Question

LO 13-1, 4, 6 13-31. Required: You are part of the audit team that is auditing Happy Chicken, Inc., a company that franchises Happy Chicken family restaurants. During the current year, management of Happy Chicken pur chased for $2 million one of its franchised locations, a store that was having financial difficulties In performing its analysis for impairment of assets at vear-end, management of Happy Chicken determined that the carrying value of the asset may not be recoverable. As a result, manage- ment developed an estimate of the fair value of the location using a discounted cash flow model. The estimated fair value of the location was determined to be $1.5 million, which resulted in an impairment loss of about $500,000. The undiscounted future cash flows are equal to $1.7 million a. State why the audit of fair values is often difficult. b. Describe how you might approach the audit of the impairment loss in this situation. c. If you decide to use the work of a valuation specialist to audit the estimate of fair value. describe your responsibilities with respect to using the specialist's work. d. List two significant assumptions that you would expect to underlie Happy Chicken man agement's estimate of the fair value of its recently purchased franchise location. e. For the significant assumptions that you identified in (d), describe the types of evidence that you would expect to examine in order to support those assumptions.

Answer 1

a) The audit of fair values is difficult due to involvement of management judgement in determining fair values. As in the above example management has used DCF techniques to arrive at fair value. Issues with DCF techniques is the assumption of constant cash flows, complexity of computation and  other assumption used in computation

b) Following steps will be taken:

1) We will have to verify and review the computation of assets acquired by the company

2) Management will have to provide details and basis of cash flows projections used in the computation of DCF techniques. Auditors will assess the objectivity of the assumptions made and review the computation.

3) Auditors should also check subsequent events such as sale of assets to know the accuracy of assumptions made by the management

4) Auditors will perform the computation of impairment loss and check against the result of managements computation

c) Following points to be considered if using the work of an expert in an audit, as per ISA620:

1) Expert should be competent, capable and objective if their reports to be used as an evidence in forming conclusion for the audit

2) Auditor should review and assess the work of the expert to use in the audit such as review the computation, discuss with other experts etc

d) Two significant assumptions made by the management could be:

1) The projections of cash flows used for computation of DCF

2) Management has to use value, which ever is higher between Value in use or fair value less cost to sell. In the given scenario company has not provided information of fair value less cost to sell figure to know if their computation of accurate

e) As an auditor I would do following test:

1) To use the work of an expert

2) To review and perform computation of impairment loss

3) To perform test of subsequent settlement to know the fair values of assets