March/June 2020

Scenario 1
This scenario relates to four requirements.

It is 1 July 20X5. You are an audit supervisor of Orange & Co planning the audit of a new
client, Scarlet Co, for the year ended 31 May 20X5. Scarlet Co manufactures chemicals for
use in domestic and commercial cleaning products.

The company's financial accountant was taken ill suddenly in May 20X5 and is unable to
undertake the preparation of the year-end draft financial statements. As a result, the
company recruited a temporary financial accountant in early June 20X5 who will prepare the
draft financial statements. The year-end financial statements need to be finalised quickly as
the company is looking to raise finance through a bank loan to replace three machines in the
production facility. The bank has asked for a copy of the audited year-end financial
statements by the end of September 20X5 before they will agree to the loan and the
directors are keen to report strong results in order to obtain this financing.

In the year, the company also purchased a specialised machine to develop a new range of
chemicals for a major customer. Only trained staff are allowed to operate this machine and
staff members had to undertake two days of training, followed by an assessment at the end
of the training period. The training costs of $15,000 have been capitalised as part of the cost
of the asset.

The company sources many of its raw materials to be used in the chemical manufacturing
process from an international supplier and goods can be in transit for up to three weeks. The
agreement with the international supplier contains a clause which states that Scarlet Co is
responsible for the goods as soon as they leave the supplier's warehouse.

You have carried out a preliminary analytical review which indicates that the receivables
collection period has increased from 38 days to 52 days. The credit controller has confirmed
that some customers are currently taking longer to pay than in previous years as they are
awaiting payment from their customers.
On 29 May 20X5, the directors announced that one of its brands was being discontinued due
to a fall in demand for the product. This resulted in four staff members being made
redundant. The payroll department has calculated the levels of termination costs associated
with the redundancy and they will be paid in the July 20X5 payroll run.

The directors each received a significant bonus in the year which has been included in the
payroll charge for the year in the statement of profit or loss. Local legislation requires
separate disclosure of directors' bonuses in the financial statements.

During the year the company sold a batch of chemicals to a customer for $120,000. At the
beginning of May 20X5, the customer returned these chemicals because the chemical mix
was not in line with the customer's specifications. A credit note is yet to be issued to the
customer and the chemicals have been written down to their scrap value within inventory.

The company usually pays its suppliers by the end of each month. However, due to the
financial accountant's illness, the payment run for May 20X5 was not performed until 1 June
20X5. The finance director has informed you that in order to show consistent results with
the prior year, this payment run is shown as an unpresented item on the year-end bank
reconciliation.

ISA 210 Agreeing the Terms of Audit Engagements requires auditors to issue an engagement
letter.

(a) Explain the PURPOSE of an audit engagement letter and list FOUR items
which should be included in an audit engagement letter. (4 marks)

(b) Explain WHY the following factors should have been considered by
Orange & Co prior to accepting Scarlet Co as a new audit client. (5 marks)

Pre-acceptance factors Explanation

The outgoing auditor's response
Management integrity
Pre-conditions for an audit
Independence and objectivity
Resources available at the time of the audit
(c) Describe EIGHT audit risks, and explain the auditor's response to each risk,
in planning the audit of Scarlet Co. (16 marks)

(d) Describe substantive procedures the auditor should perform to obtain

sufficient and appropriate audit evidence in respect of the redundancy costs. (5 marks)

(30 marks)

Question 2
This scenario relates to four requirements.

It is 1 July 20X5. You are an audit supervisor with Rocky & Co, reviewing extracts from the
internal controls documentation in preparation for the interim audit of Snowdon Co. The
company's year end is 30 September 20X5. The company provides training services for
individuals looking to become qualified engineers. Snowdon Co's customers are the
employers that send their employees for training on a weekly basis. Snowdon Co runs
classes in its 45 training centres across the country.

The company has a small internal audit (IA) department, which has experienced significant
staff shortages and is currently under-resourced. This has resulted in a reduction in their
programme of work for the year in many areas.

Non-current assets
Snowdon Co's training centres are either owned by the company or are held under a long-
term lease. The company also has a head office and central warehouse for storage of
training materials. Each training centre is set up as a separate department and is given an
annual capital expenditure budget but some departments have already significantly
exceeded their annual budgets.

When new equipment is acquired the finance department classifies the expenditure
between capital and revenue, noting the classification on the purchase order. The
classification is made with reference to guidelines established by the finance director, who
sample checks that the capital or revenue expenditure allocation has been correctly applied.
Part of the work which Snowdon Co's IA department is required to carry out is a comparison
of the assets per the non-current assets register and those physically present in each of the
centres. This year's programme of visits, which has been planned and carried out on the
same basis as previous years, means that by the year end lA will only have visited the four
largest centres and five of the other centres randomly selected.

