Question 1

You are a manager in the audit department of Huntsman & Co, a firm of Chartered Certified Accountants, responsible for the audit of several companies and for evaluating the acceptance decisions in respect of potential new audit clients.

One of your audit clients is Redback Sports Co, which operates a chain of sport and leisure centres across the country.  The company has a financial year ending 28 February 20X9, and you are about to start planning the audit. Stella Cross, the audit engagement partner, met with the company’s finance director last week to discuss business developments in the year and recent financial performance.

In addition, Stella has been approached by Mick Emu, the managing director of Emu Gyms Co. Mick has enquired regarding whether Huntsman & Co can provide the company with an audit or limited assurance review, and Stella would like you to evaluate this request. Huntsman & Co already provides a payroll service to Emu Gyms Co and has assisted Mick with his personal tax planning in the past. Mick also has a suspicion that several employees are carrying out a fraud at the company, and he has asked whether an audit or limited assurance review would have alerted him earlier to the situation.

You are provided with the following exhibits:

1. An email you have received from Stella Cross, in respect of both Redback Sports Co and Emu Gyms Co.

2. Notes of a meeting which Stella held recently with the finance director of Redback Sports Co.

3. Extracts from the latest management accounts of Redback Sports Co.

4. Notes of a telephone conversation which Stella had yesterday with Mick Emu, managing director of Emu Gyms Co.

Required:
Respond to the instructions in the email from the audit engagement partner. (46 marks)

Note: The split of the mark allocation is shown in the partner’s email (Exhibit 1).

Professional marks will be awarded for the presentation and logical flow of the briefing notes and the clarity of the explanations provided. (4 marks)

Exhibit 1 – Email from audit engagement partner
To: Audit manager
From: Stella Cross, Audit engagement partner for Redback Sports Co
Subject: Audit planning for Redback Sports Co, and evaluation of accepting Emu Gyms Co as a potential audit client

Hello
I have provided you with some information in the form of a number of exhibits which you should use to help you with planning the audit of Redback Sports Co for the financial year ending 28 February 20X9.

Using the information provided in Exhibits 2 and 3, I require you to prepare briefing notes for my own use, in which you:
(a) Evaluate the business risks to be considered in planning the company’s audit. (8 marks)

(b) Evaluate the risks of material misstatement to be considered in developing the audit strategy and audit plan.
(18 marks)

(c) Design the principal audit procedures to be used in the audit of the grant received from the government in September 20X8. (6 marks)

In Exhibit 4, I have also provided you with some information relating to Emu Gyms Co. In respect of this, in your briefing notes you should also:

(d) Evaluate the matters to be considered in deciding whether to accept an engagement to provide Emu Gyms Co with an audit or limited assurance review. (8 marks)

(e) In relation to the suspicion of fraud being carried out at Emu Gyms Co:
Discuss whether an audit or limited assurance review of financial statements in previous years could have uncovered the fraud. (6 marks)

Thank you.

Exhibit 2 – Notes of a meeting held on 30 November 20X8
Meeting attendees:

Stella Cross, audit engagement partner, Huntsman & Co
Aneta Bay, finance director, Redback Sports Co

Business background
Redback Sports Ltd operates 20 sport and leisure centres across the UK. Each centre has a large gym and a swimming pool, and many also have tennis and badminton courts. Given the nature of the company’s operations, it has to comply with health and safety regulations set by the UK government, and its facilities are inspected regularly to ensure that all regulations are being followed, and for the company to retain its operating licence.

The company is not listed and therefore does not need to comply with the UK Corporate Governance Code. However, the company’s chief operating officer and chairman consider it good practice to have independent input to the board, and there are two non-executive directors. One of the non-executive directors is a leisure industry expert who was chairman of a rival company, Lyre Leisure Ltd, for ten years. The second non-executive director is an academic who specialises in organisational behaviour and who has written several books on performance management in the sport and leisure industry.

The company’s board has approved a plan to expand through acquiring other leisure and sport facility providers. The strategy is not likely to be implemented for another two years, when the board would like the first acquisition to take place. However, potential target companies will be identified in the next 12 to 18 months. Ultimately, the board would like to seek a flotation of the company within five years, and they consider that expanding the company would improve profits and make a stock exchange listing more feasible.

Redback Sports Co has a small internal audit department with two staff who report to the finance director, as the board does not have an audit committee.

The company offers a membership scheme whereby, for an annual subscription, members can use the facilities at any of the centres. Customers who are not members can pay to access a centre for a day under the company’s ‘pay as you go’ plan. The membership scheme accounts for approximately 85% of the company’s revenue, with the remaining revenue resulting from ‘pay as you go’ sales.

Business developments in the year 
The industry is competitive and the company’s strategy is to encourage customers to renew their membership and to attract new members by offering a range of new activities. According to the finance director, a successful initiative which started in March 20X8 is the ‘Healthy Kids’ campaign; this offers children two hours coaching per week in a range of sports including swimming and tennis. This coaching is provided free as part of their parents’ membership, and it has proved to be very successful – the finance director estimates that it has led to 3,000 new members since it
was launched.

In June 20X8, the company opened a new coastal sport and leisure centre which, as well as offering the usual facilities, also has a scuba diving centre and offers other water sports facilities. An investment of £12 million was also made in new gym equipment across all centres, to ensure that the company offers the most modern facilities to its customers.

An advertising campaign has been launched, to promote the company brand generally, and to make customers aware of the investments in the facilities which have been made. As part of this campaign, the company paid £1 million to a famous athlete to endorse the company for a period of two years. The athlete will appear at the opening of the new coastal sports centre and has agreed to feature in poster advertisements for the next two years.

