- 30 Marks
Question
You are a manager in Puposola & Company (Chartered Accountants) responsible for the audit of the Honey Group (the Group), a quoted company. The Group’s main activity is steel manufacturing and it comprises of a parent company and three subsidiaries. Your firm currently audits all components of the Group. You are working on the audit of the Group’s financial statements for the year ended June 30, 2017. This morning, the audit engagement partner left a note for you.
“Hello
I have gone through the draft consolidated financial statements and accompanying notes which summarise the key audit findings and some background information.
Although, at the planning stage, materiality was initially determined to be N900,000, and was calculated based on the assumption that Honey Group is a high-risk client due to its listing status. However, due to a number of issues that arose during the audit, there is a need to revise the materiality level for the financial statements as a whole. The revised level of materiality should now be N700,000.
Thank you.”
The Group’s draft consolidated financial statements, with notes referenced to key audit findings, are shown below:
Draft Consolidated Statement of Comprehensive Income
| Note | June 30, 2017 Draft (N’000) | June 30, 2016 Actual (N’000) |
|---|---|---|
| Revenue | 98,795 | 103,100 |
| Cost of sales | (75,250) | (74,560) |
| Gross profit | 23,545 | 28,540 |
| Operating expenses | (14,900) | (17,500) |
| Operating profit | 8,645 | 11,040 |
| Share of profit of associate | 1,010 | 900 |
| Finance costs | (380) | (340) |
| Profit before tax | 9,275 | 11,600 |
| Taxation | (3,200) | (3,500) |
| Profit for the year | 6,075 | 8,100 |
| Other comprehensive income for the year, net of tax: | ||
| Gain on property revaluation | 800 | —– |
| Actuarial losses on defined benefit plan | (1,100) | (200) |
| Other comprehensive loss | (300) | (200) |
| Total comprehensive income for the year | 5,775 | 7,900 |
Notes: Key Audit Findings on Statement of Comprehensive Income
- Revenue has been stable for all components of the Group with the exception of one subsidiary, Copesink Company, which witnessed a 25% decrease in revenue.
- Operating expenses for the year to June 2017 is shown net of profit on a property disposal of N2 million. Our evidence includes agreeing the cash receipts to the bank statement and sale documentation, and we have confirmed that the property has been removed from the non-current asset register. The audit junior noted when reviewing the sale document that there is an option to repurchase the property in five years’ time, but did not discuss the matter with management.
- The property revaluation relates to the Group’s head office. The audit team has not obtained evidence on the revaluation, as the gain was immaterial based on the initial calculation of materiality.
- The actuarial loss is attributed to an unexpected stock market crash. The Group’s pension plan is managed by Axial Company, a firm of independent fund managers who maintain the necessary accounting records relating to the plan. Axial Company has supplied written representation as to the value of the defined benefit plan’s assets and liabilities at June 30, 2017. No other audit work has been performed other than to agree the amount reported in the financial statements to supporting documentation supplied by Axial Company.
Draft Consolidated Statement of Financial Position
| Note | June 30, 2017 Draft (N’000) | June 30, 2016 Actual (N’000) |
|---|---|---|
| ASSETS | ||
| Non-current assets | ||
| Property, plant and equipment | 81,800 | 76,300 |
| Goodwill | 5,350 | 5,350 |
| Investment in associate | 4,230 | 4,230 |
| Non-current assets held for sale | 7,800 | – |
| Total non-current assets | 99,180 | 85,880 |
| Current assets | ||
| Inventory | 8,600 | 8,000 |
| Receivables | 8,540 | 7,800 |
| Cash and cash equivalents | 2,100 | 2,420 |
| Total current assets | 19,240 | 18,220 |
| Total assets | 118,420 | 104,100 |
| EQUITY AND LIABILITIES | ||
| Equity | ||
| Share capital | 12,500 | 12,500 |
| Revaluation reserve | 3,300 | 2,500 |
| Retained earnings | 33,600 | 29,400 |
| Non-controlling interest | 4,350 | 4,000 |
| Total equity | 53,750 | 48,400 |
| Non-current liabilities | ||
| Defined benefit pension plan | 10,820 | 9,250 |
| Long-term borrowings | 43,000 | 35,000 |
| Deferred tax | 1,950 | 1,350 |
| Total non-current liabilities | 55,770 | 45,600 |
| Current liabilities | ||
| Trade and other payables | 6,200 | 7,300 |
| Provisions | 2,700 | 2,800 |
| Total current liabilities | 8,900 | 10,100 |
| Total liabilities | 64,670 | 55,700 |
| Total equity and liabilities | 118,420 | 104,100 |
Notes: Key Audit Findings on Statement of Financial Position
- The goodwill relates to each of the subsidiaries in the Group. Management has confirmed in writing that goodwill is stated correctly, and our other audit procedure was to arithmetically check the impairment review conducted by management.
