Osier Co
(a)    Cost of inventory
Matters
Materiality
Inventory costs represent 1·1% of total assets and 19·6% of profit. Inventory is therefore material to both the statement of financial position and the statement of profit or loss.
Risk of material misstatement
The calculation of the cost of inventory is complex. This complexity increases the risk of error in the calculation, which increases the risk of misstatement.
The calculation is also subject to a number of estimates; the average production time per unit, the forecast annual wage cost, the scheduled hours of production and the forecast units of production are all estimates. These estimates increase the risk of both error and manipulation of the calculation to suit management’s bias.
Given both the complexity and subjectivity involved in the calculation there is a significant risk that the inventory cost may be misstated.
Evidence expected to be on file:
– Documentation of the system for obtaining the data used in the costing exercise and calculating the final cost. This should identify the key controls that operate in this system and there should be evidence on file that these controls have been appropriately tested.
– A copy of the summary of inventory purchase costs. A sample of the purchase costs, including the additional costs of transport and handling, should have been confirmed through inspection of original purchase invoices, copies of which should also be on file.
– Documentation of the results of a discussion with the production manager to ascertain how they estimate the average production time per unit of inventory. Any calculations referred to by management should have been reperformed by the audit team to confirm their mathematical accuracy and agreed to corroborating documentation.
– A copy of the calculation of the forecast annual wage cost. The initial staffing levels should have been confirmed through inspection of current human resource records and for a sample of the staff their initial wages should have been confirmed through inspection of payroll records.
– Forecast wage increments should have been agreed to either post year end confirmation issued by human resources or minutes of board meetings approving pay rises.
– Documentation of the results of a discussion with management regarding how the forecast is made and who is ultimately responsible for reviewing and approving the forecast.
– A copy of the calculation of forecast units of production. This should have been analytically reviewed in comparison to the previous year’s production levels. Where there are significant differences explanations should have been sought from management.
– A copy of the calculation of forecast production overheads. This should have been analytically reviewed by category of overhead in relation to the previous year to identify any significant variances. Corroborating evidence, such as rental and utilities agreements, should have been obtained where possible.
– There should be evidence on all management’s schedules that the figures have been recalculated by the audit team to confirm the mathematical accuracy of management’s calculations.
(b)    Impairment
Matters
Materiality
The impairment of $9 million represents 0·47% of total assets and 8·41% of profit. While it is not material to the statement of financial position it is material to the statement of profit or loss.
Calculation of recoverable amount
The fair value of the retail outlets, the disposal costs and the value in use are all management estimates. This increases the risk of material misstatement through both error and management manipulation of the reported figures.
In particular, while the estimate for the fair value appears to have a reasonable basis, the estimate of value in use appears to be too basic. The assumption that the cash flows attributable to the whole of the retail division will grow at 1% per annum is too simplistic and appears to lack commercial justification. It is likely that each retail outlet will be subject to regional variations in growth and growth rates will also be subject to annual fluctuations based upon economic variables. There is also no justification as to why 1% growth has been selected to represent ‘poor performance’, at the very least this should be benchmarked to more widespread and reliable growth forecasts, e.g. national forecasts of economic growth.
Allocation of the impairment
The impairment has been allocated against all of the tangible assets in the cash generating unit. This is incorrect; as a cash generating unit the impairment should firstly be allocated against any goodwill relating to the cash generating unit in accordance with IAS 36 Impairment of Assets. It should then be allocated against the remaining assets on a pro-rata basis bearing in mind that an asset should not be impaired below the highest of either its fair value less costs of disposal or its value in use.
Evidence expected to be on file:
– Copies of the offers received to purchase the retail outlets, confirming the amounts offered. These should have been used to recalculate the average used for the estimate of fair value.
– Documentation of enquiries with management with regard to how they estimated the disposal costs and what experience they have had with the sale of similar operations.
– A copy of the forecast cash flows attributable to the retail outlets. This should contain evidence of analytical review in comparison to the year ended 31 March 2017 to confirm the accuracy of the base cash flows.
