AF 304 SEMESTER 2 - 2019 MAJOR ASSIGNMENT (15%) Due date: Friday 11th October 2019 @ 3.30pm with School of Accounting Secretary Audit Cases - A Practical Approach to Auditing 1.0 Introduction Audit Firm: Assume that you are part of the highly qualified audit team employed by the DisneyLand Audit Company Limited, an auditing firm, which is internationally recognized and one of the largest professional accounting firm globally. DisneyLand Audit & Co, has been chosen as the Independent external auditors of one of the US's largest multinational company known as 'Las Vegas Group Corporation (USA) Limited' which will be your audit client hereafter. You have been engaged to carry out a financial statements audit for this client 'Las Vegas Group Corporation (USA) Limited'. Company Background: Las Vegas Group Corporation (USA) Limited is based in United States of America with its head office in Las Vegas City, State of Nevada. It is the parent body of the many subsidiary companies which operates in the international market in dealing with a wide range of items for exports to other countries. The company operates in most of the countries including, Australia, New Zealand, Hong Kong, Singapore, Malaysia, China, Japan, and Fiji. Las Vegas Group Corporation has been incorporated in 1990 and has been in operation since then till today. The company has 5 major subsidiaries which are specialized in different segments as follows: Parent - Subsidiary Company's: Subsidiary 1 - Carpets International (USA) Limited Subsidiary 2 - Fashion Designers Limited Subsidiary 3 - Computek Electronics Limited Subsidiary 4 - Enron Electric Limited Subsidiary 5 - General Machinery Company Limited Introduction to Subsidiary Companies: Subsidiary 1 - Carpets International (USA) Limited The Carpets International (USA) Limited Pty Limited is an American subsidiary company of Las Vegas Group Corporation (USA) Limited which is listed on the New York Stock Exchange. Your firm DisneyLand Audit & Co, provides a clearance report to your clients Las Vegas Office as Well as an audit report on the statutory accounts of the American subsidiary. The company manufactures Carpets and sells internationally. The primary raw material used in the manufacture of the company's product, carpet, is wool which is purchased from Australia. 1 Subsidiary 2 - Fashion Designers Limited Fashion Designers Limited is also an American subsidiary company of Las Vegas Group Corporation (USA) Limited which is listed on the New York Stock Exchange and its major shareholder (51%) is the US parent which controls the use of the accessory brand names throughout the world. Fashion Designers Ltd is a large multi-national manufacturer and distributor of fashion accessories. Fashion Designers Ltd operates predominantly out of Australia and is rapidly expanding into Asia and Eastern Europe. Subsidiary 3 - Computek Electronics Limited Computek Electronics Limited, is a wholly owned subsidiary of the US parent company, Las Vegas Group Corporation (USA) Limited. The principal activities of Computek Electronics Ltd are the importation and distribution of modems and personal computers. It has offices in all capital cities in US and around Australia. All inventories are purchased either from its US parent or related companies in Hong Kong and Taiwan. Computek Electronics Ltd was incorporated in 1991. Subsidiary 4 - Enron Electric Limited The Enron Electric Limited is also a subsidiary company of Las Vegas Group Corporation (USA) Limited. Enron Electric Ltd., is a manufacturer and distributor of household electrical products. The Company contains a number of subsidiaries with diverse operations. Subsidiary 5 - General Machinery Company Limited The General Machinery Company Limited, is another subsidiary company of Las Vegas Group Corporation (USA) Limited. The General Machinery Company Limited is primarily a distributor of a range of machinery and equipment and also engages in other business activities. It has assets of approximately $4m, including current assets of nearly $2m. 2.0 Instructions for Students: This will be an individual assignment on practical approach to auditing and you need to complete this task as a member of the audit team. This assignment is based on 'a practical approach to auditing' for the company 'Las Vegas Group Corporation (USA) Limited'. This company is the parent body and has been in operation since 1990. This assignment is produced for helping 300-level auditing students of USP in broadening their understanding of applying the basic auditing principles, procedures, concepts and techniques in a practical audit situation in an ever-challenging audit environment. You need to make an individual effort to complete this assignment. 3.0 Requirements for Students: DisneyLand Audit & Co, your auditing firm is seeking your assistance in auditing the financial statements of the 5 major Las Vegas Group Corporation's subsidiary companies operating globally. There are 5 sections in this case study. The requirements are provided specifically in each section of the case study. You need to individually complete and present in a report form. Each case in each section needs to be considered independently. 2 There will be 1 part for your assignment: 1. 