Type # 2 - June 2015-Q1

Audit risk (with results of analytical procedures

already given)
Briefing note
To:
From:
Re:
Introduction:
…………………………………………………………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………………………………………………………
…………………………………………………………………………………………………………………………………………………………………
………………
Matters - Audit strategy (initial engagement)
In planning the initial audit engagement for Ted Co , the audit firm should correspond with Crilly & Co, the
previous auditor to obtain understanding of key aspects of the business and any potential areas of risk in financial
statements.
Further, the firm should carefully evaluate the results of analytical procedures to understand the trends in the
financial information and to identify unusual trends as risky areas in the financial statements
The firm should also carefully consider the accounting policies of Ted Co and ensure that these policies do not
possess any risk of material misstatements. Specific consideration should be giving in initial engagement to
opening balances and it must be confirmed that the opening balances are properly carried forward.
Audit risk
New audit client
Ted Company (Ted) is a new audit client for Craggy Co therefore the audit firm will have less knowledge of
business thereby increasing the detection risk in the first year audit.
Further, there could be a risk of material misstatements in opening balances if such balances are wrongly brought
forward by Ted management.
Listed company
Being a listed company, there is a risk of management bias in manipulating results for showing better
performance. Thus Ted management could overstate assets/ profit and understate liabilities/ expenses. Revenue
has increased by 46% and profit by 48 % indicates such risk might exist.
Further being a newly listed company there could be further risk of material misstatement in all applicable
financial reporting standards which would be applied for the first time by Ted Co management.
Intangible assets
There is a substantial increase of 66 % in development cost recognized this year. There is a risk that the
development cost has not met the criteria for capitalization as stated in IAS-38. This could have resulted in

Page 1 of 11
overstatement of profit which has already increased by 48 % over the last year and understatement of operating
expenses. Further there could be a risk that even the research cost is capitalized as well.

Online sales
25% of the sales are made online through website. There are several risks associated with sales made online.
There is a high detection risk with on line sales due to non-availability of records due to paperless environment
and it would be difficult to find the audit trail.
Moreover, there is a risk related with revenue recognition, if online sales are recorded early from the point they
should be recorded i.e. the online sales are recognized when order is placed on website will result in
overstatement of revenue and profit.
License
The license income represents 13.4% of the total assets and is therefore material. As Ted has given an exclusive
license means that risk and rewards are fully transferred and Ted has no managerial involvement then revenue
from the sale of a license should not be deferred at all. Thus currently deferred income is overstated, revenue
and profit is understated.
Internal audit
The company does not have an internal audit function; this will make monitoring of overall internal control
system weak in the company there by increasing the risk of material misstatements in the financial statements.
---------------------------------------- (17 marks answers end here in a top down approach) ---------------------------------
NEDs
One non-executive director is insufficient number. Less number of NEDs will make overall monitoring of system
weaker in the company thereby increasing the risk of material misstatements in the financial statements.
Short term investment
Speculative investments in equity shares should be measured at fair value through profit or loss. Currently the
short term investment is held at cost of $ 8 million. Thus STI and profit is overstated by $ 2 million. The short
term investment is _____% of the total assets, thus material to the statement of financial position.
EPS
EPS to be calculated based on the profit or loss for the year (post-tax) attributable to ordinary shareholders as
presented in the statement of profit or loss. The EPS is wrongly calculated based upon adjusted profit before tax
number. Thus EPS currently is distorted and misstated.
Analytical review – result
Significant growth in revenue i.e.46% and profitability (both gross profit i.e. 62.5% and net profit i.e. 48%)
increases the risk that the growth could contain potential risk of material misstatements. This could be in line
with the risk of management bias due to listed company. Revenue could be overstated to show better profitability
to shareholders.
Moreover, there could be understatement in cost of sales and operating expenses to show better gross profit and
net profit.
Note: Total marks till this point are 28. You need to score 17 marks in exam paper i.e. 9 audit risk will give you
that multiple by 2.

