2、You are the manager responsible for the audit of Thurman Co, a manufacturing company which supplies stainless steel components to a wide range of industries. The company’s financial year ended on 31 July 2016 and you are reviewing the audit work which has been completed on a number of material balances and transactions: assets held for sale, capital expenditure and payroll expenses. A summary of the work which has been performed is given below and in each case the description of the audit work indicates the full extent of the audit procedures carried out by the audit team.
(a) Assets held for sale
Due to the planned disposal of one of Thurman Co’s factory sites, the property and associated assets have been classified as held for sale in the financial statements. A manual journal has been posted by the finance director to reclassify the assets as current assets and to adjust the value of the assets for impairment and reversal of depreciation charged from the date at which the assets met the criteria to be classified as held for sale. The finance director asked the audit senior to check the journal before it was posted on the basis of there being no one with the relevant knowledge to do this at Thurman Co.
The planned disposal was discussed with management. A brief note has been put into the audit working papers stating that in management’s opinion the accounting treatment to classify the factory as held for sale is correct. The manual journal has been arithmetically checked by a different member of the audit team, and the amounts agreed back to the non-current asset register. (9 marks)
(b) Capital expenditure
When auditing the company’s capital expenditure, the audit team selected a material transaction to test and found that key internal controls over capital expenditure were not operating effectively. Authorisation had not been obtained for an order placed for several vehicles, and appropriate segregation of duties over initiating and processing the transaction was not maintained.
The audit team noted details of the internal control deficiencies and updated the systems notes on the permanent audit file to reflect the deficiencies. The audit work completed on this order was to agree the purchase of the vehicles to purchase invoices and to the cash book and bank statement. The rest of the audit work on capital expenditure was completed in accordance with the audit programme. (7 marks)
(c) Payroll expenses
The payroll function is outsourced to Jackson Co, a service organisation which processes all of Thurman Co’s salary expenses. The payroll expenses recognised in the financial statements have been traced back to year-end reports issued by Jackson Co. The audit team has had no direct contact with Jackson Co as the year-end reports were sent to Thurman Co’s finance director who then passed them to the audit team.
Thurman Co employs a few casual workers who are paid in cash at the end of each month and are not entered into the payroll system. The audit team has agreed the cash payment made back to the petty cash records and the amounts involved are considered immaterial. (9 marks)
Required:
In respect of each of the three matters described above:
(i) Comment on the sufficiency and appropriateness of the audit evidence obtained;
(ii) Recommend further audit procedures to be performed by the audit team; and
(iii) Explain the matters which should be included in a report in accordance with ISA 265 Communicating Deficiencies in Internal Controls to Those Charged with Governance and Management.
Note: The split of the mark allocation is shown against each of the matters above.
(a) Assets held for sale
(i) Audit evidence obtained
The evidence does not appear to be sufficient to draw a conclusion on the appropriateness of classifying the property and any other related assets and liabilities as held for sale. A discussion with management regarding the accounting treatment is relevant, as the audit team will need to understand management’s rationale. However, management’s explanation should not be accepted at face value and should be corroborated through further audit procedures. It is not sufficient to simply put management’s justification for the accounting treatment on the audit file and conclude that it is correct. For example, the factory can only be classified as held for sale if it is available for immediate sale in its current condition, which may not be the case.
In terms of the manual journal, checking that it is arithmetically correct, while relevant, is not sufficient evidence. Further evidence should be obtained in order to conclude that the basis of the calculation is in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations and there should be consideration as to whether other requirements of the standard other than those related to the reclassification and measurement of the asset have been complied with. For example, the results specific to the factory may need to be disclosed as a discontinued operation in the statement of profit or loss and the statement of cash flows. No audit evidence appears to have been obtained in respect of these issues.
(ii) Further audit procedures
– Review board minutes to confirm that the sale of the factory has been approved and to agree the date of the approval to the board minutes and relevant staff announcements.
– Obtain correspondence with estate agents to confirm that the factory is being actively marketed.
– Obtain confirmation, for example, by a review of production schedules, inventory movement records and payroll records, that production at the factory has stopped and thus it is available for immediate sale.
– Use an auditor’s expert to confirm the fair value of the property and agree that this figure has been used in the impairment calculation.
– Using management accounts, determine whether the factory is a separate major line of business in which case its results should be disclosed as a discontinued operation.
(iii) Report to those charged with governance
ISA 265 Communicating Deficiencies in Internal Controls to Those Charged with Governance and Management requires the auditor to communicate significant deficiencies in internal control to those charged with governance and management. In deciding whether a control deficiency is significant, one of the matters which should be considered is the importance of the control to the financial reporting process. Controls over the period-end financial reporting process such as controls over non-recurring journal entries can be important as they often deal with one-off material matters which are being accounted for outside the normal accounting system.
Therefore the journal posted by the finance director should be subject to some form of internal control, for example, approval by the board or the audit committee. The report to those charged with governance should recommend that controls are established over period-end journals posted to ensure their accuracy and validity.
