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Corporate governance
The company does not have to comply with corporate governance requirements as it is not a listed entity. However, it is
good practice to have an established audit committee, especially for a large company like Pale Co which is seeking a stock
market flotation in the relatively near future. The internal audit team is small and lacking in independence as they report
directly to the CFO. This means that the scope of their work is likely to be quite limited due to insufficient resources, and any
recommendations made could potentially be ignored by Mark York. This has implications for controls over financial reporting,
which could be deficient, and increases control risk. There is a high scope for errors in financial reporting processes and for
deliberate manipulation of balances and transactions, as the internal audit team does not have sufficient resources for thorough
monitoring and reporting.
Pressure on results
The company is not a listed entity, but the existing and new shareholders will be looking for a return on their investment in
the form of a dividend payment. In addition, in the run up to a potential stock market flotation, there will be pressure for the
company to show good financial performance. The company also has ambitious international expansion plans. Pressure to
return a better performance creates an incentive for management bias which means that management may use earnings
management techniques, or other methods of creative accounting, to create a healthier picture of financial performance than
is actually the case. This creates an inherent risk of material misstatement at the financial statement level.
The fact that the projected profit before tax is 30% higher than the previous year’s figure could indicate that operating expenses
are understated. Management bias could also have led to some of the accounting treatments suggested by Mark York, which
work to improve the company’s profit for the year.
Government grant
A government grant of $20 million has been awarded to Pale Co, this amounts to 3·6% of total assets and is material to the
projected statement of financial position. Mark York has suggested that he will recognise $10 million of the amount received
in profit for the year – projected profit before tax is only $6·5 million, so increasing the profit by this amount would be highly
material to the statement of profit or loss.
The audit risk relates to whether this should be recognised as income in the current accounting period. IAS® 20 Accounting
for Government Grants and Disclosure of Government Assistance requires that government grants are recognised in profit or
loss on a systematic basis over the periods in which the entity recognises expenses for the related costs for which the grants
are intended to compensate. Mark York is planning to recognise half of the grant as income this year, however, this is not
appropriately justified. The grant has not been awarded to compensate for management time in planning the international
expansion, so the appropriate accounting treatment would seem to be that the entire amount of the grant should be recognised
as deferred income in this financial year, as the expenditure for which the grant is specifically provided has not yet been
incurred. Therefore, there is a risk that the company will recognise the income too early, leading to overstated profit and
understated liabilities.