Answers

Strategic Professional – Options, AAA – INT

Advanced Audit and Assurance – International (AAA – INT) March/June 2022 Sample Answers

1 Briefing notes

To: Brian Fox, Audit engagement partner

From: Audit manager
Subject: Audit planning in relation to The Infinite Co and assessment of client acceptance performed on Meadow Co
Introduction
These briefing notes have been prepared to assist in planning the audit of The Infinite Co for the year ending 30 September 20X5.
The notes begin with an evaluation of the risks of material misstatement which should be considered in planning the audit. The
notes include the recommended principal audit procedures which have been designed in respect of the valuation of the theme park
rides. A discussion of the matters to be considered and the implication for the audit of the issues surrounding the renewal of the
operating licence for the rides is provided along with recommended actions to be taken by the firm. The notes then discuss risk
factors relating to money laundering arising from The Infinite Co’s operations and our responsibility as auditors with respect to money
laundering. Finally, the notes evaluate the weaknesses in Pascal & Co’s client acceptance of the client Meadow Co and recommend
improvements to the firm’s client acceptance procedures.

(a) Evaluation of risks of material misstatement

Licence/going concern
The company is dependent on licences for its ability to operate. There is a risk that these licences are revoked if breaches in
regulations occur. The company will then not be allowed to offer the products and services covered by the licence, affecting the
company’s ability to operate as a going concern. In particular, the licence to operate the theme park rides may be revoked due
to health and safety breaches. Although this is not the sole activity at the park, it does form a major part of the offering on which
other areas rely to attract customers, and, as such, the potential loss of the operating licence may require disclosures to be
made in the notes to the accounts describing the uncertainty arising. Such disclosures are material to the users’ understanding
of the financial statements and there is a risk that these disclosures are not included within the financial statements.
Valuation of land
The company holds land representing 63% of the company’s total assets. This is highly material. The company is correct not
to depreciate the land held. The use of a revaluation model is permitted by IAS® 16 Property, Plant and Equipment, however,
where this is used, the valuation must be kept up to date. The most recent valuation was carried out seven years ago and this
is likely to require updating for 20X5. Any gain or loss on revaluation, which is not a result of impairment, should be shown
within other comprehensive income and recognised in equity. As such values require specialist knowledge to calculate, it is
likely that an expert will be required to value the land.
There is a risk of inaccurate valuation of land if the valuation is not up to date or if the valuer is not appropriately independent
and qualified. This is likely to result in either an over or understatement of the land and equity.
Valuation of rides
The rides represent 15·1% of total assets and are material to the financial statements. According to IAS 36 Impairment of
Assets, an entity should assess at the end of each reporting period whether there is any indication that an asset or a cash
generating unit may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset.
The standard states that potential impairment indicators include obsolescence and physical damage. The findings of the
government inspector suggesting that the assets are aging, lack modern safety features and are not properly maintained are all
indicators of impairment and as such management should prepare an impairment review of the park’s rides.
IAS 36 states that an asset or cash generating unit is impaired when the carrying amount exceeds the recoverable amount and
it defines recoverable amount as the higher of the fair value less costs of disposal and the value in use.
There is a risk that management does not conduct an impairment review or that the review does not take into account the
inspector’s findings resulting in the overvaluation of property, plant and equipment and understatement of costs.
Revenue
The Infinite Co operates a business where a large amount of revenue is received in cash. In a company where a substantial
proportion of revenue is generated through cash sales, there is a high risk of unrecorded sales arising from the theft of cash
received from customers. This risk is increased through the use of so many casual workers. Management appears to try to
reduce this risk via the use of management’s family in areas where cash accepted is unusually high. However, it is not possible
for family members to accept all cash sales. If this is the case, then revenues and cash may be understated.
There is also a risk of revenue overstatement within the park. As The Infinite Co’s business is cash-based, it provides an ideal
environment for cash acquired through illegal activities to be legitimised by adding it to the cash paid genuinely by customers
and posting it through the accounts. This is discussed further later in these notes.
Inventory
The company holds inventory in the form of food, drinks and merchandise. Inventories represent 3·7% of assets and are
material. The food and drinks are of a perishable nature and as such have a short life span. The merchandise appears to be

