Suggested solution - Thornham Textiles Co

Briefing notes
To: Wendy Runton, audit engagement partner
From: Audit manager
Subject: Thornham Textiles Co – audit planning

Introduction
These briefing notes have been prepared to assist in planning the audit of new audit
client, Thornham Textiles Co. The briefing notes contain an evaluation of the
significant audit risks which should be considered in planning. These notes
recommend the audit procedures with respect to the assets held for sale at the
company and the new share-based payment scheme. Finally, they consider the
factors to be considered when evaluating the nature and extent of reliance which can
be placed on the internal audit department of Thornham Textiles Co.

(b) Evaluation and prioritisation of significant audit risks

Materiality

5 – 10% of profit before tax = range of $440,000 - $880,000.

This benchmark is only a starting point for determining planning materiality and
professional judgement will need to be applied in determining a final level to be applied
during the course of the audit. This is a new client and we are not familiar with the
internal controls and systems at Thornham Textiles Co. Significant changes have
taken place during the year such as setting up the new operation in Farland and
litigation against three retailers. Further changes are planned with the closure of the
Holt factory due to take place in November 20X5. Therefore, materiality has been
based on 5% of profit before tax and has been set at $440,000.

New client
This is the first year that Sheringham Associates has audited the company which
increases detection risk, as our firm does not have experience with the client, making
it more difficult to detect material misstatements.

In addition, there is a risk that opening balances and comparative information may
not be correct. However, because the prior year figures were not audited by
Sheringham Associates, we should plan to audit the opening balances carefully, in
accordance with ISA 510 Initial Audit Engagements – Opening Balances, to ensure
that opening balances and comparative information are both free from material
misstatement.

Analytical review
The company is a listed entity, and the results of the preliminary analytical
procedures carried out by the audit team indicate that there is a significant growth in
revenue of 38.5% along with growth in profits of 35.4%. There will be pressure from
shareholders for the company to return a better performance which creates an

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incentive for management bias, especially given the significant proposed changes in
strategy. This means that management may use earnings management techniques,
or other methods of creative accounting, to create a healthier picture of financial
performance than is actually the case. This creates an inherent risk of material
misstatement, at the financial statement level.

The audit team should apply professional scepticism to areas of the audit where the
accounting treatment is subject to management’s judgement, especially if that
treatment results in the acceleration or inflation of revenue, or the deferral of
expenditure.

Share-based payment scheme

Thornham Textiles Co has introduced a share option scheme in the financial year. In
accordance with IFRS 2 Share-based Payments, such transactions must be
recognised as an increase in equity with a corresponding expense over the vesting
period. The total expense recognised will be calculated as the number of options
expected to vest multiplied by the fair value of the options at the grant date. This is
then allocated over the vesting period, in this case three years.

The expense for the financial year ending 30 September 20X5 will be $481,667,
([850 staff - x 1,000 options x £1.70]/3). This amount is material.
It is possible that management’s assumptions regarding staff turnover may be
incorrect, leading to errors in the calculation. As a new item in the financial
statements, it would be considered a significant audit risk due to the estimations
involved and the assumptions made by management.

If management fails to recognise the accounting impact of the share-based payment

scheme, then equity and expenses would be understated. Further, if management
does not recognise sufficient staff turnover in their calculations, it will be the case
that equity and expenses would be overstated.

Tutorial note: Additional credit will be given for candidates linking that the
redundancy payments might require amounts to be included for the loss of the share
options and questioning the need for an increase in the provision if it has not already
been included with calculations.

Assets held for sale – classification

The company plans on closing the Holt factory and selling either individual assets or
the mill as an ongoing business. The carrying amount of the assets to be sold is
$4.7million and is therefore material to the statement of financial position.

These items therefore are likely to fall within the scope of IFRS 5 Non-current Assets
Held For Sale and Discontinued Operations. In general, the following conditions
must be met for an asset (or 'disposal group') to be classified as held for sale:

• management is committed to a plan to sell;

• the asset is available for immediate sale;
• an active programme to locate a buyer is initiated;
• the sale is highly probable, within 12 months of classification as held for sale
(subject to limited exceptions);

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 • the asset is being actively marketed for sale at a sales price reasonable in
relation to its fair value;
• actions required to complete the plan indicate that it is unlikely that plan will
be significantly changed or withdrawn.
From the discussion with the audit committee, it would appear that the company is
actively trying to find a buyer as it has been in negotiations to sell the mill as an
ongoing business.

There is a risk of material misstatement in relation to the classification of the Holt

factory as held for sale depending on whether the IFRS 5 criteria have been met by
the year end. If the classification is not appropriate, then there is a risk of incorrect
presentation and disclosure in the financial statements in relation to the Holt factory,
for example, the assets and liabilities of a disposal group should be separately
presented in the statement of financial position.

Assets held for sale – measurement

In accordance with IFRS 5, immediately prior to classifying an asset or disposal
group as held for sale, an impairment review is performed in accordance with the
applicable IFRS Standards. Any impairment loss is recognised in profit or loss. After
classification as held for sale, an additional impairment loss based on the difference
between the adjusted carrying amounts of the asset/disposal group and fair value
less costs to sell is recognised. Assets classified as held for sale are not subject to
depreciation.

The assets should be valued at the lower of carrying amount and recoverable
amount where the recoverable amount is the higher of value in use and fair value
less costs of disposal. The carrying amount of the assets in the disposal group is
$4.7 million and the estimated $4 million negotiation amount would be the expected
fair value. As the staff are being made redundant and production wound down at the
mill, value in use is unlikely to be a significant amount, hence it would appear that
the assets of the disposal group are impaired by $0.7 million, which is material. It is
also a non-routine transaction which further increases audit risk.

