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ACCA P7 Interim Assessment - Answers 2014
acca financial reporting (ACCA F7)
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ACCA
Paper P
Advanced Audit & Assurance
December 2014
Interim Assessment – Answers
To gain maximum benefit, do not refer to these answers
until you have completed the interim assessment
questions and submitted them for marking.
ACCA P7 : ADVANCED AUDIT & ASSURANCE
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ACCA P7 : ADVANCED AUDIT & ASSURANCE
The grant of a licence may be valued at either cost or fair value. The directors have estimated the fair value, which is inherently risky. The licence may be unique (i. for a period of five years in a national park) and in the absence of an active market it appears unlikely that an estimate of fair value can be justified.
Even if the fair value can be estimated there is a risk that the amortisation of the licence is incorrect. The intangible should be amortised over its useful life. In this case the useful life is only four years, not the full five years granted. This is because the project is due to complete in winter 2016 and the gravel quarried at the site is exclusively for this project. If amortised over five years the annual charge will be $150k pa, whereas over four years it would be $188k. The difference is not material.
Restoration There is a risk that provisions are overstated and intangible assets are understated. At 3% of profit and 0% of total assets the annual provision for restoration is not material to the accounts. However, annual provisioning is contrary to IAS 37. An estimate of the full cost of restoration should have been made at the outset and included in the cost of the license on the statement of financial position. Presumably the full cost will be (4 x $75k) $300k, which should be discounted to a present value. Using an estimated rate of 7% the appropriate discount factor would be 0. This would provide an additional intangible asset of $230k. This approximation represents 1% of total assets and 9% of profits which is material.
The additional cost would also require amortisation over the four year useful life of the licence. This would lead to additional amortisation of $58k per annum. Whilst this is not material on its own it may be in conjunction with other adjustments proposed to the annual amortisation charge.
Government Grant There is a risk that other income is overstated and that deferred income liabilities are understated.
The grant should not be recognised in income until all the conditions have been satisfied. The grant should be held on the statement of financial position as deferred income and released to the statement of profit or loss to match the costs incurred meeting the recruitment/training goal.
Trevor Cramphorn has recorded all $200k in this year’s statement of profit or loss. It is likely that the grant has some condition relating to the retention of local employee’s for the duration of the project.
In this instance it would be prudent to release $50k per annum to the statement of profit or loss to match the four year life of the project. In this case the $150k reduction of income and the consequent recognition of deferred liabilities would be material to the statement of profit or loss at 6% of profits (although not to the statement of financial position at less than 1% total assets).
INTERIM ASSESSMENT ANSWERS
New Non Current Assets
There is a risk that non-current assets are overstated on the statement of financial position.
As per IAS 16 the new machinery and vehicles should be depreciated over their useful economic lives. According to IAS 16 this is the period over which they will provide benefit to the reporting entity. So, whilst the machinery may have a total life of 10 years, the useful life to Moonstone is only four years because after this period they will be sold.
Moonstone should depreciate these assets down to their residual value ($250k) by 30 November 2016. This would require an annual depreciation charge of $188k, not the $100k currently being applied. Whilst this is not material to the accounts it will lead to a cumulative error that would become material in the next accounting period. However, it is likely that this adjustment in combination with the other proposed increases in amortisation will be material to the 2013 accounts.
Provision for Staff Fatality
There is a risk that provisions are understated.
As per IAS 37 Moonstone should provide for all foreseeable costs that meet the following criteria:
y Present obligation as a result of a past event.
y Probable outflow of economic benefit.
y Reliable measurement of the amount.
Whilst Mr Moon finds the widow’s response laughable there is a real possibility that she will pursue legal compensation for her husband’s death. In this case it is likely that Moonstone will incur significant fines or penalties.
At this point it is impossible to estimate the amount to provide. It would be necessary to contact the company’s solicitors. However, it should be reviewed as part of audit testing. If the criteria are not met then there is almost certainly a case for recording a contingent liability in the notes to the accounts.
