MINI AUDIT - COOK'S FURNITURE LTD. BACKGROUND INFORMATION BDC, Chartered Accountants is a medium size accounting firm located in Auckland with four audit partners, eight business advisory partners and four tax partners. It also has affiliations with other network firms in other countries. The firm has been approached to audit Cook's Furniture Ltd. The firm adopts procedures for acceptance and continuance of clients following ISA (NZ) 220 and PES 1. To determine whether BDC should accept a new client, an audit partner needs to interview the prospective client to determine what services the client needs and the ability of the firm to provide those services. As the prospective audit manager on the engagement, you accompanied the audit partner Charles Kirby on the interview. The following is a summary of your notes from the interviews with senior management of Cook's Furniture. NOTES FROM CLIENT INTERVIEW Cook's Furniture Ltd is New Zealand company incorporated in 1985 by Colin Cook who is an experienced carpenter. The company is a manufacturer of furniture and cabinetry for commercial use. The products include desks, chairs, sofas, filing cabinets, bookcases, credenzas and European- style cabinets. The company's manufacturing plant and executive offices are located in a building leased from Colin Cook (the founder of the company), which adjacent to delivery and warehouse facilities. Two adjacent buildings house the corporation which located in Manukau Auckland. The company purchases raw materials including coil steel, metal bar stock, hardware, laminated particleboard, timber board, casters, fabric, rubber and plastic products, paint and shipping cartons. Raw materials are delivered to the warehouse by common carriers or by supplier's trucks. Some the raw materials are sourced within New Zealand, others are imported from multiple countries. The company sells both domestically and to Australia. Finished products are shipped FOB from the warehouse or picked up by the customer. Cook's Furniture has five delivery trucks for local orders. The company has 120 employees involved in manufacturing operations (i.e. measure, design and make) and 16 in the offices. The company's work force is stable and highly skilled. Many of the employees have been with the company for more than five years. The company's work environment and solid reputation has allowed it to attract and keep employees in a tight market place. Cook's Furniture offers profit-sharing plans to their employees. The plans have been in place for over 15 years. Unfortunately, due to the lockdown and perceived economic downturn, the company had to cut back on its workforce. The company laid off 25 employees from April May 2020. Cook's Furniture commits to sustainable practice relating to the use, storage, and transportation. Where possible, they use durable and recycled materials. The company meets the ISO 14001 standards for its manufacturing process, logistics and transport facilities. ISO 14001 is an Environmental Management System that aids companies in minimising adverse impacts on the environment, increasing efficient resource use and complying with environmental legislation and regulations. Cook's Furniture is family owned and not publicly traded; 1,000,000 shares were issued. Major stockholders include the founder, who recently retired as the Chairman of the Board, Colin Cook. He holds 30% of the outstanding shares. Colin is 73 years old, and until his retirement, was closely involved in all major decisions affecting the company. He is very proud of the strong reputation his company has for being ethical and for meeting its commitments and promises. His son, Carl Cook, has worked in the business for the last 20 years, is the current CEO and Chairman of the board, and under his father's guidance during the last 5 years, has assumed the responsibility of overseeing the business's day-to-day operations. Carl is also a 30% owner. Other family members own an additional 30% of the business. The Chief Operating Officer (COO) and Chief Financial Officer (CFO) are the only non-family owners at 5% each. Cook's senior management is comprised of Carl Cook, the CEO and Chairman of the Board; Steven Chen, the COO; and Claire Tuner, the CFO. Chen joined the company two years ago after working for 11 years in the industry for a major office furniture manufacturer. Turner has worked for the company for about 18 months. She was a senior audit manager of BDC prior to joining Cook's Furniture. The Board of Directors (BOD) includes Colin Cook, Carl Cook, a family member with a business background in the retail residential furniture sector (Howard Cook), another family member trained in architecture and interior design (Catherine Cook), and a lawyer Lisa Greenwood. During the on-site interview, you and Kirby met with Colin Cook for over two hours, then were introduced to and interviewed individually the other members of the senior management team. Each of these interviews extended beyond an hour, and allowed Kirby the opportunity to explore the business goals driving the company. Office furniture is a competitive, multibillion-dollar annual market in Australasian. Its growth depends on building and renovation of commercial spaces. With a strong economy the market had a grown about 8% per year over the last two years prior to the COVID-19 pandemic. However, industry experts expect this growth to slow down in the years ahead. Cook's does not have significant market share, and competes with a number of nationally recognized companies. Cook's primary