ANALTTICAL PROCEDURES.docx

8/14/2019 ANALTTICAL PROCEDURES.docx

1/170

[ T y p e t h e c o m p a n y a d d r e s s ] Page 1

ANALTTICAL PROCEDURESAnalytical procedures refers to the analysis of significant ratios and trends including the resulting investigation offluctuations and relationships that are inconsistent with other relevant information or which deviate from predictedamounts.

Nature of analytical proceduresThese may be achieved through the consideration of comparisons of the entitys financial information with, for example:

Comparable inf ormation for prior periods The entitys anticipated results Similar industry information .

When performing analytical procedures, the auditors examine both financial data and nonfinancial data, such as thenumber of employees. Before starting their analytical procedures, auditors estimate the expected value (of the ratio/trend/ account balance/ transaction, etc.) before calculating the actual value so as to avoid the actual value being biasedfor the auditors estimate of the expected value. The expect ed results are estimated based on preliminary discussionswith the clients.

After having performed their analytical procedures, the auditors then compare the actual results with those expectedand look for reasons for any significant variations. Unexplained variations may indicate a misstatement in the figures inthat area, which would lead the auditors to plan their audit work to devote more time and resources to those areas.When the application of analytical procedures does not identify any unusual or unexpected differences, the resultsprovide evidence in support of managements assertions.

Timing and purpose of analytical proceduresAnalytical procedures may be performed at any of all three stages in the audit process: the planning phase, the testingphase and the completion phase.

During the planning phase, analytical procedures can be used as risk assessment procedures. They help auditors identifysignificant matter s requiring special consideration later in the audit engagement, such as to:

understand the clients industry and business indicate possible misstatements reduce detailed tests.

During the testing phase, analytical procedures can be used as substantive procedures in collecting appropriate auditevidence. They can be performed together with other substantive procedures (substantive tests of transactions andtests of details of balances) and they help to:

indicate possible misstatements reduce detailed tests.

During the completion phase, analytical procedures can be used as part of an overall review of the financial statementsfor the auditors to reach conclusions about the fair presentation of the financial statements. The analytical procedureshelp the auditors to take a final review of the audited financial statements objectively and help to:

assess going concern indicate possible misstatements.

Limitation of analytical procedures as substantive proceduresAnalytical procedures only provide conclusions on reasonableness of data rather than precision and cannot easily belinked to specific assertions (i.e. the nature or cause of a difference); therefore analytical procedures are less persuasive


2/170


than tests of details of balances. The substantive evidence gathered using analytical procedures is thus generally used tocorroborate other substantive evidence gathered, rather than being used as a sole source of evidence.

Cost-benefit of analytical proceduresAnalytical procedures cost the least because of the relative ease of making calculations and comparisons. It is quiteoften easier for auditors to obtain considerable information about potential misstatements by simply comparing two orthree numbers.

Advice on the use of analytical procedureAnalytical procedure is a powerful tool that has the potential to increase the efficiency of audits since it is a relativelylow-cost procedure that seems to have considerable power in identifying errors or irregularities and in guiding audits.Although the calculation of ratios and comparison of trends are relatively easy tasks, the analysis of ratios and trendsrequires a good understanding of the clients business and industry. Hence analytical procedures are preferably handledby a more senior auditor within the audit team.

Types of Analytical Procedures1. Ratios2. Trend Analysis3. Predictive Tests4. Data Analysis

AUDIT METHODOLOGIES

The audit strategy document describes the audit methodology to be used in gathering evidence.

Following are the main methodologies currently used by the auditors:

1. Risk Based Audit.2. Top down approach.3. System audit.4. Balance sheet approach.5. Directional testing

Risk based audit:

Consider for example you are auditing a small manufacturing company. The company owns the land and building in itsstatements of financial position which it depreciates over 50 years and has always been valued at cost. The other majoritem is inventory.

Now considering the nature of business, inventory is likely to be far more complex. The chance of audit engagementpartner drawing an inappropriate conclusion about inventory is higher than the risk in connection with land andbuilding.

Under risk based auditing the auditor will do less work on land and building and will apply more audit procedures oninventory.

Top down approach:

With a top down approach also known as business risk approach, controls testing is aimed at high level controls andsubstantive testing is reduced. Following such approach the auditor:

1. Pays greater attention to high level controls such as control environment and corporate governance rather than


3/170


the detailed procedural controls testing under traditional approaches2. Apply analytical procedures more heavily to understand the entitys business rather than to prove financial

statement figures.3. Reduce its substantive testing.

Advantages:

1. Added value to the clients as the approach focuses on the business as a whole.

2. Increase efficiency and reduce cost as substantive testing is reduced.3. Responds to the importance that regulators and government have placed on corporate governance in recent

years.4. Lower engagement risk through broader understanding of the clients business and practices.

Systems audit :

Also known as traditional approach to auditing in which auditor assesses the system of controls (such as for sales,purchases, payroll, receipts and disbursements) put in place by the management and ascertain whether they areeffective enough for the auditors to reduce their substantive procedures.

Balance sheet approach:

Under this approach the auditor seek to concentrate efforts on substantiating the closing position in the year, shown inthe statement of financial position, having determined that the closing position from the previous year has beencorrectly transferred to be the opening balance in the current year.

Such an approach can be undertaken with reduced element of substantive testing under business risk approach.

Such approach is effective for small companies whose financial statement contains very few material items and thereare no sophisticated controls in such a company. But it can be costly as substantive procedure usually takes time to beperformed.

Directional testing:

It is a method of undertaking detailed substantive testing. Substantive testing seeks to discover errors and omissions andthe discovery of these will depend on the direction of the test.

Broadly speaking, substantive procedures can be said to fall in to two categories:

1. Test to discover errors (resulting in over or understatement)2. Test to discover omissions (resulting in understatements)

Test to discover errors:

Such test starts with accounting records in which transactions are recorded and then trace to supporting documents.

Example if the test is to check sales are priced correctly, the test would begin with a sales invoice selected from the salesledger. Prices would then be checked to the official price list.

Test to discover omissions:


4/170


These test start outside the accounting record and then check back to those records.

Example if the test is designed to discover whether all raw material purchases have been properly processed, the testwould start say with goods received notes, to be checked to the inventory records or purchase ledger.

Directional testing is particularly useful when there is high level of detailed testing to be carried out for example whenthe auditors have assessed the c ompanys controls and accounting systems as ineffective.

AUDIT OPINION

S.NO REASON OPINION1. Material misstatements Qualified (except for) Refer

Illustration 1 2. Material and pervasive misstatements Adverse Refer Illustration 2 3. Material inability to obtain sufficient

and appropriate audit evidenceQualified (except for) ReferIllustration 3

4. Material and pervasive inability toobtain sufficient and appropriateaudit evidence

Disclaimer of opinion ReferIllustration 4

Emphasis of Matter Paragraph

A paragraph included in the auditors report that refers to a matter appropriately presented or disclosed in the financialstatements that, in the auditors judgment, is of such importance that is fundamental to users understanding of thefinancial statements.

Example of situations where Emphasis of Matter Paragraph is used:

1. Uncertain outcome of material litigation.2. Early application of accounting standard that has a pervasive effect on the financial statements in advance of its

effective date.3. A major catastrophe that has had, or continues to have, a devastating effect on the entitys financial position. 4. The financial reporting framework is unacceptable but for the fact that it is prescribed by law or regulation.5. There is a material uncertainty relating to events or condition that may cast significant doubt on the entitys

ability to continue as a going concern.

The emphasis of matter paragraph should be included immediately after the opinion paragraph in the auditors reportand should be clearly identified as an Emphasis of Matter.

Example

We draw attention to note 22(a) to the financial statements which describes the uncertainties related to the outcome ofthe law suits filed against the Company. Our opinion is not qualified in respect of this matter.

Other Matter Paragraph

A paragraph included in the auditors report that refers to a matter other than those presented or disclosed in thefinancial statements that, in the auditors judgment, is relevant to users understanding of the audit, the auditorsresponsibilities or the auditors report.


