Audit Assignment Preconditions And Process

Audit Risk and Components

Question:

Write an essay on “Karrick Gold & Copper Ltd”.
 

In order to accept an audit assignment ‘preconditions for an audit’ as required under ISA 210 – “Agreeing the terms of audit engagement” should be present. As per ISA 210 an auditor is required to:

• Check whether the financial statements of a company are prepared according to the appropriate financial reporting framework (FRM), and
• Check that those who are in charge of management understand and acknowledge their responsibilities.

If the above mentioned conditions are not present then an auditor should not accept the audit unless it is required under the law.

• Client’s Background –auditor have to collect the information about client’s business and assess his standing / reputation to ensure the level of risk associated with the client’s business. Auditor also has to assess the integrity of management.
• Client’s Industry –Analyze the nature of business in order to identify the applicable rules / regulations / standards to the client’s industry.
• Risk –Auditor has to evaluate the following in order to assess risk associated with client:
• Weak / poor accounting system,
• Ineffective management,
• Appointment of new auditors frequently,
• Related party transactions,
• Market report about client, etc.
• Competency – auditor should make sure that he has all the required skills / competence / expertise to conduct the audit of his client.
• Conflict of Interest – auditor should make sure that there will be no conflict of interest with the existing clients after accepting the new audit engagement.
• Ethical Requirement –auditor has to ensure that there will be no threats to his integrity, objectivity and independence by accepting any audit assignment.
• Resources – the auditor should ensure that he has the required resources to conduct the audit of a large business organization such as competent audit team which can complete the assignment timely.
• Communication with Previous Auditor – it is a mandatory requirement under the law that the auditor before accepting an audit assignment has to communicate in writing with the outgoing auditor to make sure that there are no ethical / professional / legal reasons for non acceptance of audit assignment. Auditor has to obtain the client’s permission before communicating with outgoing auditor and in case client declines, then auditor should not accept the audit assignment. Similarly, outgoing auditor also has to obtain client’s permission to reply back to the new auditor and in case client declines, then the auditor should not accept the audit assignment.

After considering all the above factors and procedures auditor may accept or reject the audit proposal. In case of acceptance of audit assignment following procedure would be followed:

• Removal of outgoing auditor is conducted as per the prescribed rules and regulations under the applicable law.
• Appointment of new auditor is in compliance with the statutory requirements.
• Preparation of “Engagement Letter”. (KAPLAN, 2012)

Audit risk involves that the auditor cangive an incorrect opinion on the financials of a company, such as, qualification made in the report where no qualification was required, no qualification being made where a qualification was justified, fail to disclose any material fact in his report, etc. Audit risk is a product of many risks that occurs while conducting an audit. Auditor must analyze the level of risk for each component of audit risk for maintaining the total audit risk within the acceptable level of risk. There are 3 major components of audit risk which are as follows:

• Inherent Risk – risk that material misstatement will occur in the financials due to error or omission. Where estimations and high degree of judgment are involved, inherent risk is also considered high.
• Control Risk – risk that material misstatement will occur in the financial due to inefficiency and in effectiveness of client’s internal control system which will fail to prevent / detect / correct errors.
• Detection Risk –risk that auditor will fail to detect errors through his audit procedures.

For analyzing the overall audit risk an auditor will use ‘Audit Risk Model’, in which he will calculate the total audit risk by using the following formula: 

Audit Risk = Inherent Risk * Control Risk * Detection Risk 

In the given case the product of all the risk is 4 % (.80 * .10 * .50) which is very low for an audit assignment, therefore, auditor should accept the audit assignment of KGC Ltd. 

Audit program contains a list of audit procedures which are to be conducted by the audit team for obtaining sufficient audit evidence. After analyzing the accounting system of the company and after finalizing the audit strategy which is to be followed individual audit procedures are planned. A proper audit program includes audit procedure for each and every area of business, audit strategies to be followed, audit tools which are to be used, substantive audit tests which will be performed by the audit team. Following are the points which will be included in the audit program of KGC Ltd. mine in PNG:

• General Items:
• Obtain financial information such as monthly / quarterly financial reports, yearend trial balance, etc.
• Last year’s audit report, unusual items.
• Analysis of internal controls.
• Cash &Bank (reconciliation, bank statements, physical verification).
• Amounts due from others.
• Property, Plant and Equipment and Vehicles (valuation, depreciation, impairment, etc).
• Accounts payable.
• Operating Procedures.
• Special Items:
• Analysis of estimates made for investment in new PPE over the next 7 years of $ 5.0billion AUD.
• Analyze whether license agreement allows for renewal in case of new findings for silver and lead ore after the expiry.
• Evaluation of manager’s expectation in relation to finding of commercial quality silver ore in near future.
• Making provisions for the cost of remediating the sludge spill. It is favorable to make provisions as per higher compensation limit, i.e., $ 60 billion AUD.
• Evaluation of sludge control system to check its efficiency so that in future no such incidence occurs. 

