Auditing of Havelock Company - Research Paper Example

Auditing Risk related to Inventory valuation Havelock’s inventory balance has risen by 51% from £ 7.874 mn (2011) to £ 11.926 mn (2012). This inventory level is mainly because of the reason that the company has high demand for its good in first two quarters. Due to limited capacity of production, Havelock might have started production this year. However, the risk associated is with the inventory valuation. Accounting policy is to measure the production overheads of the company at normal production capacity (Havelock Europa, 2012f). This gives room to the company not to recognize the increased costs of production in the form of over-timings paid to employees, high wage rates, high fuel costs being charged by the vendors in case of urgency etc. The company might be interested in recording such expenses in administrative costs of the company rather than inventory. This will help Havelock achieve the increase in loss and thus claiming tax refunds. Havelock might not be interested in paying taxes to improve its cash flows. Havelock operates in a dynamic industry, which comprises of retail customers as well (Havelock Europa, 2012d). The choices and demands from the customers change very often which may lead to decline in NRV of the inventory. There is a risk that Havelock may ignore to lower down its inventory valuation to NRV. Risk of Liquidity Crisis Though current ratio of Havelock is 1.4, it is facing liquidity pressures. Payments to the suppliers have also been delayed. Average period of payment to the vendor is 52 days as compared to 36 in 2011 (Havelock Europa, 2012b). The company is under pressure to meet the tough deadlines of the financers on a quarterly basis. In case, it does not pay the interest and principal due, the bank would be entitled to whole of the principal repayment on an immediate basis (Havelock Europa, 2012e). Due to such pressures, the company has not announced any dividend payments. Amounts on charities have also decreased from £ 900,000 in 2012 as compared to £2,443,000 in 2011 (Havelock Europa, 2012b). The company has resorted to additional overdraft facilities in order to meet its liquidity requirements. More credit facilities have been opted for by Havelock (Havelock Europa, 2012d). The fact that the company will increase its production is still remote. It has just entered into an agreement with HP financers to purchase new plant, which will increase its production by 50% (Havelock Europa, 2012a). Before the production starts, Havelock will have to meet its additional capital expenditure requirements along with the working capital requirements discussed above. More interest cost will be added to Havelock’s finance charges. Risks of Over-statement of Revenue The company has gone through losses for two consecutive years including 2011 and 2010 (Havelock Europa, 2011). Competition in the market is also increasing. Due to financial and market pressures, Havelock had to back out from the diversification. The revenue from that component has also been eliminated from the financial statements of Havelock. Despite this, company has made an increase of 20% in revenue as compared to last year. The accounting policy of the company allows the revenue recognition under IAS 11 as per the progress completion method (Havelock Europa, 2012f). This is where Havelock can manipulate the revenue. The company can show the progress of the project as it desires, since it knows how to maneuver the operational aspects of the project and that the knowledge of auditors is normally restricted to the financials. The fact that external confirmation from the customer will be sufficient evidence to show the completion progress is not conclusive because Havelock can influence the vendor due to its familiarity. Moreover, foreign currency translation of the revenue brings the inherent risks of currency valuation. There is a risk of inappropriate selection of the currency rate. This will enable the company to inflate or deflate the revenues as per its wishes. Risk of Over-Statement of Non-Current Assets The Property, plant and equipment have decreased by 16% this year. Havelock has suffered from Impairment losses of £500,000 in the current year. All of the impairment pertains to the land and building. In the industry of interior designing, building is of high importance. Havelock might not have been able to update its own infrastructure due to losses. Styles and designs that keep on changing may have led to the obsolescence of the building, it is a risk that impairment due to such obsolescence might be understated. This is possible because risks relate to specific assets are also considered while charging impairment (Havelock Europa, 2012f). There may be risks associated which may remain undetected. Identification and application of such risks is a subjective matter. Moreover, the company can manipulate the effective discount rate. Many a times, it happens that asset-specific rate is unavailable. In such a case the company has to use other borrowing rates, which may or may not be the true representative of the currency, price and other such risks (Deloitte, 2014). This risk is specific to the Interiors industry in which Havelock operates. Havelock would be interested in decreasing its impairment so that its profitability improves. Risks related to the Disposal of Show Card Print There is a risk that the gain attributable to the disposal transaction is allocated to the operations of the entity so that Havelock’s operations are in profits. There is a risk that due to early settlement of the debt, the financers charge penalty, which is not properly accounted for or is offset against the gain on disposal. Since the disposal took place in the middle of the period at which employees and management are not habitual of closing the books, it is possible that the income statement items are not accounted for properly. Some expenses and income may remain un-booked. The interest charge against the loan up till 26th April of 2012 should be charged for at the effective rate. There is a risk of such interest not being calculated accurately. Havelock should charge impairment related to fixed assets using the appropriate discount rate. The risk exists that such impairment may remain un-charged or may be under-stated. Since all the figures will be re-stated, the changes in corresponding figures have to be checked as re-classifications may be at incorrect amounts. Risk is probable that inaccurate amounts of loans are removed from the current and non-portion of the outstanding liabilities in respect of the loan settled. Detailed Audit Procedures for Disposal of Show card Print In respect of the risks identified, following procedures shall be performed: Financial Statement Item Procedures Revenues The revenues of the Show card