Analysis of ratios demonstrating business risk assessment skills and critical and reflective judgement


Case study You are planning the 31 December 2016 audit of Alex Blenheim Pty Limited, a discount clothing company based in Sydney but with outlets across New South Wales, Queensland and Victoria. Using the company’s financial report, its budget for 2016 and industry benchmarks, as well as your understanding of Alex Blenheim under ASA 315, you have compiled the following preliminary information:   Key ratios include: Ratio Actual 2016 Budget 2016 Actual 2015 Industry Benchmark Return on equity % 12.9 16.6 14.8 15.5 Return on total assets % 10.7 14.2 13.1 14.5 Gross margin % 8.5 9.0 9.5 9.0 Marketing expenses/sales % 2.6 1.8 2.0 2.2 Admin expenses/sales % 1.6 1.6 1.8 2.0 Interest coverage ratio 5.4 8.1 6.4 6.0 Days in inventory 33.1 30.4 31.1 30.0 Days in accounts receivable 50.0 48.0 49.7 45.0 Current ratio 1.3 1.2 1.2 1.5 Quick asset ratio 0.81 0.77 0.77 1.0 Debt to equity ratio 0.51 0.33 0.41 .40   The business environment Alex Blenheim operates in a low gross margin environment, which typically means that large volumes are required to cover overhead costs and generate profits. It also means that overheads need to be kept under control to ensure that a net profit results from its operations. The company did not reach industry benchmarks with regard to profitability in the previous year, and budgeted to do better this in the current year. It thought that it could do so by keeping its costs down in relation to sales while allowing its gross margin to drop, evidently planning to generate a larger volume of sales. The company also planned to improve its working capital management by reducing levels of inventory and accounts receivable. It budgeted for a drop in debt levels, indicating that it expected to produce a healthy cash flow to enable it to do so. Inventory system Alex Blenheim uses an on-line computer system. No items are manufactured in-house; rather, Alex Blenheim maintains a stock of raw materials and sub-contracts the manufacture of its items to factories in Fiji. Approximately 50 suppliers and sub-contractors are used and all have proven to be reliable. You have made the following notes about the inventory system: Procedures for raw materials Separate systems, staff and warehouses are maintained for both raw materials and finished goods. Purchase orders are automatically generated by the computer when stocks of any raw material fall below 70% of the prior month’s usage. The purchase orders contain the following details: • date; • supplier name and address; • raw material needed. Three copies of the purchase order are produced and distributed as follows: • Copy 1—to warehouse to enable follow up of late orders. • Copy 2—filed by accounts clerk in date order. • Copy 3—sent to supplier. When raw material stocks are received, the bar codes attached to the delivery boxes by the supplier are scanned into the system. A two-part Goods Received Note (GRN) is then produced: • Copy 1—matched to warehouse copy of purchase order by stores staff. • Copy 2—filed by accounts clerk. The scanning process is aborted if the codes do not match those on the masterfile. Procedures for finished goods Production orders are automatically generated when finished goods fall below 60% of the prior month’s sales. The production orders contain the following details: • date; • sub-contractor’s name; • raw materials required; • finished goods needed. Two copies of the production order are produced: • Copy 1 – to raw materials store for use as a picking slip, then it is packed with goods and sent to the supplier. • Copy 2 – filed by production controller in date order. When the finished goods stocks are received, the bar codes attached to the delivery boxes by the supplier are scanned into the system. A two-part GRN is then produced: • Copy 1 – matched to production controller’s copy of production order. • Copy 2 – filed by accounts clerk. The scanning process is aborted if the codes to not match those on the masterfile. General notes The computer automatically selects the supplier of both raw materials and finished goods based on: • the latest price (as per their most recent invoice). • their delivery times (based on the number of days between the date the purchase/ production order is raised and the date the goods are scanned by the warehouse).   Password access is as follows: Stores staff  (raw materials)     Purchase order printing for raw materials only. GRN printing for raw materials. Stores staff (finished goods)    GRN printing for finished goods. Production controller               Production order printing, masterfile amendments. Accounts clerk                       Masterfile amendments. Masterfile amendments The stock masterfile contains details of: • existing stock items including codes and warehouse location; • approved suppliers and sub-contractors. Orders will only be generated to suppliers and sub-contractors recorded on the masterfile. Masterfile changes are made by the production controller for both raw materials and finished goods inventory. A masterfile amendment form is completed by the production controller as a record of the changes made.   