• Provisions e.g. for site restoration costs.
• Contingent liabilities, e.g. arising from pending legal action.
• Assets values, e.g. inventory or non-current assets which may be subject to environmental concern.
• Accounting for capital or revenue expenditure on cleaning up the production process or to meet legal or other standards.
• Product redesign costs.
• Product viability/going concern considerations.                                        (1 mark each or any 3 valid points)

Actions that should be undertaken

• Obtain an appropriate understanding of the company, its operations and in particular, its environmental issues.
• Evaluate whether there is any possible risk of misstatement in the financial statements as a result of environmental issues.
• Enquire of management as to any systems or controls which are in place to identify risk, evaluate control, and account for environmental matters.               (1 mark each or any 3 valid points)

Audit Procedures

• Obtain an understanding of the control environment operating within the client.
• Obtain written representations from management on any environmental matter.
•  Obtain evidence from environmental experts where this is necessary.
• Seek corroborative evidence of any statements by management.
• Use professional judgement to consider whether the evidence in relation to environmental matters is sufficiently persuasive.
• Consider minutes of directors, board, committees or environmental officers.
• Review documentation.
• Review all assets for impairment.
• Review liabilities and provisions to ensure all have been included.
• Review contingencies and ensure adequate disclosure.
• Include environmental issues in the review of the appropriateness of going concern.        (1 mark each for any 4 valid points)

The main possible reasons why the directors are reluctant to provide the note to the financial statements are that they fear that:
The note will send a wrong signal to the stakeholders as follows;

• The prospective loan creditor may refuse to provide the needed funds on the basis that the company is not a going concern.
• Trade Creditors may refuse further credit and resort to cash on delivery transactions with the company.
• If the company is a listed entity, its share prices may fall.
• The existing shareholders may think that management is not running the affairs of the company properly.
• Potential investors may be scared away from investing in the company.
• Predators may pick it as signal to make take-over bid for the company.                (Any 5 points)

• If the directors refuse to provide the note, the auditors may consider that the financial statements are materially misstated in account of the non-disclosure of the going concern uncertainty.
• In the height of this, the auditors would consider this disagreement on the type of opinion to issue which might be other than unmodified.
• This failure to disclose the going concern problem will result in an adverse opinion. The auditors could also assess the implication of management refusal on their continued association with the client.
• If they consider that it amounted to serious non-co-operation with them by management, they may consider terminating the client relationship.
• However, they have to seek legal counsel and also draw the attention of the shareholders of the problem.

1) In the new clarity project on the ISAs, the IAASB reiterated that the next of the ISAs is authoritative and must be followed even in the audit of SMEs.
2) However, the IAASB did state that the work an auditor will need to do in order to comply with the ISA will vary, a small simple entity being likely to require less work than a large and complex one.
3) The auditor needs to use professional judgement in applying the ISAs in order to determine the procedures necessary to comply with their requirements.
4) To take a specific example, the IAASB stated that, the requirement of ISA 315 to obtain an understanding of the entity and its environment is relevant to smaller entities but that because smaller entities are typically simpler, it will be much easier to obtain this understanding.
5) Individual clarity ISAs include guidance on specific points relating to small entity audits.

6) The purpose of this guidance is to assist in the application of the requirement of the ISA to a small entity audit.
7) The clarity project does not limit or reduce the responsibility of the auditor to apply and with requirement of ISAs.

The following audit opinions are recommended.
1) Since the inconsistency is traced to the financial statements, it may be considered that the financial statements are materially misstated. The pervasiveness of the effect of the matter will be considered and if it is only material, a qualified opinion “except for” will be issued. On the other hand, if the effect is considered as being both material and pervasive, an adverse opinion will be appropriate.

2) GHS2.0 million reduction in the value of stocks amount to 10% of the total assets of the company. This is material. This amounts to material misstatement of the financial statement and non-compliance with applicable financial reporting framework. The recommended audit opinion will be a “qualified opinion”.

