You are a first-year trainee accountant at Dynamic Auditors, and part of the team currently engaged in the external audit of Hofstein Ltd, a listed company. Hofstein holds a 51% interest in Retailers Online Ltd (Reton), an online catalog retailer selling household appliances and furniture. Reton has a 30 September year-end. Dynamic Auditors also holds the appointment as an external auditor of Reton. The following extracts are from the 2018 audit file of Reton: Working paper reference Document B-100 Overview of the group activities C-100 Extracts from separate financial statements K-100 System description: Revenue and receivables K-101 Internal control weaknesses: Revenue and receivables Q-101 Inventory Overview of the group activities B-100 1/2 Reton Prepared by X Trainee Date: 15/07/2018 Year ending 30 September 2018 Reviewed by X Manager Date: 29/07/2018 1 Introduction Reton sells household appliances and furniture for cash (30%) and on credit (70%). Via its online portal to +- 300 000 customers. The company performs internal credit-worthiness checks on all new customers. The company procures its stock form within the Hofstein group as well as from external suppliers. Approximately 60% of its suppliers are local and 40% foreign. The company hedges against currency movements, but does not apply hedge accounting. 2 Business overview Trading conditions were challenging in 2018 as consumers faced high transport and utility costs, which resulted in less disposable income. However, continued merchandise innovation and focused market strategies have enabled the company to maintain its gross profit margins. Management expects trading conditions to remain unchanged. 2 3 Corporate governance Mr John Hayes, the CEO, leads a robust board of directors with strong independent directors. It maintains a culture of effective corporate governance and ensures the company complies with best practice corporate governance codes in all material respects. 4 Outsourcing of website maintenance and catalogue design Outsourcing of website maintenance and catalogue design to a company CTO was approved during February 2018. CTO is a company formed by the previous chief information officer of Reton, Mr Hamish Martin. Mr Martin is now the CEO of CTO. On 1 July 2018 Reton obtained a 51% interest in CTO in return for intellectual property rights transferred to CTO. The key management of CTO, who are all former staff members of Retons Information Technology Department, holds the remaining interest via the CTO management Trust. Mr Martin remains on Retons board of directors as a non-executive director. The board of Reton approved a three-year loan of $8 million which was advanced to CTO on 30 September 2018 as start-up capital. 5 Strategy and risk Areas that impact on sustainable growth are identified annually and are aligned to the stakeholder engagement process. The following are stakeholders with an interest in the business: Customers; Suppliers of merchandise and services; Shareholders and the broader investment community; Communities in which the group operates; Employees at head office and stores throughout the group; and Industry regulators who monitor compliance. Overview of group activities B-100 2/2 Reton Prepared by: X Trainee Date: 15/07/2018 Year ending 30 September 2018 Reviewed by: X Manager Date: 29/07/2018 The following are material matters and key risks which have been identified by the board of directors: Strategic objective Key risks Management plans Credit management Optimise the quality of the debtors book by improving collections, reducing debtor costs and exploring further sales opportunities Inability to maintain optimal quality of debtors book owing to: High level of unemployment Deteriorating economic conditions Focus on increasing the number of satisfactorily paying customers Implement customer segmentation and credit limit strategies 3 Strategic objective Key risks Management plans Merchandising Maintain competitive advantage by sourcing exclusive, quality, value-for-money merchandise Suppliers and distribution partners perform below standard Lack of depth in supplier base Exchange rate fluctuations Establish reliable back-up supplier channel Further improve supply chain management through system enhancements Manage foreign currency risk Maintain customer focus Poor execution of the customerfocused business model Selling goods at low or no profitability Insufficient experienced operational staff Grow the customer base through new customer acquisition and retention initiatives Expand the store foot-print Focus on stable store management through training, recruitment and selection strategies Capital management Manage financial risk and the liquidity requirements of the business effectively Ineffective capital management could impact on profitability and returns to shareholders Ensure access to capital at all times Manage currency exposure Manage the investment portfolio Human capital Institute ongoing development of staff for management positions Ensure retention of current management Attract competent individuals as required Inability to attract, develop and retain suitable staff for executive and operational management positions Run training and development programmes Establish employee incentive schemes Use focused recruitment and 4 Strategic objective Key risks Management plans selection practices Extracts from separate financial statements C-100 1/2 Reton Prepared by: X Trainee Date: 17/11/2018 Year ending 30 September 2018 Reviewed by: X Manager Date: 19/11/2018 Statement of profit and loss and other comprehensive income (000) Notes 2018 Not audited 2017 audited Revenue 456 800 409 600 Merchandise sales 229 200 204 000 Finance income 91 300 90 300 Insurance premiums 75 100 61 200 Other 61 200 54 100 Cost of sales 145 000 133 000 Net profit after tax 105 000 90 000 Statement of financial position (000) Notes 2018 not audited 2017 audited Non-current assets Property, plant and equipment 27 800 25 100 Intangible assets 9 100 7 000 Loan to CTO 1 8 000 - Current assets Inventory 2 97 700 47 300 Trade and other receivables 353 500 342 700 Extract from separate financial statements C-100 2/2 Reton Prepared by: X Trainee Date: 17/11/2018 Year ending 30 September 2018 Reviewed by: X Manager Date: 19/11/2018 Notes to the annual financial statements 1 Loan to CTO The company made a loan to CTO on 30 September 2018. The loan is unsecured, bears no interest and is repayable on 30 September 2021. 