2、You are a senior manager in Macau & Co, a firm of Chartered Certified Accountants. In your capacity as engagement quality control reviewer, you have been asked to review the audit files of Stanley Co and Kowloon Co, both of which have a financial year ended 31 December 2015, and the audits of both companies are nearing completion.
(a) Stanley Co is a frozen food processor, selling its products to wholesalers and supermarkets. From your review of the audit working papers, you have noted that the level of materiality was determined to be $1·5 million at the planning stage, and this materiality threshold has been used throughout the audit. There is no evidence on the audit file that this threshold has been reviewed during the course of the audit.
From your review of the audit planning, you know that a new packing machine with a cost of $1·6 million was acquired by Stanley Co in March 2015, and is recognised in the draft statement of financial position at a carrying amount of $1·4 million at 31 December 2015. The packing machine is located at the premises of Aberdeen Co, a distribution company which is used to pack and distribute a significant proportion of Stanley Co’s products. The machine has not been physically verified by a member of the audit team. The audit working papers conclude that ‘we have obtained the purchase invoice and order in relation to the machine, and therefore can conclude that the asset is appropriately valued and that it exists. In addition, the managing director of Aberdeen Co has confirmed in writing that the machine is located at their premises and is in working order. No further work is needed in respect of this item.’
Inventory is recognised at $2 million in the draft statement of financial position. You have reviewed the results of audit procedures performed at the inventory count, where the test counts performed by the audit team indicated that the count of some items performed by the company’s staff was not correct. The working papers state that ‘the inventory count was not well organised’ and conclude that ‘however, the discrepancies were immaterial, so no further action is required’.
The audit senior spoke to you yesterday, voicing some concerns about the performance of the audit. A summary of his comments is shown below:
‘The audit manager and audit engagement partner came to review the audit working papers on the same day towards the completion of the audit fieldwork. The audit partner asked me if there had been any issues on the sections of the audit which I had worked on, and when I said there had been no problems, he signed off the working papers after a quick look through them.
When reading the company’s board minutes, I found several references to the audit engagement partner, Joe Lantau. It appears that Joe recommended that the company use the services of his brother, Mick Lantau, for advice on business development, as Mick is a management consultant. Based on that recommendation, Mick has provided a consultancy service to Stanley Co since September 2015. I mentioned this to Joe, and he told me not to record it in the audit working papers or to discuss it with anyone.’
Required:
Comment on the quality of the audit performed discussing the quality control, ethical and other professional issues raised. (13 marks)
(b) Kowloon Co works on contracts to design and manufacture large items of medical equipment such as radiotherapy and X-ray machines. The company specialises in the design, production and installation of bespoke machines under contract with individual customers, which are usually private medical companies. The draft financial statements recognise profit before tax of $950,000 and total assets of $7·5 million.
The audit senior has left the following note for your attention:
‘One of Kowloon Co’s major customers is the Bay Medical Centre (BMC), a private hospital. In June 2015 a contract was entered into, under the terms of which Kowloon Co would design a new radiotherapy machine for BMC. The machine is based on a new innovation, and is being developed for the specific requirements of BMC. It was estimated that the design and production of the machine would take 18 months with estimated installation in December 2016. As at 31 December 2015, Kowloon Co had invested heavily in the contract, and design costs totalling $350,000 have been recognised as work in progress in the draft statement of financial position. Deferred income of $200,000 is also recognised as a current liability, representing a payment made by BMC to finance part of the design costs. No other accounting entries have been made in respect of the contract with BMC.
As part of our subsequent events review, inspection of correspondence between Kowloon Co and BMC indicates that the contract has been cancelled by BMC as it is unable to pay for its completion. It appears that BMC lost a significant amount of funding towards the end of 2015, impacting significantly on the financial position of the company. The manager responsible for the BMC contract confirms that BMC contacted him about the company’s financial difficulties in December 2015.
The matter has been discussed with Kowloon Co’s finance director, who has stated that he is satisfied with the current accounting treatment and is not proposing to make any adjustments in light of the cancellation of the contract by BMC. The finance director has also advised that the loss of BMC as a customer will not be mentioned in the company’s integrated report, as the finance director does not consider it significant enough to warrant discussion.
Kowloon Co is currently working on six contracts for customers other than BMC. Our audit evidence concludes that Kowloon Co does not face a threat to its going concern status due to the loss of BMC as a customer.
Your review of the audit work performed on going concern supports this conclusion.
Required:
(i) Comment on the matters to be considered, and recommend the actions to be taken by the auditor; and (7 marks)
(ii) Explain the audit evidence you would expect to find in your review of the audit working papers. (5 marks)
(a) Quality control, ethical and professional matters
The audit of Stanley Co does not seem to have been performed with a high regard for the quality of the audit and there appear to be several ways in which the ISA requirements have been breached.
