Analysing the issues with JDM's clients

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Background

You are the audit manager of JDM, an accounting firm with offices in the Sydney metropolitan area. JDM is a middle tier auditing firm specialising in the audit of firms in the manufacturing and property development industries. During May 2020 you met with the audit senior of JDM, Tyrone Vickery, to discuss a number of findings and issues Tyrone has identified relating to several of JDM’s clients.

Lightning Ltd

One of JDM’s biggest clients is Lightning Ltd. Lightning is involved in the property development industry and until last year had been very profitable, however the economic downturn has started having a financial impact. Tyrone tells you he has just had the final audit meeting with the CEO of Lightning, Ben. At this meeting there were discussions about the main findings and the adjustments which need to be made to the accounts. Tyrone says one major issue with the audit is lingering doubts over Lightning’s status as a going concern. Lightning has been close to violating it’s loan contracts which require it to maintain a current ratio of 1.7:1. Tyrone says the issue has caused him many sleepless nights of late – he says the people who run Lightning are likable, and he is aware of the negative impact that Lightning’s closure would have on its stakeholders including its creditors and employees. Tyrone is also worried that Lightning’s violation of loan terms could have a negative impact on his own career prospects, with Lightning being such an important client.

Tyrone says Lightning’s year-end is 30 June and that JDM carried out most of its work during February. At that time all of the projections looked fine, however recently Tyrone found out that one of Lightning’s major customers, Autumn Ltd has been placed into administration. At year-end Autumn owed Lightning $2.3 million. Tyrone says that if this amount were to be written off Lightning would definitely be breaching its loan contracts. Tyrone says he asked Ben whether any provision had been created in relation to the amount due from Autumn or whether any updates to the projections originally audited in February had been made. Ben advised Tyrone that he didn’t think that was necessary and justified this by saying that the administrator of Autumn believed that Autumn would be able to meet all of its outstanding debts. Tyrone said he hoped this was true, but he advised Ben that he still needed to obtain assurances from the administrator directly. Tyrone tells you that Ben reacted to this angrily, asking why that would be necessary as he was happy to provide a letter validating the administrators views. Tyrone says he advised Ben that he has to do his job, but that this made Ben even angrier, and Ben starting shouting, saying that “this is the first sign of trouble for our company and JDM are willing to help the bank shut our doors. This will be a disaster for our creditors and our employees!” Tyrone tells you than upon concluding the meeting Ben said to him that all Lightning was asking for was time – to be given a chance to trade out of the situation - and that as far as he was concerned, the accounts would not be altered. Ben also said that if Lighting were to collapse, he would let all their stakeholders know who caused the closure of this business – the auditors.

Cardinal Ltd

After discussing the audit of Lightning, Tyrone informs you of the latest developments regarding another of your clients, Cardinal Ltd, a company which provides warehousing and distribution for chemicals used in the manufacture of household cleaning products. Tyrone tells you that Cardinal was carrying a very high level of inventory in its audited balance sheet at the time a successful takeover offer was made by Spruce Ltd.

Tyrone says that two months after the takeover, it was discovered that the inventories held by Cardinal were considerably over valued and that they did not in fact possess the quantity of inventory claimed at the time of the audit. Tyrone also says that Spruce is filing court action against JDM and that they have evidence supporting the following:

  • JDM did not attend all stocktakes at year-end. While JDM were present at stocktakes for the Sydney based operations of the company, the inventory at the Sydney warehouse was also found to have been overvalued by 27%.
  • While JDM correctly accounted for the quantity of the Sydney stock, they accepted managements’ valuation, which did not take account of significant quantities of chemicals which were in poor condition and were therefore not of merchantable quality.
  • 50% of the company’s inventory is purportedly held at the company’s facility in Goulburn and is it this inventory that Spruce is claiming does not exist.

Tyrone says that Spruce are also claiming that JDM were subjected to considerable pressure by Cardinal’s management to complete the audit within one month of the balance date. Tyrone says that JDM has undertaken this audit for the past six years, that there was no evidence of any previous misstatements of the value of inventory and that Spruce is claiming that they had relied on the audited financial statements in making their takeover offer. Tyrone tells you that there is no evidence that anyone at JDM was aware of this intended use of the accounts.

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