SOLUTION SET 1 ANSWERS 1 Part A a) The elements required for establishing an auditor s liability for negligence to clients are: 1. The duty to conform to a required standard duty of care 2. Failure to act in accordance with that duty 3. A causal connection between the negligent action and the client s damage, and 4. Actual loss or damage to the client (4 marks) b) The following measures can be taken at the firm level to minimize legal liability against auditors: 1. Instituting sound quality control and review procedures 2. Ensuring that members of the firm are independent 3. Following sound client acceptance and retention procedures 4. Being alert for risk factors that may result in lawsuits 5. Performing and documenting work diligently 6. Pushing for tort reform (any 3 x 1 mark = 3 marks) Part B The public accounting firm, AH & Co., is potentially liable to its client because of the possible negligence. The audit senior-in-charge apparently has failed in carrying out his duties within the scope of his employment. To be successful in a legal action for negligence, the following 4 elements must be proven: The auditors owed a duty of care The auditors breached the duty of care Plaintiff suffered financial loss There is a causal relationship between the breach and his financial loss The main issue here is whether the duty of reasonable care was breached when the senior-in-charge failed to probe further the twenty disbursements without receiving reports. The senior-in-charge of the audit is governed by the usual professional standards in auditing, that is, he should perform his duties according to the requirements of the prevailing standards. However, when the exceptions in the purchase and disbursements transactions were brought to his attention, he did not investigate further. The exceptions in this case constituted 20% of the vouchers payable examined, it is therefore doubtful whether he has conducted the audit properly and obtained the necessary audit evidence. 1
On the question of causal relationship, the plaintiff would have to substantiate whether further actions by the senior-in-charge would have disclosed the fraud. If the plaintiff can establish both the lack of due care and causal relationship, recovery for negligence will be available. If the auditor is found to be negligent, the liability would be limited to those losses that would have been avoided if reasonable care has been exercised by the senior-in-charge. (8 marks) [Total: 15 marks] QUESTION 2 a) The objective of sales and collection cycle is to evaluate whether the account balances affected by the cycle are fairly presented in accordance with generally accepted accounting principles. b) Strengths of the control procedures: c) Possible misstatements i. Adequate documents and records Prenumbered ii. Adequate documents and records Timely preparation iii. Adequate documents and records Multiple use iv. Independent checks on performance Accounting department ensure for completeness of details and authorisation. v. Adequate separation of duties Treasury (physical custody of cheque) and accounting department (record keeping) vi. Independent checks on performance Remittance advice and mailing list of cheques. vii. Aged trial balance is prepared monthly Basis for follow-up (Any 6 points x 1 mark = 6 marks) Misplaced. Completeness, not all transactions are recorded. Unmatched revenue and expenses. Cutoff, transaction are not recorded in the correct period. Information is not matched. Accuracy, information may not tally from the ordering until billing. Information is not valid and matched. Occurrence and Accuracy, recoding are made for purchases of personal items. Misappropriation of cash. Opportunity for cash to be stolen. Information is not matched. Accuracy, information may not tally from the receiving until depositing. Inadequate allowance for doubtful debts. Realizable value, the amount shown as accounts receivable may not realised in the next financial year. (Any 6 x 1½ marks = 9 marks) d) Ask a series of related questions. Response with Yes, No or Not Applicable. Can obtain reasonably quickly on the deficiency of internal control. 2
e) i) Occurrence the sale or revenue occurred during the period ii) Completeness a sale transaction or event took place which pertains to the business iii) Valuation the receivables is recorded at an appropriate carrying value iv) Presentation and disclosure sales and receivables are disclosed, classified and described in accordance with acceptable accounting policies and legal requirements (Any 3 points = 3 marks + 3 marks for explanations = 6 marks) [Total: 25 marks] QUESTION 3 a) The objective of an agreed-upon procedures engagement is for the auditor to carry out procedures of an audit nature to which the auditor, the entity and any appropriate third parties have agreed for the engaged auditor to issue a report of findings based on specific procedures performed on the subject matter (no assurance). The objective of a review engagement of financial statements is to enable an auditor to state whether, on the basis of procedures which do not provide all the evidence that would be required in an audit, anything has come to the auditor s attention that causes the auditor to believe that the financial statements are not prepared, in all material respects, in accordance with an identified financial reporting framework (negative assurance). (4 marks) b) Four (4) procedures applied in performing an agreed-upon procedures engagements include: 1. Inquiry and analysis of information. 2. Observation. 3. Inspection of document. 4. Re-computation, comparison and other clerical accuracy checks. 5. Confirmation and analytical procedures. (any 4 x 1/2 mark = 2 marks) c) Four (4) types of inquiries made during a review engagement include: 1. Inquiries concerning the entity s accounting policies and practices. 2. Inquiries concerning the entity s procedures for recording, classifying and summarizing transactions. 3. Inquiries concerning actions taken at meetings of shareholders, the board of directors and other meetings. 4. Inquiries of persons having responsibility for financial and accounting matters concerning whether all transactions have been recorded, changes in the entity s business activities and accounting policies and practices. 5. Inquiries about subsequent events up to the date of the review report that may require adjustments to or disclosure in the financial statements. 3 (any 4 x 1 mark = 4 marks) [Total: 10 marks]
