Question
You are an auditor on the audit of Generation-Z Limited (GZ). GZ is the manufacturer, distributor,
and seller of youth clothing. The factory and administrative building of GZ are based in Cape Town,
and GZ has over 100 stores across the country.
The management team of GZ places a lot of emphasis on financial management, and management
accounts are prepared on a monthly basis. These management accounts also form the basis for
your analytical review procedures for planning purposes of the audit.
FINANCIAL INFORMATION
Your audit team is currently performing the system work of the audit. The audit senior extracted
the following information from the management accounts for the year ended 31 December 2018
and performed analytical procedures thereon:
30/11/2018 (11 MONTHS) 31/12/2018 (12 MONTHS)
Sales
– wholesalers 22 000 000 23 000 000
– retailers 8 000 000 9 000 000
Total sales 30 000 000 32 000 000
Cost of sales 18 000 000 16 000 000
Analytical information
40% 50%
Gross profit %
Inventory per general ledger R6 000 000 R5 000 000
Inventory turnover ratio 41⁄2 months 31⁄2 months
Inventory: creditors 130% 110%
The audit senior has discussed the above findings with the financial and production directors,
after which he was informed that the directors are worried about the decline in the gross profit
percentage. This was a major concern since there were no changes in the gross profit mark-up
percentage.
SYSTEM WORK
One of the trainee accountants on the audit team has done a system description. Some of the
strong points of the system as evident from the description, are the following:
Sales
1. Immediately after receipt of an order from a client, a numerical internal sales order form is
prepared. The sales manager inspects the numerical sequence of the processed internal sales
orders on a regular basis.
2. The credit controller inspects on a continuous basis the creditworthiness of clients and signs
the internal sales order form as evidence of the client’s creditworthiness.
Expenses
1. The cheque signatories are responsible for agreeing the cheque amount with the order, goods
receipt note and suppliers invoice. When signing the cheque the abovementioned persons cancel
the documents by signing the document.
2. The management accountant is responsible for ensuring that all purchases on which a
“settlement discount” is claimable, are paid timeously, to qualify for the maximum benefits. He
then stamps the invoice “pay immediately” as evidence of the payment thereof.
Fixed assets
1. The factory manager performs a physical verification of fixed assets per the fixed asset register
on an annual basis with the objective of assessing whether the useful life and carrying amounts
are still appropriate. If this is not the case, he then reports this to the financial manager who
processes the necessary adjustments.
FIXED ASSETS
Fixed assets include a significant amount for delivery vehicles, which are used for delivery of goods
to shops. As the company has only limited cash resources, all fixed assets are leased from a finance
house. The period of the lease contracts ranges between four and seven years and the ownership
of the vehicles will pass to New Age Limited at the end of the term. It is the policy of the company
to capitalise all vehicles leased.
During the year, two new contracts were entered into for vehicles, while one contract has expired.
REQUIRED:
(a) List the controls in the system of Generation-Z Limited which are of external audit importance
(key controls) and formulate tests of controls you would perform to test whether the identified
key controls function effectively. (15 marks)
(b) Discuss, with motivation, whether Generation-Z Limited is correct in its accounting treatment
to capitalise leased vehicles. (5 marks)
(c) Formulate the audit procedures you would perform to obtain sufficient appropriate audit
evidence over the vehicles held as finance lease liabilities. (25 marks)
and seller of youth clothing. The factory and administrative building of GZ are based in Cape Town,
and GZ has over 100 stores across the country.
The management team of GZ places a lot of emphasis on financial management, and management
accounts are prepared on a monthly basis. These management accounts also form the basis for
your analytical review procedures for planning purposes of the audit.
