Background

You are a manager in the audit division at Miller Yates Howarth (MYH), an accounting firm with offices throughout the major regional centres of NSW and Queensland. Although a medium sized firm by national standards, MYH is the second largest regional accounting firm in Australia. Most of MYH's audit clients are in the agriculture, mining, manufacturing and property industries. All of those industries are currently under pressure, either from a downturn in commodity prices or fierce competition from overseas competitors.

You are gathering information in order to prepare the audit plan of GPSA Limited for the year ended 30 June 2017. Along with Morgan Fertilisers, GPSA is one of MYH's most significant and longstanding clients. The following information has been gathered to date.

Principal activities of GPSA

research and development of technologies relating to medical equipment;

manufacture and distribution of medical equipment;

investment of surplus funds; and

investment in the property market.

GPSA was incorporated in 1992 and has operated successfully and profitably since that date. In the last few years it has branched out into the property market, acquiring a number of commercial properties which are let mainly to medical practitioners.

The directors of GPSA are:

Mr. John Stanton, Chairman

Ms Jane Quade, Chief Executive Officer

Mr. Joe Quade

Dr Barry Jones

Dr Beryl Yeo

Doctors Jones and Yeo are independent non-executive directors and have been directors since 2003. The other three executive directors have been employed by the company since its incorporation and have considerable experience in the industry. Mr Stanton controls a number of private companies.

In prior years MYH placed reliance on internal controls based on satisfactory results of extensive tests of control. Recent discussions with the client have revealed no changes in the system of internal control since last year. The company does not have an internal audit function.

In February 2016, research activities relating to a new laser surgery device commenced. Significant costs were incurred in relation to this research. In April 2017 a competitor announced that it had successfully developed and patented a similar device. In order to finance the research activities noted above the company borrowed from its bankers an additional $5 million during the year. The loan agreement contains a covenant to the effect that should the company's debt to equity ratio (measured as total liabilities: shareholders' equity) increase above 1.2:1.0 at any time, the bankers have the right to demand immediate repayment.

Throughout the 2017 financial year, the property market has been in decline. The end of financial year audit is scheduled to start on 1 August 2017 and should take about two weeks to complete. The client completed a stock count on 30 June 2017. The directors require the signed audited final financial report by 28 August 2017.

Your audit partner, John Richards, has approached you and advised that there are several areas he is concerned about and he wants to you to report back to him about these areas before you complete your audit program. These areas and accounts are:

Accounts receivable

Current investments

Property assets

Intangible assets

Research and development capitalisation

Ratios extracted from an unaudited set of financial reports at 30 June 2017 together with audited comparatives for the year ended 30 June 2016 and 2015are set out below for your review.

Ratio2017 (Unaudited)2016 (Audited)2015 (Audited)Return on equity %7.1918.6122.17Return on total assets %4.8613.715.52Gross margin %31.7630.0024.94Net profit margin%10.3820.2717.85Times interest earned1.903.514.10Days in inventory166.53127.89115.85Days in accounts receivable83.0760.6553.24Current ratio : 11.801.541.66Quick asset ratio : 10.890.780.82Debt to equity ratio : 11.111.021.04

Internal controls

The financial controller at GPSA has been refining the system of internal controls and informs you, at the planning stage of the current year's audit, that he has put together an internal control manual for the company. He has stated that this manual will create greater awareness of controls in the company, particularly with management which, in the past, has not been overly conscious of the need to implement and enforce effective internal controls.

Management staff receive bonuses based on certain agreed-upon target ratios which include measures such as targeted monthly sales volumes, variance of actual to budget departmental overheads and profit before interest and tax. The major shareholder takes an active interest in the performance of the company and is quick to request explanations on variances from the agreed-upon monthly budgets.

Two years ago, the company devoted significant time and resources to the development and implementation of a new IT system. All teething problems associated with the implementation phase have now been resolved, and the financial controller is satisfied that the automated controls in place are assisting in producing accurate and complete accounting records. The sales director also looks after the IT function as the position is not regarded by management as being a full-time job. Once application programs have been tested, strict password control exists over access to the programs. Passwords are not required for access to databases.

