AUDITING & ASSURANCE SERVICES PAPER

AdoreU Children Fashion Ltd Mini Audit Project

QUESTIONS

Part A: Professional Ethics and Audit Planning

BACKGROUND INFORMATION

Wallace & Davey Partners, Chartered Accountants is a medium size accounting firm located in Auckland with four audit partners, seven business advisory partners and four tax partners. The firm has been appointed to audit AdoreU Children Fashion Ltd for the year ended 31 December 2018. The former auditor has been rotated off the client. The engagement partner is Patrick Wallace, and you are the audit manager assigned to this client. Your firm does not have experience in the children fashion industry, but Wallace thinks it is a good opportunity to learn about the industry. The fee for the financial audit of AdoreU is $150,000, which is about 16% of total audit fees your firm generates. The company would also require advice on taxation and treasury. Since this is a first time audit, you accompanied Wallace to meet the senior management of the client. The following is a summary of your notes from the interviews with senior management of AdoreU Children Fashion.

NOTES FROM CLIENT INTERVIEW

The company profile

AdoreU Children Fashion is an Auckland company incorporated in 1990. It was founded by Sally Hall, a former childrenswear buyer, and a mum. Hall spotted a gap in the market for quality and fashionable childrenswear and started the brand with a mail order catalogue. Halls mail order catalogue was very popular and soon after she opened the first AdoreU retail store. By 1994, AdoreU headed into Australia as a mail order catalogue, opening its first Australian store three years later. AdoreUs rise seemed unstoppable in the early 2000s. It secured its first US wholesale partner Nordstrom in 2002, and in 2003 added Australian department store David Jones as a distribution channel. In 2004 it listed on the New Zealand stock exchange and opened franchise partner stores across the Middle East. Retail stores in the US, franchises in Singapore, Malaysia, Indonesia, South Africa and Pakistan followed, along with the companys first ecommerce website in 2006. Around that time, the founder Hall stepped down from the Board, leaving the Directors to find a new managing director. Since then, the company has changed three Managing Directors. The fast expansion of AdoreU was heavily financed through debts, which contributed to a highly geared financial position. It created pressure for the company in serving the high level of debts. The companys expansion ceased in 2007 and its shares price peaked in January 2007 at $4.95 per share. By November 2018, the share price dropped by 60% to $1.98. As of 2015, the company closed its stores in nearly all international markets, with just 92 stores remaining across Australia, New Zealand and Ireland. Market commentators believe that the deterioration of AdoreU financial performance was largely because of its inability to sustain the rapid global expansion.

Despite the highly competitive retail market, the core retail businesses in New Zealand and Australia have performed well in the current financial period and progress has been made to improve stock efficiency. Despite the difficulties in performance, the new Managing Director Neil Jenkins, who was appointed in June 2017, is confident that the company can be turned around because the brand is still strong and well recognised. The company also has reduced net banking debt by $20 million, and its banking facilities are secured until the end of 2018. Before he was appointed as the managing director, Jenkins was an experienced director and was the CFO of a large retailing chain in NZ. At the meeting, you discovered that Jenkins daughter works for your firm as an audit graduate.

The new Managing Director Neil Jenkins is changing its business strategy, which aimed at repositioning itself in the market. The new MD has a turnaround plan. He says that AdoreUs must redirect its focus to customers, the style of clothes parents desire to buy for their kids and enhance customers experience in the stores. To achieve this, an investment will be required in the new design of products, marketing channels and various customer communication mediums.

Competition in the market

In recent years, clothing retailers in Australia and New Zealand have struggled. Although AdoreU is the biggest player in the Australasian market, it claims to have 12% of the children fashion market. It competes with brands carried by department stores as well as small boutiques such as Seed, H&M and Cotton On Kids etc.

Financial situation

AdoreU delivered a $9,079,000 after-tax loss for the year ended 31 December 2018, an improvement compared to the prior year loss of $11,495,000. Jenkins said "the financial position of the company has improved significantly over the last year in particular and we have formed a very strong working relationship with the bank. Over the last 12 months, we have made significant progress in reducing inventory level. Our debts (interest bearing liabilities) also have dropped from over $60 million last year to around $40 million this year. In our view, this is material and has created the platform for us to move forward."

