Principal Audit Risks of Manuf Co

Legal claim
The claim should be investigated seriously by Manuf Co. The chief executive officer’s (CEO) opinion that the claim will not result in any financial consequence for Manuf Co is naïve and flippant. Damages could be awarded against Manuf Co if it is found that the machinery is faulty. The recurring high level of warranty provision implies that machinery faults are fairly common and therefore the accident could be the result of a defective machine being supplied to Law Co Ltd. The risk is that no provision is created for the potential damages under IAS 37 Provisions, Contingent Liabilities and Contingent Assets, if the likelihood of paying damages is considered probable. Alternatively, if the likelihood of damages being paid to Law Co Ltd is considered a possibility then a disclosure note should be made in the financial statements describing the nature and possible financial effect of the contingent liability. As discussed below, the CEO, Odo Pa Nye, has an incentive not to make a provision or disclose a contingent liability due to the planned share sale post year end.

A further risk is that any legal fees associated with the claim have not been accrued within the financial statements. As the claim has arisen during the year, the expense must be included in this year’s income statement, even if the claim is still on- going at the year end.

The fact that the legal claim is effectively being ignored may cast doubts on the overall integrity of senior management, and on the integrity of the financial statements. Management representations should be approached with a degree of professional scepticism during the audit.

Law Co Ltd has cancelled two orders. If the amounts are still outstanding at the year end then it is highly likely that Law Co Ltd will not pay the invoiced amounts, and thus receivables are overstated. If the stage one payments have already been made, then

Law Co Ltd may claim a refund, in which case a provision should be made to repay the amount, or a contingent liability disclosed in a note to the financial statements.

Law Co Ltd is one of only five major customers, and losing this customer could have future going concern implications for Manuf Co if a new source of revenue cannot be found to replace the lost income stream from Law Co Ltd. If the legal claim becomes public knowledge, and if Manuf Co is found to have supplied faulty machinery, then it will be difficult to attract new customers.

A case of this nature could bring bad publicity to Manuf Co, a potential going concern issue if it results in any of the five key customers terminating orders with Manuf Co. The auditors should plan to extend the going concern work programme to incorporate the issues noted above.

Warranty provision
The warranty provision is material at 2·6% of total assets (2018 – 2·7%). The provision has increased by only GHS 100,000, an increase of 4·2%, compared to a revenue increase of 21·4%. This could indicate an underprovision as the percentage change in revenue would be expected to be in line with the percentage change in the warranty provision, unless significant improvements had been made to the quality of machines installed for customers during the year. This appears unlikely given the legal claim by Law Co Ltd, and the machines installed at Mmere Pa Nye Company Ltd operating inefficiently. The basis of the estimate could be understated to avoid charging the increase in the provision as an expense through the income statement. This is of special concern given that it is the CEO and majority shareholder who estimates the warranty provision.

Inventories
Work in progress is material to the financial statements, representing 8·9% of total assets. The inventory count was held two weeks prior to the year end. There is an inherent risk that the valuation has not been correctly rolled forward to a year end position.

The key risk is the estimation of the stage of completion of work in progress. This is subjective, and knowledge appears to be confined to the chief engineer. Inventory could be overvalued if the machines are assessed to be more complete than they actually are at the year end. Absorption of labour costs and overheads into each machine is a complex calculation and must be done consistently with previous years.

It will also be important that consumable inventories not yet utilised on a machine, e.g. screws, nuts and bolts, are correctly valued and included as inventories of raw materials within current assets.

Overseas supplier
As the supplier is new, controls may not yet have been established over the recording of foreign currency transactions. Inherent risk is high as the trade payable should be retranslated using the year end exchange rate per IAS 21 The Effects of Changes in Foreign Exchange Rates. If the retranslation is not performed at the year end, the trade payable could be significantly over or under valued, depending on the movement of the dollar to euro exchange rate between the purchase date and the year end. The components should remain at historic cost within inventory valuation and should not be retranslated at the year end.

Revenue Recognition – timing
Manuf Co raises sales invoices in three stages. There is potential for breach of IFRS 15 Revenue from Contract with Customers.
The core principle of IFRS 15 is that an entity will recognise revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. This core principle is delivered in a five-step model framework.