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 low quality with frequent breakages and a health and safety risk. IAS 2 Inventories requires inventory to be held at the lower
of cost and net realisable value. It is possible that defective items or goods past their sell by date have not been written off
appropriately. If this is the case, then inventories are overstated, and cost of sales understated.
Sale and leaseback
The company is entering into a sale and leaseback with regard to the park buildings. The value of the buildings in the projected
statement of financial position is $854,000. This represents 9% of total assets and is material.
Under IFRS® 16 Leases, where a sale has occurred, The Infinite Co should recognise a right of use asset for the buildings
replacing the previously held building asset. This would be measured at the proportion of the previous carrying amount which
is retained for use by The Infinite Co.
The present value of the lease in this case is $934,666. This represents 93·5% ($934,666/$1,000,000) of the market value
of the buildings. The proportion of the previous carrying amount which is retained for use by the company is therefore 93·5%
of the carrying amount of $854,000, which equates to $798,205.
The Infinite Co should therefore recognise a right of use asset of $798,205 and a lease liability at present value of the future
cash payments of $934,666. It will recognise a cash receipt of $1,000,000 and derecognise property, plant and equipment
of $854,000. The remaining difference is the gain on disposal of the buildings which is recognised in the statement of profit
or loss.
Example:
Dr Cash $1,000,000
Dr Right of use asset $798,205
Cr Property, plant and equipment $854,000
Cr Lease liability $934,666
Cr Gain on disposal $9,539
The finance director intends to account for the sale as a simple disposal and then recognise a rental expense each year. This
would result in a gain of $146,000 being recognised on the disposal, overstating profit on disposal. In addition, both assets
and liabilities would be understated as the right of use asset and the present value of lease payments would not be included
in the statement of financial position. Failure to unwind the discount on the lease liability would result in an understatement of
finance costs and the rentals charged against profit would overstate expenses.
Legal cases – food poisoning
There is currently outstanding litigation against the company. The amounts of the claims are not yet known. Management is not
planning on making disclosures in the financial statements regarding the case as this may prejudice the outcome of the case.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires that contingent liabilities are disclosed in the notes to
the financial statements, hence there is a risk of insufficient disclosure which could be material by nature.
General provisions
The projected statement of financial position shows a general provision of $250,000, representing 2·6% of assets which is
material to the statement of financial position. The increase in the general provision in the year of $120,000 represents 5·2%
of profit before tax (PBT) and is material to the profit for the year.
IAS 37 states that 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.
The general provision does not appear to relate to a present obligation and, as such, is not permitted. This could be a means
by which the company reduces profits in order to reduce the tax payable or a means of profit smoothing. As a result, it is likely
that if this provision remains, then liabilities are overstated and expenses overstated.
Related party disclosures
The managing director appears to move funds from the company with the description ‘drawings’. It is unclear if this represents
salary, dividends or a loan. IAS 24 Related Party Disclosures defines a related party transaction as a transfer of resources,
services, or obligations between related parties, regardless of whether a price is charged. Related party transactions are
material by nature. As the managing director is a related party, this means that transactions between himself and the company
will need to be disclosed in the notes to the financial statements. There is a risk that appropriate disclosures are not made for
all related party transactions.
Tax
The projected tax expense for the year is material at 10% PBT. This figure represents an effective tax rate of 10% compared to
15% in the previous year. This appears low. The use of general provisions and the treatment of the owner manager’s ‘drawings’
may result in an incorrect profit figure on which to calculate company tax liabilities. This would result in understated tax
expense in the statement of profit or loss and understated liabilities.

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 Payroll
The payment of wages in cash creates a risk that not all wages payments are recorded in the financial statements and therefore
wages paid out of cash sales are unrecorded as well as the associated cash sales; there is therefore a risk both revenue and
expenses are understated.
In addition, there is a risk with employees paid in cash that incomplete deductions have been made for employee taxes. This
may give rise to further compliance risks and liabilities for unpaid employee tax.
Management override
The owner manager and his family appear to take a very active role in the business and to fail to make a distinction between the
business as a separate entity and themselves. There is evidence that management bypasses controls within the business through
direct access to the company funds and accounts. There is a lack of segregation of duties and given that the management
appears to have a disregard for certain laws and regulations, this is likely to mean that the control environment is weak and
there is a resulting higher risk of fraud and error in the financial statements.

(b) Audit procedures in relation to the impairment of rides

– Obtain the report from the safety inspector and review the outcome of the inspection to identify specific rides of concern
and to understand maintenance failings which could be an indicator of impairment.
– Obtain and review the regulations regarding the maintenance and upgrades of rides to understand the company’s
obligations in this respect in order to assist in assessment of value in use.
– Obtain The Infinite Co’s maintenance reports and review the schedule in comparison to the regulations to identify any
rides which may not be appropriately maintained or defective and hence provide indicators of impairment of specific rides.
– Obtain management’s impairment review of the rides and assess whether the assumptions are in line with the auditor’s
understanding.
– Cast management’s impairment review.
– Calculate an auditor’s estimation of impairment or engage an expert to value the rides and compare with management’s
impairment review to corroborate their calculations.
– If an auditor’s expert is used to value the rides, consider the reasonableness of assumptions used and completeness of
the information assessed.
– Assess the competence, scope and independence of the auditor’s expert.
– Physically inspect the rides on the park to ensure they are operational and that there is customer demand for the rides to
support value in use calculations.
– Obtain any ride usage and closure statistics held by management to ensure the rides are operational and hence a value
in use valuation would be appropriate.

(c) Money laundering

Money laundering is defined as the process by which criminals attempt to conceal the origin and ownership of the proceeds of
their criminal activity, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate cover for the
sources of their income.
Auditors are required to:
– perform customer due diligence, i.e. procedures designed to acquire knowledge about the firm’s clients and prospective
clients and to verify their identity as well as monitor business relationships and transactions;
– create channels for internal reporting within the audit firm including appointment of a money laundering reporting officer
(MLRO) to receive the money laundering reports to which personnel report suspicions or knowledge of money laundering
activities;
– keep records, including details of customer due diligence and supporting evidence for business relationships, which need
to be kept for five years after the end of a relationship and records of transactions, which also need to be kept for five
years;
– take measures to make relevant employees aware of the law relating to money laundering and terrorist finance, and
to train those employees in how to recognise and deal with transactions which may be related to money laundering or
terrorist financing;
– put in place ongoing monitoring procedures to ensure that policies are up to date and being followed.
The MLRO will be responsible for reporting incidents to the relevant authorities. Auditors must be careful to avoid tipping off
any party suspected of money laundering.
The Infinite Co’s business is cash-based, making it an ideal environment for cash acquired through illegal activities to be
legitimised by adding it to the cash paid genuinely by customers and posting it through the financial statements. This is known
as placement.

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 There are a lot of cash transactions and it would be possible to incorporate funds to be laundered with the funds from
customers. The ticket sales for rides would be an ideal place for this to occur as there is no monitoring of the number of people
actually taking part in the ride, so actual sales would be hard to prove. The fact that ride sales have fallen since the introduction
of electronic payments and at the same time the gift shop run by the owner’s son has seen increased volumes of cash sales
and higher margins suggests that this may have been the case previously and that the shop may now be used for money
laundering.
The use of family members for areas of high cash transactions and the managing director making transfers to his international
account outside of the normal accounting for the business further increases the risk that money laundering may be occurring.
It may be that the staffing choice is for the valid business purpose of reducing risk of theft from staff and that the transactions
are properly accounted for and valid, however, it is not clear in this case.
The fact that the managing director likes to be left in peace and the finance director does not query transactions could also
represent a red flag.

