Auditor Independence and Fraud Allegation: A Case Study of RetailSmart Ltd

Case facts

You are an audit senior at a reputable audit firm, and you have been assigned to plan the audit engagement for "RetailSmart Ltd.," a mid-sized retail company with multiple locations. RetailSmart Ltd. has approached your firm for its first-ever audit engagement. The company has provided you with its financial statements for the year ended on 30^th June 2023, along with relevant documentation related to internal controls and transactions.

The company operates a chain of electronics stores and has been experiencing increased competition and shifts in consumer preferences. The draft financial statements reveal the following:

Net sales: $10 000 000

Cost of Goods Sold (COGS): $6 00 000

Gross Profit Margin: 40%

Inventory Turnover: 6 times per year

The CEO of RetailSmart Ltd. has expressed concerns about the company's profitability and internal controls due to recent challenges faced by the retail industry. Furthermore, it has come to your attention that Rachel, one of the audit team members, has a close personal relationship with Alex Thompson, RetailSmart Ltd's Chief Financial Officer (CFO). Rachel and Alex have been friends since college and have maintained a close bond over the years.

Additionally, an anonymous tip has been received regarding potential financial statement fraud involving the overvaluation of inventory to inflate the company's financial ratios. The tipster alleges that inventory levels have been artificially inflated by including obsolete and unsellable items in the inventory count.

Required: As part of your audit planning, reflect on your understanding of the unit in addressing the following questions:

a. Based on the potential overvaluation of inventory, identify inherent risks related to financial reporting that RetailSmart Ltd. might face.

b. Given the potential for overvalued inventory, design an analytical procedure that involves analyzing sales data, and inventory turnover. Consider the impact of obsolete items on the inventory turnover ratio and its implications on financial ratios.