Question: Planning and risk Assessment:

201. Knight Electronics:

It is 1 July 20X5. Your firm, Hercules & Co, has recently won the audit of a new client,
Knight Electronics Co, for the year ending 30 September 20X5. Knight Electronics Co
sells products enabling 'smart building' systems which allow customers to efficiently
control their security, lighting and networking needs. The audit manager held a
preliminary meeting with the finance director and has provided you with the following
notes:

Planning meeting notes

Since its launch five years ago, Knight Electronics Co has experienced high levels of
growth such that the founder and CEO, William Knight, is considering a stock
exchange listing next year.

Knight Electronics Co has both corporate and domestic customers. On 1 October

20X4 Knight Electronics Co began to offer customers the option to purchase a three-
year servicing agreement. This provides three annual services for products
purchased. Customers pay for the servicing agreement in full at the start of the
agreement.

Component parts are purchased from a number of suppliers. Prices of components

have been steadily increasing over the past two years leading to a reduction in the
gross profit margin. The forecast financial statements for the year ending 30
September 20X5 show inventory valued at cost.

In June 20X5, Knight Electronics Co decided to revalue its premises, which had
previously been accounted for using the historic cost model. Properties with a carrying
amount under the cost model of $3.8m were revalued to $8.4m based on a valuation
performed by management. The finance director also carried out an extensive review
of non-current asset lives and decided to extend the useful life of plant and equipment
from five years to eight years.

In May 20X5, defective equipment used by Knight Electronics Co resulted in a small

fire at its premises. The company has commenced legal action against the supplier of
the equipment. Knight Electronics Co's lawyers have advised that the legal action is
likely to be successful and, as a result, the finance director has included a receivable
for the damages likely to be received from the supplier in the forecast financial
statements.

During the year the company's credit controller was ill and was absent from work for
four months. Due to staff shortages, no replacement credit controller was appointed.
The receivables collection period has increased from 45 days to 75 days.
An instance of payroll fraud was also discovered during the year. A payroll clerk had
set up a number of fictitious employees and the wages were then paid into the clerk’s
own bank account. Controls have now been implemented to prevent this from re-
occurring and the clerk involved no longer works for the company. However, the audit
manager is concerned that additional fraud may have taken place in the payroll
department prior to the controls being implemented.

William Knight would like the audit to be completed by 31 October 20X5.

Audit risk Audit response

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202. Lapis:

It is 1 July 20X5. You are an audit supervisor with Indigo & Co and are planning the audit of
your client, Lapis Co, for the year ending 30 September 20X5. Forecast profit before tax for
the year is $68.9m and forecast revenue is $192.3m. The audit manager has attended a
planning meeting with the finance director and has provided you with the following notes of
the meeting:

Planning meeting notes

Lapis Co manufactures televisions at six factories located across Europe and purchases most
of its raw materials from overseas suppliers. These raw materials are shipped directly to one
of the company’s factories and the goods are usually in transit for up to six weeks. Lapis Co
has responsibility for goods in transit from the point of dispatch by the supplier. The
company’s internal audit department undertakes controls testing across all factories, visiting
each site at least once every year. The audit manager has discussed with the finance director
that the external audit team may rely on the controls testing which is carried out by the internal
audit department.

The company sells televisions to wholesale customers and directly to individual members of
the public via the company’s website. A significant wholesale customer has recently informed
Lapis Co that it is experiencing financial difficulties, however the finance director indicated that
an allowance for receivables is not required in the year-end financial statements.

Lapis Co offers customers a three-year warranty on any new televisions purchased. The
finance director has confirmed that the warranty provision for the year ended 30 September
20X5 will remain at a similar level to the prior year. In December 20X4 Lapis Co changed one
of its television speaker suppliers to a cheaper alternative. This has resulted in an increase in
warranty claims for television speaker deficiencies.

In May 20X5, a payroll clerk was dismissed after it was discovered that they had carried out a
number of fraudulent transactions. Controls have since been implemented to prevent this
reoccurring.

The finance director has informed the audit manager that she only intends to disclose the
amount of remuneration payable to each director in the financial statements. Local legislation
in the country in which Lapis Co is based requires disclosure of the names of the directors and
the total amount of remuneration payable to each director.

One of Lapis Co’s suppliers is offering the company an annual rebate on the condition that it
purchases a minimum number of units by 30 September 20X5. The amount of the rebate will
be claimed in November 20X5. It is likely from orders placed to date and forecast orders that
Lapis Co will exceed the minimum volume required to claim this rebate, therefore, it is
anticipated that the draft financial statements will include a receivable of $0.8m.

Lapis Co is developing a new smart television model. All $1.6m of costs incurred to date will
be capitalised within intangible assets by the year end. The model is still under development
and it is not anticipated that it will be available for commercial production until 20X6.

In order to finance the development of the new smart television model, Lapis Co secured a
$2.5m interest-bearing bank loan in April 20X5. This is repayable in arrears over four years in
quarterly instalments.

