It is 1 July 2019. You are an audit supervisor of Orange & Co planning the audit of a new client, Scarlet Co, for the year ended 31 May 2019. Scarlet Co manufactures chemicals for use in domestic and commercial cleaning products. The company’s financial accountant was taken ill suddenly in May 2019 and is unable to undertake the preparation of the year-end draft financial statements. As a result, the company recruited a temporary financial accountant in early June 2019 who will prepare the draft financial statements. The year-end financial statements need to be finalized quickly as the company is looking to raise finance through a bank loan to replace three machines in the production facility. The bank has asked for a copy of the audited year-end financial statements by the end of September 2019 before they will agree to the loan and the directors are keen to report strong results in order to obtain this financing. In the year, the company also purchased a specialized machine to develop a new range of chemicals for a major customer. Our trained staff are allowed to operate this machine and staff members had to undertake two days of training, followed by an assessment at the end of the training period. The training costs of $15,000 have been capitalized as part of the cost of the asset. The company sources many of its raw materials to be used in the chemical manufacturing process from an international supplier and goods can be in transit for up to three weeks. The agreement with the international supplier contains a clause which states that Scarlet Co is responsible for the goods as soon as they leave the supplier’s warehouse. You have carried out a preliminary analytical review which indicates that the receivables collection period has increased from 38 days to 52 days. The credit controller has confirmed that some customers are currently taking longer to pay than in previous years as they are awaiting payment from their customers. On 29 May 2019, the directors announced that one of its brands was being discontinued due to a fall in demand for the product. This resulted in four staff members being made redundant. The payroll department has calculated the levels of termination costs associated with the redundancy and they will be paid in the July 2019 payroll run. The directors each received a significant bonus in the year which has been included in the payroll charge for the year in the statement of profit or loss. Local legislation requires separate disclosure of directors’ bonuses in the financial statements.

During the year the company sold a batch of chemicals to a customer for $120,000. At the beginning of May 2019, the customer returned these chemicals because the chemical mix was not in line with the customer’s specifications. A credit note is yet to be issued to the customer and the chemicals have been written down to their scrap value within inventory. The company usually pays its suppliers by the end of each month. However, due to the financial accountant’s illness, the payment run for May 2019 was not performed until 1 June 2019. The finance director has informed you that in order to show consistent results with the prior year, this payment run is shown as an unpresented item on the year-end bank reconciliation.

(a) Explain the PURPOSE of an audit engagement letter and list FOUR items which should be included in an audit engagement letter.

(b) Explain WHY the following factors should have been considered by Orange & Co prior to accepting Scarlet Co as a new audit client. 

Pre-acceptance Factors	Explanation
The Outgoing Auditors Response
Management Integrity
Pre-condition for an audit
Independence and Objectivity
Resources available at time of the Audit

(c) Describe EIGHT audit risks, and explain the auditor’s response to each risk, in planning the audit of Scarlet Co.

Audit risk

Auditor’s response

(d) Describe substantive procedures the auditor should perform to obtain sufficient and appropriate audit evidence in respect of the redundancy costs.