Metal recycling business - valuation of metal scrap

We came accross an instance where we met up with business personnel, who are in metal recycling business. This business collect metal scrap from all other businesses - metal scrap collector collect, segregate and sort the metal scrap into different grade and dislose them to steel mill.

The collector usually has piles of metal scrap in the collection centre. It is almost impossible to weight the piles of metal scrap efficiently.

Based on our research, we understand that there are professional valuers who will measure the weight of the piles of metal scrap scientifically. It is understppd that the professional valuer measure the weight based on the principle of computing a cone- i.e. width x height x density.

We believe that management need to engage professional valuer to estinate the tonnage of the metal scrap. As auditor, we should carry out the work on test of management expert and observe the stock take.

Revenue recognition - is IAS 18 comprehensive enough for all industries?

As we gained different exposure to different industries - your client portfolio starts to move away from trading / manufacturing into construction, utilities, or other unique industry. The financial reporting standards states the principle. Dealing with more complicated accounting issues, FRS might not have comprehensive guidance in-place to prescribe the accounting treatment.


This is especially so for revenue recognition - IAS 18 - it is almost impossible for this legendary accounting standard to deal with the revenue recognition of almost all industries - corporate world is diversified and the world is changing rapidly - new type of service might be invented by creative entrepreneur - how does accountant account for it and how does auditor audit the accounting treatment proposed by client?


There is an increasing volume from our clientele to call in to seek for auditor's advise on the appropriateness of revenue recognition policy on new revenue stream. Are the accounting standard moves fast enough to cope with the business development or economy development?


Apart from the new business / service developed, certain financial statement users have sought for changes to existing revenue recognition accounting standard -e.g. accounting for bundle contract, which has been in the pipeline for a number of years.


End result - accounting standard getting more and more comprehensive and complicated and prescriptive - are non-accountant financial statement user able to analyze or understand the future financial statement easily ? Fundamental of relevance?

Presentation of dividend income and dividend payment in cash flow statement

We receive a question from our reader to ask us on how to present dividend income in cash flow statement. We would like to do a re-cap before we answer the questions.

In an indirect cash flow statement, there are 3 types of activities presented on the face of cash flow statement,

-          Operating activities

-          Investing activities

-          Financing activities

The titles of these activities explain how the cash flow statement should be presented.

Dividend income relates to income earned from the Company’s investment in subsidiary or other investment (e.g. investment in associate or investment in available-for-sale investment). As a result, dividend income should be deemed as investing activities.

What about dividend paid by the Company to the shareholders? It should be presented as financing activities. Why? Divided payment relates to the return generated by shareholders from the financing provided by the shareholders (i.e. equity – share capital). As a result, dividend payment should be presented as part of financing activities.

Please free to contact us at myauditing@gmail.com if you need any clarification.

Reasonableness test of licence fee

You audit client may be in regulated industries or providing services that are tightly regulated. In this intance, there are chances whereby the audit client is required to pay certain licence fee for the right to operate within that industry or the right to provide such service.

It is important for the auditor to review the agreement to review that allowable services to be provided by your audit client and whether if the licence has expired. This is to help to identify any non-compliance with the rules.

More often than not, your audit client is required to pay certain license fee - which could be based on certain % of revenue , specific rates for certain volume, etc.

Audit client must maintain a process to track the recording of these activities to ensure that the transactions recorded are complete. We, as auditor, also need to review the process in place to check that there is a robust process to ensure the completeness of these transactions. We also need to review the reasonableness of the license fee payable computed to test that the amount is not materially different for audit purpose.

A comparison of current year licence fee payable and prior year licence fee payable could help to identify fluctuation or absence of fluctuation that are expected.

 

Internship in Big 4, mid-tier audit firm or other acocunting firms

We received an email from an anxious intern - who has been accpeted to do her internship in one of the Big 4 accounting firms in Australia. As I understand that it is competitive to secure an internship in Big 4, the reader drop us an email to find out what to prepare and what is expected from an intern.

