Question

You are an audit supervisor of Pluto & Co and are currently planning the audit of your client, Venus Magnets Co (Venus) which manufactures decorative magnets. Its year end is 31 December 20155 and the forecast profit before tax is $9·6 million.

During the year, the directors reviewed the useful lives and depreciation rates of all classes of plant and machinery. This resulted in an overall increase in the asset lives and a reduction in the depreciation charge for the year.

Inventory is held in five warehouses and on 28 and 29 December a full inventory count will be held with adjustments for movements to the year end. This is due to a lack of available staff on 31 December. In October, there was a fire in one of the warehouses; inventory of $0·9 million was damaged and this has been written down to its scrap value of $0·2 million. An insurance claim has been submitted for the difference of $0·7 million. Venus is still waiting to hear from the insurance company with regards to this claim, but has included the insurance proceeds within the statement of profit or loss and the statement of financial position.

The finance director has informed the audit manager that the October and November bank reconciliations each contained unreconciled differences; however, he considers the overall differences involved to be immaterial.

     A directors’ bonus scheme was introduced during the year which is based on achieving a target profit before tax. In order to finalize the bonus figures, the finance director of Venus would like the audit to commence earlier so that the final results are available earlier this year.

Required:

Based on the above describe FIVE audit risks, and explain the auditor’s response to each risk, in planning the audit of Venus Magnets Co

Answer 1

Auditor’s Risk	Auditor’s response
The directors have reviewed the useful lives and depreciation rates of all classes of plant & machinery which has resulted in a reduction of depreciation charge for the year. As per IAS 16, Property, Plant and Equipment, lives of the assets should be reviewed annually, and if the asset lives increase due to the review which causes the depreciation to decrease, then this change could be reasonable. But, there is a risk that the depreciation has been reduced, in order to achieve the profit targets. If the profit targets are achieved, bonus will be provided as per the new scheme. So depreciation could have been reduced to achieve the profit targets in order to receive bonus. In such a case, then profit has been overstated and plant & machinery has been overvalued.	A discussion should be done with the directors to understand their reasoning for increasing assets lives and hence leading to a reduction in depreciation charge. Samples should be taken of those assets whose lives have been revised to review the useful life taken and compare it with how often are the assets replaced as that would give a logical basis for determining useful life. Comparison would help to understand whether the revised useful life has been taken correctly.
The company is planning to undertake a full year end inventory count before the year end (before 31st December) due to staff unavailability on the year end. The company will then make adjustments to the inventory to account for those transactions that take place between stock take date and year end to arrive at the inventory for year end. The risk involved here would be that all required adjustments should be considered, as well as it should be recorded accurately or else year end inventory could be over stated or under stated.	A greater amount of checking and review should be done of the inventory cut off testing at the year end. All the year end adjustments made should be reviewed properly and in detail and supporting documents should be acquired for all the adjusting items by the audit team.
There was a fire in one of the warehouses in October, which caused the inventory to be written off to its scrap value which is from $0.9m to $0.2m. The profit and loss account should be charged with the write down. There is a risk that the scrap value is overstated and inventory overvalued, if goods remain unsold at the year end.	The basis of the $0.2m taken should be discussed with the management. The scrap value should be reviewed to verify its reasonableness as well it should be further discussed with management for a possibility of further write down.
The profit and loss account includes an insurance claim of $0.7m, despite that the Company has not received any reply for the insurance company. Such an insurance claim can be considered as a contingent asset. As per IAS 37, Provisions, Contingent Liabilities and Contingent Assets, any contingent asset should not be recognized until its receipt is virtually certain. Since the company has not received any reply with regards to the claim, it is not virtually certain and hence including the insurance claim in profit and loss overstates profit and receivables.	Follow up should be taken from the management if there has been any response received from the insurance company. If the receipt if virtually certain, then the current treatment adopted is proper and correct. If not, the management should not consider the insurance claim in the profit and loss and neither disclose it as a receivable. The management should include a note mentioning the disclosure of the contingent asset.
There is an existence of unreconciled amounts for the month of October and November. The finance director believes the overall unreconciled differences to be immaterial. Errors in bank reconciliations may come to a small amount but could actually represent large errors which are actually net off to a small amount. Unreconciled items could exist because of fraud. If the differences are not fully reconciled, it could result in bank balances being under or overstated.	Discuss this issue with the relevant person in charge and request that for the month of December, bank reconciliation needs to be properly done. The reconciling items and its supporting documentation should be tested, verified, reviewed in detail. The audit team are required to maintain an attitude of professional skepticism at all times.
A directors’ bonus scheme was introduced which is based on achieving a target profit before tax. Such a bonus could pressurize the directors to manipulate the results through the assumptions taken or through the use of provisions to achieve the target profit to be eligible to recieve the bonus...	The audit team will be required to be alert and will be further required maintain an attitude professional skepticism. The audit team will need to do a detailed review and testing to greater extent on assumptions taken, judgmental decisions, including provisions basis and reasoning. This should be further compared with amounts taken in prior years to obtain reasoning if any additional provisions have been considered in the current year which was has not been considered in previous years. Further, a written representation should be obtained from management confirming the basis of any significant judgments.
The finance director has requested that the audit to commence earlier so that final results are available earlier. Such a reduction will put a greater degree of additional pressure on the audit team in obtaining sufficient and appropriate evidence as well it could increase detection risk. This will further also provide less time to finance team to prepare the financial information leading to an increased risk of errors.	The time table should be discussed and confirmed with the finance director, and if it is to be reduced, the auditor should perform an interim audit which will help ease out the pressure of the final audit. The audit team will be required to maintain an attitude of professional skepticism at all times. In addition to this, the audit team will require a greater degree of alertness to the increased risk of errors occurring.