3 (@ ) Seinflower Understanding an entity ‘Source of information Prior year audit fie Information expect to obtain Identification of issues that arose in the prior year ay Prior year financial statements ‘Accounting systems notes Discussions with management Current year budgets and management ‘accounts of Sunflower Stores Co (Sunflower) Permanent aucit fe Provides information in relation to matters of continuing importance for the company and the audit team, such as statutory books information or important agreements. Sunflower's website Recent oress releases fiom the company may provide background on changes to the business during the year as this could lead to ‘ditional aucit risks, Provides information on the internal control deficiencies noted in the prior year; if these have not been ecified by management then they could arse in the current year audit as wel, ‘This will provide information about Sunflower’s competitors, in relation to their financial results and their accounting policies, This will be important in assessing Sunfiower's performance in the year ‘Audit risks and auditor responses Audit risk ‘Sunfiower has spent $1:6m on refurbishing its 25 food supermarkets. This expenditure needs to be reviewed to ‘assess whether itis of a capital nature and should be included within non-current assets or expensed as repairs During the year a small warehouse has been disposed of at 2 profit. The asset needs to have been correctly removed ‘rom property plant and equipment to ensure the non-current asset register Is not overstated, and the profit on disposal should be included within the income statement. Sunflower has borrowed $1-5m from the bank via a five year loan, This loan needs to be correctly spit between ‘current and non-current liabilities In addition, Sunflower may have given the bank a charge cover its asseis as security for the loan. Theve 's a risk that the cisclosure of any security given is not complete. Sunflower will be undertaking a number of simultaneous Inventory counts on 31 December including the warehouse {and all 25 supermarkets. It is not practical forthe autor to attend ali ofthese counts; hence it may nt be possible to gain sufficient appropriate audit evidence over inventory counts, 14 {and also when undertaking the going concem review. Auditor response Review a breakdown of the costs and agree to invoices to assess the nature ofthe expenditure and, if capital, agree to inclusion within the asset register and, if repairs, agree to the income statement, Review the non-current asset register to ensure thatthe asset has been removed. Also confirm the disposal proceeds 25 well as recalculating the profit on disposal. Consideration should be given as to whether the profit on disposal is significant enough to warrant separate disclosure within the income statement, During the audit the team would need to confirm thatthe $1:5m loan finance was received. In addition, the spit between current and non-cutrent liabilities and the disclosures for this loan should be reviewed in detail to censure compliance with relevant accounting standards. The loan agreement should be reviewed to ascertain whether any security has been given, and this bank should be circularised as part of the bank confirmation process. The team should select a sample of sites to vist Its likely that the warehouse contains most goods and therefore should be selected. In relation to the 25 supermarkets, the team should visit those with material inventory balances andjor those with a history of inventory count issues,©) @ Audit risk Sunflowers inventory valuation policy is selling price less average profit margin, Inventory should be valued at the lower of cost and net realisable value (NRV) and if ths is not the case, then inventory could be under or overvalued, IAS 2 inventories allows this as an inventory valuation method 2s long as its a close approximation to cost. If this 's not the case, then inventory could be under or overvalued. The opening balances for each supermarket have been transferred into the head office's accounting records at the beginning of the year. There is a risk that f this transfer has ‘not been performed completely and accurately, the opening balances may not be correct. ‘Tnere has been an increased workload for the finance department, the financial controler has left and his replacement will only stat in late December. This increases the Inherent risk within Sunflower as errors may have been made within the accounting records by the ‘overworked finance team members. The new financial controller may nat be sufficiently experiences to produce the financial statements and resolve any audit issues. Internal audit department Prior to establishing an internal aut (IA) department, the finance director of Sunflower should consider thy 0 The costs of establishing an 1A department will be significant, therefore prior to commit Auditor response Testing should be undertaken to confirm cost and NRV of inventory and that on a line-by-ine basis the goods are valued correct, In addition, valuation testing should focus on comparing the cost af inventory tothe selling price less margin to confirm whether this method is actualy a close approximation to cost Discuss with management the process undertaken to transfer the data and the testing performed to confirm the transfer was complete and accurate. Computer-assisted aucit techniques could be utilised by the team to sample test the transfer of data from each supermarket to head office to identify any enor. ‘The team should remain alert throughout the audit for ‘additional errors within the finance department. In addition, discuss with the finance director whether he will be able to provide the team with assistance for any auclt issues the new financial controller is unable to resolve. lowing these costs and management time, @ cost benefit analysis should be performed. w