Extract of his or her email :

" For example, would I need to know audit assertions, control procedures, pivot tables & VLookup, or should I just refresh my accounting 101, know my debits & credits and be nice to people and ask for work?"

Being in one of the Big 4 before, I reverted to her to give him or her my personal opinion:

To me, the attitude and basic accounting knowledge plays a significant part in assessing an intern performance. I would expect the intern to demonstrate positive attitude and fundamental accounting knowledge (i.e. debit and credit of the accounting entries). That's it. I do not expect intern to know any other fancy accounting stuff.

Also, I mentioned to him or her that: she should not be afraid to ask, she should not be afraid to participate, she should not be afraid to do simple work. He or she just has to relax herself and enjoy her time during the entire internship.

 

Accounting for sign-on bonus paid to customers

In service industry, it is common for your audit client to give out sign-on bonus to particular customer to entice the customer to stay with the audit client for a certain period. Sign-on bonus could be upfront payment or payments could be straggerred throught the contractual period.

How should the sign-on bonus be accounted.

We are of the view that the sign-on bonus should be capitalised in full and amortized over the contractual peiod.

For instance, Audit Client A may pay offer customer XY for security guard services a sign-on bonus of US$2million for customer XY to stay with the Audit Client A for a period of 3 years. During this period, customer XY is not allowed to engage other security guad services provider. We are of the opinion that the US$2million should be capitalised and amortized over a period of 3 years.

This is to match the expenses and economic benefit over the contractual period.

Please let me know if you have different views on this :)

Myauditor - myauditing@gmail.com

Data Analytics - impact to financial audit

Recently, data analytics is a very common topic. We were looking at Deloitte website and it appears to us that data analytics provide an insightful analysis of the business which assist the auditor (or even management) to look at the business from a different ankle and assist to identify potential weakness within the business (including: weakness in business process).

We are lucky enough to work on a number of data analytics project. How we felt? It is not easy to apply data analytics to all the audit client, as your audit client's IT system or data may not capture the information we need or the client's IT system might not be commonly use and may not allow us to conduct further analysis.

Having said that, data analytic is useful if the data is available. For instance, it may share with you a list of transactions with unusual preparer ID (e.g. CEO post entries into revenue account) - this may assist the auditor or audit commitee to identify red flags.

Data analytic is portraited as the future of audit tool and we believe that greater emphasis would be placed on data analytic going forward. It is time for auditor to educate the audit client to capture more information / data into the system for more in-depth analysis.

Please feel free to contact us if you need assistance on data analytics.

Payroll Audit: Over/ underpayment to staffs

In payroll audit - auditor need to be cautious and maintain high level of professional skepticism - as payroll is a sensitive area. Payroll has implication on the Company's cost, as well as individual's payment. In certain circumstances, employee union or industry union is also stakeholder.

There could be instances where by there would be over payment or under payment to employee - and this may not be identified by the reviewer of the monthly payroll costs nor the employee. Hence, it is important not only ensure that the payroll costs stated in the payroll summary is correct. Auditor should also test the details within the payroll summary. This is especially true for individual not withdrawing full monthy salary for various reasons, for instance:

- new joiner who joins during the month;
- resignee who leave during the month;
- employee took unpaid leave during the month
- part time employee who were paid based on the number of days work

The computation of the payroll costs for different scenario should be cross-checked against the employment contract to test that correct details have been captured. There could be huge consequences for over payment and/or under payment for payroll costs.

Accounting for derivatives - things to take note

Derivatives are financial instruments recognised as fair value through profit or loss. The contractual term for some derivatives is more than one year.

For instance, interest rate swaps for a non-current loan is typically more than one year - hence, the fair value includes current and non-current portion. Management should assess and determine the current and non-current portion of these derivatives on balance sheet appropriately. This is one of the items to take note.

Also, we also have to disclose the notional amount of the derivative contracts in the financial statement. For instance, the interest rate swap is entered into to hedge a loan amonut of S$10million. This would be the notional amount to be disclosed. This would assist the financial statement user to understand how many % of the loan has been hedged with the derivatives

Besides the points above, the fair value of the derivatives should not be offset against each other. For instance, one derivative contract is in asset position, while the other derivative contract is in liability position as at year-end. These contracts should not be offset against each other on the balance sheet.

