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BRIEFING NOTES
TO: Ted Hastings, Audit Engagement Partner

FROM: Audit Manager

SUBJECT: Audit Planning of Mercurio Co

DATE: 1 July 20X5

Introduction

These briefing notes are prepared to assist in planning the audit of Mercurio Co for the year ending
30 September 20X5. These notes includes the evaluation of business risks faced by the company
and the significant risks of material misstatements are identified, prioritised and explained. In
addition, the notes also discuss the impact which the company's outsourced credit control function
will have on our audit planning, and finally recommend the principal audit procedures in relation to
the holiday pay obligation.

Materiality

For the purpose of these briefing notes, the overall materiality level used to assess the significance
of identified risks is $3 million based on the profitability of the company as requested.

Justification

Using profit before tax of $60 million as suggested benchmark, the materiality level range is of $3
million ($60m*5%) to $6 million ($60m*10%). Although, Mercurio Co is an existing client, the
company is listed and has taken new loans during the year. There has been a significant amount of
change in business operations as the company purchased properties from Lakewell Co since the
last financial statements. As there is increased detection risk, the materiality level should be set at
the lower end of the range.

This benchmark is only the starting point for determining the materiality and professional judgement
will need to change this materiality level through out the audit as and when required by any
identified misstatement.

8/8
(a)Evaluate the significant business risks faced by Mercurio Co.

Animal welfare - The company sells pet-related products for a wide variety of animals and also
sells small animals such as rabbits and fish. Here, there is a risk that animal welfare standards are
not maintained. The animals which are for sale should be kept in a safe and clean environment,
and if there is any breaches to relevant regulations, there can arise a risk to the reputation of the
company. The company should ensure that they are buying animals only from reputable suppliers
to ensure that Mercurio Co avoids buying animals which do not have appropriate documentation or
have illegal or unknown origin.

Staff Training - Staff must be correctly trained and there is a risk that training is not sufficient or
correct. Staffs are required to take care of the animals and while taking care there is a risk that may
hurt themselves or to animals if not handled properly. These risk is particularly to more to unusual
pets such as spiders, snakes and other reptiles. There could also be a risk of poorly trained staff
mishandling an animal and can result causing injury to a customer.

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The training in respect of offering nutritional and other advice to customers should be correct and
strong, there is a risk that due to lack of knowledge and experience wrong advice could be given
which can result in a significant reputational damage, loss of customer goodwill if customers do not
have faith or are harmed by advice given to them.

Mercurio brand - The company has started to sell products under its own brand, introducing the
‘Mercurio Range’ of premium pet food and accessories. The products are manufactured in another
country and imported, and purchases of Mercurio brand goods from foreign suppliers. This
exposes the company to the risks associated with international trade, such as currency exposure,
inflation, changing regulatory frameworks. The sale of goods from range is expected to increase
significantly from next year, so dealing with exchange gains and losses will become more important
for the company. There is also a risk associated with the quality of goods produced in foreign
countries, if regulations are not stringent in the country of production.

There is also risk that the amount invested in the Mercurio Range does not yield a satisfactory
return on investment. The company may not have the resources to compete effectively with other
brands.

Poor quality financial reporting & management information produced by company systems
- There seems to be a risk that business systems are not operatively effectively, indicated by the
problems experienced with the payroll system. Issues of this type can be detacted in other systems
resulting in inaccurate financial reporting and management information.

Control over payroll do not appear to be effective and the problems in the payroll system indicate a
risk of fraud. Employee records could have been duplicated on purpose with the objective of paying
an employee twice. There is also a risk of tax implications if the payroll sytem and controls
surronding it are not sufficiently robust. Employee taxes could be incorrectly calculated and
underpaid.

(b)Evaluate and prioritise the significant risks of material misstatement which need to be
considered in our audit planning. 11/18

i) Classification and measurement of acquired properties - The properties acquired from Lakewell
Co are material as they are clearly above the materiality threshold. There is a risk that the
3 properties might not be correctly classified. The properties which will be refitted should be classified
as property, plant & equipment. Any properties which are going to be sold should be classified
either as property held for sale or as investment property depending whether the property is
meeting the criteria given in IFRS 5 Non-current Assets held for sale Discontinued operations or
IAS 40 Investment property.

There are measurement and disclosure implications of inappropriate classification, for eg:
investment properties may be mesaured at fair value, while assets held for sale be measured at
lower of carrying amount and fair value less costs to sell. The properties could therefore, be
overstated or understated in value if classification is not appropriate.