The structure of the Board of Directors

The Board of Directors consists of five members: the Managing Director and four independent directors at the end of 2018 financial year. Three of the four independent directors are also members of the Audit Committee. The Company has a formal Code of Conduct and Ethics Policy. This policy provides guidance to all Directors, managers, employees and contractors of AdoreU Limited expected conduct when undertaking business on behalf of the company.

Communication with the prior auditor

With the clients approval, the predecessor auditor shared their audit file for the last financial year. You noted in the audit file, a concern regarding the valuation of inventory. The predecessor auditor believed that one of the inventory range called Comfort maternity wear had a long turnover time and should be written off. The value of this particular label was 10% of the total inventory. However, management believed that it can still be sold at cost. Eventually, no write-off was made for this inventory range in the last financial statements. The previous auditor also noted that they questioned about the companys risk of breaching its bank covenant because the turnover was disappointing. The management argued that the company is in a transition period and the poor performance was partially contributed by the failure of two suppliers because of major flooding in a key supply region in China. They had to find other reputable suppliers which caused delays in production.

Part A Audit Planning and Professional Ethics

Required:

2. Following the above meeting, the engagement partner asks you to review the unaudited financial statements for the year 31 December 2018 (attached as a separate Excel document) and to produce the audit planning workpaper discussing the potential risks of material misstatement that the firm may encounter in this audit. (30 marks)

Your audit planning workpaper must cover the following:

a) Identify ten risks factors (conditions) that the financial statements maybe misstated.

b) Explain the potential impact of each of the identified risk factor on the assertions of the financial statements or the audit.

c) Determine the audit strategies or procedures that should address each identified risk.

Use the following format to present your answer.

Identify the risks (facts) (a)

The potential impact on the assertions of financial statements or the audit. (b)

Audit strategies or procedures to address the risks (c)

