Tutorial 3- Audit Risk and Materiality

MCQ
Q1. For a given assertion, the relationship between the level of detection risk (DR)
and assessed control risk (CR) and inherent risk (IR) is shown correctly in which
of the following, where + means increase, - means decrease:
a. +DR if +CR and +IR.
b. +DR if -CR and -IR.
c. +DR if +CR and -IR.
d. +DR if -CR and +IR.

Q2. If inherent risk and control risk are both assessed as low, detection risk will be:
a. low.
b. high.
c. the same as audit risk.
d. medium.

Q3. Inherent risk is defined in terms of:

a. a total absence of controls.
b. an ideal set of controls.
c. the existing controls.
d. the standard controls for the client's industry.

Q4. For a particular assertion, control risk is the risk that:

a. a material misstatement will occur in the accounting process.
b. audit procedures will fail to detect a weak control system.
c. control procedures will not detect a material misstatement that occurs.
d. the prescribed control procedures will not be applied uniformly.

Q5. When the lower assessed level of control risk approach is used, the final
assessment of control risk is made after completing:
a. the procedures to obtain an understanding.
b. the documentation of the understanding.
c. all the planned tests of controls.
d. all the above.

Q6. Professional standards recognise that a misstatement that is quantitatively

immaterial may be qualitatively material. In regard to these items, professional
standards require the auditor to:
a. plan the audit to search for them.
b. design explicit procedures to detect them.
c. be on the alert for them.
d. report them directly to client management.

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Q7. In making judgements about materiality at the account balance level, the auditor
must consider the relationship between it and overall materiality. This should lead
the auditor to plan the audit to detect misstatements that:
a. are individually material to the statements taken as a whole.
b. are individually immaterial to the statements taken as a whole.
c. bring the cumulative total of known misstatements to the level of materiality
established by management.
d. may be immaterial individually, but may aggregate with misstatements in
other accounts to a material level

Q8. All else being equal, as the level of materiality decreases, the amount of evidence
required will:
a. increase.
b. decrease.
c. remain the same.
d. change in an unpredictable fashion.

Short Essay questions

1) Discuss the component of the audit risk model and its limitation of audit risk
model. How the model may be used in planning and audit?

Pointers:
Audit risk is defined as the risk that the auditor may give an inappropriate OR
wrong opinion when he financial statements are materially misstated. The auditor’s
standard report states that the audit provides only reasonable assurance that the
financial statements do not contain material misstatements. The term “reasonable
assurance” implies that there is some risk that a material misstatement could be
present in the financial statements and the auditor will fail to detect it. For eg. Audit
Risk of 5% means that the is 5 chances in 100 of giving the wrong opinion.

Audit Risk Model:

Audit Risk(AR)= Inherent Risk (IR) X Control Risk(CR) X Detection Risk (DR)

Inherent Risk is the susceptibility of an assertion to material misstatement assuming

no related internal controls.(Risk or likelihood of material error being present in the
financial statement if there were no internal control operating) This types of risk
derives from 3 sources:

 Management integrity –mgt ‘s moral and ethical stance,

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  Account risk-the level of uncertainty or degree of judgement involved in an
account (eg provision of doubtful debt),
 Business risk –External and Internal eg the extent to which the client biz is
vulnerable to changes in the economy, competition and or technological
advancement.(Refer to the lecture notes for more examples)

Internal control Risk is the risk that material misstatement that occur will not be
prevented or detected by the internal controls. Some internal control risk will always
be present because any system of internal control has inherent limitations (eg
collusion)
Note: IR and CR are not under the direct control of Auditor, but with the
Auditee to certain extent.

Detection Risk- Detection Risk is the risk that the auditor will not detect a material
misstatement that exists in the financial statements. This risk can be influenced by the
auditor. Inherent risk and control risk differ from the detection risk in that they exist
independently of the audit of financial statements whereas detection risk relates to the
auditor ‘s procedures and can be changed at the auditor’s discretion. Detection risk
has and inverse relationship to inherent and control risk. Given the desired AR, if
IR and CR are assessed to be high, then, the amount of Substantive test will be
increased.
Note: DR can be decomposed further into Analytical Procedures risk (APR) and
Substantive test of details risk

The use of the model in planning the areas of the audit on which to concentrate (the
areas of greatest risk of material misstatement) and in planning the amount of detailed
testing should then follow.

The limitations of Audit Risk Model are as follows:

 First: the model assumes that its component are independent of one another
while they are likely to be dependent in the real world.

 Second: since the auditor assesses IR and CR, such assessments may be
higher or lower than the actual IR and CR that exist for the client

 Last, the audit risk model does not consider the possibility of non sampling
risk.
(An aspect of audit risk that results from an incomplete examination of the
available data. It is the failure of an auditor to catch a mistake or a
misstatement. This may be caused by either misinterpreting the evidence or
misapplying procedures that are inappropriate)

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 Indicate which of these components is under the control of the auditor and
indicate the relationship of this component to the other components of audit
risk.

Answers
The component that is under the control of the auditor is detection risk. There is an
inverse relationship between inherent and control risks and the level of detection
risk that the auditor can accept for an assertion.

Question 2
Distinguish between the terms tolerable misstatement and preliminary judgement
about materiality. How are they related to each other?
Answers:
A preliminary judgment about materiality is set for the financial statements as a
whole. Tolerable misstatement is the maximum amount of misstatement that would
be considered material for an individual account balance. The amount of tolerable
misstatement for any given account is dependent upon the preliminary judgment
about materiality. Ordinarily, tolerable misstatement for any given account would
have to be lower than the preliminary judgment about materiality. In many cases, it
will be considerably lower because of the possibility of misstatements in different
accounts that, in total, cannot exceed the preliminary judgment about materiality.

Question 3
Explain briefly what is meant materiality in the context of financial reporting and
discuss why this concept is important to the auditors.

Answers:

Materiality MFRS 101/ISA 320 Definition: Information is material if non

disclosure/omission could influence the economic decisions of users taken on the
basis of the financial statements. Materiality depends on the size of the item or error
judged in the particular circumstances of its omission or misstatement. The concept of
materiality is reflected in the wording of the auditors ‘standard audit report through
the phrase “the financial statements give true and fair view or present fairly in all
material respects.”This is the manner in which auditor communicates the notion of
materiality to the users of auditor’s report

Materiality is considered a relative concept because an amount such as RM 10K

might be considered highly material for a small entity but would be clearly
immaterial for a large multinational company with assets in billions. The is why the

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 calculation of the preliminary judgement is based on the relative size (eg total assets
or total revenues) of the entity. There is no specific guidance and it is a matter of
Professional Judgement

Qualitative and Quantitative factors that may affect the assessment of materiality
must be taken into consideration.

Qualitative factors include: fraud and irregularities, small amounts that might
violate covenants in the contract, on compliance with laws or regulations,
amount that might affect the trend in earning.

Quantitative factors: Total Assets, total revenues, Net Income before tax, Gross
Profit, average of 3 year income before tax.
According to ISA 320 the auditor should consider materiality and its relationship
with audit risk when conducting audit (Inverse relationship).

This concept is important to the auditors for the following reasons:

a) Determining the nature(compliance/substantive testing),extent (amount of audit
evidence)and timing (year end and interim audit)of audit procedures

b) Evaluating the effect of misstatement.

