THE AUDITOR AND THE COMPANIES ACT-Introduction
Audit Test Questions and Answers
FRAUD & ERROR (iSA 240) Questions and Answers
QUIZ
- list the professional ethics that the auditor is expected to adhere to.
- What is the purpose of an engagement letter?
- Integrity, Competence, Confidentiality, and independence.2. The purpose of an engagement
letter
- The letter defines the scope of work to be carried out and the respective responsibilities of the auditor and the client under the engagement. This helps in avoiding misunderstandings between the client and the auditor as regards to the scope of the work to be carried out and the respective responsibilities of both parties.
- The letter documents and confirms the auditor’s acceptance of the appointment
- it explains the forms of any reports to be issued under the engagement
- To educate the client on:-
- His duty to maintain proper books of accounts and to prepare financial statements that show a true and fair view.
- his duty to prevent errors and frauds.
- his duty to provide all the necessary information
- That the audit should not be relied upon to detect errors and frauds.
- To explain the the audit will be carried out on a test basis.
- basis of charging his fees.
- minimise auditor’s liability to third parties.
- Commit client to his obligations in an audit.
QUESTION ONE
Your firm has been approached by the directors of UB Bank Ltd. a newly formed commercial bank to undertake the audit for its first complete financial year ended 31 December 1996. Your manager has assigned you the responsibility for leading the team. You have had various discussions with the directors about the timetable and the respective responsibilities of management and the auditor. You have drafted a letter of engagement and have sent it to the managing director for approval and acceptance but the management has not yet responded to your letter.
Required:
- Explain why a letter of engagement is sent before any new audit appointment is accepted.
- Set out the main contents of a letter of engagement.
- itemize the actions you would take in response to the non-reply by the management to your draft engagement letter.
- State when it might be necessary to re-draft an engagement letter and have it reaffirmed by the client’s management.
QUESTION TWO
The objectivity of the external auditor may be threatened or appear to be threatened where:
- There is undue dependence on any audit client or group of clients.
- The firm, its partners or staff have any financial interest in an audit client.
- There are family or other close personal or business relationships between the firm, its partners or staff and the audit client.
- The firm provides other services to audit clients.
Required:
- For each of the four examples given above, explain why the objectivity of the external auditor may be threatened, or appear to be threatened, and why the threat is important.
- Describe requirements that reduce the threats to auditor objectivity for each of the four examples given above.
QUESTION THREE
- Describe the matters to consider within your firm and the other procedures that must be undertaken before accepting the appointment as auditor to a new client.
- Explain why it would be inappropriate to commence the audit before consideration of the matters and the procedures referred to in (a) above have been completed.
- Explain the purpose of an engagement letter and list its contents.
QUESTION FOUR
You are a recently qualified Chartered Certified Accountant in charge of the internal audit department of zX, a rapidly expanding company. Turnover has increased by about 20% p.a. for the last five years, to the current level of Kshs50 million. Net profits are also high, with an acceptable return being provided for the four shareholders. The internal audit department was established last year to assist the board of directors in their control of the company and to prepare for a possible listing on the stock exchange. The managing Director is keen to follow the principles of good corporate governance with respect to internal audit. however, he is also aware that the other board members do not have complete knowledge of corporate governance or detailed knowledge of international auditing Standards. required:
Write a memo to the board of zX that:
- Explains how the internal audit department can assist the board of directors in fulfilling their obligations under the principles of good corporate governance.
- Explains the advantages and disadvantages to zX of an audit committee.
QUESTION FIVE
- Explain the situations where an auditor may disclose confidential information about a client.
- You are an audit manager in McKay & Co, a firm of Chartered Certified Accountants. You are preparing the engagement letter for the audit of Ancients; a public limited liability company, for the year ending 30 June 2006.ancients has grown rapidly over the past few years, and is now one of your firm’s most important clients. Ancients has been an audit client for eight years and mcKay & Co has provided audit, taxation and management consultancy advice during this time. The client has been satisfied with the services provided, although the taxation fee for the period to 31 December 2005 remains unpaid. audit personnel available for this year’s audit are most of the staff from last year, including mr. Grace, an audit partner and mr. Jones, an audit senior. mr. Grace has been the audit partner since ancients became an audit client. You are aware that Allyson Grace, the daughter of mr. Grace, has recently been appointed the financial director at Ancients. To celebrate her new appointment, Allyson has suggested taking all of the audit staff out to an expensive restaurant prior to the start of the audit work for this year.
