Additional practise questions p7

Test your understanding 1


You are the audit manager in charge of the audit of Hydrasports for the year ending 31 December 20X4.


Hydrasports, a limited liability company and national leisure group, has sixteen centres around the country and a head office. Facilities at each centre are of a standard design which incorporates a heated swimming pool, sauna, air-conditioned gym and fitness studio with supervised childcare. Each centre is managed on a day-to-day basis, by a centre manager, in accordance with company policies. The centre manager is also responsible for preparing and submitting monthly accounting returns to head office.


Each centre is required to have a licence from the local authority to operate. Licences are granted for periods between two and five years and are renewable subject to satisfactory reports from local authority inspectors. The average annual cost of a licence is $900.


Members pay a $100 joining fee, plus either $50 per month for ‘peak’ membership or $30 per month for ‘off-peak’, payable quarterly in advance. All fees are stated to be non-refundable.


The centre at Verne was closed from July to September after a chemical spill in the sauna caused a serious accident. Although the centre was reopened, Hydrasports has recommended to all centre managers that sauna facilities be suspended until further notice.


In response to complaints to the local authorities about its childcare facilities, Hydrasports has issued centre managers with revised guidelines for minimum levels of supervision. Centre managers are finding it difficult to meet the new guidelines and have suggested that childcare facilities should be withdrawn.


Staff lateness is a recurring problem and a major cause of ‘early bird’ customer dissatisfaction with sessions which are scheduled to start at

07.00. New employees are generally attracted to the industry in the short-term for its non-cash benefits, including free use of the facilities – but leave when they require increased financial rewards. Training staff to be qualified lifeguards is costly and time-consuming and retention rates are poor. Turnover of centre managers is also high, due to the constraints imposed on them by company policy.


Three of the centres are expected to have run at a loss for the year to 31 December 20X4 due to falling membership. Hydrasports has invested heavily in a hydrotherapy pool at one of these centres, with the aim of attracting retired members with more leisure time. The building contractor has already billed twice as much and taken three times as long as budgeted for the work. The pool is now expected to open 2 months after the year-end.


Cash flow difficulties in the current year have put back the planned replacement of gym equipment for most of the centres.


Insurance premiums for liability to employees and the public have increased by nearly 45%. Hydrasports has met the additional expense by reducing its insurance cover on its plant and equipment from a replacement cost basis to a net realisable value basis.




Prepare briefing notes for the audit engagement partner which:


(a)    Evaluate the business risks faced by Hydrasports.            (12 marks)


  • Evaluate the risks of material misstatement to be considered when

planning the audit of Hydrasports.                                                                                                                     (10 marks)


  • Describe the audit procedures to be performed in respect of the carrying amount of the following items in the statement of financial position of Hydrasports as at 31 December 20X4:



(i)     Deferred income, and



(4 marks)




(ii)    Hydrotherapy pool.


(5 marks)



  • Suggest performance indicators that could be set to increase the

centre managers’ awareness of Hydrasports’ social and environmental responsibilities and the     which should be


available to provide assurance on their accuracy.                                                                                                                        (5 marks)


Professional marks will be awarded for the presentation, logical flow and

clarity of explanation of the briefing notes.                                                                                                                                   (4 marks)


(Total: 40 marks)



Test your understanding 2


You are the audit manager in charge of the audit of Cerise for the year ending 31 December 20X4.


Cerise, a limited liability company, manufactures computer controlled equipment for production-line industries such as cars, washing machines, cookers, etc. On 1 September 20X4 the shareholder-managers decided, unanimously, to accept a lucrative offer from a multinational corporation to buy the company’s patented technology and manufacturing equipment.


By 10 September 20X4 management had notified all the employees, suppliers and customers that Cerise would cease all manufacturing activities on 31 October 20X4. The 200-strong factory workforce and the majority of the accounts department and support staff were made redundant with effect from that date, when the sale was duly completed.


The marketing, human resources and production managers will cease to be employed by the company at 31 December 20X4. However, the chief executive, sales manager, finance manager, accountant and a small number of accounting and other support staff expect to be employed until the company is wound down completely.


Cerise’s operations extend to fourteen premises, nine of which were put on the market on 1 November 20X4. Cerise accounts for all tangible, non-current assets under the cost model (i.e. at depreciated cost). Four premises are held on leases that expire in the next two to seven years and cannot be sold or sub-let under the lease terms. The small head office premises will continue to be occupied until the lease expires in 20X7. No new lease agreements were entered into during 20X4.


All Cerise’s computer controlled products carry a one-year warranty. Extended warranties of three and five years, previously available at the time of purchase, have not been offered on sales of remaining inventory from 1 November onwards.


Cerise has three-year agreements with its national and international distributors for the sale of equipment. It also has annual contracts with its major suppliers for the purchase of components. So far, none of these parties have lodged any legal claim against Cerise. However, the distributors are withholding payment of their account balances pending settlement of the significant penalties which are now due to them.




Prepare briefing notes for the audit engagement partner which:


  • Evaluate the audit risks to be considered when planning the audit of

Cerise for the year ending 31 December 20X4.                      (14 marks)


  • Explain how the extent of the reliance to be placed on analytical procedures and written representations should compare with that for


the prior year audit.                                                                                     (6 marks)


  • Describe the audit procedures to be performed in respect of the

amounts due from distributors                                                               (5 marks)


Professional marks will be awarded for the presentation, logical flow and

clarity of explanation of the briefing notes.                                                (4 marks)


(Total: 30 marks)



Test your understanding 3


You are the audit manager in charge of the audit of Geno Vesa Farm (GVF) for the year ending 30 September 20X4.


GVF, a limited liability company, is a cheese manufacturer. Its principal activity is the production of a traditional ‘Farmhouse’ cheese that is retailed around the world to exclusive shops, through mail order and web sales. Other activities include the sale of locally produced foods through a farm shop and cheese-making demonstrations and tours.


The farm’s herd of 700 goats is used primarily for the production of milk. Kids (i.e. goat offspring), which are a secondary product, are selected for herd replacement or otherwise sold. Animals held for sale are not usually retained beyond the time they reach optimal size or weight because their value usually does not increase thereafter.



There are two main variations of the traditional farmhouse cheese: ‘Rabida Red’ and ‘Bachas Blue’. The red cheese is coloured using Innittu, which is extracted from berries found only in South American rain forests. The cost of Innittu has risen sharply over the last year as the collection of berries by local village workers has come under the scrutiny of an international action group. The group is lobbying the South American government to ban the export of Innittu, claiming that the workers are being exploited and that sustaining the forest is seriously under threat.


Demand for Bachas Blue, which is made from unpasteurised milk, fell considerably in 20X2 following the publication of a research report that suggested a link between unpasteurised milk products and a skin disorder. The financial statements for the year ended 30 September 20X3 recognised a material impairment loss attributable to the equipment used exclusively for the manufacture of Bachas Blue. However, as the adverse publicity is gradually being forgotten, sales of Bachas Blue are now showing a steady increase and are currently expected to return to their former level by the end of September 20X4.


Cheese is matured to three strengths – mild, medium and strong – depending on the period of time it is left to ripen, which is six, 12 and


18 months respectively. When produced, the cheese is sold to a financial institution, Abingdon Bank, at cost. Under the terms of sale, GVF has the option to buy the cheese on its maturity at cost plus 7% for every six months which has elapsed.


All cheese is stored to maturity on wooden boards in GVF’s cool and airy sheds. However, recently enacted health and safety legislation requires that the wooden boards be replaced with stainless steel shelves with effect from 1 July 20X4. The management of GVF has petitioned the government health department that to comply with the legislation would interfere with the maturing process and the production of medium and strong cheeses would have to cease.


In 20X3, GVF applied for and received a substantial regional development grant for the promotion of tourism in the area. GVF’s management has deferred its plan to convert a disused barn into holiday accommodation from 20X4 until at least 20X6.




Prepare briefing notes for the audit engagement partner which:


  • Evaluate the audit risks to be considered when planning the final audit of GVF for the year ending 30 September 20X4.


(16 marks)



  • Describe the audit procedures to be performed in respect of the carrying amount of the following items in the statement of financial position of GVF as at 30 September 20X4:


(i)     Goat herd                                                                                               (5 marks)


(ii)    Cheese.                                                                                                   (5 marks)


Professional marks will be awarded for the presentation, logical flow and

clarity of explanation of the briefing notes.                                                (4 marks)


(Total: 30 marks)



Test your understanding 4


Bellatrix is a carpet manufacturer and an audit client of your firm. Bellatrix has identified a company in the same business, Scorpio, as a target for acquisition in the current year.


As audit manager to Bellatrix and its subsidiaries for the year ended 31 December 20X4, you have been asked to examine Scorpio’s management accounts and budget forecasts. The chief executive of Bellatrix, Sirius Deneb, believes that despite its current cash flow difficulties, Scorpio’s current trading performance is satisfactory and future prospects are good. The chief executive of Scorpio is Ursula Minor.


The findings of your examination are as follows:


Budget forecasts for Scorpio, for the current accounting year to

31 December 20X4 and for the following year, reflect a rising profit trend.


Scorpio’s results for the first half year to 30 June 20X4 reflect $800,000 profit from the sale of a warehouse that had been carried in the books at historical cost. There are plans to sell two similar properties later in the year and outsource warehousing.


About 10% of Scorpio’s sales are to Andromeda, a limited liability company. Two members of the management board of Scorpio hold minority interests in Andromeda. Selling prices negotiated between Scorpio and Andromeda appear to be on an arm’s length basis.


Scorpio’s management accounts for the six months to 30 June 20X4 have been used to support an application to the bank for an additional loan facility to refurbish the executive and administration offices. These management accounts show inventory and trade receivables balances that exceed the figures in the accounting records by $150,000. This excess has also been reflected in the first half year’s profit. Upon enquiry, you have established that allowances, to reduce inventory and trade receivables’ to estimated realisable values, have been reduced to assist with the loan application.


Although there has been a recent downturn in trading, Ursula Minor has stated that she is very confident that the negotiations with the bank will be successful as Scorpio has met its budgeted profit for the first six months. Ursula believes that increased demand for carpets and rugs in the winter months will enable results to exceed budget.




  • Identify and comment on the implications of your findings for Bellatrix’s plan to proceed with the acquisition of Scorpio.


