You are an audit manager at Hogan & Associates and have been assigned to the audit of Looking Good Ltd (LGL) for the year ending 30 June 2015. LGL is an Australian manufacturer, wholesaler and retailer of ladies handbags and shoes. LGL manufactures all its products at its Brisbane factory and sells via retail outlets throughout Australia. LGL is listed on the Australian Securities Exchange and Hogan & Associates has been its auditor for several years. In recent years, LGL has been finding it difficult to meet its projected profit forecasts due to increased competition from new local competitors, imported products and online shopping; the increasingly high Australian dollar; and the impact of the global and European financial crisis on consumer spending. 

During the planning stage of the audit you become aware of the following matters: 

1. LGL has significant loans from its bank. The bank has indicated that it is concerned about LGL’s ability to meet specific loan covenants, particularly the return on total assets (net profit/total assets). 

2. The aged trade accounts receivable listing indicates that the percentage of accounts receivable exceeding 90 days has jumped from 15 per cent to 37.5 per cent during the last 12 months. The credit manager has indicated that this is because some of LGL’s customers are currently experiencing financial difficulty. 

3. In order to reduce costs, LGL changed one of its major suppliers of raw materials in February 2015 to a cheaper overseas supplier. However, the number of product returns has increased significantly since April 2015, and your discussions with management have indicated that the increased returns have involved customer complaints concerning the quality of the product. 

4. Your review of the payroll system has indicated that when an employee is hired or terminated, the payroll clerk immediately prepares the paperwork and enters the information into the master file of the payroll computer system. 

5. The payroll department at LGL’s head office processes payroll on a weekly basis. All timesheets that are submitted by factory workers are signed off by the factory manager. The timesheets are input into the computer by the factory manager and payment is then made by the payroll department. 

Required: 

(a) Describe the two types of misstatement in a financial report that may arise from fraud. Explain what is meant by ‘Fraud Triangle’?

 (b) For each matter 1 to 3 above, outline how each matter is a fraud audit risk factor in relation to LGL’s financial report. 

(c) For each matter 4 and 5 above, outline one weakness in either the control activities or information systems. 

(d) Describe how the internal control weakness in (c) above could lead to material misstatement in the financial report.