1. Briefing notes

To: Emmet Green, Audit engagement partner

From: Audit manager

Subject: Audit planning in relation to Elijah Co

Date: 1 July 20X5

Introduction

These briefing notes have been prepared to assist in planning the audit of Elijah Co. The notes begin with an evaluation of the business risks facing the company and continue by evaluating the audit risks which should be considered in planning the audit. The notes also include the recommended principal audit procedures which have been designed in respect of a change in fair value to the company’s timber plantation following a recent storm. Finally, the notes discuss some ethical and other professional issues arising from a recent phone call with the company’s Charlie finance officer (CFO) which impact on our audit planning.

• Business risks

International expansion

The expansion into Swellview introduces a business risk in that the company will be managing operations in a foreign country for the first time. Swellview is remote, so it may be difficult for Elijah Co’s management team to plan regular visits to the new operations, so establishing robust management oversight and controls could be difficult. In addition, Swellview may have different laws and regulations compared to the company’s home jurisdiction, so there is a heightened risk of non-compliance. Even the type of trees growing in the rainforest will be different, and management may not have experience in their harvesting, processing and the sale of timber products. All of these issues create a risk that the international expansion may not be successful, and at the same time will represent a drain on management’s time and resources. Operations in the home country of Elijah Co may suffer as a result.

Gold Standard accreditation

There is a risk that the Gold Standard accreditation may not be renewed, with implications for reputation, and more specifically for the new contract with Hart Co, which largely accounts for an increase of 5·5% in the company’s revenue this year.

Several of the key performance indicators (KPIs) which need to be met to retain the Gold Standard seem to be in jeopardy, forexample, there has been a decline in the percentage of timber which is harvested in line with Gold Standard requirements, and the projected metric of 82% is only just above the required level of 80%. In addition, the Gold Standard is linked to ethical business practice, and there are some indications that the company’s business ethics are questionable – for example, the legal case being brought by employees and the incentive payment made to a government official. If the Gold Standard accreditation is lost, Hart Co and other customers may cancel contracts, resulting in a loss of revenue and cash flow.

Legal case

The legal action against the company by its own employees is a significant risk. If the issue becomes public knowledge, there will be reputational problems, and the amount which is being claimed, $19 million, exceeds the company’s cash balance. If the legal claim were to go against the company, it would struggle to find the funds to pay the damages given that it is already at the limit of its borrowing arrangements. The situation could also indicate poor governance of the company, if decisions are being made which put the lives of employees at risk and result in days lost due to accidents at work, and the matter seems to be dismissed as unimportant by the management team and legal advisers.

Damage to assets caused by storms

The recent storms have caused significant damage to the company’s timber plantation asset. Unpredictable weather patterns could cause further harm or even totally destroy the company’s timber plantations. Assuming that trees will be replanted to replace the damage caused by the storm, it can take many years for trees to grow to a harvestable size, so the company faces a significant depletion of its future cash inflows for years to come. This risk is very difficult to mitigate, perhaps the diversification into tropical rainforest is a way to reduce the risk exposure of the company’s operations being concentrated in one geographical area.

Liquidity

The financial information provided indicates that the company’s liquidity position has deteriorated over the year. The company has only $4·5 million of cash – a reduction of 33·8% compared to the end of the last financial year. While this has been explained as due to inflationary pressures, management should be doing more to maintain a reasonable level of cash in order to properly manage its working capital. Inventory levels have increased significantly by 67·4% and while again the reason for the increase has been explained by management, if the inventory of processed timber cannot be shipped to customers in the near future, working capital will continue to deteriorate. The company may become unable to meet obligations as they fall due, especially if the industrial action continues to restrict the possibility of export sales which account for 30% of the company’s revenue.

Industrial action

The industrial action at the country’s ports has already meant lost sales, and, as explained above, there is a risk that revenue and cash inflows will continue to be negatively impacted. Export sales account for 30% of total revenue, approximately $12·75 million, making this a potentially very significant issue should the industrial action continue. Customers may begin to look elsewhere for their supply of timber, leading to cancelled future orders and contracts.

There is also an issue that the increased storage of timber which is awaiting export to foreign customers will incur additional storage costs.

Incentive payment

The fact that the payment is being reported in the media indicates that there is something unusual about the payment and, in fact, the incentive payment could be a bribe. The reputational risk to the company is high, especially given that it should be adhering to a high standard of business ethics in accordance with its Gold Standard accreditation. Customers may not wish to associate themselves with a supplier which engages with unethical and possibly illegal payments. The company could face legal action if, indeed, the payment is a bribe, and aside from this exacerbating the reputational risk, it has very little cash available to pay any fine or penalty imposed.

If the incentive payment is proven to be a bribe, there could be implications for the government grant, which contains stipulations regarding ethical business practices. In the worst case, the grant may need to be repaid if the terms and conditions are found not to have been complied with.

This issue is discussed further in part (d) to these briefing notes in terms of how it impacts on our role as auditor.

Tutorial note: Credit will be awarded for discussion of other relevant business risks, for example, the solvency issue raised by the company being at the limit of its borrowing agreement, the lack of cash other than relating to the government grant available for establishing operations in Swellview, the lack of an audit committee and independent internal audit team, the reputational damage which may be caused by the legal case and incentive payment, and the inflationary pressures which will make costs hard to control.

• Evaluation of audit risks

New client

This is the first year in which Charlie & Co has audited the company, which increases detection risk, as our firm does not have experience with the client, making it more difficult to detect material misstatements.

In addition, there is a risk that opening balances and comparative information may not be correct. The prior year figures were not audited by Charlie & Co, therefore we should plan to audit the opening balances carefully, in accordance with ISA 510  Initial Audit Engagements – Opening Balances, to ensure that opening balances and comparative information are both free from material misstatement.

Tutorial note: Credit will also be awarded for discussion of Elijah Co operating in a specialised industry, which could create a detection risk given the audit firm’s lack of experience in auditing clients in this industry.

Corporate governance

The company does not have to comply with corporate governance requirements as it is not a listed entity. However, it is good practice to have an established audit committee, especially for a large company like Elijah Co which is seeking a stock market flotation in the relatively near future. The internal audit team is small and lacking in independence as they report directly to the CFO. This means that the scope of their work is likely to be quite limited due to insufficient resources, and any recommendations made could potentially be ignored by Mark Holt. This has implications for controls over financial reporting, which could be deficient, and increases control risk. There is a high scope for errors in financial reporting processes and for deliberate manipulation of balances and transactions, as the internal audit team does not have sufficient resources for thorough monitoring and reporting.

Pressure on results

The company is not a listed entity, but the existing and new shareholders will be looking for a return on their investment in the form of a dividend payment. In addition, in the run up to a potential stock market flotation, there will be pressure for the company to show good financial performance. The company also has ambitious international expansion plans. Pressure to return a better performance creates an incentive for management bias which means that management may use earnings management techniques, or other methods of creative accounting, to create a healthier picture of financial performance than is actually the case. This creates an inherent risk of material misstatement at the financial statement level.

The fact that the projected profit before tax is 30% higher than the previous year’s figure could indicate that operating expenses are understated. Management bias could also have led to some of the accounting treatments suggested by Mark Holt, which work to improve the company’s profit for the year.

Government grant

A government grant of $20 million has been awarded to Elijah Co, this amounts to 3·6% of total assets and is material to the projected statement of financial position. Mark Holt has suggested that he will recognise $10 million of the amount received in profit for the year – projected profit before tax is only $6·5 million, so increasing the profit by this amount would be highly material to the statement of profit or loss.