(10 marks)


  • Explain what impact the acquisition will have on the conduct of your audit of Bellatrix and its subsidiaries for the year to 31 December


20X4.                                                                                                                     (15 marks)


(Total: 25 marks)



Test your understanding 5


You are the manager responsible for the audit of Volcan, a long-established limited liability company. Volcan operates a national supermarket chain of 23 stores, five of which are in the capital city, Urvina. All the stores are managed in the same way with purchases being made through Volcan’s central buying department and product pricing, marketing, advertising and human resources policies being decided centrally. The draft financial statements for the year ended 31 March 20X4 show revenue of $303 million (20X3: $282 million), profit before taxation of $9.5 million (20X3: $7.3 million) and total assets of $178 million (20X3: $173 million).


The following issues arising during the final audit have been noted on a schedule of points for your attention:


  • On 1 May 20X4, Volcan announced its intention to downsize one of the stores in Urvina from a supermarket to a ‘City Metro’ in response to a significant decline in the demand for supermarket-style shopping in the capital. The store will be closed throughout June, re-opening on 1 July 20X4. Goodwill of $5.5 million was recognised three years ago when this store, together with two others, was

bought from a national competitor. 60% of the goodwill has been

written off due to impairment.                                                                                                                        (7 marks)


  • On 1 April 20X3 Volcan introduced a reward scheme for its customers. The main elements of the reward scheme include the awarding of a points to customers’ loyalty cards for every $1 spent, with extra points being given for the purchase of each week’s special offers. Customers who hold a loyalty card can convert their

points into cash discounts against future purchases on the basis of

$1 per 100 points.                                                                                                                        (6 marks)




  • In October 20X3, Volcan commenced the development of a site in a valley of outstanding natural beauty on which to build a retail megastore and warehouse in late 20X4. Local government planning permission for the development, which was received in April 20X4, requires that three 100-year-old trees within the valley be preserved and the surrounding valley be restored in 20X5. Additions to property, plant and equipment during the year include $4.4 million for the estimated cost of site restoration. This estimate includes a provision of $0.4 million for the relocation of the 100 year-old trees.


In March 20X4 the trees were chopped down to make way for a car park. A fine of $20,000 per tree was paid to the local government in

May 20X4.                                                                                                         (7 marks)




For each of the above issues:


  • Comment on the matters that you should consider; and


  • State the audit  that you should expect to find, in undertaking your review of the audit working papers and financial statements of Volcan for the year ended 31 March 20X4.


Note: The mark allocation is shown against each of the three issues.


(Total: 20 marks)



Test your understanding 6


You are the manager responsible for the audit of Albreda Co, a limited liability company, and its subsidiaries. The group mainly operates a chain of national restaurants and provides vending and other catering services to corporate clients. All restaurants offer eat-in, take-away and home delivery services. The draft consolidated financial statements for the year ended 30 September 20X4 show revenue of $42.2 million (20X3: $41.8 million), profit before taxation of $1.8 million (20X3: $2.2 million) and total assets of $30.7 million (20X3: $23.4 million).


The following issues arising during the final audit have been noted on a schedule of points for your attention:


  • In September 20X4 the management board announced plans to cease offering home delivery services from the end of the month. These sales amounted to $0.6 million for the year to 30 September

20X4 (20X3: $0.8 million). A provision of $0.2 million has been made as at 30 September 20X4 for the compensation of redundant employees (mainly drivers). Delivery vehicles have been classified as non-current assets held for sale as at 30 September 20X4 and measured at fair value less costs to sell, $0.8 million (carrying


amount, $0.5 million).                                                                                 (8 marks)


  • Historically, all owned premises have been measured at cost depreciated over 10 to 50 years. The management board has decided to revalue these premises for the year ended 30 September 20X4. At the statement of financial position date two properties had been revalued by a total of $1.7 million. Another 15 properties have since been revalued by $5.4 million and there remain a further three properties which are expected to be revalued during 20X5.


A revaluation surplus of $7.1 million has been credited to equity.


(7 marks)


  • During the year Albreda paid $0.1 million (20X3: $0.3 million) in fines and penalties relating to breaches of health and safety regulations. These amounts have not been separately disclosed but

included in cost of sales.                                                                                                                        (5 marks)




For each of the above issues:


  • Comment on the matters that you should consider, and


  • State the audit  that you should expect to find, in undertaking your review of the audit working papers and financial statements of Albreda Co for the year ended 30 September 20X4.


Note: The mark allocation is shown against each of the three issues.


(Total: 20 marks)



Test your understanding 7


You are the manager responsible for the audit of Visean, a limited liability company, which manufactures health and beauty products and distributes them through a chain of 72 retail pharmacies. The draft accounts for the year ended 31 December 20X3 show profit before taxation of $1.83 million (20X2: $1.24 million) and total assets

$18.4 million (20X2: $12.7 million).


The following issues are outstanding and have been left for your attention:


  • Visean owns nine brand names of fragrances used for ranges of products (e.g. perfumes, bath oils, soaps, etc), four of which were purchased and five internally generated. Purchased brands are recognised as an intangible asset at cost amounting to $589,000 and amortised on a straight-line basis over 10 years. The costs of generating self-created brands and maintaining existing ones are recognised as an expense when incurred. Demand for products of


one of the purchased fragrances, ‘Ulexite’, fell significantly in January 20X4 after a marketing campaign in December caused


offence to customers.                                                                                                                        (8 marks)


  • In December 20X3 the directors announced plans to discontinue the range of medical consumables supplied to hospital pharmacies. The plant manufacturing these products closed in January 20X4.


A provision of $800,000 has been made as at 31 December 20X3 for the compensation of redundant employees and a further $450,000 for penalties relating to early cancellation of contracts with

customers and suppliers.                                                                         (7 marks)


  • Historically the company’s statement of cash flows has reported net

cash flows from operating activities under the ‘indirect method’.

However, the statement of cash flows for the year ended

31 December 20X3 reports net cash flows under the ‘direct method’

and the corresponding figures have been restated.                (5 marks)




For each of the above issues:


  • Comment on the matters that you should consider; and


  • State the audit  that you should expect to find, in undertaking your review of the audit working papers and financial statements of Visean for the year ended 31 December 20X3.


(Total: 20 marks)



Test your understanding 8


  • Explain the importance of the role of objectivity to the auditor-client

relationship.                                                                                                      (5 marks)


  • You are the audit partner in a firm which provides a variety of accountancy-related services to a large portfolio of clients. The firm’s gross practice income is $1 million. The firm has a particularly successful tax department, which carries out a great deal of recurring and special tax work for both audit and non-audit clients. The tax manager has recently involved you in discussions with a major tax client who is considering changing its auditors. The client, Rainbow, would expect audit fees of around $100,000 (which is a reasonable fee for the audit). Your adult daughter has been working as an administrative assistant in the sales department of Rainbow for a year, after being introduced by the tax manager. She has just joined an employee share benefit scheme.


The client is keen to use the firm to provide audit services as he is pleased with the taxation services they provide. The managing director and major shareholder, Mr Parkes, has therefore offered an incentive to the audit fee of an additional 1% of profits in excess of $20 million, annually where relevant. The current recurring taxation fees from Rainbow are $35,000, and last year special tax work amounted to $25,000. Last year’s fees remain outstanding.


The managing director has suggested that you give consideration to the matter while staying for the weekend at his villa in Tenerife. He has arranged flights for both you and your spouse.




Comment on the matters that you should consider in deciding whether or not your audit firm can accept appointment as auditors of


Rainbow.                                                                                                                     (10 marks)


(Total: 15 marks)



Test your understanding 9


You are an audit manager in Sepia, a firm of Chartered Certified Accountants. Your specific responsibilities include advising the senior audit partner on the acceptance of new assignments. The following matters have arisen in connection with three prospective client companies:


  • Your firm has been nominated to act as auditor to Squid, a private limited company. You have been waiting for a response to your letter of professional enquiry to Squid’s auditor, Krill & Co, for

several weeks. Your recent attempts to call the current engagement partner, Anton Fargues, in Krill & Co have been met with the response from Anton’s personal assistant that ‘Mr Fargues is not

available’.                                                                                                                        (5 marks)


  • Sepia has been approached by the management of Hatchet, a company listed on a recognised stock exchange, to advise on a takeover bid which they propose to make. The target company, Vitronella, is an audit client of your firm. However, Hatchet is not.


(5 marks)


  • A former colleague in Sepia, Edwin Stenuit, is now employed by another audit firm, Keratin. Sepia and Keratin and three other firms have recently tendered for the audit of Benthos, a limited liability company. Benthos is expected to announce the successful firm next week. Yesterday, at a social gathering, Edwin confided to you that

Keratin lowballed on their tender for the audit as they expect to be

able to provide Benthos with lucrative other services.                                                                                                                        (5 marks)




Comment on the ethical and professional issues raised by each of the above matters and the steps, if any, that Sepia should now take.


Note: The mark allocation is shown against each of the three issues.


(Total: 15 marks)


Test your understanding 10


  • Explain why  may be difficult to implement in a smaller audit firm and illustrate how such difficulties may be overcome.


(5 marks)


  • Kite Associates is an association of small accounting practices. One of the benefits of membership is improved  through a peer review system. Whilst reviewing a sample of auditor’s reports issued by Rook & Co, a firm only recently admitted to Kite Associates, you come across the following modified opinion on the financial statements of Lammergeier Group:


Qualified opinion arising from material misstatement accounting treatment relating to the non-adoption of IAS 7 The management has not prepared a group statement of cash flows and its associated notes. In the opinion of the management it is not practical to prepare a group statement of cash flows due to the complexity involved. In our opinion the reasons for the departure from IAS 7 are sound and acceptable and adequate disclosure has been made concerning the departure from IAS 7. The departure in our opinion does not impact on the truth and fairness of the financial statements.


‘In our opinion, except for the non-preparation of the group statement of cash flows and associated notes, the financial statements give a true and fair view of the financial position of the Company as at 31 December 20X3 and of the profit of the group for the year then ended, and have been properly prepared in accordance with …’


Your review of the prior year auditor’s report has revealed that the 20X2 audit opinion was identical.




Critically appraise the appropriateness of the audit opinion given by Rook & Co on the financial statements of Lammergeier Group for

the years ended 31 December 20X3 and 20X2.                     (10 marks)


  • You are also the audit manager responsible for the audit of Hegas. The audit is nearly complete and you are reviewing the other information contained in the annual report before your firm’s auditor’s report is signed. The financial statements of Hegas, a privately owned civil engineering company, show total assets of $120 million, revenue of $261 million, and profit before tax of $9.2 million for the year ended 31 March 20X5.


