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Mercurio Co

Briefing notes

To: Ted Hastings, audit engagement partner

From: Audit manager

Subject: Audit planning – Mercurio Co

Date: 1 July 20X5

Introduction:

These briefing notes have been prepared to assist with the audit planning of Mercurio Co for the year ending 30 September 20X5. The briefing
notes starts with an evaluation of significant business risk faced by Mercurio Co. The briefing notes move on to the evaluation and prioritisation of
significant risks of material misstatement.

Additionally, a discussion is done on the the impact which outsourcing the credit control function will have on our audit planning. Finally the
briefing notes ends with the principal audit procedures to be performed in respect of the holiday pay obligation.

Materiality

For the purpose of these briefing notes the overall materiality level used to assess the significant risk of material misstatement is $4 million as
requested.

Justification

Using profit before tax of $60 million as a suggested benchmark, results in a suggested range of $3million to $6million.

Materiality should be set the lower end of the range because Mercurio Co is a listed client and has taken out bank loan. Mercurio Co has also
started its new brand and has purchased a store from Lakewell Co, due to this detection risk is high.

This benchmark is only a starting point for determing the materiality and professional judgement will need to be applied in determining a final level
to be used during the course of the audit.

(a) Business risks

7/8
Animal welfare standards

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Mercurio sells small and other unsual animals, It is highly likely that Mercurio Co has to comply with special animal welfare legal requirements.
The animal requires a clean and safe environment to live and there is a risk that Mercurio Co does not meet these welfare regulations, this could
result in loss of reputation for the Company and along with the sale of animals the sale of animal related products could also be effected.

Veterinary Clinics

Mercurio faces another reputational risk if the Health and safety standards for the Veterinary Clinics are not met. If Mercurio does not comply with
health and safety regulations in its clinics it could result in animals being treated with unhygenic tools which could result in loss of life of the
animals.

Furthermore Mercurio co offers annual pet healthcare plan which covers the cost of essential vaccinations and quaterly health checks. The cost of
vaccinations and health checks have increased over recent years and Mercurio Co has not been able to increase the prices. If Mercurio Co is not
able to rise its prices for the vaccinaction and health check it offers, it could lead to mercurio Co making little to none profit in the future.

Stores purchasaed

Mercurio co has purchased 20 new stores using their cash reserves. The stores need to be reffited which will cost Mercurio Co $180 million and
Mercurio Co plans to complete this in 3 months time.

Mercurio Co's cash balance is $36 million which is sufficient enough to be used for only 4 stores, that is if Mercurio Co uses all of its Cash
balance, which is unlikely as Mercurio Co has to use its cash for operational purposes too.

Mercurio Co is likely to take out loans in order to complete its store and there is a risk that Mercurio Co will take out more loans then it can repay.

If Mercurio Co is not able to refit all of the stores there is still a risk that the remaining stores will not be sold and Mercurio co will be left with
unused assets and low cash balance to carry out its operational activities.

(b) Risks of material misstatement 14/16

Revenue

Mercurio Co offers full range of veterinary services, Customers can take an annual pet healthcare plan.

According to IFRS 15 revenue, revenue should only be recognised when the performance obligation has been satisfied. In the case of Mercurio
co the performance obligation to treat animals will be satisfied over the period of one year, so the revenue should be recognised over the period of
time.

There is a risk that Mercurio Co has recognised full year revenue at the start of commencement of the annual health care plan which is not
allowed under IFRS 15.
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If Mercurio co has recognised full year revenue then the profit will be overstated.

The health care plans constitutes 10% of the company's total revenue which turn out to be $ 80.3 million, based on the materiality level this
amount is highly material and if wrongly recognized the financial statement will be materially misstated.

There is also a risk of management bias with regards to revenue recognition as Mercurio Co is expanding its business and took out a loan and it
is expected that further loan will be taken out. By increasing the Revenue figure the Net profit of Mercurio will increase significantly it would help
the management to secure the loan application if the acceptance of Loan application is based on net profit.