Provisions due to Environmental Protests
Again there is a risk that provisions are understated.
As per IAS 37 Moonstone should perhaps make a provision for any legal costs they incur challenging the environmentalists case to close the site down. It is unclear whether such costs would be material to the accounts. In addition to this there is a direct threat to the continuance of the M project. If this is shut down Moonstone would lose significant amounts of revenue and be left with large amounts of new plant and equipment that has no use elsewhere in the business. If this were to happen there would be serious implications to the going concern status of Moonstone and, once again, it must be ascertained whether the accounts should be prepared on a break up basis. Other Issues
There is some concern over the accounting controls within Moonstone. The FD, Trevor Cramphorn, appears to have a limited knowledge of the requirements of accounting standards and the MD, Alfie Moon, appears too eager to overlook certain issues that could have significant financial
INTERIM ASSESSMENT ANSWERS
(b) Audit Exemption
Arguments in Favour
The main arguments in favour of increasing the audit exemption limit can be summarised as follows:
Reduction of the costs of compliance imposed on smaller companies, which in turn may encourage unincorporated businesses to incorporate.
The granting of choice to smaller companies. Those companies whose stakeholders make substantial use of the financial statements may continue having a full audit performed to maintain the credibility of the financial statements; those who make little use of the statements (e. proprietary companies largely financed by the owner/ directors) may choose to dispense with a full audit.
In any event, it is becoming increasingly common for lenders and other interested parties to place more reliance on information which is not covered by the scope of the statutory audit, for example cash flow projections, personal guarantees of directors, etc. This trend reduces the importance of the role of a full audit for many smaller companies.
The use of an independent professional review will provide assurance (moderate assurance) that the financial statements are free from material misstatement at a lower cost to the company.
An independent professional review should ensure that appropriate accounting standards have been applied.
If users require a full audit (or other assurance service), they can request one which is specific to their needs.
In setting the audit threshold, a distinction should be made between ‘public interest’ entities and others.
Arguments Against
Arguments against increasing the audit exemption limit include the following:
Financial statements will lose a degree of credibility if no independent check is performed at all or if an independent review with a narrower scope replaces a full statutory audit.
Scope for the manipulation of financial statements will be increased for those companies or their directors who may feel inclined to undergo manipulation.
It is undoubtedly the case that some stakeholders place heavy reliance on audited financial statements when making decisions. The loss of the assurance currently provided by a full audit may have significant repercussions on the decision-making processes of a variety of stakeholders, including, for example, banks when considering lending decisions and tax authorities when levying corporate income and other tax charges.
Overall, the quality of financial reporting may suffer since auditors police compliance with statute law and accounting standards. This service is widely relied upon by smaller companies, who tend to find it difficult to apply the more complex aspects of, say, IASs and may leave much of the more technical aspects of their financial reporting to their auditors.
Companies not subject to a full audit are losing more than a simple ‘verification process’. Modern auditing will often identify weaknesses in controls and systems, and suggest suitable improvements. Many auditors now take a ‘value-added’
ACCA P7 : ADVANCED AUDIT & ASSURANCE
approach to their audits, aiming to provide client companies with practical business advice. This broader aspect of the role of the auditor may be lost to smaller companies – who may need it most – if the audit exemption threshold is increased.
ACCA marking scheme Marks (a) Report to Engagement Partner (i) Audit risks: Generally ½ mark each risk identified (to a maximum of 4) and up to 1½ marks for a thorough discussion Ideas
- Materiality calculations (½ each, max 2)
- Industry decline (and going concern risk)
- Licence − Fair value estimate − UEL
- Restoration provision
- Grant deferred income
- Non-current assets UEL
- Provision for staff fatality
- Provision for protests
- Other issues (max 1 mark) Maximum 14 (ii) Principle Audit Work on UEL of Licence: Generally 1 mark per explained procedure (1/2 mark for just listing procedure).
