ntroduction
In this report, first it calculates several ratios to find out the performance of Triple Steel Corporation in both 2009 and 2010. Then according to these ratios to determine which areas needed to pay more attention during the auditing. After that, two special issues are discussed, the first one is inventory internal control system. The second one is the dividend payment issues in 2010.
Evaluation and assessment of the company's performance
The following ratios are calculated during the analytical review:
Current ratio = Current assets / Current liabilities
Quick ratio = (Cash + Short-term investments + AR)/ Current liabilities
| | 2009 | 2010 |
| Current ratio | 3.7125 | 2.9503 |
| Quick ratio | 2.3238 | 1.6492 |
Table 1: Current ratio and Quick ratio of Triple Steel Corporation (2009, 2010)
The higher the current ratio, the greater the assurance that current liabilities can be paid in a timely manner (Leung & Corman, 2009, p259). From Table 1, the current ratio of Triple Steel Corporation (TSC) for 2010 is 2.95 which is greater than 1.
The larger the quick ratio means the greater the liquidity (Leung & Corman, 2009, p 259). The quick ratio of TSC in 2010 is 1.64, which is also greater than 1.
Besides that, the "Operating cash flow ratio" is also calculated to determine the liquidity of TSC.
Operating cash flow ratio = (Cash flows from operations)/ Current liabilities
= 1,531,000/ 2,992,000 = 0.5116
The operating cash flow ratio is only 0.5116 which means that TSC may not have enough money or exchangeable securities. Also, in the Cash Flow Statement, the Net Cash Flow is negative $34,000. Because of the low level of operating cash flow ratio, TSC has lower potential to generate cash and they will have lower probability to expand their business range.
From the current ratio and quick ratio, it is clearly that TSC has a good liquidity, but the low operating cash flow ratio indicates there may be a potential problem with its cash flow.
Accounts receivable turnover = Sales / Accounts Receivable
Asset turnover = Sales/ Total asset
| | 2009 | 2010 |
| Accounts receivable turnover | 10.31 | 14.65 |
| Asset turnover | 1.0837 | 0.9957 |
Table 2: accounts receivable turnover and asset turnover of TSC (2009, 2010)
According to the equation of Accounts receivable turnover, a low ratio implies the company should re-assess its credit policies in order to ensure the timely collection of imparted credit that is not earning interest for the firm. And the Asset turnover measures a firm's efficiency at using its assets in generating sales or revenue - the higher the number the better. The both ratios of TSC are high, so the efficiency of TSC is good. But from Table 2, it also shows that the accounts receivable turnover is increased in 2010 compared with 2009, from 10.31 to 14.65. On the other hand, the asset turnover is slightly decreased in 2010. Accounts receivable is one component of Total Asset, the two ratios changed in different ways, potentially there may be some problem with accounts receivable or total asset.
Debt to equity= Total liabilities/ Shareholders' equity
Times interest earned= EBIT/ interest expense
| | 2009 | 2010 |
| Debt to equity | 0.4529 | 0.4773 |
| Times interest earned | 13.5 | 4.2234 |
Table 3: Debt to equity, times interest earned of TSC (2009, 2010)
Debt to equity is to measure the extent to which a company is using its debt financing capacity (Leung & Corman, 2009, p259). In this case, the debt to equity is stable, a little change between 2009 and 2010. The Times interest earned is to measure the number of times a company can meet its fixed interest charges with earnings. In 2010, this ratio is 4.2234, it means TSC can cover its interest expense. But compared with this ratio in 2009, it is reduced from 13.5 to 4.2234. There must be some big changes in either EBIT or interest expense of TSC in 2009 and 2010. The details will be discussed in the next part.
To sum up, from Debt to equity and Times interest earned, TSC has ability to pay its liabilities and it does not use so much loan or debt to run the business.
Performance (Profitability) Analysis
Return on sales= Operating profit/Sales
Return on assets= Operating profit/Total assets
| | 2009 | 2010 |
| Return on sales | 17.42% | 5.15% |
| Return on assets | 17.42% | 5.13% |
Table 4: return on sales, return on assets of TSC (2009, 2010)
The return on sales ratio is to reveal profits earned per dollar of sales. This ratio indicates ability to earn satisfactory profits for owners, as well as the entity's ability to withstand adverse conditions such as falling prices, rising costs and declining sales. The return on assets is to indicate profitability based on total assets available (Leung & Corman, 2009, p260). The two ratios of TSC are basically the same in the same year, but compared between 2009 and 2010, they reduced from 17% to 5%. So the profitability is reduced a lot.
