ProSalam manufacturing Bhd is considering having a nationally competent audit firm to review its annual reports in order to allow it to make an initial public offer. Khlif and Samaha (2014) assert that a corporation should have competently audited statements in order to float its shares. Since, the company wants to engage Siti & Co., the audit firm asks its assistant audit manager to carry out preliminary investigations of the prospective client in order for the firm to make a prudent acceptance or non-acceptance decision. Following the challenges in ProSalam manufacturing Bhd, the assistant audit manager will carry out the analytical procedures and compare with the industry’s ratios for 2016 audited statements. Furthermore, the manager will perform the walkthrough and substantive tests to understand Prosalam’s business, hence, gather enough evidence.
A company to be allowed to Task 1
An auditor should perform the following procedures to determine whether to accept a client or not.
Request Information on the Characters of the Top Management, the Organization, and the Influential Stockholders
The auditor should look for the information on the characters of the top management, the organization, and the influential stockholders. According to Furnham and Gunter (2015), the auditor should consider in a prudent way any issue, which might damage the integrity of the administrators. The auditor should confirm such information from the bankers and lawyers of the prospective client, among other third parties.
Understand the Business of the Client and how they Operate
An auditor should understand the business of the client and how they operate before engaging them by looking at the client’s financial statements, which include the balance sheets, income statements, and the tax returns (Knechel and Salterio 2016).
The Reaction to the Opinions for the Internal Controls’ Enhancements
The auditor should look at the reaction of the management to the opinions for the internal controls’ enhancements that both the internal and the outgoing auditors made before (Mbewu and Barac 2017).
Independence between the Audit Committee and Board Members
Samaha, Khlif, and Hussainey (2015) assert that the auditor should look at the structure, and the independence that exists between the audit committee and board members, and also the external directors’ number.
Communication with the Outgoing Auditor
Chen, Peng, Xue, Yang, and Ye (2016) assert that the auditor needs to communicate with the outgoing auditor in order to know the management’s integrity as well as why the client wants to change the auditing firm.
Of the five procedures above, the auditing standards require the auditor to communicate with the outgoing auditor. According to Chen, Khalifa, Morgan, and Trotman (2018), the Statement on Auditing Standards number 84 (AU315) requires the auditor to investigate the management’s integrity and know why the client wants to change the auditing firm.
The financial statements presented in the question are for 2015, 2016, and 2017. Since, the question requires the comparison and the major differences with the industry’s ratios, I will use the firm’s 2016 figures to perform the analytical procedures and compare with the industry’s ratios for 2016. The reason for choosing to use the firm’s 2016 figures is because they are the latest audited results of the company.
Return on Equity (ROE)
ROE = (Net Earnings /Total Shareholders’ Equity) X 100
= ($2,521,000/$35,469,000) x100 = 7.11%
The industry’s 2016 ROE = 28.50%.
Therefore, ProSalam manufacturing Bhd produces less income from every dollar of the ordinary shareholders’ equity than the industry. This performance shows that the firm needs to work harder in order to match other companies in the sector. According to Raza and Farooq (2017), the ROE measures the extent to which the organization is able to make profits from the funds of the firm’s stockholders.
Return on Assets (ROA)
ROA = (Net Earnings / Total Assets) X 100
= ($2,521,000/$66,821,000) x100 = 3.77%
The industry’s 2016 ROA = 8.80%.
Therefore, ProSalam manufacturing Bhd produces less income from its total assets than the industry. The performance means that the firm should work harder in order to match other companies in the sector. According to Idawati and Wahyudi (2015), the ROA shows how better an organization performance is through comparing the earnings that the firm makes to the total assets value.
Assets to Equity
Assets to Equity = Total Assets / Total Shareholders’ Equity
= $66,821,000/$35,469,000= 1.88
The industry’s 2016 assets to equity = 3.06.
