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May 02, 2023


Solution To Part A

Question 1

It is to be noted that the auditor firm, “Mole & Co.” is certainly not responsible for detection and prevent of fraud according to ISA 240. ISA 240 states that it is the management or persons charged with the responsibility of governing and overseeing the day-to-day operations to timely detect and prevent any kind of fraudulent activity. So, it is not the responsibility of the auditor to detect or prevent fraud. However, ISA 240 also states that the auditor should possess as well as acquire “reasonable assurance” that the financial statements prepared by the organisation is free from any kind of “material misstatements”, “fraud” and errors.”

Audit risk


There is an inherent risk of overstating the expenses. The last CFO of Ratty Ltd left the organisation just before the year end complaining about the fraudulent expenses. This issue was also raised by the newly appointed CFO.

The substantive procedures concerning the test of various expenses must be carried out by the auditors in order to obtain reasonable assurance regarding the presence of fraudulent expenses transactions such as verification of purchase invoices regarding different incurred expenses such as advertising. Confirmation can also be drawn from the vendors if suspicion arises.

Inherent risk in the “Intangible asset” account as the account might be overstated. It is to be noted that within the year, Ratty have incurred a total of £1.2m million towards development of certain new products which are at different stages of development including an unsuccessful attempt of developing a vaccine for Covid-19. The whole amount has been capitalized by Ratty just to portray and added net profit because of the loan covenant where it states of maintenance of a specific amount of net profit every year. This is why the entire amount of £1.2m million has been capitalized and not recorded as an expense which is not advisable according to IAS 38 because the vaccine development attempt has failed and many new products are in different stages of development where there is no fixed proof that the assets have entered it final development phase and ready to be used or sold.

There should be a substantive review of all development expenditure just in order to prove that all assets which has been capitalised met the capitalisation criteria as stated under IAS 38.

Inherent risk in the “Sales account” as there are enhanced reported cases of sales return within the year and post the year end concerning the sales effected during the year. So, there may be situation of overstatement of sales just to enhance and maintain the net profit.

All sales related transactions must be substantially checked in details both concerning the test of balances and test of transactions juts to prove that all sales transactions and sales return transactions have been properly accounted for. There should be “Inspection” of all sales return invoices on a random basis and verified against the transactions passed within the sales ledger to check that all sales returns transactions have been accounted for.

Inherent risk the inventory account. It has been reported by the auditor who attended the inventory count of Ratty stated that there was actual movement of inventory when the count was taking place.

Physical inventory check is to be re-done. Inspection of all relevant documentation concerning the inward and outward movement of inventory is to be checked for both completeness and Accuracy.

Inherent risk within the “Plant and equipment account” as the surplus plant was sold for a profit of £130,000 which is to be investigated.

The documents concerning the sale of the machinery must be reviewed such as sales invoices. An additional “Confirmation” may also be drawn from the purchaser regarding the data and purchase price. The accounting policy especially concerning depreciation must be checked to review the accuracy of the calculation and accounting for the sale of surplus plant.

The two substantive audit procedures which Mole & Co. should carryout during the audit of Ratty’s inventory firstly includes “Physical inventory count.” The physical inventory count has already been done but there are noticeable glitches such as movement of inventory during count so re-counting should be conducted. The second procedure may include taking out random samples from the inventory records and tracing it back to the warehouse records which would check for the existence of the inventory. The record for outward movement of inventory as per the warehouse records could be verified against the delivery confirmation receipts to check for existence and accuracy.
The two ethical principles which are at risk here if Mole & Co intends to accept the internal audit function apart from providing the external audit service and discussing such matter while playing golf with the new CFO of the audit client are “Objectivity” and “Professional behaviour.” The “Objectivity” is at risk because there may be an undue influence by the new CFO and presence of conflict of interest if the internal audit function is accepted by Mole which might affect the professional judgement of Mole as an external auditor. Apart from this fact there is a “Familiarity” threat to the independence of the auditor may rise if the auditor accepts the invitation to visit the golf club and play golf with the current audit client’s CEO amidst the on-going external audit. The “Professional behaviour” may be at risk if Mole intends to accept the internal audit service along with the performance of the external audit because the law, rules and regulations stipulates an external auditor to perform certain other assurance services such as internal audit for the same client under an external audit.
According to the recent changes being integrated within the “Sarbanes Oxley Act of 2002”, the external auditors cannot specifically rely on the management’s version or narrative on the internal controls or audit to reach a desired conclusion. The external auditors are now not allowed by the Act to carryout similar audit strategies which has been adopted by the internal audit. Now, internal audit function may portray the management’s narrative and hence the external auditors must not rely on it and should carry out an independent independent assessment of the fairness and reliability of the financial records that is whether it is reasonably devoid of material misstatement, frauds and errors. Hence, the offer of conducting an “Internal audit function” along with an external audit performance should not be done by “Mole & Co.” So, Mole should not accept the offer of the current CFO of Ratty.
The two limitations of external audit firstly include that the external audit is very time consuming and a costly affair where there is a substantial need of time to conduct the audit and involvement of a substantial outflow of funds to the external auditor or audit firm for conduction of the audit. The second limitation is that the external audit being a costly affair does not provide an absolute assurance and only provides a mere “reasonable assurance” as it is based upon “test checks” and choice of samples which may not completely reveal the presence of all fraudulent transactions or errors.

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