Total assets are forecast to increase by 12.6% which is in line with the new retail shops purchased
2 as well as increase in receivables during the year. The gearing ratio is decreased by 20% which is
consistent with the new bank loan taken to aid the cashflows for refitting the retail units. Trade
receivables has an unusual increase of 91% and no information has been explained by the client.
The current ratio is increased by 86% which is again not explained by the client. The auditor should
maintain professional scepticism as there is a motivation for the directors to overstate the current
ratio in order to make more favourable bank applications.
3
ii) Revenue recognition - According to IFRS 15 Revenue from contracts with customers states that
revenue should be recognised when the performance obligation is satisfied by the entity. The pet
health plan creates a risk of material misstatement in respect of timing of recognising the revenue.

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As given in the case, the entity receives an advance for an annual plan, there is a risk that the
revenue is not recognised at correct time.

There is a risk that the revenue might be overstated and the deferred revenue might be
understated if revenue is recognised before a performance obligation. This is clearly a material
issue because the income from sales pf these plan represents 10% of revenue which is above the
materilaity threshold.

Operating profit is projected to increase by 56.4% which is in contrast to increase in revenue by

7.8% and profit before tax by 7.1%. Arnott & Co should excercise caution while auditing the profit
and loss entries affecting the operating profit as this may seek to overstate the operating profit.

iii) Lost shipment - According to the contract with the international supplier, ownership of the goods
which were destroyed had passed on to Mercurio Co and hence, any loss should be recognised in
2
the financial statements. Mercurio Co is recognising the goods at purchase price of $12 million in
the statement of financial position and in this case as the goods are destroyed, it is incorrect
recognition. The destroyed goods are above the materiality threshold.

There is a risk that the inventory and profit has been overstated giving rise to material
misstatement. The insurance policy gives rise to a possible contingent asset. the inflow of
1 economic benefit is probable as Mercurio Co has received informal confirmation from the insurance
company that they are processing the claim. As per IAS 37 Provisions, contingent liabilities and
contingent assets, such assets should not be recognised, rather they should be disclosed when it is
more likely that there ia an inflow of economic benefit.

There is a risk of inadequate disclosure or inappropriate treatment of the insurance claim.

Contingent asset should be recognized when it is virtually certain not when it is probable.
CONLUSION Email which informed about the approval of the insurance is an informal email as mention in the question.
So, it is probable that it will be received but not virtually certain hence should only be disclosed. There is a risk that
the contingent asset have been recongnized overstating the assets.
The risks of material misstatement have been ordered with regard for the estimated magnitude of
any misstatement and the likelihood of such a misstatement occuring. Similarly, revenue
recognition of the annual pet plans might affect 10% of revenue and could also impact the prior
year figures. Also, foreign exchange movements are carried out as standard by many companies
and should be lower risk of material misstatement than other risks.

6/7
(c)Discuss and conclude on the impact which outsourcing the credit control function will
have on our audit planning.

When an audited entity chooses to outsource one or more business activities, then ISA 402 Audit
considerations relating to an entity using a service organisation is the source of guidance for the
auditors. ISA 402 states that the auditor should obtain an understanding of the nature and
significance of the services provided by the service organisation and their effect on the user entity's
internal control relevant to the audit, sufficient to identify and assess the risk of material
misstatement which is relevant to the planning of the audit.

According to ISA 402, following matters should be considered when obtaining an understanding:

- The nature and materiality of the transactions processed or accounts or financial reporting
processed affected by the service organsiation.

- The nature of the services provided by the service organisation and the significance of those
services to the user entity.

- The nature of relationship between the user entity and the service organisation, including any
contractual relationship.

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- The degree of interaction between the activities of the service organisation and those of the user
entity.

A key consideration is whether Fairbank Co's services are limited to recording and processing
transactions or whether they execute any transactions, taking on accountability for those
transactions. In the given case, Fairbank Co is providing credit control function to Mercurio Co,
then the audit firm must understand whether Fairbank Co is making any decision about
adjustments needed for irrecoverable debt or level of allowance for receivables, and the materiality
of the amounts involved.

The audit firm should conduct procedures at the planning stage to develop an understanding in
order to assess the risk of material misstatement, including:

- Obtaining type 1 and type 2 reports, if available.

- Review reports issued by Fairbank Co to determine the effectiveness of the credit control
function.

- Visiting the service organisation and performing certain procedures to ensure that the information
provided is relevant.

