Briefing notes
To: Joss Dylan, Audit engagement partner
From: Audit manager
Subject: Audit planning for the Adams Group
Date: 1 July 20X5
Introduction
These briefing notes are prepared for use by the audit engagement partner of the Adams Group, and relate to the planning of the audit of the Group for the year ended 31 May 20X5. The notes contain an evaluation of audit risk, and the matters to be considered in respect of using the work of Clapton & Co, and the relevant procedures to be performed. The notes also detail the procedures to be conducted in relation to the investment in Stewart Co, an associate of the group and the Adams brand name. Finally, the notes discuss the ethical and professional issues which need to be addressed as a result of the requests made by the audit committee of the Adams Group.
(a) Evaluation of audit risk
New audit client
The Group is a new client of our firm which may create detection risk as we have no previous experience with the client. However, thorough planning procedures which focus on obtaining a detailed knowledge and understanding of the Group and its activities will minimise this risk. We need to obtain a thorough understanding of each of the subsidiaries as they are all significant components of the Group, with Ross Co, Lynott Co and Beard Co’s assets representing respectively 20%, 22·3% and 26% of Group assets. There is also a significant risk that comparative information and opening balances are not correct.
Analytical review
Relevant trends and ratio calculations:
 – Revenue increased by 11·5%
 – Gross profit increased by 12·7%
 – Operating profit increased by 59·5%
 – Cash fallen by 54·5%
 – Inventories increased by 100%
 – Receivables increased by 59·1%
                                     20X5                  20X4
 Gross margin                36·1%               35·8%
 Operating margin           1·7%                1·2%
 Interest cover                  12·2                  7·7
 Current ratio                    1·8                   2·2
 Gearing                            22·5%              25·1%
The analytical review indicates that the Group’s revenue generation and profitability has improved during the year. There could be valid business reasons to explain the trends, however, the audit team should be alert for possible overstatement of revenue and understatement of expenses.
The risk is increased due to the bonus scheme which gives rise to a risk of material misstatement at the financial statement level. Management will be biased towards accounting treatments which lead to overstatement of revenue, for example, the early recognition of revenue.
There is also a risk of management manipulation of the financial statements due to the renegotiation of the Group’s lending facilities, for example, it would be favourable to present a good interest cover to the bank as an analysis of interest cover is likely to feature in their lending decision.
The current ratio has fallen, largely due to the significant reduction in cash of 54·5%. Other changes within current assets could indicate audit risk, as both inventories and trade receivables have increased significantly, by 100% and 59·1% respectively. Given that revenue has increased by only 11·5% in the year, these increases appear very large and could indicate potential overstatement.
The analytical review also reveals that the amount recognised in respect of property, plant and equipment has not changed over the year. This seems unlikely to be reasonable, as the Group would presumably have incurred some capital expenditure in the year, disposed of some assets and charged depreciation. There are implications for operating profit, which, for example, is overstated if any necessary depreciation has not been charged.
Brand name
The brand is material at 7·4% of Group assets. It is recognised in the statement of financial position as an intangible asset which is appropriate given that the brand is a purchased intangible asset. However, the asset is recognised at its original cost and there is risk attached to the policy of non-amortisation of the brand. IAS® 38 Intangible Assets states that an intangible asset with a finite useful life is amortised, and an intangible asset with an indefinite useful life is not. The risk is that the assumption that the brand has an indefinite life is not correct, and that the asset is overstated and operating expenses understated through the lack of an annual amortisation charge against the asset.
There is also a risk that the brand could be impaired given the bad publicity and allegations made by the journalist against the Group. IAS 36 Impairment of Assets requires an impairment review to be carried out when indicators of potential impairment exist. The allegations may have damaged the Group’s reputation, with consequential impact on revenue and cash flows, though the increase of 11·5% in the Group’s revenue could indicate that this is not the case, as claimed by the Group finance director. However, sales of certain products could be in decline, and the fact that inventories have doubled in value could indicate problems in selling some of the Group’s products. The risk is that if any necessary impairment has not been recognised, the asset is overstated and operating expenses understated by the amount of the impairment loss.
Associate
A new associate has been acquired during the year, which gives rise to several risks. It is material at 11·2% of Group assets.
Because this is the first addition to the Group for many years, there is an inherent risk that the Group lacks accounting knowledge on the appropriate accounting treatment. Associates are accounted for under IAS 28 Investments in Associates and Joint Ventures, which states that an entity with joint control of, or significant influence over, an investee shall account for its investment in an associate or a joint venture using the equity method. There is a risk that the equity method has not been properly applied. The investment in the associate recognised in the statement of financial position has increased in value since acquisition by $0·5 million, presumably due to the inclusion of the Group’s share of profit arising since investment. There is a risk that this has not been calculated correctly, for example, it is not based on the correct share of profit, and the investment may therefore be over- or understated.
