Case Background

You are the audit senior on the audit of Best Furniture Manufacturers Pty Ltd (Best). Your firm has recently been appointed as the first auditors of the company.

You interview the managing director of the company to obtain background information on Best and to understand its business operations, its environment and system of internal control. You noted and documented the following:

Best was founded 30 years ago and makes 'grandfather' clocks (freestanding, weight driven, pendulum clocks).

The clocks are made in one factory and are distributed through boutique homeware and antique furniture stores.

The clocks are advertised mainly in local newspapers and through pamphlet drops.

In order to promote longer production runs and minimise finished goods stocks, Best's retail distributors are offered stock on a 'sale or return' basis. This means that the homeware and antique furniture stores are invoiced immediately, subject to a 90-day term of payment, but are allowed to return the stock up to 30 days before payment is due. Only the marketing manager has been given the authority to make these offers.

All of Best's timber is obtained from offshore sources. Timber prices, which are denominated in US dollars, have risen substantially over the past two years and the recent drop in the value of the Australian dollar has caused them to rise even further.

Timber purchases are secured by providing Best's suppliers with letters of credit which become due when the container shipment of timber arrives in Australia.

Labour costs are high due to the craftsmanship and quality required for the production of the grandfather clocks. Skilled labour is not easy to obtain and wage rates have recently risen.

Best has found it difficult to pass on these timbers and labour price increases to customers.

An analysis of costs indicates that there have been material negative purchase price variances in purchases of timber over the course of the year. You have compiled the following information from Best's financials:

the current ratio as at 30 June 2020 is 1.24

the shareholders' funds to total assets ratio is 30%

gross profit margins and net profit margins for the year ended 30 June 2020 have dropped to the level where losses are being incurred.

NB: An excerpt of Best's Financial Reports is attached.

Best Furniture Manufacturers Pty Ltd (Best) Balance Sheet 2020 201 9 2018 Current assets Debtors 748,681 774,469 665,939 Sale or return debtors 483,020 499,657 429,638 Inventory 300,035 305,013 256,376 1,531,737 1,579,140 1,351,953 Non-current assets Property, plant and machinery 1,967,404 1,993,058 1,867,593 Total assets 3,499,141 3,572,198 3,219,546 Current liabilities Trade and other creditors 395,019 343,545 289,049 Bills payable 509,494 517,947 435,355 Bank overdraft 135,576 13,337 55,672 Current portion of bank loans 200,000 200,000 200,000 1,240,090 1,074,830 980,076 Non-current liabilities Bank loans 1,200,000 1,400,000 1,600,000 Equity Share capital 500,000 500,000 500,000 Retained earnings 559,051 597,368 139,470 1,059,051 1,097,368 639,470 3,499,141 3,572,198 3,219,546 Profit and Loss Account Gross sales 6,077,296 6,233,124 5,350,321 Returns - 200,551 - 153,958 - 123,057 Net sales 5,876,745 6,079,166 5,227,264 Cost 01 sales Materials 2,066,281 2,100,563 1,765,606 Labour 1,397,778 1,153,128 963,058 Other 516,570 506,130 438,726 3,980,629 3,759,820 3,167,390 Standard Cost Variances Purchase price (121,546) (49,865) (16,051) Labour cost 182,319 62,331 26,136 303,865 112,196 42,187 Operating profit 1,592,252 2,207,149 2,017,686 Expenses Administration 791,918 754,208 600,841 Sales and marketing 663,198 642,012 524,331 Financing 175,452 156,789 123,457 1,630,569 1 ,553,009 1,248,630 Net profit (loss) (38,317) 654,140 769,057 Tax 0 196,242 230,717 Net profit after tax (loss) 38,317 457,898 538,340