advantages are smart design, competitively pricing, consistently high-quality products and NZ made. Its low profit margins are part of a pricing strategy to build market share by undercutting the competition. The company underwent major retooling from August to October 2019, which approximated 85% of the capital expenditures that year. The retooling was financed with significant long-term debt. The improvements enabled the company to manufacture customised ready-to-install cabinets. This is a unique product line; it offers a custom-built-in look not readily available from other manufacturers. Demand is steadily growing. Customers include hotels, hair saloon, gyms, schools and corporate offices etc. The customised office cabinetry grants the company a wider profit margin and sales growth potential. The company plans on expanding its marketing in this niche. The COO, Steven Chen would like to see this product line grow to a total of $ 60 million in sales in the next three to five years. The company also has developed award-winning new designs in office furniture that stress the efficient and ergonomic use of technology such as tables, workbays (see picture below), phone booth. All products have a ten-year warranty. The modern workplace demands office furniture that caters to a technology-based work environment. The new designs offer functional and comfortable furniture which maximises the use of office space and give a spacious feel. The new designs are expected to boost the sales of the existing product line. Management estimates that the maintenance of the current physical plant is between $350,000 and $500,000 per year, which can support its production capacity up to $50 million in sales without significant additions of manufacturing and distribution capacity. Cook's Furniture has a show room and design space in Parnell Auckland to meet with potential customers and discuss their needs. Cook's Furniture has recently worked on major banks and accounting firm offices. Carl heard from his niece Heather who works as an audit senior at BDC that the office premises of BDC will be relocated in 2021. Carl offers 30% discount on customised office cabinetry and furniture to Charles Kirby Workbays Colin and Carl Cook have been the driving force behind the company's success over its history. They made it clear they know and understand the industry. In their view, succeeding in the increasingly competitive office furniture market place necessitates that the company focus its resources on taking calculated risks to increase its market share and name recognition. They also believe the company must specialize its product lines. They see the customised office cabinetry niche as one the company can develop more fully so that this product line is capable of catering to the growing preference for a customized office work environment at a reasonable cost. They are confident the company has assembled a management team capable of improving profitability and sales. The company distributes its products through a network of approximately 10 office furniture dealers in major Australasian cities and towns. Recently, the company placed its products with the Warehouse-club chains. Most of the sales growth over the last two years is attributed to this new distribution channel; it made up 20% of the 2020 income year sales. This marketing channel competes on price and stock availability. The company also has a website where orders can be placed online. Individuals customers (which currently comprise about 5% of total sales) can order directly from Cook's Furniture's website. Customers may also place orders in the showroom. When asked about the change in accounting firms, Carl Cook informed Kirby that the prior auditor was very skilled at completing the audit to meet debt covenants, but the company needed a Chartered Accounting firm capable of helping Cook's Furniture move beyond the present. This included assistance with financial planning, developing better performance measures for the company, and improving the incentive compensation plan for key employees. Beginning this year, the company put a bonus plan in place for key executives based on sales growth. They saw no reason for any scope limitations and expect BDC to offer suggestions to facilitate the firm's desire to expand their sales. They also said that they would contact their previous auditor and grant them permission to talk candidly with BDC about the potential change in auditors. Cook' banker and attorney separately recommended BDC as a firm capable of understanding the forces driving business success, and capable of forming a mutually beneficial working relationship. The interview with the other senior management team members added details to the company's business position. Steven Chen, the COO, explained that the current production management systems have been stressed by the company's growth over the past three years. Significant technology improvements are in process. The timeline for completing the implementation of a new production management system indicates that it should be fully operational in the second quarter of year 2021. The company expects to spend between $700,000 and $800,000 in 2021 to complete the project. Claire Turner, the CFO, is concerned about improving cash flow from operations and speeding up the operating cycle, changes which could involve reassessing Cook's credit and payment terms. However, Steven is worried that tightening credit terms would hinder sales growth. Carl is adamant about maintaining sufficient inventory to