AS & A Level Accounting (9706)
Auditing and stewardship Rare
3 questions · about 1% of the marks we indexed · examined in 2 of 9 sessions.
Practice questions
Original questions written by HomiLabs in the style of the exam, with answers and mark schemes. They are not
Cambridge past paper questions and have not been reviewed by Cambridge. Try each one before opening the answer.
Q1Auditing and stewardship · Core · Paper 3 style · 4 marksKarakoram Foods Limited has 4,000 shareholders. The company is run by a board of five directors.
- (a) Explain the term stewardship in the context of a limited company. [2]
- (b) State two ways in which directors demonstrate good stewardship. [2]
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- (a) Stewardship is the responsibility of the directors to look after the company's resources (assets) properly on behalf of the shareholders who own it, and to account to them for how those resources have been used.
1 mark: directors manage/safeguard resources for shareholders; 1 mark: accountability/reporting to owners.
- (b) Any two: keeping proper accounting records; preparing annual financial statements that give a true and fair view; safeguarding assets and preventing fraud through internal controls; having the statements audited and presenting them at the annual general meeting; using resources efficiently in shareholders' interests.
1 mark each.
- (a) State two differences between an internal auditor and an external auditor. [4]
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- (a) Any two: appointment — internal auditor is an employee appointed by management, external auditor is independent and appointed by the shareholders; reporting — internal auditor reports to the directors/audit committee, external auditor reports to the shareholders; purpose — internal audit reviews systems, controls and efficiency for management, external audit gives an opinion on whether the statements give a true and fair view; legal requirement — external audit is required by law for most companies, internal audit is optional; qualification/independence — external auditor must be a registered, independent accountant.
2 marks per difference (both sides compared).
- (a) State three statutory rights of a company's external auditor. [3]
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- (a) Any three: right of access at all times to the company's books, records and vouchers; right to require information and explanations from directors and officers; right to receive notice of and attend general meetings; right to speak at general meetings on matters concerning them as auditor; right to make written representations if they are to be removed or not reappointed.
1 mark each.
- (a) Explain the meaning of the phrase 'a true and fair view'. [2]
- (b) State who is responsible for preparing a company's financial statements. [1]
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- (a) The financial statements are free from material misstatement and fairly present the company's financial performance and position, prepared in accordance with accounting standards and the law. It does not mean that every figure is exactly correct.
1 mark: free from material misstatement / faithfully presented; 1 mark: in accordance with standards / not absolute accuracy.
- (b) The directors (not the auditors).
1 mark.
- (a) State who appoints the external auditors of a limited company, and to whom they report. [2]
- (b) Explain why it is important that the external auditor is independent of the directors. [2]
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- (a) They are appointed by the shareholders (usually at the annual general meeting) and report to the shareholders.
1 mark each.
- (b) The auditor checks the statements prepared by the directors; if not independent they might be influenced to accept misstatements, so shareholders could not rely on the opinion.
1 mark: checking directors' work / objective opinion; 1 mark: shareholders' reliance/confidence.
- (a) State four items normally included in an external auditor's report. [4]
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- (a) Any four: title and addressee (the shareholders); the auditor's opinion; basis for opinion (statement that the audit was done under auditing standards and the auditor is independent); key audit matters (for listed companies); material uncertainty related to going concern, if any; responsibilities of the directors for the financial statements; responsibilities of the auditor; auditor's name, signature, address and date.
1 mark each.
- (a) Explain two threats to the independence of an external auditor. [4]
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- (a) Self-interest: e.g. the auditor owns shares in the client or depends heavily on its fees, so may avoid a qualified opinion. Self-review: the audit firm also prepares the accounts it audits. Familiarity: a long relationship or family ties with directors. Intimidation: directors threaten to remove the auditor. Advocacy: the auditor promotes the client's interests.
2 marks each: threat named + example/explanation.
- (a) Other than shareholders, name two groups who rely on a company's audited financial statements, and explain why each relies on the audit. [4]
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- (a) Any two: banks/lenders — deciding whether to lend and checking loan covenants, need assurance figures are reliable; suppliers — deciding whether to give credit; tax authorities — assessing tax payable; potential investors — deciding whether to buy shares; employees/trade unions — job security and pay negotiations; government/regulators.
1 mark each group; 1 mark each reason linked to reliability.
