Reference no: EM13510279

QUESTION

You are the audit senior responsible for the external audit of Lion Ltd for the financial year ending 31 March 2005. The company is listed on the JSE Securities Exchange. The company has an exclusive right to import and distribute the well-known brand of "HIFI" sound and vision electronic equipment.

Inventory is imported directly from factories in Taiwan and Japan, as well as in the British Virgin Islands (a tax haven). In fact, the supplier in the British Virgin Islands (Virgin Ltd) is the principal shareholder in Lion Ltd, with a holding of 40% of the company's issued share capital. Lion Ltd sells its inventory, on a wholesale basis, to large retail entities within Southern Africa. Turnover from this source is expected to exceed R150 million for the current financial year.

Your audit team is engaged on the 2005 year end audit and you have recently met with the financial director, Thomas Munyai CA(SA), to update your knowledge of the business since the interim audit and to plan the year end audit visit. Your audit report deadline is 20 April 2005.

Set out below is some of the information you have ascertained about the business:

Share price performance

The share price of Lion Ltd has been increasing significantly in recent months following publication of the unaudited interim results to 30 September 2004, which contained predictions by the directors that significant offshore income would be generated in the second half of the 2005 financial year from new asset management activities. The share price moved from 430 cents per share in March 2004 to a high of 800 cents per share at the beginning of March 2005. The JSE Securities Exchange has recently issued a warning to the CEO of Lion Ltd, Jodi Chan CA(SA), for failing to report his dealings in 10 000 Lion Ltd shares during December 2004, as required by the Listing Requirements. In common with all listed companies, Lion Ltd shares are dematerialised and shareholders' records are maintained in electronic sub-registers by central securities depository participants (CSDPs) registered with STRATE Ltd.

Accounting policies

There are no changes in accounting policies that will affect the 2005 financial year. The directors of Lion Ltd are aware of the JSE Securities Exchange requirement that the company must implement International Financial Reporting Standards (IFRS) from 1 April 2005, but have not yet considered its impact on the financial statements or commenced any IFRS conversion process.

Application software environment

Lion Ltd operates a sophisticated financial accounting application system, which integrates all aspects of sales, accounts receivable, purchases, inventory and general ledger processing. As customers prefer to work on a JIT supply basis, all sales orders are made electronically via Lion Ltd's B2B e-commerce website. These sales orders are then automatically numbered and accumulated in an orders master file.

Standard sales prices and customer discounts are maintained as standing data in a pricing file for use in the invoicing process. Transaction processing and general ledger updating take place on-line, in real time and generate regular comprehensive reports that are monitored closely by management. The company has four bulk warehouses where operations staff processes the sales orders overnight for daily delivery to customers by road transport. Delivery dates are captured on-line. Inventory counts are conducted on a cyclical basis.

As in previous years, your interim audit work has included tests of application controls over the financial accounting system and comprehensive analytical reviews of turnover, gross margins, accounts receivable and inventory. Although a small number of control weaknesses were identified during the interim audit, none of these were considered significant to your audit and you have satisfied yourself that these weaknesses have since been appropriately addressed by management.

Share capital

On 1 July 2004, the directors of Lion Ltd issued 10 million shares of R1 each to Virgin Ltd, as part of a rights issue to all shareholders. Instead of receiving a cash consideration for the shares, Lion Ltd entered into the "Procurement and asset management" contract described below with Virgin Ltd. The share issue required an increase in the authorised share capital of Lion Ltd. The company has adopted articles of association in the format of Table A.

Procurement and asset management contract

Lion Ltd agreed the following terms with Virgin Ltd in a procurement and asset management contract:

• Lion Ltd has the right to receive 50 000 units of a new "HIFI" inventory line with an invoice value of R50 million.

• The 10 million Lion Ltd shares will be held in a trust fund on behalf of Virgin Ltd. Jodi Chan is appointed the sole trustee and the shares are currently registered in his name as nominee for Virgin Ltd.

• In terms of the agreement, Virgin Ltd will pay a management fee to Lion Ltd comprising any excess of the increase in market value of the shares over a predefined benchmark, being the percentage change in the ALSI share index over the period of the contract.

• The agreement expires on 30 June 2005, on which date any management fees arising under the agreement become due and payable.

Lion Ltd intends to recognise R40 million in the income statement for the year ending 31 March 2005, being the present value of three-quarters of the management fees anticipated from the contract. A receivable has been recognised for the same amount. However, cash flows are not due until three months after the financial year end of Lion Ltd.

You have been unable to establish the names of the directors of Virgin Ltd and confirmation requests sent by you to the postal address in the British Virgin Islands stated in the procurement and asset management contract have been returned unopened.

Accounts receivable

Lion Ltd provides credit terms of between 30 and 45 days to its customers. Your review of the trade receivables age analysis at 31 January 2005, totaling R18,5 million, indicated average days sales of 43 days. However, you noted an amount of R3 million owing by an associate company, Electronics (Pty) Ltd, which had been outstanding in excess of 120 days. The credit controller has indicated that Electronics Ltd is a "slow payer". You have not yet received back responses to all your positive circularisation requests.

Sales revenue

The audit team has prepared the following analytical review of the gross margins achieved by Lion Ltd from the sales of "HIFI" sound and vision electronic products for the year to date. Explanations were obtained from the sales director, Sammy Naidoo, for variances in excess of 10% of the average gross margin percentage for the period April 2004 to December 2004.

Lion Ltd - 2005 Audit

Analytical review of gross margins for the nine months ended 31 December 2004
Month Gross margin
percentage
Explanations for significant variances
April
May
June
July
August
September
October
November
December
42
43
29
50
41
39
42
46
39

Increased trade discount allowed to customers as part of marketing promotion to clear two inventory models, which were being discontinued.

Sales mix for the month included a large proportion of a new higher margin product. A nationwide marketing campaign accompanied the product launch.

Sales mix for the month included a large proportion of higher margin executive goods.

Average 41

You are concerned about the significant fluctuations in revenue during the year and the unusual terms of the procurement and asset management contract with Virgin Ltd. In addition, the recent actions of the directors have raised serious concerns regarding management integrity and a possible increase in fraud risk.

REQUIRED

(a) Set out the substantive audit procedures you would perform in order to obtain sufficient appropriate audit evidence regarding all aspects of the transaction with Virgin Ltd that affect the Lion Ltd financial statements for the year ending 31 March 2005. Assume that the effect of the transaction is material to both the income statement and balance sheet.

Your answer should specify the financial statement component and the financial statement assertion(s) addressed by each substantive audit procedure. Your answer should not address the timing and extent of the procedures.

(b) With a view to obtaining sufficient appropriate audit evidence of the completeness of Lion Ltd's sales revenue -

(i) discuss the factors you would consider in determining whether to obtain audit evidence from manual controls and automated application controls, rather than solely from substantive audit procedures;

(ii) describe the nature of the manual controls and automated application controls which you would expect to find in place and would test as a basis for obtaining such audit evidence; and

(iii) set out the additional substantive audit procedures you would perform at year end to establish the completeness of sales revenue.

(c) In the context of the information and audit work described above, outline the additional steps you would take to ensure that you have sufficiently addressed, for purposes of the audit opinion, the risk of fraudulent financial reporting in respect of related party transactions.

(d) Discuss the corporate governance and Companies Act requirements which the directors of Lion Ltd should have considered specifically in relation to the issues arising from the information about the business.