5/170


Example of situation where Other Matter Paragraph is used:

1. Where prior period financial statements were unaudited.2. Where prior period financial statements were audited by a predecessor auditor.3. When repor ting on prior period financial statements in connection with the current periods audit, if the

auditors opinion on such prior period financial statements differs from the opinion the auditor previouslyexpressed.

4. If the revision of other information is necessary and management refuse to make the revision.5. The auditor is unable to withdraw from the engagement and yet is unable to obtain sufficient appropriate audit

evidence, when the auditor has been requested to report on other matters or to provide more clarifications inline with legal jurisdiction of the country.

The other matter paragraph is included immediately after the opinion paragraph and any emphasis of matter paragraph.

Example

The financial statements of the Company for the year ended 30 June 2009 were audited by another firm of charteredaccountants whose report dated 11 September 2009 expressed an unqualified opinion on those financial statements.However, the said auditors report included an emphasis of matter paragraph regarding short pro vision of taxation inrespect of prior years.

ILLUSTRATIONS

Illustration 1: An auditor's report containing a qualified opinion due to a material misstatement of the financialstatements.

Illustration 2: An auditor's report containing an advers e opinion due to a material misstatement of the financialstatements.

Illustration 3: An auditor's report containing a qualified opinion due to the auditor's inability to obtain sufficientappropriate audit evidence.

Illustration 4: An auditor' s report containing a disclaimer of opinion due to the auditor's inability to obtain sufficientappropriate audit evidence about a single element of the financial statements.

Illustration 5: An auditor's report containing a disclaimer of opinion due to the auditor's inability to obtain sufficientappropriate audit evidence about multiple elements of the financial statements.

Illustration 1:

Basis for Qualified Opinion

The company's inventories are carried in the balance sheet at xxx. Management has not stated the inventories at thelower of cost and net realizable value but has stated them solely at cost, which constitutes a departure fromInternational Financial Reporting Standards. The company's records indicate that had management stated theinventories at the lower of cost and net realizable value, an amount of xxx would have been required to write theinventories down to their net realizable value. Accordingly, cost of sales would have been increased by xxx, and incometax, net income and shareholders' equity would have been reduced by xxx, xxx and xxx, respectively.


6/170


Qualified Opinion

In our opinion, except for the effects of the matter described in the Basis for Qualified Opinion paragraph, the financialstatements present fairly, in all material respects, (or give a true and fair view of) the financial position of ABC Companyas at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended in accordancewith International Financial Reporting Standards.

Illustration 2:

Basis for Adverse Opinion

As explained in Note X, the company has not consolidated the financial statements of subsidiary XYZ Company itacquired during 20X1 because it has not yet been able to ascertain the fair values of certain of the subsidiary's materialassets and liabilities at the acquisition date. This investment is therefore accounted for on a cost basis. UnderInternational Financial Reporting Standards, the subsidiary should have been consolidated because it is controlled by thecompany. Had XYZ been consolidated, many elements in the accompanying financial statements would have beenmaterially affected. The effects on the consolidated financial statements of the failure to consolidate have not beendetermined.

Adverse Opinion

In our opinion, because of the significance of the matter discussed in the Basis for Adverse Opinion paragraph, theconsolidated financial statements do not present fairly (or do not give a true and fair view of) the financial position ofABC Company and its subsidiaries as at December 31, 20X1, and (of) their financial performance and their cash flows forthe year then ended in accordance with International Financial Reporting Standards.

Illustration 3:

Basis for Qualified Opinion

ABC Company's investment in XYZ Company, a foreign associate acquired during the year and accounted for by theequity method, is carried at xxx on the balance sheet as at December 31, 20X1, and ABC's share of XYZ's net income ofxxx is included in ABC's income for the year then ended. We were unable to obtain sufficient appropriate audit evidenceabout the carrying amount of ABC's investment in XYZ as at December 31, 20X1 and ABC's share of XYZ's net income forthe year because we were denied access to the financial information, management, and the auditors of XYZ.Consequently, we were unable to determine whether any adjustments to these amounts were necessary.

Qualified Opinion

In our opinion, except for the possible effects of the matter described in the Basis for Qualified Opinion paragraph, thefinancial statements present fairly, in all material respects, (or give a true and fair view of) the financial position of ABCCompany as at December 31, 20X1, and (of) its financial performance and its cash flows for the year then ended inaccordance with International Financial Reporting Standards.

Illustration 4:

Basis for Disclaimer of Opinion

We were not appointed as auditors of the company until after December 31, 20X1 and thus did not observe thecounting of physical inventories at the beginning and end of the year. We were unable to satisfy ourselves by alternative


7/170


means concerning the inventory quantities held at December 31, 20X0 and 20X1 which are stated in the balance sheetat xxx and xxx, respectively. In addition, the introduction of a new computerized accounts receivable system inSeptember 20X1 resulted in numerous errors in accounts receivable. As of the date of our audit report, managementwas still in the process of rectifying the system deficiencies and correcting the errors. We were unable to confirm orverify by alternative means accounts receivable included in the balance sheet at a total amount of xxx as at December31, 20X1. As a result of these matters, we were unable to determine whether any adjustments might have been foundnecessary in respect of recorded or unrecorded inventories and accounts receivable, and the elements making up the

income statement, statement of changes in equity and cash flow statement.

Disclaimer of Opinion

Because of the significance of the matters described in the Basis for Disclaimer of Opinion paragraph, we have not beenable to obtain sufficient appropriate audit evidence to provide a basis for an audit opinion. Accordingly, we do notexpress an opinion on the financial statements.

AUDIT OPINION QUESTIONS

December 2007Question 5

You are the audit manager for two clients of Bertie & Co, a firm of Chartered Certified Accountants. The financial yearend for each client is 30 September 2007.

You are reviewing the audit seniors proposed audit re ports for two clients, Alpha Co and Deema Co.

Alpha Co, a listed company, permanently closed several factories in May 2007, with all costs of closure finalized and paidin August 2007. The factories all produced the same item, which contributed 10% of Alp ha Cos total revenue for theyear ended 30 September 2007 (2006 23%). The closure has been discussed accurately and fully in the chairmans

statement and Directors Report. However, the closure is not mentioned in the notes to the financial statements, norseparately disclosed on the financial statements.

The audit senior has proposed an unmodified audit opinion for Alpha Co as the matter has been fully addressed in thechairmans statement and Directors Report.

In October 2007 a legal claim was filed against Deema Co, a retailer of toys. The claim is from a customer who slipped ona greasy step outside one of the retail outlets. The matter has been fully disclosed as a material contingent liability in thenotes to the financial statements, and audit working papers provide sufficient evidence that no provision is necessary asDeema Cos lawyers have stated in writing that the likelihood of the claim succeeding is only possible. The amount of theclaim is fixed and is adequately covered by cash resources.

The audit senior proposes that the audit opinion for Deema Co should not be qualified, but that an emphasis of matterparagraph should be included after the audit opinion to highlight the situation.

Required:

Evaluate whether the audit seniors proposed audit report is appropriate, and where you disagree with the proposedreport, recommend the amendment necessary to the audit report of:


8/170


(i) Alpha Co; (6 marks)(ii) Deema Co. (4 marks)

Answer

Alpha CoThe factory closures constitute a discontinued operation per IFRS 5 Non-Current Assets Held for Sale and DiscontinuedOperations, due to the discontinuance of a separate major component of the business. It is a major component due tothe 10% contribution to revenue in the year to 30 September 2007 and 23% contribution in 2006. It is a separatebusiness component of the company due to the factories having made only one item, indicating a separate incomegenerating unit.

Under IFRS 5 there must be separate disclosure on the face of the income statement of the post tax results of thediscontinued operation, and of any profit or loss resulting from the closures. The revenue and costs of the discontinuedoperation should be separately disclosed either on the face of the income statement or in the notes to the financialstatements. Cash flows relating to the discontinued operation should also be separately disclosed per IAS 7 Cash FlowStatements.

