Briefing notes
To: Ben Duval, Audit engagement partner
From: Audit manager
Subject: Audit planning for Margot Co
Introduction
These briefing notes are prepared in respect of audit planning for our client Margot Co, with a financial year ending 30 June 20X9. The notes begin with an evaluation of the significant risks of material misstatement which should be considered in planning the audit. The notes then contain the audit procedures which have been designed in relation to two matters – the impairment of property, plant and equipment and capitalised development costs. A discussion is provided on the use of an auditor’s expert in the audit of the company’s biological assets. Finally, a member of the client’s staff has alerted us to some suspicious behaviour, which could indicate a breach of law and regulations. The notes discuss this issue and recommend actions to be taken by our firm.
(a) Evaluation of significant risks of material misstatement
 Results from preliminary analytical procedures
The limited analytical procedures which have been performed indicate several potential risks of material misstatement. First, the current ratio has increased significantly, from 1·4 in 20X8, to a projected figure of 2·6 in 20X9. Using the information provided, the current liabilities in 20X8 were $1·564 million ($2·19 million/1·4) and are projected to be $1·288 million in 20X9 ($3·35 million/2·6).
Current assets are projected to increase by 53% and current liabilities projected to reduce by 17·6%. Given that the management accounts show that the cash balance is relatively static, there is a risk that other current assets, presumably inventory and receivables, could be overstated. However, the increase in current assets can at least partly be explained by the inclusion of the $450,000 prepayment relating to restoring the damaged factory; this is discussed in more detail later in the briefing notes. There is also a risk that the current liabilities are understated; this risk is particularly significant given that according to the finance director, current liabilities includes a provision of $450,000 in relation to restoring the damaged factory.
The projected movement in the gearing ratio is small, from 32% to 28%. This fall in the gearing ratio is inconsistent with the fact that the company has taken a loan of $375,000 to finance the research and development. The expectation would be for the gearing ratio to increase, unless there has been a repayment of finance of which we are unaware.
Looking at the operating margin and return on capital employed, both ratios have improved by a small amount. This trend is worthy of scrutiny during the audit as the offers and discounts offered to customers by the company should act negatively on margins and profitability, so the improvements in ratios could indicate a potential overstatement of operating profit.
Another trend which is worth further investigation relates to online sales, which are projected to increase by 90·5% in the year. This is a significant increase, and while the finance director has asserted that the increase in sales is due to the success of the advertising campaign, this needs to be corroborated further. There is a risk of overstatement of revenue in relation to online sales which is explored in more detail below. There is also a risk that revenue from other sources is overstated. Excluding online sales, revenue from other sources is projected to increase by 5·3%, a significant increase, which could also indicate overstatement of revenue.
Management bias
This is a private company where a majority of shares are owned by the Margot family. This brings a risk of management bias, especially as one of the family members is the company’s chief executive officer, who is in a position to influence the financial statements. The extract from the management accounts shows that a significant dividend payment is made each year, so there is an expectation from the family members that the company will make sufficient profit to be able to pay these dividends each year. There is therefore a significant inherent risk at the financial statement level that profit will be overstated. The risk that the financial statements are being deliberately manipulated is indicated by the accounting treatment applied to impairment which is discussed in more detail below.
Online sales​​​​​​​
The online sales make up an increasing proportion of the company’s revenue – according to the management accounts online sales are projected to represent 7% of total revenue in 20X9 (4% – 20X8).
Online sales can bring a number risks of material misstatement, for instance, cut off and timing of revenue recognition can be problematical. In the case of Margot Co, risks attach to the discounts which are offered on online sales as the discounts offered to customers appear to change frequently. This brings some complexity into the accounting, and the company should ensure that internal controls are operating effectively so that the accounting system is updated whenever the level and range of discounts and offers to customers are changed. Revenue could be over or understated if discounts are not accounted for appropriately, either because a discount is not recorded at all by the accounting system or is applied to the wrong products.
