Question

Biotech Limited

Financial year end 30 June 2020

You are an auditor in Smit & Chandra, a mid-tier audit firm. Your firm is the incumbent auditor on Biotech Ltd, a pharmaceutical company. Since the previous audit, the company has listed on the Australian Securities Exchange which means the company has to meet additional reporting regulations. Due to rapid growth, Biotech Ltd is financially stretched and its accounting systems are struggling to cope with the growth in the business. You recently read an article in the Australian Financial Review, which stated that Biotech Ltd is currently under investigation by the Australian Taxation Office (ATO) for alleged failure to pay the appropriate amount of Pay As You Go (PAYG) tax on their payroll.

Biotech Ltd is a pharmaceutical company, developing drugs to be licensed for use around the world. Products include medicines such as tablets, medical gels and creams. The market is very competitive, encouraging rapid product innovation. New products are continually in development and improvements are made to existing formulations. Drugs must meet very stringent regulatory requirements prior to being licensed for production and sale. You are aware that during the 2020 financial year, Biotech Ltd lost several customer contracts to overseas competitors.

Biotech Ltd approached its bank during the year to extend its borrowing facilities. An extension of $20 million was sought to its existing loan to support the on-going development of new drugs. The long-term borrowings are subject to debt covenants in which the company must maintain a current ratio of 3.5:1.

In addition, the company asked the bank to make cash of $5 million available if an existing court case against the company is successful. The court case is being brought by an individual who suffered severe side effects when participating in a clinical trial in 2016.

On 8 June 2020, the Company announced to the market it had been the victim of a cyber-security incident that resulted in supplier and customer details being disclosed on the dark web. The Company is assessing the costs of the incident and the subsequent reduction in revenue. The Company expects this to have a material impact on future earnings.

In December 2019, the internal audit department of Biotech Ltd performed a review of the operation of controls over processing of overtime payments in the Payroll department. It was found that the company’s specified internal control procedures in relation to the processing of overtime payments were not followed.

Below are some results of the analytical review procedures performed by the Senior Auditor (David) during the planning stage:

Sales                                                                                                            12.5% decrease since prior year

Net profit after tax                                                                                20% decrease since prior year

Accounts payable                                                                                   15% decrease since prior year

Cash at Bank                                                                                             16% increase since prior year

Accounts receivable                                                                              18% increase since prior year

Inventories                                                                                               6%   increase since prior year

Current ratio:                                                                                            3.6:1

Debt to Equity ratio:                                                                               0.6

Minutes from the Audit Planning meeting with Simon Jones (Finance Director of Biotech Ltd) held on 30^th April 2020:

Due to the current government restrictions, the planning meeting with Simon Jones was held via Zoom. In attendance at the meeting was the Audit Partner (Michael), the Audit Manager (Amanda) and the Audit Senior (David).

The following key items were discussed during the meeting:

• Mr Jones raised concerns about the conduct of the previous audit, stating numerous examples of when he and his staff had been interrupted when they were busy. He stated that he wanted guarantees that this year's audit will be more efficient, less intrusive and cheaper, otherwise he will seek an alternative auditor in future.
• Michael reminded Mr Jones that fees relating to the audit engagement from the previous year were still outstanding.
• Both Michael and Mr Jones also discussed the range of non-audit services provided to Biotech Ltd, which includes payroll preparation, tax computation and advice.
• Mr Jones gave the audit team an update on the court case pertaining to the individual who suffered severe side effects from a company trial (refer above). According to legal advice provided to Mr Jones by the company’s legal counsel, it is more likely than not that Biotech will lose the court case, which would result in a significant amount of cash having to be paid as a settlement.
• Amanda asked Mr Jones if he considered the decline in profitability as an indicator of a material uncertainty surrounding the going concern assumption. Mr Jones responded by saying, “Look, everything might seem dire, but we have it under control. We will be here this time next year, so keep that in mind”. Michael then looked at Amanda and David and said, “Make sure that you mention the conversation that we have just had with Mr Jones about the appropriateness of the going concern assumption in the audit working papers. This should be sufficient enough audit evidence for us.”
• Mr Jones also mentioned the following: “As you know, Biotech Ltd has a Goodwill asset on the balance sheet. This is an indefinite useful life intangible asset. In accordance with the Accounting Standards (AASB 138), we are required to test the asset for impairment every year. We usually prepare a Value in Use calculation based on discounted future cash flows that we expect to generate in the next five years. I have completed this year’s calculation by rolling forward the prior year’s calculation and have just updated the dates. There was no need to update the future cash flow figures.”

