Question

Background 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 Internal Controls 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. Required: 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 Accounts Receivable Lease income 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.

Answer 1

Executive Summary

Big Machine Limited has undergone some major changes during the current year, with changes in systems and software for payment to contractors. Also, it has shifted its focus from leasing and maintenance of manually operated machines to computer controlled equipment, which has led to significant borrowings in the year. The market for the company is in resurgence mode after years of sluggish growth and decline, whereby in the current year, the gold and coal markets to which the company supplies machines have both grown vis-à-vis previous 4-5 years. However, the iron ore market still shows no signs of improvement. The below report gives a brief analysis of the major accounts of the company, namely:

• Plant and equipment

• Machinery Finance Liabilities

• Accounts Receivable

• Lease income

Also, major ratios of the company have been analyzed, taking into consideration the unaudited results of 2017, the audited results of 2016 and the industry standards.

The report also outlines some of the key business risks the company faces and a detailed analysis of the new system of contractors payroll and the internal controls system within it.

Question 1A

Analysis of the ratios and the additional information associated the with four accounts

(i) Plant and equipment

Account Analysis: The Return on total assets % for 2017 (14%) has decreased as compared to 2016 (17%), and is significantly lower than the industry average (20%). This is mainly due to decline in demand for machinery already owned, and increased demand for computer controlled equipment, because of which new equipment has been purchased, thereby increasing the total assets held by the company without commensurate increase in lease income on the same.

Audit Risk: During plant visit, it was noticed that several large used mining machines, probably the earlier manually operated machines were standing idle in the yard. There is a risk of impairment of the same due to change in technology.

Audit steps: It would be necessary to test such idle machinery for impairment, and value them accordingly.

(ii) Machinery Finance Liabilities

Account Analysis: As per discussion with management, borrowings have increased in the year for purchase of new computer controlled equipment. However, the debt-equity ratio has reduced from 1.35 in 2016 to 1.05 in 2017 (still lesser than industry ratio of 1.50), as the borrowings seem to have been paid during the year, which can be seen from the decrease in current ratio to 1.02 in 2017 vis-a-vis 1.54 in 2016.

Audit Risk: Despite of increase in borrowings in the year, there is decrease in debt-equity ratio, probably due to repayment, which has hit current and quick ratio badly. The company does not seem to maintain adequate liquid assets on hand.

Audit steps: The terms of such borrowings and repayment schedule need to be verified.

(iii) Accounts Receivable

Account Analysis: The average Days in accounts receivable have increased from 53 in 2016 to 62 in 2017, still much higher than industry average of 45 days. This indicates slow collection rate, mainly because of ineffective credit policies.

Audit Risk: The company has slow collection rate of receivables, however, the interest earned multiple of 1.9 in 2017 is significantly lower than industry average and 2016 data of 4.1 and 3.51 respectively

Audit steps: The credit period given to customers and credit policy needs to be thoroughly studies to ensure its effectiveness

(iv) Lease income

Account Analysis: The Profit/lease income % has decreased from 12% in 2016 to 8% in 2017, mainly because of decline in demand for existing machinery, despite slow re-growth in the gold and coal market. Also, since borrowings have increased, there profits have significantly decreased on account of interest costs.

Audit Risk: In spite of slow but steady growth in the gold and coal market, the company's lease income has not grown significantly. The company can be said to have a weak marketing policy, as well as slow response to changes in technology, which might leave obsolete assets and less scope for revenue growth.

Audit steps: The terms of contracts will need to be scrutinised, to see whether the company is tapping the growth in market adequately. Also, interest expense needs to be verified to identify decrease in profits.

Question 1B

After almost 5 years of decline in the markets of major customers of the company, namely metals like gold, iron ore and coal, there has been slight increase in gold market of 9.25% in 2017 corresponding to decrease of 24.95% over the previous years. Also, iron ore market increasing at a sluggish pace of 10% approx. since 2012 has increased at 18.35% in this year. This will give rise to major opportunities for the firm, which is already evident from the fact that the demand for computer controlled equipment has increased in the year.

On observation and analysis of certain ratios of the company, we can see that the gross margin % of 25% is unchanged from 2016, though still lesser than industry margin of 30%. However, the net profit margin has decreased from 18.5% in 2016 to 14.5% in 2017, also much lower than industry ratio of 20.27%. This is mainly due to increase in borrowings in 2017, leading to higher interest expenses.

On the other hand, return on total assets of 15% in the current year is significantly lower than industry standard of 26% and 22% in 2016, because of increase in asset base of the company in current year by purchase of computer controlled equipment as per market demand. However, the lease income and profits have not correspondingly increased, since it is the first year of lease of such equipement.

Question 2A

After a study of the new system of payroll for contractors, we have observed the following internal controls within the same to be potentially effective:

Control	Risk alleviated	Test of control
Details for new employee can only be entered in payroll account from a hard copy form signed by the employee and the contracts manager and a signed income tax installment declaration form	Risk of payroll accounts being created for fictitious employees	Verification of such signed hard copy form and income tax installment declaration form
Employee can enter their own hours but that this must be approved by the contracts manager before the pay-run can be processed	Risk of hours being overstated by employee in the system to get extra pay	Approval of hours by contracts manager, timing of the same and further approval by clerk
System automatically calculates the monthly payments based on hourly rate and the current tax rate and also superannuation accrual	Manual modification of hourly rate by employee or clerk, or errors in tax calculation	Recalculation of monthly salary of some employees randomly.
Pay-run is automatically posted to the general ledger on approval by the contracts manager	Risk of error in amount or selection of ledger account	Verifying some monthly posting entries with system generated monthly pay run report
Contracts manager approves processing of payments on the bank website.	Risk of diversion of amount for other purposes or payment of excess amount than actual	Checking approval on bank’s website

Question 2B

Some weaknesses in internal control for contract payroll are listed below:

• ‘Add new employee’ payroll account is only on the basis of forms signed by contracts manager, which is then created by clerk. However, there should be an approval mechanism within system, to ensure that no fictitious employees’ accounts are created.
• Employee can enter their own hours, however, due to practical difficulties, the contract manager may not remember exactly the hours worked, hence instead of manually entering, hours should flow in the system from certain biometric devices directly, with no chance of modification other than in exceptional circumstances.