Internal Control Weaknesses and Audit Risks in Two Companies: Lawsons Ltd and Madestone Ltd

Lawsons Ltd

1. Lawsons Ltd is an IT maintenance company located in Wales. The company has contracts with a number of schools and colleges as well as local businesses. The company has been trading for 15 years and is run by Chris Freeman who is also the majority shareholder. The company is exempt from statutory audit but Chris has appointed auditors in respect of the year ended 31st March 2019 because he needs audited accounts before meeting with his bank to discuss options for funding his growth. 

Chris employs two full-time administrators and has three full-time and two parttime IT engineers working with him. Chris is very involved in the service side of the business, far more than the administrative side. The company is run from a small office bought in 2007 for £300,000 which is still its value in the financial statements. A similar property nearby sold recently for £185,000. 

Chris is responsible for following up on all enquiries and quoting for work. He visits all potential clients and offers them on the spot quotations. The quotes are recorded in his diary and passed on verbally to the office. If the quote is accepted then Chris either takes the job himself or allocates it to one of the other engineers. All engineers must keep an online diary detailing their visits. Once the work is complete a work summary is prepared by the engineer, signed by the customer and then passed to the office administrators who will raise an invoice. No credit checks are carried out on new customers and although the invoices all state payment is to be made within 30 days, there is no credit control carried out. 

During the company audit in respect of the year ended 31st March 2019 the audit junior found four work summaries for work carried out but had not been invoiced. The estimated invoice value is £35,000. In addition the audit work discovered that of the £150,000 trade receivables owed to the company at the year-end, 40% had been outstanding for more than 30 days and half of these were more than 90 days overdue. 

Required

a) Identify the internal control weaknesses in the sales system at Lawsons Ltd and the subsequent risks to sales and trade receivables as a result of these weaknesses. Make recommendations to rectify the weaknesses identified.

b) What risks are associated with the valuation of non-current assets and what audit work should an auditor take in response to these risks?

Identifying Internal Control Weaknesses and Associated Risks

2. Madestone Ltd is a company based in the South of England. The company manufactures and sells agricultural machinery. The company has been trading for 50 years; the majority shareholder is the original founder of the company, Max Madestone. The remaining shareholders are all family members. Max Madestone is no longer involved in the day-to-day running of the company. His nephew Samuel Madestone is the managing director. Max’s daughter, Daisy, is the finance director (FD). Daisy is a qualified chartered accountant and has been FD of the company for almost 10 years. Madestone Ltd prepares its financial statements each year to 31st December and has been subject to an audit for the past 20 years. During the year ended 31st December 2018 the company changed its auditor to Treby and Sons, a local sixpartner firm with experience in the farming industry.

Dawn Harrow is the audit partner for the audit of Madestone Ltd and from her meetings with the directors of Madestone Ltd she has learnt: 

1) The most active overseas market is the US and Canada which has continued to see growth during the year ended 31st December 2018 with a 6% increase in sales compared to the previous year. The European market in contrast has struggled during the year, resulting in a 15% fall in sales compared to the previous year. The UK sales market has seen a 2% reduction in sales.

2) Concerns over the uncertainties around the European market have led the company to seek to expand in other parts of the world such as Mexico and Latin America. The directors are aware that there are some large competitors already active in these parts of the world but think there is market share to exploit. Daisy and Samuel have carried out extensive research on the areas and put together a detailed business plan. They have agreed to meet with the bank once the current audit is signed off to seek funding. Treby and Sons have provided support to Madestone Ltd in preparing their business plan although Dawn Harrow has not been involved.

3) During the year ended 31st December 2018 the company signed a significant contract with a customer in Canada to manufacture and supply 100 new agricultural machines over a 5-year period.

4) Madeston has warehouses in the UK, in the USA and in Germany. Manufacturing takes place exclusively in the UK and the factory will shut down completely over the period from 24th December to 2nd January.