Page 2 of 11
Procedures
Portfolio of short term investment (4 procedures needed)
1. Review board minutes for the approval of $ 8 million investment in equity shares of listed company
2. Review the bank statement to confirm the payment of $ 8 million
3. Discuss with management that the short term investment is to be carried at fair value at year end
4. Review the draft financial statements to confirm the adjustment has been made.
5. Review the stock exchange quotations at the year end to confirm the fair value of short term investment
at the year end
6. Recalculate the fair value (No.of share held * market value of share at year end)
7. Review the management working for the fair value of shares held in listed companies.
Earnings per share (4 procedures needed)
1. Discuss with management that the EPS is based upon profit attributable to shareholders rather adjusted
profit
2. Confirm the number of shares as at 31st May from the share prospectus, board minutes etc.
3. Recalculate the EPS based upon the profit after tax
4. Review the draft financial statement to confirm that the EPS has been adjusted.
Conclusion
There are several risk of material misstatement as identified through this briefing note within the financial
statements of Ted Company, therefore the audit should be carefully planned in each of these risky areas in order
to reduce the detection risk to an acceptable level .

Student guidance notes:

1. Procedures starts with action verb, carefully see how procedures are written above, each procedure carry
1 mark if properly written with reasons. See the list of 7 procedures above for guidance and see how I
started them, they all started with a definite verb, review, discuss re-calculate.
2. Conclusion is to be written at the end of the briefing note for the requirement which need to be evaluated,
in this case the audit risk is to be evaluated so the conclusion has been given for audit risk.
3. Further see, the format, logical flow of the briefing note as well.

Page 3 of 11
TYPE 3 – DECEMBER 2015 –Q1 AUDIT RISK (WITH
VERY LIMITED NUMBER/ EXTRACTS OF
FINANCIAL STATEMENTS)
Briefing note
To:
From:
Re:
Introduction:
………………………………………………………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………………………………………………………
………………………………………………………………………………………………………………………………………………………………………
Audit risk
Recent listing – management bias
The recent listing and a planned listing ahead creates a risk of management bias in manipulating results for
showing better performance. Thus Dali Co management could overstate assets/ profit and understate liabilities/
expenses. Revenue has increased by near 2% and profit by near 6% indicates such risk might exist.
Recent listing- further applicable standards
The recent listing means that the company now needs to comply with additional financial reporting standards
for example IAS-33 and IFRS-8. There is a risk of incomplete or inadequate disclosures in respect of these
standards and thus the FS could be materially misstated.
Purchases from foreign supplier
Dali Company purchases components from foreign supplier. Such transactions should initially be recorded using
spot rate and further the payables should be re-translated at the yearend using closing rate. If inappropriate
exchange rates are used it could result in under or overstatement of profit, exchange gain or losses and liability.
Payment in advance
The revenue needs to be recognized at a point when control is passed to customer. Thus the 30% payment in
advance should be treated as deferred revenue at the point when payment is received. The revenue could be
recognized too early resulting in overstatement of revenue and profit.
New Non-executive directors
The new non-executive directors will take time to understand the entity, its system &process and in this span the
overall monitoring of controls could be weaker, increasing risk of misstatements in financial statements.
New finance director
The new finance director is basically responsible for the oversight of the financial statements. However the
decisions taken by the new finance director on some of the accounting practices in the case demonstrates that he
is not very competent on the financial reporting practices which increases the risk of material misstatements in
the financial statements where ever such accounting treatments are wrongly applied.
Page 4 of 11
Cash settled share based payment plan
A liability in respect of the cash settled share based payment plan should be measured at fair value at the year
end with the expense recognized in the statement of profit or loss. Thus no liability and expense has been
recognized in respect of cash settled share based payment plan, therefore overstating profit, understating
expense and liability.

Deferred tax recognition

The revaluation surplus of $3.5 million is 3.9% of the total assets and is material to the statement of financial
position. The revaluation of the manufacturing sites would give rise to a taxable temporary difference between
tax base of an asset and its carrying value and thus a deferred tax liability should be recognized irrespective
whether the asset is to be disposed or not . Thus at present deferred tax liability is not recognized, which
understate the liabilities.