• Identify the contract(s) with a customer
• Identify the performance obligations in the contract
• Determine the transaction price
• Allocate the transaction price to the performance obligations in the contract
• Recognise revenue when (or as) the entity satisfies a performance obligation.

These steps ensure revenue should only be recognised once the seller has the right to receive it, in other words the seller has performed its contractual obligations. This right does not necessarily correspond to amounts falling due for payment in accordance with an invoice schedule agreed with a customer as part of a contract. Manuf Co appears to receive payment from its customers in advance of performing any obligation, as the stage one invoice is raised when an order is confirmed i.e. before any work has actually taken place. This creates the potential for revenue to be recognised too early, in advance of any performance of contractual obligation. When a payment is received in advance of performance, a liability should be recognised equal to the amount received, representing the obligation under the contract. Therefore a significant risk is that revenue is overstated and liabilities understated.
Disputed receivable
The amount owed to Mmere Pa Nye Company Ltd is highly material as it represents 50·9% of profit before tax, 2·3% of revenue, and 3% of total assets. The risk is that the receivable is overstated if no impairment of the disputed receivable is recognised.

Majority shareholder
Odo Pa Nye exerts control over Manuf Co via a majority shareholding, and by holding the position of CEO. This greatly increases the inherent risk that the financial statements could be deliberately misstated, i.e. overvaluation of assets, undervaluation of liabilities, and thus overstatement of profits. The risk is severe at this year end as Odo Pa Nye is hoping to sell some Manuf Co shares post year end. As the price that she receives for these shares will be to a large extent influenced by the financial position of the company at 31 March 2019, she has a definite interest in manipulating the financial statements for her own personal benefit. For example:

• Not recognising a provision or contingent liability for the legal claim from Law Co Ltd
• Not providing for the potentially irrecoverable receivable from Jacks Mines Co
• Not increasing the warranty provision
• Recognising revenue earlier than permitted by IFRS 15 Revenue from Contract with Customers

Related party transactions
Odo Pa Nye controls Manuf Co and also controls Pacific Co. Transactions between the two companies should be disclosed per IAS 24 Related Party Disclosures. There is risk that not all transactions have been disclosed, or that a transaction has been disclosed at an inappropriate value. Details of the lease contract between the two companies should be disclosed within a note to the financial statements, in particular, any amounts owed from Manuf Co to Pacific Co at 31st December, 2019 should be disclosed.

Other issues

• Odo Pa Nye wants the audit to be completed as soon as possible, which brings forward the deadline for completion of the audit. The audit team may not have time to complete all necessary procedures, or there may not be time for adequate reviews to be carried out on the work performed. Detection risk, and thus audit risk is increased, and the overall quality of the audit could be jeopardised.
• This is especially important given that this is the first year audit and therefore the audit team will be working with a steep learning curve. Audit procedures may take longer than originally planned, yet there is little time to extend procedures where necessary.
• Odo Pa Nye may also exert considerable influence on the members of the audit team to ensure that the financial statements show the best possible position of Manuf Co in view of her share sale. It is crucial that the audit team members adhere strictly to ethical guidelines and that independence is beyond question.
• Due to the seriousness of the matters noted above, a final matter to be considered at the planning stage is that a second partner review (Engagement Quality Control Review) should be considered for the audit this year end. A suitable independent reviewer should be indentified, and time planned and budgeted for at the end of the assignment.

Conclusion
From the range of issues discussed in these briefing notes, it can be seen that the audit of Manuf Co will be a relatively high risk engagement.          (15 marks)