Adore Children Fashion Ltd STATEMENTS OF COMPREHENSIVE INCOME For the year ended 31 Dec 2018 Notes Unaudited 31-Dec-18 $'000 238,537 -115,901 122,636 231 100.0% -48.6% 51.4% 31-Dec-17 $'000 240,902 -120,120 120,782 100.0% -49.9% - 50.1% 2.20 - 2.07 Inventory turnover 173 3 -45.4% -1.7% -7.6% 0.85 3.23 Interests coverage ratio -108,223 -4,011 -18,056 -7,423 -1,656 -9,079 -45.3% -1.4% -9.5% -5.9% -3.1% Revenue Cost of goods sold Gross profit Other operating income Expenses Selling expenses Finance expenses Administrative and general expenses Loss from continuing operations before income tax Income tax (expense)/credit Net loss from continuing operations Profit from discontinuing operations (net of tax) Loss for the year Other comprehensive loss Items that may be reclassified subsequently to loss: Exchange differences on translation of foreign operations Net movement on cash flow hedges Income tax relating to components of other comprehensive income Other comprehensive income/(loss) for the year Total comprehensive loss for the year, net of tax Total comprehensive loss for the year is attributable to equity holders -109,016 -3,352 -22,778 -14,191 2,579 -11,612 -117 -11,495 -9,079 2,093 1,818 -59 -4,128 -509 3,402 -5,677 1,157 -3030 -14,525 -5,677 -14,525 BALANCE SHEETS As at 31 December 2018 12/31/2018 Notes $'000 12/31/2017 $'000 12/31/2016 $'000 ASSETS Current assets 0.21328 0.58460 0.32539 Quick ratio Cash and cash equivalents Trade and other receivables Derivative financial instruments Inventories Current tax receivables Total current assets Non-current assets 1,870 13,458 5,808 41,230 1,016 63,382 1,077 16,845 1,009 64,318 3,679 14,957 8,348 51,957 83,249 78,941 0.881922 2.715497 1.378328 Current ratio 11 28,420 2,803 3,567 Property, plant and equipment Intangible assets Non-current tax receivables Derivative financial instruments Deferred tax assets Total non-current assets 32,436 5,756 3,475 278 7,932 49,877 133,126 40,113 9,690 2,958 614 3,563 56,938 135,879 5,550 40,340 103,722 Total assets 27,305 25,451 41,000 1,210 2,968 1,239 71,868 356 1,112 1,884 30,657 24,608 25,000 662 5,509 1,494 57,273 27,000 LIABILITIES Current liabilities Trade and other payables Interest bearing liabilities Lease Provisions Derivative financial instruments Other Provisions Total current liabilities Non-current liabilities Interest bearing liabilities Lease Provisions Deferred landlord contributions Derivative financial instruments Total non-current liabilities Total liabilities Net assets EQUITY Share capital Reserves Retained earnings / (deficit) Total equity 512 2,971 66,000 488 2,102 74 68,664 99,321 33,805 518 2,105 1,054 3,677 75,545 28,177 57 30,540 87,813 48,066 1.273023 1.674015 Debt/equity 59,343 3,006 - 34,172 - 28,177 59,331 433 25,093 - 33,805 59,147 3,734 14,815 48,066 Note 2 SEGMENT INFORMATION An operating segment is a component of an entity that engages in business activities which earns revenue and incurs expenses on which the chief operating decision maker reviews the operating results on a regular basis and makes decisions on resource allocation. The Company is organised into operating segments, depicting the three geographical regions the Company operates in and the centralised support function based in New Zealand. Management has determined the operating segments based on the business activities of the Company together with the information and the manner in which decisions regarding performance and resource allocation are made by the Senior Management Team. The "Chief Operating Decision Maker" is considered to be the Senior Management Team who consider the business from a geographic and support function perspective, being New Zealand, Australia and other International markets while the performance of the centralised support function is assessed separately. The International segment includes the results of continuing operations in markets located outside New Zealand and Australia. The following is an analysis of the Company's revenue and results by operating segment. Revenue reported below represents revenue from the sale of children's clothing products to external customers. Revenue is allocated based on the country where the sale is generated. There were no inter-segment sales in the year (2015: nil). Geographic segment profit represents the profit earned by each segment without allocation of central administration costs, finance costs, income tax, store impairment and lease provisions. These costs are recorded in the centralised support segment Australia New International Centralised Total Zealand Support 2018 $'000 $'000 $'000 $'000 $'000 Revenue 151,923 46,833 39,781 - 