(Auto-Graded) Professional Application, Question 4.15

You are the audit senior of Rhino & Co. and you are planning the audit of Kaine Construction Co. for the year ended March 31, 2020. Kaine specializes in building houses and provides a five-year building warranty to its customers. Your audit manager has held a planning meeting with the finance director. He has provided you with the following notes of his meeting and financial statement extracts: Kaine has had a difficult year; house prices have fallen and, as a result, revenue has dropped. In order to address this, management has offered significantly extended credit terms to customers. However, demand has fallen such that there are still some completed houses in inventory where the selling price may be below cost. Management needs to meet a target profit before interest and taxation of $0.5 million in order to be paid their annual bonus. In addition, to try to improve profits, Kaine changed its main supplier to a cheaper alternative. This has resulted in some customers claiming on their building warranties for extensive repairs. To help with operating cash flow, management borrowed $1 million from the bank during the year. This is due for repayment at the end of 2020.

		2020		2019
Gross margin		46%		42%
Operating margin		6%		10%
Inventory turnover		2.4		4.5
Receivable days		89 days		52 days
Payable days		73 days		45 days
Current ratio		2:2		4:4
Quick ratio		1:5		3:3

Which of the following are possible reasons for the increasing gross margin but the falling operating margin?

Cost of goods sold being misclassified as operating expenses

Understated purchase costs

Overstated purchase costs

Understated closing inventory

Overstated sales this period

Increased advertising costs

Which of the following are appropriate conclusions for the auditor given the above results?

Accounts receivable may be overvalued.

Inventory may be overvalued.

Kaine has adequate cash on hand.

There must be a material misstatement as the warranty provision must be inadequate.

There may be going concern issues.

There is a management bias to overstate profits.

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