Background

You are the audit manager of JDM, an accounting firm with offices in the Sydney metropolitan area. JDM is a middle tier auditing firm specialising in the audit of firms in the manufacturing and property development industries. During May 2020 you met with the audit senior of JDM, Tyrone Vickery, to discuss a number of findings and issues Tyrone has identified relating to several of JDM's clients.

Impact of business risk at Simo Ltd.

Simo Ltd is an Australian owned company that obtains and refurbishes second hand computer parts such as hard drives and motherboards. Recently Simo has begun using a new refurbishment technique which is claimed to be more effective and cost efficient. Simo has also made a decision to focus on the export market, and has been selling parts to several Indian companies where the parts are used in the manufacture of computers. Recently however, there have been delays in delivering the parts to India due to strike action amongst custom officials at Australian ports. The delays have angered Indian customers who have threatened to reduce the amounts owing by 15% because of lost production time. Adding further concern to Simo is that one of their customers, Calc Ltd, is claiming that the latest batch of parts they received was faulty, and are refusing to pay their account which is already 3 months overdue.

Sufficiency and appropriateness of audit evidence at Perkins Ltd.

Tyrone has indicated that he has completed testing on accounts payable and sales Perkins Ltd, a small manufacturer of confectionary goods. Tyrone has performed the following tests:

• In relation to accounts payable, Tyrone selected a random sample of creditors from the accounts payable ledger and agreed these to statements, invoices and reconciliations. The balance of the accounts payable ledger was then agreed to the general ledger and the trial balance. Tyrone found no discrepancies.
• A positive debtors confirmation was performed on the 30 June balances. Baker Pty Ltd had an outstanding balance as per the confirmation of $10,000, however in their reply they noted that they only owed $9,000. The difference is due to invoice 1938 dated 1 July 2020. Tyrone has noted that Baker's account appears to be overstated but the amount is immaterial and he has not performed any additional work.
• Tyrone performed tests of control over payroll. Out of 50 items he found 4 breaches of control. Tyrone notes that as the errors were immaterial and the error rate was below 10% no further work is required as everything complied with the accounting standards and controls over payroll can be relied on.

Using analytical procedures to assess risk at Emms Ltd

Emms Ltd, is a manufacturer of laser printers. Tyrone has closely scrutinised the financial reports of the company and is concerned about its status as a going concern. Tyrone has calculated various ratios which are provided below.

2016

2017

2018

2019

Net profit ratio

-0.5%

-7%

-6%

-10%

Gross profit ratio

12%

11%

13%

12%

Current ratio

0.8:1

0.7:1

0.7:1

0.7:1

Quick asset ratio

0.4:1

0.31:1

0.35:1

0.38:1

Debt to total assets ratio

66%

92%

96%

98%

Inventory turnover

4.5

4.6

4.4

4.2

Receivables turnover

5.5

5.4

5.3

4.1

Tyrone also tells you that in an attempt to expand into overseas markets, Emms automated a lot of its operations in 2017 with the purchase of some highly sophisticated plant and machinery. The new plant and machinery was largely financed with a secured variable loan of $50,000 and a bank overdraft facility.

Emms purchases the parts that make up the printers from a variety of local and overseas suppliers. Emms has plans to broaden its sales base to both local and overseas markets (currently 85% of its sales are to one discount office supplies chain). This broadening of the company's sales base revolves around the development and production of a state of the art printer that will be tailored to meet the needs of the premium end of the market. The development of the new printer however will require a significant injection of capital that the directors hope will come via a new public issue of shares and promises of loans and other forms of assistance from business acquaintances of the CEO.

Evaluation and testing of controls at Hales Ltd

Tyrone has provided a narrative of controls over inventory at Hales Ltd and would like you to provide some advice on making the preliminary control risk assessment. Hales is a distributor of haircare products, including shampoos, conditioners and styling products throughout Australia. Hales uses an on-line ordering system. Hales does not manufacture any goods in house, instead, an inventory of raw materials is kept, with manufacturing being outsourced to other companies. Hales has around 35 suppliers and 15 manufacturers. These companies have proven to be reliable in the past. Tyrone has made the following notes about three particular elements of the inventory system.