Redback Sports Ltd is also involved with a UK government initiative to help unemployed people have access to sport facilities.

The company received a grant of £2 million in September 20X8, under the terms of which it allows unemployed people three hours of free access to its facilities per month. By the end of November, 33,900 free hours of facility use have been provided under this scheme. The government intends the initiative to run for three years, to promote long-term health of participants.

A new data management system has been introduced, which integrates membership information with accounting software. This allows more efficient management of the customer database which is used extensively for marketing purposes, as well as providing more timely information on financial performance to management. Data from the previous system was transferred to the new system in July 20X8, and the two systems ran in parallel for two months while training was given to staff and the new system was monitored. One feature of the new system is that it records and reports on the free hours of access provided to unemployed people, which the company has to report on a monthly basis to the government.

Exhibit 3 – Extracts from management accounts of Redback Sports Co

Note Based on 
projected figures to 
28 February 20X9
Based on 
audited figures to 
28 February 20X8
Revenue 1 £53 million £45 million
Income from government grant 2 £2 million
Operating margin 3 15% 10·7%
Profit before tax £6·9 million £4·6 million
Capital expenditure and associated borrowings 4 £32 million £20 million
Cash £1·4 million £5·6 million
Total assets £130 million £110 million
Number of sport and leisure centres 5 20 18
Number of members 6 38,000 33,800
Number of ‘pay as you go’ entry tickets sold 108,000 102,600

Notes
1. Revenue is forecast to increase significantly this year. This is largely due to the success of the advertising campaign featuring the celebrity athlete and the ‘Healthy Kids’ programme (referred to in Exhibit 2).

2. The grant received of £2 million, the details of which are explained in Exhibit 2, has been recognised in full as income for the year.

3. The company’s operating expenses includes the following items:

20X9 20X8
£’000 £’000
Staff costs 15,300 14,300
Marketing 8,500 8,500
Maintenance and repairs of facilities 5,500 5,300

4. Capital expenditure was mostly financed through borrowings. On 1 March 20X8, a ten-year £30 million loan was received from the company’s bank. The loan does not bear interest and is repayable at par value of £34 million. As well as the bank loan, a loan of £1 million was advanced to the company from its managing director, Bob Glider, on 1 July 20X8. The terms of this loan include 3% interest paid to Bob annually in arrears, and the capital will be repaid in seven years’ time in 20Y5.

5. Two new sport and leisure centres were opened this year. As well as the coastal sport and leisure centre (referred to in Exhibit 2), a new centre was opened in an affluent urban area in the capital city.

6. The management information system shows that members visit a sport and leisure centre on average three times per week.

Exhibit 4 – Notes of a telephone conversation between Stella Cross and Mick Emu, managing director of Emu Gyms Co

Notes taken by Stella Cross:
Mick Emu phoned me this morning to discuss developments at Emu Gyms Co and to enquire whether our firm could carry out either an audit of the company’s financial statements, or a limited assurance review of them. This would be the first time that the financial statements have been subject to audit or limited assurance review.

Business background
The company was founded by Mick in 20X5, and since that time our firm has provided a payroll service for the company’s staff, which now number 35 employees working in the company’s four gyms, all located in urban areas.

We have also provided Mick with advice on his personal tax position and financial planning in respect of his retirement, as he wants to sell the company in a few years’ time. Mick runs the company with his son, Steve, who is a qualified personal trainer, and with his daughter, Siobhan, who is the marketing director. The company employs one accountant who prepares the management and financial accounts and who deals with customer memberships.

The company has grown quite rapidly in the last year, with revenue of £8 million for the financial year to 30 September 20X8, and with total assets of approximately £5·5 million. The comparative figures for 20X7 were revenue of £6·5 million and total assets of £4·8 million.

Loan application
Mick thinks that it will be difficult to attract more members for his gyms in existing locations, and would like the company to expand by constructing a new gym. He has discussed a loan of £4 million with the company’s bank to fund the necessary capital expenditure. The bank manager has asked for the company’s financial statements for the year to 30 September 20X8 and comparative information, and has also requested a cash flow and profit forecast for the next three years in order to make a lending decision within the next two months.

Mick has asked whether a representative of the firm can attend a meeting with Mick and the company’s bank manager, to support the loan application and answer questions from the bank manager, assuming that we are engaged to perform either an audit or a limited assurance review on the financial statements.

Suspected fraud Mick mentioned that one of the reasons he would like an audit or limited assurance review of the financial statements is because he has noticed some unusual trends in the company’s financial information. This has led him to suspect that several employees are carrying out a fraud. Each gym has a small shop selling gym wear and a café, where customers can buy light meals, drinks and snacks. Mick has noticed that the cash receipts from sales in the shops and cafés have reduced significantly in the last year, however, there has been no reduction in purchases from suppliers. As a consequence, the gross margin for these sales as reported in the management accounts has fallen from 32% to 26%.

This indicated to him that staff members could be giving away items for free to customers, or they could be taking inventories from the shops and cafés for their personal use or to sell.

The shops and cafés keep a relatively small amount of inventory which is replenished on a regular basis. Until this year, sales in the shops represented approximately 5%, and café sales represented approximately 8% of the company’s revenue. The figures for this year are 3% and 6% respectively.

Mick wonders whether the potential fraud would have been uncovered earlier, had the financial statements been subject to audit or limited assurance review in previous years.