Case Background You are the audit senior on the audit of Resilient Furniture Manufacturers Pty Ltd (Resilient). 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 Resilient and to understand its business operations, its environment and system of internal control. You noted and documented the following: Resilient was founded 30 years ago and makes 'grandfather' clocks (freestanding, weight driven, pendulum clocks). The clocks are made in one factory (situated in the Alice Springs) 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, Resilient'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 given authority to make these offers. All of Resilient'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 Resilient'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. Resilient has found it difficult to pass on these timber 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 Resilient's financials: the current ratio as at 30 June 2019 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 2019 have dropped to the level where losses are being incurred. . NB: An excerpt of Resilient's Financial Reports is attached. Resilient Furniture Manufacturers Pty Ltd (Resilient) Balance Sheet 2019 2018 2017 Current assets Debtors Sale or return debtors Inventory 748,681 483,020 300,035 1,531,737 774,469 499,657 305,013 1,579, 140 665,939 429,638 256,376 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 Bills payable Bank overdraft Current portion of bank loans 395,019 509,494 135,576 200,000 1,240,090 343,545 517,947 13,337 200,000 1,074,830 289,049 435,355 55,672 200,000 980,076 Non-current liabilities Bank loans 1,200,000 1,400,000 1,600,000 Equity Share capital Retained earnings 500,000 559,051 1,059,051 500,000 597,368 1,097,368 500,000 139,470 639,470 3,499,141 3,572, 198 3,219,546 Profit and Loss Account Gross sales Returns Net sales 6,077,296 200,551 - 5,876,745 6,233,124 153,958 6,079,166 5,350,321 123,057 5,227,264 Cost of sales Materials Labour Other 2,066,281 1,397,778 516,570 3,980,629 2,100,563 1,153, 128 506,130 3,759,820 1,765,606 963,058 438,726 3,167,390 Standard Cost Variances Purchase price Labour cost (121,546) (182,319) (303,865) (49,865) (62,331) (112,196) (16,051) (26,136) (42,187) Operating profit 1,592,252 2,207,149 2,017,686 Expenses Administration Sales and marketing Financing 791,918 663,198 175,452 1,630,569 754,208 642,012 156,789 1,553,009 600,841 524,331 123,457 1,248,630 Net profit (loss) Tax Net profit after tax (loss) (38,317) 0 (38,317) 654,140 196,242 457,898 769,057 230,717 538,340 Asia Pacific College of Business & Law Semester 2 2020 Resilient's bank finances the company's timber purchases using bills of exchange drawn at 90 days from the date of payment of the shipment. It has also extended loan finance to Resilient. The bank covenant, which is due for review shortly, requires Resilient to: maintain a current ratio of 1.2 maintain a shareholders' funds to total assets ratio of at least 30% maintain net sales of a minimum of $100,000 per quarter prepare a general purpose financial report for the year ended 30 June 2019 and have it audited according to Australian Auditing Standards. Note that this is a requirement of the bank covenant as Resilient is not required to produce a general purpose financial report under the Corporations Act. Required - Q3 Part 1: For parts (a), (b) and (c) of this question, please disregard all going concern considerations. Based on the background information above and your use of preliminary analytical procedures, answer the following questions: a) Identify and explain two (2) asset accounts at risk of material misstatement (6 marks). b) Describe one (1) issue regarding the prior year's figures and explain why (2 marks). c) Describe three (3) factors that may bring into question the going concern assumption for Resilient. Disregarding the evaluation of management's assessment of the going concern assumption, briefly describe the effect of the facts on your audit planning (6 marks). [6 + 2 + 6 = 14 marks] Now, after examining Resilient's detailed trial balance, you notice that one of the expenses of the sales and marketing department is 'sales bonuses'. You question this expense and the company's accountant informs you that a monthly bonus of 10% of salary is paid to all sales and marketing staff if sales for the month exceed the budgeted target. The marketing manager is entitled to a 20% bonus if the targets are achieved. This incentive was implemented during the previous financial year and was in place for the last six months of the year. You note that the bonus has been paid every month since the incentive was implemented (except for the previous month, when sales were much lower than expected). This seems a little unusual because Resilient had only achieved its budgeted sales targets in two out of the six months prior to the start of the scheme. You investigate results for the last six months of the year and find that: sales were above the monthly budget figure when bonuses were paid there was no significant change in gross margins returns of stock sold on the 'sale or return' basis were well below those in the first six months except in the final month of the year debtors' levels (measured in days outstanding) were above their budgeted levels but returned to a more normal level at year end. . On further enquiry, the accountant advises that the marketing manager is authorised to do the following with regard to the stock sold on a 'sale or return' basis: offer customers a 'sale or return' deal as long as the deal is within the company's pricing structures and the terms of the scheme initiate and approve the invoicing of customers when a sale is made (i.e. if the stock is not returned within 60 days) initiate and approve the issue of credit notes for these customers when returns are made within 60 days or when pricing or quality issues arise. Required -Q3 Part 2: Based on the background information above, answer the following questions: a) Explain one (1) internal control issue at Resilient (2 marks). b) Identify and explain two (2) fraud risk factors at Resilient (4 marks). c) Identify two (2) assertions (as defined by ASA 315) at risk as a result of the fraud risk factors identified in (b) above. Justify your answer with reference to the background scenario (6 marks). d) Describe two (2) audit procedures that would address potential misstatements arising from fraudulent financial reporting. Ensure that your procedures are specific to the scenario and the fraud risk factors identified in (b) above. You may wish to refer to Appendix of ASA 240 (4 marks). Case Background You are the audit senior on the audit of Resilient Furniture Manufacturers Pty Ltd (Resilient). 