Misclassification of expenses

Forecast ratios from the finance director show The classification of costs between cost of
that the gross margin is expected to increase sales and operating expenses should be
from 56% to 60% and the operating margin is reviewed in comparison to the prior year and
expected to decrease from 21% to 18%. any inconsistencies investigated.

This movement in gross margin is significant

and inconsistent with the fall in operating
margin. There is a risk that costs may have
been omitted or included in operating
expenses rather than cost of sales.

Misclassification of expenses would result in

understatement of cost of sales and
overstatement of operating expenses.

Inventory valuation
Valuation testing should be conducted,
Peony Co values its inventory using the focusing on comparing the cost of inventory
selling price less average profit margin. The to the selling price less margin for a sample
directors consider this to be a close of items to confirm whether this method is
approximation to cost. actually a close approximation to cost.

As per IAS2: Inventory should be valued at

lower of cost and NRV. There is a risk that the
valuation method Peony Co is using is not
accurate which will result in year-end
inventory valuation to be misstated.

Perpetual inventory system

The company utilises a perpetual inventory The timetable of the perpetual inventory
system at its warehouse rather than a full counts should be reviewed and the controls
year‐end count. Under such a system, all over the counts and adjustments to records
inventory must be counted at least once a should be tested.
year with adjustments made to the inventory
records on a timely basis.

Inventory could be under or overstated

if the perpetual inventory counts are
not all completed, such that some
inventory lines are not counted in the
year.
Obsolete PPE

A number of assets which had not been fully Discuss the depreciation policy for noncurrent
depreciated were identified as assets with the finance director and assess
being obsolete. its reasonableness. Enquire of the finance
This is an indication that the company’s director if the obsolete assets have been
depreciation policy of non‐current assets may written off. If so, review the adjustment for
not be appropriate, as depreciation in the past completeness.
appears to have been understated. If an
asset is obsolete, it should be written off to
the statement of profit or loss.

Therefore depreciation may be

understated and profit and assets
overstated.

Outsourced payroll function

During the year, Peony Co outsourced Discuss with management the extent of
its payroll function to an external service records maintained at Peony Co for the
organisation. period since May 20X5 and any monitoring of
controls which has been undertaken by
A detection risk arises as to whether sufficient management over payroll.
and appropriate evidence is available at
Peony Co to confirm the completeness and Consideration should be given to
accuracy of controls over the payroll cycle contacting the service organisation’s
and liabilities at the year end. auditor to confirm the level of controls
in place. A type 1 or type 2 report could
be requested.

Data transfer
The payroll function was transferred to the Discuss with management the transfer
service organisation from 1 May 20X5, which process undertaken and any controls
is five months prior to the year end. which were put in place to ensure the
completeness and accuracy of the data.
If any errors occurred during the transfer
process, these could result in wages and Where possible, undertake tests of
salaries being under/overstated. controls to confirm the effectiveness of
the transfer controls.

In addition, perform substantive testing

on the transfer of information from the
old to the new system.
Sales returns

There have been a significant number of Review a sample of the post year-end sales
sales returns made subsequent to the returns and confirm if they relate to pre-year
year-end. As these relate to the pre sales, that the revenue has been reversed
year-end, they should be removed from and the inventory included in the year-end
revenue in the draft FS & the inventory ledgers.
reinstated.

If the sales returns have not been correctly

recorded, then revenue will be overstated & In addition, the reason for the increased
inventory understated. level of returns should be discussed with the
management. This will help to assess if
there are underlying issues with the net
realizable value if the inventory.

Inventory count movements

During Sycamore’s year-end inventory count During the final audit, the goods received
there were movements of goods in & out. If notes & goods dispatch notes received
these goods in transit were not carefully during the inventory count should be
controlled, then goods could have been reviewed & followed through into the
omitted or counted twice. This would result inventory count records as correctly
in inventory being under or overstated included or not.
Research & Development

Company has incurred expenditure in Obtain a breakdown of the expenditure and

developing a new range of products. This verify that it relates to the development of
expenditure is classed as R & D. The the new product.
standard requires the research to be
expensed to profit or loss & development
costs to be capitalised as an intangible
asset. Discuss the accounting treatment with the
finance director & ensure that is in
There is a risk the intangible asset could be accordance with IAS 38.
overstated & expenses understated.

Revenue recognition

Customers pay a 25% deposit on signing The audit team should obtain a copy of the
the contract to purchase the playgrounds. contracts with customers & review them to
understand the performance obligations.

The deposit should not be recognized as

revenue immediately & instead should be They should discuss with management the
recognized as deferred income within criteria for determining whether performance
current liabilities until the performance obligations have been satisfied & the
obligations have been, as per the contract, treatment of deposits received to ensure it is
have been satisfied appropriate & consistent with relevant
standards

This is likely to be at a point in time, when

control of the playground is passed to the During the final audit, the audit team should
customer. undertake increased testing over the cut-off
of revenue & the completeness of deferred
income.