The directors of Lapis Co are intending to propose a final dividend once the financial
statements are finalised.

Audit risk Audit response

203. Magpie:

It is 1 July 20X5. You are the audit supervisor at Crow & Co and are finalising the planning for
your new client Magpie Co for the forthcoming audit for the year ending 31 July 20X5.

Magpie Co is a retailer of garden supplies which operates from 20 stores across the country
and employs 400 staff. The audit manager has attended a meeting with the finance director
and has provided you with the following notes of that meeting and financial statement
extracts:

Notes of planning meeting

During the year the company spent $0.75m on refurbishing its stores to improve the customer
experience. All of this expenditure has been recognised in the statement of financial position
as property, plant and equipment. In addition, the company also installed a new sales system
during the year which records all sales and receivables. The system enables daily sales from
each store to be automatically reported to the centralised finance department at the end of
each working day. As the system is from a market leading provider, it was not felt necessary
to run the old and the new systems in parallel.

Customers are able to pay for their goods using either cash or credit card. At the end of the
working day, the store manager generates a report from each cash register which confirms
the cash takings. The cash is then counted and compared to the report. Since the new sales
system was installed, head office now receives daily cash takings reports which have shown
an increasing number of cash shortages at each store. These differences have not been
investigated or reconciled on the basis that they have only been small amounts.

The company has a number of corporate customers who buy goods on 90 day credit terms
and the level of receivables which are overdue for payment has increased from the prior year.
However, the finance director has said she does not intend to make any further allowance for
receivables as overdue payments are becoming common in the industry.

The payables ledger clerk has carried out supplier statement reconciliations during the year
and in a number of instances the supplier statements have shown a balance owing by the
company which is higher than the balance on the payables ledger. These differences have
been included as reconciling items on the supplier statement reconciliations by the payables
ledger clerk, but no further work has been performed on these differences.

It has been discovered that the soil relating to a batch of plants with a cost price of $0.1m is
contaminated, meaning that the plants may not be able to be sold. Tests are currently being
carried out to determine whether the contamination can be remedied.

The report to management issued following the 20X4 audit indicated a significant number of
deficiencies noted in the payroll cycle of the business.

Financial statement extracts for the year ending 31 July are as follows:

20X5 Forecast $m 20X4 Actual $m

Revenue 22 26

Cost of sales (10.9) (14.5)

Gross profit 11.1 11.5

 Operating profit 0.4 1.2

Inventory 1.6 1.1

Trade receivables 9.0 7.2

Cash in hand 1.3 4.2

Trade payables 1.9 3.2

The audit assistant has already calculated some key ratios for Magpie Co which you have
confirmed as accurate.

Gross profit margin 50% 44%

Inventory holding period 54 days 28 days

Receivables collection period 149 days 101 days

Audit risk Audit response

(b) Using the table below, calculate the following TWO ratios, for BOTH years, to assist
you in planning the audit of Magpie Co: operating profit margin and payables payment
period.
(2 marks)

204. Esk:
It is 1 July 20X5. You are an audit supervisor with Bannock & Co and are responsible for
planning the audit of a new client, Esk Co, for the year ending 31 August 20X5. Your audit
manager recently met with the finance director of Esk Co and has provided you with the
following planning meeting notes and financial statement extracts:

Planning meeting notes

Esk Co is a manufacturer and wholesaler of plumbing supplies. It operates from two

warehouses which are situated in the north and south of the country. Extracts from the
forecast financial statements for the year ending 31 August 20X5 and the final financial
statements for 20X4 are as follows:

Forecast 20X5 Final 20X4

$m $m

Revenue 30.9 27.5

Cost of sales (22.5) (19.9)

Gross profit 8.4 7.6

Inventories 8.3 6.4

Trade receivables 7.2 4.9

Trade payables 2.4 3.5

In September 20X4, Esk Co purchased a patent for $2.6m which gives it the exclusive right to
manufacture a waste disposal system for a four-year period. The purchase cost capitalised
comprises the cost of the patent and other costs such as legal fees and administrative costs
incurred in negotiating the contract. In order to finance this purchase, Esk Co obtained an
interest-bearing bank loan of $2.5m during the year. The bank loan is payable in five equal
annual instalments, with the first instalment due to be paid on 1 September 20X5.

The payables ledger clerk has recently discovered a batch of supplier invoices that had been
mis-coded and therefore had not been recorded as trade payables. This error has now been
corrected but investigations are still ongoing to determine how this happened and whether any
other batches of invoices have been mis-coded.

There was a fire in the south warehouse in June 20X5 which resulted in damaged inventory.
An inventory count immediately following the fire identified that inventory costing $1.1m
required to be fully written off. The damaged inventory has not yet been replaced as there is
sufficient inventory in the north warehouse to satisfy demand. The directors have raised a
claim against Esk Co's insurance company to cover the full extent of the lost inventory.
Although no confirmation has been received from the insurance company, the directors are
confident that the full amount claimed of $1.1m will be received and have included this amount
as other receivables within current assets.

