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Auditing_and_Assurance_Services_in_Australia_----_Appendix.pdf

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APPENDIX: Continuous case study

Background information

You are the audit senior with Rogers & Brown and you have been approached to undertake the audit of Reliable Printers Ltd (RPL) for the year ended 30 June 2018, taking over from the small audit firm of Jones & Associates. RPL prints books, magazines and advertising material for the publishing, educational and advertising industries on a print-on-demand basis. Printing on demand means that publishers can print the exact quantities ordered by retail outlets, rather than estimating in advance how many books are required and often printing too few or too many. The average print turnaround time for RPL is two business days for small orders and five to ten business days for large orders. In addition, four years ago, RPL further expanded its earnings base by having publishers’ titles available as searchable ‘e-books’ that could be downloaded directly by readers from RPL’s website.

Purchases and inventory

RPL purchases 50 per cent of its inventory requirements of paper, ink and binding materials from Australian sources and 50 per cent from Asia. When inventory is received at RPL’s warehouse (whether it is purchased from Australia or Asia), the accounts payable clerk, Clare Kirby, records the arrival of the inventory and also its value and quantity in the accounts payable system. Inventory is paid for in the relevant currency of the country from which it is purchased. Raw materials have been valued at average cost

Gay, Grant E., and Roger Simnett. Auditing and Assurance Services in Australia, McGraw-Hill Australia, 2018. ProQuest Ebook Central, http://ebookcentral.proquest.com/lib/swin/detail.action?docID=5729228. Created from swin on 2019-04-26 05:00:51.

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and an allowance for inventory obsolescence has existed in previous years to cover the estimated decline in value from the effects of storage hazards. Work-in-progress is immaterial due to the quick turnaround time of printing jobs. Any work-in-progress is assessed at the cost of raw materials and labour and a proportion of manufacturing overheads based on normal capacity. At year end, the warehouse is closed from 28 to 30 June for stocktake, so sales must be invoiced in the system by close of business on 27 June. The stock must have been sent to the customer (that is, it must either be on a truck, ship or plane on its way to the customer, or it must already have arrived at the customer’s premises; it must no longer be in RPL’s warehouse).

Print-on-demand revenue and receivables

Each time a publisher wants to add a book to RPL’s ‘digital library’ (a server storing all of the publisher’s books in digital format, ready to print), it emails the book to RPL in portable document format (PDF). The digital library is backed up at the close of business every day, with the backup tapes kept off site. Once the book is stored in the digital library, the publisher can order copies to be printed as required.

When the publisher confirms the order, the accounting system automatically retrieves details of the publisher’s credit record and stops any orders from publishers that have exceeded their credit terms and limits. A printout of the transaction history of that publisher is generated and must be signed by both Amanda Payne, the head of publishing, and Jim Lane, the head of accounts at RPL, before the order can continue. After the transaction history has been signed and dated, accounts receivable staff file it.

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If there are no credit problems with the order, it is processed and printed by casual staff in the relevant warehouse, who then load the books onto pallets for shipping. When printing is finished, the sales clerk, Bob Watkins, prepares an invoice and dispatch docket and forwards them to the accounts receivable department. The accounts receivable clerk, Rebecca Chan, checks the prices and arithmetic accuracy of the invoices and signs the invoice as evidence of her check. Rebecca records the sale in both the accounts receivable subsidiary ledger and the general ledger, and the books are shipped to the publisher’s nominated destination (or the publisher will arrange pick up at the warehouse if it has its own distributors). The client accepts liability for the goods when they are received in accordance with the purchase order, and signs the dispatch docket as proof of delivery.

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E-book revenue

The proceeds from each e-book sale are paid to the publisher net of a 5 per cent commission. Proceeds are sent to publishers automatically upon download (the commission is withheld by RPL). Revenue from the commission is recognised when it is withheld from payment to the publisher.

RPL also charges publishers an annual ‘storage’ fee, payable 12 months in advance, for keeping the e-book on RPL’s website. Publishers are invoiced on the date the first download of a title occurs. As new books are downloaded on an ongoing basis, the storage fees are invoiced at different times of the year. Revenue from the storage fees has been recognised in the month the fees are invoiced, notwithstanding the fact that the fees are charged 12 months in advance.