To assist in the planning for the current year's audit engagement, you extracted the following information from a review of the systems notes in the permanent file and perusal of the new internal control manual:

1. manual delivery notes for dispatch of tiles to customers are raised by the dispatch department from the sales order form. Where a delivery is only partially filled, the delivery note is marked 'hold for invoice' and placed on the incomplete deliveries file. At month end, the supervisor of the dispatch department is responsible for follow-up of the reasons why incomplete deliveries have been outstanding for greater than 30 days.
2. returns ofmedical equipmentby customers due to inferior quality, incorrect specifications or oversupply are received by the dispatch department where staff are required to check quantity and condition of the returned tiles. Details noted by the dispatch personnel, including the reason for the return, are recorded on a 'goods returned' note. Once completed, this document is passed on to the trade receivables clerk who raises a credit note and sends it to the customer.
3. once a delivery has occurred, the office copy manual delivery note is forwarded to the trade receivables clerk who is responsible for generating an invoice on the computer system. An invoice is raised by inputting the total quantity delivered (Note: this could be a number of partial deliveries) and the stock code which is also recorded on the delivery note. The computer then automatically retrieves the stock code price from the selling price master file. Posting to the debtors account occurs automatically once the trade receivables clerk has performed a screen check on the accuracy of the input of delivery details.
4. for valued customers, discounts are applied in accordance with the company's volume rating system. The trade receivables clerk is responsible for updating the individual customer volume ratings every six months after preparing the 'sales volume analysis by customer' report. This report is authorised by the sales director prior to updating the customer discounts.
5. asales journal summarising all sales invoices is prepared monthly by the computer system. This journal is then used by the trade receivables clerk for posting to the general ledger.
6. receipts from debtors are passed on to the trade receivables clerk after having been opened by the mail room. The trade receivables clerk lists all receipts from the debtors and then prepares a bank deposit slip. The list prepared by the trade receivables clerk is used to enter the debtors' payments on the computer system. The batch total of postings to the individual debtors' accounts is balanced to the bank deposit slip before processing occurs on the system. At each month end, the trade receivables clerk prepares a reconciliation of the trade receivables ledger to the debtors control account in the general ledger.
7. the computer generates an aged analysis at month end based upon all invoices that have been processed onto the system for the period up until the last day of the month.
8. the financial controller obtains the latest trade receivables aged analysis at the end of each month and reviews all amounts outstanding for longer than 90 days. The trade receivables clerk is required to detail reasons for delays in payment by long outstanding debtors and the financial controller discusses items of concern with the clerk.
9. usually an action plan is agreed for follow-up; this may include involvement of debt collectors or the issuing of writs. Where necessary the financial controller records details of amounts that should be provided for as doubtful debtors. Whilst performing this re view, the financial controller notes the level of individual debtors' balances and, in instances where he is uncomfortable with the level of this balance, he instructs the dispatch area to withhold any shipments until a minimum prescribed payment is received.

John Richardsyour partner on the audit has mentioned to you that, in the past, a substantive approach had been adopted for the audit of GPSA. He now feels that, with the improvements that the client claims to have made to the systems of internal control, an opportunity exists to place reliance on the internal controls and therefore reduce the extent of substantive work.

Required

Write a report, including a brief executive summary, to your managing partner that addresses the questions below. Where indicated, use the required format to answer that question.

Question 1A 8%

Analyse the ratios and additional information associated with the five accounts listed by your audit partner, John Richards. Identify the potential audit risks and any particular audit steps that need to be undertaken to reduce audit risk.

Answer this question using the following headings:

(a) Account (b) Analysis (c) Audit risk (d) Audit steps to reduce risk

Question 1B 2%

Analyse the ratios and additional information to outline business risks that GPSA faces.

Question 2A 7%

Identify the internal controls in the system that are potentially effective, the risk that the control could alleviate and one test of control for each of the identified potentially effective controls.

Answer this question using the following headings:

(a) Effective control (b) Riskalleviated (c) Test of control

Question 2B 2%

List and justifythe weaknesses in internal control for sales and trade receivables.

Rationale

Thisassessment has been designed to assess your ability to:

• be able to demonstrate risk management methodologies and the role of internal controls in an audit context;
• be able to design an audit plan and select and apply appropriate audit procedures for a financial statementaudit;
• be able to exercise critical and reflective judgment.