In addition, as Alpha Co is a listed company, IFRS 8 Operating Segments requires separate segmental disclosure ofdiscontinued operations.

Failure to disclose the above information in the financial statements is a material breach of International AccountingStandards. The audit opinion should therefore be qualified on the grounds of disagreement on disclosure (IFRS 5, IAS 7and IFRS 8). The matter is material, but not pervasive, and therefore an except for opinion should be issued.

The Basis for Qualified Opinion paragraph should clearly state the reason for the disagreement, and an indication of thefinancial significance of the matter.

The audit opinion relates only to the financial statements which have been audited, and the contents of the other

information (chairmans statement and Directors Report) are irrelevant when deciding if the financial statements showa true and fair view, or are fairly presented.

Deema CoThe claim is an event after the balance sheet date. If the accident occurred prior to the year end of 30 September 2007,the claim gives additional evidence of a year end condition, and thus meets the definition of an adjusting post balancesheet event. In this case the matter appears to have been properly disclosed in the notes to the financial statements perIAS 10 Events After the Balance Sheet Date and IAS 37 Provisions, Contingent Liabilities and Contingent Assets. Aprovision would only be necessary if the claim was probable to succeed and there is sufficient appropriate evidence thatthis is not the case. There is therefore no disagreement, and no limitation on scope.

Therefore the senior is correct to propose an unqualified opinion.

However, it is not necessary for the audit report to contain an emphasis of matter paragraph.

ISA 701 Modifications to the Independent Auditors Report states that an emphasis of matter paragraph should be u sedto highlight a matter where there is significant uncertainty.

Uncertainties are normally only regarded as significant if they involve a level of concern about the going concern statusof the company or would have an unusually great effect on the financial statements. This is not the case here as there isenough cash to pay the damages in the unlikely event that the claim goes against Deema Co. This appears to be a one-


9/170


off situation with a low risk of the estimate being subject to change and thus there is no significant uncertainty.

June 2009

Question 5

You are the partner responsible for performing an engagement quality control review on the audit of Pluto Co, a listedcompany. You are currently reviewing the engagement partners proposed audit repor t on the financial statements of

Pluto Co for the year ended 31 March 2009. During the year the company has undergone significant reorganization,involving the discontinuance of two major business segments. Extracts of the proposed audit report are shown below:

Adverse opinion arising from disagreement about application of IAS 37The directors have not recognized a provision in relation to redundancy costs associated with the reorganization duringthe year. The reason is that they do not feel that a reliable estimate of the amount can be made, and so the recognitioncriteria of IAS 37 have not been met. We disagree with the directors as we feel that an estimate can be made. Thismatter is more fully explained in a note to the financial statements. We feel that this is a material misstatement as theprofit for the year is overstated.

In our opinion, the financial statements do not show a true and fair view of the financial position of the company as of31 March 2009, and of its financial performance and its cash flows for the year then ended in accordance withInternational Financial Reporting Standards.

Emphasis of matter paragraphThe directors have decided not to disclose the Earnings per Share for 2009, as they feel that the figure is materiallydistorted by significant discontinued operations in the year. Our opinion is not qualified in respect of this matter.

Required:Critically appraise the proposed audit report of Pluto Co for the year ended 31 March 2009.Note: you are NOT required to re-draft the extracts from the audit report. (9 marks)

Answer

Adverse opinion paragraphThe title of the opinion paragraph clearly states that it is an adverse opinion. For the sake of clarity it may be better justto state that the opinion is adverse rather than go into the reason for the opinion in the title, i.e. remove wordingarising from disagreement about application of IAS 37.

Normally the reason for any modification to the audit report affecting the opinion is explained in a separate paragraphimmediately preceding the opinion paragraph. Here the reason for the modification is explained within the opinionparagraph which could be confusing for the readers.

ISA 701 Modifications to the Independent Auditors Report states that a clear description of all of the substantive

reasons for any modification to the opinion should be included in the report, including, where practicable, an estimateof the financial effect. The proposed audit report partially explains the disagreement but does not go into sufficientdetail. Specifically no estimate of the financial effect has been provided. Quantification of the amount of the omittedprovision must be available, as this is the basis of the disagreement with management. Other detail of the provisionshould also be provided, such as the timing of the probable cash outflow.

To aid the readers understanding of the breach of financial reporting standards that has occurred, it would be useful tofully state the title of IAS 37 Provisions, Contingent Liabilities and Contingent Assets.

The paragraph refers to a note to the financial statements where the matter is more fully explained. This is ambiguous.


10/170


11/170


audit plan.

Scope refers to:

1. The financial reporting framework.2. Industry specific reporting requirement.3. Expected audit coverage.4. Extent of usage of work of another auditor

5. Reporting currency.6. Extent of usage of work of internal auditor.7. The effect of information technology.8. Extent of usage of prior year working papers.

Timing refers to:

1. Tentative deadlines for audit deliverables such as audit report.2. Timing of communication of significant matters with management and those charged with governance.

Direction refers to:

1. Setting of materiality.2. Indentifying areas where there is high risk of material misstatement.3. Selection of engagement team.4. Assignment of audit work to team members.5. Engagement budgeting.6. Assessment of internal controls at entity.7. Assessment of significant business development.8. Changes in accounting policy.

What is audit plan?

The audit plan includes the nature, timing and extent of audit procedures to be performed in response to theconclusion drawn at the time of developing the audit strategy.

Who are involved in a planning process?

Planning involves the engagement partner and other key members of the engagement team.

What factors influence the nature and extent of planning?

1. Size and complexity of the entity.2. Previous experience with the entity.3. Changes in circumstances that occur during the period under the audit.

What is the appropriate time for planning?

Planning is a continual process that begins shortly after the completion of the previous audit and continuesuntil the completion of the current audit engagement.

What are preliminary mandatory engagement activities?

1. Performance of procedures regarding the continuance of client relationship.2. Evaluation of compliance with ethical requirement including independence.


12/170


3. Establish an understanding of the terms of the engagement.

What are additional considerations in Initial Audit Engagements?

1. Perform procedures regarding the acceptance of the client.2. Communicate with the previous auditor.

What are the advantages of planning?

1. Appropriate attention is devoted to important areas of the audit.2. Potential problems are identified and resolved on a timely basis.3. Adequate planning also assists in the proper assignment of work to team members.4. Facilitates the direction and supervision of engagement team members and the review of their work.

RISK ASSESSMENT QUESTIONS

December 2007

Question 1

Your client, Island Co, is a manufacturer of machinery used in the coal extraction industry. You are currently planning theaudit of the financial statements for the year ended 30 November 2007. The draft financial statements show revenue of$125 million (2006 $103 million), profit before tax of $56 million (2006 $51 million) and total assets of $95 million(2006 $90 million). Your firm was appointed as auditor to Island Co for the first time in June 2007.

Island Co designs, constructs and installs machinery for five key customers. Payment is due in three installments: 50% isdue when the order is confirmed (stage one), 25% on delivery of the machinery (stage two), and 25% on successfulinstallation in the customers coal mine (stage three). Generally it takes six months from the order being finalised untilthe final installation.

At 30 November, there is an amount outstanding of $285 million from Jacks Mine Co. The amount is a disputed stagethree payment. Jacks Mine Co is refusing to pay until the machinery, which was installed in August 2007, is running at100% efficiency.

One customer, Sawyer Co, communicated in November 2007, via its lawyers with Island Co, claiming damages forinjuries suffered by a drilling machine operator whose arm was severely injured when a machine malfunctioned. KateShannon, the chief executive officer of Island Co, has told you that the claim is being ignored as it is generally knownthat Sawyer Co has a poor health and safety record, and thus the accident was their fault. Two orders which were placedby Sawyer Co in October 2007 have been cancelled.

