Topic: Risks Assessment

Question 1:

Your firm has recently been appointed as the external auditor of Acer Movies Bhd (Acer) and
at the same time was appointed to provide tax advisory services to Acer. You are the audit
senior responsible for planning the audit for the year ending 30 September 20X9.

Acer rents movies on DVD to customers in the Malaysia and South East Asia, through its
website. Customers either pay for each individual DVD rented or join the subscription service
whereby the customer pays an up-front quarterly fee to rent an unlimited number of DVDs
during the quarter. Acer despatches DVDs one at a time to subscription customers, only
despatching subsequent DVDs once the customer returns the current rental in the pre-paid
postage envelope provided. Individual rental payments are made by customers through Acer's
website by debit or credit card and subscriptions are automatically collected from customers'
bank accounts. All amounts are in the customer's local currency.

Acer has been highly successful in expanding its customer base and both individual rentals
and subscriptions have increased rapidly over the past year. However, strong competition
exists, and Acer has significantly increased its expenditure on advertising and the postage
costs associated with its well-advertised commitment to deliver DVDs to customers the next
day. A Malaysia consumer television programme recently criticised Acer for delaying
postage of DVDs to high-usage subscription customers in order to reduce the number of
DVDs customers can rent during each quarter.

Acer is highly dependent on its relationships with the studios which supply movies. Acer is
currently negotiating a new contract with Twinkle Movies (Twinkle), a major movie studio as
its current contract ended on 31 August 20X9. Twinkle is demanding significantly higher
contract fees for providing its movies to Acer and prolonged negotiations have resulted in
Twinkle's movies currently being unavailable on the Acer website. This has led to a number
of complaints from customers.

Acer also faces significant competition from cable television companies which supply movies
direct to customers' televisions. Acer decided to make a large investment during 20X9 in the
development of a download service whereby its customers can download movies through the
internet direct to their PC or televisions. The development was undertaken by Acer's own in-
house development team. Acer proposes to treat the development costs as intangible non-
current assets. The download service became ready on 30 June 20X9. However, it was not
launched to customers until 1 September due to a delay in the marketing campaign. Since its
launch, the download service has attracted new customers to Acer as well as seeing 10% of
existing subscription customers transfer to the new service.

Finance for the development of the download service was provided by Mega plc (Mega), a
large online retailer, in return for 30% of the ordinary shares of Acer and the appointment of
Shelby Storm, a director of Mega, to Acer's board of directors. As part of the finance
agreement, Mega's own DVD rental business, 'Megaview', is now run and managed by Acer
on Mega's behalf. The agreement began on 1 January 20X9 and Mega will pay Acer an
annual fee for operating the 'Megaview' DVD rental business. The fee is to be determined on
31 December each year depending on rental volumes and Acer meeting certain performance
criteria specified in the agreement.

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Acer classifies its DVDs as tangible non-current assets. Prior to the current year, Acer
depreciated DVDs over three years. For the year ending 30 September 20X9, Acer proposes
to change the useful life of DVDs to four years to reflect its decision to keep DVDs in
circulation longer in order to manage Acer's increasing costs. At the end of each quarter, any
DVDs not proving popular are transferred to inventory and sold to customers through the
website for a low price.

Yesterday you met with the audit manager, Bella Najimy, who provided you with some
preliminary financial information obtained from Acer:

Latest forecast Actual

Year ending Year ended
30 September 20X9 30 September 20X8
RM'000 RM'000
Revenue 91,754 66,489
Loss before tax (28,626) (18,569)

Bella also asked you to consider the following key areas of audit risk:
(1) Going concern
(2) Revenue
(3) Intangible non-current assets
(4) Tangible non-current assets

Bella met with Acer's finance director, Jonathan McCrea, last week. Bella has told you that
during the meeting Jonathan offered her the role of financial controller once the current year
audit is complete. Jonathan also suggested offering all the members of the audit team a free
one-year DVD subscription. Jonathan asked Bella to request a meeting with the firm's tax
manager as he needs advice on whether formally to challenge the Inland Revenue Board
(IRB) in respect of its assessment of Acer's carried forward tax losses. Assistance in making
any such challenge would also be required.

