• 15 Marks

AAA – Nov 2020 – L3 – Q2a – Planning | Audit Evidence | Evaluation and Review

Identify and explain significant audit risks and other matters when planning the final audit for Manuf Co. for the year ended 31 March 2019.

Using the information provided, identify and explain the significant audit risks, and any other matters to be considered when planning the final audit for Manuf Co. for the year ended 31 March 2019. (15 marks)

  • Legal claim: The claim should be investigated seriously by Manuf Co. The chief executive officer’s (CEO) opinion that the claim will not result in any financial consequence for Manuf Co is naive and flippant. Damages could be awarded against Manuf Co if it is found that the machinery is faulty. The recurring high level of warranty provision implies that machinery faults are fairly common and therefore the accident could be the result of a defective machine being supplied to Law Co Ltd. The risk is that no provision is created for the potential damages under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, if the likelihood of paying damages is considered probable. Alternatively, if the likelihood of damages being paid to Law Co Ltd is considered a possibility, then a disclosure note should be made in the financial statements describing the nature and possible financial effect of the contingent liability. As discussed below, the CEO, Odo Pa Nye, has an incentive not to make a provision or disclose a contingent liability due to the planned share sale post year-end.
  • A further risk is that any legal fees associated with the claim have not been accrued within the financial statements. As the claim has arisen during the year, the expense must be included in this year’s income statement, even if the claim is still ongoing at the year-end.
  • Law Co Ltd has cancelled two orders: If the amounts are still outstanding at the year-end, then it is highly likely that Law Co Ltd will not pay the invoiced amounts, and thus receivables are overstated. If the stage one payments have already been made, then Law Co Ltd may claim a refund, in which case a provision should be made to repay the amount, or a contingent liability disclosed in a note to the financial statements.
  • Warranty provision: The warranty provision is material at 2·6% of total assets (2018 – 2·7%). The provision has increased by only GHS 100,000, an increase of 4·2%, compared to a revenue increase of 21·4%. This could indicate an underprovision as the percentage change in revenue would be expected to be in line with the percentage change in the warranty provision unless significant improvements had been made to the quality of machines installed for customers during the year. This appears unlikely given the legal claim by Law Co Ltd and the machines installed at Mmere Pa Nye Company Ltd operating inefficiently. The basis of the estimate could be understated to avoid charging the increase in the provision as an expense through the income statement. This is of special concern given that it is the CEO and majority shareholder who estimates the warranty provision.
  • Inventories: Work in progress is material to the financial statements, representing 8·9% of total assets. The inventory count was held two weeks prior to the year-end. There is an inherent risk that the valuation has not been correctly rolled forward to a year-end position.
  • Overseas supplier: As the supplier is new, controls may not yet have been established over the recording of foreign currency transactions. Inherent risk is high as the trade payable should be retranslated using the year-end exchange rate per IAS 21 The Effects of Changes in Foreign Exchange Rates. If the retranslation is not performed at the year-end, the trade payable could be significantly over or under-valued, depending on the movement of the dollar to euro exchange rate between the purchase date and the year-end. The components should remain at historic cost within inventory valuation and should not be retranslated at the year-end.
  • Revenue Recognition – timing: Manuf Co raises sales invoices in three stages. There is potential for a breach of IFRS 15 Revenue from Contracts with Customers.
  • Disputed receivable: The amount owed to Mmere Pa Nye Company Ltd is highly material as it represents 50·9% of profit before tax, 2·3% of revenue, and 3% of total assets. The risk is that the receivable is overstated if no impairment of the disputed receivable is recognized.
  • Majority shareholder: Odo Pa Nye exerts control over Manuf Co via a majority shareholding and by holding the position of CEO. This greatly increases the inherent risk that the financial statements could be deliberately misstated, i.e. overvaluation of assets, undervaluation of liabilities, and thus overstatement of profits. The risk is severe at this year-end as Odo Pa Nye is hoping to sell some Manuf Co shares post year-end. As the price that she receives for these shares will be to a large extent influenced by the financial position of the company at 31 March 2019, she has a definite interest in manipulating the financial statements for her own personal benefit.
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