Sample

Question 2a

(a) It is 1 July 20X5. You are a manager in the audit department of Peart & Co, a firm of Chartered Certified Accountants, responsible for the audit of Lifeson Co for the year ended 31 March 20X5. Lifeson Co is an unlisted retail company which is a new audit client of your firm this year. The company’s draft financial statements recognise profit before tax of $2·15 million (20X4 – $1·95 million) and total assets of $13·8 million (20X4 – $12·7million).

The audit is nearly complete and you are reviewing the audit working papers. The audit supervisor has brought the following matters to your attention:

(i) Sale and leaseback transaction
On 31 March 20X5, Lifeson Co sold a property to a leasing company, Clive Co, for its fair value at this date. The property is situated in a sought after area with a high demand for rental properties for retail purposes. Clive Co has assessed the remaining life of the property to be in excess of 50 years, and under the terms of the sales agreement, Lifeson Co will lease the property back from Clive Co for a period of ten years. Lifeson Co has treated the transaction as a sale and leaseback transaction in accordance with IFRS® 16 Leases, and derecognised the property in its financial statements and recorded a sale in accordance with IFRS 15 Revenue from Contracts with Customers. (8 marks)

(ii) Investment property
Lifeson Co owns a building which it has used as a warehouse to store inventory. On 1 April 20X4 the building, which had not suffered any historic impairments, had a carrying amount based on depreciated historic cost of $323,000 and a fair value of $348,000. On this date, Lifeson Co vacated the building and moved the inventory to new larger premises. Management decided to keep the building in order to rent it out as a storage facility to local businesses and to benefit from any increases in property valuations. On 31 March 20X5, the building had not been let and it had a fair value, according to an external valuer, of $353,000.

The draft financial statements for the current year recognise the building as an investment property at a carrying amount of $353,000 and include a fair value gain of $30,000 in profit before tax for the year. Since reclassification as an investment property, depreciation has not been charged in relation to the building. (6 marks)

(iii) Shopping mall
Lifeson Co purchased a shopping mall on 1 April 20X3 for $9·5 million. At the date of purchase, the mall was estimated to have a remaining useful life of 20 years and a nil residual value. On 31 March 20X4 following an impairment review, the property was written down to its recoverable amount based on value in use of $8·25 million and an impairment loss of $775,000 was recognised in the statement of profit or loss for the year ended 31 March 20X4.

Lifeson Co conducted a further impairment review as at 31 March 20X5 which indicated that the property’s recoverable amount, based on value in use, was now $8·85 million. As a result, Lifeson Co has recognised an impairment reversal of $1·034 million in its profit before tax for the current year. The impairment reversal of $1·034 million has been calculated as its new recoverable amount of $8·85 million less its carrying amount of $7·816 million. The audit supervisor has prepared the following working paper which summarises the accounting transactions in relation to the shopping mall:

Summary of transactions

Date $ million  Accounting treatment by management
1 April 20X3  Cost of asset  9·500
Depreciation (9·5m/20 years)   (0·475) Depreciation charge for the year to 31 March 20X4
Impairment  (0·775) Impairment loss charged to profit for the year to 31 March 20X4
31 March 20X4 Year end carrying amount  8·250
Depreciation (8·25m/19 years)   (0·434) Depreciation charge for the year to 31 March 20X5
7·816  Carrying amount prior to impairment review
Reversal of impairment   1·034 Reversal of impairment credited to profit for the year to 31 March 20X5
----------
31 March 20X5 Year end carrying amount 8·850
----------
(6 marks)

Required:

Comment on the matters to be considered and explain the audit evidence you would expect to find during your review of the audit working papers in respect of the issues described above.

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

Evidence expected to be on file:

A copy of the sale and leaseback agreement reviewed to confirm the key details including in particular the rights of the lessee and the lessor to control the asset.

A working paper detailing all key aspects of the agreement required to identify the detailed accounting treatment including the sale proceeds, rental amounts and timings, the lease term and the interest rate implicit in the lease.

Agreement of the sale proceeds as per the sale agreement to the cash book and/or bank statement to confirm the correct calculation of the gain or loss on disposal.

Notes of discussions with management in relation to the transfer of control to confirm whether the correct treatment of the sale and leaseback arrangement has been determined.

A copy of any client working papers in relation to the calculation of the right-of-use asset to identify whether the client has recognised the right-of-use asset at the correct amount.

A review of the board minutes for evidence of management’s discussion of the sale and leaseback transaction and any evidence in relation to the transfer of control.

A review of the local property market including trade journals, press articles, official statistics to confirm high demand for retail leases.

A review of surveyor reports on the property to confirm the expected remaining life of the property.

A copy of the client’s working papers for the calculation of the present value of the lease payments and a recalculation of the present value of the lease payments by the auditor in order to form a basis for confirming the detailed accounting treatment of the lease.

Agreement of the carrying amount of the property to the non-current asset register to determine whether the correct amount has been derecognised and whether the gain or loss on disposal has been recorded correctly.

A schedule calculating any gain or loss on the transaction, recalculated by the audit team and confirming that it only represents the gain or loss on rights transferred to Clive Co.

Review of the draft financial statements to confirm that details of the sale and leaseback transaction, such as the gain or loss arising on the transaction, have been disclosed in line with the requirements of IFRS 16.

(ii) Investment property

Matters

Materiality
The carrying amount of the investment property represents 2·6% ($353,000/$13·8 million) of Lifeson Co’s total assets
at the reporting date and is material to the financial statements.

