CASE 1
You are the audit manager on the audit of Cross Ltd for the year ended 30 June 2013. Cross Ltd is a furniture manufacturer and wholesaler and purchases large quantities of inventory near 30 June, as July is one of its largest sales months. As a result, a material amount of inventory arrives in its Adelaide warehouse around balance date.
When goods from suppliers are delivered to its Adelaide warehouse, a goods received note (GRN) is prepared and signed by the warehouse foreman. The GRN is dated the day the goods are received and includes details of the type and number of goods received. The warehouse foreman then sends a signed copy of the GRN together with the supplier’s invoice to its accounts payable department. The accounts payable clerk, Judy Essex, matches each GRN to the original purchase order. Judy then immediately enters the GRN details into Cross Ltd’s purchasing system, which updates the inventory records and the accounts payable records. The date the GRN is entered into the system by the accounts department is the posting date for the transaction.
Sam Penman, your audit senior, has performed a test of controls procedure over GRN transactions processed in Cross Ltd’s purchasing system. A tolerable deviation rate of 5 per cent was set and from the total population of 250 GRN transactions for the year, a sample of 50 GRN transactions were randomly selected including the periods either side of balance date. The test revealed five errors in posting to the correct date. Sam noted on the audit working papers that two of the errors were not valid deviations, because Cross Ltd’s purchasing officer had advised him that these GRNs had been cancelled and replaced. Sam also noted that the five GRNs in question were not material, either individually or on an aggregate basis, and concluded that the controls around the GRN transactions were reliable.
As a material amount of Cross Ltd’s inventory is located at its Chinese production facility, Sam instructed the Chinese auditing firm, Tan & Chan, to attend the stocktake in China and sign off on the inventory account balance at the Chinese warehouses as at 30 June 2013. Tan & Chan reported that, while there were some minor discrepancies between warehouse stock and the count sheet, they were not material. Sam concluded that no further work was required to be undertaken on the existence of the inventory located in China on the basis that the stocktake was audited by Tan & Chan and the discrepancies found were not material.
In testing the ‘valuation and allocation’ assertion for fixed assets, which is a material balance, Sam focused on the increase in the fixed asset account balance between 30 June 2012 and 30 June 2013. Sam ensured that the dollar value of the asset additions for the year ended 30 June 2013 were included on the fixed asset depreciation schedule. As all fixed assets additions were properly included and appropriately depreciated, Sam concluded that the valuation and allocation of the fixed asset account balance was correct.
In testing research and development, which is a material balance, Sam reviewed the expenses accounts listed in the trial balance to determine what amounts should be capitalised.
Required:
(a) Identify one manual control and one IT application control associated with the receipt of goods from suppliers and explain the objective of each control.
(b) Provide three reasons why Sam’s conclusion regarding the controls around the GRN transactions is not correct.
(c) Indicate whether you agree with Sam’s conclusions for inventory and fixed assets.
CASE 2
Spinner Ltd is a bedding manufacturer that achieved a net profit before income tax of $1 842 000 for the year ended 30 June 2013. Spinner Ltd has a major loan from Greater Western Bank (GWB) for financing daily and other operations, carrying an interest rate of 7 per cent per annum.
Spinner Ltd is required to adhere to financial covenants imposed by GWB and in the event that the covenants are breached the annual interest rate on the loan will increase to 10 per cent. Spinner Ltd has disclosed these details in the notes to the financial report.
You are satisfied that the note in the financial report complies fully with the accounting standards; however, you form the view that your audit report should draw attention to this note. In addition you have identified the following matters from your audit work:
1. Spinner Ltd’s inventory amounted to $1 941 000 at 30 June 2013. In order to move some of its old stock, in July 2013 the company sold 25 per cent of its finished goods inventories held at 30 June 2013 for $82 189 below their original cost. Management has indicated that as the sales occurred after 30 June 2013, it believes that the value of finished goods at that date should remain at cost. The remainder of the inventory has only been purchased recently and is in great demand.
2. Spinner Ltd’s accounts payable at 30 June 2013 amounted to $1 726 000. Subsequent payments testing revealed that in July 2013, invoices totalling $53 751 were paid that related to June 2013 purchases of inventories. The relevant invoices were omitted from the balance of accounts payables at 30 June 2013. Management has indicated that it does not intend to adjust the financial report in relation to this issue.
3. Spinner Ltd’s accounts receivable balance at 30 June 2013 amounted to $2 540 000. Your testing has revealed that the accountant used an incorrect exchange rate to translate overseas debtors at 30 June 2013. As a result, the balance of the accounts receivable account was overstated by $75 650. Again, management has indicated that it does not intend to adjust the financial report in relation to this issue. Required:
(a) Explain the two circumstances under which a modified audit opinion is issued and explain the three different types of modified opinions.
(b) Explain whether drawing attention to the note will result in the expression of a modified audit opinion. Justify your answer.
(c) Explain whether the issues arising from your audit work (matters 1 to 3 above) will individually have any effect on your audit opinion. Justify your answer, using calculations.
