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ACCT7103 Auditing Case Study
(40 marks = 20% of the course) You are a senior auditor of the accounting firm QJL Partners. Your audit team is currently planning the 2020 audit of Good-job Limited, a medium sized listed company in Australia that manufactures and sells office equipment and office supplies. The company has a few retail stores in shopping centres across Australia. This is the second year your accounting firm is engaged to perform the audit for this client. The financial year under audit ended on 31st December 2020. Past audit work and initial inquiries this year have revealed the following information. Good-job Ltd (hereafter referred to as “the company” or “the audit client”) had slow but stable growth in the past. After the Coronavirus crisis started in early 2020, the company’s store sales declined due to a variety of reason. For example, lockdown restrictions caused a drop in the number of people visiting the audit client’s stores. Moreover, the company had to keep paying rent for its stores. Sales to businesses also decreased as there was less need for office supplies when employees worked from home. However, demand from individual consumers increased because a lot of people had to work from home. In response, the audit client’s CEO closed some stores where shopping centre management refused to lower rent payments. The CEO then spent a substantial amount of money to quickly upgrade the company’s website from a basic website that just displayed a small number of the company’s main products to a new system that allows customers to order and pay for any of the company’s products online. The accounting system was also gradually upgraded to be integrated with the online sales system. Both the new online sales system and the accounting system crashed several times initially because they could not handle the volume of online transactions, but these issues were resolved reasonably quickly and now the systems can process a large volume of online sales. One of the audit client’s main competitors started to offer free home delivery from November 2020 to gain market share. The audit client was forced to match the offer, but this significantly affected the company’s profit margin. As online sales increased, the company started to experience inventory shortage problems because both domestic and overseas suppliers often had to reduce or stop production due to COVID-19 related issues such as shortage of raw materials and labour. There were also long delays in product delivery times as both domestic and international freight services were affected by governments’ border restrictions. Inventory shortages resulted in lost sales, so the audit client had to find alternative suppliers even though the products from new suppliers were often more expensive and some products were of lower quality, resulting in a negative impact on sales and profit margins. As a result, there was an increase in sales returns and customer requests for repair or refund for faulty products. 2021-2 Auditing Case Study, p.2 Another problem for the audit client was that, as lockdown periods became longer and occurred more frequently, many employees were sometimes required to self-isolate in home or hotel quarantine so they could not go to work. Many departments including the manufacturing department and the accounting department had a shortage of both junior and senior staff. It was not always possible to immediately hire replacement staff who were qualified with sufficient experiences, so the company had to employ some casual staff and gave them quick training sessions. Various department managers expressed concerns about the quality of work by the casual staff. For example, the manufacturing department had an increase in material wastage, faulty products, and machine down times, caused by new employees who were not familiar with their work. There was also a shortage of experienced staff for important work such as product quality control checks and machine maintenance. To help fund the company’s operations, the audit client took out a $10 million bank loan in October 2020, to be repaid after 5 years. One of the conditions in the debt contract requires the audit client’s return on assets ratio (calculated as net profit divided by total assets) to be above 5% for the duration of the loan. The board of directors showed understanding for the challenges faced by the management team. The board approved a special cash bonus to be paid to the Chief Executive Officer (CEO) if profit growth for the 2020 financial year reached 3%. About 15% of the CEO’s normal pay package was in the form of company shares. As the company encountered various challenges throughout the financial year, the CEO kept the employees updated by sending regular e-mails to ask all employees to help improve revenues and cut costs to reduce the necessity of staff cuts. The CEO also asked the Human Resources department to negotiate lower wages/salary payments with current employees as a condition for contract renewals. The audit client’s accounting department is separate from other operating departments. Only the accounting staff and the CEO have access to the accounting system. However, the company’s policies require the CEO to consult with the chief accountant about any proposed changes to the accounting records. Such discussions are required to be documented by both the accounting department and the CEO’s secretary. The computer systems for sales, inventory management and accounting are integrated. However, access to different systems is restricted to authorised staff via individual passwords so that only sales staff has access to the sales computer system, and only accounting staff has access to the accounting system, etc. The audit client uses a perpetual inventory system. When customers make an order online, they need to specify the product and the quantity they wish to buy. Other product information such as product price and special discounts are automatically provided by the online sales system. When the order is processed, the sales system sends the details of the customer order to the inventory