It is accepted that financial statements may give a true and fair view even if they
include errors or misstatements so long as the errors or misstatement are not material.
The responsibility of the auditor is to detect material errors and misstatement (the
audit will be impossible if the auditor were to responsible for detecting all the errors.

Question 4
Identify the two levels of materiality that are important in audit planning and indicate the
reason for each level.

Level 1 ─ Financial statement level (overall materiality), because the auditor expresses an
opinion on the financial statements taken as a whole.

Level 2 ─ Account balances and class of transactions level (account balances level),
because the auditor verifies account balances in reaching an overall conclusion on the
fairness of the financial statements.

The relationship between materiality for planning purposes and materiality for
evaluation purposes

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 The auditor's judgment about materiality for planning purposes may be different from
materiality for evaluation purposes because the auditor, when planning an audit, cannot
anticipate all of the circumstances that may ultimately influence judgment about
materiality in evaluating the audit findings at the completion of the audit. If
significantly lower materiality levels become appropriate in evaluating the audit
findings, the auditor should re-evaluate the sufficiency of the audit procedures already
performed.

Question 5
When planning a financial statement audit, an auditor must understand audit risk and its
components.

Required:
For each illustration, select the component of audit risk that is mostly directly illustrated.
The components of audit risk may be used once, more than once, or not at all.

Component of Audit Risk:

A. Auditor business risk
B. Control risk
C. Detection risk
D. Inherent risk

Illustration Component of Audit

Risk
1. A client fails to discover employee fraud on a timely basis B Control Risk
because bank accounts are not reconciled monthly
2. Cash is more susceptible to theft than an inventory of steel D Inherent Risk
bars
3. Confirmation of receivables by an auditor fails to detect a C Detection Risk
material misstatements
4. Disbursements have occurred without proper approval. B Control Risk
5. There is inadequate segregation of duties B Control Risk
6. A necessary substantive audit procedure is omitted. C Detection Risk
7. Accounts receivable are susceptible to material D Inherent Risk
misstatement, assuming there are no related internal controls.
8. Technology developments make a major product obsolete D Inherent Risk
9. An auditor complies with auditing standards on an audit A Auditor business
engagement, but the shareholders sue the auditors for issuing Risk
misleading financial statements.
10. Client lacks sufficient working capital to continue operations D Inherent Risk

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Scenario question
Question 1
Elliot Ltd operates a road maintenance company. Consider the following information:

(i) Your firm has just been appointed auditor of Elliot at its annual general
meeting. During your planning of the audit, you notice that Elliot is unlisted
public company and its directors do not consider it to be a reporting entity.
Elliot has prepared special purpose financial reports for the past 5 years. It has
significant bank debts and is required to lodge audited accounts with its
bankers within 90 days of year-end

(ii) Elliot recently won substantial contract to perform road maintenance work for
the Queensland government for the next 3 years, As a result of winning the
contract, to meet the increased demands and satisfy the specialized nature of
the work for the government, Elliot purchased additional machinery. The
machinery has an expected life of 10 years.

(iii) Elliot is also involved in the manufacture of backyard water tanks. A

revolutionary process developed a couple of years ago has enabled Elliot to
build a tank far superior to any of its competitors, at half the price. It has
therefore dominated the market over the past few years. However, you
recently read a weekend newspaper in which you saw an article previewing
Elliot’s main competitor’s new tank. it is made of a new material Lycrafon,
and it will be superior to Elliot’s tanks and cost 25%.

(a) Discuss why each of these situations represents a risk.

(b) Identify the main account or group of accounts affected by this risks and how
the specific aspects of the audit plan would be affected by these risks.

(i). Unlisted public company / Significant bank debts

It appears that the purpose of these financial reports is to meet the requirements of the
bank loan contracts. In this situation there is an increased level of inherent risk
because the management will have incentives to make the financial statements look
good for the bank and to comply with any applicable loan covenants.
Audit plan — In the audit plan the focus will be on accounts that are relatively easy to
manipulate by management to increase income. The auditor should take particular
care to ensure that accruals have been completely recorded, inventory is fairly stated,
and sales cut-off has been properly performed.

(ii).Additional machinery
In this case there is increased inherent risk associated with the account balance class
of machinery because of the potential for obsolescence after three years.
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 Audit plan — In the audit plan the auditor should perform extra work on the
machinery associated with this road maintenance work. The auditor should consider
the likelihood of the company obtaining further contracts to utilise the machinery and
the potential resale value of the machinery. Although the useful life is potentially 10
years it may be effectively 3 years if there is little likelihood of further work from the
government. The residual value will be very low if there is not a reasonable market to
sell the machinery. Allocating depreciation over 3 years instead of 10 years would
have a significant effect on profit for the year.

(iii).Backyard water tanks

The introduction of this new competitor will possibly have a significant impact on the
profitability of Elliott relative to the industry. This will increase the overall inherent
risk for the company and could affect a number of account balances and transaction
classes.
Audit plan — In the audit plan the auditor should consider some of the issues
associated with ensuring the company remains a going concern. The auditor should
look at forecasted financial statement data and discuss with management the potential
impact of this change in the market. The auditor should also consider the effect of this
change on the values of the property, plant and equipment held by Elliott. However,
the effect on this year’s audit will probably be just a note to the financial statements
as the company would probably not feel the main effects of this change until the
following year.

Question 2

For each of the following situations, explain how inherent risk should be assessed and
what effect that assessment will have on detection risk.

a. Alex Services is a fast-growing transportation company. Alex and his sons own
55 percent of the issued share capital. Mr. Alex is chairman of the board and
CEO. He personally makes all major decisions with little consultation with the
board of directors. Most of the directors, however, are either members of the Alex
family or long-standing friends. The board basically rubber-stamps Mr. Alex’s
decisions.

b. CM Stores Bhd has experienced slower sales during the last year. There is a new
director of finance and a new controller. Mr. Musa, chairman of the company, has
a reputation for hard-nosed business tactics, and he is always concerned with
meeting forecast earnings.

c. EML is one of several companies engaged in the manufacture of high-speed,

high-capacity disk drives. The industry is very competitive and subject to quick
changes in technology. EML’s operating results would place the company in the

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 second quartile in terms of profitability and financial position. The company has
never been the leader in the industry with its product typically slightly behind the
industry leader’s in terms of performance.

d. The Premier Finance Bhd has been your client for the past two years. During that
period you have had numerous arguments with the CEO and the controller over a
number of accounting issues. The major issue has related to the provision for
doubtful debts and the value of collateral. Your prior audits have indicated that a
significant adjustment is required each year to the provision.