make sure orders can be shipped with minimal backorders. Claire commented that the major reason for the audit is to satisfy a debt covenant of the lender and explained the company's debt maturities are accelerating, hampering cash flows available for investing to expand sales. In expanding capacity to grow sales, she suggests that the company consider venture capital to grow the company until it is ready for an Initial Public Offering (IPO). In the past, the major lender has been the primary banks along with several creditors, but the CFO plans on showing the financial statements and in-house projections to potential venture capitalists as well. OTHER INFORMATION After the interview, Kirby contacted the prior auditor, Will Dunn, CA, regarding the potential change in auditor. Dunn was not surprised that Cook's Furniture was considering a change in auditor. He had been Colin Cook' auditor for nearly 20 years. In recent years, Carl had taken more responsibility and had been more aggressive about growing the company. Dunn expressed no concern about the integrity of management. Several years ago, Dunn said that Carl Cook had raised several questions about revenue recognition on some possible "bill and hold" sales in advance of negotiating a sales agreement with a national office supply and furniture chain. No problems were noted in the subsequent audit. Dunn expressed concern about the current accounting system that is expected to be replaced in 2021. Audit adjustments in the last few years resulted from cut-off problems, from an adjustment due to an error in counting inventory, and from discussions over allowance of bad debt. Finally, he noted that if Kirby's firm was selected as auditor, he would cooperate by allowing Kirby to review his working papers to the extent needed to prepare for the upcoming audit. FINANCIAL INFORMATION The audited financial results for 2019 along with the un-audited financial information for 2020 are included in the related exhibits filed in Excel file posted on the Blackboard under assessment tab. Cook's Furniture Ltd. Statement of Financial Position As at 30/06/20 Note 2020 Draft $000 2019 Audited $000 9 Assets Cash and Cash Equivalents Accounts Receivable Inventory Other financial assets Prepaid Expenses Total current assets 10 11 14,514 443 15,039 272 748 31,015 18,293 932 18,088 727 490 38,528 12 13 14 Property, Plant & Equipment Intangible Assets Total non-current assets Total Assets 37,066 951 38,017 69,032 45,944 1,189 47,133 85,661 15 16 Liabilities Borrowings Trade creditors Other creditors and accruals Deferred revenue Current tax payable Provisions Total Current Liabilities 17 5,440 4,478 2,514 10,529 145 1,362 24,468 10,181 5,789 3,040 13,199 654 1,477 34,339 18 15 6,650 17 18 Borrowings Deferred revenue Provisions Deferred tax Total Non Current Liabilities Total Liabilities Net Assets 8,025 68 2,322 76 10,491 34,958 34,073 2,440 400 9,490 43,829 41,832 19 Equity Share capital Reserves Retained Earnings Total Equity 1,346 212 32,516 34,073 1,682 718 39,432 41,832 Cook's Furniture Ltd. Income Statement For the Year Ended 30 June 2020 2020 $'000 2019 $'000 Note 3 Sales Cost of Goods Sold Gross Profit 107,210 39,754 67,456 125,384 46,781 78,603 4 Depreciation and amortisation Selling Expenses Employment Expenses General and Administrative Expenses Property Expenses Financial Costs Other Expenses Total Expenses Operating Income 1,701 8,556 15,251 4,296 13,573 421 672 44,470 22,986 1,890 9,504 18,128 4,682 14,968 464 4 514 50,148 28,455 434 331 97 395 375 204 Rent received Interest income Other income Net gain on disposal of plant and equipment Total other revenue Income Before Taxes 12 974 874 23,860 29,429 Income Taxes 7,014 8,940 Net Income 16,846 20,490 Exchange differences on translation Other comprehensive income 3 217 1 702 Retained Earnings at the End of the Year 16,632 21,191 Note 3 Revenue Recognition and measurement - Revenue and income recognition Revenue is recognised at an amount that reflects the consideration to which the consolidated entity is expected to be entitled in exchange for transferring goods or services to a customer. Revenue is recognised for major business activities as follows: Sale of goods When recognising revenue in relation to the sale of goods to customers, the key performance obligation of the consolidated entity is considered to be the point of delivery of the goods to the customer, as this is deemed to be the time that the customer obtains control of the promised goods. 2019 $'000 2020 Note 4 Expenses $'000 Profit before income tax includes the following specific expenses Included within employee benefits expenses Salaries and wages 12,150 Supernnuation expenses 1,100 Share-based payments 41 1,960 15,251 *Other employee benefits include commissions, payroll tax, workers compenstions and contract stuff 14,302 1,348 140 2,338 18,128 Other * Included within property expenses Operating lease payments 11,290 11,988 Recognition and measurement - Expenses Leases and operating leases Leases are classified at their inception as either operating or finance leases based on the economic substance of the agreement so as to reflect the risks and benefits incidental to ownership. Leases where the lessor retains substantially all the risks and benefits of ownership of the asset are classified as operating leases. Operating leases are recognised as an expense in the statement of comprehensive income on a straight-line basis over the lease term of the lease. Note 9 Cash and cash equivalents Cash at bank and on hand Short-term deposits