QUESTION: Winter 2019

You are the audit manager assigned to the audit of Astron Computers Limited (ACL) for the year ended
30 November 2019. Following information is available:

i)
The main business of the company is the importation of servers, laptops, desktop
computers, LCD screens and related accessories for sales to large customers and retailers.
ACL was incorporated in 2002 and operated profitably until 2016 when it turned into a loss-
making entity due to increased availability of refurbished computers in the market.

ii) Extracts from the draft profit and loss account:

2019 2018
Description
Rs. In 'million'
Sales 430 648
Cost of sales (388) (583)
Loss before taxation (32) (64)

iii) Draft statement of financial position:

2019 2018 2019 2018
Assets Equity & Liabilities
Rs. In 'million' Rs. In 'million'
Non-current Assets Equity and reserves
Fixed Assets 45 51 Share capital 6 6
Deferred tax 27 24 Reserves 27 50
72 75 33 56
Current Assets: Non-current
Inventories - in hand 97 90 Warranty provision 9 16
Inventories - in transit 12 7
Trade receivables 90 81 Current liabilities
Cash and bank 1 2 Payables 50 30
200 180 Provisions 172 138
Running finance 8 15
230 183
272 255 272 255

iv) In June 2019, ACL decided to discontinue import and sale of desktop computers and LCD
screens and to concentrate selling servers and laptops. It also decided to introduce an All-In-
One PC which is not currently available in the refurbished market. To further boost the
sales, ACL has started offering extended warranties in addition to a two-year warranty
period for all of its products at a nominal increase in price. ACL is presently negotiating with
its bank to enhance the running finance facility in order to meet the additional working
capital requirements.

v)
In September 2018, ACL had entered into contracts with two leading chains of schools for
supplying 20,000 desktop computers and LCD screens at a nominal margin. ACL has already
supplied 6,000 units before deciding to discontinue this product segment. ACL is presently
negotiating with the management of both schools to change the contract from the supply
of desktop computers and LCD screens to All-In-One PC. One of the schools has agreed to
this change while negotiations with other school is in progress. In case, the other school
does not agree to the change, ACL would either terminate the contract by paying a penalty
 In September 2018, ACL had entered into contracts with two leading chains of schools for
supplying 20,000 desktop computers and LCD screens at a nominal margin. ACL has already
supplied 6,000 units before deciding to discontinue this product segment. ACL is presently
negotiating with the management of both schools to change the contract from the supply
of desktop computers and LCD screens to All-In-One PC. One of the schools has agreed to
this change while negotiations with other school is in progress. In case, the other school
does not agree to the change, ACL would either terminate the contract by paying a penalty
of Rs. 6 million or procure the remaining units from any other supplier whose cost might be
even more than the contract price.

vi)
In May 2019, ACL ordered desktop computer accessories at a landed cost of Rs. 20 million
from a company based in Hong Kong. Due to the political unrest in Hong Kong, the
shipment was delayed for more than five months despite the ordered units were
manufactured on time. On discontinuance of the business of desktop computers and LCD
screens, ACL asked the manufacturer to cancel the order. However, the manufacturer
refused to cancel the order. In November 2019, the manufacturer shipped the ordered units
which were received by ACL on 2 December 2019. CEO has informed that they are under
negotiation with a local distributor to dispose of the entire desktop computer accessories.

Required:
Discuss the audit risks that exist in the above scenario and suggest the key audit procedures that you
would perform to address those risks.

i) Going concern:

There is a risk that there is a material uncertainty related to going concern of ACL since:
• it is the third consecutive year in which the company is making loss and the revenue has
also fallen by 34% as compared to previous year.
• current liabilities exceed the current assets and the current ratio has decreased from 0.98 to
0.87.

ii) Fraudulent financial reporting:

Since the company is planning to enhance the running finance facility and the results of the
company have also not been encouraging, there exists a risk of fraudulent financial
reporting to present better results for obtaining the loan.

iii) Warranty provision:

There is a risk that ACL has not recognized the warranty provision correctly because the
warranty provision has decreased by almost the same percentage of the decrease in
revenue, despite the fact that ACL is offering extended warranties. Further, even if the
revenue decreases it is not necessary that the warranty provision would also decrease
because it also covers the sales of prior years.
 There is a risk that ACL has not recognized the warranty provision correctly because the
warranty provision has decreased by almost the same percentage of the decrease in
revenue, despite the fact that ACL is offering extended warranties. Further, even if the
revenue decreases it is not necessary that the warranty provision would also decrease
because it also covers the sales of prior years.

