ausons The audit senior, Mox Turner, has brough! several matters to your attention {Cooper Co's factories ore recognised within properly, plant and equipment ot o carrying value of $60 million. Half ofthe factories produce a chemical which is used in form cnimal feed. Recently the government has inlroduced o regulation stipulating that the chemicol is phased out over the nex! three years. Soles of the chemical ore stil buoyant, however, and ore projected to account for 45% of Cooper Co's revenue for the year ending 31 Jonvary 20X5. Cooper Co hos started to research o replacement chemicel which is ellowed under the new regulation, and has spent $1 million on Feasibility study into the development of this chemical. {i In October 20X3, Cooper Co's finance director, Hannah Osbourne, purchased ¢ car from the company. The carrying value of the cor at the dote of its disposal fo Honnoh ‘wos $50,000, and its market value wos $75,000. Cooper Co raised an invoice for $50,000 in respect of the disposal, which is sill outstanding for payment (15 marks) Required Comment on the matters to be considered and exploin the auait evidence you should expect to find during your review of the udit working papers in respect of each of the issues described above, {b] Max noticed that « section of the audit file had not been completed on the previous yeor's ‘audit. The incomplete section relates to expenditure incurred in the year to 31 Jonuary 20X3, which appears not to have been audited at all in the prior yeor. The expenditure of $1.2 milion was incurred in the development of an internally generated brand name, The amount ‘was copitalised as an intangible asset at 31 Jonvary 20X3, and that amount is sill recognised cat 31 January 20X4, Required Explain the implications of this matter for the completion of the audit, and ony other professional issues raised, recommending ony actions to be token by the auditor. (5 marks) (Fotal = 20 merks) 2 (PF 12AT2) (anes. 3} 98 wine 2} You are © menager in Foo & Co, responsible for the audit of Grohl Co, @ company which produces circuit boards which ore sold to manufacturers of electrical equipment such os computers end mobile phones. It is the first time that you hove managed this cudit client, taking over from the previous audit manager, Bob Halen, last month. The cudit planning for the year ended 30 November 20X2 is about fo commence. You have been provided with he following exhibits: 1 Ancemail which you have received from Mic Voi, the audit engagement poriner 2 Noles from your meeting with Mo Satriani, the finance director of Grohl Co. 3. Financial information provided by Mo Sotrian. Required Respond to the instruction in the email from the audit engagement partner. (38 marks) «The split ofthe mark ellocation is shown within the partner's emoil (Exhibit 1) rofessional morks will be awarded for the presentation and logical flow of the briefing notes cond the nd clarity of the explanations provided. (4 marks)Exhibit 1 ~ Eraail from the audit engagement parter To: ‘Audit monager From: Mio Voi, Audit portner, Foo & Co Subject: Groh! Co — cuit planning Hello | {Lam meeting with the ether auclt poriners tomorrow to discuss forthcoming adits ond related | issues. | understond thot you recently had a meeting with Mo Satriani, the finance director of Grohl Co. Using the information from your meeting together with the financial information that | | understand Mo has sent you, | would like you to prepare briefing notes for my use in which you: [il Evaluate the business risks foced by Grohl Co; (18 meirks) fi) Evoluote the risks of motralmistremen! oe considered in planing the suits ond (20 mers) | li) Discuss any ethical issues raised, and recommend the relevant actions to be token by | | (8 tnveickes) | l | Exhibit 2 ~ Notes from the meeting with Mo Satriani Business overview Grohl Co's principal business activity remains the production of circuit boards. One of the key matericls used in production is copper wiring, all of which is imported. As a cost cuting measure, in April 20X2 0 contract with a new overseas supplier was signed, and cll of the company's copper wiring is now supplied under this contract. Purchases are denominated in a foreign currency, but the company does not use forward exchange contracts in relation to its impor's of copper wiring Grohl Co hos two production focilifes, one of which produces goods for the export market, cand the other produces goods for the domestic morket. About half ofits goods are exported, but the export morket is suffering due to competition from cheaper producers overseas. Most domestic sles ore made under contract with opproximately 20 customers, Recent developments In early November 20K2, production was helted