MCQ

1. Which of the following situations would require adjustment or disclosure in the

financial statements?

A. A merger discussion.
B. The application for a patent on a new production process.
C. Discussions with a customer that would lead to 40% increase in the client’s sales.
D. The bankruptcy of a customer who regularly purchased 30% of the company’s
output.

2. Which of the following document is obtained from the management at the completion
of an audit?

A. Internal control questionnaire.

B. An engagement letter.
C. Audit planning memorandum.
D. Client representation letter (Written representation)-ISA 580.

3. Which of the following statement is correct concerning an auditor’s required

communication with those charged with governance (ISA 260)?

A. This communication is required to occur before the auditor’s report on the

financial statements is issued.
B. This communication should include management’s changes in the application of
significant accounting policies.
C. Any significant matter communicated to those charged with the governance
should also be communicated to management.
D. Significant audit adjustments proposed by the auditor and corrected by
management need not be communicated to those charged with governance.

4. The representation letter (ISA 580) is used to

A. Allow management to corroborate oral representations to the auditor.

B. Confirm the term in audit engagement.
C. List material weaknesses with respect to internal control noted by the auditor.
D. Make recommendations to the client based on the observations made during the
audit

5. If the auditor discovers that management intends to liquidate the entity:

A. the going concern basis is inappropriate.
B. it is irrelevant if they did not intend to liquidate the entity at reporting date.
C. it requires inclusion as a disclaimer of opinion.
D. it requires inclusion as an ‘except for’.

1
Short Questions

Question 1
Discuss when does a company make accounting estimates and the required
considerations and approach to audit of accounting estimates

Answer

The management of a company will make an accounting estimation in a particular account

when they face a situation where a precise measurement is not available.

The auditor should gain an understanding of the procedures and methods used by
management to make accounting estimates. The auditor should adopt one or a
combination of the following approaches in the audit of an accounting estimate:

(A) Review and test the process used by management or the director to develop the
estimates.
(B) Use an independent estimate for comparison with the one prepared by the
management or the directors.
(C) Review subsequent events which confirm the estimate made.

Question 2
Are analytical procedures required as part of the overall review of the financial
statements? What is the purpose of performing such analytical procedures?

Answer

ISA 520, "Analytical Procedures" requires that the auditor perform analytical procedures
at the final review stage of the audit. The objective of conducting analytical procedures
near the end of the engagement is to help the auditor assess the conclusions reached on
the financial statement components and evaluate the overall financial statement
presentation

Question 3
What are “events after the date of financial statements” as set out in MFRS 110 and how
are they accounted for in the financial statements? Give 2 examples

Answer

2
Events after the balance sheet date are those events, favourable or unfavourable, that
occur between the balance sheet date and the date when the financial statements are
authorised for issue. Two types of subsequent events require consideration by directors
and evaluation by the auditor:

1. Events that provide additional evidence about conditions that existed at the date of
Financial statements and affect the estimates that are part of the financial statement
preparation process. These types of events are referred to as adjusting events and
require adjustment of the financial statements.

2. Events that provide evidence about conditions that did not exist at the date of
financial statements but arose subsequent to that date. These are referred to as
non-adjusting events and usually require financial statement disclosure.

Examples of the first type of event or condition are:

 An uncollectible account receivable resulting from continued deterioration of a
customer's financial condition leading to bankruptcy after the balance sheet date.

 The settlement of a lawsuit after the balance sheet date for an amount different from
the amount recorded in the year-end financial statements.

Examples of the second type of event or condition are:

 Purchase or disposal of a business by the entity.
 Issues of shares or bonds by the entity.
 Loss of the entity's manufacturing facility or assets resulting from a casualty such as a
fire or flood.

Question 4
Define what is meant by contingent liability. What is the accounting treatment for
contingent liability according to MFRS 137? Give 2 common examples of contingent
liability

Answer

A contingent liability is
1. A possible obligation that arises from past events and whose existence will be
confirmed only by occurrence of uncertain future events, or
2. A present obligation that arises from past events but is not recognised because an
outflow of resources is not probable or the amount of the obligation cannot be
reliably measured.

Examples of contingent liabilities include:

Pending or threatened litigation.
Actual or possible claims and assessments.
Guarantees of obligations to others.

3
 Agreements to repurchase receivables that have been sold.

Question 5
Provide 2 examples of commitments that are often disclosed in the notes to the financial
statements

Answer:

Examples of commitments include committed subscription to purchase shares or rights

issues in other companies, capital expenditure authorised and contracted, non-cancellable
long term leasing arrangements.

Question 6
What procedures should the auditor apply to examine identified related party
transactions?

Answer

The audit evidence for related party transactions may sometimes be limited. The auditor
may need to perform audit procedures such as the following:
 Confirm with the related party, the terms and amount of the transaction.
 Discuss with management the purpose and nature of the transaction.
 Inspect documentary evidence in the possession of the related party.

In addition to other audit procedures, the auditor is required to obtain written

representation from management concerning the following:
 The completeness of information provided regarding the identification of related
parties, and
 The adequacy of related party disclosures in the financial statements.

If the auditor is unable to obtain the sufficient appropriate audit evidence relating to
related parties and related party transactions, or if he concludes that their disclosure in the
financial statements is not adequate, the auditor should modify the auditor’s report
appropriately.

Question 7
Why does the auditor obtain are representation letter from management?

Answer

The auditor obtains a representation letter in order to corroborate oral representations

made to the auditor and to document the continued appropriateness of such
representations. The representation letter also reduces the possibility of misunderstanding
concerning the responses provided by management to the auditor's inquiries.

4
Question 8
What information does the auditor ask the solicitor to provide pending or threatened
litigation?

Answer

The auditor requests that the lawyers provide the following information on pending or
threatened litigation:
 A list and evaluation of any pending or threatened litigation to which the solicitor
has devoted substantial attention. This includes claims or actions against the client
and actions brought by the client. The list may be provided by the client.
 A listing of unasserted claims and assessments considered by management to be
probable of assertion and reasonably possible of unfavourable outcome.
 The status and progress of the cases, the action the entity plans to take and the
amount or range of potential loss.
 A request that the solicitor evaluates and provides his opinion on the outcome of
each case.
 Counter claims by the company, if any.
 A description of any materiality levels agreed upon for the purposes of the inquiry
and response.
 An unasserted claim or assessment is one in which the injured party or potential
claimant has not yet notified the entity of a possible claim or assessment. Lawyers
may be reluctant to provide the auditor with information about the unasserted
claims because of client-solicitor privilege. Solicitors may also be concerned that
disclosure of the unasserted claim may itself result in lawsuits.

Scenario Questions

Question 1 (This question will be discussed in the lecture)

The following items of subsequent events are unrelated. For each of the following items,
you are to indicate the required accounting treatment of the event. Assume that the
external auditor has completed the field work and is preparing the auditor’s report on the
client’s financial statements for the year end 31 October 2006.

a) A large account receivable from a customer, ABC company (material to the

financial statement) was considered fully collectable at 31st October 2006. ABC
suffered a plant explosion on 28 November, 2006. Because ABC was not insured, it
was unlikely that the account will be collected.

5
Answer:
The explosion in ABC's plant which led to the uncollectibility of the accounts
receivable was an event whose conditions did not exist at the balance sheet date.
However, as the effect is material, it would require disclosure in the financial
statements.

b) The court ruled in favour of the client company on 26 December, 2006 for the
lawsuit from a customer that involved in the alleged breach of contract in 2005. The
client had been provided for the full amount of the potential liability from the
claim. The customer will not appeal the court’s ruling.