(d) Identify the type of audit opinion that you will include in your audit report for Spinner Ltd for the year ended 30 June 2013. Justify your answer.
CASE 3
You are an audit manager at Hogan & Associates and have been assigned to the audit of Looking Good
Ltd (LGL) for the year ending 30 June 2013. LGL is an Australian manufacturer, wholesaler and retailer of ladies handbags and shoes. LGL manufactures all its products at its Brisbane factory and sells via retail outlets throughout Australia. LGL is listed on the Australian Securities Exchange and Hogan & Associates has been its auditor for several years.
In recent years, LGL has been finding it difficult to meet its projected profit forecasts due to increased competition from new local competitors, imported products and online shopping; the increasingly high Australian dollar; and the impact of the global and European financial crisis on consumer spending.
During the planning stage of the audit you become aware of the following matters:
1. LGL has significant loans from its bank. The bank has indicated that it is concerned about LGL’s ability to meet specific loan covenants, particularly the return on total assets (net profit/total assets).
2. The aged trade accounts receivable listing indicates that the percentage of accounts receivable exceeding 90 days has jumped from 15 per cent to 37.5 per cent during the last 12 months. The credit manager has indicated that this is because some of LGL’s customers are currently experiencing financial difficulty.
3. In order to reduce costs, LGL changed one of its major suppliers of raw materials in February 2013 to a cheaper overseas supplier. However, the number of product returns has increased significantly since April 2013, and your discussions with management have indicated that the increased returns have involved customer complaints concerning the quality of the product.
4. Your review of the payroll system has indicated that when an employee is hired or terminated, the payroll clerk immediately prepares the paperwork and enters the information into the master file of the payroll computer system.
5. The payroll department at LGL’s head office processes payroll on a weekly basis. All timesheets that are submitted by factory workers are signed off by the factory manager. The timesheets are input into the computer by the factory manager and payment is then made by the payroll department.
Required:
(a) Describe the two types of misstatement in a financial report that may arise from fraud.
(b) For each matter 1 to 3 above, outline how each matter is a fraud audit risk factor in relation to LGL’s financial report.
(c) Describe how the internal control weakness in matter 4 and 5 above could lead to material misstatement in the financial report.
CASE 4
You are an audit manager at Fenley & Associates working on the audit of Femme Fatale Clothing
Company Ltd (FFC) for the year ending 30 June 2013. FFC has two separate divisions. One division manufactures exclusive women’s lingerie and the other division manufactures women’s evening wear made from fabric imported from France. The divisions operate from two separate locations.
FFC operates throughout Australia and its customers include a number of exclusive women’s retail clothing boutiques and upmarket department stores. A significant amount of stock on hand is represented by unsold stock returned by customers. Sales terms provided to FFC’s customers are as follows:
•Settlement is required within 30 days of the invoice date.
•Any goods remaining unsold by a customer after six months can be returned for a full cash refund based on the original invoice price of the unsold goods.
FFC creates a provision for refunds based on an analysis of the trend in refunds over the previous three years.
Any unsold goods that are returned after the six months are then sold in FFC’s factory shop to the general public at cost. Any stock remaining unsold in the factory shop after three months is donated to local charities.
Sales have declined by 15 per cent over the last two years, because Australian customers have become nervous about the impact of the European debt crisis upon local economic conditions. FFC’s sales manager estimates that sales will continue to decline at the rate of 4 per cent per annum for at least the next couple of years.
The following are key balances extracted from FFC’s draft financial report for the year ending 30 June 2013:
$
Net profit before tax 4 150 000
Inventories 1 350 000
Property, plant & equipment (cost less accumulated depreciation) 5 300 000
Current liabilities 900 000
Owners’ equity 7 121 430
The following events have come to your attention during the final review of the audit:
1. Fixed assets: In accordance with the accounting standards, FFC’s accountant tested the fixed assets of both of the manufacturing divisions for impairment. The impairment test revealed that the evening wear division required the recognition of an impairment loss of $200 000 to its manufacturing equipment. You raised this matter with the CFO, who stated that he did not believe that there was any need to record an impairment loss because the relevant fixed assets will be used for their entire useful life. He stated that the calculation of the impairment loss was based on the present value of future cash flows, which he believes is irrelevant to the current valuation of these assets.
2. Provision for refunds: After reviewing FFC’s recent sales, you have calculated that the provision for refunds account is overstated by $140 000. However, FFC’s CFO has informed you that he does not wish to reduce the provision and would rather release the excess from the provision in future financial years should profitability decrease.
