TeamsLtd is a large public construction company with annual sales of Sh 25 billion and its draft income statement shows a profit from operations for the year-ended 30 September 2016 of Sh 3 billion.This is the first audit by your audit firm.Inquiry of the previous auditors revealed no reasons for concern.On completing the audit work at the company's premises, the audit senior has drafted a memo extracts from which are reproduced below:

1.Inventory valuation

Inventories include Sh 525 million at cost of scrap rubber.This material is widely used as a road surface in other countries.Contracts for road building with this country's Ministry of Construction, the state authority for road construction does not currently permit the use of this material.However, the matter was known to be under review and on being offered a special purchase of this material.AZ Ltd speculated on a favorable outcome of the review and purchased the material.In November 2016, shortly before the financial statements were approved by the directors, the ministry of construction reported that it would not currently accept the use for this material.If used on non-ministry of construction contracts, the materials net realizable value would not exceed Sh 150 million.The chief financial officer maintains that as the Ministry of Construction's report was issued after the balance sheet date, the write down of the inventory should be reflected in the next period's financial statements.

2.Depreciation

In 2012, the company purchased two computer controlled earthmovers at a cost of Sh 188 million each and a further two at the same price in 2014.Depreciation has been provided at 10% per annum straight line, the same basis as it previously depreciated conventionalearthmovers.

This year, 2016, the company decided that improvements in technology made it worthwhile scrapping the first two computer controlled earthmovers and replacing them with the latest model at a cost of Sh 300 million each.The company's chief engineer tells you that technology is developing so rapidly it appears likely they will continue to replace these machines every five years.The chief financial officer claims that the depreciation rate of 10% is in the line with industry standards and reflects the physical life of the machines.He argues that continued improvements in technology cannot be foreseen and that there is no justification for increasing deprecation to 20% per annum because of the possibility of technological obsolescence.

3. Contingent liability

The company is being sued for Sh 4 billion by the Ministry of Construction for defective work on a recently completed road.The company maintains that it met the ministry's construction's specifications and that it is the Ministry's engineers who are at fault in drawing up the specifications.AZ ltd maintains that it has no case to answer, that the possibility of loss is remote and that the claim need not be disclosed as a contingent liability.

An investigative journalist has recently published an article suggesting that other roads constructed by the company exhibit similar faults.The chief executive officer has admitted that the company's road building techniques are under investigation by the Ministry of construction.If the company were to lose the case, its future as a going concern would be threatened.

Required:

Explain the effect of each of the three matters, namely: inventory valuation, depreciation and contingent liability (i) on the financial statements and (ii) if the company were to refuse to amend the financial statements on the auditor's report. (Total: 20 marks)