There is also a risk that the price at which extended warranty is offered is recognized as
revenue at the time of sale.

iv) Inventories - in transit:

The inventories in transit reported in the financial statements is Rs. 12 million whereas the
inventories ordered from Hong Kong only is worth Rs. 20 million. It appears that ACL have
not yet accounted for such inventory.

It also needs to be ascertained the value of the inventory at which it needs to be reported,
i.e. (either at cost or NRV).

v) Onerous contracts:

There is a risk that due to the increased cost, the pending orders may result in an onerous
contract and ACL would have to recognize a provision for the present obligation.

vi) Deferred tax:

Deferred tax asset can only be recognized to the extent that ACL expects that it would
generate sufficient profits to realize the benefit. In the given scenario it seems difficult for
the company to generate sufficient taxable profits in the near future to realize the deferred
tax assets.

vii) Foreign exchange translation:

Since the company is exposed to foreign exchange risk due to significant imports, there is a
risk that gains and losses on translation of foreign currencies are wrongly credited/debited
to purchases instead of charging to profit and loss account.

viii) Trade receivables:

Despite a significant decrease in sales, the debtor balances have increased. Furthermore,
the debtor collection period has increased from 1.5 months to 2.5 months.

ix) Inventory obsolescence:

The inventory in hand has almost remained same despite a 34% decrease in sales.
Furthermore, the inventory turnover rate has increased to 3 months as compared to 1.8
months in the previous years.
QUESTION:

You are the audit manager of Mehmood Auto Limited (MAL), a listed company, for the year ending 31
December 2017. MAL assembles and manufactures a wide range of motor vehicles. All motor vehicles sold by
MAL are under warranty up to a mileage of 50,000 km and are also eligible for free service every quarter for
two years.

The extracts from the draft financial statements prepared by the management are as follows:
2017 2016
Description
Rs. In 'million'
Revenue from sales of motor vehicles 54,000 70,000
Revenue from sales of spare parts 1,500 1,000
Cost of sales (49,950) (63,190)
Gross profit 5,550 7,810

Assets
Property, Plant and Equipment 6,600 4,510
Deferred tax 233 194
Instalment sales receivables 1,200 700
Stock in trade 16,000 13,000
Other assets 13,817 15,476
37,850 33,880

During the course of the audit, you came to know that there have been 37 instances of serious accidents
involving newly manufactured cars where MAL had to pay compensation aggregating Rs. 145 million plus
cost of repairs amounting to Rs. 14 million.

An investigation into the matter has revealed that 15 such accidents were because of failure of the brakes.
The management has assured you that the fault has been identified and appropriate corrective measures
have been taken in this regard. However, you have noted that the entire compensation amount is being
shown as receivable from a supplier who has provided the brake system.

Required:
Identify the audit risks in the above situation and specify the key audit steps which you will perform in respect
thereof.

SOLUTION:
Following are the risks in the given situation and the related procedures which may be undertaken:

i) Litigations and claims:

Risk:
Even though the company has to pay Rs. 145 million in damages and Rs. 14 million in repairs, there is
• still a risk that our audit team might not be aware of further damage claims filed against MAL.
• There is also a risk that further accidents may occur or further cases are filed against MAL after the
balance sheet date.
ii) Impairment of plant and machinery
Risk:
• Sales of MAL has declined by 23% and is expected to remain under pressure in the future also, because
of the situation. Therefore, there is a risk that value in use of the plant and machinery may have been
reduced.

iii) Warranty provision

Risk:
• In the given scenario, the probability / size of warranty claims may exceed the initial estimate and
therefore the existing provision may not be adequate.

iv) Write down of inventory to NRV:

Risk:
•
There is a risk that the company might not be able to sell the affected cars or witness decline in its
price, therefore there is a risk that net realizable value of the inventory may be lower than its cost.

v) Refund liability:
Risk:
• There is risk that the customers might return back cars or MAL may have to recall sold cars.

