2017-1 Auditing Case Study, p.12017-1 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 currentlyplanning the 2016 audit of Posh Limited, a listed company that buys and sells home and officefurniture. This is the third year your accounting firm is engaged to perform the audit for thisclient. The financial year being audited ends on 31st December 2016. Past audit work and initialaudit inquiries this year have revealed the following information:Posh Limited hired a new Chief Executive Officer (CEO) in 2013, and the companyâs sales andprofit grew at an average rate of about 6% between 2013 and 2015. The board of directors wassatisfied with the companyâs profit and share price performance, and rewarded the CEO with anannual cash bonus each year when profit growth exceeded 5%. The CEO is keen to maintain thegood performance and started a plan to open 15 new stores around the country between 2016 and2018. To raise the money required for the expansion plan, the company borrowed $7 million inFebruary 2016 from a local bank. The debt contract requires the audit clientâs interest coverageratio 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 alsoplanning to make a major public share issue in April 2017. To obtain the best share pricepossible, it is important for the company to show a strong and healthy financial report. The CEOe-mailed all employees in September 2016 to encourage all staff to focus on increasing revenuesand cutting costs. A special bonus would be paid to all staff if the companyâs profit growthreached 5% for the 2016 financial year.The company spent a substantial amount of money in 2016 on its plan to open 7 new stores thisyear. 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 thetwo locations while the renovation continues. Inventories were purchased for all 7 stores at thebeginning of 2016. Inventories that are not on display in the stores are kept in the companyâscentral warehouse. A cyclone in December 2016 caused severe flooding of the centralwarehouse. Consequently, water damage and mould/rust are serious concerns for the inventoriesin the warehouse.The auditor noted last year that inventory turnover slowed down in 2015. One of the reasons isbecause the companyâs main competitors also opened new stores close to the audit clientâsstores. In addition, the companyâs sales staff said some of the furniture that was trendy during2013 and 2014 have become less popular with customers. The companyâs competitors havestarted to mark down the selling prices of such furniture since the end of 2015. The audit clienthas not held a clearance sale for older inventories yet.The audit client uses a perpetual inventory system. The accounting department is separate fromother operating departments. Only the accounting staff has access to the accounting system. TheCEO does not have direct access to the accounting records. The CEO needs to consult with thechief accountant about any proposed changes to the accounting records. If the chief accountantagrees that an adjustment is appropriate, the chief accountant would then make the change in thecomputer system. 2017-1 Auditing Case Study, p.2The computer systems for sales, inventory management and accounting are integrated.However, access to different systems is restricted to authorised staff via individual passwords sothat only sales staff has access to the sales computer system, and only accounting staff has accessto the accounting system, etc. Authorisation of transactions is also performed via individualpasswords.When customers make an order in store, sales staff enters the details for a sales invoice into thesales computer system. The sales system then sends the details of the sales invoice to theinventory management system. The warehouse staff uses this information to prepare deliverydocuments. Customers are required to sign a paper copy of the delivery document upon receiptof the furniture. Sales invoices and delivery documents are serially numbered. The originalcopy of the customer-signed delivery document is then sent to the accounting department whilethe warehouse staff keeps a duplicate copy of the document. At the end of each day, thewarehouse manager gives authorisation in the inventory management system to process salestransactions for which delivery has been made. The system then updates the perpetual inventoryrecords, and sends the sales transactions to the accounting system. The accounting staff checksthe online sales invoices and the signed delivery documents before giving authorisation for theaccounting system to record the sales in the accounting records. The accounting staff is requiredto regularly check recent sales transactions to see whether there are duplicate or missing salesinvoice numbers, and whether each sales transaction has both a sales invoice number and adelivery document number.Monthly inventory reports are prepared by the inventory management computer system. Thesereports list different types of inventories by the date the last sale was made for a particular typeof inventory. That is, these âlast salesâ reports help show inventory categories that have not hada sale for some time. The total value of each inventory category is also shown in the report. Acopy of the report is distributed to the sales manager, purchase manager, chief accountant and theCEO. These reports are often used for reference when senior accounting staff holds meetings todiscuss major accounting issues such as inventory write-downs.The audit clientâs draft financial statements for 2016 do not include an inventory write-downexpense or an allowance for inventory obsolescence account. Inquiries of the accounting staffreveal that the chief accountant said there is no need to recognise unrealised inventory lossesbecause the amount of the loss is uncertain so the information would be misleading to financialreport users. The chief accountant told the staff that inventory write-down expense will berecorded only when inventory items are actually sold.The chief accountant was hired by the CEO three years ago and they are close friends. The chiefaccountant keeps the CEO updated about the companyâs financial progress and discusses majoraccounting issues with the CEO. However, they both say that the CEO does not attempt tooverride the chief accountantâs professional judgment. Both the CEO and chief accountant arevery friendly to the auditors and the directors. These managers have a good relationship with theboard of directors. 2017-1 Auditing Case Study, p.3The following table shows some of the audit clientâs ratios over the period of 2013 to 2016. Theratios for 2016 are based on unaudited financial results.2016 full year(unaudited)2016 (first 9months) 2015 2014 2013Interest coverage ratio 10.1 9.6 11 11.7 12.4Debt/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 6.51Interest 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 byprior period profit, i.e., (Profit t â Profit t-1) / Profit t-1.Inventory turnover = cost of goods sold for year t divided by average inventory (i.e., the averageof beginning and ending inventory balances for year t).RequiredFor the (A) occurrence general audit objective of the sales revenue account, and (B) the netrealisable value general audit objective of the inventory account, answer all of the followingquestions in accordance with the Australian Auditing Standards. You need to perform youranalysis using the facts in the case study. For each of the two audit objectives of the accountsspecified above:(1) Assess inherent risk and perform analytical procedures to assess the likelihood ofmisstatements for each of the general audit objectives of the accounts given above. Analyseand explain your findings. (Total 20 marks)(2) Assess control risk for each of the general audit objectives of the accounts given above. Inyour answer, identify existing internal controls that are relevant to the specified auditobjectives and briefly explain how each internal control can prevent/detect misstatements forthe specified audit objectives. (12 marks)(3) Identify an existing internal control that is specific to each of the two general auditobjectives of the accounts specified above, and design one test of control for each case. Theinternal 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 ofthe accounts specified. (4 marks)(4) Design one substantive procedure that produces reasonably reliable evidence for each of thegeneral audit objectives of the accounts given above. Do NOT use the same procedures hereas the tests of controls in part (3). Do NOT use analytical procedures for sales occurrence. (4marks)