(a)    Decommissioning provision
Matters
The provision is material as it amounts to 22·6% of total assets. The provision has changed in value over the year, declining by $58 million which is a significant reduction of 11·9%.
According to ISA 540 Auditing Accounting Estimates including Fair Value Accounting Estimates and Related Disclosures, the audit team should have tested how management made the accounting estimate, and the data on which it is based. The audit team should also have tested the operating effectiveness of any relevant controls, and developed their own point estimate or range in order to evaluate management’s estimate.
The value of a decommissioning provision would normally be expected to increase, as the date of the anticipated settlement of the liability draws closer, so the audit team must fully understand the reasons for the reduction in the provision. There could be valid reasons, for example, the estimated costs of dismantling the assets have reduced, or the estimated date of decommissioning is later, but the change in value should have been fully investigated by the audit team.
IAS 37 Provisions, Contingent Liabilities and Contingent Assets requires that the amount recognised as a provision should be the best estimate of the expenditure required to settle the present obligation at the reporting date, and that provisions are measured at present value. For the decommissioning provision recognised by Goldfinch Gas Co, where the obligation will not be settled for many years, the method used to discount the liability to present value will have a significant impact on the measurement of the provision. For example, the use of 8% to determine the discount factor, rather than 6%, will have reduced the value of the provision and the reasons for the change in interest rate should have been an important consideration for the audit team.
Consideration should be given to the accounting entries which have been made to effect the change in the value of the provision. When a decommissioning provision is first recognised, there is no profit impact, because the cost is capitalised as part of the relevant non-current asset. Subsequent adjustments to the value of the provision could be charged or credited to profit, or recognised as an adjustment to the asset value, depending on the reason for the adjustment. The audit work should conclude on the appropriateness of how the change to the provision of $58 million has been recognised in the current year financial statements. In particular, the validity of any credit entries made to profit should be scrutinised, as this could indicate creative accounting, specifically earnings management.
In previous years management has engaged an expert to provide the estimate, but this year the estimate has been prepared by management. There is therefore increased risks of both error and management bias in the estimation techniques and methodology which have been used. The audit team should approach this issue with professional scepticism and consider whether the expense of engaging an expert is the real reason as to why a management estimate has been used this year.
Evidence
– A copy of management’s calculation of the $430 million provision, with all components agreed to underlying documentation, and arithmetically checked.
– Notes of a meeting with management, at which the reasons for the reduction in the provision were discussed, including the key assumptions used by management. In particular, management should provide justification of the change in interest rate used in their estimation from 6% to 8%.
– Copies of the source data used to produce management’s estimate, including information on the relevant assets’ estimated useful lives and expected date of their decommissioning, which may be part of a licence agreement to operate gas production and storage facilities.
– A comparison of the calculation of this year’s provision with previous years, confirming consistency in the overall approach and methodology applied in creating the estimate.
– Copies of the underlying information relating to the expected costs of the decommissioning, evaluated for reasonableness by the audit team, for example, by comparison to the cost of any current decommissioning which is taking place.
– An evaluation of all key assumptions, considering consistency with the auditor’s knowledge of the business, and a conclusion on their validity.
– An independent estimate prepared by the audit team, compared to management’s estimate, and with significant variances discussed with management.
– As an alternative to the above, if the audit team does not have the necessary skill to prepare the estimate, an estimate prepared by an auditor’s expert should be included in the audit file, with all workings and assumptions evaluated by the audit team.
– A schedule obtained from management showing the movement in the decommissioning provision in the accounting period, checked for arithmetic accuracy, and with opening and closing figures agreed to the draft financial statements and general ledger.
– Evaluation by the audit team, and a conclusion on the appropriateness of the accounting entries used, especially in relation to the profit impact of the entries.
– A copy of the notes to the financial statements which describe the decommissioning provision, reviewed for completeness and accuracy
(b)    Depreciation
The plant and equipment is recognised at $65 million; this is material to the financial statements as it represents 3·4% of total assets. The depreciation which has been recognised in profit for the year represents 9·2% of profit before tax, and is also material.
There are two main issues to be considered regarding the accounting treatment of the depreciation. First, the reason for the change in the estimated useful life needs to be properly justified. There is nothing wrong in amending the estimated useful life of non-current assets, indeed it is a requirement of IAS 16 Property, Plant and Equipment that the useful life of an asset should be reviewed at least at each financial year end.
