Question

Extech Ltd's sales revenue budget for 2018 is $350,000. Extech Ltd manufactures tables and its production costs as a percentage of sales revenue are:

Raw materials 25%

Direct Labour 25%

Overheads 10%

Raw materials, which are added at the start of production, are carried in inventory for ten days and finished goods are held in inventory before sale for twenty days.

Work in progress is held at levels where products are assumed to be 50% complete in terms of labor and overheads.

The production cycle is five days and production takes place evenly through the year.

Extech Ltd receives 60 days credit from suppliers and grants 30 days credit to its customers.

Overheads are incurred evenly throughout the year.

(a) Determine Extech Ltd’s total working capital requirement

(b) Extech Ltd are owed $10,000 by a supplier who has just been declared bankrupt. The owner of Extech wants to sue the supplier’s auditors for the $10,000 as she had reviewed their audited accounts and understood that the business would continue for the foreseeable future. Discuss, with reference to the “performance gap” and the “expectations gap” what an auditor does and does not do, and whether the owner of Extech is correct in their understanding.

Answer 1

(a) Working Capital = Current Assets - Current Liabilities
		% of Sales	Value
Sales			$350,000
Raw Materials		25%	$87,500
Direct Labor		25%	$87,500
Overheads		10%	$35,000
Raw Material Inventory is quantity for ten days of production
Given that production is even throughout the year
Computation of Raw Materials Inventory
Total value of Raw Materials consumed during the year				$87,500
Value of Raw materials consumed per day				$240
Value of Raw materials consumed in ten days				$2,400
Raw materials inventory levels				$2,400
Computation of Finished Goods Inventory
Total value of Finished Goods sold during the year				$350,000
Value of Finished goods sold per day				$959
Value of Finished goods sold for twenty days				$19,180
Finished goods inventory levels				$19,180
Computation of Work-in-progress Inventory
Since,production cycle is for five days, Work in progress includes
a. Five days of raw materials inventory
b. 50% of five days of direct labor cost
c. 50% of five days of overheads cost
	Daily Cost	Days	% of Completion	Value
Inventory	$240	5	100%	$1,200
Direct Labor	$240	5	50%	$600
Overhead	$96	5	50%	$240
Work-in-progress inventory levels				$2,040
Computation of Accounts Receivables
Credit period allowed to customer(in days)				30
Average daily sales				$959
Sales value for 30 days				$28,770
Average Accounts Receivables				$28,770
Computation of Accounts Payable
Credit period allowed by suppliers(in days)				60
Average daily purchases				$246
Purchase value for 60 days				$14,760
Average Creditors				$14,760
Note - Purchase = Raw Materials Consumed + Raw Material Inventory
= $ 87,500 + $ 2,400
= $ 89,900
Average daily purchase = $ 89,900/365
= $ 246
Current Assets
Raw Material Inventory			$2,400
Work-in-progress Inventory			$2,040
Finished Goods Inventory			$19,180
Accounts Receivable			$28,770
Total Current Assets			$52,390
Current Liabilities
Accounts Payable			$14,760
Total Current Liabilities			$14,760
Working Capital = Current Assets - Current Liabilities
= $ 52,390 - $ 14,760
Working capital requirement = $ 37,630

(b)

Expectation gap is the difference between the public perception of an auditor's

role and responsibilities regarding audits of financial statements and what the

auditor's legal responsibilities actually are.

Expectation gap may be categorized into

(i) Performance gap which signifies the difference between the level of work an

auditor is required to do by the auditing standards and what public believes they

ought to do.

(ii) Liability gap which signifies the mis-perception regarding the legal liability of the

auditor.

The auditing process has certain limitations.The auditor has to express his

opinion on the financial statements of the auditee on basis of the information he

gathers on the basis of the data made available to him.This data is collected in

form of samples ans these samples are a subset of transactions during the

financial year.The auditor does not tests the whole records and it is possible that

the sample tested does not truly represent the total financial data for the year.

Also,the evidences available to the auditor may not always be conclusive.The

auditor relies on his judgement if the evidence is persuasive.

It is for these reasons that the auditor expresses his opinions on the financial

statements and does not certify it.

Hence,the auditor would not be legally liable if the supplier is declared bankrupt

where he had expressed his opinion that the business of the supplier would

continue for forseable future,if he was satisfied with the evidence made available

to him and performed his audit tests with due diligence.This is irrespective of the

opinion of Extech Limited that it was the duty of the auditor to predict that the

said supplier would become bankrupt because the audit engagement does not

create any liability on the auditor to certify that the financial statements show the

exact and precise conditions of the company.