vi) Receivable from supplier:

Risk:
• MAL cannot record a receivable from the supplier until it is virtually certain that the amount will
received, therefore, there is a significant risk that receivable may need to be written off.

vii) Provision for doubtful installment sales receivable:

Risk:
• The sales for the year have decreased but the installments sales receivable has increased. It indicates
that there is a risk that more than usual number of installments may have become overdue and might
not be recoverable.

viii) Separate revenue for free service:

Risk:
• Providing free service after a certain mileage is a separate performance obligation. As it is provided to
all customers, it’s revenue should be recorded separately by appropriately bifurcating the revenue
from sale of cars. There is a risk that the revenue may have been included in the revenue from sale of
motor vehicles.
QUESTION:

You are the engagement manager in Hasan Abdali and Company, Chartered Accountants. One of your clients is
Falcon Limited (FL) which owns six shopping malls and four office building complexes in different cities for rental
purposes. FL also constructs and sells residential apartments in major cities of Pakistan.

The following matters were discussed in the planning meeting of the audit for the year ending 31 December
2018:

i) CFO informed that FL has implemented a new enterprise resource planning system (ERP). He stated that FL
has successfully revamped the entire accounting system through this new ERP.

ii) A shopping mall located in Multan has been witnessing low turnout of customers. FL has been trying to
persuade its tenants for not vacating their shops and have offered that they pay 50% of the rent and pay
the remaining amount when conditions improve. Some of the tenants have accepted FL’s offer and have
formally negotiated a two-year relaxation period.

iii) FL’s head office was shifted to a central location in a newly constructed building. Two floors of the building
which were surplus to FL’s need have been rented out to MM Limited (MML) which is owned by a director of
FL. MML provides maintenance services to various building projects. FL and MML have agreed that FL will
not charge any rent for the two floors in consideration for free maintenance of Multan shopping mall and
the head office.

iv) Construction of four residential projects started during the year. The projects are in various stages of
completion. About 70% of the apartments have already been booked. FL offers different terms to its
customers depending upon which option they choose.

v)
The balcony of one of the apartments constructed in 2012 fell off, severely injuring three persons. The news
surfaced in the media and caused severe criticism on FL and a show cause notice was also received by FL
from a regulatory authority. FL’s management is of the view that the construction was up to the required
standards and the residents had made some modifications which caused this incident.

Required:
Discuss the audit risks that exist in the above scenario and suggest the key audit procedures to be performed in
respect of the identified risks.

SOLUTION:
i) Risk of improper implementation of ERP:
Improper implementation of new ERP system creates the risk of generating incorrect financial information
and records.
There is a risk of improper capitalization of the cost of new ERP or the useful live for calculating the
amortization may not be appropriate.
ii) Risk of decrease in fair valuation of investment property:
There is an inherent risk in the fair valuation of investment property because of the estimates and
judgements involved.

iii) Risk of classification and impairment of receivables:

There is a risk that amounts due from tenants who have not availed the offer may have incorrectly been
classified as non-current assets and vice versa.

Furthermore, due to low turnout of customers and the fact that the tenants won’t be paying 50% of the rent
for two years, a provision of doubtful receivables may need to be made against rent receivable.

iv) Risk of related party transactions:

There is a risk of inappropriate classification of the two floors given to MML. The two floors could be
classified as PPE as well as investment property, depending upon the conditions specified in the IFRS.
Letting out two floors to MML is a related party transaction. There is a risk that the transaction with MML
may have not been made on arm’s length. Moreover, the way the agreement has been made poses a risk of
incorrect determination of the amount of revenue and expenses to be recognized.

v) Risk of revenue recognition:

There is a risk of error in recognizing the revenue from the construction of residential apartments as
different basis of recognition have been specified by the IFRS i.e. it is either recognized at a point in time or
over the period of completion. In case the terms of sale agreement suggest that revenue should be
recognized over the period then there is a risk that the stage of completion may not be correctly assessed,
resulting in over or under statement of revenue.
vi) Litigation and claim:
There is a risk that a provision for damages may be required to be made in the financial statements for
injuries caused by fall of the balcony.
Further, if fault in construction is proved, a provision for repair cost/fine related to other apartments may
also be required.