1. Written Report Submission 15 % Total weighting towards coursework 15 % Written Report Submission in Week 13 (15%): For written report submission, you need to submit ONE assignment in a report format, typed using Microsoft 12-point time's new roman font. All reports must be typed and binded. Hand-written reports will not be accepted. Late submissions will incur a penalty of 10% marks off each day late from their total marks. No reasons or excuses will be accepted for late submissions. The mark allocation for the written submission will be as follows: Section 1 Section 2 Section 3 Section 4 Section 5 Total marks for the content of the report Format & Presentation Clarity & Completeness Computations & Calculations Preciseness & Understanding Bibliography & References Total marks for Written submission 2% 2% 2% 2% 2% 10 % 1% 1% 1% 1% 1% 15 % Note: This is one of the major course assessments for your coursework and final grades in this AF304 auditing course. This assignment is compulsory and failure to meet all these requirements will affect your performance and weighting towards the 15% marks in your course assessment. This will result in the course lecturers' discretion for your final marks and grades in this AF304 course. 4.0 Format of the Report: Your final report need to be arranged in the following format and order: Title page including members' details Table of contents Auditors report for the group (Extract)* Solutions for section 1 Solutions for section 2 Solutions for section 3 Solutions for section 4 Solutions for section 5 Bibliography & References *You may not be able to prepare a detailed audit report for the overall parent company, however, you need to prepare the type of audit report you seem to be suitable for Las Vegas Group Corporation overall considering the 5 subsidiaries. You need to provide a typical format of the auditors report including sections on auditors' responsibility, independence and auditors opinion. 3 Section 1: Subsidiary 1 - Carpets International (USA) Limited You are involved in the audit of Carpets International (USA) Limited, a subsidiary company of Las Vegas Group Corporation (USA) Limited. The client has presented you with the following draft Statement of Financial Position and Statement of Financial Performance as follows: Unaudited 11 months 30/11/X2 $'000 Audited 12 months 31/12/X1 $'000 58 4579 3624 8261 73 3928 2047 6048 28763 2000 30763 39024 29417 2000 31417 37465 5000 2500 643 8143 7500 2473 610 10583 22000 547 22547 30690 8334 20000 510 20510 31093 6372 5000 3334 8334 Statement of financial performance Revenue 20007 Gross profit 6702 Operating expenses 3486 Net Profit before tax 3216 Taxation 1254 Net Profit after tax 1962 Accumulated profits at the beginning of the year 1372 Accumulated profits at the end of the period. 3334 5000 1372 6372 Current Assets Cash Receivables Inventories Total Current Assets Non-current Assets Property, plant & equipment Receivables Total Non-current Assets Total Assets Current Liabilities Bank borrowings - Secured Trade Creditors Provisions Total Current Liabilities Non-Current Liabilities Bank borrowings - Secured Provisions Total Non-current Liabilities Total Liabilities Net Assets Shareholders' Equity Share Capital Accumulated Profits Total Shareholders' Equity 19943 4515 3047 1468 572 896 476 1372 The following additional information is provided: 1. 2. 3. The company is a subsidiary of Las Vegas Group Corporation (USA) Limited which is listed on the New York Stock Exchange. Your firm provides a clearance report to your firm's Las Vegas Office as well as an audit report on the statutory accounts of the American subsidiary. The company manufactures carpets. Approximately 80% of the company's sales arise as a result of exports. Where the company sells abroad the customers are invoiced in the currency of that country. 4 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. The primary raw material used in the manufacture of the company's product is wool which is purchased in Australia. You have been informed that the company's profitability has improved due to the recent slump in wool prices. With the exception of the managing director, Mr. L, an American executive, all of the local management is American. Mr. L is on a 5 year secondment from the US parent. He has a reputation for delivering results from subsidiaries which have not performed well in the past. It is his intention to return to the US Company in a year's time as a director. In the past you have found the financial controller, Mr. C, to be competent in day to day accounting issues but somewhat lacking in assessing the 'broad picture'. Both management and statutory accounts are subject to Mr. L's approval. He frequently insists on adjustments to the draft accounts. The US parent's management was dissatisfied with the company's 19X1 result and has paid close attention to the company's performance during 19X2. The company operates a standard costing system and the finished goods inventory is valued at standard cost. Raw materials are valued at actual invoiced cost. Due to the Christmas shutdown no work in progress exists at year end. During 19X2 production has been increased by 10% compared to 19X1 levels. This has resulted in favourable absorption variances which have contributed to the improved profitability during 19X2. Tests on the company's inventory and debtors controls in prior years have shown the system to be reliable. The systems are capable of producing reports on the ageing of inventory and debtors and the sales history of individual product lines. Approximately 80% of the company's trade debtors are overseas customers and the debt is denominated in foreign currency. Most of these customers are on 60 day credit terms. Midway