- Inspect licence
- Inspect supply contracts
- Inspect press reports
- Inspect forecasts
- Analytically review forecasts to actual
- Enquiry of directors re. forecasts
- Review assumptions
- Inspect/re-compute impairment reviews
- Enquire about forecast dates of supply
- Inspect board minutes
- Re-compute UEL Maximum 7 Professional marks: 1 mark for report format, 1 for introduction/ conclusion and up to 2 marks for presentation of report and clarity of explanation Maximum 4 (b) Audit Exemption: Generally 1 mark for each well explained argument Argument for increasing exemption limit Ideas
- Reduction in costs of compliance
- More choice
- Lenders reliance on other reports
- Can choose review at lower cost than audit
- Review will ensure compliance with accounting standards
- Specific audit could be requested
- Public interest Argument against increasing exemption limit Ideas
- FSs will lose credibility
- Increase risk of management manipulation of figures
- Stakeholder reliance
- Reduction in quality of financial reporting
- Added value of audit Maximum 10 Total
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ACCA P7 : ADVANCED AUDIT & ASSURANCE
The company may be seeking to protect margins by sourcing inferior quality supplies. There is evidence of increasing product defects and returns during the year. From a business perspective this could lead to the loss of customer goodwill and reduced repeat trade, not to mention the damaging effect on Macrohard’s reputation.
Cash flow The current cash flow crisis may have serious implications and repercussions for the business. Macrohard are currently in arrears with tax payments. This could ultimately lead to penalties and interest may be accruing on tax liabilities still outstanding.
An inability to pay debts on time may also lead to suppliers withdrawing credit facilities or, in the worst case scenario, refusing to supply Macrohard. This would place an even bigger cash burden on Macrohard as it would be likely that new suppliers would seek credit references and also refuse them credit.
Given the current cash position of the company the bank may refuse the application for the loan. The contracts for the building work have already been signed and construction has commenced. Failure to secure funding could have a disastrous effect on the business. Once again they would possibly be subject to penalties for breaking the terms of the contract. They will at least have to pay any legal fees incurred, design fees and fees for construction to date. Historic problems with credit control could be exacerbated by anticipated growth. The employment of a bookkeeper may not necessarily solve this problem given that the bookkeeper’s primary function will be to maintain the accounting records of the business. This in itself appears as though it will provide some challenge given the obvious deficiencies in the system due to the material unreconciled differences and the difficulties experienced processing meaningful management accounts. This may be heightened by the fact the bookkeeper is not a qualified accountant. In all there is concern over the accounting and credit control environment. Managing director The company operates under the dominant influence of Mr Fence, who is also the majority shareholder. As a result he is able to abuse his authority and put the remaining shareholders’ investments at risk, for example by committing the company to a building contract without consultation and without the necessary funding secured.
The company’s systems may also be prone to error because the organisation structure appears inadequate to cope with the size and growth of the business. This would be particularly evident if Mr Fence were absent for any period of time. Given the lack of a qualified accountant, or experienced supervisor of any form, it is likely that errors would go undetected.
There also appears to be a high risk of management bias, leading to manipulation of the accounts, because:
The bank are basing their loan decision on profit forecasts. Mr Fence is seeking repayment of his director’s loan. Mr Fence is seeking to increase his remuneration. One way of achieving this might be to introduce some form of performance bonus based on profits.
INTERIM ASSESSMENT ANSWERS
Financial information and internal systems
The annual budget and management accounts are not sufficiently accurate to provide information for decision-making purposes. There are also discrepancies in the control accounts that could indicate that proper accounting records have not been kept. Whilst the difference on the payables ledger is immaterial at 0% of total assets the difference on the receivables ledger represents 1% and, hence, is a material discrepancy.