If management does not write down the Holt factory to its recoverable amount, then
assets would be overstated and profits overstated.

Redundancy provision
The company is planning to make 150 staff redundant with the closure of the Holt
factory. The cost of the redundancy at $1.2 million is a material amount.

In accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets,

an entity must recognise a provision if, and only if:

• a present obligation (legal or constructive) has arisen as a result of a past

event (the obligating event),
• payment is probable ('more likely than not'), and
• the amount can be estimated reliably.

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In the case of the redundancy payments expected to be paid in November 20X5, a
provision would be required if there was a constructive or legal obligation to make
the redundancy payments. Such an obligation would exist if management has made
the employees aware of the plan and begun negotiations over the amounts of
redundancy pay.

The figure quoted by the audit committee may represent an estimate of the amounts
and therefore is of a judgemental nature and may or may not take into account the
implication of the share-based payment scheme or the potential transfer of 75 staff to
the potential buyer interested in purchasing the Holt factory. As such the figure is
susceptible to errors and is high risk.

The provision could be as high as the stated total cost of $1.2million, or potentially
reduced to $600,000 (75/150 x 1.2million)

If the provision for redundancy costs is not sufficient, then the assets and profits
would be overstated, and the expenses understated for the year ending 30
September 20X5.

Farland Mill
While the company routinely sells internationally and is likely to have strong systems
and controls over its sales, the opening of a new mill in Farland and the purchase of
assets internationally introduces new foreign currency transactions and balances
outside of the day-to-day sales system. In particular, the company has purchased
property plant and machinery worth 14 million Pobbles. This translates to $6.3 million
at the date of purchase and is material to the statement of financial position.

According to IAS 21 The Effects of Changes in Foreign Exchange Rates, a foreign

branch would account for the transactions in its own functional currency throughout
the financial period and then its financial statements would be translated into the
presentation currency of the company for inclusion in the financial statements of the
company as a whole. In order to do this, the statement of profit or loss is translated
at the average rate for the year and the statement of financial position at the year-
end rate. This would mean that the Farland branch would prepare its own accounts
in Pobbles and these would be translated into dollars when incorporated into
Thornham Textiles Co’s financial statements.

As management has no experience with international acquisitions or operations, it is

possible they either do not have sufficient accounting knowledge or appropriate
systems in place to capture the correct information, hence this is a significant audit
risk.

Incorrect exchange rates at conversion or incorrect use of the foreign exchange rules
for translation of individual transactions and balances would mean that the profits
and assets of the company could be under or overstated depending on the direction
of currency movements at the period end.

Inventory
Inventories have been damaged due to a severe flood and therefore may not be
saleable. IAS 2 Inventories requires inventory to be held at the lower of cost and net

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realisable value. Management is estimating the damage at $625,000 hence there
may need to be a write down of damaged items, and this is a material amount.

Failure to write down damaged assets would result in overstatement of inventory and
understatement of costs.

As the flooding also affected the warehouse, there are likely to be additional costs to
make this dry and watertight again. Therefore, the audit plan must ensure that
sufficient attention is paid to any costs incurred prior to the year end.

Litigation
It appears that Thornham Textiles Co is involved in litigation against certain retailers.
The company are seeking damages from the three companies of $2 million which is
material.

This potentially gives rise to a contingent asset for any damages awarded. IAS 37
requires that a contingent asset which is virtually certain is recognised as an asset of
the company and that a contingent asset which is probable is disclosed in the notes
to the financial statements. Failure to properly account for the contingent asset could
result in either under or overstatement of assets and profits depending on the
likelihood that the claim will be successful.

There is also a risk of inadequate disclosure of the litigation in the notes to the
financial statements.

Conclusion
Given the audit issues stated above, the audit team should focus on the areas where
management judgement and estimation may materially affect the financial
statements. Therefore, the audit team should focus on the sale of Holt factory as this
is material both quantitatively (at $4.7 million) and qualitatively as it will affect the
presentation and the users’ understanding of the financial statements. As this is a
new client, and there are several changes proposed to the business, it is important
that the audit team gains a thorough knowledge of the internal controls at the
business, as well as understanding the accounting policies, in particular, in respect
of judgemental areas such as provisions and classification of the Holt factory sale.

(b) Audit procedures

(i) Audit procedures in respect of the non-current assets relating to the

planned closure of the Holt Factory
– Obtain a list of the assets relating to the Holt factory and agree to the
non‑current asset register to confirm carrying amount.
– Discuss with management the stage of progress of negotiations with the
potential buyer and whether there is any interest from other parties as
evidence that the sale of the mill as an operating unit is likely to occur.
– Review correspondence with the potential buyer for the mill to assess the
progress of negotiations and for evidence of the purchase price.

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– Obtain management’s impairment review and assess whether the
assumptions are in line with the auditor’s understanding.
– Cast management’s impairment review for arithmetical accuracy.
– Obtain the most recent surveyor’s report for the Holt factory property to
confirm the likely net realisable value for the property as an individual asset.
– Obtain current market prices for used mill equipment from the trade press or a
specialist valuer to identify realisable value of the machinery.
– Confirm that impairment losses are correctly allocated to the assets of the unit
by evaluating management’s method for determining the impairment loss.
– Review board minutes for evidence the sale has been approved and to
understand the progress of negotiations.
– Review the financial statements to ensure reclassification as held for sale has
occurred in the statement of financial position and appropriate disclosures
regarding the proposed sale have been disclosed in the notes to the financial
statements.
– Obtain a written representation from management that it is their intention to
complete the sale of the Holt factory within 12 months of the classification as
assets held for sale.
– Review the components of the total depreciation charge for the year to
confirm that no depreciation has been charged after reclassification as assets
held for sale.

