Audit Risks and Procedures for Top Notch Homes Ltd. and Grove Clark Firm

Factors concerning auditors for Top Notch Homes Ltd.

Top Notch Homes Ltd. (TNH) is a privately owned company selling a luxury range of home equipment. Fiona Fielding, the daughter of the company’s founder, took over responsibility for running the company in December 2018. She has little management experience. Her main interest is in developing a new business line to broaden the company’s activities. She has no interest in day-to-day internal control activities preferring instead to adopt a more informal management style. Fiona found a supplier of a new design of hot tub in Norway. She immediately started to import these hot tubs financed by a substantial bank overdraft. The company sells to retailers at £2,000 per unit representing a typical mark-up of 100% on cost. At first sales averaged 50 units per month. Demand was so great that Fiona was forced to engage a second supplier in Finland but at a purchase cost of £1,500 per unit. That supplier required Fiona to sign a three-year contract committing to purchase 400 units per annum.In the last two months of the accounting period ended 31 December 2019, sales of the hot tubs have fallen significantly and the selling price has had to be reduced by 30%. The hot tubs are sold with a three-year warranty. Some of the units bought from Finland have developed faults which cannot be rectified on site. Customers have insisted that the faulty units be replaced or a complete refund given. Fiona is reluctant to tell the auditors exactly how many units have had to be replaced. At the year-end, inventory consisted of 200 saunas. Fiona is adamant that these should be valued at cost.Payments due to the suppliers have been delayed because there have been problems reconciling the invoices payable to suppliers with the deliveries received from them. The supplier in Norway is threatening legal action to enforce payment and the supplier in Finland is insisting on cash upfront before any more deliveries are made.REQUIRED:1. Identify EIGHT specific factors that should concern the auditors and explain why each factor is of concern?2. Outline FIVE substantive audit procedures that the auditors of TNH could undertake and explain the purpose of each.Grove Clark is a ten-partner accountancy firm. It has been approached by five potential audit clients and the partners are considering the independence and ethical risks associated with taking on these audits. Client A is a company in the financial services industry. Grove Clark have no experience in this industry but they would like to build up some expertise in this industry. The chief financial officer of Client A used to be a Grove Clark partner. Client B has been recommended to Grove Clark by Client H. Clients B and H are both in the manufacturing industry and have worked together on several large contracts. If Grove Clark accept Client B, Company H expect a discount on its next audit as commission for making the recommendation.Client C is a new company with ambitious plans for growth and stock market listing. Whilst Client C is currently exempt from statutory audit, the directors wish an audit to be conducted to make it easier to negotiate lending arrangements with its bank. A meeting with the bank has been scheduled for three months after the year-end and the directors insist that the audited financial statements with an unmodified report be available before the meeting. Client D is a start-up company owned and managed by a couple of scientist/inventors who have discovered a way of converting insects into food fit for human consumption. They need to be associated with a reputable accounting firm in order to approach large corporations for the finance needed to develop their scheme and as a result they are happy to pay a higher fee.Client E is a medium-sized I.T. company which has developed a new app for down-loading music from the internet. The CFO resents having to pay an audit fee and suggests instead that the audit fee could be taken either as new shares issued by Client E or by the firm agreeing to accept 5% of the profits generated by the new app. Required:a) For each potential client highlight any independence or ethics risks the partners should consider and why. In addition, suggest safeguards that could be considered to mitigate the relevant risksb) Explain what is meant by ‘professional scepticism’ and how it is relevant to the conduct of an audit of financial statements. You are the partner in charge of audit quality in your firm. There are five audit partners in the firm and you have reviewed the completed audit files of one client for each audit partner. In each case, an unmodified audit opinion was issued. You have found the following: Client A: faced severe cashflow problems just before the end of the financial year but the financial statements had been drawn up on the going concern basis. The directors had been in negotiations with the bank to seek additional funding. The negotiations were on-going at the time the financial statements were finalised. The directors refused to disclose anything about the liquidity crisis in the notes to the financial statements. Client B: a computer hacker had accessed and corrupted the accounting data in the accounts payable/suppliers’ ledger. There was no way of recovering the lost data. The audit partner had been persuaded that given this year’s high profit figure, the amount of possible misstatement of accounts payable would not be material.Client C: was in need of capital investment and the major shareholders had agreed in principle to inject new capital. The directors therefore produced the financial statements on the going concern basis; they have made full disclosure in the notes to the financial statements. The audit partner was satisfied that the additional information was sufficient.Client D: the audit team discovered a number of minor discrepancies that together would suggest that reported income might be overstated by 0.01%. Client E: your firm was appointed during the year following the sudden death of the previous auditor, a sole practitioner. Although it had not been possible to find evidence to support this year’s opening balances, the audit partner considered that the previous auditor was highly professional and therefore last year’s figures could be relied onRequired:a) For each client, indicate the extent to which you agree with the issuing of an unmodified audit opinion and explain why. Where you disagree, explain your reasoning and suggest a more appropriate form of audit opinionb) In addition to the auditors’ opinion, what other messages would readers expect to see in an audit report on a company’s financial statements?  You have recently been appointed the auditor of Freak Beans Ltd., which operates a chain of health food shops in the south-west of England. Originally, the company began 10 years ago with just one store catering to less conventional customers but with increasing concern about consumers’ health and the sustainability of food sources, the company attracted more mainstream customers. Demand in the last five years has grown to the extent that the company has opened a new store every year. Control is largely through the daily involvement of the owner, Mr. Semolina. Each store has a manager hand-picked by Semolina himself. Each is paid a basic salary with a generous profit-related bonus. Semolina believes this not only incentivises the managers to work hard but also to be honest – if they skim from the takings, their bonus will be reduced.The accounting and control systems have remained much the same as when only one store was operating. Semolina has noticed that one of his six stores routinely reports modest sales figures but high net profits; it has high inventory levels but not very much cash. Semolina is concerned but has been too busy to investigate fully. Semolina recognises the need to formalise the financial control systems especially as he is keen to continue to expand the business. However, he has no more of his own money to invest and does not want to increase the company’s indebtedness to the bank. One day, a friend of a friend introduced Semolina to a business contact, an overseas investor, John Sago. Semolina instantly liked Sago who seemed very knowledgeable about the health food industry and especially about the emerging market for hemp-based food supplements. Sago explained that UK and European regulations allowed the sale of certain hemp-based products. Sago went on to explain that he believed he had discovered a loophole in the regulations which allowed him legally to import and sell products that the regulators had yet to approve. These products could produce very high profit margins while they remained unregulated, but Sago warned that tighter regulations could be introduced in two or three years. Sago said that he could sign contracts of supply that very day and he urged Semolina to act fast. As if to demonstrate his credentials, Sago showed Semolina a briefcase full of cash. On the spot, Sago offered to invest £1million for a 10% stake in Freak Beans Ltd. Sago said that his offer would stand until the end of the week; Semolina could either take it or leave it.Semolina comes to you, as the auditor, for advice.Required:a) From the above scenario, what are you principal concerns about your new client and his request for advice?