238,537 Expenses 135,734 - 38,611 - 37,857 - 33,758 - 245,960 Segment result before income tax 16,189 8,222 1,924 - 33,758 - 7,423 Income tax - 1,656 Loss for the year 9,079 Segment total assets (other than deferred tax) 39,844 18,745 18,653 20,930 98,172 Segment non-current assets (other than deferred tax) 18,910 4,869 90 10,921 34,790 Acquisitions of property, plant and equipment, intangibles 3,028 188 - 649 3,865 and other non-current segment assets Depreciation and amortisation expense 3,438 - 1,275 - 97 - 4,117 - 8,927 Finance expense - 4,011 - 4,011 2017 Revenue Expenses Segment result before income tax Income tax - Income tax - Profit from discontinuing operations (net of tax) 149,914 47,971 - 130,993 - 39,527 - 18,921 8,444 43,017 38,845 - 4,172 - - Loss for the year Segment total assets (other than deferred tax) Segment non-current assets (other than deferred tax) Acquisitions of property, plant and equipment, intangibles Depreciation and amortisation expense Finance expense - 240,902 45,728 - 255,093 45,728 - 14.191 - 2,579 117 - 2,696 -- 11495 16,935 125,194 14,696 41,945 3,542 8,567 5,077 - 11,010 3,352 - 3,352 51,217 20,139 4,045 4,471 - 25,410 6,639 757 1,335 - 31,632 471 223 127 - - - - (1) The Company's liabilities are not analysed on a segmental basis and therefore have not been reported. (ii) Revenue comprises the fair value for the sale of goods and services, net of sales tax and discounts and after eliminating sales within the Company. - Sales of goods - retail Sales of goods are recognised when a Company entity sells a product to the customer. Retail sales are usually in cash or by credit card either in store or online. Sales of goods-wholesale Wholesale sales are recognised in accordance with the terms of sales when the title has transferred and the benefits of ownership and risk pass to the customer. This is dependent on customer specific terms of trade. - Interest income Interest income is recognised using the effective interest method. 31-Dec-18 31-Dec-17 - Other income - Interest received 941 830 P&L Balance Sheet Equity Note 2 Notes 3,7,8 Note 10 Notes 11,12,13 Note 15 oth ... + 37 Note 7 TRADE RECEIVABLES, PREPAYMENTS AND OTHER ASSETS 38 Accounting Policy 39 Trade receivables are recognised initially at fair value and subsequently at amortised cost less provision for doubtful debts. Collectibility of trade receivables is reviewed on an ongoing basis. Debts which are known to be uncollectible are written off. A provision for doubtful receivables is established when there is objective evidence that the Company will not be able to collect all amounts due according to the original terms of receivables. The amount of the provision is the difference between the asset's carrying amount and the present value of estimated future cash flows. The amount of the provision is recognised in the Income Statement. Significant financial difficulties of the debtor, probability that the debtor will enter bankruptcy or financial reorganisation, and default or delinquency in payments are considered indicators that the trade receivable is impaired. 31 Dec 31 Dec 2018 2017 $'000 $'000 42 Trade receivables 6,531 12,704 43 Prepayments 5,454 2,739 Other receivables 1,473 1,402 13,458 16,845 46 The carrying amounts of the Company's trade and other receivables are denominated in the following currencies: 47 NZD 2,974 3,357 48 USD 6,219 12,479 49 AUD 3,728 70 50 GBP 251 588 51 EUR 286 351 13,458 16,845 The Company has assessed total trade receivables as being impaired and has recognised a doubtful debt provision of $2.1m based on additional information in relation to economic developments so subsequent to year end. All other remaining balances at 31 Dec 2018 are considered current and within terms. 52 54 55 Note 8 INVENTORIES 56 Accounting Policy Finished goods are stated at the lower of cost and net realisable value. Costs are assigned to individual items of inventory on the basis of weighted average costs, and include expenditure incurred in acquiring the assets and bringing them to their existing location and condition. Net realisable value is the estimated selling price in the ordinary course of business. The Company annually reviews the carrying value of inventory to ensure it remains valued at lower of cost or net realisable value. An inventory provision is created to reflect instances where the 58 forecast selling value is lower than cost. 31 Dec 2018 31 Dec 2017 $'000 $'000 50 Finished Goods 41,230 64,318 51 Inventory provisions of $1,093,000 (2017: $1,566,000) have been included in the Income Statement to reflect the recoverable value of the company;s aged stock provision. Adore