(d) Acceptance procedures

Auditors are required, prior to establishing a client relationship or accepting an engagement, to have controls in place to
address the risks arising from it. The risk profile of the business should show where particular risks are likely to arise, and so
where certain procedures will be needed to tackle them. These procedures should be easy to understand and easy to use for
all relevant employees who will need them. Sufficient flexibility should be built in to allow the procedures to identify, and adapt
to, unusual situations.
Different clients will have different levels of risk and the level of risk should dictate the level of client due diligence performed.
Criticisms of the content of the client acceptance documentation
Overall, the acceptance document appears too brief and there is a lack of information to support the conclusions within the
document. Where a conclusion is given in the acceptance form, the evidence to support that conclusion should be filed with
it.
There is no section evidencing and justifying the type of customer due diligence required. Depending on the nature of the
client and the risks, either standard, simplified or enhanced due diligence will be required. The form of due diligence to be
used and the basis for that decision should be included within the acceptance documentation. Part of this would include an
assessment of client integrity, which does not appear to be considered anywhere on the form, even though it is a requirement of
ISQC 1 Quality Control For Firms That Perform Audits and Reviews of Financial Statements, and Other Assurance and Related
Services Engagements.
ISQC 1 also requires the firm to consider whether it is competent to perform the engagement and has the capabilities, including
time and resources, to do so and whether it can comply with relevant ethical requirements. None of these issues appear to have
been considered.
There is no reference to the beneficial owners and the control structure of the company. The auditor should seek to prove the
identity of the company and key individuals including all directors and shareholders with more than 25% of the shares or voting
rights of the company. There should also be a section for the source of wealth and funds of the business.
The money laundering risk assessment is too brief. This should identify whether there are any potential areas of high risk
for money laundering. Such things include: unusual or unexplained transactions, a cash intensive business, and unusual or
complicated corporate structures.
Specific criticisms of the information gathered for Meadow Co
The first thing to note is that the documentation does not state what its objective is, so that the person completing it is obtaining
the information with its objective in mind, for example, the following could be included at the beginning of the assessment:
Objective
To obtain appropriate evidence regarding the organisation and the identity of its owners in order to comply with the money
laundering regulations.
The assessment should also document:
– Whether full understanding has been gained regarding the ownership structure of the organisation.
– Evidence which has been obtained regarding the organisation’s activity and how it has been established and agreed as
bona fide.
No references have been received prior to acceptance of the client which means that the firm’s client due diligence procedures
have not been properly adhered to.
The professional clearance from the predecessor auditor should be received in writing prior to acceptance and this should be
reviewed for potential issues and filed with the form on the permanent file. Where this is not received, the firm should document
the reasons why and whether they have reported this to their regulatory body.
Client risk assessment states that the company has no high/unusual risk. A cash-based business is likely to give rise to risks
and the fact that Meadow Co is being investigated with respect to money laundering suggests that risks existed which were not
considered on the acceptance form.

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 The money laundering section appears too brief, client identity would involve more people than just the owner and his wife.
This should be extended to shareholders who ultimately own or control more than 25% of the shares along with other directors
of the company. If the business is deemed to be sufficiently high risk that enhanced due diligence is required, then a second
document such as a driving licence would also be required.
For confirming the company identity, a certificate of incorporation alone is not sufficient to confirm the principal trading address,
current directors and major shareholders.
The checklist does not state whether it has been confirmed that the person the firm is dealing with is properly authorised to do
so by the client. It should document the appropriate steps taken to be satisfied that the person the firm dealing with is properly
authorised by the client.
There has been no partner assigned to the client prior to acceptance and no signature of a partner to approve the client
acceptance. This is a failure in the firm’s control procedures as it should not be possible to accept new clients without partner
level approval and evidence that the risk assessment has been reviewed.

2 (a) (i) Specific enquiries relating to Brodie Co’s intangible assets

In relation to the import licence:
– Enquire with management to ascertain the acquisition date of the import licence and confirm that the licence lasts
for three years. This indicates to Morrissey Co when the next licence will need to be acquired.
– Obtain evidence (original invoice, contract, details of the terms and conditions regarding the import licence) regarding
the initial cost and expected period which the licence will be valid for to assess whether the current amount in the
financial statements (cost and amortisation) is accurate.
– To obtain understanding of the nature and scope of the licence, discuss and confirm the terms with management,
including the specific goods covered by the licence and whether the licence applies to goods imported only from
certain countries.
– Ask management to provide information to show the value of purchases of dye made during the financial year under
the import licence – this will indicate how important the licence is to the operations of the company and whether it
is essential that the licence is reacquired once it expires.
– Enquire with management whether they envisage any problem with the import licence being reacquired at the
end of the three‑year period, for example, if there were political sanctions against the country from which the dye
is imported. Any potential problems with reacquiring the licence could disrupt the company’s procurement and
manufacturing process.
– Enquire with management whether there have been any breaches of the import licence, such as fines, which could
affect the likelihood of Brodie Co obtaining a new import licence once the three years are complete.
– Discuss with management whether there are any plans to source the dye from an alternative supplier, perhaps a
supplier for which an import licence would not be necessary, saving on the cost of reacquiring a licence.
In relation to the patent:
– Obtain evidence (original invoice, contract, details of the terms and conditions regarding the patent) regarding
the initial cost and expected period which the patent will be valid for to assess whether the current amount in the
financial statements (cost and amortisation) is accurate.
– Discuss the terms of the patent, to obtain an understanding of matters including:
– The specific manufacturing process to which it relates,
– Whether the patent applies to all of the company’s manufacturing, or just part of it,
– If the patent applies just in the country in which it was issued, or does it apply in other countries.
– Discuss whether the patent can be renewed when it expires, and if so, whether an additional fee is payable to the
patent authority. This will help Morrissey Co to understand the period over which the manufacturing process can be
protected in the future.
– Enquire with management as to whether there have been any infringements of the patent by competitors, or whether
management is aware of any competitors developing a similar manufacturing process. This could indicate that when
the patent expires in three years, and if it cannot be renewed, the company will face increased competition should
other manufacturers develop a similar production process.
– Assess whether there is any impairment of the patent, caused by a new process superceding the one attached to the
patent.
– Discuss with management whether there are any factors which may affect the carrying amount of the patent in the
financial statements.
– Ask management to provide information showing the value of sales made under the ‘PureFab’ label, to confirm that
there is economic benefit being generated from the patented manufacturing process.
– Request permission that the Intellectual Property Office (or local equivalent) send Marr & Co a certified copy of the
register entry. This will include details of the owner of the patent and the time period for the patent.