The audit risk relates to whether this should be recognised as income in the current accounting period. IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that government grants are recognised in profit or loss on a systematic basis over the periods in which the entity recognises expenses for the related costs for which the grants are intended to compensate. Mark Holt is planning to recognise half of the grant as income this year, however, this is not appropriately justified. The grant has not been awarded to compensate for management time in planning the international expansion, so the appropriate accounting treatment would seem to be that the entire amount of the grant should be recognised as deferred income in this financial year, as the expenditure for which the grant is specifically provided has not yet been incurred. Therefore, there is a risk that the company will recognise the income too early, leading to overstated profit and understated liabilities.

Tutorial note: Credit will also be awarded for discussion relating to the company’s use of the grant for building accommodation for employees, and relevant audit risks, e.g. the recognition of the accommodation as property, plant and equipment and treatment of the part of the grant relating to the construction of assets.

There could be a further issue in that the terms of the grant may require complete or partial repayment if the conditions of the grant are not satisfied, for example, if Elijah Co does not retain its Gold Standard accreditation or if the circumstances of the employees’ legal case are considered to be indicative of unethical business practice by the company. The company should evaluate whether the terms are likely to be met, and if not, should consider whether it would be appropriate to recognise a provision or disclose a contingent liability in the notes to the financial statements. According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised where a present obligation exists as a result of a past event which can be reliably measured and is probable to result in an outflow of economic benefit.

The risk is therefore that this has not been considered by management, leading possibly to understated liabilities or inadequate disclosure as required by IAS 37.

Legal case

The legal case could also give rise to a risk of understated liabilities or inadequate disclosure if the company fails to provide for the $19 million claimed by employees or to disclose the matter as a contingent liability. It will be a matter of significant judgement to decide whether the legal claim is likely to go against Elijah Co or not at this early stage, however, the matter is material at 3·5% of total assets and being close to three times projected profit for the year therefore warrants careful consideration. Due to its sensitive nature, the auditor may also consider the issue to be material by nature.

Reduction in fair value of timber plantation

The company’s timber plantation asset, prior to recognising any change in fair value, is projected to amount to 90·9% of the company’s total assets and is therefore highly material.

The company has correctly obtained an expert’s opinion on the change in fair value of the destroyed and damaged trees caused by the storm. The expert’s valuation has helped management to determine that a reduction in fair value of $70·5 million should be recognised in the financial statements within profit. This amount is material in its own right at 14·1% of the timber plantation asset and being more than ten times projected profit. When the loss in value is recognised, it will turn the projected profit into a significant loss. There is a risk that management will not recognise the loss in full due to the impact it will have on profit. This is therefore a very significant issue for the audit planning.

There is a risk that the expert’s valuation is not appropriate, for example, if the expert does not have appropriate expertise to perform this specialist valuation, which would lead to issues in whether the valuation can be relied upon. In addition, the expert has considered only the value of the destroyed and damaged trees and not considered any other impact of the storm, for example, if other assets such as roads and buildings have been affected by the storm and should be tested for impairment.

Therefore, based on the issues discussed above, there is a risk that the loss is not fully recognised in profit for the year, and the carrying amount of non-current assets is overstated.

Inventory

The level of inventory has increased significantly, by 67·4%, and the value of inventory at 30 June 20X5 represents 2·8% of projected total assets. The inventory is therefore material to the financial statements. There is a risk that if the industrial action continues, and the company cannot fulfil its export sale contracts, the customers will cancel their orders. The inventory then may not be saleable to other customers, perhaps if the timber has been cut to customer specification or requires modification to secure a sale to a different customer. According to IAS 2 Inventories, inventory should be recognised at the lower of cost and net realisable value, and there is an audit risk that inventory is overstated if any necessary write down to net realisable value is not recognised. This would result in overstated current assets and overstated profit.

Going concern

There are several indicators that despite its projected increase in revenue and profit, the company faces going concern problems.

These indicators include, but are not limited to, operational problems including the destroyed timber plantation and industrial action, reputational damage caused by the legal claim and possible illegal payment, financial problems caused by lack of cash and the fact that its results are likely to be much worse than that projected by management when the decrease in fair value of the destroyed timber plantation is taken into account.

IAS 1 Presentation of Financial Statements requires that management provides a note to the financial statements which discusses any material uncertainty over the company’s ability to continue as a going concern. If management fails to disclose this note, or provides the note but with inadequate detail, then the requirements of IAS 1 may not have been followed, creating a significant audit risk.

• Change in fair value of the timber plantation asset
• Obtain the expert’s report on the value of the destroyed and damaged timber plantation to:
• Gain understanding and allow evaluation of the methodology and assumptions used, e.g. the basis of determining the amount of any income which may be generated from the timber to be salvaged from damaged trees.
• Confirm the geographical extent of damage by the storm.
• Confirm the basis of determining whether trees have been completely destroyed or damaged.
• Discuss the expert’s methodology and assumptions with management to confirm their rationale and compliance with the measurement requirements of IAS 41 Agriculture.
• Obtain confirmation of the expert’s qualifications and experience in assessing storm damage to timber plantation assets and quantifying financial losses.
• Obtain confirmation that the expert is independent from Elijah Co and its management team.
• If possible, visit the site of the storm damage to form a view on the scale of the destruction and to evaluate whether any assets other than the trees have been destroyed or damaged.
• Discuss with management the actions which have been taken in response to the storm, e.g. the extent of progress made to clear the destroyed trees and harvest the damaged trees.
• Obtain any documentation relating to any potential sale of damaged trees, e.g. customer orders, to confirm any realizable value of damaged trees.
• From the non-current asset register, confirm the carrying amount of the standing trees prior to any change in fair valuebeing recognised.
• Consider whether the use of an auditor’s expert is necessary to provide sufficient and appropriate evidence given the materiality of the figures.
• Develop an auditor’s estimate of the fair value of the timber plantation, in accordance with the IAS 41 requirements, and compare to management’s estimate of the change in fair value.
• Obtain a copy of the company’s insurance policy and review the terms and conditions to confirm whether the storm damage is covered by insurance.

• Ethical issues

Assurance on key performance indicators (KPIs)

There are several issues to consider with regard to providing this service. A significant issue relates to auditor objectivity. TheKPIs include financial and non-financial metrics. The financial metrics, including revenue, operating profit and profit before tax, will be extracted from, or reconciled to, the figures as shown in the audited financial statements.

While the KPIs will not form part of the audited financial statements, they will be published in the annual report and therefore form part of the ‘other information’ in relation to which the auditor has responsibilities under ISA 720 The Auditor’s Responsibilities Relating to Other Information. ISA 720 requires that auditors read the other information in order to identify anymaterial inconsistencies between the financial statements and the other information.

There is therefore a potential self-review threat to objectivity in that the audit firm has been asked to provide assurance on theseKPIs which would be read by the audit team as part of their review of other information. The team performing the assurancework would be reluctant to raise queries or highlight errors which may have been made during the external audit when reading the other information.

Tutorial note: Credit will be awarded for discussion of other relevant threats to objectivity created by providing an assuranceservice on the KPIs, including the advocacy threat and self-interest threats.

The IESBA International Code of Ethics for Professional Accountants (the Code) provides guidance when auditors provide additional services to an audit client. Charlie & Co needs to evaluate the significance of the threat and consider whether any

safeguards can reduce the threat to an acceptable level. For example, a partner who is independent should be involved in reviewing the audit work performed.

There is also an ethical issue in respect to the fee proposed by Elijah Co for the assurance engagement. If the firm decides to take on the engagement, it should be treated as an engagement separate from the audit and with a separate fee charged for the work and confirmed in a separate engagement letter. The suggestion to simply amend and increase the audit fee and todetermine it on a contingent basis, as in the fee is only payable if the assurance is favourable, is not appropriate. Contingent fees can give rise to a self-interest threat, as it is in the financial interest of the audit firm to give a favourable assurance opinion in order to secure the income. The Code prohibits the use of contingent fees for audit services, but they are allowed for other types of work, depending on factors such as the nature of the engagement and the range of possible fee outcomes. The most prudent course of action, should Charlie & Co take on the engagement, would be to charge the fee on a non-contingent basis, separate from the audit fee, to remove any ethical issues relating to the fee.

