Audit Risk of a Scapa Company - Case Study Example

Audit Risk Analysis Audit Risk Analysis Introduction Scapa is a huge entity that has a diversified market. Its products expand to the industrial, healthcare and electronics sectors. The products are sold across the globe from North America to India. Scapa has performed well this year. Europe was a challenge to the company’s growth. The company made an acquisition of Webtec to confront this challenge. The acquisition was accompanied by a disposal of the subsidiary in the same year. Such significant transactions in the year have raised some serious risks, which are discussed as follows: Risk of Understatement of Profits Despite the fact that the operating profit of Scapa increased by 14%, the net profit decreased by 40%. This is mainly due to an increase in taxes paid by the company. The Group might have been induced to manipulate the taxes because previous tax losses available for claim might be expiring this year. Exceptional items were more than the current year in the previous year, yet there was no taxation charge in the previous year (Scapa Group, 2013a). The calculation of the tax over the exceptional items has to be checked in detail. The operating profits increased by 14 % and the tax charge on them increased by 32%. The application of the new (changed) tax rate over the profits has to be reviewed. Classification of the exceptional items is also of high risk. The rationale for such classification of exceptional items has to be inquired for. Scapa has disposed off one of its subsidiaries and faced pressures from European side (Scapa Group, 2013b). In order to present a better picture, Scapa might have engaged in showing a better Trading profit to Revenue ratio. This ratio is 6.5%, which is 1.1% better than the previous year ratio. Had exceptional items been included in trading profit, the ratio would have come down to 6% showing just 0.5 % improvements with respect to previous year ratio. Significant Decline in Other Receivables Other Receivables have decreased by 98.5 % from $19.6 mn to $0.3 mn. This variation is mainly because of the re-classification of the assets of the Georgia subsidiary (Scapa Group, 2013c). This amount pertained to the insurance claim. The status of the claim and its valuation is a critical matter. It might be possible that a claim might have decreased, but it is transferred at the amount of the opening balance. Moreover, this liability is discounted at risk free interest rate of 3.35% (Scapa Group, 2013d). The assumption on the basis of which this rate is taken has to be reviewed. Change in rate may change the valuation of the insurance claim. Secondly, the discounted asset has not been unwound by the rate used in this year. The amount of the asset is same. Ideally, applying the rate of interest would have increased this asset. The reason for such constant value has to be examined. Moreover, the classification of the other receivables has to be checked. The Scapa current ratio was 1.7 in the previous year. By misclassifying the non-current assets to current assets, Scapa can improve its current ratio. Scapa has already improved its current ratio to 1.4 in this year. Risks Related to Provisioning Provision is an estimate; therefore, management is at ease to manipulate the provision due to change in the assumptions and projections. Specifically, in case of Scapa, only those estimates are discounted that are material to the financial statement. This materiality threshold is subjective in nature and can be maneuvered by the management as per their desires. This year, provisions decreased by 91% from $26.9 mn to $2.3 mn. This provision mainly contained the claims related to asbestos. All such cases were in the name of Waycross, which has been sold now. Scapa has, therefore, removed these provisions from the books. There is a risk that if the verdict comes against the Waycross, as it happened in March 2010, Scapa may be jointly liable in that verdict. Environmental provisions relating to North America have remained constant. In North America, Scapa has been able to regain the customers. It achieved a growth in hockey sector also. When sales and operations are increasing, the environmental provisions should also increase. There is a risk of understatement of the provisions. Complexities Related to Actuarial Valuation In 2013, actuarial loss increased by 27% from $10.9 mn to $13.8 mn in the current year. Actuarial valuation is a complex issue that works on assumptions. Many statistical techniques are applied. This makes it inherently risky. This year, the company has sustained experience losses of $20.6 mn. This increases risks even more with respect to the valuation of the Scheme. The assumptions are proved true on a consistent basis. In