the greater the need for an IA department. At Sunflower The size and complexity of Sunflower should be considered. The larger, more complex a verse a company is, then there are 25 supermarkets anda head office and therefore it would seem that the company is diverse enough to gain benefit fram an IA departnypt ay The role of any {A department should be considered. The finance director should | performing, He should consider whether ne wishes them to undertake i sider what tasks he would envisage ery counts at the stores, or whether he would want them to undertake such roles as intemal controls reviews. ww o (Ifthe possibilty of fraud is high, then the greater the possibly undertake fraud investigations. As Sunt fraud of both inventory and cash Fundamental principles Integrity ~ to be straightlonward and hong Objectivity ~to not alow bias, cont Having identified the role of any A department, the fiance directors for employees who could perform these tasks, therefore reducing t The finance director should assess the current control envoy stores with a history of contol deficiencies. I this isthe cas (4 consider whether there are existing managers ‘eed to establish a separate IA department. fent and determine whether there are departments or then it increases the need for an IA department for an 1A department to act as both a deterrent and also to ‘operates 25 food supermarkets, it will have a significant risk of in all professional and business relationships. A interest or undue influence of others to overide professional or business judgements. Professional Competence and Oyué Care ~ to maintain professional knowledge and skil atthe level required to ensure that a client receives competent pycfessional services, and to act piofessional stands lligently and in accordance with applicable technical and 15Fundamentals Level in Skills Module, Paper F8 (INT) ‘Audit and Assurance (Intemational) 1 @ wo ‘Audit risk and its components ‘Audit sk isthe risk that the aualtor expresses an inappropriate audit opinion when the financial statemes misstated. Audit risk fs @ function of two main components being the risks of material misstatemes (of material misstatement is made up of two components, inherent risk and control risk Inherent rskis the susceptibility of an assertion about a class of transaction, a ‘that could te material, elther individually or wien aggregated with ot contrat. Control risk isthe risk that a misstatement whit ‘Au ks and responses Audit risk Minty has incurred $5m on updating, repairing and replacing @ significant amount of the production process machinery. If this expenciture is of a capital nature, it should be capitalised as part of property, plant and equipment (PPE) in tne with IAS 16 Property, Plant and Equipment. However, iit elates more to repair, then it should be ‘expensed to the statement of profit or loss (income statement). Ifthe expenditure is not correctly classified, pioft and PPE could be under or overstated, [At the year end there will be inventory counts undertaken in all 15 warehouses, Its unlikely that the auctor will be able to attend all 15, inventory counts and therefore they need to ensure that they ‘obtain suficient evidence over the inventory counting, controls, and completeness and existence of inventory for any warehouses not visited Inventory is stored within 16 warehouses; some are owned by Minty and some rented from third parties. Only warehouses owned by Minty should be included within PPE, There isa risk of overstatement of PPE and lnderstatement of rental expenses if Minty has capitalised all 15 warehouses ‘A new accounting general ledger system has been introduced at the beginning of the year and the old system ‘was run in parallel fortwo months “There is @ risk of opening balances being misstated and loss of data if they have not been transferred ffom the old system correctly. In addition, the new general ledger system will require documenting and the controis over this will need fo be tested, The finance director of Minty has decided to release the ‘opening provision of $1°5 milion for allowance for receivables as he feels it is unnecessary There is a risk that receivables will be overvalued, as despite having a credit controller, some balances wil be Inrecoverable and so will be overstated if not provided against. In addition, due to the damaged inventory there is an increased risk of customers refusing to make payments in ful ents. Detection risk is affected by sampling and non-sampling risk. December 2013 Answers €imaterally detection risk. Risk ance or disclosure to a misstatement Fslaternents, before consideration of any related ‘Secur in an assertion about a class of transaction, account balance ‘Auditor response ‘The auditor should review a breakdown of these costs to ascertain the split of capital and revenue expenciture, and further testing should be undertaken to ensure thatthe Classification in the financial statements is corect, ‘The aucitor should assess which ofthe inventory sites they vill attend the counts for. This will be any with material inventory or which have a history of significant eros, For those not visited, the auditor will need to review the level of exceptions noted during the count and discuss with management any issues which arose during the count. ‘The auditor should review supporting documentation for all warehouses included within PPE to confiam ownership by Minty and to ensure non-curtent assets are not overstated The auditor should undertake detailed testing to confirm that all opening balances have been correctly recorded in the new general ledger system, They should document and test the ew system. They should review any management reports run comparing the ld and new system during the parallel run to identify any Issues with the processing of accounting information. Extended post year-end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation and the need for an allowance for receivables.