through the financial year the previous credit controller resigned. His replacement, Mr. B, was appointed 6 weeks later. Mr. B has informed you that a number of customers have complained about product quality problems. An analysis of the company's fixed assets is a s follows: 19X2 $'000 Property - Factory building 27000 Plant & Equipment (including Vehicles) 1763 28763 Additions and disposals of fixed assets during 19X2 have not been significant. The factory was acquired 6 years ago. Since that date no independent valuation has been carried out. Mr. L has assured you that the current market value of the property is not less than $27m. 15. Bank borrowings are secured by a fixed charge over the company's buildings. A loan repayment of $5m due on 30 November 19X2 was reduced to $500,000. Mr. L has stated that this was done with the agreement of the bank and that the bank is comfortable with the company's performance, and points out that the company has made all of its interest payments on time. 16. The non-current receivables is an Export Market Development grant. 17. In prior years no serious differences between the auditors and management arose. The audit has always been completed on time and an unqualified opinion issued. 18. You have just received a memo from Las Vegas office stating that due to the client's head office management's desire to issue the results of the group earlier this year they will require clearance on the American company's accounts by 18 January 19X3. For 19X1 clearance was given on 30 January 19X2. You are required to complete the following: 5 A) Specify the analytical review procedures you consider should be carried out as part of your audit planning. B) Identify what you consider to be the risk factors which will impact on the audit of receivables and inventories. C) What other risk factors will impact on the audit. D) Set the levels of materiality for your audit plan for the Statement of Financial Position and the Statement of Financial Performance. Justify the selection of these levels. E) In respect of the following draft a memo to the audit partner setting out the audit approach to be adopted: i) Receivables ii) Inventory iii) Land and Buildings - current value for disclosure. 6 Section 2: Subsidiary 2 - Fashion Designers Limited You are required to audit Fashion Designers Limited, a subsidiary company of Las Vegas Group Corporation (USA) Limited. Fashion Designers Ltd is a large multi-national manufacturer and distributor of fashion accessories. The company is listed on the New York Stock Exchange and its major shareholder (51%) is the US Company which controls the use of the accessory brand names throughout the world. Fashion Designers Ltd operates predominantly out of Australia but is rapidly expanding into Asia and Eastern Europe. In 1992 overseas operations accounted for 15% of the group turnover and 10% of the Group profit. In 1993 this is expected to increase to 23% of turnover and 18% of profit. As the American market is considered to be stagnant, future growth is expected to come from the Asian and European markets. The audit structure is such that all overseas operations are audited by the same international audit firm, XYZ & Co, who were the auditors of the major US shareholder. Your audit firm, DisneyLand Audit & Co, is responsible for the audit of all the American branches. The consolidated Statement of Financial Performance and Statement of Financial Position for Fashion Designers Ltd for the year ended 31 December 1992 and the estimate for the coming year ending 31 December 1993 are as follows: Statement of Financial Performance Estimate Audited 31/12/93 31/12/92 $'000 $'000 Operating profit before abnormal items 113220 86974 Abnormal items (17050) Operating profit before income tax 96170 86974 Income tax expense (25970) (24720) Operating profit after income tax 70200 62254 Retained profits at the beginning of the year 114257 52003 Dividends paid (53274) Retained profits at the end of the year 131183 114257 Statement of Financial Position Current Assets Cash Receivables Inventories Total Current Assets Non-Current assets Property, plant & equipment Investments Brand names Total Non-current Assets Total Assets Current Liabilities Creditors & borrowings Provisions Total Non-current Liabilities Non-current Liabilities Creditors and borrowings Provisions Total Non-current Liabilities Total Liabilities 7 21720 391278 189702 602700 24915 352307 153978 531200 573291 8357 474852 1056500 1659200 495973 21952 398115 916040 1447240 587294 170446 757740 401253 219077 620330 392877 79803 472680 1230420 360112 68328 428440 1048770 Net Assets Shareholders Equity Share Capital Reserves Retained Profits Total Shareholders Equity 428780 398470 101908 195689 131183 428780 101563 182650 114257 398470 The abnormal item relates to the loss made on the sale of an investment during the year. 