The audit team must maintain professional skepticism when performing the audit of Revenue.

Non-current assets IAS 16 = cost or revaluation model IFRS 5= Fair vlaue less cost to sell.... measurement value will be different depending how assets
are classified. So, risk of figures also materially misstated if not properly classified.
Mercurio Co has purchased 20 new stores at the cost of $171 million as part of its expansion plan. There is a risk that all of the stores are not
classified correctly which would overstate the non-current assets.
if Mercurios is actively advertising the properties for sale at reasonable price, intend to sell in 12 month, sale is highly probable they IFRS 5 criteria will be met
Mercurio Co has plan to sell the stores which cannot be retained in the business, according to IFRS 5, if the criteria of non-current asset held for
sale has been met then the asset should be classified separately as asset held for sale.

If the conditions of IFRS 5 has been met for the stores which will not be retained for use in the business at the year end then the assets must be
classified seprately and not within non-current assets. There is a risk that management has incorrectly classified asset held for sale under non-
current assets.

Substantive testing would need to be performed during the course of the audit to determine whether the managemet has plans to sells some of
the stores and if the criteria has been met for IFRS 5, if it has then those balances should be removed from the Non-current asset head under the
statement of Financial position.

4 Holiday pay obligation

The holiday pay obligation has increased significantly by 82% and based on the materiality threshold it is highly material.

The employees are entitled to carry forward a maximum of 3 days of unused holiday entitlement. The Management estimates a holiday pay
obligation relating to unused holiday entitlement at the year-end using the previous year’s obligation and adjusting it for pay rises and changes in
staff levels. The employee number has increased by 800 in the current year which is an increase of 13% from the previous year, this is not
enough to justify the 82% increase in Holiday pay obligation.

There is a risk that the management has used the wrong judgment to determine the holiday pay obligation, which is even more possible because
the payroll system has deficiencies and manual records are maintained, this could means that the management judgment is not based on
accurate information from the payroll system.

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2 Destroyed inventory

Mercurio Co purchased $12 million of pet food supplies from an international supplier, with the sales contract stating that ownership of the goods
passed to Mercurio Co at the date of shipping. During transit the ship was involved in an accident which destroyed the entire supply.

According to the contract, the control of inventory has been passed to Mercurio Co hence the destroyed goods, recorded as inventory, must be
derecognised from current assets.

Mercurio Co has not yet derecognised the destroyed inventory from its current asset which leads to overstated assets and profit. The correct
accounting treatment would be to remove the assets and expense them out through a statement of Profit or loss.

There is a risk of management bias that the management wants to show a healthy position of the company to get loan approval.

1.5 Insurance claim

80% of the destroyed goods are covered by Insurance. If the receipt of Insurance proceeds is probable then a contengent asset is disclosed in
the financial statements and if the receipt is Virtualy certain then the Proceeds are recognised in the statement of financial statement.

In this case, Mercurio co has received an informal email that the claim had been received and was due to be processed. It seems that in this case
that it is probable that the insurance proceeds will be received by the company hence according to IAS 37 disclosure is required for contingent
asset.

There is a risk that the management has not disclosed this contingent asset of $9.6 million for the insurance proceeds receivable.

2.5 Financial analysis

The company's revenue is expected to increase by 7.8% in the current year and the operating profit is expected to increase by 56%. And the
operating profit margin is expected at 21.4% in the current year while in the last year, it was 14.7% This increase in profit is not in line with the
increase in Revenue. This could mean that the management is using creative accounting to show a good performance of the company. The risk of
management bias is high considering that the company might be looking to approve new loan for expansion.

Conclusion

The significant risk of material misstatement are highlighted above based on their impact and the probability of their occurance, however the
most significant risk of material misstatement is the purchase of non-current assets as they are highly material and incorrect treatment of these
non-current assets will have a significant impact on the financial statements.

