Chapter:5

Quality Control

Wasequl H Reagan, Partner, Mahfel Huq & Co.

*Generic guidance purpose only and not a replacement for study manual.

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Key Areas covered:

▪ The need for quality standards

▪ Consequences of quality failure
▪ Approach to quality management
▪ Risk assessment, governance and leadership
▪ Ethical requirements and acceptance and continuance
▪ Human resource and Engagement performance
▪ Information and communication and Monitoring
▪ Getting the assurance opinion wrong
▪ Auditor liability
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The need for professional ethics: What could go wrong?
•May have insufficient knowledge of clients business
•May fail to pass the knowledge of the business to the team
•May select wrong team for the audit
The •May not adequately brief and supervise the team
Engagement •May not review the work carried out by the team with sufficient care
•May not consult sufficiently with colleagues and outside experts
Partner •May not draw correct conclusion from the evidence available

•May have inadequate understanding of clients business

•May not brief and direct client the staff properly
The supervisor •May not carry out sufficient supervision
•May fail to deal with the issues adequately
•May fail to communicate issues to the engagement partner

•May have inadequate understanding of the

business of the client
The individual auditor •Work not up to adequate standard
•Work not documented/recorded

•May be incompetent
The client •May be negligent
•May be misleading audit team, fraud

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The consequences of quality failure

Fines

The Publication
consequence
s of quality
failure Loss of practicing certificate

Loss of reputation and clients

During iCAB review, which is designed to be constructive rather than

disciplinary in tone, the reviewers working on behalf of ICAB, will examine
files and procedures in all the firms departments. They will compare what
they find with standards set out by ICAB and where appropriate, make
recommendations for improvements.

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Approach to quality control

Quality management

ISQM1: Quality
management for firms that
ISA 220 (revised): Quality
perform audits or reviews of ISQM2: Engagement Quality
management for an audit of
FS, other assurance and Control Reviews
FS
related services
engagements

International Standard on Quality Management (ISQM) 1

replaced International Standard on Quality Control (ISQC)
1, Quality Control for Firms that Perform Audits and Reviews of
Financial Statements and Other Assurance and Related Services
Engagements.

ISQM 1 applies to all firms that perform engagements under the

IAASB international standards. Firms are required to have
systems of quality management designed and implemented in
accordance with ISQM 1 from 15th December, 2022.

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Approach to quality management

Firm's risk assessment International Standard on Quality Management (ISQM) 1

process
replaced International Standard on Quality Control (ISQC)
1, Quality Control for Firms that Perform Audits and Reviews of
Governance and
leadership
Financial Statements and Other Assurance and Related Services
Engagements.
management (SOQM) must address 8

Relevant ethical
ISQM 1 applies to all firms that perform engagements under the
ISQM1: Firm's system of quality

requirements
IAASB’s international standards. Firms are required to have
Acceptance and systems of quality management designed and implemented in
components

continuance of client accordance with ISQM 1 from 15th December, 2022.

relationships

Engagement performance

Resources Ethical and professional

Information and Client acceptance and

communication continuance

Monitoring and
Engagement performance
remediation process

Elements of a firm’s system of quality

management (SOQM)
REAGERIM
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Risk Assessment Process

▪ Firms must design and implement a risk assessment process that sets quality objectives and identifies risks.
The firm’s specific situation and environment is considered and will include the technologies employed by
the firm, their networks, and any external service providers. This is an ongoing monitoring process rather
than one-off, enabling the SoQM to adapt with any changes. This approach will allow the firm to tailor to
address the specific risks within their firm, and it will vary according to the size of the audit firm and their
client portfolio.

▪ By maintaining this tailored focus on risks and their mitigation, the firm should be able to focus on ensuring
the right engagement or audit report is issued for each assignment. This may be due to more competent
and well-trained individuals performing complex or risky audits, audit partners feeling more empowered to
issue modified audit reports, by ensuring acceptance procedures fully identify threats to independence and
ensure safeguards are enacted and many other factors. The most crucial point is that this approach is
tailored to address the specific risks arising in specific firms and not expected to be the same for every
audit firm regardless of size or client portfolio.

