Oak co

You are an audit manager of Elm and co and are finalizing audit of F/s of Oak co for year ended 31 May 20X6. You are reviewing results if final analytical procdures and other outstanding [points on the auidt file prior to recommending the final auditor’s opinion whihc is due to be signed on 12 Dec 20X6

The following ratio analysis has been competed as part of final analytical procedures:
20X6 (final) 20X6 (planning) 20X5 (final)
GP margin 9% 11% 12%
Quick ratio 0.2 0.6 0.8
Payables days 45 40 37
Inv days 50 40 42

Discussion with finance director have also revealed following

a) Oak co lost a major customer beech co in May 20×6 but new business has been won post year end which has mitigated the impact of loss of beech co

b) Oak co is due to repay substantial loan on 31 Jan 20X7. Oak co is currently negotiation revised terms with bank but it is unlikely that negotiations will be concluded before auditor’s report is signed. This will be disclosed in F/S

The F/S for year ended 31 May 20X6 have been prepared on GC basis

As part of GC assessment following additional issues have been noted on audit file

1) A number of personnel in purchasing dept left during the year and have not been replaced
2) A major supplier to Oak co has just gone out of business with number of unfulfilled orders
3)A new product which was due to account for 30% of revenue has proved to be unsuccessful
4)A litigation claim has been raised against Oak co after the year end with potential damages totaling 3% of this year’s profit

Which of the issues identified could individually cast doubt over the GC assumption for Oak co?

a) 1 and 3
b) 2, 3 and 4
c) 2 and 3 only
d) 1, 2 and 4

Correct ans is C. But please can you explain me why 2 and 3 are correct and why 1 and 4 are incorrect?

Aren’t 1 and 4 also GC indicators as a litigation claim can result in penalties charges to company which they may not be able to satisfy. And if number of people in purchasing dept have left and if they are not yet replaced then it would be difficult for company to make new products leading to reduces sales, reduced profit, reduced cash leading to GC problem