MINI AUDIT - COOKS 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 Cooks 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 Cooks Furniture.

NOTES FROM CLIENT INTERVIEW

Cooks 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. Cooks 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. Cooks 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.

Cooks 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.

Cooks 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.

Cooks 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 Cooks 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. Cooks does not have significant market share, and competes with a number of nationally recognized companies. Cooks 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. Cooks Furniture has a show room and design space in Parnell Auckland to meet with potential customers and discuss their needs. Cooks 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.

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 Cooks 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 Cooks 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 Cooks 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 Cooks 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.

When considering accept a new client, auditors need to comply with ethical requirements of the professional standards. Referring to the information given:

1. Identify four situations that may impose ethical threats to the auditors and the audit firm.
2. For each situation, explain potential threats to professional ethical requirements.
3. Discuss possible safeguards to address each threat (refer to the relevant PES standards in your answer).