AA – L2 – Q24 – Planning an Audit

Describe matters to consider in planning the audit of Rylan Products and actions for specific issues. Explain why auditors must understand the client’s legal framework per ISA 250 and actions for non-compliance. Explain the importance of planning an audit per ISA 300.

Question

Your firm has been the auditor of Rylan Products, a listed company, for a number of years. The engagement partner has asked you to describe the matters you would consider when planning the audit for the year ended 31 January 20X5.
During a recent visit to the company you obtained the following information:
(i) The management accounts for the 10 months to 30 November 20X8 show revenue of €13 million and a profit before tax of €400,000. Assume revenue and profits accrue evenly throughout the year. In the year ended 31 January 20X5, Rylan Products had revenue of €11 million and a profit before tax of €800,000.
(ii) The company installed a new computerised control system which has operated from 1 June 20X8. As the control system records inventory movements and current inventory quantities, the company is proposing:

to use the quantities on the computer to value the inventory at the year-end; and
not to carry out a physical inventory count at the year end.
(iii) You are aware there have been reliability problems with the company’s products, which have resulted in legal claims being brought against the company by customers, and customers refusing to pay for the products.
(iv) The revenue increase in the 10 months to 30 November 20X8 over the previous year has been achieved by attracting new customers and by offering extended credit. The new credit arrangements allow customers three months credit before their debt becomes overdue, rather than the one month credit period allowed previously. As a result of this change, the age of receivables has increased from 1.6 to 4.1 months.
(v) The financial director and purchasing manager were dismissed on 15 August. A replacement purchasing manager has been appointed but it is not expected that a new financial director will be appointed before the year end of 31 January 20X5. The chief accountant will be responsible for preparing the financial statements for audit.

Required

(a) Describe the reasons why it is important that auditors should plan their audit work.

(b) Explain why ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements requires auditors to obtain a general understanding of the legal and regulatory framework applicable to their client and how their client is complying with that framework. Set out the action auditors should take if they suspect material areas of non-compliance.

(c) Describe the matters you will consider in planning the audit and the further action you will take concerning the matters listed in (i) to (v) above.

Answer

(a) ISA 300 Planning an audit of financial statements requires that auditors shall plan the audit work so as to perform the audit in an effective manner. It goes on to say that planning entails developing a general strategy and a detailed approach for the expected nature, timing and extent of the audit.
As this is a continuing audit, the general strategy will probably be similar to last year’s audit. However, it will be modified by problems experienced in last year’s audit and significant events which have taken place in the company since last year’s audit. The timing of the audit work is important, as time will be wasted if it is planned to carry out audit work when the appropriate information is not available from the company. The timing of the audit work will influence the makeup of the audit staff during the audit (i.e. the balance between junior and experienced audit staff). It will be necessary to agree a timetable with the company of when information will be available and this will determine when the audit work is carried out. Also, the following dates will be important:

the physical inventory count;
when the full financial statements are available for audit;
when the financial statements are agreed and signed by the directors and the auditor;
the date of the annual general meeting when the financial statements are approved by the shareholders.
The extent of the audit work in each area will have to be considered. This will be based on a number of factors, including the materiality of the item and the audit risk, based on experience in previous years’ audits.
A budget will be prepared which suggests the time which should be spent on each aspect of the audit and the completion dates of each part of the audit.
During the audit, progress will be compared with the audit plan. Any adverse (and favourable) variances against the plan will be investigated, and the plan amended if it is considered appropriate.
Planning an audit is important. One would not build a house without a plan, so one should not carry out an audit without a plan. The requirement to plan an audit ensures senior staff have considered the work which is required to complete the audit, and the timing of that work so that it fits in with the dates information is available from the company and the planned completion date when the financial statements are approved by the directors and the auditor. By having a plan, the auditor should take a more considered approach to the audit which will improve the quality of the audit, and thus both minimise the time spent on the audit and the overall audit risk. When the audit is carried out, the progress can be monitored against the plan, and action taken when the audit starts to take more time than expected, both in terms of staff time and in reaching deadlines.

(b) Reasons for obtaining a general understanding of the legal and regulatory framework and how client is complying with that framework
Obtaining a general understanding of the legal and regulatory framework (per ISA 250) is part of obtaining an understanding of the entity and its environment as required by ISA 315. Because non-compliance with relevant laws and regulations could leave the company open to fines or even the threat of closure, non-compliance could mean that provisions or disclosures are needed in the financial statements. Hence, if there is a risk of non-compliance, there is a risk that material amounts or disclosures in the financial statements could be misstated.
Action to be taken if auditors suspect material areas of non-compliance
If the auditor identifies material areas of non-compliance ISA 250 requires him to perform the following procedures:

obtain an understanding of the nature of the act and the circumstances in which it occurred;
obtain further information to evaluate the possible effect of the non-compliance on the financial statements;
discuss the matter with management or those charged with governance, unless prohibited by law or regulation. If compliance is not proved, consider seeking legal advice;
if there is insufficient evidence consider the impact on the auditor’s opinion (this may be a limitation on scope);
consider whether the non-compliance impacts on other areas of the audit (e.g. on overall risk assessment);
consider how to report the non-compliance (to those charged with governance and/or to shareholders and/or to the authorities).