Classification as investment property
The auditor should consider whether the requirements of IAS 40 Investment Property have been satisfied and confirm if the warehouse held by Lifeson Co is actually an investment property. IAS 40 defines an investment property as land and/or buildings held to earn rentals or for capital appreciation, or both. Lifeson Co’s warehouse has been held to earn rentals and for capital appreciation from 1 April 20X4 and therefore qualifies as an investment property from this date.

The fact that the property has not yet been let by the reporting date does not impact on this classification. The end of owner-occupation of the warehouse is evidence of the change in use to an investment property.

Fair value
The warehouse is recognised at fair value of $353,000 and according to IAS 40, the fair value model is acceptable provided the treatment of any other investment property held by Lifeson Co is consistent. On transfer of an owner-occupied property recognised at depreciated historical cost, which has not been previously impaired, to investment property carried at fair value, IAS 40 requires that any resulting increase in the carrying amount should be recognised in other comprehensive income as a revaluation surplus within equity. Thereafter, any further increase in fair value is recognised in profit or loss for the year. In this case, Lifeson Co should recognise the initial increase of $25,000 ($348,000 – $323,000) in other comprehensive income rather than in its profit for the year and the additional increase of $5,000 ($353,000 – $348,000) which arises during the current year should be recognised in this year’s profit or loss. Lifeson Co’s recognition of the full $30,000 gain in its profit before tax for the current year is incorrect and therefore results in an overstatement of profit by $25,000.

Evidence expected to be on file:

Notes of discussions with management to confirm its intention to hold the property to earn rentals and for capital appreciation.

Inspection of title deeds held by Lifeson Co to confirm its ownership of the investment property.

Board minutes for evidence of management discussion of the change of use and for confirmation of the date when owner-occupation ceased.

Record of the physical inspection of the building by the auditor in order to confirm its general condition and that it is no longer occupied by Lifeson Co.

Agreement of the accounting policy to the notes to the financial statements this year and in previous year, to confirm that the fair value model is to be adopted and is consistent with any other investment properties held.

A market valuation of the building by an independent and external auditor’s expert at the date of the change of use and at the reporting date to determine the respective fair values and the resulting gains.

Details of the external expert valuer and a working paper detailing the assessment of their professional qualifications, experience, reputation, independence and objectivity.

Agreement of the carrying amount at the date of the change of use to the non-current asset register to confirm the correct amount of the fair value gain.

Written representations from management confirming the change of use, the relevant date and future intentions.

Notes of discussions with management in relation to the incorrect recording of the gain and the need to include the error in the auditor’s schedule of uncorrected misstatements.

Review the disclosures made in the financial statements, such as details of the external valuation, to ensure they comply with the requirements of IAS 40.

(iii) Asset impairment

Matters

Materiality
The carrying amount of the shopping mall represents 64·1% ($8·85 million/$13·8 million) of Lifeson Co’s total assets at the reporting date and is therefore highly material to the company’s financial statements.

Value in use
The auditor should consider whether the client’s calculation of the shopping mall’s recoverable amount based on value in use is in line with the requirements of IAS 36 Impairment of Assets. This should include an assessment of whether the client has used an appropriate discount factor for calculating value in use based on the rate which reflects current market assessments of the time value of money and the risks specific to the asset. In line with IAS 36’s definition of recoverable amount as the higher of its fair value less costs to sell and its value in use, the auditor should also consider whether the fair value less selling costs of the shopping mall exceeds its value in use.

Reversal of impairment loss
IAS 36 requires that the increased carrying amount of an asset, such as property, attributable to a reversal of an impairment loss should not exceed the carrying amount which would have been determined, net of depreciation, had no impairment loss been recognised for the asset in prior years. In this case, therefore, recognition of the reversal of the impairment loss should be calculated as follows:

$million  $million 
Carrying amount as at 31 March 20X5 prior to recognition of impairment reversal ($8·25m x 18/19) 7·816
Recoverable amount based on impairment review as at 31 March 20X5 8·850
Capped to $9·5m x 18/20 = 8·550 8·550
---------
Impairment reversal to be recognised 0·734
---------

As a result of Lifeson Co’s failure to limit the impairment reversal to $0·734 million, profit and assets are overstated by $300,000 (1·034m – 0·734m).

Evidence expected to be on file:

Agreement of the opening balances for the property to the non-current asset register as at 1 April 20X4 to confirm the correct amount has been brought forward in the client’s working papers.

Physical inspection of the shopping mall property to confirm its condition, occupancy level and to assess the reasonableness of the depreciation policy and forecast cash flows for the value in use calculation.

Copy of the client working papers for impairment review giving evidence of the client’s basis for assessing the fair value less selling costs of the mall and detailed calculations of its value in use

Copy of the client’s cash flow forecasts and budgets supporting the value in use calculations.

Notes of discussions with management in relation to the bases for the calculation of recoverable amount including an assessment of the reasonableness of the assumptions used by management in its forecasts and calculations and the appropriateness of the discount factor used in the value in use calculations.

Written representations attesting to the reasonableness of its assumptions and other related management judgements.

A recalculation of the value in use of the shopping mall by the auditor in order to confirm the accuracy of the client’s calculation.

Sensitivity analyses on the forecasts and the value in use calculations in order to assess the impact of any changes in the key assumptions.

External confirmation of the shopping mall’s net realisable value by an appropriately qualified, independent expert in order to ensure the recoverable amount has been correctly determined.

Notes of discussions with management in relation to the incorrect recording of the impairment reversal and the need to include the error in the auditor’s schedule of uncorrected misstatements.