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(c) Impact of outsourcing the credit control function 3/7

The auditor must obtain an understanding of the outsourced function of the client to effectively plan the audit, during the process of obtaining the
understanding, the auditor must take into account several key considerations

The auditor should

Evaluate the nature of the service provided by the service organization and the significance of that service to the client.
Consider the materiality of the transactions that are processed.
Understand the relationship between the client and the service orginistion and the relevant contractual terms between them.

In the case of Fairbank Co the auditor must establish whether Fairbank Co is only involved in recording and processing the transactions or if it
also executes the transactions. The decisions made by Fairbank Co should be evaluated by the auditor, especially those of a judgmental nature,
for example, bad debts and allowances for receivables.

(d) Principal audit procedures in respect of holiday pay obligation 5/7

Discuss with the management how they have estimated the obligation for the current year and what assumptions were used by them to
reach this amount, and discuss the reasonbleness of the assumptions
Evaluate the effectiveness the controls surrounding the payroll system to determine the accuracy of information used.
For a sample of employees recalculate the holiday pay obligation taking into account the 3 days carried forward unused holidays.
Compare the previous year's Holiday pay obligation to actual amount paid and assess the accuracy of management's judgement.
Obtain written representation from the management, whether they believe the estimates used to reach the obligation amount is reasonable.

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(a) Evaluate the matters to be considered by Gnome & Co before accepting Kobold Co as a client and the engagement to review and report on
the capital expenditure forecast. (10 marks)
>Learn acceptance procedure specific to PFI.
5/10
Matters to consider before accepting

ISQM1 provides guidance on what matters are to be considered before accepting a client for a review engagement. In addition to that Gnome Co
should also assess the ethical and professional issues that could arise if the client is accepted.

Customer due diligence

Gnome & Co should do due diligence of the client to assess if the key management personnel of Kobold Co are involved in anything illegal like
money laundering, insider trading etc.

Customer due diligence is an important step for understanding the integrity of the management and understanding the reputation of the client. If
the key personnel are involved in illegal activities or the company has a bad reputation the Firm could also face negative consequences.

Appointment of a different firm

Ideally, Kobold Co's external auditors are in a better condition to perform the assurance review because they are already have the knowledge of
Kobold Co. Gnome & Co should inquire from the management the reason for not considering their external auditors for the assurance review. It
might be possible that the management of Kobold & Co don't want to challanged in the use of their assumption used for creating the capital
expenditure forecast. Gnome & Co, by the permission of Kobold Co, should contact the external auditors and to obtain relevant information.

Assessment of resources available

Before accepting the engagement Gnome & Co should assess whether or not they have the workforce available to be engaged in this
assignment. Consideration should also be given as to whether the team that will be involved in the engagement has the necessary skills and
expertise to perform this assurance engagement effectively.

Gnome & Co also needs to know the timing of the report required by the management and should assess whether in the given time the
assignment could be completed or not.

Scope of work

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Gnome Co should know the specific requirements of the management in terms of assurance engagement so proper planning can be done
beforehand. Gnome Co should assess the requirements of the bank and the details required by the bank in the form of a report. Since this is a
non-audit assingment and an assurance engagement, negative assurance will be given by the professional accountant, Gnome Co should make
sure that they are being asked for negative assurance only.

Intended use

Gnome & Co should enquire from the management about the intended use of the report. It must be clear from the start whether the report is only
for the purpose of securing the bank loan or the management has plans to use the report somewhere else too.

Ethical issues

Since this is the first time Gnome & Co are being engaged with Kobold Co, Gnome & Co should assess any ethical threats that could potentially
arise after accepting the engagement. Gnome & Co should make sure that the team selected for the assignment has professional competence
and no threat to objectivity, otherwise the report will not be reliable.