- (a) Explain how publishing an audited annual report helps the directors carry out their stewardship responsibility. [3]
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- (a) The annual report shows shareholders how the directors have used the company's resources and what results they achieved; the audit gives independent assurance that this account is true and fair; shareholders can then question directors and vote on their reappointment at the AGM, so the directors are held accountable.
1 mark: reports use of resources/results; 1 mark: independent assurance; 1 mark: accountability (AGM/votes).
During the audit of Chitral Tea Limited, the auditor identified the following errors in the draft statement of financial position, which shows net assets of $2,460,000:• Damaged inventory not yet written down to net realisable value: effect on net assets −$36,000• Accrued audit fee not recorded: effect on net assets −$18,000• Prepaid rent omitted: effect on net assets +$12,500
- (a) Calculate the corrected net assets of the company. [2]
- (b) The directors agree to make all the corrections. State the type of audit opinion that is likely to be given and explain why. [2]
Show answer
- (a) $2,418,500
2,460,000 − 36,000 − 18,000 + 12,500 = 2,418,500. M1 A1.
- (b) An unmodified opinion: once the misstatements have been corrected, the statements give a true and fair view in all material respects, so there is no reason to modify the opinion.
1 mark unmodified; 1 mark explanation.
- (a) Distinguish between an unmodified (unqualified) audit opinion and a qualified audit opinion. [4]
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- (a) Unmodified: the auditor concludes that the financial statements give a true and fair view in all material respects. Qualified: the auditor concludes that the statements give a true and fair view except for the effects of a specific matter, which is material but not pervasive (a material misstatement, or an inability to obtain enough evidence about one area).
2 marks each: meaning + key words ('true and fair', 'except for', material but not pervasive).
- (a) Describe the three types of modified audit opinion and state when each is given. [6]
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- (a) Qualified opinion ('except for'): a misstatement or lack of evidence that is material but not pervasive. Adverse opinion: misstatements are material and pervasive, so the statements do not give a true and fair view. Disclaimer of opinion: the auditor cannot obtain sufficient appropriate evidence and the possible effects are material and pervasive, so no opinion is expressed.
1 mark each type named; 1 mark each correct circumstance.
The auditors of Ravi Garments Limited found that closing inventory was overstated by $48,000 because obsolete stock had been valued at cost. The directors refuse to adjust it. Profit before tax was $620,000. The audit firm treats any misstatement above 5% of profit before tax as material. No other problems were found.
- (a) Calculate the misstatement as a percentage of profit before tax, correct to two decimal places. [1]
- (b) Identify the type of audit opinion the auditor is likely to give. Justify your answer. [3]
Show answer
- (a) 7.74%
48,000 ÷ 620,000 × 100 = 7.74%.
- (b) A qualified ('except for') opinion. The overstatement of inventory is material (well above the 5% threshold the firm uses) but it affects only one area of the statements, so it is not pervasive; the rest of the statements give a true and fair view.
1 mark qualified; 1 mark material (with reference to the figure); 1 mark not pervasive / limited to inventory.
Mehran Retail Limited runs 45 supermarkets across Pakistan and has set up an internal audit department.
- (a) Explain three functions of an internal audit department. [6]
Show answer
- (a) Reviewing and testing internal controls (e.g. authorisation of purchases, segregation of duties) to see that they work; checking the accuracy and reliability of accounting records and reports to management; detecting and preventing fraud and error; reviewing the efficiency and value for money of operations; checking compliance with laws, regulations and company policies; helping the external auditor, who may rely on its work.
2 marks each: function identified (1) + explanation (1), max 3 functions.
- (a) Explain two limitations of an external audit. [4]
Show answer
- (a) Auditors test samples of transactions, not every one, so some errors may go undetected; many figures rely on judgement and estimates (e.g. depreciation, allowances, provisions), so the opinion is reasonable not absolute assurance; auditors rely on information and explanations from management, which may be incomplete or deliberately misleading (collusion/fraud); the audit is of past information and is out of date when published; time and cost limits.
2 marks each: limitation + explanation.
- (a) Explain why shareholders of a large company need an external audit. [4]
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- (a) Ownership is separated from control: shareholders do not run the company and cannot check the records themselves. The directors prepare the statements and could present results favourably to protect bonuses or reputation. An independent expert's opinion that the statements are true and fair gives shareholders confidence when assessing directors' stewardship and making decisions (buy/sell/vote). It also helps deter fraud and error.
1 mark each for four points, or 2 marks each for two developed points.
After a cashier at Sadiq Motors Limited was found to have stolen $18,000 over two years, a shareholder complained at the annual general meeting that the auditors 'should have found the fraud'.