Exam: Explain/evaluate a firm's risk assessment process and recommend actions for
improvement.

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Governance and Leadership

Firms should create an environment which demonstrates a commitment to quality through its culture and
recognises its role in serving the public interest. This responsibility is firm wide rather than at the individual audit
level, with the chief executive or managing partner assigned the responsibility and accountability for the SoQM.

This should ensure the ‘tone at the top’ enforces a commitment to quality and ethics across the whole firm.

Systems and policies should be in place to reward commitment to quality rather than focusing on client retention
and engagement profit. This should allow audit engagement partners to challenge client judgements without fear
of the negative consequences of losing the revenue arising from the loss of the client. In this way, all employees of
the firm are supported to fulfil their legal and regulatory requirements without undue commercial pressures or
self-interest resulting in inappropriate decision making.

Explain the importance of governance and leadership in maintaining the SoQM or may be required to evaluate a
scenario’s weaknesses in this area, alongside recommendations for improvement.

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Relevant ethical requirements

The SoQM should include objectives and policies for ensuring the fulfilment of ethical requirements. These
processes will again differ depending on firm size and client portfolio; the scalability of the standard requires firms
to have in place mitigations for ethical risks arising which are appropriate to the firm rather than a fixed response
to a given risk.

Relevant ethical requirements for a firm depend on the jurisdiction it operates in; these may go beyond those set
out in the IESBA International Code of Ethics for Professional Accountants (the Code). It is also the case that many
firms will have in place policies to mitigate ethical threats which go beyond the minimum required by
the Code and regulatory requirements of the jurisdiction in which the firm operates: ISQM 1 requires firms to
ensure these requirements are also captured by the SoQM. For example, many firms or jurisdictions prohibit the
acceptance of gifts, even of trivial value. Failure to adhere to the firm’s policies would be seen as a failure of its
SoQM despite not giving rise to a breach of the Code.

Appraise ethical threats arising in the scenario whilst considering whether the firm is compliant with the firm’s
SoQM. In addition, you might be asked to identify breaches of the SoQM which may not breach the Code but are
relevant to the given scenario addressing any resulting implications for the engagement and provide
recommendations to prevent future breaches.

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Acceptance and continuance of client relationships

Firms must assess the integrity and ethical values of the client and its management, as well as the firm’s ability to
perform the engagement within legal and professional requirements. The SoQM should ensure that the firm’s
financial and operational priorities do not lead to inappropriate judgements when deciding whether to accept or
continue with a client engagement. The decision to continue with or accept a new client should focus on the
firm’s ability to provide a quality engagement.

Existing business relationships should be reassessed at the start of each new year prior to reappointment as
auditor. This may mean performing fresh identity checks, reperformance of independence declarations of
employees, and re-evaluating conflicts of interest and/or competence to perform the audit. It will also involve
assessing whether new information, had it been known at point of acceptance, would have prevented the firm
from accepting the client. For example, a client involved in breaches of regulations may not be a client with values
compatible with the audit firm.

Candidates may have to discuss the importance of acceptance and continuation assessments or to apply the
requirements of ISQM 1 in this regard when evaluating whether to accept a new client, undertake additional work
for existing clients or accept reappointment for the audit of a continuing client.

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Engagement Performance

Engagement teams must understand their responsibilities for ensuring a quality audit. Less experienced
engagement team members should be appropriately supervised and reviewed. ISQM 1 specifically references the
need for the audit engagement partner to be sufficiently and appropriately involved throughout the engagement.

Audit teams should ensure professional scepticism and judgement are exercised. Processes should ensure
professional scepticism and judgement are exercised by engagement teams. If an audit team has insufficient time
to perform necessary procedures, or team members are not experienced enough to challenge management or
identify misstatements, then detection risk increases and audit quality will be compromised. For audits to be
effective, and to maintain public trust, they must be performed in such a way as to ensure the audit reports
issued are appropriate in the circumstances and that firms and their personnel fulfil their responsibilities in
accordance with applicable legal and professional standards.

