Question 1 (40 marks)
You are the audit manager of a medium-sized firm and have just received a package from Rachel Jones, the financial controller of KidSpace Ltd., an electronic toy manufacturer. This is your firm’s first year as auditor of KidSpace Ltd. The information below was prepared for a board meeting and Rachel, the acting Chief Financial Officer, felt it might be useful to you in preparation of the forthcoming audit for the year ended 30 June 2017.
| KidSpace Ltd. | |||
| Statement of Financial Position $’000s | |||
| Current assets | 2017 | 2016 | 2015 |
| Cash | 1,586 | 1,743 | 830 |
| Accounts receivable and other receivables | 13,734 | 11,200 | 9,623 |
| Inventory | 16,498 | 11,731 | 7,197 |
| Total current assets | 31,818 | 24,674 | 17,650 |
| Non-current assets | |||
| Property, plant and equipment | 14,606 | 12,840 | 9,572 |
| Long-term loan receivable | 5,200 | 3,600 | 3,300 |
| Intangible assets | 1,400 | ||
| Total non-current assets | 21,206 | 16,440 | 12,872 |
| Total assets | 53,024 | 41,114 | 30,222 |
| Current liabilities | |||
| Trade payables and other payables | 9,012 | 6,288 | 2,021 |
| Provisions | 4,875 | 3821 | 4577 |
| Total current liabilities | 13,887 | 10,109 | 6,598 |
| Non-current liabilities | |||
| Long-term loan | 20,000 | 16,000 | 12,000 |
| Total liabilities | 33,887 | 26,109 | 18,598 |
| Net assets | 19,137 | 15,505 | 11,624 |
| Shareholder’s equity | |||
| Share capital | 2,000 | 2,000 | 2,000 |
| Retained earnings | 17,137 | 12,505 | 9,624 |
| Total shareholder’s equity | 19,137 | 14,505 | 11,624 |
| KidSpace Ltd. | |||
| Income Statement $’000s | |||
| 2017 | 2016 | 2015 | |
| Sales revenue | 76,945 | 74,927 | 89,735 |
| Cost of sales | 51,840 | 51,765 | 63,066 |
| Gross profit | 25,105 | 23,162 | 26,669 |
| Depreciation | 5,595 | 4,332 | 2,796 |
| Inventory obsolescence | 990 | 1,173 | 670 |
| Selling expenses | 2,405 | 3,153 | 3,317 |
| Administrative expenses | 8,925 | 8,727 | 11,516 |
| Finance costs | 1,040 | 1,275 | 1,140 |
| Total expenses | 18,955 | 18,660 | 19,439 |
| Profit before tax | 6,150 | 4,502 | 7,230 |
| Tax expense | 1,518 | 1,621 | 2,386 |
| Profit after tax | 4,632 | 2,881 | 4,844 |
| Notes: | |||
| Trade Receivables | 12,034 | 10,655 | 9,300 |
| Pre-paids | 1,600 | 500 | 300 |
| Other receivables | 100 | 45 | 23 |
| Total Trade & other receivables | 13,734 | 11,200 | 9,623 |
| Inventory | |||
| Raw Materials | 6,599 | 5,866 | 3,845 |
| WIP | 4,333 | 2,588 | 1,550 |
| Inventory held for sale | 6,699 | 3,520 | 1,972 |
| 17,631 | 11,974 | 7,367 | |
| Provision for Inventory obsolescence | (1,133) | (243) | (270) |
| Total inventory | 16,498 | 11,731 | 7,197 |
| Ratios | 2017 | 2016 | 2015 |
| Profit ratio | 7.99% | 6.01% | 8.06% |
| Return on shareholder equity | 24.20% | 19.86% | 41.67% |
| Quick Ratio | 0.99 | 1.18 | 1.54 |
| Times Interest Earned | 6.91 | 4.53 | 7.34 |
| Accounts Receivable Turnover (times) | 6.78 | 7.51 | 9.33 |
| Asset Turnover | 1.45 | 1.84 | 2.94 |
| Inventory Turnover (times) | 3.50 | 5.35 | 8.76 |
During a brief telephone call with Rachel, you made the following notes:
1. One of the conditions of the long-term loan is that the company is not to exceed a debt-to equity ratio of 2:1 at any time and they must maintain a current ratio of 2:1. The loan is reviewed each year on 31 July.
2. Provision for obsolescence of finished inventory held for sale and work-in-progress is provided for at a flat rate of 10%. The amount provided in previous years was 20%. Rachel said that the company believes it has been overly conservative in previous years and 10% is a more realistic level, given the nature of its products.
3. To combat declining sales a senior management incentive scheme based on sales and profit levels was introduced in July 2016.
4. The long-term loan receivable is from a company involved in the development and production of computer software. It is owned by one of the directors.
Required:
a) Identify and explain what the inherent risks for KidSpace Ltd. that you will need to consider. (6 marks)
b) From the information provided, perform additional preliminary analytical procedures:
i) Simple comparison (3 marks)
ii) Current ratio (1 mark)
iii) Return on assets (1 mark)
iv) Gross profit ratio (1 mark)
v) Debt-to-equity ratio. (1 mark)
c) Drawing on information from a) & b), identify and justify:
i) Three key account areas that would require special attention during the audit of the 30 June 2017 financial statements. Also, indicate if those accounts are likely to be over or understated. (12 marks)
ii) Two key assertions at risk for each of those account areas. (12 marks)
d) Identify and discuss any going concern issues to be considered at this stage?. (3 marks)