Esk Co's sales staff receive bonuses if they meet sales targets each quarter. A higher level of
sales bonus is available in the quarter to 31 August each year as a reward for efforts during
the year as a whole. Esk Co offers its regular customers discounts of up to 10%, which are
negotiated and documented by the sales director. This year, in order to easily monitor the
amount of the customer discounts, they have been recorded separately as an expense in cost
of sales. In previous years, revenue has been recorded net of the discount.

The manager in Esk Co's credit control department has been off work since December 20X4
due to ill health and has been replaced by an inexperienced temporary manager. As a result,
Esk Co has not been monitoring the ageing of its receivables and only follows up on
outstanding invoices when the system alerts credit control that a customer invoice has been
outstanding for 90 days or more. The standard credit terms are 30 days.

During the year, Esk Co was informed by the tax authorities that it was under investigation for
a breach of legislation relating to sales tax. Esk Co has appointed a tax consultant who has
advised that there does appear to have been a breach of tax legislation and has estimated
that a fine and penalty totalling $0.6m will be payable. The directors do not intend to record
anything in the financial statements until final notification is provided by the tax authority,
which is due to be received on 31 January 20X6.

Audit risk Audit response

205. Peach:

It is 1 July 20X5. You are an audit supervisor with Apricot & Co and have been assigned to
the audit of Peach Co, a soft drinks manufacturer which sells to wholesale customers. You are
currently planning the year-end audit for the year ending 31 August 20X5 and have received
the following notes from the audit engagement partner. Materiality for the draft financial
statements has been calculated as $153,000, which is 5% of profit before tax.

Planning meeting notes

A new accounting system was introduced via direct changeover in March 20X5. It had been
successfully tested prior to its implementation and management had such confidence in the
new system that they did not consider it necessary to undertake further testing after
implementation.

Peach Co has been developing a new production process which will help to reduce sugar in
its drinks by 50%. Development commenced on 1 November 20X4 and the total amount
capitalised was $0.8m. On 1 May 20X5, the food safety authority approved the process and
production of the new reduced-sugar soft drinks commenced.

Peach Co has inventories of high-sugar drinks costing $227,000 which it can no longer sell in
its home market due to a lack of demand. The directors believe Peach Co can sell the
remaining inventories to an international customer at a price that marginally exceeds cost but
Peach Co will be responsible for all costs relating to the delivery and shipping of the drinks.

Peach Co replaced two items of machinery in its production line to accommodate a change in
the type of bottles used. There were significant staff costs involved in preparing the site for the
new machinery and in testing that the new machinery was operating correctly. These costs
have been included within the wages and salaries expense for the period. Despite the old
machinery being sold at a significant loss, during the year the directors of Peach Co decided
to extend the useful lives of plant and machinery by an average of five years.

A member of the finance team was dismissed by Peach Co in May 20X5 after it was
discovered that they had been fraudulently purchasing non-current assets for personal use.
Peach Co started to investigate the fraud at the beginning of June 20X5 by reconciling all
physical assets to the non-current asset register but will not have completed the reconciliation
by the year-end date.

Peach Co entered into a contract on 1 May 20X5 with a new supplier of bottles. Peach Co has
committed to a minimum order quantity of 150,000 bottles per month for a period of 12 months
commencing 1 May 20X5. No costs have been accounted for to date as no amounts are
payable for the first six months. Three equal instalments are then payable across the
remainder of the contract term. Peach Co's previous supplier has launched a legal claim
against Peach Co for breach of contract, stating that Peach Co did not have the right to exit
the agreement early. Peach Co's lawyers have indicated that it is likely to lose the case and
have estimated the amount payable to be in the region of $0.3m.

In order to fund the development of the new production process and the purchase of new
machinery, Peach Co obtained an interest-bearing bank loan of $1.2m on 1 March 20X5
repayable over the next three years in arrears. In order to secure the bank loan, Peach Co
agreed to maintain a minimum net profit margin and meet specific sales targets.

Audit risk Audit response

206. Corley Appliances:

Audit risk Audit response

207. Hart:

Audit risk Audit response

208. Scarlet:
It is 1 July 20X5. You are an audit supervisor of Orange & Co planning the audit of a new
client, Scarlet Co, for the year ended 31 May 20X5. Scarlet Co manufactures chemicals for
use in domestic and commercial cleaning products.

The company's financial accountant was taken ill suddenly in May 20X5 and is unable to
undertake the preparation of the year-end draft financial statements.

As a result, the company recruited a temporary financial accountant in early June 20X5 who
will prepare the draft financial statements.

The year-end financial statements need to be finalised quickly as the company is looking to
raise finance through a bank loan to replace three machines in the production facility.
The bank has asked for a copy of the audited year-end financial statements by the end of
September 20X5 before they will agree to the loan and the directors are keen to report strong
results in order to obtain this financing.

