Assignment
ancienmchiw
DemoAssignment.docxExecutive summary
The report aims to determine whether the auditing firm should engage in the audit of Alto Metals Limited. The research has used a number of analysis methods including collecting information from formal industry website such as aasb.gov.au, using horizontal analysis, as well as analysing financial ratios such as quick ratio, ROE, EPS. In relation to the report’s findings, the research has obtained general understanding of the client’s business and mining industry, and identified a number of business and audit risks for mining businesses including capital optimization, capital access, innovation, social license to operate, exploration risk. Further, it has also found certain unusual changes of several accounts from financial statements contributing to the auditor’s doubt, and calculated some common financial ratios to point out possible financial difficulties that Alto could encounter in the ongoing periods. Ultimately, it is concluded that the audit would not be undertaken based on the significant changes and likely financial difficulties of AME in the ongoing operation period. In facts, this report has also existed several limitations, including the lack of communication with the predecessor auditors to collect more essential information of the Company, and the insufficient resources to provide the detail assessment of the client’s business.
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1. Body of the report
1.1.Overview of the client’s business and industry
• General information of mining industry
For mining industry, it has been known as a driving force for lots of the exploration of Australia’s remote inland and for Australia’s industrial development, from the gold rushes of the 19th Century, from the iron ore and nickel booms of the 1960s, from the later growth of the coal industry, and to the current booming demand for minerals to fuel throughout the world. Regarding Australia’s Mineral Commodities, Australia’s mineral resource sector covers the exploration, extraction and processing of resource such as coal, uranium, iron ore, nickel, bauxite, gold, lead, copper, mineral sands and diamonds. The main industry activities are coal mining, oil and gas extraction and mining, and contract and mining support services.
Most importantly, mining is viewed to be significant primary industry and contributor to the Australian economy through contributing relatively substantial benefits to Australia from the growth of recent resources, indicated in high rates of economic growth, reduction in the level of unemployment and increasing incomes for Australians.
• Overview of client’s business
Alto Metals Limited was known as a listed Australian public company on the 20 December 2012 with the name of Enterprise Uranium Limited. In 2016, the company has changed its name to Alto Metals Limited after completing the acquisition of Sandstone Exploration Company. The Group has comprised two key controlled entities, namely Cue metals Pty Ltd and Sandstone Exploration Pty Ltd, which are viewed as fully owned subsidiary of AME Limited. AME has been managed by experienced an Executive Director and three Non-Executive Directors with extensive skills in exploration, mining accounting, corporate governance and provision of corporate advice. More importantly, its major objective is to
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discover or acquire projects with potential for plus million ounce gold deposits that can establish the highly profitable mining company providing high returns to shareholders in recent years. In order to achieve the objective, a number of strategies is designed relating to the creation or identification of certain highly prospective projects, and the application of latest advanced practice mineral exploration technology and support experienced team of people with good management and leadership.
In relation to AME’s operation and investments, the principal activities of the Group in the financial period were the exploration of a number of gold and uranium tenements in Western Australia. In the year 2015, the Company started conducting an active search for an advanced gold and base metals project in Australia because the Sandstone Gold project was considered as an excellent exploration opportunity for the Company. Thus, Sandstone Exploration Pty Ltd has been acquired in March 2016 by completing the agreement of the acquisition. Besides, it is also emphasized that the future of the Group’s core uranium project has been still kept in conjunction with the acquisition of the Sandstone Gold Project. For financing area, Alto Metals limited currently has 144,475,415 stocks on issue, with 100% ownership of the Sandstone Gold Project and a small portfolio of uranium projects. Surprisingly, the Company has no debt, thus there is no external obligation of capital; in other words, the primary source of the Group’s capital is equity funds.
1.2. Business and audit risks for mining companies
Business risk is broader than the risk of material misstatement of the financial report, though it includes the latter. Business risk may arise from change or complexity. A failure to recognise the need for change may also give rise to business risk (ASA 315, Aus A30). In addition, ASA 315 (Aus A31) also indicates that an understanding of the business risks facing the entity increases the likelihood of identifying risks of material misstatement, since most business risk will eventually have financial consequences and, therefore, it affects the financial report. In the
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case of mining industry, obtaining an understanding of related business risks which may lead to a risk of material misstatement of financial report would be considered in relation to the following angles:
• Cash optimization
Cash management has become primary area which mining companies have been focusing on. This is because they tend to maintain strong balance sheet and plan for longer-term profitability. However, the challenges are imposed that market volatility are unpredictable and there may have limited visibility of demand and the change in commodity prices on the market. As a consequence, it could have substantial impact on the liquidity management of a company’s balance sheet when these changes occur. Therefore, possible potential risk of misstatements can arise with respect to overstatement or understatement of accounts, such as cash and cash equivalent, cost of sales and inventories, which will affect the fair presentation of financial reports.
