4、You are an audit manager in Brearley & Co, responsible for the audit of the Hughes Group (the Group). You are reviewing the audit working papers for the consolidated financial statements relating to the year ended 31 March 2018. The Group specialises in the wholesale supply of steel plate and sheet metals. The draft consolidated financial statements recognise revenue of $7,670 million (2017 – $7,235 million), profit before taxation of $55 million (2017 – $80 million) and total assets of $1,560 million (2017 – $1,275 million). Brearley & Co audits all of the individual company financial statements as well as the Group consolidated financial statements. The audit senior has brought the following matters, regarding a number of the Group’s companies, to your attention:
(a) Dilley Co
The Group purchased 40% of the share capital and voting rights in Dilley Co on 1 May 2017. Dilley Co is listed on an alternative stock exchange. The Group has also acquired options to purchase the remaining 60% of the issued shares at a 10% discount on the market value of the shares at the time of exercise. The options are exercisable for 18 months from 1 May 2018. Dilley Co’s draft financial statements for the year ended 31 March 2018 recognise revenue of $90 million and a loss before tax of $12 million. The Group’s finance director has equity accounted for Dilley Co as an associate in this year’s group accounts and has included a loss before tax of $4·4 million in the consolidated statement of profit or loss. (7 marks)
(b) Willis Co
Willis Co is a foreign subsidiary whose functional and presentational currency is the same as Hughes Co and the remainder of the Group. The subsidiary specialises in the production of stainless steel and holds a significant portfolio of forward commodity options to hedge against fluctuations in raw material prices. The local jurisdiction does not mandate the use of IFRS Standards and the audit senior has noted that Willis Co follows local GAAP, whereby derivatives are disclosed in the notes to the financial statements but are not recognised as assets or liabilities in the statement of financial position. The disclosure note includes details of the maturity and exercise terms of the options and a directors’ valuation stating that they have a total fair value of $6·1 million as at 31 March 2018. The disclosure note states that all of the derivative contracts were entered into in the last three months of the reporting period and that they required no initial net investment. (6 marks)
(c) Knott Co
Knott Co is a long-standing subsidiary in which the Group parent has a direct holding of 80% of the equity and voting rights. Audit work on revenue and receivables at Knott Co has identified sales of aluminium to its parent company in March 2018 with a total sales value of $77 million which have been recorded in the subsidiary’s financial statements. Audit procedures have identified, however, that the receipt of aluminium was not recorded by the parent company until 2 April 2018. The group has made no adjustment for this transaction in the draft consolidated financial statements. Knott Co makes a 10% profit margin on all of its sales of aluminium. (7 marks)
Required:
Comment on the matters to be considered and explain the audit evidence you should expect to find during your review of the Group audit working papers in respect of each of the issues described above.
Note: The split of the mark allocation is shown against each of the issues above.
(a) Dilley Co
Matters
The key matter to be considered is the status of the investment in Dilley Co in the consolidated financial statements of the Group. Although the 40% holding falls within the usual percentage presumption range for an associate following IAS 28 Investments in Associates and Joint Ventures, the existence of the share options over the remaining 60% is indicative of control following IFRS 10 Consolidated Financial Statements. IFRS 10 contains specific guidance on situations where control may exist when the investor does not hold a majority of the voting rights. According to IFRS 10, control and therefore status as a subsidiary may be based on potential voting rights provided such rights are substantive. In the case of Dilley Co, the potential voting rights are exercisable in the near future (within one month of the reporting date) and the 10% discount on market price makes them commercially attractive to the Group. The options therefore represent substantive potential voting rights and Dilley Co’s statement of profit or loss should be consolidated line by line from the date of acquisition.