Payroll
Snowdon Co has a human resources (HR) department, responsible for setting up all new
joiners. Pre-printed joiners' forms, which require all necessary data, are completed by HR for
new employees and once verified, a copy is sent to the payroll department so that the
employee can be set up for payment. The joiner's form includes the staff member's assigned
employee number and the system requires the new joiner's employee number to be entered
before they can be added to payroll. All members of the payroll department can amend
employees standing data in the payroll system as they have access to the password, which is
changed by the payroll director on a quarterly basis.

On a monthly basis the employees are paid by bank transfer. The senior payroll manager
reviews the list of bank payments and agrees this to the payroll records. If any discrepancies
are noted, the senior payroll manager always makes the adjustment in the payroll records.

Sales and bank

After passing a credit check, new customers are set up in the receivables ledger master file
and a credit limit is set by the sales director. The credit limits then remain unchanged in the
system unless a review is requested by the customer.

Each new customer is allocated a client services manager from Snowdon Co, who is
responsible for managing the customer relationship and maximising sales. Standard credit
terms for customers are 30 days and on a monthly basis sales invoices which are over 90
days outstanding are notified to the relevant client services manager to chase payment
directly with the customer.

Every month, the cashier reconciles the bank statements to the cash book. The
reconciliations are reviewed by the financial controller, who also investigates all reconciling
items and evidences his review by way of a signature.
Auditors are required, under ISA 265 Communicating Deficiencies in Internal Control to
Those Charged with Governance and Management, to communicate in writing to those
charged with governance any significant deficiencies in internal control.

(a) Describe FOUR matters the auditor may consider in determining whether
a deficiency in internal control is significant (4 marks)

(b) In respect of the internal control system of Snowdon Co:

(i) Identify and explain THREE KEY CONTROLS on which the auditor may seek to place
reliance; and

(ii) Describe a TEST OF CONTROL the auditor should perform to assess if each of these
key controls is operating effectively.

Note: The marks will be split equally between each part. (6 marks)

(c) Identify and explain FIVE DEFICIENCIES in Snowdon Co's internal control
system and provide a recommendation to address each of these deficiencies. (10 marks)

(20 marks)

Question 3
This scenario relates to four requirements.

It is 1 July 20X5. You are an audit supervisor with Velo & Co and you are working on the final
audit of Encore Co for the year ended 30 April 20X5. Encore Co is a waste management
company, supplying its services to a variety of governmental and business organisations.
Encore Co's draft profit before tax is $5.3m (20X4: $4.6m) and total assets are $40.1m (20X4:
$33.9m). You have been provided with the following information regarding the draft
financial statements.
Vehicle additions and disposals
On 1 February 20X5, Encore Co replaced 20 of its recycling vehicles. The old vehicles had a
carrying amount of $1.8m, as recorded in the non-current assets register and were given in
part-exchange against new vehicles costing $4.6m. Cash consideration of S3.9m was also
paid.

Trade receivables
Encore Co's credit controller left the company in January 20X5 and has only recently been
replaced. The trade receivables collection period increased from 49 days as at 31 December
20X4 to 66 days as at 30 April 20X5. Year-end trade receivables amounted to $9.1m (20X4:
$7.1m) and an allowance for irrecoverable receivables of $182,000 (20X4: $142,000) has
been made.

Potential breach of transport regulations

In March 20X5, a former employee of Encore Co made a complaint to the transport
authority, alleging that Encore Co has breached the regulations concerning maximum driving
hours and compulsory rest breaks for drivers on a number of occasions. The transport
authority has launched an investigation but the directors of Encore Co are not intending to
disclose this issue or make any provision as they do not believe that the potential fine, which
is $50,000 per breach, is material.

(a) Describe substantive procedures the auditor should perform to obtain

sufficient and appropriate audit evidence in relation to Encore Co's vehicle
additions and disposals (6 marks)

(b) Describe substantive procedures the auditor should perform to obtain

sufficient and appropriate audit evidence in relation to the VALUATION of
Encore Co's trade receivables. (5 marks)

(c) Describe substantive procedures the auditor should perform to obtain

sufficient and appropriate audit evidence in relation to the potential breach
of transport regulations by Encore Co. (4 marks)
It is now 26 August 20X5 and the auditor's report for Encore Co is being finalised. On 12
August 20X5, the transport authority announced that it was taking legal action against
Encore Co in respect of 17 breaches of the regulations.

Encore Co's lawyers have advised that it is probable Encore Co will be found guilty of all of
the breaches. Encore Co's directors have informed you that no provision will be made in
respect of this matter, as the decision by the authority to take legal action was made after
the year end, but they have agreed to disclose the issue in the notes to the financial
statements.

(d) Discuss the issue and describe the impact on the auditor's report, if any,
should this issue remain unresolved. (5 marks)

(20 marks)