Audit Planning for Belmont Pharmaceuticals – Year Ended 31 December 20X8

(a) Capitalisation of Drug Development Costs (Project Horizon)

• (i) Matters to Consider:
  • Compliance with IAS 38: Under IAS 38, research costs (C8m) must be expensed as incurred, while development costs (C15m) can be capitalised only if specific criteria are met (e.g., technical feasibility, intention to complete, ability to use or sell, probable future economic benefits, and reliable measurement of costs). The claim of “substantial progress” and “hope” for a future drug suggests uncertainty about technical feasibility and market approval, which may preclude capitalisation.
  • Materiality: The C15m capitalised is significant relative to profit before tax (C3.46m), and incorrect treatment could materially misstate the financial statements.
  • Management Bias: The directors may have capitalised costs to boost reported profits, requiring scrutiny of their assumptions and judgements.
  • Impairment Risk: Given the drug is not yet market-ready, there is a risk that the capitalised asset may be impaired if development stalls or regulatory approval is denied.
• (ii) Audit Evidence:
  • Review project documentation, including feasibility studies, technical reports, and regulatory submissions, to assess whether IAS 38 development criteria are met.
  • Obtain management’s detailed breakdown of the C15m costs, distinguishing between research and development phases, and verify with invoices, contracts, and timesheets.
  • Inspect board minutes or strategic plans confirming the intention to complete and market the drug.
  • Engage an auditor’s expert to evaluate the technical feasibility and likelihood of regulatory approval.
  • Perform a retrospective review of prior R&D projects to assess the reliability of management’s capitalisation decisions.
  • Test for impairment indicators by reviewing market analysis, competitor activity, or regulatory updates.

(b) Legal Claim for Asthma Tablet (C20m)

• (i) Matters to Consider:
  • IAS 37 Provisions: A provision is required if there is a present obligation from a past event, a probable outflow of resources, and a reliable estimate of the amount (C20m). The lawyers’ advice that the claim is “very likely” to succeed indicates a probable outflow, necessitating a provision in 20X8, unlike 20X7 when uncertainty existed.
  • Materiality: The C20m claim is highly material compared to profit before tax (C3.46m), and failure to provide could lead to a material misstatement.
  • Disclosure: If the amount or likelihood is uncertain, a contingent liability disclosure may be required instead of a provision.
  • Going Concern: A C20m liability could impact the company’s financial position, requiring assessment of its effect on liquidity and solvency.
• (ii) Audit Evidence:
  • Obtain the lawyers’ letter confirming the claim’s status, likelihood of success, and estimated amount (C20m).
  • Review correspondence with claimants and court documents to confirm the timing and nature of the claim.
  • Inspect board minutes discussing the claim and management’s response.
  • Verify the absence of a provision in 20X7 financial statements and assess the appropriateness of that decision based on information available at the time.
  • Perform a cash flow analysis to evaluate the impact of a C20m outflow on going concern.
  • Confirm with management any insurance coverage or potential recoveries related to the claim.

(c) Revenue Recognition for Health Voucher (C4m)

• (i) Matters to Consider:
  • IFRS 15 Revenue Recognition: Revenue should be recognised when control of goods or services is transferred to the customer. The vouchers are not redeemable until 14 February 20X5, suggesting that performance obligations are not met by 31 December 20X8. Recognising C4m in 20X8 is likely premature and non-compliant with IFRS 15.
  • Materiality: C4m is material relative to profit before tax (C3.46m), and incorrect revenue recognition could mislead users of the financial statements.
  • Contract Liability: The proceeds from voucher sales should likely be recorded as a contract liability (deferred revenue) until redemption occurs.
  • Management Bias: The directors’ decision to recognise revenue based on an “80% take” assumption may reflect pressure to inflate profits.
• (ii) Audit Evidence:
  • Review the terms and conditions of the voucher scheme, including redemption period and “2 for 1” offer details, to confirm performance obligations under IFRS 15.
  • Obtain sales records and cash receipts for voucher sales to verify the C5m issued and C4m recognised.
  • Inspect management’s calculations and assumptions for the 80% redemption rate, comparing with historical data from similar voucher schemes.
  • Check post-year-end redemption rates (if available) to assess the accuracy of the 80% estimate.
  • Review financial statement disclosures for contract liabilities and ensure C4m is not recognised as revenue.
  • Discuss with management the rationale for recognising revenue in 20X8 and evaluate for consistency with IFRS 15.

Conclusion:

• The C15m capitalisation of development costs is likely inappropriate unless IAS 38 criteria are fully met, requiring detailed evidence to support technical feasibility.
• A C20m provision for the legal claim is likely required given the high probability of outflow, with significant implications for financial position.
• The C4m revenue recognition for vouchers is premature and should be deferred as a contract liability until redemption in 20X5.