King Appliances Limited Case: Audit Planning Memo

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in KAL. Ashley and Bradley King are considering the idea of selling their shares of KAL to Paul at an agreed purchase price based on a multiple of earnings. When this proposal is taken into consideration it seems logical to use earnings to determine an appropriate materiality. Using professional judgment and experience it seems appropriate to base the overall planning materially on 5% of the average income before tax from the years 2014 and 2015. Since the purpose of this audit is to verify that the agreed purchase price is based on accurate earnings figures, Ashley and Bradley will be extremely sensitive to small differences in the earnings. Therefore, the CPA student’s calculation of materiality should not be used as used 9% of net income before tax, which is at the higher end of the suggested range. Further basing materiality on the average income before tax from 2014 and 2015 allows the materiality to be set using a more normalized figure then solely using 2015 earnings before tax. The calculation of materiality is presented below.

Materiality = 5% x (894,000+1,551,000) = 122,250 ~ 122,200 rounded down

The importance of the accuracy of the earnings before tax combined with the moderately high level or risk determined in the risk assessment eludes to the conclusion that performance materiality should be set low. Therefore, Performance materiality would be calculated as 50% of planning materiality as shown below.

Performance Materiality = 50% x 122,200 = 61,100 ~ 61,000 rounded down

Both overall and performance materiality figures are subject to change as necessary during the progression of the audit progresses.

Accounting Issues and Their Impact to the Financial Statement

Revenue recognition for maintenance contracts

Revenue earned from maintenance service contract is not recognized at the end of the year even though cost of $98000 has incurred for providing maintenance service to their client. So revenue has been understated partially. According to the revenue recognition policy, revenue must be recorded when earned. As customer would need maintenance service every three months for their freezer to keep in running order, so by the last half of year 2015 maintenance service would have been provided twice to the customers. Fixing this issue will increase revenues; thereby it will increase the value of the business and the purchase price that Paul would have to pay both Ashley and Bradley.

Audit procedure

The audit procedure for maintenance contract is to recalculate the revenue recognition, which will test the valuation assertion of revenue account and is outlined below.

This is the actual revenue received from selling maintenance service contracts for two years: $2500*200=$500000).

By the last half of year 2015, revenue is partially earned as we are assuming maintenance service is provided twice as to keep those freezers in running order maintenance is required every three months.

The amount of revenue that should be recognized and recorded: $500000*6/24=$125000.

Government grant

Government grant received from the provincial government of $300000 for three years is not correctly recorded under revenue. They have just recognized $10000 of government grants for the year 2015 whereas the actual amount of $100000 is to be recognized and recorded. As of 2015 we are assuming they maintained the required workforce to be eligible for government grants, so they should recognize $100000 in the year 2015.

Audit Procedure

The audit procedure would be confirmation with the government about the grants, enquiry with HR about the workforce. This will test both valuation and existence assertion.

Inventory Assets

The amount stated for inventory possibly understated by $100000 due to the fluctuation, and there was no inventory count at the end of December and completely relied on software. If ending inventory is understated, it will overstate the cost of sales thus profit will be understated which in turn will lower the purchase price of the company.

Audit Procedure

The audit procedure for inventory is to recalculate the inventory physically and have a detail observation about the software to make sure inventory is counted and valued accurately. This would test the valuation and existence assertion of inventory account.

Website development expenses

The whole amount of $798,000 was treated as an expense but a portion of it should be treated as an expense and the remaining as capital assets. So the cost of advertising should be treated as an expense. The remaining cost related to registration of receiving payments, planning of website, software development and the purchasing of domain name should be treated as capital assets as these costs will provide long term benefits.

Audit Procedure

The first audit procedure for website development would be to enquire with Michelle to determine how she has recorded the transaction. This will test the valuation assertion of expense account.

The second audit procedure would be the recalculation of whole cost for website development and distribute it to expense and capital assets properly. This would test both valuation assertion for both asset and expense account.

The cost incurred for advertising would be treated as an expense, which is $75000.

The remaining amount of $7230000 spend for the registration of receiving payments, planning of website, software development and the purchasing of domain name would treated as an intangible asset under the asset section of financial statement.

Assessment of internal controls

KAL has currently have some good internal controls, however many of them weaknesses that allow them to be circumvented that makes them unreliable to us as auditors and can be strengthened.

Master price list

Salespeople have full discretion to set prices, subject to Paul’s approval.

Paul required to manually approve every sales order. Potential for incorrect pricing should Paul miss anything.

A master price list, pre-approved by Paul, that salespersons would be forced to use by default. Paul would only need to approve deviations from the master price list,