It must also be considered that the new computer system, which may be prone to initial ‘teething problems’ could lead to errors. If the system proves to be deficient in any way it may be difficult to rectify the problem because the author of the software works for the police force, and is unlikely to assist given that he is now Mr Fence’s ex-brother-in-law. Macrohard do not appear to employ an IT specialist and they do not appear to have any maintenance contracts.
Given these doubts it is considered highly unlikely that the management team (Mr Fence) will have reliable information upon which to base strategic decisions and this casts doubts upon the businesses future success.
Going concern The company may not be a going concern given all of the issues mentioned above:
- Threat of obsolescence of inventory
- Exposure to exchange rate fluctuations
- Cash flow problems
- Loan application
- Bad publicity and damage to reputation
- Poor control environment.
Conclusions
Macrohard appear to be facing a number of serious business risks, most of which appear to relate to the chosen methods of operation and internal growth strategies. In combination they appear to suggest there is significant doubt over the company’s ability to continue as a going concern into the foreseeable future. The poor internal controls, the cash flow difficulties being experienced and the perceived deteriorating quality of the products could all conspire against the business in the short term. All these factors must be considered before we decide to nominate ourselves as auditors.
(ii) Factors to Consider before Making a Proposal for the Audit
Standard considerations
Independence
In accordance with the Ethical Code of Conduct, Vitality & Sons must consider whether they are in a position to carry out the engagement independently. They must consider whether there are any relationships with the client or their shareholders to avoid any self interest threats.
Vitality should also consider whether they perform any other accounting services for the client to avoid any self review threats. This could become a problem in the future because Mr Fence has indicated he would like to receive advice about a potential stock market flotation. It must be considered whether
INTERIM ASSESSMENT ANSWERS
Going concern Many of the points covered so far indicate potential going concern problems, for example:
a need for new finance exceeding overdraft limits
tax payment arrears overdue amounts from customers
faulty products over-reliance on Mr Fence. The assessment of going concern will become a significant risk area of the audit. More importantly, from a credit control perspective, Vitality & Sons must be certain that they can recover any fees from Macrohard. Given their current situation it might be considered too risky to offer the company any form of credit and serious consideration should be given to whether to offer any services at all. Audit evidence
A number of factors indicate problems with the availability of reliable audit evidence. In the main, these problems arise from poor accounting systems and a high possibility of management override. It may, of course, be possible that the recently recruited bookkeeper could improve the current systems but there is insufficient information with regard to the calibre of this recruit. This may make it difficult to support audit objectives and, ultimately, this could impose a limitation to the sufficiency of audit evidence.
Potential modification Any going concern uncertainty must be adequately disclosed in the financial statements. If there is not adequate disclosure, a modification would result. Although this in itself is not a reason for declining to make a proposal, it would appear prudent to assess Mr Fence’s possible reaction to such an outcome. Fees These are always an important factor in any proposal. However, there can be no doubt Macrohard would be a high-fee client and it should be considered how sensitive Mr Fence will be to the fee basis.
(b) Money Laundering Procedures
Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the proceeds of criminal activity, allowing them to maintain control over the proceeds, and ultimately providing a legitimate cover for their sources of income. The objective of money laundering is to break the connection between the money, and the crime that it resulted from.
ACCA P7 : ADVANCED AUDIT & ASSURANCE
Procedures performed prior to and on acceptance of a client include: (1) Client Due Diligence:
y Establish the identity of the entity, its business activity, the key
individuals involved and its address by:
Obtaining a certificate of incorporation
Obtaining a copy of the registered address
Obtaining a copy of the register of shareholders and directors. If the client is an individual, obtain official documentation including:
Passport
Photographic drivers licence
Recent utility bills.
(2) Consider whether the commercial activity makes business sense (i. it is not just a ‘front’ for illegal activities) (3) Client understanding:
Pre-engagement communication may be considered, to explain to Mr Fence, and any other directors, the nature and reason for client acceptance money laundering procedures. Best practice also recommends that the engagement letter should include a paragraph outlining the auditor’s legal responsibilities in relation to money laundering to avoid any problems if a conflict of interest with confidentiality arises.
