Audit Planning and Internal Control
Assessment item 3
This report deals with Internal Control of Big Machine Limited (BML) and framework to draw an Audit Plan. Internal audit is overall examination of organisations functional units and effectiveness. This Document contains analysis of Ratios and Business Risk Associated with it. A ratio analysis is comparison between various components of financial statements. Ratio analysis deals with efficiency, liquidity, profitability and solvency of a company. Business risk is the risk that company may not be able to perform as it has been performing.
“Internal Control are a system consisting of specific policies and procedures designed to provide management with reasonable assurance that the goals and objectives it believes important to the entity will be met”. (Institute of Chartered Accountants of India (ICAI), n.d.)
Each audit plan is different and made according to organization’s needs. However, there are common elements that the audit committee should expect to see when reviewing the audit plan, albeit in practice these elements might be presented in many different ways. These elements are discussed below.
Overview of the audit approach
The audit committee should expect the audit planning document to set out that the audit plan has been developed by:
— taking account of the risks identified by the organization
— using the internal auditor’s experience regarding organizations risk
— discussing all identified risks and other relevant issues with the organization
Question No 1 A
Analysis of Ratio and other information along with potential audit risk with various Audit steps to reduce audit risks.
Account Analysis Audit Risk Audit steps to reduce risk
Plant and Equipment Plant and Equipment are tangible non-current assets and its analysis can be done through Return on Total Assets (Plant and Equipment).
Return on Total Assets(Plant and machinery)= Revenue ÷ Total Plant and Equipment
Asset turnover ratio is the ratio between the value of a company’s sales or revenues and the value of its assets. It is an indicator of the efficiency with which a company is deploying its assets to produce the revenue. Thus, asset turnover ratio can be a determinant of a company’s performance. The higher the ratio, the better is the company’s performance. Asset turnover ratio can be different from company to company. Usually, it is calculated on an annual basis for a specific financial year (THE ECONOMIC TIMES, n.d.)
Return on Total Assets is lower by 3% than that of previous year computed ratio and 6% less than that of industry average which signifies company has not utilised assets as efficiently as it should be. A concern with this measurement is that the denominator is derived from book values, rather that market values. This is of particular concern when a business has a large investment in fixed assets that have a higher value than is indicated by their reported book values. In this case, the calculated return on total assets is higher than is really the case, since the denominator is too low.
Another concern with this measurement is that it does not focus on how assets were financed. If a business used high-cost debt to buy its assets, the return on total assets could be favourable, while the business is actually at risk of defaulting on the associated interest expense.
For the purpose of computing Return on Total assets market value of assets can be taken to reflect true and fair ratio.
Ratio of Debt-Equity financing assets should considered rather than completely relying in Return of total Assets Ratio.
Machinery Finance Liabilities The debt-to-equity ratio (D/E) is a financial ratio which represent amount debt to capital of shareholder. Company’s Machinery finance liabilities ratio is determined by Debt-Equity ratio.
Company’s D/E ratio is 1.05 which is lower than that of previous year audited ratio and industry average which signifies that company financed it’s assets more with equity rather than debt compare to industry. In company there involves the issuance and repayment of debt and equity, as well as payment of interest and dividends. Concern for both of these types of transactions is proper authorization by the appropriate official in the company or by the board of directors.
Risk may be associated with payment of debt interest and shareholders dividends. For the purpose of Reducing audit risk following tests of accounts should be
1. Inspection of Minutes and Articles.
2. Debt Covenant Violations
3. Stockholders’ Equity
4. Capital Acc
Accounts Receivable The receivables turnover ratio is an activity ratio measuring how efficiently a firm uses its assets. Receivables turnover ratio can be calculated by dividing the net value of credit sales during a given period by the average accounts receivable during the same period.
The Accounts Receivable ratio is the approximate amount of time that it takes for a business to receive payments owed in terms of accounts receivable.
Days in accounts receivable is higher in BML than previous year data and industries data which concludes that company takes much longer time to collect it’s owed receivables than previous year and industry as a whole.
A concern with this measurement is that while computing Receivable turnover ratio Net credit sales should be considered. Similarly Accounts receivables frequently change every day so average should be considered and risk may be associated with process of computation of average.
Computation of days in year plays significant role to give exact days for collection period.
For the purpose of reducing audit risk following steps can be taken:
1. Total Sales and Credit Sales can verified through accounts.
2. Process for computation of average should be determined.
3. Proper Assumption taken for computation no of days in year should be checked.
Lease income Lease income is one of the main source of income for BML. Profit on lease income ratio can be computed by dividing net profit with total Lease income.
