BUACC3741 Auditing

RBL’s Finance Director provided you with the following statement of financial position and income statement information which included actual figures for years ending 31 December 2013 to 2015, with estimated figures for 2016.

RBL produces gadgets. This was once a fairly profitable industry but both the size and profitability of the industry in Australia have declined significantly in recent years due to advanced technology and replacement products (which RBL is unable to produce with its existing plant and equipment). Over recent years a number of its competitors and customers have closed down and existing tariffs, quotas and import duties on imported gadgets have been scheduled to be abolished at the beginning of 2016.

RBL’s factory closed in late November, pending the resolution of an industrial dispute (factory workers demanding a 15% wage rise and reduced hours). It is unlikely that work will resume prior to the Christmas shutdown and consequently the estimated figures for 2016 are not, in the opinion of the Finance Director, expected to change.

Required

(A) The responsible partner for accepting new clients has requested you to prepare a preliminary analytical review on the information provided by RBL’s Finance Director. The partner suggests that as a minimum you should provide him with the following information bearing in mind that any change above 10% is material.

(A:1) Horizontal analysis for 2016 and 2015. 

(A:2) Calculate 2 liquidity ratios, 2 activity ratios, 4 profitability ratios and 2 solvency ratios over the period 2013 to 2016. Use the ratios to assess if the company has a going concern problem.

(B)    List four areas of high inherent risk based on your findings in (a) above and explain how they could affect the financial statements of 2016. 

A1: Horizontal analysis of income statement and balance sheet.

Note: All the amounts are in thousands.

The liquidity ratio is the calculated in order to determine the ability of the company to pay off the short term debts of the company (Piper, 2015). The current ratio is calculated to see that whether the company is able to pay off the current liabilities of the company using the current assets. The most favourable current ratio is considered to be 2. Here, it can be observed that the current ratio is expected to be the higher in the year 2016 which is a good sign. The company’s current ratio was the best in 2014 and in 2015 there was a decline (Izhar & Hontoir, 2001). Since, the 2016 figures are estimated we can say if the estimations are correct then the current ratio is very good.

The quick ratio is another type of liquidity ratio but in this it excludes inventories. As we know, that inventories do not fetch us the cash instantly. So, many times it is excluded from the aspect of current assets. The trend of quick ratio is also similar to that of current ratio.

Average inventor is the average of opening and closing inventory. However, we donot have the information of opening inventory of 2013.

There is a requirement of various assets in the company in order to carry out operations. It becomes difficult for the company to have higher returns if there is an obsolete technology and no replacement of old machineries. The assets should be used in the best possible manner to higher the turnover of the company (Loughran, 2011). It has been observed that the total asset turnover of the company is declining which is considered to be unfavourable. It is also dependent on the efficiency of the management and therefore, activity ratios are also called efficiency ratio.

The inventory turnover ratio is calculated to see how many times the inventory is sold during a given time span. This ratio is considered higher the better. The 2016 figure shows a great fall which is unfavourable for the company as it indirectly shows the fall in the revenue of the year (Harrison, Horngren & Thomas, n.d.).

The primary of a company is to earn profits. We can see from the above profitability ratios that the gross profit and net profit ratios are falling drastically which mean that the performance of the company is getting deteriorated. The performance of the company may be because of the inefficiency of the management along with the obsolete technology. A company needs to make maximum utilisation of its assets which the company is failing and which have been depicted quantitatively through the return on asset ratio. Hence, the falling profitability of the company creates a doubt of its existence (Spiceland, Thomas & Herrmann, n.d.).

In order to survive in the long run, the company has to pay off the short term and long term liabilities of the company. The ability or the inability to pay off its debts is determined by calculating the solvency ratios. However, there are not much variation in the ratio but the increase in the liabilities may question the going concern of the company. Logically speaking, it is difficult for a company to pay off its obligations if it has decreasing profits (Kimmel, Weygandt & Kieso, n.d.).

The four areas where I could see the inherent risk in my finding are:

• Interest expense – The amount of interest appearing in the income statement is net of interest income. According to which the interest expense is falling but this may not be the reality. It can be possible that the interest income is huge which is protecting the company. As we know, high interest is paid by the companies that are having huge debt in its balance sheet. Therefore, there may be a chance that te company is trying to hide this material information (Weygandt, Kieso & Kimmel, n.d.).
• In the balance sheet of the company we can observe that the amount of intangibles is falling. Intangibles may include patents to produce the gadgets or the goodwill of the company (Libby, Libby & Short, 2014). However, if the patent is expiring then the company may be overpowered by the competitors who may lead to closure also. However, loss of reputation is a great risk as there are many companies in the industry that are ready to take advantage of such situations.
• It has been observed that there is 15% fall in the revenues. However, the fall in the gross profit is 40%. It is a matter of concern that how is it possible that a slight fall in revenues is affecting the gross profit at such a higher rate (Ittelson, 2009). It is suspected that the company may have made any adjustments in order to avoid tax.
• The values taken for the year 2016 are all estimated figures. Therefore, there lies a lack of clarity about the estimates. It is easier to evaluate the performance and analyse it with the actual data than the estimated data as there will always lie an ambiguity(Warren., 2015).

References

Harrison, W., Horngren, C., & Thomas, C. Financial accounting.

Ittelson, T. (2009). Financial statements. Franklin Lakes, NJ: Career Press.

Izhar, R., & Hontoir, J. (2001). Accounting, costing, and management. Oxford: Oxford University Press.

Kimmel, P., Weygandt, J., & Kieso, D. Financial Accounting.

Libby, R., Libby, P., & Short, D. (2014). Financial accounting. New York, NY: McGraw-Hill/Irwin.

Loughran, M. (2011). Financial accounting for dummies. Hoboken (NJ): Wiley.

Piper, M. (2015). Accounting made simple. [United States]: [CreateSpace Pub.].

Spiceland, J., Thomas, W., & Herrmann, D. Financial accounting.

Warren. (2015). Financial Accounting. Cengage Learning.

Weygandt, J., Kieso, D., & Kimmel, P. Financial accounting.