Assurance — Integrated Problem 3

Solution
The following solution is a “best” response, demonstrating a level much higher than
competent. However, there may be additional acceptable and reasonable points that
are not reflected in this response.

In addition, candidates are not expected to prepare a response of this level given the
time constraints involved and, if applicable, page limits provided.

Memo

To: Partner
From: CPA
Subject: Luxury Living Inc. (LLI) 2022 financial statement audit

Assessment Opportunity #1

The candidate discusses the appropriate accounting treatment for the convertible bonds
accounting issue.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.4 Analyzes treatment for complex events or transactions (Elective – Level B)

Convertible bonds

Issue

The bonds were recorded as a liability in the amount of $10,000,000, the total proceeds
received. However, the bonds have a conversion feature that needs to be accounted
for. The issue is how the conversion feature should be treated under IFRS.

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2022-09-07
Assurance — Integrated Problem 3 Solution

Handbook and analysis

IAS 32 Financial Instruments: Presentation provides guidance on accounting for

compound financial instruments which may contain both a liability and equity
component. Per IAS 32, paragraph 29:

An entity recognizes separately the components of a financial instrument that

(a) creates a financial liability of the entity and

(b) grants an option to the holder of the instrument to convert it into an

equity instrument of the entity.

For example, a bond or similar instrument convertible by the holder into a fixed
number of ordinary shares of the entity is a compound financial instrument. From
the perspective of the entity, such an instrument comprises two components: a
financial liability (a contractual arrangement to deliver cash or another financial
asset) and an equity instrument (a call option granting the holder the right, for a
specified period of time, to convert it into a fixed number of ordinary shares of the
entity).

The paragraph above describes the bonds issued by LLI, because it is the holder of the
bonds who decides whether or not to exercise the conversion option, and the
conversion rate is fixed at 10 common (ordinary) shares per $1,000 bond. Therefore,
the bonds are a compound instrument, meaning there is a financial liability and an
equity instrument component to the bond.

Per IAS 32, paragraph 31:

Equity instruments are instruments that evidence a residual interest in the assets
of an entity after deducting all of its liabilities. Therefore, when the initial carrying
amount of a compound financial instrument is allocated to its equity and liability
components, the equity component is assigned the residual amount after
deducting from the fair value of the instrument as a whole the amount separately
determined for the liability component.

Because the equity component will be the residual interest after deducting the amount
determined for the liability component from the fair value of the instrument as a whole,
we must calculate the fair value of the bonds without the conversion feature, including
the value of the interest payments. Similar bonds in the market that do not have the
conversion feature are sold to yield 8%, and LLI’s bonds yield 6%.

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Assurance — Integrated Problem 3 Solution

Rate = 8%
Number of periods (nper) = 10 years
Payment (pmt) = –600,000 ($10,000,000 × 6%)
Future value (fv) = –10,000,000
PV function in Excel = (0.08,10,-600,000,-10,000,000)
Type = 0 or omitted (end of period payments)
Fair value of the bond component = $8,657,984 (rounded)

Using the residual method to calculate the equity component:

Total proceeds $10,000,000

Less: Fair value of bond (8,657,984)
Value assigned to equity $ 1,342,016

Recommendation

The convertible bond issuance was recorded incorrectly. To correct this, the following
adjusting journal entry is needed:

DR Bonds payable 1,342,016

CR Contributed surplus — conversion rights 1,342,016

Interest expense must be recorded each fiscal period using the effective interest
method based on the fair value of the liability component of the bond. At December 31,
interest expense of $692,639 ($8,657,984 × 8%) should be recorded:

DR Interest expense 692,639

CR Bonds payable 92,639
CR Cash 600,000

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Assurance — Integrated Problem 3 Solution

Assessment Opportunity #2

The candidate discusses the appropriate accounting treatment for the revenue
recognition accounting issue.

The candidate demonstrates competence in Financial Reporting.

CPA Map Competencies:

1.2.2 Evaluates treatment for routine transactions (Core – Level A)

Revenue recognition

Issue

LLI sold goods in 2022, and each sale over $4,000 entitled the purchaser to a month of
free rent in January 2023. All sales revenue was recorded in 2022, despite the furniture
and the rent having different patterns of transfer. The issue is whether this arrangement
is considered a contract, and if so, if the revenue has been recorded appropriately.

Handbook and analysis

IFRS 15 Revenue from Contracts with Customers provides guidance on recognizing

revenue. There are five steps to be applied in determining the revenue to recognize.