– There should then be evidence of a recalculation of the future cash flows using management’s estimates of 1% growth to confirm the mathematical accuracy of management’s calculation.
– There should be evidence of a recalculation of the value in use using a range of growth rates to assess the sensitivity of management’s calculations to economic variables. The differences between these valuations and management’s valuation should have been reviewed to assess the likelihood of a material under or overvaluation.
– Evidence of an analytical review of performance by retail outlet or geographical area of operations, referenced to sales and cash flow records where available, to confirm whether growth rates are consistent across the brand or whether there are variances.
– Documentation of enquiries with management relating to their expectations for specific retail outlets or areas of operations and whether there are any specific matters which they are aware of which may affect regional performance, e.g. the opening of new out-of-town shopping facilities or competitors setting up in the same location.
– A schedule of any goodwill included in the statement of financial position with analysis of its various components to assess whether any part is attributable to the retail outlets as a cash generating unit. This is specifically relevant to any acquired brands which may be sold through the retail stores or any retail brands acquired by Osier Co.
– A recalculation of the allocation of the impairment by the auditor, firstly against any goodwill determined to be attributable to the cash generating unit, then against the remaining assets pro rata.
– Copies of previous forecasts. Where the retail outlets forecast performance exceeds the 1% currently predicted by management there should be evidence of discussion with management to ascertain the reasons for changing their outlook.
(c)    Warranty provision
Matters
Materiality
The year end provision represents 0·36% of total assets and 6·54% of profit. It is not, therefore, material to the statement of financial position but it is material to the statement of profit or loss.
Estimates
The estimate of returns is clearly subject to significant subjectivity. This increases the risk of material misstatement due to both error and manipulation.
The estimate is made by the sales director; while this may be the best person to forecast sales they may not be the best person to predict returns. Returns are likely to be influenced more heavily by product quality, which the production or quality control manager may be better placed to predict. This implies that the forecast amount is based on simplistic, general estimates using sales levels rather than consideration of specific product quality issues.
Evidence of prior overstatement
The risk of misstatement is amplified by the evidence of large overstatements in the past. The reversal of unutilised provisions suggests that previous estimates were too high, which indicates inaccuracy in the forecasting process. The reversal of unutilised provisions represents 2·9% of profit so is not individually material to the financial statements.
Possible creative accounting
Provisions can be used to smooth profits; i.e. a provision made in a year where profits are high and reversed in future years (i.e. released back to the statement of profit and loss) when earnings targets are not being met.
The reversal of unutilised provisions in the year has increased Osier Co’s profits by $3·1 million. While this is not a material amount on its own, with other creative accounting devices, such as the manipulation of estimates of the cost of inventory and impairments, this could lead to a material overstatement of profits.
This should be considered a particular risk for Osier Co as their profits have declined during the year, despite a 5·5% increase in revenue during the year. The decline in performance provides an increased incentive for management to adopt manipulative accounting practices to help achieve targets and smooth profits.
Evidence expected to be on file:
– Copies of the terms of sale offered to customers to confirm the length of the warranty period.
– Notes of a discussion with the sales director confirming the basis of the calculation for forecast returns. These should specifically note any general rates of return applied to the calculation and any specific matters the director has taken into consideration, such as known faults or poor quality.
– A copy of the calculation of the provision. The components of the calculation should have been recalculated and analytically reviewed in comparison to previous years and any fluctuations should have been corroborated to supporting evidence.
– A schedule analysing the total returns received following the year end. A sample of these returns should have been matched to the original sales invoice, confirming the date upon which the goods were first sold.
– This schedule should also have been analytically reviewed in comparison to the same period in previous years to identify whether returns levels were consistent. Any significant fluctuations should have been corroborated with evidence or management enquiry.
– A schedule confirming the calculation of the total unutilised provisions reversed during the year. These should be accompanied with the notes of a meeting with management identifying the reasons why these provisions were not needed and, where possible, what time period the original provision related to.
– Notes of a discussion with the production or quality control manager identifying whether there are any known problems with goods sold during the warranty period, and what products were affected. If any such matters exist there should be evidence that these have been traced through to the provision calculation.