Briefing notes
Subject: Business risks facing Retail Specialist Co. Ltd (RSCL)
Introduction
These briefing notes evaluate the business risks facing our firm’s new audit client, Retail Specialist Co. Ltd (RSCL), which operates in the retail industry, and its year under review ended 31 December 2018.
Ability to produce fashion items
The company is reliant on staff with the skill to produce high fashion clothes ranges, and also with the ability to respond quickly to changes in fashion. If Retail Specialist Co. Ltd (RSCL) fails to attract and retain skilled designers then the clothing ranges may not be desirable enough to attract customers in the competitive retail market. The high staff turnover in the design team indicates that Retail Specialist Co. Ltd (RSCL) struggles to maintain consistency in the design team. This could result in deterioration of the brand name and, ultimately, reduced sales.
There would be a high cost associated with frequently recruiting – this would have an impact on operating margins.
Inventory obsolescence and margins
There is a high operational risk that product lines will go out of fashion quickly, because new ranges are introduced so quickly to the stores (every eight weeks), leading to potentially large volumes of obsolete inventory. These product lines may be marked down to sell at a reduced margin. The draft results show that operating margins have already reduced from 17·9% in 2017 to 16·8% in 2018. Any significant mark down of product lines will cause further reductions in margins.
Wide geographical spread of business operations
Retail Specialist Co. Ltd (RSCL) operates a large number of stores, many distribution centres, and has an outsourced function which is located overseas. This type of business model could be hard to control, increasing the likelihood of inefficiencies, systems deficiencies, and theft of inventories or cash.
E-commerce – volume of sales
On-line sales now account for GH¢ 255 million (GH¢ 250 per order x 1,020,000 orders). In the previous year, on-line sales accounted for GH¢ 158 million (GH¢ 300 per order x 526,667 orders). This represents an increase of 61·4% (255 – 158/158 x 100%). One of the risks associated with the on-line sales is the scale of the increase in the volume of transactions, especially when combined with a new system introduced recently. There is a risk that the system will be unable to cope with the volume of transactions, leading possibly to unfilled orders and dissatisfied customers. This would harm the reputation of the company and the RSCL brand.
The company has recently upgraded its computer system to integrate sales into the general ledger. A disaster plan should have been put into place, for use in the event of a system shutdown or failure. The risk is that no plan is in place and the business could lose a substantial amount of revenue in the event of the system failure.
E-commerce – security of systems
It is crucial that the on-line sales system is secure as customers are providing their credit card details to the site. Any breach of security could result in credit card details being stolen, and Retail Specialist Co. Ltd (RSCL) may be liable for losses suffered by customers if their credit card details were used fraudulently. There would clearly be severe reputational issues in this case. Additionally, the system must be secure from virus infiltration, which could cause system failure, interrupted sales, and loss of customer goodwill.
E-commerce – tax and regulatory issues
There are several compliance risks, which arise due to on-line sales. Overseas sales expose Retail Specialist Co. Ltd (RSCL) to potential sales tax complications, such as extra tax to be paid on the export of goods to abroad, and additional documentation on overseas sales that may be needed to comply with regulations. Another important regulatory issue is that of data protection. Retail Specialist Co. Ltd (RSCL) faces the risk of non-compliance with any data protection regulation relevant to customers providing personal details to the on-line sales system.
Retail Specialist Co. Ltd (RSCL) is now making sales overseas. If these sales are made in a different currency to Retail Specialist Co. Ltd (RSCL)’s currency, the business will be exposed to exchange rate fluctuations which will have an impact on the company’s profit margin.
Outsourcing of phone ordering system