The chairman’s statement contains the following information:


‘Hegas has now achieved a position as one of the world’s largest generators of hydroelectricity, with a dedicated commitment to accountable ethical professionalism’.


Audit working papers show that 14% of revenue was derived from hydro-electricity (20X4: 12%). Publicly available information shows that there are seven international suppliers of hydro-electricity in Africa alone, which are all at least three times the size of Hegas in terms of both annual revenue and population supplied.




Explain the auditor’s responsibilities for other information in documents containing audited financial statements and identify and comment on the implications of the above matter for the auditor’s report on the financial statements of Hegas for the year ended


31 March 20X5.      (10 marks)


(Total: 25 marks)



Test your understanding answers


Test your understanding 1


Briefing notes


To:                                     Audit partner


From:                              Audit manager


Date:                                01 December 20X4


Subject:                         Planning of the audit of Hydrasports for the year


ended 31 December 20X4




These briefing notes evaluate the business risks and risks of material misstatement in respect of Hydrasports. Audit procedures in respect of the deferred income and hydrotherapy pool have been included. Performance indicators in relation to social and environmental responsibilities along with the     that should be obtained to provide assurance over the indicators have been suggested.


  • Business risks Customer dissatisfaction


Sauna facilities are currently not available for members to use. Childcare facilities are considering being withdrawn due to complaints about levels of supervision. Hydrasports’ inability to retain lifeguards increases the risk that pools cannot open due to health and safety regulations. In addition, gym equipment is obsolete and therefore will not reflect the most up to date technology.


These issues are likely to lead to customer dissatisfaction. Additional expenditure will need to be incurred to resolve any problems. Members may ask for a partial refund on their membership fees as they do not have use of all of the facilities for which they are paying which will reduce future revenue.


Health and safety


Hydrasports could be sued if a member suffers injury as a result of unsafe equipment or due to a lack of qualified lifeguards. This will result in legal costs and may result in compensation payments.


Serious accidents may prompt investigation by local authority resulting in penalties, fines and/or withdrawal of licence to operate.




Hydrasports cannot operate a centre if a licence is suspended, withdrawn or not renewed (e.g. through failing a local authority inspection or failing to apply for renewal). Revenue will fall as a result.


Advance payments


Membership fees are received in advance. If cash flow is not managed properly, Hydrasports may not have the money in the bank to be able to meet pay future liabilities when they fall due.


Monthly accounting returns


Centre managers prepare monthly accounting returns. The managers may not have sufficient knowledge to do this accurately or efficiently. This could result in submission of inaccurate returns and incorrect management information being used for decision making. Centre managers may not have enough time to fulfil their day-to-day responsibilities (e.g. relating to customer satisfaction, human resources, health and safety) if the management information to be reported takes up too much of their time.


Centralised control


Centralised control through company policy is resulting in inefficient and ineffective operations as managers cannot respond on a timely basis to local needs. This may lead to poor decision making which will reduce profitability and customer dissatisfaction which may affect reputation and the ability to generate revenues.


Insurance cover


The reduction in insurance cover reduces the recoverable amount of assets in the event of loss. Due to Hydrasports’ cash flow issues, they may not have adequate resources to replace any assets not covered by insurance. This will impact the facilities that can be offered to members limiting the amount of revenue that can be earned.


High staff turnover


High staff turnover will lead to higher recruitment and training costs.

Employees will not be fully productive until they are familiar with Hydrasports’ working practices. This will reduce profitability.


  • Risks of material misstatement Non-compliance with health and safety regulations


There are several potential health and safety issues present in Hydrasports:


–    Childcare facilities are not adequately supervised.


–    Obsolete equipment may be unsafe to use.


– Accidents may occur due to pools being operated without a qualified lifeguard on duty.


Breaches of regulations could lead to fines and penalties.


Liabilities may be understated if adequate provision for fines/ penalties imposed by the local authority has not been made.



Overstatement of assets


There are several indicators of impairment:


–    The saunas are no longer in use.


–    Childcare facilities may be withdrawn.


– Pools may need to close if there are no qualified lifeguards to supervise.


– The continued construction of the hydrotherapy pool may be threatened by cash flow problems. This may mean it does not get completed.


– Gym equipment needs to be replaced. Assets which are obsolete but not fully depreciated will be overstated if an impairment review is not performed.


The carrying amount of non-current assets may be overstated if an impairment review is not performed.


Provision for refunds


Although fees are non-refundable, suspension of a facility (e.g. sauna) may result in customers asking for partial refund. In particular Hydrasports may have an obligation to refund fees paid in advance when centres are closed (e.g. the Verne centre from July– September).


Liabilities may be understated if provisions for refunds are not adequately made.




Revenue should only be recognised when the performance obligations of the membership contract are fulfilled in accordance with IFRS 15 Revenue From Contracts with Customers. As fees are paid in advance, revenue may need to be deferred.


If Hydrasports’ revenue recognition policy does not comply with, IFRS 15, revenue is likely to be overstated and deferred income is likely to be understated.




Hydrasports requires a licence to operate from the local authority. The licence should be capitalised as an intangible asset and amortised over the licence period in accordance with IAS 38 Intangible Assets.


Intangible assets may be overstated if they have not been amortised appropriately or if there is any indication of impairment affecting the ability of a leisure centre to generate economic benefits.


Going concern disclosure


Due to the problems mentioned above which are likely to lead to a loss of future revenue, in addition to the cash flow problems already being experienced, Hydrasports may have difficulty continuing as a going concern.


Going concern uncertainties may not be adequately disclosed in the financial statements.


Monthly accounting returns


Accounting information flowing into the financial statements may not be properly captured, input, processed or output by the centre managers resulting in misstatements in the financial statements.


Centralised control


Management circumvention or override of control procedures laid down by head office may result in system deficiencies and increased control risk.


If errors arising are not detected and corrected the risk of misstatement in the financial statements is increased.


  • Audit procedures


  • Deferred income


– Trace a sample of peak/off-peak membership fees and joining fees to member contracts to verify the income that should be deferred.


–    Reconcile membership income to fees paid. If customers

can renew their membership without payment there should be no deferral of income (unless the debt for unpaid fees is also recognised).


– Inspect correspondence from members to identify any disputes which may mean membership fees should be refunded.


– Recalculate the deferred income element of fees received in the three months before the statement of financial position date to verify arithmetical accuracy.


– Compare the year-end balance with prior year and investigate any significant variance.


  • Hydrotherapy pool


– Inspect the contract with the builder, contractors billings and stage payments to confirm the cost of the asset.


– Review the expert’s assessment of stage of completion as at the statement of financial position date, estimated costs to completion, etc. Hydrasports is likely to be advised by its own expert (a quantity surveyor) on how the contract is progressing.


– Physically inspect the construction at the year-end to confirm work to date and assess the reasonableness of stage of completion.


– Agree borrowing costs associated with the construction to the loan agreement to confirm finance terms and payments.


– Recalculate the borrowing costs capitalised to confirm arithmetical accuracy.


– Confirm that the basis of capitalisation complies with IAS 23 Borrowing Costs (e.g. interest accruing during any suspension of building work should not be capitalised).


– Critically evaluate management’s assessment of possible impairment (of the hydrotherapy pool and the centre). As the construction has already cost twice as much as budgeted, its value in use (when brought into use) may be less than cost.


  • Performance indicators Member satisfaction


–    Number of people on membership waiting lists (if any).


– Number of referrals/recommendations to club membership by existing members.


–    Proportion of renewed memberships.


– Actual members: 100% capacity membership (sub-analysed between ‘peak’ and ‘off-peak’).


Membership dissatisfaction


–    Proportion of members requesting refunds per month/quarter.


–    Proportion of memberships ‘lapsing’ (i.e. not renewed).




–    Average number of staff employed per month.


–    Number of starters/leavers per month.


–    Staff turnover/average duration of employment.


–    Number of training courses for lifeguards per annum.




– Number of late openings (say more than 5, 15 and 30 minutes after advertised opening times).


– Number of days closure per month/year of each facility (i.e. pool, crèche, sauna, gym) and centre.




– Number of instances of non-compliance with legislation/ regulations (e.g. on chemical spills).


– Energy efficiency (e.g. in maintaining pool at a given temperature throughout the year).


– Incentives for environmental friendliness such as discouraging use of cars/promoting use of bicycles (e.g. by providing secure lock-ups for cycles and restricted car parking facilities).


Other society


– Local community involvement (e.g. facilities offered to schools and clubs at discount rates during ‘off-peak’ times).


– Range of facilities offered specifically to pensioners, mothers and babies, disabled patrons, etc.


– Participation in the wider community (e.g. providing facilities to support sponsored charity events).




– Incidents reports documenting the date, time and nature of each incident, the extent of damage and/or personal injury, and action taken.


–    Number of accident free days.




– Membership registers clearly distinguishing between new and renewed members, also showing lapsed memberships.


– Pool/gym timetables – showing sessions set aside for ‘over 60s’, ‘ladies only’, schools, clubs, special events, etc.


–    Staff training courses and costs.


– Staff timesheets – showing arrival/departure times and adherence to staff rotas.


– Documents supporting additions to/deletions from payroll standing data (e.g. new joiner/leaver notifications).


– Engineer’s inspection reports – confirming gym equipment, etc is in satisfactory working order.


– Engineer and safety check manuals and the maintenance program.


–    Levels of expenditure on repairs and maintenance.


– Energy saving equipment/measures (e.g. insulated pool covering).



–    Safety drill reports (e.g. alarm tests, pool evacuations).


– Accident report register – showing date, nature of incident, personal injury sustained (if any), action taken (e.g. emergency services called in).


– Any penalties/fines imposed by the local authorities and the reasons for them.


–    Copies of reports of local authority investigations.


– The frequency and nature of insurance claims (e.g. to settle claims of injury to members and/or staff).




The risks detailed above demonstrate that the audit of Hydrasports is a high risk engagement. These risks must be addressed by designing appropriate audit procedures to be included in the audit plan. Appropriately experienced staff must be assigned to the audit team to ensure any material misstatements are detected.


