4) INDIANA CO.
It is 1 August 20X5. You are a manager in the audit department of Indiana & Co, a firm of Chartered Certified Accountants. You are working on the audit of the Don Group (the Group), which has a financial year ending 30 October 20X5. The Group, a listed entity, offers an internet television network, with over 9 million subscription members in eight countries.
You are provided with the following exhibits:
- An email which you have received from the Group audit engagement partner.
- Background information and matters relevant to audit planning.
- Selected financial information from the Group management accounts.
- An extract from the audit strategy document prepared by Narayan Associates, the component auditor which audits one of the Group’s subsidiaries.
- Details of the planned acquisition of a new foreign subsidiary, Michelle Co, and a possible joint audit arrangement.
Required:
Respond to the instructions in the email from the audit engagement partner. (46 marks)
Note: The split of the mark allocation is shown in the partner’s email (Exhibit 1).
Professional marks will be awarded for the presentation and logical flow of the briefing notes and the clarity of the explanations provided. (4 marks)
(50 marks)
Exhibit 1 – Email from audit engagement partner
To: Audit manager
From: Daniel Morgan, Audit engagement partner
Subject: Audit planning for the Don Group
Date: 1 August 20X5
Hello
I have provided you with some information in the form of a number of exhibits which you should use to help you with planning the audit of the Don Group (the Group) for the financial year ending 30 October 20X5.
I require you to prepare briefing notes for my own use, in which you:
(a) Using the information in all exhibits, evaluate the audit risks to be considered in planning the Group audit. (24 marks)
(b) Using the information provided in Exhibit 4:
(i) Evaluate the extract from the component auditor’s strategy, commenting on the audit strategy responses and ethical matters relating to the issues identified; and (10 marks)
(ii) Design the principal audit procedures which you will instruct the component auditor to perform on the sale of property to the Group chief executive officer. (6 marks)
(c) Using Exhibit 5, discuss whether it is appropriate for a joint audit to be performed on Michelle Co, commenting on the advantages and disadvantages of a joint audit arrangement. (6 marks)
Thank you
Exhibit 2 – Background information
The Group started to offer an internet streaming service for films and TV programmes ten years ago. The Group’s business model is to acquire licences for films and TV programmes and customers pay a monthly subscription fee to access them and watch online.
The Group has a subsidiary in each country in which it offers its subscription service. Indiana & Co audits all of the subsidiaries with the exception of Keith Co, one of the Group’s foreign subsidiaries, which is audited by a local firm called Narayan Associates. All companies within the Group have the same financial year end, and with the exception of Keith Co, which reports under local accounting standards, the Group companies all use IFRS® Standards as their financial reporting framework.
Matters relevant to audit planning
Following a discussion between the Group audit engagement partner and a representative of the Group audit committee, several matters were noted as being relevant to the audit planning:
Annual incentive scheme
For several years, the Group has operated an annual incentive scheme for staff, under the terms of which employees are eligible to receive an annual incentive payment linked to the achievement of selected targets. The scheme operates across all Group companies, with some employees’ targets linked to profitability, while others are aligned to non‑financial measures including customer satisfaction. Participants in the scheme are entitled to earn a maximum annual incentive payment of 5% of their salary. Approximately 6,590 employees, including the senior executive directors, are entitled to participate in the annual incentive scheme. Last year the average bonus payment was $1,250 per participant.
Legal case
In February 20X5, a legal case was initiated against the Group by Ken Co, a film production company. Ken Co claims that the Group has infringed copyright by streaming a film in specific countries for which a licence has not been acquired. The Group insists that the film is covered by a general licence which was acquired several years ago. The Group finance director is not willing to recognise the legal claim within the financial statements as he is confident that the claim against the Group will not be successful, and he does not want to discuss it further with the audit team, emphasising that there is no relevant documentation available for evaluation at this time.
Keith Co
Narayan Associates provides the audit service to Keith Co, one of the Group’s foreign subsidiaries. Keith Co is one of the Group’s larger subsidiaries, it is a listed company in its home jurisdiction, with total assets of $140 million. Keith Co is the only subsidiary which does not follow IFRS Standards, as in its local jurisdiction companies must follow local accounting rules. It uses the same currency as the rest of the Group.
Keith Co was acquired several years ago, and goodwill of $38 million is recognised in the Group financial statements in respect of the company.
Exhibit 3 – Selected financial information
Note Projected to Actual to
30 October 20X5 30 October 20X4
$ million $ million
Group revenue 1 980 780
Operating profit 78·4 70·2
Profit before tax 60·1 58·7
––––– –––––
Total assets 780 600
––––– –––––
Included in total assets:
Intangible assets – licences 2 580 420
Intangible assets – goodwill 3 135 135
Number of subscription customers 10,500,000 8,070,000
Notes:
- The Group’s main source of revenue is from monthly membership fees. Members are billed in advance of the start of their monthly membership and revenue is recognised when the bill is sent to the customer, all of whom pay by credit card. The price of a regular subscription has remained at $8·20 per month throughout 20X4 and 20X5. Occasionally, the Group offers a free trial period to new customers. This year, the Group also introduced a new premium subscription package, which allows customers to add two family members to their subscription for an additional fee of $5 per month.
- The Group acquires content licences per title in order to stream film and TV content to its subscribers. The content licences are each for a fixed time period, varying between three and five years. The Group capitalises the cost per title as an intangible asset. Group policy is to amortise licences over a five-year period, the finance director justifies this as being ‘the most prudent’ accounting treatment.
- Goodwill arising on business combinations is tested annually for impairment in accordance with IAS® 36 Impairment of Assets. Due to the strong performance of the Group, no impairment of goodwill has been recognised in recent years.
Exhibit 4 – Extract from component auditor strategy document
The three points below are an extract from the audit strategy prepared by Narayan Associates in relation to their audit of Keith Co. Other sections of the audit strategy, including the audit risk assessment, have been reviewed by the Group audit team and are considered satisfactory so you do not need to consider them.
Issue identified by Narayan Associates Audit strategy response by Narayan
Associates
Materiality
Internet services in the country have been Materiality will be based on total assets for the
subject to considerable disruption. As a first time this year due to the significant
result of this, a significant number of reduction in revenue and profit.
customers have cancelled their subscriptions Based on 1% of assets, materiality is determined
and the company is projected to make a loss at $1·4 million.
this year. In the previous year, materiality based on revenue
was determined to be $1·2 million.
Payroll Planned audit procedures:
From 1 November 20X4, payroll accounting – Agree the total payroll figure, estimated to be
services are provided to Keith Co by $6 million, from the statement of profit or
Narayan Associates as an additional loss to the payroll reports generated by Narayan
non-audit engagement. Associates.
– No further audit procedures are considered necessary.
Sale of property Planned audit procedures:
Keith Co sold a small, unused building – Confirm $50,000 is included in receivables
located on the coast to the Group’s chief within current assets.
executive officer (CEO) in March 20X5, for – No further audit procedures are considered
$50,000. The amount is still outstanding for necessary because the transaction is not material to
payment. the financial statements, and local accounting
The Group CEO is planning to use the rules do not require disclosure of the transaction.
property as a holiday home.
Exhibit 5 – Potential new subsidiary
The Group is planning the acquisition of a new foreign subsidiary, Michelle Co, which is located in Farland. The negotiations are at an advanced stage, and it is likely that the acquisition will take place in November 20X5.
The Group’s audit committee has suggested that if the acquisition goes ahead, due to the distant location of the company and the fact that Indiana & Co has no offices in Farland, a joint audit could be performed with Michelle Co’s current auditors, Lucille Associates, a small local firm of Chartered Certified Accountants