vii) Risk related to negative publicity:

Due to the falling of balcony and the resultant media criticism, there is a risk of serious damage to the
reputation of the company.
QUESTION:

Your firm has been appointed as the auditor of Best Industries Limited (BIL) for the year ending 30 June 2019. BIL
is a listed company and has three production plants. Plants A and B manufacture industrial chemicals whereas
Plant C is used in manufacturing of various cosmetic and skin care products.
The following information has been gathered by the audit team:

i) Ghufran is the CEO and holds, directly and indirectly, majority of the shareholdings in BIL. There are seven
other directors on the board who meet four times a year to approve the quarterly financial statements and
endorse the decisions taken by Ghufran during the quarter.

ii) Considering the decline in demand of the products, BIL has taken the following decisions during the year:
• Close Plant B with effect from 31 August 2019. The public announcement of this decision was made on 15
April 2019.
• Introduce a new incentive package for distributors in January 2019 to boost the sales of industrial
chemicals. The sales commission rate is dependent on achieving the various annual target levels set by the
BIL’s management.
• Launch a customer loyalty program in February 2019 in which customers are awarded loyalty points on
each purchase of cosmetic and skin care products from selected retail outlets and online stores. The
management believes that this initiative would increase the demand of cosmetic and skin care products.

iii) Staff at production and marketing departments are hired at low salaries but they are given high annual
bonuses on achieving their targets.

iv) Last year, BIL was selected for tax audit in which the income tax department had disallowed certain
business expenditures. BIL filed an application against the order issued by the income tax department.
However, it lost the first appeal and has recently filed a second appeal to the relevant income tax authority.

Required:
Discuss the audit risks that exist in the above scenario and suggest the key audit procedures that you would
perform to address those risks.

SOLUTION:
i) Opening balances:
It is the first year audit and there is the possibility that prior year balances are materially misstated, are not
correctly brought forward and the accounting policies are not consistently applied.
ii) Ineffective governance structure
Ghufran being the majority shareholder and taking all the decisions, which are later on endorsed by the
board indicates that the board may be overly influenced by Ghufran. This ineffectiveness may affect the
company’s operational efficiency, control environment, exposure towards legal and regulatory risks, etc.

The Board of Directors meets four times only for approving the accounts, there is a risk that BIL may be in
non-compliance of Code of Corporate Governance which require the board to have other sub-committees of
HR, risk, etc. and their related meetings.
iii) Fraudulent financial reporting / management override of controls:
Due to the dominant nature of Ghufran and ineffective governance structure there is a risk of management
override of controls.

Furthermore, there is an increased risk of fraudulent financial reporting as the staff in production and
marketing department receive low salaries but are given high annual bonuses on achieving their annual
targets.
iv) Assets held for sale
There is a risk that the criteria for classification of non-current assets as held for sale is not met resulting in
in-appropriate accounting and disclosures.
In case the criteria for recognition as held for sale is met there is an inherent risk, due to the high level of
judgment, involved in estimating the fair value and the significant carrying amounts of the assets and
liabilities associated with it.

v) Restructuring costs and liabilities

Since BIL has decided to close one of the chemical production plant and public announcement has been
made in this regard, there exists a risk that restructuring provision might not be appropriately recorded and
disclosed.

There is also a risk that the criteria for recognition of restructuring provision is not met resulting in in-
appropriate accounting and disclosures.

vi) Sales commissions:

Since the commission paid to distributors depends on achievement of annual targets, judgement would be
required in assessing whether they would be able to meet their targets and accruing the sales commission
accordingly.
vii) Loyalty programs:
There is significant judgement involved in determining whether customers would make future purchases
and redeem their loyalty points. Therefore, there is a risk of material misstatement in recoding revenues
and associated liabilities resulting from such transactions.

viii) Tax liabilities:

There is a risk of material misstatement due to the high level of judgment required to assess the outcome of
tax litigations.

ix) Impairment of plant and machinery:

Decline in demand of BIL’s products is an indicator of impairment of the plant and machinery. Therefore,
there is a risk that the plant and machinery may have been impaired0

x) Inventory:
There is a risk that that due to decline in the demand of BIL’s product, there may be obsolete inventory
which require to be written down to net realizable value
QUESTION:

You are the audit manager of Maryam & Company, Chartered Accountants, responsible for planning the audit of
Turbo Pakistan Limited (TPL) for the year ending 30 June 2022. TPL is engaged in selling branded motorcycles
which it imports from China.

