Question

You are the audit supervisor of Seagull & Co and are currently planning the audit of your existing client, Eagle Heating Co., for the year ending December 31, 2020. Eagle manufactures and sells heating and plumbing equipment to a number of home improvement stores across the country.

Eagle has experienced increased competition and is facing significant pressure to meet sales targets. As a result, it has decreased the selling price of its products significantly since September 2020. The finance director has informed your audit manager that he expects increased inventory levels at the year end. He also notified your manager that one of Eagle's key customers has been experiencing financial difficulties. Therefore, Eagle has agreed that the customer can take a six-month payment break, after which payments will continue as normal. The finance director does not believe that any allowance is required against this receivable.

In October 2020, the financial controller of Eagle was dismissed. He had been employed by the company for over 20 years, and he has threatened to sue the company for unfair dismissal. The role of financial controller has not yet been filled and so his tasks have been shared between the existing finance department team. In addition, the accounts payable supervisor left in August and a replacement has been appointed in the last week. However, for this period no supplier statement reconciliations or accounts payable reconciliations were performed.

You have undertaken a preliminary analytical review of the draft year-to-date statement of profit or loss, and you are surprised to see a significant fall in administration expenses.

Required

Discuss the factors that will impact the risk of material misstatement at the financial statement and account levels in planning the audit of Eagle.

Answer 1

Answer:-

Factors that INCREASE the risk of material misstatement at the financial statement level:

• There is increased competition in the industry which puts pressure on management to meet sales targets. This increases the risk of material misstatement as there is a greater risk of overstatement of revenues to meet sales targets.
• In October, 2020, the controller was dismissed and his tasks are being shared between existing staff. This increases the risk of material misstatement as errors may have been made within the accounting records by the overworked finance team members and there is no one working in a supervisory capacity.

Factors that impact the risk of material misstatement at the account and assertion level:

• There is an expectation that due to slower sales, selling prices may be written down and more inventory may be on hand at year end. This increases the risk of material misstatement of inventory as it may be overvalued. There is a risk of theft, and the risk that inventory will become obsolete as inventory levels increase. There may also be a need to write the inventory down to net realizable value as welling process are written down.
• A key customer of Eagle has been experiencing financial difficulties and Eagle has agreed a six-month payment break; however, the finance director does not believe an allowance is required. If the customer is experiencing difficulties, there is an increased risk that the accounts receivable is not recoverable. Therefore, there is an increased risk of material misstatement of overstatement of accounts receivable.
• The financial controller of Eagle was dismissed in October and is threatening to sue the company for being unfairly dismissed. This increases the risk of misstatement of understatement of liabilities as a contingent liability may need to be set up.
• The purchase ledger supervisor left in August and no reconciliations of supplier statements and the purchase ledger control account have been performed. There is an increased risk of errors within accounts payables and an increased risk of material misstatement as year-end payables may be under or overstated.
• Preliminary analytical review of the draft income statement has identified a significant fall in administration expenses. Administration expenses do not tend to fluctuate significantly with changes in sales volumes. Therefore, there is an increased risk of material misstatement that administration expenses are understated.