FINANCIAL INFORMATION
Your audit team is currently performing the system work of the audit. The audit senior extracted
the following information from the management accounts for the year ended 31 December 2018
and performed analytical procedures thereon:
30/11/2018 (11 MONTHS) 31/12/2018 (12 MONTHS)
Sales
– wholesalers 22 000 000 23 000 000
– retailers 8 000 000 9 000 000
Total sales 30 000 000 32 000 000
Cost of sales 18 000 000 16 000 000
Analytical information
40% 50%
Gross profit %
Inventory per general ledger R6 000 000 R5 000 000
Inventory turnover ratio 41⁄2 months 31⁄2 months
Inventory: creditors 130% 110%
The audit senior has discussed the above findings with the financial and production directors,
after which he was informed that the directors are worried about the decline in the gross profit
percentage. This was a major concern since there were no changes in the gross profit mark-up
percentage.
SYSTEM WORK
One of the trainee accountants on the audit team has done a system description. Some of the
strong points of the system as evident from the description, are the following:
Sales
1. Immediately after receipt of an order from a client, a numerical internal sales order form is
prepared. The sales manager inspects the numerical sequence of the processed internal sales
orders on a regular basis.
2. The credit controller inspects on a continuous basis the creditworthiness of clients and signs
the internal sales order form as evidence of the client’s creditworthiness.
Expenses
1. The cheque signatories are responsible for agreeing the cheque amount with the order, goods
receipt note and suppliers invoice. When signing the cheque the abovementioned persons cancel
the documents by signing the document.
2. The management accountant is responsible for ensuring that all purchases on which a
“settlement discount” is claimable, are paid timeously, to qualify for the maximum benefits. He
then stamps the invoice “pay immediately” as evidence of the payment thereof.
Fixed assets
1. The factory manager performs a physical verification of fixed assets per the fixed asset register
on an annual basis with the objective of assessing whether the useful life and carrying amounts
are still appropriate. If this is not the case, he then reports this to the financial manager who
processes the necessary adjustments.
FIXED ASSETS
Fixed assets include a significant amount for delivery vehicles, which are used for delivery of goods
to shops. As the company has only limited cash resources, all fixed assets are leased from a finance
house. The period of the lease contracts ranges between four and seven years and the ownership
of the vehicles will pass to New Age Limited at the end of the term. It is the policy of the company
to capitalise all vehicles leased.
During the year, two new contracts were entered into for vehicles, while one contract has expired.
REQUIRED:
(a) List the controls in the system of Generation-Z Limited which are of external audit importance
(key controls) and formulate tests of controls you would perform to test whether the identified
key controls function effectively. (15 marks)
(b) Discuss, with motivation, whether Generation-Z Limited is correct in its accounting treatment
to capitalise leased vehicles. (5 marks)
(c) Formulate the audit procedures you would perform to obtain sufficient appropriate audit
evidence over the vehicles held as finance lease liabilities. (25 marks)
Answers
GPT-4o mini
### (a) Key Controls and Tests of Controls
#### Key Controls
1. **Sales Order Process:** A numerical internal sales order form is prepared immediately after receiving an order, and the sales manager regularly inspects the numerical sequence of processed internal sales orders.
2. **Credit Control:** The credit controller inspects the creditworthiness of clients and signs the internal sales order form as evidence.
3. **Cheque Signing Process:** Cheque signatories are responsible for agreeing the cheque amount with the order, goods receipt note, and suppliers’ invoice before signing.
4. **Settlement Discounts:** The management accountant ensures all claimable purchase invoices are paid timeously and stamps those invoices as “pay immediately.”
5. **Physical Asset Verification:** The factory manager performs a physical verification of fixed assets annually to assess the appropriateness of useful life and carrying amounts.
#### Tests of Controls
1. **Sales Order Process:**
- Test a sample of sales orders for proper completion, ensuring each is sequentially numbered.
- Review the sales manager's inspection records for evidence of review.
2. **Credit Control:**
- Select a sample of sales orders and verify the credit control signature.
- Confirm the creditworthiness of a sample of clients through third-party confirmations or reviews of credit records.
3. **Cheque Signing Process:**
- Select a sample of paid cheques and trace them back to the associated documentation (goods receipt note, supplier invoice) to ensure authorization and agreement.
- Inquire about the consistency of procedures followed by cheque signatories.
