UniversityofNewSouthWalesSchoolofAccounting

AuditingandAssuranceServices2015

LECTURE3BusinessRisk

LectureSummary

Theaimsofthislectureare Todiscusstherequirementstoperformriskassessmentprocedures.

Todiscussbusinessriskanditslinktofinancialstatementerrors.

Todiscussthequalitativeandquantitativefactorsthatauditorsexaminewhenassessingbusinessrisk.

TheAuditProcess

Thebasicauditprocessis Decidetoacceptordeclinetheaudit. Assesstheriskoftheclient

Businessrisk. Internalcontrols

Collectsufficientappropriateauditevidence Testsofcontrols Substantiveprocedures

Formandissueanauditopinion

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RiskAssessmentProcedures

Theauditorshallperformriskassessmentprocedurestoprovideabasisfortheidentificationandassessmentoftheriskofmaterialmisstatementatthefinancialreportandassertionlevels.Riskassessmentproceduresdonotprovidesufficientappropriateauditevidenceonwhichtobasetheauditopinion. ASA315.5

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IdentifyingandAssessingRisk

TheAuditorshallidentifyandassesstheriskofmaterialmisstatementat: (a)thefinancialreportlevel;and (b)theassertionlevelforaccountbalances,classesoftransactionsanddisclosures

toprovideabasisfordesigningandperformingfurtherauditprocedures. ASA315.25

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IdentifyingandAssessingRisk

Forthispurposetheauditorshall: (a)Identifyrisksthroughouttheprocessofobtaininganunderstandingoftheentityanditsenvironmentincludingrelevantcontrolsthatrelatetotherisksandbyconsideringtheclassesoftransactions,accountbalancesanddisclosuresinthefinancialreport;

(b)Assesstheidentifiedrisksandevaluatewhethertheyrelatemorepervasivelytothefinancialreportasawholeandpotentiallyaffectmanyassertions;

ASA315.26

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IdentifyingandAssessingRisk

Forthispurposetheauditorshall: (c)Relatetheidentifiedrisktowhatcangowrongattheassertionlevel,takingaccountofrelevantcontrolsthattheauditorintendstotest;and

(d)Considerthelikelihoodofmisstatement,includingthepossibilityofmultiplemisstatements,andwhetherthepotentialmisstatementisofamagnitudethatcouldresultinamaterialmisstatement.

ASA315.26

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BusinessRisk

Businessriskmeansariskresultingfromsignificantconditions,events,circumstances,actionsorinactionsthatcouldadverselyaffectanentitysabilitytoachieveitsobjectivesandexecuteitsstrategies,orfromthesettingofinappropriateobjectivesandstrategies.

(ASA315.4(b))

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BusinessRiskandError Businessriskmatterbecausebusinessrisksarethesourcesoferrors.

Ifyoucanidentifywherethebusinessrisksare,youhaveabetterchanceoffindingtheerrors.

Forexample: Acompanythatisdoingbadlyismorelikelytomanipulatefinancialfiguresthatonethatisdoingwell,

Acompanyinarapidlychangingindustryismorelikelytohaveovervaluedassetsthatonethatisinastableindustry.

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RiskAssessmentProcedures Theriskassessmentproceduresshallincludethefollowing: (a)Enquiriesofmanagement, (b)Analyticalprocedures.[quantitativetechniques] (c)Observationandinspection.

(ASA315.6) Youmustactivelycollectevidenceanduseprofessionaljudgmenttoassessrisksbasedonthisevidence.

Youmustdocumentyourevidenceandjudgments.

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SourcesofBusinessRisk

Businessriskcomesfrombothinternalandexternalfactors.Examplesinclude: Lawsandregulations, Economicconditions, Marketconditions, Businessstructureandoperations Boardandmanagementquality, Companystrategy, FinancialReportingissues.

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LawsandRegulations

Taxation Specificindustryregulations(e.g.banks) Labourlaws Environmentallaws Healthandsafetylaws Foreigntraderegulations

Freetradeagreements ASXlistingrules

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EconomicConditions

Economicgrowth Local International

Interestratesandavailabilityoffinancing Inflation Unemployment Foreignexchangeratemovements

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MarketConditions Demand

Newcustomers,lossofcustomers Capacity

Newcompetitors Industrystructure

Competitive,oligopoly,monopoly Cyclicalorseasonalactivity. Technologicalchange Availabilityofsupplies

Rawmaterials,labour,energy,transportetc.

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BusinessStructureandOperations Natureofrevenuesources,productsorservices Conductofoperations

Howdoesthecompanymakeanddistributeitsproductsandservices?

Alliances,jointventures,andoutsourcingactivities.

Geographicdispersionandindustrysegmentation.

Locationofproductionfacilities,warehouses,andoffices,andlocationandquantitiesofinventories.

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BoardandManagementQuality

Qualityofthemembersoftheboard. Experience,reputation.

Qualityofboardprocedures. Independenceoftheboard. Qualityofseniormanagement.

Inparticular,thequalityofthosemanagersinthefinance/accountingarea(e.g.theCFO).

