2017-1 ACCT7103 Auditing Case Study (40 marks = 20% of the course)
You are a senior auditor of the accounting firm CST Partners. Your audit team is currently
planning the 2016 audit of Posh Limited, a listed company that buys and sells home and office
furniture. This is the third year your accounting firm is engaged to perform the audit for this
client. The financial year being audited ends on 31st December 2016. Past audit work and initial
audit inquiries this year have revealed the following information:
Posh Limited hired a new Chief Executive Officer (CEO) in 2013, and the company’s sales and
profit grew at an average rate of about 6% between 2013 and 2015. The board of directors was
satisfied with the company’s profit and share price performance, and rewarded the CEO with an
annual cash bonus each year when profit growth exceeded 5%. The CEO is keen to maintain the
good performance and started a plan to open 15 new stores around the country between 2016 and
2018. To raise the money required for the expansion plan, the company borrowed $7 million in
February 2016 from a local bank. The debt contract requires the audit client’s interest coverage
ratio to be above 10, and the debt to assets ratio is required to be below 60%.
The bank loan is not sufficient to cover all costs for the expansion plan, so the company is also
planning to make a major public share issue in April 2017. To obtain the best share price
possible, it is important for the company to show a strong and healthy financial report. The CEO
e-mailed all employees in September 2016 to encourage all staff to focus on increasing revenues
and cutting costs. A special bonus would be paid to all staff if the company’s profit growth
reached 5% for the 2016 financial year.
The company spent a substantial amount of money in 2016 on its plan to open 7 new stores this
year. All premises have been rented and five stores were opened by August 2016. However,
renovation for the other two stores is behind schedule. The company has to pay the rent for the
two locations while the renovation continues. Inventories were purchased for all 7 stores at the
beginning of 2016. Inventories that are not on display in the stores are kept in the company’s
central warehouse. A cyclone in December 2016 caused severe flooding of the central
warehouse. Consequently, water damage and mould/rust are serious concerns for the inventories
in the warehouse.
The auditor noted last year that inventory turnover slowed down in 2015. One of the reasons is
because the company’s main competitors also opened new stores close to the audit client’s
stores. In addition, the company’s sales staff said some of the furniture that was trendy during
2013 and 2014 have become less popular with customers. The company’s competitors have
started to mark down the selling prices of such furniture since the end of 2015. The audit client
has not held a clearance sale for older inventories yet.
The audit client uses a perpetual inventory system. The accounting department is separate from
other operating departments. Only the accounting staff has access to the accounting system. The
CEO does not have direct access to the accounting records. The CEO needs to consult with the
chief accountant about any proposed changes to the accounting records. If the chief accountant
agrees that an adjustment is appropriate, the chief accountant would then make the change in the
computer system.
2017-1 Auditing Case Study, p.2
The computer systems for sales, inventory management and accounting are integrated.
However, access to different systems is restricted to authorised staff via individual passwords so
that only sales staff has access to the sales computer system, and only accounting staff has access
to the accounting system, etc. Authorisation of transactions is also performed via individual
passwords.
When customers make an order in store, sales staff enters the details for a sales invoice into the
sales computer system. The sales system then sends the details of the sales invoice to the
inventory management system. The warehouse staff uses this information to prepare delivery
documents. Customers are required to sign a paper copy of the delivery document upon receipt
of the furniture. Sales invoices and delivery documents are serially numbered. The original
copy of the customer-signed delivery document is then sent to the accounting department while
the warehouse staff keeps a duplicate copy of the document. At the end of each day, the
warehouse manager gives authorisation in the inventory management system to process sales
transactions for which delivery has been made. The system then updates the perpetual inventory
records, and sends the sales transactions to the accounting system. The accounting staff checks
the online sales invoices and the signed delivery documents before giving authorisation for the
accounting system to record the sales in the accounting records. The accounting staff is required
to regularly check recent sales transactions to see whether there are duplicate or missing sales
invoice numbers, and whether each sales transaction has both a sales invoice number and a
delivery document number.
Monthly inventory reports are prepared by the inventory management computer system. These
reports list different types of inventories by the date the last sale was made for a particular type
of inventory. That is, these “last sales” reports help show inventory categories that have not had
a sale for some time. The total value of each inventory category is also shown in the report. A
copy of the report is distributed to the sales manager, purchase manager, chief accountant and the
CEO. These reports are often used for reference when senior accounting staff holds meetings to
discuss major accounting issues such as inventory write-downs.
The audit client’s draft financial statements for 2016 do not include an inventory write-down
expense or an allowance for inventory obsolescence account. Inquiries of the accounting staff
reveal that the chief accountant said there is no need to recognise unrealised inventory losses
because the amount of the loss is uncertain so the information would be misleading to financial
report users. The chief accountant told the staff that inventory write-down expense will be
recorded only when inventory items are actually sold.
The chief accountant was hired by the CEO three years ago and they are close friends. The chief
accountant keeps the CEO updated about the company’s financial progress and discusses major
accounting issues with the CEO. However, they both say that the CEO does not attempt to
override the chief accountant’s professional judgment. Both the CEO and chief accountant are
very friendly to the auditors and the directors. These managers have a good relationship with the
board of directors.
2017-1 Auditing Case Study, p.3
The following table shows some of the audit client’s ratios over the period of 2013 to 2016. The
ratios for 2016 are based on unaudited financial results.
2016 full year
(unaudited)
2016 (first 9
months) 2015 2014 2013
Interest coverage ratio 10.1 9.6 11 11.7 12.4
Debt/Assets 59% 62% 51% 49% 45%
Profit growth 5.1% 4.7% 5.5% 6.2% 6.7%
Inventory turnover 5.15 5.22 5.96 6.78 6.51
Interest coverage ratio = Net profit divided by interest expense.
Debt to assets ratio = Total liabilities divided by total assets.
Profit growth = the difference between current period profit and prior period profit divided by
prior period profit, i.e., (Profit t – Profit t-1) / Profit t-1.
Inventory turnover = cost of goods sold for year t divided by average inventory (i.e., the average
of beginning and ending inventory balances for year t).
Required
For the (A) occurrence general audit objective of the sales revenue account, and (B) the net
realisable value general audit objective of the inventory account, answer all of the following
questions in accordance with the Australian Auditing Standards. You need to perform your
analysis using the facts in the case study. For each of the two audit objectives of the accounts
specified above:
(1) Assess inherent risk and perform analytical procedures to assess the likelihood of
misstatements for each of the general audit objectives of the accounts given above. Analyse
and explain your findings. (Total 20 marks)
(2) Assess control risk for each of the general audit objectives of the accounts given above. In
your answer, identify existing internal controls that are relevant to the specified audit
objectives and briefly explain how each internal control can prevent/detect misstatements for
the specified audit objectives. (12 marks)
(3) Identify an existing internal control that is specific to each of the two general audit
objectives of the accounts specified above, and design one test of control for each case. The
internal controls and tests of controls must be based on the facts given in the case study.
Briefly explain how the tests of controls specifically check the relevant audit objectives of
the accounts specified. (4 marks)
(4) Design one substantive procedure that produces reasonably reliable evidence for each of the
general audit objectives of the accounts given above. Do NOT use the same procedures here
as the tests of controls in part (3). Do NOT use analytical procedures for sales occurrence. (4
marks)
