Financial Statements and Auditing;
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Q1
You are auditing JJ Ltd, a large clothing manufacturer that sells clothing wholesale to large department stores. The industry is highly competitive and fast-moving due to continual changes in fashion. JJ Ltd has been established for 20 years but for the last three years has been making only small profits. JJ Ltd has a bank loan that is contingent on JJ Ltd producing at least break-even results.
You have noted the following independent events in relation to the 30 December 20X3 audit:
1. Due to increased competitive pressures, JJ Ltd has recently moved the manufacture of some of its clothing lines to China. The fabric is made in Australia, sent to China to be cut and stitched, then returned to Australia in finished form. JJ Ltd saves around 20% in cost compared to the equivalent Australian-made item. However, the manufacturing process takes longer and on a few occasions late delivery from China has resulted in lost sales.
2. Sales staff is currently paid a salary based on years of experience, plus a flat $5000 bonus each per quarter if quarterly sales targets are met or exceeded. This system will end on 30 September 20X3 and a new scheme will be implemented. Under this new scheme, sales staff will be paid a lower salary and sales will be tracked by the individual staff member. If an individual's target is met or exceeded, the salesperson will receive a commission of 5% of their sales.
3. At present JJ Ltd maintains warehouses in each state to ensure goods can be delivered to customers with minimal delay. Unfortunately this has resulted in high warehousing cots due to the duplication of premises and staff. On 1 November 20X3, the lease agreements for the state warehouses will be terminated and the warehouses closed. All inventories will be transferred to a new, leased warehouse in an industrial estate on the outskirts of Melbourne.
4. In the past 18 months, JJ Ltd has experienced staff shortages in the accounts payable area. Clerical work in this area is highly specialized and JJ Ltd has been unable to recruit the appropriate personnel. This has resulted in errors in the accounts payable ledger, particularly double-counted invoices. However, last month JJ Ltd secured the services of two experienced accounts payable clerks, both on 2 year contracts. They are slowly clearing the backlog of entries and intend to fully reconcile each creditor's account prior to year-end.
5. With the move of some manufacturing offshore, JJ Ltd has found itself with some excess factory machinery. A proposed sale to a small firm in Brisbane has recently fallen through, and JJ Ltd is having difficulty finding other buyers. The accountant has told you that JJ Ltd is considering consigning the machinery to an auction house to sell it for the best possible price.
6. Recent reports have appeared in the financial press trading PM Pty Ltd, a chain of 100 retail clothing shops operating in all parts of Australia. PM Pty Ltd's owners are seeking to exit the business and JJ Ltd has entered into a contract to purchase the store leases and stock as at 31 December 20X3. JJ Ltd's move into retail is driven by a desire to improve its trading results; retail margins are on average 10% higher than wholesale. JJ Ltd intends holding a 'closing down' sale in January to clear old stock; it will then close and refurbish the stores, re-stock them with its own lines, and re-open in early February.
7. In order to reduce its wages expense and gain a more flexible workforce, JJ Ltd has recently signed enterprise bargaining agreements with its factory workers. Under these agreements, the workers will be contractors instead of employees from 1 January 20X4. Although JJ Ltd will pay a 20% higher hourly rate, it will no longer incur sick, annual or long service leave.
8. In order to secure its key customers as long-term clients, JJ Ltd now offers some of its clothing lines on a 'sale or return' basis. The accountant estimates that around 30% of sales are now made on these terms. Sales staff estimate around 10% of 'sale or return' items are returned to JJ Ltd for a refund. At present, manual records are kept of 'sale or return' items, which for accounting purposes are recorded as sales at the time the goods are delivered. As 'sale or return' sales are expected to increase, the accountant is considering having the computer system modified to automatically track these goods.
Required
Identify the financial report areas/accounts affected by each of the above independent events. Would audit risk for each area increase or decrease and why? Where appropriate, include discussion of the key audit assertions affected.
Q2.
You are the audit senior on the 30 June X1 audit of QP Limited. You have just been given the audit file to review by your assistant. Materiality for this client has been set at $200 000. The client is based in Orange, NSW. The following information has been obtained from reading the audit file and talking with the assistant:
1. The balance noted for borrowings in the general ledger at 30 June 20X1 is $158 000. This compares with a balance as at 30 June 20X0 of $450 000. The audit assistant noted that 'As the borrowings balance is immaterial in the current year, only limited audit work is necessary'. The only work performed by the assistant was to select the three largest borrowings from the client's detailed listing (which had been agreed to the general ledger) and agree them to statements provided by the lenders.
2. QP holds stock at a number of different locations in New South Wales. The balances noted by the client for the various locations at balance date are as follows:
$000
Orange 817
Dubbo 204
Parramatta 989
Total $2010
You note that assistant has attended the stock take at Orange and Dubbo only. He has documented all test counts and found no exceptions.
When you asked the assistant why he had not attended the stock take at Parramatta, he replied:
I had originally planned to go to Parramatta, but I had already exceeded the budgeted time allocated for stock. As I considered Parramatta to be too far away, I attended the stock take at Dubbo instead. I rang the warehouse manager at Parramatta and received verbal confirmation that the stock take had proceeded smoothly and that only minor exceptions from the perpetual records were noted.
Required
(a) For each situation, comment on whether the audit assistant has obtained sufficient appropriate audit evidence.
(b) If you conclude that sufficient appropriate audit evidence has not been obtained, what further procedures should the assistant perform?
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Solution Summary
The problem describes different financial situations and the response identifies the places where these problems occur. There are examples given for most situations.
Solution Preview
Identify the financial report areas/accounts affected by each of the above independent events. Would audit risk for each area increase or decrease and why? Where appropriate, include discussion of the key audit assertions affected.
STEP 1
The financial report area that are affected is the income statement, because if the cost of making goes down by 20% then the profits are expected to go up. Also, if deliveries come in late then the work in progress will go up and be reflected in the income statement as well as the balance sheet. The audit risk goes up because while the goods are in transit there is no control over their return. There may be lost goods in transit. In addition, the cost of cutting and stitching can be different from that disclosed in the company accounts. This disparity increases the audit risk. It is difficult for the auditor to verify exactly the cost incurred in cutting and stitching if these activities are done in China. The chances of fraud are higher.
STEP2
This again affects the income statement because it will affect the salaries paid. In addition a new item, commission will have to be paid to employees. This increases the audit risk because tracking sales can lead to errors and frauds and a higher commission may be paid to sales staff. Also there is a degree of subjective ness in the target setting and can lead to fraud.
STEP 3
Warehouse changes will affect the income statement, as the cost of warehousing will come down. In addition, the leasehold property will be affected in the balance sheet. This will reduce audit risk because the number of transactions and locations is reduced. The terms and conditions of the new leased warehouse can be carefully examined. In addition, audit ...
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