Answer:
The court ruling in favour of the client company is an event whose conditions
existed at the date Financial Statements and which involves the revision of an
estimate. The financial statements should be adjusted to reflect the favorable ruling.

c) On 15 December 2006, the client applied to the Securities of Commission for the
issuance of 20 million new ordinary shares of RM1.00 each. The proposed new
issuance represents 10% of the issued and paid up capital of the company as at 31
October 2006.

Answer:
This is an event whose conditions did not exist at the balance sheet date. This event
should be disclosed in the financial statements.

d) On 22 December 2006, P. Sam a major investment advisor, issued an unfavourable

report on the client’s long term prospects. The share prices of the company
subsequently declined by 30%.

Answer:
This is not an event that is considered a subsequent event for financial statement
poses.

e) As at 5 November 2006 meeting, the board of directors decided to increase

substantially the advertising budget for the coming year and authorized a change in
advertising agencies.

Answer:
This is not an event that is considered a subsequent event for financial statement
purposes.

f) On 30 November 2006, the company entered into a conditional sales and purchases
agreement to acquire 30% of equity interest in ASP Designs SDN BHD at a
consideration of RM1.9 million to be satisfied by cash payment.

Answer:

6
 This is an event whose conditions did not exist at the statement of financial position
(balance sheet) date. This event should be disclosed in the financial statements.

Question 2
You are the auditor of Q-Best Sdn Bhd, whose principal activities are manufacturing and
retailing. The audit for the year ended 30 June, 2000 was completed on 15 August, 2000.
The profit for the year ended 30 June, 2000 was RM50 million. The board of directors
approved the accounts on 20 October, 2000.

Required

(a) Describe the extent of your responsibilities in respect of subsequent events and
the procedures that you need to perform.

(b) Your audit report includes an emphasis of matter in respect of uncertainty on the
outcome of a major lawsuit alleging infringement of certain patent rights by a
third party. On 15 October, 2000, the financial controller informed you that
judgment on the lawsuit has recently been delivered and that Q-Best Sdn Bhd has
to pay RM20 million to the third party. He further informed you that the accounts
are due to be issued to the shareholders on 25 October, 2000. You checked your
records and noted that you have signed the auditors’ report on 28 September,
2000.

Discuss the course of action that you should undertake.

Answer

(a) Responsibilities in respect of subsequent events and procedures

Overall, the auditor should consider the effect of subsequent events on the accounts
and on the auditors’ report - require adjustment or disclosure in the accounts.
- events up to the date of the auditors’ report – auditor is responsible
- events after auditors’ report - auditor is not responsible to perform procedures or
make any inquiry regarding the accounts. Responsibility lies with management.

Procedure that you need to perform:

- review procedures management has established to ensure that subsequent events
are identified
- read minutes of the meetings of shareholders, board of directors, audit
committee and executive committees held after the year end and inquire about
matters discussed at meetings for which minutes are not yet available
- read the latest interim accounts and any other management reports
- inquire from Q-Best Sdn Bhd’s lawyers concerning litigation and claims
- inquire from management of any subsequent events that have occurred which
might affect the accounts.

7
 - Request a written representation from Management under ISA 580

(b) Action to be taken

Materiality: 20%/50% x100%=40% This misstatement is material
 Even though you have signed the audit report, you should still consider the
effect of the judgment that has been finalized and discuss with the
management. The judgment provides further evidence of a situation already
in existence as at the balance sheet date in that the company had infringe the
patents rights and has to bear the liability and this has to be adjusted in the
accounts.
 The auditors’ report should be recalled from Q-Best Sdn Bhd.

There are 2 potential outcomes:

- Management amends the accounts and includes the necessary provision as the
requirements of provision, MPER/MFRS has been fulfilled) You need to remove
the emphasis of matter in your audit report and issue a clean report. The new
auditors’ report should not be dated earlier than the date the amended accounts
are approved and signed and therefore you should carry out the normal
procedure required for subsequent events up to the date of the new report.
- Management does not want to amend the accounts, when you believed that this
is required. You should amend your audit report to express a qualified (if
material) or an adverse opinion.(if based on prof judgement, auditors are of the
opinion that the misstatement is so material and pervasive)

Question 3
APEX Sdn Bhd is a private company manufacturing wooden frames, doors and staircases
for domestic houses. It has prepared draft financial statements for the year ended 30
September, 2013. As the external auditor, you are concerned that the company may have
serious going concern problems. Excerpts of the Income Statements and Balance Sheets
for the last three years are as follows:
2011 2012 2013
Income Statements (RM ‘000) (RM ‘000) (RM ‘000)
Sales 2,242 3,322 3,762
Cost of sales (1,924) (2,652) (3,020)
Gross Profit 318 670 742
Other expenses (322) (480) (576)
Finance costs (116) (180) (234)
Net profit/(loss) (120) 10 (66)
2011 2012 2013
Balance Sheets (RM ‘000) (RM ‘000) (RM ‘000)
Fixed Assets 1,088 1,200 1,174
Current Assets
Inventory 362 614 898
Receivables 606 626 728

8
 968 1,240 1,626
Less: Current Liabilities:
Payables 710 880 1282
Bank overdraft 422 538 730
Hire purchase payable 196 184 118
1,328 1,702 2,130
Total net assets 728 738 670
Represented by:
Share capital 34 34 34
Reserves 94 104 36
128 138 70
Long term loan 600 600 600
728 738 670

The company has been in business for about fifteen years. In 2011, it decided to build a
new factory on a site leased from the local authority which would facilitate a major
increase in sales. This new factory was completed a year later. The factory was financed
by a bank overdraft and a long term loan of RM600,000.

Banking facilities are secured by a fixed and floating charge on the leasehold factory and
other assets of the company.

The company purchases its main raw material (i.e. wood) from timber wholesalers. It sells
about 80% of its production to local and national builders of new domestic houses.

Required:

(a) Based on the excerpts of the financial statements provided, what are the relevant
factors you would consider in determining whether the company is facing a going
concern issue?

(b) What are the audit procedures that should be conducted in reviewing the going
concern problem?

Answer:

The following significant accounting ratios are based on the accounts provided in the
question:

2011 2012 2013

Gross profit (%) 14.20 20.20 19.70
Other expenses sales (%) 14.40 14.40 15.30

9
 Interest sales (%} 5.20 5.50 6.20
Net profit (%) (5.40) 0.30 (1.80)
Current Ratio 0.73 0.73 0.76
Liquidity ratio 0.46 0.37 0.34
Gearing 9.52 9.58 20.69
Stock (months) 2.28 2.77 3.57
Debtors (months) 3.24 2.26 2.32
Creditors (months) 4.43 3.98 5.09

Notes:
Stock age = year end stock x 12
Cost of sales
Debtors age = year end debtor x 12
Sales
Creditor age = year end creditor x 12
Cost of goods sold
Gearing = long term loans + bank overdraft + hire purchase
Shareholders funds

(a) The various factors in the accounts which may be indicative of going concern
problems

 Losses or low profits only being made - the company is not generating enough
funds to finance the expansion required
 Increase in bank overdraft
 Signs of overtrading
 High and increasing gearing
 Low current ratio
 Low and decreasing liquidity ratio
 Increasing stock levels
 Increasing value and age of creditors
 High and increasing interest charges
 Fluctuating gross profit

(b) Important steps to be taken by the auditor in determining whether or not the
company may be properly regarded as a going concern at year end

 Reviewing carefully the cash and profit forecasts for the next year to see if they
suggested any improvement in the company’s position
 Seeking some evidence that the company’s bank is prepared to continue supporting
the company
 Review the level of post balance sheet trading to see if this supports the forecasts
and show any signs of improvement in the company’s position

10
 Examine correspondence files for any evidence that creditors might be putting
pressure on the company for repayment of amount owing
 Consider how the company’s position compares with similar companies in the
same business
 Generally discuss the situation with management and review any recovery plans
which they have in mind
 Request for written representation from management-ISA 580

Question 4
EastVale Co manufactures a range of dairy products (for example, milk, yoghurt and
cheese) in one factory. Products are stored in a nearby warehouse (which is rented by
EastVale) before being sold to 350 supermarkets located within 200 kilometres of
EastVale’s factory. The products are perishable with an average shelf life of eight days.
EastVale’s financial statements year-end is 31 July.