There is a risk that revenue is overstated &

current liabilities understated if the deposits
have been recorded as revenue.
Loan covenants – going concern impact if
breached Review the covenant calculations
prepared by Sycamore and identify
The loan has a minimum profit target whether any defaults have occurred; if
covenant. If this is breached, the loan so, determine the effect on the
would be instantly repayable. company.

If the company does not have sufficient Review cash flow forecasts and enquire
cash flow to meet this loan repayment, of management how they will deal with
then there could be going concern any need to make the loan repayment.
implications.
There is a risk of inadequate disclosure
of going concern issues.

Rights issue

Hart Co made a rights issue in the year. The audit team should obtain legal
This is a non-standard transaction & there is documentations in support of the rights issue
increased risk that the issue has not been to agree the number of shares issued & the
recorded correctly. rights price.

The rights issue has been made at a They should recalculate the split of share
premium & therefore requires to be split into capital & share premium & agree this to the
its share capital & share premium elements. journal entry to record the rights issue.

There is a risk that the split between share

capital & share premium has not been
accounted for correctly & that these
balances are misstated.
PPE

Hart Co placed an order for $2.4m of Review the NCA asset register to determine
machinery, paying $1m in advance. The if the 1m paid in advance has been
machinery was due to be received in July capitalized. Discuss the correct accounting
20X5 but will now be delivered post year treatment with management to confirm that
end. the amount paid in advance incorrectly
recognized review the correcting journal
entry.

Only assets physically exist at the yearend

should be capitalized as PPE. The 1$
deposit paid in advance should be
recognized as a prepayment.

If the deposit of 1m paid in advance has

been capitalized prepayments are
understated & PPE will be overstated

New audit client

Scarlet Co is a new audit client of the firm. Orange & co should ensure that it has a
The audit engagement team will be suitably experienced team deployed on the
unfamiliar with the accounting policies, audit.
transactions and balances of the client,
hence there will be an increased detection
risk on the audit.
In addition, sufficient time must be set aside
so that the team members can familiarize
themselves with the new client, document its
In addition, there is less assurance over systems & controls & understand the risk of
opening balances as Orange & co did not material misstatements.
perform last year’s audit

Increased audit procedures should be

performed on the opening balances
Bank loan – risk of profit manipulation

Scarlet Co is looking to raise finance by The audit engagement team should

taking a loan from the bank to replace three maintain professional skepticism throughout
machines. The directors are keen to report the course of the audit.
strong results in order to obtain the finance.

Detail cut-off testing of areas such as

There is a riNAsk that the financial revenue, inventory & payables should be
statements are subject to fraud, as the performed to ensure that cut-off has been
directors have an incentive to falsify their correctly applied & substantive procedures
accounts in order to get finance from the performed on estimated & judgements to
bank. ensure accuracy.

There is a risk that the Scarlet’s expenses

are understated and profit overstated.

Machinery – staff training costs

A specialized machine was acquired & staff Discuss the accounting treatment with the
members had to be trained in the machine’s directors & request that an adjustment is
use at a cost of $15,000 which had been made to ensure appropriate treatment of the
capitalized as part of the cost of the training costs.
machine.

Obtain a breakdown of the remaining

IAS 16 PPE prohibits training costs from capitalized costs & agree to supporting
being capitalized & there ore profits and documentation to ensure that they meet the
PPE will be overstated, & expenses recognition criteria in IAS 16.
understated if the training costs are not
written off to the SOPL.
Receivables valuation

An extended credit terms is offered to the Review the aged receivables analysis of the
customers on the condition that their sales Co and assess the adequacy of provision for
order quantities were increased & receivables doubtful debts recorded in the FS.
days have increased from 38 days to 51
days.

There is increased risk that provision for

doubtful debt & bad debts may not have been
charged to reflect in receivables days, &
provision may be understated & receivables
may be overstated.

Contingent asset

A current asset of $360,000 has been If the receipt is not virtually certain,
included within the SOPL & assets. It management should be requested to remove
represents an anticipated pay out from it from profit & receivables.
liquidators handling the bankruptcy of a
customer who owed BB Co $0.9m. If the receipt is probable, the auditor should
request the management to include a
BB co has not received a formal notification contingent assets disclosure note.
from the liquidators confirming the payment &
this would therefore represent a possible
contingent asset.

According to IAS 37, this should not be

recognised until the receipt is virtually certain.

With no firm response to date, the inclusion of

this sum overtates profit & current assets.

Unfair dismissal claim

The financial accountant of BB co was Review the correspondence between the Co
dismissed & is threatening to sue the Co & their lawyer to assess the likelihood of
for unfair dismissal. success of claim by the financial accountant.

If it is probable that BB Co will make a

payment to the financial accountant, a
provision for unfair dismissal is required.

If the payment is possible rather than

probable, a contingent liability disclosure
would be necessary.

If BB Co has not done this, there is a risk

over the completeness of any provisions
or contingent liability.