In the year, the company also purchased a specialised machine to develop a new range of
chemicals for a major customer.

Only trained staff are allowed to operate this machine and staff members had to undertake
two days of training, followed by an assessment at the end of the training period.

The training costs of $15,000 have been capitalised as part of the cost of the asset.

The company sources many of its raw materials to be used in the chemical manufacturing
process from an international supplier and goods can be in transit for up to three weeks.

The agreement with the international supplier contains a clause which states that Scarlet Co is
responsible for the goods as soon as they leave the supplier's warehouse.

You have carried out a preliminary analytical review which indicates that the receivables
collection period has increased from 38 days to 52 days.

The credit controller has confirmed that some customers are currently taking longer to pay
than in previous years as they are awaiting payment from their customers.

On 29 May 20X5, the directors announced that one of its brands was being discontinued due
to a fall in demand for the product. This resulted in four staff members being made redundant.

The payroll department has calculated the levels of termination costs associated with the
redundancy and they will be paid in the July 20X5 payroll run.

The directors each received a significant bonus in the year which has been included in the
payroll charge for the year in the statement of profit or loss.

Local legislation requires separate disclosure of directors' bonuses in the financial statements.

During the year the company sold a batch of chemicals to a customer for $120,000. At the
beginning of May 20X5, the customer returned these chemicals because the chemical mix
was not in line with the customer's specifications.

A credit note is yet to be issued to the customer and the chemicals have been written down to
their scrap value within inventory.

The company usually pays its suppliers by the end of each month. However, due to the
financial accountant's illness, the payment run for May 20X5 was not performed until 1 June
20X5.

The finance director has informed you that in order to show consistent results with the prior
year, this payment run is shown as an unpresented item on the year-end bank reconciliation.
 Audit risk Audit response

209. Harlem:
It is 1 July 20X5. You are an audit supervisor of Brooklyn & Co and are planning the audit of
Harlem Co for the year ending 30 September 20X5. The company has been a client of your
firm for several years and manufactures car tyres, selling its products to wholesalers and
retailers. The audit manager attended a planning meeting with the finance director and has
provided you with the following notes of the meeting and financial statement extracts:

Planning meeting notes

Harlem Co sells approximately 40% of its tyres to wholesale customers. These customers
purchase goods on a sale or return basis. Under the terms of the agreement, wholesale
customers have 60 days during which any returns can be made without penalty. The finance
director has historically assumed a return rate of 10%, however, he now feels that this is
excessive and intends to change this to 5%.

The company purchased a patent on 30 September 20X4 for $800,000, which was capitalised
in the prior year as an intangible asset. This patent gives Harlem Co the exclusive right to
manufacture specialised wet weather tyres for four years. In preparation for the manufacture
of the wet weather tyres, this year the company conducted a review of its plant and
machinery. As part of this review, surplus items of plant and machinery were sold, resulting in
a loss on disposal of $160,000.

In May 20X5, the financial controller of Harlem Co was dismissed after it was alleged that she
had carried out a number of fraudulent transactions against the company. She has threatened
to sue the company for unfair dismissal as she disputes the allegations. The company has
only recently started to investigate the extent of the fraud in order to quantify the required
adjustment.

A problem occurred in June 20X5, during production of a significant batch of tyres, which
affected their quality. The issue was identified prior to any goods being dispatched and
management is investigating whether the issues can be rectified and the tyres can
subsequently be sold.

Harlem Co’s finance director has informed you that in March 20X5 a significant customer was
granted a payment break of six months, as it has been experiencing financial difficulties.
Harlem Co maintains an allowance for trade receivables and it is anticipated that this will
remain at the same level as the prior year.

The report to management issued by Brooklyn & Co following last year’s audit highlighted
significant deficiencies relating to Harlem Co’s purchases cycle.

The finance director has informed you that the company intends to restructure its debt finance
after the year end and will be looking to consolidate its loans to reduce the overall cost of
borrowing. As a result of the planned restructuring of debt, Harlem Co has not paid its
shareholders a dividend this year, choosing instead to undertake a bonus issue of its $0.50
equity shares.

You have been asked by the audit manager to complete the preliminary analytical review and
she has provided you with the following information:

Financial statement extracts for year ending 30 September

Forecast Actual

20X5 20X4

$'000 $'000

Revenue 23,200 21,900

Cost of sales (18,700) (17,300)

Gross profit 4,500 4,600

Finance costs 290 250

Profit before tax 450 850

Intangible asset 800 800

Inventory 2,100 1,600

Long and short-term borrowings 13,000 11,000

Total equity 10,000 9,500

The audit assistant has already calculated some key ratios for Harlem Co which you have
confirmed as accurate. She has ascertained that the trade receivables collection period has
increased from 38 to 51 days.
 Audit risk Audit response

210. Peony:
You are an audit supervisor of Daffodil & Co and are planning the audit of Peony Co for the
year ending 31 May 20X9. The company is a food retailer with a large network of stores
across the country and four warehouses. The company has been a client of your firm for
several years and the forecast profit before tax is $28.9m. The audit manager has attended a
planning meeting with the finance director and has provided you with the following notes of
the meeting:

Planning meeting notes

Peony Co has an internal audit (IA) department which undertakes controls testing across the
network of stores. Each store is visited at least once every 18 months. The audit manager has
discussed with the finance director that the external audit team may rely on the controls
testing which is undertaken by IA.