for @ week at the production facility which supplies the domestic morket. A number of customers had returned goods, claiming faults in the circuit boards supplied. On inspection, it was found that the copper used in the circuit boards was corroded and was therefore unsuitable for use. The corrosion is dificult to spot as it cannot be identified by eye, ond relies on electrical testing, All customers were contacted immediately ond, where necessary, products recolled and replaced. The corroded copper remaining in inventory has been identified and separated from the rest ofthe copper. Work has recenily started on @ new production line which will ensure thot Grohl Co meets new regulatory requirements prohibiting the use of ceriain chemicals, which come into force in ‘March 20X3. In July 20K2, a loon of $30 million with an interest rote of 4% was negotiated ‘with Gohl Co's bonk, the mein purpose of the loan being to fund the copital expenditure necessary for the new production line. $2.5 milion ofthe lean represents an overdraft which was converted into longterm finance. :Website sales Grohl Co started to develop a website for soles on 1 December 20X1, which was completed cond available for use by 31 May 20X2. The website has facies for customers to design their ‘own circuit boards, o choose the products they need and to make « payment, The total cost of ‘website development in the year ended 30 November 20X2 was $200,000. This was copitalised and isto be writen off over five years. Alter initial development, the operation of the website, including collection of payments from customers, wos outsourced to a specialist provider, Khalifa Co. Khalifa Co pays Grohl Co ‘each month, after deducting its fee. Grohl Co's prices hove been reduced by roughly 10% for ‘online soles, which by the end of the year mode up obout o quarter of Grohl Co's totel Tho website initiates the fulfilment process automatically once payment has been made by the ‘customer, working on the bosis ofthe information entered by the customer. Grohl Co has clso ‘outsourced the final delivery of goods fo a courier company. Grohl Co has experienced some difficulties with the website, including relatively high rates of returns from customers. There have also been errors in goods delivered arising from customers! misunderstanding of the website. Other matters Several of Grohl Co's executive directors and the financial controller left in October 20X2, to se! up © company specialising in the recycling of old electronic equipment, This new company is not considered to be in competition with Grohl Co's operations. The directors left on good terms, and replacements for the directors have been recruited. One of Foo & Co's audi managers, Bob Helen, is being interviewed for the role of financial controller ot Grohl Co, Bob is o good candidate for the posiion, os he developed good knowledge of Grohl Co's business when he was managing the audit AY Grohl Co's most recent board meeting, the audit fee wos discussed. The boord members expressed concern over the size of the audit fee, given the company's loss for the yeor. The board members would lite to know whether the audit can be performed on a contingent fee basis Exhibit 3 ~ Financiol information provided by Mo Soi EXTRACT OF DRAFT STATEMENT OF PROFIT OR LOSS FOR THE YEAR ENDED 30 NOVEMBER 20x2 20x2 20x1 Droh Actual $000 $'000 Revenue 12,500 13,800 Operating costs 12,000) 12,800} Operating profit 500 1,000 Finance costs 1800) (800) Profit/{oss) before tox {300} 200 ‘The draft statement of financial postion has not yet been prepared, but Mo siates that the total ‘assets of Grohl Co ct 30 November 20X2 are $180 milion, and cash at bank is $130,000, Based on draft figures, he company's current ratio is 1.1, and the quick ratio is 0.8. (b} fer hoving completed your briefing notes for Mia Vai, you received a phone call from Mo Satrioni, Grohl Co's finence director, in which he made the folowing comments. "There is something | forgot to mention in our mesting. Our business insurance covers us for specific occasions when business is interrupted. | putin o claim on 28 November 20%2 for $5 million which | have estimated to cover the period when our production wos halled due tothe problem with the corroded copper. This is not yet recognised in the financial statements, but 1 want to make on adjusiment to recognise the $5 million as a receivable as ot 30 November." Roquired Comment on the matters that should be considered, ond design the audit procedures to be petformed, in respect of the insurance claim. (8 marks) {Total = 50 marks) You are a manager in the audit deporiment of Bison & Co, a firm of Chartered Certified ‘Accountants, responsible for the audit of the Eogle Group {the Group], which hos a financial year tending 31 December 20X8. Your firm is appointed to oul the parent company, Eagle Co, and cll ofits subsidiaries, with the exception of Lynx Co, 0 newly acquired subsidiary located in o foreign ‘courity which is audited by « local firm of auditors, Vulture Associates. All companies in the Group report using IFRSR Standards as the opplicable financial report framework and have the same financial year end. 8 You ore provided with the following exhibits: 1 Anemail which you have received from Maya Crag, the auclt engagement partner. 