Government grant
The government grant of $ 10 million is 11.1% of the total assets and is thus material to the statement of financial
position The grant is recognized as income over the period necessary to match the grant received with the related
cost which the grant intend to compensate. Thus $2 million grant should be immediately recognized as income
in relation to an expense already incurred. However the remaining $8 million grant will need to be treated as
deferred income over the next 5 years till 2020. The risk is that entire grant is recognized as income, thus
overstating profit and understanding deferred income.
---------------------------------------------- (18 marks end here – top down approach) ----------------------------

WIP

The WIP of $ 12 million is 13.3% of the total assets and is thus material to the statement of financial position.
WIP is a subjective area as it requires assessment of stage of completion. Any are which involve assessment or
subjectivity is inherent by nature and thus WIP could be overvalued if stage of completion is not rightly
determined. Thus inventory could be overstated.

Warranty provision
Dali Co replaces faulty products free of charge indicates that a provision should be recognized on the best
estimate of future economic outflow. If it is not recognized it will understate operating expense and liability and
overstate profit

Additional information (Maximum 5 needed – 5 marks)

1. Floatation agreement confirming the number of shares issued as part of listing process
2. WIP inventory valuation report to confirm that the stage of completion of each order for properly
assessed and valued.
3. Grant agreement to confirm the conditions associated with grant
4. Expert report confirming the assumption used to revalue the company’s manufacturing sites
5. Personnel files of the new directors to confirm their qualifications, background and experience.
6. Cash flow forecast to assess the foreseeable future in terms of its liquidity
7. Board minutes confirming the number of members included within the scheme and its details. / Further
the basis and rationale behind another planned listed in 2016.

Page 5 of 11
Procedures:

Government grant (Maximum 4 needed for 4 marks)

1. Review the grant agreement confirming the amount of grant received (i.e. $ 10 million) and the conditions
associated with the grant.
2. Review the payroll register to confirm the amount of salaries and wages incurred in deprived areas for
the year ended 31/12/15.
3. Discuss with Dali Co management how they have recognized the amount of the government grant (i.e. $
2 million and $ 8 million) to confirm that the management has followed the right accounting treatment.
4. Discuss with management their future plans / intentions to continue their manufacturing operations in
the deprived areas by 2020
5. Request a written representation from the management confirming their intentions to continue their
operations in deprived areas by 2020.
WIP (Maximum 4 needed for 4 marks)

1. Observe the inventory count process at the yearend to confirm completeness of the count undertaken
and adherence to management instructions
2. Analyze the increase in WIP inventory (i.e. 26%) from over the last year and discuss with management
the reason of such a significant increase in WIP inventory at the year end.
3. Review the WIP inventory valuation schedule to identify orders which are older than 3 months for
machine and 1.5 months for smaller equipment and discuss reasons of such old orders still appearing in
WIP schedule with management
4. Discuss with management the process of assigning the stage of completion to each order for material,
labor and overheads.
5. Request a representation letter for confirming the completeness of the WIP inventory and the assessment
of the stage of completion of each order.
6. For a sample of order in WIP confirm the cost allocated to each order by reviewing relevant purchase
invoices, payroll record and overhead absorption schedule.

Conclusion

Thus Dali Company financial statements contain numerous risks of material misstatements. The audit should be
carefully performed with focus on material misstatements identified in order to keep the detection risk at an
acceptable level.

Page 6 of 11
Further Learning - Other issues – student can think of

 Receivable possess the risk of overstatement – due to increase in receivable days [ from 70 to 90]
 Overall weaker working capital position / liquidity issues – Need to disclose material uncertainty relating
to going concern in notes to financial statements

Knowledge: IFRS-15 (Summary relevant for P7)

Under IFRS-15 Revenue from contract with customers, revenue should only recognize as control is passed either
over time or a point in time. Factors indicating a control is passed include transference of physical asset,
transference of legal title or customer accepting significant risk or rewards associated with ownership of asset.