Tutorial note: Credit will be awarded for other risks relating to online sales, where relevant to the question scenario, for example, related to the launch of the new online sales portal, which implies a change to the system used to record revenue, with related control risks.
Research and development​​​​​​​
In this financial year, $220,000 of research and development costs have been capitalised as an intangible asset. This represents 1·8% of total assets and 10·5% of profit before tax, and would be considered material to the financial statements.
This relates to research and development into new plastic-free packaging. According to IAS® 38 Intangible Assets, a distinction has to be made between research costs, which must be expensed, and development costs, which should only be capitalised if certain criteria are met including that the technical and commercial feasibility of the asset has been established. It appears that the full amount paid to ProPack has been capitalised, which indicates that no distinction has been made between research costs and development costs. Only development costs can be capitalised, so there is a potential overstatement of the intangible asset if it includes research costs, which should be expensed. This means that the entity must intend and be able to complete the intangible asset and either use it or sell it and be able to demonstrate how the asset will generate future economic benefits.
There is a further risk of material misstatement because costs which are development costs may have been capitalised but the necessary criteria demonstrating that an asset has been created have not been met. Given that ProPack is only at the stage of testing prototypes, it appears that there is not yet demonstrable evidence that the new packaging is technically feasible or that Margot Co will be able to use the packaging. In addition, there may problems in demonstrating that Margot Co has control of the development of new packaging, given that the development has been outsourced to another company. In this case, the IAS 38 criteria for capitalisation do not appear to have been met; this will result in overstatement of intangible assets and understatement of operating expenses.
Impaired factory​​​​​​​
The carrying amount of the impaired factory is material to the statement of financial position, representing 7% of total assets. The damage to the factory has triggered an impairment review, as required by IAS 36 Impairment of Assets. However, the finance director has not prepared the impairment calculations in accordance with IAS 36, specifically the recoverable amount has not been correctly determined. The recoverable amount is the higher of value in use and fair value less costs to sell the asset. However, a review of the calculation provided indicates that the determination of value in use is not correct. According to IAS 36, the cash flow projections which are used to determine the value in use of the impaired asset should relate to the asset in its current condition – expenditures to improve or enhance the asset’s performance should not be anticipated. The finance director’s estimate of value in use is based on the assumption that the building is repaired and new machinery purchased – neither of these assumptions should be included in the determination of value in use.
It is likely that the value in use, when properly determined, is much lower than the finance director’s estimate, meaning that the impairment loss to be recognised is greater than the $210,250 as per the finance director’s calculations. There is also a risk that the fair value less cost to sell is overestimated – if the factory is damaged and the machinery needs to be completely replaced, then a value of $135,000 included in management’s calculation may be over optimistic. Therefore there is a risk that the impairment loss is understated, and the carrying value of the asset is overstated.
Tutorial note: Credit will be awarded for further development of the impairment issue, for example, whether the impairment loss has been appropriately allocated over the assets of the cash generating unit.
Provision for restoring the damaged factory and acquiring new machinery
Related to the point above, the financial statements include a provision forrepairing the factory and buying new machinery. A provision should only be recognised if it meets the criteria of IAS 37 Provisions, Contingent Liabilities and Contingent Assets, including that there is a present obligation as a result of a past event, and that a probable future outflow of economic benefit which can be reliably estimated exists. In this case there does not seem to be a present obligation, the company is not contractually obliged to repair the damage and there is no evidence that a constructive obligation exists. Neither does it appear appropriate to recognise a prepayment for an expense which has not yet been incurred. Therefore, the provision and related prepayment should not be recognised, and unless an adjustment is made to the financial statements, both current assets and current liabilities are overstated. The amount recognised represents 3·6% of total assets and is material to the statement of financial position, though it has no impact on profit.