Step 1: Identify the contract

IFRS 15 paragraph 9 states:

An entity shall account for a contract with a customer that is within the scope of
this Standard only when all of the following criteria are met:
(a) the parties to the contract have approved the contract (in writing, orally or in
accordance with other customary business practices) and are committed to
perform their respective obligations;
This criterion has been met. The customers approved the contract when they
purchased the furniture and LLI committed to offering them one month of free
rent.
(b) the entity can identify each party’s rights regarding the goods or services to
be transferred;
This criterion has been met. LLI is entitled to the consideration paid, and in
exchange the customers are entitled to the delivery of their furniture and one
month free rent.

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Assurance — Integrated Problem 3 Solution

(c) the entity can identify the payment terms for the goods or services to be
transferred;
This criterion has been met. The consideration was paid at the time of sale,
and thus payment terms required up-front payment.
(d) the contract has commercial substance (i.e., the risk, timing or amount of the
entity’s future cash flows is expected to change as a result of the contract);
and
This criterion has been met. The transaction has commercial substance
because cash was exchanged for products and free rent.
(e) it is probable that the entity will collect the consideration to which it will be
entitled in exchange for the goods or services that will be transferred to the
customer.
This criterion has been met. The consideration has already been paid by the
customers, and thus collection has occurred.

As all of the above criteria have been met, a contract has been identified.

Step 2: Identify performance obligations

IFRS 15 paragraph 22 states:

At contract inception, an entity shall assess the goods or services promised in a

contract with a customer and shall identify as a performance obligation each
promise to transfer to the customer either:
(a) a good or service (or a bundle of goods or services) that is distinct; or
(b) a series of distinct goods or services that are substantially the same and that
have the same pattern of transfer to the customer.

Paragraph 27 discusses the criteria for distinct goods or services:

A good or service that is promised to a customer is distinct if both of the following

criteria are met:
(a) the customer can benefit from the good or service either on its own or
together with other resources that are readily available to the customer (i.e.,
the good or service is capable of being distinct); and
(b) the entity’s promise to transfer the good or service to the customer is
separately identifiable from other promises in the contract (i.e., the promise to
transfer the good or service is distinct within the context of the contract).

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Assurance — Integrated Problem 3 Solution

There are two distinct performance obligations in this contract. One is to provide
furniture and the other is to provide a month of free rent in January 2023. The customer
can benefit from the furniture separately from the benefit of having free rent in
January 2023 — one is not required to enjoy the other. Based on the description of the
transaction, it is easy to separately identify these obligations.

Step 3: Determine the transaction price

The total transaction price is $335,000.

Step 4: Allocating the transaction price to performance obligations

In allocating the transaction price, paragraph 73 states:

The objective when allocating the transaction price is for an entity to allocate the
transaction price to each performance obligation (or distinct good or service) in
an amount that depicts the amount of consideration to which the entity expects to
be entitled in exchange for transferring the promised goods or services to the
customer.

The revenue has been recognized entirely in 2022, even though LLI only completed one
distinct performance obligation: delivery of the goods (furniture). They have not yet
performed the service (provide free rent). All of the revenue was assigned to one
performance obligation, which is not in accordance with IFRS 15.

Paragraphs 76 and 77 explain how to allocate the price:

To allocate the transaction price to each performance obligation on a relative

stand-alone selling price basis, an entity shall determine the stand-alone selling
price at contract inception of the distinct good or service underlying each
performance obligation in the contract and allocate the transaction price in
proportion to those stand-alone selling prices.

The stand-alone selling price is the price at which an entity would sell a promised
good or service separately to a customer. The best evidence of a stand-alone
selling price is the observable price of a good or service when the entity sells that
good or service separately in similar circumstances and to similar customers. A
contractually stated price or a list price for a good or service may be (but shall not
be presumed to be) the stand-alone selling price of that good or service.

The furniture was sold at the manufacturer’s suggested prices, which reflect a
reasonable stand-alone value. The stand-alone value of the free rent is the amount of
rent that is forgone, as this is what the tenants would have paid based on their current
rental agreement. The total fair value (FV) is therefore $335,000 in furniture + $184,250
in free rent = $519,250.

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Assurance — Integrated Problem 3 Solution

Allocation of revenue: Allocation

Revenue × (FV component / total of
FV) revenue
Furniture $335,000 × ($335,000 / $519,250) = $216,129
Rent $335,000 × ($184,250 / $519,250) = $118,871
Total $335,000

Therefore, $216,129 of revenue is allocated to the furniture sales and $118,871 of

revenue to the forgone rent.

