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CASE STUDY 2 (30) Your audit firm was recently appointed as auditors of The House of Persia (Pty) Ltd (following the unexpected resignation of the previous auditor), a medium sized company which sells expensive carpets. The company has a public interest score of around 200 and its annual financial statements are compiled internally. The following information pertains to the company: 1. The company was started twenty years ago and has grown into a large business with ten outlets situated in upmarket shopping malls in three major cities in South Africa. Individual outlets are not particularly large, but collectively the inventory of carpets is considerable. 2. The shares in the company are held by the Iran family and a small number of private investors who are not active in the business and who cumulatively have a minor holding, and all senior positions are held by members of the family. Other positions, for example in the accounting department are also held be family members. The accounting system is computerised. 3. All carpets are imported. Suppliers are mainly situated in Turkey, Iran and Morocco. Ronnie Irani, the managing director and major shareholder of The House of Persia (Pty) Ltd, and his oldest son are responsible for purchasing the carpets. They visit suppliers three or four times a year. 4. A major issue in the imported carpet trade is the sale of fake carpets, and many of the dealers in South Africa have dubious reputations. Fake carpets, which can be obtained very cheaply, are sold to the public as genuine hand knotted imported carpets. It is very difficult for anyone who does not have the necessary expertise and experience to determine whether a carpet is genuine or fake. The House of Persia (Pty) Ltd claims that it deals only in genuine carpets, but is currently in dispute with a wealthy customer who is challenging the authenticity of a number of carpets she purchased. 5. Every carpet is unique (no two carpets are the same) in terms of colour, pattern, material used and density of the knots and cost can vary considerably. Whilst each carpet is supported by some form of purchase documentation, this documentation is not always comprehensive and is frequently in a foreign language, e.g. Turkish. Purchases are made in various foreign currencies. Carpets do not carry any form of identification tag or number, but each carpet can be identified by an expert, by its style, colour, pattern, region, etc. When carpets are sent to The House of Persia (Pty) Ltd.'s outlets a label, giving a brief description of the carpet and its selling price is attached to the carpet. All selling prices are set by Ronnie Irani. Because of the uniqueness of each carpet, there is no standard mark up, and prices can vary considerably. As the carpets sell consistently and do not deteriorate over time, only a small allowance for "obsolete stock" is made each year. 6. There is no tight audit deadline for the upcoming financial year-end audit. However, as the bank relies on the audited financial statements when reviewing its continued support of the company's overdraft banking facilities, a copy must be sent to the bank once the audit is complete. The private investors also require a set of the audited financial statements. 7. Although the Irani family is concerned about political tensions in the Middle East, they are satisfied that their supply of carpets will be unaffected. REQUIRED: Your audit partner has asked you to critically evaluate the above information and submit a report in which you: 2.1 Evaluate the risk that the annual financial statements, on which your firm will report, contain material misstatement as a result of fraudulent financial reporting. (8) 2.2 Discuss your audit strategy for the upcoming audit of The House of Persia (Pty) Ltd. (10) 2.3 Assess the risk of material misstatement of The House of Persia (Pty) Ltd.'s inventory for the upcoming financial year-end audit. Structure your response in terms of the assertions. You are not required to consider assertions relating to presentation or related disclosures. (12)