Work in progress is valued at $85 million at 30 November 2007. A physical inventory count was held on 17 November2007. The chief engineer estimated the stage of completion of each machine at that date. One of the major componentsincluded in the coal extracting machinery is now being sourced from overseas. The new supplier, Locke Co, is located inSpain and invoices Island Co in Euros. There is a trade payable of $15 million owing to Locke Co recorded within currentliabilities.

All machines are supplied carrying a one year warranty. A warranty provision is recognised on the balance sheet at $25million (2006 $24 million). Kate Shannon estimates the cost of repairing defective machinery reported by customers,and this estimate forms the basis of the provision.


13/170


Kate Shannon owns 60% of the shares in Island Co. She also owns 55% of Pacific Co, which leases a head office to IslandCo. Kate is considering selling some of her shares in Island Co in late January 2008, and would like the audit to befinished by that time.

Required:

Using the information provided, identify and explain the principal audit risks, and any other matters to be consideredwhen planning the final audit for Island Co for the year ended 30 November 2007.

Answer

ISLAND COBriefing NotesSubject: Principal Audit Risks Island Co

Revenue Recognition timing

Island Co raises sales invoices in three stages. There is potential for breach of IAS 18 Revenue , which states that revenueshould only be recognised once the seller has the right to receive it, in other words the seller has performed itscontractual obligations. This right does not necessarily correspond to amounts falling due for payment in accordancewith an invoice schedule agreed with a customer as part of a contract. Island Co appears to receive payment from itscustomers in advance of performing any obligation, as the stage one invoice is raised when an order is confirmed i.e.before any work has actually taken place. This creates the potential for revenue to be recognised too early, in advance ofany performance of contractual obligation. When a payment is received in advance of performance, a liability should berecognised equal to the amount received, representing the obligation under the contract. Therefore a significant risk isthat revenue is overstated and liabilities understated.

Tutorial note: Equivalent guidance is also provided in IAS 11 Construction Contracts and credit will be awarded wherecandidates discuss revenue recognition under IAS 11 as Island Co is providing a single substantial asset for a customerunder the terms of a contract.

Disputed receivable

The amount owed from Jacks Mine Co is highly material as it represents 509% of profit before tax, 23% of revenue, and3% of total assets. The risk is that the receivable is overstated if no impairment of the disputed receivable is recognised.

Legal claim

The claim should be inv estigated seriously by Island Co. The chief executive officers (CEO) opinion that the claim will notresult in any financial consequence for Island Co is nave and flippant. Damages could be awarded against Island Co if it

is found that the machinery is faulty. The recurring high level of warranty provision implies that machinery faults arefairly common and therefore the accident could be the result of a defective machine being supplied to Sawyer Co. Therisk is that no provision is created for the potential damages under IAS 37 Provisions, Contingent Liabilities andContingent Assets , if the likelihood of paying damages is considered probable. Alternatively, if the likelihood of damagesbeing paid to Sawyer Co is considered a possibility then a disclosure note should be made in the financial statementsdescribing the nature and possible financial effect of the contingent liability. As discussed below, the CEO, Kate Shannon,has an incentive not to make a provision or disclose a contingent liability due to the planned share sale post year end.

A further risk is that any legal fees associated with the claim have not been accrued within the financial statements. Asthe claim has arisen during the year, the expense must be included in this years income statement, even if the claim is


14/170


still ongoing at the year end.

The fact that the legal claim is effectively being ignored may cast doubts on the overall integrity of senior management,and on the integrity of the financial statements. Management representations should be approached with a degree ofprofessional scepticism during the audit.

Sawyer Co has cancelled two orders. If the amounts are still outstanding at the year end then it is highly likely thatSawyer Co will not pay the invoiced amounts, and thus receivables are overstated. If the stage one payments have

already been made, then Sawyer Co may claim a refund, in which case a provision should be made to repay the amount,or a contingent liability disclosed in a note to the financial statements.

Sawyer Co is one of only five major customers, and losing this customer could have future going concern implications forIsland Co if a new source of revenue cannot be found to replace the lost income stream from Sawyer Co. If the legalclaim becomes public knowledge, and if Island Co is found to have supplied faulty machinery, then it will be difficult toattract new customers.

A case of this nature could bring bad publicity to Island Co, a potential going concern issue if it results in any of the fivekey customers terminating orders with Island Co. The auditors should plan to extend the going concern workprogramme to incorporate the issues noted above.

InventoriesWork in progress is material to the financial statements, representing 89% of total assets. The inventory count was heldtwo weeks prior to the year end. There is an inherent risk that the valuation has not been correctly rolled forward to ayear end position.

The key risk is the estimation of the stage of completion of work in progress. This is subjective, and knowledge appearsto be confined to the chief engineer. Inventory could be overvalued if the machines are assessed to be more completethan they actually are at the year end. Absorption of labour costs and overheads into each machine is a complexcalculation and must be done consistently with previous years.

It will also be important that consumable inventories not yet utilised on a machine, e.g. screws, nuts and bolts, are

correctly valued and included as inventories of raw materials within current assets.

Overseas supplierAs the supplier is new, controls may not yet have been established over the recording of foreign currency transactions.Inherent risk is high as the trade payable should be retranslated using the year end exchange rate per IAS 21 The Effectsof Changes in Foreign Exchange Rates . If the retranslation is not performed at the year end, the trade payable could besignificantly over or under valued, depending on the movement of the dollar to euro exchange rate between thepurchase date and the year end. The components should remain at historic cost within inventory valuation and shouldnot be retranslated at the year end.

Warranty provision

The warranty provision is material at 26% of total assets (2006 27%). The provision has increased by only $100,000,an increase of 42%, compared to a revenue increase of 214%. This could indicate an under provision as the percentagechange in revenue would be expected to be in line with the percentage change in the warranty provision, unlesssignificant improvements had been made to the quality of machines installed for customers during the year. Thisappears unlikely given the legal claim by Sawyer Co, and the machines installed at Jacks Mine Co operating inefficiently.The basis of the estimate could be understated to avoid charging the increase in the provision as an expense through theincome statement. This is ofSpecial concern given that it is the CEO and majority shareholder who estimates the warranty provision.


15/170


Majority shareholderKate Shannon exerts control over Island Co via a majority shareholding, and by holding the position of CEO. This greatlyincreases the inherent risk that the financial statements could be deliberately misstated, i.e. overvaluation of assets,undervaluation of liabilities, and thus overstatement of profits. The risk is severe at this year end as Kate Shannon is

hoping to sell some Island Co shares post year end. As the price that she receives for these shares will be to a largeextent influenced by the balance sheet position of the company at 30 November 2007, she has a definite interest inmanipulating the financial statements for her own personal benefit. For example:

Not recognising a provision or contingent liability for the legal claim from Sawyer Co Not providing for the potentially irrecoverable receivable from Jacks Mines Co Not increasing the warranty provision Recognising revenue earlier than permitted by IAS 18 Revenue .

Related party transactionsKate Shannon controls Island Co and also controls Pacific Co. Transactions between the two companies should bedisclosed per IAS 24 Related Party Disclosures . There is risk that not all transactions have been disclosed, or that atransaction has been disclosed at an inappropriate value. Details of the lease contract between the two companiesshould be disclosed within a note to the financial statements, in particular, any amounts owed from Island Co to PacificCo at 30 November 2007 should be disclosed.

Other issues Kate Shannon wants the audit to be completed as soon as possible, which brings forward the deadline for completionof the audit. The audit team may not have time to complete all necessary procedures, or there may not be time foradequate reviews to be carried out on the work performed.

This is especially important given that this is the first year audit and therefore the audit team will be working with asteep learning curve. Audit procedures may take longer than originally planned, yet there is little time to extend

procedures where necessary.

Kate Shannon may also exert considerable influence on the members of the audit team to ensure that the financialstatements show the best possible position of Island Co in view of her share sale. It is crucial that the audit teammembers adhere strictly to ethical guidelines and that independence is beyond question.

