Elounda Co manufactures chemical compounds using a continuous production process. Its year end was 31 July 20X6 and the draft profit before tax is $13·6 million. You are the audit supervisor and the year-end audit is due to commence shortly. The following matters have been brought to your attention.
(i) Revaluation of property, plant and equipment (PPE)
At the beginning of the year, management undertook an extensive review of Elounda Co’s non-current asset valuations and as a result decided to update the carrying value of all PPE. The finance director, Peter Dullman, contacted his brother, Martin, who is a valuer and requested that Martin’s firm undertake the valuation, which took place in August 20X5.
(ii) Inventory valuation
Your firm attended the year-end inventory count for Elounda Co and ascertained that the process for recording work in progress (WIP) and finished goods was acceptable. Both WIP and finished goods are material to the financial statements and the quantity and stage of completion of all ongoing production was recorded accurately during the count.
During the inventory count, the count supervisor noted that a consignment of finished goods, compound E243, with a value of $720,000, was defective in that the chemical mix was incorrect. The finance director believes that compound E243 can still be sold at a discounted sum of $400,000.
(iii) Bank loan
Elounda Co secured a bank loan of $2·6 million on 1 October 20X4. Repayments of $200,000 are due quarterly, with a lump sum of $800,000 due for repayment in January 20X7. The company met all loan payments in 20X5 on time, but was late in paying the April and July 20X6 repayments.
Required:
Describe substantive procedures you should perform to obtain sufficient, appropriate audit evidence in relation to the above three matters.
Note: The mark allocation is shown against each of the three matters above.
(i) Substantive procedures for revaluation of property, plant and equipment (PPE)
– Obtain a schedule of all PPE revalued during the year and cast to confirm completeness and accuracy of the revaluation adjustment and agree to trial balance and financial statements.
– Consider the competence and capability of the valuer, Martin Dullman, by assessing through enquiry his qualification, membership of a professional body and experience in valuing these types of assets.
– Consider whether the valuation undertaken provides sufficiently objective audit evidence. Discuss with management whether Martin Dullman has any financial interest in Elounda Co which along with the family relationship could have had an impact on his independence.
– Agree the revalued amounts to the valuation statement provided by the valuer.
– Review the valuation report and consider if all assets in the same category have been revalued in line with IAS 16 Property, Plant and Equipment.
– Agree the revalued amounts for these assets are included correctly in the non-current assets register.
– Recalculate the total revaluation adjustment and agree correctly recorded in the revaluation surplus.
– Recalculate the depreciation charge for the year to ensure that for the assets revalued during the year, the depreciation was based on the correct valuation and was for 12 months.
– Review the financial statements disclosures relating to the revaluation to ensure they comply with IAS 16.
(ii) Substantive procedures for inventory valuation
– Obtain a schedule of all raw materials, finished goods and work in progress (WIP) inventory and cast to confirm completeness and accuracy of the balance and agree to trial balance and financial statements.
– Obtain the breakdown of WIP and agree a sample of WIP assessed during the count to the WIP schedule, agreeing the percentage completion as recorded at the inventory count.
– For a sample of inventory items (finished goods and WIP), obtain the relevant cost sheets and confirm raw material costs to recent purchase invoices, labour costs to time sheets or wage records and overheads allocated are of a production nature.
– For a sample of inventory items, review the calculation for equivalent units and associated equivalent unit cost and recalculate the inventory valuation.
– Select a sample of year-end finished goods and review post year-end sales invoices to ascertain if net realisable value (NRV) is above cost or if an adjustment is required.
– Select a sample of items included in WIP at the year end and ascertain the final unit cost price, verifying to relevant supporting documentation, and compare to the unit sales price included in sales invoices post year end to assess NRV.
– Review aged inventory reports and identify any slow moving goods, discuss with management why these items have not been written down or if an allowance is required.
– For the defective chemical compound E243, discuss with management their plans for disposing of these goods, and why they believe these goods have a NRV of $400,000.
– If any E243 has been sold post year end, agree to the sales invoice to assess NRV.
– Agree the cost of $720,000 for compound E243 to supporting documentation to confirm the raw material cost, labour cost and any overheads attributed to the cost.
– Confirm if the final adjustment for compound E243 is $320,000 (720 – 400) and discuss with management if this adjustment has been made; if so follow through the write down to confirm.
– Review the financial statements disclosures relating to inventory and WIP to ensure they comply with IAS 2 Inventories.
(iii) Substantive procedures for bank loan
– Agree the opening balance of the bank loan to the prior year audit file and financial statements.
– For any loan payments made during the year, agree the cash outflow to the cash book and bank statements.
– Review bank correspondence to identify whether any late payment penalties have been levied and agree these have been charged to profit or loss account as a finance charge.
– Obtain direct confirmation at the year end from the loan provider of the outstanding balance and any security provided; agree confirmed amounts to the loan schedule and financial statements.
– Review the loan agreement for details of covenants and recalculate to identify any breaches in these.
– Agree closing balance of the loan to the trial balance and draft financial statements and that the disclosure is adequate, including any security provided, that the loan is disclosed as a current liability and disclosure is in accordance with accounting standards and local legislation.
Describe the procedures which the auditor of Elounda Co should perform in assessing whether or not the company is a going concern.
Going concern procedures
– Obtain Elounda’s cash flow forecast and review the cash in and out flows. Assess the assumptions for reasonableness and discuss the findings with management to understand if the company will have sufficient cash flows to meet liabilities as they fall due.
– Discuss with management their ability to settle the next instalment due for repayment to the bank and the lump sum payment of $800k in January 20X7 and ensure these have been included in the cash flow forecast.
– Review current agreements with the bank to determine whether any key ratios or covenants have been breached with regards to the bank loan or any overdraft.
– Review the company’s post year-end sales and order book to assess the levels of trade and if the revenue figures in the cash flow forecast are reasonable
– Review post year-end correspondence with suppliers to identify whether any restrictions in credit have arisen, and if so, ensure that the cash flow forecast reflects the current credit terms or where necessary an immediate payment for trade payables.
– Enquire of the lawyers of Elounda Co as to the existence of litigation and claims; if any exist, then consider their materiality and impact on the going concern basis.
– Perform audit tests in relation to subsequent events to identify any items which might indicate or mitigate the risk of going concern not being appropriate.
– Review the post year-end board minutes to identify any other issues which might indicate financial difficulties for the company.
– Review post year-end management accounts to assess if in line with cash flow forecast and to identify any issues which may be relevant to the going concern assessment.
– Consider whether any additional disclosures as required by IAS 1 Presentation of Financial Statements in relation to material uncertainties over going concern should be made in the financial statements.
– Obtain a written representation confirming the directors’ view that Elounda Co is a going concern.