question

Use your professional judgement and scepticism to identify and explain the key risks of material misstatement using the data and information contained in the scenario

Pegee plc is a construction company listed on the London Stock Exchange. It has been listed for over twelve years. Pippa Evans is an audit partner at major firm Leopard LLP and has recently taken over as reporting partner after a partner rotation change following completion, approval and issue of the 2018 annual financial statements. Coincidentally Ravi Khan a Chartered Accountant has taken over as financial director at the same time. Ravi is known as a 'hands on' leader and he attends audit committee meetings and where he is able monthly project team meetings for construction contracts. Ravi has brought in several members of his finance team from his previous company that is a client of Leopard LLP, which Pippa had partner in charge responsibility for until 2018 Ravi has already made his views known regarding what he sees as a required focus on financial market requirements for shareholder returns at an acceptable risk./ The Pegee plc board have brought Ravi in to pursue a strategy of debt reduction and to improve working capital management. At his interview Ravi impressed the board with his analysis of Pegee, plc's weaknesses and risks when he commented upon what he saw as risks associated with low operating margins and gearing issues. Ravi also showed insight in recommending operational changes that were required in project management processes to improve project quality control and estimation procedures. Leopard LLP undertakes both tax advisory and non-statutory assurance work for Pegee plc and out of the total fee some 23% relates to non-audit services. This has been approved by the audit committee and Ravi is keen to use the firm's tax and assurance expertise in the future. He intends to disband the current internal audit function and put the work out to tender with the major firms in order to shift work away from financial audit towards operational audit and support for greater operational efficiency. The audit committee consists of two independent non-executive directors who are construction industry specialists but from the operational side and one non-executive director, Sally Leadbetter, a Chartered Accountant, who joined after the issue of the 2018 accounts worked with Ravi Khan three years ago in his finance team in the previous company he was with after which she left the company for a banking industry appointment as finance director an appointment that she held for the last two years. Pippa has already had sight of the draft annual report to 31st December 2019 and extracts from the financial statements, included in the five-year summary below. m Revenue Operating profit 2019 220 10.2 2018 216 6.3 2017 213 6.4 2016 212 5.3 2015 211 5.3 Finance costs are significant and have been increasing. m 2019 2018 2017 2016 2015 Revenue 220 216 213 212 211 Operating 10.2 6.3 6.4 5.3 5.3 profit Finance 3.3 3.2 3 2.7 2.4 costs Profit 6.9 3.1 3.4 2.6 2.9 before tax Tax 0.5 0.5 0.4 0.4 0.4 Profit for 6.4 2.6 3.0 2.2 2.5 the year The company has applied the provisions of IAS 11 and then IFRS 15 with respect to its construction contracts with no significant changes required. Pegee, plc uses the input method to recognise profits and losses as contracts progress. The audit team have assessed risks and undertaken tests of control and tests of detail in relation to business and accounting processes in the areas of cash payments and receipts, payroll, materials, expense and contractor invoice processing and contract billing. They concluded that internal controls over processing were effective but did not review controls or test journal entries since these will be covered by final year end work. Tests of detail showed transaction processing to be materially, complete and accurate. Several site visits were made and meetings with project teams relating to a sample of construction contracts undertaken and the team expressed concerns regarding what they saw as a more aggressive approach despite several contracts having delays and construction technical difficulties. The audit team flagged this up as a concern requiring extended testing at the year end. This work has commenced and initial findings are given below. The audit team have recommended that discussions are held and evidence obtained to understand the implications of a new scheme of supplier payments whereby suppliers have been offered preferred status and better terms but have had scheduled payments extended to eighty days and beyond. Balance sheet data is provided as at 31st December 2018 and 2019: m 2019 2018 Non-current assets Property plant and equipment 14.6 10.7 Goodwill 52.0 52.0 Working capital (0.2) 3.3 Non-current liabilities Interest bearing loans Retirement benefit obligations (20.0) (20.0) (20.0) (22.0) Net assets 26.4 24.0 Share capital Retained earnings 21.0 5.4 21.0 3.0 Shareholder equity 26.4 24.0 A cash dividend was paid