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 (ii) Additional information to be made available in relation to the company’s financing arrangements
– In relation to the equity shares, the number of equity shares in issue, the value per share, and the voting rights
attached to each share. This is essential information for Morrissey Co to consider how many shares to acquire in
order to gain control of Brodie Co.
– The company’s authorised share capital, to ascertain the capacity of Brodie Co to issue further shares. This will help
form an understanding as to whether Morrissey Co’s shareholding will result from a fresh share issue or whether
existing shareholders will need to be bought out of their shareholding.
– The rate of interest payable on the bank loan and venture capitalist funds, whether interest is fixed or variable rate
for forecasting the relevant cash flows.
– The redemption dates of the bank loan and venture capitalist funds, and whether a premium is payable on the
redemption of any debt, for forecasting the relevant cash flows.
– Whether any loan covenants exist, in particular in relation to the bank loan, and the terms of such covenants. The
acquisition itself could trigger a breach of covenant or lead to changes in payment terms.
– Management should also be asked to confirm whether any covenants have been breached in the past, this indicates
their capability of managing the company’s finances.
– In relation to the bank loan, details of the charge over company property, plant and equipment, in particular whether
it is a fixed charge over certain assets, for example, does it apply specifically to the company’s head office, or
manufacturing plant.
– The terms of the finance provided by the venture capitalists, in particular the repayment date and the terms of
repayment, for example, whether some or all of the debt could be converted to equity shares. The existence of
convertible debt would mean a potential future dilution of control in relation to Morrissey Co’s shareholding in Brodie
Co.
– Details of any other sources of finance used by the company, for example, lease arrangements, debt factoring,
directors’ loans to the company. This is to ensure that all sources of finance have been identified and that Morrissey
Co has complete understanding of Brodie Co’s financing arrangements.
– Enquire if management has any plans for alternative arrangements should current facilities not be extended, this
will give an idea of how the company will overcome any difficulties encountered as a result of not being able to
renegotiate current facilities.

(b) Ethical and professional issues

Ethical issues
On the acceptance of client relationships and audit engagements, ISA 220 Quality Control for an Audit of Financial Statements
requires the audit firm to determine whether the firm and the engagement team can comply with relevant ethical requirements.
This involves consideration of many factors, for example, whether there are any existing relationships between the audit firm
and potential client, which could create threats to auditor objectivity.
In this case, a significant self‑review threat arises should Marr & Co accept the appointment as auditor. The threat arises
because Marr & Co, having performed the due diligence assignment on Brodie Co, and having helped Morrissey Co with the
financial arrangements relating to the acquisition, will have been involved with many aspects of the individual and Group
financial statements. This means that the audit firm may not approach elements of the audit of the financial statements with
appropriate professional scepticism, not properly evaluating the results of previous judgements made, and over‑relying on the
work previously performed by the audit firm.
Marr & Co will need to evaluate the significance of this threat, based on matters such as the materiality of the balances and
transactions involved, for example, the intangible assets of Brodie Co, and the level of subjectivity involved. It may be possible
for Marr & Co to safeguard against the threat, for example, by using staff on the audit who had not previously worked on the
due diligence or corporate finance engagements.
A related self‑review threat relates to the finance director’s request for Marr & Co to produce the Group financial statements.
The IESBA International Code of Ethics for Professional Accountants (the Code) states that providing an audit client with
accounting and bookkeeping services, such as preparing accounting records or financial statements, might create a self‑review
threat (as explained above) and also a risk of assuming management responsibilities when the firm subsequently audits the
financial statements. The risk of assuming a management responsibility arises where the auditor is taking on the decisions and
responsibilities belonging to management, in this case, the preparation of the Group financial statements.
The significance of the self-review threat and risk of assuming a management responsibility depends on the nature and extent
of the accounting services provided to the audit client and the level of public interest in the entity. The Code states that the audit
firm shall not provide services related to the preparation of accounting records and financial statements to an audit client unless
the services are of a routine and mechanical nature. Preparing the Group accounts would not be routine and mechanical – it
would involve the auditor making judgements and taking responsibility for the whole of the consolidated financial statements.
This would also be perceived as taking on significant management responsibility, and Marr & Co should decline the service on
this basis.