(ii) Audit procedures in respect of the share-based payment scheme

– Obtain a copy of the terms and conditions of the share‑based payment scheme
to confirm the vesting conditions and the number of shares and prices
involved.

– Identify any terms in the agreement regarding redundancy or transfer of

employment.
– If necessary, seek legal clarification regarding the staff of the Holt factory and
their entitlement to retain their share options.
– Obtain board minutes to confirm approval of the share‑based payment
scheme.
– Discuss with management how the fair value at the grant date and other
assumptions have been performed and assess their basis for consistency with
auditor’s understanding.
– If an expert was used to provide the fair value of the options at the grant
date, consider the independence and competence of the expert to assess the
extent of reliance which can be placed on them.
– Discuss with Human Resources (HR) how many staff have been awarded
share options and whether any of those staff have left the company.
– Discuss with HR the historical levels of staff turnover to assess the
reasonableness of the assumption that no staff will leave during the vesting
period.

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 – Review the calculation of the annual expense for the share options and
ensure the completeness and accuracy of the calculation.

(c) Matters which should be considered in determining the amount of reliance

to be placed on Thornham Textiles Co’s internal audit department

According to ISA 610 Using the Work of Internal Auditors, the external auditor may
decide to use the work of the audit client’s internal audit function to modify the nature
or timing, or reduce the extent, of audit procedures to be performed directly by the
external auditor.
In some jurisdictions the external auditor may be prohibited, or restricted to some
extent, by law or regulation from using the work of the internal audit function.
Therefore Sheringham Associates should consider whether it is prohibited by the law
or regulations which it must adhere to from relying on the work of Thornham Textiles
Co’s internal audit department or using the internal auditors to provide direct
assistance. However, at a minimum the external auditor can review the findings of
the internal audit team’s work on internal controls to obtain understanding and inform
their evaluation of control risk. This will be especially useful given that this is the first
year that Sheringham Associates has performed the audit of Thornham Textiles Co.
Sheringham Associates must evaluate the internal audit department to determine
whether its work is suitable by evaluating:
– The extent to which the internal audit function’s organisational status and
relevant policies and procedures support the objectivity of the internal
auditors;
– The level of competence of the internal audit function; and
– Whether the internal audit function applies a systematic and disciplined
approach, including quality control.
In assessing the first of these requirements, one of the criteria is whether the internal
audit team is objective. The internal auditor should be able to report their findings in
an unbiased way without fear of repercussion from management. As such, it would
be expected that the internal audit department reports directly to the audit committee.
When assessing competence, the qualification and experience of the head of internal
audit and the internal audit staff should be considered. It would be expected that the
department has staff who are qualified accountants with internal audit experience. A
programme of ongoing training and development would also be expected to ensure
that the department is up‑to‑date with new developments in financial reporting and
other issues. The resources available to the internal audit department will also impact
on the competence of the department as a whole. An understaffed department is
likely to be less effective than a department with sufficient resources to carry out the
role.
To assess the final requirement, Sheringham Associates would need to review the
reports and findings of the internal audit department to assess whether the nature
and quality of the documentation and the conclusions are appropriate. They would
investigate what level of review and authorisation was performed on the findings and
the process for planning the work to be performed. If the department is free to plan
its own investigations rather than focus only on areas allowed by management and

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where management acts upon the findings, a higher level of reliance would be
possible.
Even when the requirements are all met, it is required that the external auditor makes
all significant judgements in the audit engagement and it is expected that the higher
the level of risk of misstatement an item involves, the lower the reliance on internal
audit shall be.
If the external auditor wishes to make use of direct assistance with procedures from
the internal audit function, this cannot cover procedures which involve making
significant judgements in the audit or relate to higher assessed risks of material
misstatement where the judgement required in performing the relevant audit
procedures or evaluating the audit evidence gathered is more than limited. In
addition, the procedures cannot relate to work in which the internal auditors have
already been involved.

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Marking Guide - Thornham Textiles Co -

(a) Evaluation of audit risks

Up to 3 marks for each audit risk evaluated unless otherwise indicated.

In addition, ½ mark for relevant trends or calculations which form part of the evaluation
of business risk or risk of material misstatement (max 3 marks).

Up to 3 additional marks for materiality, comprising the appropriate calculation of

the lower and upper thresholds based on projected revenue - 1 mark for each
calculation, plus 1 mark for justification of materiality determined within the range.

• New client – increased detection risk (2 marks)

• Analytical review (2 marks)
• Share-based payment (4 marks)
• Assets held for sale – classification
• Assets held for sale – measurement
• Provision for redundancy (up to 4 marks)
• Foreign exchange - opening of Farland Mill
• Inventory
• Litigation - contingent asset
Maximum 23 marks

(b) Audit procedures

Generally, 1 mark for each well-described procedure.

(i) Assets held for sale

– Obtain a list of the assets relating to the Holt factory and agree to the
non‑current asset register to confirm carrying amount.
– Discuss with management the stage of progress of negotiations with the
potential buyer and whether there is any interest from other parties as
evidence that the sale of the mill as an operating unit is likely to occur.
– Review correspondence with the potential buyer for the mill to assess the
progress of negotiations and for evidence of the purchase price.
– Obtain management’s impairment review and assess whether the
assumptions are in line with the auditor’s understanding.
– Cast management’s impairment review for arithmetical accuracy.
– Obtain the most recent surveyor’s report for the Holt factory property to
confirm the likely net realisable value for the property as an individual asset.
– Obtain current market prices for used mill equipment from the trade press or a
specialist valuer to identify realisable value of the machinery.
– Confirm that impairment losses are correctly allocated to the assets of the unit
by evaluating management’s method for determining the impairment loss.

