Identifying and Managing Audit Risk
Sovereign Pharmaceuticals Ltd (‘Sovereign Pharmaceuticals’) develops, manufactures and sells a range of pharmaceuticals and has a wide customer base across Europe and Asia. You are the audit manager of Majesty & Co and you are planning the audit of Sovereign Pharmaceuticals Ltd whose financial year end is 31 December 2020. You attended a planning meeting with the finance director and engagement partner and are now reviewing the meeting notes in order to produce the audit strategy and plan. Revenue for the year is forecast at £250 million.
During the year the company has spent £24 million on developing several new products. Some of these are in the early stages of development whilst others are nearing completion. The finance director has confirmed that all projects are likely to be successful and so he is intending to capitalise the full £24 million. Once products have completed the development stage, Sovereign Pharmaceuticals begins manufacturing them. At the year-end it is anticipated that there will be significant levels of work in progress. In addition the company uses a standard costing method to value inventory; the standard costs are set when a product is first manufactured and are not usually updated. In order to fulfil customer orders promptly, Sovereign Pharmaceuticals Ltd has warehouses for finished goods located across Europe and Asia; approximately one third of these are third party warehouses where Sovereign Pharmaceuticals just rents space. In December a new accounting package was introduced. This is a bespoke system developed by the information technology (IT) manager. The old and new packages were not run in parallel as it was felt that this would be too onerous for the accounting team.
Two months after the system changeover the IT manager left the company; a new manager has been recruited but has not yet started work. In order to fund the development of new products, Sovereign Pharmaceuticals has restructured its finance and raised £10 million through issuing shares at a premium and £25 million through a long-term loan. There are bank covenants attached to the loan, the main one relating to a minimum level of total assets. If these covenants are breached then the loan becomes immediately repayable. The company has a policy of revaluing land and buildings, and the finance director has announced that all land and buildings will be revalued as at the year end. The reporting timetable for audit completion of Sovereign Pharmaceuticals Ltd is quite short, and the finance director would like to report results even earlier this year. The ongoing Covid-19 pandemic has not been included in your planning processes so far, therefore any relevant issues relating to the client also need to be considered and incorporated into the risk assessment.
Substantive Procedures for Inventory and Revaluation
a) Using the information provided, identify and describe FIVE audit risks and explain the auditor’s response to each risk in planning the audit of Sovereign Pharmaceuticals Ltd. (10 marks)
b) Describe substantive procedures you should perform to obtain sufficient appropriate evidence in relation to: i) Inventory held at the third party warehouses; ii) Revaluation of land and buildings (4 marks)
c) Explain why going concern is an important part of the audit process and why this could be a significant issue in the audit of Sovereign Pharmaceuticals (4 marks)
d) Explain why the Letter of Representation will be an important piece of audit evidence in the audit of Sovereign Pharmaceuticals and what disclosures should be included. (5 marks)
e) Caparo was an important case for the audit profession. Explain its significance. (3 marks)
f) Outline why the Audit Expectation Gap is an important concept in the audit profession. (4 marks) ?
In respect of each of the situations outlined below, reach a conclusion on whether or not you would modify your audit report. Give reasons for your conclusion and describe the effect on your audit report. The year end in each scenario is 30 September 2020
a) Wainwright Technology Ltd In July 2020, the company received a government grant of £3m in respect of assistance with the acquisition of fixed assets to manufacture 5G technology. It is estimated they will have useful economic lives of seven years. £1m has been credited directly to the profit and loss account for the year ended 30 September 2020, £1m has been used to purchase new machinery under the terms and conditions of the grant and a further £1m has been transferred to their revenue reserves due to the economic uncertainty of the Covid 19 pandemic. The directors insist that they will not be using all of the grant, hence only using £1m to purchase assets and the remaining £2m recorded as revenue and reserves. The auditors have informed Wainwright Technology Ltd that this treatment is not in accordance with the accounting requirements of the grant or the relevant accounting standard which requires such grants to be credited to profit and loss over the useful economic lives of the assets to which the grant relates. The pre-tax profit of Wainwright Technology Ltd for the year ended 30 September 2020 is £0.6m. (5 marks)
b) Indulgence Fashion Ltd Indulgence Fashion Ltd is a manufacturer and distributor of luxury ladies Fashion and shoes and exports a significant amount of its products globally. Indulgence Fashion Ltd has major warehouses and distribution centers in a number of overseas country. Due to the Covid 19 pandemic, travel restrictions have been imposed by a number of governments in which the business has operations. As a result of travel restrictions, it was not possible for your firm to attend the year end stocktake or to complete essential on site tests. It is estimated following the work completed during our interim audit that inventory held at these overseas warehouse and distribution centres represented £2.7m (85%) of Indulgence Fashion Ltd ’s total inventory. Indulgence Fashion Ltd’s forecast profit is £2.6m and materiality is £1.7m. (5 marks)
c) Special Times Special Times is a web based company that delivers luxury cards, gifts and flowers. The year end is 30 September 2020. The year-end audit is almost complete and the statements are due to be signed shortly. Year-end revenue is £5.2m and profit before tax and interest is £0.6m. A key customer with a year-end receivables balance of £150,000 has notified Special Times on the 10th November 2020 that they are experiencing cash flow difficulties due to Covid 19 and are unable to make any payments in the near future. The Finance Director has notified the Audit Partner that the outstanding balance will be written off as an irrecoverable debt next year in the 2020/21 financial statements. (5 marks)
d) Bright Resolution Ltd HMRC commenced a major enquiry into all aspects of the tax affairs of the company on the 10th October 2020. Until the enquiry is completed it is not possible to estimate with any reasonable degree of certainty any ultimate liability which may fall upon the company. Consequently, no liability in respect of this matter has been included in the financial statements. The directors have included a note to the accounts explaining the situation. (5 marks)