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 There is also a possible self‑interest threat arising from the range of services provided to Morrissey Co. This could give rise to
fee dependency, meaning that the audit firm is reluctant to act in a way which could jeopardise the relationship between audit
firm and client, for fear of losing the fee income. The potential level of fee income should be estimated and compared to Marr
& Co’s total practice income, to see if fee dependency could be an issue.
A further ethical issue arises from the invitation from Morrissey Co to attend the industry conference in Hawaii. The offer by the
client to pay for the audit partner and manager to attend this event constitutes an offer of gifts and hospitality, which according
to the Code can give rise to familiarity, self‑interest and intimidation threats to objectivity.
The familiarity threat means that close relationships between the client and audit firm lead to the auditor being too sympathetic
or accepting of the client’s work, resulting in a loss of professional scepticism. The self‑interest and intimidation threats arise
due to the financial benefit of the gifts and hospitality, which could be seen as a bribe, and impact on the perceptions of the
auditor’s objectivity. The audit firm is likely to act in a way to keep the client happy, for example, overlooking accounting errors
such as those indicated in the payroll system, in order to secure the trip to Hawaii.
The Code states that the existence and significance of any threat will depend on the nature, value, and intent of the offer, and
should not be accepted unless clearly trivial or inconsequential. The offer of the trip to Hawaii should be declined as its value
is likely to be more than trivial or inconsequential. The finance director may not realise that his offer puts the audit firm in a
difficult position, and the problem raised by his offer should be explained, and the offer turned down.
ISA 220 contains a specific requirement that the auditor shall include in the audit documentation all significant threats to the
firm’s independence as well as the safeguards applied to mitigate those threats. The matters outlined above and the auditor’s
responses should be appropriately documented in accordance with ISA 220.
Other professional issues
Integrity
ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements and Other Assurance and Related
Services Engagements suggests that the reasons for the proposed appointment of the firm and removal of the previous firm
should be considered when evaluating client integrity. According to ISQC 1, one of the matters, which impacts on integrity,
is whether the client is aggressively concerned with maintaining the audit fee as low as possible. The comment made by the
finance director regarding the reason for dismissal of Butler Associates could indicate that Morrissey Co has an expectation of
low fees, which can impact on the quality of the audit and can increase detection risk if too few resources are allocated to the
audit in an attempt to reduce the audit firm’s costs.
The removal of the previous audit firm could also indicate that Morrissey Co may be difficult to deal with, possibly confrontational
and aggressive in their attitude to the audit firm, though the invite to attend the industry event in Hawaii could indicate that
management is keen to establish a good relationship with the audit firm. Their concerns regarding the previous audit firm’s
invoice may also be legitimate.
Audit preconditions
ISA 210 Agreeing the Terms of Audit Engagements requires an audit firm to establish whether the preconditions for an audit
are present and if certain preconditions are not present, the audit engagement should not be accepted.
In this case, the finance director has stated that he does not want to provide notes to the consolidated financial statements, on
the grounds that they are not useful. Failing to disclose notes to the consolidated financial statements would mean that they are
not prepared in accordance with IFRS® Standards, as IAS 1 Presentation of Financial Statements requires notes, comprising
a summary of significant accounting policies and other explanatory notes, to be presented in order for the financial statements
to be complete.
This matter will need to be discussed, and if the audit firm believes that management will not accept that they have a
responsibility to prepare consolidated financial statements in accordance with IFRS Standards, then the appointment should
not be accepted.
Internal control and quality of financial reporting
There is evidence that the internal control environment may not be strong due to the errors found by Butler Associates in
payroll processing. In addition, the request by the finance director also raises an issue relating to the competence of the client.
A finance director would be expected to have the necessary knowledge and skill to be able to prepare consolidated financial
statements, and the fact that he has asked for assistance could indicate that there will be a high inherent risk of material
misstatement in the financial statements. While these issues do not mean that the audit should be declined, they indicate that
Marr & Co would need to approach the audit as high risk.
Competence and resources
Marr & Co should consider whether audit staff have experience in the textile industry and whether there will be enough staff
available at the time when the audit needs to be performed. Manufacturing is not particularly unusual or challenging for an
audit firm, so competence is unlikely to present a problem, especially as Marr & Co already has several audit clients who are
manufacturers.
It is important to note that Marr & Co is a relatively small audit firm, and especially with the year end being less than a month
away, there may be pressure on resources if the firm’s other audit clients have the same year end, meaning that audit staff are
already busy with other work. The firm should therefore confirm that it is able to complete the audit engagement within the

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3 Matters and audit evidence in relation to Byres Co

(a) (i) Matters and evidence in relation to the new product

Matters
The carrying amount of the capitalised development costs in relation to the new product are immaterial as they amount
to 0·8% of assets and immaterial to profit before tax at 4·0%.
There is a significant risk that the requirements of IAS 38 Intangible Assets have not been followed. Research costs must
be expensed and strict criteria must be applied to development expenditure to determine whether it should be capitalised
and recognised as an intangible asset. Development costs are capitalised only after technical and commercial feasibility
of the asset for sale or use have been established. Byres Co must also demonstrate an intention and ability to complete
the development and that it will generate future economic benefits. Additionally, Byres Co must demonstrate the existence
of a market, which given the product design director’s comments appears uncertain.
There is a risk that research costs have been inappropriately classified as development costs and then capitalised,
overstating assets and understating expenses. The product design director is uncertain as to whether the new product
will generate sufficient economic benefits due to the sale price being unlikely to exceed the production costs per unit. It is
therefore unlikely that the costs in relation to this product development continue to meet the criteria for capitalisation, so
there is a risk that they have not been written off, overstating assets and profit.
Evidence expected to be on file:
– Review of board minutes for discussions relating to the commercial feasibility of the smart vacuum cleaners.
– Notes of a discussion with management regarding the accounting treatment of the research costs and confirmation
that they were written off.
– A schedule itemising the individual costs capitalised to date in the production of the smart vacuum cleaner prototype
to ensure there are no research elements.
– Review of the results of tests performed on the products to demonstrate that the prototype is fully operational.
– Analysis of Byres Co’s budgets for the development of the prototype against actual expenditure to determine if the
product costs have deviated significantly from original budgets.
– Alternative market research of any similar existing products to determine if a price point over $2,000 per unit would
be commercially viable.
– Details of discussions with the product design director of any difficulties in the development of this product which
have caused it to run over budget.
– Written representation from management detailing their intention to complete the project, including a commitment
of resources and the ability to fund the future cash requirements to bring the product to market.
(ii) Matters and evidence in relation to the warranty provision
Matters
The warranty provision is material as it amounts to 6·6% of total assets and 33·3% of profit before tax respectively. The
provision has changed in value over the year, declining by $2·2 million which is a significant reduction of 51·2%. This
is despite revenue increasing during the year by $5·5 million which is a significant increase of 11·0% and the provision
has historically and effectively been based on a percentage of total sales in prior years.
Based on the information provided, in 20X4, the warranty provision was 8·6% of revenue (4·3/50m). In 20X5, the
warranty provision is only 3·8% (2·1/55·5m) of revenue. Therefore, since the chief executive officer’s (CEO) involvement
with estimating the warranty provision, the value of the provision has reduced significantly compared to the value which
would normally be expected.
According to ISA 540 Auditing Accounting Estimates including Fair Value Accounting Estimates and Related Disclosures,
the audit team should have tested how management made the accounting estimate, and the data on which it is based.
The audit team should also have tested the operating effectiveness of any relevant controls and developed their own point
estimate or range in order to evaluate management’s estimate.
The value of the warranty provision would normally be expected to increase in line with revenue, particularly as the sales
director has indicated neither the range of customers nor the nature of the warranty have changed significantly compared
to the prior year. There has also not been any change in the level of customer complaints or faulty items which, if present,
may indicate problems with the quality of the company’s products. The audit team must fully understand the reasons for
the reduction in the warranty provision. There could be valid reasons, for example, the sales mix between products could
be different which failed to trigger a similar level of warranty provision, but the change in value should be fully investigated
by the team.
Consideration should also be given to the accounting entries which have been made to effect the change in the value of
the provision. The validity of any credit entry to profit as a result of the reduction in value of the provision should have
been scrutinised as this could indicate creative accountancy and earnings management. In the event that the provision
has been underestimated in the current year, then future accounting periods would require higher expenses charged to
the statement of profit or loss.

