Question Practice on Risk
1 Events, discoveries and accounting issues and implications for the audit
A common format of a question on business or audit risk is to present you with notes from a recent planning meeting with a client, or an email from a partner raising certain issues affecting the client. You then have to identify the audit risks (ROMM and detection risk) arising and have to say how you would respond or describe how you would gather sufficient appropriate audit evidence. The information is given as a number of paragraphs each usually dealing with one piece of information. Generally, each paragraphs will have at least one implication for the audit of the financial statements. It is rare to be provided with information that is of little importance.
A similar question can ask about business risk rather than audit risk. There you do not have to talk about evidence as we are not yet at the stage of carrying out an audit. Remember, auditors are interested in business risks because these frequently lead to audit risks.
Below is a selection of the type of issues that might be presented to you in exam questions. For each, identify the issue(s) raised and what the implications are for the audit.
Suggested answers are provided at the end of this chapter, but you might find it easier to listen to the lecture as each item is talked about there.
During an inventory count at a company which makes jam and marmalade, a box containing 12 jars was dropped and the jars were broken. It was immediately noticed that the contents had a bad smell and had obviously gone off or had been contaminated.
On the final review of an audit file, the partner in charge discovered that a junior audit assistant had marked as ‘Correctly accounted for’ the purchases of a car where the VAT element had been posted by the client to Input VAT. [Note: VAT on cars is not recoverable.]
Non-current asset schedule:
$000 | Motor vehicles | Freehold land and buildings | Computers |
|---|---|---|---|
Cost b/f | 260 | 10,000 | 2,000 |
Additions | 50 | – | 600 |
Disposals | 70 | – | 400 |
Cost c/f | 240 | 10,000 | 2,200 |
Depreciation b/f | 180 | 600 | 1,400 |
Disposals | 80 | – | 100 |
Charge for year | 60 | 200 | 220 |
c/f | 160 | 800 | 1,520 |
Depreciation rates (all straight line): cars 25%, land and buildings 2%, computers 10%. Cars are 5 years old when sold.
A television company has built a small village to be used in the filming of a popular and long-running TV program. The village has been build in an area of natural beauty and permission to build was granted on the condition that the village is demolished and the site landscaped on the earlier of filming ceasing and 20 years.
The first audit of a new client is in progress. The parent imports small decorative items from abroad. Its subsidiary trades through 12 take-away pizza shops which are very profitable. Dividends are regularly paid by the subsidiary to the parent.
During the audit, an inventory count showed that the parent had imported some modern items which appear to be made of ivory, which is a banned import. Invoices for these items traced through goods received notes described them as made from a synthetic material.
A large printing machine originally cost $5 million and its accumulated depreciation amounts to $3 million.The sale value of the machine to an overseas buyer in the country of Burunda, net of selling costs, is believed to be 10 million Burundan pounds. The exchange rate at year end was 4 Burundan pounds to $1. The value in use, using cash flow projections and a discount rate of 5%, is $1.5 million.
You are the auditor of a group of companies and one of the subsidiaries has had very poor cash flow and it seems that the bank is unlikely to renew its borrowing facility.
The finance director of the parent has told you that it will make the required loan to the subsidiary to keep it solvent.
A company has changed the way in which it values inventory from the FIFO to the weighted average cost basis and has also changed its depreciation rate on machinery from 20% to 15%.
2 Business risk
As mentioned above, business risks occur when something either has gone wrong or might go wrong in the business. In the examples below, identify the business risk and suggest how this might lead to misstatements in the financial statements.
Suggested answers are provided at the end of this chapter, but you might find it easier to listen to the lecture as each item is talked about there.
A company has started selling goods on the Internet.
A company has started to export goods.
The finance director has recently left and at period end, has not been replaced.
A company has failed to file its tax return on time.
An employee was badly injured carrying out his duties.
A computer virus disrupted the IT system for two days. All seems fine now.
