(a) Clark Co
(i) Matters to be discussed with management in relation to the audit supervisor’s proposed adjustments
Lease of testing equipment
The lease at Clark Co’s largest site is material to the statement of financial position at 2·2% of total assets. The leases at the other two sites are also material at 2·8% of total assets.
The general recognition and measurement requirements of IFRS 16 Leases require lessees to recognise a right-of-use asset and a lease liability at the commencement date of the lease at the present value of the lease payments. The standard defines the commencement date as the date the asset is available for use by the lessee. Given that the commencement date is 31 May 20X8 therefore, it is appropriate on this basis to recognise the lease on the statement of financial position as at this date.
It is significant, however, that IFRS 16 also contains an optional exemption for short-term leases of less than 12 months’ duration with no purchase option. If Clark Co elects to apply this exemption, it does not recognise the leased assets or lease liabilities on the statement of financial position but rather, it recognises the lease payments associated with those leases as an expense in the statement of profit or loss for the year on either a straight-line basis over the lease term or another systematic basis. However, IFRS 16 also requires that if this exemption is taken, it must be applied consistently by each class of underlying asset. Hence in this case, the client must either capitalise the leases across all three of the sites or apply the exemption consistently and not capitalise the leases across any of the sites. On either of these bases, as the commencement date of the lease coincides with the reporting date, there would not yet be any impact on Clark Co’s statement of profit or loss for the year.
The audit manager should discuss the option of taking the short-term lease exemption with the finance director at tomorrow’s meeting:
(i) if the client elects not to take the exemption across the three sites, assets and liabilities will be materially understated. Hence the audit supervisor’s proposed adjustment is correct and a right-of-use asset and lease liability of $475,000 should be recognised on the statement of financial position.
(ii) Alternatively, if the client does elect to take the exemption across all three sites, then assets and liabilities are materially overstated and right-of-use assets and lease liabilities of $625,000 should be derecognised on the statement of financial position.
Impact on audit opinion:
If the client does not make any adjustment to the financial statements, the statement of financial position is materially misstated on the basis of misapplication of an accounting standard and the audit opinion should be qualified on this basis with an ‘except for’ opinion.
(ii) Legal claim​​​​​​​
The legal claim is material to the statement of financial position being 5·5% of Clark Co’s total assets.
Following the requirements of IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised when: an entity has a present obligation (legal or constructive) as a result of a past event; it is probable that an outflow of resources embodying economic benefits will be required to settle the obligation; and a reliable estimate can be made of the amount of the obligation. In this case the customer has already won the action against the company, the amount of the claim has been agreed by the courts and settlement is still outstanding at the reporting date. Hence, a provision of $1·2 million should be recognised on the statement of financial position.
AS 37 also states that contingent assets are not recognised in financial statements since this may result in the recognition of income which may never be realised. However, the standard continues by stating that when the realisation of income is virtually certain, then the related asset is not a contingent asset and its recognition is appropriate. With respect to Clark Co’s insurance claim therefore and the verified letter dated 25 May 20X8, the settlement of the claim as at the reporting date is virtually certain and an asset should be recognised separately on the statement of financial position.
The audit supervisor’s proposed adjustment is correct and the finance director should therefore be requested to adjust the financial statements to include the separate recognition of the asset and the provision. If the adjustment is not made, both assets and liabilities will be materially misstated. There is no net impact on the statement of profit or loss for the year.
The finance director should also be advised that the financial statements should include full disclosure of the facts and amounts surrounding the provision for the legal claim together with full details of the expected reimbursement from the insurance company recognised as an asset.
Impact on audit opinion:
If the client does not make any adjustment to the financial statements, the statement of financial position is materially misstated and the audit opinion should be qualified on this basis with an ‘except for’ opinion.
(iii) Asset impairment​​​​​​​
The asset impairment of $85,000 is not material in isolation to either the statement of financial position (0·4% of total assets) or the statement of profit or loss for the period (3·7% of profit before taxation).
According to IAS 36 Impairment of Assets, an entity should assess at the end of each reporting period whether there is any indication that an asset or a cash generating unit may be impaired. If any such indication exists, the entity shall estimate the recoverable amount of the asset. The standard states that potential impairment indicators include external sources of information such as significant changes in the market in which the entity operates. As each of Clark Co’s sites is considered a cash generating unit for impairment review purposes it seems appropriate therefore for the company to have conducted an impairment review at this site.
