Question

Question 2

You are an auditor on the BLUE Limited (BLUE) audit engagement for the financial year ending 30 September 2019. BLUE is a large hotel company with more than 1000 hotels in Australia and Asia under a range of hotel brands. You are in the process of undertaking audit planning procedures for the BLUE audit. You have noted a number of significant risks outlined below.

BLUE’s revenue is made up of management fees earned from hotels managed by BLUE under long-term contracts with hotel owners, and from the rental of rooms and food and beverage sales from hotels owned and leased by the company directly. In hotels owned and leased directly by BLUE, the company’s practice is to confirm hotel bookings by taking credit card details and collecting payment for accommodation and incidentals at the end of a customer’s stay. You have noted an increasing incidence of corporate clients prepaying for their employees’ accommodation. These have been recorded as revenue when payment has been received.

It has also come to your attention that there have been a growing number of disputes with hotel owners in relation to the amount of management fees being charged. Management fees included a base fee, a percentage of hotel revenue, and an incentive fee based on the hotel’s profitability. Individual contracts negotiated with hotel owners include provisions for percentage increases of the base fee either annually or biannually to take effect at specific dates. Based on your initial review of the correspondence, it appears that BLUE has been applying percentage increases to the base fee charged to hotel owners prior to their effective date as contained in the contracts with individual hotel owners.

BLUE runs a hotel loyalty program which enables members of the program to earn points for every dollar spent on accommodation, food and beverages at BLUE branded hotels. These points may be redeemed at a later date for free accommodation or other benefits. BLUE records a loyalty program future redemption liability on the basis of the number of points expected to be redeemed prior to their expiry multiplied by redemption cost per point. An announcement was made on 30 May 2017 that points earned under the loyalty program would now expire in two years rather than five years from the time they are earned. BLUE’s management subsequently reduced the amount provided in the loyalty program future redemption liability by $80 million based on their estimate of the revised amount required to meet the liability given the impact of the change.

BLUE has embarked on a large-scale software development project in the current year to internally develop improved guest reservation and hotel management systems. An amount of $37 million for the year has been capitalised as software development during the year. Your initial review has revealed that this amount includes repairs and maintenance of a range of BLUE’s hardware incurred during a year.

Required

(a) Considering the information provided, determine the four key account balances and related assertions at risk. Briefly justify your answer. (4 X 5 Marks = 20 Marks)

b) Recommend one audit procedure in relation to each of the assertions identified above (4 X 2.5 Marks = 10 Marks)

Answer 1

(a) Considering the information provided, determine the four key account balances and related assertions at risk. Briefly justify your answer.

(b) Recommend one audit procedure in relation to each of the assertions identified above.

Answer.

Below are the four Key account balances:

1.     Revenues: Management fees - under long-term contracts with hotel owners; charging includes:

o  Base fee - includes provision for percentage increases of the base fee which are applied prior to effectivity date as contained in the contracts.

o  Percentage of hotel revenue

o  Incentive fee based on hotel's profitability

Risk: Risk of material misstatement due to over-recording of revenues.

Explanation: Under the auditing standards, revenues are generally considered as significant risk. For this instance, BLUE records revenues based on increases which are not conforming with the contract. As such there may be a need to adjust the revenues of BLUE for the revenues to conform with agreement. (Auditing based on Revenue Standard: Revenue from Contracts with Customers)

Assertion: Accuracy

Audit Procedure: Conduct an examination of a sample of long-term contracts with hotel owners and document the requirements of the Revenue Standard. Also consider if correct amounts of revenues are recorded based on the agreed amount per contract.

2.     Revenues: Rental of rooms and food and beverage sales - prepayments of corporate clients are recorded immediately as revenue

Risk: Risk of material misstatement due to over-recording of revenues.

Explanation: BLUE for this matter immediately records revenue whereas it is still unearned on its part. It is unearned since BLUE was yet to render its performance obligation. Under the revenue standard revenues can only be recognized once it was able to render its performance obligation. Hence there may be a need to adjust revenue if as of year-end these recorded revenue are still considered unearned.

Assertion: Cut-off

Audit Procedure: Conduct an examination of a sample of invoices, official receipts and cash receipts related to the recorded revenues. Select samples days before and days after the balance sheet date and check if recording of revenues are conducted in the proper period. (The number of days will depend on the operating cycle of the business)

3.    Loyalty program:

o  Loyalty program future redemption liability - based on the number of points expected to be redeemed prior to the expiry times redemption cost per point

Risk: Risk of material understatement of redemption liability

Explanation: Estimates made by BLUE amounting to $80million must be checked since this is based on management estimate. There is a risk that management may understate its liability to make its balance sheet look better. Also the auditor must check if the reduction of expiration was valid under the laws which the company is domiciled.

Assertion: Valuation and Rights and Obligation

Audit Procedure: Perform a substantive analytics on the estimates made by management through recalculating the future redemption liability based on points provided by BLUE to its customers. Consider if management's estimate is reasonable under circumstances and check whether the reduction of expiration term is valid.

4.    Internally generated software development project

o  Amounts to $37million for the year has been capitalized as software development. Amount includes repairs and maintenance on BLUE's hardware incurred during the year

Risk: Risk of material misstatement of capitalized intangible asset

Explanation: Based on the information, BLUE capitalized repairs and maintenance which should have been expense at the time these expenses were incurred. Also the auditor must consider if the $37million capitalized under intangible asset software development qualifies the criteria of capitalization under the accounting standards.

Assertion: Existence, Accuracy/Valuation

Audit Procedure: Examine capitalized amount during the year and gather supporting documents to support the validity of the capitalized amount. Supporting documents may include status report on work(including the nature of work), payments made to contractors, invoices. The auditor may also confirm with patent lawyers if the asset is patented