AAA - Revision Material

Dec 2011 Q3 - Beech

QUESTION

You are a manager in the audit department of Beech & Co, responsible for the audits of Fir Co, Spruce Co and
Pine Co. Each company has a financial year ended 31 July 2011, and the audits of all companies are nearing
completion. The following issues have arisen in relation to the audit of accounting estimates and fair values:

(a) Fir Co

Fir Co is a company involved in energy production. It owns several nuclear power stations, which have a
remaining estimated useful life of 20 years. Fir Co intends to decommission the power stations at the end of their
useful life and the statement of financial position at 31 July 2011 recognises a material provision in respect of
decommissioning costs of $97 million (2010 – $110 million). A brief note to the financial statements discloses the
opening and closing value of the provision but no other information is provided.

Required:

Comment on the matters that should be considered, and explain the audit evidence you should expect
to find in your file review in respect of the decommissioning provision.
(8 marks)

(b) Spruce Co

Spruce Co is also involved in energy production. It has a trading division which manages a portfolio of complex
financial instruments such as derivatives. The portfolio is material to the financial statements. Due to the
specialist nature of these financial instruments, an auditor’s expert was engaged to assist in obtaining sufficient
appropriate audit evidence relating to the fair value of the financial instruments. The objectivity, capabilities and
competence of the expert were confirmed prior to their engagement.

Required:

Explain the procedures that should be performed in evaluating the adequacy of the auditor’s expert’s
work.
(5 marks)
(c) Pine Co
Pine Co operates a warehousing and distribution service, and owns 120 properties. During the year ended 31
July 2011, management changed its estimate of the useful life of all properties, extending the life on average by
10 years. The financial statements contain a retrospective adjustment, which increases opening non-current
assets and equity by a material amount. Information in respect of the change in estimate has not been disclosed
in the notes to the financial statements.

Required:

Identify and explain the potential implications for the auditor’s report of the accounting treatment of the
chance in accounting estimates.
(5 marks)
(18 marks)
 AAA - Revision Material
Dec 2011 Q3 - Beech

SOLUTION

(a) Fir Co

Dismantling provision is future costs and, therefore, their estimation can be uncertain. Given the significance of
the dismantling costs, independent third party estimation of the dismantling costs may be necessary.

The estimate then has to be discounted back to its present value. The entity must use a relevant discount rate in
line with the entity’s general rate of borrowing and not one that is excessively high resulting in a low asset base
and associated depreciation charge. The present value of the dismantling liability should be included in the cost
of the asset which will then be written off over the assets useful life which is stated in the question at 20 years.
Each year the present value of the liability would need to be increased by multiplying it by the rate used for
discounting.

Evidence:

1) Recalculation proving that the discount rate in the calculation is in line with the client’s cost of debt. The
bank letter may provide evidence of the rates of borrowing that the entity is exposed to.

2) The useful life of an asset can be confirmed by review of the license to drill for the 20 years.

3) Recalculation of the interest charge on the audit file showing that the interest rate has been applied to
the closing liability from last year’s financial statements.

(b) Spruce

Procedures:

1) To ensure that where market-based observations of fair value have been used, the terms of the
instrument used for comparison are identical to the terms of the instrument used by our client.

If the terms are not identical we should ensure that any adjustments to the market-based observation
appear reasonable given the difference in terms from the instrument that we are valuing. If there is no
observable data and a fair value model is used, we should ensure that a full range of inputs to the model
has been used by reference to similar models and that the values assigned to these inputs appear
reasonable by reference to industry quoted data.
 2) To test the output from the model against actual valuations to ensure that the model is producing values
that are a fair approximation to the market price.

3) To ensure that any assumptions used by the expert are in line with the auditor’s understanding of the
client, the industry and the financial instruments being valued.

(c) Pine Co

Remember:
When discussing the impact on the auditor’s report it is a good idea to approach your answer in three stages.
The first would be to identify whether there has been an accounting disagreement or a limitation of scope. The
next stage would be to discuss whether the misstatement is material or pervasive. The final stage is for deciding
on the type of opinion to be issued.

There has been an accounting disagreement since changes in accounting estimates should be accounted for
prospectively and not retrospectively.

Although there are no financial values in the scenario if we assumed a value of $100 over 50 years this would
give depreciation of $2 per annum and to write the full value off over 60 years would give a value of $1.6 per
annum. In other words, the reduction in depreciation charge is 0.4% of the asset base and therefore appears
material and not pervasive.

Finally, the audit opinion would be ‘except for’ opinion the incorrect treatment of the change in accounting
estimate the accounts give a true and fair view.

A significant number of properties (120) are subject to this error. It is likely to be material relative to an
adjustment in relation to one property.

In an ideal world, we would be able to look in the marketplace and find an identical instrument to our own. This is
known as a level 1 valuation and presents a little risk since the data is observable and identical to the instrument
that we are valuing.

It is likely, however, that when we look in the marketplace we find an instrument that is similar but not identical to
our own. This is known as a level 2 fair value measurement. It is based on observable data but is subjective in
that a valuation adjustment has to be made in respect of the attribute which is different from our own instrument.
There is a higher level of risk associated with level 2 compared against level 1.

The highest level of risk is for level 3 valuations. This is where there is no observable data and therefore a
modelling technique has to be used. If the model does not include the correct inputs or inappropriate values are
assigned to those inputs, the model will not produce accurate data. This is the highest risk in fair value
measurement since there is no observable data upon which to base the fair value.

The model can be tested by comparing the values produced against actual values and assumptions used can be
tested by reference to the assumptions that others are using in their model.