Question

Highnix ’s research and development expenditure.

Highnix Electronics Sdn Bhd develops and manufactures computer components and its year end was 31 December 2018 . The company has a large factory, and two warehouses, one of which is off-site. You are an audit supervisor of Tipah & Co and the final audit is due to commence shortly. Draft financial statements show total assets of RM23.2m and profit before tax of RM6.4m. The following three matters have been brought to your attention:

Inventory valuation

Your firm attended the year-end inventory count for Highnix Electronics and confirmed that the controls and processes for recording work in progress (WIP) and finished goods were acceptable. WIP and finished goods are both material to the financial statements and the audit team was able to confirm both the quantity and stage of completion of WIP.

Before goods are dispatched, they are inspected by the company’s quality control department. Just prior to the inventory count, it was noted that a batch of product line ‘Crocus’, which had been produced to meet a customer’s specific technical requirements, did not meet that customer’s quality and technical standards. This inventory had a production cost of RM450,000. Upon discussions with the production supervisor, the finance director believes that the inventory can still be sold to alternative customers at a discounted price of RM90,000.

Research and development

Highnix Electronics includes expenditure incurred in developing new products within intangible assets once the recognition criteria under MFRS138 Intangible Assets have been met. Intangible assets are amortised on a straight line basis over four years once production commences. The amortisation policy is based on past experience of the likely useful lives of the products. The opening balance of intangible assets is RM1.9m.

In the current year, Highnix Electronics spent RM0.8m developing three new products which are all at different stages of development.

Sales tax liability

Highnix Electronics is required by the relevant tax authority in the country in which it operates to charge sales tax at 10% on all products which it sells. This sales tax is payable to the tax authority. When purchasing raw materials and incurring expenses in the manufacturing process, the company pays 10% sales tax on any items purchased. The company is required to report the taxes charged and incurred by completing a tax return on a quarterly basis, and the net amount owing to the tax authority must be remitted within two months. The draft financial statements contain a RM1.1m liability for sales tax for the quarter ended 31 December 2018 .

Required:

Describe any SIX substantive procedures each, the auditor should perform to obtain sufficient and appropriate audit evidence in relation to

Highnix ’s research and development expenditure.

Answer 1

R&D can arise from two main areas.
1. Potential for the creation or improvement of products, processes or knowledge. For example, the
product or service may be the first of its kind in the world.
2. R&D can also arise when substantial improvements are made to an existing, maturing technology
or product, for example mobile phone series 7, 8 and 9, one simple refinement to an existing
product to improve its saleability, or creating a new way of operating that brings significant
benefits (such as speed, cost, safety) to a business process.

Potential risks to the success of R&D activity
Risks will be dependent upon the sector in which the organisation operates. The list below provides
details of some generic risks.
However, it is vital that we as auditors hold discussions with key stakeholders to understand the
risks specific to the industry in which we operate and the tolerance levels that would be deemed
acceptable, for example:
1. Pharmaceutical companies and the development of life saving drugs.
◦ Will not tolerate side effects that could seriously debilitate or kill patients – almost zero
tolerance.

Potential risks and responses
1. There is no strategic objective including a clear vision or direction set within the
business to undertake the R&D activity..

Potential impact

• There is a loss of the organisation’s competitiveness reducing market share.
• The organisation is not able to reach out to new customers or markets.
• Lack of clarity on potential markets for any R&D output.
• Money is spent on the wrong thing.
• No new products or services are launched by the company or the products/services are of poor
quality.

R&D is a high-risk area for any business, if it is well controlled and managed the wins are
potentially huge eg increased revenue share, competitive advantage, increased profile and the
opportunity to be leading edge. However, if the controls are weak, the risks not identified, assessed
and managed the threats are equally huge eg loss of revenue, damage to reputation, financial loss,
and customer loss.
Because of the importance of R&D, internal auditors need to understand the risks to the
organisation if R&D initiatives are not undertaken; they also need to appreciate the risks inherent in
R&D activity and in a business being at the forefront of a technology/product development.

Potential response.

• Strategic objectives agreed by the board include the objectives for R&D activities.
• Responsibility for the R&D is assigned to a senior executive.
• A business plan/strategy has been prepared and agreed within the organisation.
• A governance committee is in place to provide oversight and monitor the R&D processes.
• Clearly defining the market and fully understanding its needs and wants through market
validation.
• Estimated production costs and potential selling price are included in business case
assumptions and updated when relevant data is obtained