Please feel free to contact us if you need clarification on the accounting for derivatives at myauditing@gmail.com

Inventory theft

Inventory may theft may occur to your audit client. As audit, you may or may not detect this event, if it is not revealed by your audit client. To illustrate, your audit client maybe using one of the inventory system:

a> Perpetual inventory system

By using this system, the audit client track every single inventory movement - its in and out - there would be a account created (i.e. inventory differences) to record the the discrepancies noted between actual physical count while carrying out the stock count. Generally, the stock conut is carried out on a monthly or quarterly basis. If the auditor noticed a higher than usual inventory difference, we should ask management to share with us the reason on the rationale for significant inventory differences.

b> Periodic inventory system

More often than not, there is no inventory difference account created to track the difference between the stock quantity per book against physical account. This is because the inventory theft, if any would have been recorded in cost of sales. As auditor, we may be able to identify large inventory difference that would have an impact on the gross margin of the company. However, inventory theft loss as a percentage of cost of sales might not be significant -it is not easy for management nor auditor to detect this.

As auditor, we should understand from management what is the process implemented by management to prevent inventory theft and what is the controls in place to detect this. This is important as safeguaring the Company's asset is important. 

EVA : Economic value added - Auditors should know this as well

Economic value added ("EVA") statement is commonly seen as another measurement of the financial performance of a company. EVA statement is usually seen in the annual report/ reporting of conglomerate.

Economic value added (EVA) is an internal management performance measure that compares net operating profit to total cost of capital. Stern Stewart & Co. is credited with devising this trademarked concept.

(Extracted from www.investinganswers.com)

Please research more details on the nature of EVA as it is useful to know and audit work may arise from this area.

You may visit the following page for more information:

http://www.investinganswers.com/financial-dictionary/financial-statement-analysis/economic-value-added-eva-2925

Presentation of Asset Held For Sale - something interesting to note

Today, the founders of accounting and auditing blog learn something "new" today. We were reading through annual report of a listed entity, who had recorded asset held for sale as at year-end.

As you maybe aware,

" .....An entity shall present a non-current asset classified as held for sale and the assets of a disposal group classified as held for sale separately from other assets in the statement of financial position. The liabilities of a disposal group classified as held for sale shall be presented separately from other liabilities in the statement of financial position. Those assets and liabilities shall not be offset and presented as a single amount. "

Just to emphasize that asset held for sale should be presented as gross asset and gross liabilities with no offset. To illustrate, if a Group has decided to dispose an entity and management has assessed it meets the criteria of asset held for sale - its asset and liabilities should be presented at gross on asset and liabilities seprately.

The other new element we learned about today is regarding the following

" An entity shall present separately any cumulative income or expense recognised in other comprehensive income relating to a non-current asset (or disposal group) classified as held for sale. "

In this juncture, items gone through other comprehensive income should be presented as reserve of disposal group. For instance, asset revaluation reserve of disposal group should be presented on the balance sheet.

This is not new but not many readers are aware of this - hence, we would like to share this you.

Please feel free contact us if you need any clarification - myauditing@gmail.com

Accrual not recorded

More often than not, there are certain accrual for expenditure need to be made by the Company - for instance, accrual maybe made for services received before year-end, but suppliers' invoices not received. Hence, accrual need to be accordingly. There could also be instances where accrual be made for potential expenditure relating to the current financial year.

Often, our consideration as auditor is about the completeness of accrual - it is important to educate management of audit client that to set up a process in place to identify and review the reasonableness of accruals.

As the reviewer of audit file, it is also important to think from the big picture perspective on the completeness of accrual items before going into details (i.e. assessing and evaluating the basis) - an oversight of the accrual is important to identify missing accrual item, if any.

A good understanding of business and development during the year can also help to identify potential accrual not recorded.