Test your understanding 2


Briefing notes


To:                                     Audit partner


From:                              Audit manager


Date:                                01 December 20X4


Subject:                         Planning of the audit of Cerise for the year ended 31


December 20X4




These briefing notes evaluate the audit risks to be considered when planning the audit of Cerise. Audit procedures in respect of the amounts due from distributors have been included. The briefing notes also cover the extent to which reliance on analytical procedures and written representations will differ from the prior year audit.


  • Audit risks Cessation of trade

– Cerise ceased to trade during the year. The financial statements therefore not be prepared on a going concern basis, but on a ‘break-up’ or other ‘realisable’ basis.


–    This has implications for:


– the reclassification of assets and liabilities (from non-current to current)


–    the carrying amount of assets (at recoverable amount)


–    the completeness of recorded liabilities.


– There is a risk that the basis of preparation used is inappropriate.


Computer controlled equipment for production-line industries


– Cerise is ceasing manufacturing two months prior to the year-end. Any items remaining in inventory at the year-end will need to be written down to the lower of cost and NRV in accordance with IAS 2 Inventories.


– There is a risk that inventory is overstated if sufficient allowance is not made for items that will not be sold.


Redundant workforce


– Although statutory redundancy pay, holiday pay, accrued overtime etc may have been settled before the year-end, there may be additional liabilities in respect of former employees e.g. pension obligations.


– Liabilities may be understated if there are claims arising from the redundant workers if their statutory or contractual rights have been breached.


Sale of patented technology and manufacturing equipment


– All assets sold should be derecognised and the profit on disposal disclosed as an exceptional item arising from the discontinuance of operations.


–    Plant and equipment will be overstated if:


– manufacturing equipment that has been sold is still included in the financial statements


– assets that were not part of the sale are not tested for impairment (in accordance with IAS 36 Impairment of Assets).


– There is also a risk that the profit or loss on disposal has not been calculated correctly.


Accounts department


– Fewer staff will be employed in the accounts department until the company is wound down completely. This may increase the risk of errors arising as staff assume wider areas of responsibility. Staff may also not take as much care with their work as they know they will not be working for the company in the near future.


– The risk of errors arising not being detected by the control system is also likely to increase as levels of supervision and segregation of duties may be reduced.


– There is a greater risk of misstatement in the financial statements as a result.


Leased premises


– Four of Cerise’s premises are leased and cannot be sold or sub-let under the lease terms.


– The right of use asset will be impaired if the recoverable amount (value in use) is less than the carrying value in accordance with IAS 36 Impairment of Assets.


– There is a risk that tangible assets are overstated if the impairment charge is not recognised.




– If the unsold properties meet all the criteria of IFRS 5 Non-current Assets Held for Sale and Discontinued Operations at the statement of financial position date they should be:


–    separately classified as held for sale


– carried at the lower of carrying amount (i.e. depreciated cost) and fair value less estimated costs to sell.


– Any after-date losses on disposal would provide     of impairment.


– The financial statements will be materially misstated if non-current assets held for sale are not separately disclosed in accordance with IFRS 5.


Product warranties


– Cerise’s products have been sold with either a one, three or five year warranty. Adequate provision must be made for warranties of:


–    one year (sales in the year to 31 December 20X4)


– up to three years (sales between 1 January 20X2 and 31 October 20X4) and


– up to five years (sales between 1 January 20X0 and 31 October 20X4).


– As Cerise can no longer undertake the warranty work itself, arrangements will have to be made to honour the warranty obligations, e.g. by outsourcing it to another company which may be more expensive than performing the work in-house.


– There is a risk that the warranty provision is understated if the basis of its calculation is no longer appropriate.


Breach of agreements/contracts


– Since Cerise no longer has the means of fulfilling contracts with distributors, provision should be made for any compensation or penalties arising. Where the penalties due to distributors for breach of supply agreements exceed the amounts due from them, the receivables should be written down.


– Adequate provision should be made for breaches of contracts with suppliers. If suppliers do not exercise their rights to invoke penalty clauses, disclosure of the contingent liability may be more appropriate than a provision.


– There is a risk that provisions are understated or contingent liabilities are not adequately disclosed.


  • Reliance on audit work


  • Analytical procedures


– Overall the extent of reliance on analytical procedures is likely to be less than that for the prior year audit as the scale and nature of Cerise’s activities will differ from the prior year.


– There are a number of individually material transactions in the current year which will require detailed substantive testing (e.g. sale of patented technology and manufacturing equipment and sale of premises).


– Budgetary information used for analytical procedures in prior periods (e.g. budgeted production/sales) will have less relevance in the current year as the cessation of trade is unlikely to have been forecast.


– Information will only be comparable with the prior year for 10 months (January to October). Costs incurred in November and December will relate to winding down operations rather than operational activities therefore cannot be compared with the prior year.


– The impact of the one-off circumstances on carrying amounts is more likely to be assessed through detailed substantive testing (e.g. after-date realisation) than reliance on ratios and past history.


– For example, analytical procedures on an aged trade receivables analysis and calculation of average collection period used in prior years will not be relevant to assessing the adequacy of the write-down now needed. Similarly, inventory turnover ratios will no longer be comparable when inventory is no longer being replenished.


– Some reliance will still be placed on certain analytical procedures. For example, in substantiating charges to the statement of profit or loss for the 10 months of operations.



  • Written representations


– Overall the extent of reliance on written representations is likely to be increased as compared with the prior year audit.


– The magnitude of matters of judgment and opinion is greater than in prior years. For example, inventory and trade receivable write-downs, impairment losses and numerous provisions.


– The auditor will seek to obtain as much corroborative     as is available. However, where amounts of assets have still to be recovered and liabilities settled, management will be asked to make representations on the adequacy of write-downs, provisions, and the completeness of disclosures for claims and other contingent liabilities.


– Where negotiations are under discussion but not yet formalised (e.g. with a prospective buyer for premises), management may be the only source of     (e.g. for the best estimate of sale proceeds). However, the extent to which reliance can be placed on representations depends on the extent to which those making the representation can be expected to be well-informed on the particular matters. Therefore, as the human resources and production directors will not be available after the statement of financial position date particular thought should be given to obtaining representations on matters pertaining to areas of judgment, for example, employee obligations and product warranties.


  • Audit procedures


Amounts due from distributors


– Review after-date cash to assess whether payments have been received post year-end.


– Review of agreements with distributors to confirm the unexpired period (up to three years) and the penalties stipulated.


– Recalculate amounts due to distributors for the early termination of the agreements with them.


– Review correspondence with distributors relating to financial settlement, and any responses received.


– Discuss with management whether they can provide any further     regarding amounts due to be received from distributors or penalties imposed.


– Review board minutes for discussions of management relating to disputes with distributors.





The risks detailed above demonstrate that the audit of Cerise is a high risk engagement. These risks must be addressed by designing appropriate audit procedures to be included in the audit plan. Appropriately experienced staff must be assigned to the audit team to ensure any material misstatements are detected.



Test your understanding 3


Briefing notes






Audit partner





Audit manager





01 September 20X4





Planning of the audit of GVF for the year ended 30 September 20X4






These briefing notes evaluate the audit risks to be considered when planning the audit of GVF. Audit procedures in respect of the goat herd, Bachus Blue manufacturing equipment and cheese have been included.


  • Audit risks Goat herd

The goat herd will consist of:


–    mature goats held for use in the production of milk

(i.e. accounted for as depreciable non-current tangible assets


– IAS 16 Property Plant and Equipment)


– kids which are held for replacement purposes (accounted for as biological assets under IAS 41 Agriculture), and


– kids which are to be sold (held as inventory under IAS 2 Inventories).


There is a risk that due to the complexities of the various accounting standards, the non-current assets, biological assets and inventories are misstated.


There is a risk that the carrying amount of the production animals will be misstated if, for example:


–    useful lives/depreciation rates are unreasonable


–    estimates of residual values are not kept under review.


Animals raised during the year should be recognised initially and at each statement of financial position date at fair value less estimated point-of-sale costs. Such biological assets will be understated in the statement of financial position if they are not recorded on birth.



The net realisable value of animals held for sale may fall below cost if they are not sold soon after reaching optimal size and weight.


Unrecorded revenue


Raised (bred) animals are not purchased and, in the absence of documentation supporting their origination, could be sold for cash and the revenue unrecorded.


Although the controls over retailing around the world are likely to be strong, there are other sources of income – the shop and other activities at the farm.


There is a risk that revenue could go unrecorded due to lack of effective controls.


Skin disorder


If Bachas Blue has been specifically cited as a cause of a skin disorder then GVF could face compensation for pending litigation.


If it is probable that GVF would have to make payments, a provision should be recognised. If it is possible, a contingent liability should be disclosed.


There is a risk that provisions are understated or contingent liabilities have not been disclosed in respect of any claims.


Maturing cheese


The substance of the sale and repurchase of cheese is that of a loan secured on the inventory. Therefore revenue should not be recognised on sale to Abingdon Bank. The principal terms of the secured borrowings should be disclosed, including the carrying amount of the inventory to which it applies.


Borrowing costs should be capitalised in accordance with IAS 23 Borrowing Costs since the cost of maturing cheese includes interest at 7% per six months and the borrowings are specific. The cost of inventories should include all costs incurred in bringing them to their present location and condition of maturity.


There is a risk that, if the age of maturing cheeses is not accurately determined, the cost of cheese will be misstated.


Health and safety legislation – non-compliance


New legislation came into effect on 1 July which required wooden boards to be replaced with stainless steel shelves. At 30 September 20X4 the legislation will have been in effect for three months.


If GVF’s management has not replaced the shelves, fines/penalties may be payable due to non-compliance.


There is a risk that liabilities are understated if any fines/penalties have not been accrued.



Health and safety legislation – impairment of assets


If the legislation is complied with the wooden boards previously used will be impaired and should be written down.


GVF are concerned that the new process will interfere with the maturing process and production of medium and strong cheeses will have to cease. This will also indicate impairment of equipment.


There is a risk of overstatement of plant and equipment if they are impaired as a result of the impact of the new legislation.




GVF received a substantial regional development grant in 20X3 but has deferred its plans to use this grant until 20X6.


If the terms of the grant required the money to be used within a specified timeframe the grant may have become repayable as the terms have not been complied with. In this case the grant should be presented as a payable in the statement of financial position.


There is a risk of understatement of liabilities if GVF will have to repay the grant money.


  • Audit procedures


  • Goat herd


– Physically inspect the number and condition of animals in the herd and confirming, on a test basis, that they are tagged (or otherwise ‘branded’ as being owned by GVF).


