You are a senior auditor of the accounting firm West Partners. Your audit team is currently planning the 2020 audit of Barrow Limited, a listed company that manufactures and sells household appliances such as televisions, refrigerators, washing machines and air-conditioning units. They also manufacture and sell a limited range of smaller appliances like coffee machines, printers, recording devices and headsets. The company has many stores in shopping centres across Australia. This is the third year your accounting firm is engaged to perform the audit for this clientand no material misstatements were found in the previous audits. The financial year under audit ends on 31st December 2020 (FY2020). Past audit work and initial inquiries this year have revealed the following information.StrategyBarrow Ltd (hereafter referred to as “the company”) used to be very profitable because it directly sells products to consumers through their own retail outlets in shopping centres without using wholesalers or other retailers. However, in the last two years, a new competitor entered the market that sells many appliances with new “smart technology” features so the demand for the more traditional products sold by the audit client decreased substantially. Another factor that affected the audit client’s sales is the growing number of consumers who buy products online. As a response to these challenges, the audit client lowered the selling price of many products in February 2020 to try to retain customers. The audit client’s CEO told the directors in a board meeting in January 2020 that there was not much room for cutting production costs (including the cost of inventory purchases), so the price reduction strategy was used to increase sales volume. The directors questioned the CEO on the sustainability of such a pricing strategy. The CEO said the company has started developing appliances with popular smart technology features. Some of these products became available for sale from April 2020 at prices similar to the competitor’s prices. However, the manufacturing costs of these smart appliances are higher than the traditional products, so these new products have a lower gross margin at the moment. The company experienced mixed fortunes when COVID-19 hit. On the positive side, demand for certain items such as televisions, air conditioners and many of the smaller appliances soared, especially with the pricing strategy in place. However, the strict social distancing measures implemented in all their stores from mid-March 2020 in response to Government restrictions, and the lack of an online presence, hampered the company’sability
3to maximise the opportunities from increased demand. At an emergency strategy meeting held at the beginning of April 2020 it was decided that an online presence was essential to ensure profitability, and that they would simultaneously look to close some of the quieter brick and mortar stores once the online sales began to roll in. It was agreed that this was a sensible approach that would also have the advantage of cutting some of their overheads in the long run such as rent, wages and utilities. To kick off the online stores, a consultant was brought on board to advise on the most cost-effective and rapid move to online. The consultant recommended three key initiatives: 1) an appropriate online sales and inventory software package be installed toprocess the orders; 2) a regional warehouse should be established to store and dispatch inventory; 3) a substantial marketing campaign to launch the online stores. To help fund these initiatives, the audit client took out a $17 million bank loan in July 2020 to be repaid after 5 years. One of the conditions in the debt contract requires the audit client’s return on assets ratio (calculated as net profit divided by total assets) to be above 5% for the duration of the loan. The audit client’s return on assets was 4.3% at the end of September 2020 based on net profit for the first 9 months of the financial year. The ratio increased to 5.1% by 31 December 2020 based on unaudited financial results.As the audit client experienced negative profit growth over thelast 3 years, the directors had expressed concern about the CEO’s performance at the last board meeting in 2019. Some directors believed the company should replace the current CEO with someone external to the company. However, the board decided to give the CEO another chance and promised to give the CEO a special bonus if the CEO can turn the negative profit growth into positive profit growth in FY2020. At the strategy meeting held in April, it was decided that due to the uncertainties of COVD-19, they still expected the CEO to steer the company towards positive profit growth, however his tenure would be decided after comparing the company’s performance to their industry peers at the end of the year. Further, if he was able to achieve positive profit growth, he would be rewarded with a significant bonus that was double the initial bonus offered. During FY2020, the CEO held several meetings with the managers of all departments to discuss strategies to improve profitability. The CEO encouraged the managers to tell their staff that every employee in this company has a responsibility to help increase revenue and cut costs because that is the only way to avoid staff cuts.
4Operations: online salesFollowing the consultant’s advice, a new software package to facilitate online sales, that integrates the sales, inventory management and accounting functions, was purchased and installed. Even though the inventory sales and accounting systems are integrated, access to each system is password protected. Therefore, only staff within each department can access that part of the system. For instance, only accounting staff can access the accounting system.Due to the urgency of getting the online sales ‘live’, limited testing of the new software system was conducted. When a customer wishes to place an online order,the system requires that the customer creates a username and password. The system then sends an email confirmation to the customer to confirm that a valid email address has been entered. For each item selected, a drop-down list for the quantity of items is shown on the computer screen, and the price of the relevant products are automatically displayed based on an internal master list of current selling prices, and using quantity times price. The customer submits their online order and pays using a credit card. At the time of placing the order, the system will not allow an order to be placed for inventory items that are not in stock. To process theorder, the system verifies that a valid credit card is utilised for payments and customers are required to enter a valid address for delivery. Once verified, the items are authorised for shipping. A picking list is automatically prepared by the system andsent to the warehouse, where staff collect and prepare the items for delivery. A physical inspection of the items for shipment is performed and a shipping notice is prepared and filed electronically. A bill of lading is prepared prior to goods being dispatched and all items are shipped with two copies of the bill of lading and a copy of the picking list. Customers are required to sign one copy of the bill of lading on receipt of goods. The warehouse sends a third copy of the bill of lading and a copy of the picking list to the accounting department to initiate the process of recognising the sales transactions. Once delivery has taken place, the delivery staff enter relevant details into the computer system and this serves as authorisation for the accounting system to automatically record the sales revenue for goods that have been delivered (based on data entered by the sales staff and delivery staff). Accounting staff then checks the journal entries against electronic copies of sales invoices and delivery documents to see if the details are correct. Regular checks are also performed to see whether the recorded selling prices are consistent with the prices on the master price list, and whether special discounts were properly authorised by a store manager.