The fact that Retail Specialist Co. Ltd (RSCL) engaged the outsource provider offering the least cost could lead to business risks. Staff at the call centre may not be properly motivated, due to low wages being paid, and may fail to provide a quality service to Retail Specialist Co. Ltd (RSCL)’s customers, leading to loss of customer goodwill. As the call centre is overseas, the staff may have a different first language to Retail Specialist Co. Ltd (RSCL)’s customers, leading to customer frustration if they are not understood, and incorrect orders possibly being made. In addition, there may be staff shortages due to the low wage offered, leading to delay in answering calls and lost sales.
Overseas call centres are not always popular with customers, so Retail Specialist Co. Ltd (RSCL) may find that fewer customers use this method of purchase. However, the on-line system is there as an alternative for customers, and is proving popular, so this may not be a significant risk for the company.
The fact that Retail Specialist Co. Ltd (RSCL) opted for the lowest cost provider for the phone ordering system could pose a potential problem in that the provider may not be sustainable in the long term. If the provider fails to generate sufficient profit or cash, it may shut down, leaving Retail Specialist Co. Ltd (RSCL) without a crucial part of the sales generating system.
Ethical Trading Initiative
Retail Specialist Co. Ltd (RSCL) has aligned itself to an initiative supporting social and environmental well-being, presumably to promote its corporate social responsibility. The risk associated with this is that the claims that products have been produced in a responsible way can easily be undermined if the supply chain is not closely managed and monitored. Such claims are often closely scrutinised by the public and pressure groups, and any indication that Retail Specialist Co. Ltd (RSCL)’s products have not been sourced responsibly will lead to loss of customer goodwill and waste of expenditure on the advertising campaign.
Distribution centres
There is a risk of non-compliance with the operating licence issued by the local government authority. The authority will monitor the operating hours of the distribution centres, and also the noise levels created by them. Breaches of the terms of the licence could lead to further revocations of licences, causing huge operational problems for Retail Specialist Co. Ltd (RSCL) if the centres are forced to close for any period of time. Fines and penalties may also be imposed due to the breach of the licence.
Financial performance
Total revenue has decreased by GH¢ 80 million, or 5·2% (80/1,535 x 100). Operating profit has also fallen, by GH¢ 30 million, or 10·9% (30/275 x 100). The information also shows that the average spend per order has fallen from GH¢ 300 to GH¢ 250. These facts may signify cause for concern, but operating expenses for 2010 are likely to include one-off items, such as the costs of the new on-line sales system, and the advertising of the ‘fair-trade’ initiative. The fall in spend per customer could be a symptom of general economic difficulties. The company has increased the volume of on-line transactions significantly; so on balance the overall reduction in profit and margins is unlikely to be a significant risk at this year-end, though if the trend were to continue it may become a more pressing issue.
Retail Specialist Co. Ltd (RSCL)’s finance costs have increased by GH¢ 3 million, contributing to a fall in profit before tax of 13%. The company has sufficient interest cover to mean that this is not an immediate concern, but the company should ensure that finance costs do not escalate.
Conclusion
Retail Specialist Co. Ltd (RSCL) faces a number of operational and compliance risks, the most significant of which relate to the need for constant updating of the product lines and the potential for obsolete inventory. The new on-line sales system also raises risks in terms of security, systems reliability and the sheer volume of transactions. Retail Specialist Co. Ltd (RSCL) must also carefully manage the risk of non-compliance with local government authority regulations. The trend in financial performance should be carefully monitored, as further reductions in revenue and margins could indicate that a change in business strategy is needed.