Recommendations to Rectify Weaknesses

5) Madestone Ltd owns the factory in the UK but leases all the warehouses. 

Required:

a) Consider all the information above and prepare a memo detailing the potential audit risks that Dawn Harrow should consider in planning the audit of Madestone Ltd for the year ended 31st December 2018. You should explain why the issue may pose an audit risk and the additional information required or action to be taken in response to the risk. (

b) What factors should the auditors take into account when setting the materiality level?

3. You are the partner in charge of five clients which all have March 31 yearends. Each of the audits has now been completed and you are currently reviewing the files of audit work and need to decide on the appropriate audit opinion in each case.

Client A: suffered a serious decline in sales after alarm in the media about the safety of its products. It required extra short-term funding from the bank to pay creditors. Sales continued to fall after the year-end. There is no possibility of shareholders contributing more capital. The financial statements have been drawn up on the going concern basis. The directors refuse to disclose anything about the liquidity crisis.

Client B: a computer malfunction resulted in the loss of some of its accounting records relating to one of its branches. There is no back-up or other data-recovery method available. The area involved is considered material but not fundamental to the financial statements.

Client C: the audit team discovered a number of minor discrepancies which in total produce an understatement of 0.5% of net income. The draft financial statements have been sent to the printers and the chief financial officer refuses to adjust the figures.

Client D: your firm were appointed during the year after the previous audit firm resigned suddenly. It is not possible within the budget to audit the brought forward figures from the previous year.

Client E: is in the process of restructuring. It needs additional loans and is currently seeking out potential lenders. The directors consider that a lender will be found and have drawn up the financial statements on the going concern basis; they have made a full disclosure in the notes to the financial statements with which you cannot find fault. 

Required:

a) For each client, indicate which type of audit opinion should be given and explain your reasoning.

b) In addition to the opinion paragraph, what other information can readers expect to see in the auditors’ report on financial statements?

Madestone Ltd

4. You have been engaged by a firm of registered auditors, KPDE, to advise on a number of their audit clients whose case files have been selected for investigation by the audit regulatory authorities.

Client O: is a large listed company that engaged specialists from KPDE to devise a valuation for intangible assets. The monetary figure that the KPDE team calculated was included in the financial statements that the KPDE audit team audited.

Client P: was brought to the stock market in an initial public offering in the last 12 months. As a private company, Client P was seen to be a rising star much talked about in the offices of KPDE. A number of KPDE staff, both audit and other departments, subscribed for and received Client P shares when the company went public. KPDE audited Client P’s financial statements before and after public listing.

Client Q: dismissed its chief financial officer for misconduct just before its year-end. KPDE seconded a senior staff member and two juniors to help Client Q with its year-end financial statement preparation. KPDE are now planning the audit of those statements.

Client R: Patrice Ho had been the partner in charge of Client R’s audit. She had become disappointed with KPDE’s management style and looked for a career change. She recently resigned from KPDE and took up the position of Client R’s Chief Finance Officer.

Client S: the KPDE audit partner has had serious disagreements with the management of Client S over their selection of accounting policies which she regards as optimistic. She has been told bluntly that if she does not agree with the management of Client S, they will find another audit firm to conduct the audit. 

Required:

a) For each of the above client situations, explain what ethical issue(s) are at stake and what KPDE might have done to reduce the threat to their audit independence.

b) What can audit firms do to try to ensure that audit staff understand the importance of audit independence?

5. Despite the increase in audit regulation over the past 20 years, audit scandals continue. Discuss possible reasons for this phenomenon and what further action might be taken to reduce the risk of future scandals.

6. The dominance of the Big 4 accounting firms and the lack of competition in the audit market is perceived by many as a barrier to improving audit quality. To what extent do you believe that this is true, and why?

7. Explain to a non-accountant how the audit of financial statements is worth the cost of the audit fee that for a large client can often amount to very significant sums of money.

8. Describe and critically evaluate how the legal duty of care owed by auditors to third parties has changed over the years.