SECTION A- This ONE question is compulsory and MUST be attempted
(a) It is 1 July 20X5. You are a manager in the audit department of Charlie & Co, a firm of Chartered Certified Accountants. You are assigned to the audit of Elijah Co which has a financial year ending 30 September 20X5. Elijah Co manages timber plantations, its core business being the management of timber plantations and the production and sale of a range of timber products. It is not currently a listed entity.
The following exhibits, available on the left-hand side of the screen, provide information relevant to the question:
- Partner’s email – an email which you have received from Emmet Green, the audit engagement partner.
- Background information – information relevant to audit planning.
- Notes from meeting – summary of business developments discussed at a recent meeting between the chief finance officer (CFO) and the audit engagement partner.
- Key performance indicators – a summary of financial and non-financial information
- Notes from phone call – a summary of issues raised by the CFO during a discussion with the audit engagement partner.
This information should be used to answer the question requirement within your chosen response option(s).
Exhibit 1: Partner’s Email
To: Audit manager
From: Emmet Green, Audit engagement partner
Subject: Audit planning for Elijah Co
Date: 1 July 20X5
Hello
I have provided you with some information which you should use to help you in planning the audit of Elijah Co for the financial year ending 30 September 20X5.
As you know, Elijah Co is a new audit client of our firm. I hope you are looking forward to working on this interesting new client which is the first timber company we have secured as an audit client. You should also be aware that the management team is planning for Elijah Co to achieve a stock market listing within the next two years.
I require you to prepare briefing notes for my own use, in which you:
(a)Evaluate the business risks to be considered in planning the audit of Elijah Co.(10 marks)
(b)Evaluate the audit risks to be considered in planning the audit of Elijah Co.(20 marks)
Note: In relation to the company’s timber plantation asset (referred to in Exhibit 4) you are only required to consider audit risks relating to changes in fair value. Any other relevant audit risks relating to the timber plantation asset will be dealt with separately, later in the planning stage of the audit.
(c)Design the audit procedures to be performed in relation to the change in fair value of the timber plantation asset caused by the recent storms. Your procedures should include those relating to the evaluation of the expert appointed by management and the work they have performed.(6 marks)
(d)Using Exhibit 5, explain the ethical issues and other audit planning implications which arise in relation to the phone call from the company’s chief finance officer, Mark Holt.(10 marks)
Thank you
Exhibit 2: Background Information
Elijah Co owns and manages several large timber plantations. Approximately 5% of the trees are harvested each year. The company immediately processes the timber which is harvested from felled trees in its own sawmills (a facility where trees are processed into logs and other timber products). The processed timber, which is mainly logs and planks of wood, is then sold to a range of customers including construction companies and furniture manufacturers. Approximately 30% of the timber is exported.
Your firm was appointed as auditor to Elijah Co in March 20X5 following the resignation of the previous auditor, Bear Associates. As part of your firm’s client acceptance procedures, communication was received from Bear Associates indicating that their reason for resignation was due to the retirement of the partner responsible for the audit and that they had no issues to bring to your attention regarding the audit.
Elijah Co has a small internal audit department with two staff who report to the company’s CFO, as the company does not have an audit committee.
Exhibit 3: Notes From Meeting
Meeting date: 10 June 20X5
Attendees: Emmet Green, audit engagement partner
Mark Holt, chief finance officer (CFO)
Accounting policies
Mark Holt confirms that Elijah Co applies the requirements of IAS® 41 Agriculture as follows:
- Standing timber, which means trees which are growing in the timber plantation prior tobeing felled, are biological assets, measured at fair value less costs to sell. The change infair value less costs to sell is included in profit or loss for the period in which it arises.
- Felled trees are agricultural produce which are measured at fair value less costs to sellat the point of harvest. Immediately after felling, trees are processed, so that the value offelled trees awaiting processing is minimal at any point in time.
- Processed timber such as logs are measured in accordance with IAS 2 Inventories.
A technical expert from the audit firm has confirmed that the accounting policies outlined above appear appropriate in the context of Elijah Co’s activities.
International expansion
Elijah Co’s operations are currently all based in its home jurisdiction. However, the board has recently approved the acquisition of several large areas of tropical rainforest in Swellview, a remote developing country. The expansion will allow the company to process new types of timber for which there is significant demand from luxury furniture manufacturers. The acquisition of the areas of the rainforest will cost $25 million and the purchase is due to take place in August 20X5. The cost of $25 million is equivalent to the fair value of the rainforest. Swellview uses the same currency as Elijah Co so the expansion is not creating any foreign exchange risk exposure to the company.
The purchase is being funded through a share issue to existing and new shareholders, who are mainly family members of the Elijah family, who established the company 20 years ago. A share issue was the only option for funding the international expansion as the company is at the limit of its bank borrowing agreement.
An international development agency has agreed to provide a grant of $20 million to assist Elijah Co in its Swellview expansion, on condition that the expansion represents sustainable and ethical business practice.