Step 5: Recognize revenue when each obligation is satisfied

The obligation to provide furniture was met in 2022 because all furniture was delivered
within 12 hours of purchase. Therefore, $216,129 of revenue can be recognized in 2022
on the days of sale of the furniture. The obligation to provide free rent for a place to live
in January is not met until January 2023. Therefore, $118,871 must be reversed from
revenue in 2022 and instead reported as deferred rent revenue as of year end.

Recommendation

This arrangement is considered a contract; however, it was not appropriate to recognize

the full $335,000 of revenue in 2022. An adjustment is needed in the financial
statements to allocate the portion of revenue related to January 2023 rent to deferred
revenue. The adjusting journal entry is:

DR Sales revenue 118,871

CR Deferred rent revenue 118,871

The adjusting journal entry must be recorded to reflect the contract appropriately in the
2022 financial statements.

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Assurance — Integrated Problem 3 Solution

Assessment Opportunity #3

The candidate assesses the risk of material misstatement at the assertion level and
designs substantive audit procedures for the accounting issues.

The candidate demonstrates competence in Assurance.

CPA Map Competencies:

4.3.5 Assesses the risks of the project, or, for audit engagements, assesses the risks of
material misstatements at the financial statement level and at the assertion level for
classes of transactions, account balances, and disclosures (Elective – Level A)
4.3.6 Develops appropriate procedures, including Audit Data Analytics (ADA), based on
the identified risk of material misstatement (Elective – Level A)

CAS 315.5 requires a separate assessment of inherent and control risk at the assertion
level. However, there are insufficient case facts to assess control risk so we have made
a conclusion based on the risk factors presented. Note that if we ultimately do not intend
to test the operating effectiveness of controls, 315.34 states that the risk of material
misstatement is the same as the assessment of inherent risk.

Convertible bonds

Account and assertions: Bonds payable and equity — Classification and accuracy,
valuation, and allocation

Risk:

The convertible bonds would carry a high risk of material misstatement for the following
reasons:
• The convertible bond issuance is non-routine in nature, which increases inherent risk
of material misstatement. Management is more prone to making errors when
accounting for unfamiliar transactions.
• As well, accounting for a convertible bond requires management judgment, which
increases the risk of material misstatement. For example, estimation is required to
allocate the bond proceeds to debt and equity. Because the bond component does
not trade without the conversion option, management must estimate the value of the
bond component without the option to convert to equity. Management will use
judgment to select comparable bonds in the market, in order to arrive at the
appropriate interest rate to be used in calculating the bond liability.

The risk of material misstatement at the assertion level is high for classification and
accuracy, valuation, and allocation of the bonds payable and the associated equity
component.

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Assurance — Integrated Problem 3 Solution

Procedures:
• Inspect the bond agreement to confirm issuance price, face value, and terms of
issuance.
• Discuss with management the market comparables used to value the liability (bond
payable) portion of this compound financial instrument. Inspect the supporting
information that was used by management to arrive at this valuation to assess its
reasonability.
• Recalculate management’s work. Recalculate the value assigned to the bond and
residual proceeds assigned to equity.
• Inspect financial statements and note disclosures to ensure that amounts calculated
are properly presented and disclosed in the financial statements.

Revenue from holiday promotion

Account and assertions: Revenue — Occurrence and accuracy

Risk:

The revenue recognized from the holiday promotion would also carry a high risk of
material misstatement for the following reasons:
• The terms of the promotion are unique and dissimilar from any promotions offered
by LLI in the past, which increases the risk of material misstatement. Management
is more prone to making errors when accounting for unfamiliar transactions.
• Management may have an incentive to overstate revenues relating to the holiday
promotion in order to improve results for the period under audit and meet or exceed
the expectations of its shareholders. This is supported by the fact that LLI decided
to hold the promotion in December, the final month of the year, to increase sales,
which had been slow. This increases the risk of material misstatement at the
assertion level, as management may wish to recognize more revenues in 2022.

The risk of material misstatement at the assertion level is high for occurrence and
accuracy of revenue.

Procedures:

• Obtain evidence of the promotion from promotional materials distributed by LLI, and
review terms of the agreement, including the amount required to be spent to qualify
for the free rent, the month the free rent would pertain to, and so on.
• Obtain a detailed listing of qualifying sales under the agreement and select a
sample of transactions. For each transaction selected, obtain supporting
documentation for the sale, including purchase receipt, evidence of cash being
deposited, and a delivery slip. Ensure that each qualifying sale was over $4,000.

