Question

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.

What are the strengths and weaknesses in the payroll cycle?

What misstatements this control should prevent? State the control test that one could undertake to the test the control is operating as expected?

Answer 1

STRENGTH

A payroll financing solution offers numerous advantages for your company, especially if the company is growing quickly. The most important advantages include:

1. Enables you to grow your business

The most important advantage of using a payroll financing solution is that it helps you grow your business. Commercial clients typically pay their invoices slowly, in 30 to 60 days. This delay can hurt your cash flow and may prevent you from adding staff to handle business growth. Payroll financing enables you to add the staff you need to fulfill new client orders and grow.

2. Some types of payroll financing are easy to get

Some types of payroll financing, such as factoring, are easy to get. Usually, the most important requirement to qualify for factoring is to work with creditworthy commercial/government clients.

Factoring companies don’t require the traditional underwriting that banks go through. This advantage is important for small and growing businesses that can’t meet bank lending requirements. By the way, if you are looking for other solutions, read “Seven Payroll Financing Alternatives”.

3. Most lines are flexible

Lines offered through a factoring solution are flexible and can grow with your business. This key advantage can be helpful while your business is getting new orders and needs additional staff. The line is adaptive and grows as long as your clients have good commercial credit and your company continues to meet the funding requirements.

4. Can be transitioned to conventional financing

Another advantage is that factoring can be used as a stepping stone to conventional financing solutions, such as business lines of credit. Companies often use factoring for a couple of years and move to other solutions once they have built a track record.

Although lines of credit tend to have more restrictions, they are usually more cost-effective. As a result, lines of credit are a good option for businesses that are maturing.

5. Allows you to offer net-30 terms to clients

Perhaps one of the most significant challenges for businesses is that most commercial clients pay in 30 to 60 days. However, businesses have to pay employees every one to two weeks. Unless you have a cash reserve, this model does not sustain growth. Your reserve eventually run outs. This problem is especially difficult for staffing and consulting companies.

Payroll financing helps you bridge the gap between rendering a service and getting paid. This solution allows you to offer competitive terms to your clients and provides a financial platform for adding clients.

6. Can be obtained quickly

Some payroll funding solutions can be obtained quickly. For example, a factoring line can usually be obtained in a week or so. Obviously, the time it takes to deploy a line varies based on clients’ individual circumstances.

7. Factoring does not incur debt

Lastly, factoring transactions are usually structured as the sale of your receivables, rather than as a loan against them. This structure can be important for larger companies who may look for conventional funding later on.

WEAKNESS

Payroll financing solutions are not perfect. The two most important disadvantages are:

1. Costs more thank bank lines of credit

Payroll financing, especially factoring, usually costs more than conventional bank financing. Consequently, payroll financing is best used by companies that have higher margins or companies that get paid quickly.

Factoring costs are determined through a combination of volume and the payment speed of your clients. It works best if your company has a minimum gross margin of 15%; however, higher margins are better. If your clients pay invoices slowly (i.e., 60 days or longer), consider financing only those invoices that have higher gross margins.

2. Some lines are not transparent to your clients

Lastly, factoring lines are not always transparent to your clients. However, factoring companies always work with you to determine the right way to deploy the solution and minimize client issues.