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.