Discussion Questions

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

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31 December each year depending on rental volumes and Acer meeting certain performance
criteria specified in the agreement.

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

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 Intangible non-current assets
 Tangible non-current assets
(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)

SUGGESTED SOLUTIONS:

2.1:
Going concern
Justification

The business has experienced rapid expansion which may be indicative of overtrading
resulting in cash flow problems. In addition, the new venture could create further cash flow
issues.
Acer operates in a highly competitive market which will put pressure on margins.

Acer is loss-making whilst costs are increasing, resulting in an increase in the loss as a
percentage of revenue, from 28% for 20X8 to a predicted 31% for 20X9.
Twinkle, a major supplier, is demanding higher contract fees. Failure to reach an agreement
with Twinkle may result in loss of customers.

Acer has experienced bad publicity and complaints resulting from Twinkle movies being
unavailable as well as criticism over delaying postage to high usage customers.
The new download technologies in the market may lead to the DVD rental market shrinking
or disappearing.

Procedures
Obtain post year-end management accounts and review Acer's performance.

Obtain cash flow forecasts to ascertain whether Acer can pay its debts as they fall due and
whether the assumptions appear reasonable. Perform sensitivity analysis on forecasts for key
variables, such as Twinkle contract fees.

Ascertain from management how it plans to address the issues of increasing costs and losses.
Obtain a written representation regarding the feasibility of management's future plans and the
appropriateness of the going concern presumption.

Identify any bank covenants and ascertain whether Acer is complying.

Ascertain whether a resolution to the Twinkle negotiation has been reached and review
correspondence with Twinkle for any indication of the likely outcome.

Discuss with management its plans if an agreement with Twinkle cannot be reached
including whether management believes the company would be able to continue.

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Discuss with management whether recent adverse publicity has impacted Acer's rate of
growth or resulted in lost customers. Enquire as to management's actions to address these
issues.

Review press for any further publicity over unavailable movies or postage issues.

Review the press for popularity of competitor companies and the introduction of any new
technologies.

Review projected future revenues and costs for the download service to ascertain its viability.

Revenue
Justification
Sales are made online which could lead to systematic recording errors.
Subscriptions may run over the year end and be recognised in the incorrect accounting
period.
Revenue has increased by 38% which may indicate overstatement.
Some existing customers are transferring to the new download service which may result in
errors in how this is accounted for.

The annual agreement fee from Mega won't be determined until 31 December 20X9 which
may be after the financial statements are finalised. This could lead to an inappropriate
estimate or amounts being recognised in the incorrect accounting period.

Sales are made in South East Asia in foreign currencies leading to a risk of translation errors.

Procedures
Ascertain and test control procedures over recording of online sales.
Select a sample of subscriptions and ensure revenue is matched to the period over which
services are provided.

Compare actual revenue by country/product to forecasts and budgets and ascertain reasons
for any significant deviations.

Obtain a copy of the agreement with Mega to understand how revenue is generated.

Review the basis of management's estimate of revenue generated from the agreement and
assess for reasonableness.

Identify the performance criteria in the agreement and ascertain if Acer has met the criteria in
the nine months to 30 September 20X9.

Check the basis of the allocation of revenue between accounting periods and re-perform the
calculation.

If revenue has been received from Mega before Acer's financial statements are finalised,
vouch the income to the post year-end cash receipt.

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Select a sample of sales made in foreign currencies, check the exchange rate applied to an
appropriate external source and re-perform the calculation.

Intangible non-current assets

Justification

Acer may have capitalised costs inappropriately as part of the new download service.
Management's estimate of useful life may be inappropriate and the amortisation charge may
be incorrectly calculated given that it was not launched until 1 September 20X9 but was
ready for use on 30 June and should be amortised from this date.

The download service has only recently been launched and its future viability has not yet
been proven. If it is not viable impairment may need to be recorded.

Procedures
Obtain a schedule of costs capitalised as part of the intangible non-current asset and ensure
items meet recognition criteria.

Review the time records of the in-house development team and agree to the schedule of
capitalised costs.

Review expense accounts to ensure no other costs should have been capitalised.
Discuss the basis of the estimated useful life with management to ascertain whether it is
reasonable.

Re-perform the amortisation calculation.

Review customer uptake of service since 1 September to ascertain whether the service
appears viable and profitable.