After obtaining the preliminary understanding and performing the related procedures, your audit team has
presented the following significant matters:

i) TPL provides one-year warranty on the motorcycles. The warranty covers free of cost repair of any defect
and replacement of any faulty part. Up to last year, TPL maintained a warranty provision of 6% of total
sales.

The management has informed that the quality of motorcycles has significantly been improved over the
period and they are considering the reduction in warranty provision. The audit team reviewed the last year
provision and observed that actual claims were slightly higher than the provision.

ii) During the year, in order to boost sales, TPL has relaxed its credit policy from 30 days to 60 days. This
relaxation is expected to increase the sales by at least 10% as compared to last year. Up to last year, TPL
maintained provision for bad debts at 5% of the total debtors balance at year-end. The management has
informed your audit team that TPL will continue to maintain the same level of provision for current year as
well.

iii) The internal auditors of TPL reported that cash collected from certain small dealers were not recorded and
deposited in the bank on timely basis and they have recommended to avoid cash collections from dealers.

Required:
Identify and discuss the audit risks from the above information and explain auditor’s response to each risk in
planning the audit of TPL.

SOLUTION:

i) Audit risk related to warranty provision:

Since TPL is an importer of motorcycles and is not involved in manufacturing process, it has no control over
quality of motorcycles. Further, last year’s warranty provision was also not adequate as actual claims
exceeded the provision made by the management. This shows that TPL’s management assumptions
regarding provision are not adequate.

Considering the above matters, reduction in the provision will enhance the risk of understatement of
warranty provisions.
ii) Audit risk related to doubtful debts:
TPL has relaxed its credit policy as compared to last year, resulting in increase in receivable collection
period and aggregate amount of debtors at year-end. Maintaining same level of provision for doubtful
debts will enhance risk of understatement of doubtful debts provision.As a result, the receivables maybe
overstated.
iii) Audit risk related to financial risk management:
TPL has increased its debtor collection period, however there is no change in the credit period for the
import of motorcycles. It increases the credit risk and liquidity risk of TPL. There is a risk that it might not be
appropriately disclosed in the financial statements under financial risk management.
iv) Audit risk related foreign exchange translation:
TPL is importing motorcycles from China, it would face foreign exchange rate fluctuations and would have
to translate its outstanding liabilities and transactions which would result in exchange gain or loss. There is
a risk that it might not be correctly recorded.

v) Audit risk related to fraud/misrepresentation:

TPL’s policy to allow cash collection from customers is one of the causes of frauds /misappropriation. Since
the company has not discontinued cash collection policy from its dealers, the risk of fraud and
misappropriation is still there.
QUESTION:

You are the audit manager of Maryam & Company, Chartered Accountants, responsible for planning the audit of
Turbo Pakistan Limited (TPL) for the year ending 30 June 2022. TPL is engaged in selling branded motorcycles
which it imports from China.

After obtaining the preliminary understanding and performing the related procedures, your audit team has
presented the following significant matters:

i) TPL provides one-year warranty on the motorcycles. The warranty covers free of cost repair of any defect
and replacement of any faulty part. Up to last year, TPL maintained a warranty provision of 6% of total
sales.

The management has informed that the quality of motorcycles has significantly been improved over the
period and they are considering the reduction in warranty provision. The audit team reviewed the last year
provision and observed that actual claims were slightly higher than the provision.

ii) During the year, in order to boost sales, TPL has relaxed its credit policy from 30 days to 60 days. This
relaxation is expected to increase the sales by at least 10% as compared to last year. Up to last year, TPL
maintained provision for bad debts at 5% of the total debtors balance at year-end. The management has
informed your audit team that TPL will continue to maintain the same level of provision for current year as
well.

iii)
The internal auditors of TPL reported that cash collected from certain small dealers were not recorded and
deposited in the bank on timely basis and they have recommended to avoid cash collections from dealers.

Required:
Identify and discuss the audit risks from the above information and explain auditor’s response to each risk in
planning the audit of TPL.