'Brand names' relates to the price paid for the brand names purchased from the major shareholder. The asset is not being amortised as the company believes that asset to be a tangible asset with a value which will never decrease below that paid due to the proven success of the brand names worldwide for over half a century. The stock valuation system used by Fashion Designers is an average costing system. Each time a delivery is entered into the stock system, the system automatically uses the new cost and the current average cost in the computer to calculate a new average cost. All stock is physically counted at balance date and then the average cost in the computer is applied to the units on hand to calculate the year end inventory valuation. Fashion Designers also runs several fashion accessory stores. The inventory in the stores is valued using the retail inventory method. You are required to complete the following: A) Set a group materiality level based upon the estimated 31 December 1993 figures. B) Prepare a memorandum to the audit partner detailing the procedures required regarding reliance on the audit work performed by XYZ & Co. on the overseas operations. C) What audit procedures would you adopt to verify the carrying value of the brand names? D) Assuming you disagree with the non-amortisation of the brand names to the extent that a qualified audit opinion is required, what type of qualification would you issue? E) Prepare an audit strategy document outlining the audit procedures which should be adopted in the verification of the stock valuation assumption of Fashion Designers and each of its retail outlets. F) You have ascertained and recorded the system of internal control and decided that you wish to place reliance on the controls in many areas. The results of your compliance tests on purchases and stocks reveal that: i) Out of 100 purchase invoices selected for inspection, 2 could not be found and 2 were not initialed as checked and approved for payment. ii) Out of 120 stock cards inspected, 4 contained an instance where the delivered quantity had been altered by a significant amount. iii) One supplier is regularly paid before supplies are delivered on the basis of pro forma invoices which are processed through the creditors' ledger system on receipt so as to initiate the necessary payments. No other exceptions were noted. 1) Outline what further procedures should be carried out in order to be able to reach a conclusion on whether the company's system of internal controls can be relied upon, indicating what factors you would consider in reaching your conclusion. 8 2) G) H) Having reviewed your files you find that previous management letters have outlined the problem that one supplier is being paid based on pro forma invoices prior to delivery. No action has been taken by management to rectify this problem. What should be done about this? The credit controller of Fashion Designers Ltd has provided you with an aged debtor's trial balance as at 30 November 1993. There are over 5000 individual accounts distributed over a wide range of values. The system of internal control over debtors has been assessed as satisfactory and reliable. 1) What audit objectives would you be concerned with in testing the trade debtor's balance? 2) Describe the steps that you would include in an audit program to test the trade debtors balance as at 30 November 1993. 3) What further testing would you perform as at year end? 4) What analytical review procedures could be used to examine the possible overstatement or understatement of the provision for doubtful debts? While reviewing Fashion Designers payroll computer system you note the following weaknesses in internal control: i) When the weekly timesheets are received the details are keypunched into a transaction file. An edit report is then generated and the details are agreed back to the timesheets. Once all the timesheets have been input the employees' master file is then updated by a batch program. There is no output from the batch update program. ii) A special password and user ID is required to be entered by payroll staff before they can input changes to employee pay rates. This special password and user ID is the same for all of the payroll staff members who input pay rate details. Describe the potential impact each of the above weaknesses could have and suggest control procedures which would overcome them. 9 Section 3: Subsidiary 3 - Computek Electronics Limited (Case for Audit Supervisor) You are assigned to the audit of Computek Electronics Limited, a subsidiary company of Las Vegas Group Corporation (USA) Limited. Computek Electronics Ltd. is a wholly owned subsidiary of a US parent. The following information has been provided to you: 1. The principal activities of Computek Electronics Ltd are the importation and distribution of modems and personal computers (PCs). It has offices in all capital cities in US and around Australia. 2. All inventories are purchased either from its US parent or related companies in Hong Kong and Taiwan. 3. Computek Electronics Ltd was incorporated in 1991 and had operated profitably until 1996 when significant losses were incurred, principally due to the downturn in the economy, competition from other manufacturers and the availability of cheaper clones. 4. The company is well established in the modem market; however, it has not been doing well in the PC market for the reasons given above and has consequently decided to get out of the PC market and concentrate on enhancing its position in the modem market. This decision has been communicated to the public via computer journals and publications. 5. The stock level of PCs, modems and spares as at 30 October 1998 was as follows: $'000 Modems 4426 PCs 3142 Spares 1563 9131 6. Your manager has advised you that 2 of the largest debtors have gone into liquidation and the client has provided 50% of these debts as they are covered by credit insurance. There is no correspondence from the insurance company regarding whether or when the claim in respect of these debts will be settled. The insurance company has requested Computek to provide evidence that the company has fulfilled all the conditions of the insurance policy before it will settle. In view of previous experiences by the company with such insurance claims, it is unlikely that any notification on recovery will be received before year end. The financial controller has assured your manager that they have complied with all the conditions of the insurance agreement. 