Part 2 Examination – Paper 2.6(INT)Audit and Internal Review (International Stream)June 2003 Answers1(a)
(i)The company has increased its revenues by 12% and its gross profit by 16% which in a competitive market is verygood (if not entirely credible) however, increased operating expenses have resulted in a reduction in operating profits of 20%.(ii)The gross margin is very high; this is not abnormal in this sector, especially for software (although the margin is highfor hardware), but it may also be the result of errors, because the information has been produced very quickly. This isalso true of the other figures.(iii)Total expenses as a percentage of revenue have increased substantially with the result that operating profit as apercentage of revenue has reduced by around a third.(iv)The increase in the selling expenses as a percentage of revenue may reflect the need for the company to spend moreon advertising.(v)The increase in the distribution costs as a percentage of revenue may reflect inefficiencies in the method of distributionin an industry that separates these functions.(vi)The administrative expenses as a percentage of revenue have halved although they do not represent a significant amountin absolute terms.(vii)The reduction in operating profits has been partially offset by increased net interest receivable but profit before tax is stilldown 10%.(viii)The reduction in profit before tax and the increased tax charge have resulted in a reduction in profit after tax of over40%.(ix)Total dividends have been increased, despite the lower profits.(x)The reduction in earnings per share is partly due to the reduction in profits but there is insufficient information to statewhether it is also attributable to an increase in the number of shares, although this seems likely.
Higher risk areas and audit procedures
Gross margin and operating expenses
(i)I would obtain a detailed schedule of revenue and cost of sales showing the opening and closing inventory figures forboth software and hardware and I would perform a detailed review of changes on, say, a monthly, quarterly and half-yearly basis.(ii)I would ascertain the accounting policies for revenue recognition for both software and hardware and ensure that theywere in accordance with relevant International Accounting Standards. I would then test the application of these policiesto individual transactions. IAS 38
requires that certain development costs be capitalised in the balancesheet and that research costs and costs that do not meet the criteria for capitalisation be expensed.(iii)I would seek to establish why all three categories of operating expenses have changed so dramatically, by enquiry andby obtaining a schedule of operating expenses and a breakdown of the cost of sales figure.(iv)I would perform detailed analytical procedures on operating expenses and cost of sales/gross margins, on a quarterlyand monthly basis and I would also perform detailed testing of transactions in these areas in order to ensure thatmisclassifications have not occurred.(v)Audit evidence provided by balance sheet work on the inventory figures (such as analytical procedures performed onthe inventory levels and attendance at the inventory count) will also provide evidence in relation to cost of sales.(vi)It is possible that some reclassifications or even errors have been made – some costs appearing as operating expensesmight properly belong in cost of sales. It certainly seems odd that whilst sales have increased by 12%, the cost of salesfigure has hardly increased at all. The reduction in administrative expenses should also be investigated.(vii)I would obtain schedules relating to non-current assets and establish the extent to which these had contributed to anincrease in depreciation costs. I would enquire as to the nature of the additions and their purpose. Additional non-currentassets would also be expected to contribute to revenues. If the change in the earnings per share figure is (partly) a resultof a new issue of shares, it may be that the cash generated has been used for investment in non-current assets.(viii)Because of the possibility of errors, I would increase my sample sizes during tests of controls over the recording,processing and posting of transactions that are posted to revenue, cost of sales and operating expense accounts.(ix)I would perform detailed substantive testing on samples of transactions in these areas from source documentation (suchas licensing documentation, payroll records, purchase invoices for components etc.) through to the daybooks, ledgers,and schedules supporting the income statement (for completeness), and vice versa.(x)The extent of substantive procedures will depend on the extent to which controls are shown to be effective and I wouldbe particularly careful to follow up any errors discovered in both tests of controls and substantive testing. I would alsopay particular attention to any unauthorised, substantial or late adjustments.