You were recently employed by AD Chartered Accountants as a Manager. You are currently preparing the planning memorandum for your client, Manuf Co., a manufacturer of machinery used in the bauxite extraction industry. The Company is a member of the Manufacturing Association of Ghana and has won several awards for manufacturing environmentally friendly products. You are also planning the audit of the financial statements for the year ended 31 March 2019. The draft financial statements show revenue of GH¢100 million (2018 – GH¢50 million), profit before tax of GH¢1 million (2018 – GH¢0.5 million) and total assets of GH¢200 million (2018 – GH¢150 million). Your firm was appointed as auditor to Manuf Co. for the first time in October 2018.
Below is an extract of the business operation and development of Manuf Co:
One of the key customers, Law Co Ltd, communicated in January 2019, via its lawyers with Manuf Co., claiming damages for injuries suffered by a drilling machine operator whose arm was severely injured when a machine malfunctioned. Odo Pa Nye, the Chief Executive Officer of Manuf Co., has told you that the claim is being ignored as it is generally known that Law Co Ltd has a poor health and safety record, and thus the accident was their fault. Two orders which were placed by Law Co Ltd in February 2019 have been cancelled.
All machines are supplied carrying a one year warranty. A warranty provision is recognised on the balance sheet as GH¢2.5 million (2018 – GH¢ 2.4 million). Odo Pa Nye estimates the cost of repairing defective machinery reported by customers, and this estimate forms the basis of the provision.
Work in progress is valued at GH¢ 15 million as at 31 March 2019. A physical inventory count was held on 23 March 2019. The Chief Engineer estimated the stage of completion of each machine at that date. One of the major components included in the bauxite extracting machinery is now being sourced from overseas. The new supplier, Osoro Co., is located in Germany and invoices Manuf Co in euros. There is a trade payable of GH¢ 1.5 million owing to Osoro Co. recorded within current liabilities.
Manuf Co. designs, constructs and installs machinery for three key customers. Payment is due in three instalments: 70% is due when the order is confirmed (stage one), 15% on delivery of the machinery (stage two), and 15% on successful installation in the customer’s bauxite mine (stage three). Generally it takes four months from the order being confirmed until the final installation.
At 31 March 2019, there was an amount outstanding of GH¢1.5 million from Mmere Pa Nye Company Ltd which was in dispute. Mmere Pa Nye Company Ltd is refusing to pay until the machinery, which was installed in August 2017, is running at 100% efficiency.
Odo Pa Nye owns 60% of the shares in Manuf Co. She also owns 55% of Pacific Co., which leases a head office to Manuf Co. Odo Pa Nye is considering selling some of her shares in Manuf Co. in late January 2019, and would like the audit to be finished by that time.
Required:
Explain the significant audit procedures to be performed during the final audit in respect of the estimated warranty provision in the statement of financial position of Manuf Co. as at 31 March 2019. (3 marks)
View Solution
ISA 540 Audit of Accounting Estimates requires that auditors should obtain sufficient audit evidence as to whether an accounting estimate, such as a warranty provision, is reasonable given the entity’s circumstances, and that disclosure is appropriate. One, or a combination of the following approaches should be used:
- Review and test the process used by management to develop the estimate
- Review contracts or orders for the terms of the warranty to gain an understanding of the obligation of Manuf Co
- Review correspondence with customers during the year to gain an understanding of claims already in progress at the year end
- Perform analytical procedures to compare the level of warranty provision year on year, and compare actual to budgeted provisions. If possible disaggregate the data, for example, compare provision for specific types of machinery or customer by customer
- Re-calculate the warranty provision
- Agree the percentage applied in the calculation to the stated accounting policy of Manuf Co
- Review board minutes for discussion of on-going warranty claims, and for approval of the amount provided
- Use management accounts to ascertain normal level of warranty rectification costs during the year
- Discuss with Odo Pa Nye the assumptions she used to determine the percentage used in her calculations
- Consider whether assumptions used are consistent with the auditors’ understanding of the business
- Compare prior year provision with actual expenditure on warranty claims in the accounting period
- Compare the current year provision with prior year and discuss any fluctuation with Odo Pa Nye.
- Review subsequent events which confirm the estimate made
- Review any work carried out post year end on specific faults that have been provided for. Agree that all costs are included in the year end provision.
- Agree cash expended on rectification work in the post statement of financial position period to the cash book
- Agree cash expended on rectification work post year end to suppliers invoices, or to internal cost ledgers if work carried out by employees of Manuf Co
- Read customer correspondence received post year end for any claims received since the year end. (Any three well explained points) (3 marks)