In: Accounting
You are the auditor in charge of the financial statement audit of RoyTech Limited (RTL) for the year ended September 30, 2014. RTL, a private company formed in 1992, manufactures and sells components for computers, including screens and printers. RTL provides components to a variety of big name computer manufacturers all around the world. It is now November 2014. The following are highlights from the team meeting for the RTL engagement:
1) RTL’s main competition consists of foreign manufacturing and a very successful multinational conglomerate that has excellent customer recognition, including a distribution network.
2) RTL’s net income has fallen in recent years because it lost several large sales contracts to provide ink-jet printers. RTL is expecting that its new production methods for laser printers, which are increasing in popularity, will lead to recovery. However, to date, RTL has not secured any new significant sales contracts for laser printers. Revenue and sales information for RTL’s last five years are:
Year | Revenues | Net Income (Loss) Before Income Taxes |
2014 (unaudited) | $ 12,000,000 | $ 200,000 |
2013 | 24,000,000 | 2,200,000 |
2012 | 56,000,000 | 4,900,000 |
2011 | 68,000,000 | 5,400,000 |
2010 | 52,000,000 | (800,000) |
3) During fiscal 2014, the President of RTL authorized a change in credit policies. Previously, customers were granted credit based upon the credit ratings developed by RTL’s credit manager, which took into account the outstanding balance of the customer’s account and an analysis of its financial condition. Due to the recent financial difficulties in the technology sector, the President decided that RTL must use a more lenient credit policy to keep sales flowing. Accordingly, as a cost cutting measure, the credit manager was laid off in December 2013, and the President now evaluates each customer contract or purchase order individually to determine whether credit should be granted. As a result of this new policy, no customer orders were declined for poor credit since December 2013.
4) The collection of accounts receivable has slowed considerably. The summary aging of accounts receivable from RTL’s 600 customers for the current and prior year is shown below:
date | total | Current<30 Days | 31-60 days | 61-90 Days | >90 Days |
sept 30, 2014 | $1,805,509 | $ 722,009 | $ 270,000 | $ 255,000 | $ 558,500 |
Sept 30, 2013 | $2,099,080 | 1,045,080 | 210,500 | 222,000 | 621,500 |
5) RTL has commenced a lawsuit against a major competitor for patent infringement and industrial espionage. Management has evidence that it believes will result in a successful action, and wishes to record the estimated gain on settlement of $4 million. Although no court date has been set, legal correspondence shows that the competitor intends “to fight this action to the highest court in the land.”
6) Earlier this calendar year, RTL negotiated a $3.5 million term bank loan, which is secured by RTL’s assets. The loan agreement requires RTL to undergo an annual work safety assessment of its production facilities. To date, RTL has not conducted an assessment. As of September 2014, assets (rounded to the nearest thousand) consisted of:
Current Accounts Receivable $ 1,806,000 Inventory 1,650,000 Prepaid Expenses 45,000 ---Total current assets $ 3,501,000
Long-term Capital Assets $ 2,120,000 Patents 835,000-- Total Assets $6,456,000
7) Each year, senior management receives a bonus of five percent of their salary if the actual net income exceeds the budgeted net income by more than 10%. Senior management expects to receive their bonus since the current unaudited numbers exceed the budgeted net income by about 15%.
Required:
A) Assess audit risk for the RTL engagement.
Assess audit risk for the RTL engagement :
RTL expects that the new production methods for laser printers will lead to the recovery of losses caused due to the inability of securing significant sales contracts of ink-jet printers. The expectation of the company is unrealistic and not based on reliable assumptions because no significant sales contract has been secured as yet. The profit has declined from $2,200,000 to $200,000 in the last year. Due to declining market of the product, the president of the company has decided to provide more lenient credit policies to the customers which has raised the credit risk of the company to an alarming rate. The credit manager with expertise in credit methods has also been laid off which depicts the unprofessional behaviour of management and also signifies the improper credit policies which could lead to blockage of company’s funds in future.
As the credit policies are not based on analytical review by the experts, the collection of accounts receivable has slowed down significantly. Due to this slowdown, certainty of recoverability of accounts receivable is also under doubt. Further, RTL has commenced a lawsuit against a competitor and believes in successful action against the same and also wishes to recognise the estimated gain. This again is without any basis as the case has not yet been heard in the court and there are no evidences proving the certainty of recoverability of amount.
The term loan agreement requires the company to undergo annual work safety assessment which has not been undertaken by the company yet and from the facts, the probability of same also seems low. As the condition is a part of agreement, non-compliance with the same may terminate the agreement and may lead solvency issues for the company.
The accounts receivable (not certain for recovery) and other current assets forms a major part of total assets of the company which is not a good sign. Even after performing so terribly in the recent past, the unaudited income statement reflect net income more than the budgeted income which signifies that the figures reported by the management may be inflated and far from the reality.
The risk assessment of the firm for the purposes of audit will be high and as an auditor it will be moral duty for us to check the reasonableness of going concern assumption of the business.