4. **Settlement Discounts:**
- Review a sample of invoices paid within the period for the “pay immediately” stamp and check if the payments were made within the discount period.
- Verify appropriate documentation for settlement discounts claimed.
5. **Physical Asset Verification:**
- Obtain the fixed asset register and perform a test count of selected assets to confirm their existence and compare with recorded amounts.
- Review documentation related to adjustments made based on the factory manager's physical verification findings.
---
### (b) Capitalization of Leased Vehicles
**Evaluation:**
Generation-Z Limited's policy to capitalize vehicles leased from a finance house aligns with the accounting treatment prescribed by International Financial Reporting Standards (IFRS), specifically IFRS 16 - Leases.
**Motivation:**
According to IFRS 16, a finance lease (now referred to as a right-of-use asset) is defined as a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Since the vehicles are leased and ownership will pass to Generation-Z Limited at the end of the lease term, it indicates that substantially all risks and rewards are being transferred during the lease term.
As such, Generation-Z Limited is correct in capitalizing the leased vehicles as fixed assets in accordance with the relevant accounting framework, reflecting both the asset and associated liability (finance lease liability) on the balance sheet.
---
### (c) Audit Procedures for Vehicles held as Finance Lease Liabilities
1. **Review Lease Agreements:**
- Obtain and review all lease contracts for the vehicles to confirm terms, conditions, and classification as finance leases.
- Ensure agreements are correctly characterized as finance leases based on ownership transfer criteria.
2. **Confirm Liabilities:**
- Recalculate the outstanding finance lease liability based on the terms of the leases, ensuring the total liability is appropriately reflected in the accounts.
- Confirm lease liability with the finance house or leasing providers to verify agreement with the recorded amounts in the financial statements.
3. **Assess Rate Implicit in Lease:**
- Verify the interest rates used in calculating the lease liability and ensure they are consistent with the lease agreements.
- Evaluate the appropriateness of any assumptions made regarding the lease terms and payments.
4. **Check Compliance with Amortization:**
- Review the amortization schedule for the lease liability to ensure correct treatment of interest expense and principal repayment in the financial statements.
- Confirm that interest expense is consistent with the effective interest rate method.
5. **Valuation of Leased Assets:**
- Validate the recorded values of the right-of-use assets related to the leased vehicles, ensuring they reflect the present value of future lease payments.
- Conduct physical verification of the vehicles against the fixed asset register to corroborate existence and condition.
6. **Review Financial Statement Disclosures:**
- Examine disclosures related to leases in the financial statements for compliance with accounting standards, confirming accuracy and adequacy of information provided to users regarding finance leases.
7. **Inquire About Future Lease Payments:**
- Inspect management documentation for future commitments on lease payments and ensure these are reflected appropriately in the financial statements.
8. **Evaluate Impairment Factors:**
- Assess whether any indication of impairment exists related to the leased vehicles, such as additional damages or declining market values, which might require adjustment in the recorded amounts.
9. **Assess Related Costs:**
- Review expenses associated with leasehold vehicles (maintenance, fuel, insurance, etc.) for proper allocation and expense recognition according to accounting policies.
By performing these procedures, the audit team would gather sufficient appropriate evidence to ensure that the finance lease liabilities and the associated leased vehicles are reported accurately in the financial statements.
#### Key Controls
1. **Sales Order Process:** A numerical internal sales order form is prepared immediately after receiving an order, and the sales manager regularly inspects the numerical sequence of processed internal sales orders.
2. **Credit Control:** The credit controller inspects the creditworthiness of clients and signs the internal sales order form as evidence.
3. **Cheque Signing Process:** Cheque signatories are responsible for agreeing the cheque amount with the order, goods receipt note, and suppliers’ invoice before signing.
4. **Settlement Discounts:** The management accountant ensures all claimable purchase invoices are paid timeously and stamps those invoices as “pay immediately.”
5. **Physical Asset Verification:** The factory manager performs a physical verification of fixed assets annually to assess the appropriateness of useful life and carrying amounts.