In September 2017, RPL acquired Medical Books Ltd (MBL). The main rationale behind this lay in the value of the copyright MBL held over a large range of specialised medical textbooks. Although the potential print run for the textbooks was not large, each textbook had a high profit margin and had been used in universities across the world for many years. RPL acquired the business operations of MBL (not the shares), paying for net assets (including the right to the copyright). However, in June 2018 an article was published in a medical journal about a new theory that could result in MBL’s medical textbooks becoming obsolete. If the new theory is valid, the textbooks are unlikely to be reprinted or used as textbooks at universities in the future, effectively making them unviable as e-books.

Cash receipts

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Some payments from accounts receivable are received by cheque through the mail, and the cashier, Carly Barnes, records these in an inwards remittance register when the mail is opened. She then banks the cheques and forwards the payment advices to Rebecca for posting to the accounts receivable ledger. Most payments, however, are received by electronic funds transfer (EFT). Each day, Carly downloads the previous day’s receipts from online banking and provides a copy to Rebecca for posting. Carly then reconciles the total of the batch postings to accounts receivable to the amount banked for the day. The assistant accountant, Terry Graham, prepares a bank reconciliation at the end of each month.

Fixed assets

Since RPL’s incorporation, depreciation on assets has been calculated using the straight-line method, to allocate their cost over their estimated useful lives as follows:

Finance

During 2018, RPL has entered into a $7.5 million loan from Trim Finance Ltd. The loan has debt covenants requiring RPL to maintain a current ratio of at least 1.5 and a debt to equity ratio of less than 1. Failure to maintain these key financial ratios under the specified benchmarks would result in Trim

printing presses up to 20 years

other production equipment up to 15 years

other equipment up to 10 years.

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Finance having the right to recall the loan.

Appointment of new CEO and internal audit

William Jackson was appointed the new chief executive officer (CEO) of RPL in January 2018. William has extensive experience in the printing business. The previous CEO, Rebecca Styles, who is now semi-retired, will remain on the board as a non-executive director. A component of William’s remuneration package is a performance bonus based on RPL achieving an annual growth of 10 per cent in total revenue and 10 per cent in net profit after tax. Based on William’s recommendation, the board also established a new internal audit department, headed by Cody Baines, a former audit manager with a Big Four audit firm, with two other recently qualified chartered accountants. Cody reports directly to the board.

New IT system

During 2018, RPL decided to invest in a new IT system that would fully computerise and integrate all the current accounting processes across the organisation, including integration with the general ledger system.

Under extreme pressure from the board, the IT department at RPL managed to get the new accounting system installed in June, although the IT manager, Andy Rogers, complained several times about how the installation was handled. Andy claimed that excess pressure had been placed on staff to get the system installed and that there was simply not enough staff to do the

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proper reconciliations and testing before the new system went live prior to year end.

Andy’s preliminary testing showed that some transactions conducted around year end were not being allocated to the correct period. The problem appeared to be the interface between the new accounting system and one of the existing software systems. A software ‘patch’ had to be written to fix the problem.

Board year-end reporting discussions

At a board meeting held in June 2018, issues relating to the forthcoming year end were discussed. William stated that he believed that the valuation of raw material inventories at average cost was no longer appropriate as the current cost of paper was substantially above the average cost. Further, he argued that the allowance for obsolescence of inventory to cover the estimated decline in value from the effects of storage hazards was unnecessary, as such a loss was unlikely. William also stated that based on his experience in the printing industry he believed that RPL’s printing presses had a potential maximum life of 30 years, although he noted that another leading entity in the printing industry adopted the policy of depreciating its printing presses over a 20-year period on a straight-line basis, similar to what RPL had done in the past. After much discussion, the board resolved that the allowance for obsolescence of inventory be written back and that raw materials be valued based on a first in, first out (FIFO) basis. Further, it was resolved to change the depreciation of the company’s printing presses from 20 years to 30 years on a straight-line basis. In addition, following a review of the e-book facilities by internal audit, Cody recommended in a report to the board that RPL

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change the method it used to account for its revenue from e-book publications to ensure compliance with the applicable accounting standard. The board agreed that the revenue from e-books would be recognised in accordance with the stage of completion of each transaction (i.e. percentage of completion method).