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 In previous years, the finance director and finance department had dealt with the judgement when estimating the warranty
provision, however, this year the CEO has had significant input. There is therefore an increased risk of management bias
in the estimation techniques. The audit team should approach this issue with professional scepticism and consider the
motivation of the CEO in involving himself in accounting issues which had previously been left to the finance director.
Evidence expected to be on file:
– A copy of management’s calculation of the $2·1 million warranty provision, with all components agreed to underlying
documentation, and arithmetically checked.
– Notes of a meeting with management, at which the reasons for the reduction in the warranty provision were
discussed, including the key assumptions used by management.
– Analysis of total sales in terms of product mix against prior years with investigation into differences and a quantification
of the effect this might have on the warranty provision.
– A copy of any quality control reports, disaggregated by product, reviewed for any indications that certain product
lines have fewer warranty claims than in previous years.
– Notes of the meeting with the customer services manager where the levels of customer complaints and product
faults were discussed.
– A comparison of the prior year’s calculation with actual warranties claimed post year end to determine the accuracy.
– An evaluation of all key assumptions, considering consistency with the auditor’s knowledge of the business, and a
conclusion on their validity.
– An independent estimate prepared by the audit team, compared to management’s estimate, and with significant
variances discussed with management.
– A schedule obtained from management showing the movement in the provision in the accounting period, checked
for arithmetic accuracy, and with opening and closing figures agreed to the draft financial statements and general
ledger.
– Evaluation by the audit team, and a conclusion on the appropriateness of the accounting entries used, especially in
relation to the profit impact of the entries.
– A file note documenting that the auditor has requested an adjustment requiring the warranty provision to be increased
in line with the prior year estimation method.

(b) Implications for the auditor’s report

Warranty provision
Accounting estimates are always difficult to determine with any degree of certainty, however, the work carried out by the
audit team suggests that the value of the warranty provision has been suppressed. Assuming that the provision should have
increased consistently with the increase in revenue of 11%, it would be expected that the year-end warranty provision should
be around $4·8 million. The actual provision recorded in Byres Co’s financial statements is only $2·1 million; therefore, the
liability appears to be understated by $2·7 million. At 8·5% of total assets, the likely error in the provision is highly material to
the statement of financial position.
Overall impact on the auditor’s report
The misstatement in relation to the warranty provision is individually material and if management fails to amend the financial
statements, the auditor’s opinion should be modified due to the material, but not pervasive, misstatement. The misstatement
of the warranty provision is confined to specific accounts in the financial statements and does not represent a substantial
proportion of the financial statements. A qualified opinion should therefore be given.
The auditor’s report should include a qualified opinion paragraph at the start of the report. This paragraph should be followed
immediately by a basis for qualified opinion paragraph which should explain the reasons for the qualified auditor’s opinion and
which should quantify the impact of the matters identified on the financial statements.
(c) Proposed sale implications for the auditor work
In accordance with ISA 315 (Revised 2019) Identifying and Assessing the Risks of Material Misstatement, the auditor should
obtain an understanding of the entity and its environment, including the nature of the entity and its ownership. The fact that
William Byres, the CEO and majority shareholder of Byres Co, is in advanced talks with a venture capitalist regarding the sale
of his company implies that the intention and process of selling the company must have begun some time before the audit
completion meeting. The failure to disclose important information regarding the proposed sale would therefore indicate that the
CEO lacks management integrity. Proposed changes in the ownership of a company have a significant effect on the risk profile
of a company during an audit.
When there is a potential sale of a company, the audit risk is increased as the results of the company could be manipulated to
make it look more favourable to any potential purchaser. It is likely that materiality should be decreased in order to ensure that
more testing is carried out and smaller errors are considered for adjustment to the financial statements than would otherwise
be the case.

