First Intuition Mock Exam 3 September 2020

1) Island Co

Briefing Notes
To: Jo Cave, audit partner
From: Audit Manager
Subject: Island Co audit planning
Introduction
The following briefing notes have been prepared in response to the queries in your email to be used
at the planning meeting surrounding the audit for Island Co, year ended 30 November 20X7.
a) Audit Risks and other planning matters

Revenue Recognition
There is a risk that the revenue being recognised in 3 instalments per order is not in
compliance with the financial standards IFRS 15 Revenue Recognition.

Per IFRS 15, revenue should be recognised once the financial product (or service) has been
transferred to the opposite party, completely. In this case, this would deem the final stage as
the point of which revenue is to be recognised as this is when the machine is delivered as
well as the installation completed. For this reason, recognising the majority of this revenue
early on may be in accurate.

Since it takes 6 months to complete the finalisation of an order, it may be the case that
some of the orders at year end are only a few months into their process, but 50-75% of this
revenue has been recognised.

The first 75% of the revenue should be recognised as deferred income, in line with this
being, by nature, a sort of deposit towards the total product and service. This would then be
released to revenue within the statement of profit or loss upon completion.

There is a risk that deferred income on the statement of financial position is understated,
and revenue is overstated due to this form of revenue recognition from the client.

Jacks Mine Co
There is a risk that the outstanding $2.85m has not been recognised correctly within the
statement of financial position.

This is 2.28% of total draft revenue so is immaterial by quantity, however since this is
forming a dispute between Island Co and Jacks Mine Co, this should be considered further.
At the year end, Jacks Mine Co has not paid this amount, however, the installation has been
completed. Therefore, this would be deemed as rightful cash yet to be collect from the
client. If the auditors assume this to be valid and probable, this could be disclosed as a
contingent asset and released to revenue in the following year.

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 Since the remaining 25% of the order is due on ‘successful’ installation, and the dispute is
regarding the machine running at 100% efficiency, the auditors should consider and enquire
into the details of this, and what is holding the installation from achieving this.

The risk is that the $2.85 million has overstated revenue, and consequently overstating
profit, and understated trade receivables in the statement of financial position.

Damage Claim
There is a risk that this claim for injuries has not been recognised as a provision in the
financial statements due to management bias as per IAS 37 Provisions.

There should be an assessment per the criteria of recognising a provision as of the probable
economic outflow of this, and the total claim should be measured reliably.

In this case, it could appear probable as other orders have been cancelled, which may mean
the trading relationship between Sawyer Co and Island Co is in jeopardy. If Sawyer Co takes
this forward and seeks legal advice, this would be a provision to recognise and disclose.

However, since it is generally known that they have a poor health and safety record, and
Kate is ignoring this claim, it may be more appropriate to recognise this as a contingent
liability which is only possible rather than certain to pay.

This would need to be quantified so further information would be required regarding the
claim, and possibly a discussion with the legal advisors as to the position of this claim.

Since this appears to have not been recognised at all currently, it may be that provisions are
understated, and disclosures are inadequate within the financial statements.

Inventory
There is a risk that the inventory as at 17 November 20X7 is dated and inaccurate in
comparison to the year-end date. Consequently, stock may be overstated and cost of sales in
the statement of profit and loss may be overstated.

Since orders go out with 6 month time frames, it may be that an order has been processed
between 17 November and year end 30 November, and a machine has been dispatched or
an additional completion stage has passed. Therefore, the inaccuracy could be significant.

The current work in progress at $8.5 million is 8.9% of total assets and is therefore material
by quantity.

The auditors should consider requesting a more recent physical count which they should
observe with the client in order to confirm the balance as at year end where possible.

Forex Payables

There is a risk that the trade payable has not been translated at the correct rate per IAS 21
Forex.

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 Assets and liabilities should be translated at the closing rate and the differences in rates may
impact the gains on profit or loss in the statement of financial position.

The payable, recognised in current liabilities, is 1.6% of total assets, and 26.8% of profit
before tax. This is material by quantity per the profit before tax, and is material by nature
due to the volatilities surrounding exchange rates.

There is a risk that liabilities is misstated (dependent on the exchange rate, could be over or
under), and consequently impacting the gains and losses on foreign exchange, touching the
statement of profit or loss, and profit before tax.

Warranty Provision
There is a risk that the estimated provision of $2.5 million is unreliable, and is understated,
therefore total liabilities may be understated.

Revenue has increased by 21.4% since 20X6, but provisions have increased only by 4.2%. this
is 2.63% of total assets and so is not material by quantity.

The movement in provisions is inconsistent with the movement in revenue, and therefore
questionable. It would be expected that if revenue increases and more orders are placed,
then there should be greater provision for the repairs due. This is also in light of the Sawyer
Co injury claim of the machine malfunction. It could be possible that bad reputation would
render a higher provision in the event of additional returns.

Estimates are based on judgement, but should have a calculated and appropriate basis.

The auditors should consider increasing their audit testing and enquiry into this estimate,
and increase professional scepticism here in order to confirm the appropriateness of this
estimate.

Disclosures re RPT
There is a risk that the disclosures may be inadequate and incomplete regarding the shares
in Pacific Co.

Related party transactions and relationships in accordance with IAS 24 must be disclosed
clearly, with regards to the 55% Pacific Co ownership and the leases.
They are material by nature rather than by quantity, and the auditors should exercise
professional scepticism and judgement on these transactions in order to ensure correct
compliance.

i) Warranty Provision procedures

Discuss with management the assumptions and basis upon which this estimate has
been derived. Obtain the cost calculations of repairing the defective machinery and
recalculate for accuracy.