It is four months since the year-end at your audit client of EastVale and the annual audit
of EastVale is almost complete, but the auditor’s report has not been signed.

The following events have just come to your attention. Both events occurred in late
November.

(a) A fire in the warehouse rented by the company has destroyed 60% of the inventory
held for resale.

(b) A batch of cheese produced by EastVale was found to contain some chemical
impurities. Over 300 consumers have complained about food poisoning after eating the
cheese. 115 supermarkets have stopped purchasing EastVale’s products and another 85
are considering whether to stop purchasing from EastVale. Lawyers acting on behalf of
the consumers are now presenting a substantial claim for damages against EastVale.

Required:
In respect of EACH of the events at EastVale Co mentioned above:

State, with reasons, whether or not the financial statements for the year-end require
amendment
Answers:
Amendment to financial statements
Fire at warehouse

– Enquire whether the directors have considered whether the event needs disclosure in
the financial statements.  Disclosure is unlikely given that the inventory was not in
existence at the year-end and on the assumption that insurance is adequate to cover the
loss.

11
– Amendment is not required as the fire did not affect any company property and the
inventory would not have been in existence at the yearend (inventory turn being very
high).

Batch of cheese

– The event should be disclosed in the financial statements in accordance with IAS 37
(MFRS 137) Provisions, Contingent Liabilities and Contingent Assests as it may have a
significant impact on EastVale. Over two-thirds of EastVale’s customers have either
stopped purchasing products from the company or are considering taking this action.

– No adjustment is required for the event itself as it was not a condition at the balance
sheet date.

– However, the event may become adjusting if company’s reputation has been damaged
and the amount of the legal claim is significant. In this situation the directors may decide
that EastVale is no longer a going concern so the financial statements may have to be re-
drafted on a break-up basis. This action complies with International Accounting Standard
1(MFRS 101); the break-up basis is used where the directors have no realistic alternative
but to liquidate the company.

Question 5
During the audit of Sutera Bhd, the auditor has satisfactorily completed the examination
of the accounts payable and other liabilities and now plans to determine whether there are
any contingent liability arising from litigation and claims.
Required:

What audit procedures should the auditor follow to determine whether there is any
contingent liability arising from litigation and claims?

Answer

Audit procedures to determine the existence of contingent liability arising from litigation
and claims should include the following:
• Inquire and discuss with directors or appropriate level of management the policies
and procedures adopted for identifying, evaluating, and accounting for litigation
and claims.
• Obtain from management a description and evaluation of litigation and claims
that existed at the date of the balance sheet being reported on, and during the
period from the balance sheet date to the date the information is furnished,
including an identification of those matters referred to legal counsel, and obtain
assurances from management, ordinarily in the form of a representation letter, that
they have disclosed all such matters required to be disclosed by approved
accounting standards.

12
• Examine documents in the client's possession concerning litigation and claims,
including correspondence and invoices from lawyers.
• The auditor should request the client's management to send a letter of inquiry to
those lawyers with whom they consulted concerning litigation, claims, and
assessments.
• Obtain assurance from management, ordinarily in the form of a representation
letter, that they have disclosed all unasserted claims that the lawyer has advised
them are probable of assertion.

Examples of other procedures undertaken for different purposes that might also disclose
contingent liability arising from litigation and claims are the following:
• Reading minutes of shareholders, directors, and appropriate committee meetings
held during and subsequent to the period being audited.
• Reading contracts, loan agreements, leases, and correspondence from IRB or
other governmental agencies, and similar documents.
• Obtaining information concerning guarantees from bank confirmation letters.
• Inspecting other documents for possible guarantees by the client.

Question 6
that the company has recently lost a major government contract. You know that Excel’s
projections include a major share of the work from this contract. The company has been
experiencing some cash flow difficulties, although this is not unusual in the industry.
Management has recently fully extended their bank credit facility in order to pay day to
day expenses. The audit partner is concerned that the company may be facing going
concern problem, but the managing director maintains that they intend to cut back future
capital expenditure to alleviate the going concern issue.

Required:

a. Identify five indicators of a financial nature that may arise doubt on an entity’s
ability to continue as a going concern.
b. In addition to the plan of action mentioned by the managing director, what are other
possible mitigating factors that may help a company to alleviate its going concern
problem?
c. What evidence should the auditor obtain with respect to management’s plan about
the various mitigating factors identified in part (b)?

Answer
a. Examples of a financial nature that may raise doubt on an entity’s going concern
ability include:
 Recurring operating losses.
 Accumulated deficit or current-year deficit.
 Negative net worth.
 Negative working capital.

13
  Negative cash flow.
 Inability to meet interest payments.

b. Other possible mitigating factors include:

 The ability to raise additional equity.
 The ability to extend even further the credit period being taken from
suppliers; conversely, the ability to improve debt collection.
 The willingness of a third party or affiliated company to guarantee the
company’s liabilities.
 The ability to obtain additional financing by leasing, factoring, or further
borrowings.
 Extending the overdraft arrangement.
 The sale and leaseback of plant and/or other capital assets.
 The company could factor its debtors.

c. The evidence to be obtained should be in relation to any six (6) of the following
factors:
 Cutting back or deferring capital expenditure commitments—the auditor
should identify future capital expenditures and assess just how crucial
these are to the future viability of the company. The auditor would need to
sight budgets and forecasts of capital commitments.
 Disposal of surplus assets should be tested by examining subsequent sales
of such assets (in the period after audit; it is expected that if truly surplus
there will have been attempts to sell them). In addition, contracts for sale
could be examined. The auditor should consider the marketability of these
assets by considering how frequently such assets are sold in the market
place.
 The potential of debt restructuring or extending the maturity of loans—the
auditor would want to sight correspondence from the company’s lenders to
confirm that this was indeed feasible. If the debt has been restructured
after year-end, inspect the restructure documentation.
 The auditor will need to ascertain existing financing arrangements and
assess the feasibility of obtaining new or extended terms. The auditor
should examine the existing loan agreement and determine to what extent
the facility has been utilised and whether the proposed further extension
will be granted by the lender. The auditor should also check that all
relevant loan covenants have been, and, to all intents and purposes, will
continue to be, complied with.
 The auditor should sight bank documentation and any relevant
correspondence from the company’s bankers.
 The auditor should ask management to show proposal details of any sale
and leaseback arrangements.
 Sight documentation showing third party guarantees.
 The cost/benefit of factoring the company’s debtors ledger needs to be
addressed. Again, the auditor would be asking management to provide

14
 evidence that they have done their sums properly and that this is a valid
option. Inspect documentation if the factoring has taken place after year-
end.
 Question 7

Zeta Software Bhd (ZSB) was incorporated in 1987 as a pioneer specialized in software
applications in the IT industry. The company develops both off-the-shelf packages
software and tailored software to order, mainly for business applications. The off-the-
shelf packages require substantial investment in R&D and intellectual capital before they
are ready to be marketed. To fund these needs, ZSB went public with an initial public
offering in 2004. The public offering was successful and ZSB’s ambitions management is
convinced that they must report a good profit this year (2006) to maintain the current
market price of the shares. ZSB’s chairman recently stressed this point when he told his
chief accountant, Alladin, “If we don’t make RM1.25 million pre tax this year, our shares
will fall significantly.”