Materiality
First, it is not appropriate that the materiality level was determined at the planning stage of the audit but has not been reviewed or adjusted since. ISA 320 Materiality in Planning and Performing an Audit requires the auditor to determine materiality for the financial statements as a whole at the planning stage of the audit, and to revise it as the audit progresses as necessary where new facts and information become available which impact on materiality. It may be the case that no revision to the materiality which was initially determined is necessary, but a review should have taken place and this should be clearly documented in the audit working papers.
Audit of property, plant and equipment
The audit of the packing machine has not been properly carried out, and there seems to be a lack of sufficient, appropriate audit evidence to support the audit conclusion. The cost of the asset is material, based on the initial materiality, therefore there is a risk of material misstatement if sufficient and appropriate evidence is not obtained. By the year end the asset’s carrying value is less than materiality, presumably due to depreciation being charged, but this does not negate the need for obtaining robust audit evidence for the cost and subsequent measurement of the asset.
The packing machine should have been physically verified. Obtaining the order and invoice does not confirm the existence of the machine, or that it is in working order. In addition, without a physical verification, the audit team would be unaware of problems such as physical damage to the machine or obsolescence, which could indicate impairment of the asset.
Relying on the distribution company to provide evidence on the existence and use of the asset is not appropriate. ISA 500 Audit Evidence states that audit evidence obtained directly by the auditor is more reliable than audit evidence obtained indirectly or by inference. External confirmations can be used to provide audit evidence but in this case the external confirmation should corroborate evidence obtained directly by the auditor, rather than be the only source of evidence. The relationship between Stanley Co and Aberdeen Co should also be understood by the auditor, and evidence should be obtained to confirm whether or not the two companies are related parties, as this would impact on the extent to which the external confirmation can be relied upon as a source of evidence.
Inventory count
In respect of the inventory count attendance, the audit team should have discussed the discrepancies with management as they could indicate more widespread problems with the inventory count. Given the comment that the inventory count appeared unorganised, it is possible that count instructions were not being followed or that some items had not been included in the count. One of the requirements of ISA 501 Audit Evidence – Specific Considerations for Selected Items is that while attending an inventory count, the auditor shall evaluate management’s instructions and procedures for recording and controlling the results of the entity’s physical inventory counting. It is not clear from the conclusion of the audit work whether the problems noted at the inventory count have been discussed with management. The auditor attending the inventory count should have raised the issues at the time and assessed whether a recount of all of the inventory was required. Training may need to be provided to audit staff to ensure that they understand the auditor’s role at an inventory count and can deal with problems which may arise in the appropriate manner.
The discrepancies noted at the inventory count should be subject to further audit work. The results of the test counts should be extrapolated over the population in order to evaluate the potential misstatement of inventory as a whole. The results should then be evaluated in accordance with ISA 450 Evaluation of Misstatements Identified during the Audit which requires that the auditor shall accumulate misstatements identified during the audit, other than those which are clearly trivial, and that misstatements should be discussed with management. The issues raised by the way in which the inventory count was performed could represent a significant control deficiency and should be raised with those charged with governance in accordance with ISA 265 Communicating Deficiencies in Internal Control to Those Charged with Governance and Management.
Working paper review
The audit senior’s comments in relation to the review by the manager and partner indicate that elements of ISA 220 Quality Control for an Audit of Financial Statements have been breached. ISA 220 requires that the engagement partner shall, through a review of the audit documentation and discussion with the engagement team, be satisfied that sufficient appropriate audit evidence has been obtained to support the conclusions reached and for the auditor’s report to be issued. It appears that in this case the partner has not properly reviewed the working papers, instead relying on the audit senior’s comment that there were no problems in the audit work. ISA 220 does state that the audit partner need not review all audit documentation, but only a ’quick look’ at the working papers could indicate that areas of risk or critical judgement have not been reviewed in sufficient detail.
There is also an issue in that the manager and partner reviews took place at the same time and near the completion of the audit fieldwork. Reviews should happen on a timely basis throughout the audit to enable problems to be resolved at an appropriate time. Reviews should also be hierarchical and it appears that the audit partner has not reviewed the work of the audit manager.
Ethical considerations
Finally, there appears to be a potential threat to objectivity due to the audit engagement partner’s brother providing a management consultancy service to the audit client. This amounts to a self-interest threat in that the partner’s brother receives income from the audit client. The audit partner’s objectivity is therefore threatened, and this is a significant risk due to his position of influence over the audit. He may even receive an introducer’s commission from his brother.
The matter should be investigated further, and a senior member of the audit firm or the firm’s partner responsible for ethics should discuss the comments made in Stanley Co’s board minutes with Joe Lantau in order to evaluate the ethical threat and determine any necessary actions. The amount which is being paid to Mick Lantau should be made known, as well as whether the amount is a market rate, and whether other providers of management advice were considered by the company.
