AAA – Revision

Q5 - Blues
Question

The Blues Group (Blues) has been a client of yours for a number of years and is involved in the manufacture and
retail of sports equipment. It has always been a UK based business with 3 wholly owned subsidiaries, until this
year when it acquired 100% of the ordinary share capital of Vista Ltd.

Vista Ltd is located in Spain and will continue to use Euros as its functional currency. Blues and Vista Ltd have the
same year-end but you are aware that the new subsidiary may use different accounting policies and practices to
the rest of the group. Vista Ltd contributes 16% of the group total assets.

It is expected that your firm will take over the audit of Vista Ltd, meaning that you will be the sole auditor in the
group.

During the year, Blues set up a share based payment scheme for all of its employees. The scheme gave the
employees the option to buy 500 shares each in Blues in three years’ time. The only vesting condition was that
the employees need to remain with Blues for the entire period. A liability and a corresponding expense have been
included in the financial statements. This has been calculated by multiplying the current number of employees by
the fair value of the option at the grant date and then spreading the cost over 5 years because that is the date
that the options can be exercised (the vesting period is 3 years but the exercise date is later).
The expense/ liability included for this year is $1.2m.

Blues has a number of items of Property, Plant and Equipment (PPE). The PPE is mainly plant and machinery and
is being depreciated over anything between 3 and 10 years. Blues has recently discovered that some of its plant
needs replacing due to technological changes. The carrying value of the PPE is $20.2m.

Blues is currently fighting a court case against the accusation that it uses child labour in the manufacture of some
of its equipment. The company strongly denies this and nothing has been included in the financial statements in
respect of a possible provision or disclosure in relation to this matter. You have seen a figure quoted in the minutes
of a board meeting that says Blues are being sued for $10m over this issue.
The management of Blues are keen to obtain a stock exchange listing as soon as possible and are keen to take
advantage of the fact that this year's figures are a big improvement on last year's by floating within in the next 6
months.

Blues regularly has big clearance sales in its retail outlets to dispose of old and obsolete inventory and you have
been informed that there is one planned for just after the year-end. This year's inventory figure is $15.1m. The total
assets of Blues for this year are $ 78.3m, but this is the only benchmark that is currently available to you.

Required:

You are the audit manager for Blues and the engagement partner has asked you to produce a planning document
with the following three sections;

a) Evaluate the financial statement risks that relate to the Blues group.
(18 Marks)
b) Explain the term" Professional Scepticism" and give THREE examples of issues to which it could
apply for the audit of the Blues Group.
(8 Marks)
c) List and describe the audit procedures that you would carry out on the share based payment scheme.
(5 Marks)
4 Professional marks for clarity and presentation
(Total 35 Marks)
 AAA – Revision
Q5 - Blues
Solution

To: Engagement partner

From: Audit manager
Subject: Audit Planning Document for the Blues Group

Introduction
This document will be divided into three sections and will provide an explanation of the relevant financial statement
risks, an illustration of three of the key areas where professional scepticism will need to be applied, and a
description of the key audit procedures that will be used for the share based payment expense.

Financial Statement Risks

Inventory
Inventory is a material amount because it represents 19.3% of group assets. Inventory should be valued at the
lower of cost and net realisable value. Due to the way in which Blues operates, there is a possibility that inventory
has been overstated if the old and obsolete items have not been written down to net realisable value. If this has
not been done, then both inventory and profit will be overstated.

Variable useful economic lives

Property, plant and equipment (PPE) is material because it is 25.8% of total assets. It is perfectly acceptable to
have PPE with different lengths of useful economic lives. It does, however, increase the chances of an
inappropriate length of life being either deliberately or accidentally selected. This could result in significant
misstatement of PPE. Both of the first two risks here will have been relevant for previous year audits as well, so it
is hoped that these will not be as big a problem as some of the ones that have occurred for the first time this year.