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 – Review board minutes for evidence the sale has been approved and to
understand the progress of negotiations.
– Review the financial statements to ensure reclassification as held for sale has
occurred in the statement of financial position and appropriate disclosures
regarding the proposed sale have been disclosed in the notes to the financial
statements.
– Obtain a written representation from management that it is their intention to
complete the sale of the Holt factory within 12 months of the classification as
assets held for sale.
– Review the components of the total depreciation charge for the year to
confirm that no depreciation has been charged after reclassification as assets
held for sale.

(ii) Share-based payment scheme

– Obtain a copy of the terms and conditions of the share‑based payment scheme
to confirm the vesting conditions and the number of shares and prices
involved.

– Identify any terms in the agreement regarding redundancy or transfer of

employment.
– If necessary, seek legal clarification regarding the staff of the Holt factory and
their entitlement to retain their share options.
– Obtain board minutes to confirm approval of the share‑based payment
scheme.
– Discuss with management how the fair value at grant and other assumptions
have been performed and assess their basis for consistency with auditor’s
understanding.
– If an expert was used to provide the fair value of the options at the grant
date, consider the independence and competence of the expert to assess the
extent of reliance which can be placed on them.
– Discuss with Human Resources (HR) how many staff have been awarded
share options and whether any of those staff have left the company.
– Discuss with HR the historical levels of staff turnover to assess the
reasonableness of the assumption that no staff will leave during the vesting
period.
– Review the calculation of the annual expense for the share options and
ensure the completeness and accuracy of the calculation.

Maximum 10 marks

(c) Factors to be considered when evaluating the nature and extent of reliance
that can be placed on the internal audit department.

Generally, up to 2 marks for each area discussed

– General introduction (1 mark max)

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 – Organisation status and objectivity
– Competence
– Systematic processes and quality control
– Direct use on internal audit staff
Maximum 7 marks

Professional marks

Communication
• Briefing note format and structure - use of headings/sub-headings and
an introduction
• Style, language and clarity - appropriate layout and tone of briefing
notes, presentation of materiality and relevant calculations, appropriate use
of the CBE tools, easy to follow and understand
• Effectiveness and clarity of communication - answer is relevant and
tailored to the scenario
• Answering the specific angle and requirements of the question

Analysis and Evaluation

• Using the information in the scenario to evaluate the magnitude and
consideration of risks
• Effective prioritisation of the results of the risk evaluation to demonstrate
the likelihood and magnitude of risks and to facilitate the allocation of
appropriate responses
• Identification of audit procedures which address areas of judgement
and/or risk

Professional scepticism and professional judgement

• Effective challenge of information supplied, and techniques carried out
to support key facts and/or decisions
• Determination and justification of a suitable materiality level,
appropriately and consistently applied
• Appropriate application of professional judgement to draw conclusions
and make informed decisions about the courses of action which are
appropriate in the context of the audit engagement
• Identification of possible management bias or error.

Commercial acumen
• Use of effective examples and/or calculations from the scenario to
illustrate points or recommendations
• Appropriate recognition of the business implications of situations in the
scenario on the client and the audit firm.

Maximum marks 10 marks

Total Question One 50 marks

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Suggested solution - Soba

(a) International Standard on Quality Management 1 Quality Management for

Firms that Perform Audits or Reviews of Financial Statements or Other
Assurance or Related Services Engagements (ISQM1) has been introduced
with the intention of increasing the proactive focus on audit quality of firms
providing audit and assurance services.

Acceptance and continuance

Firms will be required to have robust acceptance and continuation procedures

in place to determine whether it is appropriate to act as auditor. This
requirement puts an emphasis, not only on the suitability of new clients, but on
ensuring existing clients are reassessed before each engagement, to
determine if they are still suitable to be a client of the firm.

The considerations associated with these decisions place focus on the

desirability of existing and potential clients by requiring the audit firm to assess
the integrity and ethical values of the client in deciding whether it is appropriate
to accept each engagement. This covers matters such as client identity and an
assessment of the behaviour and reputation of the company, its directors and
owners.

For existing clients, the firm is assessing whether information has been
obtained which would have prevented the firm from accepting them as a new
client had it been known at the time of acceptance. For example, if a client
refuses to allow the auditor access to information, refuses to correct a material
misstatement, or engages in illegal practices, then the firm would not have
accepted them and therefore should not agree to continue their appointment
for the next financial year’s audit.

Alongside an assessment of the client, firms must assess whether they have
the competence and ability to perform the audit in accordance with applicable
professional and legal requirements. For an existing client, it may be the case
that the client company has grown or diversified in such a way that the firm no
longer has appropriate specialist partners and staff available to provide a quality
audit.

By focusing on whether the firm would wish to be associated with a client and
on the firm’s ability to perform a quality audit for that client, ISQM1 should result
in auditors only accepting or continuing an audit engagement if they believe a
quality audit can be performed.

The firm must ensure the resources are in place to enable audit quality to be
maintained. This will mean have sufficient competent employees to perform the
audit and other roles such as the engagement quality review. It will also mean

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specialised resources are used where necessary such as auditors with
specialist industry knowledge or appropriate IT skills.

Firm-wide culture and system of quality management

The changes required by ISQM1, particularly when combined with the

improvements to engagement quality reviews in International Quality
Management Standard 2 – Engagement Quality Reviews (ISQM 2) provide a
framework which aims to ensure audit quality is a primary objective for firms
providing audit and assurance services. This focus on improving audit quality
should in time reduce the occurrence of audit failings which undermine public
trust in the process.

