QUESTION TWO
The following is the draft balance sheet of ACGC Limited for the year ended 31 March 2012.
ACGC LIMITED
BALANCE SHEET AS AT 31 MARCH 19X9
20112012
KshKsh
Fixed Assets
Tangible assets99,400 73,000
Investments 85,100 101,400
184,500 174,400
Development expenditure 59,810
244,310 174,400
Current Assets
Stock58,190 63,010
Debtors184,630 156,720
Cash at Bank and in hand 9,970 62,620
252,790 282,350
Creditors: amounts falling due within one year 276,510 215,900
Net current (liabilities)/assets (23,720) 66,450
Total assets less current liabilities220,590 240,850
Creditors: amounts falling due after more than one year 53,100 46,320
Provisions for liabilities and charges
Deferred taxation 3,080 2,520
Capital and reserves
Share capital 89,700 89,700
Share premium account 11,300 11,300
Revaluation reserve 9,750 9,750
Profit and loss account 63,660 81,260
174,410 192,010
ACGC Ltd produces garden furniture and has incurred expenditure during the year ended 31 March 2012 on the development of moulding for a new range of plastic garden furniture. The directors wish to carry forward the development expenditure indefinitely as they feel that the company will benefit from the new mouldings for many years. The product range is being developed because profits have been declining over the last few years owing to the uncompetitiveness of the products made by the company. The company has sold many of its fixed assets during the year and purchased new machinery which will enable the company’s productivity to increase. The directors decided not to fund the above expenditure using outside finance but to generate the necessary resources internally by taking extended credit from its suppliers and utilising its liquid funds held at the bank. The company also sold part of its investments, which are made up of stocks and shares of public limited companies.
One of the reasons for this method of financing the expenditure was that the company already has a loan of Ksh 45,000 outstanding which has been included in the figure for creditors: amounts falling due after more than one year. This loan is secured on the fixed assets of the company and is repayable over ten years. The sale of the fixed assets and investments did not yield as much as was expected and a small loss on sale of Ksh1, 200 has been included in the profit and loss account as part of the amounts shown for `other expenses’.
As well as selling some of its assets the company had the remainder revalued by a professional valuer. The gain on revaluation of fixed assets has been credited by the company to the profit and loss account and treated as an extraordinary gain.
The directors felt that the shareholders should share in this `windfall’ gain and have increased the proposed dividend accordingly. Over 90% of the shares of the company are held by the directors.
Answers
Existence Test on the value of development expenditure
One of these is existence test through physical inspection of the new machinery. The auditor would need to inspect the condition of the new machinery in order to obtain valuable evidence to the reasonableness of valuation.
Test for right of obligations
The ownership rights of the new machinery and assets sold through inspection of the available documents that provide proof of sale and purchase. This will help to gather evidence that the company has been paid for the assets sold and has paid for the assets purchased (Gray & Manson, 2007).
Test for occurrence
Test for occurrence involves verifying that the stated transactions took place during the stated period. This can be done through inspection of document such as purchase invoices raised by supplier of the new machinery (Gray & Manson, 2007).
Test for Completeness
This test is designed to confirm that there are no unrecorded transactions, assets and liabilities related to the development expenditure. This involves investigation of any missing numbers in the numerical sequence for documents that are pre-numbered (Gray & Manson, 2007).. Cut-off procedures are performed in order to confirm that transactions with their related movement of assets have been fully recorded in the same and correct accounting periods. An auditor will also need to review the reconciliation between subsidiary records and control accounts and between third party records and subsidiary records.
Valuation test
This involves determination of ACGC Ltd’s accounting policy and testing of suitability and applicability of the policy (Gray & Manson, 2007). The accounting policy adopted by this company determines the valuation results of the development expenditure.
Measurement:
It involves determining that recorded transactions or events related to development expenditure have been recorded in the correct amounts and if the company’s revenue or expenses have been allocated to the correct period (Gray & Manson, 2007)..
Presentation and Disclosure tests
This involves between the company’s presentation and disclosure of transactions and balances in books of accounts with the presentation and disclosure requirements. This will help to provide evidence as to the occurrence and completeness and measurement of balances and events (Gray & Manson, 2007)..