SOLUTION:

i) Audit risk related to warranty provision:

Since TPL is an importer of motorcycles and is not involved in manufacturing process, it has no control over
quality of motorcycles. Further, last year’s warranty provision was also not adequate as actual claims
exceeded the provision made by the management. This shows that TPL’s management assumptions
regarding provision are not adequate.

Considering the above matters, reduction in the provision will enhance the risk of understatement of
warranty provisions.
Audit procedures:
• Obtain evidences from management on the basis of which they represented improvement in quality of
motorcycles. This may include correspondence with the supplier regarding steps taken by them for
improving the quality, if any.
• Review contracts or orders for the terms of the warranty to gain an understanding of the obligation.
• Perform analytical procedures to compare the level of warranty provision year on year basis, and compare
prior years actual claims to budgeted provisions.
• Perform comparative analysis of claims lodged in previous year and current year and conclude whether it
indicates declining trend.
• Review the calculation of warranty provision made by management and evaluate its reasonableness in the
light of claims received in the period.
• Review the management underlying assumptions supporting their provision and their rationale.
• Review claims made in subsequent year to assess reasonableness of provision recommended by the
management.

ii) Audit risk related to doubtful debts:

TPL has relaxed its credit policy as compared to last year, resulting in increase in receivable collection
period and aggregate amount of debtors at year-end. Maintaining same level of provision for doubtful
debts will enhance risk of understatement of doubtful debts provision.As a result, the receivables maybe
overstated.
Audit procedures:
• Review and test the controls placed by management to assess the recoverability of receivable balances and
other credit control processes to ensure that they are operating effectively.
• Carry out review of the working of provision for doubtful debts made by management and ensure that
appropriate provision has been made.
• Perform procedures to review recoveries made from debtors subsequent to yearend.
• Obtain age analysis report and review overdue balances which require provisioning.
• Circulate confirmation to the debtors and enquire if there are any disputes with any dealers for
recommending additional provisions.

iii) Audit risk related to financial risk management:

TPL has increased its debtor collection period, however there is no change in the credit period for the
import of motorcycles. It increases the credit risk and liquidity risk of TPL. There is a risk that it might not be
appropriately disclosed in the financial statements under financial risk management.
Audit procedures:
• Obtain the disclosures prepared by the management and verify that it is properly disclosed.

iv) Audit risk related foreign exchange translation:

TPL is importing motorcycles from China, it would face foreign exchange rate fluctuations and would have
to translate its outstanding liabilities and transactions which would result in exchange gain or loss. There is
a risk that it might not be correctly recorded.

Audit procedures:
• Check that appropriate exchange rates used in translation of foreign currency
• Check on a sample basis that any gains/losses arising on the translation of foreign currency are correctly
recognized as per the requirements of IAS-21.

v) Audit risk related to fraud/misrepresentation:

TPL’s policy to allow cash collection from customers is one of the causes of frauds /misappropriation. Since
the company has not discontinued cash collection policy from its dealers, the risk of fraud and
misappropriation is still there.
 Audit procedures:
• Discuss with CFO and CIA regarding details of findings reported by internal audit with regard to cash
collection not timely recorded and deposited in the bank.
• Enquire what procedures have been adopted to date for identified adjustments, if any, based on internal
audit findings.
• Review the evidences gathered by the internal auditor in respect of their findings.
• Enquire further with CFO about what additional controls have been placed to prevent any such
irregularities in future.
• Perform additional substantive procedures on receivables, cash collections and bank reconciliation. In
addition, the audit team should maintain professional skepticism in view of risk of fraud.
QUESTION:

Your firm has been appointed as the auditor of a recently launched innovative food business venture by the
name of Macaw Foods (Private) Limited (MPL). Extracts from draft financial statements for the year ended 31
October 2021, provided by the management are as follows:

Rupees
Statement of Profit or Loss
Joining fee – non refundable 12,500,000
Service charges 50,000,000
Profit on supply of ingredients 7,500,000

Statement of financial position:

Current assets:
Inventory 12,000,000
Cash and bank 10,000,000
Current Liabilities:
Payable to restaurants (net of service charges and profit on
ingredients) 10,000,000
Equity:
Share capital 300,000,000

Following additional information is available regarding MPL:

Background:

Marium and Mujtaba are the co-founders of MPL and are also involved in the entity’s operational activities. They
had approached a venture capital fund (the fund) for financing the start up. The fund financed MPL in return of a
40% equity stake in the business. Being a high risk investment for the fund, they have a superior right on MPL’s
assets and payouts over other stakeholders. Remaining amount was raised through a Rs. 100 million bank loan.

