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Background

You are an experienced audit manager at Samway Baker Fitzgerald (SBF), an accounting firm with offices in Orange, Wagga Wagga, Tamworth, Port Macquarie and Albury in NSW, Toowoomba in Queensland and Ballarat in Victoria. In the next 18 months, you hope to be promoted to partner at the Orange office. Although a medium sized firm by national standards, SBF includes Australia’s largest regionally based auditing practice. Most of SBF’s audit clients are in the mining, manufacturing, and agriculture industries. For various reasons all of those industries are currently under pressure—mining from a downturn in commodity prices, manufacturing from fierce overseas competition and agriculture from a devastating drought that continues to grip Eastern Australia.

It’s just before Christmas and you are meeting with your audit senior, Wayne Wiadrowski, to finalise planning the audit of Always Precise Instruments Pty Limited (API), a manufacturer and supplier of small arms military equipment (i.e., rifles, machine guns, ammunition) with factories in Wagga Wagga and Toowoomba and warehouses in Sydney, Brisbane, and Perth. Using the company’s financial report, its budget for 2018 and industry benchmarks, as well as your 5 years of experience on the API assignment, Wayne has compiled the following information:

Ratio	2018 (Unaudited)	2018 Budget	2017 (Audited)	Industry benchmark
Current ratio: 1	1.64	1.54	1.54	1.84
Quick asset ratio: 1	0.91	0.87	0.87	1.1
Return on equity %	14.7	18.4	16.6	17.3
Return on total assets %	12.5	16.0	14.9	16.3
Gross margin %	6.5	10.8	10.3	10.8
Marketing expense %	4.4	3.6	3.8	4.0
Admin expenses/sales %	3.4	3.4	3.6	3.8
Times interest earned	3.6	6.3	4.6	4.2
Days in inventory	34.9	32.2	32.9	31.8
Days in accounts receivable	53.0	49.8	51.5	46.9
Debt to equity ratio: 1	0.61	0.43	0.52	0.50

The business environment

Although API is one of only a few military equipment manufacturers and suppliers in Australia, the Australian Government is seeking to control defence budget costs and has recently awarded some contracts to overseas manufacturers. Consequently, API has been trying to cut costs to remain competitive and profitable. The company did not reach industry benchmarks with regard to profitability in the previous year and budgeted to do better in the current year. It thought that it could do so by keeping its costs down in relation to sales while allowing its gross margin to drop, evidently planning to generate a larger volume of sales. The company also planned to improve its working capital management by reducing levels of inventory and accounts receivable. It budgeted for a drop in debt levels, indicating that it expected to produce a healthy cash flow to enable it to do so.

Inventory system

API relies heavily on a range of sub-contractors to supply raw materials for the approximately 160 inventory items it produces, as well as suppliers for the 25 finished goods (mostly ammunition) inventory items it resells. 45 sub-contractors and suppliers are used and all have proven to be reliable. Separate systems, staff, and warehouses are maintained for both raw materials and finished goods.

Procedures for raw materials

Purchase orders are automatically generated by the computer when stocks of any raw material fall below 70% of the prior month’s usage. The purchase orders contain the following details:

• date
• supplier name and address
• raw material needed

Three copies of the purchase order are produced and distributed as follows:

• Copy 1—to warehouse to enable follow up of late orders
• Copy 2—filed by accounts clerk in date order
• Copy 3—sent to supplier

When raw material stocks are received, the barcodes attached to the delivery boxes by the supplier are scanned into the system. A two-part Goods Received Note (GRN) is then produced:

• Copy 1—matched to warehouse copy of purchase order by stores staff
• Copy 2—filed by accounts clerk

The scanning process is stopped if the codes do not match those on the Masterfile.

Procedures for finished goods

Production orders are automatically generated when finished goods fall below 60% of the prior month’s sales. The production orders contain the following details:

• date
• sub-contractor’s name
• raw materials required
• finished goods needed.

Two copies of the production order are produced:

• Copy 1 - to raw materials store for use as a picking slip
• Copy 2 - filed by production controller in date order.

When the finished goods stocks are received, the barcodes attached to the delivery boxes by the supplier are scanned into the system. A two-part GRN is then produced:

• Copy 1 - matched to production controller’s copy of production order.
• Copy 2 - filed by accounts clerk.

The scanning process is stopped if the codes do not match those on the Masterfile.

General notes

The computer automatically selects the supplier of both raw materials and finished goods based on:

• the latest price (as per their most recent invoice).
• their delivery times (based on the number of days between the date the purchase/ production order is raised and the date the goods are scanned by the warehouse).

Password access is as follows:

Staff	Password access to
Stores staff (raw materials)	Purchase order printing for raw materials only. GRN printing for raw materials.
Stores staff (finished goods)	GRN printing for finished goods.
Production controller	Production order printing, Masterfile amendments.
Accounts clerk	Masterfile amendments.

Masterfile amendments

The stock Masterfile contains details of:

• existing stock items including codes and warehouse location;
• approved suppliers and sub-contractors.

Orders will only be generated to suppliers and sub-contractors recorded on the Masterfile. Masterfile changes are made by the production controller for both raw materials and finished goods inventory. A Masterfile amendment form is completed by the production controller as a record of the changes made.

Stock listing

To support stocktakes, the inventory system can produce a complete stock listing at any time showing:

• stock code
• quantity held by location
• total quantity held
• cost per unit
• total cost per stock item

The inventory system also produces a stock sheet report for each location, which lists a description and the stock code of each item held at that location, matching the perpetual records. Quantities are not included, as these are completed by the count teams.

Required

Write a memo to Wayne Wiadrowski that addresses the questions below. Use the required format to answer each question.

Question 2 8%

Identify the internal control weaknesses in the inventory system outlined above and the potential audit risk. For each potential audit risk, outline an audit procedure that could be undertaken to reduce that audit risk. Answer this question using the following headings in a table:

Internal control weakness	Audit risk	Audit procedure to reduce risk

Answer 1

Sr. No.	Internal Control weakness	Audit risk	Audit procedure to reduce risk
1	Lack of control as to authorization of transactions	Inherent risk	Authorization of transactions should be done depending on the size of business,level of authority to avoid extra spending on resources
2	Quotation	Inherent risk	Where finished goods are purchased for an amount say, more than $ 2000,more than one quotation for the same should be acquired so as to be cost effective.
3	Physical inventory count	Control risk	It ensures that the companies inventory management system is up-to-date and the goods are not lost or stolen.
4	Lack of periodic audit counts	Detection risk	Bills of raw material, materials which have been scraped, materials which have been transferred from one warehouse to the other should be periodically audited so as to locate errors or any overstatements or understatements of materials in inventory.
5	Password access	Control risk	Masterfile ammendments provide access to Stock items, their location, suppliers etc. The functions of an accounts clerk should be restricted to passing of appropriate accounting entries and should not be given access to alterations in masterfile as the data can be easily changed without any person being aware of it.