Graeme Brown, chartered accountant, has been the partner in charge of the audit of Merkle Manufacturing Ltd, a client listed on the Australian Stock Exchange, for 13 years. Merkle has had excellent growth and profits in the past decade, primarily as a result of the excellent leadership provided by Bill Merkle and other competent executives. Brown has always enjoyed a close relationship with the company and prides himself on having made several constructive comments resulting from consultancies over the years that have aided in the success of the firm. In particular, a number of recommendations were implemented from his firm's work on installing the company's new computer system. Brown has also made a valuable contribution as a member of the company's audit committee. Several times in the past few years, Brown's firm has asked him to consider rotating a different audit team on the engagement, but this has been strongly resisted by both Brown and Merkle, as the staff are very familiar with the company and its processes, and such a change will serve only to increase audit costs. Mandatory rotation of the audit partner won't occur for some time.

For the first few years of the audit, internal controls were inadequate and the accounting personnel had inadequate qualifications for their responsibilities. Extensive audit evidence was required during the audit, and numerous adjusting entries were necessary. However, because of Brown's constant prodding, the internal controls improved gradually and competent personnel were hired. In recent years no audit adjustments had normally been required, and the extent of the evidence accumulation was gradually reduced. During the past three years, Brown has been able to devote less time to the audit because of the relative ease of conducting the audit and the cooperation obtained throughout the engagement.

In the current year's audit, Brown decides that the total time budget for the engagement should be kept approximately the same as in recent years. The senior in charge of the audit, Phil Warren, is new on the job and highly competent, though this is his first involvement in an audit in the industry in which Merkle operates. The fact that Merkle had recently acquired a new division through merger will probably add to the audit time, but Warren's efficiency will probably compensate for it.

The interim tests of internal controls take somewhat longer than expected because of the use of several new assistants, a change in the accounting system to computerise inventories and several other aspects of the accounting records, a change in accounting personnel, and the existence of a few more errors in the tests of the system. Neither Brown nor Warren is concerned about the deficit in the audit budget, however, because they can easily make up the difference at year-end.

At year-end, Warren assigns responsibility for inventory to an assistant who also hasn't been on the audit before but is competent and extremely fast at his work. Even though the total value of inventory has increased, he reduces the size of the sample from that of other years because there have been few errors in the preceding year. He finds several items in the sample that were overstated due to errors in pricing and obsolescence, but the combination of all the errors in the sample is immaterial, and therefore projection of errors to the inventory balance is considered unnecessary. He completes the tests in 25% less time than in the preceding year, helped by the fact that the CIS manager had written a program for Warren to list all obsolete inventory items on the company's inventory master file. This was done because Warren wasn't familiar with CIS systems and needed the computer program to save time and cost. There were many obsolete items listed on the obsolete inventory report, but none were material and Warren decided they didn't require further action. The entire audit was completed on schedule and in slightly less time than in the preceding year. There were only a few adjusting entries for the year and only two of them were material. Brown was extremely pleased with the results and wrote a special letter to Warren and the inventory assistant, complimenting them on the audit.

Six months later, Brown received a telephone call from Merkle and was informed that the company was in serious financial trouble. Subsequent investigation revealed that the inventory had been significantly overstated. The main cause of the misstatement was the inclusion of obsolete items in inventory (especially in the new division), errors in pricing due to a fault in the inventory valuation program in the new computer system, and the inclusion of non-existent inventory in the final inventory listing. The new financial controller had intentionally overstated the inventory to compensate for the reduction in sales volume from the preceding year. Errors were also found in the computer report of obsolete items produced for Warren by the CIS manager.

REQUIRED

a. List the major deficiencies in the audit, and state why they took place. For each item listed, suggest a different audit approach and/or discuss further audit evidence that should have been gathered by the auditors.

b. If Brown's firm is sued by (a) the shareholders or (b) the creditors, what is the likely outcome?