• Capital access
Securing funding and credit terms have been more tightly and difficult in the recent economic environment and have posed many challenges for mining firms. In facts, trade and debt financing is extended only to companies with sufficient security and at an increased cost, while most mining companies have used loan capital to refinance infrastructures. Therefore, raising capital has been increasingly a struggling issue with these companies when high uncertainty of capital access occurs in the ongoing periods. It is indicated that the business risk may arise from the difficulty of raising capital in the continuing operation periods. This can give a rise to audit risks relating to the changes in the level of liabilities, as well as shareholders’ equity in Financial Position Statement.
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• Social license to operate (SLTO)
A series of problems has incurred, such as mine accidents, mining-related diseases, community protects and non-responsibility for mine reconstruction. These issues have posed a lot of regulatory activities, and much more corporate liability. Hence, these issue result in substantial impact on the company’s image and the ability of the companies to maintain their social license to operate. It is more likely to increase audit risk associated with the companies’ compliance with laws or legal regulations.
• Innovation
Innovation is viewed as a major enabler of productivity improvement which will contribute to long-term competitive edge when market improves. However, in facts, a vast majority of mining companies has invested significantly less than other areas in innovation; thus, with the downwards trend of commodity prices, there are many innovation strategy, whilst innovation budget is limited, and thus a plenty of innovation programs have been delayed. This contributes to failure in implementing companies’ objectives since the sector transformation only stems from innovation.
• Exploration risk
Mineral exploration and development can be considered as a high-risk area as there is no certainty about the achievement of economic deposit from exploration activities. In practice, the current and future exploration activities of mining companies has faced a series of factors including geological conditions, limitations on activities due to permitting requirements, availability of appropriate exploration equipment, exploration costs, seasonal weather patterns, unpredictable operational and technical difficulties, industrial and environmental accidents and other factors relating to the companies’ control. Consequently, these factors will affect mostly companies’ operational activities, such as discontinuing of exploration activities due to weather
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changes or encountering environmental accidents; being limited on exploration activities owing to different legal regulation in foreign countries.
1.3. Specific reporting requirements for mining companies
Mining industries play a crucial role in promoting economic development in Australia, therefore, investors, government and public are interested in its operations and reports. Consequently, there are a number of particular regulations that are set under ASX Listing Rule, The Australian Code for Reporting of Exploration Results, Mineral Resources and Ore Reserves (JORC Code, 2012).
• Completion of each quarter financial report for mining exploration entity
A company traded as mining exploration must give to ASX the completed financial report for each quarter of its financial year in order to release to the market (ASX Listing Rule, 2014). The report takes into account of details of the activities that relates to exploration, mining production and development, and the sum of the expenditures incurred.
• Preparation of public report
Rule 5.6, ASX Listing Rule (2014) states that mining entities must prepare public report complying with Chapter 5 – AXS Listing Rule if the report containing to any of statements, namely exploration targets; exploration results; mineral resources or ore reserves; and production target.
• Transparency
Requirement of readers of public report is provided with sufficient information, which they are able to understand clearly and unambiguously. Those information could not be misstated or an omission, which could affect the decision-making of the report’s users. (JORC Code, 2012).
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• Materiality
The JORC code (2012) requires that a public report must consist of all relevant information that reasonably meet the need of investor’s and professional adviser’s requirement in order to make a reasoned and balanced judgment.
• Competence
The public report must fairly represent and be based on information and works that are proceeded by a named competent person who is suitably qualified, experienced and subject to an enforceable professional code of ethics. (ASX Listing Rule, 2014; JORC Code, 2012).
1.4. Analysis of changes in account balances of the company from 2015 to 2016
Based on the company’s financial reports, it is obvious that there are certain unusual changes in accounts balance during the two years period 2015-2016 from the two main financial statements, namely balance sheet and income statements as below:
• Cash and cash equivalent
There is an increase in cash and cash equivalent to 16% in 2016 compared with 2015. A component reason of the change results primarily from raising more fund from issuing shares during the period.
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• Available for sale financial assets, and financial assets
While available for sale financial assets has gone up significantly at 182% that is compared its figure in 2016 to that in 2015, the amount of financial assets has declined fully at 100% in the same period. This is because financial assets, as options, were converted into fully paid shares during the year 2016, therefore, it is reclassified in Available for sale financial assets.
