Hijau Sdn Bhd

(a) Identify the areas of audit risk and explain the factors which have led you to
identify that risk means what are the factors that may negatively impact your
audit work, what could possibly make you incur an error in judgement, where in
the f/s may contain misstatement, what can pose problems to the company’s
operation/survival etc and why?

Basically, watch out for the BR and AR (AR = IR x CR x DR). Refer back to my
slides on risk assessment (Ch 9).

In solving this kind of question, read and re-read the case line by line, identify
all the accounts involved and think of what could possibly go wrong with those
accounts. It is possible that every account mentioned in the case would carry
some elements of risk to it; therefore, just cite them and explain. Watch out for
factors that may impact BR and going concern. Cite and explain them too.

Ans:
First year audit (1)
[Hijau is a new client] and as such [the firm will lack cumulative audit knowledge
and experience].
[This will increase the risk that the firm’s audit procedures do no detect material
misstatements in the financial statements].
[It may be difficult to gain assurance over opening balances as the firm did not
audit these in the prior year].

Going concern
[Hijau is increasingly reliant on loans from the bank and has plans to increase
debt further in order to finance its diversification plans which will put further
strain on its cash flow]. (18)
[The bank may also be unaware that RM1.5 million of the recent loan was used
to pay for the sponsorship deal]. [If this falls outside the purpose of the loan the
bank may require the loan to be repaid in full immediately]. (7)
[Hijau is also subject to import licence terms and is regularly inspected for
compliance. Any non-compliance may result in the licence being withdrawn and
impact on Hijau’s ability to continue trading]. (12)

Non-current tangible assets/ assets under construction (4)

A programme of building works has been ongoing during the year. This may
result in [inappropriate capitalisation of costs associated with the building
works] or could [lead to costs being included in the statement of profit or loss
that should be capitalised].
In addition, [management’s determination of useful lives may be inappropriate]
or [depreciation may be charged in error while assets are still under
construction].

Inventory
[Inventory days has increased from 25 days to 35 days which may suggest
obsolete or slow-moving inventory], particularly given the perishable nature of
some of the inventory in question. (16)
[Trees and plants are purchased from overseas and invoiced in suppliers’ local
currencies]. This could [lead to translation errors or an inappropriate exchange
rate being applied]. (11)
[Certain species of plant may be difficult to recognise] if those undertaking the
inventory count are not specialists and consequently, [inappropriate values
maybe be applied to the items counted]. (10)

Liabilities
[The bank loan was obtained on 31 October 2020] and is repayable over three
years]. [There is a risk that the loan balance may not be correctly classified as
current and medium-term liabilities]. (5)
[Were Hijau to fail an inspection as part of its requirement to have an import
licence, this may lead to fines or penalties, which may not be properly recorded
or disclosed in the financial statements]. (12)

Revenue

Hijau’s business is a [cash-based retail business resulting in an increased risk

that sales are made without some transactions being recorded], [resulting in an
understatement of revenue]. (3)
However, [revenue has increased by 34.3% from the prior year] which indicates
a possible [overstatement of revenue]. (13)

Purchases and trade payables

[Trade payable days have fallen from 36 to 31 days] (17) and the [gross profit
margin has increased from 30 to 36.6%] (14) both of which may [indicate an
understatement of purchases] and trade payables].

Finance cost
[Interest on the loan is due quarterly in arrears which may result in a failure to
accrue for the payment due in the last quarter of the year]. (6)
 In addition, [finance costs in the draft financial statements have increased only
by 2.5% on the prior year]. (15) [The increase would be expected to be greater
given that the directors obtained a new loan] on 31 October 2020].

Wages and salaries and balances due to IRB (9)

[A large volume of temporary workers is employed in the peak sales season
between April and September].
This [may result in errors in recording payroll costs and the associated Pay-As-
You-Earn (PAYE) and Net Interest Cost (NIC) payments due to Employee’s
Provident Fund (EPF) and Inland Revenue Board (IRB).

Sponsorship payment (8)

[The sponsorship agreement covers a two-year period].
[The expense should be matched to the periods which benefit from the
sponsorship arrangement. For example, matching 1/8th (3/24 months) to the
current financial period] and recognising 7/8th as a prepayment].
[If there is any question as to whether there is any future benefit arising from
the sponsorship arrangement then it may be necessary to recognise all of the
related cost in the current year’s financial statements], reducing the risk of
misstatement].

