General Machinery Company Limited, a subsidiary company of Las Vegas Group Corporation (USA) Limited, is primarily a distributor of a range of machinery and equipment and also engages in other business activities. It has assets of approximately $4m, including current assets of nearly $2m. The draft Statement of Financial Performance of the company has just been completed by the company accountant and presented to the auditors, Disneyland Audit Company Ltd., to enable them to complete their audit. You, as the partner in charge of the audit, is surprised to find out that the company has made a profit this year, because your audit work during and after the end of the financial year had led you to expect a significant loss. The draft Statement of Financial Performance and some of the notes are shown below.

General Machinery Company Limited Statement of Financial Performance

For the year ended 30 June 1997

1997 $ 1996 $

Revenue 30020000 30450000

Operating profit 165000 1240000

Income tax expense (10000) (605000)

155000 635000

Extraordinary items 230000

155000 865000

Retained profit b/f 555000 440000

710000 1305000

Dividend 500000 750000

Retained profit c/f 210000 555000

Notes to the accounts:

1. Accounting methods

Inventory – the company values spare parts held for its machinery customers at average cost. Costs of spare parts representing more than 3 years’ expected consumption are written off.

2. Operating profit before income tax has been determined after:

Including an abnormal credit $150000, not subject to income tax, resulting from the revaluation of a block of land written off against profits several years ago when a quarrying operation was discontinued; it is now proposed to develop the site as a tavern and service station to serve the growing population of the area.

During your ensuing investigations, you ascertained the following:

i) Land revaluation – is treated as an abnormal item. The company had for some year’s extracted rock and gravel from a block it acquired in a village near Collie. The cost of the block, which was $3000, had been written off many years ago when the useful material was exhausted, but the land title had been retained. In view of the growing prosperity from mining development in the area, the directors had concluded that there were prospects for a tavern and probably a service station and store on the block, and they were now drawing up plans preparatory to applying for rezoning of the land and then either undertaking the project themselves or selling the block and plans. On the basis of the opinion of a local estate agent that ‘residential land of an equivalent area in the village would be worth about $150 000’ the directors have revalued the block in the accounts at that amount. This is the company’s only holding of land.

ii) Inventory accounting policy – described in Note 1. The auditors had been concerned for some time at the high value of slow-moving spare parts inventory. They had accepted the financial statements in the previous year because they had not been able to establish that net realizable value was less than cost, but they had requested a reconsideration of inventory valuation in the year just ended. It had been tentatively agreed between the auditors and the directors that a maximum of 2 years’ expected consumption, based on the last 2 years’ sales, should be valued for financial reporting purposes and any surplus written off. The directors have since decided to increase this to 3 years. The cost of the stock on hand representing the additional year’s consumption has been estimated by the auditors at $27000.

iii) Factory reorganization – in order to restore its competitive position, the company had over several weeks in May and June been reorganizing its production facilities and replacing some older plant. The planning and execution of the program had absorbed a lot of time of senior personnel and the engineering design office. As a result, the directors had decided to carry forward as non-current assets not only the cost of draftsmen and engineers at their normal rates per hour but also a proportion of the salaries of the senior personnel involved. The auditors were shown time and cost calculations for senior personnel which supported the cost carry forward of $72000. The cost of engineering design carried forward was $56000. The auditors have been assured by the factory manager as well as the financial director that the reorganization will improve productivity. The capitalization of these costs has not been separately disclosed in the financial statements.

As an Audit Partner of your Audit team, you are required to complete the following:

A). Discuss the reasonableness of the directors’ proposed treatment of the 3 items above. Justify any changes or additional disclosure you would require in order to be able to give an unqualified audit opinion on the financial statements. Assume for the purpose of this part that you are able to satisfy yourself that the company’s continuation in business is not threatened.

B). Assume now that you have found that the company is fully utilizing its $300000 bank overdraft facility, which is secured over its assets, and your audit investigations have given you serious cause for concern as to the ability of the company to continue in business. Reconsider the treatment of the disclosures that you outlined for A above, and determine the type of audit report to be issued.

C) The audit has now been completed. A number of difficulties were experienced during the audit, including significant disagreements over the valuation of investment property holdings. You as the audit partner have suggested that the property value was overstated by $10m, a figure which was twice the level of materiality set for the audit. As a result of discussions with the audit committee, the CEO agreed to revise the valuations downward by $8m. All other issues were resolved to the satisfaction of you, resulting in an overall misstatement of the accounts of $2m. The audit partner is now considering the effect of the misstatement on the audit report.

Discuss the effect of the misstatement on the audit report.

D) Discuss the auditor’s responsibility for information accompanying a financial report.

Answer rating: 100% (QA)

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