Answered Essay: You are the audit manager of a medium-sized firm and have just received a package from Rachel Jones, the financial controller of Kid

Question 1 (40 marks)

You are the audit manager of a medium-sized firm and have just received a package from Rachel Jones, the financial controller of KidSpace Ltd., an electronic toy manufacturer. This is your firm’s first year as auditor of KidSpace Ltd. The information below was prepared for a board meeting and Rachel, the acting Chief Financial Officer, felt it might be useful to you in preparation of the forthcoming audit for the year ended 30 June 2017.

KidSpace Ltd.
Statement of Financial Position $’000s
Current assets 2017 2016 2015
Cash 1,586 1,743 830
Accounts receivable and other receivables 13,734 11,200 9,623
Inventory 16,498 11,731 7,197
Total current assets 31,818 24,674 17,650
Non-current assets
Property, plant and equipment 14,606 12,840 9,572
Long-term loan receivable 5,200 3,600 3,300
Intangible assets 1,400
Total non-current assets 21,206 16,440 12,872
Total assets 53,024 41,114 30,222
Current liabilities
Trade payables and other payables 9,012 6,288 2,021
Provisions 4,875 3821 4577
Total current liabilities 13,887 10,109 6,598
Non-current liabilities
Long-term loan 20,000 16,000 12,000
Total liabilities 33,887 26,109 18,598
Net assets 19,137 15,505 11,624
Shareholder’s equity
Share capital 2,000 2,000 2,000
Retained earnings 17,137 12,505 9,624
Total shareholder’s equity 19,137 14,505 11,624
KidSpace Ltd.
Income Statement $’000s
2017 2016 2015
Sales revenue 76,945 74,927 89,735
Cost of sales 51,840 51,765 63,066
Gross profit 25,105 23,162 26,669
Depreciation 5,595 4,332 2,796
Inventory obsolescence 990 1,173 670
Selling expenses 2,405 3,153 3,317
Administrative expenses 8,925 8,727 11,516
Finance costs 1,040 1,275 1,140
Total expenses 18,955 18,660 19,439
Profit before tax 6,150 4,502 7,230
Tax expense 1,518 1,621 2,386
Profit after tax 4,632 2,881 4,844
Notes:
Trade Receivables 12,034 10,655 9,300
Pre-paids 1,600 500 300
Other receivables 100 45 23
Total Trade & other receivables 13,734 11,200 9,623
Inventory
Raw Materials 6,599 5,866 3,845
WIP 4,333 2,588 1,550
Inventory held for sale 6,699 3,520 1,972
17,631 11,974 7,367
Provision for Inventory obsolescence (1,133) (243) (270)
Total inventory 16,498 11,731 7,197
Ratios 2017 2016 2015
Profit ratio 7.99% 6.01% 8.06%
Return on shareholder equity 24.20% 19.86% 41.67%
Quick Ratio 0.99 1.18 1.54
Times Interest Earned 6.91 4.53 7.34
Accounts Receivable Turnover (times) 6.78 7.51 9.33
Asset Turnover 1.45 1.84 2.94
Inventory Turnover (times) 3.50 5.35 8.76

During a brief telephone call with Rachel, you made the following notes:

1. One of the conditions of the long-term loan is that the company is not to exceed a debt-to equity ratio of 2:1 at any time and they must maintain a current ratio of 2:1. The loan is reviewed each year on 31 July.
2. Provision for obsolescence of finished inventory held for sale and work-in-progress is provided for at a flat rate of 10%. The amount provided in previous years was 20%. Rachel said that the company believes it has been overly conservative in previous years and 10% is a more realistic level, given the nature of its products.
3. To combat declining sales a senior management incentive scheme based on sales and profit levels was introduced in July 2016.
4. The long-term loan receivable is from a company involved in the development and production of computer software. It is owned by one of the directors.

Required:

a) Identify and explain what the inherent risks for KidSpace Ltd. that you will need to consider. (6 marks)
b) From the information provided, perform additional preliminary analytical procedures:
i) Simple comparison (3 marks)
ii) Current ratio (1 mark)
iii) Return on assets (1 mark)
iv) Gross profit ratio (1 mark)
v) Debt-to-equity ratio. (1 mark)

c) Drawing on information from a) & b), identify and justify:

i) Three key account areas that would require special attention during the audit of the 30 June 2017 financial statements. Also, indicate if those accounts are likely to be over or understated. (12 marks)
ii) Two key assertions at risk for each of those account areas. (12 marks)

d) Identify and discuss any going concern issues to be considered at this stage?. (3 marks)

Expert Answer

 

a) Meaning of Inherent Risk: Inherent Risk is the probability that an ommission or misstatement will exist in the financial statements due to uncontrollable factors and will not be caught in audit.

The risk of misstatements may be high, where there is high degree of management estimates involved, which may go wrong leading to incorrect financial statements.

In the above scenario, the management had provided Provision for Obsolescence on Inventory held for sale and Work-in-Progress at a flat rate of 10% against previous year provision of 20% for the same. In this scenario if the management estimate of 10% goes wrong and the actual Obsolescence of stock is more than 10%, then this will lead to overstatement of Inventory in the above financials.

The Other inherent risk involved is the collection of Long Term Loan Receviable 5200, given to a Company invloved in development and Production of Computer Software which was owned by one of the Company Directors. There is always a chance of inherent risk when the funds were lent to a related party and it clearly looks like diversion of borrowed funds for another business.

Here, it is no where mentioned that the Company is receiving interest on loan given to related party, whereas the Company incurrs Finance Cost on long term loan borrowed, so looking from this Company point of view, it is a loss for the Company to invest interest bearing funds in unpoductive investments. Moreover, there is an inherent risk of non-recovery of the funds lent by it to the related party in the event of uncertainity of profits made by the other Company.

b) i. Simple Comparision: Following points may be observed on simple comparision of Current Year figures with previous year figures.

The Inventory Turnover (times) decreased from 8.76 in 2015 to 5.35 in 2016 to 3.5 in 2017, which means either poor sales or excess holding of inventory which will possibly cost high working capital to the Company.

Accounts Receivable Turnover (times) also decreased from 9.33 in 2015 to 6.78 in 2017, which means the Debtors credit period is increased from approx 40 days (365/9.33) in 2015 to 54 days (365/6.78) in 2017, which will result in delay in collection of receivables and thereby requiring more working capital

ii. Current Ratio

Particulars 2017 2016 2015
Current Assets – A 31818 24674 17650
Current Liabilities – B 13887 10109 6598
Current Ratio – A/B 2.29 2.44 2.67

ii. Return on Assets = Net Income/ Total Assets

Particulars 2017 2016 2015
Net Income – A 4632 2881 4844
Total Assets – B 53024 41114 30222
Return on Assets – A/B 0.09 0.07 0.16

iii. Gross Profit Ratio = Gross Profit/ Turnover

Particulars 2017 2016 2015
Gross Profit – A 25105 23162 26669
Turnover – B 76945 74927 89735
Gross Profit Ratio – A/B*100 32.63% 30.91% 29.72%

iv. Debt Equity Ratio = Total Liabilities / Equity share holders funds

Particulars 2017 2016 2015
Debt (Total Liabilities)- A 33887 26109 18598
Equity (Equity Shareholder Funds) – B 19137 14505 11624
Debt Equity Ratio – A/B 1.77 1.8 1.60
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