ISQM1 places the responsibility for engagement quality at the firm level rather
than the level of individual engagements. It requires the firm to demonstrate a
commitment to quality and ethics through the culture of the firm and requires
firms to include quality as part of their strategic goals. The ultimate responsibility
and accountability for the firm’s system of quality management (SoQM) is
assigned to the chief executive officer/managing partner or their equivalent.
Operational responsibility can be assigned to other individuals, but they are
required to have the knowledge, experience, time, influence and authority to
discharge those responsibilities.

By moving the responsibility for audit quality from the engagement partner
assigned to an individual audit, to a firm wide ‘tone at the top’, ISQM1 supports
the commitment to quality across the firm. This should result in systems and
policies which reward commitment to quality rather than focusing on client
retention and engagement profit. As a result, overall quality should improve as
personnel feel empowered to ensure appropriate decisions and procedures are
performed to ensure each auditor’s report issued is appropriate for the
circumstances and all professional and legal requirements have been followed
in conducting the audit.

Firms cannot simply create a SoQM and assume it functions to mitigate all the
threats to quality management. There must be a process for monitoring both
the appropriateness of the design of the system and compliance with the
system. Where deficiencies are found in the design or operation of system and
controls, there must be actions taken to address those deficiencies.

In order to ensure quality audits are performed the SoQM must also address
quality at the engagement level. This includes ensuring all members of the team
understand their role and responsibilities on the audit and that the work of the
engagement team is appropriately supervised and reviewed to ensure that all
the evidence required to support the audit opinion is obtained. This will include
ensuring proper professional scepticism is demonstrated and the team are
confident to challenge management.

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Tutorial note: Candidates would not be expected to produce an answer of this
length, this is provided to show the range of points where credit may be
awarded. Please refer to the marking guide for more information on how the
credit would be awarded.

(b) Udon Co

Forensic auditing is the process of gathering, analysing and reporting on data,

in a pre-defined context, for the purpose of finding facts and/or evidence in the
context of financial and legal disputes. The investigation for Udon Co will
involve undertaking a full financial investigation in relation to the estimated
profit that would have been made on the inventory destroyed by the flood.

Scope of the investigation

Soba & Co should establish with Udon Co the specific work which they are
expected to perform. It is likely that the assurance of the loss represents an
agreed upon procedures engagement and this would need to be confirmed
with Udon Co in advance. The report should contain a clear overview of the
sources of information used in the report.

Soba & Co would need to establish the time period Udon Co would like them
to consider. This is likely to be defined by the insurance policy held by Udon
Co as business interruption insurance is typically for a set time period until the
company is able to resume operations.

Professional competence and due care

As with any engagement, the firm should consider its ability to perform the
engagement with the required level of expertise and competence. Soba & Co
has a forensic department so it is likely that the firm has performed similar
engagements in the past. Additionally, the firm needs to have sufficient
knowledge of the business and industry to perform a meaningful investigation.
The insurance claim is for business interruption, requiring Soba & Co to
forecast the profits that would have been made had the flood not happened,
and as such comprises prospective financial information. Prospective financial
information requires a high level of skill for assurance as best-estimates and
assumptions may have little basis and will lead to higher risk.

Industry
As Udon Co is in the fashion industry and inventory is fast moving, there is a
risk that Soba & Co is not familiar with the margins and valuation of inventory.
The distribution centre suffered extensive damage and Soba & Co will need to
establish the type of inventory held there, e.g. was it for the forthcoming
season, or last season’s clothing. This will have implications on the potential
margins that the finance director will have calculated on the potential losses.

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Fashion is not always sold at full price, especially as there are regularly sales
with significant discounts on previous season’s clothing. Soba & Co will need
to ensure that they are familiar with the industry and refer to the expert reports
as to the losses of inventory incurred.

The types of reports and prospective users

The firm must confirm with Udon Co what type of report they would expect as
a result of the engagement and to whom the report would be distributed. In
forensic engagements, the procedures to be performed would normally be
agreed and then the results of those procedures would be reported. Due to the
insurance claim, it is likely that this report will be used by third parties in which
case the engagement is higher risk.

Resource availability
In addition to having staff with the appropriate competencies to conduct the
engagement, it is also crucial that those staff are available to conduct the
agreed upon procedures and report in the required time frame. Udon Co have
requested a very short deadline on the assurance work of only two weeks
which significantly increases the time pressure. Soba & Co must consider the
extent of the possible reporting and whether they are able to commit the
necessary resources without adversely affecting other client commitments or
the quality of the work performed. There is a risk that two weeks is insufficient
time to obtain the necessary evidence to support any conclusion on the
insurance report.

Fees
The contingent fee constitutes a self-interest threat to the objectivity and
independence of the forensic engagement. Soba & Co is required to provide
objective analysis of Udon Co’s projected profits from the flood damaged
inventory and this independence would be impeded by a contingent fee
whereby Soba & Co were to benefit if the claim was submitted within the very
short timeframe. The contingent fee should be rejected by Soba & Co and an
appropriate fee based on the time and skill level of the staff required should be
agreed prior to the commencement of work. The report produced should
contain confirmation that any fees paid are not on a contingent basis.

Advocacy threat
In an assignment such as this, it is crucially important that Soba & Co maintain
their independence and provide evidence in a manner which is within their
expertise and the scope of the engagement. There may be the expectation,
particularly from the finance director of Udon Co, that Soba & Co will actively
serve the interest of Udon Co leading to an advocacy threat, however the duty
to provide unbiased assurance overrides any obligation to the person/company
instructing or paying them. Forensic experts must not serve the exclusive

4
interest of those who retain them. Although it may appear that Soba & Co are
representing and acting on behalf of Udon Co, the report must include a
declaration that the contents of their report are true to the best of their
knowledge.

