Question

In your planning of the audit of Mama Joan’s Plc (as above) you have established the following. For the year ended 31 December 2017 the forecast profit before tax is £3.4 million. This is after the deduction of £1.6 million which, in your view, relates to non-recurring expenses. During the year a process of refurbishing a majority of the restaurants has been undertaken, with significant purchases of furniture and fittings and some changes to freehold property at a cost of £5 million in total. Some of this work has been delayed beyond the year end. Payments to the relevant supplier have therefore been withheld until completion. The supplier is in dispute with the company over the delay in payment. In order to finance the refurbishment, the company borrowed £5 million from the bank, repayable over a five year period. During the year Mama Joan’s acquired rights to the recipes of Flaming Ferdinand’s chili based pizzas, at a cost of £2 million. Since these rights have been granted outright for perpetuity the finance director has informed you that she has capitalized the cost with no amortization. During the year Mama Joan’s has outsourced its payroll processing to the payroll service organization, Tabor Financial, a subsidiary of the company’s bank. Tabor handles all elements of the payroll cycle and sends monthly reports to Mama Joan’s detailing the payroll costs. The company previously ran its own payroll. Mama Joan’s has a policy of revaluing land and buildings and the finance director has announced that all land and buildings will be revalued at the year end. During a review of the management accounts for the month of December 2017, you have noticed that receivables have increased significantly on the previous year end. The finance director has informed you that the company is planning to close 5 of its restaurants (10% of the total number of restaurants), making approximately 40 employees redundant after the year end. The decision was announced to affected members of staff shortly before the year-end, but the restaurants were not closed until the second week of January.

Required:

a) Describe how an auditor will use materiality in planning and performing an audit, including consideration of the quantification of overall materiality for this audit.

b) Describe audit risk and the components of audit risk.

c) Explain in detail SIX audit risks arising on the audit of Mama Joan’s Plc for the year ended 31 December 2017, and explain the auditor’s response to each risk in planning the audit.

Answer 1

a). The concept of materiality is therefore fundamental to the audit. It is applied by auditors at the planning stage, and when performing the audit and evaluating the effect of identified misstatements on the audit and of uncorrected misstatements, if any, on the financial statements.​

Considering Materiality in Planning and Performing an Audit as per following steps:

1. Establishing a Materiality Level for the Financial Statements as a Whole

2.Establishing Materiality Levels for Particular Accounts or Disclosures

3. Determining Tolerable Misstatement

4. Considerations for Multi-location Engagements

Based on the audit risk, the auditor may select a value inside this range. (For example)

1. 0.5% to 1% of gross revenue;
2. 1% to 2% of total assets;
3. 1% to 2% of gross profit;
4. 2% to 5% of shareholders' equity;
5. 5% to 10% of net profit.

b). Audit Risk is the risk that an auditor expresses an inappropriate opinion on the financial statements. Components of audit risk are as follows.

1. Inherent Risk

Inherent Risk is the risk of a material misstatement in the financial statements arising due to error or omission as a result of factors other than the failure of controls (factors that may cause a misstatement due to absence or lapse of controls are considered separately in the assessment of control risk).

Inherent risk is generally considered to be higher where a high degree of judgment and estimation is involved or where transactions of the entity are highly complex.

2. Control Risk

Control Risk is the risk of a material misstatement in the financial statements arising due to absence or failure in the operation of relevant controls of the entity.

Organisations must have adequate internal controls in place to prevent and detect instances of fraud and error. Control risk is considered to be high where the audit entity does not have adequate internal controls to prevent and detect instances of fraud and error in the financial statements.

3. Detection Risk

Detection Risk is the risk that the auditors fail to detect a material misstatement in the financial statements.

An auditor must apply audit procedures to detect material misstatements in the financial statements whether due to fraud or error. Misapplication or omission of critical audit procedures may result in a material misstatement remaining undetected by the auditor. Some detection risk is always present due to the inherent limitations of the audit such as the use of sampling for the selection of transactions.

c). SIX audit risks arising on the audit of Mama Joan’s Plc for the year ended 31 December 2017 can be summarises as follows:

1. Non-recurring expense of £1.6 million to be checked

2. During the year a process of refurbishing a majority of the restaurants has been undertaken, with significant purchases of furniture and fittings and some changes to freehold property at a cost of £5 million in total. Risk of under capitalisation or wrong capitalisation.

3. Some of this work has been delayed beyond the year end. Payments to the relevant supplier have therefore been withheld until completion. The supplier is in dispute with the company over the delay in payment. Risk of delay in payment, contingent risk of court case in case of dispute.

4. Wrong amortisation or no amortisation of intangible assets.

5. Risk of inaccurate payroll data, inadequate agreement with the third party for payroll processing, risk of loss data confidentiality.

6. The finance director has informed you that the company is planning to close 5 of its restaurants (10% of the total number of restaurants), risk of going concern, discontinuing operation.