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Assurance — Integrated Problem 3 Solution

• For a sample of tenants who have qualified for free rent, request a copy of the
tenant’s rental agreement. Inspect the monthly rent amount to determine whether
the appropriate amount of revenue has been allocated to the free rent portion of the
sale.
• Recalculate revenue from furniture sales and deferred rent revenue to be recorded
at period end. Compare this to what has been recorded on the financial statements.

Assessment Opportunity #4

The candidate assesses the procedures proposed by the co-op student to address the
inventory valuation assertion.

The candidate demonstrates competence in Assurance.

CPA Map Competencies:

4.3.6 Develops appropriate procedures, including Audit Data Analytics (ADA), based on
the identified risk of material misstatement (Elective – Level A)

Memo

To: Co-op student

From: CPA
Subject: LLI inventory procedures

You have worked hard and used relevant resources to develop a list of procedures. This
is a great starting point.

Procedure 1: Use the financial statements to calculate inventory turnover and days
sales in inventory ratios for 2022 and compare to industry norms. Discuss the trend with
management (given).

The ratio analysis suggested is a commonly used analytical procedure for inventory.
However, for LLI, it would have limited use.

For the ratios suggested — inventory turnover and days sales in inventory — there is no
prior-year comparative to use to calculate a trend because this is the first year that LLI
has ventured into selling furniture. As well, a comparison to industry is unlikely to be
meaningful because LLI’s business model is unique and not comparable to other firms
that specialize in furniture sales. Whether or not LLI’s ratios are in line with industry
norms would not provide us with valuable audit evidence in this case.

Procedure 2: Using inventory purchase data, recalculate aging of BTI inventory, based
on the date of purchase, to identify any slow-moving inventory. This can help identify
inventory that is slow to sell and may be reported at an amount above net realizable
value (NRV). Discuss findings with management (given).

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Assurance — Integrated Problem 3 Solution

These analytical procedures would be useful in the planning phase of an audit as the
auditors try to identify areas where there may be misstatements or areas of high audit
risk of misstatement. However, it is too late in the process for these procedures for LLI.

We are now in the execution phase and have already identified the exact area of risk of
material misstatement. We know that the entire furniture inventory is slow moving and,
in fact, is being liquidated. Therefore, this procedure is effectively not necessary at this
stage because we have already obtained the evidence we would have been seeking
when performing this procedure.

Procedure 3: Using sales data for the year and the period since year end, review
volume of sales trends for the partnership with BTI on a month-to-month basis, including
the month immediately following year end. Declining sales trends would indicate a
possible issue with inventory accuracy, valuation, and allocation (given).

Sales volume trends can sometimes be a good indicator of overvalued inventory, since
inventory items with declining sales volume trends may be unlikely to sell or may be
required to sell at a discount.

However, in this case, this type of analysis would not provide us with valuable
information, since we already know that the BTI inventory has been slow to sell. In fact,
the information provided by this type of analysis may be conflicting, since sales volume
may actually be trending upwards since period end as a result of the deep discounts
now being offered on these products. While there are some situations in which this
procedure would be applicable, it is not appropriate in this circumstance.

Procedure 4: Combine the use of sales data and inventory purchase data to compare
the purchase price for items in inventory to the most recent selling price for the same
inventory items. Analyze the data to identify any items that have been sold at a price
below the purchase cost, indicating that the inventory may be recorded at an amount
above its NRV (given).

This is a good procedure that will be key to testing the accuracy, valuation, and
allocation of the inventory. This procedure will allow us to determine if any of the items
in inventory have been sold at a price below the inventory’s original cost, especially
given the recent sale on BTI inventory. Looking at the cost of sales information and
sales price given in regard to the December promotion, the cost of sales is
approximately 60% of selling price, so it is likely that those items selling at the discounts
offered will be sold for less than the purchase price as the discounts are 50 to 75%.

Data validity considerations

We should also obtain supporting documentation that verifies the validity of the data
used for the analysis. For example, we should select a sample of recent sales
transactions and obtain copies of sales receipts for January to corroborate the prices
that the inventory on hand was actually being sold for. In addition, we can select a
sample of inventory purchases and obtain the related invoice from BTI to determine
whether or not the price paid, as shown in the data, is accurate.

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