Answer:
a. Two factors are particularly important in assessing the risk of material
misstatement for Alex Services. First, one individual, who also has majority
control of the issued share capital, dominates the decision making in the company.
This factor should lead to a higher assessment for the risk of material
misstatement because there is no review of important decisions and actions
may be taken that are not in the best interest of the company or its shareholders.
Second, Alex Services is expanding rapidly in its operations. Such expansion
may result in material misstatements since decision making may become
decentralised without adequate internal control. The increase in the risk of
material misstatement due to these two factors will result in a lower determination
of detection risk and an increase in the scope of the auditor's work.

b. A number of the risk factors are present for CM Stores. First, the company is
experiencing a slowdown in sales. Second, there has been turnover in two
financial positions within the company. Third, the chairman of the company is
aggressive and places undue emphasis on meeting earnings expectations.
These factors lead to an increased assessment for the risk of material
misstatement, resulting in a lower assessment of detection risk and more
substantive testing.

c. The factors affecting the assessment of the risk of material misstatement for EML
all relate to industry characteristics. First, the industry is very competitive,
which can lead to price-cutting and its related effects on revenues. Second, the
industry is affected by changes in technology, and EML is not one of the
industry leaders in technology. Its products usually are not competitive with the
industry leaders in terms of performance. Third, the company is not as
profitable or financially strong as the major companies in the industry. The
industry factors result in an increased assessment of the risk of material
misstatement for EML, leading to a lower determination of detection risk and
more substantive procedures.

d. The risk of material misstatement should be increased for Premier for the
following reasons. First, the audit firm has been the company’s auditors for
only two years. Second, there has been contentious accounting issues related
to provision for doubtful debts and the value of collateral. Third, prior audits

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 have indicated the presence of misstatements in the provision for doubtful
loan receivable. Based on these risk factors, detection risk should be set lower
and increased substantive procedures performed.

Question 3

Your firm is the auditor for JJ Holdings, a fast-growing metal products manufacturer.
While you have previously worked on this engagement, this is your first year as the audit
manager. As you planned the engagement, you identified a number of risk factors (such
as strong interest in maintaining the company’s earning and share price, unrealistic
forecasts, and high dependence on debt financing for expansion) that indicated that fraud
might exist.

Required:
a. How should you respond to the risks of fraud you have identified? What is the
required documentation for assessment of fraud risks?
b. If you had evidence that suggested that fraud existed, what would be your
communication responsibilities to management, and those charge with
governance?

Answer:

a. The auditor has a responsibility to plan and perform the audit to obtain reasonable
assurance about whether the financial statements are free of material misstatement,
whether caused by error or fraud. If the auditor’s risk factor assessment indicates that
fraud may be present, the auditor might respond as follow:
 Increase professional scepticism by questioning and critically assessing audit
evidence.
 Assign more experienced auditors who have the knowledge, skill, and ability
commensurate with the increased risk of the engagement.
 Consider management's selection and application of significant accounting
policies, particularly those related to revenue recognition, asset valuation, or
capitalising versus expensing.
 Modify the nature, timing and extent of audit procedures to obtain more reliable
evidence and use increased samples sizes or more extensive analytical
procedures.

The auditor should document the risk of material misstatement for all material
accounts and classes of transactions. The auditor’s documentation includes the
following:
 The nature and results of the communication among audit team members that
occurred in planning the audit regarding the risks of material misstatement due to
fraud.
 The steps performed in obtaining and supporting knowledge about the entity’s
business and its environment. The documentation should include: the risks
identified, an evaluation of management’s response to such risks, and the auditor's

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 assessment of the risk of fraud after considering the entity’s response.
 The nature, timing, and extent of the procedures performed in response to the risks
of material misstatement due to fraud and the results of that work.
 Fraud risks or other conditions that caused the auditor to believe that additional
audit procedures or other responses were required to address such risks or other
conditions.
 The nature of the communications about fraud made to management, the audit
committee, and others.

b. If the auditor had evidence that suggested that fraud might exist, the matter should be
brought to the attention of an appropriate level of management. If the fraud
involved management or the fraud causes a material misstatement of the financial
statements, the auditor should report it directly to those charged with governance. In
addition, the auditor should reach an understanding with those charged with
governance regarding the expected nature and extent of communications about
misappropriations perpetrated by lower level employees.
The auditor has no responsibility to disclose the fraud to parties other than the
entity’s management and those charged with governance because of ethical or legal
obligations of confidentiality. The auditor should recognise, however, that in the
following circumstances a duty to disclose outside the entity may exist:
 To comply with certain legal and regulatory requirements.
 In response to a subpoena

Question 4

During the audit of inventory a large number of slow-moving inventory items has been
found. Comment on the impact of this finding upon the assessment of inherent risk of the
audit of inventory as medium? Does this discovery have any implications for the
assessment of control risk?

Answers:

This raises doubts about the realisable value of the inventory. (Refer to MFRS 102-
Inventory should be value lower of cost and NRV) This should be an important element
in assessing audit risk. It should not affect the initial assessment of inherent risk unless it
has a material impact upon the realisable value of the inventory. It raises some question
about management control over slow-moving inventory.

For example, how often management review the slow moving? Did they do it regularly?
Certain industry for example supermarket selling perishable items, need to review their
stocks on everyday. Hence this may have some impact upon the assessment of control
risk.

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Question 5
You are an audit partner attending the planning meeting for the audit of Bauer Sdn Bhd, a
large technology company with two main divisions. The year end is 31 December. The
first division manufactures computer hardware for use by intelligence and security
agencies and the second produces and distributes bespoke and off-the-shelf software for
use on the hardware. All the products are exported to USA
As part of your audit planning you attend a meeting with Bauer's Finance Director, Jack
Tan. He informs you that there have been no major changes in the business's operations
during the year, but the following significant events had occurred:

(a) Owing to an unexplained improvement in the security situation in the Los

Angeles area, a significant contract with the American Government for new
hardware has not been renewed. This was a surprise and as a result 100 (out of
1,000) American staff were made redundant during December.
(b) During the year development commenced on new software for use in satellite
tracking of vehicles. This has been capitalised as an intangible asset. In order to
commence development significant staff training costs were incurred.

Answers:
(a) As the timing of the redundancies is towards the year-end, it is important that the
timing of the announcement is ascertained, if it is made before the year
end then a provision should be made for any redundancy costs not paid as
at 31 December. If the announcement is made post-year end then the costs
would not be recognised until next year.
Any provision would have to meet the criteria of MFRS 137 Provisions,
contingent liabilities and contingent assets for a restructuring provision:
• Sale or termination of a line of business
• The closure of business locations in a country or region

• Changes in management structure

• Fundamental reorganisations that have a material effect on the nature
and focus of the entity’s operations

If these criteria are not met, then it may be possible that a provision exists in any case
if MFRS 137’s general criteria are met (present obligation as a result of a past event,
which can be measured reliably).
The unexpected loss of this major contract gives rise to a potential going concern
problem. Since only 10% of the American staff have been lost as a result it is
unlikely that this in itself would be enough to affect the going concern status of the
entire business. This should however form part of the overall assessment of going
concern. Consideration should be given as to the reasons for the improvement in the
security situation and whether similar improvements may occur in other markets.

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(b) Close attention will need to be paid to the software development costs to ensure
that they meet the 6 criteria laid out in MFRS 138 and have been correctly
capitalised and disclosed.
It will be important to ensure that the training costs for the new software have not
been included in the amounts capitalised. These do not represent a part of the
software (which is an intangible asset) and so these training costs should be
recognised as an expense when incurred.

Question 6
Recorder Communications Co (Recorder) is a large mobile phone company which
operates a network of stores in countries across Europe. The company’s year end is 30
June 2014. You are the audit senior of Piano & Co. Recorder is a new client and you are
currently planning the audit with the audit manager. You have been provided with the
following planning notes from the audit partner following his meeting with the finance
director. Recorder purchases goods from a supplier in South Asia and these goods are
shipped to the company’s central warehouse. The goods are usually in transit for two
weeks and the company correctly records the goods when received. Recorder does not
undertake a year-end inventory count, but carries out monthly continuous (perpetual)
inventory counts and any errors identified are adjusted in the inventory system for that
month.

