- 20 Marks
AA – L2 – Q18 – Planning an Audit
Question
You are the audit manager in charge of the audit of Seaford Supplies Ltd., a limited liability company. The company’s year-end is 31 December, and Seaford Supplies Ltd. has been a client for seven years. The company purchases and resells fittings for ships including anchors, compasses, rudders, sails, etc. Clients vary in size from small businesses making yachts to large companies maintaining large luxury cruise ships. No manufacturing takes place in Seaford Supplies Ltd.
It is now early in 20X8. Information on the company’s financial performance is available as follows:
| 20X8 Forecast | 20X7 Actual | |
|---|---|---|
| ₵’000 | ₵’000 | |
| Revenue | 45,928 | 40,825 |
| Cost of sales | (37,998) | (31,874) |
| 7,930 | 8,951 | |
| Gross profit | ||
| Administration costs | (4,994) | (4,758) |
| Distribution costs | (2,500) | (2,500) |
| Net profit | 436 | 1,693 |
| 20X8 Forecast | 20X7 Actual | |
| ₵’000 | ₵’000 | |
| Non-current assets (at net book value) | 3,600 | 4,500 |
| Current assets | ||
| Inventory | 200 | 1,278 |
| Receivables | 6,000 | 4,052 |
| Cash and bank | 500 | 1,590 |
| 10,300 | 11,420 | |
| Total assets | ||
| Capital and reserves | ||
| Share capital | 1,000 | 1,000 |
| Accumulated profits | 5,300 | 5,764 |
| Total shareholders’ funds | 6,300 | 6,764 |
| Non-current liabilities | 1,000 | 2,058 |
| Current liabilities | 3,000 | 2,598 |
| 10,300 | 11,420 |
Other information
The industry that Seaford Supplies Ltd. operates in has seen moderate growth of 7% over the last year.
Non-current assets mainly relate to company premises for storing inventory. Ten delivery vehicles are owned with a net book value of ₵300,000.
One of the directors purchased a yacht during the year.
Inventory is stored in ten different locations across the country, with your firm again having offices close to seven of those locations.
A computerised inventory control system was introduced in August.
Inventory balances are now obtainable directly from the computer system. The client does not intend to count inventory at the year-end but to rely instead on the computerised inventory control system.
(a) According to ISA 300, the auditor should plan the audit work so that the engagement will be performed in an effective manner.
Required:
Explain why it is important to plan an audit
(b) Using the information provided above, prepare the audit strategy for Seaford Supplies Ltd. for the year ending 31 December 20X8.
Answer
(a) According to ISA 300, the auditor should plan the audit work so that the engagement will be performed in an effective manner. Specifically, planning is required for the following reasons:
- To develop a general strategy and detailed approach for the specific nature, timing, and extent of the audit work. This will help to ensure that the audit is carried out in an efficient and timely manner.
- So that attention is devoted to the important areas of the audit. Planning will also help to identify problem areas so they can be addressed in a timely fashion.
- To determine the amount of work to be carried out and therefore assist in determining the number of staff required to perform the audit work.
- To provide a document as a reference for an initial discussion of the approach to the audit with the company’s audit committee. The plan will also help ensure that audit work is coordinated with client staff: e.g., for production of specific documentation to assist the auditor.
- To act as a basis for the production of the audit program.
(b) Audit strategy
Client: Seaford Supplies Ltd.
Year ended: 31 December 20X8
Prepared by: A Manager
Characteristics of entity
Seaford Supplies Ltd. requires a normal statutory audit – there are no audit or filing exemptions available.
The financial reporting framework is the International Accounting Standards/International Financial Reporting Standards and there are no industry-specific reporting requirements.
Seaford Supplies Ltd. buys and then resells all types of fixtures and fittings for ships from yachts through to large cruise ships. The company has ten warehouses, seven of which are located near to branches of our audit firm.
Key dates
Key dates in the audit timetable are:
- Interim audit
- Final audit
- Meeting with audit committee
- Financial statements approved by management
Specific dates are to be confirmed.
Overview of audit approach
The shipping supply industry has grown by 7% during the last year. Seaford Supplies Ltd.’s revenue increase is 12%, indicating that the company continues to perform well within the industry.
There have been no changes to the accounting policies of Seaford Supplies Ltd. during the year.
The overall audit approach will be to use tests of control where possible. However, the fall in gross profit indicates that revenue may be understated or cost of sales (COS) overstated, so additional substantive procedures may be required in this area.
Materiality determination
Materiality will initially be set at ½ to 1% of revenue as this figure appears to be more accurate than gross profit.
Materiality on the statement of financial position will be based on net asset values.
Performance materiality will be set for specific areas.
Identification of risk areas with a higher risk of misstatement
A review of the draft financial statements for the company shows the following:
- Revenue has increased by 12% but COS by 19%. There is a risk of COS being overstated.
- Inventory on the statement of financial position is down significantly on last year, indicating that there may be valuation or quantity misstatements.
- Trade receivables have increased by about 50%, significantly more than the increase in revenue. This indicates that the company may have debt collection problems. Additional testing may be required on after-date cash collections to check for bad debts.
- Non-current assets have fallen by ₵900,000, which is significant given that most non-current assets are land and buildings. The reason for the sale must be ascertained.
- Non-current liabilities have also fallen by ₵1 million. While not necessarily linked to the fall in non-current assets, there is a possibility that non-current assets have been sold to pay off the liabilities.
Audit approach – extent of controls testing
Audit testing will focus on the use of tests of controls where possible. However, changes have been made to the inventory system during the year, limiting the extent of testing of controls. Client systems have changed in the year with a new computerised inventory control system. Unfortunately, the change was not identified until audit planning started. Three actions are necessary in respect of this system:
- Audit initial installation of the system including transfer of balances. One of the reasons for the low inventory value could be omission of inventory balances on transfer.
- Test count inventory at the year-end and agree to the computerised inventory records (and vice versa) to test their accuracy. Note that the client will not be counting inventory at the year-end but relying on the computerised system.
- Test check bookings into and out of inventory from the purchases and sales systems.
Other risk areas
The client appears to be a going concern, although the fall in gross profit must be investigated. Cash and profit forecasts for the next 12 months must also be obtained to confirm ongoing profitability and that the fall in cash balances will not continue.
There is the possibility of related party transactions. One of the directors purchased a yacht during the year. Checks to be made to determine whether company products were purchased, and if so, whether these were in the normal course of business.
Assistance may be required on the inventory count; three warehouses are located away from our offices.
- Tags: Audit Efficiency, Audit Planning, Audit Strategy, ISA 300, Resource Allocation
- Level: Level 2
- Topic: Planning an Audit
- Uploader: Samuel Duah