7. The company maintains fully computerized accounting systems for sales/debtors, inventories and general ledger functions. Audit testing in prior years has shown that controls over these systems appear to be strong. The sales/debtors system matches cash receipts to outstanding items, and maintains back order details where customer orders cannot be filled immediately. 8. Computek has a wholly owned subsidiary in New Zealand which has been making losses since its incorporation in 1995. As a result, the subsidiary has a large deficiency in shareholders' funds. The New Zealand company figures have not been consolidated in the attached financial information. 9. A large stock of PCs at a cost of $600,000 was ordered and is currently in transit from the overseas parent. These PCs are the latest machines which have been brought to Australia for the first time. However, since Computek has resolved to concentrate on the modem market, it has decided not to release the machines into Australia. The parent company from which these stocks were purchased will not accept them back, but the company's directors are looking to on-sell them to another related company in Hong Kong. 10 10. Initial discussions with management have revealed that the company has significant tax losses which management is keen to carry forward as an asset in the year end balance sheet. 11. All modems and PCs sold by the company have a warranty of 12 months from the date of sale. 12. One modem stock item (XP1000) which was released in early 1997 was found to have a factory fault. This defect only occurs in modems which are used excessively. Computek had established a provision of $480,000 for returns of this item, but only $80,000 of this provision had been utilized up to October 1998. The returns of this item have slowed down to only 1 per month. There are 100 units of this item still on hand. Computek Electronics Limited Statement of Financial Performance Unaudited 10 months 31/10/98 $'000 Operating revenue 47787 Operating profit (loss) (3652) Abnormal items Income tax expense Operating loss after income tax (3652) Retained profits/(losses) at beginning of financial year (23816) Retained profits/(losses) at end of financial period (27468) Statement of Financial Position Current Assets Cash 153 Receivables 10353 Inventories 7723 Other Total Current Assets 18229 Non-current Assets Investments 1 Property, Plant & Equipment 1800 Total Non-current Assets 1801 Total Assets 20030 Current Liabilities Creditors & Borrowings 16537 Provisions 890 Total Current Liabilities 17427 Non-current Liabilities Creditors & Borrowings 29034 Provisions 37 Total Non-current Liabilities 29071 Total Liabilities 46498 Net Assets (26468) Shareholders' Equity Share Capital 1000 Retained profits/(losses) (27468) Total Shareholders' Equity (26468) You are required to complete the following: 11 Audited 12 months 31/12/97 $'000 72007 (5561) (1583) (7144) (16672) (23816) 1107 14310 18073 40 33530 1 2166 2167 35697 27177 1672 28849 29634 30 29664 58513 (22816) 1000 (23816) (22816) A). i) What are the key factors that indicate that the company may have a going concern problem? ii) What additional information would you obtain to evaluate this problem? B). Assume the audit partner has concluded that the company is likely to remain a going concern. Describe the substantive procedures to be performed to address the key audit assertions for the following balances: i) Trade debtors ii) PC inventory iii) Returns provision iv) Operating revenue v) Amounts owing to parent entity C). Assume you were given the following information: The parent company has advised local management that should Computek not show a turnaround to profits for the year ended 31 December 1999 it will proceed to wind up local operations early in 2000. What effect would this information have on the audit? D) Indicate the type of error that each of the following audit procedures is designed to or is likely to disclose: i) review of the repairs and maintenance account. ii) confirmation of a portion of accounts receivable. iii) reconciliation of interest expense with loans payable. E) Having just completed the annual financial audit, the audit partner and supervisor are holding a final debriefing meeting with the client. As part of this meeting the managing director of Computek Electronics Ltd indicates: I'm glad we got a clean bill of health on that audit report. I had some concerns about controls at the warehouse but I see there is nothing to worry about.' The audit partner replied: 'our procedures did not involve a full review of controls, so I don't know whether your specific concerns would be addressed or not.' The managing director retorted, 'Well, what are we paying you for then? Advise the partner on an appropriate reply to the managing director. 