Due to the seriousness of the matters noted above, a final matter to be considered at the planning stage is that asecond partner review (Engagement Quality Control Review) should be considered for the audit this year end. A suitableindependent reviewer should be identified, and time planned and budgeted for at the end of the assignment.

Conclusion

From the range of issues discussed in these briefing notes, it can be seen that the audit of Island Co will be a relativelyhigh risk engagement.

June 2008

QuestionYou are a senior audit manager in Mitchell & Co, a firm of Chartered Certified Accountants. You are reviewing someinformation regarding a potential new audit client, Medix Co, a supplier of medical instruments. Extracts from notestaken at a meeting that you recently held with the finance director of Medix Co, Ricardo Feller, are shown below:


16/170


Meeting notes meeting held 1 June 2008 with Ricardo Feller

Medix Co is a provider of specialised surgical instruments used in medical procedures. The company is owner managed,has a financial year ending 30 June 2008, and has invited our firm to be appointed as auditor for the forthcoming yearend. The audit is not going out to tender. Ricardo Feller has been with the company since January 2008, following thedeparture of the previous finance director, who is currently taking legal action against Medix Co for unfair dismissal.

Company background

Medix Co manufactures surgical instruments which are sold to hospitals and clinics. Due to the increased use of lasersurgery in the last four years, demand for traditional metal surgical instruments, which provided 75% of revenue in theyear ended 30 June 2007, has declined rapidly. Medix Co is expanding into the provision of laser surgery equipment, butresearch and development is at an early stage. The directors feel confident that the laser instruments currently beingdesigned will eventually receive the necessary licence for commercial production, and that the laser product will replacesurgical instruments as a leading source of revenue. There is currently one scientist working on the laser equipment,subcontracted by Medix Co on a freelance basis. The building in which the research is being carried out has recentlybeen significantly extended by the construction of a large laboratory.

A considerable revenue stream is derived from agents who are not employed by Medix Co. The agents earn acommission based on the value of sales they have secured for Medix Co during the year. There are many suppliers intothe market and agents are used by all manufacturers as a means of marketing and distributing their products.

The companys manufacturing facility is located in another country, where ope rating costs are significantly lower. Thefacility is under the control of a local manager who visits the head office of Medix Co annually for a meeting with seniormanagement. Products are imported via aeroplane. The overseas plant and equipment is owned by the company andwas constructed 12 years ago specifically for the manufacture of metal surgical instruments.

The company has a bank overdraft facility and makes use of the facility most months. A significant bank loan, which willcarry a variable interest rate, is currently being negotiated. The terms of the loan will be finalised once the auditedfinancial statements have been viewed by the bank.

After receiving permission from Medix Co, you held a discussion with the current audit partner of Medix Co, Mick Evans,who runs a small accounting and audit practice of which he is one of two partners. Mick told you the following:

Medix Co has been an audit client for three years. We took over from the previous auditors following a disagreementbetween them and the directors of Medix Co over fees. As we are a small practice with low overheads we could offerlower fees than our predecessors. We could also do the audit very quickly, which pleased the client, as they like to keepcosts as low as possible.

During our audits we have found the internal systems and controls to be quite weak. Despite our recommendations,

there always seemed to be a lack of interest in making improvements to the accounting systems, as this was seen to be awaste of money. There have been two investigations by the tax authorities, which we did not deal with, as we are nottax experts. In the end the directors sorted it all out, and I believe that the tax matter is now resolved.

We never had a problem getting access to accounting books and records. However, the managing director, Jon Tate,once gave us what he described as the wrong cash book by mistake, and replaced it with the proper version later in theday. We never found out why he was keeping two cash books, but cash was an immaterial asset so we didnt worryabout it too much.

We are resigning as auditors because the work load is too much for our small practice, and as Medix Co is our only audit


17/170


client we have decided to focus on providing non-audit services in the futu re.

You have also found a recent press cutting regarding Medix Co:

Extract from local newspaper business section, 2 June 2008

It appears that local company Medix Co has breached local planning regulations by building an extension to its researchand development building for which no local authority approval has been given. The land on which the premises is

situated has protected status as a greenfield site which means approval by the local authority is necessary for anymodification to commercial buildings.

A representative of the local planning office stated today: We feel that this is a serious breach of regulations and it isnot the first time that Medix Co has deliberately ignored planning rules. The company was successfully sued in 2003 forconstructing an access road without receiving planning permission, and we are considering taking legal action in respectof this further breach of planning regulations. We are taking steps to ensure that these premises should be shut downwithin a month. A similar breach of regulations by a different company last year resulted in the demolition of thebuilding.

Required:

Using the information provided, identify and explain the principal business risks facing Medix Co. (12 marks)

AnswerBusiness risks include the following:

Product life cycleDemand is declining for the main revenue generating product. The market is moving such that demand for laser surgicalinstruments is increasing, while demand for traditional metal instruments is declining. The continued loss of a mainrevenue stream will have significant detrimental profit and cash flow implications.

Demand has been declining for four years, yet it seems that research has only recently commenced into a new source ofrevenue. The management appears not to be focused on the long term strategy needed for survival in this competitivemarket.

Research is at an early stage. It may take many years for the development stage to be reached. Research anddevelopment necessitates a significant cash outflow, and this is happening at the same time as loss of cash inflows fromthe main revenue stream. As the company is already short of liquid funds, as evidenced by the on-going use of anoverdraft facility, it could be that there will be insufficient funds to continue to develop the new product.

The research is being conducted by only one scientist, who is not employed by the company. The scientist is critical forthe successful development of a replacement revenue stream. If the scientist were to leave, Medix Co would lose theknowledge base of the new technology, hindering progress into the new market. Given that this is a very specialist role,it may be a difficult and lengthy process to find a new scientist to work on the project. It is a significant risk to rely so

heavily on a person not employed by the company for such a crucial role in the future success of the business.

There may also be confidentiality issues if the scientist is freelancing for any competitor of Medix Co, the new laserequipment designs could be copied and used unless Medix Co secures protection of the design e.g. by taking out apatent.

Finally, the industry is highly regulated, and licences are necessary in order to take medical instruments to market. If thelicence is not granted, the research and development funds will have been wasted and the continuation of the businessas a going concern could be jeopardised.


18/170


New research premisesAn extremely important problem is shown in the press cutting. If the local authority is successful in shutting down thenewly constructed research laboratory, the company will have to find new premises, which could be expensive and taketime. Any delay in the development of the new products will compound the cash flow pressures the company is alreadysuffering.

There is also the possibility that fines or penalties could be imposed on the company, and that the extension, or eventhe whole building may have to be demolished, which Medix Co may have to pay for, putting the company into further

financial distress.

The potential impairment of the building at the year end would have a detrimental impact on the companys net assetposition at the year end, in turn affecting the ability to raise finance and causing potential going concern problems.

Further bad publ icity could follow, and demand for Medix Cos products may suffer as a result.

Tutorial note: Planning regulations have already been breached. Candidates should not focus their answer on the breachitself, which has already occurred, but on the possible consequences of the breach i.e. financial risk of fines having to be

paid, the need to find new premises, and operational risk of further decline in demand for products.

Use of agents for marketing and distribution

Medix Co appears to rely heavily on agents to secure sales to hospitals and clinics. If the agents are unsuccessful, ordecide to reduce the effort they put into promoting Medix Cos products in preference for products from an alternativesupplier, then the company will face a substantial reduction in revenue and cash inflows.

A second risk associated with the use of agents is that there is a scope for fraud the agents could deliberately overstatethe value of sales in order to maximise the commission they receive. When this point is linked to the poor internalsystems and controls as indicated by Mick Evans, it is likely that such frauds would not be detected.

Overseas location of manufacturing facility

The fact that products are manufactured abroad could lead to problems in controlling and monitoring production.Decisions made locally may not be compatible with the overall operating strategy of the company. Also, ifcommunication channels are not operating efficiently then decisions made at the head office may take time to berelayed to the foreign manager. This could lead to production inefficiencies, e.g. if an agent secures a contract to supplya particular product, it may take time for this to be communicated to the manufacturing facility, and delays in fulfillingthe order will then be inevitable, leading to loss of agent and customer goodwill.

