Background of Plush Limited
It is now 30 November 2021 and you are part of your firm’s team engaged on the audit of the financial statements of Plush Limited (Plush) for the year ended 30 September 2021.The company is a new client of your firm and the following points are pertinent to the audit.
1) Plush is a UK retailer with a chain of shops selling jewellery, gem stones and watches. In its early years of trading, the company profited well from the buoyant conditions in the UK economy. In more recent years, it has bucked the trend of poor performance by high street retailers, by combining very effective discounted purchasing activity with some excellent marketing strategies.
2) It was founded 1997 by Ali and Lucy Plush, a married couple who are joint Chief Executive Officers and two of the four directors of Plush .They each own 40% of the company's share capital. The remaining 20% is owned by several other individuals who aren’t employees of Plush and are unrelated to Ali and Lucy. In 2018 Plush paid £1,200,000 for a minority shareholding in an overseas company called Whim Ltd, a holiday villa and apartments developer. Up to the time of Plush purchasing its shares and through 2019 Whim Ltd was profitable but since then it has incurred very heavy trading losses and continues to operate in an extremely competitive market place in difficult market conditions.
3) You firm was appointed as the company’s auditors in March 2021 following a loss of confidence by its directors in the previous auditors. This was because in the first instance, contrary to the directors’ Expectations the auditors had refused to write a letter of support to Plush’s bank to accompany the company’s application for an increased bank overdraft facility ( the increased facility was granted eventually ) and in the second, the auditors had failed to detect a fraud perpetrated against Plush by the company’s finance and operations directors, acting in collusion. The fraud resulted in over-reimbursements of business travelling expenses to the operations director during the year ended 30 September 2020. The consequent overpayments and losses by Plush amounted to £4,874.
Ali and Lucy only became aware of the fraud when they were approached by a loyal employee who became suspicious about the directors’ actions when he heard them chatting about the company’s expenses reimbursement policy; and though both directors were dismissed for gross misconduct in this respect, no action was taken to recover the monies because the ( now former) operations director is Ali’s brother.
Pertinent Information regarding Plush Limited
Discovering that the company had been defrauded by their fellow directors (since replaced) was a shock for Ali and Lucy in that they had fully Expected the auditors to detect the fraud. It was also a chastening experience which made them think carefully about the way the company was being run. They’d thought the auditors had been negligent in not detecting the fraud and reflected about other possible problems at the company not picked up by the auditors which could result in further damage, issues and losses for the company .Therefore, they resolved to move forward with a new approach to the way they governed the company and part of this new approach was to find a new firm of external auditors with an Expectation of working with the firm in an informal directors/ external auditor working partnership; working closely together for the greater good and future prosperity of Posh. Following a series of pitches to the company’s directors for the appointment, by three audit firms including your own, your firm was engaged as the company’s new auditors. One of the directors’ Expectations of your firm is that it will be more vigilant than the previous auditors when carrying out its audit procedures and so be certain to detect any fraudulent acts perpetrated against Plush by any of its directors and employees.
4) When chatting to your firm’s audit manager Ali and Lucy commented that they understood the need for auditors to adopt a suspicious approach when obtaining whatever audit evidence they obtain to meet objectives, and Expected your firm to adopt this approach given the earlier incidence of fraud by two former directors.
However, they also have Expectations that as they are the joint majority shareholders in Plush, your firm should place a high degree of trust in the reliability of any written and verbal representations made by them when obtaining audit evidence.
In later discussions with the manager, the new financial director (Amalia Smart) stressed all the directors felt that Ali and Lucy’s Expectations in this respect were justified because Ali and Lucy have nothing to gain by being untruthful when communicating with external auditors; and such an approach would mean your firm could spend less time on the audit and allow a consequent reduction in the audit fee.
Similarly - and again something which Amalia discussed with your firm’s audit partner prior to the commencement of the audit - Ali and Lucy cannot see any need for your firm to have any concerns about the business risk profile of their company, but if it does then they’ll Expect the audit team to access the register of business risks faced by Plush, as maintained by Ali, so enabling the audit team to explore significant business risks Plush faces in every area of its operations at every level. Compiled by Ali over the last 15 years and reviewed and updated regularly following discussions with his co-directors, senior employees and external consultants; the computer-based register contains details of significant business risks including the likelihood of the linked threat materialising into an event or activity which will adversely impact Plush, the potential effect on the company’s day - to - day operations at branch shop level and the measures in place to avoid or reduce the risk. As mentioned by Amalia, though not understanding the need for your firm, as Plush’s external auditors, to explore the consequences of every business risk faced by Plush, Ali and Lucy Expect your firm’s audit partner to attend the company’s board of directors’ meetings and be part of Plush’s executive decision making process with regard to risk avoidance ad mitigation matters.