However, the adjustment to the estimated useful life appears to be fairly significant, resulting in a $3 million reduction in the annual depreciation charge, equivalent to a reduction of 20% of the expense recognised in the previous year, and increasing profit before tax in 2017 by 2·3%. Management could have changed the estimated useful life with the intention of boosting profit, and the audit team should be sceptical of the reasons used to justify the change in estimated useful life. The need to be sceptical is augmented by the boost to profit which may have been achieved through the reduction in the decommissioning provision.
Second, the change in estimate has been accounted for incorrectly. According to IAS 16, when a change in estimated useful life is recognised, this is accounted for prospectively as a change in estimate under IAS 8 Accounting Policies, Changes in Accounting Estimates and Errors. In this case, it has been incorrectly accounted for as a prior year adjustment, effectively being treated as an error rather than a change in estimation technique.
Based on the information provided, both non-current assets and retained earnings are overstated by $20 million. This represents 1·1% of total assets, and is borderline in terms of its materiality to the financial statements, though given the possibility of earnings management techniques being used to boost profit, the audit team should consider revising its risk assessment for the audit as a whole and reducing the level of materiality applied when evaluating the risk of material misstatement. Further, this is effectively the misapplication of an accounting policy and is therefore likely to be considered material by nature.
Evidence
– Notes of a meeting with management where the incorrect accounting treatment of the change in estimate has been discussed, along with confirmation from management that a correction will be made to account for it prospectively rather than retrospectively.
– Confirmation that the carrying value of the plant and equipment and the retained earnings have been adjusted to remove the $20 million incorrectly recognised as a prior year adjustment.
– Agreement of the carrying value of the plant and equipment to the non-current asset register and physical verification of a sample of assets where the asset life has been extended to confirm condition and operation of the asset.
– Documentation supporting the extension of the useful lives of the assets concerned, for example, maintenance reports indicating continued efficiency of the assets, and engineers reports showing that there are no major operational problems with the assets.
– A written representation from management explaining the justification for the amendment to the estimated life of the assets.
– A copy of management’s calculation of the amended depreciation charge, checked for arithmetical accuracy by the audit team, and each element of the calculation agreed to supporting documentation.
(c)    Trade receivables
The total trade receivables is material to the financial statements, representing 23·7% of total assets.
The analytical procedures performed by the audit team reveal an unusual trend in that the trade receivables collection period for residential customers has increased from 58 to 65 days, whereas the collection period for business customers has reduced from 55 to 50 days. The reasons for this inconsistent trend should be fully explored with management. Net trade receivables in total have increased by 15·4%. The use of additional judgement could increase the risk of material misstatement, particularly in relation to the residential customers who are deemed to be historically late in paying their bills.
The changes in collection period could be related to the new customer billing system which has been introduced during the year, and management should confirm whether this relates to both residential and business customers, or to just one of them.
The allowance for credit losses has increased significantly, by 45·5%. The allowance is material to the financial statements as it represents 3·4% of total assets and the movement in the allowance in the year represents 15·3% of profit. The note to the financial statements indicates that the introduction of the new billing system has impacted on how management estimates the allowance for credit losses, and the reasons for this should be discussed with management. It would seem unusual that the introduction of a new billing system would have such a significant effect on the level of bad or doubtful debts, so possibly there is another reason to explain why the allowance has increased by such a large amount.
The audit team should have documented and evaluated the new system, using walk through tests to confirm understanding of how the system works, and controls should also have been evaluated for effectiveness in their design and operation. This is particularly important given that there are significant changes in the collection periods for both residential and business customers since last year end, which could indicate that customers are not being billed in the same way or that there is some misallocation between residential and business customers’ accounts.
Evidence
– Notes of a discussion with management on the change in the trade receivables collection period, including management’s reasons for the increase in the residential customers’ collection period, and reduction in the business customers’ collection period.
– A copy of the aged receivables analysis, reviewed for significant changes in the year, for example, an increase in the age profile of the receivables could justify the increase in allowance against old receivables balances.
– Documentation on the new billing system, to confirm understanding of the system and the results of the evaluation of the controls which operate over the system.
– Further analytical procedures performed on the allowance for credit losses, for example, procedures which show a breakdown of the allocation of the allowance against residential and business customers.
– Notes of a discussion with management which include the assumptions used by management in determining the amount of the allowance, and the method by which it was calculated, for example as a % of receivables balances or specific allocation to individual customers’ balances, and how the introduction of the new billing system has impacted on the determination of the allowance.
Tutorial note: Credit will be awarded for audit evidence on the collectability and existence of trade receivables including after date cash tests, relevant enquiries with credit controllers and receivables confirmations and reconciliations.