Part 3 – Accounting issues
In the Advanced Audit and Assurance exam you will be required to discuss accounting issues in many contexts. It could be that during planning you are asked identify areas of audit risk or risk of material misstatement arising from accounting issues. You may be expected to discuss accounting issues and their treatment in a completion question, where the appropriateness of a treatment is considered, or areas of risk exist. Accounting issues could arise in reporting questions where there may be an impact on the auditor’s report and the type of opinion which will be given. This list is not exhaustive but illustrates how important it is to have a good understanding of the accounting and financial reporting issues covered in all of the financial reporting areas of the qualification. In addition you will be required to recommend audit procedures or explain the evidence you would expect to see in the audit file in order to conclude on the appropriateness of these treatments and amounts.
As such, bringing forward a sound knowledge of financial reporting is crucial when preparing for the Advanced Audit and Assurance exam. Some of those areas may be relatively straight forward, for example the valuation of inventory at the lower of cost and net realisable value while others can be more involved or complex such as financial instruments, revenue recognition or pensions.
The purpose of this article is to utilise past questions from the Advanced Audit and Assurance exam to illustrate how accounting issues could be examined and to recap the accounting treatment on some of the areas candidates typically find difficult in this exam.
It is rare to see an Advanced Audit and Assurance exam which does not cover impairment and the requirements of IAS 36 Impairment of Assets. This is a crucial standard which you need to understand as impairment considerations apply to so many assets within a set of financial statements.
A summary of the key financial reporting principles from IAS 36 is provided below:
IAS 36 paragraph 36.2 lists the assets which fall outside the scope of the standard including inventories, deferred tax assets, financial assets and non-current assets held for sale.
This is an example from a matters and evidence style question. These questions are typically set at the completion stage of an audit. Materiality, accounting treatment and risks are typical areas which would count as matters to be considered. In these questions the auditor’s report implication is only relevant if you are asked specifically to consider this area.
You are the manager responsible for the audit of Osier Co, a jewellery manufacturer and retailer. The final audit for the year ended 31 March 2017 is nearing completion and you are reviewing the audit working papers. The draft financial statements recognise total assets of $1,919 million (2016 – $1,889 million), revenue of $1,052 million (2016 – $997 million) and profit before tax of $107 million (2016 – $110 million).
In this question you can open with the materiality of the impairment. The impairment loss of $9m represents 0.47% of total assets and 8.41% of profit before tax and is material to the statement of profit or loss (1 mark for an appropriate calculation and conclusion).
Most of the credit will be available for determining and explaining the risks arising and applying the accounting treatment to the information you have available.
We’re told that
As auditors we need to look for risks in the process and treatment. Based on the information you can conclude that the carrying value is relatively low risk – we audited last year’s figures and it’s not an inherently risky area in general so in the absence of other information to the contrary you need to focus on the more risky areas.
The net realisable value carries some risk – external offers though are a good source of evidence and while not set in stone there have been several parties interested so it’s likely that the company would be able to sell the retail outlets for that price.
So what are the key risk areas and the matters which should be considered?
The matters part of this question as illustrated within the boxes above and answer points which focussed on these risk areas would attract maximum credit for that part of the question.
As this was a matters and evidence question remember that you also need to go on to explain evidence you would expect to find on the audit file. The requirement is for the evidence to be explained in these questions so listing sources of evidence is not sufficient. Your answer points must also explain what they are providing evidence of in order to attract high marks. If you write out evidence as a list of described procedures then this will be acceptable and well described, relevant procedures will generally receive a mark each.
Intangible assets are non-monetary assets without physical substance such as patents, trademarks, customer lists, quotas, brands, franchise agreements etc
A summary of the key financial reporting principles from IAS 38 Intangible Assets is provided below:
This is an extract from a planning question which asked candidates to evaluate risks of material misstatement arising from a scenario where the Group holds several purchased brand names for products.
|Acquired brand names are held at cost and not amortised on the grounds that the assets have an indefinite life. Annual impairment reviews are conducted on all brand names. In December 2016, the Chico brand name was determined to be impaired by $30 million due to allegations made in the press and by customers that some ingredients used in the Chico perfume range can cause skin irritations and more serious health problems. The Chico products have been withdrawn from sale.|
When answering a requirement to evaluate risks from a scenario relating to specific accounting issues you should start by calculating the materiality of the issue- in this question, total assets were $358 million and PBT $28million. The impairment of the Chico brand is 8.4% of total assets and more than 100% of PBT and is therefore material to both the statement of financial position and the profit and loss for the year.
How this should be written up in a risk question has been illustrated in the second article in this series.
Here, the company has decided to hold brands at cost as they deem them to have an indefinite life – this is an acceptable treatment under IAS 38 however the important part of the standard which we need to consider is that this should only be done if there is no foreseeable limit to the periods of benefit. There’s also a requirement that this assumption should be reviewed annually and additionally an impairment review performed. The scenario tells us that an impairment review has been performed but not that a review of the indefinite life has occurred hence there is a risk that this may not have been done
That decision to hold the brands with an indefinite life is a judgement call on behalf of management – judgements are subjective and therefore are a source of inherent risk. Quite often the justification for such a decision would be linked back to expenditure on the brand and marketing efforts along with market research. These costs cannot be capitalised but do provide evidence to support an indefinite life.
Similarly, impairment reviews for a brand would be looking at value in use based on the discounted value of future expected cash flows which is complex and judgemental.
In the exam you need to communicate these risk areas arising above- an example of a description for each that would be sufficient in an exam is shown below:
|Risk 1 – Management’s judgement that the brands have an indefinite life may be incorrect
Risk 2 – Management may not have reviewed the useful life of the brands in the reporting period to ensure that the assumption of indefinite life is still correct
Risk 3 – The impairment review may not be accurate as the assumptions used by management may not be appropriate as the calculation is complex and judgemental. (IAS 36)
The scenario goes on to describe the impairment of the Chico brand after allegations made about the products. The products have been withdrawn from sale. This brings in the impairment consideration in more detail. Here there has been a specific indicator of impairment for both the brand and inventory relating to Chico and therefore poses more risks.
|Risk 4 – The impairment of the Chico Brand may not be sufficient (we can’t tell if it has been fully written down IAS 36)
Risk 5 – The inventory relating to Chico products may need to be written off if its net realisable value is below cost (IAS 2 Inventories)
Risk 6 – Other brands and inventory may be affected by the negative publicity regarding Chico and may also need to be written down (IAS 36)
No credit is awarded for the name or number of auditing and financial reporting standards.
You should avoid describing audit approach or evidence/procedures unless you have been asked to do this in the requirement.
The above examples aim to demonstrate how candidates can effectively apply their accounting knowledge in the Advanced Audit and Assurance exam in order to maximise their marks in a variety of questions including those which cover planning and matters and evidence considerations. As with most areas of the Advanced Audit and Assurance exam, it is the application of that accounting knowledge to a scenario rather than the knowledge itself which will attract marks. This means that when preparing for this exam, a good grasp of the accounting knowledge underpinning the syllabus is important but practising questions and developing the skills of applying that knowledge is the key to passing.
Written by a member of the P7 examining team