Case Study B - audit planning and internal control
Due date: 06-May-2018
Return date: 29-May-2018
Length: 2,000 words
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You are a manager in the audit division at Miller Yates Howarth (MYH), an accounting firm with offices throughout the major regional centres of NSW and Queensland. Although a medium sized firm by national standards, MYH is the second largest regional accounting firm in Australia. Most of MYH’s audit clients are in the agriculture, mining, manufacturing and property industries. All of those industries are currently under pressure, either from a downturn in commodity prices or fierce competition from overseas competitors.
You are gathering information to prepare the audit plan of Big Machine Limited (BML), a company that leases and services large mining machinery to several of the gold mines in the region. The following information has been gathered to date.
Principle activities of BML:
• mining machine leasing, mainly to gold, coal and iron ore miners.
• machine maintenance, and
• contracting machine operators to the mines.
BML was incorporated as a private company in 1979 importing and maintaining mining equipment. It survived the downturn in mining in 1982/3 operating profitably as a private company until the current mining boom began in 2005. At that point the directors decided that the company needed an injection of funds enabling the company to capitalise on the need for extensive new machinery in the mining sector. A combination of share issue and bank finance provided the capital to expand and update the machines that BML could offer the industry.
The directors are:
• Mr. Matthew Collins, Chairman
• Mr David Long, Chief Executive Officer
• Ms Cynthia Brown
• Mr Brent Allen
• Mr Patrick Singh
Mr Brent Allen and Mr Patrick Sing are independent, non-executive directors and have been directors since 2010. Mr David Long was recently hired as CEO, coming to the firm with extensive experience in the mining industry. The other two executive directors were employed by the company prior to its public share issue.
MYH has placed reliance on most internal controls based on satisfactory results of extensive tests of control. Recent discussion with the client revealed that there have been changes to the systems and software used to record and pay contractors. No other changes to the internal control system have been made since the last audit when the permanent file was updated. In past audits reliance had been placed on the internal controls thus reducing the amount of substantive testing.
Over the past 18 months there has been a decline in the demand for the machinery already owned and an increased demand for computer controlled equipment and for contract staff to maintain this equipment. As a result, BML has had to increase borrowings to finance the new equipment required.
You have walked around the main warehouse and yard and noticed that there are several large used mining machines standing idle in the yard.
Ms Leanne Hopkins, the audit partner for BML, has identified several areas she is concerned about and wants you to report back to her about these before you complete the audit program. She has advised you about a few changes in the metals market that may have an impact on BML’s operations. The metals market has fluctuated with:
• gold dropping 24.95% since 2012 but has risen 9.25% over the past year
• Iron ore dropping 43.78% since 2012 and dropping 9.71% in the past year
• coal rising 9.99% since 2012 and rising 18.35% in the past year.
The areas and accounts are:
• Plant and equipment
• Machinery Finance Liabilities
• Accounts Receivable
• Lease income
Ratios extracted from an unaudited set of financial reports at 31 December 2017 together with audited comparatives for the year ended 31 December 2016 and the industry averages are set out below for your review.
Ratio 2017 (Unaudited) 2016 (Audited) Industry average
Return on equity % 15 22 26
Profit/lease income % 8 12 No data
Return on total assets % 14 17 20
Gross margin % 25 25 30
Net profit margin % 14.5 18.5 20.27
Times interest earned 1.90 3.51 4.10
Days in accounts receivable 62 53 45
Current ratio : 1 1.02 1.54 1.66
Quick asset ratio : 1 0.70 0.78 0.82
Debt to equity ratio : 1 1.05 1.35 1.50
The Financial Controller for BML has provided you with the latest internal control manual which includes details of the controls over contract payments. As the system is new you also walk through the system checking that the walkthrough matches the information in the internal control manual. Details of the controls over contract payments your walkthrough are listed below:
BML tenders for a contract to operate a set of machines at a set price over a certain period. When the contract is accepted an accounts receivable account is set up by the accountant responsible for the contracts and a payroll account set up for the employee who will do the work.
The payroll clerk demonstrates the set up of the payroll account entering a supper user name and password specifically set up for the walk through.
The menu screen appears and displays many functions. The clerk selects the ‘add new employee’ function.
You are advised that the details can only be entered from a hard copy form signed by the employee and the contracts manager and a signed income tax instalment declaration form.
The clerk then enters the following information:
• employee name
• employee number
• contract number
• employee address
• employee phone number
• employee email
• start date
• employee date of birth
• employee tax file number
• hourly rate
• general exemption from tax Y/N
The fictitious employee is now set up in the system. The clerk goes back to the main screen and clicks the item ‘enter hours’ and explains that the employee can enter their own hours but that this must be approved by the contracts manager before the pay-run can be processed. The clerk then approves the hours.
Then the clerk selects ‘process pay-run’ and explains that the system automatically calculates the monthly payments based on hourly rate and the current tax rate. The system also calculates the superannuation accrual for the employee.
The system then generates a standard report entitled ‘monthly pay-run’ that lists the employees, their payments and the total tax paid. This report is then approved by the contracts manager who then, in a live pay run, uploads the Australian Bankers Association (ABA) file to the bank. The pay-run is automatically posted to the general ledger on approval by the contracts manager.
The contracts manager's bank login gives him the rights to approve processing of payments on the bank website. The bank account is reconciled monthly by the accountant who also has a bank login that gives him the right to approve processing of payments on the bank website. Other regular payments through the bank account occur on a weekly basis when the accountant uploads the ABA creditors payment file to the bank and apporves it for processing.
You note that the contracts payroll can be checked to the contracts accounts receivable by deducting from the accounts receivable amount the standard mark-up on the contracts.
Write a report, including a brief executive summary, to your managing partner that address the questions below. Where indicated use the following format to answer the question.
Question 1 A 8%
Analyse the ratios and the additional information associated the with four accounts listed by your audit partner, Ms Leanne Hopkins. Identify the potential audit risks and any related audit steps that need to be undertaken to reduce audit risk.
Respond to this part of the assignment using this format:
Account Analysis Audit Risk Audit steps to reduce risk
Plant and Equipment
Machinery Finance Liabilities
Question 1B 2%
Analyse the ratios and additional information to outline the business risks that BML faces.
Question 2A 7%
Identify the internal controls in the system that are potentially effective, the risk that the control could alleviate and one test of control for each of the identified potentially effective controls.
Answer this question using the following headings in a table format:
Control Risk alleviated Test of control
Question 2B 2%
List and identify the weaknesses in internal control for contract payroll.
This assessment has been designed to assess your ability to:
• be able to demonstrate risk management methodologies and the role of internal controls in an audit context;
• be able to design an audit plan and select and apply appropriate audit procedures for a financial statement audit;
• be able to exercise critical and reflective judgment.