3. Inventory: On 12 June 2013, FFC placed an order with its French supplier for high-quality silk fabric worth $700 000. In accordance with the FOB terms of the purchase agreement, ownership of the goods passes to FFC and a liability to the supplier is incurred when the container is loaded onto the ship at the overseas port. The container was loaded onto the ship in France on 26 June 2013 and arrived at FFC’s warehouse on 11 July 2013. Given that no entry has been recorded to recognise the transaction in the year ending 30 June 2013, you advise the CFO that an entry should be recorded to recognise an asset ‘stock in transit’ and a liability ‘accounts payable’, and the asset and liability be included in the statement of financial position at 30 June 2013. However, the CFO has stated that the transaction does not need to be recorded, as the shipment was received after the reporting date.
4. Bank overdraft: Although FFC’s sales have declined over the last couple of years, FFC’s bank is still confident about the company’s future profitability and financial stability, and on 23 July 2013, FFC renegotiated its current bank overdraft facility. The new facility provides for the relaxation of the debt covenants, a reduction of the charge over accounts receivable from 100 per cent to 75 per cent and a reduction in the interest rate by 1 per cent. The new overdraft facility will significantly improve FFC’s financial flexibility, as well as reduce its future costs of borrowing. However, the CFO has stated that it is unnecessary to include details of this event in the financial report since the renegotiation occurred after the reporting date.
The audit report was subsequently signed and issued on 14 August, 2013. However, on 29 August the chief executive officer (CEO) advised you that it had been discovered that the Melbourne warehouse manager had committed fraud and covered it up by including a material amount of fictitious stock in the 30 June stocktake sheets. As the audited financial report has already been issued, the CEO stated that nothing could be done in relation to the 2013 financial report and that it would have to be adjusted next year.
Required:
Treating events 1 to 4 above as completely independent, identify the most likely audit opinion that you would express on FFC’s financial report based on each separate event. Justify your answer, using calculations.
Explain what actions, if any, the auditor should take in relation to the discovery of the fictitious stock error after the issue of the financial report? Justify your answer.
CASE 5
An unqualified audit report normally states that the financial statements to which the report refers give a true and fair view of the state of the company’s affairs at the Statement of Financial Position date and its profits for the year ended on that date.
Bearing in mind the above statement the directors of Midland Builders Ltd have drawn up accounts for the year ended 30 June 2013 which do not reflect certain events which have occurred since the year end. They justify their action on the grounds that the books and records correctly reflect what was known at the year end. The following are the events which are not reflected in the draft financial statements (in all cases the figures are material).
(i)At a meeting in July 2013 the local planning authority rejected the company’s plans to develop one of its freehold sites. The site was included in the company’s assets at its cost of $500,000, but it is likely that the site will have to be sold and will realise no more than $350,000 because of its reduced development potential.
(ii)Following the completion of a long-term contract in July 2013 it has been possible to calculate the final profit on the contract. It appears that the profit accrued at 30 June 2013 was underestimated by $220,000. This arose from a material error at 30 June 2013 in estimating the amount of work still to be completed.
List two detailed procedures which an auditor should adopt in order to detect post Statement of Financial Position events.
CASE 6
As a senior auditor in charge of the audit of F Limited, you have asked your audit staff to review the audit files and make a list of items for inclusion within the letter of representation form the management. The staffs have provided the following draft list of points:
Equity and reserves
• All statutory records and registers required to be kept in accordance with the corporations Act 2001 have been properly kept.
• All share transfers have been appropriately recorded in the statutory registers. Liabilities
• All contingent liabilities have been discussed and appropriate disclosures made in respect of all known contingencies.
• All known subsequent events have been discussed and appropriately treated in the financial report.
• All trade payables have been completely recorded in the financial report.
Property, plant and equipment
• All non-current assets are stated at a value below their recoverable amount.
• All assets are being depreciated over their estimated useful lives.
Trade receivables
• Adequate allowance has been made for all known doubtful trade debtors.
• Current assets include other receivables of $850,000 in respect of amounts receivable on settlement of a contract for the sale of commercial property. The directors confirm that it is their intention to settle the contract during the 2010/2011 financial year.
Other
• Directors believe that the $600,000 shown as deferred expenditure will be recovered in full in future periods.
• All known controlled entities have been included within the consolidated financial report.
• All books, records and other documents have been made available to us for the purpose of our audit.
Required
(i) What is the main purpose (as according to ASA 580) of a letter of representation from the management?
(ii) From the information gathered above outline the items which should be included within the management representation letter, giving reasons
CASE 7
You are the audit senior on the audit of EasyFit Pty Limited, a large manufacturer of shoes. EasyFit Pty Limited’s main market lies with 18 to 24 year olds.
This is the first year in which your firm has performed the audit. As part of the planning work, you have performed analytical procedures on an annualised basis and compared the results to industry averages and last year’s audited financial information. The results are given below:
Industry average EasyFit Pty Limited
Ratio 20X7 20X6 20X7 20X6
1 Current ratio 2.84 3.27 1.89 2.24
2 Receivables turnover ratio 4.9 4.6 6.3 7.0
3 Inventory turnover ratio 3.7 3.8 5.0 5.5
4 Return on total assets 7% 5% 13% 11%
5 Net profit ratio 0.06 0.06 0.04 0.04
6 Gross margin 0.20 0.26 0.20 0.18
Required:
Explain the general meaning of each of the above ratios, discuss the conclusions that you can draw about EasyFit’s financial position and identify potential audit risks to be investigated further.