- (a) Explain the responsibility of (i) the directors and (ii) the external auditor in relation to fraud. [4]
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- (a) (i) The directors are primarily responsible for preventing and detecting fraud, by setting up and monitoring internal controls and a culture of honesty. (ii) The auditor must plan and perform the audit to obtain reasonable assurance that the statements are free from material misstatement whether caused by fraud or error; they are not required to find all fraud, but must report material fraud they discover to the appropriate level of management/shareholders.
2 marks each part.
- (a) State four responsibilities of the directors of a limited company relating to its financial records and statements. [4]
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- (a) Any four: keep adequate accounting records; prepare annual financial statements that give a true and fair view and follow accounting standards; select suitable accounting policies and apply them consistently; make reasonable judgements and estimates; safeguard the company's assets; take reasonable steps to prevent and detect fraud; assess whether the company is a going concern; file the statements as required by law.
1 mark each.
The internal auditor of Indus Hardware Limited attended the year-end inventory count. The inventory records show a book value of $145,600. The physical count, valued at cost, is $138,950.
- (a) Calculate the inventory shortage and express it as a percentage of the book value, correct to two decimal places. [2]
- (b) Suggest three possible causes of the shortage. [3]
- (c) State one internal control that would reduce the risk of this happening again. [1]
Show answer
- (a) $6,650; 4.57%
145,600 − 138,950 = 6,650; 6,650 ÷ 145,600 × 100 = 4.57%. M1 A1.
- (b) Any three: theft by staff or customers; goods sent out without being invoiced; recording errors (e.g. purchases recorded twice); damaged goods thrown away and not recorded; count errors; goods returned to suppliers not recorded.
1 mark each.
- (c) E.g. regular surprise inventory counts by staff independent of the storekeeper; restricted access to the store; goods-out notes authorised for every dispatch.
1 mark.
- (a) Explain the term segregation of duties. [2]
- (b) Give two examples of segregation of duties in the purchases system of a company. [2]
Show answer
- (a) Dividing the stages of a transaction between different people so that no one person controls it from start to finish; this makes fraud harder because it would need collusion, and errors are more likely to be spotted.
1 mark meaning; 1 mark benefit.
- (b) Any two: the person who orders goods is not the person who receives them; the person who records invoices is not the person who authorises payment; the person who signs payments is not the person who keeps the purchases ledger; a different person reconciles supplier statements.
1 mark each.
Swat Marble Limited has 2,500 shareholders, none of whom work in the business. This year its external auditor gave a qualified audit opinion.
- (a) Explain why the external auditor's report is addressed to the shareholders rather than to the directors. [2]
- (b) State three possible consequences for Swat Marble Limited of receiving a qualified audit opinion. [3]
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- (a) The auditor is appointed by, and acts for, the shareholders, who own the company but do not manage it. The report gives them an independent opinion on the statements the directors have prepared, so it is a check on the directors' stewardship.
1 mark appointed by / acts for shareholders; 1 mark checks directors' stewardship for owners who do not run the company.
- (b) Any three: shareholders lose confidence in the directors and may vote against their reappointment; the share price may fall; banks may refuse loans or charge higher interest; suppliers may reduce credit; potential investors may be put off; the company's reputation may suffer.
1 mark each.
The honorary auditor of the Peshawar Squash Club checks the treasurer's records for the year. Cash in hand at the start was $3,850. Receipts recorded were: subscriptions $46,200; event ticket sales $18,750; donations $9,500. All recorded payments, supported by receipts, totalled $61,400. The cash counted at the year end was $11,280.
- (a) Calculate the amount of cash that should be held at the year end, and the amount missing. [3]
- (b) Explain two controls the club committee could introduce to improve the stewardship of its funds. [4]
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- (a) Should hold $16,900; missing $5,620
3,850 + 46,200 + 18,750 + 9,500 − 61,400 = 16,900 (M1 A1); 16,900 − 11,280 = 5,620 (A1).
- (b) Any two developed: all receipts banked intact and promptly, with numbered receipts issued; two signatories required for payments; regular bank reconciliations reviewed by someone other than the treasurer; an independent honorary auditor checks the accounts annually; monthly reports to the committee comparing receipts with members' list.
2 marks each: control + how it protects funds.
Pak Agro Exports Limited has no internal audit department. Last year losses from undetected errors and staff fraud were estimated at $140,000. The finance director proposes an internal audit department costing $95,000 a year, which is expected to reduce such losses by 60%. The external auditor has said it may be able to rely on some of the internal auditors' work.