during 2018 of 3m and this has been increased by 1m and has been paid this year. The change in the retirement benefit obligations arose upon changes to assumptions relating to inflation and scheme returns. An analysis of working capital follows: m 2019 Inventories 0.9 Balances with customers 34.6 Trade receivables 35.6 71.1 + Provisions Trade payables Interest bearing loans Bank overdraft 1.5 47.8 21.0 1.0 71.3 Net current liabilities 0.2 Provided below are detailed analyses of three major contracts at the financial year end that commenced during 2019 and were won in highly competitive circumstances and all three have run into difficulties that your audit team had commented upon already. The figures in the table immediately below were included in the draft financial statements for 2019. m A B Costs to date 16.2 20.2 12.4 Profit/(loss) recognised 1.16 1.9 0.73 17.36 22.1 13.13 Progress billings (15.25) (17.0) (10.9) Amount with customer 2.11 5.1 2.23 Progress billings Cash received Net receivable 15.25 (11.25) 4.0 17.00 (16.00) 1.00 10.9 (7.5) 3.4 Commenced Planned completion Expected completion Contract price Total expected costs Costs to complete Total expected profit 1 Jan 2019 31 Mar 2020 30 June 2020 24.0 22.4 6.2 1.6 1 Apr 2019 31 Mar 2020 31 July 2020 28.0 25.6 5.4 2.4 1 July 2019 31 Dec 2020 30 Apr 2021 36.0 34.0 21.6 2.0 Your audit team after discussions with project managers and examination of contracts, correspondence with customers and sub-contractors and review of project position papers have set out an analysis of an alternative set of project outcomes for these three material contracts, versions one and two are set out below: B 6.4 22.2 8.0 26.8 m A Costs to complete 7.4 V1 Costs to complete 8.8 V2 Notes Unplanned costs and rectification work Unplanned costs Quality problems, unplanned costs and rectification work. Likely that the customer will not pay all sums billed. Ravi has told the audit team that V1 is the most likely outcome despite project managers warning that V2 was a more likely outcome. Ravi also argues that unplanned costs and rectification work included in V2 can be recovered from contractors or through customer claims where additional requirements were met. Project managers are sceptical about such recoveries. Ravi has provided a cash flow forecast to the end of 2020 that shows little change to the current cash and debt position and is based on assumptions consistent with those made in preparing the annual financial statements with an expectation of efficiency gains but relatively flat revenue growth, the forecast operating profit is 11.5m. Pegee plc is a construction company listed on the London Stock Exchange. It has been listed for over twelve years. Pippa Evans is an audit partner at major firm Leopard LLP and has recently taken over as reporting partner after a partner rotation change following completion, approval and issue of the 2018 annual financial statements. Coincidentally Ravi Khan a Chartered Accountant has taken over as financial director at the same time. Ravi is known as a 'hands on' leader and he attends audit committee meetings and where he is able monthly project team meetings for construction contracts. Ravi has brought in several members of his finance team from his previous company that is a client of Leopard LLP, which Pippa had partner in charge responsibility for until 2018 Ravi has already made his views known regarding what he sees as a required focus on financial market requirements for shareholder returns at an acceptable risk./ The Pegee plc board have brought Ravi in to pursue a strategy of debt reduction and to improve working capital management. At his interview Ravi impressed the board with his analysis of Pegee, plc's weaknesses and risks when he commented upon what he saw as risks associated with low operating margins and gearing issues. Ravi also showed insight in recommending operational changes that were required in project management processes to improve project quality control and estimation procedures. Leopard LLP undertakes both tax advisory and non-statutory assurance work for Pegee plc and out of the total fee some 23% relates to non-audit services. This has been approved by the audit committee and Ravi is keen to use the firm's tax and assurance expertise in the future. He intends to disband the current internal audit function and put the work out to tender with the major firms in order to shift work away from financial audit towards operational audit and support for greater operational efficiency. The audit committee consists of two independent non-executive directors who are construction industry specialists but from the operational side and one non-executive director, Sally Leadbetter, a Chartered Accountant, who joined after the issue of the 2018 accounts worked with Ravi Khan three years ago in his finance team in the previous company he was with after which she left the company for a banking industry appointment as finance director an appointment that she held for the last two