CASE 8
Consider the following independent situations found during audit testing of CD Ltd, which has a balance date of 30 June 20X7. Assume that all the situations are material.
(i) Recent industrial action has seen trade unions win a pay increase of 4% for all their members. Under the terms of the agreement, the pay increase will be backdated to 1 January 20X7. Management have agreed to the pay increase, however, they have not made any adjustments to the 30 June 20X7 financial report.
(ii) A large order from an overseas supplier was shipped FOB (free on board) from its port of origin on 1 June 20X7. The order arrived on 20 July 20X7. The purchase is not reflected in the 30 June 20X7 financial report.
(iii) The draft chairman’s report to go with the financial report states that the profits of a particular segment of the company’s operations increased by 70% during the period. On checking the figures, you found profits increased by only 4%.
iv. Your New Zealand branch office disclaimed responsibility for the inventory figures in the New Zealand division’s reporting package. This is because sudden flooding prevented the auditors from attending the stocktake, and destroyed documentation which would have enabled them to substantiate inventory by other means. The New Zealand division represents about 10% of CD Ltd’s operations.
v. The entire Queensland operations of the company are under investigation by the Tax Office for alleged failure to pay the appropriate amount of PAYG tax. Your preliminary investigations reveal that the Tax Office has a strong case against the company. No mention of the dispute is made in the financial report.
Required:
Assume that no adjustments are made. For each situation, identify the type of audit opinion required and explain the basis of your answers.
CASE 9
You are part of the audit team assigned to ABC Ltd, a large distributor of imported floor and wall tiles and supplies tiling contractors and retail stores. You are assigned the task of reviewing and evaluating the internal control over the sales and collection cycle. You have been provided with the following narrative relating to the internal control system over this area. Sales recording, maintenance of accounts receivable and collection procedures are shared between the accounts receivable clerk, a cashier/ secretary and the receptionist. Their procedures in regard to billing and collection have been described as follows.
After opening the mail the receptionist hands customers’ purchase orders to the accounts receivable clerk. To prevent delays in dispatch of orders accounts receivable clerk prepares a five part sales invoice for distribution to various departments.
Since ABC has a liquidity problem, the deposit of receipts is also expedited. The receptionist hands all mail receipts and related correspondence to accounts receivable clerk who examines the cheques and determines whether or not the accompanying vouchers or correspondence contain enough detail to permit posting of the accounts. The accounts receivable clerk then endorses the cheques and gives them to the cashier who prepares the daily deposit. No cash is received in the mail and no goods are sold over the counter.
The accounts receivable clerk uses the vouchers or correspondence that accompanied the cheques to post sales details to the accounts receivable ledger and to prepare cash receipts register. Monthly, the general ledger clerk summarises the cash receipts register for posting to the general ledger accounts. The accounts receivable clerk also corresponds with customers about unauthorised deductions for discounts, allowances, returns, and prepares the appropriate credit notes. Disputes involving large amounts are turned over to the sales manager for settlement. Each month accounts receivable clerk prepares a trial balance of the accounts receivable to agree with the general ledger. Required:
Based on the available information above, list any of the two weaknesses in ABC’s internal control over customer billings and collections, the potential consequences (effects) of those weaknesses and how the weakness could be corrected (strengthened).
CASE 10
The following sales procedures were encountered during the annual audit of Marvel Wholesale Ltd.
Customer orders are received by the sales order department. A clerk calculates the approximate dollar amount of the order and sends it to the credit department for approval. Credit approval is stamped on the order and sent to the accounting department. A computer is then used to generate two copies of a sales invoice. The order is filed in the customer order file.
The customer copy of the sales invoice is held in a pending file awaiting notification that the order was shipped. The shipping copy of the sales invoice is routed through the warehouse, and the shipping department has authority for the respective departments to release and ship merchandise. Shipping department personnel pack the order and manually prepare a threecopy bill of lading: the original copy is mailed to the customer, the second copy is sent with the shipment, and the third is filed in sequence in the bill of lading file. The sales invoice shipping copy is sent to the accounting department with any changes resulting from lack of available merchandise.
A clerk in accounting matches the received sales invoice shipping copy with the sales invoice customer copy from the pending file. Quantities on the two invoices are compared and prices are compared on an approved price list. The customer copy is then mailed to the customer, and the shipping copy is sent to the data-processing department. The dataprocessing clerk in accounting enters the sales invoice data in the computer, which is used to prepare the sales journal and update the accounts receivable master file. She files the shipping copy in the sales invoice file in numerical sequence.
Required
Assuming you are the auditor of Marvel Wholesale Ltd, what actions would you take to ensure all invoices are posted to the customers’ accounts receivable master file and all merchandises shipped have been invoiced and uncollected amount in the customers’ accounts represent the balance of the trade receivables?
