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Your firm has recently accepted the appointment as external auditor of XYZ Limited, a subsidiary of All Media Stuff (AMS) Limited. AMS is a large listed group of companies involved in the media industry. XYZ was founded two years ago to explore opportunities in the cell phone and music download market. AMS funded the initial establishment of XYZ in return for a 50% shareholding but has since purchased the remaining 50% from the founders.

The AMS group has a strong visionary management team. The group ensures that its activities are compliant with applicable laws and regulations. Management is dedicated to the growth and development of the company and has a positive attitude towards a sound control environment. Bonuses for executive directors and senior management throughout the group are based on performance and profitability.

You have been assigned as the first-year trainee responsible for the 2018 audit of XYZ. The groups financial year-end is 28 February. Materiality for the 2018 audit of XYZ is $800 000. At an audit planning meeting, it was agreed that the overall audit strategy and audit approach for the 2018 audit of the group would be controls based, with the focus on testing the operating effectiveness of key controls where possible.

The following extracts from the 2018 audit working papers relating to XYZ are attached:

UNDERSTANDING THE ENTITY AND ITS ENVIRONMENT

Nature of the business

XYZ offers online music download facilities locally which enable customers to purchase their favorite music. XYZ sells music from well-known local and overseas artists through the Internet and by means of SMS downloads. XYZ has licensing agreements with local and international record companies, which provide for royalties to be paid to the record companies for music downloads. In line with XYZs objective of reaching all locals, payment methods include online purchases using credit cards, charges against cell phone airtime, and an online prepaid system similar to prepaid phone vouchers.

With thousands of transactions taking place daily, XYZ is dependent on reliable information technology (IT) systems.

Directors and governance

XYZ has five directors, namely, two entrepreneurs who founded the company and three nominees appointed by AMS. The business is managed by the two founders while the three AMS appointees attend monthly board meetings in a non-executive capacity.

The industry

The industry is characterised by a high level of competition amongst major players in the market, which are mainly the record companies and various international music download operators. There is no specific regulatory body for the recording industry except for an association that represents all major record companies. There are also various bodies responsible for the protection of intellectual property rights pertaining to the local industry.

Accounting policies

The companys accounting policies conform to the International Financial Reporting Standards.

Outsourcing arrangements

The company outsources all IT general and application software services to Network Applications. This involves the maintenance and operation of the companys systems which run on a server located at the head office.

SYSTEM FOR MUSIC DOWNLOADS

The system for music downloads is as follows: All transactions are denominated in NZ dollars

Online downloads using credit cards

A customer accesses XYZ music website using a computer or appropriately enables handheld device

The customers are then able to browse through XYZs music catalogues and select tracks

Selected tracks are put into an online shopping basket

After completing the selection of tracks, the customer enters XYZs secure payment website and enters his or her credit card details

Once the customer has entered all details, the payment website collects payment from the credit card company

The music website then enables the download of the purchases tracks

Cell phone downloads

A customer who has an appropriately enabled cell phone is able to download an application which facilities browsing through the music catalogues and selecting tracks for download

Customers send an SMS of the music they would like to purchase by artists name and song title to a five-digit XYZ number, which is freely available and is advertised regularly in newspapers and on television

The customer will then receive an SMS with the artists name, title of the song and the airtime required for the download

Once the customer has sent an SMS approving the purchase, the track(s) is downloaded to the customers phone

Where a customer has a monthly contract with a cell phone service provider, XYZs IT system interfaces with the relevant cell phone network to enable the purchase. XYZ then submits monthly statements to the various cellular service providers then invoice the customer for the purchases, and pay XYZ the total value of the airtime downloaded for the month, less 20% administration

In the case of post-paid (contract) customers, the IT system interfaces with the various cell phone networks to determine if the customers have sufficient credit available with regard to their predetermine monthly credit limits to pay for the downloads

Where a customer is using a pay-as-you-go contract for downloads, the XYZ IT system interfaces with the relevant cell phone network to deduct the required airtime from the customers prepaid airtime

XYZ has service level agreements with the various cellular service providers. The cellular service providers pay XYZ the total value for the airtime downloaded for the month, less the 20% administration fee, on a monthly basis

Prepaid system

XYZs banking details are available on the music website and a customer who wishes to pay a prepaid amount may do so through an electronic funds transfer

The customer then faxes or emails the proof of payment to XYZ and, on receipt of the payment, an accounts clerk records the payment as a credit to the customers prepaid account

The accounting system for recording prepaid amounts has appropriate controls in place

When these customers want to download music, they follow the process as described under online downloads using credit cards. However, after completing the selection of tracks, the customer clicks on an icon entitled Use my prepaid balance, logs in with a password and the system then debits the charge to the customers prepaid account

The music website next enables the download of the tracks purchased

Cell phone service providers

The following queries resulting from our circulation of accounts receivable at 31 December 2017:

Cell Bee:

You have requested us to confirm a balance of $1 682 344 outstanding per your clients accounts receivable system. The balance per our system is $844 981. Regrettably, we are not able to provide further details with regard to this discrepancy as our system does not provide a comparison between our records and your clients records. Our system simply processes transactions recorded on our system and the balance outstanding reflects the total of individual outstanding transactions.

Verging Cellular

We are not able to confirm the balance of $956 811 reflected in your letter. We are, however, able to advise that our system reflects a balance of $455 890 at 31 December 2017.

TMM, Eitsa and Crashua Cellular

Despite second requests and further attempts to contact the following debtors, these debtors have not responded to our requests for confirmation of their balances outstanding:

TMM $428 789

Eitsa $678 633

Crashua Cellular $590 234

Required

Question 1. Describe the controls that you would expect XYZ to have implemented to ensure the occurrence and completeness transactions for the revenue from music downloads.

Question 2. Describe the substantive procedures required to address the risk of fraudulent financial reporting in respect of related party transactions with related party cell phone service providers.

Question 3. For the 2018 annual financial statements of XYZ, describe the risks of material misstatement

i) at the overall financial statement level; and

ii) at the assertion level for revenue.

Ignore risks relating to the presentation and disclosure assertions.

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