Question

You are a senior auditor of the accounting firm QTP Partners. Your audit team is currently planning the 2018 audit of GreenHome Limited, a medium sized listed company that manufactures and sells household appliances such as televisions, refrigerators and washing machines. The company has many stores in shopping centres across Australia. This is the second year your accounting firm is engaged to perform the audit for this client. The financial year under audit ends on 30th June 2019. Past audit work and initial inquiries this year have revealed the following information.

GreenHome Ltd (hereafter referred to as “the company” or “the audit client”) had several years of stable profit growth because it focused on manufacturing energy saving appliances. The manufacturing costs and selling prices of such products are higher than those of traditional products sold by competitors. However, as consumers have become more conscious of environmental issues, there is a niche market for your audit client’s products. However, since February 2018, your audit client’s main competitor, BetterLiving Limited, which is substantially larger in size than GreenHome, gradually introduced a new range of energy saving appliances that are similar to your audit client’s products. Although the competitor’s products are still inferior to your audit client’s products in terms of energy efficiency, the competitor is able to sell its products at lower prices due to economy of scale. This development has had an obvious impact on the audit client’s sales, which declined by 20% in the previous financial year.

In response to BetterLiving Ltd’s new products, the CEO of GreenHome launched an intensive advertising campaign throughout the 2018 financial year to emphasise that GreenHome’s products are both more energy efficient and more durable. A substantial amount of money was spent on the advertising campaign. When the advertising campaign was proposed to the board of directors in July 2018, one of the directors asked the CEO whether the company has any scientific evidence to show that its products are more durable than the competitor’s products. The CEO said no formal study was conducted but the company’s product designers and the staff in the manufacturing department both think the company’s products are of better quality than the competitor’s. The directors were not given any written report of such opinions.

In August 2018, The CEO obtained the directors’ permission to invest a lot of money into new product development because the CEO argued that the company needs to develop better products to maintain its competitive advantage. The CEO also reported to the directors that the depreciation of the Australian dollar keeps increasing the costs of raw materials and components imported from overseas. As the competitor is selling similar products at lower prices, the CEO believes it is not feasible to increase selling prices. Instead, in September 2018, the CEO asked the manufacturing department to switch to cheaper but lower quality raw materials and components. When the directors questioned whether this change will make the products less durable and thus render the key message of the company’s advertising campaign (that the company has more durable products) misleading, the CEO said the company’s products are still of good quality. The CEO also said selling slightly less durable products can help improve long- term sales because customers need to replace the products more frequently.

To help fund increasing operating costs including advertising and research and development costs, the audit client took out a $5 million bank loan in August 2018 to be repaid after 3 years. One of the conditions in the debt contract requires the audit client’s return on assets ratio (calculated as net profit divided by total assets) to be above 7% for the duration of the loan.

In May 2018, the board of directors approved a new remuneration (pay) package for the CEO for the 2018 financial year to motivate the CEO to lead the company out of its difficulties. Based on the new package, about 20% of the CEO’s remuneration would be paid with the company’s shares, and a special cash bonus will be paid if the company returns to positive profit growth for the 2019 financial year. The CEO believes it is important that all employees of the company should be aware of the company’s situation so the CEO e-mailed all employees in November 2018 to encourage them to help improve revenues and cut costs as better profit performance will reduce the necessity of staff cuts.

The audit client’s accounting department is separate from other operating departments. Only the accounting staff has access to the accounting system. The CEO does not have direct access to the accounting records. The CEO needs to consult with the chief accountant about any proposed changes to the accounting records. If the chief accountant agrees that an adjustment is appropriate, the chief accountant would then make the change in the computer system.

The computer systems for sales, inventory management and accounting are integrated.
However, access to different systems is restricted to authorised staff via individual passwords so that only sales staff has access to the sales computer system, and only accounting staff has access to the accounting system, etc.

When customers make an order in store, sales staff enters the details for a sales invoice into the sales computer system. The sales system then sends the details of the sales invoice to the inventory management system. The warehouse staff uses this information to prepare delivery documents. Customers are required to sign a paper copy of the delivery document upon receipt of the appliances they ordered. Sales invoices and delivery documents are serially numbered. The original copy of the customer-signed delivery document is then sent to the accounting department while the warehouse staff keeps a duplicate copy of the document. At the end of each day, the warehouse manager gives authorisation in the inventory management system to process sales transactions for which delivery has been made. The system then updates the perpetual inventory records, and sends the sales transactions to the accounting system. The accounting staff checks the sales invoices in the accounting system against the signed delivery documents before giving authorisation for the accounting system to record the sales in the accounting records. The accounting staff is required to regularly check recent sales transactions to see whether there are duplicate or missing sales invoice numbers, and whether each sales transaction has both a sales invoice number and a delivery document number.

The audit client usually offers 1-year free warranty for most of its products. The rate of faulty products used to be quite stable between the financial years 2014 to 2017. In July 2018, to improve sales after the competitor introduced new products, the audit client’s CEO changed the warranty policy and started offering 2-year free warranty for products worth more than $500.

When warranty costs are incurred, the accounting staff checks the reasonableness of the cost for the type of technical problem reported against an official list of common technical faults and related costs. The company uses the provision method to record warranty expenses.

