It is 1 July 20X5.

You are an audit supervisor with Oogway & Co, which has recently
been appointed as auditor to Lotus Blossom Co (Lotus), and you are planning your
first audit which will be for the year ending 31 July 20X5. Lotus develops and
manufactures electrical components.

The audit engagement partner had a meeting with Crane Wing, Lotus’ finance
director, and has advised you of the following:

Inventory is valued at the lower of cost and net realizable value. Cost is made up of
the purchase price of raw materials and costs of conversion, including labor and
production overheads. The finance director has reviewed the inventory valuation
policy and has decided to include some additional overheads this year as they
consider them to be production related.

Inventory is held in two main warehouses close to the manufacturing facility. The
company plans to conduct full inventory counts at the warehouses on 29 and 30
July, and any necessary adjustments will be made post year end to reflect
movements of inventory occurring on 31 July.

During the year, whilst calculating depreciation, the directors extended the useful
lives of plant and machinery from three years to five years.

The company receives a trade discount from one of its main suppliers, Bamboo Co,
which is linked to the total amount purchased during the year. The amount is
reclaimed post year end in September 20X5 and is based on the actual volumes
purchased during the year ended 31 July 20X5. During the last month it has become
clear that Lotus will reach the volume required to reclaim this discount. The finance
director has advised that they are expecting to include a receivable in relation to
this trade discount of $0·9m at the year end along with a corresponding entry in
cost of sales, as the discount relates to goods which will have all been sold by the
year end.

The directors need to meet a target profit before tax of $1.5 million in order to be
paid their annual bonus.

In May 20X5 the financial controller of Lotus was dismissed. He had been employed
by the company for over 20 years, and he has threatened to sue the company for
unfair dismissal. The role of financial controller has not yet been filled and so his
tasks have been shared between the existing finance department team. In addition,
the purchase ledger supervisor left in March and a replacement has been appointed
in the last week. However, for this period, no supplier statement reconciliations
were performed.

Lotus’ payroll function is outsourced to an external service organization, Harmony

Co, which is responsible for all elements of payroll processing and maintenance of
payroll records.

(a)Describe EIGHT audit risks and explain the auditor’s response to

each risk in planning the audit of Lotus Co. (16 marks)

Audit risks Auditor’s response

New client: Oogway & Co has been
recently appointed as the auditor to Oogway Co should ensure that the
Lotus Blossom Company and the first audit team should comprise of
audit is being planned out. experienced staffs particularly in the
The auditors maybe unfamiliar field of electricals manufacturing
with the policies, transactions and companies.
balances in the company resulting in
errors in the F/S which can go In addition, sufficient time should be
undetected. given to the audit team members so
Since we did not do audit that they can be familiar with the
previous year, there is less assurance accounting policies and transactions.
over the opening balances of the
company resulting in its Increased substantive procedures
misstatement. should be performed on the o/b to
verify they are accurate.