• Exploration and evaluation & Trade and other payables
The volatility of exploration and evaluation, and trade and other payables are notable with the figure of 132% and 157% for each item respectively within two years. In facts, the deviation between the two years primarily derives from payment of purchase of Sandstone Exploration Company. For exploration and evaluation, the purchase of Sandstone Exploration properties accounted for 87% of total cost, and similarly, for trade and other payables, deferred payment of purchase of Sandstone Exploration Pty Ltd had over 60% of total payable items.
• Plant and equipment
The item has declined sharply by 55% from 2015 to 2016. It is clear that the difference of the carrying amount of plant and equipment is from the change in accumulated depreciation over the years; however, the Company has not acquired any more PPE during the period.
• Issued capital
An increase by 45% from 2015 to 2016 is the change in issued capital because there were many raising fund events occurred in June 2016, such as raising over $1million in additional funds through a placement to sophisticated investors, equity raising to purchase Sandstone project, and issuing performance shares to vendors of Sandstone Exploration Company.
Regarding the reasons of analysing these particular items, it could take into account their relationship with business risks that can lead to increased risk of material misstatement when
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conducting the audit. Firstly, according to ASA 315 (A25), significant changes in the entity from the prior period may give rise to the risk of misstatement in financial reports. In facts, both these accounts has changed substantially between 2015 and 2016, even there is some items changed unusually over the years, as mentioned above. This will attract the auditor’s concern about these noticeable changes in order to confirm whether there will have potential risk of misstatements.
The second reason can be from potential risks that are identified within the period 2015-2016, which is directly related to these account items, including credit risk, liquidity risk, market risk, and price risk on available for sale assets. First of all, credit risk in relation to financial assets mainly derives from the potential on-performance by counterparties of contract obligations which can result in a financial loss to the company. This could lead to increase in audit risk associated with overstating net profit during the fiscal year. The second one is liquidity risk which reflects the fact that the Group has encountered difficulty in repaying its debts or meeting its obligations in conjunction with financial liabilities. The financial liabilities of the AME Company usually refer to trade and other payables that are non-interest bearing and due within 12 months of the financial year. This can be contributor to increased audit risk with respect to the valuation of cash and cash equivalent over the years.
For market risk, the risk may arise from the changes in currency exchange or the volatility of interest rate that can affect the AMEs earnings at the end of financial period. As such, the audit risk which can arise from market risk is in the valuation of assets and liabilities, such as cash and cash equivalent, financial assets, trade and other payables, and in overstatement of companies ‘income. Finally, price risk on available for sale assets refers to equity securities price risk and results from listed investments held by mining companies and classified on the balance sheet as available for sale. In reality, listed investment have been computed at the quoted market bid price at the end of reporting period. The volatility of listed equity prices will
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have effect on profit and equity when all remaining variables being unchanged. As a consequence of price risk, the AME business would be able to face increased risk of misstatement with respect to overstatement or understatement of profit and equity’s value which will affect the fair presentation of financial reports.
1.5. Financial ratio analysis of company’s losses in 2016
Under Auditing Standard ASA 570, one of the important responsibility of auditors in the audit of the company’s financial report is to assess the ability of the company in pertaining to its continuing operations in the foreseen future which is named as going concern. In order to process the assessment, auditors would consider risks that might cause significant impacts on the company’s ability to continue. Using key financial ratio would be a workable approach for auditors to deal with going concern assessment. As a result, the following ratio can be taken into account for Alto Metals Limited (AME):
• Quick ratio
Quick ratio represents the entity’s ability to pay off its current liabilities by using its most liquid assets, which is one condition in the going concern concept under ASA 570. There is a dramatic decrease in the firm’s quick ratio to 3.62 (2016). It could be caused by the decline of cash and cash equivalent or trade receivable or the increase in short-term obligations. Apparently, the firm’s quick ratio in 2016 is above 1, which means that the firm has more liquid asset than its current obligations and be able to pay off its near-term liabilities. In comparison to Energy Metals Limited (EME- $21m Market Capital) and Eclipse Metals Limited (EPM-$7m Market
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Capital), the firm’s quick ratio is far less than that of EME with 138.55 and quite greater than that of EPM with 2.24. This scenario could be a result of the difference size among companies. However, this is essential for Alto Metals Limited to improve the quick ratio in order to raise the potential money from lenders or investors.