– Perform tests of controls on management’s system of identifying and distinguishing held-for-sale animals (inventory) from the production herd (depreciable non-current assets).


– Compare GVF’s depreciation policies (including useful lives, depreciation methods and residual values) with those used by other farming entities to assess reasonableness.


– Perform a proof in total of the depreciation charge for the herd for the year.


–    Observe test counts of animals held for sale.


– Inspect market values of kids, according to their weight and age, as at 30 September 20X4 – for both held-for-sale and held-for-replacement animals.


– For held-for-sale animals only, vouch (on a sample basis) management’s schedule of point-of-sale costs

(e.g. market dealers’ commissions).



  • Cheese


– Examine the terms of sales to Abingdon Bank to confirm the bank’s legal title (e.g. if GVF were to cease to trade and so could not exercise buy-back option).


– Obtain a direct confirmation from the bank of the cost of inventory sold by GVF to Abingdon Bank and the amount repurchased as at 30 September 20X4 (the net amount being the outstanding loan).


– Inspect the cheese as at 30 September 20X4 (e.g. during the physical inventory count) paying particular attention to the factors which indicate the age and strength of the cheese e.g. its location or physical appearance.


–    Observe how the cheese is stored. If on steel shelves

discuss with GVF’s management whether its net realisable value has been reduced below cost.


–    Inspect, on a sample basis, the costing records supporting the cost of batches of cheese.


– Confirm that the cost of inventory sold to the bank is included in inventory as at 30 September 20X4 and the nature of the bank security adequately disclosed.


– Agree the repurchase of cheese which has reached maturity at cost plus 7% per six months to purchase invoices (or equivalent contracts) and cash book payments.


– Inspect GVF’s aged inventory records to production records. Confirm the carrying amount of inventory as at 30 September 20X4 that will not be sold until after

30 September 20X5, and agree to the amount disclosed in the notes to inventory as a ‘non-current’ portion.




The risks detailed above demonstrate that the audit of GVF is a high risk engagement. These risks must be addressed by designing appropriate audit procedures to be included in the audit plan. Appropriately experienced staff must be assigned to the audit team to ensure any material misstatements are detected.



Test your understanding 4


Tutorial note:


The first part of this question is essentially a due diligence question. You have been asked to examine the management accounts and forecasts of a target company that your client is interested in acquiring.


  • Implications of findings


$800,000 profit on sale of property


Although the profit on sale of the property arises from ordinary activities, it needs to be separately identified (IAS 1) so that Scorpio’s current trading performance can be assessed (by Bellatrix and the bank). It should be excluded from any trading results that are being extrapolated to provide figures for profit forecasts. To include it would result in a distortion of sustainable profits.


Scorpio’s properties are being valued at historical cost in its financial statements (IAS 16). Bellatrix should obtain an independent valuation of the properties before finalising a purchase price for the acquisition of Scorpio.


The property sale could have been made to realise cash and so mitigate current cash flow difficulties. The proposed sale of two more properties and outsourcing of warehousing may further improve the cash flow situation in the short-term. However, outsourcing warehousing could place a further burden on cash flow if an agreement is entered into and no buyer can subsequently be found for the properties.


Scorpio’s management is seeking (or negotiating with) a suitable organisation to provide warehousing. However, one of the synergies to be obtained from acquiring Scorpio may be utilising Bellatrix’s spare warehousing capacity. Bellatrix should therefore obtain warranties and indemnities in the purchase contract in respect of any contingent liabilities that could arise. For example, penalties may be incurred if an agreement to outsource warehousing is entered into and subsequently cancelled.


Sales to Andromeda


The two members of the management board of Scorpio will be related parties (IAS 24) if they are key management personnel (i.e. having authority and responsibility for planning, directing and controlling the activities of Scorpio).


Andromeda will be a related party if the management board members have the ability to exercise influence over Andromeda’s financial and operating policy decisions. This seems likely, as 10% of Scorpio’s sales constitutes material inter-company transactions. (Control of Andromeda is not an issue as the two members have only a minority interest.)


Sales to Andromeda appear to be related party transactions which should be disclosed in Scorpio’s financial statements for the year to 31 December 20X4.


Although prices appear to be on an arm’s length basis, the transactions may not be at arm’s length if other trading terms (e.g. delivery or payment terms) are more or less favourable than transactions with unrelated parties. If credit terms are not normal commercial terms these sales could be contributing to Scorpio’s current cash flow difficulties.


The sales to Andromeda are material to Scorpio and may be lost after the acquisition (e.g. if the two minority shareholders do not continue to hold positions on the management board of Scorpio). A proportional (i.e. 10%) reduction in gross profit would also be expected (assuming margins on sales to Andromeda are not dissimilar to those on other sales).


Bank loan application


The $150,000 discrepancy between the current asset values per the management accounts and the balances per the accounting records appears to be an irregularity that could constitute a fraud against the bank. It casts serious doubts over the integrity of Scorpio’s management. Revising the accounting estimates for allowances against asset values downwards is clearly inappropriate as it is most likely that they should be increased (as inventory levels increase with falling demand and receivables are more likely to be bad or doubtful debts).


Refurbishing the offices is unlikely to constitute essential expenditure when the company is experiencing cash flow difficulties. Also it is possible that refurbishment may not be required when Bellatrix acquires Scorpio because the functions of the executive and administration offices may be relocated elsewhere within the Bellatrix group of companies.


Although current trading performance is clearly below budget (after deducting the profit on disposal and reinstating the allowances for inventory and receivables), the loan finance is not being sought for a purpose that would increase the company’s revenue-earning opportunities. This may cast doubt on the business acumen of Scorpio’s management. It is possible that the loan finance would not be forthcoming if the bank were aware of Scorpio’s true position.


Bellatrix should seek to have the negotiations with the bank suspended until after the acquisition, when the need for loan finance can be reassessed. Bellatrix should obtain guarantees from Scorpio’s executives in the event that they pursue the loan application (which may possibly create charges over Scorpio’s assets).


Budget forecast


The profit estimates made by the management of Scorpio appear to be unduly optimistic because the first six month’s budget has only been met by the inclusion, in the reported results of:


–    a non-sustainable profit on disposal of a warehouse


–    unwarranted reversals of allowances against asset values.


Perhaps it is more likely that the forecast ‘rising profit trend’ will be achieved (and the annual budget exceeded) through profits arising on the disposals of two more properties rather than increased demand.


Budgeted profits should therefore be disregarded in the determination of the purchase price.


  • Impact of acquisition on audit Tutorial notes:


  • The acquisition will be completed before 31 December 20X4 (see 1st para ‘acquisition in current year’).


  • Accounting year-ends will be coterminous (‘first half year to 30 June 20X4’).


  • You will be appointed as auditor to Scorpio (‘as audit manager to Bellatrix and its subsidiaries’).


  • ‘Conduct of your audit’ requires consideration of the whole audit process, not just audit testing.




It is possible that audit objectivity may appear to be impaired (e.g. due to a closer relationship between Bellatrix’s management and the audit team having developed during the acquisition assignment). An engagement   review may therefore be required as an appropriate safeguard.


Bellatrix’s individual company accounts


The acquisition will constitute an addition to investments in subsidiaries in Bellatrix’s own financial statements. The purchase consideration paid (or contingently payable) should also be disclosed.


The cost of acquisition should be verified to the sale agreement. Cash consideration must be agreed to entries in the cash book and bank statements. Company minutes and entries in the share register will     consideration in shares.


Bellatrix’s consolidated accounts


Statement of financial position


Scorpio’s assets and liabilities, at fair value to the group, will be combined on a line-by-line basis and any goodwill arising recognised.


The fair value of such assets as the properties (assuming that they have not yet been sold) may be material to the consolidated statement of financial position. Assuming that the properties were independently valued prior to the acquisition, it will be appropriate to seek to place reliance on the work of the expert valuer.


The calculation of the goodwill arising on acquisition must be recalculated and the component figures agreed. Goodwill must be reviewed for impairment by Bellatrix’s management. The auditor will need to assess this impairment review for appropriateness to ensure the asset is not overstated.


Statement of profit or loss


As Scorpio will be acquired quite late on in the year (certainly the second half of the year) it is possible that its post-acquisition results are not material to the consolidated statement of profit or loss.


Unless accounting adjustments are required (e.g. to bring any accounting policies of Scorpio into line with Bellatrix) the addition of one more subsidiary into the consolidation working papers is unlikely to have a significant impact.


Other subsidiaries


The materiality of other subsidiaries, in the group context, should be reassessed in terms of the enlarged group. The existence of another company (Scorpio) in the same business within the group may extend the scope of analytical procedures available. This could have the effect of increasing audit efficiency.


Scorpio’s financial statements




Much of the collection of background information associated with planning the conduct of a new audit assignment will have already been obtained as a result of the pre-acquisition work.


Materiality assessment


Material matters requiring attention will include:


–    sales to Andromeda


–    property valuations


–    inventory valuations (raw materials, WIP and finished goods)


–    trade receivables balances


–    liabilities (including bank loans).


The management accounts for the six months to 30 June should provide information sufficient to make an initial evaluation of materiality. However, as the reliability of certain management information is in doubt, this should be reassessed before detailed work commences.


The materiality of these items should also be assessed in the context of monetary amounts in the consolidated financial statements.


Risk assessment


Specific areas of audit risk have already been identified, thereby reducing the time required to assess the risk of misstatement at the planning stage.


In particular:


– Inherent risk is high due to Scorpio’s management overstating profit (even if the management board has since been replaced)


– Inventory may be overstated/allowances understated due to inventory having increased (due to a fall in demand)


– Trade receivables may be overstated/allowances for bad and doubtful debts understated due to Scorpio’s management having manipulated these figures to achieve their profit estimates.


Ascertaining the systems and internal controls


Some systems review work may have already been undertaken (e.g. when considering the source of information used in the preparation of Scorpio budgetary information).


The relevance of Scorpio’s current accounting systems and internal controls will depend on Bellatrix’s plans for change. For example, a Bellatrix office may account for Scorpio’s transactions. If significant changes are proposed it may be more appropriate to adopt a substantive approach to the first audit of Scorpio.




Some audit     should have been obtained for the due diligence file e.g. concerning the sales to Andromeda and the sale of property. This should be copied and referenced to the audit working papers to ensure that work is not unnecessarily re-performed.


