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ACCOUNTING ISSUES
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TAPintoPaperP7
AverycommonthemeinPaperP7questionsistopresentyouwithinformationthatembodiesan
accountingissue.Sometimestheinformationispresentedasastandalonerequirementbutisoften,for
example,includedinasetofnotesofaconversationwithanauditclientsfinancedirector.
Forexample:
December2012Question1contains:
WorkhasrecentlystartedonanewproductionlinewhichwillensurethatGrohlComeetsnewregulatory
requirementsprohibitingtheuseofcertainchemicals,whichcomeintoforceinMarch2013.InJuly2012,
aloanof$30mwithaninterestrateof4%wasnegotiatedwithGrohlCosbank,themainpurposeofthe
loanbeingtofundthecapitalexpenditurenecessaryforthenewproductionline.
June2012Question1contains:
StarlingCoreceivedagrantof$35mon1March2012inrelationtoredevelopmentofitsmain
manufacturingsite.Thegovernmentisprovidinggrantstocompaniesforcapitalexpenditureon
environmentallyfriendlyassets.StarlingCohasspent$25moftheamountreceivedonsolarpanels
whichgenerateelectricity,andintendstospendtheremaining$10monupgradingitsproductionand
packaginglines.
December2011Question1contains:
On1July2011,OakCoenteredintoaleasewhichhasbeenaccountedforasafinanceleaseand
capitalisedat$5m.TheleasedpropertyisusedastheheadofficeforOakCosnewwebsitedevelopment
andsalesdivision.Theleasetermisforfiveyearsandthefairvalueofthepropertyattheinceptionofthe
leasewas$20m.
Typicallythequestionrequirementswillthenbesomethingalongthelinesof:
EvaluatethebusinessrisksfacedbyXCo.
IdentifyandexplaintherisksofmaterialmisstatementtobeconsideredinplanningtheauditofXCo.
Inrespectoftherisksofmaterialmisstatement,suggestsuitableauditprocedures.

Businessrisks
Rememberthatwhenyouaredescribingbusinessrisks,youshouldsaynothingaboutpotential
misstatementsinthefinancialstatements.Businessrisksexistquiteindependentlyofthefinancial
statementsandtheydonotdependonauditprocedures.Businessriskiswherethedirectorsmakewrong
decisionsorwhereeventshaveoccurredwhichthreatenthebusinesssfuture.Businessrisksareoften
classifiedas:
Strategicrisks(forexample,investinginoutofdatetechnology).
Operationalrisks(forexample,manufacturingproductswhichhavefaults).
Regulatoryrisks(forexample,thefinesanddamagesthatmightbepayableasaconsequenceofbreachinghealth
andsafetyregulations).
Financialrisks(forexample,aninabilitytopayinterestorrentbecauseofpoorcashflow).

Althoughdraftingfinancialstatementsdoesnotaffectthebusinessrisks,understandingthebusinessrisks
cangiveinsightsintowherethefinancialstatementsmightcontainmaterialmisstatements.Forexample,
investinginoutofdatetechnologycouldcausegoingconcernproblemsandqueriesaboutthe

Pakistan

MyACCA

impairmentoftheoutofdate,thoughpossiblyrelativelynew,machinery.Regulatoryriskscangiveriseto
problemsoverassessingandpresentingliabilitiesorcontingentliabilities.
Risksofmaterialmisstatement
Theriskofmaterialmisstatementreferstotheriskthatamaterialmisstatementispresentinthefinancial
statementsthatarebeingaudited.Itisthepurposeoftheaudittoensurethatthesemisstatementsdonot
appearinthepublishedfinancialstatementsoriftheydothatthereisanappropriatelymodifiedaudit
opinion.
Materialmisstatementsattheassertionlevelariseifarelevantassertioniswrong.Forexample,the
amountcouldbeincomplete,avaluationcouldbewrong,atransactionmightnothaveoccurred.
Assertionsalsocoverpresentationanddisclosure.Forexample,theclassificationandunderstandability
assertionrequiresthatfinancialinformationisappropriatelypresentedanddescribed,anddisclosures
areclearlyexpressed(ISA315).
Broadly,therefore,misstatementscanbedividedintotwogroups:
Thetreatmentofthetransaction,eventorbalance,includingitspresentationanddisclosurecouldbeincorrect.
Theamountofthetransaction,eventorbalancecouldbeincorrect.

