Background

You are the audit manager of RFC, an accounting firm with offices located throughout regional NSW and Victoria, including towns such as Bendigo, Albury, Wagga, Bathurst and Tamworth. RFC is a middle tier firm which provides audit and accounting services across a range of industries. During July 2021 you met with the audit senior of RFC, Wayne Campbell to discuss several findings related to some of RFCs clients.

Knights Ltd

Wayne tells you he is planning the 30 June 2021 Audit of Knights Ltd, a company that produces and exports timber products to South East Asian countries. Knights contracts timber cutters to deliver set tonnages of logs to its mill throughout the year. The timber is then transported to Asia on charter vessels, which make an average of one trip a month. Timber is purchased in 50 hectare lots from plantations and state forests. In the past, 75% of timber was sourced from plantations, however this has fallen to 40% in the current year. The corresponding increase in timber sourced from state forests has angered environmental groups. Protests have been held in several forests, which has slowed production and frustrated the contractors, who are only paid once set tonnages of timber are delivered to the mill. These issues have meant that several shipments of timber have been delayed, angering the Japanese customers who are threatening to deduct 20% from amounts owing as compensation for lost production time. A recent downturn in the Japanese economy is also affecting forward orders, which have fallen by 15%. Wayne also says that one of Knights customers, Chip Corporation, is claiming that the latest batch of timber products it received was contaminated with a microbe. This microbe affects the physical structure of the timber, reducing its strength and durability. This has made the timber useless for heavy duty items such as china hutches and bookcases. Chip Ltd is refusing to pay its account, which is already five months overdue. Knights Ltd has launched an investigation into the allegations but has not been able to substantiate them as yet.

Bowden Ltd

Next up, Wayne tells you about Bowden Ltd, a small manufacturer of confectionary goods. Wayne has indicated that he has completed testing on accounts payable, sales and related expenses and has performed the following tests:

• Wayne selected 30 invoices to test the control that the sales assistant verifies that sales prices agree with the approved price list. He found 3 instances where the sales assistant had not placed her signature in the correct box on the invoice verifying that this check took place. The sales manager told Wayne that the sales assistant verifies the prices match, but sometimes forgets to sign the box. As the prices on all the invoices agreed with the authorised price list, Wayne concluded that the control was operating satisfactorily.
• As part of his work on subsequent events, Wayne noted that there were many returns in July of a product called SugarHit! As this product only went to market in May 2021 and represented only 2.5% of sales for the year, Wayne concluded that the amount was immaterial and no further work was necessary.
• Advertising expenses for 2021 are material, although only 47% of 2020s advertising expenses. Wayne selected a substantial sample of entries and vouched them to supporting documents. Wayne found no errors and concluded that advertising expenses were fairly stated.
• As part of the audit of payables, Wayne carried out a search for unrecorded liabilities. He tested a sample of 20 payments made after 30 June, 2021 and found 3 instances of electronic funds transfers (efts) that related to services provided in June, which had not been accrued. However, as the total of the 3 efts was immaterial, he concluded that no adjustment was required for unrecorded liabilities.

Francis Ltd

Wayne is also planning the 30 June audit of Francis Ltd, a company that runs a chain of home wares retail stores in regional New South Wales and Victoria. Using the companys financials as well as his understanding of Francis under ASA315, he has compiled the following preliminary information:

Ratio	2021	2020	2019	2018	2017
Current Ratio	2.44	1.97	2.18	2.11	2.18
Quick Ratio	0.84	1.17	1.58	1.53	1.43
Times interest earned	2.18	2.78	3.57	4.61	6.18
Receivables Turnover	3.65	4.79	3.57	4.70	4.87
Days in receivables	75.60	57.97	77.45	58.80	56.71
Inventory turnover	1.57	1.60	2.33	2.91	2.92
Days in inventory	176.41	172.58	121.10	95.07	94.51
Net Sales/Tangible Assets	0.52	0.56	0.64	0.60	0.58
Profit Margin	0.09	0.11	0.14	0.13	0.12
Return on Assets	0.07	0.08	0.10	0.09	0.08
Return on Equity	0.03	0.05	0.09	0.09	0.10

Francis import all their products, primarily from China, Europe and North America. Some items are sourced from Africa and South America. The company operates in a low gross margin environment, which typically means that large sale volumes are required to cover overhead costs and generate profits. It also means that overheads need to be kept under control to ensure that a net profit results from its operations. Francis did not reach industry benchmarks for profitability in 2020, so to do better in 2021, management planned to keep costs down in relation to sales while allowing its gross margin to drop, evidently planning to generate a larger volume of sales. The company also planned to improve its working capital management by reducing levels of inventory and accounts receivable. It budgeted for a drop in debt levels, indicating that it expected to produce a healthy cash flow to enable it to do so.

Edwards Ltd

The next client Wayne tells you about is Edwards Ltd, where Wayne is evaluating the internal controls in the sales and receivables areas. Edwards manufactures small scale water purifiers which are then sold to retailers, with a year ending 30 June 2021. Wayne has identified the following internal control procedures.