management system. The warehouse staff uses this information to prepare delivery documents. Customers are required to sign a paper copy of the delivery document upon receipt of the goods they ordered. Sales invoices and delivery documents are serially numbered. The original copy of the customer-signed delivery document is then sent to the accounting department while the 2021-2 Auditing Case Study, p.3 warehouse staff keeps a duplicate copy of the document. At the end of each day, the warehouse manager gives authorisation in the inventory management system to process sales transactions for which delivery has been made. The system then updates the perpetual inventory records and sends the sales transactions to the accounting system. The accounting staff checks the details in the customer orders and sales invoices against signed delivery documents before giving authorisation to the accounting system to record sales in the accounting records. Senior accounting staff are required to regularly check recent sales transactions to see whether there are duplicate or missing sales invoice numbers, and whether each sales transaction has both a sales invoice number and a delivery document number. The audit client usually offers 1-year free warranty for most of its products. The rate of faulty products used to be quite stable between the financial years 2017 to 2019. In June 2020, to improve sales, the audit client’s CEO changed the warranty policy and started offering 2-year free warranty for products worth more than $500. When warranty costs are incurred, the accounting staff checks the reasonableness of the cost for the type of technical problem reported against an official list of common technical faults and related costs. The company uses the provision method to record warranty expenses. The audit client prepares monthly reports to show actual warranty costs for different types of products. Quarterly meetings are held to discuss the reasonableness of these costs and whether product design should be changed to reduce the rate of faulty products. These meetings are attended by senior managers from departments such as manufacturing, sales, accounting, research and development, and technical support and maintenance departments. Records of these meetings are sent to the CEO for review. The reports in the last few months of the financial year show that after the company started using new suppliers who provided lower quality materials and components, the rate of faulty products and the costs of repair/refund have both increased. At the end of the financial year, the CEO and the chief accountant meet to discuss major accounting issues such as appropriate accounting estimates to be reported in current year financial statements. Data such as the monthly warranty cost reports are used for such decisions. Discussions in these meetings are documented by a secretary. The chief accountant told the auditor that the accounting estimate for warranty expense takes into consideration other information such as sales volume for different products in the current year and the frequency of faults reported for different products. The chief accountant was hired by the CEO five years ago and they are close friends. The chief accountant keeps the CEO updated about the company’s financial progress and discusses major accounting issues with the CEO. However, they both say that the CEO does not attempt to override the chief accountant’s professional judgment. Both the CEO and chief accountant are very friendly to the auditors and the directors. These managers have a good relationship with the board of directors. 2021-2 Auditing Case Study, p.4 Extracts of the audit client’s financial ratios for the last few years are provided below. 2020 full year (unaudited) 2020 (first 9 months) 2019 2018 2017 Profit growth 3.1% 2.5% 6% 5.4% 5.2% Return on assets 5.1% 3.9% 7.5% 6.8% 6.2% Warranty expense/Sales 5.6% Not applicable 7.6% 7.2% 6.9% Profit growth is calculated as the difference between current period profit and prior period profit divided by prior period profit, i.e. (Profit t – Profit t-1) / Profit t-1. Return on assets ratio = Net profit divided by total assets. Warranty expense is an accounting estimate. Required For the (A) occurrence general audit objective of the sales revenue account, and (B) the accuracy general audit objective (under the valuation assertion) of the provision for warranty account, answer all of the following questions in accordance with the Australian Auditing Standards. You need to perform your analysis using the facts in the case study. For each of the two audit objectives of the accounts specified above: (1) Assess inherent risk and perform analytical procedures to assess the risk of misstatements for each of the two general audit objectives of the accounts given above. Analyse and explain your arguments. In your answer, state one type of fraud that would breach the general audit objective (i.e., one type of fraud for sales occurrence and one type of fraud for the accuracy objective of provision for warranty account). (Total 20 marks) (2) Assess control risk for each of the two general audit objectives of the accounts given above. In your answer, identify existing internal controls that are relevant to the specified general audit objectives, and briefly explain how each internal control can prevent/detect misstatements for the specified general audit objectives for sales and provision for warranty. (12 marks) (3) Identify an existing internal control that is specific to each of the two general audit objectives of the accounts specified above, and design one test of control for each case. The internal controls and tests of controls must be based on the facts given in the case study. Briefly explain how the tests of controls specifically check the relevant general audit objectives of the accounts specified. (4 marks) (4) Design one substantive procedure that produces reasonably reliable evidence for each of the two general audit objectives of the accounts given above. Do NOT use analytical procedures for the sales occurrence objective. (4 marks)
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