During the meeting, the finance director provided some forecast financial information.
Revenue for the year is expected to increase by 3% as compared to 20X8; the gross margin is
expected to increase from 56% to 60%; and the operating margin is predicted to decrease
from 21% to 18%.

Peony Co values inventory in line with industry practice, which is to use selling price less
average profit margin. The directors consider this to be a close approximation to cost.

The company does not undertake a full year-end inventory count and instead undertakes
monthly perpetual inventory counts, each of which covers one-twelfth of all lines in stores and
the warehouses. As part of the interim audit which was completed in January, an audit junior
attended a perpetual inventory count at one of the warehouses and noted that there were a
large number of exceptions where the inventory records showed a higher quantity than the
physical inventory which was present in the warehouse. When discussing these exceptions
with the financial controller, the audit junior was informed that this had been a recurring issue.

During the year, IA performed a review of the non-current assets physically present in around
one third of the company's stores. A number of assets which had not been fully depreciated
were identified as obsolete by this review.
The company launched a significant TV advertising campaign in January 20X9 in order to
increase revenue. The directors have indicated that at the year end a current asset of $0.7m
will be recognised, as they believe that the advertisements will help to boost future sales in
the next 12 months. The last advertisement will be shown on TV in early May 20X9.

Peony Co decided to outsource its payroll function to an external service organisation. This
service organisation handles all elements of the payroll cycle and sends monthly reports to
Peony Co which detail wages and salaries and statutory obligations. Peony Co maintained its
own payroll records until 31 December 20X8, at which point the records were transferred to
the service organisation.

Peony Co is planning to expand the company by opening three new stores during July 20X9
and in order to finance this, in March 20X9 the company obtained a $3m bank loan. This is
repayable in arrears over five years in quarterly instalments. In preparation for the expansion,
the company is looking to streamline operations in the warehouses and is planning to make
approximately 60 employees redundant after the year end. No decision has been made as to
when this will be announced, but it is likely to be in May 20X9.

Audit risk Audit response

211. Darjeeling:
You are an audit supervisor of Earl & Co and are planning the audit of Darjeeling Co for the
year ending 30 September 20X8. The company develops and manufactures specialist paint
products and has been a client of your firm for several years. The audit manager has attended
a planning meeting with the finance director and has provided you with the following notes of
the meeting and financial statement extracts. You have been asked by the audit manager to
undertake preliminary analytical procedures using the financial statement extracts.

Planning meeting notes

During the year Darjeeling Co has spent $0.9m, which is included within intangible assets, on
the development of new product lines, some of which are in the early stages of their
development cycle. Additionally, as the company is looking to expand production, during the
year it purchased and installed a new manufacturing line. All costs, incurred in the purchase
and installation of that asset, have been included within property, plant and equipment. These
capitalised costs include the purchase price of $2.2m, installation costs of $0.4m and a five-
year servicing and maintenance plan costing $0.5m. In order to finance the development
projects and the new manufacturing line, the company borrowed $4m from the bank which is
to be repaid in instalments over eight years and has an interest rate of 5%. Developing new
products and expanding production is important as the company intends to undertake a stock
exchange listing in the next 12 months.

The company started a number of initiatives during the year in order to boost revenue. It
offered extended credit terms to its customers on the condition that their sales order quantities
were increased. In addition, Darjeeling Co made an announcement in October 20X7 of its
‘price promise’; that it would match the prices of any competitor for similar products
purchased. Customers who are able to prove that they could purchase the products cheaper
elsewhere are asked to claim the difference from Darjeeling Co, within one month of the date
of purchase of goods, via its website. The company intends to include a refund liability of
$0.25m, which is based on the monthly level of claims to date, in the draft financial
statements.

The finance director informed the audit manager that a problem arose in June 20X8 in relation
to the mixing of materials within the production process for one particular product line. A
number of these faulty paint products had already been sold and the issue was identified
following a number of complaints from customers about the paint consistency being incorrect.
As a precaution, further sales have been stopped and a product recall has been initiated for
any of these specific paint products sold since June. Management is investigating whether the
paint consistency of the faulty products can be rectified and subsequently sold.

Financial statement extracts for year ending 30 September

Forecast 20X8 $'000 Actual 20X7 $'000

Revenue 19,850 16,990

Cost of sales (12,440) (10,800)

Gross profit 7,410 6,190

Inventory 1,850 1,330

Trade receivables 2,750 1,780

Bank (810) 560

Trade payables 1,970 1,190

Audit risk Audit response

Calculate THREE ratios, for BOTH years, which would assist you in planning the audit
of Darjeeling Co. (3 marks)

212. Blackberry:

You are an audit senior of Loganberry & Co and are planning the audit of Blackberry Co for
the year ending 31 March 20X8.