The grant is provided specifically for training the local workforce and building accommodation for the workforce in a town near to the rainforest.The grant is due to be received in September 20X5 and relevant expenditure will commence in November 20X5. Mark Holt is planning to recognise half of the amount received as income in this year’s financial statements, on the basis that it “will cover some of management’s expenses in planning the international expansion”.
Gold Standard
The company is proud to have recently been awarded an industry ‘Gold Standard’ accreditation for its sustainable timber management. To achieve the Gold Standard, which denotes the highest possible level of sustainable timber management and ethical business practice, the company must adhere to a number of strict standards. This includes maintaining the biodiversity of the timber plantation, ensuring that rare species of tree are not harvested, and that animal habitats within the timber plantation are preserved. To maintain the Gold Standard accreditation, one condition is that at least 80% of timber sold must be harvested according to the strict standards set by industry regulators. The Gold Standard applies to all of the company’s activities, including the Swellview expansion.
Contract with Hart Co
The company’s revenue has increased this year, largely due to it signing a significant contract with a new customer, Hart Co. The contract was signed on the basis of Elijah Co receiving the Gold Standard accreditation for its timber.
Legal case
A group of employees has recently commenced legal action against the company, claiming that breaches of health and safety guidelines regularly take place. The company has made some redundancies this year, which has put pressure on the remaining staff to work harder in order to maintain productivity; the employees are alleging that this has caused an increase in the number of accidents at work, some of which have resulted in fatalities. The company’s management and legal advisors believe that the legal claim, which amounts to $19 million, is unjustified and will not be successful. Mark Holt does not intend to recognise a provision for the claim or make any disclosure in the financial statements in relation to this issue as it is at such an early stage in the legal proceedings.
Use of expert – change in fair value due to recent storms
In the last month, several storms caused damage to some areas of timber plantation. An independent expert has been appointment by management to determine the extent of damage caused and to quantify any financial implications, including determination of the change in fair value of the standing trees which have been damaged by the storm. The expert’s report indicates a large number of trees have been completely destroyed, and many have been badly damaged. Based on the expert’s report, management has determined that a reduction in fair value of $70·5 million should be recognised in respect of the timber plantation asset recognised in the statement of financial position
Exhibit 4: Key Performance Indicators
The information in the table below will be published as part of the Annual Report, in a section titled ‘Key results for the year’, which forms part of management’s commentary on the company’s performance. The financial information is before recognising the change in fair value of the timber plantation caused by the recent storm, and also before accounting for the government grant.
Projected Actual %
30 September 30 September change
20X5 20X4
Financial key performance indicators: $ million $ million
Revenue 42·5 40·3 +5·5%
Operating profit 22·0 21·0 +4·8%
Profit before tax 6·5 5·0 +30%
Social and environmental key performance indicators:
% timber harvested in line with ‘Gold Standard’ 82% 85%
Number of employees 1,300 1,420
Total staff days lost due to accidents at work 78 65
You are also provided with the following information relating to balances which are extracted from management accounts as at 30 June 20X5:
Total assets – $550 million (20X4 – $545 million)
Timber plantation – $500 million (20X4 – $490 million) – this amount, relating to standing timber, is before accounting for any change in value caused by the recent storms referred to in Exhibit 3.
Inventory – $15·4 million (20X4 – $9·2 million) – the increased level of inventory is explained by management as follows: “In the last two months, industrial action at the country’s ports meant no containers of processed timber could be shipped to our export customers. The missed export sales so far amount to about $2·1 million. We continued to harvest and process timber during this time, leading to an increased level of inventory. The industrial action is ongoing.”
Cash – $4·5 million (20X4 – $6·8 million) – cash levels are depleted this year due to inflationary pressures and demands for higher wages from our employees, which we have met.
Exhibit 5: Notes From Phone Call
Notes from a phone call yesterday between Emmet Green, audit engagement partner and Mark Holt.
Request from Mark Holt
Elijah Co publishes a wide range of non-financial social and environmental Key Performance Indicators (KPIs) as part of the Annual Report, including the three shown as part of Exhibit 4. Mark has asked if our firm can provide assurance on these KPIs as part of performing the annual audit. Mark has suggested that in order to pay for this extra work, the agreed audit fee will be increased by 20%, assuming that the assurance provided on the KPIs is favourable.
News report
Mark informed us that a news report has emerged in Swellview, alleging that Elijah Co paid a government official a sum of $15,000 in order to secure the purchase of tropical rainforest which is taking place next month. Mark wanted to make us aware of the story, which is spreading quickly on social media, and to inform us that these incentive payments are routine business practice in Swellview. He also strongly urged us not to investigate the payment as part of our audit procedures, saying that the amount is insignificant. He suggested that making enquiries regarding the payment might mean more media attention is focussed on the issue, which he is keen to avoid given the company’s plans to obtain a stock market listing within the next two years.
Requirements
Respond to the instructions in the email from the audit engagement partner.
Note: The split of the mark allocation is shown in Exhibit 1 – Partner’s email.
(46 marks)
Professional marks will be awarded for the presentation and logical flow of the briefing notes and the clarity of the explanations provided.
(4 marks)
- 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.
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.
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.
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
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
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.
- 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.
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.
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.
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
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
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