ANSWER 4 Part A a) Suggested computer based controls for the respective misstatements are: 1. Processing control such as validation test which compares the customer to customer file. The comparison would have revealed that the customer is no longer active. 2. Processing control such as reasonableness test which would have indicated that it is not possible to work for more than 24 hours per day. 3. Segregation of duties. The functions of programming, computer operations, and control should be assigned to different employees. Programmers' access to computers should be limited to testing and debugging once the system is already in place. 4. Processing control such as the matching test can check that the approved price list contained in a master file in the computer are matched with product numbers on the delivery orders (transaction file) to obtain appropriate prices. 5. Processing control such as sequence tests to check for sequence of dates. Note: Consider also other acceptable answers. (5 x 1 mark = 5 marks) b) The elements of the control environment affected by IT are: 1. The assignment of authority and responsibility - Clear lines of authority and responsibility are important in an IT system because, unlike a manual system, multiple users may have access to data. 2. Human resource policies and practices - in an IT environment, it is very important that personnel have the skills and knowledge necessary to operate the information system. (2 x 2 mark = 4 marks) c) Control activities affected by IT are: 1. Segregation of duties - Proper segregation of duties is important because in a computerized system, programs perform many of the functions that would be performed by different individuals in a manual system.therefore, the functions of programming, computer operations, and control should be assigned to different employees. 2. Physical controls - Physical controls over assets and records are important in a computerized system because many of the assets and records are concentrated in the IT department or can be accessible through the computer system. Note: Consider also other acceptable answers. (2 x 2 mark = 4 marks) 4
Part B a) 4 typical testing using CAATs Calculation checks, select high value, negative value. Detecting violation of system rules e.g. the program checks all accounts on sales ledger to ensure no customer has a balance above credit limit. Detecting unreasonable items e.g. check that no customers are allowed trade discount of more than 50% Conducting new calculations and analyses e.g. obtain analysis of static and slow moving stock. (4 x 1 mark = 4 marks) b) Four (4) factors should be considered computer knowledge, expertise and experience of the auditor availability of suitable CAATs and the client s CIS facilities efficiency and effectiveness of using CAATs over manual techniques time constraint integrity of the information system and IT environment level of audit risk (any 4 x 1 mark = 4 marks) c) Two (2) common types of CAAT QUESTION 5 1. Audit software is a computer programs used for audit purposes to examine the contents of the client s computer files. 2. Test data are data used by the auditors for computer processing to test the operation of the client s computer programs. (2 x 2 marks = 4 marks) [Total: 25 marks] a) Sufficiency: The measure of quantity of the audit evidence i.e., whether the quantity of evidences accumulated from the performance of audit procedures is adequate to enable the auditor to arrive at a conclusion. Appropriateness: The measure of the quality of audit evidence and its relevance to a particular assertion and its reliability. b) i. Confirmation letter received directly by the auditor from the bank./ ii. Purchase requisition form. iii. Recomputation of depreciation charges./ debtors confirmation. iv. Bank reconciliation statement obtained from the client./ stock listing. (4 marks) 5
c) Positive confirmation: A letter, addressed to the debtor requesting the debtor to indicate directly on the letter whether the stated account balance is correct or incorrect. / QUESTION 6 Negative confirmation: A letter, addressed to the debtor requesting the debtor to response only if he disagrees with the stated account balance. / (2 x 1 mark = 2 marks) [Total: 10 marks] a) Knowledge of both contingencies and capital commitments is extremely important to users of financial statements because they represent the encumbrance of potentially material amounts ( ) of resources during future periods ( ), and thus affect the future cash flows ( )available to creditors and investors ( ). (4 x 1 mark = 4 marks) b) Two examples for contingent liabilities and two examples of capital commitments = Examples of contingent liabilities are: i) Pending litigation ii) Income tax disputes iii) Product warranties iv) Notes receivable discounted v) Guarantees of obligations of others vi) Unused balances of outstanding letters of credit vii) Notes payable viii) Accounts payable ix) Accrued interest payable x) Income taxes payable xi) Payroll withholding liabilities xii) Accrued salaries and wages Examples of commitments are: i) Committed subscription to purchase shares or rights issues in other companies ii) Capital expenditure authorised and contracted iii) Non-cancellable long term leasing arrangements (Any 2 x 2 marks = 4 marks) c) The reasons for performing the final analytical reviews are: (i) (ii) Useful as a final review for material misstatements or financial problems not noted during other testings, Helps the auditor take a final objective look at the financial statements Note: Consider other acceptable answers. (2 x 1 mark = 2 marks) 6
d) The major considerations the auditor should take into account in determining how extensive the subsequent events review should be are: i) The company's financial strength and stability of earnings ii) The effectiveness of the company's internal controls iii) The number and significance of the adjustments made by the auditor iv) The length of time between the year end and the completion of the audit v) Changes in key personnel (5 x 1 mark = 5 marks) 7