Aside from ethical issues, Charlie & Co must also consider whether they have the competence to perform the work. Providing assurance on non-financial KPIs is quite a specialist area, and it could be that the audit firm does not have the appropriate levels of expertise and experience to provide a quality service. In particular, the firm would need to ensure that it fully understands the Gold Standard accreditation. Given that this is a specialised industry, and this is the first client which Charlie & Co has in the industry, it is questionable whether the firm has the competence to carry out the work.

Aside from competence, the firm should also consider whether it has resources in terms of staff availability to complete the work to the desired deadline and to perform appropriate reviews of the work which has been completed.

Incentive payment

Mark Holt has suggested that incentive payments are ‘routine’, but it could be against the law. The incentive payment raises concerns that the company may not be complying with relevant law and regulations. The incentive payment could be a bribe and an illegal payment. If so, this indicates a lack of integrity of management, as clearly Mark Holt is aware of the payment and seems to be justifying it.

The auditor also needs to consider the requirements of ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements. ISA 250 states that while it is management’s responsibility to ensure that the entity’s operations are conducted in accordance with the provisions of laws and regulation, the auditor does have some responsibility in relation to compliance with laws and regulations, especially where non-compliance has an impact on the financial statements.

Therefore, the auditor should ensure they have a full knowledge and understanding of the relevant laws and regulations, and the implications of non-compliance. ISA 250 requires that when non-compliance is identified or suspected, the auditor shall obtain an understanding of the nature of the act and the circumstances in which it has occurred, and further information to evaluate the possible effect on the financial statements. Therefore, procedures should be performed to obtain evidence about the suspected non-compliance, for example, to obtain any documentation which may exist to support Mark Holt’s claim that the payment is in the normal course of business. The planned audit procedures should be sufficient for the audit team to conclude on the accounting treatment and on whether the auditor has any reporting responsibilities outside the company, for example, to communicate a breach of anti-corruption legislation to the appropriate authorities.

ISA 250 also requires the matter to be discussed with management and, where appropriate, with those charged with governance. Given the potential impact of the news story for the company’s reputation, the matter should be discussed as soon as possible.

Finally, there appears to be an intimidation threat. Mark Holt has urged the audit team not to investigate the incentive payment, attempting to restrict the audit team’s ability to obtain audit evidence in relation to the payment. According to ISA 210 Agreeing the Terms of Audit Engagements, the management of a client should acknowledge their responsibility to provide the auditor with access to all information which is relevant to the preparation of the financial statements which includes unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence. The comment by Mark Holt would appear to be an imposed limitation on the scope of the audit, and the audit engagement partner should raise this issue with the company’s management team.

The CFO would appear to lack integrity as he is trying to keep the issue a secret. The audit engagement partner should consider whether other representations made by Mark Holt should be treated with an added emphasis on professional scepticism, and the risk of management bias leading to a risk of material misstatement could be high. This should be discussed during the audit team briefing meeting.

Conclusion

These briefing notes highlight that the company faces significant business risk, in particular, in relation to its financial position and the recent storm damage. There are a number of significant audit risks which will need to be carefully considered during the planning of the audit, to ensure that an appropriate audit strategy is devised. Going concern should be a key focus of the audit. We need to perform detailed work on the highly material change in fair value of the timber plantation due to the recent storm, as detailed in the notes. Finally, there are several ethical matters to be discussed with management and incorporated into our audit planning. The assurance engagement on the company’s KPIs should only go ahead once all ethical implications have been carefully evaluated and appropriate safeguards put in place.

• Business risks

Up to 2 marks for each business risk evaluated. In addition, ½ mark for each relevant trend or calculation which form part of a relevant explanation of the risk (max 2 marks).

• International expansion
• Gold Standard accreditation
• Legal case
• Damage to assets caused by storm
• Liquidity
• Industrial action
• Incentive payment

Maximum marks 10

• Audit risks

Up to 3 marks for each audit risk evaluated unless otherwise indicated. Marks may be awarded for other,relevant risks not included in the marking guide.

Materiality calculations should be awarded 1 mark each (max 3 marks).

In addition, ½ mark for each relevant trend or calculation which form part of a relevant explanation of the risk (max 2 marks).

• New client (up to 2 marks)
• Corporate governance (up to 2 marks)
• Pressure on results
• Government grant (up to 4 marks)
• Legal case
• Change in fair value of standing trees
• Inventory (up to 2 marks)
• Going concern

Maximum marks 20

• Audit procedures

1 mark for each well explained audit procedure, examples of which include:

• Obtain the expert’s report on the value of the storm-damaged timber plantation to understand methodology and overall results
• Discuss the expert’s methodology and assumptions with management to confirm their rationale and compliance with accounting requirements
• Obtain confirmation of the expert’s qualifications and experience
• Obtain confirmation that the expert is independent
• Visit the site of the storm damage to form a view on the scale of the destruction
• Discuss with management the actions which have been taken in response to the storm
• Obtain any documentation relating to the potential sale of damaged trees
• From the non-current asset register, confirm the carrying amount of the standing trees prior to anychange in fair value being recognized
• Consider whether the use of an auditor’s expert is necessary to provide sufficient and appropriate evidence given the materiality of the figures
• Develop an auditor’s estimate of the change in fair value and compare to management’s estimate
• Obtain a copy of the company’s insurance policy and review the terms and conditions to confirm whether the storm damage is covered by insurance

Maximum marks 6

• Ethical and audit planning implications

1 mark for each point discussed:

• KPIs are ‘other information’ which the auditor must review for material inconsistencies
• Self-review threat to objectivity (additional credit to be awarded for other relevant threats to objectivity explained)
• Assurance can be provided on the KPIs if safeguards can reduce threat to an acceptable level
• Example of safeguard, e.g. separate team to perform the work, separate partner review
• Fee for the assurance work must be separate from the audit fee
• Fee for audit cannot be on a contingent basis
• Fee for assurance work can be on a contingent basis but more prudent if not on that basis
• Competence issues due to specialist nature of the work
• Resource issues, i.e. staff availability to perform the work
• Incentive payment could be a bribe and illegal
• Auditor to obtain understanding of relevant law and regulations, e.g. anti-bribery legislation
• Audit procedures to be planned to obtain evidence relating to the payment
• Discuss with management team of the company and consider external reporting obligations
• Intimidation from CFO/limitation on the scope of the audit
• Lack of integrity – should assess other representations/apply professional skepticism

Maximum marks 10

Professional marks 4

Generally 1 mark for heading, 1 mark for introduction, 1 mark for use of headings within the briefing notes, 1 mark for clarity of comments made.

1. Briefing notes

To: Emmet Green, Audit engagement partner

From: Audit manager

Subject: Audit planning in relation to Elijah Co

Date: 1 July 20X5

Introduction

These briefing notes have been prepared to assist in planning the audit of Elijah Co. The notes begin with an evaluation of the business risks facing the company and continue by evaluating the audit risks which should be considered in planning the audit. The notes also include the recommended principal audit procedures which have been designed in respect of a change in fair value to the company’s timber plantation following a recent storm. Finally, the notes discuss some ethical and other professional issues arising from a recent phone call with the company’s Charlie finance officer (CFO) which impact on our audit planning.

• Business risks

International expansion

The expansion into Swellview introduces a business risk in that the company will be managing operations in a foreign country for the first time. Swellview is remote, so it may be difficult for Elijah Co’s management team to plan regular visits to the new operations, so establishing robust management oversight and controls could be difficult. In addition, Swellview may have different laws and regulations compared to the company’s home jurisdiction, so there is a heightened risk of non-compliance. Even the type of trees growing in the rainforest will be different, and management may not have experience in their harvesting, processing and the sale of timber products. All of these issues create a risk that the international expansion may not be successful, and at the same time will represent a drain on management’s time and resources. Operations in the home country of Elijah Co may suffer as a result.

