- 14 Marks
AAA – L3 – Q32 – Planning
Question
You are a manager in the audit department of Yao Asaglo & Co, a firm of Chartered Certified Accountants, and you have just been assigned to the audit of TechNova Limited, a new audit client of your firm, with a financial year ended 31 May 2015. TechNova Limited has just been listed on the Accra Stock Exchange (ASE). It is an e-commerce facility and has grown rapidly in the last few years.
TechNova Limited was formed ten years ago by Ms. Esi Mensah, a graduate in e-commerce from Kofi University. The company designs, develops software for e-commerce with high security features which have won industry awards. In the last two years, the company invested AC₵400m in creating new software to appeal to a large number of multi-national companies, and sales are now made in over 10 countries. The software is developed in this country, but the manufacture of the security features, for obvious reasons, takes place overseas.
The software is largely sold through retail outlets, but approximately 30% of TechNova Limited’s revenue is generated through sales made on the company’s website.
In some countries, TechNova Limited’s products are distributed under a franchise agreement which gives the franchise holder the exclusive right to sell the products in that country. The cost of each franchise to the distributor depends on the estimated sales in the country to which it relates, and the franchise lasts for an average of five years. The revenue which TechNova Limited receives from the sale of a franchise is deferred over the period of the franchise. At 31 May 2015, the total amount of deferred revenue recognised in TechNova Limited’s statement of financial position is AC₵72 million.
As part of a five-year strategic plan, TechNova Limited obtained an ASE listing in December 2014. The listing and related share issue raised a significant amount of finance, and many shares are held by institutional investors. Esi Mensah retains a 20% equity shareholding, and a further 10% of the company’s shares are held by her family members.
Despite being listed, the company does not have an internal audit function, and there is only one non-executive director on the board.
(a) Comment on the matters that you should consider specific to initial audit engagement when developing the audit strategy for TechNova Limited. (b) Evaluate the audit risks to be considered in planning the audit of TechNova Limited.
Answer
(A) In an initial audit engagement, there are several factors which should be considered in addition to the planning procedures which are carried out for every audit. ISA 300 Planning an Audit of Financial Statements provides guidance in this area.
ISA 300 suggests that unless prohibited by laws or regulation, arrangements should be made with the predecessor auditor, for example, to review their working papers. Therefore, communication should be made with the previous auditor to request access to their working papers for the financial year ended 31 May 2014. The review of the previous year’s working papers would help us in planning the audit, for example, it may highlight matters pertinent to the audit of opening balances or an assessment of the appropriateness of TechNova Limited’s accounting policies.
It will also be important to consider whether any previous years’ auditor’s reports were modified, and if so, the reason for the modification.
As part of the client acceptance process, we should request from previous auditors if there are any professional or other reasons why we cannot take up the audit of TechNova Limited.
Any matters which were brought to our firm’s attention by the previous auditor should be considered for their potential impact on the audit strategy.
There should also be consideration of the matters which were discussed with TechNova Limited’s management in connection with our appointment, such as significant accounting policies which may impact on the planned audit strategy.
Particular care should be taken in planning the audit procedures necessary to obtain sufficient appropriate audit evidence regarding opening balances, and procedures should be planned in accordance with ISA 510 Initial Audit Engagements – Opening Balances. For example, procedures should be performed to determine whether the opening balances reflect the application of appropriate accounting policies and whether the prior period’s closing balances have been correctly brought forward into the current period.
With an initial audit engagement, it is particularly important to develop an understanding of the business, including the legal and regulatory framework applicable to the company. This understanding must be fully documented and will help the audit team to perform effective analytical review procedures and to develop an appropriate audit strategy.
Obtaining knowledge of the business will also help to identify whether it will be necessary to plan for the use of any experts.
Our firm should have quality management policies and procedures in place for use in the case of initial engagements, for example, the involvement of another partner or senior individual to review the overall audit strategy prior to commencing significant audit procedures.
Given that this is a new audit client, and that it is newly listed, when developing the audit strategy, consideration should be given to using an experienced audit team in order to reduce detection risk. (B)
Rapid growth
We were told that the company has seen rapid growth during the last few years. The growth could indicate a control risk, in that systems and personnel may struggle to keep pace with the volume of transactions which are being processed, leading to accounting errors being made. This is exacerbated by the lack of an internal audit function to provide assurance on systems and controls.
