- 20 Marks
AAA – L3 – Q26 – Audit Planning and Risk Analysis
Question
Kumasi Playthings is a prestigious toy retailer trading from a single urban retail district. The accounts and administration offices are above the shop. The company is the wholly-owned subsidiary of a prominent retail group. Kumasi Playthings is headed by its dynamic managing director, Kofi Mensah, aged 70.
At Kofi Mensah’s insistence, your firm, as local to Kumasi Playthings, has recently been appointed as the auditor. Kumasi Playthings is now the only group company not to be audited by the group auditors.
The following matters have come to light during the preliminary discussions with Kofi Mensah and those members of his staff to whom he has allowed you access:
(1) The parent company wishes Kumasi Playthings to develop operations in a number of out-of-town shopping centres. Kofi Mensah regards this as unacceptable because it would destroy the goodwill and prestige built up over 150 years of quality retailing.
(2) The company has approximately 30,000 lines of inventory. Contrary to group accounting instructions, no physical count is planned for the year end. The company intends to rely on the continuous inventory system which commenced operation in March 20X8. Two major problems have occurred with the system to date. Firstly, a trainee failed to enter all the inventory lines before the system went live. Secondly, due to a dispute with the IT provider, there has been no maintenance service for five months.
(3) Kofi Mensah has just returned from a toy fair at which he placed an order for 50,000 dolls produced by a little-known youth cooperative led by his only niece. The chief buyer is said to be fuming over the incident.
(4) In the year to 31 January 20X8, Kofi Mensah received a bonus of C2m, but you were unable to obtain any information in respect of the calculation and authorization of the bonus. No other director of Kumasi Playthings received a bonus in that year and the next highest paid director received a total emoluments package of C300,000.
(5) There is a dispute with a major supplier over the credit facilities offered to Kumasi Playthings. The supplier manufactures and supplies 30% of Kumasi Playthings’ purchases and claims that Kumasi Playthings has continually exceeded its credit period and that its accounting staff are impatient and incompetent.
(6) The company’s overdraft limit of C2.5m is due for renegotiation in April 20X5.
Required
Identify the potentially high risk areas of the audit.
Answer
New client
Inherent risk is increased by the lack of cumulative audit knowledge and experience which means that the new auditors are not aware of misstatements in prior years.
It is possible that the group auditors would have been appointed had they been locally represented. In insisting on a local firm, the managing director may well have been asserting his independence from the parent company. He may think he is owed a favour in this respect – which may colour initial relationships with the auditors.
The business
As a prestigious toy retailer, business risk is not unduly high. However, revenue will be seasonal and there is a high risk of inventory obsolescence when toys are no longer fashionable.
Management
Inherent risk is increased because the financial statements are subject to the dominant influence of Kofi Mensah. There may be management bias to overstate results, for example, to:
- justify the parent company’s retention of the company
- justify the C2m bonus or a repeat of it
- empire build this location and prevent out-of-town development
- increase the purchase consideration if the parent company decides to sell Kumasi Playthings.
Kofi Mensah is in a position to override controls and abuse his authority. This will lead to high control risk as suggested by: - his undermining of the buyer’s authority in ordering 50,000 dolls
- the lack of information about his bonus
- a lack of compliance with parent company’s directives (to develop operations out-of-town and conduct a year-end inventory count).
Limitation of scope
Kofi Mensah may attempt to dominate the conduct of the audit and seek to limit access to staff and accounting records. There is a risk that some disclosable transactions not be identified. The known purchase of the 50,000 dolls may be a related party transaction but there may be other such transactions.
Staff
There is a high risk of misstatements and even irregularities arising due to:
- lack of training and supervision of trainees
- poor morale (as Kofi Mensah appears to consistently undermine the authority of others).
Going concern
There may be some doubts about the appropriateness of the going concern basis of accounting. In particular:
- if Kofi Mensah retires, he may not be replaced
- proceeding with the out-of-town development may impact on goodwill
- consistently exceeding the major supplier’s credit limit may indicate cash flow problems
- if supplies are subsequently withheld, another supplier may not be found
- if the bank does not renew the overdraft, continued trading may depend on the support of the parent company.
Inventories
Specific risks include:
- obsolescence of toys which lose their popularity
- understatement of inventory quantities due to omissions on changeover
- misstatement of inventory quantities due to the lack of system maintenance
- possible overvaluation (e.g. of the 50,000 dolls).
- Topic: Audit Evidence, Planning
- Uploader: Salamat Hamid