Legal and regulatory considerations

Gnome and Co should assess if they are familiar with the legal and regulatory framework surrounding Kobold Co. Since Kobold Co is in the
construction sector, the laws and regulations for construction are usually strict. For the assurance report on capital expenditure forecast, Gnome
Co would be assessing if the construction is not in breach of any laws and regulations.

(b) Assuming Gnome & Co accepts the engagement, recommend the examination procedures to be performed in respect of Kobold Co’s capital
expenditure forecast. (10 marks) 8/10

Obtain the breakdown for each of the category of the forecast, cast to confirm the arithmetical accuracy.
For the elements of the forecast, such as legal fees, and Architect and surveyor fees, obtain the quotations from the management and
assess whether the correct amount is reflected in the forecast.
Obtain the contracts for the elements of forecast and assess whether any further fee could be charged for the construction and discuss with
the management for inclusion of any additional fee.
The elements for which judgment has been used by the management such as site preparation and tree removal, discuss with the
management on how they applied their judgement and assess its reasonableness.
Perform analytical review on the forecast figures and compare them with any other capital expenditure.
Obtain written representation from the management to confirm the assumption used in preparing the forecast are reasonable and all
relevant has been provided in the forecast.
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Discuss with the management whether any additional elements should be included in the forecast, such as any restoration cost of nearby
land.
Review board minutes to assess if all of the costs which are required to complete the construction are included in the forecast.

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(a) Matters to be considered and audit evidence expected

(i) Lease 8/9 Wrong treatement

During the start of the year management leased a new property. The property is correctly treated as a right-of use asset and a lease liability of
$28.9 million. According to IFRS 16 a lease liability is the present value of future lease payments and also include any lease payment made
before or on the commencement of the lease. The right-of-use asset is depreciated and the lease liability is increased every month by the interest
rate implicit in the contract.

The first year of the lease liability is a rent free period and management has not charged any depreciation on the right of use asset because of
this. This is not in accordance with IFRS 16. The right of use asset will be depreciated regardless of rent is paid on the lease or not.

The depreciation charge for the period is $4.12 million which is above the materiality threshold of $1.1 million. The treatment proposed by
management to begin depreciation in the next year over 6 years time is incorrect. Depreciation should be charged for the current year, failing to
do so will result in non-current assets and profit overstated.

Evidence

Copy of lease agreement, highlighting the lease terms such as the lease period and the interest rate.
Recalculation of working performed for determining the lease liability in the lease working paper.
Copy of fixed asset schedule which confirms the right of use asset is recorded correctly.
Evidence of the physical inspection performed on the property to confirm the existence.
Copy of the depreciation policy to determine if it is applied consistently.

(ii) Inventory 6/7

As per the agreement with the new supplier the supplier can require the return of the products at any time. according to IFRS, asset can only be
recognied in the statement of financial position when the control of the asset has passed from the supplier to the customer. In the case of Marlos
Co, the control is still with the supplier hence the inventory should not be recognised in current asset.

Instead of recognising inventory, the amount of $8.1 million should be recognised as receivable as Marlos has right to refund if the supplier
requests the inventory to return. The amount of $8.1 million is highly material and if not corrected the financial statement would be materially
misstated.

Evidence

Copy of the contract with the new supplier, highlighting the clause for rights of goods and the total amount of goods.
Notes to the discussion with the management for the wrong accounting treatment applied in respect of the inventory.
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Copy of year-end inventory report to determine the amount of the unsold inventory.
Calculation of goods that were returned to supplier if they were unsold.

(b) Implication for the auditor's report

If the adjustment is not made in respect of the depreciation, the profit and non-current assets will be overstated by $4.12 million, which is above
the materiality threshold. The Implication of this non-adjustment would result in the financial statements being materially misstated, however it is
only material and not pervasive.

The audit opinion would be modified and a qualified opinion would be given, the opinion paragraph would be presented as Qualified opinion and
would be worded as "Except for .... the financial statements are free from material misstatement".

The qualified opinion paragraph will be followed by Basis for qualified opinion which will explain the reason for the qualification

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