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 Any enquiries with management, particularly the CEO, would require additional scrutiny and corroboration in order to eliminate
the heightened threat of management bias. Judgements, such as the development capitalisation and the warranty provision,
should be under further scrutiny as the company owner has a vested interest in selling the company for as high a price
as possible. The effect of biased judgements over these areas of the financial statements would be to overstate assets and
overstate profit, which would in turn raise the price which an outside investor would be prepared to pay for Byres Co. Wheeler
& Co would have to plan additional procedures over any judgemental areas of the financial statements, particularly those with
direct input from William Byres.
The auditor would have to review the audit work already performed with an increased level of professional scepticism,
particularly with any representations made by the owner or any senior management who were party to the proposed sale.
The routine written representations obtained from management, for example, around valuations, liabilities and accounting
estimates would require more detailed scrutiny owing to management’s incentive to influence the financial statements and
achieve the best sales price for the company. Furthermore, the representations obtained by the auditor, as part of their going
concern assessment, for the future strategic direction of the company are clearly compromised with the lack of communication
of the intention to sell the company.
Wheeler & Co would also have to ensure that the financial statements were not to be relied upon by any potential third-party
investors and that such parties will conduct their own independent due diligence on Byres Co.

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Strategic Professional – Options, AAA – INT
Advanced Audit and Assurance – International (AAA – INT) March/June 2022 Sample Marking Scheme

Marks
1 (a) Risk of material misstatement evaluation
In relation to the matters listed below:
Up to 3 marks for each risk of material misstatement evaluated unless otherwise indicated.
In addition, ½ mark for relevant ratios and ½ mark for relevant trends to a maximum of 3 marks.
Relevant materiality calculations will be awarded to a maximum of 3 marks.
– Going concern – potential operating licence withdrawal
– Valuation of land – lack of recent valuation
– Valuation of rides – impairment
– Inventory valuation (2 marks)
– Revenue, risk of overstatement (2 marks)
– Revenue, risk of understatement
– Sale and leaseback (up to a max of 5 marks)
– Legal case – contingent liability (2 marks)
– General provisions
– Related party transactions (2 marks)
– Tax
– Payroll costs – cash based
– Management override/lack of segregation of duties (2 marks)
Maximum marks 24

(b) Audit procedures to be performed in relation to the rides

Generally, 1 mark for each well explained procedure:
Impairment of rides
– Obtain the report from the safety inspector and review the outcome of the inspection to identify specific
rides of concern and to understand maintenance failings
– Obtain and review the regulations regarding the maintenance and upgrades of rides to understand the
company’s obligations in this respect
– Obtain The Infinite Co’s maintenance reports and review the schedule in comparison to the regulations
to identify any rides which may not be appropriately maintained or defective
– Obtain a list of rides and their depreciation rates and assess whether the rates are realistic given the
age of rides by comparing with industry averages and the safety report findings
– Obtain management’s impairment review of the rides and assess whether the assumptions are in line
with the auditor’s understanding
– Cast management’s impairment review
– Calculate an auditor’s estimation of impairment or engage an expert to value the rides and compare
with management’s impairment review to corroborate their calculations
– Physically inspect the rides on the park to ensure they are operational and that there is customer
demand for the rides
– Obtain any ride usage and closure statistics held by management to ensure the rides are operational
Maximum marks 6

(c) Money laundering

Generally, 1 mark for each relevant point of discussion/explanation:
– Definition of money laundering
– Customer due diligence
– Reporting channels
– Recordkeeping
– Training
– Cash-based business/placement
– Unexpected trends in ride sales/shop sales and margins
– Use of family
– Money transfers
Maximum marks 8

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 Marks
(d) Acceptance procedures
Generally, 1 mark for each relevant point of discussion/explanation:
– General requirement for customer due diligence (CDD) before acceptance
– Level of CDD depends on the level of risk at client
– Form too brief
– Form lacks supporting evidence
– No justification of CDD level required
– Insufficient identification of beneficial owners and directors
– Money laundering flags not all considered
– References outstanding
– Professional clearance should be in writing and reviewed
– Risk assessment appears incorrect/insufficient
– Company identity does not prove current directors and address
– No partner assigned/approval
Maximum marks 8
Professional marks
Generally, 1 mark for heading, 1 mark for introduction, 1 mark for use of headings within the briefing notes,
1 mark for clarity of comments made
Maximum marks 4
–––
Maximum 50
–––

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 Marks
2 (a) (i) Specific enquiries relating to Brodie Co’s intangible asset
Up to 1 mark for each enquiry recommended and adequately explained.
In relation to the import licence:
– Acquisition date of the import licence, and confirm that the licence lasts for three years. This
indicates to Morrissey Co when the next licence will need to be acquired
– Obtain evidence (original invoice, contract, details of the terms and conditions regarding the
import licence) regarding the initial cost and expected period which the licence will be valid for to
assess whether the current amount in the financial statements (cost and amortisation) is accurate
– The terms of the licence, including the specific goods covered by the licence and whether the
licence applies to goods imported only from certain countries
– Value of purchases of dye made during the financial year under the import licence – this will
indicate how important the licence is to the operations of the company
– Any problem foreseen with the import licence being reacquired at the end of the three‑year period,
any potential problems with reacquiring the licence could disrupt the company’s procurement
and manufacturing process
– Any plans to source the dye from an alternative supplier, perhaps a supplier for which an import
licence would not be necessary, saving on the cost of reacquiring a licence
– Enquire with management whether there have been any breaches of the import licence, such as
fines, which could affect the likelihood of Brodie Co obtaining a new import licence once the three
years are complete
In relation to the patent:
– Obtain evidence (original invoice, contract, details of the terms and conditions regarding the
patent) regarding the initial cost and expected period which the patent will be valid for to assess
whether the current amount in the financial statements (cost and amortisation) is accurate
– The terms of the patent, to obtain an understanding of matters including: the specific manufacturing
process to which it relates, whether the patent applies to all of the company’s manufacturing, and
if the patent applies just in the country in which it was issued, or does it apply in other countries
– Whether the patent can be renewed when it expires, and if so, whether an additional fee is
payable to the patent authority
– Whether there have been any infringements or any competitors developing a similar manufacturing
process, indicating increased competition
– Discuss with management whether there are any factors which may affect the carrying amount
of the patent in the financial statements
– The value of sales made under the ‘PureFab’ label, to confirm that there is economic benefit being
generated from the patented manufacturing process
– Request permission that the Intellectual Property Office (or local equivalent) send a certified copy
of the register entry. This will include details of the owner of the patent and the time period for
the patent