Having the production facility operating abroad could also lead to problems with monitoring the quality of output. This isa highly regulated industry, where suppliers of faulty equipment could face fines and bad publicity in the event ofsupplying a poor quality item. Agents would withdraw their support for the products immediately in preference to those

of competitors.

Importing goods using aeroplanes exposes the company to fluctuating overhead costs as fuel prices and freight costs arenotoriously difficult to predict. Higher levels of tax could also be imposed on imported goods.

Finally, as the company manufactures abroad, it is inevitable that it will make payments in foreign currency and willtherefore be exposed to exchange rate risk.

Capital expenditure and financial management


19/170


Plant and equipment appears to be fairly old, constructed twelve years ago. In the future, if the research anddevelopment into new laser equipment is successful, then capital expenditure will be needed to create the capacity tomanufacture the new products. The risk is that finance may not be available to invest in new plant.

The company appears to have a problem managing liquidity. Continually operating using an overdraft is expensive interms of finance costs. A bank loan carrying a variable interest rate exposes the company to the economic risk offluctuations in the interest rate, making planning and budgeting cash flows difficult.

Internal systems and controls

The comments made by Mick Evans show that the company has a weak control environment and poor systems. Fraudsare more likely to occur in the absence of controls and the quality of financial information used by the directors forplanning and reviewing business performance could be inadequate. Medix Co is an owner-managed business, and itappears that Jon Tate, the managing director, has a dominant style leading to frequent disagreements (with previousauditors and finance director) and flouting of rules (tax and local authority investigations). This increases the likelihoodof management disregard for, and override of, controls.

Tax investigations

Recent tax investigations could indicate that the company is not complying with relevant tax regulations, which in turnleads to the risk of fines and penalties, which could be severe if this is a recurring breach of regulations which has notbeen resolved.

December 2009

Question


20/170


You are the manager responsible for the audit of Papaya Co, a listed company, which operates a chain of supermarkets,with a year ending 31 December 2009. There are three business segments operated by the company two segments aresupermarket chains which operate under internally generated brand names, and the third segment is a new financialservices division.

The first business segment comprises stores branded as Papaya Mart. This segment makes up three -quarters of thesupermarkets of the company, and are large out of town stores, located on retail parks on the edge of towns and cities.These stores sell a wide variety of items, including food and drink, clothing, household goods, and electrical appliances.

In September 2009, the first overseas Papaya Mart opened in Farland. This expansion was a huge drain on cashresources, as it involved significant capital expenditure, as well as an expensive advertising campaign to introduce thePapaya Mart brand in Farland.

The second business segment comprises the rest of the supermarkets, which are much smaller stores, located in citycentres, and branded as Papaya Express. The Express stores offer a reduced range of products, focussing on food anddrink, especially ready meals and other convenience items.

The company also established a financial services division on 1 January 2009, which offers loans, insurance services andcredit cards to customers.

The following information was provided during a recent meeting held with the finance director of Papaya Co. All of thematters outlined in the notes below are potentially material to the financial statements.

Notes from meeting held 29 November 2009

On 31 August 2009, Papaya Co received notice from a government body that it is under investigation, along with threeother companies operating supermarket chains, for alleged collusion and price fixing activities. If it is found guilty,significant financial penalties will be imposed on Papaya Co. The company is vigorously defending its case.

To help cash flows in a year of expansion, the company raised finance by issuing debentures which are potentially

convertible into equity on maturity in 2015.

To manage the risk associated with overseas expansion, in October 2009, the company entered for the first time intoseveral forward exchange contracts which end in February 2010. The contracts were acquired at no cost to Papaya Coand are categorised as fair value through profit or loss financial instruments.

The property market has slumped this year, and significant losses were made on the sale of some plots of land whichwere originally acquired for development potential. The decision to sell the land was made as it is becoming increasinglydifficult for the company to receive planning permission to build supermarkets on the land. Land is recognised at cost inthe statement of financial position.


21/170


Papaya Co has 35 warehouses which store non-perishable items of inventory. Due to new regulation, each warehouse isrequired to undergo a major health and safety inspection every three years. All warehouses were inspected in January2009, at a cost of $25,000 for each inspection.

Required

Using the specific information provided in respect of Papaya Co:

Assess the financial statements risks to be addressed when planning the final audit for the year ending 31 December2009, producing your answer in the form of briefing notes to be used at the audit planning meeting . (16 marks)

Answer

Briefing notes to be used at audit planning meetingSubject: Financial statement risks identified at planning meeting

Introduction

At a recent planning meeting held with the finance director of Papaya Co, several issues were discussed which could leadto financial statement risks. All of these issues relate to matters which are potentially material to the financialstatements.

Alleged collusion and price fixing

It appears that several companies are under investigation for breaching regulations, and Papaya Co could facepotentially material financial penalties if found guilty. The situation needs to be assessed by reference to IAS 37Provisions, Contingent Liabilities and Contingent Assets . The risk is that the financial statements do not reflect thesituation as either a provision or a contingent liability, depending on the evaluation of the potential outcome of thecase. If it is considered that the company faces a probable cash outflow, then a provision and associated expense shouldbe recognised. If the outflow is considered possible, then a note to the financial statements should describe thecontingent liability and show an estimate of the potential financial effect. Therefore the financial statement risk is both

understated liabilities and overstated profit, if the cash outflow is considered probable but no provision is made.Alternatively, the risk is incomplete disclosure if the outflow is considered possible and no note is provided.

Convertible debentures

According to IAS 32 Financial Instruments: Presentation , convertible debt instruments should be presented in thestatement of financial position split into two separate components. This is because the company does not know if it hasan obligation to pay cash on the redemption of the debt in 2015, or whether the debt will be settled by an equitydistribution. Therefore, on the receipt of cash proceeds, the credit entry is split between debt and equity. The debt isvalued by discounting the potential cash outflows to present value, with the credit entry to equity a residual balancing


22/170


figure. The financial statement risk is firstly that split accounting has not been applied, so the whole of the credit hasbeen recognised as either debt or equity, and therefore incorrectly recognised in the statement of financial position.This would then have a further consequence for the statement of comprehensive income, as any finance chargecalculated on the basis of an incorrect debt component would then also be incorrectly measured.

Forward exchange contracts

These contracts are derivative financial instruments. As such, they must be recognised in the statement of financialposition at the year end, as a financial asset or a financial liability, depending on whether the terms of the derivativecontract are favourable or unfavourable at the reporting date. The financial statement risk is that the derivatives havenot been recognised at all, particularly because the contracts were acquired at no cost, so there is no accounting entrywhen the contract is taken out. A second risk relates to the valuation of the derivative asset or liability. This could becomplex to calculate, and if not performed by an experienced specialist, could cause the over or understatement of thefinancial instrument recognised, and an associated incorrect entry recognised in profit. Finally, IFRS 7 FinancialInstruments: Disclosures imposes potentially onerous disclosure requirements in relation to derivative instruments. Therisk is that disclosures made in the notes to the financial statements are incomplete.

Land held for development potential

There are indicators that the land could be impaired at the year end. Some land was sold at a loss during the year, and itseems that planning permission for the development of the sites is becoming harder to obtain, meaning that the valueof the land has fallen. Following IAS 36 Impairment of Assets , an impairment review must be carried out if there areindicators of impairment to an asset. It is likely that land will be overstated in the statement of financial position, andexpenses understated, unless an impairment review is conducted and any resulting loss fully recognised. In addition, thelosses made on the disposal of land during the year should be separately disclosed in the statement of comprehensiveincome or a note to the financial statements per IAS 1 (Revised) Presentation of Financial Statements , so there is a risk ofinadequate disclosure if this is not done.