Appointment of new external audit firm
5) The company has eight branch shops located in large cities throughout the UK. Each of the branches employs a manager who is assisted by one full - time and one part-time (Saturday only) assistant. Staff at each branch are entitled to individual wages bonuses based on monthly sales. Approximately seventy per cent of the company's sales are made to individual shoppers at the branches with some twenty per cent coming from its internet sales operation and approximately ten per cent from wholesale exports to various independent boutique design jewellery shops located in France , Germany and Italy. Conversations with Ali revealed that since the UK left the European Union, exports to these countries have decreased significantly so he has been looking to other export markets, including Asia and Indonesia to try to replace the lost sales.
6) Plush purchases most of its merchandise (goods for resale) from Africa, Sri Lanka and China. As a consequence of this, the vast majority of its purchase invoices are invoiced to the company in foreign currency. The company pays the invoices in foreign currency, by bank credit transfer.
7). In May 2021, with a view to improving the company's gross profit margins - by selling in - house crafted jewellery, the company issued extra share capital to all existing shareholder such that all owned the same proportion of the company’s shares before and after the issue; and Ali and Lucy also made a long-term loan of £80,000 to Plush. They re-mortgaged their home to put their monies into the company.
The additional share capital and loan financed the setting up of a jewellery workshop operation. This involved converting the upper floor accommodation at two of the branch shops into workshops, and employing four jewellery makers at each to make nine- carat gold rings, gemstone necklaces and bracelets from imported raw material components. The workshops were opened on 1 July 2021, with each of the eight jewellery makers attracting a gross salary cost of £40,000 per annum for Plush from that date. Both workshops have expensive fittings and security features and are kitted out with brand new expensive high technology cutting, colouring and fixing equipment - some items of which are very small, transportable and easily damaged.
Additionally, contracts were signed with three separate independent jewellery making companies - each with their own workshop premises - to produce hand-crafted jewellery for Plush. The contracts include a clause that raw materials paid for by Plush will be delivered to the dealers for safekeeping, held as inventory on behalf of Plush and used in the production of merchandise but at all times the inventory remains the property of Plush, with Plush retaining all legal rights of ownership. Lucy has estimated that in terms of value, at any one time approximately fifteen per cent of Plush’s total inventory is held in the independent jewellers' and company workshops.
Expectations of Plush's Directors
8) Ali and Lucy, all branch managers and five head office staff employees are each provided with a company car. Lucy mentioned in a meeting with the audit manager that all branch staff had received an annual increase on their basic pay of 3% as compared to the previous year.
9) Amalia Smart is the daughter of Lucy’s best friend. With the support of two full - time and one part-time accounts assistants, she prepares the company's monthly and annual financial statements using a highly complex computer-based accounting system which was installed in January and ran live with effect from 1 February 2021, fully replacing the old outdated system from that date. Amalia previously worked as an audit assistant at your firm. She is a friendly individual age 27 years, who left school with 3 Advance Level certificates including one in Accountancy. However, she lacks drive and ambition as evidenced by her very limited progress with her professional accountancy exams (ACCA), after eight years of trying. Disillusioned by this, and attracted by the prospect of being provided with a company car, in May 2021 Amalia commenced employment with Plush. Lucy and Ali consider Amalia to be a charming and delightful young lady and certainly someone who will always work in the best interest of Plush. Your firm was sorry to see her leave because she was a reasonably effective employee despite possessing a rather lazy approach to keeping up-to-date with developments in accounting standards.
10) During a conversation with Felix Forraduke who is a member of your firm’s audit team, one of the accounts assistants remarked:
“The idea that your audit team use assertions when auditing our company's financial statements is silly. You’re just auditing the figures disclosed in the financial statements to make sure there’s no errors of any kind in them, aren’t you? Plain and simple - you’re not bothered about anything else - it’s the figures you focus on and any errors in them! To say you’re using ‘assertions’ confuses people with jargon and makes an audit sound more difficult than it really is – the only time auditors are interested in assertions is when they make them in their auditor’s report about the honesty of the directors and the company’s performance“.
11) In March 2021, Plush commenced a refurbishment (improvement), repairs and decoration programme of its branch shops, using a national firm of shopfitters to carry out the work. The objective of the programme is to remodel each shop both internally and externally to attract more customers and generally improve the “customers’ shopping experience". To date, works on three of the company's shops has been completed and two others are in the midst of being remodelled. Expenditure incurred on the programme is considered to be material in the context of the company's financial statements.
