It is 1 July 20X5. You are an audit supervisor of Brooklyn & Co and are planning the audit of Harlem Co for the year ending 30 September 20X5. The company has been a client of your firm for several years and manufactures car tyres, selling its products to wholesalers and retailers. The audit manager attended a planning meeting with the finance director and has provided you with the following notes of the meeting and financial statement extracts:
Planning meeting notes
Harlem Co sells approximately 40% of its tyres to wholesale customers. These customers purchase goods on a sale or return basis. Under the terms of the agreement, wholesale customers have 60 days during which any returns can be made without penalty. The finance director has historically assumed a return rate of 10%, however, he now feels that this is excessive and intends to change this to 5%.
The company purchased a patent on 30 September 20X4 for $800,000, which was capitalised in the prior year as an intangible asset. This patent gives Harlem Co the exclusive right to manufacture specialised wet weather tyres for four years. In preparation for the manufacture of the wet weather tyres, this year the company conducted a review of its plant and machinery. As part of this review, surplus items of plant and machinery were sold, resulting in a loss on disposal of $160,000.
In May 20X5, the financial controller of Harlem Co was dismissed after it was alleged that she had carried out a number of fraudulent transactions against the company. She has threatened to sue the company for unfair dismissal as she disputes the allegations. The company has only recently started to investigate the extent of the fraud in order to quantify the required adjustment.
A problem occurred in June 20X5, during production of a significant batch of tyres, which affected their quality.
The issue was identified prior to any goods being dispatched and management is investigating whether the issues can be rectified and the tyres can subsequently be sold.
Harlem Co's finance director has informed you that in March 20X5 a significant customer was granted a payment break of six months, as it has been experiencing financial difficulties. Harlem Co maintains an allowance for trade receivables and it is anticipated that this will remain at the same level as the prior year.
The report to management issued by Brooklyn & Co following last year’s audit highlighted significant deficiencies relating to Harlem Co's purchases cycle.
The finance director has informed you that the company intends to restructure its debt finance after the year end and will be looking to consolidate its loans to reduce the overall cost of borrowing. As a result of the planned restructuring of debt, Harlem Co has not paid its shareholders a dividend this year, choosing instead to undertake a bonus issue of its $0.50 equity shares.
You have been asked by the audit manager to complete the preliminary analytical review and she has
provided you with the following information:
Financial statement extracts for year ending 30 September
| | Forecast 20X5 ($'000) | Actual 20X4 ($'000) |
| Revenue | 23,200 | 21,900 |
| Cost of sales | (18,700) | (17,300) |
| Gross profit | 4,500 | 4,600 |
| | | |
| Finance costs | 290 | 250 |
| Profit before tax | 450 | 850 |
| | | |
| Intangible asset | 800 | 800 |
| Inventory | 2,100 | 1,600 |
| | | |
| Long and short-term borrowings | 13,000 | 11,000 |
| Total equity | 10,000 | 9,500 |
The audit assistant has already calculated some key ratios for Harlem Co which you have confirmed as accurate. She has ascertained that the trade receivables collection period has increased from 38 to 51 days.
Scenario 1: requirements
a) Describe the auditor’s responsibilities in relation to the prevention and detection of fraud and error.(2 marks)
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