 

Singapore Straits Times article - Tax Cheats

Singapore Straits Times reported a news today relating to tax cheats in Singapore where certain individuals are targeting at government scheme or incentives roll out by Singapore government. It is reported that some of the individual used fictitious invoices to claim productivity and innovation credit scheme ("PIC")

There are certain cash payout or enhanced deduction if the Company invested in specific items ( for example, IT and automation equipment approved by IRAS). It is reported that some individuals have fictitiously claimed the PIC benefit with fictitious invoices - i.e. they may not have purchased the items specified by IRAS, but had proceed to claim benefit.

Some individuals had been charged because of the matters above. This matter have the following implication to us, as the auditor:

- while reviewing the PIC claims, we should also maintain professinal skepticism if the PIC claims is supported by appropriate purchases of specific equipments;
- to consider the sighting of equipments if material;
- to assess if the items the Company is claiming qualify under PIC scheme - as only specific items are eligible for PIC
- to review if the Company has developed a process to monitor this PIC scheme

Given that there could be incentives for individual to claim deductions - it is important for the auditor to maitain skepticism in this area of work.

Managerial Accounting : Budgeting - its implication to auditor

We would like to discuss some managerial accounting matters that are related to our audit. The first matter we want to discuss relates to the budgeting process of your audit client. Some blog readers may wonder, given that budgeting is likely to be related to management accounting, hence, not really related to financial accounting. Hence, as auditor, we should not be overly concerned about the budgeting process of the audit client. The truth is, budgeting process is part of the internal controls and assessments carried out / ought to be carried out by management of audit client - this has a significant impact on the extent of our audit and key areas of audit focus.

A comprehensive budgeting process allows management to understand the financial results of the company, identify significant developments not expected, identify key risk areas and identify unusual transactions recorded but not identified. Comparing the actual results against budgeted results and developing understanding on the variance, management is able to make better decision in its resource allocation.

An audit client with no budgeting process in place indicate a relatively higher risk profile of the audit client - as your audit client may not be able to gain the complete picture of the financial affairs of the Company. At this juncture, auditor may have to extend the testing of entity-level controls to review for absence of mitigating controls. Also, a higher level of professional skepticism need to be exercised during the course of our audit to detect any unusual transactions, for which a budgeting process may assist to discover.

The extent of our audit testing may be reduced, if the audit client's entity level controls, including: budgeting process is working effectively. This is because, if the client's process is able to identify risks / unusual transactions - we would be able to rely on the client's process on certain areas.

Please feel free to contact us if you need service on how to develop a comprehensive budget. Please drop us a note at myauditing@gmail.com

Settlement of account receivable via shares / interest in the Company

Let us explore something that is not common but it may have happened in the real business world.

Your audit recorded an account receivable from a particular customer, who is understood to be in financial difficulty. As a result, your audit client had determined that the colleatability of this debt is not uncertain, hence, they had provided for with provision.

After a while, this external customer in financial diffulty situation went through some restructuring, and they had agreed to settle the debt by issuing its own shares to the creditors as a partial settlement plan. As a result, your audit client may hold hold interest in this external customer.

What is the accounting implication to management? Management is required to assess the value of the shares obtained via this arrangement - due to the financial difficulty encountered by this external cutomer, it is probably worth minimal. Nevertheless, it is important to remove the accont receivable and provision for doubtful debt previously provided for - as there is no more such balance.

Instead, the management should record the value of this investment - and this amount should not be higher than the gross account receivable previously recorded, whilst the Company may reverse the provision amount by the value of investment received.

The above scenario is not straightforward and may involve complex discussion. Please feel free to seek clarification from us - myauditing@gmail.com

Review of discount rate / WACC in a discounted cash flow analysis ("DCF") of different subsidiaries within the client Group

Your client may have a number of subsidiaries in different countries / different regions. From holding company, the Company records investments in subsidiaries on its company's balance sheet. When there is indication of impairment, the holding company is usually required to estimate the recoverable amount via the following:

- estimated value-in-use; or
- fair value less cost of disposal

The recoverable amount is higher of one the above.