Management bias
The second audit risk identified relates to TechNova Limited becoming a listed entity during the year. This creates an inherent risk at the financial statement level and is caused by the potential for management bias. Management will want to show good results to the new shareholders of the company, in particular the institutional shareholders, and therefore there is an incentive for the overstatement of revenue and profit.
There is a related risk of overstatement due to Esi Mensah and her family members retaining a 30% equity interest in TechNova Limited, which is an incentive for inflated profit so that a high level of dividend can be paid.
It appears that governance structures are not strong. For example, there are too few non-executive directors, and therefore Esi Mensah is in a position to be able to dominate the board and to influence the preparation of the financial statements. This increases the risk of material misstatement due to management bias.
There is also a risk that management lacks knowledge of the reporting requirements specific to listed entities, for example, in relation to the calculation and disclosure of earnings per share.
E-commerce
With 30% of revenue generated through the company’s website, this represents a significant revenue stream, and the revenue generated through e-commerce is material to the financial statements. E-commerce gives rise to a number of different audit risks, including but not limited to the following:
- For the auditor, e-commerce can give rise to detection risk, largely due to the paperless nature of the transactions and the fact there is likely to be a limited audit trail, making it difficult to obtain audit evidence. For the same reason, control risk is increased, as it can be hard to maintain robust controls unless they are embedded into the software which records the transaction. The auditor may find it difficult to perform tests on the controls of the system unless audit software is used, as there will be few manual controls to evaluate.
- A risk also arises in terms of the recognition of sales revenue, in particular cut-off can be a problem where sales are made online as it can be difficult to determine the exact point at which the revenue recognition criteria of IFRS 15 Revenue from Contracts with Customers have been met. Hence, over or understatement of revenue is a potential risk to be considered when planning the audit.
- TechNova Limited also faces risks relating to the security of the system, for example, risks relating to unauthorized access to the system, and there is an increased risk of fraud. All of these risks mean that there is high audit risk in relation to the revenue generated from the company’s website.
Franchise revenue
The franchise revenue which is deferred in the statement of financial position represents 13.4% of total assets and is therefore material.
IFRS 15.B56 explains that entities must determine if a franchise transfers to a customer at a point in time or over time. If a franchise transfers to a customer over time, the revenue shall be recognised over the term of the franchise agreement. Where a franchise transfers to a customer at a point in time, the revenue is recognised at that point.
There is a risk that the accounting treatment is not appropriate, and there are two separate risks which need to be considered.
First, it may be the case that the revenue from the sale of a franchise should not be deferred at all. The revenue recognition criteria of IFRS 15 need to be applied to the transaction, and if, for example, it were found that TechNova Limited has satisfied the performance obligation at a point in time, then the revenue should be recognised immediately and not deferred. This would mean a significant understatement of revenue and profit.
Second, if it is appropriate that the revenue is deferred, for example, if TechNova Limited satisfies the performance obligation over time, then the period over which the revenue is recognized could be inappropriate, resulting in over or understated revenue in the accounting period.
Foreign exchange transactions
TechNova Limited’s products sell in over 10 countries, and the products are manufactured overseas, so the company is involved with foreign currency transactions which can be complex in nature. There is a risk that the requirements of IAS 21 The Effects of Changes in Foreign Exchange Rates have not been followed. For example, if transactions have not been retranslated to TechNova Limited’s AC₵ at the date of the transaction, then the amounts involved may be over or understated.
There is also a risk that outstanding receivables and payables have not been retranslated at the year-end closing exchange rate, leading to over or understatement of assets and liabilities and unrecorded exchange gains or losses.
Non-compliance with laws and regulations
TechNova Limited does not comply with the Corporate Governance Code for Listed Companies 2020. The company does not have an internal audit function, which the Code states to be compulsory. In addition, there is only one non-executive director on the Board, even though the Code states that a majority of the directors shall be non-executive directors.
The Code states that in the event of a breach, penalties may be imposed by the Commission. There is a risk that TechNova Limited has not included a provision for such a penalty, or that a provision is too low. This could result in an understatement of expenses and liabilities.
Yao Asaglo & Co will also need to assess the impact of the non-compliance with the Code on other areas of the audit. They will need to ascertain whether the non-compliance influences their original assessment of management’s integrity and whether this impacts other areas of their risk assessment and the reliability of written representations.
- Topic: Planning
- Uploader: Salamat Hamid