CASE 3 : 7 SUGGESTED SOLUTION

Page 1 of 5 pages

Part (a)

Risks at the financial statement level:

1. With the health clubs operating in all the major centres of South Africa and with there
being no financial director, there is a risk that material misstatements will arise due to
the preparers of the financial statements not being aware of all matters that may
impact on the financial statements (including fraudulent conduct by the health club
employees). (1½)
1.1. This risk is increased due to the decentralised management style that has been
adopted, which will provide club general managers with the opportunity to
engage in fraudulent conduct (e.g. misappropriation of assets and fraudulent
reporting). (1)
1.2. Due to the managing director, Mr Tone, spending most of his time at his golf
shop in George, his ability to exercise close oversight over the staff (and
specifically the club general managers) is diminished, increasing their
opportunity to engage in fraudulent conduct and deviate from the company’s
policies and procedures (including the system of internal controls). (1)
1.3. As each health club maintains its own accounting records, there is a risk that all
transactions have not been recorded (e.g. all expense transactions), providing the
general managers with a further opportunity to overstate the reported profits. (1)
2. As each club general manager is awarded an annual bonus based on the profits
reported by his/her club, there is a risk that the club revenues reported to head office
are overstated, and the expenses understated, in order to maximise the general
manager’s bonus (i.e. there is an incentive to engage in fraudulent financial
reporting). (1)
3. With like amounts from the trial balances of each health club and head office simply
being added together to compile the company financial statements, there is an
increased risk of material misstatement as:
3.1. Inter-branch transactions may not be eliminated, which will lead to an
overstatement of revenues and expenses; (1)
3.2. Each health club accountant may not fully understand the requirements of IFRS
and the company’s accounting policies, which may mean that the amounts in the
individual trial balances are incorrectly determined. (1)
3.3. Errors may be made in capturing the data onto MS Excel, and given the lack of
supervisory checks, these may not be detected. (1)
4. As a firm of professional accountants is appointed to prepare the annual financial
statements this should reduce the risk pertaining to the disclosure-related assertions. (1)
4.1. Whilst this firm simply prepares the financial statements based on the
information provided by the client, they are also likely to detect some of the more
obvious misstatements, thus reducing to some extent the risks arising from point
3. (1)
5. The risks pertaining to the inappropriate use of the going concern basis of accounting
in the financial statements is increased due to the following:
CASE 3 : 7 SUGGESTED SOLUTION
Page 2 of 5 pages

5.1. Mr Tone, the company’s founder and key contributor to its success to date, has
“lost much of his passion for the business” which will make it more difficult
for the company to compete successfully with other health clubs. (1)
5.2. The fact that the board recognised that the “health and fitness market is
overtraded”, means that the company’s pricing will come under pressure,
which will reduce revenues (and profits) into the future. (1)
5.3. Moreover, the disposable income of current members is declining, which
means that they are likely to find it more difficult to settle their debts (which
will translate into bad debts and losses), and they may also cancel their
memberships, thereby further reducing revenues and profits. (1)
5.4. The profit before tax has been consistently declining since FY2018, and given
the concerns about the overstatement of revenue (see the discussion of risks for
the revenue assertions), a loss may actually have been suffered during the 2020
financial year. (1)
Reducing this risk are the following factors:
5.5. Getfit (Pty) Ltd has “adequate liquidity to fund its operations”; and (1)
5.6. The company has taken the decision to rebrand certain of its health clubs, and
scale back on the “more expensive to maintain facilities”. (1)

Risks at the assertion level:

Revenue

1. The large number of members (in excess of 30,000) together with the different
pricing plans increases the risk that material misstatements may arise in the accuracy
assertion due to the volume of transactions. (1)
1.1. But the sophisticated membership software is likely to contain strong controls to
mitigate this risk. (1)
1.2. However, the fact that the membership software and database is accessible from
all the health clubs will increase the risk that unauthorised access may be
obtained and changes made – increasing the risk of material misstatement for all
revenue assertions. (1)
2. The risk for the occurrence of revenue is increased due to:
2.1. The possibility that the 20% amount payable upfront for contracts and the once-
off joining fee for month-to-month plans are recognised as revenue on receipt,
rather than over the period that the service will be rendered. (1)
2.2. The possibility that members are invoiced for membership fees despite their
having cancelled their memberships (especially given the club general managers
bonus incentives). (1)
2.3. There being no joining fee from March to June 2020 for month-to-month plans,
and as managers receive annual bonuses based on the number of new members
signed, there is a risk that new members joining during this period, and the
associated membership revenue, are fictitious. (2)
CASE 3 : 7 SUGGESTED SOLUTION
Page 3 of 5 pages

2.4. The potential materiality of the risk factors in 2.2. and 2.3 is evidenced by the
material increase in trade receivables from 30/6/2019 to 31/5/2020. (1)
2.5. Revenue recognition for the membership contracts relating to the health clubs to
be rebranded may be complicated due to members being dissatisfied with the
changes and intend to terminate their contracts. (1)
3. The risk for the completeness of revenue is increased due to:
3.1. Walk-in visits, paid in cash, may not be recorded in the company’s records, and
the cash misappropriated by staff at the reception desk. (1)

