It is 1 July 20X5. You are an audit manager in Arnott & Co, responsible for the audit of Mercurio Co, a listed company with a financial year ending 30 September 20X5. Mercurio Co is the country’s leading specialist retailer of small domestic pets, pet food and pet accessories, operating 264 stores across the country.
The following exhibits, available below, provide information relevant to the question:
Partner’s email – an email which you have received from Ted Hastings, the audit engagement partner.
Background information – information and matters relevant to audit planning.
Selected financial information – extracts from Mercurio Co’s management accounts, including the results of preliminary analytical procedures, which have been performed by a member of the audit team.
Meeting notes – extracts from meeting notes taken at a recent meeting with the finance director of Mercurio Co.
This information should be used to answer the question requirement.
Requirement: Respond to the instructions in the email from the audit engagement partner.
Note: The split of the mark allocation is shown in Exhibit 1 – Partner’s email. (40 marks)
Professional marks will be awarded for the demonstration of skill in communication, analysis and evaluation, professional scepticism and judgement, and commercial acumen in your answer. (10 marks)
Exhibits 1. Partner’s email
To: Audit manager
From: Ted Hastings, audit engagement partner
Subject: Audit planning – Mercurio Co
Date: 1 July 20X5
With the year end approaching, I need you to start planning the audit of Mercurio Co. I met with the company’s finance director, Kate Fleming, last week to discuss recent developments for the business. I have provided you with a summary of the matters discussed at the meeting along with some projected financial information. Based on the analysis I have done on this industry, it is appropriate for overall materiality to be based on the company’s profit before tax as this is a key measure for investors and providers of finance. I require you to prepare briefing notes for my use in which you:
(a) Evaluate the significant business risks faced by Mercurio Co. (8 marks)
(b) Evaluate and prioritise the significant risks of material misstatement which need to be considered in our audit planning.
Please note that you should NOT evaluate risks relating to the audit of animal inventory as these will be addressed separately at a later stage by an auditor’s expert as in prior years.
Note: You should use ALL exhibits when carrying out the requested risk evaluations.
(c) Discuss and conclude on the impact which outsourcing the credit control function will have on our audit planning. (7 marks)
(d) Design the principal audit procedures to be performed in respect of the holiday pay obligation. (7 marks)
Exhibits 2. Background information
Mercurio Co is a large listed company, established 15 years ago when the founders observed a growth in demand for pet-related products. The company has grown steadily and is now the largest retailer of pet-related products in the country, with over 7,000 employees, who are mainly staff working in the stores.
As well as selling pet-related products for a wide variety of animals, the stores also sell small animals such as rabbits and fish. Staff members are fully trained to give advice to customers on matters including nutrition and general animal health, and staff members are also trained in handling all types of animals which are sold. Some stores sell more unusual pets such as spiders, snakes and other reptiles and require compliance with specific import restrictions and welfare standards.
Mercurio Co also operates veterinary clinics within most of its stores. The veterinary clinics are staffed by fully qualified vets who offer a full range of veterinary services. Customers can pay as they go for appointments and treatment of their animals, or they can take out an annual pet healthcare plan which covers the cost of essential vaccinations and quarterly health checks. The pet healthcare plans are extremely popular as they offer good value for money to the customer, and the annual income from sales of these plans historically accounts for 10% of the company’s revenue.
The costs associated with the vaccinations and health checks have risen over recent years, however, Mercurio Co has not been able to increase the prices due to customer price sensitivity over annual pet healthcare plans. The company’s accounting policy is to recognise the revenue from the sale of a healthcare plan on the date when the healthcare plan commences.
Exhibits 3. Selected financial information
Extracts from the management accounts of Mercurio Co for the year ending 30 September 20X5
Projected 20X5 Actual 20X4
Note $ million $ million
Extract from Statement of profit or loss:
Revenue 803 745
Operating profit 172 110
Profit before tax 60 56
Extract from Statement of financial position:
Total assets 1,078 957
Included in total assets:
Assets relating to stores purchased from Lakewell 1 171 -
Trade receivables 2 42 22
Goods in transit (part of inventory) 3 12 -
Cash and cash equivalents 36 81
Included in total liabilities:
Holiday pay obligation 4 21.1 11.6
Employee numbers 7,000 6,200
Bank loans 251 75
Current ratio 2.6 1.4
Gearing ratio 31% 11%
Assets relating to stores purchased from Lakewell Co To expand into new locations, 20 stores were purchased from Lakewell Co, a clothing retailer, on 1 May 20X5, at a cost of $171 million. Mercurio Co purchased the stores using their cash reserves. Lakewell Co was facing going concern problems and offered the stores for sale as part of a restructuring programme. The stores need to be completely refitted at an estimated cost of $9 million each. Mercurio Co’s management has not yet decided how many of the stores will be retained for use in the business; any which are not retained will be sold. The stores will be refitted during the period November 20X5 to January 20X6.