• All sales are made on credit, with outstanding accounts due and payable within 30 days. Customers can purchase the water purifiers from Edwards by emailing or telephoning through their purchase order. Immediately on receipt of a customers request, a sales clerk prepares a sales order.
• Sales orders are manually pre-numbered and produced in triplicate. One copy of the sales order is sent to the shipping department, one to the invoicing department and one copy is filed in the sales department.
• On receipt of the sales order by the shipping department, the shipping clerk obtains the items from the warehouse, packages them, prepares a shipping note and arranges transport.
• Shipping notes are also manually pre-numbered and produced in duplicate. The original shipping note is sent to the invoicing department, and the second copy is filed by the shipping clerk.
• The shipping clerk transfers the information from the shipping note to a delivery docket, which is pre-numbered and produced in triplicate. Two copies of the delivery docket are given to the carrier. One of these is retained by the customer, while the other is signed by the customer and retained by the carrier. The shipping clerk forwards the third copy of the delivery docket to the invoicing department.
• A clerk in the invoicing department checks that the information on the purchase order, the shipping note and the delivery docket match each other and then prepares the sales invoice. Sales invoices are pre-numbered and produced in triplicate. One copy of the sales invoice is sent to the customer, one is forwarded to the accounting department, and the third is filed by the invoicing clerk.
• The accounts clerk uses the invoice to make an entry to the sales journal, which is used to update the sales ledger and the accounts receivable subsidiary ledgers. The sales invoice is then filed by customer name.
• All payments are made by cheque and mailed to Edwards along with the remittance advice. Two staff are assigned to receive these payments one who opens the mail and records the receipt of the payment on a cheque list. The other staff member takes custody of the cheques and matches them to the remittance advice, then forwards them to the accounts receivable clerk.
• The accounts receivable clerk updates the subsidiary ledger.
• Bank reconciliations are performed monthly by an accounting clerk, who is not responsible for receiving payments.
• Sales returns and allowances are only processed after the financial controller has authorised them.
• Bad debts are written-off only on the authorisation of the financial controller, after discussion with the credit manager.

Murphy Ltd

Finally, Wayne tells you about Murphy Ltd, a large client with a diverse set of operations. During Waynes audit of Murphy he found the following:

• Murphy manufactures wheat, yeast and various other goods needed to bake bread which it exports to bakers in Saudi Arabia. Recently the Saudi Arabian currency (Saudi riyal) has fallen in value and a number of Murphys customers are unable to settle their accounts. By the end of the year, Murphy is expecting to have outstanding receivables in excess of $1 million.
• Murphy also manufactures soft drink. Part of Murphys agreement with its distributors is that Murphy will supply fridges and advertising signs for the distributors to use. These fridges are rented to the distributors and recorded as fixed assets on Murphys balance sheet. Most distributors are small retailers, such as petrol stations and convenience stores.
• Murphy has recently been finding it difficult to recruit and then retain skilled people to work in its factories. Consequently, senior management at Murphy have decided to implement a new bonus scheme. The method for allocating bonuses will be based on factors including length of tenure, pay rate, rank within the organisation and an estimate by senior management of the employees contribution to the profitability of Murphy.

Required

Write a memo to Wayne Campbell, the audit senior at RFC that advises him on:

Question 1 (3 marks)

The business risk impact and the accounts (as well as the related assertions) most likely affected by the events outlined in relation to Knights Ltd.

Question 2 (4 marks)

Whether Waynes testing has obtained sufficient appropriate evidence for the relevant assertions (where appropriate) pertaining to Bowden Ltd.

Question 3 (7 marks)

Regarding Francis Ltd, based on the ratios and other information provided:

• The conclusions that can be drawn about the potential of Bowden to continue as a going concern.
• Three (3) account balances that could be at risk of material misstatement and would require special attention during the audit. You should provide Wayne with a justification as to why these three (3) accounts are at risk and a statement as to whether they are likely to be overstated or understated.
• For each of the three (3) account balances identified above, two (2) key assertions that are at risk and an explanation as to why they are at risk.

Question 4 (7 marks)

Regarding Edwards Ltd:

• Three (3) internal control activities in Edwards sales and receivables, and whether these activities are intended to prevent or detected material misstatements and how this is achieved.
• For each control identified above, one (1) test of control that could be undertaken to verify the effectiveness of the internal control.
• Three (3) weaknesses in Edwards internal controls around sales and receivables, along with an explanation as to why they are weaknesses.
• For each weakness outlined above, one (1) account balance at risk of material misstatement and the related assertion most at risk, along with a justification as to why this account and assertion is at risk.

Question 5 (4 marks)

Regarding Murphy Ltd:

• Three (3) account areas that are at risk of material misstatement.
• For each account area identified above, one (1) key assertion that could be at risk.
• The audit procedures you would perform to gather sufficient appropriate evidence for each assertion.