During the year the company introduced a bonus based on sales for its sales persons. The
bonus target was based on increasing the number of customers signing up for 24-month
phone line contracts. This has been successful and revenue has increased by 15%,
especially in the last few months of the year. The level of receivables is considerably
higher than last year and there are concerns about the creditworthiness of some
customers. Recorder has a policy of revaluing its land and buildings and this year has
updated the valuations of all land and buildings. During the year the directors have each
been paid a significant bonus, and they have included this within wages and salaries.
Separate disclosure of the bonus is required by local legislation.

Required:
Describe FIVE audit risks, and explain the auditor’s response to each risk, in planning
the audit of Recorder

Audit risk Auditor’s Response

Recorder Communications Co (Recorder)
is a new client for Piano & Co. As the team
is not so familiar with the accounting
policies, transactions and balances of
Recorder, there will be an increased
detection risk on the audit.
Recorder purchases their goods from South
Asia and the goods are in transit for two
weeks. At the year-end there is a risk that
Piano & Co should ensure they have a
suitably experienced team. Also, adequate
time should be allocated for team members
to obtain an understanding of the company
and the risks of material misstatement.
The audit team should undertake detailed
cut-off testing of goods in transit from the
suppliers in South Asia to ensure that the

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the cut-off of inventory, purchases and
payables may not be accurate. The
company correctly accounts for goods
when they receive them. Therefore at the
year-end only goods which have been
received into the warehouse should be
included in the inventory balance and a
respective payables balance recognised.
The company undertakes continuous
(perpetual) inventory counts at its central
warehouse. Under such a system all
inventory must be counted at least once a
year with adjustments made to the
inventory records.
Inventory could be under or overstated if
the continuous (perpetual) inventory counts
are not complete and the inventory records
accurately updated for adjustments
MFRS 102/IAS 2
A sales-related bonus scheme has been
introduced in the year; this may lead to
sales cut-off errors with employees aiming
to maximise their current year bonus.
Receivables are considerably higher than
the prior year and there are concerns about
the creditworthiness of some customers.
There is a risk that some receivables may
be overvalued as they are not recoverable.
MFRS 9-Impairment Financial Assets
In addition, receivables could be overstated
as a result of the bonus scheme; some of
the customers signed up for contracts may
not actually exist.
Recorder has a policy of revaluing its land
and buildings and these valuations have
been updated during the year. Property,
plant and equipment could be under or
overvalued if the recent valuation has not
been carried out in accordance with IAS
16(MRFS 116) Property, Plant and
Equipment and adequate disclosures may
not have been made in the financial
statements.
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cut-off is complete and accurate.
The completeness of the continuous
(perpetual) inventory counts should be
reviewed. In addition, the level of
adjustments made to inventory should be
considered to assess whether reliance on
the inventory records at the year end will
be acceptable
Increased sales cut-off testing will be
performed along with a review of any post
year-end cancellations of contracts as they
may indicate cut-off errors.
MFRS 15-Step NO 5-Satisfy the
performance obligation
Extended post year-end cash receipts
testing and a review of the aged receivables
ledger to be performed to assess valuation.
Also consider the adequacy of any
allowance for receivables.(Credit loss
allowance)
External confirmation of receivables to
confirm that customers exist and represent
valid amounts due.
Discuss with management the process
adopted for undertaking the valuation,
including whether the whole class of assets
was revalued and if the valuation was
undertaken by an expert. This process
should be reviewed for compliance with
IAS 16.)(MRFS 116) Review the
disclosures of the revaluation in the
financial statements for compliance with
IAS 16.(MFRS 116)
The directors have each been paid a
significant bonus and separate disclosure of
this in the financial statements is required
by local legislation. The directors’
remuneration disclosure will not be
complete and accurate if the bonus paid is
not disclosed in accordance with the
relevant local legislation.
Purchase goods from oversea, there is an
inherent risk that the foreign rates were
wrongly applied in relation MFRS 121
Discuss this matter with management and
review the disclosure in the financial
statements to ensure compliance with local
legislation
Review the rate used by the client in SPL
and SFOP , whether gain or loss is
correctly calculated

Question 7
You are the audit manager of Chestnut & Co and are reviewing the key issues identified
in the files of two audit clients.

Palm Industries Co (Palm)

Palm’s year end was 31 March 2015 and the draft financial statements show revenue of
$28·2 million, receivables of $5·6 million and profit before tax of $4·8 million. The
fieldwork stage for this audit has been completed. A customer of Palm owed an amount
of $350,000 at the year end. Testing of receivables in April highlighted that no amounts
had been paid to Palm from this customer as they were disputing the quality of certain
goods received from Palm. The finance director is confident the issue will be resolved
and no allowance for receivables (CREDIT LOSS ALLOWANCE) was made with
regards to this balance.

Ash Trading Co (Ash)

Ash is a new client of Chestnut & Co, its year end was 31 January 2015 and the firm was
only appointed auditors in February 2015, as the previous auditors were suddenly unable
to undertake the audit. The fieldwork stage for this audit is currently ongoing. The
inventory count at Ash’s warehouse was undertaken on 31 January 2015 and was
overseen by the company’s internal audit department. Neither Chestnut & Co nor the
previous auditors attended the count. Detailed inventory records were maintained but it
was not possible to undertake another full inventory count subsequent to the year end.
The draft financial statements show a profit before tax of $2·4 million, revenue of $10·1
million and inventory of $510,000.
Required:
For each of the two issues: Discuss the issue, including
(i) An assessment of whether it is material;
(ii) Audit procedures

Palm Industries Co (Palm)

(i) A customer of Palm’s owing $350,000 at the yearend has not made any post
year-end payments as they are disputing the quality of goods received. No
allowance for receivables has been made against this balance. As the balance is
being disputed, there is a risk of incorrect valuation as some or all of the

15
 receivable balance is overstated, as it may not be paid. This $350,000 receivables
balance represents 1·2% (0·35/28·2m) of revenue (BENCHMARK 0.5 TO 1%),
6·3% (0·35/5·6m) of receivables and 7·3% (0·35/4·8m) (BENCHMARK 5%)of
profit before tax; hence this is a material issue.
(ii) A procedure to adopt includes:
– Review whether any payments have subsequently been made by this customer
since the audit fieldwork was completed.
– Discuss with management whether the issue of quality of goods sold to the
customer has been resolved, or whether it is still in dispute
– Review the latest customer correspondence with regards to an assessment of
the likelihood of the customer making payment.

(iii) If management refuses to provide against this receivable, the audit report will
need to be modified. As receivables are overstated and the error is material but
not pervasive a qualified opinion would be necessary. A basis for qualified
opinion paragraph would be needed and would include an explanation of the
material misstatement in relation to the valuation of receivables and the effect on
the financial statements. The opinion paragraph would be qualified ‘except for’.

Ash Trading Co (Ash)

(i) Chestnut & Co was only appointed as auditors subsequent to Ash’s year end and
hence did not attend the year-end inventory count. Therefore, they have not been
able to gather sufficient and appropriate audit evidence with regards to the
completeness and existence of inventory. Inventory is a material amount as it
represents 21·3% (0·51/2·4m) of profit before tax (benchmark PBIT 5%) and 5%
(0·51/10·1m) of revenue (Benchmark 0.5 to 1%); hence this is a material issue.