Theauditormustdevisesuitableprocedurestocollectsufficientappropriateauditevidenceaboutthe
assertionslyingbehindbothoftheseaspectsofitemsinthefinancialstatements.
Remember,thetreatmentmustberight,theamountsmustberightandsufficientappropriateaudit
evidenceisneededforboth.
Sowhenyouarepresentedwithaquestionintheexamaboutfinancialstatementriskandaudit
procedures,dontsitscratchingyourhead:TAPitinsteadandremember:
Treatment
Amount
Procedures
Treatmentandamount
IAS8,AccountingPolicies,ChangesinAccountingEstimatesandErrors,requiresthatfinancial
statementscomplywithanyspecificIASorIFRSapplyingtoatransaction,eventorcondition,and
providesguidanceondevelopingaccountingpoliciesforotheritemsthatresultinrelevantandreliable
information.IntheabsenceofaStandardoranInterpretationthatspecificallyappliestoatransaction,
othereventorcondition,IAS8.10statesthatmanagementmustuseitsjudgmentindevelopingand
applyinganaccountingpolicythatresultsininformationthatis:
relevanttotheeconomicdecisionmakingneedsofusersand
reliablesothatthefinancialstatements:
representfaithfullythefinancialposition,financialperformanceandcashflowsoftheentity
reflecttheeconomicsubstanceoftransactions,othereventsandconditions,andnotmerelythelegalform
areneutral,iefreefrombias
areprudentand
arecompleteinallmaterialrespects

Inapplyingitsjudgment,IAS8requiresmanagementtoconsiderthedefinitions,recognitioncriteria,and
measurementconceptsforassets,liabilities,income,andexpensesintheIFRSconceptualframework.
So,lookingagainatthethreequestionexamplesgivenatthestartofthisarticle:
TheDecember2012Question1raisesthematterofthetreatmentofinterestpayments.Toquotethe
ACCAanswer:
Thenewproductionprocesswouldappeartobeasignificantpieceofcapitalexpenditure,anditiscrucial
thatdirectlyattributablecostsareappropriatelycapitalisedaccordingtoIAS16,Property,Plantand
EquipmentandIAS23,BorrowingCosts.Directlyattributablefinancecostsmustbecapitalisedduringthe
periodofconstructionoftheprocessingline,andiftheyhavenotbeencapitalised,noncurrentassetswill
beunderstatedandprofitunderstated.
TheJune2012Question1raisesthematterofthetreatmentofgovernmentgrants.ToquotetheACCA
answer:
StarlingCohasreceivedagrantof$35minrespectofenvironmentallyfriendlycapitalexpenditure,of
which$25mhasalreadybeenspent.Thereisariskintherecognitionofthegrantreceived.Accordingto
IAS20,AccountingforGovernmentGrantsandDisclosureofGovernmentAssistancegovernmentgrants
shallberecognisedasincomeovertheperiodsnecessarytomatchthemwiththerelatedcostswhich
theyareintendedtocompensate.Thismeansthatthe$35mshouldnotberecognisedasincomeon