As Scorpio is in the same business as Bellatrix, ratio analysis and other substantive analytical procedures should provide a more cost-effective approach to obtaining audit     than tests of detail.


The relationship between the two members of Scorpio’s management board and Andromeda after the date of acquisition must be established and the extent of transactions between them, if any. For example, these non-controlling interests of Andromeda may no longer hold board positions, and/or sales to Andromeda may have ceased.


The proportion of sales should be disclosed (e.g. 10%) along with factual information concerning the pricing policy. Audit tests must verify, for example, that price is determined based on a published price list.

Test your understanding 5


  • Store impairment


  • Matters


The carrying value of goodwill of $2.2m ($5.5m × 40%) represents 1.2% of total assets and 23% of PBT, and is also material.


If more than $475,000 of goodwill is attributable to the supermarket, then its write-off would be material to PBT ($9.5m × 5% = $475,000).


The event provides     of a possible impairment of the supermarket which is a cash-generating unit. The goodwill assigned to it is also likely to be impaired.


Management should have considered whether the other four stores in Urvina (and elsewhere) are similarly impaired. There is a risk that assets including goodwill are overstated in the financial statements if an appropriate impairment review has not been undertaken.


The announcement is after the statement of financial position date and is therefore a non-adjusting event insofar as no provision for restructuring (for example) can be made.


  • Audit


– Board minutes approving the store’s refurbishment and documenting the need to address the fall in demand for it as a supermarket.


– Recalculation of the carrying amount of goodwill (40% × $5.5m = $2.2m).


– A schedule identifying all assets that relate to the store under review and the carrying amounts agreed to the underlying accounting records (e.g. non-current asset register).



– Recalculation of value in use and/or net selling price of the cash-generating unit that is to become the City Metro as at 31 March 20X4.


– Agreement of cash flow projections to approved budgets/forecast revenues and costs for a maximum of five years, unless a longer period can be justified.


– Written representation from management relating to the assumptions used in the preparation of financial budgets.


– Agreement that the pre-tax discount rate used reflects current market assessments of the time value of money (and the risks specific to the store) and is reasonable. For example, by comparison with Volcan’s weighted average cost of capital.


– Inspection of the store (if this is the month it is closed for refurbishment).


–    Actual after-date sales by store compared with budget.


–    Revenue budgets and cash flow projections for:


–    the two stores purchased at the same time


–    other stores in Urvina


–    the stores elsewhere.


  • Reward scheme


  • Matters


If the entire year’s revenue ($303m) attracted loyalty points then the cost of the reward scheme in the year is at most $3.03m. This represents 1 % of revenue and 31.9% of profit before tax which is material.


To the extent that points have been awarded but not redeemed at 31 March 20X4, Volcan will have a liability at the statement of financial position date.


In accordance with the accruals concept, the expense and liability of the reward scheme should be recognised as revenue is earned.


The calculation of the expense and liability will need to take into consideration


– Any restrictions on the terms for converting points (e.g. whether they expire if not used within a specified time).


– The proportion of reward points awarded which are not expected to be claimed (e.g. the ‘take up’ of points awarded may be only 80%, say).


– The proportion of customers who register for loyalty cards and the percentage of revenue (and profit) which they represent (which may vary from store to store depending on customer profile).


There is a risk that liabilities and expenses in relation to the reward scheme are understated.


  • Audit


–    New/updated systems documentation explaining how:


– loyalty cards (and numbers) are issued to customers


–    points earned are recorded at the point of sale


– points are later redeemed on subsequent purchases.


– Reconciliation of the total balance due to customers at the yearend under the reward scheme to the sum of the points on individual customer reward cards.


– Documentation of walk-through tests (e.g. on registering customer applications and issuing loyalty cards, awarding of points on special offer items).


– Results of tests of controls supporting the extent to which audit reliance is placed on the accounting and internal control system. In particular, how points are extracted from the electronic tills (cash registers) and summarised into the weekly/monthly financial data for each store which underlies the financial statements.


– Analytical procedures on the value of points awarded by store per month with explanations of variations. For example, similar proportions (not exceeding 1% of revenue) of points in each month might be expected by stores, possibly increasing following any promotion of the loyalty scheme.



– Results of tests of detail on a sample of transactions with customers undertaken at store visits. For example, for a sample of copy till receipts:


– check the arithmetic accuracy of points awarded (1 per $1 spent + special offers)


– agree points awarded for special offers to that week’s special offers


– for cash discounts taken confirm the conversion of points is against the opening balance of points awarded (not against purchases just made).


  • Site restoration


  • Matters


The provision for site restoration represents nearly 2.5% of total assets and is therefore material.


The estimated cost of restoring the site is a cost directly attributable to the initial measurement of the tangible non-current asset to the extent that it is recognised as a provision under IAS 37 Provisions, Contingent Liabilities and Contingent Assets (IAS 16 Property, Plant and Equipment).


A provision should only be recognised for site restoration if there is a present obligation as a result of a past event that can be measured reliably and is probable to result in a transfer of economic benefits (IAS 37).


The provision is overstated by nearly $0.34m since Volcan is not obliged to relocate the trees and only has an obligation of $60,000 as at 31 March 20X4 (being the penalty for having felled them). When considered in isolation, this overstatement is immaterial (representing only 0.2% of total assets and 3.6% of PBT).


It seems that even if there are local government regulations calling for site restoration there is no obligation unless the penalties for non-compliance are prohibitive (unlike the fines for the trees).


It is unlikely that commencement of site development has given rise to a constructive obligation, since past actions (disregarding the preservation of the trees) must dispel any expectation that Volcan will honour any pledge to restore the valley.


Consideration should also be given to whether commencing development of the site and destroying the trees conflicts with any statement of environmental responsibility in the annual report.


There is a risk that provisions are overstated and profit understated if this provision does not meet the criteria of IAS 37.


  • Audit


– Payment of $60,000 to local government in May 20X4 agreed to the bank statement.


– The present value calculation of the future cash expenditure making up the $4.0m provision.


– Agreement that the pre-tax discount rate used reflects current market assessments of the time value of money (as for (a)).


–    Asset inspection at the site as at 31 March 20X4.


– Any contracts entered into which might confirm or dispute management’s intentions to restore the site. For example, whether plant hire (bulldozers, etc) covers only the period over which the warehouse will be constructed, or whether it extends to the period in which the valley would be ‘made good’.


– A copy of the planning application and permission granted setting out the penalties for non-compliance.



Test your understanding 6


  • Cessation of home delivery service


  • Matters


$0.6m represents 1.4% of reported revenue (prior year 1.9%) and is therefore material.


The home delivery service is not a component of Albreda and its cessation does not classify as a discontinued operation in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations because:


– It is not a cash-generating unit because home delivery revenues are not independent of other revenues generated by the restaurant kitchens.


–    1.4% of revenue is not a major line of business.


– Home delivery does not cover a separate geographical area (but many areas around the numerous restaurants).


The redundancy provision of $0.2m represents 11.1% of profit before tax (10% before allowing for the provision) and is therefore material. However, it represents only 0.6% of total assets and is therefore immaterial to the statement of financial position.


As the announcement was made before the year-end, there is a present obligation and a probable outflow of economic benefits in respect of the redundancies therefore the provision is appropriate.


The delivery vehicles should be classified as held for sale if their carrying amount will be recovered principally through a sale transaction rather than through continuing use. For this to be the case the following IFRS 5 criteria must be met:


– the vehicles must be available for immediate sale in their present condition, and


–    their sale must be highly probable.


However, even if the classification as held for sale is appropriate, the measurement basis is incorrect. Non-current assets classified as held for sale should be carried at the lower of carrying amount and fair value less costs to sell.


It is incorrect that the vehicles are being measured at fair value less costs to sell which is $0.3m in excess of the carrying amount. This amounts to a revaluation and should be reversed. $0.3m represents just less than 1% of assets and 16.7% of profit which is material.


Comparison of fair value less costs to sell against carrying amount should have been made on an item by item basis (and not on their totals).


There is a risk that the delivery vehicles held for sale are overstated.


  • Audit


– Copy of board minute documenting management’s decision to cease home deliveries (and any press releases/internal memoranda to staff).


– An analysis of revenue (e.g. extracted from management accounts) showing the amount attributed to home delivery sales.


– Redundancy terms for drivers as set out in their contracts of employment to assess adequacy of the redundancy provision.


– A proof in total for the reasonableness/completeness of the redundancy provision (e.g. number of drivers × sum of years employed × payment per year of service).


– A schedule of depreciated cost of delivery vehicles extracted from the non-current asset register to confirm carrying value of assets held for sale.


– Second hand market prices as published/advertised in used vehicle guides to verify fair value.


– After-date net sale proceeds from sale of vehicles and comparison of proceeds against estimated fair values to confirm fair value.


– Physical inspection of condition of unsold vehicles to assess whether they are likely to be sold for the estimated fair value in their current condition.


– Draft financial statements to assess the appropriateness of the disclosure of assets held for sale on the face of the statement of financial position or in the notes, and shown in the reconciliation of carrying amount at the beginning and end of the period.


  • Revaluation of owned premises


  • Matters


The revaluations are material as $1.7m, $5.4m and $7.1m represent 5.5%, 17.6% and 23.1 % of total assets, respectively.


The change in accounting policy, from a cost model to a revaluation model, should be accounted for in accordance with IAS 16 Property, Plant and Equipment (i.e. as a revaluation).


Independence, qualifications and expertise of valuer(s) should be considered to determine the reliability of the valuations.


IAS 16 does not permit the selective revaluation of assets thus the whole class of premises should have been revalued.


The valuations of properties after the year-end are adjusting events (i.e. providing additional     of conditions existing at the year-end) per IAS 10 Events After the     Date.


The revaluation exercise is incomplete. If the revaluations on the remaining three properties are expected to be material and cannot be reasonably estimated for inclusion in the financial statements perhaps the change in policy should be deferred for a year.


There is a risk that property is overstated as the revaluations do not comply with the requirements of IAS 16.


  • Audit


–    A schedule of depreciated cost of owned premises

extracted from the non-current asset register.


– Calculation of the difference between valuation and depreciated cost by property to assess materiality.


– Copy of valuation certificate for each property to confirm the valuation amount.


– Physical inspection of properties with the largest surpluses (including the two valued before the year-end) to confirm condition.


– Extracts from local property guides/magazines indicating a range of values of similarly styled/sized properties.