Required:
identify and explain the risks to independence arising in carrying out your audit of ancients for the year ending 30 June 2006, and suggest ways of mitigating each of the risks you identify.
The Auditor and the Compainies’Act
QUESTION ONE
- Why the letter of engagement is sent before any new audit appointment is accepted.
It is the purpose of a letter of engagement to dearly define the extent of the auditor’s responsibilities and so minimize the possibility of any misunderstanding between the auditor and the client.
It provides a written confirmation of the auditor’s acceptance-of the appointment, the scope of the audit, form of his report and scope of non audit services. if a letter of engagement is not sent to clients both new and existing, there is scope for argument about the precise extent of the respective obligations of the clients and its auditors and directors.
- Contents of a letter of engagement.
Definition and scope of audit: it should be made dear that an audit involves the examination of and expression of opinion on the financial statements of an enterprise by an appointed auditor in pursuance of that appointment and in the case of a statutory audit, that the matters to be reported upon are laid down in Companies act 1962 or any relevant legislation.
Fraud and irregularities: the responsibility of the prevention and detection of errors and frauds rests with the management and this responsibility is fulfilled mainly through the implementation and continued operation of an adequate internal control system.
accounting, Taxation and other services:-the letter should delineate clearly the accountant’s and the client a responsibilities in relation to these services and the day to day book-keeping, the maintenance of all accounting records and the preparation of financial statements.
Fees: mention should be made of fees and the general basis on which fees are computed and rendered.
- The auditor should ensure that; proper accounting records and returns have been kept.
The accounts kept are in agreement with the accounting records and returns. if they are not in agreement the directors should readily provide the auditor with all the explanations and information he requires.
- When it might be necessary to re-draft an engagement letter and have it re-affirmed by the client’s management:
When there are new clients who have appointed the auditor
When there is an existing client who has not received it previously in particular statutory audits.
Where there is a change in circumstances which will lead to change in duties of the auditor e.g. an extra assignment.
QUESTION TWO
External auditor objectivity
(a) Why external auditor objectivity may be, or appear to be, threatened
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.
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.
Family or other close personal or business relationships
Where there is 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.
Other services
Many audit firms provide their audit clients with services other than audit services. It is very common for auditors 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.
(b) requirements most of the following are requirements of rules of professional conduct.
- Undue dependence
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.
There are exceptions where a practice is being set up or run down. The rules are also applied to members practicing part-time.
A review mechanism should be triggered within the firm where the gross fee income exceeds 10% (5%) of gross practice income.
More generally, there is a requirement for firms to carry professional indemnity insurance to cover professional negligence claims and ACCA monitors practicing 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.
- Financial interest
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.
There are exceptions where collective investments are held by third parties, where the individual concerned has no control over the composition of investments.
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.
THE AUDITOR AND THE COMPANIES ACT-Questions and Answers
There are some exceptions for transactions on normal commercial terms with money lending institutions – a normal mortgage from a bank, for example.
Firms, their partners and staff should not make loans to, or guarantee the borrowings of, any audit client, or vice versa.
- Family or other close personal or business relationships
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 ).
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.
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.
- other services
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 finalization of the statutory accounts (assistance of a mechanical nature) or in an emergency situation.
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.
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.
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).
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.
QUESTION THREE
- internal matters and other procedures before appointment Before accepting appointment the firm should ensure that:
- it has the necessary staff with appropriate competencies to complete the audit (this seems likely given that the firm has other clients in this sector)
- The staff are available at what is a busy time of year for the firm (it may be possible that all of the staff with the necessary competencies are otherwise occupied)
- The firm is independent of client. It is unlikely that there will be any issues concerning shareholdings in the client (because it is owned and run by two entrepreneurs) however, there may be staff or partners who are related to the client or are otherwise connected with it.
- There are no conflicts of interest that cannot be properly managed. Conflicts of interest may exist because the firm has other clients in this sector. Other procedures The firm should:
- Seek the directors’ permission to communicate with the company accountant about the nature of the ‘disagreement’ and the directors should authorize the accountant to cooperate with the firm.
- Seek the directors’ permission to communicate with the incumbent auditors. if permission is refused, the appointment should not be accepted.