ACCA P7 : ADVANCED AUDIT & ASSURANCE
3 HENLEY CO
Key answer tips Part (a) is a typical requirement of the completion questions that appear in the P7 exam. Matters to consider at the review stage include: materiality, the relevant accounting treatment, whether sufficient appropriate evidence has been obtained and the risk of material misstatement.
Remember to describe the evidence you would expect to see on file carefully. You must ensure that you describe the documentation that the audit team should have prepared in order to demonstrate the audit procedures performed and the results of those procedures. Part (b) is more unusual, and requires a good understanding of one of the most fundamental concepts in auditing, materiality. Knowing the commonly used thresholds is important in securing a good mark. Part (c) is more unusual, but a common sense approach will provide a good answer. Note the three overarching reasons why a company would change auditor, i. because they want to, because they have to, or because the auditor chooses to end the relationship.
(a) Matters to consider IAS 12 states that a deferred tax asset can only be recognised where the recoverability of the asset can be demonstrated. Unutilised tax losses can be carried forward for offset against future taxable profits, so one matter to consider is whether Henley Co has demonstrated that future tax profits will be available for the losses to be fully utilised. If this has not been demonstrated then the deferred tax asset recognised should be restricted to the level of future profits that can be measured with reasonable certainty. The financial statements currently show a profit before tax of $0 million and it is the first year that Henley Co has made a profit. Given this detrimental underlying trend in profitability, and given the past losses generated by the company, it could be difficult to demonstrate that the tax losses are recoverable against future profits. If this is the case then the deferred tax asset is overstated. At $60,000 the deferred tax asset is material: $60,000 is 12% of profit before tax, 0% of revenue and 1% of total assets. If the deferred tax asset is overstated, the financial statements may therefore be materially misstated, dependent on the level of future profits that can be measured with reasonable certainty. Audit Evidence
A copy of Henley Co’s current tax computation and deferred tax calculations with figures agreed to any relevant tax correspondence and/or underlying accounting records.
An independent expectation of the estimate and compared to management’s estimate and confirmation of the reasonableness of the latter.
INTERIM ASSESSMENT ANSWERS
Copies of forecasts of profitability and agreement that there is sufficient forecast taxable profit available for the losses to be offset against.
An evaluation of the assumptions used in the forecast against business understanding. In particular consideration of assumptions regarding the growth rate of taxable profit in light of the underlying detrimental trend in profit before tax.
An assessment of the time period it will take to generate sufficient profits to utilise the tax losses, including a conclusion whether the recognition of the asset should be restricted if it is going to take a number of years to generate such profits.
Copies of relevant tax correspondence, to verify that there is no restriction on the ability of Henley Co to carry the losses forward and to use the losses against future taxable profits.
(b) Materiality
Materiality was initially set at $95,000 based on a profit before tax of £500,000 and revenue of £7 million.
This in itself may be high as it is above normal benchmarks and as this is the first year that the firm has audited Henley Co, detection risk is therefore already high. It would therefore have been appropriate to set preliminary materiality at the lower end of the traditional ranges used for materiality.
Based on the initial figures in the draft financial statements, $95,000 represents 19% profit, 1% of revenue and more than 2% of total assets. These are all more than the higher end of the traditional materiality benchmarks (5% profit before tax, ½% revenue and 1% total assets). In particular, this is nearly double the higher end of the traditional benchmark for profit.
This is the first year that Henley Co has made a profit, and therefore using profit may give an unreasonably low level of materiality. It may therefore be more appropriate to set materiality using revenue and total assets.
More than $92,000 (2% total assets) is material to the statement of financial position therefore materiality should have been set so as not to exceed this amount. Less than $35,000 (½% of revenue) is not material to the statement of profit or loss (or to the statement of financial position) so materiality should not be less than this amount. $46,000 (1% total assets) represents 0% revenue. As this is at the lower end of the assets range, this would be a relatively prudent measure of materiality (resulting in a higher level of audit work). $70,000 (1% of revenue) represents 1% of total assets. Materiality might be set at this end of the range had this been a recurring audit. However, as this is a first audit, materiality is likely to be lower.