The company changed over from its old to its new IT system part-way through the year. The change-over seemed to go smoothy.
3 Suggested answers
3.1 Audit risk
During an inventory count at a company which makes jam and marmalade, a box containing 12 jars was dropped and the jars were broken. It was immediately noticed that the contents had a bad smell and had obviously gone off or had been contaminated.
Obviously that packet will be written off,
The auditor should investigate other inventory to see if this is an isolated incident of contaminated food. First choose jars from the same batch, then choose some others at random and perhaps extend to different products.
An explanation should be sought from management as to how the contamination might have occurred.
Examine records showing previous production problems.
If other inventory items cannot be shown to be safe with confidence, they will have to be written down too.
A recall scheme might be urgently needed to get customers to return the affected products.
If some products have already been sold to consumers, newspaper ads and social media should warn them too and ask them to return goods for a refund.
Try to discover if any end-consumers have had health issues after consumption of the product.
Assess liabilities for damages and the value of sales to be reversed etc.
Examine the company’s insurance policies to see if they have any policies that could help eg public liability insurance.
Consider whether the company would survive any adverse publicity (going concern issues).
If the issue concerns a specific brand which is recognised in the SOFP, consider impairment/write-downs.
On the final review of an audit file, the partner in charge discovered that a junior audit assistant had marked as ‘Correctly accounted for’ the purchases of a car where the VAT element had been posted by the client to Input VAT. [Note: VAT on cars is not recoverable.]
Make an appropriate journal adjustment for that vehicle.
Investigate the treatments of other vehicles acquired as this might not be an isolated mistake. Make adjustments as needed.
Look at the treatment of other amounts where expenditure is not allowable for VAT (such as entertainment expenditure).
Encourage the company to come clean with the VAT authorities and assess payments due together with any penalties.
Review the performance and skill level of the audit team members. Consider additional training.
The error should have been picked up at earlier reviews ie before getting to partner level. Look at the review processes and skills of other staff members.
Non-current asset schedule:
$000 | Motor vehicles | Freehold land and buildings | Computers |
|---|---|---|---|
Cost b/f | 260 | 10,000 | 2,000 |
Additions | 50 | – | 600 |
Disposals | 70 | – | 400 |
Cost c/f | 240 | 10,000 | 2,200 |
Depreciation b/f | 180 | 600 | 1,400 |
Disposals | 80 | – | 100 |
Charge for year | 60 | 200 | 220 |
c/f | 160 | 800 | 1,520 |
Depreciation rates (all straight line): cars 25%, land and buildings 2%, computers 10%. Cars are 5 years old when sold.
Assess depreciation rates. Are these usual for the classes of assets. 10% for computers looks low.
Following up that point, the cost of computers disposed off is 400, but the accumulated depreciation is only 100. This implies under-depreciation
Freehold land and buildings presumably contain freehold items so these should not be depreciated. Depreciation of 2% has been applied to the total amount.
A television company has built a small village to be used in the filming of a popular and long-running TV program. The village has been build in an area of natural beauty and permission to build was granted on the condition that the village is demolished and the site landscaped on the earlier of filming ceasing and 20 years.
Examine the legal agreement with respect to planning permission and the requirement to demolish.
The demolition costs must be capitalised as part of the construction costs and a long-term provision set up (FRS15). A difficult estimate
However, this amount needs to be the estimated demolition cost discounted for 20 years at the company’s cost of capital. Cost of capital will have to be estimated.
The discounting on the provision and the amount capitalised have to be ‘unwound’ over the life of the asset.
A depreciation rate of 5% is probably appropriate.
Investigate any borrowing costs incurred during construction as these have to be capitalised also (from commencement of construction to when the asset is first brought into use.)
The first audit of a new client is in progress. The parent imports small decorative items from abroad. Its subsidiary trades through 12 take-away pizza shops which are very profitable. Dividends are regularly paid by the subsidiary to the parent.