- ask the client to write to the incumbent auditors notifying them of the change and giving them permission to communicate with the firm (if client refuses to give permission to the incumbent auditors the appointment should not be accepted)
- Communicate with the incumbent auditors (preferably in writing) requesting all the information which ought to be made available to enable the firm to decide whether or not to accept the appointment (if there are no such matters, the incumbent auditors should inform the firm of this)
- Seek appropriate transfer information (such as a copy of the last set of accounts and a detailed trial balance reconciled to the accounts).
- indicate a likely fee (or the basis on which fees are calculated) to client, ensure that this is acceptable and that the client is able to pay.
- Ensure that the incumbent auditor has properly resigned, been dismissed or has not sought re-appointment in accordance with legal requirements.
- Starting the audit it is inappropriate to start the audit before the procedures referred to above have been completed because:
Without the staff with appropriate competencies, the firm will be in breach of the rules (and may be found negligent if things were to go wrong).
Without complying with the requirements relating to independence and conflicts of interest, the firm will not only be in breach of the rules, but will lack objectivity and may find that the client (or other party) objects to the appointment to another client in the same sector.
Without performing appropriate procedures the firm will be unable to form an opinion on the integrity of the client. It may find itself associated with an entity engaging in doubtful or even illegal activities (taking account of the disagreement over disclosures).
Without agreeing a fee it is almost inevitable that misunderstandings or disagreements will arise.
Without communicating with the accountant and the incumbent auditor, it is quite possible that disagreements over disclosures will arise, similar to those that have arisen in the past
Without ensuring that the incumbent auditor is no longer in place, it will be inappropriate for the firm to seek appointment.
(c) Engagement letter
The engagement letter is of benefit to both the client and auditor and helps prevent misunderstandings. it:
- Confirms the auditor’s acceptance of appointment and constitutes a contract between the auditor and the client.
- Summarizes the respective responsibilities of directors and auditors.
- Contains details on:
- The responsibilities of the directors (for accounting records, the financial statements and the accounting policies on which they are based).
- The responsibilities of auditors and the scope of the audit (their duty to conduct an audit in accordance with auditing standards, to review accounting policies and disclosures, to perform tests and to form an opinion on the financial statements).
- The form of report to be issued.
- other services to be provided.
- The basis of calculation of fees.
- applicable legislation.
QUESTION FOUR
memo
From: Chief internal auditor
To: board of zX
Subject: role of audit Committee
Date: June 2005
(a) areas where the internal audit department can assist the directors with the implementation of good corporate governance in an organization include:
Board reports
reviewing reports to the board and reports produced by the board to ensure that they do present a balanced and understandable assessment of the company’s position and prospects. The internal audit department will have good knowledge of the operations of the company as well as access to accounting information. The department can effectively ‘audit’ board reports to ensure they are accurate and understandable.
internal controls
The board needs to maintain a sound system of internal control. The internal audit department will be able to review existing controls and recommend improvements to ensure this objective is met.
Application of ISAs and IASs.
The board needs to have a policy for applying appropriate international Statements on auditing (iSa) and international accounting Standards (iaS) to the organization. internal audit will certainly be aware of new auditing standards and will have the technical expertise (especially where internal auditors are professionally qualified) to identify changes required by accounting standards. Amendments to control systems for new auditing standards and financial accounting systems for new accounting standards can therefore be recommended.
Communication with external auditors
Under corporate governance regulations, communications with external auditors will normally be via the audit committee, although the board must maintain an appropriate relationship with the external auditors. however, internal and external auditors can also work together to ensure that the internal control system is sufficient; possibly by external audit delegating work to internal audit, and each auditor reviewing the work of the other auditor. The board will therefore receive reports from both sets of auditors which will be accurate because they have been properly checked.
Communication to the board
The internal auditor can also check that appropriate information is provided to the board from the external auditor. iSa 260 provides a list of matters which should be communicated to the board and the internal auditor can work with the external auditor to ensure that this information is provided.
(b) The advantages of an audit committee include:
Public confidence
It provides increasing public confidence in the credibility and objectivity of published financial information. This will be particularly important for zX if listing arrangements go ahead. While an internal audit department is not normally necessary for incorporated companies, the provision of that department will provide additional confidence in the accuracy of the financial statements and hopefully make zX an attractive investment.
Financial reporting
It supports the directors in fulfilling their financial reporting obligations. The directors have to prepare financial statements for ZX. The committee can assist by checking the financial statements to ensure that they comply with appropriate reporting requirements. This is especially important where the board do not have detailed knowledge of accounting requirements.