2 Background information about the Group including o request from the Group finance director in respect of « non-oudit engagement. 3 Exiacis from the Group financial statements projected to 31 December 20X8 and Comporstives, extracied from the management accounts, and accompanying explanatory notes. 4 Management's determination of the goodwill arising on the acquisition of lynx Co. 5 An extract from the audit strategy document prepared by Vulture Associates relating to lynx Co. Required Respond to the instructions inthe email rom the audit engagement partner. (46 marks) ‘the split of the mark allocation is shown in the partner's email {Exhibit 1). Professional marks will be awarded for the presentation ond logical flow of the briefing notes ond. the clarity of the explonetions provided. (4 marks) (Fotal « 50 marks) jvorn audit engagement pariner ‘fos Audit monoger From: Moya Crag, Audit engagement portner Subjects Audit planning for the Eagle Group Hello | have provided you with some information in the form of a number of exhibits which you should use| in planning the audit of the Eagle Group (he Group}. | held a meeting yesterday with the Group finance director and representatives from the Group audit commitee, and we discussed a number of | issues which wil impact on the audit planning, |Procedures. Inspect cloim ond supporting documentation Inspect insurance terms and conditions Review correspondence Communicate with insurance provider Enauiry with lawyers Maxieu~ Mio Vei ‘Audit manager Dec 20x2 Subject: Grohl Co audit planning Introduction These notes will evaluate the business risks foced by Grok! Co; identify and explo cof material misstatement to be considered in audit planning; and discuss relevant «*~ «and recommend actions to be token by our firm “) Evaluation of business risks Overseas supplier Copper wiring is key production material, and is imported from overse: therefore a risk of unstable supply as o result of it being transported c-= distonce, across borders. Any ofthe following could pose problems Arise in fuel prices could afect the cost of materials © Political instability could lead to difficulties ronsporting across borders » Goods may not be subject to the same regulatory standards as those own jurisdiction, and could be of poor quality «Environmentol disruption could affect eg shipping or aviation, =~ disruption ofthe supply of materials F there were a stock out ofthis key moterial then this would severely offec > production, and its ability to supply is customers. This could lead to a loss ‘and of customer goodwil Exchange rate iste Purchases are made in « foreign currency, and fluctuations are not hedged c2- leaves Grohl Co exposed to the risk of price rises, which could affect & position and its shorkrun profitability. it may be advisable for the come: forward contract te help mitigate this risk Key supplior Grohl Co is reliant on just one supplier forall ts copper wiring. Itis thus exes sks resulting from problems with this supplier, eg price rises, problems \ guality controlGrohl Co also moved cll ofits copper purchases fo just one new supplier, before having used the supplier for « trial period. It was therefore highly exposed fo any problems with the new supplier. Competitive pressure Grohl Co operates in o competitive industry and is subject to price competition from overseas. There is @ sisk thot Grohl will be unable to keep its prices low enough to compete on this basis, i mey need to consider alternative strategies! The indusity is dynamic and subject to rapid change, s0 in order to remain competitive Grohl Co must adopt quickly to any changes. It may not have sufficient resources to do Quality problems with the new copper supply have led to goods being returned by customers. This seems likely tobe related to the use of a new, cheaper supplier. There is © risk of losing customers as o result of poor quality products, which may be particularly dangerous in this competitive market. li may be necessary in future for Grohl Co to test the quality of copper purchosed. This would incur costs, which would in turn put furher pressure on Grohl Co's already fight operating margins. New