Profit On lease income Ratio of BML is 8% Which is Quite low than that of Previous year audited ratio which is 12%.The Drop of 4% Signifies that there is decline in profit from leasing of Plant and Machinery. Risk May Be Associated with income computation. Income Recognition process is important factor to determine lease income. Similarly Decline in Leasing of Plant And Machinery maybe caused due to Decision of Board Of Directors to diversify the business of BML. To Reduce Audit Risk Minutes of Boards of Directors can be checked to know whether new investment decisions are carried out. Income recognition standards must be followed to recognise income from Lease.
Solution to 1 B
Analysis of Ratios and Business Risk
Business risk is the risk where a business might not run smoothly as it was run and profit anticipated may not be received.
1. Total Debt / Total Equity
The debt/equity (D/E) ratio is a key financial ratio that provides a comparison of debt financing to equity financing. It is an indicator of a company’s ability to meet outstanding debt obligations. Again, a lower ratio value is generally preferred because it indicates the company is financing operations more through its own financial resources than through debt financing. Companies with stronger equity positions are usually better. Higher D/E ratios may negatively impact a company’s ability to secure additional financing when needed.
Big Machine Limited has lower Debt-Equity ratio than industries and previous year ratio which is good because it has able e meet the financing requirement of assets through capital. This helps to save interest on debt increasing profitability in an organisation.
2. Interest Coverage Ratio – The interest coverage ratio is calculated as follows:
Earnings before Interest and Taxes (EBIT) / Interest Expense
This ratio measures the protection available to creditors.It calculates the number of times over the EBIT can cover the interest expense. The ratio value reveals the number of times that a company can make the required annual interest payments. A relatively lower coverage ratio indicates a greater debt service burden on the company causing greater financial insolvency. A lower ratio value means a lesser amount of earnings available to make financing payments, and it also means the company is less able to handle any increase in interest rates. However, an excessively high ratio can indicate the company is failing to take advantage of its available financial leverage.
Times Interest Earned ratio of BML is lower than that of industry which indicates that company has lower ability to cover interest from its Earnings before Interest and Tax.
Solution of 2 A
Identification of Internal Controls in the system that are potentially effective its alleviation and test of Control are given below.
Control Risk alleviated Test of control
1. To provide tender for contract is one of the effective manner inviting offer. It is legal and beneficial for both the parties.
2. The Walkthrough System in payroll department to set up payroll Account can be done by payroll clerk with the help of Username and password. This indicates strong Internal Control.
3. The data entered by payroll clerk in the system from a hardcopy form signed by the employee and the contracts manager and signed income tax instalment declaration form signifies strong internal control.
4. Entry of hours worked can be done by employees and prior approval is required from contract manager before entry which indicates internal control regarding payment.
5. Online payment to employee account along with payment to other creditors is easiest mode of payment. Risk may be lessened when proper documentation of second party is not collected. Numerous bid documentation process should be performed and omission of any could increase risk.
Internal control for payroll department may be affected when more interference is done with the accounts by any unauthorised person. So this requires selected people shall be authorized to pass through walk through System.
Risk may be associated regarding data entry as it requires various information of employee. To reduce risk hardcopy from which data of employee is received should be free from material misstatement.
There is a risk associated with wrong entry of hours worked by employee.
Risk may be associated regarding authority to do online payment to employees. Test of control can be performed to enhance effectiveness by maintaining checklist for Bid Documents.
Test of control can be performed by restricting unnecessary authorization in payroll section
Proper review of signed hardcopy between employee and contract manager is required to minimize the risk.
Further review system should be established to review the link between contract manager approval and hours entered by employee.
Proper authorization of payment should be established and regular cross checking of balance as per pass book and bank Statement is required.
Question 2 B
List of Weaknesses in Internal control for contract payroll of Big machine Limited:
1. Separation of Duties: To put one person in charge of the entire payroll process or not enforcing separation of duties internal controls results to embezzlement and fraud. An example of this is a scheme in which a fictitious employee gets entered into payroll system and continues getting paid until the scheme is uncovered which is a king of fraud. Without separation of duties and strict controls that may create fraud which could go on for an extended period of time. Hence a numerous fictitious employees could be paid unknowingly for long period of time. BML Does not separate duties regarding entry of employee details and payroll. In BML Payroll Department and data entry department should be separated.
2. Data Security: In today’s world security of data of employee and various components of company plays a significant role. There should not be weak security controls for hard copy information, blank checks and check stamping equipment because such can lead to theft of information, money or equipment. As we know Identity theft can result from weak internal controls which can leave the affected employee in financial ruin. This most often happens when private information is left on display when stepping away from a computer workstation. Employee information is also subject to privacy laws and violations can cost a business loss. Internal control regarding Data security of employee is weak in Big Machine Limited. Strong Computerized system is required to ensure better prosperity of business.