Software and advertising costs capitalised​​​​​​​
During the year, software development costs of $30,000 and advertising costs of $225,000 are capitalised as intangible assets. The advertising costs are material, representing 1·8% of total assets and 10·7% of profit for the year. The advertising costs have been incurred to support the ‘Fructus Gold’ brand name, and the finance director justifies the capitalisation on the grounds that the advertising expenditure has led to an increase in sales. However, IAS 38 specifically states that advertising and promotional costs must not be recognised as intangible assets and must be expensed. Therefore intangible assets are overstated and operating expenses understated by a material amount.
The software development costs represent less than 1% of total assets and only 1·4% of profit, so are not considered to be material to the financial statements, and therefore in isolation do not represent a significant risk of material misstatement in monetary terms, especially given that according to IAS 38, it is appropriate to capitalise internally developed software costs assuming that the costs incurred give rise to an asset. However, this matter is being highlighted because the finance director has used a similar justification for capitalising the advertising costs, which are likely to be materially misstated, as discussed above, and therefore this gives rise to a general concern over whether all costs relating to intangible assets are being treated appropriately.
Identification and potential misclassification of assets​​​​​​​
There is a risk that the agricultural assets are not identified and/or classified appropriately, which will have an implication for the valuation of the assets. For example, it may be difficult to distinguish between bearer plants and fruit growing on the trees, and it might be hard to identify the stage of development of fruit on the trees. This potentially impacts on the valuation of the assets, because bearer plants are measured at cost and depreciated in accordance with IAS 16 Property, Plant and Equipment, whereas the fruit should be measured at fair value in accordance with IAS 41 Agriculture.
Tutorial note: Credit will be awarded for other, relevant risks of material misstatement, for example, the risk that the storm may have damaged assets other than the factory, in particular the bearer plants, which may have suffered impairment, and the risk that inventory may be overstated due to perishable nature of the goods.
(b) Audit procedures
(i) Impaired factory
– Obtain management’s detailed calculations to gain understanding and allow evaluation of the methodology and assumptions used, e.g. the basis of determining the fair value and the future period over which value in use was determined and the discount rate used to calculate the present value of future cash flows.
– Discuss the methodology and assumptions with management to confirm their rationale.
– From the non-current asset register, confirm the carrying amount of the cash generating unit prior to any impairment being recognised, and confirm the carrying amount of each component of the cash generating unit.
– Obtain a copy of the company’s insurance policy and review the terms and conditions to confirm whether the buildings and machinery are covered by insurance.
– Develop an auditor’s estimate of the fair value less cost to sell and value in use, in accordance with the IAS 36 requirements (i.e. not including the restoration costs and replacement of machinery), and compare to management’s estimate. Developing an auditor’s estimate would involve the following procedures:
– Obtain and review the reports from the engineer to confirm the nature and extent of damage caused to the factory.
– Obtain and review any external valuation report which the company has used as a basis of the fair value less cost to sell, and evaluate the reasonableness of any assumptions used in the valuation.
– For the value in use, discuss with management to obtain their view as to whether the factory has any value in use at all in its current state.
– Visit the factory to view the extent of damage caused by the storm and evaluate whether it can be used without any further capital expenditure.
– Consider whether the use of an auditor’s expert is necessary to provide sufficient and appropriate evidence given the materiality of the figures.
(ii) Research and development costs
– Discuss the project to develop new packaging with management, to develop an understanding of matters such as how the company intends to use the new packaging, the stage of development reached by the year end and whether the project may need additional funding.
– Obtain and review progress reports and correspondence from ProPack which will indicate the progress made so far.
– Obtain and review the contract with ProPack to determine contractual terms and if the asset will be owned and controlled by Margot Co and that ProPack does not have any continuing interest in the development once it is complete.
– After receiving client’s permission, arrange to discuss the project with ProPack, to obtain further understanding on a range of matters including technical feasibility and the results of the testing on the prototype.
– Discuss with the company’s production and marketing directors to obtain understanding of how the company will use the new packaging.
– Obtain any financial budgets prepared in relation to the project, to confirm the amount of expenditure which has been approved, and that the costs are clearly distinguishable.