The threat of advocacy should be mitigated by ensuring that the terms of

engagement clearly communicate the duties and responsibilities of Soba & Co
to the insurance company and Udon Co respectively.

(c) Procedures
Procedures which could be performed in relation to the two potentially fraudulent
transactions include, but are not limited to:
Sale of land
– Inspect the sale agreement in relation to the sale of land to identify
whether the sale value is $2·8 million or $2·6 million and to confirm the
nature and amount of any other income relating to the transaction.
– Inspect historical board minutes to identify the value of the sale
which was originally communicated to the board by management.
– Inspect the terms of the sale agreement to identify the existence of
consultancy fees in relation to the transaction and to determine the
nature of the services offered for consultancy and who the named
recipient of consultancy income is.
– Trace the total payments identified in the sales agreement to Ramen Co’s
main bank account to confirm their receipt.
– Identify the details of the bank account which was used to transfer the
sales proceeds into Ramen Co’s bank account and identify any other
receipts of cash from this source. In particular, identify if the $200,000
consultancy fees come from the same source.
– Identify and document the bank account details into which the
$200,000 was transferred to obtain evidence of the destination of
potentially fraudulent transactions and to compare these against
the details of Ramen Co’s other bank account.
Lease and other bank account
– Inspect the contract to lease the land to the outdoor adventure
company and confirm the terms of the lease, including the amount of
the regular monthly lease payments and any associated management
fees.
– Review the terms of the lease to identify what the management fees relate
to and whether they relate to services provided by a named person or
company.
– Trace the contractual amounts to Ramen Co’s bank accounts to
confirm receipt of these amounts by Ramen Co. Identify the account

5
 details used to transfer the funds into Ramen Co’s account and
identify whether any additional payments have been received from
this source.
– Ask the accounts clerk if they have any information relating to the other
Ramen Co bank account, including the account details, bank
statements or even the name of the bank used.
– Send a request to the company’s bank to provide confirmation of all the
banking facilities provided by Ramen Co’s main bank. This will require
prior approval by a representative of Ramen Co.
– Inspect the minutes of the board of Ramen Co to try and identify if
and when the board approved the opening of a new account.
– If the provider of the additional account can be identified, and is different
from the company’s main bank, send a request to this alternative provider
of finance for confirmation of all banking facilities held by Ramen Co.
– If considered appropriate in light of the need for discretion, question
Bess Bell about the additional bank account, requesting all
documentation relating to the account from her, and enquiring as to
who approved the creation of the bank account and when was it
established.

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Marking guide - Soba

(a) Discuss how the requirements of ISQM 1 Quality Management for Firms
that Perform Audits or Reviews of Financial Statements, or Other
Assurance or Related Services Engagements should improve audit
quality and help to restore public trust in the audit profession. Your
answer should focus on the following key areas:

• General comments on ISQM (up to 1 mark)

• Acceptance and continuation of client relationships (up to 3 marks)

• Robust acceptance and continuance processes: E.g. more client risk
assessment, focus on quality audit if accepted
• Not just client ID but also ethics/behaviours/reputation of the company
• Existing clients:
• New information come to light, problems with access etc –
discontinue the next year
• Changes at client – do we still have competence/require
specialisms

• Firm-wide culture (up to 4 marks)

• Leadership at firm level not engagement level
• Culture: Firm wide commitment to quality and ethics
• SoQM – designated manager/leader to oversee + relevant resources,
time and influence.
• Culture – tone at the top
• reward quality not profit
• perform all necessary procedures without budget concerns
• Improved client relations
• Better decision making (firm as a whole not individual
engagements) and ensuring strong regulatory oversight on the
engagements.
• SOQM addresses quality at engagement level
• All members understand their role and responsibilities
• Ensures appropriate supervision & review to ensure the evidence
supports the opinion
• Team members display professional scepticism and challenge
management

Maximum 6 marks

(b) Generally, up to 1 mark for each issue explained.

 Scope of assignment
 Professional competence and due care - competence/expertise,
industry/business experience, forecast information higher risk/more skill

1
  Industry knowledge and awareness – fast-moving industry, risks assessing
margins on lost inventory, expert reports
 The types of reports and prospective users – use by insurance company,
additional risk,
 Resource availability – short timescale, impact on the rest of Soba & Co
business, limitation of evidence in short timescale.
 Fees – self-interest threat/threat to independence, contingent fee
 Advocacy - explained
 Safeguards

Maximum 8 marks

(c) Generally, up to 1 mark for each well explained, relevant procedure:

 Inspect sale agreement to confirm value of sale
 Inspect board minutes: – confirm reported value of sale
o confirm approval of new bank account
 Inspect lease agreement: – confirm total lease payments
o confirm nature of management fees
 Trace payments to bank statements
 Match payee details for land sale and consultancy payment
 Identify the details of the additional bank account
 Obtain documentation of the additional account from Bess Bell
 Enquire from Bess Bell who approved the additional bank account
and when it was opened
 Inspect bank letter
Maximum 6 marks

Professional skill marks

Analysis and evaluation
• Identification of procedures which address the areas of judgement or where the
key areas of risk are being addressed.
• Appropriate use of relevant technical knowledge (ie ISQM and ISRS 4400) in
respect of providing a substantial answer considering risks specific to forensic
investigations.