Gold Standard accreditation

There is a risk that the Gold Standard accreditation may not be renewed, with implications for reputation, and more specifically for the new contract with Hart Co, which largely accounts for an increase of 5·5% in the company’s revenue this year.

Several of the key performance indicators (KPIs) which need to be met to retain the Gold Standard seem to be in jeopardy, forexample, there has been a decline in the percentage of timber which is harvested in line with Gold Standard requirements, and the projected metric of 82% is only just above the required level of 80%. In addition, the Gold Standard is linked to ethical business practice, and there are some indications that the company’s business ethics are questionable – for example, the legal case being brought by employees and the incentive payment made to a government official. If the Gold Standard accreditation is lost, Hart Co and other customers may cancel contracts, resulting in a loss of revenue and cash flow.

Legal case

The legal action against the company by its own employees is a significant risk. If the issue becomes public knowledge, there will be reputational problems, and the amount which is being claimed, $19 million, exceeds the company’s cash balance. If the legal claim were to go against the company, it would struggle to find the funds to pay the damages given that it is already at the limit of its borrowing arrangements. The situation could also indicate poor governance of the company, if decisions are being made which put the lives of employees at risk and result in days lost due to accidents at work, and the matter seems to be dismissed as unimportant by the management team and legal advisers.

Damage to assets caused by storms

The recent storms have caused significant damage to the company’s timber plantation asset. Unpredictable weather patterns could cause further harm or even totally destroy the company’s timber plantations. Assuming that trees will be replanted to replace the damage caused by the storm, it can take many years for trees to grow to a harvestable size, so the company faces a significant depletion of its future cash inflows for years to come. This risk is very difficult to mitigate, perhaps the diversification into tropical rainforest is a way to reduce the risk exposure of the company’s operations being concentrated in one geographical area.

Liquidity

The financial information provided indicates that the company’s liquidity position has deteriorated over the year. The company has only $4·5 million of cash – a reduction of 33·8% compared to the end of the last financial year. While this has been explained as due to inflationary pressures, management should be doing more to maintain a reasonable level of cash in order to properly manage its working capital. Inventory levels have increased significantly by 67·4% and while again the reason for the increase has been explained by management, if the inventory of processed timber cannot be shipped to customers in the near future, working capital will continue to deteriorate. The company may become unable to meet obligations as they fall due, especially if the industrial action continues to restrict the possibility of export sales which account for 30% of the company’s revenue.

Industrial action

The industrial action at the country’s ports has already meant lost sales, and, as explained above, there is a risk that revenue and cash inflows will continue to be negatively impacted. Export sales account for 30% of total revenue, approximately $12·75 million, making this a potentially very significant issue should the industrial action continue. Customers may begin to look elsewhere for their supply of timber, leading to cancelled future orders and contracts.

There is also an issue that the increased storage of timber which is awaiting export to foreign customers will incur additional storage costs.

Incentive payment

The fact that the payment is being reported in the media indicates that there is something unusual about the payment and, in fact, the incentive payment could be a bribe. The reputational risk to the company is high, especially given that it should be adhering to a high standard of business ethics in accordance with its Gold Standard accreditation. Customers may not wish to associate themselves with a supplier which engages with unethical and possibly illegal payments. The company could face legal action if, indeed, the payment is a bribe, and aside from this exacerbating the reputational risk, it has very little cash available to pay any fine or penalty imposed.

If the incentive payment is proven to be a bribe, there could be implications for the government grant, which contains stipulations regarding ethical business practices. In the worst case, the grant may need to be repaid if the terms and conditions are found not to have been complied with.

This issue is discussed further in part (d) to these briefing notes in terms of how it impacts on our role as auditor.

Tutorial note: Credit will be awarded for discussion of other relevant business risks, for example, the solvency issue raised by the company being at the limit of its borrowing agreement, the lack of cash other than relating to the government grant available for establishing operations in Swellview, the lack of an audit committee and independent internal audit team, the reputational damage which may be caused by the legal case and incentive payment, and the inflationary pressures which will make costs hard to control.

• Evaluation of audit risks

New client

This is the first year in which Charlie & Co has audited the company, which increases detection risk, as our firm does not have experience with the client, making it more difficult to detect material misstatements.

In addition, there is a risk that opening balances and comparative information may not be correct. The prior year figures were not audited by Charlie & Co, therefore we should plan to audit the opening balances carefully, in accordance with ISA 510  Initial Audit Engagements – Opening Balances, to ensure that opening balances and comparative information are both free from material misstatement.

Tutorial note: Credit will also be awarded for discussion of Elijah Co operating in a specialised industry, which could create a detection risk given the audit firm’s lack of experience in auditing clients in this industry.

Corporate governance

The company does not have to comply with corporate governance requirements as it is not a listed entity. However, it is good practice to have an established audit committee, especially for a large company like Elijah Co which is seeking a stock market flotation in the relatively near future. The internal audit team is small and lacking in independence as they report directly to the CFO. This means that the scope of their work is likely to be quite limited due to insufficient resources, and any recommendations made could potentially be ignored by Mark Holt. This has implications for controls over financial reporting, which could be deficient, and increases control risk. There is a high scope for errors in financial reporting processes and for deliberate manipulation of balances and transactions, as the internal audit team does not have sufficient resources for thorough monitoring and reporting.

Pressure on results

The company is not a listed entity, but the existing and new shareholders will be looking for a return on their investment in the form of a dividend payment. In addition, in the run up to a potential stock market flotation, there will be pressure for the company to show good financial performance. The company also has ambitious international expansion plans. Pressure to return a better performance creates an incentive for management bias which means that management may use earnings management techniques, or other methods of creative accounting, to create a healthier picture of financial performance than is actually the case. This creates an inherent risk of material misstatement at the financial statement level.

The fact that the projected profit before tax is 30% higher than the previous year’s figure could indicate that operating expenses are understated. Management bias could also have led to some of the accounting treatments suggested by Mark Holt, which work to improve the company’s profit for the year.

Government grant

A government grant of $20 million has been awarded to Elijah Co, this amounts to 3·6% of total assets and is material to the projected statement of financial position. Mark Holt has suggested that he will recognise $10 million of the amount received in profit for the year – projected profit before tax is only $6·5 million, so increasing the profit by this amount would be highly material to the statement of profit or loss.

The audit risk relates to whether this should be recognised as income in the current accounting period. IAS 20 Accounting for Government Grants and Disclosure of Government Assistance requires that government grants are recognised in profit or loss on a systematic basis over the periods in which the entity recognises expenses for the related costs for which the grants are intended to compensate. Mark Holt is planning to recognise half of the grant as income this year, however, this is not appropriately justified. The grant has not been awarded to compensate for management time in planning the international expansion, so the appropriate accounting treatment would seem to be that the entire amount of the grant should be recognised as deferred income in this financial year, as the expenditure for which the grant is specifically provided has not yet been incurred. Therefore, there is a risk that the company will recognise the income too early, leading to overstated profit and understated liabilities.

Tutorial note: Credit will also be awarded for discussion relating to the company’s use of the grant for building accommodation for employees, and relevant audit risks, e.g. the recognition of the accommodation as property, plant and equipment and treatment of the part of the grant relating to the construction of assets.

There could be a further issue in that the terms of the grant may require complete or partial repayment if the conditions of the grant are not satisfied, for example, if Elijah Co does not retain its Gold Standard accreditation or if the circumstances of the employees’ legal case are considered to be indicative of unethical business practice by the company. The company should evaluate whether the terms are likely to be met, and if not, should consider whether it would be appropriate to recognise a provision or disclose a contingent liability in the notes to the financial statements. According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised where a present obligation exists as a result of a past event which can be reliably measured and is probable to result in an outflow of economic benefit.