Total 2020 $'000 4,240 10,274 14,514 2019 $'000 4,259 14,034 18,293 Note 10 Receivables 2020 2019 $'000 $'000 Trade debtors 116 190 Other debtors 328 742 443 932 Trade receivables are initially recognised at fair value, less any allowance for expected credit losses. Trade receivables are generally due for settlement within 30 days. The consolidated entity had no expected credit losses at reporting date. Other debtors includes contributions from landlords and claims due from suppliers. These are non-interest bearing and have repayment terms of up to 240 days. Note 11 Inventory Finished goods - at net realisable value Stock in transit 2020 $'000 12,807 2,232 15,039 2019 $'000 15,497 2,591 18,088 During the year ended 30 June 2020, $38,000 (2019: expense of $156,000) was recongised as a reducation in cost of good sold for inventories carried at net realisable value. Recognition and measurement - Inventories Inventories are valued at the lower of cost and net realisable value. Weighted average cost is used to value inventories. Costs incurred in bringing each product to its present location and condition includes purchase price plus freight, cartage and import duties. Net realisable value is the estimated selling price in the ordinary course of business, less estimated costs necessary to make the sale. Note 12 Other financial assets 2020 $'000 272 2019 $'000 727 Derivative hedge receivable Note 13 Property plant and equipment Land and buildings - at cost Less accumulated depreciation 2020 $'000 32,598 1,784 30,814 2019 $'000 40,305 1,489 38,816 Leasehold improvements - at cost Less accumulated depreciation 7,208 3,414 3,793 7,615 3,219 4,396 381 Fixtures and fittings - at cost Less accumulated depreciation 276 105 1,385 1,121 265 408 Motor vehicles - at cost Less accumulated depreciation 269 129 140 269 139 4,798 Office equipment - at cost Less accumulated depreciation 2,585 2,213 37,066 5,310 2,981 2,329 45,944 Total Recognition and measurement - Property, plant and equipment All classes of property, plant and equipment are measured at cost, less accumulated depreciation and any impairment in value. Depreciation is provided on a straight line basis on all property, plant and equipment. Major depreciation periods are: Buildings Leasehold improvements Furniture and fittings Motor vehicles Office equipment (including IT) 20-40 years 5 - 15 years 3 - 15 years 6 years 3- 12 years The residual values, useful lives and depreciation methods are reviewed, and adjusted if appropriate, at each reporting date. Leasehold improvements are depreciated at the shorter of the useful life or the term of the lease. Land is not depreciated. An item of property, plant and equipment is derecognised upon disposal or when there is no future economic benefit to the Company. Gains and losses between the carrying amount and the disposal proceeds are taken to profit or loss. The carrying values of property, plant and equipment are reviewed for impairment when events or changes in circumstances indicate the carrying value may not be recoverable. For an asset that does not generate largely independent cash inflows, the recoverable amount is determined for the cash-generating unit to which it belongs. If any such indication exists and where the carrying values exceed the estimated recoverable amount, the assets or cash-generating units are written down to their recoverable amount. Note 14 Intangibles assets 2020 $'000 951 2019 $'000 1,189 Goodwill on acquisition of stories in Christchurch Goodwill acquired through business combinations has been allocated the Christchurch stores and related distribution centre for impairment testing. The recoverable amount of the chrsitchurch stores and related distribution centre has been determined based on a value in use calculation using cashflow projections. The key assumptions used in determining the value in use are as follows: 2020 2019 Long-term growth rate 2.0% 2.0% Weighted average cost of capital 10.3% 10.3% Recognition and measurement - Intangible assets Goodwill on acquisition is initially measured at cost being the excess of the cost of the business combination over the acquirer's interest in the net fair value of the identifiable assets, liabilities and contingent liabilities. Following initial recognition, goodwill is measured at cost less any accumulated impairment losses. Goodwill is reviewed for impairment annually or more frequently if events or changes in circumstances indicate that the carrying value may be impaired. Impairment is determined by assessing the recoverable amount of the cash-generating unit to which the goodwill relates. When goodwill forms part of a cash-generating unit and an operation within that unit is disposed of, the goodwill associated with the operation disposed of is included in the carrying amount of the operation when determining the gain or loss on disposal of the operation. Goodwill disposed of in this manner is measured based on the relative values of the operation disposed of and the portion of the cash-generating unit retained. Note 15 Borrowings 2020 $'000 5,440 8,025 2019 $'000 10,181 6,650 Commerical bills payable - current Commerical bills payable -non current Recognition and measurement - Interest-bearing loans and borrowings All loans and borrowings are initially recognised at the fair value of the consideration received less directly attributable transaction costs. After initial recognition, interest-bearing loans and borrowings are subsequently measured at amortised cost using the effective interest method. Fees paid