Trade receivables While the majority of sales are for cash, an increasing number of customers have credit accounts with Mercurio Co. The company offers credit customers 60 days’ credit to pay for goods. The forecast trade receivables balance at 30 September 20X5 is $42 million (20X4 – $22 million). Due to the growth in sales to customers on account, in December 20X4 , Mercurio Co engaged Fairbank Co, a service organisation, to provide the credit control function.
Goods in transit In June 20X5, Mercurio Co purchased $12 million of pet food supplies from an international supplier, with the sales contract stating that ownership of the goods passed to Mercurio Co at the date of shipping. During transit, the ship carrying the goods was involved in an accident which destroyed the entire supply of goods. Mercurio Co’s directors had arranged insurance on the shipment of goods, and the policy states that 80% of the goods destroyed are covered by the insurance. The latest correspondence from the insurance company was an informal email that the claim had been received and was due to be processed. These purchases are made in Mercurio Co's operating currency.
Holiday pay obligation Mercurio Co has an internal audit department, who have been testing the controls in the company’s payroll system. Internal audit procedures have revealed that some employees are duplicated on the payroll system; this seems to have happened when two different systems used for recording full-time and part-time staff were merged in October 20X4. Additionally, the internal audit team’s procedures have found that while the systems have the capability of recording holidays taken by staff, this is not always used, and manual records are also maintained in relation to holiday entitlement. Employees are entitled to carry forward a maximum of 3 days of unused holiday entitlement to the next year. Management estimates a holiday pay obligation relating to unused holiday entitlement at the year end using the previous year’s obligation and adjusting it for pay rises and changes in staff levels. The holiday pay obligation forecast for 30 September 20X5 is $21.1 million (20X4 – $11.6 million).
Exhibits 4. Meeting notes
Notes from meeting with Kate Fleming, Mercurio Co finance director
This year has seen a significant business development for the company. The company has started to sell products under its own brand, introducing the ‘Mercurio Range’ of premium pet food and accessories. The products are manufactured in another country and imported, and purchases of Mercurio brand goods from foreign suppliers are predicted to be $7 million for the year to 30 September 20X5. The range was introduced for sale in June 20X5, and was heavily promoted. Having been only recently introduced, sales of products from the Mercurio Range will be insignificant in this year’s financial statements. However, projections in the management accounts indicate that the Mercurio Range is expected to account for 30% of revenue in the financial year to 30 September 20X6.
During the year, Mercurio Co took out an additional bank loan to aid with cash flows for the new Mercurio brand promotion and the forthcoming refitting of the stores purchased from Lakewell Co.
(a) Significant business risks faced by Mercurio Co
Inventory management risk: Mercurio Co sells a wide range of pet-related products, including small animals like rabbits and fish, and unusual pets such as spiders, snakes, and other reptiles. The company's inventory management system needs to be efficient, and it must ensure that the products are always available at stores. Failure to manage the inventory effectively could result in overstocking, which could lead to wastage, or understocking, which could result in lost sales.
Competitive risk: The pet retail industry is highly competitive, and there are numerous players in the market. Competitors can offer similar products at a lower price or with better customer service. Mercurio Co must continue to innovate and offer new products and services to stay ahead of the competition.
Compliance risk: Mercurio Co sells unusual pets such as spiders, snakes, and other reptiles that require compliance with specific import restrictions and welfare standards. Failure to comply with these standards could result in penalties and reputational damage.
Revenue recognition risk: The company's accounting policy is to recognise the revenue from the sale of a healthcare plan on the date when the healthcare plan commences. There is a risk that the company might recognise revenue too early, resulting in overstatement of revenue.
Economic risk: Mercurio Co is exposed to changes in the economic environment, such as a recession or an economic downturn. This could result in reduced consumer spending on pet-related products, leading to lower revenues for the company.