- (a) Calculate the expected annual saving in losses and the net annual cost or benefit of the internal audit department. [2]
- (b) Advise the directors whether they should set up the internal audit department. Justify your answer. [6]
Show answer
- (a) Saving $84,000; net annual cost $11,000
60% × 140,000 = 84,000 (M1); 95,000 − 84,000 = 11,000 net cost (A1).
- (b) Against: on these figures it costs $11,000 a year more than it saves; the saving is only an estimate; internal auditors are employees, so they are less independent than the external auditor and cannot replace the external audit. For: it reviews and tests internal controls continuously, deterring fraud as well as detecting it; it can improve the efficiency of operations and the reliability of records for management; the external auditor may rely on its work, which could reduce the external audit fee and close the $11,000 gap; it helps the directors show good stewardship of shareholders' assets. Decision: e.g. set it up, because the net cost is small and the non-financial benefits (stronger controls, possible lower audit fee) are likely to outweigh it.
Up to 2 marks for points against (using the $11,000 figure), up to 3 marks for points in favour applied to the company, 1 mark for a justified decision.
During the year, the directors of Lahore Builders Limited: (1) bought land for $1.3 million from a company owned by the managing director's brother; an independent valuer had valued it at $1.0 million, and the transaction was not disclosed in the annual report; (2) increased their own bonuses by 40% while reducing the dividend per share from 12 cents to 8 cents; (3) published the annual report four months later than usual. The company's profit for the year rose by 12% and the directors set up an internal audit department.
- (a) Discuss whether the directors of Lahore Builders Limited have carried out their stewardship responsibilities properly. Conclude with a judgement. [8]
Show answer
- (a) Against good stewardship: buying land from a company owned by the managing director's brother at 30% above valuation is a conflict of interest and may waste shareholders' funds; failure to disclose the related party transaction; directors' bonuses increased while dividends cut — possible self-interest; the delay in publishing accounts reduces accountability. For: profits rose by 12%; they set up an internal audit department and kept proper records; the land may have strategic value. Judgement: overall the directors have not fully discharged their stewardship duty because of the undisclosed related-party purchase and the bonus/dividend issue, although operational performance improved.
Level 3 (7–8): balanced discussion applied to the case with a justified judgement. Level 2 (4–6): some applied points, may be one-sided, some judgement. Level 1 (1–3): general statements about stewardship.
A flood destroyed the head office of Sindh Rice Mills Limited, including most sales and inventory records for the year. Revenue, trade receivables and closing inventory together make up most of the figures in the financial statements. The directors have estimated these figures, but there is no supporting evidence for the auditor to test.
- (a) Identify the type of audit opinion the auditor should give. Justify your answer. [5]
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- (a) A disclaimer of opinion. The auditor cannot obtain sufficient appropriate evidence for revenue, receivables and inventory, which affect most of the statements, so the possible effects are both material and pervasive. The auditor therefore does not express an opinion. A qualified opinion would only be suitable if the lack of evidence affected a limited area, and an adverse opinion needs evidence that the statements are actually misstated.
1 mark disclaimer; 1 mark inability to obtain evidence; 1 mark material; 1 mark pervasive; 1 mark distinguishing from qualified/adverse.
The bank has withdrawn all loans from Margalla Shoes Limited and the directors have decided to put the company into liquidation shortly after the year end. However, they have prepared the financial statements on a going concern basis and refuse to change them or to disclose the planned liquidation.
- (a) Identify the type of audit opinion the auditor should give. Justify your answer. [5]
Show answer
- (a) An adverse opinion. The company is not a going concern (bank has withdrawn finance, directors intend to liquidate), but the statements are prepared on a going concern basis, so assets are at cost less depreciation rather than realisable values and liabilities may be misclassified. This misstatement is material and affects the statements as a whole (pervasive), so they do not give a true and fair view. It is not a disclaimer because the auditor has sufficient evidence.
1 mark adverse; 1 mark basis of preparation wrong; 1 mark material; 1 mark pervasive; 1 mark sufficient evidence/not a disclaimer.
Thar Coal Services Limited reports profit before tax of $1,150,000. Its mining equipment cost $3,600,000 and has a useful life of 12 years with no residual value, but the directors have decided not to charge any depreciation on it this year. The external auditor disagrees. The directors tell shareholders that "the auditor is responsible for getting the figures right".