3) Since the auditors consider the effect of the matter to be both material and pervasive, it means that there was a significant inability to obtain sufficient appropriate audit evidence to determine misstatements in the financial statements. The auditors will be unable to express an opinion and therefore a disclaimer of opinion will be appropriate.

4) Since management refused to make a provision for the write-off of the debtor, the requirement of IAS 37 have not been complied and thus will be materially misstated. A qualified opinion is recommended

The auditor may consider the reason behind the directors’ refusal to effect the changes and determine whether it borders on the directors wanting to commit fraudulent financial reporting which will reflect on their integrity. It could also mean the directors are difficult and just do not want to co-operate with the auditor’s. Whatever the case, the auditors may want to bring this to the attention of the shareholders in the annual general meeting.

Leased Property

The lease taken out in July 2011 has been treated as a finance lease. However, there are indications that it is in fact an operating lease. Firstly, the lease is for only five years, which for a property lease is not likely to be for the major part of the economic life of the asset. According to IAS 17 Leases, an indicator of a finance lease is that the lease term is for the major part of the economic life of an asset.

Secondly, the amount capitalised of GH₵5 million represents only 25% of the fair value of the asset. Under IAS 17, for a lease to be classified as a finance lease, the present value of minimum lease payments (the amount capitalised) should amount to at least substantially all of the fair value of the asset. 25% is not substantially all of the fair value, indicating that this is actually an operating lease.

Therefore it appears that the accounting treatment is incorrect. The lease should have been treated as an operating lease. Currently, property, plant and equipment and non-current liabilities are overstated. The finance cost will be overstated if any interest accrued on the lease has been included. Operating expenses are understated as lease payments should have been included in this heading, and so profits are likely to be overstated. However, operating expenses will currently contain depreciation charges for the leased asset, which will need to be reversed. The overall impact on operating expenses could be minimal as the two adjustments will offset each other to an extent.

PROVISION

The provision for warranties have reduced by 20%, which is not in proportion to the reduction in revenue of 12·3%. Possibly the company has changed its policy on providing warranties, or is selling fewer products with warranties attached. However, we should be alert to the risk of the warranty provision being understated, especially given the incentive for the accounts to be subject to management bias.

It is questionable whether the warranty provisions should be classified as non-current liabilities. It is likely that some, if not all, of the provision will lead to an outflow of economic benefits within the next 12 months and it should be recognised within current liabilities. This potential misclassification affects analysis of liquidity.

Auditors should adopt one or a combination of the following audit procedures in the audit of the Provision

• Review and test the process used by management to develop the Provision;
  The steps ordinarily involved in reviewing and testing the process used by management are:
  a) evaluation of the data and consideration of assumptions on which the estimate is based;
  b) testing of the calculations involved in the estimate;
  c) comparison, when possible, of estimates made for the purposes of the preparation of prior period financial statements with subsequent actual outcomes;
  d) consideration of management’s approval procedures; and
  e) Obtaining management representations.
• Use an independent estimate for comparison with that prepared by management;
  Auditors may make or obtain an independent estimate and compare it with the warranty provision prepared by management. When using an independent estimate auditors would ordinarily evaluate the data and consider the assumptions, and may test the calculation procedures used in its development. It may also be appropriate to compare warranty provisions made for prior periods with actual results of those periods. Or
• Review subsequent events.
  Transactions and events which occur after the period end, but prior to completion of the audit, may provide audit evidence regarding a warranty provision made by management. Auditors’ reviews of such transactions and events may reduce, or even remove, the need for the auditors to review and test the process used by management to develop the warranty provision or to use an independent estimate in assessing the reasonableness of the warranty provision.  (3 points for 6 marks)

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.

An Audit committee is a sub-committee of the board of Directors which is mandated to help the main board to discharge its responsibilities in the area of achieving effective and transparent financial reporting. To play an independent role the audit committee should be composed of at least three and maximum of five members, majority of whom should be non-executive directors. Whiles the members are not required to be accounting and financial professionals they should have sufficient knowledge and experience in financial matters, especially financial reporting requirements.

