Sept 2018
Q1
Briefing Note:
To: Maya Crag, Audit Engagement partner
From: Audit Manager
Subject: Eagle Group Audit planning
Introduction:
This note includes evaluation of Audit risk when planning the Group Audit and recommend the
principal Audit procedure for the Audit of goodwill on the acquisition of new subsidiary. It then
evaluates the extract of the Audit strategy prepared by component auditor. Finally, the notes
discuss ethical and professional issue of providing non-audit service to Group’s integrated report.
(a) Evaluation the Audit Risk (24 marks)
Selected Analytical review and associated audit risk evaluation
20x8 20x7
Operating margin (operating profit/sales) 6.07% 4.51%
ROCE (PBIT/TCE) 12% 10%
Current ratio (CA/CL) 2.4 2.6
Gearing (D/D+E) 24.5% 23.9%
Interest cover (PBIT/Interest) 12.5 9
Effective tax rate (PBT/Tax expenses) 19.9% 25%
Effective tax rate
Effective tax rate has fallen from 25% to 19.9%. This could indicate management bias as the
FS suggest that accounting profit has increased but profit chargeable to tax used to
determine the tax expense for the year appear to have decreased. There is a risk that tax
expenses and associated liability could be understated.
Operating Margin and operating expenses
The Group operating margin increased from 4.5% to 6% despite a fall in revenue of 3.7%.
This could be due to a reduction in operating expenses 4.5% and increase in operating
income of 50%. There is a risk that operating expenses are understated and operating
income are overstated.
Finance cost
The interest cover has increased due to both increase in operating profit and decrease in
finance cost which is not in line with increase in borrowing of 50m in 20x7. There is a risk
that finance cost are understated.
Other operating income
There is an audit risk that other operating income are overstated. During the year a credit of
$60m has been recognized in profit for reversal of provision. In addition, a credit of $30m
has been recognized for reversal of impairment losses. There is the risk these figures have
been manipulated in order to boost profit to respond the fail in revenue in the current year.
Goodwill impairment
Group has performed annual impairment review on goodwill arising from business
acquisition and determined no impairment of goodwill. There is an indicator which is
reduction in Group’s revenue due to a new competitor taking some of the Group market
share. Thus, some of the subsidiary’s goodwill could be impaired and a loss should be
recognized. There is a risk that NCA are overstated and operating expenses are understated.
Goodwill represents 31.5% of Group total assets thus it is material to the Group FS.
(or)
Goodwill represents 31.5% of Group total assets thus it is material to the Group Financial
statement.
Group has performed annual impairment review on goodwill arising from business
acquisition and determined no impairment of goodwill.
There is an impairment indicator exist which is reduction in Group’s revenue due to a new
competitor taking some of the Group market share. Thus, some of the subsidiary’s goodwill
could be impaired and impairment loss should be recognized.
There is a risk that NCA are overstated and operating expenses are understated.
Consolidation of foreign sales
Group acquire new subsidiary, Lynex Co during the year. The assets and liabilities of Lynex
Co and other subsidiaries should be retranslated using the closing exchange rate and the
income and expense should be retranslated using the transaction date exchange rate. There
is a risk that incorrect exchange rate used leading to over (or) understatement of assets,
liabilities, income and expenses which are consolidated including goodwill.
Measurement and recognition of foreign exchange gain or loss
The exchange gain (or) loss arising as a result of retranslation of the foreign subsidiaries
balance are recognized in OCI. There is a risk that exchange gains and loss are incorrectly
recognized in P and L as the exchange gain recognized in P and L has increased by 21.7%
over the last year.
Other intangible assets
Total expenditure of $60m has been spent relating to development cost such as new IT
system, New software and etc. These cost have been capitalized as intangible assets.
The appropriate accounting treatment is that research expenses should be charged to profit
and loss and development cost should be capitalized if the recognition criteria for intangible
assets are met.
There is the risk that IA are overstated and operating expenses are understated if research
cost has been incorrectly capitalized.
Useful life of Intangible asset
There is a risk that amortization period is not appropriate as 15 years life seem to be a long
period usually technology related product are written off over a relatively short period.
There is a risk that IA are overstated and operating expenses are understated.