Professional scepticism and judgement

• Effective challenge and critical assessment of the acceptance considerations
supplied with appropriate conclusions such as observations on ethical and
professional issues, demonstrating appropriate application of QM client
acceptance guidance.

Commercial acumen
• Appropriate recognition of the wider implications on the engagement, the audit
firm and the company

Total marks 25 marks

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Suggested solution – Rashid

(a)(i) Matters to be discussed in relation to the uncorrected misstatements

Franchise agreement

In accordance with IAS® 38 Intangible Assets, those with a finite useful life should
be amortised over that period. Where there is an indication that an intangible asset
with a finite useful life might be impaired, IAS 36 Impairment of Assets requires that
an impairment test is performed. The introduction of the sugar tax is an indicator of
potential impairment of the franchise agreement hence management should have
performed a review.

In an impairment test, the carrying amount of the asset (or cash generating unit) in
question is compared to the recoverable amount of the asset. If the recoverable
amount is lower than the carrying amount, an impairment loss should be recognised
for the difference,

The recoverable amount is calculated as the higher of the fair value less costs to sell
and value in use. In relation to the franchise agreement, the rights are
non-transferable, so a sales price is not relevant; however, audit testing suggests
that value in use, and hence recoverable amount, is $35 million. The asset should be
written down from the carrying amount of $40 million to its recoverable amount of
$35 million.

The difference of $5 million is material and should be recognised in the statement of

profit or loss.

This represents a subjective material misstatement of the value of the asset as a

result of management not performing an impairment review where an indicator of
impairment is present. Management should be requested to amend the carrying
amount of the asset. Failure to adjust this amount or provide sufficient evidence to
justify their assertion that the value will not be impacted by the sugar tax will result in
a material misstatement of the financial statements.

Forward contract

Under IFRS® 9 Financial Instruments, a forward contract is an example of a financial

instrument, which should be measured at fair value through the statement of profit or
loss unless it is part of a hedging arrangement and hedge accounting is being used.
In this case, the nature of the transaction was speculative and hence hedge
accounting rules do not apply.

The asset should be revalued to fair value on 31 March 20X5. This would increase
the value of the asset from $1 million to $1·35 million with the gain of $350,000 being
taken to the statement of profit or loss.

The adjustment of $350,000 is not quantitatively material to the financial statements,

therefore failure to amend this valuation would not result in a material misstatement
of the financial statements. However, it is best practice for management to amend
such errors. It may also be argued that the incorrect accounting treatment is material
by nature as there is a misapplication of an accounting standard and if the

1
speculative use of derivatives continues, then the effects will accumulate in future
periods.

Legal action

Legal actions such as the case relating to the Shoutout brand give rise to potential
liabilities such as provisions or contingent liabilities.

IAS 37 Provisions, Contingent Liabilities and Contingent Assets defines a contingent

liability as:

• A possible obligation depending on whether some future event occurs, or

• A present obligation but payment is not probable, or the amount cannot be
measured reliably.

Entities are required to disclose contingent liabilities unless the possibility of

economic outflow is remote.

The legal action against the company in relation to the Shoutout product meets the
definition of a contingent liability as there is a possibility of losing the case and the
settlement amounts cannot be reliably estimated.

While IAS 37 allows the non-disclosure of information about provisions and

contingent liabilities where disclosure is expected to prejudice the position of an
entity in a dispute, this would only apply in extremely rare cases, and it requires that
the general nature of the dispute is disclosed together with the fact certain
disclosures have not been made and why.

As no monetary amounts can be provided regarding the potential settlement values,

no quantitative materiality can be calculated, however, this item would be material by
nature through non-disclosure and a failure to comply with the requirements of IAS
37. As such, management should be requested to disclose the general information
regarding the case action otherwise the financial statements would be materially
misstated in this regard.

(ii) Impact on auditor’s report and opinion

If management refuses to adjust the financial statements, then Bob & Co should
communicate the misstatements to those charged with governance and repeat the
request to adjust the financial statements.

When considering their opinion, the auditor must conclude whether the financial
statements as a whole are free from material misstatement. In order to do this, they
must consider whether any remaining uncorrected misstatements are material, either
on an individual basis or in aggregate.

The aggregate effect of the misstatements would be to overstate Rashid Co’s profit
by $4·65 million ($5 million – $0·35 million). Total assets on the statement of
financial position would also be overstated by this amount.

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The overstatement is material to the statement of profit or loss on an aggregate
basis based on the materiality threshold for this audit of $2.2million.

However, as the necessary adjustment regarding the impairment of the franchise

agreement is individually material, management should be informed that as the
valuation calculated by the audit team is more appropriate, then failure to incorporate
this adjustment will result in the auditor concluding that the financial statements are
materially misstated.

The lack of disclosure regarding the contingent liability is also material in isolation
and in itself creates a material misstatement.

If adjustments are still not made, based on the misstatements identified, a

modification to the audit opinion will be made in accordance with ISA 705
Modifications to the Opinion in the Independent Auditor’s Report. The type of
modification depends on the significance of the material misstatement. In this case,
the misstatement regarding the impairment is material to the financial statements but
is unlikely to be considered pervasive. Similarly, the lack of the disclosure is unlikely
to render the financial statements as a whole misleading; therefore, a qualified
opinion should be expressed. The auditor will state in the opinion that the financial
statements show a true and fair view ‘except for’ the effects of the matters described
in the basis for qualified opinion paragraph.

A basis for qualified opinion paragraph should be placed immediately after the
opinion paragraph. This should include a description of the matters giving rise to the
qualification, including quantification of the financial effects of the misstatement.