Communication
it enhances the role of zX’s external auditors by providing an appropriate channel of communication. Use of the audit committee will enable the external auditor to discuss issues with the financial statements with the internal auditor, prior to providing a final summary of key points to the board.
‘Friend’ of the board
The audit committee may also act as a ‘critical friend’ to the board by monitoring the work of the board and providing helpful guidance, where corporate governance requirements do not appear to be being met. The audit committee should have detailed knowledge of corporate governance as part of its monitoring function of the company and can share this with the board who may not have the time to obtain detailed information.
c) The disadvantages of an audit committee include:
Lack of understanding of function
as the directors in zX do not have much knowledge of corporate governance, they may see the additional involvement of the audit committee as a threat to their authority or taking away some of their responsibilities. This memo has hopefully outlined the advantages of an audit committee in supporting the work of the directors, removing this as a problem.
role of non-executive directors as the audit committee will be made up mainly from non-executive directors, the board may see this as a means of decreasing their power and possibly letting other people run the company. Again, the audit committee must be seen as fulfilling a supporting role for the main board. it will utilize the special knowledge of account production and internal controls from the external auditor and business non-executives to provide appropriate review of information being given to the board.
Cost
The audit committee will increase the expenditure of the company as the non-executive directors will require some remuneration due to their additional responsibilities. While this cannot be avoided, the benefits of the committee in terms of providing assistance to the board and raising the profile of ZX ready for possible listing must not be forgotten.
QUESTION FIVE
- Confidential information
Information obtained during an audit is normally held to be confidential; that is it will not be disclosed to a third party.
however, client information may be disclosed where:
- Consent has been obtained from the client
- There is a public duty to disclose or
- There is a legal or professional right or duty to disclose.
- independence risks
Audit partner – time in office
mr. Grace has been the audit partner of ancients for eight years. his objectivity for the audit may be threatened by the ongoing close relationship with the client. in other words, he may be too friendly with the directors of ancients. This means he may not be willing or able to take difficult decisions such as issuing a modified audit report for fear of prejudicing his friendship with the directors. rotating the audit partner would remove this threat.
Unpaid taxation fees
ancients has not paid the taxation fees for work that took place nearly six months ago. The non-payment of fees can be a threat to objectivity similar to that of an unpaid loan. in effect, mcKay is providing ancients with an interest free loan. The audit partner in mcKay may not wish to issue a modified report for fear that the client leaves and the ‘loan’ is not repaid. The unpaid fee must be discussed with the directors in ancients and reasons for non-payment obtained. mcKay may wish to delay starting the audit work for this year until the fee is paid to remove the potential independence problem. if the fee is not paid at all then mcKay may decline to carry out the audit.
Fee income
no details are provided regarding fee income obtained from ancients. however, the company is growing rapidly and mcKay does provide other services besides audit. as a limited liability company, mcKay should ensure that no more than 10% of its recurring practice income (including auditing, accountancy and other work combined) is derived from this client. Obtaining more than 10% could indicate undue financial reliance on one client, and impair objectivity regarding the audit report (again fear of issuing a modified report and losing the fee income from the audit client). if the 10% limit is close, mcKay may have to limit other services provided so that independence is not impaired. an annual review will be required on clients where the fee is between 5 and 10% to ensure that the fee income rules will not be breached.
Allyson Grace
allyson Grace is not deemed to be connected to mr. Grace because she is presumably over the age of 18. if she was still a minor, then there would be a connection and it would be inappropriate for Mr. Grace to be the audit partner as he could in theory influence Allyson’s decisions. however, there may still appear to be an independence problem as mr. Grace may not be objective in making audit decisions. he may not wish to annoy his daughter by having to qualify the financial statements.
appointing another audit partner would remove the perceived independence problem.
Meal
The offer of a meal by Allyson may appear to be a threat to independence; having received an expensive meal, the audit staff may be favorably disposed towards ancients and be less inclined to investigate potential errors. Audit staff are allowed to receive modest benefits on commercial terms; whether there is a benefit depends on how expensive the meal is. To ensure no independence issues it would appear that the invitation should be declined. one possible option would be for mr. Grace and allyson to pay personally as a purely social event even though this may be unlikely. however, this does not remove the implied independence issue.