Alladin was pleased that even after adjustments for accrued vacation pay, 2006 pre tax
profit was RM1.35 million. However, ZSB’s auditors, Haris & Co., also insisted that
RM450,000 in the capitalized software development account should be expensed, an
additional adjustment that would reduce the profit to RM900,000. This RM450,000 is
related to a project not yet completed but in relation to which the nearest competitor had
just launched an advertising campaign and begun marketing and off-the-shelf application.
The auditor argued that recovery of this expenditure was no longer assured beyond any
reasonable doubt and that the amount should be expensed.

The issue of accrued executive vacation pay arose in 2004 and 2005. At that time the
auditors did not insist on the adjustment because the amount was not material to the
years. The cumulative accrued executive vacation pay amounts to RM300,000 and has
been accrued at the end of 2006.

The audit partner, Haris, insisted that ZSB should make the adjustment for the softwares,
but the auditors was adamant. Alladin knew that the development cost of the software
was now worthless, but he reminded the auditor of the importance of this year’s reported
profit. Alladin continued his argument, “You can’t take both the write-off and the
vacation accrual in one year; it doesn’t fairly present our performance this year. If you
insist on taking that write-down, I am taking back the accrual. Actually, that’s a good
idea because the executives are such workaholics, they don’t take their vacations
anyway.”
As Alladin calmed down, he said, “Haris, let’s be reasonable; we like you – and we want
to continue our good working relationship with our firm into the future. But we won’t
have a future unless we put off this accrual for another year.”

Required:

Identify the relevant audit issues in this case and suggest the course of action the auditor
of ZSB should take.

15
Answer:

This case presents a realistic situation that can arise on an audit engagement. The main
issue of the case is whether the auditor needs to require the client to make adjustments to
the financial statements for possible misstatements that have been identified during the
audit. These proposed adjustments can result in conflicts between the auditor and client.

The first issue is the writing off of the software development account of RM 450,000.
(Materiality RM 450k/RM 1,350 k x100%- 33.3% , material misstatement, benchmark
against 5%) The auditors are of the opinion that since the competitor is already marketing
the software, recovery of the development expenses would no longer be assured. The
criteria pertaining to the amortization of development expenditure under MFRS 138
(intangible assets) are no longer applicable. Thus, the amount should be written in full
immediately.

The second issue relates to the accrued executive vacation pay. In previous years, the
auditors waived the adjustment for accrued vacation pay based on materiality
considerations. By 2006, the amount of accrued vacation pay amounted to RM300,000.
(Materiality RM 300k/RM 1,350 k x100%- 22.2% , material misstatement, benchmark
against 5%)
Since accrual of such expense is required under accounting standards and the amount is
material, the auditor should insist on accruing the executives' vacation pay. The
requirements for provision under MFRS 137 are satisfied (Present obligation, probable,
the economic outflow can be reliably estimated)

It is difficult to provide detailed guidance on how the auditor should handle the client's
demands. The audit partner should try to explain to the client that approved accounting
standards requires that such adjustments be made to make the financial statement present
a true and fair view. He should point out that under the Companies Act, 2016, it is the
directors’ responsibility to ensure that financial statements prepared are in conformity
with approved accounting standards. The audit partner should also point out that
shareholders might react very negatively if they discovered that management was
manipulating earnings from period to period in order to maintain the share's price. If the
audit partner is of the opinion that both adjustments are necessary, he must require the
client to make the adjustments. He should inform the chairman and board of directors of
the company of the possible effect on the auditor's report.

In the event that the client refuses to make the necessary adjustments, it will be
considered as “financial statements are materially misstated” (previously known as
disagreement) the auditor should consider issuing a qualified opinion (true & fair except
for) or “adverse opinion” if the auditors considers impact of misstatement to the financial
statements is so material and pervasive.

16
Question 8
Grains Sdn Bhd (Grains) manufactures breakfast cereals and has three factories, four
warehouses and three distribution depots spread across North America. The audit for the
year ended 31 December 2019 is almost complete and the financial statements and audit
report are due to be signed shortly. Profit before taxation is RM7·9 million. The
following events have occurred subsequent to the year end and no amendments or
disclosures have been made in the financial statements.

Event 1 – Fire

On 15 February 2020, a fire occurred at the largest of the distribution depots. The fire
resulted in extensive damage to 40% of the company’s vehicles used for dispatching
goods to customers; however, there have been no significant delays to customer
deliveries. The company estimates the level of damage to the vehicles to be in excess of
RM 650,000. Only a minimal level of inventory, approximately RM25,000, was
damaged. Grain’s insurance company has started to investigate the fire to assess the
likelihood and level of payment, however, there are concerns the fire was started
deliberately, and if true, would invalidate any insurance cover.

Event 2 – Inventory

On 18 February 2020, it was discovered that a large batch of Grain’s new cereal brand
‘Loopy Green Loops’ held in inventory at the year end was defective, as the cereal
contained too much green food colouring. To date no sales of this new cereal have been
made. The cost of the defective batch of inventory is RM915,000 and the defects cannot
be corrected. However, the scrapped cereal can be utilised as a raw material for an
alternative cereal brand at a value of RM50,000.

Required:
For each of the two subsequent events described above:
(i) Based on the information provided, explain whether the financial statements require
amendment; and
(ii) Describe audit procedures which should now be performed in order to form a
conclusion on any required amendment.

Answers
Subsequent events
Event 1 – Fire
A fire has occurred at the largest of the company’s distribution depots and property, plant
and equipment in excess of RM 650,000 has been damaged as well as inventory of
$25,000.

17
The company has contacted its insurance company and they have begun to investigate the
likelihood and level of any payment.

This event  occurred after the reporting period and is not an event which provides
evidence of a condition at the year end and hence this is a non-adjusting event.

Normally as the company is insured, only uninsured losses suffered by Grains 4U Co

(Grains) would need to be accounted for, which in the normal course of events would be
an immaterial amount.

However, the insurance company is investigating, as there is a possibility the fire was
started deliberately, and this would invalidate the insurance policy.

If this is the case, the total damaged assets of RM 675,000 (650 + 25) would be material
as they represent 8·5% (675/7,900) of profit before tax.

Therefore as a material non-adjusting event, the assets should not be written down to
their scrap value in the current year financial statements; however, the directors should
include a disclosure note detailing the fire and the total value of assets which may be
impacted due to the possibility of a lack of an insurance settlement.

The following audit procedures should be applied to form a conclusion on any

amendment:

– Obtain a schedule showing the damaged property, plant and equipment and agree the
net book value to the non-current assets register to confirm the total value of affected
assets.

– Obtain a breakdown of the inventory stored at the distribution centre on 15 February

2016 and compare to earlier records or despatch documents to ascertain the likely level of
inventory at the time of the fire.

– Review any correspondence from the insurance company confirming the amount of the
claim, and the current status of their investigation into the fire and any likely payments to
assess the extent of any uninsured amounts.

– Discuss with the directors whether they will disclose the effect of the fire, as a non-
adjusting event, in the year-end financial statements.