While these executives of the company cannot be members of the committee, they can be in attendance at meetings.
1) The Chief executive officer
2) The financial director or chief financial or accounting officer
3) Head of internal audit

The external auditor may also be invited when necessary to attend a meeting of the committee.

Responsibility of an audit committee
The main role and responsibilities of the audit committee are as follows:

1) To monitor the integrity of the financial statements of the company and any formal announcement relating to the company’s performance, reviewing significant financial reporting judgements contained in them.

2) To review the company’s internal financial controls and, unless expressed addressed by a separate board risk committee composed of independent directors or by the board itself, to review the company’s internal control and risk management systems.

3) To monitor and review the effectiveness of the company’s internal audit function.

4) To make recommendations to the board, for it to put to shareholders for their approval in general meeting , in relation to the appointment, re-appointment, and removal of the external auditor and to approve the remuneration and terms of engagement of the external auditor.

5) To review and monitor the external auditor’s independence and objectivity and the effectiveness of the audit process taking into account relevant professional and regulatory requirements.

6) To develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provision of non-audit services by the external firm and to report to the board identifying any matters in respect of which it considers that action and improvement is needed and making recommendations as to steps to be taken.

7) To report to the board how it has discharge it responsibilities, including

• How it has addressed significant issues arising in the financial statements
• How it has addressed the effectiveness of the audit process
• How auditors objectivity and independence is safeguarded, where the auditor provided non-audit services.                                (Any 5 points for 5 marks)

Firm Culture
The International Standard on Quality Control (ISQCI) requires that firms implement policies such that the internal culture of the firm emphasizes the importance of quality control. It is the leader of the firm who are responsible for creating and maintaining this culture through actions and messages. In other words the entire business strategy of the firm should be driven by the need for quality in its operations. The personnel responsible for establishing and maintain the firm’s system of quality control must understand ISQCI.

In this case two factors indicate that there is a lack of leadership on quality control;
*The partner responsible for quality control died and has not been replaced. While this may not have a direct impact on the audit of C. Kokuvi Ltd, the fact that there is no one responsible for quality control in the firm increases the risk that quality control deficiencies will go undetected.

*The firm is under pressure to compete the audit and provide other services for the same fee as last year in spite of the fact that additional work will be required. There is a risk that quality will suffer as audit work will not be carried out as thoroughly as it should be in order to complete the work within budget. This problem is exacerbated by the potential lack of proper quality control review due to the death of the quality control partner.

The quality control partner should be replaced as soon as possible. The budget for the audit of C. Kokuvi should be monitored carefully. The audit should be conducted properly and in accordance with ISAs. Any cost overruns should be discussed with the client and additional fees negotiated if necessary.            (4 marks)

2) Ethical requirements
A firm should have procedures in place to ensure that staff is aware of ethical requirement and comply with these. In this case the implementation of the system has not been completed. Whilst members of staff who are members of a professional body should be aware of their responsibilities they may not have all the relevant information to avoid an in advertant breach of the regulations for example details of all companies who are client of the firm. The implementation of the system started by the previous ethics partner should be completed.            (3 marks)

3) Monitoring
The fact that the audit partner (Thomas Essien) is new, and the previous partner is no longer with the firm increases the risk regarding audit monitoring. As the current audit partner is new he will not have an extensive knowledge of the audit client initially. The tight deadline for the audit accentuates this problem.To decrease this risk the audit partner must gain an understanding of the business in accordance with ISAs. If possible, it may be appropriate to retain the audit manager and audit senior from the previous year to aid continuity. Adjei & Associates may also consider a second partner review to ensure that quality control standards have been maintained.          (3 marks)

Research and development has been added back to income as it is not an allowable deduction for tax purposes in petroleum upstream operations.
In the solution above, the research and development has been added back to income.