During the audit, an inventory count showed that the parent had imported some modern items which appear to be made of ivory, which is a banned import. Invoices for these items traced through goods received notes described them as made from a synthetic material.
Note: the first audit of a new client always causes more audit risk, simply because the client, business and systems are all unfamiliar. Generally, a more skilled audit team than normal should be assigned for the first audit to reduce detection risk.
Pizza shops are largely cash based. They are reported as being very profitable. Consider the risk of money laundering.
Money is going abroad through the import business.
The client might have dealt with illegal items (ivory). We need to establish the material used.
If the imports are illegal, the client should be encouraged to tell the authorities and any penalties should be estimated and suitable provisions set up.
If the material is ivory, or the client will not allow it to be tested, the auditor should withdraw because the integrity of management is in doubt.
A large printing machine originally cost $5 million and its accumulated depreciation amounts to $3 million. The sale value of the machine to an overseas buyer in the country of Burunda, net of selling costs, is believed to be 10 million Burundan pounds. The exchange rate at year end was 4 Burundan pounds to $1. The value in use, using cash flow projections and a discount rate of 5%, is $1.5 million.
The fair value of the asset needs to be considered. Current carrying amount is $2m. NRV = 10/4 = $2.5m. Value in use is $1.5m. If the exchange rate is steady, the carrying amount should be held at $2m. However, the exchange rate only needs to fall to 5 Burundian pounds to the S1 before the NRV falls to the current carrying amount. Any further fall implies that an impairment adjustment is needed.
Also, is the asset held for sale under IFRS 5? If so, the asset should not be depreciated and appropriate disclosures need to be made.
You are the auditor of a group of companies and one of the subsidiaries has had very poor cash flow and it seems that the bank is unlikely to renew its borrowing facility.
The finance director of the parent has told you that it will make the required loan to the subsidiary to keep it solvent.
The auditors need to see a ‘letter of comfort’
Board minutes should be examined to see if financial support has been approved.
The auditors need to assess if the parent can provide any support needed.
If support seems unlikely or impossible, the subsidiary's financial statements will have to be drawn up on a break-up basis.
Costs of liquidation need to be estimated.
Loan agreements must be looked at to see if the subsidiary's failure will precipitate the breaching a borrowing covenant.
A company has changed the way in which it values inventory from the FIFO to the weighted average cost basis and has also changed its depreciation rate on machinery from 20% to 15%.
Inventory: a change in accounting policy, so a retrospective treatment of the change is needed. Last year’s comparatives and opening inventory values need to be brought up to date with respect to the new approach. A disclosure note is required.
Depreciation: a change of accounting estimate, so a prospective change. The current carrying amount will be depreciated over the remaining useful life of the asset. A disclosure note should be included if the change is material.
3.2 Business risk
A company has started selling goods on the Internet.
A risk that the web site, sales processing, goods despatch etc do not work properly.
Not clear if new receivables will be created or if payment is taken before despatch, so a credit (bad debt/default) risk.
Potential data security problems.
A company has started to export goods.
Loss of goods in transit
Irrecoverable (bad) debts
Will goods be popular abroad?
The finance director has recently left and at period end, has not been replaced.
Lack of supervision and control in the finance department.
Can the financial statements and other management accounting information be prepared properly and on time.
A company has failed to file its tax return on time.
Fines, penalties and perhaps a tax investigation started.
An employee was badly injured carrying on his duties.
Fines, damages
Health and safety investigation
Potential industrial action
Loss of reputation/bad publicity
A computer virus disrupted the IT system for two days. All seems fine now.
Loss of business during that period.
Loss of accounting information.
Has the accounting system really recommenced without loss or corruption of data?
The company changed over from its old to its new IT system part-way through the year. The change-over seemed to go smoothy.
Disruption at the time of changeover and for some time afterwards as employees get used to the new system.
There are two accounting systems to be considered. One before the change and one after the change [not really a business risk, but the auditors will probably have to almost perform two audits and also look carefully at the transfer of balances between the old and new systems.]