QUESTION
CMA303_Principles of Auditing
Major Assignment Sem 1, 2012
Your firm is the auditor of Easy Hire Pty Ltd (Easy Hire).the company hires out equipment to
industries such as construction, engineering & event management. It has 76 branches nationwide,
with its head office located in Sydney. Each branch has designated amount of stock for hire. The
amount of stock for hire is by the marketing department at head office, according to the local
demand for products.
In the past, branch managers had to obtain authority form the financial controller at head office to
purchase equipment from suppliers. Replacement equipment is issued due to either wear & tear or
loss by the customer. In the case of a customer losing or destroying the equipment, the replacement
value of the lost item is charged to the customer.
Customers are given credit, but the credit limits are set by the credit controllers at head office.
Standard terms of payment are 30 days from the date of the monthly statement.
The company has a new managing director who, early in the financial year, decided to decentralise
decision making & give the branch managers more authority. She also introduced an incentive
scheme for branch management, based on branch profits. Branch managers can now purchase
replacement equipment & set credit limits for customers.
The managing director has set up a list of designated suppliers for equipment& has negotiated
additional credit terms and /or special settlement discounts from them. A contract of repair of
equipment has been granted to an organisation with links to the main shareholder in the company.
You have the task of planning the audit & identifying the risks of material misstatement. Your
preliminary analysis, which compared the year under review to the previous year, showed the
following.
a) Branch sales & profits have increased considerably
b) Debtors levels (days outstanding) have remained relatively constant.
c) Creditors levels (days outstanding) have increased marginally.
d) Equipment write offs (due to wear & tear) have reduced relative to sales.
e) Equipment stocks at branches have increased considerably.
f) Repair-of-equipment costs have increased as a % of sales
Required:
Describe three internal control activities regarding replacement purchases that you would expect to
see in place. Give reasons for your answers.
SOLUTION
In the given case Easy Hire Pvt Ltd, the company is into business of hiring out of equipment to various construction, engineering and event management companies. The company leases out the equipments to the clients with permission from the head office and provide the customers with required credit period after taking the relevant time permit from the Head office in the laid down process and format. The policy adopted by the new managing director has decentralised certain decisions regarding the purchase and credit limit period for customers. She has designated list of suppliers with negotiated credit terms and discounts.
In planning of audit ad identifying the related risks, the auditor needs to have understanding of the business of client and its environment along with the prevailing market situations.
There has to be taken into account the related inherent risks including the fraud risks related to plant and equipment which may include the following:
-Obtaining an understanding of the Internal Control procedures related to plant, property and equipment likewise review and preparation of budgets etc.
-Assessing the relevant risk of material misstatement and designing tests for controls ans substantive procedures to ensure: Existence of the property by verifying title deeds, agreements or other ownership documents; Ensuring the completeness of the recording of property including expenses, capitalised cost of finance as well as under lease or hire purchase agreements; verifying transaction cut-offs; cross checking the rights over property with client to record ; ensuring the proper allocation and valuation of property and accurate transactions related to it; checking the appropriateness and correctness of classification in terms of long term or short term held of leases or hiring out; Determine the appropriate method for the depreciation to be charged on the effective property and checking for evaluation errors or the application of the relevant policies; valuation of remaining useful life of the property and evaluation of residual value of the equipment; the determination of carrying Cost which must be updated with the current situations’ checking the validity of assumptions taken and effective valuations by the competent authority; recognition of the Fair value of the asset; recognising the impairment or reversal of impairment if any in case of application. Such things must be ensured and applied and appropriate disclosure and presentation must be made as per the requirements and the standards set for to be adhered.
Some potential misstatements on account of fraud and error may include the following:
-inflated purchased price from some related party might distort the view; writing off the assets as obsolete, scrap, destroyed or donated, expenditures on repairs and maintenance showed as part of purchase price; capitalising the cost of the equipment which are not attributed to be included in the cost of the machinery; recording of those expenses or those transactions which relate to the purchase of the equipment but has not actually effected or received by the entity; removing the assets for which payment has been made by the entity or against the use of the assets or rather it is been recorded in the books whereas it is being used for the benefit of any other person other than the entity. Such things may occur in the organisations because the internal controls are not strong enough to check through it which may include: the management is not properly involved to watch over the employees who have been handling or have the access to assets, cash or other things which might succumb to the fraud or misappropriation; items which are considerably small as well as easily marketable has to be handled with care especially with ownership identities; timely verification and complete reconciliations of the assets with accuracy; adequate safeguards for the physical safety; misuse if assets by those who are in access to the equipments or using it for personal means of usage or for using as collateral or pledging without having the legal entitlement or with requisite documents or processes or the selling of the equipment at considerably lower price than the fair value evaluated in market in current circumstances.
Apart from all the set procedures, the auditor has also to perform certain assessment procedures relating to the risk factors which provide the basis for assessment and identification of material misstatements which will included as enlisted:
Inquiries relating to procedures of control, objectives of the entity, the various strategies, objectives and different incentive policies of the entity from the management as well as the employees or others who may be related to them; procedures regarding the analysis like the various profitability or comparability ratios which affect the decisions and observation of the surrounding environment, premises and various facilities provided by the plant in the process.