12 Section 4: Subsidiary 4 - Enron Electric Limited (EEL) (Case for Audit Manager) You are in charge of the audit of Enron Electric Limited (EEL), a subsidiary company of Las Vegas Group Corporation (USA) Limited. Enron Electric Ltd., is a manufacturer and distributor of household electrical products. The EEL Company contains a number of subsidiaries with diverse operations. A new graduate has also been assigned to assist you on the job. During discussions with management, the graduate has become aware of the following matters: A). EEL has bank borrowings totaling $2m. As part of its borrowing contract, the company agreed that it would not borrow additional money from any other financial institution. EEL management has advised you that the company has no other borrowings. B). The company has a policy of rewarding its successful salespeople with performance bonuses. For the current year, the company decided that every salesperson who achieved sales to the value of $300, 000 would be given a week-long overseas holiday for 2 people to Hawaii. The company calculated that they needed a provision of $50,000 for this bonus. C). As part of its drive to introduce innovative products to the American market place, EEL recently purchased the licence to manufacture and distribute a new generation 'kitchen whiz' from an American company at a cost of $350, 000. The new 'kitchen whiz' was launched onto the market one month prior to the company's 30 September 1998 balance date. As at 15 November 1998 sales of the new product have been disappointing, with sales only half those initially projected. However, management is very optimistic that with Christmas approaching, sales will dramatically improve. EEL has recorded the value of the licence in its accounts as at 30 September 1998 at cost price. D). Just prior to balance date, EEL's factory in Melbourne caught fire. The Melbourne factory is the smallest of its 6 factories in Australia. The entire building and all its contents, including inventory and machinery, were destroyed. Management plans to rebuild the factory totally and claim that it has suffered no loss, as all the items destroyed were covered by insurance. E). Another subsidiary company of EEL is involved in the distribution of gas. It has a large number of small customers. The gas is supplied in cylinders which are delivered to the customers' premises. The cylinders are owned by the company and recorded as fixed assets and rented to the customers. No deposits are taken on the cylinders. The written down value of the cylinders in the company's 1998 accounts was $20m. In the year ended 30 June 1997 the directors had established a general provision for lost cylinders of $100, 000. Subsequent discussions with the directors indicated that they intend to carry the same provision for the 1998 year. F). PQR is a subsidiary company which has a $10m investment in a soft drink manufacturing and distribution company which commenced operations in 1997 in Laos. This company is trying to manufacture and market American branded soft drinks but to date has incurred losses of $4m. Management has indicated that penetration of this market is a long term endeavour and does not wish to write down the value of its investment in the soft drink company. G). An importing subsidiary has been raided by the Customs Duty Department which alleges that the company has been avoiding customs duty payment on products it is importing. Management has indicated that it disagrees with this contention and will strenuously defend its position. 13 H). One American based subsidiary owns and leases out to customers certain highly specialized earthmoving equipment. The average lease term is 4 years. Due to expansion over recent years, 45% of its equipment is leased to customers who reside in New Zealand, Papua New Guinea and South East Asia. You are required to complete the following: A) In respect of each of the above A-H, advise the graduate on the audit procedures necessary to confirm the information provided by management. B) What are the general issues related to deciding whether to use a test of controls approach or a substantive approach? C) How do the risk assessments relate to the choice of audit approach? D) What audit procedures would you use for the measurement and completeness of depreciation expense objective? E) To comply with auditing standards an auditor includes certain evidence in the working papers. For example evidence that the engagement was planned and that the work of assistants was supervised and reviewed. What other evidence should an auditor include in audit working papers to comply with auditing standards? F) You are the audit manager of a new client. Management of the new client has prepared its accounts in accordance with generally accepted accounting principles but you believe that the overall view presented by this financial report is not true and fair. Outline in a report to your partner the approach that should be taken in these circumstances. 14 Section 5: Subsidiary 5 - General Machinery Company Limited (Case for Audit Partner) General Machinery Company Limited, a subsidiary company of Las Vegas Group Corporation (USA) Limited, is primarily a distributor of a range of machinery and equipment and also engages in other business activities. It has assets of approximately $4m, including current assets of nearly $2m. The draft Statement of Financial Performance of the company has just been completed by the company accountant and presented to the auditors, Disneyland Audit Company Ltd., to enable them to complete their audit. You, as the partner in charge of the audit, is surprised to find out that the company has made a profit this year, because your audit work during and after the end of the financial year had led you to expect a significant loss. The draft Statement of Financial Performance and some of the notes are shown below. General Machinery Company Limited Statement of Financial Performance For the year ended 30 June 1997 1997 $ 30020000 165000 10000 155000 Revenue Operating profit Income tax expense Extraordinary items 155000 55000 710000 500000 210000 Retained profit b/f Dividend Retained profit c/f 1996 $ 30450000 1240000 605000 635000 230000 865000 440000 1305000 750000 555000 Notes to the accounts: 1. 