The Audit Team

The audit team consists of 4 people. The partner is Michael. He has been the audit partner on the Biotech Ltd audit for 6 years. The audit manager is Amanda. This is Amanda’s first time on the Biotech Ltd audit. David is the audit senior and is responsible for the initial audit planning. David has recently completed the Graduate Diploma of Chartered Accounting. David has just been offered a well-paying accountant position at Biotech but he has not yet decided whether to accept the position. The graduate on the audit is Audrey. Audrey’s friend is the receptionist at Biotech Ltd. The receptionist has no accounting knowledge and has no involvement with the recording or processing of accounting transactions.

Accounts Receivable / Sales Accounting Cycle and Internal Control System

At the end of each month, the sales manager determines the amount of products required to meet sales demand for the following month based on sales orders received. He reviews the sales orders received from customers and then prepares the pre-numbered inventory requisition forms, which he then sends to the warehouse managers so that they can prepare the goods for delivery. One copy of the sales order and inventory requisition form is sent to the warehouse, one copy is sent to the accounts receivable department and one copy is filed in the sales department.

The warehouse prepares the goods for delivery to the customers and generates the delivery document. When the goods have been delivered, the signed delivery document, which includes the delivery details, is forwarded to the accounts receivable department. The other copy is filed in the warehouse. The accounts receivable clerk matches the signed delivery document with the sales order and inventory requisition form. Once satisfied that all of the details agree, the clerk generates the sales invoice. Once generated, the clerk does another check to ensure that all details per the sales invoice agrees to the delivery document and sales order. Once satisfied, she writes “checked” on the sales invoice and sends it to the customer. At the end of every week, a different clerk in the Accounts Receivable team reviews the bank statements for receipt of payments from customers and performs a reconciliation against the sales invoices. Once a customer has paid the sales invoice, the clerk stamps “received” on the sales invoice and files that along with all the other documents in date order.

The walk-through of the accounts receivable/sales cycle confirmed that the accounting and internal control system was working as documented above.

Test of control:

As part of the audit, Audrey tested the controls over the accounts receivable system. She selected a sample of twenty sales transactions and tested the control that all details had been checked. Out of the 20 sales transactions that were selected for testing, 5 sales invoices in the sample did not have the word “checked” written on them. When documenting the results of the test performed, Audrey concluded that the internal control did not operate effectively and consistently throughout the year but that no further audit work is required.

Substantive test

In order to test the occurrence of the sales transactions, Audrey selected a sample of sales invoices and traced them to the General Ledger to test that they were properly recorded.

Subsequent events not previously mentioned

• One of Biotech Ltd’s major customers went into liquidation in July 2020. The balance due from the customer at 30 June 2020 was $564,000. This is a material amount. There has been no provision/allowance for doubtful debts raised for this debtor in the financial statements for the year ended 30 June 2020. Biotech Ltd’s legal adviser stated in a telephone call that that the probability of any funds being received from the debtor is remote.

• On 2 July 2020, Biotech Ltd declared a one-for-five rights issue of 100,000 shares at $2.20. These shares were payable in full on 31 July 2020.

Write about the internal control system and the assertion for the same?

Answer 1

nternal controls are policies and procedures put in place by management to ensure that, among other things, the company’s financial statements are reliable. Some internal controls relevant to an audit include bank reconciliations, password control systems for accounting software, and inventory observations.

The objective of the auditor is to identify and assess the risk of material misstatement, whether due to fraud or error, at the financial statement and assertion levels. It includes understanding the entity and its environment and the entity’s internal controls in order to design the proper audit procedures to achieve the desired level of assurance.

The walk-through of the accounts receivable/sales cycle confirmed that the accounting and internal control system was working as documented above. Shows that the internal control system of the entity is having a strong internal control system

Control Environment

The control environment at the top refers to the attitudes, awareness, and actions of management and those charged with governance towards internal controls. A simpler way to describe this is to call it the “tone at the top.” It is highly important because it filters down to other employees and to all other components of control and can, therefore, have a huge impact on the company. For example, with a less committed and more relaxed tone, lower level employees are less likely to properly follow the internal controls in place.

Entity’s Risk Assessment

The entity’s risk assessment relates to how the client identifies and responds to business risks, such as new personnel and new accounting pronouncements. Is the proper training given to employees? Are the new pronouncements fully prepared for and implemented effectively?

Information Systems & Communication

The information systems component refers to how the company captures, processes, reports, and communicates transaction information. For example, does the company use distributed processing? – How does it deal with system changeovers? – Is it using well-recognized accounting software or just something that was cheap to obtain.

Control Activities

Control activities refer to the specific detailed policies and procedures, such as review of company performance through variance analysis, physical and logical controls, and segregation of duties. Segregation of duties is an important internal control that helps prevent a lot of problems, one of which is fraud. By having different employees count inventory and have access to the ledger records, this helps prevent employees from stealing inventory and writing it off on the sub-ledger.

Monitoring

Finally, monitoring controls deal with management’s ongoing and periodic assessment of the quality of the internal controls to determine which controls need modification. A common example of this in larger companies is the work done by internal auditors.