Briefing notes
To: Audit engagement partner
From: Audit manager
Subject: Rick Group – Audit planning
Introduction
These briefing notes are prepared to assist with planning the audit of the Rick Group (the Group) for the financial year ending 30 September 20X5. The notes contain an evaluation of the audit risks, which should be considered in planning the Group audit. The notes also evaluate the audit strategy, which has been prepared by Neegan Associates for the audit of Daryl Co and recommend further audit procedures to be performed by the component auditors. Finally, the briefing notes address the issue of a potential joint audit, should a new subsidiary be acquired in Farland next year.
(a) Audit risk evaluation
Annual incentive scheme
The amount to be recognised in respect of the annual incentive scheme could be material given that the bonus can be as much as 5% of employees’ salary. Based on prior year’s figures, the total bonus payable would have been $8·2 million, representing 14% of prior year’s profit before tax, and therefore material to the financial statements.
The annual incentive scheme gives rise to an inherent risk at the financial statement level. Employees whose bonus payment is linked to profitability have an incentive to maximise profit, and given that senior executives are involved with the scheme, there is a risk of management bias in the financial statements. The audit team should therefore be alert to situations where revenue could be overstated and expenses understated.
There is also an audit risk relating to the obligation for the Group to pay the bonus, which should be recognised as an accrual at the year end. There is a risk that the liability recognised is over or understated in value given the potential complexity involved in calculating the bonus payment, the calculation of which is based on a range of selected targets for different employees.
Legal case
In January 20X5, a legal case was brought against the Group. From the information provided, it is not possible to determine if it is material, however, there should be appropriate consideration as to whether the court case gives rise to an obligation at the reporting date.
According to IAS^® 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised as a liability if there is a present obligation as a result of past events which gives rise to a probable outflow of economic benefit which can be reliably measured. There is therefore an audit risk that if any necessary provision is not recognised, liabilities and expenses will be understated.
If there is a possible obligation at the reporting date, then disclosure of the contingent liability should be made in the notes to the financial statements. There is a risk of inadequate disclosure if the Group finance director refuses to make appropriate disclosure in the notes – this is an audit risk whether the situation gives rise to a provision or a contingent liability, as provisions also have disclosure requirements which may not be complied with.
Group finance director’s attitude
There may be a further issue related to the legal case regarding the attitude of the Group finance director, who appears to have dismissed the accounting implications of the legal case and is reluctant to discuss the matter with the audit team. This could indicate that the Group finance director is deliberately obstructing the work of the audit team, and perhaps has something to hide. This indicates a potential wider issue, that the Group finance director is imposing a limitation on the scope of the audit. The Group audit strategy should consider this issue, and the audit engagement partner may wish to discuss the issue with the Group audit committee as a matter of urgency.
This increases the risk that the legal claim will not be recognised appropriately in the financial statements, and the audit team must approach this issue with a heightened degree of professional scepticism.
There may be other areas in which professional scepticism should be applied, for instance, in respect of the amortisation of intangible assets, which will be discussed later in the briefing notes, and where the Group finance director appears to be using inappropriate justifications for the Group’s accounting treatment of licence fees.
Daryl Co – local accounting rules
Daryl Co is a significant component of the Group, with its assets equating to 17·9% of the Group’s total projected assets.
This company is the only component of the Group which does not use IFRS^® Standards as its financial reporting framework. Daryl Co’s financial statements will be prepared under local accounting rules and audited by Neegan Associates on that basis. In accordance with IFRS^® 3 Business Combinations, for the purpose of consolidation the Group’s accounting policies must be applied to all balances and transactions which form part of the consolidated financial statements. There is an audit risk that the Group’s policies are not applied correctly, meaning that the amounts consolidated in respect of Daryl Co are not recognised, measured or disclosed appropriately.
Daryl Co – possible impairment
The goodwill in relation to Daryl Co is material to the Group financial statements, at 4·9% of total assets.
According to IAS 36 Impairment of Assets, goodwill should be tested for impairment annually, which is the Group’s accounting policy. The audit strategy prepared by Neegan Associates indicates that Daryl Co is loss making this year, which is an indication of impairment. Therefore management will need to factor this into their impairment review. As the Group’s performance in the past has been strong, no goodwill impairment has been recognised, and management may lack experience in dealing with a loss-making subsidiary as part of their impairment testing. There is also an incentive for impairment losses not to be recognised, due to the annual incentive scheme which is based on profit.