- (a) Calculate the straight-line depreciation for the year, the corrected profit before tax, and the misstatement as a percentage of the reported profit before tax, correct to two decimal places. [3]
- (b) Explain why the directors' statement is wrong, and state with reasons the audit opinion likely to be given if the directors refuse to charge depreciation. [4]
Show answer
- (a) Depreciation $300,000; corrected profit before tax $850,000; misstatement 26.09%
3,600,000 ÷ 12 = 300,000 (B1); 1,150,000 − 300,000 = 850,000 (B1); 300,000 ÷ 1,150,000 × 100 = 26.09% (B1).
- (b) The directors are responsible for preparing financial statements that give a true and fair view; the auditor only examines them and gives an independent opinion on them. The misstatement (26.09% of profit) is material, but it is confined to one item (depreciation, carrying amount of equipment and retained earnings) rather than the statements as a whole, so it is not pervasive. The auditor is therefore likely to give a qualified ('except for') opinion.
1 mark directors prepare; 1 mark auditor gives opinion only; 1 mark material with reference to figure; 1 mark qualified because not pervasive.
At the annual general meeting of Kohat Cement Limited, shareholders must vote on reappointing Khan & Co as external auditors. Khan & Co received an audit fee of $85,000 and a further $240,000 for consultancy, including designing the company's new computerised accounting system. The same audit partner has led the audit for 11 years.
- (a) Calculate non-audit fees as a percentage of the total fees received from the company, correct to one decimal place. [1]
- (b) Advise the shareholders whether they should vote to reappoint Khan & Co as auditors. Justify your answer. [7]
Show answer
- (a) 73.8%
240,000 ÷ (85,000 + 240,000) × 100 = 73.8%.
- (b) Against: non-audit fees are almost three times the audit fee (about 74% of total), creating a self-interest threat — the firm may be reluctant to qualify its opinion and risk losing lucrative consultancy work; the firm designed the new accounting system, so it would be auditing its own work (self-review threat); the audit partner has been in charge for 11 years (familiarity threat). For: the firm knows the business well, which may make the audit efficient and cheaper; no evidence of any wrongdoing; changing auditors has costs. Decision: shareholders should not reappoint unless safeguards are put in place (e.g. rotate the audit partner, stop providing system design/consultancy, or have a separate team); otherwise appoint a new independent firm.
Up to 3 marks for independence threats applied, up to 2 marks for points in favour, 1 mark for safeguards, 1 mark for a justified decision.
The directors of Faisal Textiles Limited each receive a bonus equal to 2% of the year's profit before tax. This year the directors postponed essential machine maintenance and changed the estimated useful life of machinery from 8 to 15 years, increasing profit by $1.2 million.
- (a) Discuss the conflict of interest between the directors and the shareholders of Faisal Textiles Limited, and suggest how the shareholders could reduce the risk that the directors act in their own interest. [6]
Show answer
- (a) Conflict: the directors' bonus depends on annual profit, so they have an incentive to boost short-term profit (e.g. by delaying maintenance, cutting training, or choosing accounting estimates that increase profit), while shareholders want long-term growth in value and reliable statements; directors also control the information shareholders receive. Ways to reduce it: link part of pay to long-term targets or share price over several years (or pay part in shares); appoint independent non-executive directors and an audit committee; keep a strong independent external audit; require clear disclosure of directors' remuneration and related-party transactions; vote on remuneration at the AGM.
Up to 3 marks for explaining the conflict with reference to the case, up to 3 marks for suitable safeguards explained.
The directors of Hala Ceramics Limited propose that the company's internal audit department, which reports to the finance director, should take over the work of the external auditor. This would save the external audit fee of $120,000 a year.
- (a) Evaluate the directors' proposal. [6]
Show answer
- (a) Against: internal auditors are employees who report to the finance director, so they are not independent of the people whose statements they would check; shareholders, lenders and other users need an independent opinion that the statements give a true and fair view; an external audit is normally a legal requirement for a limited company, so it cannot simply be replaced; the external auditor is appointed by and reports to the shareholders, whereas internal audit serves management. For: the saving of $120,000 a year; internal auditors know the business well. Conclusion: reject the proposal; keep both, and instead let the external auditor rely on the internal auditors' work where appropriate, which may reduce the fee.
Up to 4 marks for points (at least one in favour for full marks) applied to the company, 1 mark for using the $120,000 or the reporting line, 1 mark for a justified conclusion.