Risk also arises in relation to any possible impairment of the investment, which may cause it to be overstated in both the individual financial statements of Adams Co, and the Group financial statements.
There is also a disclosure issue, as the Group’s share of post-investment profit of Stewart Co should be recognised in profit or loss, and IAS 1 Presentation of Financial Statements requires that the profit or loss section of the statement of profit or loss shall include as a line item the share of the profit or loss of associates accounted for using the equity method. The draft statement of profit or loss and other comprehensive income does not show income from the associate as a separate line item; it may have been omitted or netted against operating expenses, and the risk is inappropriate presentation of the income from investment.
There is also a risk that the investment should not have been classified as an associate. According to IAS 28, if an entity holds, directly or indirectly, 20% or more of the voting power of the investee, it is presumed that the entity has significant influence, unless it can be clearly demonstrated that this is not the case. If the 25% holding does not give rise to significant influence, for example, if the shares do not convey voting rights, it should be classified as an investment rather than an associate. There is a risk of inappropriate classification, recognition and measurement of the investment in Stewart Co.
Ross Co’s inventory in multiple locations
A risk arises in relation to inventory, which is held in each of the department stores. There is a risk that controls are not sufficiently strong in respect of the movement of inventory and counting procedures at the year end, as it will be hard for Ross Co to ensure that all locations are subject to robust inventory counting procedures. This control risk leads to potential over- or understatement of inventory and cost of sales.
Systems and controls
The audit committee states that the Group’s systems are out of date; this may give rise to control risk across the Group as a whole. In addition, Lynott Co has implemented a new inventory control system. A new system introduced during the year can create control risk. With any new system, there are risks that controls may take time to develop or be properly understood, and the risk of error in relation to inventories is relatively high.
Beard Co’s investment properties
The investment properties are material to both Beard Co’s individual financial statements, representing 35·7% of its total assets, and also to the Group’s financial statements, representing 9·3% of Group assets.
According to IAS 40 Investment Property, an entity can use either the fair value model or the cost model to measure investment property. When the fair value model is used the gain is recognised in profit or loss. The draft consolidated statement of profit or loss and other comprehensive income includes the investment property revaluation gain as other comprehensive income rather than as profit or loss, and therefore the gain is not presented in accordance with IAS 40.
An accounting error may have been made in the adjustment made to increase the value of the investment property. The statement of financial position shows an increase in value of investment properties of $2·5 million, however, the gain in the statement of profit or loss and other comprehensive income is stated at $1 million. There is a risk that the gain is understated and part of the gain may have been classified elsewhere in profit or loss. The gain as stated in the statement of profit or loss and other comprehensive income is material at 9·3% of total comprehensive income.
It would be important to obtain information on the type of properties which have been invested in, and whether there have been any additions to the portfolio during the year, as part of the movement in the investment property balance during the year could be explained by acquisitions and disposals. Information should also be obtained on any disposals of investment properties during the year, and whether a profit or loss was made on such disposals.
The possible error discussed above in relation to the presentation of the investment property gain is also relevant to the comparative information, which may also be materially misstated. This increases the risk that other balances and transactions in prior years have been incorrectly accounted for. The use of professional scepticism should be stressed during the audit, and further procedures planned on opening balances and comparative information.
Further information should be sought from the previous auditor of the Group in relation to the accounting treatment for the investment properties, and whether it had been identified as an error, in which case the auditor’s reports of both Beard Co and the Group should have been modified. A review of prior year auditor’s reports is necessary, as well as a review of the previous audit firm’s working papers, assuming permission is given for this to take place.
Bonus scheme
It is noticeable from the draft statement of financial position that there is no accrual recognised in respect of the bonus scheme, unless it has been included inappropriately in trade or tax payables. This indicates a potential understatement of liabilities and overstatement of profit if any necessary accrual has not been made for any bonus which is payable.
Management charges
The management charges imposed by the parent company on the subsidiaries represent inter-company transactions. In the individual financial statements of each subsidiary, there should be an accrual of $800,000 for the management charge payable in August 20X5, and Adams Co’s individual financial statements should include $2·4 million as a receivable. There is a risk that these payables and the corresponding receivable have not been accrued in the individual financial statements.
At Group level, the inter-company balances should be eliminated on consolidation. If this has not happened, the liabilities and receivables in the Group financial statements will be overstated, though there would be no net effect on Group profit if the balances were not eliminated.
Tutorial note: Credit will also be awarded for comments on relevant issues to do with transfer pricing and relevant tax implications which have not been considered and recognised appropriately in the financial statements.
Inventory
The draft consolidated statement of financial position shows that inventory has doubled in the year. Given that the Group is involved in retail, there could be issues to do with obsolescence of inventory, leading to potentially overstated inventory and overstatement of profit if any necessary write down is not recognised. This may be especially the case for the mass market fashion clothing made by Lynott Co. Inventory is material to the Group, representing 11·2% of Group assets.