The reason why development expenditure should not be carried forward indefinitely in the financial statements
According to the prudence concept of accounting, costs should be written off unless it is reasonably certain that sales will be made in the future which will fully cover these costs (Coles, 1997). Under this concept, development expenditure should be written off if be the end of an accounting period, it is not reasonably certain that profitable production will ensue. Though ACGC Ltd expects to benefit from the new mouldings in the future, it is not reasonably certain that profits will ensue. Hence, the development expenditure for ACGC Ltd should not be carried forward indefinitely in financial statements, but should be written off.
There are certain circumstances in which costs may be differed to the future. First, costs are differed only to the extent that future benefits are expected beyond reasonable doubt, to equal or exceed those costs, any previously differed costs and any future costs necessary to give rise to the expected benefits (Coles, 1997). Secondly, there should be evidence for adequate technical, financial and other resources to complete the development and to use or sell the intangible asset. Further, a cost should be carried forward to indefinite future only if the resultant asset has an indefinite useful life. (Coles, 1997).
© Audit procedure:
The following are the audit procedures that an auditor should carry out in order to verify the gain arising on the revaluation of fixed assets:
First, an auditor should obtain and prepare a summary of the fixed assets showing how their gross book value, accumulated depreciation and net book value reconcile with the opening position (Bragg, 2009)
The auditor should then make comparison the general ledger and the fixed assets register and obtain explanations for any differences in the value of fixed assets.
The auditor should confirm that the assets that physically exist are recorded in the fixed assets register
In case the fixed asset register does not exist, the auditor should obtain a schedule showing the original costs and present depreciated value of the fixed assets
This is followed by reconciliation of schedule of fixed assets with the general ledger
The auditor should confirm that the company physically inspects all items in the fixed asset register every year
Inspect the listed assets and confirm that they actually exist exist, are in use, have correct serial numbers and are in good condition
Inspect whether any acquisition or disposal of fixed assets has been authorized by the board of directors through inspection of minutes of meetings of the board
Verify valuation certificate of the valuer and consider his or her experience, the scope of work, the methods and assumptions used and whether the valuation bases followed the requirements of international accounting standards.
Re-perform calculation of revaluation gain
Inspect that all revaluation losses have been recognized and that revaluation gains have been credited to equity
Review the rates of depreciation and ensure that depreciation has been charged on all assets with a limited useful life
Ensure that the depreciation charges on re-valued items are based on the re-valued amount
Review insurance policies and consider the adequacy of fixed assets insured values and check expiry dates
Examine documents of title for the existing fixed assets
Review evidence of charges in statutory books and by company search
Examine invoices received after year-end, orders and minutes for capital commitments
Inspect a sample of fixed asset accounts for a sample of purchases to ensure they have been properly allocated
Obtain independent evidence to support the findings and discuss any variation with the management
Verify disposals of fixed assets, recalculate profit or loss on disposal and consider whether the proceeds are reasonable.
Ensure that the audit work or results are well documented in the working papers (Bragg, 2009)
(d) Audit implications of the directors’ decision to generate internally the funds required for the development of the business.
The directors for ACGC Ltd decided to generate internally the funds required for the development of the business. One of the audit implications of such a decision is that it becomes difficult identify whether and the point of time when, there is an identifiable asset that will generate probable future economic benefits (Ruppel, 2011). Secondly, it is difficult for an auditor to determine the cost of the asset reliably. Sometimes, the cost of generating an intangible asset internally cannot be distinguished from the cost of maintaining or enhancing the organization’s internally generated goodwill or of running day-to-day operations. An auditor has a task to identify the intangible asset and investigate whether future economic benefits from the asset are probable (Ruppel, 2011).
References
Bragg, S. M., (2009), Accounting Control Best Practices, London: John Wiley & Sons
Coles M, (1997), Financial Management for Higher Awards, New York: Heinemann
Gray, I. & Manson, S. (2007), The Audit Process: Principles, Practice and Cases, Washington D. C.: Cengage Learning
Ruppel, W., (2011), Wiley GAAP for Governments 2011: Interpretation and Application of Generally Accepted Accounting Principles for State and Local Governments, London: John Wiley & Sons