The 40% holding in Dilley Co has been held for 11 months of the current reporting period. The time apportioned revenue of $82·5 million ($90 million x 11/12) is therefore material to the consolidated financial statements at 1·1%. On the same basis, the time apportioned loss before tax is $11 million ($12 million x 11/12) which is $6·6 million greater than the loss recognised under the equity method of $4·4 million. The difference is also material to the financial statements at 12% of the Group’s profit before tax. Given the loss making status of Dilley Co, there is an incentive not to consolidate the entity. The auditor should exercise professional scepticism and consider whether there are any implications in relation to management integrity.
Evidence
– A copy of the legal documents supporting the acquisition of the shares and the options including the voting rights and the terms of exercise for the options.
– A review of the audit working papers for Dilley Co, including details of the issued share capital and the associated voting rights attached to shares.
– The group board minutes relating to the acquisition and the intentions of management in relation to Dilley Co.
– Written representations from management on the degree of influence exercised over Dilley Co and the future intentions of management in relation to the share options.
(b) Willis Co
Matters
The fair value of the derivatives of $6·1 million is material to consolidated profit before tax at 11·1% but in isolation, it is immaterial to consolidated assets at 0·4%.
IFRS 9 Financial Instruments requires the recognition of derivatives on the statement of financial position at fair value with the associated gains and losses being recognised in profit or loss for the period. The fair value of $6·1 million should therefore be included in current assets on the Group’s consolidated statement of financial position and given that the options were entered into in the last three months of the period at no initial net investment, a fair value gain of $6·1 million should also be recorded in the Group’s consolidated statement of profit or loss for the year. The treatment of the derivatives under local GAAP is acceptable in Willis Co’s individual entity financial statements. For group purposes, however, accounting policies must be consistent and the profit before tax in the draft consolidated financial statements is materially understated.
The auditor must also exercise professional scepticism with regard to whether the directors have the required expertise to value the derivatives and should consider the need for independent, external evidence of the fair value of the options at the reporting date.
Evidence
– Details of the fair value of the options based on prices derived from an active market or if this is not available, an independent expert valuation.
– Audit documentation of the review of derivative contracts and confirmation of the terms and maturity dates.
– Notes of a discussion with management in relation to the basis of their valuation and the accounting treatment required in the consolidated financial statements.
(c) Knott Co
Matters
Consolidated financial statements are prepared from the group perspective and intra-group transactions and balances must be eliminated on consolidation. The sales value of $77 million is material at 1% of consolidated revenue and 4·9% of consolidated assets. The unrealised profit of $7·7 million ($77m x 10%) is also material to consolidated profit before tax for the year at 14% ($7·7m/$55m). Group revenue, receivables and profit before tax are therefore materially overstated. The transactions should be verified in the accounting records of the individual entities to confirm that Knott Co has included the sale in its financial statements and that the parent company has not included the purchase in its financial statements. However, given that the goods are still in transit at the reporting date, group inventory will be understated by $69·3 million ($77m x 90%) which is also material to group assets at 4·4%. Consolidated retained earnings will be overstated by $6·16 million ($7·7 million x 80%) and non-controlling interests will be overstated by $1·54 million ($7·7 million x 20%). The accounting for the transaction within the individual entity financial statements will also be misstated.
The failure to identify and adjust for the intra-group trading transaction indicates a deficiency in internal control within the group and therefore increased control risk for the audit of the consolidated financial statements.
Tutorial note: Credit was also given to candidates who discussed the impact of the inter-company transactions on the financial statements of the individual entities.
Evidence
– Agreement of the transaction details to underlying documents such as sales invoices, goods despatch notes at Knott Co and goods received notes, purchase invoices at its parent company.
– The cost of the inventory in transit should have been confirmed to production records at Knott Co to confirm the 10% profit margin.
– A copy of the goods received note dated 2 April 2018 raised by the parent company confirming details of the inventory in transit and the transaction being recorded in inventory and the purchase ledger after the year end.
– A copy of the sales invoice traced to Knott Co’s sales ledger agreeing details of the sales value.
– The adjustments required to eliminate the transaction should be noted on a schedule of uncorrected misstatements for discussion with the client.