(ii) A procedure to adopt includes: – Review the internal audit reports of the
inventory count to identify the level of adjustments to the records to assess the
reasonableness of relying on the inventory records. – Undertake a sample check
of inventory in the warehouse and compare to the inventory records and then
from inventory records to the warehouse, to assess the reasonableness of the
inventory records maintained by Ash.

(iii) (The auditors will need to modify the audit report as they are unable to obtain
sufficient appropriate evidence in relation to inventory which is a material but not
pervasive balance. Therefore a qualified opinion will be required. A basis for
qualified opinion paragraph will be required to explain the limitation in relation

16
 to the lack of evidence over inventory. The opinion paragraph will be qualified
‘except for’.

Question 8
You are an audit manager of Morline & Co, a Public Accounting firm. The
audit engagement partner, Joe Tan, has called you into his office to discuss
a new audit client. You have been assigned to take charge of the audit for
the financial year end, 31 December 2019 of Crown Hotel Group Bhd.
(Crown Group) a listed company. The Group operates a chain of luxury
hotels across Malaysia. As part of the expansion strategy, Crown Group
has recently acquired a new hotel in Melbourne. You are very excited
about auditing this luxury group of hotels, and are hoping that you may get
to stay in one of the hotels during the audit.

Recently you had a meeting with Joe Tan, Datuk Paul Wong, the
managing director of Crown Group, and Lisa Goh, the finance director of
Crown Group. From detailed discussions with them, you note the
following information:

Background information:
Crown Group owns four hotels in Malaysia namely Dolce, Corus, Korma,
Morib, one hotel, Belux in Singapore and a newly acquired hotel in
Melbourne namely Aston, which was acquired in September 2019. Each
hotel operates through a separate legal entity, and Crown Group owns
100% of each entity. The Group prepares consolidated financial statements
on an annual basis. The Head Office is located in Petaling Jaya, Malaysia.

In 2019, the Crown Group had total revenues of RM 90 million (2018:

RM 80 million), and operating profits of RM 8,500,000 (2018: RM
11,000,000).

Lisa Goh explained that all the hotels have been performing well over the
last year, with the exception of Hotel Belux. See notes below

Information Technology (IT)

Lisa Goh highlighted that the Crown Group relies heavily on the use of
information technology (IT) and noted that approximately 96% of
bookings are made online via its website. The Group invested significantly
in IT over the last six months, which resulted in an extensive upgrade of its
website and the development of a user-friendly app. Datuk Paul Wong
said, “We have spent a significant amount of money developing our IT
systems and ensuring they are secure, as the rapid increase in cybercrime
in Malaysia is frightening.” This development cost was capitalised in
Financial Year 2019.

17
Finance team
Each hotel has a finance team, including a financial controller. At the end
of every month, a reporting pack is prepared by the financial controller,
including a copy of the management accounts, key completed
reconciliations and detailed commentary on how the hotel has met the key
performance indicators for that particular month. Each reporting pack is
submitted to the head office, and the group financial controller reviews
them and performs additional reconciliations. The group financial
controller also prepares the year-end consolidated financial statements.
Lisa Goh has, however, informed you that the group financial controller
resigned in November 2019 because he could not cope with the pressure of
the job. She has not been able to find a suitable replacement as to date.
Lisa has asked if your firm would be able to help with the finalisation of
the consolidated financial statements for the year ended 31 December
2019, as her team is currently struggling to find the time needed.

New acquisition
The hotel in Melbourne, Aston was acquired in September 2019 for RM
8,500,000, and will be included in the consolidated financial statements at
31 December 2019. The purchase of the hotel was financed by a bank
loan. Datuk Paul Wong explained this was a significant investment for the
Crown Group and that a further RM 2 million has since been spent on
capital expenditure to ensure it meets the exceptionally high standards of
the Group. Datuk Paul Wong has invited the entire audit team to travel to
Melbourne for the opening of the hotel in June 2020 as his guests. He has
also assured the team will be treated very well while there.

Valuation of the hotel properties

The group policy is to value Land and Buildings at fair value. The
calculation of fair value and the allocation of fair value to Land and
Buildings requires significant judgement. Datuk Paul Wong confirmed
professional valuation experts were appointed to value Land and Buildings
at 31 December 2019. Land and Buildings at that date were valued at RM
110 million, representing a revaluation increase of RM 12 million.

Loans and Borrowings

During the financial year to 31 December 2019, the Group borrowed RM
10,500,000 in order to finance the purchase of the Aston, and to complete
the renovation work required. The loan is repayable over 10 years and the
Group must adhere to strict loan covenants. The bank requires the Group
to provide management accounts on a quarterly basis, if a loan covenant is
breached, the loan may be due for repayment immediately. Lisa Goh has
informed you that the group is also struggling to ensure management
accounts for the quarter ended 31 December 2019 will be submitted within

18
 the allocated timeframe. The amount of interest paid was extremely
significant

Bonus
During the year, a new bonus scheme was introduced for both managers
and directors for all the hotel within the group in order to increase revenue.
The bonus is directly linked to revenue.

Advance payment
Advance deposits of 50% are collected for those booking for conferences
and wedding packages.

Hotel Belux
The hotel Belux is one of the biggest in the Group, and contributes 25% of
total revenue is located in Singapore. Although revenue has increased in
2019, profit has fallen significantly due to a number of “special offers” in
both accommodation rates and the restaurant. Datuk Paul Wong believes
the main causes for this fall are reduced gross margins (due to the
successful uptake of the various special offer promotions during the year)
and increasing costs (mainly driven by payroll). The number of special
offers were approved by management in a bid to counter the tough
economic environment within which the hotel operates and thereby
increase revenue.

Required:

Identify and explain to the audit partner SEVEN (7) key audit risks in
respect of Crown Group.

Answers

Audit Risk Reasons

1)First year audit-DR Lack of cumulative audit knowledge and experience
2) Revenue -Driven by the pressures to maintain revenues in tough economic
Recognition-(MFRS conditions/introduction of bonus scheme linked to revenue/cash
15) based business
-Revenue is a key risk area to ensure sales are not being artificially
inflated or sales made at loss

3)Fraud (ISA 240) Introduction of bonus scheme linked to a revenue create incentive to
manipulate revenue-MRFS 15