Question 1 (10%) Analyse the ratios with reference to the additional information. Identify the potential impact for the audit and any particular audit steps that need to be undertaken to reduce audit risk. For example, if there was a worsening inventory turnover, one of the audit steps would include a review for obsolete inventory. Answer this question using the following headings: (a) Ratio analysis (b) Audit impact (c) Audit steps to reduce risk Question 2 (10%) Identify the weaknesses in the internal control system described above and the potential impact on your audit. Indicate the additional audit steps that you will need to undertake to reduce audit risk. Answer this question using the following headings: (a) Internal control weakness (b) Audit impact (c) Audit steps to reduce risk Question 3 (3%) Develop and justify three (3) Computer Assisted Audit Techniques (CAATs) that you would use to assist you in this audit.  Professional communication and referencing (2%) Refer marking criteria.    Rationale This assessment has been designed to assess your ability to: be able to demonstrate risk management methodologies and the role of internal controls in an audit context; be able to design an audit plan and select and apply appropriate audit procedures for a financial statement audit;  be able to exercise critical and reflective judgment. Marking criteria   Criteria   High Distinction Distinction Credit Pass Question 1         Analysis of ratios demonstrating business risk assessment skills and critical and reflective judgement (6 marks). Correct interpretation of all ratios provided, demonstrating a sophisticated understanding of how the ratios can be used to analyse the risks that a business faces. Correct interpretation of all ratios provided, demonstrating a clear understanding of how the ratios can be used to analyse the risks that a business faces. Most interpretations of ratios provided correct, demonstrating an understanding of how the ratios can be used to analyse the risks that a business faces. Most interpretations of ratios provided correct but a limited understanding of their usefulness in identifying the risks that a business faces. Identification of audit tests that minimise audit risk identified through the analysis of the ratios and the additional information (4 marks). All appropriate audit tests identified with a clear statement as to how these will minimise audit risk, demonstrating a sophisticated level of audit planning.   Most appropriate audit tests identified. A clear understanding of how audit tests minimise audit risk. Many appropriate audit tests identified. Some understanding of how audit tests minimise audit risk. Some appropriate audit tests identified. Basic understanding of how audit tests minimise audit risk. Question 2         Appraisal of the client’s internal control environment and application to the audit risk model (6 marks) Well supported and coherent explanation for choice of internal control weaknesses that most significantly threaten the client’s business risk environment.   Well constructed explanation for choice of internal control weaknesses that most significantly threaten the client’s business risk environment.   Competent explanation for choice of internal control weaknesses that may threaten the client’s business risk environment in relation to inventory. Basic explanation for choice of internal control weaknesses that may threaten the client’s business risk environment in relation to inventory Development of a series of audit steps to overcome the audit risk resulting from the weak controls (4 marks). Development of a comprehensive series of audit steps designed to overcome the audit risk. This demonstrates a deep understanding of the audit process. Development of most of the audit steps designed to overcome the audit risk. This demonstrates a clear understanding of the audit process. Development of some of the audit steps designed to overcome the audit risk. This demonstrates a moderate understanding of the audit process. Some attempt to develop the audit steps designed to overcome the audit risk. This demonstrates a basic understanding of the audit process.  Question 3         Development and justification of the use of CAATs in this audit (3 marks). A sophisticated development of and justification for the use of 3 CAATs to support the audit process. A considered development of and justification for the use of 3 CAATs to support the audit process. Development of and justification for the use of 3 CAATs to support the audit process. Development of at least 2 CAATs but limited demonstration of how they support the audit process. These last two criteria relate to the whole of the case study. Professional communication (Note: you are required to space between paragraphs; use Arial 10pt or TNR 12 pt; use 1.5 or double line spacing) (1 mark). Work contains distinct understandable statements with no errors. Extremely well organised. Content is structured in a manner that facilitates the reader’s understanding.   Work contains distinct understandable statements with minimal errors. Answer is well organised. Content is structured in a manner that facilitates the reader’s understanding.   Minor spelling, grammar and punctuation errors. Work shows evidence of proofreading.  Well-structured with one main idea or argument provided per paragraph.   Some spelling, grammar and punctuation errors found but the work is readable and structured.  Work may include too many ideas in one paragraph. Appropriate resources and correct referencing (1 mark).   Used a range of sources. All work has been referenced correctly as per APA (6th edn) requirements.   Used two or more sources. All work has been referenced correctly as per APA (6th edn) requirements.   Used one or more sources. All work has been referenced within the body of the answer and in the reference list, with some omissions or errors in terms.   No additional sources used other than the text. Others’ work is not always acknowledged and there are a number of errors or non-compliance with the APA (6th edn).

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