You have just been employed by Mr Dogood CA as his new Audit Manager. Mr Dogood is a principal in private practice.
You arrive at the office on your first day to find the place in turmoil. It appears that something has gone wrong with a previous audit. Mr Dogood’s secretary hands you a file and says: “Please go and show this to Mr Dogood, I dare not go in!”
As you walk towards Mr Dogood’s office, you look at the file and see it is the working papers of an audit completed last year on Alpha Manufacturing Ltd (Alpha). You enter Mr Dogood’s office and he asks if you have the Alpha file. You say you do, and hand it to him. He shows you a letter of demand that arrived that morning from a local firm of solicitors asking for $2 million on behalf of Alpha. The letter claims that the previous year’s audit failed to point out to the directors that the factory manager was putting the company at risk, and therefore Mr Dogood should pay for the resultant loss.
“I cannot understand it!” said Mr Dogood as he flicked though the audit file. “Can you sort this out and write me a memo as to why they should be writing this letter?”
With that Mr Dogood waved you out of the room.
You take the Audit file to your office and look through the part covering the factory. There is a short note by your predecessor stating that most of the factory raw materials were imported and setting out the raw materials purchasing arrangements that were part of the factory manager’s duties. In part it states “…The factory manager has been entering into derivative/hedge contracts other than those required to match off with the purchases and fix the AUD value of these purchases. This is contrary to the Alpha procedures manual….” You also find the following letter:

Alexander Dogood Accountant
15 Latrobe St
West Sale 3914
Tel 03 98765432
Fax 03 98765433
Email: Reception@ dogoods.com.au
Web: dogoods.com.au

15 August, 20XX

Mr Fred Smith
Factory Manager
Alpha Manufacturing Ltd
5 High St
East Sale 3915

Dear Fred:
Derivative Contracts,
It is noted that Alpha has a significant open position with regard to its derivative contracts, which do not match with outstanding orders for raw materials. This is contrary to Alpha Manufacturing’s procedures manual, and should stop. The positions need to be closed.
Yours sincerely,

Joe Smith
Manager
Audit Team

You find no other mention of anything unusual in the part of the audit file covering the factory or the factory manager’s operations.  


Assessment Tasks:
Answer all questions below.

Question 1
Required:
Prepare a memo to Mr Dogood setting out the legal implications of your discovery. Quote the applicable case law.                    
   

In late April, your firm is approached by Mr Clive Putters, the Chairman of the Board of Black Goods Pty Ltd (BG) a retail business with a chain of six shops to conduct the audit of BG. Mr Putters explains that the previous auditor was too expensive, and they are looking for a more economical audit, and Mr Dogood is invited to tender for it. You and Mr Dogood prepare a tender and it is accepted.

As part of your review of BG you undertake enquiries of businessmen in the neighbourhood. There is nothing directly adverse known about BG, however there is a rumour that is circulating that Mr Putters ran a clothing store for some years in another state. Further enquiries indicate that this clothing store failed about ten years ago, and ASIC barred Mr Putters from holding a company directorship for 6 years.  You approach Mr Putters and ask about this. Mr Putters explains that this shop was a small listed company , and his accountant had prepared the annual accounts showing a significant debt due 3 months after the date of the accounts as a deferred liability. It was all most unfortunate as the debt could not be refinanced and the company failed, and as the director signing the directors’ report, ASIC blamed him.  You talk to the company’s accountant about the way the company is run, and are told that MR Putters can be extremely difficult to work with, especially if any adverse event needs to be reported.

You ask Mr Putters to supply a letter of authority to the previous auditor to discuss the audit history with your firm. Mr Putters explains that he is so disappointed with the previous auditor, that he will not correspond with him at all and will not write the letter you have requested.


Question 2.
Do you accept BG as a client? If not why not? if so, why so?


Question 3.
Mr Dogood advises you that the firm needs the business so he will accept BG as a client. Explain in detail what is the first step Dogood will take after deciding to accept BG as a client, and why this is important.  

 
Question 4.
You have commenced planning the audit of BG, and are going to use the “Audit Risk Model as a planning tool. Your assistant, a recent graduate of an Ivy League university, asks what is this “Audit Risk Model”?
Explain fully to your assistant the concepts behind the Audit risk model and how the Audit Risk Model works.

You visit BG and ask to see its procedures manuals. These are well written and the various procedures contain good controls, such that when staff follow the manual, all the well structured controls would be applied, and there would be little room for mistake or fraud. You discuss this with one of the accounting department staff, who advise that, to maximise efficiency, Mr Putters encourages staff to work independent of standard procedures and bypass any checks if they slow down operations.


Question 5.
Critically outline in detail the audit strategy you will follow based on this information.

In planning the audit, you tell your assistant you plan to prove the management assertions behind the accounts. You tell your assistant he is to be responsible for proving the management assertions relative to the profit or loss statement. He asks you to tell him what are management assertions and what are the management assertions covering the profit and loss statement?


Question 6.
Write a memo to your assistant which explains critically the management assertions concerning the profit and loss accounts.
                 

You send your assistant out to verify the purchases for occurrence, and he returns, very pleased. It appears that Mr Putters was very helpful. You assistant explains that as instructed he used the random number table to select the items he would investigate. He selected several invoices and traced them to the journal and from the journals to line items in the Purchases Ledger. All the items traced were correct.


Question 7.
Has your assistant tested for occurrence? Provide a detailed explanation.

You set out to confirm the inventory held in the three warehouses operated by BG.  On arrival you find it locked, and on contacting Mr Putters are told that to minimise staff, the warehouse operation rotates between the three warehouses, and if you return tomorrow it will be in full operation. You return the next day, and complete the inventory count in the warehouse. All appears to be in order.

 
Question 8.
(Part i) Provide a full explanation of the term used to describe the nature of the audit evidence being gathered by your tests.
(Part ii) Given everything is in order, would you require further testing of the inventory? Critically set out your decision reasons.

It is now the end of July, and you are finalising the audit. On 10th July, one of BGs warehouses burnt out. You note from your working papers that it was full of stock and the insurance does not fully cover the loss and there is a material discrepancy between the expected insurance payout and the loss.

Question 9.
Explain critically what you expect BG’s management to do relative to the accounts in this circumstance.

Mr Putters has been asking you daily when you might be ready to sign the audit report. The accounts seem to be in order, but the notes do not include any statement about the fire. You receive the signed director’s report and certification of the accounts and decide to present the audit report to Mr DoGood tomorrow to sign.

You then leave the office and as you have worked late decide to eat on the way home. You go to a local Chinese Restaurant for a meal. At the restaurant you meet a member of the local fire brigade, who is talking about the latest fire, the fire that destroyed BG’s warehouse. He explains that it struck him as strange that the warehouse rubble was so small. He says that when warehouses burn, they are normally full of stuff, and that creates lots of rubble to clear up, but this warehouse had no rubble left after the file. This is the first time in fifty warehouse fires he has attended that there was no smouldering rubble left after the fire was put out.