The materiality set of $95,000 is in excess of the range suggested above. Setting materiality at this level would significantly increase the risk of giving an inappropriate opinion. This level of materiality would not be appropriate.
Materiality may need to be revised as a result of new information or a change of the auditor’s understanding of the entity and its operations as a result of performing further audit procedures. For example, if during the audit it appears as though actual financial results are likely to be substantially different from the anticipated period-
INTERIM ASSESSMENT ANSWERS
- The audit firm may decide to resign based on strategy, e. a decision to concentrate in other markets/industries.
ACCA marking scheme Marks (a) (i) Matters to consider Generally 1 mark per matter:
- Offset losses against future profits – if any
- May not generate sufficient future profits
- Material
- FSs materially misstated if restriction necessary Maximum 3 (ii) Evidence Generally 1 mark per evidence • Tax computation
- Independent estimate
- Forecasts
- Evaluation of assumptions
- Assessment of time period
- Tax correspondence Maximum 4 (b) Materiality Generally 1 mark per comment: • High risk – materiality appears high
- Calculations
- Profit not appropriate measure
- Max/min figures
- $46,000 prudent
- First audit – appropriate to use lower ends of thresholds
- Materiality is above max threshold – audit risk high
- Revise materiality
- Additional audit procedures may be necessary
- Adjustments will also impact materiality Maximum 7 (c) Reasons for changing auditor Generally, up to 1 mark per adequately discussed reason. Maximum of 3 within each category:
- Chosen to change
- Compelled to change
- Auditor resigns/retires Maximum 6
Total
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ACCA P7 : ADVANCED AUDIT & ASSURANCE
4 GOLD PARTNERS
Key answer tips This question is typical of many of the ethical and professional issues questions that appear in the P7 exam.
Remember that the auditor will always consider the significance of a matter as part of evaluating the issue. Don’t forget to consider both ethical and professional issues.
When discussing relevant actions, the focus for ethical issues will be safeguards – include any specific rules within the Codes of Ethics.
Finally, note the number of marks that are available for each scenario described, and adjust the number of points you write accordingly.
(i) Sprinters Co The IFAC and ACCA Codes of Ethics state that a business relationship involving the purchase of goods or services from an audit client by the audit firm does not generally create a threat to independence if the transaction is:
- In the normal course of business
- On an arm’s length basis
(UK Syllabus: Business relationships are permitted under ES2 as long as the arrangement is: in the ordinary course of business, on an arms length basis and not material to either party)
However, if they are of such nature or magnitude that they create a self-interest threat, steps should be taken to eliminate or reduce the magnitude of the transaction.
Leasing properties is in the ordinary course of business for both parties.
‘Market rate’ implies that the transaction is on an arm’s length basis. As both parties are large, the transaction is not likely to be of such magnitude that it creates a self-interest threat. Sprinters have a large number of properties throughout Olympia and Gold Partners has 18 other offices. Gold Partners should consider whether the rate charged by Sprinters will be competitive, whether any of the vacant properties are in a suitable location, and whether the contract is appropriate (notice period, what’s included, clauses, length etc). Assuming Gold Partners is satisfied that the contract with Sprinters Co is suitable for the firm’s needs, it would appear to be appropriate to accept the Sprinters Co’s offer to lease one of their properties. (ii) Velodrome Co
Familiarity and self-interest threats are created by using the same senior personnel on an audit engagement over a long period of time. The personnel may be too trusting of the client, or reluctant to challenge the client or modify the audit opinion for fear of damaging the client relationship.
ACCA P7 Interim Assessment - Answers 2014
Module: acca financial reporting (ACCA F7)
University: Association of Chartered Certified Accountants
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