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 Resilient and to understand its business operations, its environment and system of internal control. You noted and documented the following: Resilient was founded 30 years ago and makes 'grandfather' clocks (freestanding, weight driven, pendulum clocks). The clocks are made in one factory (situated in the Alice Springs) 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, Resilient'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 given authority to make these offers. All of Resilient'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 Resilient'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. Resilient has found it difficult to pass on these timber 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 Resilient's financials: the current ratio as at 30 June 2019 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 2019 have dropped to the level where losses are being incurred. . NB: An excerpt of Resilient's Financial Reports is attached. Resilient Furniture Manufacturers Pty Ltd (Resilient) Balance Sheet 2019 2018 2017 Current assets Debtors Sale or return debtors Inventory 748,681 483,020 300,035 1,531,737 774,469 499,657 305,013 1,579, 140 665,939 429,638 256,376 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 Bills payable Bank overdraft Current portion of bank loans 395,019 509,494 135,576 200,000 1,240,090 343,545 517,947 13,337 200,000 1,074,830 289,049 435,355 55,672 200,000 980,076 Non-current liabilities Bank loans 1,200,000 1,400,000 1,600,000 Equity Share capital Retained earnings 500,000 559,051 1,059,051 500,000 597,368 1,097,368 500,000 139,470 639,470 3,499,141 3,572, 198 3,219,546 Profit and Loss Account Gross sales Returns Net sales 6,077,296 200,551 - 5,876,745 6,233,124 153,958 6,079,166 5,350,321 123,057 5,227,264 Cost of sales Materials Labour Other 2,066,281 1,397,778 516,570 3,980,629 2,100,563 1,153, 128 506,130 3,759,820 1,765,606 963,058 438,726 3,167,390 Standard Cost Variances Purchase price Labour cost (121,546) (182,319) (303,865) (49,865) (62,331) (112,196) (16,051) (26,136) (42,187) Operating profit 1,592,252 2,207,149 2,017,686 Expenses Administration Sales and marketing Financing 791,918 663,198 175,452 1,630,569 754,208 642,012 156,789 1,553,009 600,841 524,331 123,457 1,248,630 Net profit (loss) Tax Net profit after tax (loss) (38,317) 0 (38,317) 654,140 196,242 457,898 769,057 230,717 538,340 Asia Pacific College of Business & Law Semester 2 2020 Resilient's bank finances the company's timber purchases using bills of exchange drawn at 90 days from the date of payment of the shipment. It has also extended loan finance to Resilient. The bank covenant, which is due for review shortly, requires Resilient to: maintain a current ratio of 1.2 maintain a shareholders' funds to total assets ratio of at least 30% maintain net sales of a minimum of $100,000 per quarter prepare a general purpose financial report for the year ended 30 June 2019 and have it audited according to Australian Auditing Standards. Note that this is a requirement of the bank covenant as Resilient is not required to produce a general purpose financial report under the Corporations Act. Required - Q3 Part 1: For parts (a), (b) and (c) of this question, please disregard all going concern considerations. Based on the background information above and your use of preliminary analytical procedures, answer the following questions: a) Identify and explain two (2) asset accounts at risk of material misstatement (6 marks). b) Describe one (1) issue regarding the prior year's figures and explain why (2 marks). c) Describe three (3) factors that may bring into question the going concern assumption for Resilient. Disregarding the evaluation of management's assessment of the going concern assumption, briefly describe the effect of the facts on your audit planning (6 marks). [6 + 2 + 6 = 14 marks] Now, after examining Resilient's detailed trial balance, you notice that one of the expenses of the sales and marketing department is 'sales bonuses'. You question this expense and the company's accountant informs you that a monthly bonus of 10% of salary is paid to all sales and marketing staff if sales for the month exceed the budgeted target. The marketing manager is entitled to a 20% bonus if the targets are achieved. This incentive was implemented during the previous financial year and was in place for the last six months of the year. You note that the bonus has been paid every month since the incentive was implemented (except for the previous month, when sales were much lower than expected). This seems a little unusual because Resilient had only achieved its budgeted sales targets in two out of the six months prior to the start of the scheme. You investigate results for the last six months of the year and find that: sales were above the monthly budget figure when bonuses were paid there was no significant change in gross margins returns of stock sold on the 'sale or return' basis were well below those in the first six months except in the final month of the year debtors' levels (measured in days outstanding) were above their budgeted levels but returned to a more normal level at year end. . On further enquiry, the accountant advises that the marketing manager is authorised to do the following with regard to the stock sold on a 'sale or return' basis: offer customers a 'sale or return' deal as long as the deal is within the company's pricing structures and the terms of the scheme initiate and approve the invoicing of customers when a sale is made (i.e. if the stock is not returned within 60 days) initiate and approve the issue of credit notes for these customers when returns are made within 60 days or when pricing or quality issues arise. Required -Q3 Part 2: Based on the background information above, answer the following questions: a) Explain one (1) internal control issue at Resilient (2 marks). b) Identify and explain two (2) fraud risk factors at Resilient (4 marks). c) Identify two (2) assertions (as defined by ASA 315) at risk as a result of the fraud risk factors identified in (b) above. Justify your answer with reference to the background scenario (6 marks). d) Describe two (2) audit procedures that would address potential misstatements arising from fraudulent financial reporting. Ensure that your procedures are specific to the scenario and the fraud risk factors identified in (b) above. You may wish to refer to Appendix of ASA 240 (4 marks)