• 20 Marks

AAA – May 2022 – L3 – Q3 – Audit of Prospective Financial Information

Discuss auditor assurance work on prospective financial information, cash flow forecast procedures, and forming an opinion on PFI.

Tijara Nigeria Limited has a credit facility of N6 million with Godiya Bank. The facility was due to expire on December 31, 2021. The overdraft in the recently audited statement of financial position as at September 30, 2021 is N5.5 million. The directors of Tijara have started negotiations with their bankers for a renewal of the facility and to increase the amount to N9 million. To support this request, the bank has asked Tijara to provide a business plan for the coming twelve months consisting of a cash flow forecast supported by a forecast income statement and statement of financial position.

The management of Tijara has produced a cash flow forecast for the period October 1, 2021, to September 30, 2022, and, at the request of the bank, has asked an auditor to examine and report on it.

The Audit Manager, who has recently completed Tijara’s audit, has been asked to make a preliminary examination of the cash flow forecast and supporting materials. The manager has made the following observations:

  1. The cash flows from sales are based on the assumption of an overall increase in sales of 24% compared to the previous financial year. Analysis shows that this is based on an increase in selling price of 5% and an increase in the volume of sales of 18%. Just over a quarter of all Tijara sales are made to foreign customers.
  2. The cost of sales in the recently audited comprehensive income to September 30, 2021, was 80% of sales revenue, giving a gross profit of 20%. In the forecast income statement for the year to September 30, 2022, the cost of sales has fallen to 72%, giving a gross profit of 28%. Manufacturing costs are made up of equal proportions of materials, labor, and production overheads.
  3. The trade receivables collection period used in the cash flow forecast to September 30, 2022, is 61 days. In the year to September 30, 2021, this period averaged 93 days. Management has stated that it is its intention to inform all customers of a new standard 60-day credit period. In addition, an early settlement discount of 1% will apply to customers who settle their accounts within 30 days of the statement. Conversely, the credit period for trade payables has been extended from an average of 45 days in the current year to 90 days in the forecast.
  4. The cash flow forecast showed that the maximum credit required during the period would rise to nearly N9 million in August 2022.

Required:

a. Describe the general approach to the assurance work an auditor should consider before accepting the engagement of a reporting accountant on Prospective Financial Information (PFI) under ISAE 3400: The Examination of Prospective Financial Information. (8 Marks)

b. Detail the procedures applicable to the cash flow forecast of Tijara for the year to September 30, 2022. (7 Marks)

c. Prepare a summarized presentation of what the reporting accountant should consider in forming an opinion on prospective financial information (PFI). (5 Marks)

a. General Approach to Assurance Work on Prospective Financial Information (ISAE 3400)

  1. Understanding the Engagement:
    • Confirm the scope and purpose of the engagement, ensuring compliance with ISAE 3400.
    • Assess the competence and independence of the auditor to undertake the assignment.
  2. Management Responsibility:
    • Ensure management takes responsibility for the preparation and presentation of PFI.
  3. Assessing PFI Nature:
    • Evaluate the appropriateness of the assumptions and the relevance of the PFI to its intended use.
  4. Engagement Terms:
    • Agree on the terms of the engagement, including the level of assurance to be provided.
  5. Resources and Expertise:
    • Ensure sufficient resources and expertise are available to assess complex or industry-specific issues.
  6. Risk Assessment:
    • Identify risks associated with the reliability of assumptions and data used in the PFI.

b. Procedures Applicable to Cash Flow Forecast

  1. Understanding Assumptions:
    • Evaluate assumptions about sales growth, cost reduction, and credit period changes for reasonableness.
  2. Analyzing Historical Data:
    • Compare forecast data with historical trends to assess consistency and reliability.
  3. Reviewing Supporting Documents:
    • Verify contracts, agreements, and management plans that support key assumptions.
  4. Testing Sensitivity:
    • Assess the impact of changes in key variables on cash flows and financial outcomes.
  5. Assessing Liquidity and Credit Risk:
    • Analyze the sufficiency of projected cash inflows to meet obligations, including debt repayment.
  6. Examining External Factors:
    • Consider external economic factors such as inflation, foreign exchange, and market demand.
  7. Assessing Presentation and Disclosure:
    • Ensure the forecast is presented fairly and in compliance with relevant financial reporting frameworks.

c. Reporting Accountant’s Considerations in Forming an Opinion on PFI

  1. Assumptions:
    • Evaluate whether the assumptions are reasonable and internally consistent.
  2. Completeness of Information:
    • Verify that all material items are included in the forecast.
  3. Consistency with Historical Trends:
    • Confirm alignment with past performance and industry benchmarks.
  4. Compliance with Framework:
    • Ensure the PFI complies with the applicable financial reporting framework.
  5. Limitations of PFI:
    • Highlight inherent uncertainties and the non-binding nature of the forecast.
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