In estimating the value-in-use, a discount rate will be applied in estaming the value-in-use. Developing an understanding of client's discount rate estimation process is essential for the auditor the test the reasonableness of the discount rate. Typically, your audit client would use weighted average cost of capital (i.e. WACC) as its discount rate. Hence, it is important to know how client gather cost of debt, cost of equity, market premium and beta. These need to be supported by proper source (i.e. print out from Bloomberg).

When a discount rate has been estimated, it is important to perform the review of the discount rate against the industry disocunt rate/ country discount rate/ or even the discount rate within the Group.

Of course, country risk need to be considered. Generally, we would expect the discount rate for a developed nation is lower than the discount rate in an emerging market. As the risk is higher for emerging market.

Hence, it is important to understand and test the discount rate estimation process and perform review of the end result.

Increasing labour cost and its impact on net realisable value of inventories

In current economy situation, almost all entities have to face the challenges of increasing labour costs. It is not easy to manage the labour costs, as the need may fluctuate from day-to-day, whilst the number of headcount is "sticky" in economic term - i.e. headcount of a company would not change drastically within short period of time. Moreover, the change of regulation may have an impact on the labour costs - for intsance, the increase in social security fund in China.

The increasing labour cost would have an impact on net realisable value of the inventories. Why?

The above is especially true for businesses operating in manufacturing environment. Some of the labour cots represent direct labour to the company, who capitalised direct labour cost as finished goods upon completion of production, and charged to cost of sales upn sales of that particular item.

When a manufacturing accept a sales order for a particular model, they would draft a budget to estimate the raw material, labour and overhead costs. On this basis, they would propose a pricing for the customer. The pricing quote may be valid for a period of 1 year or more. In an environment where labour cost is increasing, the direct labour costs incurred may cause the inventory costs to go higher and higher and resulted in erosion of gross profit margin.

This will be very challenging for business to manage, especially for projets with minimal margin - these projects are sensitive to all the costs incurred to produce these items. The increase in direct labour cost may trigger a net realisable value write-down.

As a result, auditor need to understand how this process is being managed and concentrate on projects with minimal GP margin.

Audit of inventory: difference between allowance for stocks obsolescence and write-down of net realisable value

Dealing with the value of the inventory, auditor should have a clear idea in mind on the difference between allowance for stocks obsolescence and write-down of net realisable value of an inventory. Although the term has not been clearly defined and could be over-lapping, there are clearly two factors need to be considered.

Let's examine the following example.

Company XYZ purchased a product A from its supplier and recorded its inventory at purchased cost of US$50 dollar per item. XYZ marketed product A for a selling price of US$54 dollar.

The stocks remained unsold after 2 months, and due to the decreasing raw material prices, the product A buying price for XYZ has decreased to US$48, and the customer is asking for a buying price of US$52 dollar. Is there any net realisable value issue require XYZ to write down its inventory to US$48, prevailing purchase price? The answer is no. According to the accounting standard for inventory - the inventories need to be stated at the lower of cost and net realisable value. The cost of product A was US$50, while the selling price (i.e. net realisable value) was US$52. Hence, no write down is required.

A write-down is required when the market price / selling price drop below US$50.

This is the concept of net realisable value which generally deals with the fluctuation of selling price.

Allowance for stocks obsolescence deals with the long standing stocks, where the specific products remain relatively unsold after a pro-longed period (based on the industry standard). For instance, Company XYZ purchased 50 items of product B, which was expected to be sold within 3 months, whilst the inventory turnover for the industry is about 4 months. However, after 9 months, 10 items of product B remain unsold. This could be due to the commcerial obsolescence where product B is no longer in demand by the market. Management of Company XYZ should evaluate this and consider to provide allowance for stocks obsolescence.

Generally, allowance for stocks obsolescence deal with long standing stocks.

Audit of Fixed Assets: Construction-in-Progress 2

In previous post we discussed on certain matters to take note for the audit of construction-in-progress. We will continue to discuss on the following matters:

c) Billing status and capitalisation status
e) Intended use of construction-in-progress
f) Impairment assessment of construction-in-progress
g) Useful life of this asset upon completion

Explanation of (c) billing status and capitalisation status: it is important to request management to ensure that the amount capitalised per book represents the actual completion status. To illustrate, management may capitalise the construction in progress based on the billing received to date. However, the billing received may not be updated near year-end or supplier may raised the billing earlier than the actual completion status. As a result, it is important for auditor to obtain the budget for the entire project and compare the budget completion status % against the amount capitalised as at year-end for reasonableness.

