A very common theme in Paper P7 questions is to present you with information that embodies an accounting issue. Sometimes the information is presented as a standalone requirement but is often, for example, included in a set of notes of a conversation with an audit client’s finance director.
December 2012 Question 1 contains:
Work has recently started on a new production line which will ensure that Grohl Co meets new regulatory requirements prohibiting the use of certain chemicals, which come into force in March 2013. In July 2012, a loan of $30m with an interest rate of 4% was negotiated with Grohl Co’s bank, the main purpose of the loan being to fund the capital expenditure necessary for the new production line.
June 2012 Question 1 contains:
Starling Co received a grant of $35m on 1 March 2012 in relation to redevelopment of its main manufacturing site. The government is providing grants to companies for capital expenditure on environmentally friendly assets. Starling Co has spent $25m of the amount received on solar panels which generate electricity, and intends to spend the remaining $10m on upgrading its production and packaging lines.
December 2011 Question 1 contains:
On 1 July 2011, Oak Co entered into a lease which has been accounted for as a finance lease and capitalised at $5m. The leased property is used as the head office for Oak Co’s new website development and sales division. The lease term is for five years and the fair value of the property at the inception of the lease was $20m.
Typically the question requirements will then be something along the lines of:
- Evaluate the business risks faced by X Co.
- Identify and explain the risks of material misstatement to be considered in planning the audit of X Co.
- In respect of the risks of material misstatement, suggest suitable audit procedures.
Remember that when you are describing business risks, you should say nothing about potential misstatements in the financial statements. Business risks exist quite independently of the financial statements and they do not depend on audit procedures. Business risk is where the directors make wrong decisions or where events have occurred which threaten the business’s future. Business risks are often classified as:
- Strategic risks (for example, investing in out-of date technology).
- Operational risks (for example, manufacturing products which have faults).
- Regulatory risks (for example, the fines and damages that might be payable as a consequence of breaching health and safety regulations).
- Financial risks (for example, an inability to pay interest or rent because of poor cash flow).
Although drafting financial statements does not affect the business risks, understanding the business risks can give insights into where the financial statements might contain material misstatements. For example, investing in out-of date technology could cause going concern problems and queries about the impairment of the out-of date, though possibly relatively new, machinery. Regulatory risks can give rise to problems over assessing and presenting liabilities or contingent liabilities.
Risks of material misstatement
The risk of material misstatement refers to the risk that a material misstatement is present in the financial statements that are being audited. It is the purpose of the audit to ensure that these misstatements do not appear in the published financial statements – or if they do that there is an appropriately modified audit opinion.
Material misstatements at the assertion level arise if a relevant assertion is wrong. For example, the amount could be incomplete, a valuation could be wrong, a transaction might not have occurred.
Assertions also cover presentation and disclosure. For example, the classification and understandability assertion requires that ‘financial information is appropriately presented and described, and disclosures are clearly expressed’ (ISA 315).
Broadly, therefore, misstatements can be divided into two groups:
- The treatment of the transaction, event or balance, including its presentation and disclosure could be incorrect.
- The amount of the transaction, event or balance could be incorrect.
The auditor must devise suitable procedures to collect sufficient appropriate audit evidence about the assertions lying behind both of these aspects of items in the financial statements.
Remember, the treatment must be right, the amounts must be right and sufficient appropriate audit evidence is needed for both.
So when you are presented with a question in the exam about financial statement risk and audit procedures, don’t sit scratching your head: TAP it instead and remember:
Treatment and amount
IAS 8, Accounting Policies, Changes in Accounting Estimates and Errors, requires that financial statements comply with any specific IAS or IFRS applying to a transaction, event or condition, and provides guidance on developing accounting policies for other items that result in relevant and reliable information. In the absence of a Standard or an Interpretation that specifically applies to a transaction, other event or condition, IAS 8.10 states that management must use its judgment in developing and applying an accounting policy that results in information that is:
- relevant to the economic decision-making needs of users and
- reliable so that the financial statements:
- represent faithfully the financial position, financial performance and cash flows of the entity
- reflect the economic substance of transactions, other events and conditions, and not merely the legal form
- are neutral, ie free from bias
- are prudent and
- are complete in all material respects
In applying its judgment, IAS 8 requires management to consider the definitions, recognition criteria, and measurement concepts for assets, liabilities, income, and expenses in the IFRS conceptual framework.
