities on the assurance engagement. These are not clear from the information provided.
The closeness of the relationship. In this case they have very close relationship with each other.
The role of the David at the assurance client, i.e. whether he is in a position to exert direct and significant influence over the subject matter information of the assurance engagement. In this case he may be able to exert to significant influence because there is lack of supervision by Chris and David can easily manipulate the sales results which will form part of subject matter information.
In the light of above analysis it seems appropriate that colleague auditor should not be included in the audit team so that the potential threat is mitigated to an acceptable level.
Question 2.1 (b)
There are five elements of a sound system of internal controls which are listed below:
The Control Environment
Information and communication
The control environment at Edward Golbourne Ltd seems to be weak as the attitude of the sales director is inappropriate because, per scenario, he spends most of the time on roads. His attitude may temp the sales manager to embezzle the cash receipts, alter the sales result, etc. Organisational structure at Golbourne Ltd currently is functional structure, but many of the departments are missing at Golbourne Ltd resulting in one person performing many tasks which can lead them to commit fraud. The accounts department is itself a separate department, so it should not be a sub-section of Administration department. Moreover this structure may not be suitable in the long run to cope with the enhanced business activities of Golbourne Ltd. A divisionalised structure may be more suitable to cope with enhanced business activities, particularly in future if the growth continues.
Risk assessment at Golbourne Ltd also seems to be ineffective, because the scenario states that accounting system is not really appropriate for the size of the business. An efficient risk assessment should've been able to foresee the need for a new accounting system at right time. So, the current accounting system may not be able to cope with business activities and can result in business disruption.
Control activities are in the worst condition. The need for the segregation of duties is being felt for number of roles, such as, the task of chasing outstanding payments should be assigned to credit control department; banking customer receipts, dealing with purchase invoice receipts and supplier payments, all dealing with bankers should be performed by finance department; Raw material ordering, delivery, stock control should be done by the purchase department; control of the payroll function and paying wages should be done by a payroll department, bearing the number of employees at Golbourne Ltd this department should exist. The current desegregation of duties at Golbourne Ltd can result in different frauds, such as cash theft, embezzlement, etc. David should also be assigned as a signatory authority in addition to Amanda, to prevent any possible fake supplier schemes, for example.
Monitoring is also not good at Golbourne Ltd, as internal audit work doesn't cover all areas of their typical responsibilities, such as, assessment of effectiveness of internal controls.
Question 2.1 (c)
The expectations gap is the difference between the actual and the public perceptions of the nature of audit and the level of assurance provided by the unqualified audit report.
Normally general public expects from auditors that auditors accept responsibility of financial statements. Actually, it is responsibility of board of directors.
Directors of Edward Golbourne Ltd do not properly understand their roles and responsibilities regarding external and internal audit. Therefore, it is expected that they may perceive that auditors certify financial statements and provide guarantee that accounting records are 100% accurate while this is not the case. Auditors neither certify financial statements nor they provide guarantee on 100% accuracy of accounts, in fact auditors provide reasonable assurance on the accuracy of accounting records. It is impracticable for auditors to verify 100% accounting records. Therefore, audit is conducted on the basis of materiality/sampling techniques.
Moreover, they may also expect that fraud detection is prime responsibility of auditors but actually fraud detection is prime responsibility of board of directors and it is secondary responsibility of auditors.
Engagement letter ensures that all parties of audit i.e. external auditor and board of directors understand what their respective roles and responsibilities in relation to particular audit are. Engagement letter also clarifies scope of audit to board of directors that audit will be conducted on sampling/materiality basis in accordance with international standards on auditing. Moreover, engagement letter also indicates audit fee so that management does not create an issue on audit fee at later time. Furthermore, engagement letter helps to ensure that management understands the expected form of reports and other communications during and after completion of the audit engagement. Inclusion of these terms in engagement letter would also help to reduce expectation gap of Edward Golbourne Ltd's directors regarding nature, purpose and scope of audit.
Ref: Engagement Letter for External Audit
Date: 25th August, 2012
To: Edward Golbourne Ltd
From: Bonney, Kuteszko & Co.
Dear Board of Directors,
The purpose of this letter is to set out the basis on which we are to act as auditors of the Edward Golbourne Ltd and the respective areas of responsibility of the Edward Golbourne Ltd and of ourselves.
RESPONSIBILITIES OF EDWARD GOLBOURNE LTD AND AUDITORS
1. As Edward Golbourne Ltd, you are responsible under the international financial reporting framework for maintaining proper books or records of accounts and other financial records. You are also responsible for preparing accounts which present fairly the financial transactions and financial position of the Edward Golbourne Ltd.