​​​​​​​– By reference to the company’s cash position and available finance, evaluate whether Margot Co has sufficient funds to complete the development.
– Obtain samples of the prototype packaging from ProPack, to confirm existence.
– Agree the amount spent to date to invoices submitted by ProPack, and to the company’s cash records.
Tutorial note: Credit will be awarded for other relevant audit procedures, for example, in relation to assessing whether there are any reasons to doubt whether ProPack can continue the development.
(c) Matters to consider before placing reliance on the work of the auditor’s expert​​​​​​​
ISA 620 Using the Work of an Auditor’s Expert contains requirements relating to the objectivity, competence and capabilities of the auditor’s expert, the scope and objectives of their work, and assessing their work.
Objectivity
According to ISA 620, the auditor shall evaluate whether the auditor’s expert has the necessary objectivity and this should include inquiry regarding interests and relationships which may create a threat to the expert’s objectivity. The audit firm will need to ensure that the expert has no connection to Margot Co, for example, that they are not a related party of the company or any person in a position of influence over the financial statements. If the expert’s objectivity is threatened, little or no reliance can be placed on their work, and the audit firm should not treat it as a reliable source of audit evidence.
Competence
ISA 620 also requires the competence of the expert to be considered; this should include considering the expert’s membership of appropriate professional bodies. Any doubts over the competence of the expert will reduce the reliability of audit evidence obtained. The expert should in this case have experience in valuing the fruit which are the agricultural assets recognised in the statement of financial position, and be familiar with the framework for measuring fair value of these assets in accordance with IAS 41 Agriculture and IFRS 13 Fair Value Measurement.
Scope of work​​​​​​​
ISA 620 requires the auditor to agree the scope of work with the expert. This may include agreement of the objectives of the work, how the expert’s work will be used by the auditor and the methodology and key assumptions to be used. In assessing the work performed by the expert, the auditor should confirm that the scope of the work is as agreed at the start of the engagement. If the expert has deviated from the agreed scope of work, it is likely to be less relevant and reliable.
Relevance of conclusions​​​​​​​
ISA 620 states that the auditor shall evaluate the relevance and adequacy of the expert’s findings or conclusions. This will involve consideration of the source data which was used, the appropriateness of assumptions and the reasons for any changes in methodology or assumptions. The conclusion should be consistent with other relevant audit findings and with the auditor’s general understanding of the business. If the work involves using source data which is significant to their workings, the audit team should plan to assess the relevance, completeness and accuracy of that data. Any inconsistencies should be investigated as they may indicate evidence which is not reliable.
Tutorial note: Credit will be awarded for more specific comments in relation to evaluating the expert’s work, for example, reperformance of calculations, and establishing that assumptions are in line with the auditor’s understanding of the entity.
(d) Audit implications of email from Len Larch​​​​​​​
The alleged use of prohibited chemicals raises concerns that the company may not be complying with relevant law and regulations. The auditor needs to consider the requirements of ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements. ISA 250 states that while it is management’s responsibility to ensure that the entity’s operations are conducted in accordance with the provisions of laws and regulation, the auditor does have some responsibility in relation to compliance with laws and regulations, especially where a non-compliance has an impact on the financial statements.
There is also an ethical issue in that one of the production managers may have been bribed by one of the company directors. Clearly, if this is true, it indicates a lack of integrity and would seem to confirm that the chemicals which are being used are prohibited.
The auditor is required by ISA 315 Identifying and Assessing the Risks of Material Misstatement Through Understanding the Entity and its Environment to gain an understanding of the legal and regulatory framework in which the audited entity operates. This will help the auditor to identify non-compliance and to assess the implications of non-compliance. Therefore the auditor should ensure a full knowledge and understanding of the laws and regulations relevant to the use of chemicals in the company’s farms, and the implications of non-compliance.