Revaluation of properties (In the exam for revaluation you can think of the following points)
- The revaluation has been carried out by an external expert. However there are several risks associated
with revaluation such as:
o Though done by an expert determining the market value or fair value of property is subjective
exercise leading to a risk that properties are inappropriately revalued.
o As per IAS-16 all assets in the same class should be revalued, thus it needs to be assured that all
manufacturing sites are revalued. If not it will result is inappropriate revaluation.
o The depreciation expense has not been charged on higher amounts, thus understating operating
expense and overstating non-current asset and profit.
o The revaluation requires disclosure in notes as well, inappropriate or no disclosures itself if a risk
of material misstatements

Page 7 of 11
TYPE 4 December 2014 BUSINESS RISK ANSWER
/ WITH ROMM
Briefing Note:
To:
From:
Re:
Introduction
The purpose of writing this briefing note is to identify the business risk and risk of material misstatement facing
the Connolly Company. Further, this note also includes procedures on cold comfort brand as well as ethical issues
in planning the audit of Connolly Company.
Business risk: (11 marks / each BR is worth 2 marks to maximum of 6)
1. Connolly is a listed company
Generally listed companies needs to comply with greater sets of laws and regulations. Moreover the company
operates in a pharmaceutical industry which itself is highly regulated. Thus there is a high exposure of laws and
regulations. Any non-compliance would affect Connolly reputation, losing competitive advantage, facing
penalties or even in a worst case scenario suspension of license
2. Heavily advertised
Heavy advertisement of brand name is a regular practice of the company which will keep pressure on company’s
profit margin which has already fallen from 24% in 2013 to 20% in 2014. The sales in relevance to this high
advertisement have increased by 5% on a year on year basis. The company need to ensure they are getting the
desired benefit of advertisement into sales realization or growth otherwise it is a waste of resources and a
pressure on operating profit margin
3. Advertisement is prohibited
There is a potential risk that if Connolly advertisement is run in countries where such advertisement is not
allowed would put the company under a non-compliance risk and that would tarnish company’s reputations and
would result into penalties and damages on the company which cold effect company’s profitability
4. Competitive market
Being a competitive market, the survival depends on rapid innovation. Rapid innovation is a huge cash drain for
Connolly as already depicted in the financial results that the net cash flow for this year is negative. Rapid
innovation need financial resources and the business should have enough liquidity to manage it. This also keep
a constant pressure on company gearing as there is a constant need of loan finance and the company is already
in process or negotiating an extension of $10m loan finance.
5. Stringent regulatory requirements
This creates a risk of non-compliance with the stringent regulatory requirements which could ultimately result
into not getting the desired license for production and sale. This would a serious operational blow to the Connolly
Company as all the efforts and resources put down into research and development stage of drugs would go
wasted and the company would not derive any commercial benefit from such drugs. Currently four drugs are
under research and development stage.

Page 8 of 11
 6. Patents
The patents are rigoursly defended for potential infringement creating an overall increase in legal cost for the
business which can keep pressure on company’s operating expenses and operating profit margin. Moreover if
Connolly Company infringe competitor patent would result to reputational loss to Connolly due to a legal battle
and media spotlight
7. Extension of loan
The extension of loan would increase company gearing risk as well as increase overall finance cost for the
business though the finance is needed for the ongoing research and development of products.
8. Court case
The ongoing court case and its outcome if against the company would affect Connolly competitive positioning in
the already competitive market. The company would face a damage to its brand image and could possibly effect
company short term sales targets as well
9. New market
A new market is a diversification strategy on part of business which tough is good at one end but on the other
diversification of business means losing of management focus from other business segments. Initially the
management tries to put resources and effort on new segment that of animal health which might result in losing
focus on the existing business segment/s which could increase some operational problems for business in near
short run. Moreover diversification of business increases business operational expenses thus putting pressure
on operating profit margins.
10. Out of date accounting and MIS
The management would not be getting up to date information for decision making as MIS is out of date. Thus
company strategic decision making could be inappropriate if adequate and timely information is not produced
by out of date MIS system
11. Company financial performance
Overall the business performance demonstrated by Connolly Company in terms of growth in revenue is good.
However the business seems to follow a downward trend in its profitability with fall in operating profit margin
from 24% to 20%, negative cash flow and a decrease in EPS from 29c to 25c. The ongoing case, further research
and development and an extension of loan could well keep pressure on profitability and cash flow in near short
term.