on the establishment of loan facilities that are yield related are included as part of the carrying amount of the loans and borrowings. Borrowing costs are recognised as an expense when incurred, unless they are directly attributable to the acquisition, construction or production of a qualifying asset whereby they are capitalised. Borrowings are classified as current liabilities unless the Company has an unconditional right to defer settlement of the liability for at east twelve months after the reporting date. Note 16 Payables 2020 2019 $'000 $'000 Trade Creditors 4,478 5,789 Other creditors and accurals 2,514 3,040 6,992 8,829 Trade creditors are non-interest bearing financial instruments and are normally settled on 30 day terms. Other creditors are non-interest bearing financial instruments and are normally settled on 30 to 60 day terms. Recognition and measurement - Payables Trade and other payables are carried at amortised cost and due to their short-term nature they are not discounted. They represent liabilities for goods and services provided to the Company prior to the end of the financial year that are unpaid and arise when the Company becomes obliged to make future payments in respect of the purchase of these goods and services. Note 17 Deferred revenue 2020 2019 $'000 $'000 Customer deposits 10,510 13,199 Accidental damage warranties - current 19 10,529 13,199 Accidental damage warranties - non current 68 Customer deposits are amounts received from customers for orders not yet completed. A customer deposit is recognised as revenue when the customer accepts delivery of the order. The opening balance of customer deposits was all recognised as revenue in the current financial year. Accidental damage warranties are purchased by the customer in conjunction with the purchase of a piece of furniture and are recognised as revenue over the life of the warranty. Amounts classified as current will be recognised as revenue within twelve months of the reporting date. Accidental damage warranties have a life of up to five years from the date of purchase. The non-current deferred revenue relates to the portion of revenue which will be recognised more than twelve months after the reporting date. Note 18 Provisions current Employee entitlements Deffered lease incentives 2020 $'000 1,114 248 2019 $'000 1,362 115 1,362 1,477 353 460 non current Employee entitlements Deffered lease incentives Lease make good 1,747 222 2,322 1,721 260 2,440 Recognition and measurement - Provisions Employee entitlements Liabilities for annual leave and long service leave expected to be settled within twelve months of the reporting date are measured as the amounts to be paid when the liabilities are settled and are discounted to net present value. Deferred lease incentive The Company has received financial incentives from the lessor of certain properties. These are recorded as a liability and amortised over the term of the lease. Employee entitlements Liabilities for annual leave and long service leave not expected to be settled within twelve months of the reporting date are measured as the present value of expected future payments to be made in respect of services provided by employees up to the reporting date using the projected unit credit method. Consideration is given to the expected future wage and salary levels, experience of employee departures and periods of service. Expected future payments are discounted using market yields at the reporting date on corporate bonds with terms to maturity and currency that match, as closely as possible, the estimated future cash outflows. Lease make good A provision has been made for the present value of anticipated costs of future restoration of leased properties. The provision includes future cost estimates associated with restoring the premises to its condition at the time the Company initially leased the premises, subject to fair wear and tear. Note 19 Issued capital 2019 2020 $'000 1,346 $'000 1,682 Authorised and fully paid ordinary shares Number of shares 1000000 1000000 PART A PROFESSIONAL ETHICS AND AUDIT PLANNING (44 Marks) Question 1. Professional Ethics: (14 marks) When considering accept a new client, auditors need to comply with ethical requirements of the professional standards. Referring to the information given: a) Identify four situations that may impose ethical threats to the auditors and the audit firm. b) For each situation, explain potential threats to professional ethical requirements. c) Discuss possible safeguards to address each threat (refer to the relevant PES standards in your answer). Question 2. Audit Planning Assuming all potential threats can be mitigated and Kirby has accepted Cook's Furniture as an audit client. He has asked you to plan for the audit of Cook's Furniture Ltd for the 2020 financial year. You need to produce the audit planning workpaper outlining potential risks in this audit. Your audit planning workpaper must cover the following: (30 marks) a) Identify ten risk factors (conditions) that indicates that the financial statement might be misstated. b) Determine the potential impact of each risk factor on the financial statements or the audit (e.g. which account and assertions might be misstated). c) Determine the audit strategies or procedures that may address the risk of material misstatement. Use the following format to present your answer. Identify the risk factor (a) Potential impact on the financial statements or the audit. (b) Audit strategies or procedures to address the risk of material misstatement (C) 1 2 3 4 etc