XYZ is a giftware wholesaler operating out of Australia, Perth. The company purchases several lines of giftware, such as decorative plates, dolls, and candles, from smaller suppliers, and provides one-stop shopping for gift stores and souvenir stores across the Australianmarket. Andrew Simmons, XYZ's owner and CEO, sent over some highlights from the draft financial statements for the year ended July30, 1999 (Exhibit I).

XYZ's previous auditor retired at the end of 1998. I have already reviewed the predecessor's files and accepted the client on the firm's behalf.

XYZ's controller, Charlotte, was fired in April 1999after it was discovered that she had set up fictitious vendors and was collecting payments from XYZpersonally. Charlotte hadn't taken any time off in several years, but Andrew Simmonsconvinced her to take some vacation. During the time Charlottewas away, the fraud was discovered by the assistant controller, Max. Andrew Simmons is very concerned about this incident and wants to know how such a situation could be avoided in the future. He had Maxprovide us with details of the purchases, payables, and payments cycle.At this time, you do not need to consider the inherent risks by assertion for the accounts affected by the control deficiencies, as I will be completing this analysis.

Exhibit I

XYZ Limited

Financial Information

(Prepared by Max, Assistant Controller)

The following are selected balances from July30, 1999,

$ 1999 $1998

(Drafted) (Audited)

Account receivable net allowances of $0(1998-$26,000) 980,000 900,000

Inventory 870,000 755,000

Sales 9,855,560 9,956,000

Cost of Goods Sold 6,898,892 6,471,400

Bad Debts 33,000 50,000

Rent Expense 150,000 115,000

Net Income Before Tax 1,026,500 1,384,000

Included in net income are the following transactions:

-In September1998, XYZhad to repair the roof of the warehouse, at a cost of $24,500.

-In April1999, XYZmanagement was sent to New Zealand, Auckland, for the annual giftware trade fair, at a cost of $18,900. The purpose of the trade fair is to purchase giftware for the next Christmas season.

-Andrew Simmons's salary was $10,000 over fair market value.

-In January 1999, XYZ ended a long-standing relationship with a supplier. The supplier offered a 5% discount to XYZon all orders. Orders, before discount, for the 1998- 1999fiscal year, totalled $255,000.

-XYZ has a history of strong earnings and steady cash flows.

Exhibit II

XYZLimited

Purchases, Payables, and Payments Cycle

(Prepared by Max, Assistant Controller)

Previously, at the request of the warehouse manager, Charlotteset up all-new vendors in the system. There is no formal approval process for new vendors. Since Charlotte's departure, the warehouse manager has been setting up new vendors in the system.

The warehouse manager is responsible for all ordering activities, and for initiating purchase orders. When I covered for Charlotteduring her holiday, I received several phone calls from the warehouse manager, who asked me to create purchase orders. When I asked why he was not providing the purchase order, the warehouse manager said Charlottehad informed him, several months ago, that she would create the purchase order based on his verbal request. There is no approval of purchase orders.

When shipments are received, the receiving clerk records the date, time, and vendor name in a receiving log, and notifies the accounts,payable clerk.

The accounts payable clerk creates the payable from the purchase order on file. When the invoice is received from the vendor, the accounts payable clerk prepares the cheque for the invoice amount, files the invoice, and provides cheques to Charlottefor signing (or to Max, when Charlotteis absent). Once signed, Charlotte(Max, now that Charlottehas left) mails the cheques.

Since Charlotte's departure, Andrew Simmonsand I have been doing some financial statement analysis. We noticed a new rent expense account starting in January 1999. However, neither Andrew Simmons nor I were aware of any extra space being rented, especially since we are currently in the second year of a five-year lease for head office and the warehouse. When I looked into the background of the vendor, the address was a post office box in Charlotte's husband's name.

We also found several vendors with post office box addresses. The items ordered were giftware, but no shipping documents could be located. We are not sure whether these items were ever received.

1. Please discuss any control deficiencies and their implications, including the financial statement assertions impacted, and provide audit procedures to address the related assertions.

2 list of control recommendations based on your investigation, and explain why these improvements should be incorporated by XYZ.