- The associate is a 30% holding in Jamil Company, purchased to provide investment income. The audit team has not obtained evidence regarding the associate as there is no movement in the amount recognised in the statement of financial position.
- The non-current assets held for sale relate to a trading division of one of the subsidiaries, which represents one third of that subsidiary’s net assets. The sale of the division was announced in May 2017, and is expected to be complete by December 31, 2017. Audit evidence obtained includes a review of the sales agreement and confirmation from the buyer obtained in July 2017, that the sale will take place.
- Two of the Group’s subsidiaries are partly owned by shareholders external to the Group.
- A loan of N8 million was obtained in October 2016 at an interest rate of 2%, payable annually in arrears. The terms of the loan have been confirmed from the loan agreement provided by the bank. There was no repayment of the loan in the books as at prior year end.
Required:
a. Explain why auditors may need to reassess materiality as the audit progresses. (4 Marks)
b. Assess the implications of the key audit findings for the completion of the audit.
Note: Your assessment must consider whether the key audit findings indicate a risk of material misstatement. Where the key audit findings refer to audit evidence, you must also consider the adequacy of the audit evidence obtained, but you do not need to recommend further specific procedures. (18 Marks)
c. Discuss TWO advantages and TWO disadvantages of a joint audit being performed on the financial statements. (8 Marks)
(Total 30 Marks)
Answer
a. Materiality
Materiality is a matter of judgment and is commonly determined using a numerical approach based on percentages calculated on revenue, profit before tax, and total assets. ISA 320: “Materiality in Planning and Performing an Audit” requires that the auditor shall revise materiality for the financial statements as a whole in the event of becoming aware of information during the audit that would have caused the auditor to determine a different level of materiality initially.
During the audit, the auditor becomes aware of a matter which impacts the auditor’s understanding of the client’s business and which leads the auditor to believe that the initial assessment of materiality was inappropriate and must be revised. For example, the actual results of the audit client may turn out to be quite different from the forecast results on which the initial level of materiality was based.
Also, a change in the client’s circumstances may occur during the audit, such as a decision to dispose of a major part of the business. This again may cause the auditor to consider if the previously determined level of materiality is still appropriate.
If adjustments are made to the financial statements subsequent to the initial assessment of materiality, then the materiality level may need to be revised accordingly.
The initial calculation of materiality for the Honey Group was based on the client’s listing status and on an assumption that the group is a high-risk client. It is therefore important that events, as explained above, are taken into account in assessing a new level of materiality for this client to ensure that sufficient appropriate evidence is obtained to support the audit opinion.