Valuation of inventory: The finance

director has decided to include Review of the inventory valuation
additional overheads to the cost of the process should be done in order to
inventory. ensure that the inventories are valued
According to IAS 2 correctly.
Inventories, ‘the cost of the inventory
includes all the directly attributable Obtain a breakdown of overheads to
costs which are used to convert it be included in the cost of inventory or
from raw material to finished good.’ to be expensed out.
There is a risk that the expenses
which are not directly linked with the
conversion costs of the inventory may
still be added.
This could result in an
overstatement of the value of
inventories and understatement of
expenses in the financials of Lotus
Blossom Company.
Extension of useful lives of
assets: The directors of Lotus Co Obtain a report from an independent
extended the useful lives of plant and evaluator on the estimated remaining
machinery from three years to five useful life of the asset and agree it
years. with the useful life declared by the
According to IAS 16 PPE, ‘the management.
useful lives of the assets should be
reviewed yearly and if the
expectations differ from previous
estimates, then there should be Obtain a report on the performance
change in the useful life.’ There is a and revenue generated by the asset
risk that the useful lives of the plant and check whether the increase in
and machinery have been over- useful life is reasonable.
estimated by the directors of the
company resulting in less depreciation Review the policies for calculating
being charged for the period. depreciation and recalculation of the
This could cause an depreciation charge should be done if
overstatement of assets in the necessary.
financial position of the company and
an overstatement of profits for the
period.
Criteria for bonus of directors: The
directors need to meet a target profit Increase the substantive procedures
before tax of $1.5 million in order to over the judgement provided by the
be paid their annual bonus. directors of the company.
In order to meet this incentive,
there is a risk that the directors may Evaluate the company’s accounting
try to manipulate and increase the system and internal controls and
profits of the company. Furthermore, obtain a sample of transactions to
errors in the judgements of the ensure that the revenue, expenses
directors are more likely and there is and cost of sales are recorded
less assurance over the balances properly.
prepared by them.
This could lead to the Check and compare the company’s
overstatement of assets and profits previous period’s profits with current
for the year in the financial year and any suspicions should be
statements of Lotus company. investigated thoroughly.

Provision for unfair dismissal: The

financial controller of Lotus company, Advise the management to consult a
who had been employed by the legal practitioner.
company over 20 years was dismissed
and has threatened to sue the Discuss with the management about
company. the possible outcome of the court
Since the action could lead to case and enquire if necessary
a court case and likelihood of the provisions have been made.
outcome is unknown, a provision of
necessary amount is required. Even if Obtain a written letter from a legal
a provision is made by the company, practitioner on as whether the case
there is the risk that the accurate could result in Lotus company paying
amount is not posted. the employee. If yes, confirm the
This could lead to the amount along with sign as evidence
understatement of provisions and and make necessary provision in the
understatement of liabilities of Lotus financial statement of Lotus
Company. Company.

Vacant post of finance controller:

The role of financial controller has not Increased substantive procedures
yet been filled and so the tasks have over the judgement and the work
been shared between the existing done by the finance department.
finance department team.
There is a detection risk as Review of the work done by the
the finance department team are finance department by an
likely to review their own work in the independent senior manager.
absence of the finance controller
causing them to be more reluctant Discuss with the management on the
resulting in the errors going appointment of a competent finance
undetected. Furthermore, there is the controller through the nomination
risk of more errors being made by the committee.
finance department due to the
overload of work.
This could lead to the
misstatements in the balances of the
items of financial statements resulting
in its misinterpretation.
New purchase ledger supervisor
and lack of reconciliations: The Discuss with the management
new purchase ledger supervisor is regarding the competency of the
appointed last week and no supplier newly appointed purchase ledger
reconciliations were performed for the supervisor.
period.
There is a risk that the new Also, increase the substantive
supervisor will be unfamiliar with the procedures over the judgements used
accounting policies, balances and by the new supervisor so that any of
accounting judgements of the the material items would not be
company resulting in errors and misstated.
omissions in the financial statements.
Furthermore, lack of Advise the management to reconcile
supplier statement reconciliations supplier statements and adjustments
could result in the misstatement of should be made accordingly. Obtain a
payables in the financials of Lotus sample of the purchases from the
company. supplier and compare it with the
purchase ledger so as to ensure that
the reconciliation is done properly.
Reclamation of discount as
receivables: It is clear that Lotus will Enquire the supplier about the terms
reach the volume required to reclaim and conditions of the contracts
the discount and are expecting to regarding the discount and check
include a receivable of 0.9M in relation whether the stated amount of
to this discount. discount is correct.
Since in this case receiving
the discount is a future event, there is Enquire about the surety of the
still a risk that the company might not discount and whether the discount
be able to get the discount. will be received properly.
Furthermore, the actual discount
amount may differ from the stated Obtain a sample of transactions so as
0.9M by the finance director. to ensure that the receivables balance
This could lead to the is stated correctly.
overstatement of receivables in the
financial statements of Lotus
Company.