The company is a manufacturer of portable music players and your audit manager has
already had a planning meeting with the finance director.

Forecast revenue is $68.6m and profit before tax is $4.2m.

She has provided you with the following notes of the meeting:

Planning meeting notes

Inventory is valued at the lower of cost and net realisable value. Cost is made up of the
purchase price of raw materials and costs of conversion, including labour, production and
general overheads.

Inventory is held in three warehouses across the country.

The company plans to conduct full inventory counts at the warehouses on 2, 3 and 4 April,
and any necessary adjustments will be made to reflect post year-end movements of inventory.

The internal audit team will attend the counts.

During the year Blackberry Co paid $1.1m to purchase a patent which allows the company the
exclusive right for three years to customise their portable music players to gain a competitive
edge in their industry.

The $1.1m has been expensed in the current year statement of profit or loss. In order to
finance this purchase, Blackberry Co raised $1.2m through issuing shares at a premium.
In November 20X7 it was discovered that a significant teeming and lading fraud had been
carried out by four members of the sales ledger department who had colluded.

They had stolen funds from wholesale customer receipts and then to cover this they allocated
later customer receipts against the older receivables.

These employees were all reported to the police and subsequently dismissed.

As a result of the vacancies in the sales ledger department, Blackberry Co decided to

outsource its sales ledger processing to an external service organisation.

This service provider handles all elements of the sales ledger cycle, including sales invoicing
and chasing of receivables balances and sends monthly reports to Blackberry Co detailing the
sales and receivable amounts.

Blackberry Co ran its own sales ledger until 31 January 20X8, at which point the records were
transferred to the service organisation.

In December 20X7 the financial accountant of Blackberry Co was dismissed.

He had been employed by the company for nine years, and he has threatened to sue the
company for unfair dismissal.

As a result of this dismissal, and until his replacement commences work in April, the financial
accountant’s responsibilities have been adequately allocated to other members of the finance
department.

However, for this period no supplier statement reconciliations or purchase ledger control
account reconciliations have been performed.

In January 20X7 a receivable balance of $0.9m was written off by Blackberry Co as it was
deemed irrecoverable as the customer had declared itself bankrupt.

In February 20X8, the liquidators handling the bankruptcy of the company publicly announced
that it was likely that most of its creditors would receive a pay-out of 40% of the balance owed.

As a result, Blackberry Co has included a current asset of $360,000 within the statement of
financial position and other income in the statement of profit or loss.

Audit risk Audit response

213. Prancer Construction:
You are an audit supervisor of Cupid & Co, planning the final audit of a new client, Prancer
Construction Co, for the year ending 30 September 20X7. The company specialises in
property construction and providing ongoing annual maintenance services for properties
previously constructed. Forecast profit before tax is $13·8m and total assets are expected to
be $22·3m, both of which are higher than for the year ended 30 September 20X6.

You are required to produce the audit strategy document. The audit manager has met with
Prancer Construction Co’s finance director and has provided you with the following notes, a
copy of the August management accounts and the prior year financial statements.

Meeting notes
The prior year financial statements recognise work in progress of $1·8m, which was
comprised of property construction in progress as well as ongoing maintenance services for
finished properties. The August 20X7 management accounts recognise $2·1m inventory of
completed properties compared to a balance of $1·4m in September 20X6. A full year-end
inventory count will be undertaken on 30 September at all of the 11 building sites where
construction is in progress. There is not sufficient audit team resource to attend all inventory
counts.

In line with industry practice, Prancer Construction Co offers its customers a five-year building
warranty, which covers any construction defects. Customers are not required to pay any
additional fees to obtain the warranty. The finance director anticipates this provision will be
lower than last year as the company has improved its building practices and therefore the
quality of the finished properties.

Customers who wish to purchase a property are required to place an order and pay a 5% non-
refundable deposit prior to the completion of the building. When the building is complete,
customers pay a further 92·5%, with the final 2·5% due to be paid six months later. The
finance director has informed you that although an allowance for receivables has
historically been maintained, it is anticipated that this can be significantly reduced.

Information from management accounts

Prancer Construction Co’s prior year financial statements and August 20X7 management
accounts contain a material overdraft balance. The finance director has confirmed that there
are minimum profit and net assets covenants attached to the overdraft.

A review of the management accounts shows the payables period was 56 days for August
20X7, compared to 87 days for September 20X6. The finance director anticipates that the
September 20X7 payables days will be even lower than those in August 20X7.

Audit risk Audit response

214. Hurling:
You are an audit supervisor of Caving & Co and you are planning the audit of Hurling Co, a
listed company, for the year ending 31 March 20X7. The company manufactures computer
components and forecast profit before tax is $33·6m and total assets are $79·3m.