#### Tests of Controls
1. **Sales Order Process:**
- Test a sample of sales orders for proper completion, ensuring each is sequentially numbered.
- Review the sales manager's inspection records for evidence of review.
2. **Credit Control:**
- Select a sample of sales orders and verify the credit control signature.
- Confirm the creditworthiness of a sample of clients through third-party confirmations or reviews of credit records.
3. **Cheque Signing Process:**
- Select a sample of paid cheques and trace them back to the associated documentation (goods receipt note, supplier invoice) to ensure authorization and agreement.
- Inquire about the consistency of procedures followed by cheque signatories.
4. **Settlement Discounts:**
- Review a sample of invoices paid within the period for the “pay immediately” stamp and check if the payments were made within the discount period.
- Verify appropriate documentation for settlement discounts claimed.
5. **Physical Asset Verification:**
- Obtain the fixed asset register and perform a test count of selected assets to confirm their existence and compare with recorded amounts.
- Review documentation related to adjustments made based on the factory manager's physical verification findings.
---
### (b) Capitalization of Leased Vehicles
**Evaluation:**
Generation-Z Limited's policy to capitalize vehicles leased from a finance house aligns with the accounting treatment prescribed by International Financial Reporting Standards (IFRS), specifically IFRS 16 - Leases.
**Motivation:**
According to IFRS 16, a finance lease (now referred to as a right-of-use asset) is defined as a lease that transfers substantially all the risks and rewards incidental to ownership of an underlying asset. Since the vehicles are leased and ownership will pass to Generation-Z Limited at the end of the lease term, it indicates that substantially all risks and rewards are being transferred during the lease term.
As such, Generation-Z Limited is correct in capitalizing the leased vehicles as fixed assets in accordance with the relevant accounting framework, reflecting both the asset and associated liability (finance lease liability) on the balance sheet.
---
### (c) Audit Procedures for Vehicles held as Finance Lease Liabilities
1. **Review Lease Agreements:**
- Obtain and review all lease contracts for the vehicles to confirm terms, conditions, and classification as finance leases.
- Ensure agreements are correctly characterized as finance leases based on ownership transfer criteria.
2. **Confirm Liabilities:**
- Recalculate the outstanding finance lease liability based on the terms of the leases, ensuring the total liability is appropriately reflected in the accounts.
- Confirm lease liability with the finance house or leasing providers to verify agreement with the recorded amounts in the financial statements.
3. **Assess Rate Implicit in Lease:**
- Verify the interest rates used in calculating the lease liability and ensure they are consistent with the lease agreements.
- Evaluate the appropriateness of any assumptions made regarding the lease terms and payments.
4. **Check Compliance with Amortization:**
- Review the amortization schedule for the lease liability to ensure correct treatment of interest expense and principal repayment in the financial statements.
- Confirm that interest expense is consistent with the effective interest rate method.
5. **Valuation of Leased Assets:**
- Validate the recorded values of the right-of-use assets related to the leased vehicles, ensuring they reflect the present value of future lease payments.
- Conduct physical verification of the vehicles against the fixed asset register to corroborate existence and condition.
6. **Review Financial Statement Disclosures:**
- Examine disclosures related to leases in the financial statements for compliance with accounting standards, confirming accuracy and adequacy of information provided to users regarding finance leases.
7. **Inquire About Future Lease Payments:**
- Inspect management documentation for future commitments on lease payments and ensure these are reflected appropriately in the financial statements.
8. **Evaluate Impairment Factors:**
- Assess whether any indication of impairment exists related to the leased vehicles, such as additional damages or declining market values, which might require adjustment in the recorded amounts.
9. **Assess Related Costs:**
- Review expenses associated with leasehold vehicles (maintenance, fuel, insurance, etc.) for proper allocation and expense recognition according to accounting policies.
By performing these procedures, the audit team would gather sufficient appropriate evidence to ensure that the finance lease liabilities and the associated leased vehicles are reported accurately in the financial statements.