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Audit Challenges at Maxhoza Clothing

Maxhoza Clothing (Pty) Ltd, a medium-sized fashion retailer in South Africa, is facing declining sales due to adverse imports and increased competition, prompting management to relax credit terms. The company is under pressure to meet a pre-determined net profit before tax to avoid immediate loan calls from investors, and there are concerns about ineffective internal controls and missing documentation for cash payments. The audit is time-sensitive, with management refusing to finalize the engagement letter until after the audit is complete.

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9 views3 pages

Audit Challenges at Maxhoza Clothing

Maxhoza Clothing (Pty) Ltd, a medium-sized fashion retailer in South Africa, is facing declining sales due to adverse imports and increased competition, prompting management to relax credit terms. The company is under pressure to meet a pre-determined net profit before tax to avoid immediate loan calls from investors, and there are concerns about ineffective internal controls and missing documentation for cash payments. The audit is time-sensitive, with management refusing to finalize the engagement letter until after the audit is complete.

Uploaded by

Nhlanzeko Ncube
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PDF, TXT or read online on Scribd

QUESTION 1 (45 MARKS: 90 MINUTES)

Company background

You are a trainee accountant at a medium-sized audit firm. Your firm has recently been appointed
as auditors of Maxhoza Clothing (Pty) Ltd ( ), a company that sells upmarket fashion
wear to everyone. This is the first time your firm has a client in the fashion industry. The previous

has been operating for the last ten years and has a number of outlets in each of the five major cities
in South Africa. The company owns most of the buildings that are used for its operations.

MC Pty Ltd sells for cash and on credit. On average, 45% percent of annual sales are made from
cash. The majority entral warehouse in

displayed on the shop floor or kept in a small storeroom.

Although sales have been generally good in previous years, sales for the financial year ended 30
April 2023 have shown a decline. The directors of the company attribute this to two things: adverse

imports, and increased competition in the marketplace. In an attempt to increase sales, the directors
decided, during the current year, to relax the granting of credit by extending credit limits and credit
terms for all existing account holders. The company has a small overdraft with its bank.

When the company was incorporated ten years ago, it was financed by four private investors who
provided long-term loans. (The company has a very small share capital). None of the four long-term
loans are secured, but in terms of the loan agreement, the investors are entitled to call up their loans
immediately if the company does not achieve a pre-determined net profit before tax. The loan
agreement requires that an annual audit of the company's financial statements must be performed.
The directors are very anxious about whether the stipulated (pre-determined) net profit before tax is
achieved.

2
Additional information
a) management refused to give permission to the incoming auditor to contact the previous
auditor.
b) management has not signed the engagement letter and has only promised to finalise at the
end of the audit.
c) management has indicated that the audit should be completed in three weeks before a
governing body meeting.
d) no conflicts of interest were identified by the auditor.
e) sales have generally been good in previous years, but sales for the financial year ended 30
April 2023 have shown a decline.
f) there have been problems in the past relating to internal controls not operating effectively.

g) adverse fluctuations in foreign exchange rates have resulted in increased costs for the
has also been increased competition in the marketplace.
h) the financial controller notified the Auditor in Charge (AIC) that the budgeted figures supplied
to the auditors were for 2022 and not 2023. The system incorrectly pulled through the 2022
figures. However, the 2023 budgeted figures were also significantly adjusted because
management revised most of their estimations after an notice was received from SARS that
a new law will be passed to stop imports of the type of clothing that MC (Pty) Ltd sells. This
will impact about 20% of the sales of MC (Pty) Ltd.

Extract from management accounts and minutes of meetings

Actual information for 2022 Annual Budgeted figures for


first 6 months of 2023 Financial Year 2023
audited

Turnover R 1 605 000 R 3 506 000 R 3 705 250


Cost of Sales R 1 410 667 R 2 350 125 R 2 400 500
Operating expenses R 186 985 R 275 856 R 195 050
Total Assets R 1 786 332 R 1 650 345 R1 905 445
Total Liabilities R 1 050 550 R 986 345 R 850 240

3
Matter 1 Cash Payment

During the interim audit, you have identified some of the cash payments that were made to a
customs l did not have proper supporting documentation. Upon enquiry of these cash

works at the OR Tambo International Airport. The director initiated these cash payments. These
and the directors friend promised to ensure that
relating to imported merchandise disappeared.. The
company was facing difficulties in importing some of the merchandise that they sell. The financial

material if you consider the value of the imported merchandise.

Common questions

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The internal control environment appears to be weak based on past problems with ineffective controls and the current issue of cash payments lacking proper documentation. Failure to address these issues suggests a persistent lack of rigorous internal controls, increasing the risk of errors or fraud and undermining financial integrity and reliability .

Achieving a pre-determined net profit before tax is critical as it is tied to the conditions of the unsecured long-term loans from investors. Failure to meet these targets allows investors to call in the loans immediately, which could severely impact the company’s liquidity and operational capability, given its existing overdraft and reliance on these funds .

Extending credit terms aims to boost sales by making purchases more accessible, aligning with the strategy to counteract decreased sales. However, this could elevate the risk of increased bad debts and dependency on accounts receivable for cash flow, particularly problematic given the company’s existing overdraft and reliance on credit sales .

A three-week timeframe for audit completion is constrained and imposes significant pressure on the audit team. This could compromise the audit's thoroughness and effectiveness, potentially leading to oversight of critical issues, insufficient evaluation of financial records, and inadequate risk assessment—especially given the complexity of issues like incorrect budget figures and internal control weaknesses .

If the new law impacts 20% of sales, Maxhoza Clothing (Pty) Ltd may face a significant revenue shortfall. This could lead to cash flow issues, necessitate cost-cutting measures, or force strategic adjustments like sourcing locally or diversifying products to mitigate potential market share loss .

Relaxing the credit policy by extending credit limits and terms can increase sales in the short term but poses risks such as potential bad debts and cash flow issues. With a significant portion of sales already on credit and an existing small overdraft, the expanded credit terms could strain liquidity and increase the likelihood of defaults, affecting financial stability negatively .

Management's refusal to allow communication with the previous auditor could potentially lead to issues with gathering sufficient audit evidence. It raises concerns about the transparency of management and suggests potential undisclosed issues with past audits, such as disagreements or misstatements. This situation may also indicate possible attempts to limit the auditor's ability to fully understand the company's historical financial practices, which could compromise the audit's integrity .

Adverse fluctuations in foreign exchange rates can increase the cost of imported goods, directly affecting the cost of sales and reducing profit margins. Given that the company faces increased competition as well, this can exacerbate financial challenges, leading to higher operational costs and potentially contributing to reduced profitability .

Increased competition may compel Maxhoza Clothing (Pty) Ltd to innovate their product line, adopt competitive pricing strategies, or enhance marketing efforts to maintain their market position. The drop in sales necessitates strategic adjustments to meet consumer demand and differentiate themselves from competitors, ensuring sustained profitability .

The revelation of incorrect budgeted figures complicates the audit process as it raises concerns over the accuracy and reliability of financial data. It necessitates a thorough review and adjustment of the audit procedures to verify the actual figures for 2023, potentially increasing the complexity and time required for the audit, while also questioning the accuracy of management’s forecasting processes .

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