Hurling Co distributes its products through wholesalers as well as via its own website. The
website was upgraded during the year at a cost of $1·1m. Additionally, the company entered
into a transaction in February to purchase a new warehouse which will cost $3·2m. Hurling
Co’s legal advisers are working to ensure that the legal process will be completed by the year
end. The company issued $5m of irredeemable preference shares to finance the warehouse
purchase.

During the year the finance director has increased the useful economic lives of fixtures and
fittings from three to four years as he felt this was a more appropriate period. The finance
director has informed the engagement partner that a revised credit period has been agreed
with one of its wholesale customers, as they have been experiencing difficulties with repaying
the balance of $1·2m owing to Hurling Co. In January 20X7, Hurling Co introduced a new
bonus based on sales targets for its sales staff. This has resulted in a significant number of
new wholesale customer accounts being opened by sales staff. The new customers have
been given favourable credit terms as an introductory offer, provided goods are purchased
within a two-month period. As a result, revenue has increased by 5% on the prior year.

The company has launched several new products this year and all but one of these new
launches have been successful. Feedback on product Luge, launched four months ago, has
been mixed, and the company has just received notice from one of their customers, Petanque
Co, of intended legal action. They are alleging the product sold to them was faulty, resulting in
a significant loss of information and an ongoing detrimental impact on profits. As a precaution,
sales of the Luge product have been halted and a product recall has been initiated for any
Luge products sold in the last four months.

The finance director is keen to announce the company’s financial results to the stock market
earlier than last year and in order to facilitate this, he has asked if the audit could be
completed in a shorter timescale. In addition, the company is intending to propose a final
dividend once the financial statements are finalised.

Hurling Co’s finance director has informed the audit engagement partner that one of the
company’s non-executive directors (NEDs) has just resigned, and he has enquired if the
partners at Caving & Co can help Hurling Co in recruiting a new NED. Specifically he has
requested the engagement quality control reviewer, who was until last year the audit
engagement partner on Hurling Co, assist the company in this recruitment. Caving & Co also
provides taxation services for Hurling Co in the form of tax return preparation along with some
tax planning advice. The finance director has recommended to the audit committee of Hurling
Co that this year’s audit fee should be based on the company’s profit before tax. At today’s
date, 20% of last year’s audit fee is still outstanding and was due to be paid three months ago.

Audit risk Audit response

215. Centipede:

You are an audit supervisor of Ant & Co and are planning the final audit of Centipede Co,
which is a listed company, for the year ended 31 December 20X6. The company purchases
consumer packaged goods and sells these through its website and to wholesalers.

This is a new client for your firm and your audit manager has already had a planning meeting
with the finance director and has provided you with the following notes along with financial
statement extracts.

Client background and notes from planning meeting

Rather than undertaking a full year-end inventory count, the company undertakes monthly
perpetual inventory counts, covering one-twelfth of all lines monthly.

As part of the interim audit which was completed earlier in the year, an audit assistant
attended a perpetual inventory count in September and noted that there were a large number
of exceptions where the inventory records were consistently higher than the physical inventory
in the warehouse.

When discussing these exceptions with the finance director, the assistant was informed that
this had been a recurring issue all year. In addition, the audit assistant noted that there were
some lines of inventory which, according to the records, were at least 90 days old.

Centipede Co has a head office where the audit team will be based to conduct the final audit
fieldwork. However, there are four additional sites where some accounting records are
maintained and these sites were not visited during the interim audit.
The records for these sites are incorporated monthly through an interface to the general
ledger. A fifth site was closed down in 20X5, however, the building was only sold in 20X6 at a
loss of $825,000.

One of Centipede Co's wholesale customers is alleging that the company has consistently
failed to deliver goods in a saleable condition and on time, hence it has commenced legal
action against Centipede Co for a loss of profits claim.

The directors have disclosed their remuneration details in the financial statements in line with
International Financial Reporting Standards, which does not require a separate list of
directors' names and payments.

However, in the country in which Centipede Co is based, local legislation requires disclosure
of the names of the directors and the amount of remuneration payable to each director.

Financial statement extracts for the year ended 31 December:

Draft Final
20X6 20X5
$'000 $'000

Revenue 25,230 21,180

Cost of sales (15,840) (14,015)

Gross profit 9,390 7,165

Operating expenses (4,903) (3,245)

Operating profit 4,487 3,920

Inventory 2,360 1,800

Trade receivables 1,590 1,250

Cash - 480

Trade payables 3,500 2,800

Overdraft 580 -

Audit risk Audit response

216. Aquamarine:
You are an audit supervisor of Amethyst & Co and are currently planning the audit of your
client, Aquamarine Co (Aquamarine) which manufactures elevators. Its year end is 31 July
2016 and the forecast profit before tax is $15·2 million.

The company undertakes continuous production in its factory, therefore at the year end it is
anticipated that work in progress will be approximately $950,000. In order to improve the
manufacturing process, Aquamarine placed an order in April for $720,000 of new plant and
machinery; one third of this order was received in May with the remainder expected to be
delivered by the supplier in late July or early August.