Event 2 – Inventory
Grains has identified that inventory at the year end with a cost of $915,000 is defective,
due to an excessive amount of food colouring; the scrap value of this inventory is
$50,000.

This information was obtained after the year end but provides further evidence of the net
realisable value of inventory at the year end and hence is an adjusting event.

18
IAS 2 (MFRS 102) Inventories requires that inventory is valued at the lower of cost and
net realisable value. The inventory of RM 915,000 must be written down to its net
realisable value of RM 50,000.

The write down of RM 865,000 (915 – 50) is material as it represents 10·9% (865/7,900)
of profit before tax. Hence, the directors should amend the financial statements by
writing down the inventory to RM 50,000.

The following audit procedures should be applied to form a conclusion on the

adjustment:

– Discuss the matter with the directors and enquire if they are prepared to write down the
cost of the inventory to net realisable value.

– Review the board minutes to assess whether this event was the only case of defective
inventory as there could potentially be other inventory which requires writing down.

– Obtain a schedule showing the defective inventory and agree to supporting production
documentation that it was produced prior to 31 December, as otherwise it would not
require a write down at the year end.

– Discuss with management how they have assessed the scrap value of $50,000 and agree
this amount to any supporting documentation to confirm the value.

Question 9
Leslie Morgan, CPA, has prepared a letter of representation for the president and
controller to sign. It contains references to the following items:
1. Inventory is fairly stated at the lower of cost or market and includes no obsolete
items.
2. All actual and contingent liabilities are properly included in the financial
statements.
3. All subsequent events of relevance to the financial statements have been disclosed.

Required:

a. Why is it desirable to have a letter of representation from the client concerning

these matters when the evidence accumulated during the course of the audit is
meant to verify the same information?
b. To what extent is the letter of representation useful as audit evidence? Explain.

Answer:

19
a. It is desirable to have a letter of representation ISA 580 in spite of the accumulated
audit evidence to impress upon management its responsibility for the
representations in the financial statements and to formally document the responses
from the client to inquiries about various aspects of the audit.

c. The letter of representation is not very useful as audit evidence since it is a written
statement from a non-independent source. In effect, the client being audited
makes certain representations related to the audit of itself.

Question 10
In analyzing legal expense for the Boastman Bottle Company, Mary Little, CPA,
observes that the company has paid legal fees to three different law firms during the
current year. In accordance with her CPA firm’s normal operating practice, Little
requests standard attorney letters as of the balance sheet date from each of the three law
firms.

On the last day of field work, Little notes that one of the attorney letters has not yet been
received. The second letter contains a statement to the effect that the firm deals
exclusively in registering patents and refuses to comment on any lawsuits or other legal
affairs of the client. The third attorney’s letter states that there is an outstanding unpaid
bill due from the client and recognizes the existence of a potentially material lawsuit
against the client but refuses to comment further to protect the legal rights of the client.

Required:

a. Evaluate Little’s approach to sending the attorney letters and her follow-up on the
responses.
b. What should Little do about each of the letters.

Answer:

a. In this situation, Little need only send requests for letters to those attorneys who are
involved with legal matters directly affecting the financial statements. The letters
should be sent reasonably near to the completion of the field work, but the follow-
up on nonresponses and unsatisfactory responses should not be deferred until the
last day of field work. She should have examined the letters when they were
returned and performed follow-up work at that time. Furthermore, the third letter
should have addressed the lawsuit if the client informed the auditor of its existence.

b.

20
  The auditor would be required to follow up on the first attorney's letter by
sending a second request or calling the attorney to solicit a response.

 The second letter would not require any additional follow-up due to the nature of
the work performed by this attorney.

 Regarding the third attorney's letter, it is necessary to have a conference with

the attorney, client, and auditor to determine the nature and significance of the
lawsuit. It would be a serious violation of due care to ignore the information in
the third attorney's letter. Auditor can consider qualified opinion on the ground
of in ability to obtain sufficient appropriate evidence. In rare circumstances, a
disclaimer of opinion is necessary if the information cannot be obtained.

Question 11
Ben and Alex Bradley have a sister, Jo, who runs an interior design company, Lantern
Sdn Bhd. During a review of board minutes, performed as part of the planning of Bill
Bhd’s audit, it was discovered that Bill Bhd has paid RM 225,000 to Lantern Sdn Bhd
during the year, in respect of refurbishment of development properties. On further
enquiry, it was also found that Lantern Sdn Bhd leases an office space from Bill Bhd,
under an informal arrangement between the two companies.

Required:

(i) Explain the inherent limitations which mean that auditors may not identify related
parties and related party transactions; and

(ii) Recommend the audit procedures to be performed in relation to Bill Bhd’s

transactions with Lantern Sdn Bhd.

Answers:

(i) Related parties, and related party transactions can be difficult to identify. Management
may be unaware of the existence of all related party relationships and transactions,
resulting in them not being revealed to the auditor on enquiry.

Auditors of smaller companies can often find it difficult to identify related parties
because management does not understand the disclosure requirements or the significance
of the disclosures required.

It can also be difficult to decide if a related party relationship exists, as some of the
definitions in MFRS 124 Related Party Disclosures are subjective, also resulting in non-
disclosure to the auditor of potential related parties and transactions.

Management of larger companies may have a better understanding of recording and

disclosing related party transactions. However auditors of the larger companies have to

21
deal with larger more complex transactions that can be more difficult to understand and
follow.

There could also be a deliberate attempt by management to conceal related party

relationships or transactions. Knowledge of related party relationships is largely confined
to management, and in the absence of alternative procedures other than management
enquiry, the auditor could not know of the existence of some related party relationships,
especially the family members of key management personnel. ISA 550 Related Parties
identifies that related party relationships may represent a greater opportunity for
collusion, concealment or manipulation by management.

The accounting system may not be set up to identify related party transactions. For
example, cash payments made to a related party may not be separately identified from
payments to trade suppliers within the ledgers.

Finally, some related party transactions occur at minimal value, and sometimes at nil
value. This makes the transaction almost impossible for the auditor to detect, other than
relying on management to disclose the transaction on enquiry.

(ii) Audit procedures should include:

– Review invoices received from Lantern S/B to verify the amount of the expense.
Confirm cash payments to the cash book.
– Inspect Lantern S/B’s trade payables account to confirm any amount outstanding at the
year end.
– Compare the cost of refurbishment carried out by Lantern S/B to the cost of
refurbishment carried out by other suppliers, to determine if the transaction is at arm’s
length.
– Discuss the informal lease with management, and obtain a written representation
regarding the nature of the arrangement, and whether any amount is payable to Bill S/B.
– Confirm through enquiry with management the date the lease arrangement commenced,
and the expected period of the lease.
– Enquire if any written documentation exists regarding the lease arrangement, if so,
review and place on file.
– Review the disclosure made (if any) regarding these transactions in the draft financial
statements.(MRFS 124)

Question 12
The following are independent situations for which you will recommend an appropriate
audit report:

I. You are the auditor of Star Bhd., and you learnt that a recent fire caused
heavy damage to one of the client’s two plants and the loss will not be
reimbursed by insurance. The client did not disclose the loss caused by
fire in the financial statements.

22
 II. During the course of the audit of the financial statements of Gemilang
Bhd., the auditor was refused permission to inspect the minute books
containing the significant decisions from the board of directors’
meetings.

III. An auditor is engaged in the audit of the financial statements of Laju

Bhd., a large manufacturing company with branch offices in many
widely separated cities. The auditor was not able to count the
substantial undeposited cash receipts at the close of business on the last
day of the fiscal year at all branch offices. The management refused to
provide any evidence related to the undeposited cash receipts to the
auditor. The auditor was not able to satisfy himself as to the cash
receipts by alternative procedures.