Control risk (2)

[Hijau employs a large volume of temporary staff across 30 garden centres
which results in an increased risk of human error] or failure to understand and
apply internal control procedures].
[This may lead to an increased risk of misstatement in the financial statements].

Management bias (19)

[Hijau has applied for a further loan to finance its diversification plans].
[The bank has requested a copy of the audited financial statements before
deciding to provide Hijau with the loan requested].
[Such reliance by the bank increases the risk of management bias in the
financial statements as management will be keen to reflect the financial status
of the company in a way that will secure the additional finance sought].
Furthermore, [there may be loan covenants attached to the existing finance,
which further increases the likelihood of management bias where such
covenants relate to items in the financial statements].

(b) (1) Responsibilities of the firm to include making recommendations

ISAE 34000 The Examination of Prospective Financial Information, sets out
guidelines for firm undertaking engagements to review forecasts such as those
prepared by the directors of Hijau. Responsibilities of the firm would include the
following:
 [Assessing the reasonableness of management assumptions]
 [Consideration of whether the forecasts are properly prepared on the
basis of the assumptions]
 [Consideration of whether the forecasts are properly presented]
 [Consideration of whether the forecasts are prepared on a consistent
basis with the historical financial statements using appropriate accounting
policies]
 [Izaty’s proposal for the firm’s responsibilities goes beyond the procedures that
normally form part of such an engagement as set out ISAE3400].

[It is management’s responsibility to prepare the forecasts.]

If the firm were to advise the directors of Hijau on [the preparation of the
forecasts this may threaten the objectivity and independence of the firm].

[A management threat is likely to arise as such work would involve making

judgements and decisions about the content of the profit and cash flow
forecasts].

[An advocacy threat may also arise if the firm is seen to be supporting Hijau’s
position with regard to management’s application to the bank] with the [risk that
the firm’s views become too closely aligned with those of management].

[A self-review threat would be created if the firm were to advise the directors
of Hijau on the preparation of the forecasts] and then [also undertake the
independent examination of the forecasts as requested by the bank]. It is
[unlikely the firm would criticise its own work or highlight issues in relation to the
preparation of the forecasts in its report to the bank].

[The firm may also be exposed to future claims by Hijau if, having advised on
the content of the forecasts, the request to the bank for finance is then
unsuccessful.]

(2) Payment of firm’s fee

The fee arrangement proposed by Izaty represents a [contingent fee which is
not permitted by the ICAEW Code of Ethics].

The [provision of non-audit services on such a basis threatens the auditor’s

objectivity and independence by creating a self-interest threat].

[The firm would not be paid if the application to the bank was unsuccessful.]
Therefore [the firm may be reluctant to reach a conclusion on the examination
which may result in the application being declined by the bank].

Consequently, [the firm may reach an inappropriate conclusion].

[Such a threat is so significant that safeguards cannot adequately reduce the

threat]. It may also be perceived that [the firm’s interests become too closely
aligned with those of the directors at Hijau].

(c) Implications on audit report

(a) Not a going concern

If the financial statements are prepared with an inappropriate going concern
basis and this is explained in the notes to the financial statements, an
unmodified opinion can be given. The auditor’s report will be modified with
 an emphasis of matter paragraph highlighting the issue and drawing the
users’ attention to the note in the financial statements. There should be a
specific statement stating that the audit opinion is not qualified.

If the financial statements are prepared on the going concern basis, the
report/opinion should be modified due to material misstatement. The
opinion should be an adverse opinion (ie, ‘do not give a true and fair view’)
as the issue is material and pervasive. The reasons for the adverse opinion
and the effects on the financial statements should be explained in a
paragraph immediately after the opinion paragraph.

(b) Uncertainty regarding going concern

If the financial statements are prepared on the going concern basis and the
uncertainty is adequately explained in the notes to the financial statements,
an unqualified but modified report should be issued. There should be a
paragraph headed ‘material uncertainty related to going concern after the
opinion paragraph drawing users’ attention to the note in the financial
statements. There should be a specific statement stating that the audit
opinion is not qualified.

If the uncertainty is not, or inadequately, explained in the notes to the

financial statements, the opinion should be modified due to material
misstatement. The modification may be a qualified opinion/except for if
considered material.