Question 3 (35 marks)

Your firm has just been appointed auditor of Gravel Manufacturing Ltd. and you are planning for your first audit the year ending 30 June 2016. Gravel Manufacturing is a manufacturer of electronic smoke alarms and electronic security systems and is part of the broader electronics industry. Their operations consist of a head office and factory in the Sydney suburb of Alexandria. They have distribution outlets in each major Australian city and sales agents throughout South East Asia, the UK and USA. There has been a large amount of capital expenditure on the Sydney factory over the past two years. Your research shows that the smoke alarm and security industry is highly volatile and competitive, with heavy discounting by competitors and a prevalence of lower quality products. The industry is also affected by changes in technology, government regulations and health and safety legislation in each of the different areas in which the company operates. In discussions with the Sydney productions manager, Mr Ye, you discover he has a difficult job ascertaining production levels in a volatile market and he is often concerned at inventory fluctuations caused by over or under production of alarm and security systems.

Gravel Manufacturing operates a senior management incentive scheme where senior executives are allocated a percentage of net profit after tax. Gravel also has a long term mortgage loan with a foreign bank that requires them to maintain certain financial ratios. Breach of any of the loans will result in the bank calling in the loan within 24 hours. The requirements are that the current asset ratio must be greater that 1.5:1 and the quick asset ratio must be greater than 0.8:1.

Income Statement

30/6/201630/6/201530/6/2014$(000)$(000)$(000)Sales27,74025,28022,936Less: Cost of goods sold20,10420,80018,200Gross Profit7,6364,4804,736Interest expense500260240Other expenses4601,5802,040Profit Before Tax6,6762,6402,456Income tax expense1,5201,100800Profit After Tax5,1561,5401,656

Balance Sheet

Current AssetsCash10001,600Receivables3,8902,9601,920Inventory3,7202,6801,724Other assets1,16000Total Current Assets8,8705,6405,244

Non Current AssetsProperty Plant & Equipment5,7805,2003,812Total Assets14,65010,8409,056

Current LiabilitiesOverdraft04000Payables1,9103,1003,580Other Creditors278224100Provisions5101,7201,520Total Current Liabilities2,6985,4445,200

Non Current LiabilitiesLoans3,0001,6001,600Total liabilities5,6987,0446,800

Net Assets8,9523,7962,256

Shareholders EquityIssued capital200200200Retained profits3,5962,056400Profit/loss for year5,1561,5401,656Shareholders equity8,9523,7962,256

Required:

a) Calculate the following ratios for 2016, 2015 and 2014:

Gross profit ratio

Return on total assets

Net profit ratio (before tax)

Inventory turnover

Receivables turnover

Current ratio

Quick ratio

Times interest earned (before tax)

Note: assume inventory and receivables balances for 2013 are the same as for 2014 (12 marks)

(b) Identify and explain any going concern issues you have identified. (2 marks)

(c) Identify the four accounts that you consider most at risk of misstatement. Use the background information, financial statements and analytical results to justify your choices. (12 marks)

(d) For the accounts identified in (c) explain if the accounts are likely to be overstated or understated and identify the key assertions that would be the focal point for the audit. Justify your choice of assertion. (9 marks)

You can using the following format to present the ratios for part (a)

RatioRatio Formula201620152014The following table format can be used to answer parts (c) and (d).

Account at risk of misstatement and justificationOverstated or understatedAssertion(s) at riskJustification