- Review the contract between Fairback Co and Mercurio Co to understand the terms and
conditions of the engagement.

- Contacting the service organisation, through user entity, to obtain specific information.

(d)Design the principal audit procedures to be performed in respect of the holiday pay
obligation.
6.5/7
- Discuss with management and assess the controls around who has responsibility for calculating
the accural and how this is reviewed and approved.

- Confirm that management's estimation techniques are in accordance with requirements stated in
IAS 19.

- Discuss with management the method used to estimate the obligation to understand the
assumotions used.

- Agree the number of staff from payroll records to holiday accural schedule and confirming to the
numbers included in the management accounts.

- Obtain written representations from management on whether they believe the significant
assumptions used in making the accounting estimates are reliable and reasonable.

- Agree the pay rise and changes in staff levels to human resources records.

- Review the outcome of the prior year accural to verify how effective management has been in
prior periods at estimating this obligation.

- Develop a point estimate or a range to evaluate management's point estimate using information
sources based on:

The manual records recording holiday leave taken before the year end.
An estimate of the holiday leave which has not been taken at the year end.
Discussion with the head of HR department regrading the company's policy on holiday pay.

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(a) Evaluate the matters to be considered on the completion of the audit and the audit evidence you
should expect to find during your review of the relevant audit working papers.

(i) Lease - 9/9

According to IFRS 16 Leases, on inception of a lease, a lease liability is initially recognised and mesaured at
present value of the lease payments not paid at the commencement date, discounted at the rate implicit in the
lease if that can be readily determined. Here, in the given case, this is correctly created. In the given case, the
right-of-use asset exceeds the materiality threshold of $1.1 million and hence, this amount is material for
audit.

The rent free period changes the timing of the cash flows relating to lease but doesn't affect the value of right-
of-use asset or lease liability. Therefore, depreciation is to be charged for all the years as the entity has used
the asset, even if no lease payment is made. The depreciation charge should be $4.1 million ($28.9m/7 years)
in the first year. This depreciation amount is significant if compared to materiality threshold for the audit.
This means that non-current assets might be overstated and expenses be understated by a material amount.

EVIDENCE: use more confident tone.. line NCA is overstated.. because it is don't say might be.

- A copy of management's calculation of the present value of lease obligation and right-of use asset agrred to
the underlying lease amount.

- Recalculation of management's figures regarding lease asset.

- Evidence that a physical inspection was performed to confirm the existence of the leased asset and its
condition to determine if there are any indicators of impairment.

- Copy of lease contract to confirm the agreed period, payments required, implicit rate of interest to support
the amounts included in the financial statements.

- Copy of company policy to review the accounting treatment regarding depreciation of non-current asset.

- A copy of proposed financial statements disclosures in relation to lease, eg- finance costs of leases.

- A copy of the extract of the non-current asset register to confirm the amounts included in the financial
statements. main issue is the deduction of the depreciation from the right of use of asset.
so this point should be like this.
extract of the NCA register to confirm depreciation have been deducted.

(ii) Inventory - 7/7

According to IFRS 15 Revenue from contract with customers, the inventory remains the property of the
supplier until the customer has sold it to a third party. This means that the inventory should be recognised as
purchase corresponding inventory amounts where Marlos Co no longer has a right to return the asset. The
inventory held by Marlos Co is purchased from a new supplier and is held on consignment, therefore, Marlos
Co has no control over the inventory.

In the given scenario, the inventory should not be recognised at $8.1 million in the financial statements of
Marlos Co, instead it will show a receivable due from supplier as they potentially have a right to receive a
refund. Currently, Marlos Co is recognising the asset of the inventory at $8.1 million but as it can be
returned, this misclassification results in inventory being overstated and trade receivables being
understated.This amount of $8.1 million is significant to the materiality level for the company audit and is a
material misstatement in classification.

EVIDENCE:

- Obtain a confirmation from the supplier to confirm the amounts outstanding in respect of such goods.
This is a substantive procedure not an evidence

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- A copy of calculation of how much of the inventory held was eligible for return, to cast accuracy and agreed
to contract terms.

- Copy of contract with the new suppliers to understand and confirm the terms and conditions of the
consignment.

- Copy of inventory records to confirm the total value of inventory received from the supplier which was
unsold at the year end.

- Discussion with the management regarding the miscalssification of the inventory which can be returned and
their reasoning for classifying this as inventory.

