- 20 Marks
AA – L2 – Q72 – Inventory Valuation
Question
Mega Construct is a listed construction company with an annual revenue of GH₵350m. Mega Construct’s draft statement of profit or loss shows a profit before tax for the year ended December 31, 2008 of GH₵40m.
Mega Construct’s audit firm is conducting an audit. This is the first audit of Mega Construct that this audit firm has conducted. An enquiry to the previous audit firm revealed no reasons for concern. On completing audit work at the company’s premises, the audit senior drafts a memo, extracts from which are reproduced below:
(a) Inventory valuation
Inventories include GH₵7m, at cost, for scrap rubber from used car tyres. This material is widely used as a road surface in other countries. Contracts for road building with this country’s National Road Authority, the state authority for road construction, do not currently permit the use of this material. However, the matter was known to be under review and on being offered a special purchase of this material, Mega Construct speculated on a favourable outcome of this review and purchased the material. In February 2009, shortly before the financial statements were approved by the directors, the National Road Authority reported that it would not, currently, accept the use of this material. If used on non-National Road Authority contracts the material’s net realisable value would not exceed GH₵2m.
The finance director maintains that the issue of the National Road Authority report was a non-adjusting event after the reporting period. The write down of the inventory should, therefore, be reflected in the next period’s financial statements.
Required:
Discuss whether the financial statements require amendment and describe the impact on the auditor’s report if the issue remains unresolved.
(b) Depreciation
During the year ended December 31, 2005 the company purchased two computer controlled earth movers at a cost of GH₵2,500,000 each and a further two at the same price during the year ended December 31, 2006. Depreciation has been provided at 10% straight line, the same basis as it previously depreciated conventional earth movers. This year, 2008, the company has decided that improvements in technology made it worthwhile scrapping their first two computer controlled earth movers and replacing them with the latest model at a cost of GH₵6,000,000 each. The company provides a full year’s depreciation charge in the year of acquisition and none in the year of disposal.
The company’s chief engineer tells you that technology is developing so rapidly it appears likely they will continue to replace these machines every five years. In spite of this the finance director claims that the depreciation rate of 10% is in line with the industry standard and reflects the physical life of the machines. He urges that continued improvements in technology cannot be foreseen and that there is no justification for increasing depreciation to 20% because of the possibility of technological obsolescence.
Required:
Discuss whether the financial statements require amendment and describe the impact on the auditor’s report if the issue remains unresolved.
(c) Contingent liability
The company is being sued for GH₵50m by the National Road Authority for defective work on a recently completed road. The company maintains that it met the National Road Authority’s specification and it is the Authority’s engineers who are at fault in drawing up the specification. Mega Construct maintains that it has no case to answer, that the possibility of loss is remote and that the claim need not be disclosed as a contingent liability. An investigative journalist has recently published an article suggesting that other roads constructed by the company exhibit similar faults. The managing director has admitted that the company’s road building techniques are under investigation by the National Road Authority. If the company were to lose the case its future going concern would be threatened. No disclosure has been made in the financial statements.
Required:
For the following issue, discuss whether the financial statements require amendment and describe the impact on the auditor’s report if the issue remains unresolved.
Answer
(a). Whether the financial statements require amendment
IAS 2 Inventories states that inventory should be valued at the lower of cost and net realisable value (NRV).
As the National Road Authority will not allow the use of the material in roads, it appears that the NRV of the scrap rubber is actually GH₵2m. This means that inventory is overstated by GH₵5m, resulting in profits being overstated by a material amount.
The director’s argument that the inventory should be written down in the next period is incorrect. The adjustment to the NRV of the inventory is an adjusting event after the reporting period (as it gives further evidence of a condition which existed at the reporting date) and the inventory value should be written down in this period.
Impact on the auditor’s report
The error is material as it represents 12.5% of profit before tax (GH₵5m / GH₵40m).
If management refuse to amend this error then the auditor’s report will need to be modified. As management has not complied with IAS 2 and the error is material but not pervasive then a qualified opinion would be necessary.
A basis for qualified opinion paragraph would need to be included explaining the material misstatement in relation to the valuation of inventories. The opinion paragraph would be qualified “except for” – due to material misstatement.
(b) Whether the financial statements require amendment
Depreciation should be charged so as to write off the cost of the asset over its expected useful life to the business. IAS 16 Property, Plant and Equipment requires that the useful lives of assets should be reviewed at least at each financial year-end and if there has been a change it should be accounted for as a change in accounting estimate.
The assets have a useful economic life of only five years. The finance director is depreciating them over ten years.
(c)
Impact on the auditor’s report
(i) Contingent liability
It would appear that the financial statements should include disclosure of a contingent liability as it is possible (rather than remote) that the company may lose the case.
Lack of disclosure of the contingent liability in the financial statements is a material misstatement which is likely to be material but not pervasive. A qualified opinion would be necessary.
A basis for qualified opinion paragraph would need to be included explaining the lack of disclosure. The opinion paragraph would be qualified “except for” – due to material misstatement.
(ii) Going concern
The occurrence of litigation and a government inspection suggests that there may be a going concern problem with this client as there is a significant uncertainty as to whether it can continue to trade for the foreseeable future. The uncertainty is fundamental as it impacts on the company’s ability to continue as a going concern.
The directors do not wish to disclose the contingent liability nor the potential impact it may have on the company’s ability to continue as a going concern. The lack of disclosure regarding going concern is material and pervasive. An adverse opinion would be necessary.
A basis for adverse opinion paragraph would need to be included explaining the lack of going concern disclosure. The opinion paragraph would be adverse opinion – “the financial statements do not show a true and fair view” – due to material misstatement.
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