- 20 Marks
Question
GGC Co. Ltd (GGCL) specializes in manufacturing equipment which can help to reduce toxic emissions in the production of chemicals. The company has grown rapidly over the past eight years, and this is partly due to the warranties that the company gives to its customers. It guarantees its products for five years, and if problems arise during this period, it undertakes to fix them or provide a replacement.
You are the manager responsible for the audit of GGCL, and you are performing the final review stage of the audit and have come across the following issues:
Receivable balance owing from Nhyira Co. Ltd
GGCL has a material receivable balance owed by its customer, Nhyira Co. Ltd. During the year-end audit, your team reviewed the aging of this balance and found that no payments had been received from Nhyira Co. Ltd for over six months. GGCL would not allow this balance to be circularized. Instead, management has assured your team that they will provide a written representation confirming that the balance is recoverable.
Warranty provision
The warranty provision included within the statement of financial position is material. The audit team has performed testing over the calculations and assumptions which are consistent with prior years. The team has requested a written representation from management confirming that the basis and amount of the provision are reasonable. Management is yet to confirm acceptance of this representation.
Required:
- Describe the audit procedures required in respect of accounting estimates.
(8 marks) - For each of the two issues above:
i) Discuss the appropriateness of written representations as a form of audit evidence; and
(6 marks)
ii) Describe additional procedures the auditor should now perform in order to reach a conclusion on the balance to be included in the financial statements.
(6 marks)
(Total: 20 marks)
Answer
a) Procedures the auditor should adopt in respect of auditing accounting estimates include:
- Enquire of management how the accounting estimate is made and the data on which it is based.
- Determine whether events occurring up to the date of the auditor’s report (after the reporting period) provide audit evidence regarding the accounting estimate.
- Review the method of measurement used and assess the reasonableness of assumptions made.
- Test the operating effectiveness of the controls over how management made the accounting estimate.
- Develop an expectation of the possible estimate (point estimate) or a range of amounts to evaluate management’s estimate.
- Review the judgments and decisions made by management in the making of accounting estimates to identify whether there are indicators of possible management bias.
- Evaluate overall whether the accounting estimates in the financial statements are either reasonable or misstated.
- Obtain sufficient appropriate audit evidence about whether the disclosures in the financial statements related to accounting estimates and estimation uncertainty are reasonable.
- Obtain written representations from management and, where appropriate, those charged with governance whether they believe significant assumptions used in making accounting estimates are reasonable.
(Any 8 points @ 1 mark each = 8 marks)
b) Appropriateness of written representations
i) Receivables balance owing from Nhyira Co. Ltd
The written representation proposed by management is intended to verify valuation, existence, and rights and obligations of a material receivables balance. As management has refused to allow the auditor to circularize the balance and there has been little activity on the account for the past six months, there is very little evidence that has been obtained by the auditor.
This representation would constitute entity-generated evidence and is less reliable than auditor-generated evidence or evidence from an external source. If related control systems operate effectively, then this evidence becomes more reliable. In addition, if the representation is written as opposed to oral, then this will increase the reliability as an evidence source.
Overall, this representation is a weak form of evidence, as there were more reliable evidence options available, such as the circularization, but this was not undertaken.
(3 marks)
Warranty provision
In this case, the auditor has performed some testing of the provision in order to obtain auditor-generated evidence. The team has tested the calculations and assumptions. None of this is evidence from an external source.
The very nature of this provision means that it is difficult for the auditor to obtain a significant amount of reliable evidence as to the level of future warranty claims. Hence the written representation, whilst being an entity-generated source of evidence, would still be useful as there are few other alternatives.
(3 marks)
ii) Receivable balance owing from Nhyira Co. Ltd
In order to reach a conclusion on the balance, the following procedures should be performed:
- Discuss with management the reasons as to why a circularisation request was refused.
- Review the post year-end period to identify whether any cash has now been received from Nhyira Co. Ltd.
- Review correspondence with Nhyira Co. Ltd to assess reasons for the continued non-payment.
- Review board minutes and legal correspondence to assess whether any legal action is being taken to recover the amounts due.
- Discuss with management whether a provision or write-down is now required.
- Consider the impact on the audit opinion if the balance is considered to be materially misstated.
(Any 3 points @ 1 mark each = 3 marks)
Warranty Provisions
In order to reach a conclusion on the balance, the following procedures should be performed:
- Review the post year-end period to compare the level of claims actually made against the amounts provided.
- Review the level of prior year provisions with the amounts claimed to assess the reasonableness of management’s forecasting.
- Review board minutes to assess whether any changes are required to the level of the provision as a result of an increased or decreased level of claims by customers.
(3 points @ 1 mark each = 3 marks)
(Total: 20 marks)
- Topic: Audit evidence, Evaluation and review
- Series: MAY 2020
- Uploader: Sarah