the previous year, the loss was $11.6 mn. This shows that the actuarial valuation is not being done accurately. There is a risk with respect to the valuation of the Present Value of the Obligation. The management may be interested in increasing the losses so that the retirement benefits to be paid in the future are decreased. There is a risk that the weighted average rate used for calculating the interest from the funds is not calculated correctly. The Group operates retirement benefits fund in many countries. There is a risk of incorrect assumptions being taken as the assumptions that are not relevant to one country may be relevant to other country. Risks Related to Disposal of the Subsidiary There are significant risks associated with this disposal of the subsidiary. The net assets of the subsidiary are mainly based on estimates relating to insurance claims and subsidiaries. The reasonableness of the estimate has to be assured. The assumptions that have been taken will have to be checked whether they hold true in the current market situations or not. The risk exists that the net assets are overvalued so that the excessive gain amount is not subject to higher tax rates. There is a risk with respect to the valuation of the proceeds. There might be some contingent consideration involved. In such a case, the discount rate that has been used and the conditions that are attached have to be considered in details. During this disposal transaction, deferred tax of $2.0 mn has been written off. There is a risk that the asset is being understated or it is being waived off from the books for window dressing. Procedures for Verification of Disposal of the Subsidiary The disposal of the subsidiary has hit many line items of the balance sheet including the other receivables, provisions and assets classified for sale. For verifying the disposal, the procedures will be performed on each segment by addressing the assertions relevant to it (Karla & Audrey, 2013). Other Receivables Other receivables classification has to be checked whether all the insurance claims that have been transferred to the current portion relate to the subsidiary being sold or not. This could be verified from the insurance policies. The insurance policy will provide the evidence of the party that is the insurer. Moreover, it will also provide evidence as to the amount covered in the policy. The terms of the policy may also be evidenced with the annexure of the policy. Valuation of the other receivables has to be checked. The foreign rates applied can be verified from the business journals. Provisions Only those provisions have to be transferred to ‘held for sale’ that related to the asbestos claims. All of these claims pertained to previous years and must have been in the opening balances. The amount of such claims can be verified from the previous year working papers. Moreover, the unwinding of the provision could be verified by re-calculating the rate with the provision amount. Confirmations from legal advisor should be obtained to ensure that the provision amount has remained consistent as at the date of disposal and no revisions are required in the valuation. Proceeds The proceeds relating to the disposal can be verified from the agreement. The proceeds amount and the mode (cash, bank or financial instrument) can be evidenced from the documents of disposal. Moreover, contingent consideration, if there is any can also be verified from the same document. The proceeds received can be verified from the bank statement. If they are not reflected in the bank statements, then they must be appearing in the bank reconciliations. Direct Costs of the Subsidiary The main components of the cost of the subsidiary included Cash and Bank balances, litigations and insurance claims. The procedures for provision and litigation have been discussed in ‘Provisions’. Cash could be verified from physical cash count. At the disposal, a cash-count document must have been maintained that would have shown the notes and denominations available for each currency as at the date of disposal. Such amount of cash in different currencies would then have been translated at the foreign exchange rate of that date. Bank balances could be verified from the bank statement. However, confirmations from the banks should be called for. As the confirmation is in much more detail, it will tell about other issues as well such as any agreements, loan, covenants or liabilities with the bank. The translation of the foreign currency bank accounts would also be verified by verifying the rates from authentic and popular business journals. Applying the rates to the balances would then perform re-calculation. A deferred tax asset has been written off by the amount of $2.2 mn. The tax has been considered as not