Briefing notes
To: Kerry Dunker, audit engagement partner
From: Audit manager
Subject: Bassett Group audit planning
Introduction
These briefing notes relate to the audit planning of the Bassett Group (the Group) for the year ending 30 April 2018. As requested, the notes contain an evaluation of the audit risks which should be considered in planning the Group audit, including an initial assessment of specific areas where the audit team should exercise professional scepticism. The notes also assess whether Borzoi Co, the Group’s foreign subsidiary, is a significant component of the Group. We will be working with a component auditor, Saluki Associates, and these notes discuss the extent of involvement which our firm should have with the audit risk assessment to be performed by Saluki Associates on Borzoi Co.
(a)    (i) and (ii) Audit risk and application of professional scepticism
New audit client
This is the first year that our firm has audited the Group. This gives rise to detection risk, as our firm does not have experience with the client, making it more difficult for us to detect material misstatements. However, this risk can be mitigated through rigorous audit planning, including obtaining a thorough understanding of the business of the Group.
In addition, there is a risk that opening balances and comparative information may not be correct. There is no reason for this to be a particularly high risk, as the previous auditor’s opinions have been unmodified for the last four years. However, because the prior year figures were not audited by Whippet & Co, we should plan to audit the opening balances carefully, in accordance with ISA 510 Initial Audit Engagements – Opening Balances, to ensure that opening balances and comparative information are both free from material misstatement.
Pressure on results
The Group is a listed entity, and the results of the preliminary analytical review indicate that there is a reduction in total Group revenue of 3·2%. The book publication operating segment has the most significant reduction in revenue of 6·7%. Pressure from shareholders for the Group to return a better performance creates an incentive for management bias, especially given the significant investment in new software which has been made – shareholders will want to see a return on that investment. This means that management may use earnings management techniques, or other methods of creative accounting, to create a healthier picture of financial performance than is actually the case. This creates an inherent risk of material misstatement, at the financial statement level.
This means that the audit team should apply professional scepticism to areas of the audit where the accounting is subject to management’s judgement, especially if the accounting treatment which has been applied results in the acceleration or inflation of revenue, or the deferral of expenditure.
Operating segments
As the Group is a listed entity, it will be required to disclose information in the notes to the financial statements in accordance with IFRS® 8 Operating Segments. There is an audit risk that the disclosure may be inaccurate, or incomplete, or that it does not reflect the way information on financial performance is monitored internally by the chief operating decision maker, as required by IFRS 8. For instance, the fact that two of the three reported operating segments are showing a drop in performance while the other shows improvement could indicate inaccuracy in the information. In addition, if management is monitoring separately the performance of digital and non-digital sources of income, and if digital sales become significant in their own right, then this may need to be disclosed as a separate operating segment.
Professional scepticism should be applied to the audit of operating segments; due to management bias, the allocation of revenue, expenses and assets between segments could be subject to manipulation, for example, to mask the declining performance of the book and newspaper and magazine operating segments. Allocation is determined by management, and this judgement should be approached with scepticism, especially given the potential lack of integrity displayed by the CFO as indicated by the communication from Grey & Co.
Internally developed software
The group financial statements recognise $10 million which has been capitalised in respect of internally developed software. This is equivalent to 10·5% of Group assets and the amount is therefore material to the financial statements. An audit risk arises in that the requirements of IAS® 38 Intangible Assets might not have been followed. Software development costs can only be capitalised if they meet the capitalisation criteria, including that a future economic benefit can be demonstrated and that technical and commercial feasibility of the asset have been established. If these criteria have not been met, then the development costs should be expensed. In addition, the Group may not have distinguished appropriately between research and development costs. If research costs have been included in the amount capitalised then it is overstated, because research costs must always be expensed.
This is an area where professional scepticism should be applied, both in relation to management’s assertion that the software costs meet the necessary conditions for capitalisation, and in relation to the distinction, if any, which has been made between research and development costs. There is a risk that profit is overstated by a material amount if the accounting treatment is incorrect.
Impairment
Management is not planning to test the cash generating units for impairment, giving rise to a significant audit risk. Regardless of impairment indicators, goodwill must be tested for impairment each year according to IAS 38, and given that the Group has over 20 subsidiaries, it is likely that there is goodwill recognised in the consolidated statement of financial position and allocated into the cash generating units, meaning that they must be tested for impairment on an annual basis.
In addition, the reduction in revenue for the Group as a whole, and for the newspapers and magazines and books operating segments specifically, is an indicator of potential impairment. This should trigger an impairment review even if there is no goodwill allocated to the cash generating units. Management’s justification for not conducting an impairment review is wholly inappropriate and if an impairment review is not conducted and any necessary impairment loss not recognised, then profit and assets will be overstated, possibly by a material amount.