The SoQM should ensure that teams can consult on contentious matters; differences of opinion within the
engagement team are addressed and any issues raised by the engagement quality reviewer are brought to the
attention of the firm and resolved.

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Engagement Performance

Direction

Consultation Supervision

Engagement
performance

Documentation Review
and review •Engagement quality
control review

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Engagement Performance
Direction

The engagement Partner is responsible for ensuring team members know:

▪ What work they are supposed to be doing
▪ The nature of the entity’s business
▪ Any risks relevant to the engagement
▪ Problems that might arise during the engagement
▪ The detailed approach to the engagement

Supervision

As per ISA 220 Quality control for an Audit of Financial Statements list 4 features of supervision:
▪ Progress tracking
▪ Considering the completeness and capabilities of individual members of the audit team
▪ Addressing significant matters arising during audit
▪ Identifying matters for consultation or consideration by more experienced engagement team members during the audit
engagement
❖ Ensure that ->
• if supervision is too close, it can not stifle initiative and waste time of the supervisor
• If it is too loose, mistakes may be made or time wasted in ineffective work

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Engagement Performance
Review

The work performed by staff is reviewed by more senior staff or the engagement partner. The purpose is to ensure that the
work has been performed according to engagement strategy and whether:
▪ Whether the work has been performed as per professional standards, regulatory and legal requirements
▪ Significant matters have been raised for further consideration
▪ Appropriate consultations have taken place and the resulting conclusions have been documented and implemented
▪ There is a need to revise the nature, timing and extent of work performed
▪ The work performed supports the conclusions reached and is appropriate to support the report and
▪ The objective of the engagement procedures have been achieved

❑ Engagement quality control review

For listed entities and other entities (as determined by the firm)an engagement quality control review is conducted by a
suitably qualified partner or other person in the firm who is not a part of the engagement or by an external consultant.
Considerations should be given to:
❖ The evaluation of independence in relation to the engagement that has taken place;
❖ Whether appropriate consultation has taken place on contentious issues
❖ Whether the documentation selected for review reflects the work performed in relation to the significant judgements and
supports the conclusion reached
❖ Significant risks identified and responses to those risks
❖ Judgements made during the engagement, e.g., materiality and significant risks
❖ The significance of corrected and uncorrected misstatements
❖ The matters ot be communicated to the client

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Engagement Performance
Documentation and review

ISA 230 Audit Documentation requires that following documentations contain he following:

▪ What would be necessary to provide an experienced auditor, with no previous connection with the audit, with an
understanding of the nature, timing and extent of audit procedures, the results of audit procedures and the audit
evidence obtained and significant matters arising during the audit and conclusion reached thereon.

Consultation

When difficult issues arise the audit team must consult properly on the matter and the conclusions drawn as a result of that
communication must be properly recorded.

Any difference of opinion must be resolved prior to the assurance report being issued. The may mean that a person
independent of the engagement may have to be involved in resolving the difference of opinion.

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Human resources

Partner
The Firm

The Engagement
Staff Allocation
• Recruitment • Clients are informed • Understanding
• Performance of the identity and of/practical
evaluation role of the experience with
• Capabilities, engagement partner similar engagements
including time to • The engagement • Understanding of
perform assignments partner has the relevant professional
• Competence capabilities, and legal
• Promotion competence , requirements in
authority and time to relation to the client
• Compensation perform the role • Appropriate technical
• The estimation of • The responsibilities knowledge
professional needs of the partner in
e.g., self-appraisal • Ability to apply
relation to the professional
engagement are judgement
clearly defined and • Understanding of the
communicated to that firm's quality control
partner. procedures and
policies

Exam: May have to evaluate scenarios where inappropriate resources have been employed within an audit and
make recommendations for improvements to the firm’s SoQM.
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Information and communication

Engagement teams must understand their responsibilities for ensuring a quality audit. Less experienced
engagement team members should be appropriately supervised and reviewed. ISQM 1 specifically references the
need for the audit engagement partner to be sufficiently and appropriately involved throughout the engagement.