1(b) Principal Audit procedure on Goodwill
- Review the copy of Board Minutes for discussion relation to the acquisition of Lynex Co
and to confirm it has been approved by Board
- Agree the $50m cash paid to cash book and bank statement of the acquiring company
- Obtain the legal document and review to confirm that the figures included in goodwill
calculation relating to consideration paid and payable are complete and accuracy
- The FV of NCI should be verified by multiplying the NCI share investment in Lynex co and
the quoted share price of Lynex Co at acquisition date
- Obtain a copy of due diligence report and review for confirmation of acquired assets and
liabilities and their FV
- Evaluate the method used to determine the FV at acquired assets and liabilities to
confirm compliance with IFRS 13 FV measurement
- Recalculate the goodwill calculation to confirm arithmetic accuracy
1.(c) Evaluate the extract of the audit strategy prepared by component auditor, Vulture Associate in
respect of the Audit of Lynex Co. (10 marks)
Control Effectiveness
According to ISA, VA needs to obtain whether significant changes in control have occurred
subsequent to the previous audit.
There needs to be some observation, inspection of control to confirm that they have been no
changes in control and this work and an appropriate conclusion need to be documented in the
audit working papers.
In addition, there should be some testing of internal control each year so VA should plan to perform
some test of control each year so that over 3 year cycle all control are tested to confirm that control
are still operating effectively and therefore can continue to be relied upon.
The Group Audit team should discuss the issue with VA to ensure that adequate controls testing
performed. If VA not performed this, then the Group Audit team may decide to perform additional
testing.
Internal Audit
According to ISA 610, using the work of internal auditors, it is acceptable for the external Audit firm
to use an internal audit function of the Audit client to provide direct assistance to the external audit
team.
Assuming no local regulation restriction, Component Auditor, VA must evaluate a number of factors
before deciding whether to use IA function. These include:
- The level of competence of Internal Audit function
- The objectivity of Internal Audit function
- Whether IA function applied a systematic and disciplined approach including quality
control
If these factors are not meet, VA should not use the direct assistance from the Internal Audit
function.
VA planning to ask to perform specific procedures in relation to trade receivable but is is not
appropriate, IAS state that external Auditor shall make all significant judgement. Performing a trade
receivable circularization and evaluation of allocation for receivable both involve judgement.
In addition, external auditor should not assign internal auditor to these areas that they have been
performed during the year. This may create a significant self-review threat.
28-7-2020
(d) Ethical and professional issues of the request to provide of Group’s internal integrated report (6
marks)
The integrated report will contain financial KPI and the group has asked for input specifically relating
to the reconciliation between these KPI and financial information contained in FS. There is therefore
a potential self-review threat to objectivity. The team performing the work will be reluctant to raise
queries or highlight errors which has been made during external audit.
Working with the integrated report could create a familiarity threat whereby close working
relationships are formed, and the auditor become aligned with the views of management and is
unable to approach the work with professional scepticism.
If the firm decides to take on the engagement safeguards should be used to reduce the threats
which include reviewing the audit work performed by an independent partner.
Firm must also consider whether they have competence to perform the work because of the
specialist nature of the engagement.
The firm should also consider whether it has adequate resources in terms of staff availability to
complet6e the work to the desired deadline.
Conclusion
These briefing notes indicate that there are a number of audit risks to be considered in planning the
audit. The audit of goodwill is an areas of significant audit risk and the recommended principal audit
procedures should be performed. An evaluation of audit strategy prepared by component auditor
indicates poor quality audit. Finally, our firm needs to discuss the request to assist in preparing the
Group’s integrated report with the Group audit committee.
Q2 Sept 2018
(a) Lease of testing equipment
Lease at large site is material to SOFP representing 2.2% of total assets. It is also material to
SOPL representing 20% of PBT.
IFRS 16 lease requires lessee to recognized a right of use asset and a lease liability at the
start of the lease at the FV of lease payment. Given that the commencement date is 31 May
20x8. Therefore, it is appropriate to recognize the lease on the SOFP at this date.
IFRS 16 allows optional exemption for short-term lease at less the 12 months duration with
no purchase option. If Clark Co elects to apply this exemption, it does not recognize the
lease assets and liabilities on the SOFP.
IFRS 16 also requires if the exemption is taken, it must be applied consistently each class of
underlying asset. Hence, in this case, the client must either capitalized the leases all three of
the sites or not capitalized the leases across any of the sites.
The Auditor manager should discuss the option talking the short-term exemption with the
FD at tomorrow meeting.
Impact on Audit opinion
If the client makes no adjustment to the FS in relation to the leases, the SOFP is materially
misstated and the Audit opinion should be qualified on the basis with an “except for”
opinion.
In the “Basis for Qualified opinion” section placed immediately after the “Opinion” Section
of the Auditor report, the Auditor should explain the reason for the modification of the
opinion.
