1. You are a chartered accountant and the newly appointed internal auditor of a company that is experiencing financial difficulties. As a condition for obtaining bank loans, the company has agreed to maintain specified liquidity ratios, asset to liquidity ratios, and gross profit margins. The draft financial statements for the period end appear to show that the company has not succeeded in complying with some of these requirements. The profit figures are significantly affected by the calculation of bad debt and depreciation charges. There has been a suggestion to effect that these could be changed, in order to meet the bank%uFFFDs conditions. There is a real danger that if the bank withdraws its funding, the company will become insolvent and will have to cease trading. The chief financial accountant has asked you to sign certain internal records that have been altered in order to show that the bank%uFFFDs conditions have been met.
Explain the courses of action open to you in these circumstances
You are the external auditor of the company in financial difficulties described in (a) above. You have noted that the calculations of the bad debt allowance and depreciation provisions have been altered in the current year and that as a result, the bank%uFFFDs requirements have been met. You also note that certain accounting policy changes have been made in relation to accounting to leases and that as a result, the profit targets expected by certain investment analysts have now been met. If the changes had not been made, the targets would not have been met. The chief financial accountant is away on holiday and will not be back until shortly before the audit is due to be completed.
In relation to the facts above, explain the:
i. Implications for the audit of the financial statement
ii. Potential effect, if any, on the auditor%uFFFDs report on the financial statement
iii. Implications for the continuing relationship between the audit firm and the client
2. ISA 315 identifying and assessing the risks of material misstatement through understanding the entity and its environment says that the auditor shall identify and assess the risks of material misstatement at the financial statement level and at the assertion level for classes of transaction, account balances and disclosures. As part of the risk assessment, the auditor shall determine whether any of the risks are significant risks%uFFFD
a) Define a %uFFFDsignificant risk%uFFFD and list six factors which could indicate that a risk might Heels Co, a limited liability company has traditionally specialized in the manufacture and wholesaling of lady%uFFFDs shoes to retailers. The shoes are manufactured for lady%uFFFDs fashion retailers, who generally also sell luxury lady%uFFFDs clothes and accessories. You have been assigned as audit senior for the year ended 31st December 20X1 and have established the following at a recent planning visit.
In January 20X1, the company expanded into retailing and opened a shop selling shoes to the general public. The store was an instant success and the company rushed through the purchase of three additional stores before the end of May 20X1. These opened in June 20X1 and have also been well received. Customers can pay by cash, debit card or credit card in all stores.
In order to accommodate the retailing activities, Heels recently upgraded its computerized accounting system. The new system uses a central computer%uFFFDs head office which is linked to computers at its warehouse and retail outlets. The software includes a bespoke inventory control system.
The new retail operations are expected to account for 15% of revenue for the year to 31st December, 20X1 despite only being open for part of the year. However, as a result of the expansion, the company took out of working capital and by extending its overdraft facility.
Due to the increased volume of businesses and additional interest payments, the company is now trading at its overdraft limit. The company is seeking to increase the overdraft facility further.
b) Identify audit risks arising at the planning stage of the Heels Co audit and for each risk identified explain why it is a risk
c) For the risks identified above, describe possible audit work that could be performed in response to those risks.
On a later visit to Heels, you discovered that the retail stores have been offering a three month return period on all shoes. Customers are entitled to a refund or can exchange the shoes. Management at Heels have said they will estimate the figure for the returns relating to 20X1 sales expected between 1st January 20X2 and 31st March 20X2 (inclusive). They will then make a provision for it in the financial statements for the year ended 31st December, 20X1. The provision is likely to be material.
There is expected to be considerable time pressure on the audit this year because the board wants to get it out of the way by the middle of February 20X2 so they can focus on operational issues.
d) Define an auditor%uFFFDs point estimate and explain how the auditors of Heels could formulate and use a point estimate to gain evidence over the provision for shoe returns
e) Describe THREE other possible audit procedures you could carry out in respect of the provision.
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