Tangible non-current assets

Justification

The change in the estimate of useful life of DVDs to four years may be inappropriate given
DVDs will suffer wear and tear and new technologies eg, download service, may make them
obsolete.

The change in useful life may not have been reflected accurately in the depreciation
calculation.
The nature of DVD's could lead to overstatement due to damage, obsolescence, loss or theft.
The increased estimate of useful life may be inappropriate.

Customers may transfer to the new download service meaning more DVDs become obsolete
or have a shorter useful life.

DVDs transferred to inventory may not be correctly removed from the tangible non-current
asset register.

Procedures

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Discuss the increase in useful life with directors to ascertain the basis for the decision.
Review the historical quarterly transfer of DVDs to inventory to ascertain the average age of
DVDs when transferred to assess if the new useful life of four years is appropriate.

Re-perform the depreciation calculation and compare the depreciation charge under the new
and old policies to ascertain whether it is material.

Identify and test controls over the issue and return of DVDs and identifying obsolete and
damaged DVDs.

Select a sample of DVDs purchased in the year and agree the cost to the contract with the
movie studio or purchase invoice.

Select a sample of DVDs on the asset register and inspect the physical asset for existence and
condition.

Identify, post year-end, the rate of transfer between DVD and download subscription services
to ascertain if DVDs are likely to be obsolete.
Review current year transfer of DVDs to inventory to ensure they are appropriately
accounted for.

2.2:

Audit manager appointment as financial controller

Bella's objectivity and independence (alternative: self-interest threat) may be compromised as

she will not wish to disagree with or challenge Acer's directors for fear of losing the job
opportunity.
If Bella does accept the position this may give rise to familiarity or intimidation threats in
respect of the audit team on subsequent audits as the audit team may be reluctant to disagree
with or challenge Bella.

Actions:
Bella must notify the firm of the offer immediately.
The firm should remove Bella from the audit team immediately and any work undertaken by
Bella should be reviewed and re-performed if necessary.
If Bella accepts the position, the future composition of the audit team should be considered.

Gift of a full year's free DVD subscription

The gift creates a threat to objectivity and independence (alternative: self-interest threat)
unless the value is clearly insignificant.
The MIA By-Laws, Fees, Remuneration and Evaluation Policies, Gifts and Hospitality,
Litigation states that those in a position to influence the conduct and outcome of an audit
cannot accept such gifts.

The firm should consider whether it is probable that a reasonable and informed third party
would conclude that objectivity is likely to be impaired. This appears to be likely in the case
of a full year's free DVD subscription.

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Actions:
Bella should decline the offer of the free subscription and inform the firm.
The firm should have established policies in place on the nature and value of gifts that may
be accepted.
There are no safeguards that the firm could put in place to reduce the threat to objectivity and
therefore the firm should decline the gift on behalf of all team members.
In addition, the firm should consider whether the offer has any impact on its assessment of
management's integrity.

Advice and assistance on challenging IRB

The provision of this service may give rise to the firm taking a position closely aligned with
management or taking a proactive stance on behalf of the client and therefore gives rise to an
advocacy threat.
A self-interest threat may also arise as the decision to challenge IRB would result in further
work for the firm and greater fee income.
A self-review threat would also be created if the amounts in question have a material impact
on the financial statements meaning the firm may be unable to be impartial regarding the
accounting treatment.
Threats may not arise if the service is simply to provide information in respect of the
challenge, but the work requested by Acer appears to go beyond this.
A conflict with management may also arise if the firm recommends a challenge which
subsequently fails. This could lead to Acer seeking recompense from the firm.
A management threat may arise if the firm is asked to make management decisions.

Actions:
Clarify with management the extent of the firms expected involvement in the decision to
challenge IRB and whether the firm would be expected to represent management in the
challenge. If the engagement involves either, then it should be declined.
If the engagement is to have a continuing role by providing information, then the firm may
accept the engagement providing appropriate safeguards can be put in place:
 Separate teams to provide audit and tax services
 Independent partner review of tax aspects of audit work
 Tax services reviewed by an independent tax partner
 Monitor the level of fee income from Acer
 Assess whether there is informed management

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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
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-

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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

Suggested solutions:

2.1
Revenue
Justification

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There is a risk of understatement if cash from outlet sales is misappropriated and not recorded
as revenue. However, the risk of overstatement is greater due to the significant increase of
11.9% which is out of line with movements in purchases and inventory days. This may be
caused by:
 deliberate overstatement due to the bonus which is linked to profit;
 failure to deduct post year-end returns which relate to pre year-end sales;
 the unreliability of the new online system and failure to deduct duplicate sales; and
 inappropriate revenue recognition policies for online revenue (eg, on order instead of
despatch).
Audit procedures
 Review gross profit margins on an outlet by outlet basis to identify any which are out of
line with expectation.
 Review the results of the periodic inventory counts to identify any shortfalls between
physical inventory and records, which may indicate unrecorded revenue.
 Trace goods returned records/credit notes to adjustments to revenue figure.
 Evaluate and test the system of control over cash sales and online sales.
 Discuss the reason for the increase in revenue with management and obtain a breakdown
of revenue on outlet by outlet and online bases to identify movements out of line with
expectation.

Purchases and trade payables

Justification
Foreign suppliers are paid in their local currency, which may result in translation errors due
to calculation errors or use of inappropriate exchange rates.
Payables days have fallen from 39 to 35 days, which may indicate that payables are
understated due to unrecorded invoices and/or deliberate understatement due to the profit-
related bonus.
Audit procedures
 Evaluate and test controls over recording of invoices and payments to suppliers.
 Reperform a sample of foreign currency translations, checking the rates to a reliable
external source.
 Trace a sample of goods received records to invoices recorded in the purchases and
payables records.
 Inspect invoices/payments after date to see if they relate to the year under review.

 Reconcile suppliers' statements with the balances on the payables ledger or, if necessary,
undertake direct confirmation of balances.
 Inspect suppliers' invoices/contracts to ascertain whether there has been any change in
suppliers' terms of trading.

Inventory
Justification
Inventory days have increased from 62 to 65 days and may indicate overstatement. This may
be caused by:
 unreliable inventory records if adjustments for differences identified during the periodic
counting are not accurately reflected in the records;
 translation errors in respect of inventory purchased from overseas suppliers;
 slow-moving items due to end of shelf life/out of fashion/damaged;
 a failure to account for returns in the relevant accounting period;
 a failure to write down damaged goods that have been returned; and/or

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 the deliberate overstatement of inventory due to the profit-related bonus.
Audit procedures
 Evaluate and test controls exercised over the inventory system and the periodic counting
procedures (eg, segregation of duties, counting in pairs, noting damaged items).
 Review results of the client's counting procedures, in particular, evaluate the level of
discrepancies and consider the implications for the reliability of the EPOS system.
 Attend an inventory count during the year and undertake test counts involving two-way
counting.
 Trace a sample of goods returned records to inventory records.
 Review the aged inventory report to identify slow-moving items and discuss
provision with management.
 Inspect the inventory valuation listing and selling prices after the year end to identify items
which may have an NRV below cost.
 Test a sample of items to suppliers' invoices to check cost is correctly recorded.

Website development costs

Justification
Costs may have been misstated due to the following:
 The inclusion of incorrect material and labour costs and inappropriate items such as
training or scrapped costs;
 The misclassification of tangible and intangible elements; and/or
 Deliberate overstatement due to the profit-related bonus.
Depreciation and amortisation may have been calculated over inappropriate useful lives.
There is potential impairment if the internet business does not prove to be profitable.
Audit procedures
 Obtain a schedule of costs capitalised and review items to ensure they are capital in nature.
 Vouch amounts to contracts with/invoices from suppliers.
 Vouch labour costs to payroll details and time sheets.
 Ensure scrapped costs have been expensed.
 Discuss the basis for useful life with management and reperform depreciation and
amortisation calculations.
 Inspect post year-end management accounts to ensure internet sales are holding up.

2.2 Appointment of finance director and advice on remuneration package

Threats
A familiarity threat arises as the audit team may be reluctant to criticise the information or
explanations provided by the finance director.
A management threat arises if the directors expect the firm to be involved in the appointment
of the finance director. The firm may become too closely aligned with the views and interests
of management.
Response
Appointment of finance director
The firm should not provide recruitment services to an audit client that would involve taking
responsibility for the appointment of any director.

Remuneration package
MIA By-Laws prohibits the provision of services to an audit client that would involve the
audit firm advising on the quantum of remuneration package or the measurement criteria
because the familiarity threat is too high. Consequently this service should be refused.

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