For these reasons, there is an audit risk that goodwill could be overstated, and expenses understated, if any necessary impairment loss is not correctly determined and recognised.
Reliance on component auditors
Given the materiality of Daryl Co, the Group audit team needs to consider the extent of reliance which can be placed on the audit of the company conducted by Neegan Associates. The independence and competence of Neegan Associates will need to be evaluated by the Group audit team, though presumably as the audit firm already has experience of Neegan Associates from previous years’ audits, this evaluation will already have been performed. However, independence is threatened by the fact that Neegan Associates has been engaged in providing a non-audit service to Daryl Co since 1 October 20X4. This matter is discussed further in the section of the briefing notes dealing with the component auditor’s strategy. Any material misstatements which may remain uncorrected in Daryl Co will impact on the consolidated financial statements, leading to audit risk at the Group level.
Post year-end acquisition of Michonne Co
The acquisition of Michonne Co is planned to take place within a month of the reporting date. It is therefore a significant event which is taking place after the year end and as such, it falls under the scope of IAS 10 Events After the Reporting Period. According to IAS 10, a non-adjusting event is an event which is indicative of a condition which arose after the end of the reporting period, and which should be disclosed if they are of such importance that non-disclosure would affect the ability of users to make proper evaluations and decisions. The required disclosure includes the nature of the event and an estimate of its financial effect or a statement that a reasonable estimate of the effect cannot be made. In addition, IFRS 3 requires disclosure of information about a business combination whose acquisition date is after the end of the reporting period but before the financial statements are authorised for issue.
There is therefore an audit risk that the disclosure in relation to the acquisition of Michonne Co is not complete or accurate.
Trend in revenue
The financial information shows that total revenue is projected to increase by 25·6% this financial year. This is a significant increase and it could indicate that revenue is overstated. However, the number of subscription members is projected to increase by 30·1%, so possibly the increase in revenue is simply as a result of the Group attracting more customers – but this is a very significant increase and will need to be substantiated.
However, when looking at revenue per customer per year, this is projected to fall from $96·65 in 20X4 to $93·33 in 20X5. Revenue per customer per month is therefore projected to fall from $8·05 in 20X4 to $7·78 in 20X5. These trends seem to contradict the introduction of the new premium subscription package, which should bring in additional revenue per customer. Possibly the premium subscription has not been taken up by many customers. It is, however, unusual to see a downwards trend in revenue per customer per month, given that the price of a regular subscription has remained the same as in the previous year, at $8·20 per month. Possibly the figures are impacted by the free trial period offered to new customers. These trends will need to be investigated to ensure that revenue is being measured appropriately and recognised at the correct point in time.
There is also a risk arising from the Group invoicing customers in advance, with revenue recognised when the bill is sent to the customer. Possibly this could lead to early recognition of revenue, i.e. recognising prior to the Group providing a service to its customers. IFRS 15 Revenue from Contracts with Customers requires that revenue is recognised when a performance obligation is satisfied by transferring a promised good or service to a customer, and when providing a service over time, it can be difficult to determine how much service has been provided and therefore the amount of revenue which can be recognised at a particular point in time. There is therefore a risk of overstatement of revenue if the requirements of IFRS 15 are not adhered to.
Amortisation of licences
The licences recognised as intangible assets are highly material to the Group, representing 74·4% of total assets. Given that each licence is for a fixed period, it is appropriate to amortise the cost of each licence over that fixed period in accordance with IAS 38 Intangible Assets, which requires that the cost of an intangible asset with a finite useful life should be amortised on a systematic basis over its life.
Therefore, the Group’s accounting policy to amortise all licences over a five-year period may be too simplistic, especially given the significance of the balance to the Group financial statements. Some of the licences have a shorter life, as the licences vary between three and five years, indicating that the determination of amortisation for the class of assets as a whole may not be accurate, leading to overstatement of intangible assets and overstatement of profit.
The finance director’s assertion that the accounting policy is ‘the most prudent’ is not appropriate. The accounting policy should be based on the specific, relevant IAS 38 requirements. It could be a means of earnings management, i.e. to minimise the amortisation charge and maximise profits.