Share based payment scheme

The liability/ expense is material because it is 1.5% of total assets. (An expense would normally be compared to
profit, but all that is available is the assets figure). The share based payment expense should be calculated as it
has been here, but should be adjusted for expected leavers. This has not been done so it is currently misstated.

The credit entry should be recorded in equity. It is currently a liability, so liabilities are too high and equity is too
low. The expense is also currently understated because the total cost is being spread over 5 years. It should be
spread over the 3 year vesting period, not all the way up to the exercise date, so the expense is too low each
year at present.

Changes to technology
As already calculated, PPE is material. It could be overstated due to the changes in technology not being
accounted for correctly. The technology advancement is an impairment indicator. All relevant items of PPE
should, therefore, be tested for impairment by comparing the carrying value with the recoverable amount. If this
has not been done, then assets are overstated and the omission of the impairment expense means that profit is
as well.

Court case
The potential provision is material because it is 12.8% of total assets. A provision is required if the IAS 37 definition
is fulfilled. We do not know how likely it is that Blues will actually have to pay out. If it is likely, then liabilities are
currently understated. The board minute record is not reliable enough as a basis for the decision- we would need
direct confirmation from the legal advisers to Blues. If it is unlikely that a payment will be made, then a disclosure
would be required and that has not been done yet. So, either the liabilities are understated or a disclosure is
missing- both are financial statement risks.

New Subsidiary
The new subsidiary is material to the group because it represents 16% of total assets. It only needs to be 15% to
be a material component. The accounting policies of the new subsidiary need to be aligned with the rest of the
group. If this is not done, then there will be significant misstatement of the subsidiary figures.

Currency
Blues is based in the UK so will have pounds sterling as its functional currency. Vista Ltd has a different functional
currency, so will need to translate its results at the year-end using the closing rate method of translation. There is
a risk that the wrong exchange rates have been used. All exchange gains and losses should be recognised as
other comprehensive income. There is a risk that they have been included as part of the profit figure in error.

Goodwill
The goodwill of Vista Ltd is likely to be material due to its size. Seeing as it is the year of acquisition, it is possible
that it has been miscalculated. Perhaps unreliable fair values have been used for the net assets at acquisition.
This would mean that goodwill is misstated.
Professional Scepticism and Examples of Issues

Professional Scepticism
The term means be cautious. Auditors should never take anything at face value. They should be prepared to
question what they are told and to look past the obvious to see what is lurking underneath. As a general example
of this, any enquiry should always be supported by confirmation.

Key reasons for caution

The management of Blues wants a quick listing to take advantage of the good performance this year. This makes
me think that this year's results may have been manipulated to be very impressive in order to attract investors. In
general terms, I would be suspicious of anything that either overstates assets or that understates liabilities.

Court case
I would be sceptical about the current treatment of the court case. No provision has been made which could be a
deliberate attempt to understate liabilities. Also, there is not even a disclosure. This may have been omitted in an
attempt to hide bad news from potential investors.

Useful economic lives (UEL) / impairment

The variable UELs allows the management of Blues to potentially overstate profit by using overly long lives, so
only a small amount of depreciation is charged. It appears that impairment is needed but has not been recorded.
This could be another deliberate attempt to inflate profit by omitting an expense.

Share based payment expense

I would be sceptical about the justification for spreading the expense over 5 years instead of the 3 that would be
in accordance with the accounting standard. This, again, looks like an attempt to maximise the profit figure for the
benefit of the possible stock exchange listing.

Share based payment procedures

• I would inspect the company payroll to confirm the number of employees, which has been used in the share
based payment calculation, is accurate.

• I would inspect previous payrolls to try and confirm the number of people that usually leave the company and
ensure that this is reflected as an estimate in the calculation.

• I would re-perform the calculation of the share based payment expense to confirm accuracy.

• I would inspect the share based payment agreement in order to confirm the number of options and the length
of the vesting period. This inspection would also ensure that the scheme does apply to ALL employees and
not just the directors and senior management.
• I would inspect a copy of the financial statements of Blues to ensure that the credit entry is recorded in the
right place. It should be in equity, not as a liability.