regulations New regulations come into force after the year end. There is @ risk thot these may not bbe complied with, which could lead to significant penalties. These could be fines, or could resul in suspending production. New foan The new $30m loan is significant at 1/6 (16.7%) of total assets. It is not known what proportion of net asses this consfivtes. Annual interest on the loan is 4% x $30m = $1.2m, which is a significant amount in the context of o loss of $300,000 before tox and a cash balance of only $130,000. The fac! thet Grohl Co has © $2.5m overdraft may be indicative of a cosh shortage, © view that is borne out by low current and quick ratios. There is risk that Grohl Co my not be a going concern forthe nex! yeor. Management chonge The loss of severcl executive directors means that key business expertise has been lost, which might have been especially important given Grohl Co's current financial position. Website sales The introduction of website sales brings with it several risks. These include the risk of noncompliance with taxation, legal and other regulatory issues. There is o risk of technological foilure (crashes) resuting in business interruption and possible brand damage. There is a significant security risk from virus olfacks, which could result in loss of company or customer dota, This may in turn have legal ramifications. ‘The high rate of retuis from the website is © concern, os this may indicate o flaw in the design of the website. Qn bolance the website is likely to help improve Grohl Co's soles, but itis notable that prices have been reduced by 10%. There is a risk of lost revenve if this reduction hos nol been given adequate consideration.02 i) Gutsourcing Grohl Co has outsourced both its new website and the delivery service from it, which brings a risk that the services provided may not be of sufficient quality. Grohl Co is now reliant on two external entities for key elements of its business, over Sthich it has now relinquished control. There is also a cost risk with outsourced services, as they may be more expensive than performing the service inhouse. Draft revenue is down by $1.3m from 20K1, or 9.4%. Operating profit has fallen by $500,000, or 50%, ond the operating margin has fallen from 7.2% to 4%, a fall of 44%, Grohl Co has made @ pretox loss of $300,000, although this does not appear to include the finance cosls from the new loan [finance costs for 20K2 are the same os 20%), If these were included, then the loss would be about $0.5m higher, at $0.8m. This is @ lage loss, and may again indicate going concern problems. Ricks of material misstatement Foreign exchange There is a risk of noncompliance with IAS 21 The Effects of Changes in Foreign Exchange Rates. IAS 21 requires that non-monetary items are recognised at the historical rote, which isthe rate ot the dote of the transaction (IAS 21: poras. 21-22} This would include income and expenses in the statement of profit or loss. There iso risk that normonetary items are not recognised ct the correct historical rote, leading 0 under- or overstatement ofthese items. IAS 21 requizes monetary itoms to be measured at the closing rate (IAS 21: para. 23}. Thus any foreign currency payables ond receivables must be relranslated ot the yeor end, with any exchange gain or loss being recognised in the statement of profit or loss. There is a risk that the wrong rte is used, or that items ore translated vsing the wrong rate. There is also « risk that no exchange gain or loss is recognised i relation te payables ond receivables sotled during the year. Product vecoll Grohl Co may be liable to customers in relation to faulty goods supplied. Although # issue oppears to be resolved, itis possible that there may be further liabilites whic should be recognised in line with IAS 37 Provisions, Contingent Liabilities ar= Contingent Assets. IAS 37 requires o licbility to be recognised where o prose” obligation exits as © result of & past event, ond the outflow of resources embodyir= economic benefits is probable. There is a risk that liabiliies are understated if = provision is not recognised. There is @ further risk that the accounting treatment of the product recall was incorre: ‘Any revenue recognised on recalled items should be cancelled agoinst t+ corresponding receivables balance. The risk is therefore that revenue and receivab + may be overstated. New production line The construction of the new production line is likely to result in new aon-current asee which should be recognised inline with IAS 16 Properly, Plant and Equipment. There «risk that this has not been done correctly, leading to either under oF overstotemer: ossetsThe production line is likely to be o qualifying asset in line with