Page 9 of 11
Risk of material misstatements (8 marks / 2 marks per RMM to maximum of 4)
1. Listed company
Being a listed company there is an embedded risk within the financial statements of Connolly that management
could manipulate them to show better position. Thus FS could be material misstated particularly the income
statement which could show higher sales and profit then actual.
2. Research and development cost
Under IAS-38, the research cost is to be expensed out whereas the development cost is to be capitalized subject
to strict capitalization criteria given therein. If the company fails to secure the loan which is been negotiated or
the court case goes against the company there is a risk that development cost should not be capitalized. Already
the intangible assets have increased from last year justifying that the development cost was capitalized. Thus the
intangible assets are overstated and expense is understated.
3. Patents
Under IAS-38 Patent is to be recognized as intangible assets at cost. Once recognized, patents should be
amortized over the period of their duration, and non-amortization will overstate intangible assets/ profit and
understate operating expenses.
4. Extension of loan
It also increase risk of management bias is massaging the figures in financial statements to present a favorable
position to bank for loan extension and ensuing that the loan extension is successful. The loan extension is
material to financial statement i.e. $10m/ $200 m which is 5% of total assets.
5. Court case
The ongoing court case need to be either disclosed as either a contingent liability or a provision should be
recognized. The request by the company to the bank to make $3 million available in event of case against the
company is successful indicates a probable outflow (IAS-37) and hence a provision should be recognized. If
provision is not recognized it will overstate profit as well as understate liability and operating expenses. $3
million is _____% of total assets , thus material to the financial statements.
6. Animal health market
The animal health segment has given a 15% contribution into the total revenue thus making it a major operating
segment for business. Under IFRS-8, the company should give a disclosure of results on segmental basis. Lack of
disclosure of disaggregated basis between segments would result into material misstatement
7. Cold comfort brand
Under IAS-38, the purchased brand has been capitalized at cost of $5 million as intangible assets and is been
amortized over its useful life of 15 years which is a fine accounting treatment. However we need to ensure the
estimation of 15 year useful life to agree to an appropriate amortization otherwise if inappropriately amortized,
it would understate expense, overstate profit and intangible asset as well. $5 million in contrast to total assets is
2.5%, thus material to financial statement
8. Out of date accounting system
Being an old accounting system it could affect the way the financial statements are produced and being old might
not be functioning effectively in producing financial statements or the financial reporting standards are not up
to date. This increase the risk of material misstatement in overall financial statement of Connolly.

Page 10 of 11
Procedures (5 marks / 1 mark per procedure to maximum of 5)
1. Review the board minutes to the confirm the approval or authorization of the purchase of brand from the
rival company
2. Review the purchase agreement to confirm the cost at which the brand was acquired initially to confirm
it was recognized as intangible at the same value
3. Review the bank statement to confirm the payment made to the rival company of $5 million.
4. Discuss with directors the basis of the useful life of the brand estimated to be 15 years.
5. Recalculate the amortization to confirm accuracy of the amortization charge.
Ethical issues (7 marks / 1.0 marks per ethical issue explained / 1 mark per action)
Our firm has been asked by the bank to provide a guarantee in respect of this loan extension of $ 10 million. This
lead to an advocacy, self-review and self-interest threat to objectivity. The audit firm by giving guarantee to the
bank on loan extension would be promoting Connolly company business interest (i.e. to seek a loan extension)
and would be assuming management responsibility as well. Further, if loan extension is advocated the loan will
become a material part of Connolly balance sheet (i.e. 5%) which will generate a self-review threat later in the
audit. Moreover, if advice is provided it will generate a fee income for the audit firm which along with the audit
fee would generate self-interest of the audit firm if any dependency on client is created.
Thus the audit firm should decline to provide any guarantee on loan extension because loan is material to the
financial statements and being a listed company it is prohibited by the IESBA codes.
Further to the guarantee on loan extension, our firm has been asked to provide advice on the new system. This
again would lead to an advocacy, self-review and self-interest threat. The audit firm by giving advice on the new
system development and implementation will be promoting company’s business interest i.e. the new system and
would also be assuming management responsibility. Further, if the advice on the system is implemented, it will
generate a self-review threat as the audit firm would be reluctant to test the system during the audit. The system
includes the accounting system which itself produces the financial statements which itself in important. Thus,
being material to the financial statements, and the company being listed, it is prohibited by the IESBA codes to
offer such advice.
Conclusion
Connolly is facing numerous events and conditions that may have an adverse effect business performance in
short term. The research and development of new product and getting license is essential critical success factor
for Connolly and both have associated risk within them as highlighted above in the evaluation of business risk.

Page 11 of 11