SCOPE OF AUDIT
2. Our audit will be conducted in accordance with International Auditing Standards issued by the International Auditing and Assurance Standards Board, and will include such tests of transactions and of the existence we consider necessary. We shall obtain an understanding of the accounting systems and internal control systems in order to assess their adequacy as a basis for the preparation of the accounts and to establish whether proper books of accounts have been maintained by the Edward Golbourne Ltd. We shall expect to obtain such appropriate evidence as we consider sufficient to enable us to draw reasonable conclusions there from.
3. Our fees are computed on the basis of the time spent on your affairs by the partners and our staff and on the levels of skill and responsibility involved. The audit fee can also be a fixed fee agreed before commencement of audit. Unless otherwise agreed, our fees will be billed at appropriate intervals during the course of the audit and will be same as agreed during presentation.
AGREEMENT OF TERMS
4. We shall be grateful if you could confirm in writing your agreement to these terms by signing and returning the enclosed copy of this letter.
Bonney, Kuteszko & Co
We agree to the terms of this letter.
Board of Directors, for and on behalf of
The Edward Golbourne Ltd
Question 3.1 (a)
Liquidity ratios have deteriorated. Current ratio has fallen from 1.96 to 1.86, and quick ratio has fallen from 1.09 to 0.96, by this year from last year. Acceptable levels of liquidity ratios vary from industry to industry. As industry figures are not given, so generally current ratio between 1.5 to 3 and quick ratio more than 1 is acceptable. So, current ratio of Golbourne Ltd seems to within acceptable level but quick ratio is lower than acceptable level. Moreover, considering the fact that the balance of cash in hand/bank is nil so it may be that the company may find it difficult to meet its short-term liabilities if they fall due.
Gearing ratio has improved from 34.13% to 28.09% in this year from last year, because company has raised shareholder funds. Earnings per share of Golbourne Ltd are almost same as industry average, but the concern here is that if the company continues to pay more than what it is earning then it would result in negative retained earnings and company may find it difficult to finance any future projects. Additionally, negative retained earnings can raise doubts on the entity's ability to continue as going concern.
Inventory has increased by 72.92% while costs of sales have risen by just 22.39% and inventory holding period has increased from 42.12 days to 59.99 days from last year to current year and industry average is 40 days. Golbourne has purchased the inventory in excess of what is being used in production, so there is a risk that inventory may have become obsolete or realisable value of inventory may have fallen. So, a write-off or an impairment charge may not have been recognised, resulting in understated manufacturing costs and overstated profits and inventory.
Accounts receivables have risen by 62.96% and sales have been increased by 47.06% from last year. It indicates that there are some long outstanding receivables. Moreover, receivable days have increased from 32.21 to almost 42 days and the industry average receivable days are 35 days. Therefore, deteriorating position of receivables days indicates that there is a risk that receivables may have become impaired and the Golbourne Ltd may not have charged the impairment of receivables, resulting in overstated profits and receivables.
Account payable days have increased from 39.92 days to 56.01 days and the industry average of accounts payable days is 50 days. So, such downward trend in working capital cycle shows that Golbourne Ltd may not be able to finance its day-to-day activities and it may raise doubts on the entity's ability to continue as a going concern.
Distribution costs have doubled this year from last year and is reasonably in excess of budgeted figures. Ideally, increase in the distribution cost should be less than increase in the %age sales due to economy of scale. Therefore, such dramatic increase indicates that there is a risk of misclassification of expenses between manufacturing costs and distribution costs.
All calculations are shown below:
Inventory holding days(inventory/manufacturing costs)*365
Payable days(accounts payable/manufacturing costs)*365
Accounts receivable days(receivable balance/sales)*365
Bank and cash
Gearing ratio( debt/equity)
Current ratio(current assets/current liabilities)
Question 3.1 (b)
Misstatements, including omissions, are considered to be material if they, individually or in aggregate, could reasonably be expected to influence the economic decisions of users taken on the basis of the financial statements.
An item can be material by its nature, value and impact on the users of the financial statements. Materiality assessment will help the auditor to decide how many and what items to examine, what level of misstatement is likely to lead to a modified audit opinion, etc.
Disaggregating the information helps the auditor to review the information analytically. An example of disaggregation of information is that it allows the auditor to break down the current assets and liabilities into different parts for analytical review by calculating receivable days, creditor days, inventory days, current ratio, quick ratio, etc. Doing so helps the auditor to identify any unusual trend(s), relationship(s), significant transaction(s) and account balances(s). It allows the auditor to directly hit the areas where there is a high risk of misstatement(s). Therefore, it results in cost efficient and quality audits.
Question 3.2 (a)
There are four risk elements of the audit that are listed and explained below:
Inherent risk is the susceptibility of an account balance or class of transactions to material misstatement, either individually or when aggregated with misstatements in other balances or classes, irrespective of related internal controls. Inherent risk arises due to the factors, such as the fact that they are estimates or that they are important items in the accounts. Auditor can obtain evidence about inherent risk by understanding the entity, its business, the environment in which it operates. An auditor can gain understanding of the entity, its environment and its business by getting familiar with nature of the entity's business, applicable financial reporting framework, industry regulations and its internal controls system, etc.