IAS 36 states that an asset or cash generating unit is impaired when the carrying amount exceeds the recoverable amount and it defines recoverable amount as the higher of the fair value less costs of disposal and the value in use. In the case of Clark Co, the auditor has agreed figures for carrying value and value in use and the key issue is the correct calculation of fair value less costs of disposal. Following IAS 36, the costs of disposal should include legal costs, transaction taxes and the costs of removing the assets but should exclude the costs associated with reorganising a business. The correct amount for fair value less costs of disposal is therefore $3,515,000 ($3·9 million – $126,000 – $174,000 – $85,000). Given that this is higher than the value in use of $2·9 million, the recoverable amount of the assets is also $3,515,000 and therefore the assets are impaired by $85,000 ($3·6 million – $3,515,000). The client appears to have incorrectly omitted the costs of removing the assets from its calculation of fair value less costs of disposal and as a result the statement of financial position and the statement of profit or loss for the year are both overstated by $85,000.
The audit supervisor’s proposed adjustment is therefore correct and the finance director should be advised of this error at tomorrow’s meeting. Even though the amount is immaterial to both the statement of financial position and statement of profit or loss for the year, it is appropriate to request that the adjustment is made to the financial statements.
Impact on audit opinion:
Given that assets and profits are both immaterially overstated, if no adjustment is made to the financial statements, it follows that there will be no impact on the audit opinion in relation to this matter in isolation.
(b) Turner Co
Ethical and professional issues and actions to be taken by the audit firm
Loan to member of the audit team​​​​​​​
According to the IESBA Code of Ethics for Professional Accountants (the Code), a loan to a member of the audit team may create a threat to the auditor’s independence. If the loan is not made under normal lending procedures, and terms and conditions, a self-interest threat would be created as a result of Janette Stott’s financial interest in the audit client. The selfinterest threat arises because of the potential personal benefit derived which may motivate the audit team member to behave in a manner aimed at protecting that benefit. Such a threat would be so significant that no safeguards could reduce the threat to an acceptable level. It follows therefore that the audit team member should not accept such a loan or guarantee. The Code, however, also states that a loan from an audit client which is a bank or similar institution to a member of the audit team which is made under normal lending procedures, is acceptable. Examples of such loans include home mortgages, car loans and credit card balances.
It is possible therefore that the secured loan may be ethically acceptable and the key issue is whether ‘the very best terms which the bank can offer’ fall within Turner Co’s normal lending procedures, and terms and conditions. The bank’s standard lending terms and conditions should be obtained and reviewed alongside the documentation for Janette Stott’s loan. Ultimately, the audit engagement partner is responsible for ensuring that ethical principles are not breached, so the partner should be involved with the discussions. The matter should be discussed with Janette and the client’s business manager in order to establish whether the loan is to be made under the bank’s normal lending procedures. Janette should be advised of the outcome of the review and Turner Co’s business manager should be advised of this decision, explaining the rationale and ethical rules behind it.
Temporary staff assignment​​​​​​​
The Code states that the lending of staff to an audit client may create a self-review threat to auditor independence. The selfreview threat arises when an auditor reviews work which they themselves have previously performed – for example, if the external auditor is involved in the process of preparing the payroll figures for inclusion in the financial statements and then audits them. As a result, there is a risk that the auditor would not be sufficiently objective in performing the audit and may fail to identify any shortcomings in their own work. In addition, there is a risk of the staff member assuming management responsibilities if they are involved in making judgments and decisions which are the remit of management.
Such assistance can only therefore be given for a short period of time and the audit firm’s staff must not assume management responsibilities and must not be involved in any activities specifically prohibited. According to the Code, an audit firm cannot provide accounting and bookkeeping services (including payroll) to an audit client which is a public interest entity unless the services relate to matters which are collectively immaterial to the financial statements.
In this case Turner Co is a listed bank and is therefore a public interest entity. The assignment of a qualified member of staff as a supervisor on the client’s main payroll system is likely to be material to the financial statements of a service industry client such as a bank and, in addition, may also involve management responsibilities. The audit manager should therefore discuss details of the proposed role of the seconded member of staff with the payroll manager and other key client contacts in order to establish the significance of the role and its materiality to the financial statements. Assuming that the role is material, the audit manager should decline the proposed staff assignment.​​​​​​​