Audit teams should ensure professional scepticism and judgement are exercised. Processes should ensure
professional scepticism and judgement are exercised by engagement teams. If an audit team has insufficient time
to perform necessary procedures, or team members are not experienced enough to challenge management or
identify misstatements, then detection risk increases and audit quality will be compromised. For audits to be
effective, and to maintain public trust, they must be performed in such a way as to ensure the audit reports
issued are appropriate in the circumstances and that firms and their personnel fulfil their responsibilities in
accordance with applicable legal and professional standards.

The SoQM should ensure that teams can consult on contentious matters; differences of opinion within the
engagement team are addressed and any issues raised by the engagement quality reviewer are brought to the
attention of the firm and resolved.

Exam: You may have to evaluate scenarios with respect to these issues and make recommendations for
improvements to the firm’s SoQM in this area. Candidates should remember that I&C is embedded within all
aspects of a SoQM and may not be isolated as a topic.

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Monitoring and remediation process

Firms must put in place a process for monitoring the SoQM’s effectiveness and ensure deficiencies
are identified in a timely manner, allowing corrective actions to be implemented. This process is a
continuous cycle which firms are specifically required to undertake.
Exam: You may have to to explain how this contributes to continuous improvement of a firm’s SoQM. You may
also take the role of a reviewer performing this element of the process: identifying deficiencies and making
recommendations to remediate them.

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Monitoring
Monitoring or ‘cold’ review

Why conducted When failures are identified

▪ As a process, where partners ▪ Communication of the findings

review each others work in a firm; within the firm;
▪ By a team specifically constituted ▪ Additional training and
to conduct such reviews- usually professional development
under the direction of a partner, ▪ Changes to firms policies and
but the work is usually carried out procedures;
by suitably qualified and ▪ Disciplinary action against those
expereinced managers; who repeatedly fail to comply with
▪ By a suitably qualified external firm’s standards
consultant

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Getting the assurance opinion wrong

May be sued
under the tort of
negligence

Partners could
suffer as
partners have Loss of
unlimited and
joint and several
When reputation

liability
things
go
wrong

Face
disciplinary Cost of
action from settlement
ICAB

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Auditor liability

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Auditor liability

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Question (Mar-Apr 23)

Auditing profession and services have been changed magnificently in recent time through seamless
implementation of International Standard on Quality Management (ISQM)-1, ISQM-2 and ISA 220 (Revised)
Globally. Accordingly, stakeholders’ expectations from the auditors and audit firm have been evolved beyond
imagination in terms of quality at firm level and engagement level to protect fraudulent activities and other illicit
actions by the beneficiaries. The ICAB has initiated training and refreshing knowledge of the auditors and others
associated with the auditing processes. But adequate knowledge on ISQMs and other standards, the identification
of the requirements and its execution is vital to achieve the desired objectives.