5 Extract from separate financial statements C-100 2/2 2 Inventory Inventory, comprising merchandise held for sale, is valued at the lower of cost and net realizable value. Cost is determined using the weighted average method, net of trade and settlement discounts. Net realizable value is the estimated selling price in the ordinary course of business, less estimated costs necessary to make the sale. Provision is made for slow-moving, redundant, and obsolete inventory, as well as sales returns. System description: Revenue and receivables K-100 1/1 Reton Prepared by: X Trainee Date: 18/07/2018 Year ending 30 September 2018 Reviewed by X Manager Date: 29/08/2018 1 General system overview Sales are either for cash or on credit and orders are placed via telephone, fax or online. 2 Ordering New online customers need to open an account by registering on the system. Once registered, customers log on to the system using a unique account number and password. The credit vetting division assigns a credit limit to each new customer. Once an order has been captured on the system, customers are notified by means of a text message to their registered phone number. Orders can be canceled telephonically or online. Cash orders can be paid by electronic funds transfer or credit card. All credit card purchases are protected with a credit card verification process. 3. Deliveries Distribution to customers is done from four outlets by means of the companys delivery vehicles or through delivery agents. Each customer receives a text message upon dispatch of goods. Delivery notes are automatically generated from orders once the goods have been packed and are ready for delivery. Customers sign for deliveries to acknowledge receipt of goods. Invoices are generated once the goods have been delivered and signed delivery notes returned to the administration department. 4 Returned items Customers may return goods within 21 days free of charge via post or delivery to any of the four distribution outlets. The goods need to be accompanied by an original invoice. Returned items are inspected prior to a refund being given. 6 Internal control weaknesses: Revenue and receivables K-101 1/1 Reton Prepared by X Trainee Date: 25/07/2018 Year ending 30 September 2018 Reviewed by X Manager Date: 29/08/2018 The following system weaknesses were identified during the performance of a test of controls: Weakness 1: A review of the access rights assigned to staff in the credit vetting division showed that the debtors clerk has limited viewing rights, but are able to capture credit limits and make adjustments to limits. The access rights of the two credit managers allow them to create new customer accounts, override system functions, and process journal entries. They also have full viewing rights. Weakness 2: Not all delivery notes were signed by customers upon receipt of goods. Also, some invoices had no corresponding delivery notes whatsoever. Upon further investigation, it was found that in some instances no invoices were generated for actual shipments to customers. Inventory Q-101 1/1 Reton Prepared by X Trainee Date: 15/10/2018 Year ending 30 September 2018 Reviewed by X Manager Date: 16/10/2018 2018 not audited (000) 2017 audited (000) Cost of merchandise 93 300 45 400 Goods in transit 10 000 7 100 Provision for sales returns 5 100 4 400 Provision for obsolescence (10 700) (9 6000) TOTAL 97 700 47 300 The companys merchandising strategy is based on the philosophy that customers are attracted to its website by its products rather than by the credit which is offered. The focus is therefore on providing customers with differentiated household ranges. This is achieved by the following means: Innovative product sourcing globally, so that customers are offered distinctive and affordable furniture and appliances; Value-added features on products to ensure differentiation and increase the perceived value; and Six-monthly launches of new furniture and appliance ranges, ensuring that customers are constantly offered fresh and original products 7 Products are sourced locally and internationally, to ensure that Reton offers exclusive products. Imports ensure that furniture ranges use the latest designs and are produced with the most modern manufacturing techniques. International factories also provide a broader range of developmental designs and offer a wider variety of raw materials, which allow for more product differentiation than local factories. Furthermore, imports offer price and design advantages and mitigate the risk of local supply disruption. According to the stock controller, significant unexplained inventory losses were identified at inventory counts, during the year, but the operations director has been too busy to investigate them.

Required: Formulate the substantive procedures that you would perform to audit the loan to CTO in the financial statements as per working paper C-100. You can ignore Company Act requirements as part of your substantive procedures. 20 b) Assume during the audit of inventory a material uncorrected misstatement was detected. Which type of audit report are you likely to issue? Justify your answer by referencing the circumstances, which gives rise to such an audit report. 5 c) Assume the same information under (b). However, the misstatement was regarded as both material and pervasive. Which type of audit report are you likely to issue? Justify your answer by referencing the circumstances, which gives rise to such an audit report.