Again, this is an area where the audit team will need to apply professional scepticism, and challenge management on their assumption that an impairment review is not needed. Management’s reluctance to conduct an impairment review could be due to management bias and the pressure to return a healthy profit to shareholders.
Publication rights
The publication rights are recognised as an intangible asset with a carrying amount of $7·9 million, representing 8·3% of total assets. This is material to the financial statements. It is appropriate that the publication rights are amortised, as they have a finite life. However, the period over which they are amortised may not be appropriate. The Group accounting policy is to amortise over an average of 25 years, but the actual period to which the rights relate varies from five to 30 years. Therefore while it may be appropriate to use an average for the basis of an accounting policy, it means that some rights are being amortised over much too long a period, overstating intangible assets and understating expenses.
Management could be using this 25-year average period as a way of smoothing profits and managing earnings. The accounting policy may not be appropriate, and the audit team will need to be sceptical in relation to the appropriateness of the policy, and challenge management on its use.
Author royalty advances
The royalty advances recognised within current assets amount to $3·4 million, which is material at 3·6% of total assets. Deferring the cost, effectively treating it as a prepayment, seems to be appropriate. However, the Group accounting policy should be challenged by the audit team. Releasing the cost over a ten-year period seems to have no suitable justification and appears to be quite simplistic. While industry practice can be used to develop accounting policies, the Group must consider the specific period of amortisation relevant to its publications, and not shape its accounting policies simply based on the actions of its competitors in the market, who might have very different types of publications providing economic benefit over a different period. Presumably some books published by the Group will have a much shorter life than ten years, in which case the advance royalty payment should be spread over a shorter period.
Similar to the point raised previously in relation to the accounting treatment of the publication rights, management could be using this ten-year average period as a way of smoothing profits and managing earnings. Again, the accounting policy may not be appropriate, and the audit team will need to be sceptical in relation to the appropriateness of the policy, and challenge management on its use.
Borzoi Co – foreign currency retranslation
In order to be consolidated into the Group, the financial statements of Borzoi Co will need to be retranslated from its local currency, the Oska, into $, in accordance with IAS 21 The Effects of Changes in Foreign Exchange Rates. IAS 21 requires that assets and liabilities are translated at the closing exchange rate at the reporting date, while income and expenses are translated at the exchange rates at the dates of the transactions. The fact that the currency has been volatile over the last six months and could remain volatile for the rest of the year means that the retranslation of income and expenses is problematical; it is potentially complex and prone to contain errors, giving rise to risk of material misstatement given that Borzoi Co is a significant component of the Group (this will be discussed in more detail later in these briefing notes).
Transfer of software
The transfer of software gives rise to several audit risks. First, there is a risk that the software was overvalued when it was transferred from Bassett Co to Borzoi Co. The fair value which was recognised in the parent company accounts immediately prior to the transfer of the asset was determined by Group management, and while revaluation is permitted by IAS 38 where an active market for the asset exists, this fair value could be inappropriate. In the absence of an active market, it is unlikely the revaluation should have been recognised at all. There is a significant difference between the carrying amount of the software and the fair value determined by management, $1 million and $5·4 million respectively, giving rise to a revaluation of $4·4 million which was recognised by Bassett Co immediately prior to the transfer. The audit risk is that in the parent company, the revaluation should not have been recognised, or, if revaluation is appropriate, the amount recognised was based on an inappropriate value. In the individual financial statements of Borzoi Co, the asset could be overstated in value. Any overstatement of the asset has implications for subsequent amortisation charges, which would also be overstated in the financial statements of Borzoi Co.
The audit team should approach this issue with appropriate professional scepticism – the revaluation of the software will need to be justified by management as it could be a mechanism being used by Group management to inflate the assets of Borzoi Co and the Group as a whole. The audit team should also challenge the assertion made by management that a sufficiently active market exists to enable a reliable and realistic fair value to be determined for the software.
At Group level the transfer is an intercompany transaction and the consolidated financial statements should be prepared as if the transaction had not occurred. This is an additional and separate audit risk from the risk that the valuation of the asset is not appropriate. There is an audit risk if the elimination of the intercompany transaction does not take place as part of the consolidation process. Adjustments should be made to cancel out the intercompany payable and receivable in respect of the $5·4 million which is outstanding between Borzoi Co and Basset Co.
Corporate governance arrangements
The Group CFO blocking access to the audit committee is not acceptable. Corporate governance principles as well as ISA 260 Communication With Those Charged With Governance require that the external auditor should have unrestricted and effective communication with the audit committee and the CFO should not interfere with these communications. This situation could indicate that the CFO has something to hide, and that the control environment within the Group is not strong and this risk is augmented by the points already raised in relation to management bias. Certainly there would not seem to be a good ethical culture if the CFO is acting in this way. In line with corporate governance guidelines, the audit committee is required to assess the effectiveness of the external audit process and a key part of this is likely to be done via the direct communication the auditor and the audit committee have. As such it would appear as though the CFO may lack integrity or possibly does not understand the relevant corporate governance principles and is potentially disrupting the audit committee’s ability to discharge its responsibilities.