Purchase of raw materials

Purchase orders are generated by the computer when the inventory level of a particular material falls below 75% of what was used in the previous month. Purchase orders include the date, the suppliers name and the raw material required. Three copies of the purchase order are created. The first copy goes to the warehouse where it is used to enable the following up of overdue orders. The second copy is filed by the accounts clerk by order of date and the third copy goes to the supplier. Upon receipt of materials, barcodes on the delivery packages are scanned into the computer system. A two part receiving report is then generated. The first part is matched to the purchase order by the warehouse manager. The second is sent to the accounts clerk who files it. If the scanning of barcodes does not match data on the master file then the process is stopped.

Procedures for finished goods

When finished goods fall below 65% of the previous months sales, production orders are triggered. Production orders include a date, the manufacturers name, the raw materials needed and the volume of finished goods required. Two copies of the production order are generated. The first copy is sent to the raw materials warehouse where it is used as a picking slip by the warehouse staff. It is then included with materials which are sent to the manufacturer. The second copy is filed by the production manager by order of date. When finished goods arrive at Hales, barcodes on the delivery packets are scanned. A two part receiving report is generated, with the first copy being matched to the production order by the production manager and the second copy being filed by the accounts clerk. As with materials purchases, if the scanning of barcodes does not match the codes on the master file then the process is stopped.

Changes to the master file

The inventory master file contains information on the volumes of inventory on hand including barcode information and locations within the warehouse. The master file also has details of approved suppliers and manufacturers. Orders can only be made to suppliers and manufacturers on the master file. Changes to the master file can be made by the production manager. This applies to both raw materials and finished goods. To make changes the production manager completes an amendment form which is then kept as a record of any changes made.

Other information

There are separate warehouses, staff and procedures in place for the raw materials and finished goods. The selection of suppliers of raw materials and manufacturers is done automatically by the computer based on the latest price as per the last invoice and delivery time. Password access to the computer permits the following:

• Raw materials store staff have access to purchase order printing and goods received notes printing for materials.
• Finished goods store staff have access to goods received notes printing for finished goods.
• The production manager has access to production order printing and master file changes.
• The acounts clerk has access to master file changes.

Substantive testing at Sooty Ltd

Lastly, Tyrone brings up the audit of Sooty Ltd. Sooty manufactures machine parts which are used for servicing heavy equipment in the mining industry throughout Australia. Tyrone informs you that during the planning stage of the audit of Sooty, it was found that one of Sooty's key suppliers had gone into administration which had led to major shortages of key materials. In order to circumvent this problem, Sooty secured the supply of materials through an alternative supplier, however Tyrone notes that the alternative supplier is new to the market and that some of Sooty's production staff have been complaining that the materials are of inferior quality. Tyrone says that Sooty has also suffered from cash flow problems recently as one of their debtors, Brown Ltd, has also been experiencing financial problems, taking up to 4 months to pay amounts which are normally due within 30 days. Tyrone notes that Brown makes up 35% of Sooty's sales and that management wish to maintain a good relationship with Brown. The resulting cash flow implications has meant that Sooty has been drawing on its lines of credit, which has subsequently caused it to temporarily violate the terms of its contract with its bank, ASBC, which requires Sooty to maintain a current ratio of 2:1.

Required

Should be advising the audit senior of JDM regarding the below

Question 4

In relation to Hales Ltd:

• The weaknesses in the internal controls for each of the three aspects of the inventory system identified (raw materials, finished goods and changes to the master file).
• An assessment of the implications of each of the weaknesses you have identified.
• Three tests of control JDM's IT audit division could perform to assist Tyrone with verifying the effectiveness of the internal controls (assuming that JDM will be performing tests of control).
• Two Computer Assisted Audit Techniques (CAATs) that Tyrone could request the IT auditors run to assist him in testing the valuation of inventory.

Question 5

In regards to Sooty Ltd:

• Two key account balances at risk of material misstatement.
• For each account balance, the key assertion at risk.
• A justification as to why the account balances and assertions are at risk.
• An outline of one (1) substantive test of detail that Tyrone could undertake for each account to address the assertion and risk identified.