Inspection of warehouses

A new regulatory requirement has resulted in an inspection of all of the warehouses operated by Papaya Co. Under IAS16 Property, Plant and Equipment , costs of a major inspection should be capitalised and then depreciated over theperiod to the next inspection. The risk is that the cost has been expensed, in other words, treated as an operatingexpense. This would result in understated profit and understated non-current assets.

Other financial statement risks (not arising from notes made at the planning meeting) include the following:

Disclosure of operating segments

IFRS 8Operating Segments requires listed companies to disclose in a note to the financial statements information aboutthe performance of the various different operating segments of the business. Papaya Co has two potential newdisclosures this year end. The first is the new financial services division, which is likely to be a separate reportablesegment under IFRS 8.The second new disclosure relates to the overseas expansion of the company, as IFRS 8 requires disclosure of limited


23/170


geographical analysis of revenue and non-current assets. The financial statement risk is the non-disclosure ofinformation relating to these new operating and geographical segments.

Internally generated brand names

Papaya Mart and Papaya Express are internally generated brand names. IAS 38 Intangible Assets prohibits therecognition of internally generated brands. The risk arises from significant expenditure on the launch of the brand inFarland. If any of the associated expense has been capitalised as a brand name, this would mean that non-current assets

are overstated, and profit for the year would be overstated.

Conclusion

There are several financial statement risks identified at the planning meeting, resulting from the company operating in aregulated industry, changed market conditions, and new business activities for the company. Now that the risks havebeen identified, an appropriate audit strategy will be devised to minimise the risk of material misstatement in relation tothese matters.

Tutorial note: Credit will be awarded for other financial statement risks identified from the question scenario, such as potential over-valuation of inventories, classification of land as held for sale, incorrect timing of recognition of revenue from financial services products, and potential impairment of loans made to financial services customers.

June 2010Question

You are a senior audit manager in Vegas & Co, responsible for the audit of the Grissom Group, which has been an auditclient for several years. The group companies all have a financial year ending 30 June 2010, and you are currentlyplanning the final audit of the consolidated financial statements. The groups operations focus on the m anufacture andmarketing of confectionery and savoury snacks. Information about several matters relevant to the group audit is given

below. These matters are all potentially material to the consolidated financial statements. None of the companies in thegroup are listed.

Grissom Co

This is a non-trading parent company, which wholly owns three subsidiaries Willows Co, Hodges Co and Brass Co, all ofwhich are involved with the core manufacturing and marketing operations of the group. This year, the directors decidedto diversify the groups activities in order to reduce risk exposure. Non -controlling interests representing long-terminvestments have been made in two companies an internet-based travel agent, and a chain of pet shops.In the consolidated statement of financial position, these investments are accounted for as associates, as Grissom Co is


24/170


able to exert significant influence over the companies.

As part of their remuneration, the directors of Grissom Co receive a bonus based on the profit before tax of the group. InApril 2010, the group finance director resigned from office after a disagreement with the chief executive officer overchanges to accounting estimates. A new group finance director is yet to be appointed.

Willows Co

This company manufactures and distributes chocolate bars and cakes. In July 2009, production was relocated to a new,very large factory. One of the conditions of the planning permission for the new factory is that Willows Co must, at theend of the useful life of the factory, dismantle the premises and repair any environmental damage caused to the land onwhich it is situated.

Hodges Co

This companys operations involve the manufacture and distribution of packaged nuts and dried fruit. The governmentpaid a grant in November 2009 to Hodges Co, to assist with costs associated with installing new, environmentallyfriendly, packing lines in its factories. The packing lines must reduce energy use by 25% as part of the conditions of thegrant, and they began operating in February 2010.

Brass Co

This company is a new and significant acquisition, purchased in January 2010. It is located overseas, in Chocland, adeveloping country, and has been purchased to supply cocoa beans, a major ingredient for the goods produced byWillows Co. It is now supplying approximately half of the ingredients used in Willow Cos manufacturing. Chocland hasnot adopted International Financial Reporting Standards, meaning that Brass Cos financial statements are preparedusing local accounting rules. The company uses local currency to measure and present its financial statements.

Further information

Your firm audits all components of the group with the exception of Brass Co, which is audited by a small local firm, Sidle& Co, based in Chocland. Audit regulations in Chocland are not based on International Standards on Auditing.

Required:

Using the information provided, prepare briefing notes to be used in a discussion with your audit team, in which youevaluate the principal audit risks to be considered in your planning of the final audit of the consolidated financialstatements for the year ending 30 June 2010.

Note: Ignore those risks that relate to reliance on another auditor. (18 marks)


25/170


Answer

Briefing notesTo: Audit teamRegarding: Principal audit risks relating to the consolidated financial statements of Grissom Co, for the year ending 30June 2010.

Introduction

These briefing notes summarise the principal audit issues for the consolidated financial statements of the group. Thereare three subsidiaries in the group and several other investments. The notes consider the audit issues company bycompany, and other issues which are relevant to the whole group.

Grissom Co

Non-controlling interests

The first risk is an inherent risk that the investments have been inappropriately classified as associates. According to IAS28 Investments in Associates , an investment should only be classified and accounted for as an associate if there is powerto participate in financial and operating policy decisions, in which case equity accounting should be used to measure theinvestments in the group statement of financial position. The risk is that the investments have been classified andaccounted for incorrectly. If Grissom Co cannot demonstrate the ability to exercise significant influence, then theinvestments should betreated as trade investments, and would not be consolidated. Alternatively, the substance of theinterest in these companies could be a joint venture, if control is shared between Grissom Co and the other investors.

A second issue raised by the diversification away from the groups normal activities is that the groups finance team maynot have sufficient experience in these two new areas, for example, there may be a risk that they have insufficientknowledge to know how to correctly recognise and defer the revenue for a travel agent.

In addition, a detection risk arises from the activities of the non-controlling interests. They represent a departure fromthe other activities of the group, and our firm may have little experience or knowledge of travel agencies and pet shops.This means that we may fail to identify risks of material misstatement relating to the amounts included from theseinvestments in the consolidated financial statements.


26/170


Bonus and changes to accounting estimates

The directors receive a bonus based on group profit before tax. This leads to inherent risks of overstatement of income

and/or understatement of expenses. The directors will want to maximise profits due to their financial interest in thegroups results, which could lead to the manipulation of profits to achieve a desired bonus. The fact that the financedirector left following a disagreement could indicate that the changes to accounting estimates were inappropriate. Theestimates could have been changed as part of an earnings management strategy.

Changes to accounting estimates can represent a high risk of material misstatement. IAS 8 Accounting Policies, Changesin Accounting Estimates and Errors requires that changes to estimates are accounted for prospectively rather thanretrospectively. There is a risk that management has confused changes to estimates with changes in policies, whichrequire a retrospective accounting treatment.

No group finance director

The lack of a group finance director increases inherent risk and control risk. A group finance director should be in place,in order to ensure that group accounting policies are adhered to throughout the production of the consolidated financialstatements. It is much more likely that a material misstatement could occur during the consolidation process if there isno one overseeing it. Errors are more likely to occur, and to remain undetected, as the group finance director shouldexercise a supervisory control over the whole consolidation process.

Willows Co

Dismantling costs

According to IAS 16 Property, Plant and Equipment , the cost of an asset should include the estimated costs of

dismantling and removing the asset (also known as decommissioning costs) if there is an obligation to incur the cost atthe end of the life of the asset. A provision should also be recognised as a non-current liability. IAS 37 Provisions,Contingent Liabilities and Contingent Assets contains criteria that must be met in order to recognise a provision. Therequirement contained in the planning permission creates an obligation leading to a probable outflow of economicbenefit, and the construction of the factory is a past event.

The risk is that the decommissioning cost has not been capitalised as part of the asset, in which case the asset isunderstated, and the other side of the entry will be missing, leading to incomplete provisions. In addition, thedepreciation expense would be understated.

Even if the costs have been recognised, there are specific rules regarding the measurement of the amount recognised,which should be discounted to present value. There is risk that the calculation has not been carried out correctly, forexample, using the incorrect discount factor. Furthermore, a finance charge should be recognised each year to reflectthe unwinding of the discounted provision. The risk is that the charge has not been made, or has been measuredincorrectly.