(b) Legal claim
The legal claim is material to SOFP representing 5.5% of total assets.
In this case, the legal claim should be recognized as a provision of $1.2m on the SOFP as if
meet the recognition criteria laid down in IAS 37 present obligation, probable outflows of
benefits, reliable estimate of the amount of obligation.
The reinvestment from 3rd party, in this case, insurance company relating to the amount
provided is recognized as a separate asset when the inflows of economic benefit is virtually
certain.
In this case, verified letter from insurance company before year end, the settlement of the
claim is virtually certain and amount should be recognized separately on SOFP.
The FD should be requested to adjust the FS to include the separate recognized of asset and
provision.
Auditor should also discuss with FD impact on not amending the misstatement on FS which
is understated assets and liabilities.
Impact on Audit opinion
If the management of Clark Co do not make necessary Adjustment to FS, the SOFP is
materially misstated and the audit opinion should be qualified on this basis with an “except
for” opinion.
(c) Asset impairment
The asset impairment of $85,000 is not material in isolation to either on the SOFP
representing 0.39% of total asset or the SOPL representing 3.7% of PBT. An entity should
assess at the end of each reporting period where there is any indication that an asset or CGU
may be impaired.
In this case, there is an impairment indication exists at one of the site that experienced a
decline in market share and revenue due to emergence of new competitor.
A CGU is impaired when the CA exceed recoverable amount. In this case, RV higher of FV
less cost to sell $3.515m (FV 3.9-COS 0.124+0.174+0.085) and value in use $2.9m. Thus, the
CGU is impaired by $85,000 ($3.6m-$3.515m).
The Audit supervisor proposed adjustment is correct FD should be advised of the error and
encourage to amend it tomorrow meeting.
Impact on Audit Opinion
Given that assets and profits are both immaterially overstated. If not adjustment is made to
the FS, there will be no impact on the Audit opinion in relation to the matter is in isolation.
Ethical and professional issue and recommend
Loan to Audit team member
A self-interest threat would be created if the loan is not made under normal lending
procedures and terms and conditions. Such threat is so significant that no safeguard put in
place to reduce it. Thus, the audit team member should not accept such loan.
In this case, the key issue is whether the very best deal which the bank can offer is made
under normal lending procedures. If not, Janette should be told instruction not to take loan
form the client.
Audit manager should inform this matter to an audit engagement partner who is responsible
for ensuring that ethical principles are not breached.
Temporary staff assignment
Secondments at staff to an audit client for temporary basis may create a self-review threat
because the Auditor may review work which they themselves have previous performed.
In addition, there is a risk of the staff member assuming management responsibilities if they
are involved in making judgement and decision which are responsibility of management.
The Code prohibit firm from providing accounting services including payroll to an audit client
which is a public interest entity.
In this case, Turner Co is a public interest entity and firm should not provide temporary staff
assignment to perform senior payroll position.
Q3 Sept 2018
(a) Quality Control and Other professional issued raised (10 marks)
Resources
The staffing levels on the Audit appears to be inadequate given that there are only two
audit team members. This is an indication of poor planning.
Replace
In addition, it is clear that the Audit manager should have been replaced earlier and that
Watson Co has failed to provide adequate direction and supervision of the audit.
Assignment
The assignment of a part-qualified audit supervisor to the audit of the share-based
payment transaction is inappropriate task allocation because this area is complex area.
This complex area should be assigned to more competence senior staff.
Share-Based Payment
The Share-based payment scheme is a complex and judgemental area and only
introduced this year. It should have been identified as a key audit area.
The failure to identify the new cash share-based payment scheme as a potential high risk
area indicates inadequate planning resulting in a poor audit quality work.
Transaction
The treatment of share-based payment is incorrect. The valuation of the SAR for a cash-
settled scheme should be updated at the reporting date. Any changes in FV of liability
should be reported to P and L.
In addition, the recognition of the cumulative cost of the scheme should be recognized
as a liability, not as an equity reserve.
Related party transaction
The Audit supervisor is correct in saying the cast of the scheme this year of $195,000 is
immaterial on a quantitative basis as it represents only 0.36% of PBT and 0.34% of total
assets. However, the scheme is a related party transaction with directions which is
material in the notes to the FS. All misstatements should be accumulated and the error
should have been included in the working paper and adjustment should have been
requested.
External valuer
These appear to be a lack of evidence in relation to external firm of valuers. The auditor
must evaluate whether management’s expert possesses the necessary competence,
capabilities and objectivity to perform the valuation and whether the scope of their
work is satisfactory for Audit purpose.