years. Pippa has already had sight of the draft annual report to 31st December 2019 and extracts from the financial statements, included in the five-year summary below. m Revenue Operating profit 2019 220 10.2 2018 216 6.3 2017 213 6.4 2016 212 5.3 2015 211 5.3 Finance costs are significant and have been increasing. m 2019 2018 2017 2016 2015 Revenue 220 216 213 212 211 Operating 10.2 6.3 6.4 5.3 5.3 profit Finance 3.3 3.2 3 2.7 2.4 costs Profit 6.9 3.1 3.4 2.6 2.9 before tax Tax 0.5 0.5 0.4 0.4 0.4 Profit for 6.4 2.6 3.0 2.2 2.5 the year The company has applied the provisions of IAS 11 and then IFRS 15 with respect to its construction contracts with no significant changes required. Pegee, plc uses the input method to recognise profits and losses as contracts progress. The audit team have assessed risks and undertaken tests of control and tests of detail in relation to business and accounting processes in the areas of cash payments and receipts, payroll, materials, expense and contractor invoice processing and contract billing. They concluded that internal controls over processing were effective but did not review controls or test journal entries since these will be covered by final year end work. Tests of detail showed transaction processing to be materially, complete and accurate. Several site visits were made and meetings with project teams relating to a sample of construction contracts undertaken and the team expressed concerns regarding what they saw as a more aggressive approach despite several contracts having delays and construction technical difficulties. The audit team flagged this up as a concern requiring extended testing at the year end. This work has commenced and initial findings are given below. The audit team have recommended that discussions are held and evidence obtained to understand the implications of a new scheme of supplier payments whereby suppliers have been offered preferred status and better terms but have had scheduled payments extended to eighty days and beyond. Balance sheet data is provided as at 31st December 2018 and 2019: m 2019 2018 Non-current assets Property plant and equipment 14.6 10.7 Goodwill 52.0 52.0 Working capital (0.2) 3.3 Non-current liabilities Interest bearing loans Retirement benefit obligations (20.0) (20.0) (20.0) (22.0) Net assets 26.4 24.0 Share capital Retained earnings 21.0 5.4 21.0 3.0 Shareholder equity 26.4 24.0 A cash dividend was paid during 2018 of 3m and this has been increased by 1m and has been paid this year. The change in the retirement benefit obligations arose upon changes to assumptions relating to inflation and scheme returns. An analysis of working capital follows: m 2019 Inventories 0.9 Balances with customers 34.6 Trade receivables 35.6 71.1 + Provisions Trade payables Interest bearing loans Bank overdraft 1.5 47.8 21.0 1.0 71.3 Net current liabilities 0.2 Provided below are detailed analyses of three major contracts at the financial year end that commenced during 2019 and were won in highly competitive circumstances and all three have run into difficulties that your audit team had commented upon already. The figures in the table immediately below were included in the draft financial statements for 2019. m A B Costs to date 16.2 20.2 12.4 Profit/(loss) recognised 1.16 1.9 0.73 17.36 22.1 13.13 Progress billings (15.25) (17.0) (10.9) Amount with customer 2.11 5.1 2.23 Progress billings Cash received Net receivable 15.25 (11.25) 4.0 17.00 (16.00) 1.00 10.9 (7.5) 3.4 Commenced Planned completion Expected completion Contract price Total expected costs Costs to complete Total expected profit 1 Jan 2019 31 Mar 2020 30 June 2020 24.0 22.4 6.2 1.6 1 Apr 2019 31 Mar 2020 31 July 2020 28.0 25.6 5.4 2.4 1 July 2019 31 Dec 2020 30 Apr 2021 36.0 34.0 21.6 2.0 Your audit team after discussions with project managers and examination of contracts, correspondence with customers and sub-contractors and review of project position papers have set out an analysis of an alternative set of project outcomes for these three material contracts, versions one and two are set out below: B 6.4 22.2 8.0 26.8 m A Costs to complete 7.4 V1 Costs to complete 8.8 V2 Notes Unplanned costs and rectification work Unplanned costs Quality problems, unplanned costs and rectification work. Likely that the customer will not pay all sums billed. Ravi has told the audit team that V1 is the most likely outcome despite project managers warning that V2 was a more likely outcome. Ravi also argues that unplanned costs and rectification work included in V2 can be recovered from contractors or through customer claims where additional requirements were met. Project managers are sceptical about such recoveries. Ravi has provided a cash flow forecast to the end of 2020 that shows little change to the current cash and debt position and is based on assumptions consistent with those made in preparing the annual financial statements with an expectation of efficiency gains but relatively flat revenue growth, the forecast operating profit is 11.5m