Hodges Co

Grant received


27/170


IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that grants should berecognised as income over the periods necessary to match them with the related costs that they are intended tocompensate. This means that the income should be deferred, and recognised as income over the estimated useful life ofthe packing lines, beginning in February 2010. The risk is that the income has been immediately recognised in full,overstating profit for the year, which would help the directors to maximise their bonus.

Tutorial note: Under IAS 20, the grant should be presented on the statement of financial position either as deferred

income, or by deducting the grant in arriving at the assets carry ing value. Credit will be given for answers referring toeither accounting treatment.

Secondly, there is a condition attached to the grant. If Hodges Co fails to meet the environmental targets, the grant mayhave to be repaid, partly or in full. If this is the case, a provision should be recognised for the potential repayment (or anote should disclose a contingent liability in the case of a possible repayment). The risk is a potential understatement ofprovisions if the target has not been met.

Identifying whether the company has defaulted from the conditions of the grant poses a risk in itself, as it may bedifficult for the audit firm to obtain sufficient evidence on this matter, other than a written management representationor reliance on third party reports.

Brass Co

Mid-year acquisition

Brass Co was acquired part way through the accounting period. Its results should be consolidated into the groupstatement of comprehensive income from the date that control passed to Grissom Co. The risk is that results have beenconsolidated from the wron g point in time. Given the directors incentive to maximise group profit, the results may havebeen consolidated from too early a point in time if Brass Co is profitable.

Goodwill on acquisition

The goodwill on acquisition should be calculated according to IFRS 3 (Revised) Business Combinations . The calculation isinherently risky due to the need for significant judgements over the fair value of assets and liabilities acquired. There isalso risk that not all acquired assets and liabilities have been separately identified, measured and disclosed. Risks areheightened due to the overseas location of the company, meaning that estimations of fair value may be more complexand subjective.

Retranslation of Brass Cos financial statements

The companys funct ional and presentational currency is local, and different to the rest of the group. Prior to

consolidation, the financial statements must be retranslated, using the rules in IAS 21 The Effects of Changes in ForeignExchange Rates . The assets and liabilities should be retranslated using the closing exchange rate, income and expensesat the average exchange rate, and exchange gains or losses on the retranslation should be recognised in group equity.This is a complex procedure, therefore inherently risky, and the determination of the average rate for the year can besubjective.

The goodwill intangible asset must also be calculated using the closing exchange rate, which is effectively treated as arevaluation. The risk is that this retranslation has not occurred, and that goodwill remains at historic cost.

Adjustments necessary to bring in line with group accounting policies


28/170


Brass Co does not use the same financial reporting framework as the rest of the group. The companys financialstatements must be adjusted to align them with group accounting policies. This will require considerable expertise andskill, and combined with the absence of a group finance director, the risk of errors is high.

Intra-group transactions

The trading transactions between Brass Co and Willows Co must be eliminated on consolidation. The risk is that the

intra-group elimination is not performed, resulting in overstated revenue and operating expenses at group level (andreceivables and payables if any amounts are outstanding at the yearend).

In addition, for any items remaining in inventory which contain unrealized profit, a provision for unrealized profit mustbe made. If this adjustment is not carried out, inventory and group profi t will be overstated.

Conclusion

Due to the many factors described in these notes the audit of several material components of the consolidated financialstatements is relatively high risk. However, the consolidation of Grissom Co, Willows Co and Hodges Co is relatively lowrisk, as our firm has audited the consolidated financial statements for several years, and those companies all use thesame reporting framework, report in the same currency, and have the same year end.

How to Calculate Materiality Benchmarks in Exams

In the P7 exam you need to calculate materiality in relation to specific item. You must only use the relevant comparator,for example, total asset if the matter relates to the statement of financial position, profit before tax if the matterimpacts upon profit, and both if it relates to statement of financial position and impacts on profits, for example aprovision.

Now suppose you are auditing one of your clients namely ABC Company Limited. Following is the extract from thefinancial statements:

Total Asset: Rs. 2,000,000

Profit: Rs. 350,000

Revenue: Rs. 1,000,000

Total Trade Debts: Rs. 200,000

Total Liabilities: Assumed Equal to Total Assets

Closing stock: Rs. 250,000

Cost of Goods Sold: 500,000

Scenario 1:

One of a customer of ABC Company Limited went bankrupt. The said customer owed Rs. 50,000 to the Company. ABCLimited is not willing to provide Rs. 50,000 in its financial statements. What will be your relevant benchmarks to assess


29/170


your risk in this case?

Scenario 2:

ABC Company Limited is not accounting for goods in transit worth of Rs. 100,000 in its financial statements? What willbe your relevant benchmarks to assess your risk in this case?

Scenario 3:

ABC Company Limited is accounting all its leases amounting to Rs. 100,000 as operating lease when in substance theyare all finance leases? What will be your relevant benchmarks to assess your risk in this case?

Scenario 4:

ABC Company Limited inventory as at year consist of slow moving stock amounting to Rs. 50,000. ABC Company Limitedis reluctant to account for resultant provision. What will be your relevant benchmarks to assess your risk in this case?

Test Your Self

Auditors Confidence Level = 50%

Planning Materiality = Rs. 950,000

Administration Expense Total = Rs. 1,000,000

Breakup of Administration Expense is as follows:

Transaction 1 : Rs. 200,000

Transaction 2: Rs. 50,000












30/170


Required

Determine performance materiality and transaction which needs to be verified by you.

HOW TO TACKLE CASE STUDY IN YOUR EXAM

INTRODUCTION

Each case study question will include several separate requirements taken from separate syllabus areas. This mirrorswhat happens in the real world when, for example, an audit manager planning an assignment needs to consider not onlyhow to plan the work, but also assess the implications of any ethical, practice management, quality control, or currentprofessional issues raised from information provided by the client. At least one of the requirements could be to providea response to a specific enquiry raised by the client or potential client in the scenario. The first stage, when attempting acase study question, is to carefully read the requirements and understand exactly what is being asked for.

PROFESSIONAL MARKS

It is likely that Section A requirements containing professional marks will ask for the answer in a particular format, such

as a report or briefing notes. The professional marks will be awarded for the following:

structure and presentation clarity of explanation use of language appropriate to the addressee use of professional judgment discussion of both sides of a debate appreciation of relevant current professional issues.

CASE STUDY INFORMATION

Having read the requirements and understood exactly what has been asked for, the next step is to carefully readthrough the information provided, all the time bearing in mind the specific instructions given in the requirements.

The information provided in the scenario is likely to be both numeric and narrative, and could come from many differentsources, such as:

extracts from financial statements information from management systems details taken from working papers verbal representations from the client or members of the audit/assurance team statements from third parties.

The information in the question will need to be carefully read and it is important that sufficient time is spent digestingand understanding the information provided.

When reading the case study scenario it is important, therefore, to identify the following:

What is your role? For example, are you the manager responsible for the audit, or responsible for company-widematters such as ethics or quality control?

What is the time scale? Are you planning an assignment prior to the clients year end, or reviewing w orkingpapers at the conclusion of the audit?


31/170


What does the company do? Is it involved in manufacturing, a service industry, or financial services? Does thecompany operate in a highly-regulated industry?

What is the key relationship in the scenario? Is the company a long standing or potential client? Is this a one-offor a recurring engagement?

When reading through the scenario it is useful to highlight or underline important pieces of information. A lot of timecan be wasted by continually re-reading the scenario, so thoroughly reading and annotating the question paper shouldimprove time management.

TIME ALLOCATION

The case study questions will contain at least three discrete requirements. Time must be allocated between therequirements to ensure that each is addressed in sufficient depth .

Failing to deal with a requirement obviously reduces the overall mark available for a question, but it also detracts fromthe q

Documents

ANALTTICAL PROCEDURES.docx