The audit client prepares monthly reports to show actual warranty costs for different types of products. Quarterly meetings are held to discuss the reasonableness of these costs and whether product design should be changed to reduce the rate of faulty products. These meetings are attended by senior managers from departments such as manufacturing, sales, accounting, research and development, and technical support and maintenance departments. Records of these meetings are sent to the CEO for review. The reports in the last few months of the financial year show that after the company started using lower quality materials and components to manufacture its products, the rate of faulty products and the costs of repair/refund have both increased.

At the end of the financial year, the CEO and the chief accountant meet to discuss major accounting issues such as appropriate accounting estimates to be reported in current year financial statements. Data such as the monthly warranty costs reports are used for such decisions. Discussions in these meetings are documented by a secretary. The chief accountant told the auditor that the accounting estimate for warranty expense takes into consideration other information such as sales volume for different products in the current year and the frequency of faults reported for different products.

The CEO and the chief accountant have worked together for the company over the last five years. They have been friends for many years before they started working for this company. Both of them have friendly and charismatic personalities and can be very persuasive. They usually get on well with the board of directors and the auditors. The audit client’s board of directors consists of a majority of independent directors. The independent directors attended most of the board meetings.

Extracts of the audit client’s financial ratios for the last few years are provided below.

	2018 full year (unaudited)	2018 (first 9 months)	2017	2016	2015
Sales growth	2%	-3%	-20%	9%	8%
Profit growth	1%	-6%	-15%	5%	4%
Return on assets	7.1%	4.5%	3%	10%	8%
Warranty expense/Sales	3%	Not applicable	7%	6%	7%

Sales growth is calculated as the difference between current period sales and prior period sales divided by prior period sales, i.e. (Sales t – Sales t-1) / Sales t-1.

Profit growth is calculated as the difference between current period profit and prior period profit divided by prior period profit, i.e. (Profit t – Profit t-1) / Profit t-1.

Return on assets ratio = Net profit divided by total assets. Warranty expense is an accounting estimate.

Required

For the (A) occurrence general audit objective of the sales revenue account, and (B) thevaluation assertion (i.e., the accuracy general audit objective) of the provision for warranty account, answer all of the following questions in accordance with the Australian Auditing Standards. You need to perform your analysis using the facts in the case study.

For each of the two audit objectives of the accounts specified above:

1. (2) Assess control risk for each of the general audit objectives of the accounts given above. In your answer, identify existing internal controls that are relevant to the specified general audit objectives, and briefly explain how each internal control can prevent/detect misstatements for the specified general audit objectives for sales and provision for warranty.

Answer 1

A) On the basis of above data , We noticed following points in relates to Revenue Sales :

1) Green House Limited - past Revenue growth always on Single Digi Growth . They are maintaining Profit margin with help of Single revenue growth mainly due to they are manufacturing and selling " Energy Savings Appliances "

2) Unfortunately in 2017 , their immediate competitor Better Living also started manufacturing Lowe cost device and Green House badly impacted by AUD currency depreciation and more dependent on Import of Raw material + Currency risk, all together Company started losing Revenue stream as well as Operating Margin

Mainly due to pricing challenge , their revenue growth down by 20%, which is quite significant.

3) this pricing pressure + High Input cost + New product ( less cost) introduced by competitor firm = Green House made Negative revenue growth in 2018 ( first 9 month) and later on slightly recovery with very thing Marginal revenue growth .

Provision for Warranty - As per New Revenue recognition, Warranty divided into two parts - 1) Assurance base 2) Service base warranty ,. Standard is saying ,company can make accrual base of accounting in case of Assurance base warranty .

In past year , Warranty Provision was in line with Revenue growth BUT in 2017 , they have started giving 2 Year Warranty to Customer . This is mainly due to compete with Better Living . CEO noticed that to maintain customer base and continue doing business with high competition and Lower base price, CEO opted for 2 Year warranty and started provision accordingly .

Also product cost $500 - They will started making 2 year warranty provision and 2017 - 7% provision made against Negative revenue Growth .

B) Apparently , Green House Limited well managed and discipline company . Companies Internal control system also quite good and they are maintaining good Corporate Governance . We have noticed following points , which give us a comfort level about systematic Internal Control system :

1) Company completely managed by Independent director .. they attain most of the Board Meeting .

2) Major amount spend on Advertising Campaign -certified by Board of Director . It was never CEO's own decision

3) CEO doe not have any access on accounting record .

4) accounting team are working separately and reported separately ( even though CEO and Head of accountant are close friend - never use it in Company decision matter

5) Internal accounting Control in relates to Sales, Inventory management , Process of data flow ,Segregation of Duties are excellent .

6) basis of Warranty provision and special approval .Every policy , method of accounting , basis of provision - well explained to Auditor .

Financial ratio	2015	2016	2017	2018 ( First 9 Months )	2018 ( FY )
Sales Growth	8%	9%	-20%	-3%	2%
Profit Growth	4%	5%	-15%	-6%	1%
ROA	8%	10%	3%	5%	7%
Warranty/Sale	7%	6%	7%	NA	3%