The risk is therefore that this has not been considered by management, leading possibly to understated liabilities or inadequate disclosure as required by IAS 37.

Legal case

The legal case could also give rise to a risk of understated liabilities or inadequate disclosure if the company fails to provide for the $19 million claimed by employees or to disclose the matter as a contingent liability. It will be a matter of significant judgement to decide whether the legal claim is likely to go against Elijah Co or not at this early stage, however, the matter is material at 3·5% of total assets and being close to three times projected profit for the year therefore warrants careful consideration. Due to its sensitive nature, the auditor may also consider the issue to be material by nature.

Reduction in fair value of timber plantation

The company’s timber plantation asset, prior to recognising any change in fair value, is projected to amount to 90·9% of the company’s total assets and is therefore highly material.

The company has correctly obtained an expert’s opinion on the change in fair value of the destroyed and damaged trees caused by the storm. The expert’s valuation has helped management to determine that a reduction in fair value of $70·5 million should be recognised in the financial statements within profit. This amount is material in its own right at 14·1% of the timber plantation asset and being more than ten times projected profit. When the loss in value is recognised, it will turn the projected profit into a significant loss. There is a risk that management will not recognise the loss in full due to the impact it will have on profit. This is therefore a very significant issue for the audit planning.

There is a risk that the expert’s valuation is not appropriate, for example, if the expert does not have appropriate expertise to perform this specialist valuation, which would lead to issues in whether the valuation can be relied upon. In addition, the expert has considered only the value of the destroyed and damaged trees and not considered any other impact of the storm, for example, if other assets such as roads and buildings have been affected by the storm and should be tested for impairment.

Therefore, based on the issues discussed above, there is a risk that the loss is not fully recognised in profit for the year, and the carrying amount of non-current assets is overstated.

Inventory

The level of inventory has increased significantly, by 67·4%, and the value of inventory at 30 June 20X5 represents 2·8% of projected total assets. The inventory is therefore material to the financial statements. There is a risk that if the industrial action continues, and the company cannot fulfil its export sale contracts, the customers will cancel their orders. The inventory then may not be saleable to other customers, perhaps if the timber has been cut to customer specification or requires modification to secure a sale to a different customer. According to IAS 2 Inventories, inventory should be recognised at the lower of cost and net realisable value, and there is an audit risk that inventory is overstated if any necessary write down to net realisable value is not recognised. This would result in overstated current assets and overstated profit.

Going concern

There are several indicators that despite its projected increase in revenue and profit, the company faces going concern problems.

These indicators include, but are not limited to, operational problems including the destroyed timber plantation and industrial action, reputational damage caused by the legal claim and possible illegal payment, financial problems caused by lack of cash and the fact that its results are likely to be much worse than that projected by management when the decrease in fair value of the destroyed timber plantation is taken into account.

IAS 1 Presentation of Financial Statements requires that management provides a note to the financial statements which discusses any material uncertainty over the company’s ability to continue as a going concern. If management fails to disclose this note, or provides the note but with inadequate detail, then the requirements of IAS 1 may not have been followed, creating a significant audit risk.

• Change in fair value of the timber plantation asset
• Obtain the expert’s report on the value of the destroyed and damaged timber plantation to:
• Gain understanding and allow evaluation of the methodology and assumptions used, e.g. the basis of determining the amount of any income which may be generated from the timber to be salvaged from damaged trees.
• Confirm the geographical extent of damage by the storm.
• Confirm the basis of determining whether trees have been completely destroyed or damaged.
• Discuss the expert’s methodology and assumptions with management to confirm their rationale and compliance with the measurement requirements of IAS 41 Agriculture.
• Obtain confirmation of the expert’s qualifications and experience in assessing storm damage to timber plantation assets and quantifying financial losses.
• Obtain confirmation that the expert is independent from Elijah Co and its management team.
• If possible, visit the site of the storm damage to form a view on the scale of the destruction and to evaluate whether any assets other than the trees have been destroyed or damaged.
• Discuss with management the actions which have been taken in response to the storm, e.g. the extent of progress made to clear the destroyed trees and harvest the damaged trees.
• Obtain any documentation relating to any potential sale of damaged trees, e.g. customer orders, to confirm any realizable value of damaged trees.
• From the non-current asset register, confirm the carrying amount of the standing trees prior to any change in fair valuebeing recognised.
• Consider whether the use of an auditor’s expert is necessary to provide sufficient and appropriate evidence given the materiality of the figures.
• Develop an auditor’s estimate of the fair value of the timber plantation, in accordance with the IAS 41 requirements, and compare to management’s estimate of the change in fair value.
• Obtain a copy of the company’s insurance policy and review the terms and conditions to confirm whether the storm damage is covered by insurance.

• Ethical issues

Assurance on key performance indicators (KPIs)

There are several issues to consider with regard to providing this service. A significant issue relates to auditor objectivity. TheKPIs include financial and non-financial metrics. The financial metrics, including revenue, operating profit and profit before tax, will be extracted from, or reconciled to, the figures as shown in the audited financial statements.

While the KPIs will not form part of the audited financial statements, they will be published in the annual report and therefore form part of the ‘other information’ in relation to which the auditor has responsibilities under ISA 720 The Auditor’s Responsibilities Relating to Other Information. ISA 720 requires that auditors read the other information in order to identify anymaterial inconsistencies between the financial statements and the other information.

There is therefore a potential self-review threat to objectivity in that the audit firm has been asked to provide assurance on theseKPIs which would be read by the audit team as part of their review of other information. The team performing the assurancework would be reluctant to raise queries or highlight errors which may have been made during the external audit when reading the other information.

Tutorial note: Credit will be awarded for discussion of other relevant threats to objectivity created by providing an assuranceservice on the KPIs, including the advocacy threat and self-interest threats.

The IESBA International Code of Ethics for Professional Accountants (the Code) provides guidance when auditors provide additional services to an audit client. Charlie & Co needs to evaluate the significance of the threat and consider whether any

safeguards can reduce the threat to an acceptable level. For example, a partner who is independent should be involved in reviewing the audit work performed.

There is also an ethical issue in respect to the fee proposed by Elijah Co for the assurance engagement. If the firm decides to take on the engagement, it should be treated as an engagement separate from the audit and with a separate fee charged for the work and confirmed in a separate engagement letter. The suggestion to simply amend and increase the audit fee and todetermine it on a contingent basis, as in the fee is only payable if the assurance is favourable, is not appropriate. Contingent fees can give rise to a self-interest threat, as it is in the financial interest of the audit firm to give a favourable assurance opinion in order to secure the income. The Code prohibits the use of contingent fees for audit services, but they are allowed for other types of work, depending on factors such as the nature of the engagement and the range of possible fee outcomes. The most prudent course of action, should Charlie & Co take on the engagement, would be to charge the fee on a non-contingent basis, separate from the audit fee, to remove any ethical issues relating to the fee.

Aside from ethical issues, Charlie & Co must also consider whether they have the competence to perform the work. Providing assurance on non-financial KPIs is quite a specialist area, and it could be that the audit firm does not have the appropriate levels of expertise and experience to provide a quality service. In particular, the firm would need to ensure that it fully understands the Gold Standard accreditation. Given that this is a specialised industry, and this is the first client which Charlie & Co has in the industry, it is questionable whether the firm has the competence to carry out the work.

Aside from competence, the firm should also consider whether it has resources in terms of staff availability to complete the work to the desired deadline and to perform appropriate reviews of the work which has been completed.

Incentive payment

Mark Holt has suggested that incentive payments are ‘routine’, but it could be against the law. The incentive payment raises concerns that the company may not be complying with relevant law and regulations. The incentive payment could be a bribe and an illegal payment. If so, this indicates a lack of integrity of management, as clearly Mark Holt is aware of the payment and seems to be justifying it.