2. Accounting methods Inventory - the company values spare parts held for its machinery customers at average cost. Costs of spare parts representing more than 3 years' expected consumption are written off. Operating profit before income tax has been determined after: Including an abnormal credit $150000, not subject to income tax, resulting from the revaluation of a block of land written off against profits several years ago when a quarrying operation was discontinued; it is now proposed to develop the site as a tavern and service station to serve the growing population of the area. During your ensuing investigations, you ascertained the following: i) Land revaluation - is treated as an abnormal item. The company had for some year's extracted rock and gravel from a block it acquired in a village near Collie. The cost of the block, which was $3000, had been written off many years ago when the useful material was exhausted, but the land title had been retained. In view of the growing prosperity from mining development in the area, the directors had concluded that there were prospects for a tavern and probably a service station and store on the block, and they were now drawing up plans preparatory to applying for rezoning of the land and then either undertaking the project themselves or selling the block and plans. On the basis of the opinion of a local estate agent that 'residential land of an equivalent area in the village would be worth about $150 000' the directors have revalued the block in the accounts at that amount. This is the company's only holding of land. ii) Inventory accounting policy - described in Note 1. The auditors had been concerned for some time at the high value of slow-moving spare parts inventory. They had accepted the 15 financial statements in the previous year because they had not been able to establish that net realizable value was less than cost, but they had requested a reconsideration of inventory valuation in the year just ended. It had been tentatively agreed between the auditors and the directors that a maximum of 2 years' expected consumption, based on the last 2 years' sales, should be valued for financial reporting purposes and any surplus written off. The directors have since decided to increase this to 3 years. The cost of the stock on hand representing the additional year's consumption has been estimated by the auditors at $27000. iii) Factory reorganization - in order to restore its competitive position, the company had over several weeks in May and June been reorganizing its production facilities and replacing some older plant. The planning and execution of the program had absorbed a lot of time of senior personnel and the engineering design office. As a result, the directors had decided to carry forward as non-current assets not only the cost of draftsmen and engineers at their normal rates per hour but also a proportion of the salaries of the senior personnel involved. The auditors were shown time and cost calculations for senior personnel which supported the cost carry forward of $72000. The cost of engineering design carried forward was $56000. The auditors have been assured by the factory manager as well as the financial director that the reorganization will improve productivity. The capitalization of these costs has not been separately disclosed in the financial statements. You are required to complete the following: A). Discuss the reasonableness of the directors' proposed treatment of the 3 items above. Justify any changes or additional disclosure you would require in order to be able to give an unqualified audit opinion on the financial statements. Assume for the purpose of this part that you are able to satisfy yourself that the company's continuation in business is not threatened. B). Assume now that you have found that the company is fully utilizing its $300000 bank overdraft facility, which is secured over its assets, and your audit investigations have given you serious cause for concern as to the ability of the company to continue in business. Reconsider the treatment of the disclosures that you outlined for A above, and determine the type of audit report to be issued. C) The audit has now been completed. A number of difficulties were experienced during the audit, including significant disagreements over the valuation of investment property holdings. You as the audit partner have suggested that the property value was overstated by $10m, a figure which was twice the level of materiality set for the audit. As a result of discussions with the audit committee, the CEO agreed to revise the valuations downward by $8m. All other issues were resolved to the satisfaction of you, resulting in an overall misstatement of the accounts of $2m. The audit partner is now considering the effect of the misstatement on the audit report. Discuss the effect of the misstatement on the audit report. D) Discuss the auditor's responsibility for information accompanying a financial report. THE END 16