Inter-company transfers
Ross Co transfers goods to Lynott Co for recycling when its goods are considered obsolete. There is a risk that at Group level the inter-company trading is not eliminated on consolidation, which would lead to overstated receivables and payables. In addition, if the inventory is transferred at a profit or loss, which is then not realised by the Group at the year end, the Group inventory figure and operating profit could be over- or understated if any necessary provision for unrealised profit or loss is not recognised.
Goodwill
The draft consolidated statement of financial position does not recognise goodwill, which is unusual for a Group with three subsidiaries. It may be that no goodwill arose on the acquisitions, or that the goodwill has been fully written off by impairment. However, there is a risk of understatement of intangible assets at the Group level.
Component auditor
Lynott Co is audited by a different firm of auditors. This may introduce audit risk in that Dando & Co will be relying to some extent on their work. Careful planning will be needed to reduce this risk to a minimum, and this is discussed in the next section of the briefing notes.
Tutorial note: Credit will be awarded for relevant calculations which form part of relevant analytical review performed, such as calculations relating to profit margins, liquidity and gearing, and for discussion which is relevant to the evaluation of audit risk. Credit will also be awarded for discussion of other relevant audit risks, for example, risks associated with the lack of a deferred tax figure in the statement of financial position, and the change in effective tax rate.
(b) Matters to be considered and procedures to be performed in respect of using the work of Clapton & Co
The requirements in respect of using the work of component auditors are given in ISA 600 Special Considerations – Audits of Group Financial Statements (Including the Work of Component Auditors). ISA 600 requires that if the Group engagement team plans to request a component auditor to perform work on the financial information of a component, the Group engagement team shall obtain an understanding of four matters.
– The Group engagement team should ascertain whether the component auditor understands and will comply with the ethical requirements which are relevant to the group audit and, in particular, is independent. 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. Given that Clapton & Co is based in Farland, the ethical requirements in that location may be different, possibly less stringent, to those followed by the Group.
– The component auditor’s professional competence should also be assessed, including whether the component auditor has the relevant industry specific skills and technical knowledge to adequately obtain evidence on the component. As Lynott Co reports under IFRS® Standards, there is less likelihood of Clapton & Co having a knowledge gap in terms of the Group’s applicable financial reporting framework than if the company used local accounting rules. The fact that Clapton & Co is a member of an international network means it is likely to have access to regular training programmes and technical updates which adds to the credibility of their audit work.
– The Group audit team should also gain an understanding of Clapton & Co’s resource base to ensure it can cope with the work required by the Group. There should also be evaluation of whether the Group engagement team will be able to be involved in the work of the component auditor to the extent it is necessary to obtain sufficient appropriate audit evidence.
– Whether the component auditor operates in a regulatory environment which actively oversees auditors should be understood. The Group audit team should ascertain whether independent oversight bodies have been established in the jurisdiction in which Clapton & Co operates, to oversee the auditing profession and monitor the quality of audit. This allows greater reliance to be placed on their work.
In addition to the matters required to be considered in accordance with ISA 600 discussed above, the risk of material misstatement in the subsidiary being audited by the component auditor must be fully assessed, as areas of high risk may require input from the Group audit team, and not be subject to audit solely by the component auditors. For areas of high risk, such as Lynott Co’s inventories, the Group audit team may consider providing instructions to the component auditor on the audit procedures to be performed.
Procedures:
– Review the local ethical code (if any) followed by Clapton & Co, and compare with the IESBA International Code of Ethics for Professional Accountants for any significant difference in requirements and principles.
– Obtain confirmation from Clapton & Co of adherence to any local ethical code and the IESBA Code. Establish through discussion or questionnaire whether Clapton & Co is a member of an auditing regulatory body, and the professional qualifications issued by that body.
Obtain confirmations of membership from the professional body to which Clapton & Co belongs, or the authorities by which it is licensed.
– Discuss the audit methodology used by Clapton & Co in the audit of Lynott Co, and compare it to those used under ISAs (e.g. how the risk of material misstatement is assessed, how materiality is calculated, the type of sampling procedures used).
– A questionnaire or checklist could be used to provide a summary of audit procedures used.
– Ascertain the quality control policies and procedures used by Clapton & Co, both firm-wide and those applied to individual audit engagements.
– Request any results of monitoring or inspection visits conducted by the regulatory authority under which Clapton & Co operates.
(c) Audit procedures to be performed
(i) Investment in associate​​​​​​​
– Obtain the legal documents relating to the share acquisition, and review to confirm the terms and conditions including the number of shares purchased and the voting rights attached to each share.
– Agree the cost of investment of $11·5 million to the legal documentation and to Adams Co’s bank statement and cash book.
– Review the minutes of Group management meetings to understand the business rationale for the investment, and to confirm that the Group intends to exercise significant influence over Stewart Co, for example, through appointment of board members.