Background You are a manager in the audit division at Miller Yates Howarth (MYH), an accounting firm with offices throughout the major regional centres of NSW and Queensland. Although a medium sized firm by national standards, MYH is the second largest regional accounting firm in Australia. Most of MYH's audit clients are in the agriculture, mining, manufacturing and property industries. All of those industries are currently under pressure, either from a downturn in commodity prices or fierce competition from overseas competitors. You are gathering information in order to prepare the audit plan of GPSA Limited for the year ended 30 June 2017. Along with Morgan Fertilisers, GPSA is one of MYH's most significant and longstanding clients. The following information has been gathered to date. Principal activities of GPSA research and development of technologies relating to medical equipment; manufacture and distribution of medical equipment; investment of surplus funds; and investment in the property market. GPSA was incorporated in 1992 and has operated successfully and profitably since that date. In the last few years it has branched out into the property market, acquiring a number of commercial properties which are let mainly to medical practitioners. The directors of GPSA are: Mr. John Stanton, Chairman Ms Jane Quade, Chief Executive Officer Mr. Joe Quade Dr Barry Jones Dr Beryl Yeo Doctors Jones and Yeo are independent non-executive directors and have been directors since 2003. The other three executive directors have been employed by the company since its incorporation and have considerable experience in the industry. Mr Stanton controls a number of private companies. In prior years MYH placed reliance on internal controls based on satisfactory results of extensive tests of control. Recent discussions with the client have revealed no changes in the system of internal control since last year. The company does not have an internal audit function. In February 2016, research activities relating to a new laser surgery device commenced. Significant costs were incurred in relation to this research. In April 2017 a competitor announced that it had successfully developed and patented a similar device. In order to finance the research activities noted above the company borrowed from its bankers an additional $5 million during the year. The loan agreement contains a covenant to the effect that should the company's debt to equity ratio (measured as total liabilities: shareholders' equity) increase above 1.2:1.0 at any time, the bankers have the right to demand immediate repayment. Throughout the 2017 financial year, the property market has been in decline. The end of financial year audit is scheduled to start on 1 August 2017 and should take about two weeks to complete. The client completed a stock count on 30 June 2017. The directors require the signed audited final financial report by 28 August 2017. Your audit partner, John Richards, has approached you and advised that there are several areas he is concerned about and he wants to you to report back to him about these areas before you complete your audit program. These areas and accounts are: Accounts receivable Current investments Property assets Intangible assets Research and development capitalisation Ratios extracted from an unaudited set of financial reports at 30 June 2017 together with audited comparatives for the year ended 30 June 2016 and 2015 are set out below for your review. Ratio Return on equity % Return on total assets % Gross margin % Net profit margin % Times interest earned Days in inventory Days in accounts receivable Current ratio : 1 Quick asset ratio : 1 Debt to equity ratio : 1 2017 (Unaudited) 7.19 4.86 31.76 10.38 1.90 166.53 83.07 1.80 0.89 1.11 2016 (Audited) 18.61 13.7 30.00 20.27 3.51 127.89 60.65 1.54 0.78 1.02 2015 (Audited) 22.17 15.52 24.94 17.85 4.10 115.85 53.24 1.66 0.82 1.04 Internal controls The financial controller at GPSA has been refining the system of internal controls and informs you, at the planning stage of the current year's audit, that he has put together an internal control manual for the company. He has stated that this manual will create greater awareness of controls in the company, particularly with management which, in the past, has not been overly conscious of the need to implement and enforce effective internal controls. Management staff receive bonuses based on certain agreed-upon target ratios which include measures such as targeted monthly sales volumes, variance of actual to budget departmental overheads and profit before interest and tax. The major shareholder takes an active interest in the performance of the company and is quick to request explanations on variances from the agreed-upon monthly budgets. Two years ago, the company devoted significant time and resources to the development and implementation of a new IT system. All teething problems associated with the implementation phase have now been resolved, and the financial controller is satisfied that the automated controls in place are assisting in producing accurate and complete accounting records. The sales director also looks after the IT function as the position is not regarded by management as being a full-time job. Once application programs have been tested, strict password control exists over access to the programs. Passwords are not required for access to databases. To assist in the planning for the current year's audit engagement, you extracted the following information from a review of the systems notes in the permanent file and perusal of the new internal control manual: 1. 