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 Obtain a written representation from management i.e. Kate Shannon regarding this
estimate and her assumptions.

Obtain results of prior year provisions and compare to the actual repairs exercised in
order to deem accuracy.

Obtain post year end repairs claims to compare to the provision put in place.

Review the disclosures per the financial statements for completeness, sufficiency,
and adequacy.

Discuss the repairs with the production manager (and/or repairs manager) to
ascertain their opinion on the assumption based on the products manufactured this
year and previously.

ii) Identify and describe FOUR quality control procedures that are applicable to
individual

Check the number of staff available within the audit team and identify the various
levels i.e. engagement partner, managers, seniors, and juniors. Check their
availability in terms of time planning ahead of the audit.

Conduct a risk assessment of the client, to determine areas within the company that
are of higher risk, which would require increased testing and procedures. This could
also include conducting due diligence and know your client procedures to assess the
source information of the client, as part of ISA 315, in order to gain a better
understanding of the company.

Confirm the auditors have unrestricted access and permission from the management
of the company in order to conduct the audit. This would reduce obstacles with
obtaining information, consequently reducing delays in finalising the audit report in
the long term. In the case of Island Co, Kate Shannon appears to want this audit to
be finished by January 20X8, to enable this, the auditors should be able to conduct
the audit with minimal interruptions.

Finally, review and check the existence of relevant internal control systems. This
would deem the best approach for the audit, and possibly reduce the risk of certain
classes of transactions and balances if the auditors can access components such as
the general ledger etc easily.

iii) Problems in implementing quality control and how to overcome

Conflict of Interest
One issue is that of a conflict of interest with other clients from a similar industry.
Small audit firms may be local to an area or specialists within a field. For this reason,
they may attract similar clients. This is an issue as there may be a lack of
confidentiality and independence in the respective audits.

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 To overcome this, there should be a safeguard with different teams used to conduct
the audits of the companies, as best so where possible, based on the number of staff
and resources available. Different teams would mean that audit approaches and
confidential information would be different and specific to the client rather than
taking into account another client’s business approach.

Limited resources
A small audit company is likely to have limited resources regarding numbers and
levels of staff, and time to manage the audits. This could impact the quality of the
audit performed as they may not be able to offer the same level of detail in the audit
as if they were a bigger firm.

To overcome this, the auditors should ensure a rigorous planning approach with
plenty of time communicated very clearly and regularly between themselves and the
client. This communication should also include a thorough risk assessment.

iv) Appropriateness in continuing the audit relationship

Since this engagement has provided, on average, 16% of the annual audit fees of the firm,
this is a very questionable audit. Similarly, the audit partner has been associated with the
audit for a long time, and this has additional ethical risks.

Fees
Holding such high dependence on an audit for fees (16%) is slightly over the acceptable limit
for small companies (15%), but safeguards and procedures should have been put into place
when the client was generating even 10% of fees for the firm.

This is because the audit partners could have a threat to self-interest as they could be
rewarded as a result of bringing in increased fees to the firm. This threat to their objectivity
and integrity could have an impact on the way they conduct the audit, as they may take
actions more favourable towards the client in anticipation of receiving these higher fees.

Partner association
Since the partner has been longstanding on this audit, there is a risk of familiarity as well as
self- interest here also. Over time, personal and friendly relationships could have developed
and the same level of independence during a partner review may not be exercised.
Alternatively, as a partner, there may be less importance on the investigation and additional
procedures to undertake regarding a certain material issue, in respect of this familiarity.

While it is not clear how long exactly this association is, 5 years is often a benchmark to
consider rotation, and 10 years of the same firm should be a point at which the audit is put
out to tender again. These matters need to be considered in order to make this audit
engagement acceptable.

Continuation

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 Since there are difficulties with the rotations of the audit partner, due to a previous partner
retiring, safeguards should be put into place in order to make this acceptable.

An independent partner review from someone else in the firm should be undertaken,
possibly hot and cold, at both stages, to maintain independence.

Likewise, some of the services provided should be looked into regarding the fees of the
client, and it may be that other clients’ fees are to be increased in order to alter the
proportion of this client.

The audit firm should approach and consider the recruitment of a new audit engagement
partner, since Patrick has now retired, in order for audits to rotate between partners.

Continuing the audit with appropriate safeguards in place would be a way of mitigating
severe risks.

(d) Identification of related parties and transactions

It may be possible that management and those charged with governance (TCWG) do not understand
or are unfamiliar with the concept of related parties. For this reason, they may be exercising such a
relationship without even realising, and not disclose to the auditor during the audit.
Similarly, management and TCWG may conceal this information deliberately from the auditors.
Informing auditors of these transactions would increase risk as these transactions are material by
nature. Consequently, the auditors would increase their testing and procedures to investigate more,
and through their findings, could uncover suspicious financial activity (possibly issues surrounding
money laundering or fraudulent behaviour). To avoid this, management and TCWG may make it
harder to identify.
Additionally, the identification of related parties and material related party transactions would result
in the auditors adjusting the financial statements to include disclosures. This may be something that
the company directors may wish to avoid, due to providing information to competitors, and
consequently may make it difficult to identify for auditors.
Finally, material related party transactions could be concealed within other transactions. Therefore,
during the audit procedures and testing taking place, unless the auditors are aware of this in
advance i.e. the planning stage, and know to look out for related party activity, they may not be
aware of these transactions as related party.

Conclusion
There are certain risks to consider during the planning of this audit, and areas to exercise judgement
and professional scepticism. The quality control and related party elements of the audit should be
carefully assessed.

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