In addition, ISA 260 specifies that the auditor should determine the appropriate persons within the entity’s governance structure with whom to communicate. Further as per ISA 210 Agreeing the Terms of Audit Engagements, providing unrestricted access to persons within the entity is one of the preconditions for the audit. As such, the CFO is potentially imposing a limitation on the scope of the audit by not facilitating unrestricted and effective communication with the audit committee and the CFO should therefore not interfere with these communications.
All of these issues increase audit risk and the need for approaching the audit with professional scepticism, especially when dealing with estimates and judgements which have been determined by the CFO.
Tutorial note: Credit will be awarded for other relevant audit risks and associated matters relating to professional scepticism, for example, whether an appropriate amortisation policy has been applied to the software in which the Group had invested during the year, and whether Borzoi Co (and any other subsidiaries) has different accounting policies to the rest of the Group which would require adjustment at consolidation.
(b)    (i) Assessment of whether Borzoi Co is a significant component of the Group
ISA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors) requires the Group auditor to determine whether a component is a significant component. One of the reasons for this is because it determines the type and extent of involvement which the Group auditor should have with the work of the component auditor.
ISA 600 defines a significant component as a component identified by the group engagement team which is of individual financial significance to the group, or which, due to its specific nature or circumstances, is likely to include significant risks of material misstatement of the group financial statements.
ISA 600 suggests that benchmarks such as profit and assets should be assessed when determining significance but it does not require a specific threshold to be used. The standard does suggest that 15% could be an appropriate cut-off point for determining significance.
The total assets of Borzoi Co are 68 million Oska and if retranslated using the current exchange rate of 4 Oska:1$, its assets are $17 million. This represents 17·9% of Group assets and therefore based on the information at today’s date, Borzoi Co is a significant component of the Group.
It is important to note that given the volatility of the Oska currency, the value of the subsidiary may change by the reporting date meaning that it is no longer significant due to its size. However, Borzoi Co could be significant due to its specific nature or circumstances, being the Group’s only foreign subsidiary, which brings specific risks of material misstatement as outlined earlier in these briefing notes. There may also be regulatory or economic issues specific to the company, especially due to the political difficulties in its jurisdiction, which also impact on the Group and give rise to risks. Therefore regardless of its monetary size, it is likely that Borzoi Co will be considered to be a significant component of the Group.
(ii) The extent of involvement which our firm should have with the work of Saluki Associates
When working with a component auditor, the group engagement team should obtain an understanding on a number of matters as required by ISA 600. These matters include the competence of the component auditor, whether the component auditor understands the ethical framework relevant to the Group audit and is independent, and the regulatory environment in which the component auditor operates. The extent of involvement which our firm will have with Saluki Associates depends to an extent on the evaluation of these matters. If there are concerns over the competence, independence or diligence of Saluki Associates or the jurisdiction in which they operate, the level of involvement with their work should be increased in response.
According to ISA 600, if a component auditor performs an audit of the financial information of a significant component, the group engagement team is required to be involved in the component auditor’s risk assessment to identify significant risks of material misstatement of the group financial statements. The nature, timing and extent of this involvement are affected by the group engagement team’s understanding of the component auditor, but at a minimum should include the following:
– Discussing with the component auditor or component management the component’s business activities which are significant to the group;
– Discussing with the component auditor the susceptibility of the component to material misstatement of the financial information due to fraud or error;
– Reviewing the component auditor’s documentation of identified significant risks of material misstatement of the group financial statements. Such documentation may take the form of a memorandum which reflects the component auditor’s conclusion with regard to the identified significant risks;
– Evaluating the component auditor’s communication on matters relevant to the group audit and discuss any significant matters arising from that evaluation with the component auditor, component management or group management as appropriate; and
– Determining whether it is necessary to review other relevant parts of the component auditor’s audit documentation.
The Group audit team may need to have further involvement in the audit of the component where significant risks of material misstatement of the Group financial statements have been identified in a component. In this case, the Group audit team shall evaluate the appropriateness of the further audit procedures to be performed to respond to the identified significant risks of material misstatement of the Group financial statements. Based on its understanding of the component auditor, the Group audit team will then determine whether it is necessary to be involved in the further audit procedures.
Conclusion
These briefing notes indicate a range of audit risks to be considered in planning the Group audit. In particular, there are significant risks of misstatement in relation to intangible assets and a foreign subsidiary. There is also a significant risk of management bias, and the audit will need to be planned and performed with appropriate levels of professional scepticism, especially given that this is a new audit client. Borzoi Co, a foreign subsidiary, is a significant component of the Group and we must have involvement with risk assessment in relation to the planning of its audit.