ACCA AAA ^UK Syllabus D. Audit of Historical Financial Information - Evaluation of Misstatements - Past Papers ^{5 / 10}

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

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:

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.

The Bassett Group (the Group) is a publisher of newspapers and magazines, academic journals, and books. The Group, a listed entity, has a financial year ending 30 April 2018, and your firm, Whippet & Co, was appointed as Group auditor in September 2017. Whippet & Co will audit all Group companies with the exception of Borzoi Co, a foreign subsidiary, which is audited by a local firm of auditors, Saluki Associates. The Group aims to comply fully with the UK Corporate Governance Code.

You are the manager responsible for the Group audit, and the audit engagement partner has just sent the following email to you:

To: Audit manager
From: Kerry Dunker, audit engagement partner
Subject: Bassett Group audit planning

Hello

I have provided some information to help you with planning the Bassett Group audit. I met with the Group finance director yesterday to discuss some aspects of the Group’s business and related accounting issues. One of the audit team members has already performed limited analytical procedures based on the Group’s projected financial statements and comparatives, and I have provided you with the results of this work. I have also provided you with an extract from the communication which we received from Grey & Co, the Group’s previous auditor.

Using the information provided, I require you to prepare briefing notes to be used as part of the audit team planning meeting. Your briefing notes should evaluate the audit risks to be considered in planning the audit of the Group financial statements, and identify and explain the matters which the audit team should approach with a high degree of professional scepticism.

In respect of the audit of Borzoi Co, your briefing notes should also explain the term ‘significant component’ and assess whether Borzoi Co is a significant component of the Group. This will help the audit assistants to understand our audit strategy in relation to this subsidiary.

Finally, your briefing notes should discuss the nature and extent of involvement which our firm should have with the audit risk assessment to be performed by Saluki Associates.

Thank you

Background information and results of analytical procedures
The Group operates globally, with sales being made in over 100 countries. The Group has 20 subsidiaries which have been acquired over the last 30 years. All Group companies are located in the UK, with the exception of Borzoi Co, a foreign subsidiary whose operations focus on the translation of published content into a variety of different languages.

The Group’s publishing activities can be categorised into three operating segments, each of which are cash generating units for the purpose of impairment reviews: newspapers and magazines, academic journals, and books. The revenue and total assets for 2018 (projected) and 2017 (actual) for the Group in total and for each segment is as follows:

During the financial year the Group has invested in software which enhances and extends the Group’s range of digital publications, across all operating segments. The total investment, which is recognised as an intangible asset, was £15 million, of which £5 million relates to purchased software, and £10 million relates to internally developed software.

According to management, the implementation of this software has already led to significant increases in sales of digital publications, and while this accounts for only approximately 20% of Group revenue currently, management is confident that sales of digital publications will quickly grow, and within three years is expected to overtake sales of hard copy publications across all operating segments. Using this justification, management does not consider it necessary to perform impairment reviews on any of the three operating segments this year.

Information on some specific aspects of the Group’s operations and the associated Group accounting policies, and information in relation to Borzoi Co, is given below:

Newspapers and magazines – publication rights
A substantial portion of the Group’s newspaper and magazine publications are protected by publication rights which protect the Group’s exclusive right to publish the relevant newspaper or magazine for specified periods. The Group owns more than 200 publication rights, which range in period of exclusivity from five years to 30 years. The publication rights are recognised as an intangible asset with a carrying amount of £7·9 million. The Group’s accounting policy is to amortise publication rights over an average period of 25 years.

Books – royalty advances
The Group commissions authors to write books for which the Group owns the copyright. When a book is commissioned, the author is paid a royalty advance, the amount of which depends on the expected sales of the book. The Group’s accounting policy is to defer the cost of the royalty advance within current assets until the book is published, at which point the cost begins to be recognised as an expense, spread over a ten-year period. The Group finance director does not have a justification for this ten-year period other than it being ‘industry practice’. The total royalty advance projected to be recognised within current assets at 30 April 2018 is £3·4 million.

Borzoi Co
Borzoi Co is located in Farland, a country which has recently experienced political unrest, leading to significant volatility in the local currency, the Oska. At today’s date, the management accounts of Borzoi Co recognise total assets of 68 million Oska, and the exchange rate is 4 Oska:1£. In the last six months, the exchange rate has fluctuated between 10 Oska:1£ to 3 Oska:1£.

Farland requires the use of IFRS® Standards and therefore Borzoi Co prepares its financial statements using IFRS Standards as its applicable financial reporting framework.

To help with the company’s development of language translation operations, on 1 May 2017, Bassett plc, the parent company of the Group, transferred a piece of translation software to Borzoi Co. The software had been purchased by the parent company for £1·5 million several years ago and prior to transfer to Borzoi Co, it was held at a carrying amount of £1 million, this being its cost less amortisation to date. Immediately prior to being transferred to Borzoi Co, the software was revalued in the parent company’s financial statements to £5·4 million, this being its estimated fair value at the time of the transfer. The estimate of fair value was determined by Group management, and this amount is still outstanding for payment by Borzoi Co.

Communication from Grey & Co
The previous Group auditor, Grey & Co, states the following in their communication to Whippet & Co:

‘We have acted as Group auditor for the last four years and our audit opinion has been unmodified each year. However, we would like to bring to your attention a matter relating to the Group’s corporate governance arrangements. We found that on several occasions in the last year the Group CFO initially blocked our firm’s access to the Group audit committee, making it difficult for us to discuss matters relating to the audit with the committee.’