The partner’s comments to the audit junior indicate a lack of integrity, and indicate that the partner may have something to hide, which increases the threat to objectivity. The audit partner may need to be removed from the audit and his work reviewed.
(b) (i) Matters to consider and actions to take
The work in progress represents 4·7% of total assets and is therefore material to the statement of financial position. The deferred income is also material at 2·7% of total assets.
Even though the correspondence with BMC is dated after the end of the reporting period, BMC was suffering from financial problems during the year ending 31 December 2015 which was notified to Kowloon Co before the year end. Therefore the cancellation of the contract appears to meet the definition of an adjusting event under IAS 10 Events after the Reporting Period because it confirms conditions which existed at the year end.
Management must consider whether it is still appropriate to recognise the work in progress as an asset. According to IFRS 15 Revenue from Contracts with Customers, costs incurred to fulfil a contract are recognised as an asset if and only if all of the following criteria are met:
– The costs relate directly to a contract (or a specific anticipated contract);
– The costs generate or enhance resources of the entity which will be used in satisfying performance obligations in the future; and
– The costs are expected to be recovered.
The cancellation of the contract indicates that the costs of the work in progress are not recoverable from BMC, in which case the balance should be written off. Management is not planning to amend the balances recognised at the year end, and the audit team should investigate the reasons for this. Possibly management is asserting that the machine design costs could be utilised for a different contract, despite the fact that the machine was developed specifically for BMC. Audit work should focus on the contractual arrangements between Kowloon Co and BMC, particularly in relation to the ownership of the rights to the design work which has taken place. If the design work has been based on an innovation by BMC, then it needs to be determined if this information can still be used.
If the design work which has been undertaken to date can be used by Kowloon and results in an ability to develop a new type of product for other customers, there is the possibility that the costs (excluding any research costs) could be capitalised in line with IAS 38 Intangible Assets. This should be discussed with the project manager and finance director to assess if this has been considered and if the capitalisation criteria of IAS 38 can be satisfied.
The accounting treatment of the deferred income also needs to be considered. Depending on the terms of the contract with BMC, the amount could be repayable, though this may not be the case given that it is BMC which has cancelled the contract. If part or all of the amount is repayable, it can remain recognised as a current liability. If it is not repayable, it should be released to the statement of profit or loss.
If the costs cannot be capitalised, then there is a loss which needs to be recognised. Assuming that the advance payment is non-refundable, the net position of the development cost and the deferred income balances result in a loss of $150,000. This represents 15·8% of profit for the year and is material. If any necessary adjustments are not made there will be implications for the auditor’s report, which would contain a modified opinion due to material misstatement.
Due to the significance of the matter to the financial statements, the contract cancellation and loss of BMC as a customer should be discussed in the other information to be issued with the financial statements, in this case in the integrated report. The audit firm must consider its responsibilities in respect of ISA 720 The Auditor’s Responsibilities Relating to Other Information in Documents Containing Audited Financial Statements. ISA 720 requires the auditor to read the other information to identify material inconsistencies, if any, with the audited financial statements. Depending on the wording used in the integrated report when referring to the company’s activities during the year and its financial performance, omitting to mention the cancellation of the contract could constitute a material misstatement of fact or a material inconsistency.
The matter should be discussed with management, who should be encouraged not only to amend the financial statements but also to discuss the cancellation of the contract in the integrated report. If management refuses to make the necessary amendments and disclosures, the matter should be discussed with those charged with governance and/or the company’s legal counsel.
(ii) Evidence
– A copy of the contract between Kowloon Co and BMC reviewed for terms, in particular on whether the cancellation of the contract triggers a repayment of the payment in advance and in relation to ownership of the rights to the development which has so far taken place.
– Copies of correspondence between Kowloon Co and BMC reviewed for implications of the cancellation of the contract.
– Written confirmation from BMC that the contract has been cancelled and the date of the cancellation.
– Written representation from the project manager confirming that BMC contacted him regarding their financial difficulties in December 2015.
– Notes of a discussion with the project manager to confirm if the work in progress could be used for a different contract or the feasibility of the design work leading to a new type of product which could be produced by Kowloon Co.
– Correspondence with legal counsel regarding the ownership of the machine and whether there are any legal implications following the contract cancellation and potential proposal to sell the machine to a different customer.
– Review of post year-end orders/board minutes to assess if any conclusion regarding completion of the machine has been made and if it can be sold to an alternative customer, whether any potential customer has been identified.
– Extracts from the financial statements and journals to confirm that the necessary adjustments have been made.
– A copy of the integrated report, reviewed to confirm whether the cancellation of the contract and loss of BMC as a customer has been discussed.