© Audit risk Minty has incutred expenditure of $4-5 milion on ‘developing a new brand of fizzy drink. This expenditure is research and develoament under IAS 38 Intangible Assets. The standard requires research costs to be expensed and development costs to be capitalised as an intangible asset If Minty has incorrectly classified research costs as development expenditure, there is 2 isk the intangible asset ‘could be overstated and expenses understated. ‘A large batch of cola products has been damaged in the production process and wil be in inventory at the year end No adjustment has been made by management, The valuation of inventory as per IAS 2 inventories should be at the lower of cost and net realisable value. Hence itis likely that this inventory is overvalued, Due to the damaged cola products, a number of customers hhave complained. itis ikely that for any of the damaged goods sold, Minty will need to relund these customers, Revenue is possibly overstated if the sales returns are not ‘completly and accurately recorded. The management of Minty receives a significant annual bonus based on the value of year end total assets. There is a risk that management might feel under pressure to ‘overstate the value of assets through the judgements taken fr through the use of releasing provisions. Audit strategy document The audit strategy sets out the scope, timing and direction ofthe audit and helps the development ofthe auci consider the folowing main areas. It should identify the main characteristics of the engagement which define Its scope, For Minty following: = Whether the financial information to be audited hes been prepared in accordance with IFp ‘To what extent audit evidence obtained in previous audits for Minty willbe utilised. = Whether computer-assisted sual techniques willbe used and the elfect of IT on a = The availabilty of key personnel at Minty. It should ascertain the reporting objectives of the engagement to plan the ty communications required, such as: The aueit timetable for ceporting and whether there will be an inter = Organisation of meetings with Minty's management to discuss any = Location of the 15 inventory counts. = Any discussions with management regarding the reports 10, The timings of the audit eam meetings and review of = Ifthere ate any expected communications with third ‘The strategy should consider the factors that, in the au team’s efforts, such as = The determination of materiality for the a = The need to maintain a questioning evidence. It should consider the results of prli other engagements for Minty is relpfant, such as: ‘an overhaul of the factory = Setting the audit budget. Auditor response Obtain a breakdown of the expenditure and undertake ‘esting fo determine whether the costs relate to the research or development stage. Discuss the accounting treatment with the finance director and ensure its in accordance with las 38, Detailed cost and net realisable value testing to be performed to assess Now much the inventory requites ‘writing down by. Review the breakdown of sales of damaged goods, and ensure that they have been accurately removed from revenue. Throughout the audit the team will need to be alert to this risk. They will need to maintain professional skepticism and carefully review judgemental decisions and compare lueatment against prior years, well as final auc ’s professional judgement, are significant in directing Minty’s audit ‘and to exercise professional skeptic'sm in gathering and eveluating audit fary aul planning activites and, where applicable, whether knowledge gained on i, which may determine whether it is more efficient for the audit team to rly on intemal conto. s developments affecting Minty, such as the change in the accounting system and the significant should ascertain the nature, timing and extent of resources necessary to perform the aucit, such as: Tutorial nate: The answer is longer than required for four marks but represents a teaching ai. 102 @ o) © @ Recodo Review any correspondence with tax aut if s0, agree they are included in the year-end accrual ~ Review any disclosures made of the income lax accruat and assess whether these are in compliance w) standards and legislation, Value for money audit In performing a value for money audit, there are three areas which an aucltor will comy efficiency and effectiveness, and these are known as the ‘three Es. Economy ~ Keeping the cost of resources used to @ minimum. 5 to assess whether there are any additional outstanding paymey Aue eccounting ly focus on being economy, Efficiency - The relationship between the output from goods and services and the sources used to produce them, Effectiveness ~ How well ne organisation's objectives have been achieved! ‘Audit documentation = Provides evidence of the auditor's basis for @ conclusion abot = Provides evidence that the aucit was planned and performs requirements ~ Assists the engagement team to plan and perform = Assists members of the engagement team respoy = Enables the engagement team to be account = Retains a record of matters of continuing Audit sampling can be ‘tems and using the ie achievement ofthe overall objective ofthe aust i accordance with ISAs and applicable legal and regulatory ‘uit. le for supervision to altect, supervise and review the audit work ‘easondble assurance and hence itis not necessary to test every item within a population, Audit risks and responses Audit risk Recorder Communications Co (Recorder) is a new client for Piano & Co. As the tearm is not so familiar with the ‘accounting polices, transactions and balances of Recorder, there will be an increased detection risk on the aut Recorder purchases their goods from South Asia and the ‘goods are in transit for two weeks. At the year end there is a isk thatthe cut-off of inventory, purchases and payabies may not be