have to be verified. These could be verified on a sample basis. Invoices will assist in determining the value of the revenue. The completeness can be assured through the inspection of delivery notes and purchase orders. Costs Different cost items can be verified accordingly. Review of payroll sheets for cost of the employees can be checked. Utilities can be verified from the bills. Substantive analytical procedures would be of assistance in reducing the time of audit as the prior year ratios might be consistent with this year Administrative costs Administrative costs must be verified from source documents. Immaterial items may be skipped or may be checked analytically, if necessary. Income tax charge By applying the tax rate to the profits can check the income tax charge. The rate applied can be verified from the slab rates as per income tax authorities. Property, plant and equipment Property, plant and equipment can be verified from the source documents. However, since it was an operation to be discontinued, the company might not have made any significant additions the fixed assets. Therefore, deducting the depreciation charge from the opening balances must arrive at the valuation of the fixed assets. This could be re-calculated. In case of any impairment, the discount rate applied has to be judged with professional skepticism. Inventories As per the accounting policy, the inventory is value at weighted average method. The operation of the method must be checked by re-calculation (Havelock Europa, 2012f). It must be insured that any item transferred from Show card to the Group is accounted for as per the company stock valuation policy. Transfer pricing should be checked appropriately. Moreover, the production overheads should be split in accordance with the policy. Receivables As per the policy of the company, most of the accounts receivables are insured. Reasonable assurance can be obtained by reviewing the insurance policies. Such policies will provide the value of the sum insured, which will reasonably be close to the balance sheet value (Havelock Europa, 2012e). Moreover, an invoice wise break-up of the receivables should be obtained so that the company is not able to book fake orders. Those invoices should be traced back to the source correspondence with the concerned customer. Special care must be given to the valuation of the balances in foreign currency. They should be revalued as at April 26, 2012 (Deloitte, 2014a). Goodwill As per company policy, the impairment has to be charged to the goodwill related to that particular asset first and then to other assets on the pro-rata basis. The allocation of impairment to the goodwill should be checked (Deloitte, 2014b). Payables The payable balances can be verified from the purchase orders generated by Show cards and the invoices received by it. Invoices should be inspected for making the break-up of the payable balances available. All the liabilities denominated in foreign currency have to revalued as at 26 April, 2012. Classification of Discontinued items Once the individual items of the balance sheet of Show card have been verified, the assurance has to be obtained as to correct classification of it. All such property, plant and equipment must be removed from the group’s financial statements. None of the profits of Show card after its sale should be included in the income statement of Group. Company wise break-up of the balance sheet items have to be taken, all such balances should then be reconciled with the individual accounts of the group’s companies. This would be of assistance to identify any erroneous addition of show card assets and liabilities to the group’s financial statements. There is a risk that cash inflows obtained from the sale of Show card is misclassified in Operating revenue for improving the profitability of the group. Auditing the revenue on individual company basis can reduce this risk. Special care should be taken for items, which have been recognized after the date of sale of Show card. Review of the Legal Documents The legal agreement between Show card acquirer and Havelock has to be reviewed. Such document will provide details as to the Terms of the contract Mode and pattern of payment Parties associated to it Any contingent conditions attached to the deal Break up of payment against this deal and any other deal possible All above clauses will assist the auditor in getting assurance with regards to gain calculation, liabilities attached with the contract and the value of the sale deed. Review of Agreements with Financers There has been more than 90% decline in interest bearing loans. The decrease is because of the early settlement of loans from the proceeds of sale of Show card print. The agreement with the financer must be reviewed. That agreement will provide with the following details: Penalties for early settlement Debt amount paid off Interest related to such loan during the year Any other conditions attached thereto with the agreement This will assist in ensuring the completeness as to finance charges. Loan amount should be deducted appropriately from the current and no current section of the liability. Any outstanding liability with the bank against this loan can be verified from such agreement. It should be checked that the interest charge related to the current portion of the loan in the prior year financial statement has been charged to the income statement. While checking such interest calculation, the effective rate should be verified from the bank. Confirmations should be sent to the bank with respect to this particular transaction. It will reduce the risk of any event or transaction not being recorded. As per notes of the accounts, the consideration received against sale is in Cash (Havelock Europa, 2012f). Such cash received should be verified from the bank statement. Bank loan agreement fee is written off in the accounts. Such fees should be verified from the previous working papers if they are available. Otherwise, this could be traced from the original document to which it relates. List of References Deloitte, 2014a. IAS 21. [Online] Available at: [Accessed 17 March 2014 ]. Deloitte, 2014b. IAS 36. [Online] Available at: [Accessed 16 March 2014]. Havelock Europa, 2011. Annual report. London: Havelock Europa. Havelock Europa, 2012a. Chief Executive's statement - Annual report 2012. London: Havelock Europa. Havelock Europa, 2012b. Director's report - Annual report. London: Havelock Europa. Havelock Europa, 2012c. Finanacial Overview - Annual report. London: Havelock Europa. Havelock Europa, 2012e. Finance Director's review - Annual report 2012. London: Havelock Europa. Havelock Europa, 2012d. Finance Director's review - Annual report. London: Havelock Europa. Havelock Europa, 2012f. Notes to the accounts - Annual report. London: Havelock Europa. Read More