2. 3. 4. 5. 6. 7. 8. 9. manual delivery notes for dispatch of tiles to customers are raised by the dispatch department from the sales order form. Where a delivery is only partially filled, the delivery note is marked 'hold for invoice' and placed on the incomplete deliveries file. At month end, the supervisor of the dispatch department is responsible for follow-up of the reasons why incomplete deliveries have been outstanding for greater than 30 days. returns of medical equipment by customers due to inferior quality, incorrect specifications or oversupply are received by the dispatch department where staff are required to check quantity and condition of the returned tiles. Details noted by the dispatch personnel, including the reason for the return, are recorded on a 'goods returned' note. Once completed, this document is passed on to the trade receivables clerk who raises a credit note and sends it to the customer. once a delivery has occurred, the office copy manual delivery note is forwarded to the trade receivables clerk who is responsible for generating an invoice on the computer system. An invoice is raised by inputting the total quantity delivered (Note: this could be a number of partial deliveries) and the stock code which is also recorded on the delivery note. The computer then automatically retrieves the stock code price from the selling price master file. Posting to the debtors account occurs automatically once the trade receivables clerk has performed a screen check on the accuracy of the input of delivery details. for valued customers, discounts are applied in accordance with the company's volume rating system. The trade receivables clerk is responsible for updating the individual customer volume ratings every six months after preparing the 'sales volume analysis by customer' report. This report is authorised by the sales director prior to updating the customer discounts. a sales journal summarising all sales invoices is prepared monthly by the computer system. This journal is then used by the trade receivables clerk for posting to the general ledger. receipts from debtors are passed on to the trade receivables clerk after having been opened by the mail room. The trade receivables clerk lists all receipts from the debtors and then prepares a bank deposit slip. The list prepared by the trade receivables clerk is used to enter the debtors' payments on the computer system. The batch total of postings to the individual debtors' accounts is balanced to the bank deposit slip before processing occurs on the system. At each month end, the trade receivables clerk prepares a reconciliation of the trade receivables ledger to the debtors control account in the general ledger. the computer generates an aged analysis at month end based upon all invoices that have been processed onto the system for the period up until the last day of the month. the financial controller obtains the latest trade receivables aged analysis at the end of each month and reviews all amounts outstanding for longer than 90 days. The trade receivables clerk is required to detail reasons for delays in payment by long outstanding debtors and the financial controller discusses items of concern with the clerk. usually an action plan is agreed for follow-up; this may include involvement of debt collectors or the issuing of writs. Where necessary the financial controller records details of amounts that should be provided for as doubtful debtors. Whilst performing this re view, the financial controller notes the level of individual debtors' balances and, in instances where he is uncomfortable with the level of this balance, he instructs the dispatch area to withhold any shipments until a minimum prescribed payment is received. John Richards your partner on the audit has mentioned to you that, in the past, a substantive approach had been adopted for the audit of GPSA. He now feels that, with the improvements that the client claims to have made to the systems of internal control, an opportunity exists to place reliance on the internal controls and therefore reduce the extent of substantive work. Required Write a report, including a brief executive summary, to your managing partner that addresses the questions below. Where indicated, use the required format to answer that question. Question 1A 8% Analyse the ratios and additional information associated with the five accounts listed by your audit partner, John Richards. Identify the potential audit risks and any particular audit steps that need to be undertaken to reduce audit risk. Answer this question using the following headings: (a) Account (b) Analysis (c) Audit risk (d) Audit steps to reduce risk Question 1B 2% Analyse the ratios and additional information to outline business risks that GPSA faces. Question 2A 7% Identify the internal controls in the system that are potentially effective, the risk that the control could alleviate and one test of control for each of the identified potentially effective controls. Answer this question using the following headings: (a) Effective control (b) Risk alleviated (c) Test of control Question 2B 2% List and justify the weaknesses in internal control for sales and trade receivables. Rationale This assessment has been designed to assess your ability to: be able to demonstrate risk management methodologies and the role of internal controls in an audit context; be able to design an audit plan and select and apply appropriate audit procedures for a financial statement audit; be able to exercise critical and reflective judgment