Children Fashion Ltd STATEMENTS OF COMPREHENSIVE INCOME For the year ended 31 Dec 2018 Notes Unaudited 31-Dec-18 $'000 238,537 -115,901 122,636 231 100.0% -48.6% 51.4% 31-Dec-17 $'000 240,902 -120,120 120,782 100.0% -49.9% - 50.1% 2.20 - 2.07 Inventory turnover 173 3 -45.4% -1.7% -7.6% 0.85 3.23 Interests coverage ratio -108,223 -4,011 -18,056 -7,423 -1,656 -9,079 -45.3% -1.4% -9.5% -5.9% -3.1% Revenue Cost of goods sold Gross profit Other operating income Expenses Selling expenses Finance expenses Administrative and general expenses Loss from continuing operations before income tax Income tax (expense)/credit Net loss from continuing operations Profit from discontinuing operations (net of tax) Loss for the year Other comprehensive loss Items that may be reclassified subsequently to loss: Exchange differences on translation of foreign operations Net movement on cash flow hedges Income tax relating to components of other comprehensive income Other comprehensive income/(loss) for the year Total comprehensive loss for the year, net of tax Total comprehensive loss for the year is attributable to equity holders -109,016 -3,352 -22,778 -14,191 2,579 -11,612 -117 -11,495 -9,079 2,093 1,818 -59 -4,128 -509 3,402 -5,677 1,157 -3030 -14,525 -5,677 -14,525 BALANCE SHEETS As at 31 December 2018 12/31/2018 Notes $'000 12/31/2017 $'000 12/31/2016 $'000 ASSETS Current assets 0.21328 0.58460 0.32539 Quick ratio Cash and cash equivalents Trade and other receivables Derivative financial instruments Inventories Current tax receivables Total current assets Non-current assets 1,870 13,458 5,808 41,230 1,016 63,382 1,077 16,845 1,009 64,318 3,679 14,957 8,348 51,957 83,249 78,941 0.881922 2.715497 1.378328 Current ratio 11 28,420 2,803 3,567 Property, plant and equipment Intangible assets Non-current tax receivables Derivative financial instruments Deferred tax assets Total non-current assets 32,436 5,756 3,475 278 7,932 49,877 133,126 40,113 9,690 2,958 614 3,563 56,938 135,879 5,550 40,340 103,722 Total assets 27,305 25,451 41,000 1,210 2,968 1,239 71,868 356 1,112 1,884 30,657 24,608 25,000 662 5,509 1,494 57,273 27,000 LIABILITIES Current liabilities Trade and other payables Interest bearing liabilities Lease Provisions Derivative financial instruments Other Provisions Total current liabilities Non-current liabilities Interest bearing liabilities Lease Provisions Deferred landlord contributions Derivative financial instruments Total non-current liabilities Total liabilities Net assets EQUITY Share capital Reserves Retained earnings / (deficit) Total equity 512 2,971 66,000 488 2,102 74 68,664 99,321 33,805 518 2,105 1,054 3,677 75,545 28,177 57 30,540 87,813 48,066 1.273023 1.674015 Debt/equity 59,343 3,006 - 34,172 - 28,177 59,331 433 25,093 - 33,805 59,147 3,734 14,815 48,066 Note 2 SEGMENT INFORMATION An operating segment is a component of an entity that engages in business activities which earns revenue and incurs expenses on which the chief operating decision maker reviews the operating results on a regular basis and makes decisions on resource allocation. The Company is organised into operating segments, depicting the three geographical regions the Company operates in and the centralised support function based in New Zealand. Management has determined the operating segments based on the business activities of the Company together with the information and the manner in which decisions regarding performance and resource allocation are made by the Senior Management Team. The "Chief Operating Decision Maker" is considered to be the Senior Management Team who consider the business from a geographic and support function perspective, being New Zealand, Australia and other International markets while the performance of the centralised support function is assessed separately. The International segment includes the results of continuing operations in markets located outside New Zealand and Australia. The following is an analysis of the Company's revenue and results by operating segment. Revenue reported below represents revenue from the sale of children's clothing products to external customers. Revenue is allocated based on the country where the sale is generated. There were no inter-segment sales in the year (2015: nil). Geographic segment profit represents the profit earned by each segment without allocation of central administration costs, finance costs, income tax, store impairment and lease provisions. These costs are recorded in the centralised support segment Australia New International Centralised Total Zealand Support 2018 $'000 $'000 $'000 $'000 $'000 Revenue 151,923 46,833 39,781 - 