19
4) Group Financial
Controller resigned in Nov
2019 and has not been
replaced
5)The land & Buildings at
31 Dec. 2019 were valued at
RM10 million with a
revaluation increase of RM
12 million
6) Aston was acquired in
Sept. 2019 and will be
included in the consolidated
Financial Statements at the
year end
7)Capital expenditure of RM
2 million has been carried
out in the current year in
relation to the acquisition of
Aston
8)Breach of loan covenants
9) Hotel , Aston
(Melbourne) & Belux-
Foreign exchange risk
10)Going Concern
11) Deposit received in
advance for all events
(wedding / conferences)
12) Development of IT
Software
The group FC left in Nov 2019 and the reporting packs from each
hotel have not been reviewed since Oct 2019.-This increases control
risk
-Also the consolidated financial statements have not been prepared
for the year ended 21 December 2019
-The land & building could be under or overvalued if the recent
valuation has not been carried out with MFRS 116 PPE and
adequate disclosures may not have been made in the financial
statements
-It is important that the entity has been included within the
consolidated financial statements in accordance with MRFS 3-
Business Combinations
-In addition it is important to check goodwill was recognised in
relation to the acquisition and if it had been recognised appropriately
-It is important that the capital expenditure has been capitalised
appropriately in accordance with MFRS116 and has not been
included within expenditure in the financial statements
-The loan has bank covenants attached to it which, if
breached ,would result in the loan becoming repayable in full
immediately
-the directors will therefore be keen to ensure the financial statements
are presented in such way as satisfy the loan covenants
There is a risk that foreign currency balances on the SFOP are
valued at the incorrect FX rate or that transactions during the year are
translated at an incorrect FX rate in respect of the hotel, Aston in
Melbourne, not complying with MRFS 121
Despite the increase in group revenue, during the current year of RM
10 million there has been a decrease in profit on RM 2.5 million. The
amount of interest to service the loan is extremely significant , this
has a high impact on company cash flow
There is a risk that revenue may be overstated and full amount of
income expected for the particular event may be included in the
revenue. The deposit may be included in revenue, rather than
deferred income. The requirements of MRFS 15 have to be met
before revenue can be recognised.-STEP 5
The group capitalised development cost of the user-friendly app and
upgrade the existing website. The there is a risk that the 6 conditions
as per the MFRS 138 have not been fulfilled .in any case, should any
one of the conditions not fulfilled the development cost should be
written off immediately
20
Question 9-Self Practice
You are the partner of Pang & Co,public accounting firm ,is in charge of
the audit of PCT Berhad (PCT). PCT is a company incorporated in
Malaysia and listed on the Bursa Malaysia Securities. The financial year
end of PCT is December 31 and you have initiated the planning of the
audit for the year ending 31 December, 2019. The following information
has been gathered by your audit manager:

The principal activity of PCT is that of the manufacturing of construction

materials. It has been in the business for almost 35 years and its share of
the local market and the profit margin remain stable for the past few years.
Faced with a situation of lack of growth in the domestic market, Datuk
Oon, its managing director and the largest shareholder, decided to expand
into other markets in the South East Asia 6 years ago. As of to date, the
products of PCT are sold in two countries in the South East Asia.

Datuk Oon decided that the expansion into overseas markets can be best
achieved through the appointment of distributors which will buy the
products from the company for sales in their respective countries. For the
ease of management, one distributor is appointed for each country. Based
on his assessment, this approach of expansion requires lower capital
outlay, avoids the need of having to manage overseas operations if
overseas branch office or subsidiary was set up and thus reduces the risk
of failure.

The growth in revenue for the past three years was contributed solely by
the sales to overseas markets. 80% of the raw materials are imported from
overseas and all payment to suppliers at in US dollar

The management of PCT is very concerned on the inventory of

construction materials. Recently the invention of new technology has
caused substantial amount of those construction materials become obsolete

The Statement of Financial position also reveal that PCT has capitalised
RM 2 million R&D expenditure which incurred in 2017 on a special
project undertaken to develop a new construction material which are yet to
introduce into the market

Sometime in early January 2019, PCT’s lawyer informed the management

that a customer initiated a suit case claiming for a compensation of RM 3
million for damages suffered for using the defective construction materials
supplied by PCT. The company’s lawyer was in the opinion that it is
highly probable that PCT needs to defend this suit case.

Being the founder of PCT, Datuk Oon is instrumental to the success of the
company. Members of the board of directors consist of his wife and son,

21
 who are executive directors and three other independent non-executive
directors who are close friends of Datuk Oon. From the minutes of the
board of directors meeting, you notice that major decisions relating to the
company are made by Datuk Oon.

Research conducted by your audit manager shows that the markets for
construction material in the countries penetrated by PCT are highly
competitive. The research also shows that the prices of raw materials used
by PCT in its productions have been stable over the years.

Summary of financial information of PCT for the past two financial years
and the 10-month period ended 30 April, 2019 are as follows:

FP 2019 FY 2018 FY 2017

RM’000 RM’000 RM ‘000
Revenue 131,040 134,400 112,000

Cost of sales 10,212 107,520 91,840

Trade 71,086 27,616 18,410

receivables
Cash and bank 1,100 18,880 24,406
balances

Bank overdraft (3,900) - -

Trade payables 10,770 8,938 7,548

Required:

Using the information provided above, identify SIX (6) risk factors that you will consider
as part of the risk assessment that you will perform in relation to the 2019 audit planning.
Reasons for the risk factors identified should be explained.
Answers
The risk factors that will be considered as part of the risk management that will be
performed are:

 PCT is a listed entity which increases the public accountability of the audit. In
addition, being a listed entity, there is always pressure to report higher revenue
and profit which increase the risk of overstatement of revenue and profit.

 The company is managed by its owner and his family. This increases the risk of
management override of control. The dominant role played by the managing
director in the board of director further increases the risk.

22
  Trade receivables have increased over the years. Notably, the receivable turnover
period has also increased with significant increase in the current financial period.
This may be the result of the entity’s aggressive expansion plan. This has
increased the risk of collectability of trade receivables. MFRS 9-Impairment of
Financial Assets(For account receivable)

 By appointing one agent in each country, there is a risk of credit concentration. If

the financial condition of one or more of the company’s customers deteriorated, it
may have a significant adverse impact on the company.

 The gross profit margins of the company have increased tremendously over the
period under the review. This contradicts with the research finding that the
overseas markets the company operates in are highly competitive. Therefore,
there is a risk of overstatement of profit.

 With the longer period taken to collect from its customers, the company is
experiencing a situation of tight cash flow as evident from the negative cash and
cash equivalents. This has increased the liquidity risk faced by the company.
There is a need to consider the ability of the company to obtain financing to
enable it to operate as a going-concern. MFRS 101

 The construction materials could be overvalued since substantial amount are

obsolete, the requirement of MRFS 102 need to be complied as stock should be
valued lower of cost or NRV

 The fluctuation in foreign currency might result in material misstatement in

exchange currency in US dollar , the requirement of MFRS 121 has to be met

 The Capitalisation of Development cost of RM 2 million is material. The

requirement of MFRS 138 should be reviewed. If any of the factors within MFRS
138 is not fulfilled, this cost should be written off

 Legal case, since it is probable, it is present obligation. The amount can be

reliably estimated, it should be provided in the context of MRFS 137

Q10 ( Self Practice)

Steel Wheel Bhd (Steel Wheel), manufactures classic cars tailored to high-end customers.
You are the audit manager of Abdul, Salim & Co and you are currently
considering of auditing Steel Wheel. The company’s year-end is July 31,
2020, with a forecasted pre-tax profit of RM 1.5 million. The company is
undertaking continuous production of its plant, as such by the end of the
fiscal year, it is expected that the work in progress will be approximately

23
 RM850,000. To enhance the manufacturing process, Steel Wheel placed
an order in April for new equipment and machinery valued RM620,000;
one-third of the order was received in May and the rest is expected to be
delivered by the supplier in late July or early August. Earlier this year,
Steel Wheel received RM1.2 million patent, giving it the exclusive right to
manufacture customised classic cars for five years. For this acquisition,
Steel Wheel borrowed RM1.5 million from the bank, which is repayable
over five years. In January 2020, Steel Wheel outsourced the processing of
its payroll to third-party service provider Herron Bhd (Herron). Herron
handles all parts of the payroll matters and submits monthly reports to
Steel Wheel detailing payroll costs. Steel Wheel managed its own payroll
until December 31, 2019, when it transferred the records to Herron. The
company has a land and building revaluation policy and the chief financial
officer has announced that all land and buildings will be revalued at the
end of the year. In a review of the management accounts for the month of
May 2020, you noted that accounts receivable has increased significantly
relative to the end of the previous fiscal year, compared to May 2019. The
chief financial officer has informed you that the company expects to lay
off approximately 100 employees after the end of the year. However,
decision on further announcement of this matter has yet to be made, most
likely it will be before the end of the year.