ABC & Co., Chartered Accountants is a member firm of globally top ten audit firm has 5 partners, 100 article
students and 50 audit staff. The firm provides a range of audit, assurance, tax and advisory/consultancy services.
The firm has two branch offices in the country and serves clients of all size. The quality assurance partner of the
firm has recently resigned, and he has not yet been replaced as the remaining partners of the firm has not been
able to find a suitable replacement. Before his departure, the quality assurance partner was in the process of
implementing a system of ethical compliance for assurance staff. Based on the foregoing, article students and
audit staff would be required to confirm in writing their compliance with the Code of Ethics, hence,
implementation of this system is incomplete. Oxygen Limited is one of the firm's largest clients for which the firm
provides audit, tax and other advisory services. A new engagement partner has been assigned to the audit, as the
previous partner in charge was the one who resigned. The fee for the audit work and other services has been set at
the same level as the previous year although additional work will need to be performed because Oxygen Limited
has introduced a new computerized system. The starting date of the audit has been delayed due to problems with
the new system. The management of Oxygen Limited was very insistent that the fee should not be increased
because of implementation of new system in the company, which reduced processing time of all critical activities.
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Question
Requirements
ISQM-1: International Standard on Quality Management envisages eight elements to ensure quality standards at
the firm level. Discuss in brief the requirements of the following elements of ISQM-1 in terms of the above
scenario to ensure overall quality:
i). Relevant ethical requirements. 2
ii) Resources. 2
iii) Monitoring and remediation process 2
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Solution:
ISQM (both 1 and 2) which became effective from 15th December 2022, applies to ABC & Co., Chartered
Accountants (‘the firm’ hereafter) as appropriate (as the firm provides audits of financial statements, assurance and
related services engagements. As the firm must meet the requirements of ISQM , it should have a system in place
which addresses each of the eight elements of ISQM-1 of which ‘ethical requirements’ is one.
(i) Relevant Ethical requirements for the firm
i. ISQM 1 requires a firm to establish policies and procedures to comply with relevant ethical requirements thus:
• Communicate its independence requirements to staff, and
• Identify and evaluate circumstances and relationships that create threats to independence, assessing the impact
of such threats and applying safeguards or withdrawing from the engagement if appropriate.
i. ISQM 1 requires a firm to maintain independence where required to do so by the following requirements:
• Staff to notify the firm of circumstances and relationships that might create a threat to independence;
• Staff to notify the firm of any breach
• The firm to communicate such breaches to the engagement partner and other relevant staff; and
• The engagement partner to advise the firm of action to be taken.
• If the firm is a member of network firm the principle of confidentiality may apply to the firm’s network,
other network firms or service providers, when they have access to client information obtained by the
firm.

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Solution (contd.):

(ii) Resources
ISQM 1 requires the firm to ensure that:
i. It has sufficient personnel with the competence, capabilities and commitment to ethical principles to meet its
overall quality management objectives;
ii. For each engagement an appropriate and competent engagement partner, especially when a new
engagement partner has to take up audit of Oxygen Ltd. and team are assigned;
iii. Policies should therefore exist for the recruitment, training and development of staff. The firm should ensure
compliance with ISAs and audit staff should have a good knowledge of accounting standards and
local/national statutory accounting regulations;
iv. Given Oxygen Ltd. has introduced a new computerized system the firm should ensure that appropriate
technological resources are obtained or developed, implemented, maintained, and used, to enable the
performance of engagements such as would be required in case of Oxygen Ltd.
v. There should be procedures for ensuring that an audit team collectively has the appropriate level of technical
knowledge for the audit engagement and includes individuals with experience of audits of a similar
complexity, and an ability to apply professional judgment.
(iii) Monitoring and remediation process
This procedure should ensure that:
i. The firm is required to establish a monitoring process designed to provide it with reasonable assurance that
its quality management system is relevant, adequate and operating effectively. This process should include
inspecting, on a cyclical basis, at least one completed engagement for each engagement partner;
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Solution (contd.):

ii. Responsibility for the monitoring process should be given to a partner or other appropriate person with sufficient
experience and authority. When monitoring reviews (also referred to as ‘cold reviews’) are carried out they should
not be performed by those involved with the engagement or the engagement quality management review;
i. The firm should evaluate the effect of any deficiencies found to determine if they do indicate a failing in the
firm’s quality management system;
ii. The firm should communicate such deficiencies to relevant personnel, together with appropriate remedial
action such as:
• Action in relation to individual engagements or employees;
• Communication of findings to those responsible for training and professional development;
• Changes to the firm’s quality management system; and
• Disciplinary action, especially against repeat offenders.
i. If the results of monitoring procedures indicate that an inappropriate report may have been issued, or
procedures were omitted during the engagement, the firm should determine what further action is needed. This
might include obtaining legal advice;
ii. The firm should produce an annual report for partners setting out:
• The monitoring procedures performed;
• The conclusions drawn; and
• Any systematic deficiencies found and remedial action taken.
i. The monitoring system should include procedures for dealing with complaints and allegations against the firm.
These should include establishing channels through which employees can come forward without fear of
reprisals.
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Question
Your manager has been asked to brief your department on the new quality control
procedures that the firm has introduced. Your manager has asked you to prepare a list of
the benefits of quality control procedures in a firm, which he can use as part of his
presentation.