IV. Salt Technology Bhd., has prepared financial statements but has
decided to exclude the statement of cash flows. The management
explained to you that the users of the financial statements find that the
statement of cash flows are rather confusing to understand and prefer
not to have it included.

V. During your audit of Danga Bhd., you concluded that there is a

possibility that inventory is materially overstated. The client refused to
allow you to expand the scope of your audit sufficiently to
verify whether the balance is actually misstated.

Answers

(a)

(i) (ii) (iii)

CONDITION TYPE OF COMMENT

REPORT
I. Failure to Qualified Disclosure of this information is required in a
follow approved opinion only — footnote. Failure to do so is a violation of
accounting except for approved accounting standards and is likely to
standards has result in a qualified opinion.
led to material
misstatement
(MFRS 137-
Contingent
liability)
II. Inability to Disclaimer Failure of the client to allow the auditor to
obtain sufficient inspect the minutes book would be a material

23
 appropriate and pervasive client-imposed restriction. Due
evidence. to the importance of the minutes book, a
(Scope of the disclaimer would be necessary. The certified
audit has been copy of all resolutions and actions would not be
restricted). a satisfactory alternative procedure.
III. Inability to Qualified Because the auditor was unable to satisfy
obtain sufficient opinion –True & himself about the undeposited cash receipts, it
appropriate Fair except for would be necessary to issue a qualified opinion
evidence. on the income statement and statement of cash
(Scope of the flows as well as the beginning balance sheet.
audit has been
restricted).
IV. Failure to Qualified The standards require the use of a qualified
follow opinion only — opinion for the failure to include a statement of
approved except for cash flows. Third paragraph must be added
accounting stating the omission.
standards has
led to material
misstatement
(MFRS 107)
V. Inability to Disclaimer Because the client refuses to allow the auditor
obtain sufficient to expand the scope of his audit, a disclaimer of
appropriate * if the impact opinion is appropriate rather than a qualified
evidence. to FS is opinion.
(Scope of the material can
audit has consider
been restricted) qualified
opinion-true &
fair except for

Question 13 –Self-practice
Colorful Designs Bhd. is a kitchen manufacturing company and the company’s year
end is 30 April. You are the audit manager of Terence & Co and have been
provided with the information as follows:

Recently, Colorful Designs Bhd. has been experiencing trading difficulties, as

its major customer who owes them RM850,000, ceased trading. However, the
balance is included in the financial statements. The sales director has left
Colorful Designs Bhd. and yet to be replaced.

The monthly cash flow has shown a net cash outflow for the last two months
of the financial year and is forecast as negative for the forthcoming financial
year. As a result of this, the company has been slow in paying its suppliers
and some are threatening legal action to recover the sums owing.

24
 Due to its financial difficulties, Colorful Designs Bhd. missed a few months
of instalment for loan repayment. As a result of this breach in the loan
covenants, the bank has asked that the loan of RM5 million to be repaid in
full within four months. The directors have decided to maintain the liquidity
level, as such no final dividend will be paid in 2019.

Required:

(i) Briefly explain SIX (6) potential indicators that Colorful Designs Bhd.
may face any going concern issues.

(ii) Describe EIGHT (8) audit procedures that Terence & Co should
perform in assessing going concern issues.

(i) Going concern indicators

(i) A major customer of Colorful Designs Bhd. has ceased

trading owing them RM850,000. This will result in a
significant loss of future revenues and profit, and unless this
customer can be replaced then there will be a reduction of
future cash flows.

(ii) The sales director has recently left the company and has yet to
be replaced. Loss of a key director will impact on the
company’s sales, as Colorful Designs Bhd. has already lost a
major customer, then without an experienced sales director
to generate new sales the company will face significantly
reduced sales and cash flows.

(iii) Colorful Designs Bhd. is experiencing negative monthly cash

flows and this is expected to continue. If the company
continues to have cash outflows then it will increase its
overdraft further and will start to run out of available cash.

(iv) The company has been late paying some of its suppliers. If
suppliers are being paid late then they may refuse to supply
Colorful Designs Bhd. with goods or impose ‘cash on
delivery’ terms which will disrupt service or sales to customers.

(v) A number of the suppliers are threatening legal action. If this

occurs then Colorful Designs Bhd. will have legal costs on
top of the amounts owed already and this will further
increase the pressure on cash flows. In addition, other
suppliers may hear about the legal action and, as a result, stop
supplying goods to Colorful Designs Bhd.

25
 (vi) Colorful Designs Bhd. has missed a loan repayment which is
a breach in the loan covenant and hence the loan of RM5M
is now all repayable. The company only has six months to
raise RM5M as it currently stands they do not have this
level of cash available and unless they are able to raise
alternative finance or sell noncurrent assets, it is difficult to see
how they will be able to raise this amount.

(vii) In order to conserve cash Colorful Designs Bhd. has decided

not to pay a final dividend for 2019. This may result in
shareholders losing faith in the company and they may attempt
to sell their shares; in addition, they are highly unlikely to
invest further equity, and Colorful Designs Bhd. urgently needs
to raise finance to repay their loans.

(ii) Going concern procedures

 Obtain the company’s cash flow forecast and review the cash in
and out flows. Assess the assumptions for reasonableness and
discuss the findings with management to understand if the
company will have sufficient cash flows.
 Perform a sensitivity analysis on the cash flows to understand the
margin of safety the company has in terms of its net cash in/out
flow.
 Discuss with the finance director whether the sales director has
yet been replaced and whether any new customers have been
obtained to replace the one lost.
 Review the company’s post year-end sales and order book to
assess if the levels of trade are likely to increase and if the
revenue figures in the cash flow forecast are reasonable.
 Review the loan agreement and recalculate the covenant which
has been breached. Confirm the timing and amount of the loan
repayment.
 Review any agreements with the bank to determine whether any
other covenants have been breached, especially in relation to the
overdraft.
 Discuss with the directors whether they have contacted any
alternative banks for finance to assess whether they have any
other means of repaying the loan of RM5m.
 Review any correspondence with shareholders to assess whether
any of these are likely to increase their equity investment in the
company.
 Review post year-end correspondence with suppliers to identify if

26
 any others have threatened legal action or refused to supply
goods.
 Enquire of the lawyers of Colorful Designs Bhd. as to the
existence of any additional litigation and request their assessment
of the likely amounts payable to the suppliers.
 Perform audit tests in relation to subsequent events to identify any
items that might indicate or mitigate the risk of going concern not
being appropriate.
 Review the post year-end board minutes to identify any other
issues that might indicate further financial difficulties for the
company.

 Review post year-end management accounts to assess if in line

with cash flow forecast.
 Consider whether the going concern basis is appropriate for the
preparation of the financial statements.
 Obtain a written representation confirming the director’s view
that Colorful Designs Bhd. is a going concern.

Question 14 (Self Practice)

You are the auditor of Shukri Bhd, a company which manufactures and sells
chemical pesticides and related products. The audit of Shukri Bhd for the year
ended 31 December 2018 revealed the following events:

Date Event
15 February One of the major customers, representing 25% of the
2019 trade receivables in the statement of financial position,
went into receivership.

21 March 2019 Financial statements approved by directors.

22 March 2019 Audit work completed and auditor’s report signed.

1 May 2019 Toxic pesticide chemicals were accidentally released
into the air from the company’s factory resulting in
health hazards to the community of residents living
within the radius of 10 km.
23 May 2019 Financial statements issued to members of Shukri Bhd.