You are the audit manager on the audit of Cross Ltd for the year ended 30 June 2013. Cross Ltd is a furniture manufacturer and wholesaler and purchases large quantities of inventory near 30 June, as July is one of its largest sales months. As a result, a material amount of inventory arrives in its Adelaide warehouse around balance date.
When goods from suppliers are delivered to its Adelaide warehouse, a goods received note (GRN) is prepared and signed by the warehouse foreman. The GRN is dated the day the goods are received and includes details of the type and number of goods received. The warehouse foreman then sends a signed copy of the GRN together with the supplier’s invoice to its accounts payable department. The accounts payable clerk, Judy Essex, matches each GRN to the original purchase order. Judy then immediately enters the GRN details into Cross Ltd’s purchasing system, which updates the inventory records and the accounts payable records. The date the GRN is entered into the system by the accounts department is the posting date for the transaction.
Sam Penman, your audit senior, has performed a test of controls procedure over GRN transactions processed in Cross Ltd’s purchasing system. A tolerable deviation rate of 5 per cent was set and from the total population of 250 GRN transactions for the year, a sample of 50 GRN transactions were randomly selected including the periods either side of balance date. The test revealed five errors in posting to the correct date. Sam noted on the audit working papers that two of the errors were not valid deviations, because Cross Ltd’s purchasing officer had advised him that these GRNs had been cancelled and replaced. Sam also noted that the five GRNs in question were not material, either individually or on an aggregate basis, and concluded that the controls around the GRN transactions were reliable.
As a material amount of Cross Ltd’s inventory is located at its Chinese production facility, Sam instructed the Chinese auditing firm, Tan & Chan, to attend the stocktake in China and sign off on the inventory account balance at the Chinese warehouses as at 30 June 2013. Tan & Chan reported that, while there were some minor discrepancies between warehouse stock and the count sheet, they were not material. Sam concluded that no further work was required to be undertaken on the existence of the inventory located in China on the basis that the stocktake was audited by Tan & Chan and the discrepancies found were not material.
In testing the ‘valuation and allocation’ assertion for fixed assets, which is a material balance, Sam focused on the increase in the fixed asset account balance between 30 June 2012 and 30 June 2013. Sam ensured that the dollar value of the asset additions for the year ended 30 June 2013 were included on the fixed asset depreciation schedule. As all fixed assets additions were properly included and appropriately depreciated, Sam concluded that the valuation and allocation of the fixed asset account balance was correct.
In testing research and development, which is a material balance, Sam reviewed the expenses accounts listed in the trial balance to determine what amounts should be capitalised.
Required:
(a) Identify one manual control and one IT application control associated with the receipt of goods from suppliers and explain the objective of each control.
(b) Provide three reasons why Sam’s conclusion regarding the controls around the GRN transactions is not correct.
(c) Indicate whether you agree with Sam’s conclusions for inventory and fixed assets.
CASE 2
Spinner Ltd is a bedding manufacturer that achieved a net profit before income tax of $1 842 000 for the year ended 30 June 2013. Spinner Ltd has a major loan from Greater Western Bank (GWB) for financing daily and other operations, carrying an interest rate of 7 per cent per annum.
Spinner Ltd is required to adhere to financial covenants imposed by GWB and in the event that the covenants are breached the annual interest rate on the loan will increase to 10 per cent. Spinner Ltd has disclosed these details in the notes to the financial report.
You are satisfied that the note in the financial report complies fully with the accounting standards; however, you form the view that your audit report should draw attention to this note. In addition you have identified the following matters from your audit work:
1. Spinner Ltd’s inventory amounted to $1 941 000 at 30 June 2013. In order to move some of its old stock, in July 2013 the company sold 25 per cent of its finished goods inventories held at 30 June 2013 for $82 189 below their original cost. Management has indicated that as the sales occurred after 30 June 2013, it believes that the value of finished goods at that date should remain at cost. The remainder of the inventory has only been purchased recently and is in great demand.
2. Spinner Ltd’s accounts payable at 30 June 2013 amounted to $1 726 000. Subsequent payments testing revealed that in July 2013, invoices totalling $53 751 were paid that related to June 2013 purchases of inventories. The relevant invoices were omitted from the balance of accounts payables at 30 June 2013. Management has indicated that it does not intend to adjust the financial report in relation to this issue.
3. Spinner Ltd’s accounts receivable balance at 30 June 2013 amounted to $2 540 000. Your testing has revealed that the accountant used an incorrect exchange rate to translate overseas debtors at 30 June 2013. As a result, the balance of the accounts receivable account was overstated by $75 650. Again, management has indicated that it does not intend to adjust the financial report in relation to this issue. Required:
(a) Explain the two circumstances under which a modified audit opinion is issued and explain the three different types of modified opinions.
(b) Explain whether drawing attention to the note will result in the expression of a modified audit opinion. Justify your answer.
(c) Explain whether the issues arising from your audit work (matters 1 to 3 above) will individually have any effect on your audit opinion. Justify your answer, using calculations.