accurate. The company correctly accounts for goods when they receive them. Therefore at the year end only goods wich have been received into the warehouse should be included in the inventory balance and a respective payables balance recognised ‘The company undertakes continuous (perpetual) Inventory counts at its central warehouse. Under such a system all inventory must be counted at least once a year with adjustments made to the inventory records Inventory could be under or overstated if the continuous, (perpetual) inventory counts are not complete and the inventory records accurately updated for adjustments. AA sales-telated bonus scheme tas been introduced in the yea; this may lead to sales cut-off erors with employees aiming to maximise their current year bonus. ctr Auditor's response Piano & Co should ensure they have a suitably experienced team. Also, adequate time should be allocated for tearm members fo obtain an understanding of the company and the risks of material misstatement. The audit team should undertake detailed cut-off testing of ‘goods in transit rom the suppliers in South Asia to ensure that the cut-of is complete and accurate. “The completeness of the continuous (perpetual) inventory counts should be reviewed. In addition, the level of adjustments made to inventory should be considered to ‘assess whether reliance on the inventory records atthe year fend will be acceptable Increased sales cutof testing will be performed along with 2 review of any post year-end cancellations of contracts as they may indicate cut-off errors.) @ Auait risk Receivables are considerably higher than the prior year and there are concerns about the creditworthiness of some customers ‘There isa risk that some receivables may be overvalued as they are not recoverable. In addition, receivables could be overstated as a result of the bonus scheme; some of the customers sianed up for contracts may not actually exist. Recorder has a policy of revaluing its land and buildings and these valuations have been updated during the year. Property, plant and equipment could be under or overvalued ifthe recent valuation has not been cartied out in accordance with IAS 16 Property, Plant and Equipment and ‘adequate disclosures may not have been made in the financial statements, ‘The citectors have each been paid a significant bonus and separate disclosure ofthis in the financial statements is ‘required by local legislation ‘The directors’ remuneration disclosure will not be complete and accurate if the bonus paid is not disclosed in ‘accordance with the relevant local legislation, ‘Audit procedures for continuous (perpetual) inventory counts = The audit team should attend atleast one of the continuous (perpetual) inventory counts to review (over the inventory count are adequate. = The audit team should confirm that all of the inventory lines have been counted or are due to, 4 year by reviewing the schedules of counts undertakendue to be undertaken, ~ Review the adjustments made to the inventory records on @ monthly basis to gain a differences arsing on a month by month basis = IF signticant differences consistently arise, this could indicate that the inventory 1 Discuss with management how they will ensure that year-end inventory will no = Consider attending the inventory count at the year end to undertake test co ‘Auditor's response Extended post year-end cash receipts testing and a review of the aged receivables ledger to be performed to assess valuation. Also consider the adequacy of any allowance for receivables, Extemal confirmation of receivables to confiam that ‘customers exist and represent valid amounts due. Discuss with management the process adopted for Undertaking the valuation, including whether the whole class of assets was revelued and ifthe valuation was Undertaken by an expert. This process should be reviewed for compliance with IAS 16. Review the disclosures of the revaluation in the financial statements for compliance with IAS 16, Discuss this matter with management and review the isclosure in the financial statements fo ensure compliance ith local legislation. ‘counted at least once faderstanding of the level of is ate not adequately maintained funder or overstated. S of inventory from records to floor and {rom floor to records in order to confirm the existence and completeness ofnventory Substantive procedures for directors’ bonus and remuneration = Obtain 2 schedule ofthe directors! remuneration including the = Agtee the individual bonus payments to the payroll recor, Confirm the amount of each bonus paid by agreeing to th = Review the board minutes to confirm whether any add} = Obtain 2 written representation ftom management bonus. Review any disclosures made of the bonus a {as aid and cast the addition of the schedule. nal bonus payments relating to this year have been agreed, fiming the completeness of directors’ remuneration including the s9ess whether these are in compliance with local legislation, Conflicts of interest = Both Recorder Communications Co gd its competitor should be notified that Piano & Co would be acting as auditors {or each company and, if necessayf, consent obtained. = Advising one or both clients to sek additional independent advice. = The use of separate engagegaént teams, with cfferent engagement partners and team members; once an employee has ‘as Recotder Communications Co, then they would be prevented from being on the audit of of time. This separation of teams is known as building a ‘Chinese wall secure data filing Clear guidelines for members of each engagement team on issues of security and confidentiality, These guidelines could be includey“within the audit engagement letters. ‘the use of confidentiality agreements signed by employees and partners ofthe frm. = Regular monitoring of the application of the above safeguards by a senior individual in Piano & Co not involved in ether audit 12