being allowed for tax purposes. This could be verified from the opinion by the tax advisor of the Scapa. The auditors can corroborate the opinion from their knowledge, or from their tax advisors or by appointing their own tax advisor. Issues relating to IAS 10 The disposal transaction actually materialised after the year end. It is next year’s event and should not be accounted for in this year (Bruce et al., 2013). The impression that the conditions of disposal existed at the balance sheet is not true because those were the conditions of classifying the asset as held for sale. The conditions are discussed below. Issues relating to IFRS 5 IFRS 5 has listed certain conditions, which, if satisfied, would lead the subsidiary as being classified as held for sale. The conditions are discussed below (Ernst and Young, 2012): Asset available for immediate sale This is true because all the provisions and litigations were valued for disposal and no working need to be performed further Sale must be highly probable The sale took place on 24 April, which proves its probability Commitment of the management to selling Management was committed to selling the asset as Chairman has discussed it in the annual report. Completion of sale within 1 year Sale took place within 2 months. Terms of sale must be customary The disposal proceeds are more than the net assets. Net assets are valued at market value. Estimates are made with reasonable care. In order to assure the compliance with above conditions, the company will inspect the minutes of the meetings of the boards of the directors, the correspondence with the buyer of the subsidiary and the exchange of any legal documents made with the buyer. The confirmation could also be asked for from the buyer to assure that he is interested in this disposal transaction. References Bruce, M., Denie, C., Tapiwa, N., Edwin, S., Raymond, C., Blaise, C., et al. (2013). Interpretation and Application of International Financial Reporting Standards. New York: John Wiley and Sons. Ernst and Young. (2012). International GAAP 2012. New York: John Wiley and Sons. Karla, J., & Audrey, G. (2013). A Risk based Approach to Conducting a Quality Audit. Mason: Cengage Learning. Scapa Group. (2013a, March 31). Income Statement - Annual report. Retrieved March 23, 2014, from Scapa Group: http://www.scapa.com/files/Scapa_RA-2013.pdf Scapa Group. (2013b, March 31). Chairmans Statement - Annual report. Retrieved March 22, 2014, from Scapa Group: http://www.scapa.com/files/Scapa_RA-2013.pdf Scapa Group. (2013c, March 31). Notes to the Accounts - Annual report. Retrieved March 22, 2014, from Scapa Group: http://www.scapa.com/files/Scapa_RA-2013.pdf Scapa. (2013d). Chairmans Statement - Annual report. London: Scapa. Appendix Statement of Financial Position 2013 2012 Variation Assets in % Non-current assets Goodwill 26.4 25.1 5.2% Intangible assets 5.3 6.6 -19.7% Property, plant and equipment 38.4 40.4 -5.0% Deferred tax asset 25.6 28.3 -9.5% Other receivables 0.3 19.6 -98.5% 96 120 -20.0% Current assets Assets classified as held for sale 28.4 0.6 4633.3% Inventory 23.6 20.8 13.5% Trade and other receivables 40.5 36.9 9.8% Current tax asset 0 0.1 -100.0% Cash and cash equivalents 12.6 16.9 -25.4% 105.1 75.3 39.6% Liabilities Current liabilities Financial liabilities: − Borrowings and other financial liabilities -0.3 -0.4 -25.0% − Derivative financial instruments -0.3 0 100.0% Trade and other payables -41.3 -34 21.5% Deferred consideration -4.6 -6.3 -27.0% Liabilities directly associated with assets classified as held for sale -25.7 0 100.0% Current tax liabilities -0.9 -1.3 -30.8% Provisions -0.6 -2 -70.0% -73.7 -44 67.5% Net current assets 31.4 31.3 0.3% Non-current liabilities Financial liabilities: − Borrowings and other financial liabilities -10.1 -9.5 6.3% Trade and other payables -0.3 -0.7 -57.1% Deferred consideration 0 -2.9 -100.0% Deferred tax liabilities -5.2 -4.8 8.3% Non-current tax liabilities -1.5 -1.5 0.0% Retirement benefit obligations -46.2 -38.9 18.8% Provisions -2.3 -26.9 -91.4% -65.6 -85.2 -23.0% Net assets 61.8 66.1 -6.5% Income Statement 2013 2012 Variation 000 000 in % Revenue 208.8 195.6 7% Operating profit 13.3 11.7 14% Trading profit 13.7 10.7 28% Amortization of intangible assets -1.5 -0.4 275% Exceptional items 1.1 1.4 -21% Operating profit 13.3 11.7 14% Interest payable -0.5 -0.3 67% -0.5 -0.3 67% Net discount of provisions -0.2 -0.2 0% Other finance charges -0.2 0 IAS 19 finance cost -0.1 -0.7 -86% Net finance costs -1 -1.2 -17% Profit on ordinary activities before tax 12.3 10.5 17% Taxation on operating activities -4.5 -3.4 32% Taxation on exceptional items -3.6 0 -100% Impact of tax rate on deferred tax -0.3 -0.6 -50% Taxation charge -8.4 -4 110% Profit for the period 3.9 6.5 -40% Read More