Operations:
MPL has established large shared kitchens in the key localities of the city where MPL offers restaurants to scale
up and have immediate presence in that locality. If a restaurant brand joins MPL, all it needs to do is to share its
recipe with MPL’s team. On receiving the order, MPL will be responsible for sourcing of ingredients, cooking with
care to packaging and delivering it to the customers. The restaurants thus save huge costs of setting up their
own infrastructure through partnership with MPL.

To partner with MPL, restaurants have to enter into a three year contract under which they are required to pay a
non-refundable joining fee of Rs. 100,000 and a 30% service charge for order delivered by MPL and 25% service
charge for order delivered by any third party food delivery company. In addition, restaurants are also charged
for the cost of commonly used ingredient on a standard rate communicated to all restaurants on the first day of
the month. However, specialized ingredients are required to be supplied by the restaurants themselves. MPL
purchases ingredients in bulk quantity and resultantly obtains huge discounts. MPL’s management has
presented profit on ingredients in its financial statements on a net basis as they believe that they are acting as
an agent for restaurants.
Invoicing:
An electronic data interchange system has been set up which directly connects MPL with the restaurants
ordering system. Weekly invoices are also automatically shared with restaurants. Restaurants which do not
operate an online ordering system are catered manually. A separate ledger is maintained for each restaurant in
which all receipts and payments are recorded. Each restaurant is invoiced weekly on the basis of their ledger
balance. Being a recent start up, MPL is a bit understaffed as there are only two accountants who are
responsible for managing, processing and recording all cash inflows, outflows and preparation of management
reports.

Required:
Discuss the audit risks that exist in the above scenario and suggest the key audit procedures to be performed in
respect of identified risks.

SOLUTION:
S.no Audit Risks
1) Since the fund has preferential rights over payouts and preferential rights on liquidation, it appears to be
preference shares.
It needs to be determined whether it is equity or liability. Furthermore, all class of shares needs to be
separately disclosed in the financial statements.

2) If the preference shares are considered as debt, then the gearing ratios of MPL will be badly affected. This
may also have an effect on debt covenants agreed with the bank. Therefore there is a risk that MPL may
have breached some of the covenants.

3) It appears that all the fee has been recognized as revenue. It needs to be determined whether to recognize
revenue from non-refundable fee on receipt basis or over the contract term.

4) Instead of presenting the markup on ingredients on a net basis, it may adopt gross presentation of revenue
and expenses, because MPL carries all the risk and reward related to inventory; therefore, it is acting as a
principal.

5) There is an increased level of dependency on the computer systems of MPL and restaurant. There is a risk of
unauthorized data amendments and data errors which may go unnoticed.

6) There is a risk that MPL may not fulfill the condition to offset the financial asset and liabilities.
Furthermore, since net payables are presented in the balance sheet, there is a risk that a receivable balance
of a restaurant may have been off-set with payable of another.

7) Identify restaurants who only have receivable or payable balances and ensure that they are not set-off with
other balances.
Due to under staffing there may not be effective segregation of duties, which may be.
In this business there is a very high cash turnover which may be susceptible to theft.

8) The restaurants who are not linked with MPL’s EDI, their transactions are recorded manually. Due to the
complexity of the system and the understaffing there is a risk that the recording of such transactions may
be misstated.
 The restaurants who are not linked with MPL’s EDI, their transactions are recorded manually. Due to the
complexity of the system and the understaffing there is a risk that the recording of such transactions may
be misstated.

9) Since MPL holds the recipes of various restaurants, there is a risk that if any recipe is leaked the restaurant
may initiate litigation against MPL.

10) There is a risk that the inventory provided by the restaurant may be mixed with MPL’s inventory.
As the inventory in food business is of highly perishable nature, there is a risk that inventory which is not
usable has not been written off.