IAS 16 – ‘Property, Plant and Equipment’ provides the accounting treatment for PPE. All the property, plants and equipments are initially recognized at cost and valued subsequently either by revaluation model or cost model. AASB (Australian Accounting Standards Board) has recognized two methods for the valuation of assets. First is historical cost method and second is fair value method. In historical cost method asset is recorded at its historical cost (purchase price) in the books of accounts while in fair value method, asset is revalued to its current market price. Revaluation is done at regular intervals by comparing the price withsimilar assets. In general, fair value method seems to be an advanced method for valuation of assets but company has to face certain issues while valuing its assets as per fair value method.

The biggest issue with fair value method is that a company is able to measure the current market value of assets reliably. Fair value method also leads to unethical or wrong business practices, such as, misleading the stakeholders by wrong asset valuation in the financial statements. There are many instances of incidence happening in corporate history which exploited this method. Fair value method for valuation of assets is more relevant but it has a major drawback because it is not always reliable. Therefore, it is more like a trade-off in which we have to choose one quality over another. So it is a fact that fair value method is more relevant but it is not always reliable for the asset valuation. (Deloitte, 2016)

Audit Program

In the given case of KGC Ltd., it will face same issues which are mentioned in the above paragraph whether to use fair value method or not for the valuation of its property, plant and equipments. According to the IAS 16.31 it is clearly mentioned that the revaluation model is used only in case where the fair value is calculated reliably and depreciation / impairment can also be measured reliably. In order to resolve these issues auditor will have to value each and every asset carefully so as to get the reliable fair value and in certain cases valuation can be done with the help of a professional. Auditor has to consider the future economic benefits of the assets while valuing them. (KPMG, 2011). 

KGC Ltd. is in operation from last 30 years and is located in a very isolated area of Australia. The current business operations can be carried only for next 8 years after that license period will be expired therefore in order to maintain going concern prospect KGC Ltd. will have to find the commercial quality silver and lead ore in near future because the reserve of gold and copper will exhaust in next 7 years.Therefore as a general overview, the position of KGC Ltd. in long run is not certain and is mainly dependent on renewal of its license and finding of new ore in the licensed region.

However, there are certain aspects which are in the favor of KGC Ltd and can help themin future by thesupport of government as it is the only company which operates in the PNG region and provides employment to 3000 PNG citizens. It is a major source of revenue for PNG government and it provides water processing plant which is the only one in that region, grade schools, health centers and hospitals. Because of all these social and environmental services of KGC Ltd. there are chances that it will get full support from PNG government and its going concern factor will not get affected.

In 1994 Elkington developed the concept of the Triple Bottom Line which proposed that business goals were inseparable from the societies and environments within which they operate. The triple bottom line is made up of ‘Social, Environmental and Economic’ aspects and indicated by the phrase ‘People, Planet, Profit’ phrase.

• People – Human Capital. It implies fair and beneficial business practices towards labor community and region in which anorganization conducts its business to create long term value. For example, policy restraining use of child labor, fair pay to workforce, health and safety at work place, tolerable working hours, etc. and would not otherwise exploit a  community or its labor force.
• Planet – Natural Capital. It refers to sustainable environmental practices. A company which decides to follow triple bottom line approach always keeps in mind that it does no harm to nature or creates negative environmental impact.(The Economist, 2009)

As per the above mentioned explanation to Triple Bottom Line (TBL) approach, since KGC Ltd. has followed this approach therefore it is conducting its business operations socially and in an environmental friendly way. Therefore auditor should not hesitate in signing this statement as being true and fair.

Since KGC Ltd. wants to invest in its PPE assets and in order to carry out its research activities for finding new sources of silver and lead ores therefore it has decided to raise $ 5 billion AUD through a share issue for which it will require a duly drafted prospectus. It has stated the following statements in its prospectus:

• Operations in PNG region are its principal assets – it is correct because company’s major source of revenue is its mine in PNG.
• Its operations are low risk – this statement would justify for short term operation because its toxicity level is relatively low but in long term exposure it can create serious chronic health issues, therefore this statement cannot be justified and is inappropriate for the prospectus.
• Its operations are indefinite (permanent) in duration –this statement cannot be justified at all. It is clearly visible that it isleft with only 8 years after which its license will expire. Further it has not found any commercial source for silver ore till date and in the absence of any fresh source for ore it only has reserve for 7 years therefore, in no case it can say its operation are permanent or indefinite in durations.

Since there are unjustified statements mentioned in the prospectus therefore auditor will not sign-off this prospectus as being true and fair. 

Reference:

Deloitte, 2016, ‘IAS 16 – Property, Plant and Equipment’, viewed on 17^th June. 

KPMG, 2011, ‘Guidance note on audit of PPE’, viewed on 17^th June.

Accounting Simplified, 2013, ‘Audit Risk Model’, viewed on 17^th June.

The Economist, 2009, ‘Triple Bottom Line (TBL)’, viewed on 17^th June.