The remaining uncorrected misstatement is immaterial to the financial statements

and it will be at the discretion of management to amend and will have no impact on
the auditor’s report. Although, as previously mentioned, because of the impact on
future periods, management should be encouraged to amend for all misstatements.
If management intends to leave these as uncorrected misstatements, written
confirmation of their immaterial nature should be obtained via a written
representation.

Tutorial note: Credit will also be awarded if the remaining misstatement is considered
material by nature as it related to the misapplication of an accounting standard and is
discussed in this context.

(b) Professional and ethical issues

Due diligence engagement

It appears that this due diligence engagement has been performed outside of the
audit engagement, without the knowledge of the audit team.

This engagement gives rise to an ethical threat to the audit firm’s independence and
objectivity. A threat to the auditor’s objectivity arises due to the audit firm’s views and
interests being closely aligned to those of management and thus there is a risk of
assuming management responsibilities. This threat may be somewhat reduced by

3
Rashid Co being a listed company and therefore likely to have informed
management.

A self-review threat has also been created as the purchase of the trade and assets
of Carlos Co will form part of the financial statements to be audited and the firm may
be reluctant to highlight any errors in the value of assets, and may not approach the
issue with an appropriate degree of professional scepticism. The significance of the
threat, which has been created, should be evaluated in terms of the materiality of the
assets and the subjectivity involved in the quantification. Here the amounts were
immaterial and so the threat has been mitigated to some extent through the use of a
separate engagement team to perform the asset valuation.

By performing the due diligence engagement, Bob & Co could be perceived as

acting on behalf of Rashid Co, promoting the interests of the company, and therefore
this gives rise to an advocacy threat to independence. This is because it is in the
interests of the client to go ahead with the acquisition and the audit firm could be
perceived as assisting management in achieving this business objective.

The IESBA International Code of Ethics for Professional Accountants (the Code)
states that the firm shall not accept any engagement which includes the provision of
services where it is probable that an objective, reasonable and informed third party
would conclude that the audit firm was playing a part in management decision taking.

There are restrictions on the provision of non-audit services to a listed audit client
and depending on the exact scope and nature of the work performed, it is very likely
that this service should not have been provided.

According to the Code, whenever a possible or actual breach of the Code is

identified, the issue should be promptly communicated to the engagement partner.
The firm should then evaluate the significance of the breach to determine whether
there are safeguards that can be put in place or other actions that can be taken to
address any potential adverse consequences.

Therefore, Bob & Co should arrange for independent reviews of both the due
diligence work and the audit work prior to issuing the auditor’s report. As Rashid Co
is listed, it will already be subject to an engagement quality review. The reviewer
should be made aware of the situation, so that they can pay particular attention to
the audit of the assets acquired from Carlos Co, to verify that an appropriate amount
of professional scepticism was applied during the audit.

In addition, it is required that the audit firm reports breaches of the Code to those
charged with governance of an entity relevant to an engagement, where a breach
relates to a specific engagement or engagements in a timely manner.

The situation should therefore be discussed with the audit committee of Rashid Co,
to obtain understanding of how the audit firm was appointed to perform the due
diligence engagement, and the process by which the audit committee deemed the
appointment appropriate. The safeguards employed by the audit firm since the
breach of the Code was discovered should also be discussed.

4
The Code also requires that where a possible or actual breach is identified, the audit
firm should consider whether there is a need to resign or withdraw from the
engagement. This should also be discussed with the audit committee.

5
Marking guide - Rashid

(a)(i) Matters to discuss with management

Generally, up to 1 mark for each well explained point.

Franchise agreement

• Applicable accounting treatment (2 marks) – IAS 38, IAS 36

• Inappropriate assumption used by management
• Material misstatement due to judgments made by management – lack of
impairment review where indicators are evident.
• Request further evidence or adjustment
Forward contract
• Applicable accounting treatment
• Inappropriate treatment by management
• Does not require adjustment in isolation– best practice to amend, misapplication of
accounting standard, effects likely to accumulate.
Legal action
• Applicable accounting treatment– contingent liability, disclosure required unless
‘economic outflow is remote’
• Factual misstatement
• Material by nature– no quantitative materiality, failure to adopt IAS 37
• Request disclosure- material misstatement without disclosure
Marks 9

(ii) Impact on the auditor’s report and auditor’s opinion

Up to 1 mark for each relevant point discussed.

• Escalate the matter to TCWG if management refuse to amend financial statements

• Quantify the aggregate effect
• Assessment (including justification) of pervasiveness
• Audit opinion based on pervasiveness conclusion
o Qualified on the basis of material misstatement
• Written representation regarding uncorrected misstatements from management
Marks 5

(b) Ethical and professional matters

Up to 1 mark for each relevant point explained.
• Management responsibility - explained
• Potential advocacy threat - explained
• Prohibition on providing non-audit services to listed client
• Determine appropriate safeguards
• Bring to the attention of EQR

1
 • Required to discuss the breach and safeguards with audit committee
• Discuss audit committee’s pre-approval of the non-audit services
• Consider need to resign from the audit
Maximum marks 6

Professional skill marks

Analysis and evaluation

• Appropriate assessment of the relevant ethical and professional issues

relating to the engagement, using examples where relevant to support overall
comments
• Demonstration and appropriate application of relevant technical financial
knowledge to support conclusions and recommendations.

Professional scepticism and judgement

• Effective challenge of information and draw appropriate conclusions on the

appropriateness of the accounting treatment proposed by management
• Demonstrates professional judgement to evaluate the magnitude of the
misstatements and their impact on the auditor’s report.

Commercial acumen

• Appropriate recognition of the wider implications on the engagement, the audit

firm and the company

Marks 5
Maximum marks 25