You are the audit manager for Parker, a limited liability company which sells books, CDs, DVDs and similar items via two divisions: mail order and on-line...

You are the audit manager for Parker, a limited liability company which sells books, CDs, DVDs
and similar items via two divisions: mail order and on-line ordering on the Internet. Parker is a
new audit client. You are commencing the planning of the audit for the year-ended 31 May 2005.
An initial meeting with the directors has provided the information below.
The company’s turnover is in excess of Kshs85 million with net profits of Kshs4 million. All profits
are currently earned in the mail order division, although the Internet division is expected to return
a small net profit next year. Turnover is growing at the rate of 20% p.a. Net profit has remained
almost the same for the last four years. In the next year, the directors plan to expand the range of
goods sold through the Internet division to include toys, garden furniture and fashion clothes. The
directors believe that when one product has been sold on the Internet, then any other product
can be as well.
The accounting system to record sales by the mail order division is relatively old. It relies on
extensive manual input to transfer orders received in the post onto Parker’s computer systems.
Recently errors have been known to occur, in the input of orders, and in the invoicing of goods
following dispatch. The directors maintain that the accounting system produces materially
correct figures and they cannot waste time in identifying relatively minor errors. The company
accountant, who is not qualified and was appointed because he is a personal friend of the
directors, agrees with this view, The directors estimate that their expansion plans will require a
bank loan of approximately Kshs30 million, partly to finance the enhanced web site but also to
provide working capital to increase inventory levels. A meeting with the bank has been scheduled
for three months after the year end. The directors expect an unmodified auditor’s report to be
signed prior to this time.

Required:
Identify and describe the matters that give rise to audit risks associated with Parker .

Audit risks
1. Over-trading
The turnover of Parker is growing quite rapidly, although this growth is not matched in net profits.
The company has been expanding into the Internet, and plans to introduce other product lines
for sale in this division. There is the risk that the business will exhaust any cash reserves as it
continues to expand but does not generate sufficient additional cash to pay for that expansion.
In this situation suppliers may go unpaid and at the extreme the business will be forced into
liquidation. Therefore the financial statements may not adequately disclose doubts about going
concern.

2. Internet trading
The decision to expand the Internet business may cause other problems for Parker. Selling of
books and CDs appear to be related as they are both forms of entertainment and the customer
knows what the product is like. Selling toys may fall into a similar category, but garden furniture
and clothes are different. Garden furniture is bulky and will certainly cost more to deliver while
clothes are sold more on taste and a high level of returns can be expected. Specific risks with
this decision therefore relate to:
The overall ability of management to run the business given their apparent lack of knowledge of Internet trading.
The need to setup and manage systems for the sales of many new products.
The need to allow for a much larger volume of returns.
The possibility of inventory obsolescence if Parker overstocks on clothes which go ‘out of fashion’.

3. Control environment.
The whole environment in which the control systems should be operating appears weak. There
are errors in the systems, the extent of which is not known, and the directors and the accountant
do not appear to be inclined to attempt to remedy the situation. The skills of the accountant may
also be questioned because he appears to have been appointed not on merit, but from some
personal relationship with the directors. Other errors may also have occurred which have not
been detected. The risk is that the financial statements may have material errors in them.

4. Bank loan
The directors require additional finance to expand the business. To provide this finance it is likely
that the bank will require sight of the audited financial statements; the directors of Parker expect
the audit to be completed prior to meeting the bank. The auditor may need to write to the bank to
disclaim reliance on the audit report for the purposes of making a bank loan. There is a risk to the
audit firm of being sued if the bank relies on the report and sustains financial loss.
There is also a risk to Parker that the loan is not obtained and the company goes into liquidation.
The financial statements may need to be prepared on a breakup basis.

5. First year of audit
The audit is also risky for the audit firm because it is the first year of an audit and the client has
expectations about the type of auditor’s report to be produced. The accounting systems also
appear to be unreliable, again increasing the risk of material error. The audit firm must ensure
that sufficient time and resources are allocated to the audit to ensure that the audit opinion can
be supported. Pressure from the directors to complete the audit quickly will have to be resisted.

---

Wilfykil answered the question on April 12, 2019 at 09:32

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