Required:
Describe SIX (6) audit risks, and explain the auditor’s response to
each risk, in planning the audit of Steel Wheel Bhd.

Audit Risk Auditor’s Responses

Steel Wheel undertakes continuous
production and the work in progress
balance at the year end is likely to be
material. As production will not cease, the
exact cut-off of the work in progress will
need to be assessed. If the cut-off is not
correctly calculated, the inventory
valuation may be under or over stated.
Steel Wheel has ordered RM620,000 of
plant and machinery, two-thirds of which
may not have been received by the year
end. Only assets which physically exist at
the year-end should be included in
property, plant and equipment. If items not
24
The auditor should discuss with
management the process they will
undertake to assess the cut-off point for
work in progress at the year end. This
process should be reviewed by the auditor
while attending the year-end inventory
count. In addition, consideration should be
given as to whether an independent expert
is required to value the work in progress. If
so, this will need to be arranged with
consent from management and in time for
the year-end count.
Discuss with management as to whether
the remaining plant and machinery ordered
have arrived; if so, physically verify a
sample of these assets to ensure existence
and ensure only appropriate assets are
recorded in the non-current asset register at
yet delivered have been capitalised, PPE
will be overstated. Consideration will also
need to be given to depreciation and when
this should commence. If depreciation is
not appropriately charged when the asset
is available for use, this may result in
assets and profit being over or understated.
A patent has been purchased for RM1.2
million, and this enables Steel Wheel to
manufacture specialised elevator
equipment for the next five years. In
accordance with MFRS 138 Intangible
Assets, this should be included as an
intangible asset and amortised over its
five-year life. If management has not
correctly accounted for the patent,
intangible assets and profits could be
overstated.
The company has borrowed RM1.5
million from the bank via a five-year loan.
This loan needs to be correctly split
between current and non-current liabilities
in order to ensure correct disclosure.
MFRS 9 & 7
Also, as the level of debt has increased,
there should be additional finance costs.
There is a risk that this has been omitted
from the statement of profit or loss leading
to understated finance costs and overstated
profit.
During the year Steel Wheel outsourced its
payroll processing to an external service
organisation. A detection risk arises as to
whether sufficient and appropriate
evidence is available at Steel Wheel to
confirm the completeness and accuracy of
controls over payroll. If not, another
auditor may be required to undertake
testing at the service organisation. The
payroll processing transferred to Herron
from 1 January. If any errors occurred
during the transfer process, these could
25
the year end. Determine if the asset
received is in use at the year-end by
physical observation and if so, if
depreciation has commenced at an
appropriate point.
The audit team will need to agree the
purchase price to supporting
documentation and to confirm the useful
life is five years. The amortisation charge
should be recalculated in order to ensure
the accuracy of the charge and that the
intangible is correctly valued at the year
end.
During the audit, the team would need to
confirm that the RM1.5 million loan
finance was received. In addition, the split
between current and non-current liabilities
and the disclosures for this loan should be
reviewed in detail to ensure compliance
with relevant accounting standards. Details
of security should be agreed to the bank
confirmation letter.
The finance costs should be recalculated
and any increase agreed to the loan
documentation for confirmation of interest
rates. Interest payments should be agreed
to the cash book and bank statements to
confirm the amount was paid and is not
therefore a year-end payable.
Discuss with management the extent of
records maintained at Steel Wheel and any
monitoring of controls undertaken by
management over the payroll charge.
Consideration should be given to
contacting the service organisation’s
auditor to confirm the level of controls in
place. Discuss with management the
transfer process undertaken and any
controls put in place to ensure the
completeness and accuracy of the data.
Where possible, undertake tests of controls
 result in the payroll charge and related to confirm the effectiveness of the transfer
employment tax liabilities being controls. In addition, perform substantive
under/overstated. testing on the transfer of information from
the old to the new system.
The land and buildings are to be revalued Discuss with management the process
at the year end; it is likely that the adopted for undertaking the valuation,
revaluation surplus/deficit will be material. including whether the whole class of assets
The revaluation needs to be carried out was revalued and if the valuation was
and recorded in accordance with undertaken by an expert. This process
MFRS116 Property, Plant and Equipment, should be reviewed for compliance with
otherwise non-current assets may be MFRS 116. Discuss with management the
incorrectly valued. Receivables for the reasons for the increase in receivables and
year to date are considerably higher than management’s process for identifying
the prior year. If this continues to the year- potential irrecoverable debt. Test controls
end, there is a risk that some receivables surrounding management’s credit control
may be overvalued as they are not processes. Extended post year-end cash
recoverable .MFRS 9-Credit loss receipts testing and a review of the aged
allowance receivables ledger to be performed to
assess valuation. Also consider the
adequacy of any allowance for receivables.
Steel Wheel is planning to make Discuss with management the status of the
approximately 100 employees redundant redundancy announcement; if before the
after the year end. The timing of this year end, review supporting documentation
announcement has not been confirmed; if to confirm the timing. In addition, review
it is announced to the staff before the the basis of and recalculate the redundancy
year end, then under MFRS137 provision.
Provisions, Contingent Liabilities and
Contingent Assets a redundancy
provision will be required at the year end.
Failure to provide will result in an
understatement of provisions and
expenses.

Question 11-answers
Q1 (a) You are the audit manager of Alex & Co., a public accounting firm and
has been assigned to undertake the financial statements audit of Manuka Bhd (Manuka).
Manuka is a listed entity, manufacturing machinery for the dolomite extraction industry.
Over the past few years, this company has won several awards for manufacturing
environmentally friendly products. You are currently planning the audit for the year
ended 31 March 2022. The draft financial statements show revenue of RM 100 million
(2021-RM 50 million), profit before tax of RM 1 million (2021 – RM 0.5 million) and
total assets of RM 200 million (2021 – RM 150 million). Alex & Co., was appointed as
the external auditor to Manuka for the first time in October 2021.

Below is an extract of the business operation and development of Manuka:

26
• In January 2022, one of the major customers, Lawki Sdn Bhd (Lawki), through its
lawyers, claimed damages for injuries suffered by a drilling machine operator whose arm
was severely injured when a machine supplied was malfunctioned. Dato Tony, the Chief
Executive Officer (CEO) of Manuka, told you that the claim is being ignored as it is
generally known that Lawki has a poor health and safety record, and thus the accident
was their (Lawki) fault. Two orders placed by Lawki in February 2022 have been
cancelled.

• All machines supplied carries a one year warranty. A warranty provision is

recognised on the Statement of Financial Position as RM 2.5 million (2021 – RM 2.4
million). The CEO estimates the cost of repairing defective machinery reported by
customers and this estimate is used as the basis of the provision.

• Work in progress is valued at RM 15 million as at 31 March 2022. A physical

inventory count was held on 23 March 2022. The Chief Engineer estimated the stage of
completion of each machine at that date. One of the major components included in the
dolomite extracting machinery is now being sourced from overseas. The new supplier,
Omeki Corporation., is located in Japan and bills Manuka in Yen. There is a trade
payable of RM 1.5 million owing to Omeki Corporation was recorded under current
liabilities.