5Operations: warranty costsThe audit client usually offers 1-year free warranty for most of its products. The rate of faulty products used to be consistently low. Due to COVID-19 border closures, the company experienced significant delays from itssupplier of key components, who was located in the United States of America. Consequently, the company changed its supplier for these components in August 2020. You recently heard the audit client’s employees in the manufacturing department complain about the quality of the components from the new supplier.When customers ask for a refund or repair for faulty products, they need to complete a ‘Request for refund/repair’ form online to lodge the claim. A claim number is generated and the customer is required to include a copy of the ‘Request for refund/repair’ form with the goods being returned. Upon receipt of the goods, a technician inspects the product and prepares a ‘Warranty claim’ report in the system detailing the technical faults and associated costs. Thereport must be checked by a supervisor for approval, and the system will not allow the claim to be processed without the supervisor’s approval. A copy of the ‘Warranty claim’ report and the ‘Request for refund/repair’ form is then sent to the accounting department for recording. The accounting staff checks the reasonableness of the cost for the type of technical problem reported against an official list of common technical faults and related costs. Before recording the warranty claim, the accounting department verifies that the Warranty claim’ report matches the claim number assigned to the online warranty claim submitted by the customer. The system generates monthly reports on the warranty costs incurred by the company for each type of product. These reports are sent to the managers of all the divisions including manufacturing, sales, accounting, research and development, and technical support and maintenance departments. Management are expected to review the reports and provide a commentary on any variations between the actual warranty costs and forecast warranty costs. These commentaries are required to be submitted to the CFO for review. At the end of the financial year, the CFO and the CEOmeet to discuss major accounting issues such as appropriate accounting estimates to be reported in current year financial statements. Data such as the monthly warranty costs reports are used for such decisions. Discussions in these meetings are recorded and transcribed by an administrative assistant. The chief accountant told the auditor that the accounting estimate for warranty expense takes into consideration other information such as sales volume for different products in the current year
6and the frequency of faults reported for different products.The minutes of the meeting indicated that there had been a few teething problems with the incorporation of the new technology in the air conditioning units, and that the number of returns on these units was higher than on the traditional air conditioning units in prior years.Extracts of the audit client’s financial ratios for the last few years are provided below.2020 (full year unaudited)2020 (first 9 months)201920182017Profit growth1%-6%-3%-1.5%-1%Sales growth7%1%-6%-4%-3%Warranty expenses/Sales4%N/A6%7%7%RequiredFor the (A) occurrenceassertionof the sales revenue account, and (B) the accuracyassertionof the warranty expenseaccount, answer all ofthe 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 assertionsof the accounts specified above:
1.Assess inherent risk by indicating which factors, ONLY from the case, would either increase or decrease the inherent risk of misstatements in the occurrence of sales revenue and the accuracy of the warranty expense account. Conclude with an overall assessment of the qualitative level (high/medium/low) of inherent risk for each of the sales revenue and warranty expenses account. (10marks)
2.Assess control risk by indicating which factors, ONLY from the case, would eitherincrease or decrease the control risk of misstatements in the occurrence of sales revenue and the accuracyof the warranty expense account. In your answer, identify existing internal controls that are relevant to the specified audit objectives and briefly explain how each internal control could prevent/detect misstatements for the specified audit objectives. Conclude with an overall assessment of the qualitative level (high/medium/low) of control risk foreachof the sales revenue and warranty expensesaccount. (8marks)
73.The Audit Partner has advised that the Audit Risk on this client is to be set as “low”. a)Based on your analysis in part (1) and part (2) and the required low audit risk, apply the audit risk model using the table below to assess planned detection risk. (1marks)AccountAudit riskInherent risk Control risk Detection risk Sales revenue Low Warranty expense Lowb)Based on your evaluation of detection risk, explain what audit strategy(audit approach)you would recommend be adopted for the occurrence assertion of sales revenue and the accuracy of warranty expenses for thisclient. (1mark)
4.Suggest and briefly explain one analytical procedure that can help identify misstatements related to the occurrence assertion of sales. The procedure should be based on the facts given in the case study.(2marks)
5.Select one well-designed control from the casethat is specific to the occurrence of sales revenue and one that is specific to accuracy of warranty expenses and design an appropriate test of control to evaluate the effectiveness of each of the two selected controls(i.e. you only need to provide one test for each assertion). The tests should be based on the facts given in the case study. Briefly explain how the tests of controls specifically checks the relevant audit assertion of the account specified.