Required:

(i) Explain the auditor’s responsibilities for identifying subsequent events

in the following periods:
- 31 December 2018 to 21 March 2019

27
 - 22 March 2019 to 23 May 2019

(ii) Explain whether or not the financial statements need to be amended in

respect of the events occurring on the following two dates:
- 15 February 2019
- 1 May 2019

Answers:

(i) Auditor’s responsibilities for identifying subsequent events.

31 December 2018 to 21 March 2019

The auditor is responsible in identifying material subsequent event
affecting financial statement by performing audit procedures during
this period. This is because the event happened after the balance
sheet date and before the financial statement and the audit report is
being signed.

22 March 2019 to 23 May 2019

Auditor is not responsible to perform audit procedures to ensure all
material subsequent events have been identified. This is because the
date falls after the financial statement and the audit report have been
signed before the financial statement issued.

(ii) Event on 15 February 2019

Bankruptcy of major customer
 Event is an adjusting event because it provides further evidence
on condition existing on the date of Financial Statements.
 The information on bankruptcy of existing customers reflects the
actual receivables valuation collectible at the financial year end of
31 December 2018.
 Adjustment is to be made on receivables in balance sheet on 31
December 2018 by recognising the bad debts and decreasing the
amount of receivables. If adjustments are not made will result in
receivable and profit being overstated

Event on 1 May 2019

Accidental release of toxic pesticide chemicals

28
  Event is a non-adjusting event as it provides evidence on the
condition (condition of the event leading to the potential legal
case did not exist) which occur after the date of Financial
Statements.
 As the impact of the accident is significant and material which
might be subject to legal action by the authorities and by the
residents, disclosure on the event and its potential impact need to
be made in the notes during the financial year end.

Question 15(Self Practice)

The IAASB has published the Exposure Draft, Proposed ISA 540 (Revised) Auditing
Accounting Estimates and Related Disclosures (ED-540) stating ‘The objective of ED-
540 is for the auditor to obtain sufficient appropriate audit evidence to evaluate whether
accounting estimates and related disclosures are reasonable in the context of the
applicable financial reporting framework, or are misstated. ED-540 includes enhanced
requirements for risk assessment procedures and the auditor’s work effort in responding
to the assessed risks of material misstatement to support this evaluation.’

Required:
Explain why accounting estimates are considered to be a source of high audit risk
and discuss the reasons for the development of ED-540 commenting on its proposals
for an enhanced risk assessment in relation to the audit of accounting estimates.

Answers
ED-540 Auditing Accounting Estimates and Related Disclosures
In April 2017, the IAASB issued Proposed International Standard on Auditing 540
(Revised) Auditing Accounting Estimates and Related Disclosures (ED-540).The IAASB
has sought to make ED-540 scalable, recognising that the standard applies to all
accounting estimates from the simplest depreciation calculation through to the most
complex of derivative financial instruments and expected credit losses.

While the simpler accounting estimates will not generally give rise to high audit risk,
many measurements based on estimates, including fair value measurements and
impairments in relation to financial instruments, are imprecise and subjective in nature
and will give rise to high inherent risk. Such fair value and impairment assessments are
likely to involve significant, complex judgements, for example, regarding market
conditions, the timing of cash flows and the future intentions of the entity.

The valuations will often involve complex models built on significant assumptions such
as the predicted timing of cash flows, the most appropriate discount factor to use and

29
judgements about probability weighted averages. Management may not always have
sufficient knowledge and experience in making these judgements.

Moreover, there may even be a deliberate attempt by management to manipulate the

value of an estimate in order to window dress the financial statements. Professional
scepticism is key to the audit of accounting estimates and ED-540 contains provisions
which are designed to enhance the auditor’s application of professional scepticism and a
consideration of the potential for management bias.

Outreach activities with regulators and other key stakeholders pointed to the need for the
IAASB to focus attention on revisions to ISA 540 Auditing Accounting Estimates,
Including Fair Value Accounting Estimates, and Related Disclosures.

Feedback from the IAASB’s outreach projects revealed a perceived lack of consistency in
the extent to which auditors obtained an understanding of accounting estimates together
with evidence of insufficient and inappropriate work effort by auditors in this area.

The consultation process also identified a lack of professional scepticism being exercised
by auditors and a need for more specific risk assessment requirements and more granular
requirements regarding obtaining audit evidence. It also identified a need to enhance
communication between auditors and those charged with governance about accounting
estimates and in particular the auditor’s views about significant qualitative aspects of the
entity’s accounting practices.

The objective of ISA 540 is for the auditor to obtain sufficient appropriate evidence to
evaluate whether accounting estimates and related disclosures are reasonable in the
context of the relevant financial reporting framework or are misstated.

Consequently, ED-540 aims to include enhanced risk assessment requirements and the
draft standard emphasises that the risk of material misstatement in relation to the audit of
accounting estimates is impacted by three key factors: complexity, the application of
management judgement and estimation uncertainty. The increased emphasis on the use of
fair value measurement in IFRS Standards and the associated development of IFRS 13
Fair Value Measurement reflect the increasing complexity of the business environment.

Furthermore, given the increased emphasis on the use of external sources in IFRS 13 and
in making accounting estimates such as fair values, ED-540 aims to improve and clarify
the requirements on the use of such information as it is in the public interest to do so.

These factors, together with the implementation of IFRS 9 Financial Instruments and in
particular its complex and highly subjective expected loss approach to the measurement
of impairments and extensive disclosure requirements, highlighted a need to modernise
ISA 540 for evolving financial reporting frameworks.

The risk that an entity’s internal systems and controls fail to prevent and detect valuation
errors needs to be assessed as part of the overall assessment of audit risk. In relation to

30
complex fair value and impairment estimates, a particular problem is that the
measurement is likely to be performed infrequently for external reporting purposes and
outside the normal accounting and management systems.

This is especially true where the valuation is performed by an external specialist. As a

non-routine event, therefore, the assessment of fair value is likely not to have the same
level of monitoring or controls as a day-to-day business transaction and may give rise to
high control risk.

The auditor should always seek to manage detection risk at an acceptable level through
effective planning and execution of audit procedures. However, the audit team may lack
knowledge and experience in dealing with the estimation technique in question and
therefore may be unlikely to detect errors in the valuation and modelling techniques
applied by the client. Any resulting over-reliance on an external specialist could also lead
to errors not being identified.

Q 16-Self Practice

Answers

Indicator Why would impact going concern

If the company is not able to increase demand

for its products then it will struggle to
generate sufficient operating cash flows
Canvas has seen a significant decline leading to going concern difficulties. As the
in market is very competitive and Canvas has
demand for its products. only two products then it is very dependent
on these and must ensure that it makes
sufficient sales as otherwise it may face
difficulties in meeting all expenses.
As current products reach the end of their life-cycle
Lack of investment in future product they will bring in diminishing cash flows. Without
development new products to generate future income operating
cash flows will be strained.
If Canvas was unable to obtain finance for its
Canvas was unable to obtain suitable investment, then this could indicate that the banks
deem the company to be too risky to lend money to.
funding for its RM2 million They may be concerned that Canvas is unable to
investment in plant and machinery. meet its loan payments, suggesting cash flow
problems.
Failing to make payments to suppliers on time
could ultimately lead to some of them refusing to
Some trade payables have been paid supply Canvas. Therefore the company may need
much later than their due dates. to find alternative suppliers and they could be more
expensive which will decrease operating cash flows
and profits.
Some suppliers have withdrawn As Canvas must now make cash on delivery
credit terms from Canvas resulting in payments, then it puts additional pressure on the

31

cash on delivery payments.
The overdraft facility has increased
substantially and is due for renewal
next month.
The cash flow forecast has shown a
significantly worsening position.
The company is struggling to recruit
suitably trained staff to develop new
products.
company’s overdraft, which has already grown
substantially. This is because the company has to
pay for goods in advance but it may not receive
cash from its receivables for some time later.
Canvas’s overdraft has grown significantly and it is
heavily dependent on it to pay its expenses. If the
bank does not renew the overdraft and the
company is unable to obtain alternative finance
then it may not be able to continue to trade.
The future cash outflows are greater than the
inflows and this position is worsening rather than
improving. If Canvas cannot start to reverse this
position, then it may have difficulties in funding its
operating activities.
The company has decided that it needs to develop
new products, however, this is a highly specialised
area and therefore it needs sufficiently trained
staff. If it cannot recruit enough staff then it could
hold up the product development and stop the
company from
increasing revenue.

