Auditing Risk Three areas of heightened audit risk for Havelock Europa are cost of sales, net profit and liabilities.

Havelock's revenue was ?92,462. In 2013, it was ?89,590. In 2012, there were discontinued operations, but in 2013, none were reported. Nevertheless, the company's revenues declined in the year. Despite this decline in revenue, the company recorded a profit. The management commentary does not necessarily explain where this profit comes from. They mentioned a commitment to efficiency, and that they have paid down debt, but there is less clarity about how they made less revenue and increased their profits. The company is not paying a dividend, but they do have motivation to demonstrate to their clients that things are improving for them financially. The management commentary highlighted areas of growth in particular. While the commentary will always contain positive spin, it is fair to ask where the improved financial performance came from. Management only cites a new laser cutting machine, delivering improved efficiency to an unnamed division (p.20). It is concerning that the Group recorded its first profit in years, and is not providing much in the way of detail as to how that profit was achieved.

The next logical step, then, is to examine the margins that the Group earned, as explanatory factors in the profit improvement. The gross margin on continuing operations in 2012 was 11.1%. The gross margin on discounted operations in 2012 was 35%. The gross margin in 2013 was 12.4%. So the company improved its gross margins, but does not explain much about how it did that. Again, there are vague allusions ot efficiencies but nothing specific to explain the improvement. However, the improvement is not substantial. What is interesting is that the cost of sales declined faster than the revenue, allowing the company that little bit extra of gross profit to deliver a net profit for the first time in years. So while the numbers themselves are not especially suspicious, the cost of sales is the area where the company was able to turn last year's loss into this year's net profit. Administrative expenses are not an explanatory factor, since those barely changed. The swing in pre-tax profit was ?1147, and the improvement in the cost of sales as a percentage of revenue accounts for ?1239. This is the key number from which the profit was derived. One would expect it would be given more discussion in the annual report.

The balance sheet is also worth a closer look. The liabilities declined by ?12-086. The total assets also declined, but only by ?9667. So the company is shrinking, as evidence by declining assets and declining revenues, but it is shedding liabilities faster than the overall size decline in the company, which means that the equity has improved. There are several areas of interest within the liabilities in particular. The company noted that it is seeking to reduce its long-term debt, and there is nothing wrong with that strategy, though it usually is not undertaken during times when the company is shrinking. However, there were steep declines in payables, of ?7352, and retirement benefit obligations, of ?3293.

The payables as a percentage of cost of sales in 2012 were 28.4%. The payables as a percentage of cost of sales in 2013 were 20.36%. This is an impressive decline, from 103 days to 74 days. While it would be expected that a company with a 103 payable turnover might want to improve that figure, this is a fairly impressive improvement for a shrinking company. Again, there is little explanation of how the company managed to improve its working capital management so significantly.

The retirement benefit obligations are another issue that is worthy of investigation. These declined from ?4638 to ?1345 in the span of a year. It is fair to say that ae of the company's retirees did not pass away last year, so it is important to understand the causal factors that underlie this shift. The annual report outlines the actuarial assumptions and expected mortality for retirees but does not mention how they cut the retirement benefit obligations so sharply. The improvement was said to stem from strong performance of the investments in the fund, which reduced the deficit sharply (Huband, 2013). That sort of improvement, well in excess of the gains made on the FTSE over the same time period, is something that should be investigated. Those results were well out of line with the market, and with the returns that the company was getting on any other investments at the time.

Thus,...

The company has recorded losses for years, and in 2013 turned a profit at a time when its business was still shrinking, the revenues having declined by ?3 billion. There is little doubt that management was going to be working on improving the company's financial condition, but there is no reason to think that all of the different improvements that appeared on the financial statement could be achieved simultaneously. The liabilities are interesting because of the dramatic performance of the company's pension fund, which wiped a substantial amount of the pension obligations shortfall from the books. Furthermore, while the cost of sales improved at a level one might consider reasonable, taken with the decline in revenue, it was enough to account for more than the entire swing in net profit that the company experienced between the two years. Management did not issue any statement that provided much in the way of explanation for the improvement in the gross margin; as this was the reason the company is now profitable, one might expect management would say something about the great job it did.
Part B. The liabilities should be subject to further examination. The analytical procedures should include the following. The payables derive from the inventories, and the cost of sales, so those figures should be examined. It is important to look at the gross margin, in particular the cost of sales and why that has improved. Inventory levels are important, because the inventory turnover is a relevant statistic here. Inventory turnover must have been better, allowing the company to improve its cash conversion cycle. That is how the payables would have declined. What changed about the inventory mix that would allow this faster turnover and thus the decline in the payables? The auditor should examine the payment details, so that it can match up the payments with inventory, and with sales. The entire cash conversion cycle needs to come under scrutiny in order to make sense of both the payables and the cost of sales improvements.

There are several tests of detail that should be conducted. There are a number of different completeness tests. There should be records that can be reconciled, aligning the goods sold, their purchase orders, and the payment for those purchase orders. All three are critical to understanding this change in the cash conversion cycle. It is important to look at inventory records to determine if there were changes in the inventory mix that would have spurred these changes. The customer base can also be a factor -- what changes to the customer base have helped the more rapid turnover of inventory, and thus payables. Complete documentation for all of these things must be provided.

There should also be occurrence tests. A sampling should be done to ensure that all inventories are accounted for, as are all payables. These should be available for 2012 and 2013, so that they can be compared. Differences in product mix and customer mix can be explanatory factors. There are a number of different documents that should be examined here, including the job cards, job estimations, invoices, GRNs and the invoice register, all of which will provide the background data to ensure that all activity in the company has been accounted for -- if they sold something, there needs to be a record of them acquiring it, paying for it, selling it and receiving payment for it.

There should also be cut-off tests. It is important to ensure that the inventory and payables figures are aligned with the correct reporting period. Payables in particular should be examined -- were invoices paid in 2012 booked in early 2013, which would make the performance in 2013 look that much better? Where inventory purchases made in 2013 not booked, but paid for? This would result in payables declining faster than inventories. The two should be reconciled, and it ensured that they are in the same period.

With respect to the retirement benefits obligations, the market performance seems exceptional. An audit will require a complete accounting of the holdings of the pension fund, so that the performance of the securities within can be evaluated. The actuarial accounting should be verified as well. In particular, were they significant changes to the expected payouts? But most of the attention should be paid to the composition of the pension fund, and the performance of the individual securities within that fund. Any changes in the account, which should…