Case study - Six Island Bay Developments Limited

Using the financial statements provided, together with the supporting audit planning documentation identify the elements of the financial statements where estimates will have been used. Consider the scale of the risk derived from the inherent nature of the estimation process.

Note: For the purpose of the case study, we will not quantify materiality at either the financial statement or account heading level, nor will we consider the relative materiality levels at the individual company and group level. This part of the case study illustrates the more qualitative aspects of accounting estimates and how they might lead to material misstatements in the financial statements.

Audit planning – risk assessment

Comments on the above

At the planning stage, ISA (UK) 540 (Revised 2018) requires the auditor to:

• Identify the inherent risk of material misstatements arising from accounting estimates at the assertion level
• Consider whether the expected risk of misstatement is low, medium or high
• Apply an understanding of the entity and its environment as part of this process
• Consider the financial reporting requirement, from FRS 102 in this case

The above working clearly demonstrates the following:

• The scale and significance of the accounting risks identified. It identifies those risks where special attention will be required and those considered to be low risk. These judgements should clearly link with the audit responses planned to the identified risks.
• The nature of the accounting estimate is clearly defined, allowing the auditor to plan the appropriate audit response. When assessing accounting estimates the following should be considered:
• Whether the estimation is derived from a large population of lower value items such as bad debt provisions and revenue cut off estimates or it is an estimate related to a single or a small number of transactions such as the valuation of an investment property. The nature of the estimation will determine the appropriate audit response.
• Whether the accounting estimation process is covered by Accounting Standards, such as impairment testing of goodwill which is addressed by FRS 102 and IFRS. Or whether it is an area where management can apply a higher degree of judgement.
• Accounting estimates cannot be looked at in isolation, auditors need to consider them in the light of their understanding of the entity and their environment. It is necessary to relate the risks to the commercial decisions which are driving Six Island Bay Developments Limited. The auditor should consider, for example, why the company was formed, the resources it uses, its customers and the return they hope to achieve for the stakeholders. The auditor should assess whether they have the requisite level of skill and experience to audit the entity. In the case of Six Island Bay Developments Limited they would need to consider whether they understand how a construction company works. The planning documentation should clearly identify whether any expert help is required and whether this would be the management’s experts or the auditor’s experts. The auditor should also consider whether they are able to assess the work performed by the expert.

The remainder of the case study focusses on the most significant areas of accounting estimate, namely:

• Valuation of long-term contracts
• Intangible asset impairment and amortisation
• Valuation of freehold land

Internal controls processes documentation

Long term construction contracts

1. Initial steps

a. All tender requests for construction contracts will be considered by Mr Falmouth and Mr Armani. They will then decide if they are going to bid for the work.
b. A detailed bid proposal will then be prepared by Mr Falmouth with certain details being added by Mr Armani. The final decision as to whether to bid is Mr Falmouth’s.
c. If the bid is successful and they are selected for the project a detailed contract is prepared but this will be based on an existing precedent from an earlier contract, especially when the customer is a hotel company that they have worked for before.
d. The detailed contract or contracts are then signed and agreed by the customer and Mr Falmouth on behalf of Six Island Bay Developments Limited.
e. The company will then contract with the required sub-contractors, plumbers, plasterers, roofers, fabricators, etc. and will set the dates for when they will be needed. An initial agreement will have been discussed and negotiated as part of the bidding process.
f. A site foreman will be allocated from the staff of Six Island Bay Developments Limited and the project will be added to the project diary maintained by Mr Falmouth.
g. Project details will then be passed to Ms Hemmingway so that separate nominal accounts can be created for:
i. Contact costs
ii. Contract billings on account
iii. Debtors and creditors and cost accruals

2. Day to day project management

a. The site foreman will be given authority to approve expenditure on single purchases up to a fixed amount (usually £500). All purchases above this amount require approval from either one of the four directors.
b. Purchase orders must be submitted to the sub-contractor using a set Purchase Order Form (POF); the sub-contractor must agree to the terms in writing if they are not already covered by the project contract referred to at 1d. Copies of the POF are then retained by the site foreman or other external project manager as appropriate on site and the accounts team.
c. When goods and services are received these are checked and agreed on site to the POF. All services and goods received must be supported by delivery notes, timesheet or invoice (depending on the nature of the service).
d. Once agreed to the POF a Payment Authority (PA) is created by the site manager and sent to accounts. The PA will specify the amount, any recoverable VAT (depending on the VAT nature of the project) the payment terms and will include the project code.
e. Each project is separately coded, chronologically, 2021 – 8 for example.
f. At this stage the accounts team enter the details from the PA on the system allocating the expense to the project and the related liability.
g. Payments to suppliers are made every 2 weeks using the BACs system wherever possible. A schedule of payments is prepared and submitted to Mr Armani for approval for each BACs run. Other special payments are also approved by Mr Armani.
h. Invoices to customers are issued in accordance with the terms of the contract, typically at the end of each month to cover the assessed value of work to date, with a final invoice only on completion. A retention of 10% against the overall contract value is allowed to be deducted from the final cash payment by the customer to cover any snagging. All retentions must be paid within 12 months.
i. All sales invoices issued are initiated by the accounts team based on contract information held.
j. All changes to contract terms are subject to approval by the site foreman (up to an agreed amount depending on the project), all other change orders must be submitted by the site foreman to Mr Falmouth or Mr Armani for approval before the work can commence. If necessary, the change order will be renegotiated with the customer and an updated contract will be issued. The final decision on all such matters is Mr Falmouth’s.
k. Once issued, all sales invoices are entered on the accounts system by the accounts team. The contract will be recorded as a ‘billing on account’ with a related trade debtor asset.
l. Customers are required to pay all invoices by online payment or BACs within agreed credit terms, typically 60 days from the invoice date.
m. All receipts are checked from the bank statement, agreed to supporting information where available (such as remittance advices) and agreed to the relevant sales invoice(s).
n. Bank statements are checked each week and any unknown receipts identified as part of the reconciliation process will be passed to a member of the accounts team who will investigate.
o. Monthly statements of outstanding invoices are sent to customers and the relevant project manager.

