Section 3: Subsidiary 3 - Computek Electronics Limited (Case for Audit Supervisor)

You are assigned to the audit of Computek Electronics Limited, a subsidiary company of Las Vegas Group Corporation (USA) Limited. Computek Electronics Ltd. is a wholly owned subsidiary of a US parent. The following information has been provided to you:

1.The principal activities of Computek Electronics Ltd are the importation and distribution of modems and personal computers (PCs). It has offices in all capital cities in US and around Australia.

2.All inventories are purchased either from its US parent or related companies in Hong Kong and Taiwan.

3.Computek Electronics Ltd was incorporated in 1991 and had operated profitably until 1996 when significant losses were incurred, principally due to the downturn in the economy, competition from other manufacturers and the availability of cheaper clones.

4.The company is well established in the modem market; however, it has not been doing well in the PC market for the reasons given above and has consequently decided to get out of the PC market and concentrate on enhancing its position in the modem market. This decision has been communicated to the public via computer journals and publications.

5.The stock level of PCs, modems and spares as at 30 October 1998 was as follows:

$'000

Modems4426

PCs3142

Spares1563

9131

6.Your manager has advised you that 2 of the largest debtors have gone into liquidation and the client has provided 50% of these debts as they are covered by credit insurance. There is no correspondence from the insurance company regarding whether or when the claim in respect of these debts will be settled. The insurance company has requested Computek to provide evidence that the company has fulfilled all the conditions of the insurance policy before it will settle. In view of previous experiences by the company with such insurance claims, it is unlikely that any notification on recovery will be received before year end. The financial controller has assured your manager that they have complied with all the conditions of the insurance agreement.

7.The company maintains fully computerized accounting systems for sales/debtors, inventories and general ledger functions. Audit testing in prior years has shown that controls over these systems appear to be strong. The sales/debtors system matches cash receipts to outstanding items, and maintains back order details where customer orders cannot be filled immediately.

8.Computek has a wholly owned subsidiary in New Zealand which has been making losses since its incorporation in 1995. As a result, the subsidiary has a large deficiency in shareholders' funds. The New Zealand company figures have not been consolidated in the attached financial information.

9.A large stock of PCs at a cost of $600,000 was ordered and is currently in transit from the overseas parent. These PCs are the latest machines which have been brought to Australia for the first time. However, since Computek has resolved to concentrate on the modem market, it has decided not to release the machines into Australia. The parent company from which these stocks were purchased will not accept them back, but the company's directors are looking to on-sell them to another related company in Hong Kong.

10.Initial discussions with management have revealed that the company has significant tax losses which management is keen to carry forward as an asset in the year end balance sheet.

11.All modems and PCs sold by the company have a warranty of 12 months from the date of sale.

12.One modem stock item (XP1000) which was released in early 1997 was found to have a factory fault. This defect only occurs in modems which are used excessively. Computek had established a provision of $480,000 for returns of this item, but only $80,000 of this provision had been utilized up to October 1998. The returns of this item have slowed down to only 1 per month. There are 100 units of this item still on hand.

Computek Electronics Limited

Statement of Financial Performance

Unaudited

10 months

31/10/98

$'000

Audited

12 months

31/12/97

$'000

Operating revenue

47787

72007

Operating profit (loss)

(3652)

(5561)

Abnormal items

-

(1583)

Income tax expense

-

-

Operating loss after income tax

(3652)

(7144)

Retained profits/(losses) at beginning of financial year

(23816)

(16672)

Retained profits/(losses) at end of financial period

(27468)

(23816)

Statement of Financial Position

Current Assets

Cash

153

1107

Receivables

10353

14310

Inventories

7723

18073

Other

-

40

Total Current Assets

18229

33530

Non-current Assets

Investments

1

1

Property, Plant & Equipment

1800

2166

Total Non-current Assets

1801

2167

Total Assets

20030

35697

Current Liabilities

Creditors & Borrowings

16537

27177

Provisions

890

1672

Total Current Liabilities

17427

28849

Non-current Liabilities

Creditors & Borrowings

29034

29634

Provisions

37

30

Total Non-current Liabilities

29071

29664

Total Liabilities

46498

58513

Net Assets

(26468)

(22816)

Shareholders' Equity

Share Capital

1000

1000

Retained profits/(losses)

(27468)

(23816)

Total Shareholders' Equity

(26468)

(22816)

You are required to complete the following:

A).i)What are the key factors that indicate that the company may have a going concern

problem?

ii)What additional information would you obtain to evaluate this problem?

B).Assume the audit partner has concluded that the company is likely to remain a going concern. Describe the substantive procedures to be performed to address the key audit assertions for the following balances:

i)Trade debtors

ii)PC inventory

iii)Returns provision

iv)Operating revenue

v)Amounts owing to parent entity

C).Assume you were given the following information:

The parent company has advised local management that should Computek not show a turnaround to profits for the year ended 31 December 1999 it will proceed to wind up local operations early in 2000.

What effect would this information have on the audit?

D)Indicate the type of error that each of the following audit procedures is designed to or is likely to disclose:

i)review of the repairs and maintenance account.

ii)confirmation of a portion of accounts receivable.

iii)reconciliation of interest expense with loans payable.

E)Having just completed the annual financial audit, the audit partner and supervisor are holding a final

debriefing meeting with the client. As part of this meeting the managing director of Computek Electronics Ltd indicates: I'm glad we got a clean bill of health on that audit report. I had some concerns about controls at the warehouse but I see there is nothing to worry about.'

The audit partner replied: 'our procedures did not involve a full review of controls, so I don't know whether your specific concerns would be addressed or not.'

The managing director retorted, 'Well, what are we paying you for then?

Advise the partner on an appropriate reply to the managing director.