Property, plant and equipment

1. The relative size of this account balance increases the risk that any misstatement
relating to property, plant and equipment will be material (with reference to the
performance materiality figure). (1)
2. The risk pertaining to the completeness assertion is increased as:
2.1. the lease agreement for eight health clubs may not have been recognised and
capitalised as a right-of-use asset on commencement of the lease term (in
accordance with IFRS 16). (1)
3. The risk pertaining the accuracy, valuation & allocation assertion is increased due to:
3.1. The carrying amount of the right-of-use property, on initial recognition, not have
been correctly computed using the present value of the lease payments payable
over the lease term, together with the initial direct costs incurred by Getfit (Pty)
Ltd. (1)
3.1.1. Specifically, the incorrect lease term and/or discount rate may be used
when making the computation – i.e. these may not have been determined by
Getfit staff in accordance with the requirements of IFRS 16. (1)
3.2. The fact that the company offers “state-of-the-art” fitness equipment, but
depreciates such assets over 12 years (which is likely to be well in excess of their
useful lives). (1)
3.3. Buildings (including leasehold improvements) being depreciated over periods
from 25 to 50 years – yet the lease terms seem to be far shorter than this. (1)
3.4. Office furniture and motor vehicles are depreciated at the “wear and tear rates
allowed for income tax deduction purposes” – which may not bear a close
relationship to each asset’s useful life and residual value. (1)
3.5. The market being overtraded and the disposable income of members declining,
may mean that the recoverable amount of certain assets are below than their
carrying amounts, requiring an impairment of the carrying value – which may not
be correctly recorded. (1)
3.5.1. This risk is specifically relevant to those assets on hand at year-end that
will no longer be used in the “no frills” health clubs. (1)
CASE 3 : 7 SUGGESTED SOLUTION
Page 4 of 5 pages
Inventory

1. The risk pertaining to the existence of inventory is increased, as:

1.1. the controls over the custody of the inventory on hand appear weak – “products
are stored under the counter at health club reception desks” – which may mean
that the recorded inventory is not actually on hand. (1)
1.2. the controls to account for the movement of consumables are unlikely to be
strong, and the correct quantities on hand will only be determinable based on a
full inventory count (this also affects the risk pertaining to completeness
assertion). (1½)
2. The risk pertaining to the accuracy, valuation & allocation of inventory is increased,
should some of the company’s branded products no longer be saleable (e.g. should
the colouring become outdated, or should it refer to a health club that will be
rebranded) – in which case the inventories cost may exceed its net realisable value. (1)
3. The risk of material misstatement in respect of the overstatement of this asset is,
however, low due to it being likely that the amount of this account balance at year-
end will be below the performance materiality figure set. (1)

Maximum (22)

Part (b)

Non-compliance with health laws and regulations:

1. The assessment of the risk of material misstatement at the financial statement level
will have to be increased, as business risks do not appear to have been managed
effectively and this may give rise to material misstatements in the financial
statements. (1)
1.1. Accordingly, overall responses will have to be designed and documented in the
audit plan to address this risk (e.g. assigning more experienced staff to perform
the engagement). (1)
Reason:
• The procedures implemented to mitigate the risk of non-compliance with laws
and regulations do not seem to be particularly effective, as the mere
documenting of the applicable laws and regulations will not mean that the
company and its staff will comply with these. (1)
• It must therefore be questioned how the residual risk was assessed as being
“low” despite the above concerns. (1)
2. As part of understanding the entity and its environment, the auditor will have to:
2.1. evaluate the applicable health and safety laws and regulations (as documented)
and determine whether they are likely to have a fundamental effect on the
operations of the entity; and (1)
2.2. enquire of management regarding the policies and procedures adopted for
identifying, evaluating and accounting for legal claims. (1)
CASE 3 : 7 SUGGESTED SOLUTION
Page 5 of 5 pages

3. This understanding should then be taken into account when making the assessment of
the risk of material misstatement for the:
3.1. inappropriate use of the going concern basis of accounting in the financial
statements; and (1)
3.2. the completeness of provisions (e.g. for litigation and penalties). (1)
The nature, timing and extent of further audit procedures should be adapted to
respond to the above risk assessment. (1)

Professional services not recorded

4. Inherently, this business risk will increase the risk of material misstatement regarding
the completeness of revenue (i.e. it is a fraud risk). (1)
5. However, the system of internal control, as documented, appears to be sound which
will reduce the assessment of the risk of material misstatement (i.e. the assessment of
control risk). (1)
6. It is unlikely that substantive procedures alone will reduce the risk of material
misstatement for the completeness of revenue (as without reliance on controls, it will
be very difficult to verify that all such transactions were recorded in the company’s
records). (1)
7. Accordingly, the audit plan should include the testing of key controls in this area (e.g.
enquiring that the general manager’s checks are conducted throughout the financial
year and reperforming the reconciliation of recorded bookings to the receipts per the
cash book). (2)

Maximum (8)