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 Marks
(ii) Additional information relating to financing arrangements
Up to 1 mark for each piece of information recommended and adequately explained.
– The number of equity shares in issue, the value per share, and the voting rights attached to each
share, to consider how many shares to acquire in order to gain control
– The company’s authorised share capital, to provide understanding as to whether Morrissey Co’s
shareholding will be a fresh share issue or whether existing shareholders will need to be bought
out of their shareholding
– The rate of interest payable on the bank loan and venture capitalist funds, whether interest is
fixed or variable rate for forecasting the relevant cash flows
– The redemption dates of the bank loan and venture capitalist funds, and whether a premium is
payable on the redemption of any debt, for forecasting the relevant cash flows
– Whether any loan covenants exist, in particular in relation to the bank loan, and the terms of such
covenants; the acquisition itself could trigger a breach of covenant
– Whether any covenants have been breached in the past, this indicates management’s capability
of managing the company’s finance
– Bank loan details on the charge over company property, plant and equipment, whether it is a
fixed charge over certain assets
– The terms of the finance provided by the venture capitalists, in particular the repayment date
and the terms of repayment, whether some or all of the debt could be converted to equity shares
indicating potential future dilution of control
– Details of any other sources of finance used by the company, to ensure that all sources of finance
have been identified
– Enquire if management has any plans for alternative arrangements should current facilities not be
extended, this will give an idea of how the company will overcome any difficulties encountered
as a result of not being able to renegotiate current facilities
Maximum marks 16

(b) Ethical and other professional matters

Generally, 1 mark for each relevant and well explained point and 1 mark for each relevant and appropriate
safeguard.
– Ethical issue – self‑review threat regarding having previously performed due diligence and corporate
finance work
– Safeguards: separate team for audit
– Ethical issue – self‑review threat regarding preparation of consolidated financial statements
(management threat)
– No safeguard appropriate – management to prepare the consolidated financial statements – not ‘routine
or mechanical in nature’
– Ethical issue – self‑interest threat from providing range of services, fee dependency
– Ethical issue – self‑interest and familiarity threats re gifts and hospitality
– Low fee and impact on audit quality
– Non‑reappointment of previous audit firm – intimidation/dispute over fees
– Audit preconditions – ISA 210 requirements and management responsibility to prepare complete
financial statements
– Competence of management and quality of financial reporting
– Competence and resources
Maximum marks 9
–––
Maximum 25
–––

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 Marks
3 Matters and evidence in relation to Byres Co
Generally, up to 1 mark for each matter explained and each piece of evidence recommended (unless otherwise
stated).

(a) (i) Matters and evidence in relation to the new product

Matters
– Materiality
– Discussion of whether meets classification requirements
– Risk
– Accounting treatment
Evidence
– Review of board minutes for discussions relating to the commercial feasibility of the smart
vacuum cleaners
– A schedule itemising the individual costs capitalised to date in the production of the smart
vacuum cleaner prototype to ensure there are no research elements
– Notes of a discussion with management regarding the accounting treatment of the research costs
and confirmation that they were written off
– Review of the results of tests performed on the products to demonstrate that the prototype is fully
working
– Analysis of Byres Co’s budgets for the development of the prototype against actual expenditure to
determine if the product costs have deviated significantly from original budgets
– Market research of any similar existing products to determine if a price point over $2,000 per unit
would be commercially viable
– Details of discussions with the product design director of any difficulties in the development of
this product which have caused it to run over budget
– Written representation from management detailing their intention to complete the project,
including a commitment of resources and the ability to fund the future cash requirements to
bring the product to market
Maximum marks 7
(ii) Matters and evidence in relation to the warranty provision
Matters
– Materiality
– Discussion of estimates
– Risk
– Accounting treatment
– Influence of CEO
Evidence
– A copy of management’s calculation of the $2·1 million warranty provision, with all components
agreed to underlying documentation, and arithmetically checked
– Notes of a meeting with management, at which the reasons for the reduction in the warranty
provision were discussed, including the key assumptions used by management
– Analysis of total sales in terms of product mix against prior years with investigation into differences
and a quantification of the effect this might have on the warranty provision
– A copy of any quality control reports, disaggregated by product, reviewed for any indications that
certain product lines have fewer warranty claims than in previous years
– Notes of the meeting with the customer services manager where the levels of customer complaints
and product faults were discussed
– A comparison of the prior year’s calculation with actual warranties claimed post year end to
determine the accuracy
– An evaluation of all key assumptions, considering consistency with the auditor’s knowledge of the
business, and a conclusion on their validity
– An independent estimate prepared by the audit team, compared to management’s estimate, and
with significant variances discussed with management
– A schedule obtained from management showing the movement in the provision in the accounting
period, checked for arithmetic accuracy, and with opening and closing figures agreed to the draft
financial statements and general ledger
– Evaluation by the audit team, and a conclusion on the appropriateness of the accounting entries
used, especially in relation to the profit impact of the entries
– A file note documenting that the auditor has requested an adjustment requiring the warranty
provision to be increased in line with prior year estimation method
Maximum marks 8

17
 Marks
(b) Auditor’s report
– Material misstatement due to inappropriate accounting estimates
– Calculation of possible misstatement
– Matter is not pervasive
– Qualified audit opinion
– Basis of qualified audit opinion
Maximum marks 5

(c) Proposed sale implications for the completion of the audit

– Effect on audit risk
– Management integrity
– Materiality
– Management representations – up to 2 marks for future plans/going concern and routine management
representations over assets/liabilities/estimates
– Professional scepticism
– Venture capitalist due diligence
Maximum marks 5
–––
Maximum 25
–––

18