Control risk is the risk that a misstatement could occur in an account balance or class of transactions which could be material, either individually or when aggregated with misstatements in other balances or classes, and would not be prevented, or detected and corrected on timely basis, by the accounting and internal control systems. An auditor can obtain evidence about the control risk by carrying out the testing of controls at client. Control testing assesses that whether the controls exists and effectively working and whether they are being complied with and whether these controls are being monitored.
Detection risk is the risk that the auditor's substantive procedures will fail to detect a misstatement that exists in an account balance or class of transactions that could be material, either individually or when aggregated with misstatements in other balances or classes. Detection risk can be reduced by increasing the work of the auditor, i.e. by increasing the amount of substantive procedures.
Audit risk is the risk that auditors may give an inappropriate opinion on the financial statements. Audit risk depends on the inherent risk, control risk and detection risk.
Question 3.2 (b)
There are various methods that an auditor can use to obtain evidence but 5 of these are listed and described below:
Inspection of Assets
Inspection of assets that are recorded in the accounting records confirms existence, gives evidence of valuation of assets. Confirmation that assets seen are recorded in the accounting records gives evidence of completeness. So, auditor at Golbourne Ltd can physically inspect the assets to confirm the above assertions.
Inspection of Documentation
Confirmation to documentation of items recorded in accounting records confirms that an asset exists or a transaction occurred. Inspection also confirms completeness of transactions and assets recorded. Cut-off can be verified by inspecting reverse population. Inspection of documentation also provides evidence of valuation/measurement, rights and obligation. At Golbourne Ltd auditor can inspect on sampling basis that whether cheques are signed by Amanda to confirm authorisation. It will help him in assessment of control systems at Golbourne Ltd. Auditor at Golbourne Ltd can also confirm the assertions above by inspecting the documentations, such as he can ensure himself that sales figures recorded are complete and transactions have actually occurred. He can also inspect the documents of purchase transactions to verify their occurrence, accuracy, etc.
It involves checking arithmetic accuracy of client's records. For example, auditor at Golbourne can add-up the sales ledger account, recalculate the depreciation charge.
It involves seeking confirmation from another source of details in client's accounting records. At Golbourne Ltd, auditor can seek confirmation from, for example, suppliers to confirm rights and obligations and accuracy of accounts payables.
Reperformance is the auditor's independent execution of procedures or controls originally performed as part of the entity's internal control. At Golbourne Ltd auditor can enter an assumed sales transaction to assess that whether the system process it accurately and completely, for example.
Question 3.3 (a)
Normally the auditor uses the work of an expert to obtain audit evidence in areas where he doesn't possess the expertise. So, if the auditor using the work of an auditor's expert concludes that the work of that expert is adequate for the auditor's purposes the auditor may accept that expert's findings or conclusions in the expert's field as appropriate audit evidence. Following are the examples of areas where auditor might use the work an expert:
Valuations of complex financial instruments, land and buildings, plant and machinery, etc.
Determination of amounts using specialised techniques, for example pensions accounting.
In order to determine the extent to which work of an expert can be relied upon the auditor should evaluate whether the expert has necessary competence, capabilities and objectivity for the auditor's purposes. Doing so the auditor should consider the expert's professional certification, or membership of an appropriate professional body, his experience in that field, whether he is related in some manner to the entity, for example, by being financially dependent upon the entity, etc.
Auditor should also evaluate the adequacy and reasonableness of the expert's findings or conclusions in order to determine the extent of reliance on his work. It will require the consideration of the source data, assumptions and methods used by that expert.
Question 3.3 (b)
At Golbourne Ltd no separate internal audit function is organised. Ideally internal audit activities should be carried-out by the members of internal audit function, but at Golbourne Ltd these activities are carried-out by members of accounts department. Therefore, it is likely that they would not report any issue that they may find in their own work, so it gives rise to the issue of objectivity.
The work carried out by internal audit function is also very narrow in its scope as they are not covering many other areas of their roles, such as, fraud risk identification, value for money audit, testing the effectiveness of internal controls, etc.
Ideally the internal audit function should report to an audit committee. At Golbourne Ltd the chief accountant would be reporting to the same persons whom performance he would be assessing. So, it raises doubts on the independence of the internal auditor.
Sean is also responsible for accounts related works, as he is a chief accountant, so it is unlikely that the level of supervision and review of work of junior staff members by Sean would be sufficient and appropriate.
So in the light of above weaknesses in internal audit function it is likely that very little or no reliance will be placed on the work of internal auditor.