The scenario fits Money Laundering activity.

• Musah is given huge cash to buy his goods by his brother
• Musah’s brother does not have bank account in Ghana
• The proceeds of the transaction is not paid to his brother in Ghana, but paid into his account in foreign country.
• Though we are not sure how his brother get his money, the modus oprandi, fit money laundering.

Expectation of the risk format
In Money Laundering,

• There’s placement of illegal funds into the financial system. Here huge cash is given to Musah to buy goods and sell outside Ghana.
• Layering-Passing the money through a number of transactions, selling the good outside the country which is engagement of economic activity
• Integration-Integrating the proceeds into legitimate economy by banking in other countries.

Actions to be taken by the auditor
The auditor is then exposed to money laundering activity

• The auditor has an obligation to know the source of the money being given by Musah’s brother.
• The auditor must perform due diligence on the customer and the brother to confirm the activity of the brother.
•  If the suspicion is confirmed, the matter should be reported to the authorities.
• The auditor should avoid tipping of the client during his investigation to confirm the suspicion.

(i) Leasing of equipment and specialist staff. As Citilink Airlines leases its equipment and the most specialised of its staff from another airline, there is a risk that its equipment and/or pilots could be withdrawn leaving it unable to operate.
(ii) Conditions of exclusive right. The MOA requires Citilink Airlines’ aircraft engines be overhauled biannually. There is a risk that Citilink Airlines will be unable to meet this condition, if the lessor company does not agree to regular overhaul or that it will be too expensive for Citilink Airlines to meet this requirement and it could lose the right to operate, or its exclusivity, opening it up to competition. There may be other conditions which Citilink Airlines has to meet, such as the two weekly flights being a minimum.
(iii) Necessary service suspension. As Citilink Airlines is required to overhaul its engines every two years, there will be a significant period every two years where Citilink Airlines will either have to incur the cost of leasing other planes (assuming this is possible) or will have to suspend services. The cost of leasing other planes might be prohibitively expensive or the disruption to service might mean that conditions relating to the right to operate might not be met. As Citilink Airlines only has one plane, service would also be interrupted if there was an emergency relating to the plane, such as fire or a crash.
(iv) Age of aircraft. The aircraft being leased is old. This raises operational risks (it may not always be able to fly due to necessary maintenance), finance risks (it may require regular repair) and compliance risks (it may not meet environmental or safety standards, now or in the future).
(v) High proportion of expensive seats. The plane leased by Citilink Airlines has a high proportion of unrequired expensive seats and therefore insufficient (overbooked) cheaper seats. Although Citilink Airlines can appease customers by upgrading them, this means the airline is operating well below capacity.
(vi) Cargo. The flight route results in the airline carrying a large amount of horticultural produce. This raises various risks – that Citilink Airlines might be liable to passengers if their cargo degrades in transit, that the airline might be liable for any breaches of law by its passengers (for example, if prohibited items are transferred into or from each country. Many countries prohibit the importation of animals or meat products or plants).
(vii) On-board services. Customers are currently dissatisfied with the food provision on the flight and there is a risk that food prepared in Accra may become less appealing and even dangerous when served on a Johannesburg to Accra flight (when it has been prepared a substantial time earlier, given a six hour flight, at least an hour’s turnaround time, and time for getting to the airline in the first place). If the food makes customers ill, Citilink Airlines might be faced with compensation claims.
(viii) Pricing. There is a complex system of pricing and a large number of sales agents, and Citilink Airlines is at risk of operating at a sales value less than required to cover costs (for example, if too many of the cheapest tickets are sold).
(ix) Safety. The airline industry has stringent safety conditions and Citilink Airlines may face customer boycott or difficulty in recruiting staff if safety requirements are not met.
(x) Fuel. The aircraft cannot fly without fuel, which can be a scarce or high-cost resource. If fuel prices escalate due to world conditions, the company might not be able to meet the costs of operating.       (Any 5 points) 

(i) Lease. Citilink Airlines must ensure that the terms of the contract with the international airline ensure that aircraft and staff cannot be withdrawn without reasonable notice, and that in the event of withdrawal, substitutes will be given.
(ii) Conditions. Citilink Airlines must ensure that all staff are aware of any conditions and the importance of meeting them. However, this risk must simply be accepted as there is little Citilink Airlines can do about conditions imposed on them by the governing body of their industry.
(iii) Service suspension. Citilink Airlines must have contingency plans for service suspension, such as ensuring their contract with the international airline ensures alternative aircraft will be made available to them in the event of maintenance or damage to the aircraft, or by making arrangements to lease from a different airline in the event of emergency. As a minimum, Citilink Airlines must ensure that the airline they lease from would give them financial compensation in the event of aircraft or staff not being available so that Citilink Airlines’s customers could be compensated.
(iv) Age of aircraft. Citilink Airlines should have plans in place to be able to lease/afford newer planes if required to by law. Again, this could be written into their contract with the airline. Citilink Airlines should manage cash flow and borrowing facilities so as to be able to afford ongoing maintenance when required.
(v) High proportion of expensive seats. Citilink Airlines should negotiate a reconfiguration of the plane with the lessor so that business and first class seating could be reduced and more economy seats made available. If this is not possible with the current lessor, Citilink Airlines should investigate leasing differently configured planes from another company. If it is not feasible to adjust the plane seating, Citilink Airlines should consider its pricing and on-board facilities policies to make business and first class seats more attractive to customers. As the seats are not being sold anyway, it is probable that a reduction in prices would increase overall revenue, although this might reduce potential profit.
(vi) Cargo. Citilink Airlines should publish a cargo policy to ensure that customers are aware of their legal obligations. They should ensure that staff are sufficiently trained to discuss the contents of baggage with customers and are aware what items Citilink Airlines should not carry. They should insure against lost and damaged cargo.
(vii) On-board services. Citilink Airlines should consider entering into a contract with a company in Johannesburg to provide food for the Johannesburg to Accra journey. Obviously they must not breach any existing contract with the Accra company and so in the meantime should review the type of food provided. For example, it might be safer to only offer cold food, for example sandwiches and cake until an Johannesburg contract can be set up. Even if a new contract is set up, it might still be best to offer cold food as there is less chance of health problems arising as a result of serving cold food rather than hot food.
(viii) Pricing. As discussed above, Citilink Airlines should review the pricing policy. They should also establish limits on how many of certain types of tickets (non-refundable/single etc) can be issued for one flight and they should institute a centralised system to ensure that each agent is aware when limits have been reached. As the agents must be linked to a similar system already (to be aware of whether tickets are available for sale) this should not be too difficult to achieve) .
(ix) Safety. The company should appoint a member of staff to be specifically responsible for safety operations (such as training, updating for legal requirements, educating passengers) and should ensure that staff are regularly appraised about safety issues.
(x) Fuel. The company could take out hedging contracts against the cost of fuel. Other than this, there is little they can do about this matter, and it is another risk that has to be accepted.        (Any 5 points)                      