Key areas require special attention
According to the ratios calculated above, the following numbers changed a lot in 2010 compared with 2009.
a. The Net Sales in 2009 was $24,019,000, while $21,643,000 in 2010, reduced more than 2 millions in one year (decreased 10%). Because of reducing in Net Sales, the EBIT is reduced from $3,861,000 to $1,115,000. Reducing EBIT leads sever ratios decreased in 2010. Also the reducing Net Sales leads the Net Income decreased from $1,795,000 to negative $49,000. In the other words, TSC did not make profit on 2010. So during the audit for the year ended 2010, it should pay special attention on its sales records to find out the reasons of decreasing the sales.
b. Accounts Receivable is decreased from $2,327,000 to $1,465,000 (decreased 37%). The decreased Net Sales may be the one reason of decreased Accounts Receivable. But the other main component of current assets, cash and cash equivalents, is only decreased $34,000, while Accounts Receivable decreased $862,000. There must be some other reasons cause the decreased Accounts Receivable. So during the auditing, we should find out the other reasons for decreased Accounts Receivable.
c. On the Balance Sheet, the "Miscellaneous deposits and Accounts" records on $203,000 in 2010, but only $133,000 in 2009 (increased 52.6%). And in the Cash Flow Statement, "other deposits" records as $70,000. But no other details about what "Miscellaneous deposits and Accounts" really is. Therefore, during the auditing, it should find out the details of "Miscellaneous deposits and Accounts"
d. The Net Income and Net Cash Flow are both negative in 2010, but the Dividends Paid are both $500,000 for both 2009 and 2010.
e. As TSC uses both First In First Out and Last In First Out to manage its inventory, so inventory should also pay more attention.
There are three basic principles should be involved TSC's inventory internal controls
a. Adequate separation of duties between those responsible for the physical inventory (ordering, receiving, distributing/selling) and those responsible for the inventory accounting records (approving payments, charging departments/customers, maintaining the perpetual inventory balance in the Finance System and reconciling the Finance System) (Cliffsnotes, 2011). For example, inventory receipts should be handled and verified by 2 people. One to input the receipt into the system and another to secure the goods. The person responsible for ordering inventory should not be the same person to receive it. This procedure helps TSC to control its inventory, and make sure all the inventory transactions and activities recorded in a right way.
b. Store inventory in secure areas. Access to these areas should be restricted also. Physical control over assets and records helps protect the company's assets. These control activities may include electronic or mechanical controls (such as a safe, employee ID cards, fences, cash registers, fireproof files, and locks) or computer-related controls dealing with access privileges or established backup and recovery procedures (Cliffsnotes, 2011). This procedure can help TSC to minimise the unnecessary loss of inventory. So that, it will benefit inventory recording and valuation system.
c. Conducting a periodic count and costing of the inventory. This must be done at least annually for the TSC's June 30 fiscal year-end. More frequent counts should be made depending upon the size and vulnerability to misappropriation of the inventory. Compare the count and costing to the inventory record system and to the Finance System. All differences should be investigated and explained.
As mentioned above, in both 2009 and 2010, TSC paid $500,000 for dividend. But in 2010, the Net income of TSC is -$49,000, which means TSC paid dividend even it did not make profit in 2010. According to Corporation Act 2001 Section 254T:
A company must not pay a dividend unless:
Circumstances in which a dividend may be paid
(a) the company's assets exceed its liabilities immediately before the dividend is declared and the excess is sufficient for the payment of the dividend; and
(b) the payment of the dividend is fair and reasonable to the company's shareholders as a whole; and
(c) the payment of the dividend does not materially prejudice the company's ability to pay its creditors (Austlii, 2011).
So, first of all, auditor should make a judgement about whether this dividend payment is against the law. According to Corporation Act 2001 S254T, auditor should run three tests to determine whether TSC has breached the law.
According to Balance Sheet of TSC, TSC clearly passes the first test (Total Assets are $21,737,500, and Total Liabilities are $7,024,000), but need more information to determine whether it can pass the rest two tests.
In the case- London and General Bank (No.2) (1895) 2 Ch. 673 (Leung & Corman, 2009, p128), it states that it is no part of an auditor's duty to give advice either to directors or shareholders as to what they ought to do. It is nothing to auditor whether dividends are properly or improperly declared. So in the TSC case, the auditor could find out whether the dividend payment is valid, but no responsibility to give advice to directors or shareholders. But the auditor can write report to directors of TSC in respect of this dividend payment, as what the auditor done in London and General Bank case.
Austlii, 2011, CORPORATIONS ACT 2001 - SECT 254T, http://www.austlii.edu.au/au/legis/cth/consol_act/ca2001172/s254t.html
Cliffsnotes, 2011, Internal Control, http://www.cliffsnotes.com/study_guide/Internal-Control.topicArticleId-21081,articleId-21006.html
Leung. P., Corman. P., Cooper. B. & Richardson. P., 2009, Modern Auditing & Assurance Services, 4th edition, John Wiley & Sons, Milton, Qld
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