The auditor also needs to consider the requirements of ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements. ISA 250 states that while it is management’s responsibility to ensure that the entity’s operations are conducted in accordance with the provisions of laws and regulation, the auditor does have some responsibility in relation to compliance with laws and regulations, especially where non-compliance has an impact on the financial statements.

Therefore, the auditor should ensure they have a full knowledge and understanding of the relevant laws and regulations, and the implications of non-compliance. ISA 250 requires that when non-compliance is identified or suspected, the auditor shall obtain an understanding of the nature of the act and the circumstances in which it has occurred, and further information to evaluate the possible effect on the financial statements. Therefore, procedures should be performed to obtain evidence about the suspected non-compliance, for example, to obtain any documentation which may exist to support Mark Holt’s claim that the payment is in the normal course of business. The planned audit procedures should be sufficient for the audit team to conclude on the accounting treatment and on whether the auditor has any reporting responsibilities outside the company, for example, to communicate a breach of anti-corruption legislation to the appropriate authorities.

ISA 250 also requires the matter to be discussed with management and, where appropriate, with those charged with governance. Given the potential impact of the news story for the company’s reputation, the matter should be discussed as soon as possible.

Finally, there appears to be an intimidation threat. Mark Holt has urged the audit team not to investigate the incentive payment, attempting to restrict the audit team’s ability to obtain audit evidence in relation to the payment. According to ISA 210 Agreeing the Terms of Audit Engagements, the management of a client should acknowledge their responsibility to provide the auditor with access to all information which is relevant to the preparation of the financial statements which includes unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence. The comment by Mark Holt would appear to be an imposed limitation on the scope of the audit, and the audit engagement partner should raise this issue with the company’s management team.

The CFO would appear to lack integrity as he is trying to keep the issue a secret. The audit engagement partner should consider whether other representations made by Mark Holt should be treated with an added emphasis on professional scepticism, and the risk of management bias leading to a risk of material misstatement could be high. This should be discussed during the audit team briefing meeting.

Conclusion

These briefing notes highlight that the company faces significant business risk, in particular, in relation to its financial position and the recent storm damage. There are a number of significant audit risks which will need to be carefully considered during the planning of the audit, to ensure that an appropriate audit strategy is devised. Going concern should be a key focus of the audit. We need to perform detailed work on the highly material change in fair value of the timber plantation due to the recent storm, as detailed in the notes. Finally, there are several ethical matters to be discussed with management and incorporated into our audit planning. The assurance engagement on the company’s KPIs should only go ahead once all ethical implications have been carefully evaluated and appropriate safeguards put in place.

• Business risks

Up to 2 marks for each business risk evaluated. In addition, ½ mark for each relevant trend or calculation which form part of a relevant explanation of the risk (max 2 marks).

• International expansion
• Gold Standard accreditation
• Legal case
• Damage to assets caused by storm
• Liquidity
• Industrial action
• Incentive payment

Maximum marks 10

• Audit risks

Up to 3 marks for each audit risk evaluated unless otherwise indicated. Marks may be awarded for other,relevant risks not included in the marking guide.

Materiality calculations should be awarded 1 mark each (max 3 marks).

In addition, ½ mark for each relevant trend or calculation which form part of a relevant explanation of the risk (max 2 marks).

• New client (up to 2 marks)
• Corporate governance (up to 2 marks)
• Pressure on results
• Government grant (up to 4 marks)
• Legal case
• Change in fair value of standing trees
• Inventory (up to 2 marks)
• Going concern

Maximum marks 20

• Audit procedures

1 mark for each well explained audit procedure, examples of which include:

• Obtain the expert’s report on the value of the storm-damaged timber plantation to understand methodology and overall results
• Discuss the expert’s methodology and assumptions with management to confirm their rationale and compliance with accounting requirements
• Obtain confirmation of the expert’s qualifications and experience
• Obtain confirmation that the expert is independent
• Visit the site of the storm damage to form a view on the scale of the destruction
• Discuss with management the actions which have been taken in response to the storm
• Obtain any documentation relating to the potential sale of damaged trees
• From the non-current asset register, confirm the carrying amount of the standing trees prior to anychange in fair value being recognized
• Consider whether the use of an auditor’s expert is necessary to provide sufficient and appropriate evidence given the materiality of the figures
• Develop an auditor’s estimate of the change in fair value and compare to management’s estimate
• Obtain a copy of the company’s insurance policy and review the terms and conditions to confirm whether the storm damage is covered by insurance

Maximum marks 6

• Ethical and audit planning implications

1 mark for each point discussed:

• KPIs are ‘other information’ which the auditor must review for material inconsistencies
• Self-review threat to objectivity (additional credit to be awarded for other relevant threats to objectivity explained)
• Assurance can be provided on the KPIs if safeguards can reduce threat to an acceptable level
• Example of safeguard, e.g. separate team to perform the work, separate partner review
• Fee for the assurance work must be separate from the audit fee
• Fee for audit cannot be on a contingent basis
• Fee for assurance work can be on a contingent basis but more prudent if not on that basis
• Competence issues due to specialist nature of the work
• Resource issues, i.e. staff availability to perform the work
• Incentive payment could be a bribe and illegal
• Auditor to obtain understanding of relevant law and regulations, e.g. anti-bribery legislation
• Audit procedures to be planned to obtain evidence relating to the payment
• Discuss with management team of the company and consider external reporting obligations
• Intimidation from CFO/limitation on the scope of the audit
• Lack of integrity – should assess other representations/apply professional skepticism

Maximum marks 10

Professional marks 4

Generally 1 mark for heading, 1 mark for introduction, 1 mark for use of headings within the briefing notes, 1 mark for clarity of comments made.

Maximum marks 50

1. Money laundering

(i) Policies and procedures for anti-money laundering programme

Novato & Co should have established an anti-money laundering programme within the firm. As part of this programme, the firm should have appointed a money laundering reporting officer (MLRO) with an appropriate level of experience and seniority. The audit firm should also have established internal reporting lines which should be followed to report any suspicions. Novato & Co will probably have a standard form which should be used to report suspicions of money laundering to the MLRO. The typical content of an internal report on suspected money laundering may include the name of the suspect, the amounts potentially involved, and the reasons for the suspicions with supporting evidence if possible, and the whereabouts of the laundered cash. The firm’s internal policies should have been set up to ensure that all pertinent information is captured in this standardised report. Any individual in the audit firm who has suspicions of money laundering activities is then required to disclose these suspicions to the MLRO. The report must be done as soon as possible as any non-disclosure or failure to report such suspicions will constitute an offence under the money laundering regulations. On receipt of the internal report, the MLRO must consider all of the circumstances surrounding the suspicions of money laundering activities, document this process and decide whether to report the suspicions to the appropriate external authorities. The audit firm has a legal duty to report even though this may conflict with the auditor’s duty of confidentiality.

(ii) Evaluation of possible indicators of money laundering activities

Money laundering is the process by which criminals attempt to conceal the true origin and ownership of the proceeds of criminal activity, allowing them to maintain control over the proceeds, and ultimately providing a legitimate cover for their sources of income. In the case of Blaze Co, the circumstances which may be indicative of money laundering activities include the following:

Cash-intensive business

Blaze Co has a high level of cash-based sales (75%) and a high volume of individual sales reports. The nature of its business therefore creates a significant risk that illicit cash funds are being passed off as legitimate sales. More specifically Mr Tribbiani’ sale to a business associate for $38,000 may be an example of the placement of illegal funds in order to legitimise them as genuine sales. The size of the transaction in a business selling Blazeing products and the round sum amount may be additional grounds for suspicion in relation to this transaction.