i) Profitability
The results of the preliminary analytical review indicate that Kpandu Sika Limited is suffering from declining profitability. Revenue has fallen by 12·3% and the gross margin has fallen from 45·7% to 40%. Operating profit has fallen by 27·8%, and the operating margin has fallen from 19·3% to 15·9%. The declining sales and gross profits may be linked to the company losing several customer contracts.

Return on capital employed (ROCE) as calculated based on the information provided shows a reduction from 7% to 4·4%. However, the capital employed figure is not comparable due to the revaluation that occurred during this year.

When recalculated based on an adjusted capital employed figure, this year’s ROCE is 4·9%. Whichever measure is used for capital employed, the trend shows a reduction in efficiency in generating profit.

The falling profitability indicates that going concern should be regarded as an audit risk, especially when the company’s liquidity position is considered (see below).

The company’s interest cover has fallen from 3·7 to 2·7, indicating that while there is sufficient profit to cover interest payments this year, any further debt raised will place additional strain on the company’s ability to meet interest repayments.

In addition, there are several adjustments that may need to be made, which would further reduce the company’s profitability. These adjustments are in relation to the share-based payment and lease expenses, which will need to be recognised depending on the outcome of our audit work in these areas.

ii) Management Bias
As Kpandu Sika Limited is renegotiating long-term finance, management could be biased to present as good a profit figure as possible. We should therefore be alert to the risk of accounting practices being used which overstate revenue and understate expenses. The statement of financial position is also at a risk of misstatement, as management may wish to overstate assets and understate liabilities to improve the appearance of the company’s liquidity and solvency.

iii) Operating expenses
Operating expenses have fallen by 20%. This is not in proportion with the fall in revenue of 12·3% or the fall in cost of sales of 3%, indicating that operating expenses could be understated. Given the costs involved in setting up a new trading division, operating expenses could be expected to increase this year, due to additional set-up and advertising costs. As the trend is not as expected we must extend our audit procedures on operating expenses.

There could also be a misallocation of expenses between cost of sales and operating expenses.

iv) Share-based payment plan
Equity-settled share-based payment plans are complicated to value and account for, and are inherently risky.

IFRS 2 Share-based Payment requires that an expense should be recognised over the vesting period, calculated based on the fair value of the share options at the grant date. The condition relating to the 10% increase in share price is a market condition. Market conditions should be taken into account when determining the fair value of the share options at the grant date and are not to be taken into account for the purpose of estimating the number of equity instruments that will vest. This means where the target increase in share price has not been met, an expense should be recognised irrespective of whether that condition is satisfied, and an expense continues to be recognised over the remainder of the vesting period.

The issue here is that no expense has been recognised, and so operating expenses are understated. The corresponding entry to equity has not been made, so equity is also understated.

A further issue relating to the measurement of the expense is that it should be adjusted for the condition relating to executives and senior managers remaining in employment at the end of the vesting period. A risk of inaccurate measurement of the expense arises if no assessment of whether an adjustment being necessary is made, or if the assumptions relating to the continued service of the executives are unrealistic.

The share-based payment plan should also have a deferred tax consequence – a deferred tax asset arises due to the deductible temporary difference arising from the accounting treatment. There is a risk that assets are incomplete if this is not recognised in the statement of financial position.