Explanation on (e) - it is definitely important to understand the intended usage of construction-in-progress for documentation and understand company's strategy

Explanation on (f) - for long standing construction-in-progress that takes prolonged period/ longer than budgeted time to complete is a indication that the company may be experiencing some liquidity issue or the project is abandaoned due to commercial reason.

Explanation of (g) - it is always good to start discussing with client on the useful life of the project upon the completion of construction-in-progress such that there is no surprises at year-end or in the next financial year.

 

Audit of Fixed Assets - Construction-in-Progress

At the end of the financial year, our audit client may have certain construction-in-progress that has not been completed as of year-end. For instance, audit client may be expanding its warehouse, and the construction is still in progress at year-end. What are the items or elements we need to take note relating to the audit of construction-in-progress?

We have summarized a number of factors that we will discuss in-depth:

a) Nature of the Construction-in-Progress
b) Completion status of the Construction-in-Progress
c) Billing status and capitalisation status
d) Commencement date of the construction and expected completion date
e) Intended use of construction-in-progress
f) Impairment assessment of construction-in-progress
g) Useful life of this asset upon completion

Explanation on (a): It is important to under that the nature of the construction in progress and its intended purpose. An understanding of such construction will assist the auditor to understand the Company's strategy, operational decision etc. It is also important for the auditor to know the budgeted amonut of such asset.

Explanation on (b) : Understanding of the completion status of construction-in-progress allows the auditor to form an expectation on the amont to be capitalised at year-end. It is also fundamental for the auditor to sight the physical construction-in-progress to test that the physical progress is not materially different from management's representation, if applicable. Nevertheless, the status of construction-in-progress can be certified by external party. For instance, a quantity survevor may certify the status of completion of a physical warehouse expansion.

Explanation on (d) : Commencement date of the constrution-in-progress indicates if the project is on-track. Focus need to be given for those long standing constrution-in-progress. For instance, if a project expected to be completed 6 months remain in the Construction-in-progress list warrant auditor's investigation.

We will discuss note (c) , (e) , (f) , (g)  in our subsequent post. Please feel free to contact us at myauditing@gmail.com.

Financial audit of a hotel - key indicators of performance

Audit of a hotel is unique and the audit procedures carried out can be different from the audit of trading and manufacturing entities, which are more common in the economy. Of course, audit of each industry is unique.

Understanding how management measure the financial performance of the hotel helps the auditor to understand what is the key performance indicator measured / monitored by management closely. Auditor should consider the risk of management's manipulating the key performance indicator for their own interest (e.g. remuneration).

Generally, the following are the key indicators watched by hotel management closely:

a) Occupancy Rate:
Occupied Room / Total Avaiable Room

b) Average Room Rate

c) Revenue Per Available Room (i.e. Occupancy Rate x Average Room Rate)

d) Headcount to Room Ratio

Occupancy rate measures the volume of the business (i.e. number of rooms occupied by the hotel guests or other gueses). The occupancy rate fluctuates from time to time depending on the seasonality factor. For instance, a hotel may target on corporate customers as its marketing strategy. Based on general expectation, the occupancy rate is expected to be relatively lower as the volume for corporate customer is typically slower due to vacation.

Average room rate measures the room rate secured from the customer. A number of factors can affect the average room rate: pricing strategy of the Hotel, demand and supply for the room, volume secured etc. Every single dollar may have a significant impact on the bottom line.

Revenue per available room considers both the occupancy rate and average room rate.

Headcount to Room ratio measures the number of headcount employed divided by rooms available and/or rooms occuppied. This ratio measures the headcount efficiency as well as the proper planning of headcount based on volume.

It is important to analyse the above key indicators from month to month and compared the key indicators above to indsutry average. Significant discrepancies should be investigated.