Assessment item 3Case Study B – audit planning and internal control
Length: 2,000 wordsAlternative submission method
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 in order to prepare the audit plan of GPSA Limited for the year ended 30 June 2017. Along with Morgan Fertilisers, GPSA is one of MYH’s most significant and longstanding clients. The following information has been gathered to date.
Principal activities of GPSA
• research and development of technologies relating to medical equipment;
• manufacture and distribution of medical equipment;
• investment of surplus funds; and
• investment in the property market.
GPSA was incorporated in 1992 and has operated successfully and profitably since that date. In the last few years it has branched out into the property market, acquiring a number of commercial properties which are let mainly to medical practitioners.
The directors of GPSA are:
• Mr. John Stanton, Chairman
• Ms Jane Quade, Chief Executive Officer
• Mr. Joe Quade
• Dr Barry Jones
• Dr Beryl Yeo
Doctors Jones and Yeo are independent non-executive directors and have been directors since 2003. The other three executive directors have been employed by the company since its incorporation and have considerable experience in the industry. Mr Stanton controls a number of private companies.
In prior years MYH placed reliance on internal controls based on satisfactory results of extensive tests of control. Recent discussions with the client have revealed no changes in the system of internal control since last year. The company does not have an internal audit function.
In February 2016, research activities relating to a new laser surgery device commenced. Significant costs were incurred in relation to this research. In April 2017 a competitor announced that it had successfully developed and patented a similar device. In order to finance the research activities noted above the company borrowed from its bankers an additional $5 million during the year. The loan agreement contains a covenant to the effect that should the company’s debt to equity ratio (measured as total liabilities: shareholders’ equity) increase above 1.2:1.0 at any time, the bankers have the right to demand immediate repayment.
Throughout the 2017 financial year, the property market has been in decline. The end of financial year audit is scheduled to start on 1 August 2017 and should take about two weeks to complete. The client completed a stock count on 30 June 2017. The directors require the signed audited final financial report by 28 August 2017.
Your audit partner, John Richards, has approached you and advised that there are several areas he is concerned about and he wants to you to report back to him about these areas before you complete your audit program. These areas and accounts are:
• Accounts receivable
• Current investments
• Property assets
• Intangible assets
• Research and development capitalisation
Ratios extracted from an unaudited set of financial reports at 30 June 2017 together with audited comparatives for the year ended 30 June 2016 and 2015 are set out below for your review.
Ratio2017 (Unaudited)2016 (Audited)2015 (Audited)Return on equity %7.1918.6122.17Return on total assets %4.8613.715.52Gross margin %31.7630.0024.94Net profit margin %10.3820.2717.85Times interest earned1.903.514.10Days in inventory166.53127.89115.85Days in accounts receivable83.0760.6553.24Current ratio : 11.801.541.66Quick asset ratio : 10.890.780.82Debt to equity ratio : 11.111.021.04
The financial controller at GPSA has been refining the system of internal controls and informs you, at the planning stage of the current year’s audit, that he has put together an internal control manual for the company. He has stated that this manual will create greater awareness of controls in the company, particularly with management which, in the past, has not been overly conscious of the need to implement and enforce effective internal controls.
Management staff receive bonuses based on certain agreed-upon target ratios which include measures such as targeted monthly sales volumes, variance of actual to budget departmental overheads and profit before interest and tax. The major shareholder takes an active interest in the performance of the company and is quick to request explanations on variances from the agreed-upon monthly budgets.
Two years ago, the company devoted significant time and resources to the development and implementation of a new IT system. All teething problems associated with the implementation phase have now been resolved, and the financial controller is satisfied that the automated controls in place are assisting in producing accurate and complete accounting records. The sales director also looks after the IT function as the position is not regarded by management as being a full-time job. Once application programs have been tested, strict password control exists over access to the programs. Passwords are not required for access to databases.
To assist in the planning for the current year’s audit engagement, you extracted the following information from a review of the systems notes in the permanent file and perusal of the new internal control manual:
John Richards your partner on the audit has mentioned to you that, in the past, a substantive approach had been adopted for the audit of GPSA. He now feels that, with the improvements that the client claims to have made to the systems of internal control, an opportunity exists to place reliance on the internal controls and therefore reduce the extent of substantive work.
Write a report, including a brief executive summary, to your managing partner that addresses the questions below. Where indicated, use the required format to answer that question.
Question 1A 8%
Analyse the ratios and additional information associated with the five accounts listed by your audit partner, John Richards. Identify the potential audit risks and any particular audit steps that need to be undertaken to reduce audit risk.
Answer this question using the following headings:
(a) Account (b) Analysis (c) Audit risk (d) Audit steps to reduce risk
Question 1B 2%
Analyse the ratios and additional information to outline business risks that GPSA 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:
(a) Effective control (b) Risk alleviated (c) Test of control
Question 2B 2%
List and justify the weaknesses in internal control for sales and trade receivables.
RationaleThis assessment has been designed to assess your ability to:
The report should follow a standard business report format.