International property transactions

The performance of Mr Tribbiani’ personal taxation computation has identified a significant number of transactions involving the purchase and sale of properties in international locations. These transactions may be examples of real estate laundering by Mr Tribbiani in his personal affairs. It is possible that he may be purchasing these properties with illegal funds (‘placement’) and then selling them in order to make funds appear legitimate (‘integration’). A high volume of such transactions may also be indicative of the ‘layering’ of transactions in an attempt to make the original source of the funds more difficult to trace.

(b) Ethical and professional issues

Taxation services

Company tax computation

The performance of the company tax computation creates a self-review threat. A selfreview threat arises when an auditor reviews work which they themselves have previously performed – for example, if the external auditor is involved in the process of preparing the financial statements and then audits them. As a result, there is a risk that the auditor will not be sufficiently objective in performing the audit and may fail to identify any shortcomings in their own work. In this case therefore, a self-review threat to auditor independence arises because the tax calculation forms the basis of the tax payable and the tax charge in the financial statements and as such the audit team may be more likely to accept the tax calculations without adequate testing.

There is also a potential advocacy threat. An advocacy threat arises when the auditor is asked to promote or represent their client in some way. In this situation, there is a risk of the auditor being seen to promote the interests of Blaze Co with a third party such as the tax authorities and therefore that the auditor will be biased in favour of the client and cannot be fully objective.

Completing tax returns does not generally create a threat of management involvement by the auditor, as completing the tax return may not involve the auditor making any judgements. Provided management takes responsibility for the returns, including any judgements which have been made, the threat to objectivity is not likely to be significant.

Where tax calculations have been prepared by the auditor for the purpose of preparing accounting entries, the IESBA International Code of Ethics for Professional Accountants (the Code) and the FRC Ethical Standard state that this may be acceptable for an unlisted audit client and that the firm should consider implementing safeguards in order to reduce the self-review threat to an acceptable level. In this case, these safeguards might have included, for example, using professionals who are not members of the audit team to prepare the tax computations. The tax services should be reviewed by an independent tax partner, or other senior tax employee. Therefore, given that Blaze Co is an unlisted client, Novato & Co should ascertain which members of staff performed the taxation services and should review whether the threat to independence has been adequately assessed before the taxation services were performed and whether adequate safeguards have been applied.

Mr Tribbiani’ personal tax computation

From an ethical perspective, there is no prohibition in the Code or the FRC Ethical Standard on the preparation of personal tax returns for the directors of an audit client such as Blaze Co. However, in this case the auditor should consider whether the preparation of Mr Tribbiani’ personal tax return may result in the auditor being associated with criminal activities if the suspicions of money laundering activities noted above prove to be well founded.

The auditor should also consider the appropriateness of personal taxation services being billed to the company. Indeed, the preparation of Mr Tribbiani’ personal tax return may be a taxable benefit which should be included in his tax return and the fee for this service may need to be reflected in his director’s loan account with the company.

Website and online sales system

According to the Code and the FRC Ethical Standard, providing services to an audit client involving the design or implementation of IT systems which form a significant part of the internal control over financial reporting or generate information which is significant to the accounting records or financial statements on which the firm will express an opinion constitutes a self-review threat.

A self-review threat arises when an auditor reviews work which they themselves have previously performed – for example, if the external auditor is involved in the process of preparing the financial statements and then audits them. As a result, there is a risk that the auditor will not be sufficiently objective in performing the audit and may fail to identify any shortcomings in their own work.

In this case, the self-review threat arises as the new systems will produce data which will be used directly in the preparation of the financial statements. The audit process will therefore include reviewing and testing of financial data and systems which Novato & Co has helped to design and implement. As a result, there is a clear risk that the audit team may too readily place reliance on these systems. With reference to Blaze Co therefore, it is clear that providing assistance with the design and implementation of the website and online sales system will constitute a self-review threat as the auditor will audit sales figures which are generated by the system. There is also a risk that the firm may assume a management responsibility if they become involved in making management decisions. In the case of revenue, this selfreview threat may be heightened further by the auditor’s reliance on controls testing and on analytical review of the data summaries generated by the new system.

It also seems clear that the new online sales system will be significant to the client’s financial statements and records. Such a self-review threat may be too significant even for an unlisted client such as Blaze Co unless appropriate safeguards are put in place. Examples of possible safeguards which might assist in managing the self-review threat include the following:

• The client should acknowledge its responsibility for establishing and monitoring the system of internal controls and for the operating system and data it generates
• The respective responsibilities of the audit firm and the client should be clearly defined in a separate engagement letter in order to ensure that the client makes all management decisions in relation to the design and implementation process
• Novato & Co should use a separate team made up of non-audit staff to perform the systems design and implementation assignment and the work performed by this team should be subject to independent professional review.

If the self-review threat cannot be reduced to an acceptable level, or the engagement will result in the firm assuming a management responsibility, the service should not be provided.

Office party

The Code states that client hospitality (in this case the attendance at the office party by the audit team) may create a familiarity threat. A familiarity threat occurs when the auditor is too sympathetic or trusting of the client because of a close relationship with them. There is a risk therefore that as a result of attending the client office party, the audit staff may be getting too close to the client staff especially given that according to the audit senior, this practice has occurred every year. This close relationship may result in the audit team becoming less objective and less able to challenge explanations provided by the client.

The Code also states that gifts from a client to a member of the audit team may create a self-interest threat. A self-interest threat arises when the auditor derives a potential personal benefit from an audit client which may motivate them to behave in a manner which aims to protect that benefit. With reference to the office party therefore, the audit staff are receiving a direct financial benefit from the client (in this case in the form of vouchers).

Unless the value of such gifts is trivial and inconsequential, the self-interest threat would be too significant to mitigate with safeguards and the gifts should not be accepted.

The audit firm should consider introducing internal authorisation procedures in order to ensure transparency and to establish whether the value is trivial and inconsequential.

In this case, the value of $30 per head does appear to be trivial but the auditor might still consider declining the gifts in order to maintain a visible professional distance from a client which may be involved in criminal activities.

(a) Money laundering

(i) Reporting duties and procedures

Generally 1 mark per point

– Suspicions should be reported to nominated person within audit firm (MLRO); MLRO should possess suitable level of experience/seniority

– Audit firm should have established internal reporting lines which should be followed to report any suspicions

– Any individual in audit firm who has suspicions of money laundering activities must disclose them to MLRO; nondisclosure/failure to report constitutes an offence

– MLRO must consider all circumstances, document the process and decide whether to report to appropriate authorities; legal duty to report even though this may conflict with auditor’s duty of confidentiality

Maximum  4

(ii) Indicators of money laundering

Generally up to 2 marks for each well-explained point of explanation, for example:

Cash intensive business

– High level of cash sales and high volume of individual sales reports; risk illicit cash funds are being passed off as legitimate sales

– Mr Tribbiani’ sale to business associate for $33,000 may be example of placement of illegal funds in order to legitimise them as genuine sales.

