Reference no: EM131470366 , Length: word count:700

Auditing Assessment - Case study

Description / Requirements

MGC Ltd.

Introduction

In March 2016, Barbra Ma, an audit partner at XYZ Chartered Accountants (XYZ), a mid-tier, Melbourne based accounting firm, evaluated and recommended accepting a new audit client, MGC Ltd (MGC). MGC is a medium sized unlisted retail trading company operating in several parts of Victoria. Barbra evaluated the audit client and assessed XYZ's independence as well as competence to properly complete the audit. XYZ issued an engagement letter and started the MGC's audit for the year 2016. Alex Jones was assigned as an audit manager in charge of planning and supervising the conduct of the MGC audit. 

MGC's background

MGC is a retailer of skin care products. It operates with seven warehouses all over Victoria. The company was established as a small family business in 1991 and has since grown in size. MGC has a large amount of long-term loan from Westpak Bank. The loan agreement puts certain restrictions on further borrowing possibilities of MGC. It also requires MGC to submit its audited financial statements to Westpak Bank by January 31 of every year until the loan is fully paid. 

MGC has a board of directors comprising five members. Two of the members of the board of directors were newly assigned to replace two former directors who resigned during the current financial year. The company does not have an audit committee. MGC's internal audit director reports to the board of directors. MGC has a clear and detailed organizational structure for its size and all major transaction classes, i.e., sales, purchases, payroll, etc. are supported by of-the-shelf software packages that have been sufficiently tested in the market. MGC employees receive necessary training on the computer systems before being assigned to duty.

MGC markets its products by emphasizing that it is a socially responsible organisation and highlighting its moral commitment to sell only products not tested on animals. This policy was introduced largely because a major shareholder with a controlling vote has advocated for it. This shareholder also contributes major input on all policy decisions of MGC.

MGC has two major product lines: (a) makeup, which includes a range of cosmetics and (b) gifts, including handmade soaps, shampoos and a range of other handmade products produced in developing countries from recycled materials. MGC sells its products through mail-order catalogue, retail stores, personal selling and online via its website. In recent years, MGC experienced a trend of decreasing sales through mail-order and personal selling whereas online sales has been on the rise.

MGC pays higher prices for some of its products for which alternative products with better value-for-money could be found in the market. MGC pursues this strategy in order to maintain its commitment with its suppliers who also depend on MGC. With this spirit, the company also pays to its suppliers in advance of placing purchase orders. This business practice has resulted in a large amount of advance payments to increasing number of suppliers worldwide.

Financials

Alex and his team of three staff auditors formulated the audit plan during the first half of November 2016. This task involved conducting risk assessment, determination of the overall audit strategy, and identification of key areas of audit attention. The audit team updated the audit plan as additional information was obtained during the audit. Exhibits 1 and 2 below present information extracted from the working paper for MGC audit.

Exhibit 1. Comparative financial statement information

Statement of financial position as at 30 June

	2016 $'000	2015 $'000	2014 $'000
Current Assets
Cash in hand	1920	1488	1855
Payments in advance	3428	2380	1882
Accounts Receivables	3804	2822	1704
Inventory	17894	13476	9876
Total current assets	27047	20166	15317
Non-current assets
Property, plant and equipment net of depreciation	17407	4944	4164
Long-term receivable	4104	5483	6540
Total non-current assets	21511	10427	10704
Total assets	48558	30593	26021
Current Liabilities
Accounts Payables	7866	6558	5465
Other current liabilities	9025	7523	5400
Total current liabilities	16891	14081	10865
Non-current liabilities
Long-term loan payable	18827	6102	4901
Total liabilities	35718	20183	15766
Net assets	12840	10410	10255
Shareholder's equity
Share capital	3000	3000	3000
Retained earnings	9840	7410	7255
Total Shareholders' equity	12840	10410	10255

Income statement For the Year ended 30June

	2016 $'000	2015 $'000	2014 $'000
Sales	35239	30726	24088
Cost of sales	27985	26303	19116
Gross profit	7254	4423	4972
Depreciation	2906	1825	1451
Inventory obsolescence	581	637	199
Marketing expenses	30	96	42
Administrative expenses	1721	1363	1601
Interest expense	678	264	180
Total expenses	5916	4186	3473
Profit before tax	1338	238	1499
Tax expense	468	83	524
Profit after tax	870	155	974

Exhibit 2:  Key ratios identified by the audit team

MGC's Key financial ratios				Industry Averages
	2016	2015	2014	2016	2015	2014
Current ratio (Note 1)				2.01	2.03	2.11
Quick ratio (Note 2)				1.15	1.01	1.1
Debt-to-equity ratio (Note 3)				0.65	0.52	0.49
Times interest earned (Note 4)				4.00	5.00	6
Ave. Coll. period (days) (Note 5)				32.00	31.00	30
Ave. pay. period (days) (Note 6)				30.00	22.00	22
Days to sell inventory (Note 7)				50.00	48.00	46
Gross profit Margin (Note 8)				24.00	25.00	30
Net profit Margin (Note 9)				6	7.5	9.2

Notes

1. Current ratio = (Total current assets/Total current liabilities)

2. Quick ratio = (Cash + accounts receivable)/(total current liabilities)

3. Debt to equity ratio = (Total liabilities)/total shareholders' equity

4. Times interest earned = (profit before interest and tax)/ interest expense

5. Ave. Collection period (days) = 365/[(Net sales)/(Trade receivables balance)]

6. Ave. payment period (days) = 365/[(Cost of Goods sold)/(Trade payables balance)]

7. Days to sell inventory = 365/[(Cost of Goods sold)/(inventory balance)]

8. Gross profit Margin = (Gross profit)/Net Sales

9. Net profit Margin = (profit after tax)/Net sales

Required to:

1. Identify the risk factors present in this audit engagement. Justify your answer.

2. Conduct the analytical review with key financial ratios and identify the key areas that merit special audit attention.

3. Recommend the overall audit strategy appropriate for this engagement. Justify your answer.