Question: Rosella is the senior in charge of the current year audit

Rosella is the senior in charge of the current-year audit of Harrier Limited, a company that designs and manufactures highly sophisticated machines used to make precision plastic parts and instruments. The machines have a high dollar value (ranging from $500,000 to over $1,000,000) and there is a long lead time between receiving a customer’s order and specifications, designing the machine, building it, and testing it. Because of these business factors, sales do not tend to follow a regular pattern, but certain constraints exist that can be used to analyze the reasonability of sales for audit purposes. Customer orders are tracked as the “back-log” file, and sales can be expected to follow the backlog after allowing for design, manufacturing, and testing time. This takes between two and three months, on average. Another factor is the physical limitation of the factory and equipment: There are 12 job stations where machines can be built, so a maximum of 12 machines can be in the work-in-process inventory at any one time.
Harrier’s shares are privately held by its founder and president, and several outside investors, but it issued bonds to the public several years ago and is subject to debt covenants that require it to maintain a working capital ratio of 1.5 to 1.0 and a debt to equity ratio of 0.5 to 1.0 at each year-end.
In addition, no dividends or management bonuses can be paid out unless the net income before taxes is at least $1,000,000. The draft statements for the current year meet all covenants and show a net income before taxes of $1,300,000. In reviewing the monthly sales for the current year, Rosella notices several anomalies. First, 15 machines were shipped in December, the last month of the current year, while in December of the prior year only six were shipped. The average monthly shipment volume is between five and six machines. Also, the average gross profit on sales in prior years, and in most months, is approximately 40%. The gross profit on the December sales is 75%. The annual sales were $66 million, with $15 million of this occurring in December. The annual gross profit is $33 million, with $11 million of this occurring in December. While scrutinizing the cash records for the first month of the New Year to look for un-accrued liabilities, Rosella notices some large amounts paid for travel expenses for employees and for shipments of “spare parts” to customers. Enquiries of the employees reveals that they are engineers and technicians who were required to spend two or three weeks in various cities where the December machine sales were shipped in order to “work out the bugs” and add some parts to these machines.

a. What are the main business risks in Harrier Limited? What are the risks of financial statement misstatements that Rosella should be aware of?
b. What types of evidence collection procedures were used and what assertions do they provide evidence about?
c. Analyze the information Rosella obtained and offer reasonable explanations for the sales anomalies noted. What additional enquiries should Rosella make to form an opinion on the operating results reported in Harrier’s draft financial statements? What is your conclusion on the draft sales and gross profits amounts, based on your analysis of the facts given?
d. Harrier’s revenue recognition policy is to recognize revenue when the machines are shipped and title passes to customers. This point occurs when the machines are loaded on the truck at Harrier’s factory. Given this policy, what adjustment (if any) would be required in Harrier’s current financial statements given the conclusion you reached in part (c) above?

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  • CreatedJanuary 09, 2015
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