This 35 mark question had two question requirements, and typically for Question 1, involved the planning stages of an audit engagement. The scenario was based on Parker Co, a new audit client, and information was provided in the form of extracts from financial statements, and notes from a meeting with the company’s finance director.

The notes covered matters including a brief business review, financing arrangements, internal control issues, and future plans for expansion.

As this style of question appears regularly it was no surprise that most candidates seemed well prepared for a question on audit planning, and there were some detailed and well-focussed answers. However there were some common problems seen in candidates’ answers, which will be discussed below.

Requirement (a) was for 24 marks and asked candidates to perform analytical procedures and evaluate audit risks to be considered in planning the audit of Parker Co, and also to identify and explain additional information relevant to the evaluation. Looking first at the audit risk evaluation, this was generally reasonably well attempted, with most answers working through the information given in the scenario to identify and then discuss the audit risks. Almost all answers spotted the going concern risk facing Parker Co, and could evaluate it appropriately.

The majority of answers also included commentary on the internal control weakness in payroll, and a discussion of several risks of material misstatement including classification and measurement of a provision, a revaluation of properties, and the classification of leases. Each of these had been clearly signposted in the scenario as issues related to audit planning.

Fewer candidates picked up on the less obvious audit risks. This was often because analytical review had not been conducted, or it had been done but then not used to help identify audit risks. One of the purposes of performing analytical review is to help the auditor to identify potential risks of material misstatement, and there were many audit risks that could have been identified in this scenario from properly prepared analytical review.

For example the increase in inventory days indicates potentially obsolete inventory which may be overvalued and the deterioration in margins and interest cover add weight to the company’s going concern problems. It is therefore important that when asked to perform analytical review that candidates do not just calculate trends and ratios but go on to assess them as part of the evaluation of audit risk. Calculating trends and ratios and then leaving them unused in the written part of the answer is poor exam technique and to some extent a waste of time.

Some candidates did no analytical review at all, which meant that as well as not picking up marks for relevant calculations, they also failed to achieve marks on identifying some audit risks. There were also many scripts that focussed exclusively on calculating trends rather than ratios, which often resulted in less detailed answers. A significant number of answers included incorrect calculations, with gearing ratios and return on capital employed being the most commonly mis-calculated.

The areas of audit risk that were generally well dealt with in this scenario included the following: 
• Going concern – this was mentioned in almost every answer, and usually was quite well evaluated in some detail, with the majority of answers linking their analytical review to a discussion of the company’s going concern problems. It was also pleasing to see that many candidates developed the risk into financial statement implications, particularly that going concern issues may need disclosure in a note to the financial statements. 
• Provision for fine payable – most answers included a discussion relating to the measurement of the provision, which usually referred to the relevant financial reporting requirements. Whether the expense should be classified in cost of sales was also discussed in most answers. 
• Development costs – this was usually very well evaluated, with almost all candidates appreciating that the development costs could include in error items of research expenditure that should not be capitalised, and that development costs may not meet the criteria for capitalisation due to Parker Co’s lack of cash and the competitive nature of the market. Sound answers considered the impact on profit if the development costs had to be expensed. 
• Property revaluations – the majority of candidates appreciated that the revaluations could have been done to improve the appearance of the statement of financial position, and many answers included a comment relating the auditor having to be sceptical when auditing the valuation of the properties. 
• Finance costs – the relatively small increase in the finance cost compared to the increase in borrowings was often identified and well evaluated. 
• Internal control deficiency – most answers included a section evaluating the deficiencies uncovered by the company’s internal audit team, and its implication for audit risk. 
• First year audit – this was identified as an issue in most answers, with the most common audit planning issue discussed being the lack of familiarity of the audit team with Parker Co, and that extra care would need to be taken when auditing opening balances. Sound answers also considered the appropriateness of accounting policies.

Some issues were less well evaluated:

• Trends and their implications – while most candidates could correctly calculate trends, for example the percentage decreases in revenue, cost of sales and operating expenses, many then went on to discuss the trends incorrectly, for example saying that the trend indicated a potential understatement of expenses when it should have been overstatement, or vice versa. 
• Provisions – this was where even quite competent answers were often let down by an obvious lack of understanding of bookkeeping, with many answers stating that the provision should not be an expense at all, but should only impact on liabilities. 
• Brand – many answers asserted that the company’s brand was overvalued and should be tested for impairment. In fact there was no brand recognised in the financial statements at all, indicating that the extract from the financial statements had not been reviewed carefully enough. 
• Change in accounting policy – many answers suggested that the property revaluation was a change in accounting policy, despite there being a revaluation reserve in the comparative figures. 
• Taxation – few scripts picked up on the very low tax expense and tax liability, and even fewer calculated an effective tax rate which would have identified a significant risk of understatement.

Some of the problems noted above arise from lack of knowledge, others from poor exam technique. It is vital with this type of question to spend enough time reading the information provided, including the extracts from the financial statements, and to think about how the information gives rise to risk factors. It is obvious that when faced with an audit risk scenario, many candidates see a heading or word, for example “brand” and write an answer point that is totally irrelevant to the scenario.

As well as asking for analytical review and audit risk evaluation, this requirement also asked candidates for additional information that would help in the evaluation. Most answers contained at least a few requests for additional information, often those relating to the evaluation of going concern risk, such as cash flow forecasts and market research findings. It was pleasing to see in many scripts a wide range of information requests, and candidates are encouraged to read the model answer to this requirement in preparing for paper P7, to see examples of the kind of information requests included. Some answers however overlooked this part of the requirement, missing out on marks.

Other problems often seen in answers that scored less well on this requirement included the following: 
• Long sections at the start of the answer describing the audit risk model in enormous depth 
• Discussions of client acceptance matters such as the need for know your client procedures 
• Detailed description of analytical procedure and its use in the audit (including at completion stage) with no application at all to the scenario 
• Concentration on going concern risk and very little discussion of any other risk 
• Repeating long sections of wording from the question requirement