• Defensive Interval Ratio (DIR)
The use of Defensive Interval ratio (DIR) is to measure the number of days that the entity can operate without utilising non-current assets or can continue to pay its obligations. AME’s Defensive Interval ratio has increased to 171.11 days in 2016, which means the company can remain its operation within that time by only accessing its short-term assets. Beyond that time, the company needs other additional funds or long-term assets in order to run the business. In 2016, the DIR of EME and EPM is 7313.81 days and 308.25 days respectively. EPM’s Defensive Interval ratio is lower than that compared to other companies in mining industry.
• Return on equity (ROE) and Earnings Per Share (EPS)
Return on Equity (ROE) measures the firm’s efficiency in terms of growing its business and generating profits by using shareholder’s equity. There has been negative ROE from 2014 to 2016. Likewise, other companies in the industry have negative ROE with -0.71% for EME and -23.62% for EPM. Negative ROE is a result of the negative net income, having said that the losses that the company made. The outcome of negative ROE gives rise to the negative EPS, particularly -4.31, -4.80 and -2.40 net income earned per share from 2014 to 2016 respectively. Probably, most start-up companies lose its money, especially companies operation within mining industry. Therefore, negative income might last for several years or more because of using shareholder’s equity to invest or start to run the company.
• Free cash flow (FCF)
Even though ROE is negative, investors might look at the free cash flow to decide whether they should invest into the business. Unfortunately, the free cash flow of AME is negative over the period. The FCF seems to be better in 2016 with -$1,817,716, however it is higher than FCF of other companies, namely EME and EPM.
ROE, Earnings per share and especially FCF represent the unprofitable operation of the company and would cast consideration doubt about the continuing operation as in the foreseen future under ASA 570. Nonetheless, the result of Quick ratio and Defensive Interval Ratio reveals that Alto Metals Limited could probably operate as going concern within 171.44 days without using long-term assets and other sources. However, in order to be able to continue in the long-term and generate profit from operation, the company should consider to raise more money from investors and lenders. Because of the losses from operation, the company would face several financing difficulties.
First of all, the company would face the loss of investor support. As discussed above, the company’s free cash flow and ROE are negative over the period. It results in the doubt of investor and other lender about the ability to pay back in the future.
Secondly, it is probably that the company might struggle with excessive cost of borrowing that cannot covered by earning. The company continue to make a loss in 2016 and that might happen for the coming years. Therefore, raising more money from borrowing would be one of the tactics to continue running the business. However, borrowing cost might be a massive amount that the company could not afford by using its earning.
Next, it is reasonable to mention that insolvency might happen to the company. Although company’s quick ratio is higher than 1 and the company could continue as going concern, quick ratio might be less than 1 if the money raising from borrowing excess the quick assets.
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2. Conclusion
2.1. Making decision relating to acceptance of the audit
Reject to perform the audit
Section A8-9, ASA 220 has pointed that before accepting an engagement with a new client or continuing an audit for existing client, auditors must obtain sufficient information to determine client’s acceptability. Based on information obtained via ratio calculation and the assessment of business risks and audit risk for Alto Metals Limited, undertaking the audit for the company could be non-occurrence. The explanations are determined through the following reasons:
Firstly, trading in mining industry, the company has faced with high-risk rate as discussed above. Furthermore, failure to comply with legal legislation of the company would give rise to the occurrence of audit risk. The company’s audit risk and business risk seem to be unacceptable risks, casting significant doubt for auditors to accept an audit for the company.
Secondly, even though the company would continue as going concern, the negative free cash flow, ROE and EPS would be the reason that the audit would be unacceptable. As mentioned above, the company has struggled with high business and audit risks that beyond the acceptable level, therefore, it would cause high audit costs and audit fees (Arens, et al., 2017). Hence, the capacity to make a high payment for audit fees is probably doubtful.
The next reason could be resulted from two controlled entities. The probability that a conflict might occur between two key management, which is likely to affect the audit procedures and the audit fees. Probably, owning to the conflict, the firm could not be competent to perform the audit engagement (ASA 220, 2015)
Finally, the lack of capabilities, containing time and other resources could be the reason for auditors to reject to perform the audit for the company. Insufficient and inappropriate information could affect the professional judgement of auditor; therefore, the audit results might be unqualified.
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2.2. Limitation of the report
Although this report is prepared based on the capabilities to access financial report and annual report to obtain the essential information, several limitations exist apparently.
The first limitation is the lack of communication with the predecessor auditors. In order to collect appropriate information and investigate thoroughly the company and its industry, the permission to communicate with prior auditors would ameliorate the quality of the report.
