Question

You are an Audit Senior on the AUDIO Health Limited (AUDIO) audit engagement for the financial year ending 30 June 2019. AUDIO specialises in the design and manufacture of implantable hearing aids and invests more than twice the industry average in research and development. While undertaking audit planning procedures you become aware of the following:

AUDIO has been developing its latest hearing implant, the X5, for a number of years. AUDIO has invested heavily in research and development of the X5 and has capitalised a significant amount in relation to the development phase of the product. Market studies and prototypes of the X5 have proved successful for bringing it to the market. In July 2018, AUDIO acquired two technologically advanced machines specifically designed for manufacturing the X5, at a cost of $15 million each. Production and sales of the X5 hearing implant commenced in October 2018, and demand for the product has been extremely high since its launch. AUDIO has sold large volumes of the product and further manufactured a large stockpile of the X5 in anticipation of on-going high demand, and a substantial number have already been implanted in patients.

There has recently been a sharp increase in incidences of the implant shutting down post-surgery, resulting in a number of patients commencing legal action against AUDIO for damages and prompting the company to initiate a recall. Initial investigations reveal that the defect is attributable to a design flaw. It is likely that the product in its current form cannot be sold. Management of AUDIO is confident that it will be possible to re-engineer the two machines acquired for the manufacturing of the X5 to enable production of its four other product lines and potentially for other products currently under development.

You have raised concerns with AUDIO’s audit committee on improving the competence and objectivity of the internal audit department. Currently, the internal audit department is made up of three recent graduates with no prior experience who periodically report the Audio’s Chief Executive Officer Dr. Dave Bautista.

Required:

Prepare a memorandum to the audit manager, outlining your risk assessment relating to AUDIO Limited. When making your risk assessment:

(a) Identify three (3) key account balances from the information provided that are subjected to an increase in audit risk. Briefly explain what factors increase the audit risk associated with the three (3) accounts identified. In your explanation, please mention the key assertion(s) at risk of material misstatement.

Answer 1

Accounts balances	Factor increasing the audit risk	Assertions
Capitalisation of X5 - intangibles	1. Failure of product 2. No probability of future cash flows leading to reduced fair value 3. Impairment due to Nil fair value because product cannot be sold	1. Valuation
Inventory of X5	1. Obsolence due to faulty product not leading to any sales	1. Valuation
Provisions for the legal charges	1. Legal challenges filed already 2. Potential of increased legal charges	1. Completeness 2. Valuation 3. Rights and obligation