IAS 23 Borrowing Costs, s0 all directly allbutoble borrowing costs should be capitalised. It is not clear how much of the $0.5m finence cost from the new loan would be capitalised, as the loan ‘appears to have been used only ‘mainly’ for the new production line. Old production line - impairment The new regulations coming into force after the year end indicote that the existing production may be impaired. IAS 36 Impairment of Assets requifes management 10 condvet an impsirment review. If this is not done edequately, then non-curent assets and profit may be overstated. IAS 36 requires assets to be carried ot the lower of their corrying amount ond their recoveraible amount. In conducting the impairment review, management determines the recoverable amount, which isthe higher of the assels’ value in use, ond their fir value less costs of disposcl. Ifthe new reguialions have made the existing production line assets obsolete, then their value in use may be as low as zero; in this case the assets ‘would need to be carried at their fair value less costs of disposal. The company would then need to recognize an impairment loss for the difference between this and the assets’ corrying amount Inventory obsolescence There is a risk that some inventory may have been rendered un-usecble by the use of corroded copper. The matter is complicated by the fact that testing is required to dolermine whether an iter has been affecied. IAS 2 Inventories requires inventory to be carried at the lower of cost and net reolisable volue. There is o danger that obsolete inventory has been included in the financial slolements without being reviewed for impairment, resulting in an overstatement of inventory. This overstatement would affect both profit and total asses Website development costs Website development costs may be treated as an intemally generoted intangible asset according to IAS 38 Intangible Assels, provided thal the appropriate conditions are satisfied: it must be probable thot future economic benefits wil flow from the website, and the costs of the website must be measured reliably. IAS 38 requires the website to be feasible, which seems to be the case since itis operational. Similarly, the costs appear to be able to be measured reliably ot $200,000. It is unlikely to be correct, however, to capitalise the total costs of $200,000, since some of these must relate to the planning stage, and should therefore hove been recognised in profit or foss as they were incurred There is further risk thot subsequent costs have been included within this figure instead of being recognised as expenses. This could result in assets being overstated and expenses understated, Website soles A key risk is the use af an outsourced service provider. ISA 402 Audit Considerations Relating fp an Eniily Using a Service Organisation provides guidance on hew auditors should obtain sufficient oppropricte audit evidence when the audit client, which is o “user enti’, relies on such services. The website soles are likely fo be moterial to Grohl Co as they make up around quarter of revenue, even though they have only been launched for half a year. The oulsourced service therefore consitules a key element of Grohl Co's internal control systems, soit will need to be ossessed carefully(e) 04 Geing concern {As indicated in the evaluation of business risks, there may be going concern prot ct Grohl Co. The risk is either thatthe financial statements are prepared on the ¢ concern besis when they should not be, or that appropriate disclosures are not rr: regerding any materiol uncerlsities giving rise to significant doubis over go {ii Ethical issues Audlit menager joining sti ‘An oudit manager from Foo & Co may leave to become a financial controller = Grohl Co. According to the IESBA Code of Ethics, this could crecte fomilicrty inlimidotion treats The audit team may be so fomilior with Bob Halen that they lose independence, *: example they may not challenge him if this is necessary. They may fail to exerc:= ‘enough professional scepticism. Bob is als likely to be fomiiar with Foo & Co's ave methodology, so would be well placed to think of ways of hiding things from the av= teom, The IESBA Code stats that if ‘significant connection’ remoins between the firm or the individual who joined the client, then no safeguard could mitigate the threat and 1 firm should withdraw from the engagement. This would be the case if © Bob is entitled to benefits or payments from Foo & Co, unless in line with fxe= predetermined arrangements © Bob is owed on amount by the firm that is material to the firm © Bob confinues to participate in the firm's business or professional activities Alternotively, if there is no significant connection then safeguards