Business Operations of Plush Limited
12) In August 2021, when discussing the planning of the year- end inventory count with your firm’s audit partner Ali commented:
"we normally close our shops on the last day of the financial year to enable branch employees to carry out the inventory count in accordance with laid down procedures. A member of our head office staff is normally there to supervise, but as members of your team will be there this year, we’d like them to supervise the count. This will be much more efficient in terms of time and cost for Plush and you can have extra confidence in the count because of your firm’s extra involvement. Actually, as your firm will be responsible for the financial statements it makes much more sense for your staff to supervise the count and value the inventory as well. I’ll be much more comfortable with this arrangement, as we always struggle with the valuation process because we’re not usually great with the valuation computations. We'll obviously pay your firm the extra fee for carrying out this extra work – just let me know how much it will cost”.
13) In July 2021, a shopper was badly injured when visiting a branch shop being refurbished, because a heavy piece of a scaffolding fell onto her. As a consequence of her injuries it is likely that she will have to endure a prolonged unpaid absence from her place of work. So, she has lodged a claim for compensation against Plush in the sum of £80,000 for negligence on its part in not ensuring adequate safety measures were in place to protect her as a customer at the shop. The company's legal adviser, Mel Moskolo, is a close friend of Lucy and a recently qualified commercial solicitor specialising in property conveyancing at a small firm of solicitors. Mel supports Plush’s view that the company was not negligent, but has informed Plush’s directors that a without prejudice/ no blame compensation offer of £25,000 to settle the claim is probably the best way to bring the matter to swift expeditious closure and so avoid potentially higher further litigation costs in defending against the claim. She has entered into detailed correspondence with the claimant's firm of solicitors in this regard, and has provided Plush with copies of all correspondence between the two firms. The claimant's solicitors are adamant that Plush was negligent and are threatening to commence court proceedings imminently against the company unless their client’s claim is paid. However, in line with the directors’ opinion and consistent with Mel’s advice, the company has not made any provision for the claim in its year-end financial statements. Amalia has told your firm that it’s the director’s decision entirely as to whether a provision should be made for the claim in Posh’s financial statements. She stated there is no accounting standard ruling that a provision should be made and the directors consider that actually making a provision in respect of the incident for any amount of damages is tantamount to accepting liability for the customer’s losses caused by her injuries, and will weaken the company’s defence if the claim reaches court. Ali, Lucy and Amalia believe they are acting in all shareholders’ interests in not including any provision and they’re confident the owners of the remaining 20% of Plush’s shares would fully understand and agree with them about this – even if the claim proceeds to court and the company loses the case.
14) The draft financial statements of Plush for the year ended 30 September 2021 report a retained profit for the year of £378,000 and profit before tax of £611,000, with all jewellery workshop revenue and capital costs being amalgamated with branch shop revenue and capital costs. The planning materiality threshold for the audit has been set at 5 % of profit before tax.
1. Explain as to whether or not the Expectation of Plush Limited’s directors are reasonable; in the context of external auditors’ responsibilities and duties generally with regard to :
a) The actions of the previous auditors in not providing a letter of support to Plush Limited’s bank and not detecting the directors’ fraud; your firm’s vigilance to ensure fraud detection, and its audit approach when obtaining evidence.
b) The directors working closely in an informal working partnership with your firm for the greater good and prosperity of Plush limited, your firm placing a high degree of trust in the verbal and written representations of the directors, using the company’s business risk register and attendance by your firm’s audit partner at Plush Limited’s board of directors’ meetings. (36 marks)
2. State with your reasoning whether your firm should have supervised Plush Limited’s year-end inventory count and valued the inventory as suggested by Ali. (5 marks)
3. Comment with justifying rationale as to the validity of the remarks by the accounts assistant to Felix Forraduke about the use of assertions by the audit team. (17 marks)
4. For this requirement you must answers only (i) or(ii)
(i) Identify any audit concerns arising from the fact that a new computerbased accounting system has been implemented by Plush Ltd, with effect from 1 February 2021, and state the effect that this should have on your firm's' approach to auditing the company's financial statements for the year ended 30 September 2021.
((ii) Identify and justify in full, any concerns your firm should have in connection with the absence from the financial statements of a provision for a liability in respect of the compensation claim by customer injured at a branch shop. You must explain how this should affect your firm’s approach to this part of the audit, taking into account the view held by Plush Limited’s directors. (7 marks)
5. Identify FIVE situations from which a business risks arises for Plush Limited which your firm would need to consider when assessing the inherent risks attached to the financial statements of Plush Limited for the year ended 30 September 2021. For each risk situation identified state the business risk, and explain the linked inherent risk - being the audit concern(s) with regard to its effect on the company’s financial statements.(20 marks)
6. Carry out an analytical review of the Summary Financial Statement of Plush Limited (in the appendix below) for the year ended 30 September 2021 and identify any five specific areas which would cause particular audit concern about material misstatement. For each area identified explain the nature of the concern and support your comments with relevant calculations as appropriate. (15 marks)