Requirements
a. List of the benefits of quality control procedures in a firm
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Solution:
The benefits of quality control procedures include:
∙ Standard of all audit work completed is high and consistent
∙ Registered auditors are regarded as professionals who follow standards
∙ Quality of the work completed can be measured against a standard
∙ Individuals within firms know if the work they have completed is acceptable

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Summary:
❑ Firms need to ensure they do not draw the wrong conclusion on assurance to avoid:
❑ -professional negligence claim
❑ Disciplinary proceedings from
❑ Loss of reputation
❑ Assurance firm collapse
❑ Firms by implementing Quality control policies and procedures can void above such as:
❑ Taking on/retaining suitable clients
❑ Guidance on ethics
❑ Monitoring
❑ Procedures for ensuring staff are competent
❑ Communication, briefing, supervision, professionals skepticism, judgment
❑ Standard provide guidance under the following headings: leadership, ethics, acceptance/continuance, HR,
Engagement performance, monitoring

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Question
Your firm has recently been appointed as auditor of jog Ltd. (Jog) a company operating within the sports and leisure sector. Your
audit manager has arranged a meeting with the company’s finance director for early next week and she has asked you to assist her, in
advance of this meeting with the audit planning for the year ending 30 June 20x6. Your audit manager has also asked you to carry out
some preliminary analytical procedures on the year-end financial statements of Jog when these become available.
Jog’s business can be split into the following three divisions:

∙ Sports equipment retail outlets: 35 sports equipment retail outlets located in out of town retail parks

∙ Fitness clubs: 15 fitness club: each offering a fully equipped gym together with yoga, aerobic, and circuit training classes

∙ Machine manufacture: a manufacturing unit in which running machines and rowing machines are assembled using components
sourced from overseas:

Further information: Sports equipment retail outlets

The retail outlets are all located close to major towns and cities throughout the whole of Bangladesh. Each outlet stocks a standard
range of products which are supplied from a central warehouse operated by Jog. Salaries for the core staff at the outlets are paid by
Jog’s head office by direct bank transfer. Each outlet is run on a day-today basis by a manger who is responsible for hiring casual
staff to cover peak periods. These casual staff members are ge3nerally paid using cash from the till.

Jog received some bad publicity during the year following its inclusion in a television documentary which revealed that one its non
–Bangladesh sports shoe suppliers was making its employees work long hours for very low wages. In an attempt to manage this
adverse press attention, Jog has now had to source these products from alternative suppliers based in Bangladesh.
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Question
Fitness clubs

Jog’s 15 fitness clubs are all located directly above existing Jog retail outlets. Each club has its own on-site manager and is operated
independently of the adjacent retail outlet, Customers of the fitness clubs pay by one of three methods: on a pay per session basis
over the fitness club counter; by monthly direct debit paid into Jog’s head office bank account; or by annual subscription to head
office. Customers are then issued with a membership card which enables them to gain access to the club. The company operates a
bonus incentive scheme for the managers at both its retail outlets and fitness clubs. The size of the bonus is linked to the profitability
of their individual operation.

Machine manufacture

During the year Jog started to manufacture its own running machines and rowing machines. It sources the machine components from
China and Taiwan. These components are assembled in Bangladesh at Jog’s factory for sale both in Jog’s own stores under their own
Jog brand and also to independent sports shops under the Iron Champ brand. The latter accounts for approximately 80% of Jog’s
total production of both running and ruing machines. Sales to independent sports shops achieve a gross profit margin of 50%,
whereas sales to Jog’s own shops are made to that division at cost plus 10%.