International property transactions

– May be example of real estate laundering by Mr Tribbiani in his personal affairs; may be purchasing international property with illegal funds (placement) and then selling them in order to make funds appear legitimate (integration)

– High volume of transactions and off-shore bank accounts in Mr Tribbiani’ name may be indicative of layering of transactions in attempt to make original source of funds difficult to trace

Maximum 6

(b) Ethical and professional issues

Generally 1 mark for each point identified and explained

Taxation services

– Company tax computation is self-review threat as tax calculation forms basis of tax payable and tax charge in financial statements

– Advocacy threat re acting on client’s behalf with tax authorities

– Per IESBA Code, completing tax returns does not generally create threat to independence if management takes responsibility for returns including any judgments made

– Tax calculations for purpose of preparing accounting entries – may be acceptable for unlisted audit client; firm should consider safeguards, e.g. using professionals not members of audit team or independent senior/partner review

– Preparation of Mr Tribbiani’ personal tax return may be taxable benefit which should be included in tax return and fee should be reflected in his director’s loan account with the company

– Preparation of personal tax return may result in auditor being associated with criminal activities (i.e. money laundering as above)

Website and online sales system

– Self-review threat as auditor will audit sales figures generated by system

– New system appears to be significant to client’s financial statements and records

– Risk assume management responsibility relating to design of system and controls

– Threat may be too significant even for unlisted client unless appropriate safeguards put in place

– Examples of possible safeguards include: client acknowledges responsibility for establishing and monitoring system of internal controls; client makes all management decisions re design and implementation process; client is responsible for operating system and data it generates; separate team made up of non-audit staff performs work with independent professional review (max 2 marks for safeguards)

Office party

– Client hospitality (attendance at party) may create familiarity risks as audit staff may be getting too close to client especially given that this happens every year

– Gifts may create self-interest risk as audit staff receiving direct financial benefit from client

– Unless value is trivial and inconsequential, threats would be too significant to mitigate with safeguards and should not be accepted

– Auditor should have internal authorisation procedures to establish whether value is trivial and inconsequential

– In this case, value appears trivial but auditor should consider declining given possible criminal activities by client staff

Maximum 15

• (i) Cash transfers

This unusual, unexplained cash transfer into a foreign bank account may indicate that Alex Dunphy is using Zimzo Co to carry out money laundering. Money laundering is defined as the process by which criminals attempt to conceal the origin and ownership of the proceeds of their criminal activity, allowing them to maintain control over the proceeds and, ultimately, providing a legitimate cover for the sources of their income.

It is possible that the proceeds of criminal activity have been placed into Zimzo Co's bank account to enable them to transfer the funds into a foreign account, thus providing them with the appearance of legitimacy and creating a trail which is difficult to trace to the original source. This process is known as 'layering'. According to ACCA's Technical Factsheet 145 Anti-money laundering guidance for the accountancy sector, money laundering can result from a single transaction such as the cash placed into Zimzo Co's bank account.

The fact that Mr Dunphy retains sole control over cash management and that the financial controller has no oversight or involvement in this indicates weak controls over cash, for example, there appears to be no segregation of duty which may be the intention of Mr Dunphy to facilitate illegal activity. That he has failed to provide any documentary evidence, despite the request to do so by the audit team, only arouses suspicion further. It is also possible that the company is being used as a vehicle for money laundering without Mr Dunphy's knowledge. It is possible that the money has been accepted in good faith without the source of the funding being adequately verified.

The amount which has been transferred represents 1.3% of total assets, which is material to the financial statements. The engagement, and particularly matters relating to cash transactions, should now be considered as high risk and approached with a high degree of professional scepticism. The audit files should now be subject to an independent second partner review. The firm may also wish to seek legal advice given the potential legal implications of dealing with a client involved in money laundering.

To properly assess the impact of the transaction on the financial statements, the audit firm needs to understand the accounting entries which have been made. The debit side of the entry would be to cash, and the audit team should enquire as to where the credit side of the entry has been recognised. Possibly the credit has been recognised as revenue or possibly it has been contra-d against the cash payment which was made the next day.

The situation should be reported as soon as possible to the firm's Money Laundering Reporting Officer (MLRO). The MLRO is responsible for receiving and evaluating reports of suspected money laundering from colleagues within the firm. They will make a decision as to whether further enquiries are required and, if necessary, will make reports to the appropriate authorities.

Finally, care must now be taken during the remaining audit that no-one 'tips off' the client that their activity is being treated as suspicious and that a report will be made to the MLRO. 'Tipping off' the client could prejudice any consequent investigation and may itself be considered a criminal offence, depending on relevant legislation. According to Technical Factsheet 145, a tipping-off disclosure may be made in writing or verbally, and either directly or indirectly so the audit team must ensure that when discussing the matter with Mr Dunphy, he is not alerted to the suspicions of money laundering.

(ii) Legal dispute

The creation of provisions and their reversal in consequent years is a commonly used creative accounting technique. As such, this is a potentially high-risk area of the audit. The reversal of the provision in the current year increases the reported profit before tax by $150,000, which represents 6.8% of profit. This is therefore material and should be treated with appropriate professional scepticism.

In accordance with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, the provision should only have been recorded originally if: Zimzo Co had an obligation as a result of a past event; if it was considered probable that an outflow of cash would occur; and if a reliable estimate of the amount was available (IAS 37: para. 14). Given that this is a material amount, there should be audit evidence on the prior year file concerning the appropriateness of the original amount recorded.

It would be prudent to review the evidence held on the prior year audit file to assess the quality of evidence which was obtained relating to the assumptions made regarding the probability of payment. With legal disputes one would expect to see some documentary evidence from legal experts, such as the company's lawyers. It is unlikely that management assumptions and a written representation would have been considered appropriate as evidence in a matter where legal expertise is required.

For the same reason it is unlikely that the opinions of Mr Dunphy are likely to be considered as sufficient justification for reversing the provision in the current year. The lack of additional documentary evidence and Mr Dunphy's lack of availability to discuss the matter with the audit team further arouses suspicions of the validity of the decision to reverse the provision.

The audit manager should contact the client and request confirmation of Mr Dunphy's opinions from the company lawyers, along with any relevant documentation of legal proceedings or agreements reached with the ex-employee.

If the client is unable (or unwilling) to provide any further documentation, then the provision should be reinstated in full. This should be noted on the summary of proposed adjustments to the financial statements and sent to the client along with a request that they amend all the adjustments identified.

• The review should be conducted in line with ISRE 2410 Review of Interim Financial Information Performed by the Independent Auditor of the Entity. The key elements of the review are enquiry and analytical procedures, which do not lead to reasonable assurance.

The applicable financial reporting framework should be the same as for the annual financial statements, so IFRSs apply.

In line with IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised for the warranty on the cars. Thus the treatment in the 20X5 annual financial statements appears correct.

Patt Co has stopped offering warranties on cars sold from 1 July 20X5 onwards. However, it still has an obligation to honour warranties on cars already sold. Hence it should still provide for the cost of honouring those warranties. The interim financial statements therefore appear to understate liabilities and overstate profit.

If the same warranty provision needed to be recognised in the interim financial statements as at the year end, this would be $1.5m. This is 5% of total assets (= $1.5m / $30m), and is material.

The auditor should communicate this misstatement to management. If management does not respond appropriately, then the auditor must inform those charged with governance.

If appropriate adjustments are not made, then the report should contain a qualified or adverse conclusion. The report must include a 'Basis for qualified conclusion' paragraph immediately before the 'Qualified conclusion' paragraph.

1. Fraud and revenue recognition

Generally 1 mark for each point of discussion:

– Management targets/incentives

– High volume of transactions

– Use of judgement

– Complexity of accounting

– Cash sales

– Common in recent accounting frauds

– Not always complex/rebuttable permitted

Maximum 7

1. Implications for completion of audit

Generally 1 mark for each well explained implication for the audit or recommendation for further action:

• Cash transfers

– Indication of money laundering

– Layering

– Weakness in controls over cash

– Need to understand the accounting entries

– Failure to provide evidence

– Increased risk/need for scepticism

– Need for independent review

– Report to MLRO

– Care in avoiding 'tipping off'

• Legal dispute

– Potential creative accounting

– Material impact on profit for the year

– Review evidence on previous file

– Criteria for recognition (½ each to max of 1)

– Insufficiency of current evidence

– Request for further evidence (1 mark for each well described procedure to obtain further evidence)

– Possible need to reinstate provision to be discussed with management

Maximum 13

1. Interim financial statement review

Up to 1½ marks for each matter to be considered in forming conclusion/implication for report:

– Interim financial information should use applicable financial reporting framework

– Identify and explain unrecognised provision

– Correct calculation of materiality (1 mark)

– Communicate necessary adjustment to management/those charged with governance

– If amount unadjusted, the conclusion will be qualified

– Reason for qualified conclusion to be explained in the report

– Consider withdrawing from engagement/resign from audit appointment