In addition, the finance director should not be asking the audit team to check his figures; this could be perceived as a self-review threat to independence. This should potentially be flagged to the audit committee.
The fact that there is, according to the finance director, no one else at the company with relevant knowledge is concerning. The audit committee should be made aware of this and appropriate steps taken to ensure that sufficiently knowledgeable personnel are hired or appropriate training is provided to existing staff.
(b) Capital expenditure
(i) Audit work performed
The audit work has revealed that internal controls have not been operating and this should have led to more extensive testing of capital expenditure, rather than the audit programme being completed as planned. Generally, the audit team should extend audit testing on capital expenditure, for example, by extending sample testing and reducing the level of materiality applied in audit tests.
The audit team should also investigate why the controls are not operating, considering whether they are being deliberately ignored or overridden, whether time pressure or lack of resources is making the controls difficult to operate, or if there is a suspicion of collusion and possible fraud.
The procedures on the purchase of the vehicles do not appear to cover all relevant assertions, for example, there is nothing to confirm that Thurman Co has correctly depreciated the vehicles or that they are actually owned and being used by the company, or even that they exist.
(ii) Further audit procedures
– Obtain the insurance documents to confirm that Thurman Co is paying the relevant insurance for the vehicles.
– Physically verify the vehicles and confirm that they are being used by employees on company business.
– Obtain the log book/vehicle registration document and other relevant ownership documents such as those issued by the vehicle licensing body, to confirm the right of Thurman Co to recognise the vehicles.
– Trace the vehicles to the company’s non-current asset register.
– Recalculate the depreciation which should have been charged on the vehicles and agree to the statement of profit or loss for the year.
(iii) Report to those charged with governance
The auditor should report to those charged with governance that there appears to be a deficiency in internal controls. While the audit team’s findings do not indicate that a fraud is taking place, the lack of segregation of duties and the failure to obtain appropriate authorisation makes it easy for assets to be misappropriated and creates a significant fraud risk.
The audit firm should explain the implications of the control deficiencies to management and recommend improvements. For example, authorisation should be a pre-requisite for any order over a certain monetary amount. Thurman Co should also be encouraged to improve the control environment, for example, by training staff on the importance of controls and setting an appropriate tone at the top so that there is no tolerance of controls being ignored or deliberately circumvented.
(c) Payroll
(i) Audit work
The audit work in respect of the payroll needs to be much more thorough; simply agreeing the amounts to the reports issued by Jackson Co provides no evidence on the completeness, accuracy or validity of the payroll figures recognised in the financial statements. The audit team seems to have relied on Jackson Co’s year-end reports as being accurate and the requirements of ISA 402 Audit Considerations Relating to an Entity Using a Service Organisation do not appear to have been followed.
The audit team needs to obtain assurance on the controls which Jackson Co has implemented in order to assess the risk of material misstatement in the payroll figures and to respond to the risk with appropriate audit procedures. The controls which Thurman Co uses to verify the information received from Jackson Co also need to be understood. With the permission of Thurman Co, the audit team should contact Jackson Co with the objective of obtaining more information which can be used to assess how the payroll has been processed, and the controls which are in place. The controls in place at Thurman Co should be documented and tested.
It is recommended that further substantive procedures should be carried out to provide a wider range of evidence on the payroll expense recognised in the financial statements.
In relation to the casual employees, the fact that the amount involved is immaterial means that the audit team does not need to perform any further detailed audit procedures as there is no risk of material misstatement. However, as there is a risk over the completeness of these costs, the controls in place to ensure this process is effectively managed should be discussed with management and documented.
(ii) Further audit procedures
– Review the service agreement between Thurman Co and Jackson Co to understand the exact work which is conducted by Jackson Co as a service organisation.
– Read all reports made by Jackson Co during the year to identify any risks of misstatement in the payroll figure.
– Discuss and document relevant controls in place at Thurman Co over the information received from Jackson Co and the management of casual employees, and perform tests of controls on a sample basis.
– The amount of unpaid taxes in respect of the casual workers should be quantified by recalculations of the amounts due.
– Read any user manuals or systems overviews to assess the efficacy of controls in place over the processing of payroll.
– If necessary, obtain a type 1 or type 2 report from Jackson Co to obtain further assurance on the controls which the service organisation has in place.
– Perform a substantive analytical review on payroll, preparing an auditor’s expectation of the payroll figures and comparing it to that recognised in the financial statements and discussing any variance with management.
– Perform test of detail by selecting a sample from the payroll records and agreeing the amounts to payslips and HR records.
(iii) Report to those charged with governance
The fact that casual employees are being paid from petty cash without being put onto the company’s payroll indicates that Thurman Co may not be complying with relevant regulations, for example, that appropriate payroll taxes are not being paid. Despite the amounts involved being immaterial, the potential non-compliance should be reported to those charged with governance, along with a recommendation that all employees, whether casual or not, should be processed through the company’s payroll system. There may be implications for the financial statements if fines or penalties are imposed by the tax authorities in respect of the non-compliance.