Jog is invoiced by its non-Bangladesh component suppliers in their respective local currency. The components are sent by sea,
which means that Jog’s typical lead time for components from the placing of an order to delivery in Bangladesh is three months. Jog
is required to pay its suppliers 50% with order and 50% upon receipt of the components in Bangladesh.
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Question
Quality control

In line with your firm’s system of quality control, procedures were conducted prior to accepting Jog as an audit client, to ensure that
it was appropriate to accept such an appointment. Your audit manager has asked you to consider the other objectives of a system of
quality control and why thy may be particularly relevant to Jog.

Requirements:

(a) (i) state the objectives of a system of quality control within an audit firm.

(ii) Identify, with reasons, which of the above objectives are likely to be particularly relevant to your audit of Jog.
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Solution:

The objectives of an audit firm’s system of quality control are to ensure that the auditor performs the right work to a high
standard and adequately records the work done. It involves selecting the appropriate team, supervision staff, consulting
sufficiently with colleagues and outside experts and reviewing the work carried out by the team with sufficient care.

A system of quality control will also ensure that the auditor draws the correct conclusions from the evidence available, forms
the appropriate audit opinion and deals adequately with issues raised including reporting to management.

Quality control is also designed to protect the auditor from risks arising as a result of incompetence or negligence of the client’s
staff and will protect the firm from the risk of litigation.

Objectives relevant to the audit of Jog

Jog operates out of many locations and because it has a number of divers activities. The audit firm may not have staff with
relevant expertise. It is therefore particularly important that a team with appropriate skills and experience is selected for the
audit and that the work is supervised closely.

As Jog is a new audit client and because its business is diversified it is particularly important that the audit team has an adequate
understanding of the business. The risks arising from the client’s staff being incompetent or negligent are particularly relevant to
jog as the auditor does not yet know the client very well.

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Chapter 5: Quality Control Question
Problem:

Your firm is the external auditor of Dunlec Ltd. (Dunlec) for the year ended 31 October 20x1. The company is owned by
members of the Dunlop family, none of whom is involved in running the business. Dunlec’s principal activity is the
installation of electrical systems for customers in the retail, construction and industrial sectors in the UK. The company
operates from premises in London and six freehold regional depots throughout the UK.
All contracts are fixed-price. Customers pay 95% of the contract price on completion of the work and withhold 5% of the
contract price for up to six months from the date of completion in case remedial work is required. The materials and
components used by Dunlec are bought from UK suppliers who require payment within 30 days of the invoice date.
Dunlec made an operating loss during the year ended 31 October 20x1. This was mainly due to a substantial bad debt in
respect of a company which went into liquidation in July 20x1. with insufficient funds to pay unsecured creditors. As a
result, Dunlec experienced severe cash flow problems. In August 20x1. to ease its cash flow problems, Dunlec sold its
London freehold premises and leased new premises. Dunlec used the proceeds to:

-Pay a loan instalment on the due date in September 20x1 (final instalment due in September 20x2);
-Pay its overdue tax and related penalties; and
-Reduce the company’s overdraft.

During the year ended 31October 20x1, Dunlec suffered a fall in demand for its services in the construction sector. The
directors have undertaken a strategic review of operations and have decided to reduce the company’s cost base by:
Closing two of the regional depots and putting both premises up for sale. Contracts in those regions will be serviced by the
nearest existing depot; and Making 25% of the company’s employees redundant
The closures and redundancies were announced on 12 November 20x1 and the premises were immediately put up for sale.
As part of their assessment of the company’s ability to continue as a going concern, the directors have prepared cash flow
forecasts. These show that the company can operate within its current overdraft facility for the two years ending 31
October 20x3.
Chapter 5: Quality Control Question

Requirements

a. From the information provided in the scenario, identify the specific matters you would consider when reviewing the
assumptions underlying the receipts and payments included in the cash flow forecasts for the two years ending 31
October 20x3.

b. Discuss the implications for your firm’s auditor’s report in each of the following two circumstances:

(i) Dunlec is not a going concern.