(d) Identify the type of audit opinion that you will include in your audit report for Spinner Ltd for the year ended 30 June 2013. Justify your answer.
CASE 3
You are an audit manager at Hogan & Associates and have been assigned to the audit of Looking Good
Ltd (LGL) for the year ending 30 June 2013. LGL is an Australian manufacturer, wholesaler and retailer of ladies handbags and shoes. LGL manufactures all its products at its Brisbane factory and sells via retail outlets throughout Australia. LGL is listed on the Australian Securities Exchange and Hogan & Associates has been its auditor for several years.
In recent years, LGL has been finding it difficult to meet its projected profit forecasts due to increased competition from new local competitors, imported products and online shopping; the increasingly high Australian dollar; and the impact of the global and European financial crisis on consumer spending.
During the planning stage of the audit you become aware of the following matters:
1. LGL has significant loans from its bank. The bank has indicated that it is concerned about LGL’s ability to meet specific loan covenants, particularly the return on total assets (net profit/total assets).
2. The aged trade accounts receivable listing indicates that the percentage of accounts receivable exceeding 90 days has jumped from 15 per cent to 37.5 per cent during the last 12 months. The credit manager has indicated that this is because some of LGL’s customers are currently experiencing financial difficulty.
3. In order to reduce costs, LGL changed one of its major suppliers of raw materials in February 2013 to a cheaper overseas supplier. However, the number of product returns has increased significantly since April 2013, and your discussions with management have indicated that the increased returns have involved customer complaints concerning the quality of the product.
4. Your review of the payroll system has indicated that when an employee is hired or terminated, the payroll clerk immediately prepares the paperwork and enters the information into the master file of the payroll computer system.
5. The payroll department at LGL’s head office processes payroll on a weekly basis. All timesheets that are submitted by factory workers are signed off by the factory manager. The timesheets are input into the computer by the factory manager and payment is then made by the payroll department.
Required:
(a) Describe the two types of misstatement in a financial report that may arise from fraud.
(b) For each matter 1 to 3 above, outline how each matter is a fraud audit risk factor in relation to LGL’s financial report.
(c) Describe how the internal control weakness in matter 4 and 5 above could lead to material misstatement in the financial report.
CASE 4
You are an audit manager at Fenley & Associates working on the audit of Femme Fatale Clothing
Company Ltd (FFC) for the year ending 30 June 2013. FFC has two separate divisions. One division manufactures exclusive women’s lingerie and the other division manufactures women’s evening wear made from fabric imported from France. The divisions operate from two separate locations.
FFC operates throughout Australia and its customers include a number of exclusive women’s retail clothing boutiques and upmarket department stores. A significant amount of stock on hand is represented by unsold stock returned by customers. Sales terms provided to FFC’s customers are as follows:
•Settlement is required within 30 days of the invoice date.
•Any goods remaining unsold by a customer after six months can be returned for a full cash refund based on the original invoice price of the unsold goods.
FFC creates a provision for refunds based on an analysis of the trend in refunds over the previous three years.
Any unsold goods that are returned after the six months are then sold in FFC’s factory shop to the general public at cost. Any stock remaining unsold in the factory shop after three months is donated to local charities.
Sales have declined by 15 per cent over the last two years, because Australian customers have become nervous about the impact of the European debt crisis upon local economic conditions. FFC’s sales manager estimates that sales will continue to decline at the rate of 4 per cent per annum for at least the next couple of years.
The following are key balances extracted from FFC’s draft financial report for the year ending 30 June 2013:
$
Net profit before tax 4 150 000
Inventories 1 350 000
Property, plant & equipment (cost less accumulated depreciation) 5 300 000
Current liabilities 900 000
Owners’ equity 7 121 430
The following events have come to your attention during the final review of the audit:
1. Fixed assets: In accordance with the accounting standards, FFC’s accountant tested the fixed assets of both of the manufacturing divisions for impairment. The impairment test revealed that the evening wear division required the recognition of an impairment loss of $200 000 to its manufacturing equipment. You raised this matter with the CFO, who stated that he did not believe that there was any need to record an impairment loss because the relevant fixed assets will be used for their entire useful life. He stated that the calculation of the impairment loss was based on the present value of future cash flows, which he believes is irrelevant to the current valuation of these assets.
2. Provision for refunds: After reviewing FFC’s recent sales, you have calculated that the provision for refunds account is overstated by $140 000. However, FFC’s CFO has informed you that he does not wish to reduce the provision and would rather release the excess from the provision in future financial years should profitability decrease.
3. Inventory: On 12 June 2013, FFC placed an order with its French supplier for high-quality silk fabric worth $700 000. In accordance with the FOB terms of the purchase agreement, ownership of the goods passes to FFC and a liability to the supplier is incurred when the container is loaded onto the ship at the overseas port. The container was loaded onto the ship in France on 26 June 2013 and arrived at FFC’s warehouse on 11 July 2013. Given that no entry has been recorded to recognise the transaction in the year ending 30 June 2013, you advise the CFO that an entry should be recorded to recognise an asset ‘stock in transit’ and a liability ‘accounts payable’, and the asset and liability be included in the statement of financial position at 30 June 2013. However, the CFO has stated that the transaction does not need to be recorded, as the shipment was received after the reporting date.