Financial information

EXTRACTS FROM THE FINANCIAL REPORTS OF RPL FOR THE LAST THREE YEARS ARE AS FOLLOWS:

Statement of financial position

Note 2016 $

2017 $

2018 unaudited

Current assets

Cash 647 250 517 788 347 120

Accounts receivable 1 2 482 500 4 320 000 5 073 309

Inventories 2 2 256 188 2 671 362 4 180 500

5 385 938 7 509 150 9 600 929

Non-current assets

Property, plant & equipment

3 7 544 062 8 394 750 15 572 062

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Intangible assets – – 975 000

7 544 062 8 394 750 16 547 062

Total assets 12 930 000 15 903 900 26 147 991

Current liabilities

Accounts payable 1 950 000 3 035 250 3 525 000

Deferred revenue – – 697 500

Interest-bearing liabilities

937 500 862 500 787 500

Provisions 810 000 1 125 000 1 267 500

Accruals 82 500 97 500 120 000

3 780 000 5 120 250 6 397 500

Non-current liabilities

Interest-bearing liabilities

– – 7 500 000

Total liabilities 3 780 000 5 120 250 13 897 500

Net assets 9 150 000 10 783 650 12 250 491

Equity

Shareholders’ funds 2 250 000 2 250 000 2 250 000

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Retained profits 6 900 000 8 533 650 10 000 491

Total equity 9 150 000 10 783 650 12 250 491

Income statement

2016 $

2017 $

2018 unaudited

Revenue from operations

34 212 000 37 699 500 43 459 500

Cost of sales 28 207 500 31 620 000 36 855 000

Gross profit 6 004 500 6 079 500 6 604 500

Allowance for inventory obsolescence written back

– – 155 588

Commission income 108 000 123 000 130 500

E-book storage fees 667 500 1 027 500 1 417 500

Income from operating activities

6 780 000 7 230 000 8 308 088

Expenses

Advertising 83 725 115 923 125 778

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Audit fees 112 500 127 500 135 000

Bad debts 150 000 195 000 210 000

Depreciation 249 375 274 312 472 688

Discounts allowed 195 000 285 000 335 500

Legal fees 74 000 111 500 137 000

Foreign exchange loss

38 500 49 750 –

Rates 98 500 106 000 113 500

Repairs & maintenance

224 000 276 500 306 500

Salaries 1 965 000 2 190 000 2 445 000

Telecommunications costs

134 750 141 478 159 785

Total expenses 3 325 350 3 872 963 4 440 751

Net income before interest and tax

3 454 650 3 357 037 3 867 337

Interest expense 84 379 83 663 808 038

Profit before tax 3 370 271 3 273 374 3 059 299

Income tax 1 011 081 982 012 871 116

Profit after tax 2 359 190 2 291 362 2 188 183

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Page A5Notes to the financial report

Note 2016 $

2017 $

2018 unaudited

1 Accounts receivable 2 647 500 4 530 000 5 313 309

Allowance for doubtful debts

(165 000) (210 000) (240 000)

2 482 500 4 320 000 5 073 309

2 Inventory 2 362 500 2 797 238 4 180 500

Allowance for obsolescence

(106 312) (125 876) –

2 256 188 2 671 362 4 180 500

3 Property, plant & equipment

Land 2 775 000 3 375 000 3 375 000

Plant & equipment 5 250 000 5 775 000 13 425 000

Accumulated depreciation

(480 938) (755 250) (1 227 938)

7 544 062 8 394 750 15 572 062

Sales documents

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The following are some of the documents inspected by the auditor as part of the tests of controls for sales.

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Cash documents

The following are some of the documents inspected by the auditor as part of the tests of controls for cash.

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Source: This case study was adapted from the Chartered Accountants Program of the Institute of Chartered

Accountants in Australia, 2012 (3) audit and assurance module.

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