Marking scheme note: Credit will be awarded for comments relating to the use of option pricing models and the audit risks associated with them. In determining the expense to be recognised, Kpandu Sika Limited needs to use a valuation method for estimating the fair value of the share options at the grant date. Various models can be used, but all are based on inputs such as share price, exercise price, rate of return and estimated dividend yield. The risk is that inappropriate assumptions have been input to the valuation model, resulting in an unrealistic estimate of the fair value of share options at the grant date. Further, there is a risk that the wrong valuation model has been used.

v) Finance Costs
The financial information shows that finance costs have remained static. This seems unrealistic given that the company has built up a significant overdraft over the year. Finance costs are likely to be understated.

vi) Liquidity
Kpandu Sika Limited has moved from a positive cash position of₵2·35 million to a negative net cash position of₵1·2 million. This increases the going concern risk facing the company, and we must ensure our going concern audit procedures are extended to address this risk.

My preliminary analytical review indicates that the company is still solvent, but liquidity ratios reveal a deteriorating position. The current ratio has reduced from 2·5 to 1·4, and the quick ratio has reduced from 2·1 to 1. Any further deterioration could mean that the company cannot meet its current liabilities as they fall due.

Further indications of problems with operating cash flows are shown by the receivables collection period increasing from 55 to 64 days, and the inventory holding period increasing from 36 to 39 days. Kpandu Sika Limited is also taking longer to settle trade and other payables, with the average payment period increasing from 73 to 76 days.

Kpandu Sika Limited is clearly relying on its overdraft to fund operating cash flows. The fact that it is nearing the overdraft limit is another indication of the going concern risk facing the company this year end.

vii) Revaluation
A material revaluation occurred mid-year. A revaluation surplus of ₵10 million, representing 10·2% of total assets, has been recognised. Despite the valuations being performed by an independent expert, we should be alert to the risk that non-current assets could be overstated in value. This is especially the case given that Kpandu Sika Limited is renegotiating finance, and will want to show a healthy asset position to the provider of finance. We should consider the additional procedures that may need to be conducted to assess the work of this expert. As mentioned above, there is also a risk that depreciation was not re-measured at the point of the revaluation, leading to understated expenses.

The revaluation should also have a deferred tax consequence, as the revaluation gives rise to a taxable temporary difference. If a deferred tax liability is not recognised the statement of financial position is at risk of misstatement through understated liabilities.

Finally, a further audit risk is incorrect or inadequate disclosure in the notes to the financial statements. IAS 16 Property, Plant and Equipment requires extensive disclosure of matters such as the methods and significant assumptions used to estimate fair values, the effective date of the revaluation, and whether an independent valuer was used, as well as numerical disclosures.

viii) Current assets
Inventory and receivables have both increased, whereas revenue has fallen. As mentioned above, the receivables collection period has increased from 55 to 64 days, and the inventory holding period increased from 36 to 39 days. This could indicate that both are overstated. The nature of the products being manufactured mean a high risk of obsolescence exists. Cut-off problems may also account for the increase in inventory. Receivables could be overstated if sufficient allowance has not been made for irrecoverable balances.

ix) Long-term borrowings
The long-term borrowings are due for repayment in two equal instalments, one of which is within 12 months of the year end. The borrowings need to be split into two components of GH₵12·5 million and disclosed separately in current liabilities and non-current liabilities. If this is not done the financial statements will be materially misstated, as the borrowings equate to 25·5% of total assets. Thus the disclosure of the loan is a significant audit risk.

Marking Scheme note: Credit will be awarded where candidates include the effect of reclassification ofGH₵12·5 million as a current liability into their ratio analysis.

Given the company’s lack of cash, if the loans are not successfully renegotiated, it may not be possible for the repayments to be made, creating a going concern risk.

x) Intangible asset
The amount invested in the new website has been capitalised as an intangible asset. The risk is that amounts have been capitalised which do not meet the criteria for recognition as an asset, leading to an overstatement of non-current assets

Only costs in respect of the development of a website should be capitalised, subject to meeting the recognition criteria of IAS 38 Intangible Assets. Any costs incurred in planning must be expensed, as should expenditure incurred once the website is operational. The risk is that the costs involved in setting up the website have not been categorised correctly, leading to incorrect accounting treatment.

In addition, the website should only be recognised as an asset at all if it can be demonstrated that it will generate probable future economic benefit to Kpandu Sika Limited. There is a risk that this is not the case, in which case all of the expenses should be written off.

Finally, there is a risk that the costs involved with the advertising campaign, and possibly other costs involved in setting up this seemingly significant business division, have been capitalised. Such costs should be expensed as incurred, hence there is a risk of overstated non-current assets and understated operating expenses.