Required:
Respond to the instructions in the audit engagement partner’s email. (31 marks)

Professional marks to be awarded for presentation, logical flow, and clarity of explanations provided. (4 marks)

Discuss the three types of misstatement identified in ISA 450 Evaluation of Misstatements Identified During the Audit and comment on why it is important for the auditor to consider the type of misstatement when evaluating their effect on the financial statements and determining the further actions to be taken. (5 marks)

You are the manager responsible for the audit of Boston Co, a producer of chocolate and confectionery. The audit of the financial statements for the year ended 31 December 2015 is nearly complete and you are reviewing the audit working papers. The financial statements recognise revenue of $76 million, profit before tax for the year of $6·4 million and total assets of $104 million.

The summary of uncorrected misstatements included in Boston Co’s audit working papers, including notes, is shown below. The audit engagement partner is holding a meeting with the management team of Boston Co next week, at which the uncorrected misstatements will be discussed.

(i) During the year Boston Co impaired one of its factories. The carrying value of the assets attributable to the factory as a single, cash-generating unit totalled $3·6 million at the year end. The fair value less costs of disposal and the value in use were estimated to be $3 million and $3·5 million respectively and accordingly the asset was written down by $100,000 to reflect the impairment. Audit procedures revealed that management used growth rates attributable to the company as a whole to estimate value in use. Using growth rates attributable to the factory specifically, the audit team estimated the value in use to be $3·1 million.

(ii) Interest charges of $75,000 relating to a loan taken out during the year to finance the construction of a new manufacturing plant were included in finance charges recognised in profit for the year. The manufacturing plant is due for completion in November 2016.

(iii) One of Boston Co’s largest customers, Cleveland Co, is experiencing financial difficulties. At the year end Cleveland Co owed Boston Co $100,000, against which Boston Co made a 5% specific allowance. Shortly after the year end Cleveland Co paid $30,000 of the outstanding amount due but has since experienced further problems, leading to their primary lender presenting a formal request that Cleveland Co be liquidated. If successful, only secured creditors are likely to receive any reimbursement.

(iv) During the year Boston Co purchased 150,000 shares in Nebraska Co for $4·00 per share. Boston Co classified the investment as a financial asset held at fair value through profit or loss. On 31 December 2015, the shares of Nebraska Co were trading for $4·29. At the year end the carrying value of the investment in Boston Co’s financial statements was $600,000.

Required:
(a) Explain the matters which should be discussed with management in relation to each of the uncorrected misstatements, including an assessment of their individual impact on the financial statements; and

The following mark allocation is provided as guidance for this question:
(a) 14 marks
(b) 6 marks

You are an audit manager in Compton & Co, responsible for the audit of the Stow Group (the Group). You are planning the audit of the Group financial statements for the year ending 31 December 2013. The Group’s projected profit before tax for the year is $200 million and projected total assets at 31 December are $2,500 million.

The Group is a car manufacturer. Its operations are divided between a number of subsidiaries, some of which focus on manufacturing and distributing the cars, while others deal mainly with marketing and retail. All components of the Group have the same year end. The Group audit engagement partner, Chad Woodstock, has just sent you the following email.

To: Audit manager
From: Chad Woodstock, audit partner
Subject: The Stow Group – audit planning

Hello

We need to start planning the audit of The Stow Group. Yesterday I met with the Group finance director, Marta Bidford, and we discussed some restructuring of the Group which has taken place this year. A new wholly-owned subsidiary has been acquired – Zennor Co, which is located overseas in Farland. Another subsidiary, Broadway Co, was disposed of.

I have provided you with a summary of issues which I discussed with Marta, and using this information I would like you to prepare briefing notes for my use in which you:

(i) Explain the risks of material misstatement to be considered in planning the Group audit, commenting on their materiality to the Group financial statements; and (12 marks)

(ii) Identify any further information that may be needed. (4 marks)

Thank you.

Acquisition of Zennor Co

In order to expand overseas, the Group acquired 100% of the share capital of Zennor Co on 1 February 2013. Zennor Co is located in Farland, where it owns a chain of car dealerships. Zennor Co’s financial statements are prepared using International Financial Reporting Standards and are measured and presented using the local currency of Farland, the Dingu.

At the present time, the exchange rate is 4 Dingu = $1. Zennor Co has the same year end as the Group, and its projected profit for the year ending 31 December 2013 is 90 million Dingu, with projected assets at the same date of 800 million Dingu.

Zennor Co is supplied with cars from the Group’s manufacturing plant. The cars are sent on cargo ships and take approximately six weeks to reach the main port in Farland, where they are stored until delivered to the dealerships. At today’s date there are cars in transit to Zennor Co with a selling price of $58 million.

A local firm of auditors was engaged by the Group to perform a due diligence review on Zennor Co prior to its acquisition. The Group’s statement of financial position recognises goodwill at acquisition of $60 million.

Compton & Co was appointed as auditor of Zennor Co on 1 March 2013.

Disposal of Broadway Co

On 1 September 2013, the Group disposed of its wholly-owned subsidiary, Broadway Co, for proceeds of $180 million. Broadway Co operated a distribution centre in this country. The Group’s statement of profit or loss includes a profit of $25 million in respect of the disposal.

Broadway Co was acquired by a retail organisation, the Cornwall Group, which wished to bring its distribution operations in house in order to save costs. Compton & Co resigned as auditor to Broadway Co on 15 September 2013 to be replaced by the principal auditor of the Cornwall Group.

Zennor Co – Internal audit team

The internal audit team was established several years ago and is headed up by a qualified accountant, Jo Evesham, who has a lot of experience in designing systems and controls. Jo and her team monitor the effectiveness of operating and financial reporting controls, and report to the board of directors. Zennor Co does not have an audit committee as corporate governance rules in Farland do not require an internal audit function or an audit committee to be established.

During the year, the internal audit team performed several value for money exercises such as reviewing the terms negotiated with suppliers.

Required:
Respond to the instructions in the partner’s email.