Audit Risk Analysis: Havelock Europa Financial Review
This paper identifies and analyzes three key areas of heightened audit risk for Havelock Europa based on its 2013 annual report: cost of sales, net profit, and liabilities. Despite declining revenues, the company recorded its first profit in years, driven largely by an unexplained improvement in cost of sales. The paper examines the balance sheet, noting sharp declines in payables and retirement benefit obligations that lack adequate management explanation. It then outlines the analytical procedures and detailed audit tests — including completeness, occurrence, and cut-off tests — that an auditor should perform to reduce audit risk and verify the accuracy of the financial statements.
- Introduction to Audit Risk Areas: Three key audit risk areas identified for Havelock Europa
- Revenue, Profit, and Cost of Sales Analysis: Unexplained profit despite declining revenues raises red flags
- Balance Sheet and Liabilities Examination: Liabilities fell faster than assets as company shrank
- Payables and Working Capital Management: Payable days improved dramatically without clear explanation
- Retirement Benefit Obligations: Pension deficit fell sharply due to exceptional fund performance
- Analytical Procedures and Tests of Detail: Completeness, occurrence, and cut-off tests prescribed for audit
- Conclusion: Audit procedures needed to verify financial statement accuracy
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What makes this paper effective
- Grounds every audit concern in specific numerical evidence drawn directly from the financial statements, making each risk area concrete and defensible.
- Logically sequences the argument — moving from revenue anomalies, to margin analysis, to balance sheet items — so each section builds on the previous finding.
- Connects Part A (risk identification) to Part B (audit procedures) coherently, demonstrating that the tests proposed directly address the red flags identified.
Key academic technique demonstrated
The paper applies ratio analysis (gross margin percentages, payable days, cost of sales as a percentage of revenue) to flag anomalies, then maps each anomaly to a specific audit response. This technique — analytical review followed by substantive testing — reflects standard auditing methodology and shows how quantitative signals translate into practical audit procedures.
Structure breakdown
Part A opens with a brief identification of three risk areas, then works through each in turn: profit and cost of sales, balance sheet liabilities, payables, and pension obligations. Part B prescribes the corresponding audit response, organized by procedure type (analytical procedures, completeness tests, occurrence tests, and cut-off tests), before a brief concluding synthesis. The two-part structure mirrors a professional audit planning report.
Introduction to Audit Risk Areas
Three areas of heightened audit risk for Havelock Europa are cost of sales, net profit, and liabilities. Each of these areas presents anomalies that are not sufficiently explained in the company's annual report and therefore warrant closer examination during the audit process.
Revenue, Profit, and Cost of Sales Analysis
Havelock's revenue in 2013 was £92,462, compared to £89,590 in 2012. In 2012, there were discontinued operations, but none were reported in 2013. Nevertheless, the company's revenues declined over the year. Despite this decline in revenue, the company recorded a profit. The management commentary does not adequately explain where this profit came from. Management mentioned a commitment to efficiency and noted that the company had paid down debt, but there is little clarity about how the company generated less revenue yet increased its profits. The company is not paying a dividend, but it does have motivation to demonstrate to clients that its financial position is improving. The management commentary highlighted particular areas of growth, and while such commentary will always contain a degree of positive spin, it is fair to ask where the improved financial performance originated. Management cites only 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 without providing much detail about how that profit was achieved.
The next logical step 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 discontinued operations in 2012 was 35%. The gross margin in 2013 was 12.4%. So the company improved its gross margins but does not explain how. Again, there are vague allusions to efficiencies but nothing specific to account for the improvement. The improvement itself is not especially substantial. What is notable is that the cost of sales declined faster than revenue, allowing the company to generate just enough additional gross profit to deliver a net profit for the first time in years. While the numbers themselves are not especially suspicious in isolation, the cost of sales is the area where the company was able to convert last year's loss into this year's net profit. Administrative expenses are not an explanatory factor, as those barely changed. The swing in pre-tax profit was £1,147, and the improvement in cost of sales as a percentage of revenue accounts for £1,239 — this is the key figure from which the profit was derived. One would expect it to be given considerably more discussion in the annual report.
References
Havelock Europa 2013 Annual Report. In possession of the author.
Huband, G. (2013). Havelock Europa looking to retail upturn as losses widen. The Courier. Retrieved April 8, 2015, from http://www.thecourier.co.uk/business/news/havelock-europa-looking-to-retail-upturn-as-losses-widen-1.135390
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