3. Month end procedures

a. Each month the accounts team prepare a project summary containing the following information (this is a typical example). The contract costs at column B excludes materials delivered to site but not yet been used.

b. A project meeting is held each month with Mr Falmouth, Ms Jolly, Mr Armani, Ms Hemmingway and all the project site managers. Progress is discussed and any relevant remedial action required is agreed. This may require action on site or as part of the contract negotiation involving Mr Falmouth and Ms Jolly.

4. Project completion

a. A final project summary is prepared on completion, and this is compared with the initial project estimates created at the start of the project. This looks at issues such as:
a. Valuation and recovery of change orders; and
b. Cost estimation compared with actual and reason for ‘unders’ and ‘overs’
b. Points forward are recorded on customer files for reference when bidding for future orders from that client or for that type of work.

Freehold land and buildings

1. The land and buildings have been owned by the company for many years and they have no plans to either move, replace or extend them. The owners and board of directors review the space requirements of the business from time to time to consider if they remain appropriate. They are unlikely to be changed before any change in ownership.
2. As part of the annual reporting process, Mr Falmouth, Ms Jolly and Mr Armani perform an informal impairment valuation although this is not documented. They consider if there are any factors that would indicate an impairment in value and whether a formal impairment test is required. No such factors have been identified in recent years.
3. The business operations are situated in a commercial development which is close to residential land. Mr Falmouth believes that the land could easily be converted to land for residential use which would greatly increase its value. The local council are under considerable pressure to build more housing (including affordable housing) in the area. It should be noted that many businesses, especially in manufacturing and construction are moving away from the area due to the high-cost base. Although there is the potential for residential development there is strong local resistance to this due to the strain that extra housing would place on the local services and infrastructure.

Intangible assets

1. The goodwill arose many years ago on the purchase of an unincorporated business by the company. Mr Falmouth and Ms Jolly both had an interest in this business so full independent financial and commercial due diligence was not performed. The amount paid for the business was based on a multiple of predicted earnings which were estimated from the existing performance of the business.
2. The goodwill was originally being amortised over 20 years, but this was changed to 10 years on the adoption of FRS 102 in 2016.
3. Each October, the directors review the business for indicators of impairment, based on the management accounts for the 9 months to 30 September, the current year forecast and budget for the following year. No impairment loss has ever been recognised.

Risk assessment of internal controls

Planning of audit procedures

Comments on the above

Audit work performed can often appear to be completely separate from the work identified as needed at the planning stage. This may be due to the way audit work was documented in a traditional paper-based audit. This approach to recording audit work also ignores the commercial nature of a business.

Audit assertions need to be defined in very clear terms rather than just simply, cut-off, accuracy, completeness etc. We need to use these assertions to direct the work in the appropriate direction and in the appropriate way.

The work to be performed must be suitably relevant and challenging. The auditor should consider what evidence should be available to allow them to form their own opinion. The auditor also needs to consider what information is needed from the client and the accounting records as soon as possible. For example, profit attributable to certain cash generating units for the goodwill valuation.

The auditor will need to consider whether they have the appropriate skills and knowledge to complete the audit engagement. They need to understand the mechanics of a long-term construction project, so that they can challenge and not simply corroborate management’s explanations. This could involve asking for evidence of specific follow up actions taken by management following the monthly project meetings. They will also need to understand how freehold properties are valued to ensure that the estimates used in these areas can be effectively challenged.

It is not illustrated above but the auditor and the audit team need to know how to ask the right question in the right way and at the right time because discussion and questioning of client staff, when done well, will provide a lot of insight into the business, indicators of issues or errors and useful information which could help form our audit opinion. Points to be considered include:

• Who is the best person to ask not just who is available?
• Are we confirming facts which can be achieved with a direct ‘closed’ question, or are we looking to increase our understanding which might need a more open general question. ‘How have you managed to keep everyone busy during the pandemic?’ or ‘How will the situation in Ukraine have any impact on you?’ might be good ways to get the client talking.
• The auditor and the audit team also need to listen and see when a follow up question is needed, where the answer given just doesn’t make any sense in the light of other information available for example.
• Is a virtual meeting sufficient for these discussions or would we get a better discussion with the client if we attend site in person?