– Financial statements to confirm adequacy of the IAS 16 disclosures in the notes including:


–    the effective date of revaluation


–    whether an independent valuer was involved


– the methods and significant assumptions applied in estimating fair values


– the carrying amount that would have been recognised under the cost model


– reconciliation of carrying amount at the beginning and end of the period


– revaluation surpluses in the statement of changes in equity.


  • Fines and penalties


  • Matters


$0.1m represents 5.6% of profit before tax and is therefore material.


The payments may be regarded as material by nature as they are payments related to non-compliance with regulations. However, separate disclosure may not be necessary if, for example, there are no external shareholders.


The accounting treatment (inclusion in cost of sales) should be consistent with prior year.


The reason for the fall in expense should be investigated. This may due to an improvement in meeting health and safety regulations or due to incomplete recording of liabilities (understatement).


There is a risk of inadequate disclosure of the fines and penalties and a risk of understatement of fines and penalties if they have not been completely recorded.


  • Audit


– Cash book and bank statements confirming payment of fines.


Review/comparison of current year schedule against prior year for any apparent omissions.


– After-date cash book and bank statements for payments made in respect of liabilities incurred before

30 September 20X4.


– Correspondence with relevant health and safety regulators (e.g. local authorities) for notification of liabilities incurred before 30 September 20X4.



– Notes in the prior year financial statements confirming consistency, or otherwise, of the lack of separate disclosure.


– Written representation from management that there are no fines/penalties other than those which have been reflected in the financial statements.



Test your understanding 7


  • Brand names


  • Matters


The cost of the purchased brands represents 3.2% of total assets and 32% of profit before tax (carrying value will be less). Annual amortisation amounts to 3.2% of profit before tax. Brands as a whole are therefore material.


Ulexite is a purchased brand and therefore has a carrying value in the statement of financial position. If the carrying value of Ulexite at the year-end is greater than $91,500 (i.e. 5% PBT) its total write-off due to impairment is likely to be regarded as material.


The fall in demand in January 20X4 as a result of the marketing campaign is an adjusting event (IAS 10 Events After the     Period) providing     about the valuation of assets as at 31 December 20X3.


There is a risk that the value of intangible assets (brands) and profits are overstated if an impairment charge has not been recognised.


There is also a risk the net realisable value of inventory of Ulexite products may be less than cost and inventory is overstated.


There could be a loss of customer goodwill to Visean as a whole if customers boycott Visean’s other products by the association of Ulexite with Visean. This could result in overstatement of the other purchased brands.


  • Audit


– Cost/carrying value of Ulexite agreed to prior year working papers, less current year’s amortisation charge.


– Comparison of actual after-date sales (and/or inventory turnover) against budget, month on month, and by fragrance to identify:


–    the significance of the fall in demand of Ulexite


– whether other fragrances have been similarly affected


–    if demand is picking up again (in February to June).


– Monthly sales analysis returns received from retail pharmacies.


– The advert, promotional literature or slogan relating to Ulexite which caused the offence.


–    Media reports, if any, arising from bad publicity.


– Board minutes reflecting any decisions taken by management e.g. to discontinue the fragrance.


– Schedule of expenses incurred since April (reflected in the cash book and/or after-date invoices) to rectify the damage done (e.g. a new marketing campaign).


– Copy of correspondence and notes concerning any pending legal action and possible quantified outcomes.


  • Discontinued operation


  • Matters


The provisions have reduced profit before tax by 40% (i.e. 1.25 ÷ [1.83 + 1.25]) and now represent 68% of profit before tax and are therefore considered to be material.


The plan to close the plant facility is likely to result in a discontinued operation if hospital medical consumables are a separate line of business which can be distinguished operationally and for financial     purposes (IFRS 5 Non-current Assets Held for Sale and Discontinued Operations).


If hospital medical consumables were reported as a business segment in the notes to the financial statements for the prior year (IFRS 8 Operating Segments) this will satisfy the separate line of business criteria.


The initial disclosure event will be the earlier of:


– the directors’ announcement in December (that the factory closed in January strongly suggests that a formal detailed plan existed and was approved before it was announced)


– a binding sale agreement for substantially all the related assets (i.e. equipment and inventory – not the plant itself, as it is leased).


Tutorial note: The announcement is the more likely in the context of the given scenario.


Assuming that the announcement in December raised valid expectations that a detailed formal restructuring plan would be carried out, a constructive obligation to restructure arises (IAS 37 Provisions, Contingent Liabilities and Contingent Assets). The provision made should include:


– Redundancy costs (but not any costs of retraining or relocating continuing staff).


– Penalty clauses relating to contracts with customers and suppliers. For example, hospitals (as public sector bodies) are likely to have contracts with Visean containing penalty clauses for non-performance, breach of contract, etc.


The disposal of any assets in January is a non-adjusting event (IAS 10) which will require disclosure in the financial statements if material. No provision should be made for the loss on sale of related assets after the year-end unless a binding sale agreement was entered into before the year-end. However:


– Plant assets (plant and equipment) should be reviewed for impairment (IAS 36 Impairment of Assets), and


– Inventory of hospital consumables should be measured at the lower of cost and net realisable value (IAS 2 Inventories).


  • Audit


– Segmental information in the prior year financial statements showing hospital medical consumables to be a business segment (e.g. if this activity accounted for 10% or more of Visean’s revenue, profit or assets).


–    Initial disclosure of:


– carrying amounts of assets being disposed of (if any), and


– revenue, expenses, pre-tax profit or loss and income tax expense attributable to the discontinuing of medical consumable supplies.


– Agreement of initial disclosure to underlying financial ledger accounts, management reports, etc.


– Comparison of separate disclosure with budgeted amounts and prior year.


– Board minutes approving the formal plan to discontinue the product range, close the factory and make staff redundant.


– Copies of announcements e.g. press releases and letters to customers and employees.


– The binding sale agreement (if any) for plant, equipment and inventory.


– Contracts with hospitals and suppliers to identify penalty clauses, if any.


–    Calculations of the provisions and assumptions made.


–    Redundancy terms for employees (both contractual and

statutory) to enable verification of any redundancy provision calculation.


– Past redundancy settlements (as compared with statutory and contractual obligations).


–    After-date sales of hospital medical consumables.


  • Statement of cash flows


  • Matters


Matters affecting disclosure are material by nature.


The statement of cash flows should be prepared in accordance with IAS 7 Statement of Cash Flows i.e.     cash flows classified under the standard headings (including operating activities, returns on investments, taxation, capital expenditure, etc).


IAS 1 Presentation of Financial Statements requires comparative figures for all items in the primary statements (and therefore for the statement of cash flows).


Cash flows from operating activities may be reported using either:


– the ‘direct’ method (i.e. showing relevant constituent cash flows) or


– the ‘indirect’ method (i.e. calculating operating cash flows by adjustment to the operating profit reported in the profit and loss account).


IAS 7 the permits a change from the indirect to the direct method. It is appropriate, in the interest of comparability that the corresponding figures have been restated. The reason for reclassification should be disclosed.


The auditor’s responsibility for corresponding figures (ISA 710


Comparative Information – Corresponding Figures and Comparative Financial Statements) is to obtain sufficient appropriate audit     that they have been correctly reported and appropriately classified.


There is a risk of material misstatement if the corresponding figures have not been restated appropriately or if disclosure of the restatement has not been made adequately.


  • Audit


– Agreement of corresponding amounts for ‘Net cash from operating activities’ downwards to the prior year statement of cash flows.


– For the prior year, agreement (or reconciliation) of profit before tax adjusted for non-cash items (e.g. depreciation) and working capital changes to cash receipts from customers less cash paid to suppliers and employees.


– Schedules of cash receipts (per analysis of cash book receipts) agreed to the receivables ledger control account.


– Schedules of cash payments to suppliers and employees (per analysis of cash book payments) agreed to the payables ledger and payroll control accounts respectively.


– Analytical procedures such as the comparison of trade receivables (and payables) days (i.e. average credit periods given to customers and received from suppliers) with prior year.



Test your understanding 8


  • Objectivity is one of the fundamental principles for a member of ACCA. It is defined as being ‘The state of mind which has regard to all considerations relevant to the task in hand and no other. It presupposes intellectual honesty’.


Objectivity is particularly important to an auditor, whose role it is to provide an independent opinion on financial statements. Objectivity can only be assured if the member is independent.


The ACCA provides detailed guidance on how auditors should maintain their objectivity and independence. The guidance covers issues such as dependence on an audit client (fee-related issues), close relationships with the client, provision of other accountancy or other services to the client, and accepting goods and services.


The auditor must always strive to maintain his objectivity in all his dealings with the client.


  • Matters to be considered Undue dependence


Accepting the work of Rainbow may lead to the firm having an undue dependence on the client creating a self-interest threat. The firm may be reluctant to raise issues with the client for fear of losing the work.



The audit fee discussed is substantial and, in connection with the tax work, may affect the objectivity of the firm. ACCA suggest that recurring fees from one client should not exceed INT: 15% / UK:


10% of gross practice income.


Consideration should be given to the regularity of special work undertaken by the firm on behalf of the client. It may be arguable that this work is in some sense recurring and this would mean objectivity was impaired.


An engagement   review should be carried out to ensure the outcome of the audit has not been affected.


Contingency fee


Linking the audit fee to the success of the client’s business creates a self-interest threat. The firm may not request audit adjustments that should be made but would lead to a reduction in profit and as this would reduce the audit fee.


This type of fee arrangement is not acceptable and the firm should not accept these terms.


Unpaid fees


Overdue fees can be construed as a loan to the client, which would create a self-interest threat. The firm may be reluctant to raise issues with the client in case the fees remain unpaid.


The auditor should consider whether the unpaid fees are overdue, or whether it is normal practice for the firm to have such outstanding fees. The amount outstanding should be considered to see if the threat is significant. The length of time that the fees have been overdue would also affect the significance of the threat.


The firm should discuss the outstanding fees with the client and make arrangements for payment. If the fees are significant, an engagement   reviewer should be assigned to the audit.




The audit partner is related to a member of the client’s staff which creates a familiarity threat. The partner may be too trusting of the client and not apply sufficient scepticism when conducting the audit.


The significance of the threat is reduced as the staff member appears to be junior in the organisation and does not work in the finance department therefore does not have a direct influence over the financial statements. The daughter is no longer a dependent of the audit partner which may further reduce the significance of the threat.