The auditor should also consider whether this issue has arisen in previous years’ audits. The Group may have changed its estimation technique with regard to amortisation of intangible assets; if this is the case, the rationale for the change must be understood.
(b) (i) Evaluation of component auditor’s audit strategy
Materiality
ISA 320 Materiality in Planning and Performing an Audit acknowledges that the determination of materiality involves the exercise of professional judgement. There are no set rules about how a level of materiality should be arrived at. A percentage is often applied to a chosen benchmark as a starting point in determining materiality for the financial statements as a whole, and it is acceptable to use a benchmark of 1% of total assets as a basis for materiality. However, this would normally be used for a capital-intensive business, not for a company like Daryl Co, which is service based.
A percentage of profit is deemed an appropriate method of calculating materiality in a profit-making business. However, as we have seen with Daryl Co, this can be distorting in a year of significant losses. It is not common to ignore materiality based on profit or revenue completely. The fact that the company has made a loss this year does not mean that materiality should be based on assets alone.
Neegan Associates should revisit how materiality has been determined. It may be appropriate to use a different materiality level for profit and loss balances, for example, one based on revenue or an adjusted profit figure is more appropriate than the reported profit (or loss) before tax. ISA 320 states that where circumstances give rise to an exceptional decrease or increase in profit, the auditor might conclude that materiality for the financial statements as a whole is more appropriately determined using a normalised profit before tax from continuing operations figure based on past results.
The fact that materiality has been set at a higher level this year is not likely to be appropriate given that the company is loss making and facing unusual trading conditions with the loss of many customers. This indicates that the audit is likely to be higher risk, so a lower level of materiality should be applied and as such implies that appropriate professional judgement has not been applied.
There must be full documentation of how materiality has been determined on the audit file. This should cover the rationale for determining different materiality levels which have been decided upon for different classes of transaction and balances.
Audit of payroll
The audit work planned on payroll appears to be limited due to the audit firm, Neegan Associates, having performed a payroll service for Daryl Co since 1 October 20X4. This is not appropriate and will not provide sufficient and appropriate audit evidence regarding the $6 million payroll expense. Given that payroll is material to the company’s financial statements, based on Neegan Associates’ own materiality threshold of $1·4 million, further testing will be required.
An ethical threat to auditor’s independence is raised by the provision of the payroll service to the client. There is a significant self-review threat which means that Neegan Associates is over-relying on the work they have performed on payroll as a non-audit engagement and are not planning to audit the $6 million at all.
Providing this type of non-audit service might be allowed in the jurisdiction where Neegan Associates operates. However, according to ISA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors), when performing work on the financial information of a component for a group audit, the component auditor is subject to ethical requirements which are relevant to the group audit. Such requirements may be different or in addition to those applying to the component auditor when performing a statutory audit in the component auditor’s jurisdiction.
Therefore, the IESBA International Code of Ethics for Professional Accountants (the Code) should be applied. The Code states that for a listed company, a firm shall not provide accounting or bookkeeping services, including payroll services, which results in financial information which forms the basis of financial statements on which the firm will provide an opinion. Therefore, as Daryl Co is listed, the service should not have been provided.
There also needs to be discussion of the situation with Neegan Associates and the management of Daryl Co and the Group, with the objective of ensuring that an alternative provider is found for the payroll accounting services.
Sale of property
In the individual financial statements of Daryl Co, under local accounting rules the sale of property to the Group chief executive officer (CEO) does not need to be disclosed. However, from the Group perspective, it meets the definition of a related party transaction under IAS 24 Related Party Disclosures, and will need to be disclosed in the consolidated financial statements. As the transaction would also be considered to be material by nature, the Group audit team must therefore provide instructions to Neegan Associates on the additional audit work to be performed which will enable sufficient and appropriate evidence to be obtained in respect of the transaction and disclosure. These procedures will be outlined in the next section of these briefing notes.
The cash proceeds arising on the sale of the property are well below the materiality level determined by Neegan Associates, so this might justify the minimal audit procedures which have been planned in relation to the individual financial statements. However, the procedures do not consider how the profit or loss being made on the disposal is determined or whether the asset has been properly removed from the accounting records. The carrying amount of the asset itself may be material to the financial statements of the company.