So, looking again at the three question examples given at the start of this article:
The December 2012 Question 1 raises the matter of the treatment of interest payments. To quote the ACCA answer:
‘The new production process would appear to be a significant piece of capital expenditure, and it is crucial that directly attributable costs are appropriately capitalised according to IAS 16, Property, Plant and Equipment and IAS 23, Borrowing Costs. Directly attributable finance costs must be capitalised during the period of construction of the processing line, and if they have not been capitalised, non-current assets will be understated and profit understated.’
The June 2012 Question 1 raises the matter of the treatment of government grants. To quote the ACCA answer:
‘Starling Co has received a grant of $35m in respect of environmentally friendly capital expenditure, of which $25m has already been spent. There is a risk in the recognition of the grant received. According to IAS 20, Accounting for Government Grants and Disclosure of Government Assistance government grants shall be recognised as income over the periods necessary to match them with the related costs which they are intended to compensate. This means that the $35m should not be recognised as income on receipt, but the income deferred and released to profit over the estimated useful life of the assets to which it relates. There is a risk that an inappropriate amount has been credited to profit this year.’
The December 2011 Question 1 raises the matter of treatment of a lease. To quote from the ACCA answer:
‘The lease taken out in July 2011 has been treated as a finance lease. However, there are indications that it is in fact an operating lease. First, the lease is for only five years, which for a property lease is not likely to be for the major part of the economic life of the asset.
According to IAS 17, Leases, an indicator of a finance lease is that the lease term is for the major part of the economic life of an asset.
Second, the amount capitalised of $5m represents only 25% of the fair value of the asset. Under IAS 17, for a lease to be classified as a finance lease, the present value of minimum lease payments (the amount capitalised) should amount to at least substantially all of the fair value of the asset. 25% is not substantially all of the fair value, indicating that this is actually an operating lease.’
Having determined the correct treatment for a transaction, event or balance, its amount can then be tackled. Sometimes the accounting standard can be very prescriptive. For example, the correct treatment of inventory is to value it at the lower of cost and NRV and cost can be based on average costs or FIFO but not LIFO. Another example is found in the calculation of impairment where the carrying amount (the amount at which an asset is recognised in the balance sheet after deducting accumulated depreciation) cannot be more than its a recoverable amount, ie the higher of fair value less costs of disposal and value in use). Calculations will be needed to determine both of these amounts.
If material misstatements can be caused by either wrong treatment or wrong amounts, then audit evidence is needed to verify that both of these are acceptable.
Taking the capitalisation of a lease in the December 2011 example, evidence is needed as to whether or not it should be treated as a finance or operating lease and, depending on its treatment, evidence is then needed about either the amount capitalised or the amount appearing as an expense. Sometimes, as here, the evidence will be provided in the question, but sometimes you can be asked to suggest what procedures are needed to find the evidence.
ISA 500, Audit Evidence, categorises the procedures available to auditors as:
- External confirmation
- Analytical procedures
These are high level categories of procedures and specific, precise procedures have to be described which will both verify the correct treatment and the correct amount. Where a relevant International Standards in Auditing exists any procedures stipulated must be followed. For example:
- ISA 501 describes procedures for auditing inventory, litigation claims and segment reporting information.
- ISA 505 sets out procedures for obtaining external confirmations.
- ISA 530 sets out procedures and other matters relevant to audit sampling.
- ISA 560 sets out procedures relating to post balance sheet events.
- ISA 570 sets out procedures relating to the validity of the going concern assumption.
However, by no means all procedures covered by ISAs and candidates must be able to suggest procedures that will help in the collection of appropriate audit evidence for both the treatment of items in accordance with the accounting standards and for their amounts.
So, procedures relevant to collecting evidence about the receipt of a government grant (Q1 from June 2012):
- Inspect the grant application and subsequent correspondence with the government department to verify the amount and purpose of the grant (ie to ensure it is a grant relating to non-current assets).
- Trace the credit entry in respect of the grant either to a deferred income account or to the credit of the appropriate non-current asset register entries and the appropriate non-current asset control account.
- If credited to a deferred income account, inspect entries showing that it is being released to income over the expected life of the asset.
- Inspect the grant application and subsequent correspondence with the government department to verify the amount and purpose of the grant.
- Inspect the board minutes for mention of the grant.
- Trace receipt of the grant to the bank account.
- If the amount is being released form a deferred income account, reperform the calculation relating to the amount released to income in the current financial period.
- If the amount is credited to the cost of the asset reperform the depreciation calculation to ensure that depreciation is based on the net cost of the asset after the grant is credited.
- Financial statements will not provide a true and fair view if they include material misstatements.
- Misstatements can be caused by either incorrect accounting Treatment or incorrect Amounts.
- An audit requires Procedures to collect evidence about both treatment and amounts.
Ken Garrett is a freelance author and lecturer