Therefore, ProSalam manufacturing Bhd shareholders and debt providers own less total assets in the company than what the shareholders and debt providers in the industry own. This situation shows that ProSalam’s position is favorable than other companies in the sector because its leverage is lower. According to Choi and Richardson (2016), the assets to equity ratio shows the leverage that the corporation uses to finance its business.
Accounts Receivable Turnover
Accounts Receivable Turnover = Sales / Account receivable
= $104,026,000/$7,936,000 = 13.11
The industry’s 2016 Accounts Receivable Turnover = 7.57.
Therefore, ProSalam manufacturing Bhd collects its accounts receivables more times in a year than the industry. This situation shows that ProSalam’s position is favorable than other companies in the sector because it is able to give its clients goods on credit in an effective manner, hence, collect the money from the customers in a timely way. According to Dencic-Mihajlov, et al. (2015), the accounts receivable turnover ratio assesses the corporation’s capability to effectively give its clients goods on credit, hence, collect the money from the customers in a timely way.
Average Collection Period
Average Collection Period = (Account receivable / Sales) X 365 days in a year
= ($7,936,000 /$104,026,000) X 365 = 27.85
The industry’s 2016 Average Collection Period = 48.21.
Therefore, ProSalam manufacturing Bhd has a stricter credit policy and the more collection efforts than the industry. This condition shows that ProSalam’s position is favorable than other companies in the sector because its accounts receivables, which are in arrears past their due dates are fewer, hence, can help the firm to increase its working capital.
Inventory Turnover
Inventory Turnover = Cost of sales / Inventory
Inventory = raw and in-process inventory + finished goods inventory
= $10,487,000 + $4,843,000 = $15,330,000
Inventory Turnover = $69,177,000 /$15,330,000 = 4.51
The industry’s 2016 Inventory Turnover = 7.5.
Therefore, ProSalam manufacturing Bhd sells and replaces its inventory lesser times than the industry in a year. Hence, ProSalam’s position is not as favorable as the other companies in the sector because it does not as much as the other firms. Hançerliogullari, Sen, and Aktunc (2016) assert that the inventory turnover of a corporation shows the days the company takes to vend its stock on hand.
Days in Inventory
Days in Inventory = (Inventory / Cost of sales) X 365 days in a year
($15,330,000 /$69,177,000) x365= 80.89
The industry’s 2016 Days in Inventory = 47.67.
Hence, ProSalam manufacturing Bhd takes a lot of time to sell its inventory than the industry, which means that the firm’s position is not as favorable as that of the other companies in the sector. Pais and Gama (2015) assert that the days in inventory indicates the corporation’s performance financially, with a smaller number showing a better position.
Debt to Equity
Debt to Equity = Total Liabilities / Total Shareholders’ Equity
= $31,352,000 /$35,469,000= 0.88
The industry’s 2016 Debt to Equity = 2.06.
Hence, ProSalam manufacturing Bhd uses lesser bank loans than the shareholders’ money compared to the industry, which means that the firm’s position is favorable than the other companies in the sector. Coleman, Cotei, and Farhat (2016) assert that a greater ratio of the debt to equity shows that most of the firm’s financing comes from the creditors compared to the investors.
Times Interest Earned
Times Interest Earned = Operating income / Interest expense
= $6,242,000 /$1,474,000= 4.23
The industry’s 2016 Times Interest Earned = 2.2.
From the calculation, ProSalam manufacturing Bhd is able to pay its debt better than other firms in the industry, which is a favorable position for the firm. Tiwari, Cardenas-Barron, Khanna, and Jaggi (2016) assert that a corporation with a smaller times interest earned means that it cannot pay its debt better than the one with a higher times interest earned.
Current Ratio
Current Ratio = Current assets/ Current liabilities
= $27,064,000 /$14,118,000=1.92
The industry’s 2016 Current Ratio = 1.3.
From the calculation, the liquidity position of ProSalam manufacturing Bhd is more favorable than that of other firms in the industry. The figure shows that the company can meet its obligations well.
Profit Margin
Profit Margin = (Operating income/ Sales) X 100
= $6,242,000 /$104,026,000 X100 = 6.00%
The industry’s 2016 Profit Margin = 10.00%.