(ii) There is a significant uncertainty about going concern status of Dunlec.

c. Identify the parties to whom your firm may be liable for damages if an inappropriate opinion is provided on the financial
statements of Dunlec for the year ended 31 October 20x1 and state the circumstances under which those parties may be
successful in claiming such damages against your firm.
Chapter 5: Quality Control
Solution
(a) The following matters should be considered when reviewing the reasonableness of the assumptions underlying the
receipts and payments:
Receipts
Trading receipts reflect:
❖ The reduction in demand in the construction sector:
❖ Potential loss of business following the closure of the two depots:
❖ Ninety-five percent of the contract price is received on completion and 5% received six months later; and
❖ The fact that amounts due may not ultimately be paid.
❖ Proceeds from the sale of the two depots are realistic and reflect local property values.
Payments
❖ Payments for components and raw materials reflect the 30 day credit terms
❖ Rent is paid on the due dates and takes into account any rent reviews
❖ Final instalment of the loan is paid in September 20x2
❖ PAYE, NIC and other taxes are paid on the due dates
❖ Redundancy payments are in accordance with legal/contractual obligations
❖ Ongoing wages reflect reduced workforce following the redundancies
❖ Interest on the loan and overdraft is paid in accordance with the terms
❖ Any extra costs (e.g. Legal and selling agent);involved servicing contracts from distant depots and a fall in overheads
after the sale of the two depots are reflected
❖ Professional costs (e.g., legal and selling agent); involved with the sale of depots are included
Chapter 5: Quality Control
Assess
• Impact of changes in key variables (sensitivity analysis) on receipts, interest rate and the proceeds in the sale of the
two depots
• Consistency of items with related items in the profit forecast
(b)
(i) Not a going concern
If the financial statements are prepared on the break-up basis and this is explained in the notes to the financial
statements, and unmodified opinion can be given the auditor’s report will be modified with an emphasis of matter
paragraph highlighting the issue and drawing the users attention to the note in the financial statements. There should
be a specific statement stating that the audit opinion is not qualified.
If the financial statements are prepared on the going concern basis the report/opinion should be modified due to
material misstatement. The opinion should be an adverse opinion (i.e., do not give a true and fair view) as the issue is
material and pervasive. The reasons for the adverse opinion and the effects on the financial statements should be
explained in a paragraph immediately after the opinion paragraph.
(ii) Uncertainty about going concern status
If the financial statements are prepared on the going concern basis and the uncertainty is adequately explained in the
notes to the financial statements an unqualified but modified report should be issued. There should be a paragraph
headed material uncertainty related to going concern after the opinion paragraph drawing users’ attention to the note
in the financial statements. There should be a specific statement stating that the audit opinion is not qualified.
If the uncertainty is not or inadequately, explained in the notes to the financial statements the opinion should be
modified due to material misstatement. The modification may be a qualified opinion/except for if considered material
but not pervasive or an adverse opinion if considered material and pervasive.
Chapter 5: Quality Control

(c) The firm may be sued by the company and the shareholders as a body, (i.e., the Dunlop family), for breach of
contract if the auditor has been negligent in performing the audit.
Third parties (i.e., parties with whom there is no contract), such as the company’s bank may sue for damages under
the Tort of Negligence. The third party must demonstrate that a duty of care was owed by the auditor and that a
loss was suffered by relying on the financial statements with an unmodified auditor’s repot
However auditors may be protected from third party claims by the inclusion of a Bannerman paragraph in the
auditor’s report stating that the report is prepared for the company’s members and no other party .
Chapter 4: Professional Ethics

Any Questions

6/24/2022 WHR