4. Bank overdraft: Although FFC’s sales have declined over the last couple of years, FFC’s bank is still confident about the company’s future profitability and financial stability, and on 23 July 2013, FFC renegotiated its current bank overdraft facility. The new facility provides for the relaxation of the debt covenants, a reduction of the charge over accounts receivable from 100 per cent to 75 per cent and a reduction in the interest rate by 1 per cent. The new overdraft facility will significantly improve FFC’s financial flexibility, as well as reduce its future costs of borrowing. However, the CFO has stated that it is unnecessary to include details of this event in the financial report since the renegotiation occurred after the reporting date.
The audit report was subsequently signed and issued on 14 August, 2013. However, on 29 August the chief executive officer (CEO) advised you that it had been discovered that the Melbourne warehouse manager had committed fraud and covered it up by including a material amount of fictitious stock in the 30 June stocktake sheets. As the audited financial report has already been issued, the CEO stated that nothing could be done in relation to the 2013 financial report and that it would have to be adjusted next year.
Required:
Treating events 1 to 4 above as completely independent, identify the most likely audit opinion that you would express on FFC’s financial report based on each separate event. Justify your answer, using calculations.
Explain what actions, if any, the auditor should take in relation to the discovery of the fictitious stock error after the issue of the financial report? Justify your answer.
CASE 5
An unqualified audit report normally states that the financial statements to which the report refers give a true and fair view of the state of the company’s affairs at the Statement of Financial Position date and its profits for the year ended on that date.
Bearing in mind the above statement the directors of Midland Builders Ltd have drawn up accounts for the year ended 30 June 2013 which do not reflect certain events which have occurred since the year end. They justify their action on the grounds that the books and records correctly reflect what was known at the year end. The following are the events which are not reflected in the draft financial statements (in all cases the figures are material).
(i)At a meeting in July 2013 the local planning authority rejected the company’s plans to develop one of its freehold sites. The site was included in the company’s assets at its cost of $500,000, but it is likely that the site will have to be sold and will realise no more than $350,000 because of its reduced development potential.
(ii)Following the completion of a long-term contract in July 2013 it has been possible to calculate the final profit on the contract. It appears that the profit accrued at 30 June 2013 was underestimated by $220,000. This arose from a material error at 30 June 2013 in estimating the amount of work still to be completed.
List two detailed procedures which an auditor should adopt in order to detect post Statement of Financial Position events.
CASE 6
As a senior auditor in charge of the audit of F Limited, you have asked your audit staff to review the audit files and make a list of items for inclusion within the letter of representation form the management. The staffs have provided the following draft list of points:
Equity and reserves
• All statutory records and registers required to be kept in accordance with the corporations Act 2001 have been properly kept.
• All share transfers have been appropriately recorded in the statutory registers. Liabilities
• All contingent liabilities have been discussed and appropriate disclosures made in respect of all known contingencies.
• All known subsequent events have been discussed and appropriately treated in the financial report.
• All trade payables have been completely recorded in the financial report.
Property, plant and equipment
• All non-current assets are stated at a value below their recoverable amount.
• All assets are being depreciated over their estimated useful lives.
Trade receivables
• Adequate allowance has been made for all known doubtful trade debtors.
• Current assets include other receivables of $850,000 in respect of amounts receivable on settlement of a contract for the sale of commercial property. The directors confirm that it is their intention to settle the contract during the 2010/2011 financial year.
Other
• Directors believe that the $600,000 shown as deferred expenditure will be recovered in full in future periods.
• All known controlled entities have been included within the consolidated financial report.
• All books, records and other documents have been made available to us for the purpose of our audit.
Required
(i) What is the main purpose (as according to ASA 580) of a letter of representation from the management?
(ii) From the information gathered above outline the items which should be included within the management representation letter, giving reasons
CASE 7
You are the audit senior on the audit of EasyFit Pty Limited, a large manufacturer of shoes. EasyFit Pty Limited’s main market lies with 18 to 24 year olds.
This is the first year in which your firm has performed the audit. As part of the planning work, you have performed analytical procedures on an annualised basis and compared the results to industry averages and last year’s audited financial information. The results are given below:
Industry average EasyFit Pty Limited
Ratio 20X7 20X6 20X7 20X6
1 Current ratio 2.84 3.27 1.89 2.24
2 Receivables turnover ratio 4.9 4.6 6.3 7.0
3 Inventory turnover ratio 3.7 3.8 5.0 5.5
4 Return on total assets 7% 5% 13% 11%
5 Net profit ratio 0.06 0.06 0.04 0.04
6 Gross margin 0.20 0.26 0.20 0.18
Required:
Explain the general meaning of each of the above ratios, discuss the conclusions that you can draw about EasyFit’s financial position and identify potential audit risks to be investigated further.