From the calculation, the profitability position of ProSalam manufacturing Bhd is not as favorable as that of other firms in the industry because the business makes lesser earnings from its sales. Heikal, Khaddafi, and Ummah (2014) assert that the greater the profit margin of a firm, the more effective the corporation is at making incomes from its sales.
Change of Auditors
About three auditors have audited Prosalam in the last decade, which means that the company is active at opinion shopping.
The Resignation of the Upper Management
Prosalam’s vice-president and the financial controller resigned in October 2017 to work in other towns due to “personal issues.” The auditor needs to know other reasons for the resignations because it could be due to fraud. Internal instability and the management not agreeing on business matters, which is not ethical can be other causes for the resignations. Such issues are important to the client’s acceptance decision because if they exist the auditor might not collect evidence successfully during his or her reviews. Mr. Muniru, the new controller does not have enough knowledge and is not satisfied with Prosalam’s new IT system. The reason for ProSalam manufacturing Bhd to employ a financial controller who does not have enough knowledge is questionable. Maybe the firm tries to hide something from the public and this could jeopardize Prosalam’s going concern because of allowing inexperienced personnel to work at the management level.
Hesitation to Deliberate about the Previous Auditor
The company’s vice-president is not quick to allow the prospective auditor to talk about the previous one. Fearing to reveal such information means that the client will be difficult to handle once the engagement begins.
Disadvantages
Not Able to Satisfy the Clients’ Requirements
When an audit firm expands its existing services, the customers get happy as the auditor can tackle their assignments without many difficulties. The problem is that the firm’s workers cannot have experience in all the areas, which can lead to the loss of clients as they look for services elsewhere.
The problem of Free Services
Most audit firms begin providing the extra services free to attract customers. When a firm finally asks the clients to start paying for such services, it might lose some of them who go looking for an accommodating auditor.
Advantage
More Profits
When an audit firm expands its existing services, it gets more customers, which means more money.
Whether under the Current IAASB/AICPA Independence Rules, Siti & Co. will be Able to Help Prosalam with I.T System and Provide the Audit
Under the current IAASB/AICPA independence rules, Siti & Co. will not be able to help Prosalam with I.T system and provide the audit. Tiron-Tudor, Cordos, and Fulop (2018) assert that the auditors who provide consulting services especially on the I.T systems can have grave independence risks where there is the financial data.
Task 2
Siti & Co. should accept Prosalam as a client because from the analytical procedures and the comparison with the industry’s ratios for 2016, Prosalam seems to have a favorable position.
The reasons why Siti & Co. should accept Prosalam as a client include the company’s vice-president allowing the prospective auditor to talk to the previous one though at first was hesitant. Furthermore, other auditors have audited Prosalam in the past, and from the analytical procedures and the comparison with the industry’s ratios for 2016, Prosalam seems to have a favorable position.
The reasons why Siti & Co. could not accept Prosalam as a client include the resignation of the upper management, though was due to “personal issues.” However, Prosalam replaces them. Also, the Company produces less income from both its total assets and the shareholders’ equity than the industry. Still, the organization is able to make profits from the various funds.
Accounting and Control Systems
Since, Prosalam switched to a new computer-based accounting system, it will be a challenge for Siti & Co. to understand the systems. Therefore, the auditor will have to seek the services of an I.T expert.
Inventory Tracking and Cost Accumulation
There is a challenge in Prosalam’s inventory tracking and cost accumulation due to inexperienced workers. Hence, the auditor will need to observe the physical count of inventory and test their costs.
Failing to Keep Conventional Audit Trails
Since, Prosalam failed to keep the conventional audit trails, the auditor will need to perform substantive tests to get enough evidence.
Inaccurate Company Reports
Most of Prosalam’s reports are not accurate such as the budgets and receivables billings. Therefore, the auditor will need to perform substantive tests to get enough evidence.