may be acceptable. The threat here is significant, as Bob was in charge of the Grohl Co audit only ver, recently, and would have maintained contact with Grohl Co's mancgement Sofeguards might include reviewing any work thot Bob hes done on the aul, although there is not likely 10 be much ofthis as planning is only jst sterting Contingent fee audit The IESBA Code clearly states that an audit firm moy not enter into © contingent fee crrongement, os the selfinterest threat would be too great for safeguards to reduce to ‘on acceptable level Conelusion Grohl Co is facing some significant business risks, which may affect the going concern castertion. There ere a number of significant risks of material misstatement in relation to wihich the audit plan should design procedures to obioin sufficient appropriate cudit evidence. The ethical issve with Bob Halen requires that safeguards be putin place, ond it should be communicated to Grohl Co's Board that the audit cannot be performed ono contingent fee basis Matters to consider ‘AY $5m, the claim represents 40% of draft revenve, and would turn a loss of $0.3m into a profit of $4.7. Iris therefore highly material This is o contingent asset, IAS 37 requires thot contingent assels ore not recognised, unless iis Virtually certain tho! the inflow of economic benefits will take place (1AS 37: peras. 31-35)‘At the moment, itis not certoin that the claim will even be paid, even if is more likely to be paid than not. Whether or not itis paid will depend on the specific terms of the insurance policy, which would naed to be considered in detail and ight of eny communications withthe insurer and/or Grohl Co's legal counsel Regerding the value of the claim, production was halted for just one week so 40% of annual revenue is for too high. Itis very unlikely thot this amount will be received. Procedures © Obtein o copy of the insurance claim made and confirm that $5 million is claimed, © Enquire into the bosis of the $5 millon claimed, and review ony supporting documentation such os extracts of management accounts showing lost revenue for the period of halted production. + Inspect the terms of the insurance policy, to determine whether production halted in these specific circumstances would be covered, © Seek Grohl Co's permission to contact the insurer to ask about the status of the claim, and request written confirmation of any payment that may be made, © Review correspondence benween Grohl Co and the insurance provider, locking for confirmation of any amounts to be paid i Workbook references. Chapters 2, 6, 7 and 9. Top tips. Your general approach should be to read the requirement carefully, and then to work through the question noting down issues {audit risks) cs they occur to you. Port (a} asks you fo use enalylical procedures, and the eagle-eyed student might have noticed that it ‘even suggesls & way of gaining morks: by using the resuls of your analytccl procedures fo identify risks (Exhibit 1}. Iris crucial that you perform these calculations if you are going te poss the question; even if you scored strongly throughout the rest ofthe question, this can be the difference between passing and foiling it. Don't go t00 For, though, os the marks for analytical procedures will usually be copped {in this case they're copped at 5}. Notice also thot you're asked for ‘cudit risks! and not 'isks of meterial misstatement’, so you con include detection risks. When the examining team includes cuit risks in the requirement then this is. the result of e deliberate decision thot has been made - you can therefore take this as o clue that there will be ot least one detection risk in the question Finally, its vital that you get the marks for moterialily. There were up to 4 marks available here. Taken together withthe marks on materiality, this makes 9 marks for what ore fairly mechanical sls this level Part (b} asked for avait procedures on goodwill, and was not excessively difficult. As ever, your | conswers here should be as specific as possible, explaining why you would perform each procedure in eddition to just saying what you would do. The requirement refers to Exhibit 4, which is ¢ good | souree of ideas and thus marks Parte] was not in foc too difficult, bu this was a new style of question thot you may not have been ready fo, Really all you needed to do was to think about how these areas should be audited, and | then compare this with what has been done here, This can help you to keep an independent mind about what should be done, and not fall into the trap of struggling to find problems withthe approach suggested in the question Part |d) was on ethies requirement on a topical area ofthe syllabus. This should not have posed you too ster a tes