Audit conclusions on management bias

Two major areas were identified where management bias might be an important factor in the setting of accounting estimates:

1. The planned retirement of the founder management team and owners and the fact that they have potentially expensive, outside interests to the business; and
2. The planned sale to the existing management team with the introduction of a share purchase scheme through an employee benefit trust.

We considered that point 1 would likely create a risk of assets and profits could be overstated. However, point 2 would more likely result in an understatement of assets and profits to reduce the share value to be used in the management purchase.

We looked in detail at the assumptions and estimates being applied to the calculation of revenue and profits relating to long term contracts ongoing at the year end. Where possible we traced these contracts through to their conclusion post year. For those projects still ongoing, we inspected contract correspondence and spoke with the relevant site foreman. All key sites were visited and inspected as late in the audit as possible.

To provide external evidence and to challenge the assumptions being applied by management, we compared the original planned project timeline; including what services were to be provided by external contractors, when supplies where planned to be delivered and the key sign off dates agreed with the client. We compared theses to the actual dates by reference to supplier and contractor invoices.

On the most material projects we also inspected reports prepared by local authority building inspectors and reviewed for any inconsistencies with other statements and evidence supplied by the client management.

These risks were considered when work was performed on the accounting estimates especially in relation to the long-term contract profit allocation and asset impairment. No evidence was found of any material misstatement arising from bias.

Evaluation of audit procedures

Audit area

Long term contract – estimated costs to complete

Work performed

Inspection of calculation of estimated cost to complete the contract and comparison of the same with external documentation and correspondence. For selected contracts the schedule of costs to complete will be verified by reference to purchase and supplier invoices received post year end. Meeting notes from the most recent monthly project meeting were also inspected together with any other relevant supporting documentation.

Audit findings

Project 2021- 3 was reviewed in detail as this is a new contract that started in the year. Contract costs allocated were £850,000 and costs expected to complete were £725,000. On these numbers the contract is profitable, and a proportion of turnover and profit has been allocated to the 2021 financial results.

On inspection of supplier invoices relating to the contract after the year end, an invoice to the value of £100,000 was identified that was not included on the schedule of estimated costs to complete. On enquiry, this invoice related to a change to the original contract order as the hotel decided to use a more energy efficient heating system for the wellness centre so they can better achieve their Co2 net zero target. A full schedule of work performed is contained in a separate audit working paper (not shown).

The client subsequently amended the calculation of profits and the stage of completeness of the contract, and they have also been negotiating with the client regarding the recovery of these additional works. The new heating system was installed without first being priced, so as to avoid delaying the project and impacting on the opening date as advertised on the hotel’s website. The new facility is already generating additional bookings. The client approval of the additional costs incurred and agreement to pay them was agreed and evidenced in writing after the year end so is a contingent asset as at the year end.

Conclusions

• Based on the work performed it can be concluded that contract 2021- 3 has been fairly presented in the 2021 financial statements and the valuation of expected contract costs and the stage of completion of the contract overall are reasonable.
• Audit testing was extended and to test whether this issue also arose in other material contracts that were ongoing at the year end. We looked at the processes applied and the controls in place over the estimation of future costs and the likely final contract revenue value of ongoing contracts. No further errors or omissions were identified. It was also concluded that there did not seem to be any management bias being applied in this area, rather this was a one-off omission. However, it was noted that the lack of controls in this area allowed the error to occur. This finding should be communicated via the report to management and those charged with governance.
• The wider impact relating to the design and implementation of controls over long-term contracts, change orders (where contract scope is changed after the contract work has started), estimation of expected costs to complete and how contract budgets are prepared and compared to actual results should be considered. Work may need to be extended on other significant contracts to identify if there are any other similar omissions or errors.
• The financial statement disclosures should make clear the significance of the accounting estimates in this area and the level of judgement that needs to be applied. The accounting policies should explain the long-term contract accounting process and how it is specifically applied at Six Island Bay Developments Limited and should also separately disclose the estimation uncertainty. This should perhaps include disclosure of what an impact a 5% understatement of project estimated future costs and project stage of completion would have on key performance indicators such as operating profit and net assets.

Comments on the above

The audit documentation clearly concludes on the issue but makes it clear that the wider issue was considered as was the existence of possible management bias. With clear conclusions being provided on both issues.

Accounting estimates by their very nature are not able to be confirmed with absolute certainty, there will always have to be a degree of estimation that will require the application of judgement. Accounting estimates, the judgements and the key assumptions can be clearly disclosed. This is likely to be the most effective way to resolve any audit issues, by making the appropriate disclosures and perhaps emphasising these disclosures in the audit report.