• Manuka designs, constructs and installs machinery for three key customers.
Payment is due in three instalments: 70% is due when the order is confirmed (stage one),
15% on delivery of the machinery (stage two), and 15% on successful installation in the
customer’s bauxite mine (stage three). Generally it takes four months from the order
being confirmed until the final installation.

• At 31 March 2022, there was an amount outstanding of RM 1.5 million from

Mammoth Sdn Bhd (Mammoth) which was in dispute. Mammoth refuses to pay until the
machinery, which was installed in August 2020, is running at 100% efficiency.

• Dato Tony owns 60% of the shares in Manuka. He also owns 55% of Pacific Sdn.,
which leases a head office to Manuka. Dato Tony is considering selling some of his
shares in Manuka in late June 2022, and would like the audit to be finished by that time.

Required:

Using the information provided, identify and explain SIX (6) significant audit risk to be
considered when planning the final audit for Manuka Bhd for the year ended 31 March
2022. Reasons for the risk factors identified should be explained

Principal Audit Risks of Manuka

Legal claim

27
The claim should be investigated seriously by Manuka. The chief executive officer’s
(CEO) opinion that the claim will not result in any financial consequence for Manuka is
naïve and flippant. Damages could be awarded against Manuka if it is found that the
machinery is faulty. The recurring high level of warranty provision implies that
machinery faults are fairly common and therefore the accident could be the result of a
defective machine being supplied to Lawki.

The risk is that no provision is created for the potential damages under MRFS137
Provisions, Contingent Liabilities and Contingent Assets, if the likelihood of paying
damages is considered probable. Alternatively, if the likelihood of damages being paid to
Lawki is considered a possibility then a disclosure note should be made in the financial
statements describing the nature and possible financial effect of the contingent liability.
As discussed below, the CEO, Dato Tony, has an incentive not to make a provision or
disclose a contingent liability due to the planned share sale post year end.

Legal fees
A further risk is that any legal fees associated with the claim have not been accrued
within the financial statements. As the claim has arisen during the year, the expense must
be included in this year’s income statement, even if the claim is still on- going at the year
end. The fact that the legal claim is effectively being ignored may cast doubts on the
overall integrity of senior management, and on the credibility of the financial statements.

Two orders cancelled.

Lawki has cancelled two orders. If the amounts are still outstanding at the year -end then
it is highly likely that Lawki will not pay the invoiced amounts, and thus receivables are
overstated. If the stage one payments have already been made, then Lawki may claim a
refund, in which case a provision should be made to repay the amount, or a contingent
liability disclosed in a note to the financial statements.

Major customer-going concern

Lawki is one of the major customers, and losing this customer could have future going
concern implications for Manuka if a new source of revenue cannot be found to replace
the lost income stream from Lawki. If the legal claim becomes public knowledge, and if
Manuka is found to have supplied faulty machinery, then it will be difficult to attract new
customers.
A case of this nature could bring bad publicity to Manuka, a potential going concern issue
if it results in any of the five key customers terminating orders with Manuka. The
auditors should plan to extend the going concern work programme to incorporate the
issues noted above.

Warranty provision
The warranty provision is material at 2·6% of total assets (2021 – 2·7%). The provision
has increased by only RM 100,000, an increase of 4·2%, compared to a revenue increase
of 21·4%. This could indicate an under provision as the percentage change in revenue

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would be expected to be in line with the percentage change in the warranty provision,
unless significant improvements had been made to the quality of machines installed for
customers during the year. This appears unlikely given the legal claim by Lawki, and the
machines installed at Mammoth operating inefficiently. The basis of the estimate could
be understated to avoid charging the increase in the provision as an expense through the
income statement. This is of special concern given that it is the CEO and majority
shareholder who estimates the warranty provision.

Inventories
Work in progress is material to the financial statements, representing 8·9% of total assets.
The inventory count was held two weeks prior to the year end. There is an inherent risk
that the valuation has not been correctly rolled forward to a year-end position.
The key risk is the estimation of the stage of completion of work in progress. This is
subjective, and knowledge appears to be confined to the chief engineer. Inventory could
be overvalued if the machines are assessed to be more complete than they actually are at
the year end. Absorption of labour costs and overheads into each machine is a complex
calculation and must be done consistently with previous years. It will also be important
that consumable inventories not yet utilised on a machine, e.g. screws, nuts and bolts, are
correctly valued and included as inventories of raw materials within current assets. There
is a risk that inventory might not be valued in line with the requirements under MFRS
102

Overseas supplier
As the Japan supplier is new, controls may not yet have been established over the
recording of foreign currency transactions. Inherent risk is high as the trade payable
should be retranslated using the year end exchange rate per MFRS 121 The Effects of
Changes in Foreign Exchange Rates. If the retranslation is not performed at the year end,
the trade payable could be significantly over or under valued, depending on the
movement of the dollar to euro exchange rate between the purchase date and the year
end. The components should remain at historic cost within inventory valuation and
should not be retranslated at the year end.

Revenue Recognition – timing

Manuka raises sales invoices in three stages. There is potential for breach of MFRS 15
Revenue from Contract with Customers.
The core principle of MFRS 15 is that an entity will recognise revenue to depict the
transfer of promised goods or services to customers in an amount that reflects the
consideration to which the entity expects to be entitled in exchange for those goods or
services.

MFRS 15 ensure revenue should only be recognised once the seller has the right to
receive it, in other words the seller has performed its contractual obligations. This right
does not necessarily correspond to amounts falling due for payment in accordance with
an invoice schedule agreed with a customer as part of a contract. Manuka appears to
receive payment from its customers in advance of performing any obligation, as the stage
one invoice is raised when an order is confirmed i.e. before any work has actually taken

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place. This creates the potential for revenue to be recognised too early, in advance of any
performance of contractual obligation. When a payment is received in advance of
performance, a liability should be recognised equal to the amount received, representing
the obligation under the contract. Therefore a significant risk is that revenue is overstated
and liabilities understated.

Disputed receivable
The amount owed by Mammoth is highly material as it represents 50·9% of profit before
tax, 2·3% of revenue, and 3% of total assets. The risk is that the receivable is overstated
if no impairment of the disputed receivable is recognised. In accordance to MRFS9 –
Financial instruments, trade receivable should be impaired and credit loss allowance
should be provided if any of the receivable is expected not to be collected

Related party transactions

Dato Tony controls Manuka Bhd and also controls Pacific Bhd. Transactions between the
two companies should be disclosed per MFRS 124 Related Party Disclosures. There is
risk that not all transactions have been disclosed, or that a transaction has been disclosed
at an inappropriate value. Details of the lease contract between the two companies should
be disclosed within a note to the financial statements, in particular, any amounts owed
from Manuka to Pacific at 31st March, 2022 should be disclosed.

First time audit & Dateline

This is the first year audit and therefore the audit team will be working with a steep
learning curve. Audit procedures may take longer than originally planned, yet there is
little time to extend procedures where necessary.
Dato Tony wants the audit to be completed as soon as possible, which brings forward the
deadline for completion of the audit. The audit team may not have time to complete all
necessary procedures, or there may not be time for adequate reviews to be carried out on
the work performed. Detection risk, and thus audit risk is increased, and the overall
quality of the audit could be jeopardised.

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