CASE 8
Consider the following independent situations found during audit testing of CD Ltd, which has a balance date of 30 June 20X7. Assume that all the situations are material.
(i) Recent industrial action has seen trade unions win a pay increase of 4% for all their members. Under the terms of the agreement, the pay increase will be backdated to 1 January 20X7. Management have agreed to the pay increase, however, they have not made any adjustments to the 30 June 20X7 financial report.
(ii) A large order from an overseas supplier was shipped FOB (free on board) from its port of origin on 1 June 20X7. The order arrived on 20 July 20X7. The purchase is not reflected in the 30 June 20X7 financial report.
(iii) The draft chairman’s report to go with the financial report states that the profits of a particular segment of the company’s operations increased by 70% during the period. On checking the figures, you found profits increased by only 4%.
iv. Your New Zealand branch office disclaimed responsibility for the inventory figures in the New Zealand division’s reporting package. This is because sudden flooding prevented the auditors from attending the stocktake, and destroyed documentation which would have enabled them to substantiate inventory by other means. The New Zealand division represents about 10% of CD Ltd’s operations.
v. The entire Queensland operations of the company are under investigation by the Tax Office for alleged failure to pay the appropriate amount of PAYG tax. Your preliminary investigations reveal that the Tax Office has a strong case against the company. No mention of the dispute is made in the financial report.
Required:
Assume that no adjustments are made. For each situation, identify the type of audit opinion required and explain the basis of your answers.
CASE 9
You are part of the audit team assigned to ABC Ltd, a large distributor of imported floor and wall tiles and supplies tiling contractors and retail stores. You are assigned the task of reviewing and evaluating the internal control over the sales and collection cycle. You have been provided with the following narrative relating to the internal control system over this area. Sales recording, maintenance of accounts receivable and collection procedures are shared between the accounts receivable clerk, a cashier/ secretary and the receptionist. Their procedures in regard to billing and collection have been described as follows.
After opening the mail the receptionist hands customers’ purchase orders to the accounts receivable clerk. To prevent delays in dispatch of orders accounts receivable clerk prepares a five part sales invoice for distribution to various departments.
Since ABC has a liquidity problem, the deposit of receipts is also expedited. The receptionist hands all mail receipts and related correspondence to accounts receivable clerk who examines the cheques and determines whether or not the accompanying vouchers or correspondence contain enough detail to permit posting of the accounts. The accounts receivable clerk then endorses the cheques and gives them to the cashier who prepares the daily deposit. No cash is received in the mail and no goods are sold over the counter.
The accounts receivable clerk uses the vouchers or correspondence that accompanied the cheques to post sales details to the accounts receivable ledger and to prepare cash receipts register. Monthly, the general ledger clerk summarises the cash receipts register for posting to the general ledger accounts. The accounts receivable clerk also corresponds with customers about unauthorised deductions for discounts, allowances, returns, and prepares the appropriate credit notes. Disputes involving large amounts are turned over to the sales manager for settlement. Each month accounts receivable clerk prepares a trial balance of the accounts receivable to agree with the general ledger. Required:
Based on the available information above, list any of the two weaknesses in ABC’s internal control over customer billings and collections, the potential consequences (effects) of those weaknesses and how the weakness could be corrected (strengthened).
CASE 10
The following sales procedures were encountered during the annual audit of Marvel Wholesale Ltd.
Customer orders are received by the sales order department. A clerk calculates the approximate dollar amount of the order and sends it to the credit department for approval. Credit approval is stamped on the order and sent to the accounting department. A computer is then used to generate two copies of a sales invoice. The order is filed in the customer order file.
The customer copy of the sales invoice is held in a pending file awaiting notification that the order was shipped. The shipping copy of the sales invoice is routed through the warehouse, and the shipping department has authority for the respective departments to release and ship merchandise. Shipping department personnel pack the order and manually prepare a threecopy bill of lading: the original copy is mailed to the customer, the second copy is sent with the shipment, and the third is filed in sequence in the bill of lading file. The sales invoice shipping copy is sent to the accounting department with any changes resulting from lack of available merchandise.
A clerk in accounting matches the received sales invoice shipping copy with the sales invoice customer copy from the pending file. Quantities on the two invoices are compared and prices are compared on an approved price list. The customer copy is then mailed to the customer, and the shipping copy is sent to the data-processing department. The dataprocessing clerk in accounting enters the sales invoice data in the computer, which is used to prepare the sales journal and update the accounts receivable master file. She files the shipping copy in the sales invoice file in numerical sequence.
Required
Assuming you are the auditor of Marvel Wholesale Ltd, what actions would you take to ensure all invoices are posted to the customers’ accounts receivable master file and all merchandises shipped have been invoiced and uncollected amount in the customers’ accounts represent the balance of the trade receivables?
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