At the beginning of the year, Aquamarine purchased a patent for $1·3 million which gives
them the exclusive right to manufacture specialised elevator equipment for five years. In order
to finance this purchase, Aquamarine borrowed $1·2 million from the bank which is repayable
over five years.

In January 2016 Aquamarine outsourced its payroll processing to an external service

organisation, Coral Payrolls Co (Coral). Coral handles all elements of the payroll cycle and
sends monthly reports to Aquamarine detailing the payroll costs. Aquamarine ran its own
payroll until 31 December 2015, at which point the records were transferred over to Coral.

The company has a policy of revaluing land and buildings and the finance director has
announced that all land and buildings will be revalued at the year end. During a review of the
management accounts for the month of May 2016, you have noticed that receivables have
increased significantly on the previous year end and against May 2015.

The finance director has informed you that the company is planning to make approximately 65
employees redundant after the year end. No decision has been made as to when this will be
announced, but it is likely to be prior to the year end.

Audit risk Audit response

217. Venus:
You are an audit supervisor of Pluto & Co and are currently planning the audit of your client,
Venus Magnets Co (Venus) which manufactures decorative magnets. Its year end is 31
December 2015 and the forecast profit before tax is $9·6 million.

During the year, the directors reviewed the useful lives and depreciation rates of all classes of
plant and machinery. This resulted in an overall increase in the asset lives and a reduction in
the depreciation charge for the year.

Inventory is held in five warehouses and on 28 and 29 December a full inventory count will be
held with adjustments for movements to the year end. This is due to a lack of available staff
on 31 December. In October, there was a fire in one of the warehouses; inventory of $0·9
million was damaged and this has been written down to its scrap value of $0·2 million. An
insurance claim has been submitted for the difference of $0·7 million. Venus is still waiting to
hear from the insurance company with regards to this claim, but has included the insurance
proceeds within the statement of profit or loss and the statement of financial position.

The finance director has informed the audit manager that the October and November bank
reconciliations each contained unreconciled differences; however, he considers the overall
differences involved to be immaterial.

A directors’ bonus scheme was introduced during the year which is based on achieving a
target profit before tax. In order to finalise the bonus figures, the finance director of Venus
would like the audit to commence earlier so that the final results are available earlier this year.

Audit risk Audit response

218. Sycamore:
Sycamore & Co is the auditor of Fir Co, a listed computer software company. The audit team
comprises an engagement partner, a recently appointed audit manager, an audit senior and a
number of audit assistants. The audit engagement partner has only been appointed this year
due to the rotation of the previous partner who had been involved in the audit for seven years.
Only the audit senior has experience of auditing a company in this specialised industry. The
previous audit manager, who is a close friend of the new audit manager, left the firm before
the completion of the prior year audit and is now the finance director of Fir Co.

The board of Fir Co has asked if Sycamore & Co can take on some additional work and have
asked if the following additional non-audit services can be provided:

(1) Routine maintenance of payroll records

(2) Assistance with the selection of a new financial controller including the checking of
references
(3) Tax services whereby Sycamore & Co would liaise with the tax authority on Fir Co’s behalf

Sycamore & Co has identified that the current year fees to be received from Fir Co for audit
and other services will represent 16% of the firm’s total fee income and totalled 15·5% in the
prior year. The audit engagement partner has asked you to consider what can be done in
relation to this self-interest threat.

Audit risk Audit response

219. Recorder Communications:

Recorder Communications Co (Recorder) is a large mobile phone company which operates a
network of stores in countries across Europe. The company’s year end is 30 June 2014. You
are the audit senior of Piano & Co. Record Is a new client and you are currently planning the
audit with the audit manager. You have been provided with the following planning notes from
the audit partner following his meeting with the finance director.
Recorder purchases goods from a supplier in South Asia and these goods are shipped to the
company’s central warehouse. The goods are usually in transit for two weeks and the
company correctly records the goods when received. Recorder does not undertake a year-end
inventory count, but carries out monthly continuous (perpetual) inventory counts and any
errors identified are adjusted in the inventory system for that month.
During the year the company introduced a bonus based on sales for its sales persons. The
bonus target was based on increasing the number of customers signing up for 24-month
phone line contracts. This has been successful and revenue has increased by 15%, especially
in the last few months of the year. The level of receivables is considerable higher than last
year and there are concerns about the creditworthiness of some customers.
Recorder has a policy of revaluing its land and buildings and this year has updated the
valuations of all land and buildings.

During the year the directors have each been paid a significant bonus, and they have included
this within wages and salaries. Separate disclosure of the bonus is required by local
legislation.

The finance director of Recorder informed the audit partner that the reason for appointing
Piano & Co as auditors was because they audit other mobile phone companies, including
Recorder’s main competitor. The finance director has asked how Piano & Co keeps
information obtained during the audit confidential.

Audit risk Audit response