There may be an incentive to recognise a higher profit than is appropriate on this transaction due to trading difficulties encountered by the company during the year, so the transaction may be at risk of material misstatement with the objective of maximising the profit recognised.
There is no evidence that the transaction is bona fide – the CEO has not yet paid for the property and the whole transaction could be an attempt to window dress the financial statements. Overall, this evaluation has indicated that there are problems in how Neegan Associates has planned the audit of Daryl Co. The audit work which is planned will not provide sufficient, appropriate audit evidence in relation to the issues identified.
Therefore the Group audit team will need to consider the overall planning of the audit of Daryl Co and the level of testing they subsequently request that Neegan Associates carries out to satisfy themselves of the accuracy of the figures presented in Daryl Co’s financial statements for inclusion in the consolidated financial statements.
(ii) Audit procedures on sale of property
– Review board minutes to see if the property sale has been deliberated, i.e. has the rationale for the transaction been discussed, and formally approved by the company’s board.
– Agree the $50,000 sale price to the legal documentation relating to the sale of the property to the Group CEO.
– Confirm the carrying amount of the property at the date of disposal to underlying accounting records and the non-current asset register.
– Confirm that the asset has been removed from the company accounts at the date of disposal.
– Obtain management’s determination of profit or loss on disposal, re-perform the calculation based on supporting evidence, and agree the profit or loss is recognised appropriately in the company statement of profit or loss.
– Obtain an estimate of the fair value of the property, for example, by comparison to the current market price of similar properties and consider the reasonableness of the transaction and sale price.
– Obtain written representations from company management that all matters related to this related party transaction have been disclosed to the Group management and to the Group audit team.
– Obtain written representation from the Group CEO regarding the transaction, to confirm the amount which is outstanding, and the likely timescale for payment.
– Review cash receipts after the reporting date to confirm whether or not the $50,000 has been received from the Group CEO.
(c) Discussion and justification for a joint audit of Michonne Co
In a joint audit, two or more audit firms are responsible for conducting the audit and for issuing the audit opinion. The main advantage of a joint audit of Michonne Co is that the local audit firm’s understanding and experience will be retained, and that will be a valuable input to the audit. At the same time, Atlanta & Co can provide additional skills and resources if necessary.
Farland may have different regulations to the rest of the Group, for example, there may be a different financial reporting framework. It therefore makes sense for Lucille Associates, the local auditors, to retain some input to the audit as they will have detailed knowledge of such regulations.
The fact that the company is located in a distant location means that from a practical point of view it may be difficult for Atlanta & Co to provide staff to perform the majority of the audit work. It will be more cost effective for this to be carried out by local auditors.
Two audit firms can also stand together against aggressive accounting treatments. In this way, a joint audit can enhance the quality of the audit. The benchmarking which takes place between the two firms raises the level of service quality.
Disadvantages of a joint audit of Michonne Co
The main disadvantage is that for the Group, having a joint audit is likely to be more expensive than appointing just one audit firm. However, the costs are likely to be less than if Atlanta & Co took sole responsibility, as having the current auditors retain an involvement will at least cut down on travel expenses. Due to the size of the respective firms, Lucille Associates will probably offer a cheaper audit service than Atlanta & Co.
For the audit firms, there may be problems in deciding on responsibilities, allocating work, and they will need to work very closely together to ensure that no duties go underperformed, and that the quality of the audit is maintained. There is a risk that the two firms will not agree on a range of matters, for example, audit methodology, resources needed and review procedures, which would make the working relationship difficult to manage.
Problems could arise in terms of liability because both firms have provided the audit opinion; in the event of litigation, both firms would be jointly liable. While both of the firms would be insured, they could blame each other for any negligence which was discovered, making the litigation process more complex than if a single audit firm had provided the audit opinion.
Recommendation
On balance, the merits of performing a joint audit outweigh the possible disadvantages, especially if the two audit firms can agree on the division of work and pool their expertise and resources to provide a high-quality audit.
Conclusion
The briefing notes indicate that there are several significant audit risks to be addressed, in particular, there are risks relating to the foreign subsidiary and relating to the revenue and the accounting treatment applied to intangible assets. In respect of the component audit firm, there are some concerns over the adequacy of their audit planning, which will need further consideration in developing the Group audit strategy. Finally, performing a joint audit on Michonne Co appears to be a good way to perform a high-quality audit on this new subsidiary.