238,537 Expenses 135,734 - 38,611 - 37,857 - 33,758 - 245,960 Segment result before income tax 16,189 8,222 1,924 - 33,758 - 7,423 Income tax - 1,656 Loss for the year 9,079 Segment total assets (other than deferred tax) 39,844 18,745 18,653 20,930 98,172 Segment non-current assets (other than deferred tax) 18,910 4,869 90 10,921 34,790 Acquisitions of property, plant and equipment, intangibles 3,028 188 - 649 3,865 and other non-current segment assets Depreciation and amortisation expense 3,438 - 1,275 - 97 - 4,117 - 8,927 Finance expense - 4,011 - 4,011 2017 Revenue Expenses Segment result before income tax Income tax - Income tax - Profit from discontinuing operations (net of tax) 149,914 47,971 - 130,993 - 39,527 - 18,921 8,444 43,017 38,845 - 4,172 - - Loss for the year Segment total assets (other than deferred tax) Segment non-current assets (other than deferred tax) Acquisitions of property, plant and equipment, intangibles Depreciation and amortisation expense Finance expense - 240,902 45,728 - 255,093 45,728 - 14.191 - 2,579 117 - 2,696 -- 11495 16,935 125,194 14,696 41,945 3,542 8,567 5,077 - 11,010 3,352 - 3,352 51,217 20,139 4,045 4,471 - 25,410 6,639 757 1,335 - 31,632 471 223 127 - - - - (1) The Company's liabilities are not analysed on a segmental basis and therefore have not been reported. (ii) Revenue comprises the fair value for the sale of goods and services, net of sales tax and discounts and after eliminating sales within the Company. - Sales of goods - retail Sales of goods are recognised when a Company entity sells a product to the customer. Retail sales are usually in cash or by credit card either in store or online. Sales of goods-wholesale Wholesale sales are recognised in accordance with the terms of sales when the title has transferred and the benefits of ownership and risk pass to the customer. This is dependent on customer specific terms of trade. - Interest income Interest income is recognised using the effective interest method. 31-Dec-18 31-Dec-17 - Other income - Interest received 941 830 P&L Balance Sheet Equity Note 2 Notes 3,7,8 Note 10 Notes 11,12,13 Note 15 oth ... + 37 Note 7 TRADE RECEIVABLES, PREPAYMENTS AND OTHER ASSETS 38 Accounting Policy 39 Trade receivables are recognised initially at fair value and subsequently at amortised cost less provision for doubtful debts. Collectibility of trade receivables is reviewed on an ongoing basis. Debts which are known to be uncollectible are written off. A provision for doubtful receivables is established when there is objective evidence that the Company will not be able to collect all amounts due according to the original terms of receivables. The amount of the provision is the difference between the asset's carrying amount and the present value of estimated future cash flows. The amount of the provision is recognised in the Income Statement. Significant financial difficulties of the debtor, probability that the debtor will enter bankruptcy or financial reorganisation, and default or delinquency in payments are considered indicators that the trade receivable is impaired. 31 Dec 31 Dec 2018 2017 $'000 $'000 42 Trade receivables 6,531 12,704 43 Prepayments 5,454 2,739 Other receivables 1,473 1,402 13,458 16,845 46 The carrying amounts of the Company's trade and other receivables are denominated in the following currencies: 47 NZD 2,974 3,357 48 USD 6,219 12,479 49 AUD 3,728 70 50 GBP 251 588 51 EUR 286 351 13,458 16,845 The Company has assessed total trade receivables as being impaired and has recognised a doubtful debt provision of $2.1m based on additional information in relation to economic developments so subsequent to year end. All other remaining balances at 31 Dec 2018 are considered current and within terms. 52 54 55 Note 8 INVENTORIES 56 Accounting Policy Finished goods are stated at the lower of cost and net realisable value. Costs are assigned to individual items of inventory on the basis of weighted average costs, and include expenditure incurred in acquiring the assets and bringing them to their existing location and condition. Net realisable value is the estimated selling price in the ordinary course of business. The Company annually reviews the carrying value of inventory to ensure it remains valued at lower of cost or net realisable value. An inventory provision is created to reflect instances where the 58 forecast selling value is lower than cost. 31 Dec 2018 31 Dec 2017 $'000 $'000 50 Finished Goods 41,230 64,318 51 Inventory provisions of $1,093,000 (2017: $1,566,000) have been included in the Income Statement to reflect the recoverable value of the company;s aged stock provision