ISA 250 requires that when non-compliance is identified or suspected, the auditor shall obtain an understanding of the nature of the act and the circumstances in which it has occurred, and further information to evaluate the possible effect on the financial statements. Therefore procedures should be performed to obtain evidence about the suspected non-compliance, for example, to speak to the company’s farm managers to understand whether the allegations are founded in fact. In addition, the audit team could perform further procedures, for example, reviewing purchase invoices to establish if these chemicals are actually being purchased and used in the business, and if so, on whose authority.
ISA 250 requires the matter to be discussed with management and where appropriate with those charged with governance. Given the potential severity of the situation, and that the chemicals may be toxic, there is the risk of poisoning the company’s employees or customers, and the matter should be communicated as soon as possible.
The auditor should attempt to find out whether any member of management had issued instructions for these chemicals to be used, i.e. that there is a deliberate breach of law and regulations. ISA 250 suggests that when the auditor suspects management or those charged with governance of being involved with the non-compliance, the matter should be communicated to the next level of ‘higher authority’ such as an audit committee or supervisory board. Given the family-managed nature of Margot Co, it may be that no higher authority exists, in which case the audit firm should take appropriate legal advice if they think that the matter may not be communicated by the entity.
The auditor needs to consider the potential implications for the financial statements. The non-compliance, if proven to have taken place, could lead to regulatory authorities imposing fines or penalties on Margot Co, which may need to be provided for in the financial statements. Audit procedures should be performed to determine the amount, materiality and probability of payment of any such fine or penalty imposed.
In addition, there is a risk that the use of chemicals means that inventory of harvested fruit and the fruit trees are contaminated with poisonous chemicals and possibly will need to be destroyed. The assets could therefore need to be written down in value. If any necessary impairment of the assets is not recognised, then non-current assets and current assets could be misstated. The audit team should therefore plan procedures to determine the value of the contaminated assets.
There may be a going concern issue once the non-compliance and its implications has been established and the facts get out into the media. There would be considerable impact on the reputation of the company and its brand; customers may stop purchasing the products for fear of a health risk and this could affect the going concern of the business.
In terms of reporting non-compliance to the relevant regulatory authorities, ISA 250 requires the auditor to determine whether they have a responsibility to report the identified or suspected non-compliance to parties outside the entity. In the event that management or those charged with governance of the company fails to make the necessary disclosures to the regulatory authorities, the auditor should consider whether they should make the disclosure. This will depend on matters including whether there is a legal duty to disclose or whether it is considered to be in the public interest to do so.
Confidentiality is also an issue, and if disclosure were to be made by the auditor, it would be advisable to seek legal advice on the matter. Further advice on disclosure in the public interest is given by the IESBA’s pronouncement on Responding to Non-Compliance with Laws and Regulations (NOCLAR). The guidance gives examples of situations where disclosure might be appropriate. These examples include references to an entity being involved in bribery and breaches of regulation which might impact adversely on public health and safety. The standard also clarifies that in exceptional circumstances where the auditor believes there may be an imminent breach of a law or regulation, they may need to disclose the matter immediately. The decision to disclose will always be a matter for the auditor’s judgement and where the disclosure is made in good faith, it will not constitute a breach of the duty of confidentiality under s.140 of the IESBA Code of Ethics for Professional Accountants.
Conclusion
These briefing notes have indicated that there are several significant risks of material misstatement to consider while planning the audit of Margot Co. More information is needed to perform a detailed analytical review, which may highlight further potential risks. The briefing notes also recommend relevant audit procedures for two significant risks of material misstatement – the impaired factory and research and development costs. We will plan to use the work of an expert, following the requirements of ISA 620. Finally, we need to consider carefully the issues raised by Len Larch, as it seems that the company is operating in breach of relevant laws and regulations, and that this is a deliberate act involving bribery of company employees. There are implications for our audit planning in that we must plan to obtain detailed information about the situation, and consider our reporting responsibilities in light of the severity of the situation and its implications for public health.