5、(a) Discuss the three types of misstatement identified in ISA 450 Evaluation of Misstatements Identified During the Audit and comment on why it is important for the auditor to consider the type of misstatement when evaluating their effect on the financial statements and determining the further actions to be taken. (5 marks)
(b) You are responsible for the audit of Basking Co, a large, listed package delivery company. The audit of the financial statements for the year ended 31 July 2017 is nearly complete and you are reviewing the audit working papers. The financial statements recognise revenue of $56,360 million (2016 – $56,245 million), profit for the year of $2,550 million (2016 – $2,630 million) and total assets of $37,546 million (2016 – $38,765 million).
The uncorrected misstatements identified during the audit of Basking Co are described below. The audit engagement partner is holding a meeting with the management team of Basking Co next week, at which the uncorrected misstatements will be discussed.
(1) The accuracy of the depreciation charge was investigated for a sample of motor vehicles with a carrying value of $4·5 million. The investigation revealed that the accounting system had failed to correctly depreciate vehicles acquired during the year. Consequently, depreciation in the sample had been understated, and the carrying value of the vehicles overstated, by $350,000. The total value of all motor vehicles at the year end was $125 million (2016 – $131 million).
(2) In January 2017, the board of Basking Co approved a loan to, Mrs C Angel, who is a key member of the senior management team of the company. The total amount of the loan was $75,000. Following a review of the board minutes, it was discovered that the directors agreed that the amount was clearly trivial and have, therefore, not disclosed the loan in the notes to the financial statements.
(3) During the year Basking Co reduced the value of their provision for customer refunds which is recognised in the financial statements. For the past five years the value of the provision has been calculated based on 7% of one month’s sales, using an average monthly sales value. Management argued that due to improved internal processing systems, such a high rate of provision was no longer necessary and reduced it to 4%. Audit procedures found that refund levels were similar to previous years and there was insufficient evidence at this early stage to confirm whether the new system was more effective or not.
Required:
For each of the matters described above:
(i) Explain the matters which should be discussed with management in relation to each of the uncorrected misstatements, and
(ii) Assuming that management does not adjust the misstatements identified, evaluate the effect of each on the audit opinion.
Note: The total marks will be split equally between each matter. (15 marks)
(a) Types of misstatement
ISA 450 Evaluation of Misstatements Identified During the Audit identifies three types of misstatement:
1. Factual misstatements,
2. Judgemental misstatements, and
3. Projected misstatements.
It is important for the auditor to consider the type of misstatement as the nature of an identified misstatement will have a significant impact on the auditor’s evaluation of the misstatement and any consequent further actions necessary in response.
When the auditor discovers a factual misstatement, where there can be no doubt over the error, there is little room for discussion with management. Once a factual misstatement, such as a miscalculation of depreciation, has been established, management should be asked to correct it.
With regard to judgemental misstatements, the validity of the auditor’s opinion and any consequent corrections recommended by the auditor are more open to debate. It is therefore vital that in such matters the auditor compiles sufficient evidence to justify why they believe management’s judgement is inappropriate in a specific circumstance. Without this weight of evidence to support their position, it is unlikely that management will accept the auditor’s view. Even with sufficient evidence, management may still disagree with the auditor’s opinion and refuse to accept their judgement in a specific matter. This heightens the risk that the auditor makes an inappropriate conclusion and, ultimately, that they issue an incorrect auditor’s report. If material matters of this nature are identified, it is vital that they are considered by a suitably senior member of the audit team.
Projected misstatements assume that an error identified in a sample may be repeated throughout the whole population. The smaller the size of the population originally tested, the lower the validity of this assumption. Clearly the auditor should not recommend the correction of a projected misstatement. These should be used by the audit team to determine the potential for a material misstatement in the wider population being tested and this should guide their decisions as to whether they need to extend their testing.
(b) (1) Depreciation charge
Matters
The error identified in the sample represents less than 0·001% of total assets and less than 0·02% of profits. In isolation the error is therefore immaterial.