(c) Matters to consider in relation to the items listed in the question and their implications on planning the audit:
(i) The company’s revenue for 10 months is €13 million, which given an annualised revenue of €15.6 million, is a 41.8% increase over the previous year. The annualised profit before tax is €480,000, compared with €800,000 last year, which is a fall of 40%. It appears the company is increasing revenue at the expense of profits. If profits are falling, the actual profit for the 10 months to 30 November 20X8 may be even less than the €400,000 shown by the monthly accounts. The fall in profit indicates problems which may not be fully reflected in the monthly accounts.
(ii) Audit work will have to be carried out on the new computerised inventory control system. Computer audit specialists within the audit firm will probably have to be used. It may be appropriate to carry out this work before the year end, so that any problems with the system can be highlighted and either overcome or allowed for at the year end. The company says it will not be carrying out an inventory count at the year end, so as auditor I will have to place considerable reliance on the accuracy of the inventory quantities reported by the inventory control system.
I will have to determine from the company how frequently they count the inventory, the proportion of the inventory counted at each count, and the checks they make to the inventory quantities on the computerised system. If there are a large number of differences between the physical inventory quantities and those on the computer, physical counts should be carried out more frequently and on a larger proportion of inventory than if differences are infrequent. This information will have to be determined before the year end, as, if differences are frequent, it may be necessary to carry out a full physical count at the year end. Otherwise, there is a high risk the audit opinion will have to be modified.
(iii) Reliability problems with the company’s products could create the following problems:

certain inventory being unsaleable, and thus worth less than cost (or even being worth only scrap value);
legal claims against the company;
customers not paying for the products.
These last two points are mentioned in the question. Further details will have to be obtained about legal claims against the company and customers refusing to pay their outstanding debts. Information can be obtained for this by inspecting correspondence with customers and discussing the matter with the company’s staff, including the company secretary, sales director and the credit controller.
The audit risk with these problems include:
the difficulty in estimating the costs (i.e. the costs of defending legal claims and damages which may have to be paid, and the cost of the bad debts);
the risk that there may be more claims and bad debts, which relate to the year under view, but may not become apparent until after the auditor’s report is signed;
the value of the faulty inventory held at the year end. The selling price of inventory sold between the year end and the audit will have to be checked to ensure it is valued at the lower of the cost and net realisable value. There may be problems with determining the value of year-end inventory which is still held at the time of the audit.
(iv) The large increase in receivables age will have resulted in a large increase in receivables, from €1.47 million at 31 January 20X8 to an estimated €5.33 million at 31 January 20X5. The increase of €3.86 million will probably have been financed by increased borrowings. Thus, the increase in the credit period and sales to new customers will result in the following risks:
New customers tend to have a higher risk than existing ones, thus increasing the risk of irrecoverable receivables.
Increasing the credit period tends to attract customers who are a poor credit risk. This is for two reasons, firstly the longer credit limit will reduce the customer’s cash flow problems, and secondly it attracts customers who already have cash flow problems, as these customers are unable to pay other suppliers within the shorter credit period (e.g. the one month credit period previously allowed by Rylan Products).
A potential irrecoverable receivable, or dispute about a faulty product, may not become apparent until after the credit period is being exceeded. Thus, it will probably take at least three months before the uncertainty over the receivable becomes apparent, rather than the one month with the previous credit period. So, uncertain receivables from sales immediately prior to the year ended may not become apparent until after the auditor’s report has been signed.
In addition, the actual age of receivables is 1.1 months in excess of the current credit limit (of three months) compared with 0.6 months over the credit limit in the previous year. This indicates that there may be problems with collection of debts from customers and thus an increase in bad debts.
With the large increase in receivables, the company is probably experiencing liquidity problems. Are the company’s borrowing facilities adequate, and is there a risk the company may not be a going concern?
(v) The reasons for the dismissal of the financial director and purchasing manager will have to be ascertained. Were they carrying out a fraud (separately or together?) or were they contravening financial procedures? If this was happening, what are the financial consequences? Is it possible for this type of fraud to recur? Could our audit firm be liable for detecting these events? If the dismissed employees are claiming for dismissal and compensation from the company, the likely outcome of these claims would have to be investigated and an appropriate provision included in the financial statements. This could be a high risk area in the audit.
In addition, I will have to consider the consequences of the company being without a purchasing manager from 15 August until the new purchasing manager was appointed. There is the risk that controls during this period will have been weaker than normal, thus increasing the risk of a fraud. The new purchasing manager will take time to become effective in his post, which could increase the risk of fraud. Also, the wrong products may be purchased, or products may be purchased at an inflated price. This could mean that some products in inventory at the year-end may be worth less than cost.
The effect of there being no financial director between 15 August and the year-end means that financial records and controls may not be as effective as in previous years. The chief accountant will probably be much busier than when there was a financial director, which could mean that, with less time to prepare the financial statements, the annual accounts are less accurate and less complete. If the financial director prepared the annual draft financial statements in previous years, does the chief accountant have the skills and experience to prepare this year’s financial statements?

Tags: Audit Effectiveness, Audit Planning, Audit Strategy, ISA 300
Level: Level 2

Topic: Planning an Audit

Uploader: Samuel Duah