b. Puposola & Company (Chartered Accountants)
From: Audit Manager
To: The Audit Engagement Partner
Subject: Implications of Key Audit Findings
I refer to your note this morning regarding key audit findings on the audit of Honey Group financial statements. Please find below my viewpoint and assessment of the implications of the key audit findings as noted:
| Key Audit Findings | Assessment of the Implication of the Audit Findings for the Completion of the Audit |
|---|---|
| Statement of Comprehensive Income | |
| i. Revenue has been stable for all components except for Copeskin with a 25% decrease in revenue. | We need to verify that all revenues of Copeskin have been fully recorded and that understatement of invoices or under-billing did not occur. |
| ii. Operating expenses for the year ended June 2017 is shown net of profit on a property disposal of N2 million. | The option to repurchase the property after 5 years needs to be discussed with management. If the option results in a loan, then the N2m should be adjusted and the loan recognized (possibly with interest). Inappropriate treatment of the impact of the repurchase option could result in material misstatement of the financial statements given the amount of materiality used for audit. |
| iii. Property Revaluation | We need to obtain sufficient and appropriate audit evidence on the revaluation. Since the transaction is now considered material at N900,000 and the revised materiality level is N700,000, there is a likely risk of material misstatement. |
| iv. Actuarial loss attributed to unexpected stock market crash. | Representation letter would be obtained from the management of Honey Group. We shall carry out more audit procedures to verify the loss, which may include obtaining expert opinions such as an Actuarial Practitioner or Stocks expert. |
| Statement of Financial Position | |
| v. Goodwill relates to each of the subsidiaries in the group. | The three subsidiaries are owned and controlled by the Group. It is proper to recognize the goodwill of each of the subsidiaries at this time; however, impairment would be assessed. We have to pass an adjustment journal to recognize impairment of goodwill attributable to the subsidiaries where applicable. |
| vi. Associate is a 30% holding in Jamil Company | There is a need to obtain sufficient and appropriate audit evidence regarding this associate. A 30% holding is significant and can result in a material misstatement. |
| vii. The non-current assets held for sale relate to a trading division of one of the subsidiaries. | The non-current assets held for sale amount to one-third (33⅓%) of the net assets of the subsidiary, which is very significant. Additional audit evidence is required, especially to determine the likelihood of the future sale. |
| viii. Two of the Group’s subsidiaries are partly owned by shareholders external to the Group. | We need to ascertain the equity participation of the external shareholders to determine the extent of their interest in the subsidiaries. We shall also obtain sufficient and appropriate audit evidence to verify external shareholders’ investment in the subsidiaries. The financial statements will be materially misstated if the investments are significant and not corrected. |
| ix. Loan of N8m obtained in October 2016 at an interest rate of 2%. | We shall inquire from management regarding the reason for non-payment of the amount that fell due in December 2016. This may be an indication of going concern issues. We need to also check that interest expense relating to the unpaid loan has been fully charged in the statement of profit or loss and other comprehensive income. |
(signed)
Audit Manager
Puposola & Company (Chartered Accountants)
c. Advantages and Disadvantages of Joint Audits
Advantages of Joint Audits:
- Enhanced Transition: After the acquisition of a large subsidiary, using joint auditors may help the transition process while the group auditors become familiar with the new subsidiary. The “old” auditors are familiar with the business of the subsidiary and can pass their knowledge to the parent company auditors, accelerating their understanding of the subsidiary.
- Increased Technical Expertise: Joint auditors may provide a higher level of technical expertise than either audit firm could provide individually.
- Improved Geographical Coverage: Joint audits can enhance geographical coverage for the audit, where each of the joint auditors individually may lack offices that cover all geographical locations of the group’s components.
- Competitive Tendering for Medium Firms: Two medium-sized accountancy firms may join forces to tender for the audit of a company that would typically go to a “Big 4” firm, helping to break the “Big 4” monopoly on large audits.
Disadvantages of Joint Audits:
- Increased Cost: Using two accountancy firms is likely more expensive than employing one, leading to higher costs for the client.
- Inconsistent Audit Methods: There may be inconsistencies in audit methods used by the joint auditors, leading to potential disagreement on audit techniques.
- Division of Work: Difficulty may arise in agreeing on how to divide work between the two firms, affecting efficiency and coordination.
- Liability Issues: If there is a claim of negligence against the auditors, identifying the liable party among joint auditors can be challenging, complicating legal proceedings.
- Topic: Audit of Complex Entities
- Series: MAY 2018
- Uploader: Dotse