No Enough Understanding of Prosalam’s Business and the Industry Environment
As Siti & Co. has never audited a client in the small home appliances, it does not have enough understanding of Prosalam’s business and the industry environment. The auditor will need to perform the walkthrough tests to understand Prosalam’s business then start collecting evidence.
Reference List
Chen, F., Peng, S., Xue, S., Yang, Z. and Ye, F., 2016. Do Audit Clients Successfully Engage in Opinion Shopping? Partner?Level Evidence. Journal of Accounting Research, 54(1).
Chen, W., Khalifa, A.S., Morgan, K.L. and Trotman, K.T., 2018. The Effect of Brainstorming Guidelines on Individual Auditors’ Identification of Potential Frauds. Australian Journal of Management, 43(2).
Choi, J. and Richardson, M., 2016. The Volatility of a Firm’s Assets and the Leverage Effect. Journal of Financial Economics, 121(2).
Coleman, S., Cotei, C. and Farhat, J., 2016. The Debt-Equity Financing Decisions of U.S. Startup Firms. Journal of Economics and Finance, 40(1).
Dencic-Mihajlov, K., Cvetanovic, S., Andjelkovic, A., Popovic, Z., Stojkovic, N., Radovic, O., Barac, N., Spasic, D., Cecevic, B.N. and Marinkovic, S., 2015. Impact of Accounts Receivable Management on the Profitability during the Financial Crisis: Evidence from Serbia. Journal of Environmental Planning and Management, 11.
Furnham, A. and Gunter, B., 2015. Corporate Assessment (Routledge Revivals): Auditing a Company’s Personality. Routledge.
Hancerliogullari, G., Sen, A. and Aktunc, E.A., 2016. Demand Uncertainty and Inventory Turnover Performance: An Empirical Analysis of the U.S. Retail Industry. International Journal of Physical Distribution & Logistics Management, 46(6/7).
Heikal, M., Khaddafi, M. and Ummah, A., 2014. Influence Analysis of Return on Assets (ROA), Return on Equity (ROE), Net Profit Margin (NPM), Debt to Equity Ratio (DER), and Current Ratio (CR), against Corporate Profit Growth in Automotive in Indonesia Stock Exchange. International Journal of Academic Research in Business and Social Sciences, 4(12).
Idawati, W. and Wahyudi, A., 2015. Effect of Earnings per Shares (EPS) and Return on Assets (ROA) against Share Price on Coal Mining Company Listed in Indonesia Stock Exchange. Journal of Resources Development and Management, 7.
Khlif, H. and Samaha, K., 2014. Internal Control Quality, Egyptian Standards on Auditing and External Audit Delays: Evidence from the Egyptian Stock Exchange. International Journal of Auditing, 18(2).
Knechel, W.R., and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.
Mbewu, B.W., and Barac, K., 2017. Effective Internal Audit Activities in Local Government: Fact or Fiction? Southern African Journal of Accountability and Auditing Research, 19(1).
Pais, M.A. and Gama, P.M., 2015. Working Capital Management and SMEs Profitability: Portuguese Evidence. International Journal of Managerial Finance, 11(3).
Raza, A. and Farooq, U., 2017. Determinants of Return on Equity: Evidence from the Cement Industry of Pakistan. KASBIT Journal of Management & Social Science, 10(1).
Samaha, K., Khlif, H. and Hussainey, K., 2015. The Impact of Board and Audit Committee Characteristics on Voluntary Disclosure: A Meta-Analysis. Journal of International Accounting, Auditing and Taxation, 24.
Tiron-Tudor, A., Cordos, G.S. and Fulop, M.T., 2018. Stakeholders’ Perception about Strengthening the Audit Report. African Journal of Accounting, Auditing and Finance, 6(1).
Tiwari, S., Cardenas-Barron, L.E., Khanna, A. and Jaggi, C.K., 2016. Impact of Trade Credit and Inflation on Retailers’ Ordering Policies for Non-Instantaneous Deteriorating Items in a Two-Warehouse Environment. International Journal of Production Economics, 176.
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