The error is, however, limited to the sample audited, which represents only 3·6% of total vehicles. If the error is extrapolated to the whole population, it could potentially lead to a total error of $9·7million (0·35m/4·5m x 125m). This represents 0·03% of total assets and 0·4% of profits; and it would seem that the potential error is therefore also not material to the financial statements. The auditor should ensure that they understand how the error has occurred and if the error is isolated, for example, to a certain category of asset, as there is scope for the error to be greater depending on how the miscalculation has occurred.
Regardless of the immateriality of the projected misstatement, there is still a factual, known error in the financial statements. Management should be asked to correct the error in relation to the depreciation of newly acquired assets.
Management should be asked to make the corrected non-current asset register available to the audit team so that they are able to audit the revised register to determine its accuracy.
Furthermore, the auditor should seek evidence that, as well as correcting the error in the financial statements, the relevant system has been corrected to ensure that all new non-current asset purchases are correctly depreciated in the future so that it does not affect subsequent periods.
Opinion
If management refuses to amend the valuation of motor vehicles, then assets and depreciation will both be misstated by an immaterial amount.
As long as the auditor is satisfied that the source of the error has been corrected and this is not an ongoing issue which will effect subsequent periods, the auditor would issue a standard, unmodified audit opinion, stating that the financial statements are fairly presented in all material respects.
(2) Loan
Matters
The loan represents a related party transaction as it is between the company and one of its key management personnel.
The value of the loan may be trivial; it certainly is not material to the financial statements by value. Regardless, related party transactions are material by nature. In these circumstances, the directors of the company may be abusing their position and power for their own personal gain and it is likely that the loan is being provided to Mrs Angel on favourable or non-commercial terms.
For this reason, details relating to the loan must be disclosed in the financial statements, including the amount of the loan, who the loan has been made to and the amount outstanding at the end of the year.
The auditor in this circumstance will disagree with the judgement applied by management in their application of IAS 24 Related Party Transactions and the auditor should request that the additional disclosures are added to the financial statements.
Opinion
If management refuses to make the recommended adjustments to the financial statements, then the auditor will conclude that the financial statements are materially misstated due to a lack of appropriate disclosure. While the adjustment is material by nature, a lack of disclosure is unlikely to be considered to be pervasive to the financial statements as a whole.
In these circumstances the auditor should issue a qualified opinion, stating that ‘except for’ the matters identified the financial statements are fairly presented.
(3) Provision
A provision for 7% of one month’s sales would total $328 million ($56,360m/12 x 7%). Reducing it to 4% would create a provision of $188 million ($56,360m/12 x 4%). As a result of the change in calculation, the amount of the provision would be reduced by $140 million.
As well as reducing the provision recognised on the statement of financial position, the release of the provision would also increase the profit reported by $140 million. At 5·5% of profit and 0·37% of total assets, the adjustment is material to the statement of profit or loss but not to the statement of financial position.
This is clearly a matter of judgement. The change must, however, be reasonable and supported by evidence that it is more appropriate to the circumstances of the business. The audit team has found no evidence to support the change made by management.
The risk associated with this is heightened because the release of provisions is a known earnings management technique and Basking Co has suffered a reduction in profits this year. The auditor must apply professional scepticism in these circumstances and be aware that management may be using this as a device to restore profits to help achieve their annual targets.
In these circumstances, it would be appropriate to ask the management team of Basking Co for some form of evidence that the change to their system will lead to a lower rate of refunds. In the absence of any evidence the auditor should explain that the change is purely speculative and as it appears to be unjustified at the present time, that Basking Co should revert back to the original provision until there is evidence of improved effectiveness.
Opinion
If management refuses to amend the provision, it is likely that the auditor will conclude that the financial statements are materially misstated. In isolation it is unlikely that the auditor will conclude that this is a pervasive matter as it has limited impact on the financial statements as a whole.
In these circumstances, the auditor should issue a qualified opinion, stating that ‘except for’ the matters identified the financial statements are fairly presented.