Requirements

Using the information provided, explain why the items listed in (1) to (4) above are key areas
of audit risk in Acer's financial statements and describe the procedures that should be
included in the audit plan to address those risks.

For each area of risk:

2.1:
(a) justify why it is an audit risk; and
(b) outline the procedures that should be included in the audit plan in order to
address the risk.
Note. You should present your answers using the subheadings:
 Going concern
 Revenue
 Intangible non-current assets
 Tangible non-current assets

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 (26 marks)

2.2:
Explain the ethical issues arising from the information provided in respect of Bella's meeting
with Jonathan McCrea and identify any actions which you consider should be taken by Bella
or your firm. (10 marks)

QUESTION 2:

Your firm is the external auditor of Johan Maju Ltd (Johan Maju) for the year ended 31 May
20X1. The audit manager responsible for the external audit of Johan Maju has been taken ill
and you have been assigned to replace her. She has prepared the audit strategy but not the
audit plan. The audit strategy identifies the following as key areas of audit risk:
(1) Revenue
(2) Purchases and trade payables
(3) Inventory
(4) E-commerce development costs

The strategy also includes the following extracts from the financial statements for the years
ended 31 May:

20X1(draf) 20XO (audited)

RM’000 RM’000
Statement of profit or loss
Revenue 106,400 95,100
Purchases 84,800 77,900

Statement of financial position

Non-current assets
E-commerce development costs 3,200 -

Current assets
Inventory 15,100 13,200

Current liabilities
Trade payables 8,200 8,400

On reading the background information you ascertain

the following:

The principal activity of Johan Maju is the retailing of discounted branded goods, including
designer clothing, beauty products and household goods, at up to 60% off their recommended
retail prices. The company purchases products which are end-of-line, close to end of shelf-
life, slightly damaged and in the case of designer clothing, the previous year's designs, from
suppliers based throughout the world. The majority of overseas suppliers are paid in their
local currency.

Historically, goods were only sold through the company's 15 retail outlets in the Malaysia.
However, in March 20X1, the company launched its new website with e-commerce features

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including online ordering and payment. The development of the website was undertaken by
Webtuneex Sdn. Bhd. (Webtuneex), a company specialising in website design and e-
commerce development, in conjunction with employees from Johan Maju's IT department.
Webtuneex supplied the software and other support services. Additional hardware, necessary
for the launch, was purchased from a variety of suppliers.

Initially, the company suffered operational problems with its e-commerce sales due to a
technical fault with the online ordering system resulting in duplication of orders and
shipments. Additional costs were incurred to fix the fault and the directors are now confident
that the technical problem has been resolved and all of the inventory relating to the
duplication of orders has been recovered.

Customers buying from the retail outlets pay by cash, credit or debit card. Customers buying
over the internet pay by credit or debit card. Any customers who are not satisfied with a
purchase are entitled to a full refund, if they return the product within 30 days of purchase.

The company has standardised operating procedures, processes and structures in every retail
outlet. All outlets have electronic point of sale systems which record the sale of an item and
update the inventory records which are checked by periodic counting by store staff.
Consequently, the company does not undertake an inventory count at the year end. Each
week, the inventory system generates an inventory valuation listing and an aged inventory
report. The inventory valuation listing includes the cost, current selling price and quantity on
hand for each inventory item. The aged inventory report details the length of time each item
has been in the retail outlet.

All employees are entitled to a bonus based on the level of profit achieved by the company.
At a meeting with Navan Patel, the finance director of Johan Maju, he informed you of the
following development:
 Navan is due to retire in September and the board would like your firm to assist with the
recruitment of a suitable candidate to replace him and also advise on the remuneration
package.

Requirements
2.1 Justify why the items listed in (1) to (4) in the scenario have been identified as key areas
of audit risk and, for each item, describe the procedures that should be included in the audit
plan in order to address those risks. (35 marks)
Note: You should present your answer using the following subheadings:
 Revenue
 Purchases and trade payables
 Inventory
 Website development costs

2.2 Identify and explain the threats to objectivity and state how your firm should respond to
those threats in respect of the board's request for the provision of services regarding the
recruitment and remuneration package of the finance director.
(5 marks) Total: 40 marks