(b) Evaluate the implications for the auditor’s report of Marlos Co, assuming that the inventory matter
has been satisfactorily resolved but that no further adjustments or disclosures are made to the financial
statements with respect to the new property lease. 4/4

Considering the depreciation charge for the leased property, it appears that the profits are overstated by $4.1
million. This is a material misstatement in the financial statements of Marlos Co, but as thsi represents a
single item only, the misstatement could be considered material but not pervasive.

The audit opinion should be modified and a qualified opinion should be given on the basis of a material
misstatement. This qualified opinion should be included in the "Qualified opinion" paragaraph at the start of
the auditor's report. After the qualified opinion paragraph, basis of qualified opinion paragraph will be
mentioned which will explain the reasons for the qualification and quantify the impact of misstatement.

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6/10
(a) Evaluate the matters to be considered by Gnome & Co before accepting Kobold Co as a
client and the engagement to review and report on the capital expenditure forecast.

Before accepting a client and entering into a professional relationship with a new client, an
assurance firm is required to assess whether this would be possible under criterias stated in
ISQM1 Quality management for firms that perform audits or reviews of financial statements or other
assurance or related services. Gnome & Co should also ensure that they are following the IESBA
International code of ethics for professional accountants.

Integrity & Ethical values of client - Gnome & Co will be required to perform customer due
diligence and in particular will be expected to consider the kep personnel's of Kobold Co and those
charged with governance. This also includes obtaining documents to prove the identity of the
peoples and consider whether there are any indicators that the client might be involved in money
laundering or other criminal activities.

Gnome & Co should consider whether the use of different firms creates a risk that the client might
be hoping that the firm may not be in a position to effectively challenge the key assumptions
underlying the preparations of the forecast. The firm will also need to consider management's
reasons for appointing a different firm and also their assumptions while preparing the capital
expenditure forecast.

Ethical issues - In the given case, Kobold Co is not currently the client of Gnome & Co, so the
firm's independence from Kobold Co will not have been previously considered. In this case, it is
necessary to ensure that there are no threats to the firm's objectivity which might prevent it from
accepting the appointment. Gnome & Co should also ensure whether there are any conflicts of
interest between Kobold Co and any of the firm's existing clients. If there is any possibility of
conflicts, Gnome & Co should propose safeguards to mitigate the risks.

The intended use of the information - Gnome & Co should consider whether the capital
expenditure forecast and assurance report will be solely for the purpose of securing the loan. If
Kobold Co is planning to use the assurance report other than for raising loan, then required
changes should be made in the offer letter and this should be made clear to Gnome & Co.

Information is for general or limited distribution - If the capital expenditure forecast is intended
for general distribution, this will increase the risk for Gnome & Co as public at large will rely on the
report issued. If the forecast is for limited distribution, then the information will be solely in support
of application to bank and this should not be made available to any other parties. This should be
clearly communicated and confirmed before accepting the engagement.

The scope of work - Gnome & Co will need to consider the terms of engagement, the level of
assurance to be given in case of Kobold Co before accepting the engagement. As the report is
against the forecast, there might be uncertainties, Gnome & Co will need to confirm that it is only
being asked to provide negative assurance as to whether management's assumptions gives a
reasonable basis for capital expenditure forecast.

10/10
(b) Assuming Gnome & Co accepts the engagement, recommend the examination
procedures to be performed in respect of Kobold Co’s capital expenditure forecast.

- Obtain a copy of draft loan agreement to review the terms and conditions of the repayment of
capital amount, interest rate, guarantees if any.

- Obtain detailed analyses of each category of capital expenditure and cast to confirm their
arithmetical accuracy.

- Discuss the key assumptions underlying the preparation of the forecast with management,
including:

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Timings of payments
variability in costs
Price changes over two-year period
Confirm the assumptions appear reasonable and are consistent with firm's knowledge and
understanding of the client.

- Review board minutes for evidence of any issues regarding the project or in relation to any other
loan application.

- Discuss with management whether any additional costs might be ommited from costing analysis.

- Perform sensitivity analysis on capital expenditure by varying key assumptions to identify the
most sensitive variable and any effects of it.

- Obtain written representations from management confirming the reasonableness of their

assumptions and that all information is provided to Gnome & Co.

- Inspect the contracts with architect's plans and surveyors's reports in order to confirm
management's intention.

- Confirm the estimated costs of the site preparation and the building by reference to the
quotations.

- Review the interior designs for the facility & confirm proposed fittings to supplier price lists.

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