There should be proper separation and distribution of the duties to the various personnel so that proper control is adhered and mis-usage is prevented. There should be different people for purchase, approval of invoice, classifying and recording, maintaining custody and disposition and reconciliation for financial recording. Appropriate personnel must be appointed for accounting for purchases, classifying, for authorizing the process and approving the same. Inspection must be done and appropriate changes must be incorporated time to time with the effective conditions prevailing in the market. In certain cases of removal or sale or transfer, pre-approval from the management can be taken and in cases of theft etc , it must be immediately reported to the management so that effective and prudent steps can be taken. Some potential consequences if there is lack of accountability may be as follows: purchase of unsuited or unauthorised equipments, transfer of property to unauthorised location, personal usage of assets, inaccurate evaluation of assets for the purpose of financial and accounting records; mis-statements and misleading appropriations in case of distorted facts being sent to the relevant authorities. There should be timely and periodical review and reconciliation. There should be separation of Hire purchase agreements and leases in fact both types of lease viz. Operating and Financial lease and appropriately accounting and policies should be adopted. There should be proper counting, valuation, usage and disposition determination at consistent time period likewise quarterly or annually, comparison of present records with the present status and proper classification as to inventorial or non-inventorial, identifying the ownership and accounting with the market fair value worth, Reviewing the Insurance coverage and updating with upcoming changes and the current policies as the relevant insurance policies states with regards to the coverage plans offered to the equipment. Documentation and referrals to the upcoming changes to the databases at centralised zones or the head offices. The liability of off-site incidents and the appropriations relating to the value must be evaluated and considered for the recording and true and fair view of the financial statements. The amount assured and the relevant policies for the coverage portion must be accurately calculated upon for the assessment of the reimbursement and to the related parties and the relevant loss coverage of assured amount. The insurance apportionment in cases where the leasing is of financial or operating nature as well as entire ownership onus must be thoroughly checked upon for the appropriate treatment of the insured asset and the legal agreement terms binding upon it for the correct disclosure in the books of accounts.
The auditor has the responsibility to correctly review and analysis the Internal control system of the entity and suggest for the relevant changes from time to time as per the upcoming changes. The internal control must ensure dynamics to ensure accurately give effect to the prevention of the expected or certain unexpected misleads which might distort the view of the auditor in preparation of the financial accounts. This in turn consequently, may affect the decisions taken and further processes or decisions to be presumed on the basis of the substantiated facts as provided as information in the records for further reference.
Basically to review the internal controls following must be taken into account:
-Control of the expenditure which has been done on the equipment either acquired or constructed by self; this can be done by capital budgeting which ensures effective authorisations and helps in comparisons of actual and budgeted figures and ensures controls over it. It helps in controlling and keeping check on the capital expenditures and the allocated revenues for the stated purposes and checks the over and excess expenses.
-Control of utilisation and accountability of the equipment or the component of the equipment. It can be ensured by maintaining appropriate records and facilitating control over the custody of the assets likewise the verification physically by the management or laying down the procedures for the disposal etc, and check optimum utilisation to ensure that the objectives and goals of the entity are met.
-Controls of Information; it helps to check the reliability of the information that is used and made available for the calculations and the evaluations certain things like worth, depreciation, preparing returns, ascertaining insurance coverage and filing of the claims pertaining to it. It helps to keep check on the repair and maintenance expenses over the assets as well as the spare parts which are on time to time expended costs partially or in totality with regards to the present condition of asset and the time period for which the asset was put to use to ascertain actual evaluation.
-Safeguarding of the Assets- it ensures that the assets which are owned or used by the entity are safeguarded and proper insurance cover is made available to avoid any losses on destruction or damages through warranties or guarantees. The entity must have the process for such unforeseen circumstances for protecting the assets and appropriate personnel must be employed.
The auditor has to employ certain verification process to ensure that the laid processes are followed as intended and meet the specific and required purposes. It has to be assured by the alternates to meet the upcoming and unforeseen circumstances in ever changing environment.
It is to be ensured by examining the related documents and verifying physically the actual state of the equipment. It should be thoroughly verified and backed by the documentary evidences and vouchers and simultaneously evaluating the Internal control stated by the entity. It is primarily the responsibility of the management to ensure the applicability of such procedures and therefore they must take proper steps and resources for smooth functioning. They must check that the policies adopted are appropriate and in consistent with the strategies as decided by the management. Policies adopted for cost capitalising must be checked to ensure proper method is followed viz. Cost or valuation model is adopted and evaluation of residual values for the calculation of depreciation properly. The depreciation calculation for the assets must in consonance with the relevant documentary evidence and in consistency with the fair value ascertainment with the market standards.
The auditor should ensure that the assets which are to be capitalised must be bifurcated on the basis of the components or primarily in totality. This approach must be followed if the significant value of component is attached to the whole equipment or the useful life of the asset is significantly important to the value of the asset and it give rise to the separate capitalisation of equipment on component basis. The additions, deletions or dispositions, or the impairment of the assets must be taken into account with the relevant adjustments for the financial records and adhering to the standards and also state the required qualifications in process of adhering to the stated standards. Decline in market valuations, changes in policies, changes in technologies or any legal or economic changes wherein the entity operates and is affected must be taken into account. The appraisals of the report must be based on solid facts which are reasonable and adequate and is also entitled to the revaluations made by the experts as recommended. The auditor must ensure that reliable information is provided to the entity so that future economic benefits may come to the entity and it is in the best interest of the entity.
References:
(1) Guidance Note on Audit of Property, Plant and Equipment , viewed on 2nd april 2012,http://in.kpmg.com/knowledge_update/Guidance-Note-Audit.pdf
JE71
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