(b) Significant risks of material misstatement to be considered in audit planning
Revenue recognition risk: There is a risk that the company might recognise revenue too early or overstate it, given that the revenue from the sale of a healthcare plan is recognised on the date when the healthcare plan commences. The auditor should assess the controls in place to ensure that revenue is recognised in accordance with the accounting policy.
Inventory valuation risk: As Mercurio Co deals with a wide range of pet-related products, including live animals, there is a risk of over or under-valuation of inventory. The auditor should test the inventory management system to ensure it is working efficiently, and assess the accuracy of the inventory valuation method used.
Going concern risk: There is a risk that Mercurio Co may not be able to continue as a going concern. The company is exposed to economic risks such as a recession, and there is competition in the market. The auditor should assess the management's going concern assessment and evaluate the adequacy of disclosures made in the financial statements.
Fraud risk: Mercurio Co is exposed to fraud risks, including the risk of management overriding controls or committing fraudulent activities such as fictitious sales. The auditor should perform tests to identify fraud risks and assess the design and operating effectiveness of internal controls.
IT system and cybersecurity risk: Mercurio Co uses an IT system for various operations, including point of sale, inventory management, and accounting. The company's reliance on IT systems exposes it to risks such as data breaches, hacking, and system failures. The auditor should assess the IT controls in place to mitigate these risks and evaluate the IT system's reliability and effectiveness.
(c) Impact of outsourcing the credit control function on audit planning
Outsourcing the credit control function means that an external party is responsible for managing the company's credit control, which involves ensuring that customers pay their bills on time. This decision may have an impact on the audit planning process for several reasons:
Firstly, outsourcing credit control can affect the reliability of the company's financial statements. If the outsourced party is not competent, this could result in errors in the company's accounts, particularly in relation to the valuation of trade receivables and bad debts. This could in turn affect the company's profit figures, and potentially its compliance with covenants or regulations.
Secondly, outsourcing the credit control function means that there will be an increased reliance on the effectiveness of the company's internal controls, particularly around the accuracy and completeness of the data being supplied to the outsourced party. As a result, the auditor will need to perform additional testing to obtain evidence around the design and operation of these controls, as well as the competence and independence of the outsourced party.
Thirdly, if the outsourced party is located overseas, this may introduce additional risks around foreign currency translation and compliance with local regulations, including any tax implications.
In light of the above factors, it is important that the audit team performs a detailed assessment of the risks associated with outsourcing the credit control function. This may involve gathering additional evidence, including documentation around the contractual arrangements with the outsourced party and the due diligence performed prior to the outsourcing decision. The impact of outsourcing on the audit plan will depend on the outcome of this assessment, and the extent to which additional testing is required to obtain assurance around the reliability of the financial statements.
(d) Principal audit procedures to be performed in respect of the holiday pay obligation.
The holiday pay obligation represents the amount of money owed by the company to its employees for untaken holiday entitlement. This obligation is recognized as a liability in the company's financial statements and is therefore subject to audit.
To design the principal audit procedures for this obligation, we need to identify the key risks associated with it. The main risk associated with the holiday pay obligation is that the liability is not accurately measured, recorded, or disclosed in the financial statements. This could be due to a number of factors, such as errors in the calculation of the liability, or incomplete or inaccurate data.
To mitigate this risk, the following audit procedures may be performed:
Firstly, the auditor may review the company's policies and procedures for calculating and recording the holiday pay obligation. This would involve gaining an understanding of the methodology used to calculate the liability, and the data sources and assumptions used.
Secondly, the auditor may perform substantive testing of the holiday pay liability balance by recalculating the obligation using independent calculations. This would involve selecting a sample of employees and verifying the holiday pay entitlement using appropriate documentation such as timesheets, holiday records, and payslips.
Thirdly, the auditor may perform a review of the completeness and accuracy of data used to calculate the holiday pay liability, such as employee data, payroll data, and holiday records. This would involve obtaining a sample of data used in the calculation and testing it for accuracy and completeness.
Fourthly, the auditor may perform a review of the company's internal controls over the calculation and recording of the holiday pay liability. This would involve assessing the design and effectiveness of these controls and testing their operation.
Overall, the audit procedures would be designed to obtain sufficient and appropriate evidence to support the completeness, accuracy, and validity of the holiday pay obligation recognized in the company's financial statements.