(ii)
 Obtain the company’s cash flow forecast and review the cash in and
out flows. Assess the assumptions for reasonableness and discuss the
findings with management to understand if the company will have
sufficient cash flows.
 Perform a sensitivity analysis on the cash flows to understand the
margin of safety the company has in terms of its net cash in/out flow.
 Review any current agreements with the bank to determine whether
any key ratios have been breached.
 Review any bank correspondence to assess the likelihood of the bank
renewing the overdraft facility.
 Discuss with the directors whether they have contacted any
alternative banks for finance to assess whether they have any other
means of repaying the bank overdraft.
 Review the company’s post year-end sales and order book to assess
if the levels of trade are likely to increase and if the revenue figures
in the cash flow forecast are reasonable.
 Review post year end correspondence with suppliers to identify if
any further restrictions in credit have arisen, and if so ensure that the
cash flow forecast reflects an immediate payment for trade payables.
 Inquire of the lawyers of Canvas as to the existence of litigation and
claims, if any exist then consider their materiality and impact on the
going concern basis.
 Perform audit tests in relation to subsequent events to identify any
items that might indicate or mitigate the risk of going concern not
being appropriate.

32
  Review the post year end board minutes to identify any other issues
that might indicate financial difficulties for the company.
 Review post year end management accounts to assess if in line with
cash flow forecast.
 Consider whether any additional disclosures as required by
MFRS101 Presentation of Financial Statements in relation to
material uncertainties over going concern should be made in the
financial statements.
 Obtain a written representation confirming the director’s view that
Canvas is a going concern.

(iii) The directors of Canvas have agreed to make going concern

disclosures, however, the impact on the audit report will be dependent
on the adequacy of these disclosures. If the disclosures are adequate,
then the audit report will be unmodified. However, a material
uncertainty related to going concern paragraph would be
required. This will state that the audit report is not modified, identify
that there is a material uncertainty and will cross reference to the
disclosure note made by management, this paragraph would be
included after the opinion paragraph. If the disclosures made by
management are not adequate the audit report will need to be
modified. A material misstatement modification will be required,
depending on the materiality of the issue this will be either
qualified or an adverse opinion. A paragraph describing the matter
giving rise to the modification will be included just before the opinion
paragraph and this will clearly identify the going concern uncertainty.
The opinion paragraph will be amended to state ‘except for’ or the
accounts are not fairly presented

Q17
Glotier Bhd. (Glotier) operates a chain of food wholesalers across the
country and its financial year end is 31 December 2021. The company is
financed solely from equity including internally generated fund of the
company since incorporation.

The final audit is nearly complete and it is proposed that the financial
statements and audit report will be signed on 31 January 2022. Revenue
for the year is RM 200 million and profit before taxation is RM 30
million. Total assets amounted to RM 100 million.
The following events have occurred subsequent to the year end.

Event 1-Warehouse flooded

Glotier has three warehouses and following a heavy rain on 8 January
2022, the warehouse located in Shah Alam was flooded. All the inventory

33
 was damaged and has been written-off. The insurance company has
already been contacted. No amendments or disclosures have been made in
the financial statements.

Event 2-Lawsuit
A key supplier of Glotier is suing them for breach of contract. The lawsuit
was filed prior to the year end, and the sum claimed by them is RM 4
million. This has been disclosed as a contingent liability in the notes to the
financial statements. However, a correspondence has just arrived from the
supplier indicating that they are willing to settle the case for a payment by
Glotier of RM 1.8 million. It is likely that the company will agree to this.

Required:
For each of the two events above:
(i) Discuss the accounting treatment in financial statements of Glotier
for the financial year ended 31 December 2021.
(ii) Describe TWO (2) audit procedures that should be performed in
order to form a conclusion on the accounting treatment.
(iii) Explain the impact on the audit report should the issues remain
unresolved.

Event 1-Warehouse flooded

(i) The warehouse at Shah Alam has been subject to flood in early January 2022, the
entire inventory has been written off and the company has insurance in place. This event
occurred after the year end and the flood would not have been in existence as at 31
December, and hence this event indicates a non-adjusting event.

The financial statements should not be adjusted; however, if the impact of any
uninsured losses are material, then a disclosure of the nature of the event and any
estimates of the financial impact may be required. If the amount is not material then it
may not be necessary to include any disclosures.

(ii) The following audit procedures should be applied to form a conclusion as to the
extent of any disclosures:
 Discuss the matter with the directors, checking whether the company has sufficient
inventory to continue trading in the short term.
 Obtain a written representation confirming that the company’s going concern status
is not impacted.
 Obtain a schedule showing the inventory destroyed and compare this to the average
inventory in the other two warehouses to see if the amount claimed to be damaged is
reasonable.

34
 Review any correspondence from the insurers, confirming the amount of the
insurance claim to assess the extent of any uninsured amounts.

(iii) The amount of damaged inventory is likely to be material; however, the company has
insurance and so it is only the uninsured level of inventory which should possibly be
disclosed.
If disclosures are not required, because the uninsured loss is immaterial, then there will
be no reporting implications for the audit report.
If disclosure of this subsequent event is required and management refuse to make these
disclosures, then the audit report will need to be modified with a qualified ‘except for’
opinion.

Event 2-Lawsuit
(i) A key supplier is suing Glotier for RM4 million; the company has made contingent
liability disclosures. However, subsequent to the year end the supplier agreed to settle at
RM 1.8 million and it is likely the company will agree. The settlement was agreed after
the year end, it provides further evidence that the company had a present obligation as at
31 December 2021.
The financial statements should be adjusted with the contingent liability disclosures being
removed and instead a provision of RM 1.8 million being recorded.

(ii)
The following audit procedures should be applied to form a conclusion as to the level of
the adjustment:
 The auditor should contact the company’s lawyers to ask their view as to whether the
settlement is probable and whether RM 1.8 million is the likely amount.
 Review the correspondence with the supplier to confirm that the amount they are
willing to accept is in fact RM 1.8 million.
 Discuss with management as to whether it is probable that they will pay this sum and
obtain a written representation confirming this.

(iii) The sum being claimed is RM 2 million but the probable payment is RM 1.8 million,
this is material as it represents 6% of profit (1.8/30) and hence management should

35
provide for this. If management refuse to make a provision then the audit report will
need to be modified.
As management has not complied with MRFS 137 Provisions, Contingent Liabilities and
Contingent Assets and the error is material but not pervasive then a qualified opinion
would be necessary.

A basis for qualified opinion paragraph would be required and would need to include a
paragraph explaining the material misstatement in relation to the lack of a provision and
the effect on the financial statements. The opinion paragraph would be qualified
‘except for’.

36