The daughter has just joined the employee share benefit scheme which means a close family member is a shareholder in the audited entity. This increases the significance of the threat.


The partner should be changed to remove any threat.


Other services


Provision of other services to an audit client can create a self-review threat. If an auditor is responsible for auditing work they were responsible for preparing, they are unlikely to be critical of it and errors may remain uncorrected.


It appears that different staff would be involved in tax and audit work so (other than the fee issue above) this should not pose any issues in relation to objectivity.




Auditors should not accept excessive gifts as this can create self-interest and familiarity threats. The offer of hospitality may be seen as a bribe for an unmodified opinion.


The weekend in Tenerife appears to be excessive and should not be accepted.


The auditor should consider whether the offer of the free holiday casts significant doubt over the integrity of the director, and whether this would affect his decision to accept the audit work.



Test your understanding 9


  • Professional enquiry


Krill has a professional duty of confidentiality to its client, Squid. If Krill’s lack of response is due to Squid not having given them permission to respond, Sepia should not accept the appointment. However, in this case, Anton Fargues should have:


– notified Squid’s management of the communication received from Sepia


– written to Sepia to decline to give information and state his reasons.


Krill should not have simply failed to respond.


Krill may have suspicions of some unlawful act (e.g. defrauding the taxation authority), but no proof, which they do not wish to convey to Sepia in a written communication. However, Krill has had the opportunity of oral discussion with Sepia to convey a matter which may provide grounds for the nomination being declined by Sepia.


Steps by Sepia


Obtain written representation from Squid’s management, that Krill & Co has been given Squid’s written permission to respond to Sepia’s communication.


Send a further letter to Krill by a recorded delivery service

(i.e. requiring a signature) which states that if a reply is not received in the next seven days, Sepia will assume that there are no matters of which they should be aware and so proceed to accept the appointment. Advise also that unless a response is received, a written complaint will be made to the relevant professional body.


Make a written complaint to the disciplinary committee of the professional body of which Anton Fargues is a member so that his unprofessional conduct can be investigated.


  • Takeover bid


A conflict of interest will be created if Sepia accepts the engagement to advise on a takeover bid between Hatchet and Vitronella.


Sepia has a professional duty of confidentiality to its audit client, Vitronella. This may be difficult to achieve given the existing relationship with Vitronella.


If the engagement with Hatchet was accepted, Sepia would need to ensure no member of the audit team of Vitronella was assigned to provide the advice to Hatchet.


Vitronella may ask Sepia to give corporate finance advice on Hatchet’s takeover bid which would be incidental to the audit relationship. This would create a further conflict in terms of objectivity. It would be difficult to act as adviser to both parties involved in the takeover and remain unbiased to both.


Steps by Sepia


As it is clear that a material conflict of interest exists, Sepia should decline to act as adviser to Hatchet.


Advise Vitronella’s management that Hatchet’s approach has been declined.


  • Lowballing


Lowballing is a practice in which auditors compete for clients by reducing their fees for the external audit. Lower audit fees are compensated by the auditor carrying out more lucrative non-audit work (e.g. consultancy and tax advice).


The fact that Keratin has quoted a lower fee than the other tendering firms (if that is the case) is not improper provided that the prospective client, Benthos, is not misled about:


– the precise range of services that the quoted fee is intended to cover, and


–    the likely level of fees for any other work undertaken.


Although an admission to lowballing may sound improper, it does not breach current ethical guidance provided Benthos understands the situation. For example, Keratin could offer Benthos a free first-year audit with an understanding that future audits will be chargeable and how the cost will be calculated.


The risk is that if the non-audit work does not materialise, Keratin may be under pressure to cut corners or resort to irregular practices (e.g. the falsification of audit working papers) in order to keep within budget. If a situation of negligence was then to arise, Keratin could be found guilty of failing to exercise professional competence and due care.


Provided the auditor performs the audit to the required level of quality and issues an appropriate opinion in the circumstances, the level of fee is not an issue.


Keratin may not just be lowballing on the first year audit fee, but in the longer term, perhaps indicating that future increases might only be in line with inflation. If Keratin was to later increase Benthos’ audit fees substantially, a fee dispute could arise. In this event Benthos could refuse to pay the higher fee. It might be difficult then for Keratin to take the matter to arbitration if Benthos was misled.


Steps by Sepia


There are no steps which Sepia can take to prevent Benthos from awarding the tender to whichever firm it chooses.


If Keratin is successful in being awarded the tender, Sepia should consider its own policy on pricing in future competitive tendering situations.



Test your understanding 10


  •  in a smaller audit firm Why difficult to implement


Audit quality depends on the quality of the people. Smaller firms may lack resources and specialist expertise. In particular, small firms may not be able to offer the same reward structures to attract and retain staff as larger firms.


Larger firms can afford to recruit staff in sufficient numbers to allow for subsequent leavers and provide for their training needs. Smaller firms may not be able to offer the same training opportunities.

Prospective trainees may perceive a smaller firm’s client base to be less attractive than that of a larger firm.


Smaller practices may have less scope to provide staff with internal and on-the-job training due to their smaller client base.


The cost of external training may be prohibitive for smaller firms and also fail to provide the hands-on experience necessary for professional development.


Audit committees play an oversight role which contributes to   in larger firms (e.g. on matters of client acceptance/retention, independence issues, etc). When the client base is largely of owner-managed businesses, as for many smaller audit firms, there are no non-executive directors to support the auditor when difficult issues arise.


requires leadership within the firm. In a larger firm, one senior partner may have responsibility for establishing   policies and procedures and a different partner may have responsibility for monitoring work performed. Splitting these roles may not be practical for a smaller firm and is impossible for sole practitioners.


Small firms operate in a highly competitive environment for audit work, are often busy with non-audit work, and may be under-resourced. Technical updating on audit matters may not be as regular as desirable and audit practice may become inefficient.


How overcome


procedures in a smaller firm can be distributed between the     partners.


Smaller firms may draw on the expertise of suitably qualified external consultants (e.g. on technical matters). Small firms and sole practitioners have the same access to a wide range of technical and ethical advisory services provided by ACCA (and other professional bodies) and should take advantage of these.


Small firms may work together as a network to share training opportunities and sometimes staff. For example, an association of small firms may adopt the same methodology and meet periodically for technical updates.


  • Lammergeier Group – auditor’s report


The opinion paragraph should be positioned above the basis for opinion paragraph and should have a title referring to the type of opinion being issued i.e. Qualified Opinion.


The explanation of the material misstatement should be given in a separate section called the Basis for Qualified Opinion.


The report is clearly headed ‘Qualified opinion arising from material misstatement …’ yet the reasons for departure from IAS 7 are ‘sound and acceptable’. This is confusing.


The heading is a statement of disagreement with the application of a standard, the latter a statement of concurrence. If the auditor concurs with a departure, the opinion should not be modified.


The title of IAS 7 should be stated in full, i.e. ‘International Accounting Standard 7 Statement of Cash Flows. The full title of the accounting standard not being complied with should be stated in the basis for qualified opinion paragraph.


The auditor should not be expressing an opinion of Lammergeier’s management in their report. This is not professional.


Management’s justification should be set out in a note to the financial statements (e.g. in the accounting policies section). The auditor’s report should clearly state that there is non-compliance with IAS 7.


It cannot be true that the departure ‘does not impact on the truth and fairness …’. The requirement to prepare a statement of cash flows (and its associated notes) stems from the need to provide users of financial statements with information about changes in financial resources. If this information is omitted the financial statements cannot show a true and fair view.


‘Except for [the non-preparation of the group statements of cash flows and associated notes] ….’ is a qualified auditor’s opinion. This


contradicts Rook & Co’s assertion that the matter ‘does not impact on the truth and fairness …’.


The grounds for non-compliance is ‘the complexity involved’, which does not seem likely. IAS 7 offers no exemption on these, or any other grounds.


A statement of cash flows is required by IAS 7 and as a result the failure to include one will mean the financial statements do not give a true and fair view. This will require an adverse opinion.


A basis for adverse opinion will explain the reason for the adverse opinion. This section should be distinguishable from the opinion section by including a title ‘Basis for Adverse Opinion’.


The fact that the audit opinion was similarly modified in the prior year shows that the matter has not been resolved. It is possible that the auditor thought it was an easy option to do the same again rather than draft a more appropriate opinion for the current year.


The 20X3 opinion makes no reference to the fact that the matter is not new and that the opinion was similarly modified in the prior year.



  • Auditor’s responsibilities in relation to Other Information The auditor has a professional responsibility to read other information to identify material inconsistencies with the audited financial statements (ISA 720 The Auditor’s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements).


A material inconsistency arises when other information contradicts that which is contained in the audited financial statements or which contradicts information obtained by the auditor about the entity. It may give rise to doubts about:


–    the auditor’s conclusions drawn from the audit


–    the basis for the auditor’s opinion on the financial statements.


As a result the credibility of the financial statements and the auditor’s report thereon may be undermined by any inconsistency.


Any inconsistencies should be discussed with management, who should be asked to remove the misleading information in the chairman’s statement.


If management refuse to remove the inconsistency, the auditor should communicate this to those charged with governance.


If the inconsistency remains, the auditor should provide a description of it in the ‘Other Information’ section of the auditor’s report.


Alternatively the auditor may withhold the auditor’s report or withdraw from the engagement. In such cases legal advice should be sought, to protect the interests of the audit firm.


Implications for the auditor’s report


The assertion in the chairman’s statement claims two things:


– the company is ‘one of the world’s largest generators of hydro-electricity’, and


– the company has ‘a dedicated commitment to accountable ethical professionalism’.


The first statement presents a misleading impression of the company’s size. In misleading a user of the financial statements with this statement, the second statement is not true as it is not ethical or professional to mislead the reader and potentially undermine the credibility of the financial statements.


The first statement is materially inconsistent with the auditor’s understanding of the entity because:


– the company is privately-owned, and publicly-owned international/multi-nationals are larger


– the company’s main activity is civil engineering not electricity generation (only 14% of revenue is derived from HEP)


–    as the company ranks at best eighth against African companies alone it ranks much lower globally.


Hegas should be asked to remove these assertions from the chairman’s statement.


If the statement is not changed there will be no grounds for modification of the opinion on the audited financial statements as the Chairman’s statement does not form part of the financial statements.


The ‘Other Information’ section should include a description of the inconsistency between the Chairman’s statement and the auditor’s understanding of the company.


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