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BusinessStrategy

Growthvsdefensivestrategy Revenuegrowthvsprofitgrowth Organicgrowthvsgrowthbytakeover

Disinvestmentandspinoffs Newcapitalinvestment

Horizontalandverticalintegration Productlineexpansionandreduction IPOs Capitalstructurechoices

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FinancialReporting Accountingprinciplesandindustryspecificpractices,includingindustryspecificsignificantcategories(forexample,loansandinvestmentsforbanks,orresearchanddevelopmentforpharmaceuticals).

Revenuerecognitionpractices. Accountingforfairvalues. Foreigncurrencyassets,liabilitiesandtransactions.

Accountingforunusualorcomplextransactionsincludingthoseincontroversialoremergingareas

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AnalyticalProcedures

Analyticalproceduresarequantitativeproceduresthatauditorsusefor Riskassessmentandplanning

tobecoveredthislecture Evidencegathering(substantiveanalyticalprocedures)

tobecoveredinlecture8 Reviewoffinancialstatementsatendofaudit.

TherelevantstandardisASA520AnalyticalProcedures

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Definition(ASA520.4)

ForpurposesoftheAustralianAuditingStandards,thetermanalyticalproceduresmeansevaluationsoffinancialinformationthroughanalysisofplausiblerelationshipsamongbothfinancialandnonfinancialdata.Analyticalproceduresalsoencompasssuchinvestigationasisnecessaryofidentifiedfluctuationsorrelationshipsthatareinconsistentwithotherrelevantinformationorthatdifferfromexpectedvaluesbyasignificantamount.

Definition(ASA520.A1)

Analyticalproceduresincludetheconsiderationofcomparisonsoftheentitysfinancialinformationwith,forexample: Comparableinformationforpriorperiods. Anticipatedresultsoftheentity,suchasbudgetsorforecasts,orexpectationsoftheauditor,suchasanestimationofdepreciation.

Similarindustryinformation,suchasacomparisonoftheentitysratioofsalestoaccountsreceivablewithindustryaveragesorwithotherentitiesofcomparablesizeinthesameindustry.

Definition(ASA520.A2)

Analyticalproceduresalsoincludeconsiderationofrelationships,forexample: Amongelementsoffinancialinformationthatwouldbeexpectedtoconformtoapredictablepatternbasedontheentitysexperience,suchasgrossmarginpercentages.

Betweenfinancialinformationandrelevantnonfinancialinformation,suchaspayrollcoststonumberofemployees.

TheBasicIdea

Theauditorformsapredictionaboutthevalueanitem(suchasrevenue)shouldhave.

Theauditorcomparesthepredictedvaluetotheactualvalue.

Ifthevaluedifferbyasignificantamount,thisisevidenceofanerror.

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PredictionMethods

Ratioanalysis Trendanalysis Commonsizefinancialstatements Comparisonswithotherfirmsinindustry Comparisonswithbudgetedfigures Mathematicalrelationshipwithotherfinancialstatementfigures.

Mathematicalrelationshipwithnonfinancialinformation.

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PredictionsExample1

XYZssalesfigures 2011 $25million 2012 $26million 2013 $28million 2014 $40million

Asimpletrendanalysissuggeststhatsalesmaybeoverstatedin2014.

Arethereoverstatedsales?

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PredictionsExample1

No! InvestigationofXYZsbusinessindicatesthatitwasinvolvedinamergerwithalargecompetitorin2014.

Thisaccountsforthelargejumpinsales Inthiscase,asimpletrendanalysissuggestedaproblemthatneededtobefurtherinvestigated.

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PredictionsExample2

XYZswagesexpense 2011 $10million 2012 $11million 2013 $10million 2014 $10.5million Asimpletrendanalysissuggeststhattherearenoproblemswiththewagesexpenseaccount.

Isthiscorrect?

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PredictionsExample2

No! XYZsmergershouldhaveincreasedwagesexpense(moreemployees).

Themessage Sometimesdeviationsfromtrends(andexpectedratios)shouldbeexpected.

Aconsistenttrendcanindicateerrors. Todistinguish,understandthebusiness

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AnalyticalProcedures Example YouaretheauditorofCharlesCoy,alargehardwareretaileroperatingwithstoresthroughoutthecountry.Aspart

oftheplanningstageoftheaudityouhaveperformedanalyticalprocedureswiththefollowingresults:

ACTUAL RESULTS

BUDGETEDRESULTS

PREVIOUSYEAR

INDUSTRY AVERAGE

InventoryTurnover Ratio

4.35 5.00 4.70 4.66

CurrentRatio

1.80 1.70 1.51 1.66

Quick AssetRatio 1.10 1.10 1.10 1.20

Debt toEquity Ratio 0.60 0.55 0.62 0.58

Number of Times interest earned ratio

8.50 7.20 6.80 5.00

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AnalyticalProcedures Example

DecreaseinInventoryturnover presenceofobsoletestock. Increaseinthecurrentratio duetoincreaseininventory. Quickassetratiounchanged indicatingincreaseincurrentratiocouldbe

duetoincreaseininventorylevels. Liquiditypositionimportantinensuringthatthegoingconcernbasisof

accountingisappropriate.Noproblemshere,quickassetratioisabovenormalbenchmarkof1:1.