receipt,buttheincomedeferredandreleasedtoprofitovertheestimatedusefullifeoftheassetstowhich
itrelates.Thereisariskthataninappropriateamounthasbeencreditedtoprofitthisyear.
TheDecember2011Question1raisesthematteroftreatmentofalease.ToquotefromtheACCA
answer:
TheleasetakenoutinJuly2011hasbeentreatedasafinancelease.However,thereareindicationsthat
itisinfactanoperatinglease.First,theleaseisforonlyfiveyears,whichforapropertyleaseisnotlikely
tobeforthemajorpartoftheeconomiclifeoftheasset.
AccordingtoIAS17,Leases,anindicatorofafinanceleaseisthattheleasetermisforthemajorpartof
theeconomiclifeofanasset.
Second,theamountcapitalisedof$5mrepresentsonly25%ofthefairvalueoftheasset.UnderIAS17,
foraleasetobeclassifiedasafinancelease,thepresentvalueofminimumleasepayments(theamount
capitalised)shouldamounttoatleastsubstantiallyallofthefairvalueoftheasset.25%isnot
substantiallyallofthefairvalue,indicatingthatthisisactuallyanoperatinglease.
Havingdeterminedthecorrecttreatmentforatransaction,eventorbalance,itsamountcanthenbe
tackled.Sometimestheaccountingstandardcanbeveryprescriptive.Forexample,thecorrecttreatment
ofinventoryistovalueitatthelowerofcostandNRVandcostcanbebasedonaveragecostsorFIFO
butnotLIFO.Anotherexampleisfoundinthecalculationofimpairmentwherethecarryingamount(the
amountatwhichanassetisrecognisedinthebalancesheetafterdeductingaccumulateddepreciation)
cannotbemorethanitsarecoverableamount,iethehigheroffairvaluelesscostsofdisposalandvalue
inuse).Calculationswillbeneededtodeterminebothoftheseamounts.
Procedures
Ifmaterialmisstatementscanbecausedbyeitherwrongtreatmentorwrongamounts,thenaudit
evidenceisneededtoverifythatbothoftheseareacceptable.
TakingthecapitalisationofaleaseintheDecember2011example,evidenceisneededastowhetheror
notitshouldbetreatedasafinanceoroperatingleaseand,dependingonitstreatment,evidenceisthen
neededabouteithertheamountcapitalisedortheamountappearingasanexpense.Sometimes,as
here,theevidencewillbeprovidedinthequestion,butsometimesyoucanbeaskedtosuggestwhat
proceduresareneededtofindtheevidence.
ISA500,AuditEvidence,categorisestheproceduresavailabletoauditorsas:
Inspection
Observation
Externalconfirmation
Recalculation
Analyticalprocedures
Enquiry

Thesearehighlevelcategoriesofproceduresandspecific,preciseprocedureshavetobedescribed
whichwillbothverifythecorrecttreatmentandthecorrectamount.WherearelevantInternational
StandardsinAuditingexistsanyproceduresstipulatedmustbefollowed.Forexample:
ISA501describesproceduresforauditinginventory,litigationclaimsandsegmentreportinginformation.
ISA505setsoutproceduresforobtainingexternalconfirmations.
ISA530setsoutproceduresandothermattersrelevanttoauditsampling.
ISA560setsoutproceduresrelatingtopostbalancesheetevents.
ISA570setsoutproceduresrelatingtothevalidityofthegoingconcernassumption.

However,bynomeansallprocedurescoveredbyISAsandcandidatesmustbeabletosuggest

proceduresthatwillhelpinthecollectionofappropriateauditevidenceforboththetreatmentofitemsin
accordancewiththeaccountingstandardsandfortheiramounts.
So,proceduresrelevanttocollectingevidenceaboutthereceiptofagovernmentgrant(Q1fromJune
2012):
Treatment:
Inspectthegrantapplicationandsubsequentcorrespondencewiththegovernmentdepartmenttoverifytheamount
andpurposeofthegrant(ietoensureitisagrantrelatingtononcurrentassets).
Tracethecreditentryinrespectofthegranteithertoadeferredincomeaccountortothecreditoftheappropriatenon
currentassetregisterentriesandtheappropriatenoncurrentassetcontrolaccount.
Ifcreditedtoadeferredincomeaccount,inspectentriesshowingthatitisbeingreleasedtoincomeovertheexpected
lifeoftheasset.

Amount:
Inspectthegrantapplicationandsubsequentcorrespondencewiththegovernmentdepartmenttoverifytheamount
andpurposeofthegrant.
Inspecttheboardminutesformentionofthegrant.
Tracereceiptofthegranttothebankaccount.
Iftheamountisbeingreleasedformadeferredincomeaccount,reperformthecalculationrelatingtotheamount
releasedtoincomeinthecurrentfinancialperiod.
Iftheamountiscreditedtothecostoftheassetreperformthedepreciationcalculationtoensurethatdepreciationis
basedonthenetcostoftheassetafterthegrantiscredited.

Conclusion
RememberTAP:
Financialstatementswillnotprovideatrueandfairviewiftheyincludematerialmisstatements.
MisstatementscanbecausedbyeitherincorrectaccountingTreatmentorincorrectAmounts.
AnauditrequiresProcedurestocollectevidenceaboutbothtreatmentandamounts.

KenGarrettisafreelanceauthorandlecturer

Lastupdated:18Aug2015