Debttoequity gearinghighbutconsistentwithindustry Interest riseindicatesreducedauditriskremeetingcommitments

possiblyduetodecreasinginterestrates,goodprofitabilityorunderstatementofinterestexpense.Furtherinvestigationneededhere.

PuttingitTogether

Quantitativefactors(analyticalProcedures)tellyouthatsomethinghashappened.

Qualitativefactorstellyouwhyithashappened.

Whenyouhavebothqualitativeandquantitativefactorsyouhaveastrongbasisforhavingidentifiedarisk ofmisstatement. Onlysubstantivetestingwilltellyouifthereisanactualerror.

BusinessRiskExample1

ABCLtdmanufacturesandsellsbeachtowels Itsinventorybalanceis$5,000,000. ItisfacingincreasingcompetitionfromChineseimports.

Inventoryturnoverhasdecreasedfrom5.6to4.4timesperyear.

Thecurrentratiohasincreasedfrom1.2to1.8whilethequickratiohasremainedat0.9.

Whatistherisktotheauditor?

BusinessRiskExample1

Theratiosshowthattheinventoryissellingmoreslowlyandthestockisbuildingup.

Thequalitativefactor(Chinesecompetition)explainwhytheinventoryisnotselling.

Conclusion Inventorymightbeovervaluedandmightneedtobewrittendown.

ThisistheassertionofValuationandAllocation.

BusinessRiskExample2

XYZLtdemploysagroupofsalespeopletosellmachinerytosmallconstructionfirms. XYZhasrecentlyintroducedacommissionstructureforitssalesstaff.

Saleshaveincreasedby15%duringtheyear,comparedto5%foreachofthepreviousthreeyears.

Accountsreceivablehaveincreasedby25%anddebtorsturnoverhasfallenfrom11.5to8.4.

BusinessRiskExample2

Salespeoplehaveanincentivetooverstatesalestomakemorecommissions Bigjumpinsalessupportsthis.

Theremaybefakesales ThisistheassertionofOccurrence.

BusinessRiskExample2

Evenifthesalesarereal,someofthemmightbemadetocustomerswhocantpayfortheirequipment. Salespeoplehaveanincentivetorelaxcredittermstomakemoresales.

Largeincreaseinaccountsreceivableandfallindebtorsturnoversupportsthis.

XYZmighthaveaproblemwithbaddebts. ThisisValuationandAllocation ofA/CRec

BusinessRiskExample3

FGHLtdisanASXlistedretailerofwhitegoods Saleshavefallenfrom$150millionin2013to$120min2014.

Earningshasfallenfrom$6millionin2013to$500,000in2014.

ThecompensationoftheCEOandseniormanagementislinkedtomeetingearningstargets.

Ifalossismade,noexecutivebonuseswillbepaid. TheCEO,MrBrianShiftyresignedfromhispreviouscompanywithoutexplanation.

BusinessRiskExample3

FGHLtdhasaclearincentivetomisstateprofit. Executivepaylinkedtoearnings Massivefallinsales. Onlyjustmakingaprofit

Orarethey? Isprofitdeclinebelievablegivenfallinsales.

Managementteammaylackintegrity.

BusinessRiskExample3

Profitcannotbemanipulateddirectly. VeryfewentriesintheactualProfitaccount. Needtomanipulaterevenuesupand/orexpensesdown.

Howisthisdone?

BusinessRiskExample3

Increasingrevenuesthroughmanipulation Fakesales(occurrence) Bringforwardsalesfromnextperiod(cutoff) Recordsalesathigherpricesorfailtorecognisediscounts(accuracy)

Failtorecognisesalesreturns(completeness) Channelstuffing(classification)

BusinessRiskExample3

Decreasingcoststhroughmanipulation Omitcosts(completeness) Delaycoststillnextperiod(cutoff) Recordcostsatloweramountsorrecogniseunearneddiscounts(accuracy)

Capitalisecoststhatshouldbeexpensed(existence/valuationandallocation)

Failtowritedowninventory(valuationandallocation)

BusinessRiskExample3

Decreasingcoststhroughmanipulation Failtoimpairassets(valuationandallocation) Underprovisione.g.baddebts(valuationandallocation/completeness)

Lengthenusefullivesofdepreciableassets(accuracy)

Incorrectamortisation(accuracy) Allofthesewillneedtobetestedfor. Overallriskoffinancialstatementsishigh.

BusinessRiskSummary

Businessriskscausefinancialstatementerrors.

Businessriskscanbeinternalorexternal. Toefficientlyfinderrors,businessriskmustbeanalysedandlinkedtopossibleerrorsat Thefinancialstatementlevel. Theassertionlevel

Bothqualitativeandquantitativetechniques(analyticalprocedures)shouldbeused.