UniversityofNewSouthWales

SchoolofAccounting
AuditingandAssuranceServices
2015
LECTURE3
BusinessRisk

LectureSummary
Theaimsofthislectureare
Todiscusstherequirementstoperformrisk
assessmentprocedures.
Todiscussbusinessriskanditslinktofinancial
statementerrors.
Todiscussthequalitativeandquantitativefactors
thatauditorsexaminewhenassessingbusiness
risk.

TheAuditProcess
Thebasicauditprocessis
Decidetoacceptordeclinetheaudit.
Assesstheriskoftheclient
Businessrisk.
Internalcontrols

Collectsufficientappropriateauditevidence
Testsofcontrols
Substantiveprocedures

Formandissueanauditopinion

RiskAssessmentProcedures
Theauditorshallperformriskassessment
procedurestoprovideabasisforthe
identificationandassessmentoftheriskof
materialmisstatementatthefinancialreport
andassertionlevels.Riskassessment
proceduresdonotprovidesufficient
appropriateauditevidenceonwhichtobase
theauditopinion.
ASA315.5

IdentifyingandAssessingRisk
TheAuditorshallidentifyandassesstherisk
ofmaterialmisstatementat:
(a)thefinancialreportlevel;and
(b)theassertionlevelforaccountbalances,
classesoftransactionsanddisclosures

toprovideabasisfordesigningand
performingfurtherauditprocedures.
ASA315.25

IdentifyingandAssessingRisk
Forthispurposetheauditorshall:
(a)Identifyrisksthroughouttheprocessofobtaining
anunderstandingoftheentityanditsenvironment
includingrelevantcontrolsthatrelatetotherisksand
byconsideringtheclassesoftransactions,account
balancesanddisclosuresinthefinancialreport;
(b)Assesstheidentifiedrisksandevaluatewhether
theyrelatemorepervasivelytothefinancialreportas
awholeandpotentiallyaffectmanyassertions;
ASA315.26

IdentifyingandAssessingRisk
Forthispurposetheauditorshall:
(c)Relatetheidentifiedrisktowhatcangowrong
attheassertionlevel,takingaccountofrelevant
controlsthattheauditorintendstotest;and
(d)Considerthelikelihoodofmisstatement,
includingthepossibilityofmultiple
misstatements,andwhetherthepotential
misstatementisofamagnitudethatcouldresult
inamaterialmisstatement.
ASA315.26

BusinessRisk
Businessriskmeansariskresultingfrom
significantconditions,events,circumstances,
actionsorinactionsthatcouldadverselyaffect
anentitysabilitytoachieveitsobjectivesand
executeitsstrategies,orfromthesettingof
inappropriateobjectivesandstrategies.
(ASA315.4(b))

BusinessRiskandError
Businessriskmatterbecausebusinessrisksare
thesourcesoferrors.
Ifyoucanidentifywherethebusinessrisksare,
youhaveabetterchanceoffindingtheerrors.
Forexample:
Acompanythatisdoingbadlyismorelikelyto
manipulatefinancialfiguresthatonethatisdoing
well,
Acompanyinarapidlychangingindustryismore
likelytohaveovervaluedassetsthatonethatisina
stableindustry.

RiskAssessmentProcedures
Theriskassessmentproceduresshallincludethe
following:
(a)Enquiriesofmanagement,
(b)Analyticalprocedures.[quantitativetechniques]
(c)Observationandinspection.
(ASA315.6)

Youmustactivelycollectevidenceanduse
professionaljudgmenttoassessrisksbasedon
thisevidence.
Youmustdocumentyourevidenceand
judgments.

SourcesofBusinessRisk
Businessriskcomesfrombothinternaland
externalfactors.Examplesinclude:
Lawsandregulations,
Economicconditions,
Marketconditions,
Businessstructureandoperations
Boardandmanagementquality,
Companystrategy,
FinancialReportingissues.

LawsandRegulations

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

ASXlistingrules

EconomicConditions
Economicgrowth
Local
International

Interestratesandavailabilityoffinancing
Inflation
Unemployment
Foreignexchangeratemovements

MarketConditions
Demand
Newcustomers,lossofcustomers

Capacity
Newcompetitors

Industrystructure
Competitive,oligopoly,monopoly

Cyclicalorseasonalactivity.
Technologicalchange
Availabilityofsupplies
Rawmaterials,labour,energy,transportetc.

BusinessStructureandOperations
Natureofrevenuesources,productsorservices
Conductofoperations
Howdoesthecompanymakeanddistributeits
productsandservices?

Alliances,jointventures,andoutsourcing
activities.
Geographicdispersionandindustry
segmentation.
Locationofproductionfacilities,warehouses,and
offices,andlocationandquantitiesof
inventories.

BoardandManagementQuality
Qualityofthemembersoftheboard.
Experience,reputation.

Qualityofboardprocedures.
Independenceoftheboard.
Qualityofseniormanagement.
Inparticular,thequalityofthosemanagersinthe
finance/accountingarea(e.g.theCFO).

BusinessStrategy
Growthvsdefensivestrategy
Revenuegrowthvsprofitgrowth
Organicgrowthvsgrowthbytakeover
Disinvestmentandspinoffs
Newcapitalinvestment

Horizontalandverticalintegration
Productlineexpansionandreduction
IPOs
Capitalstructurechoices

FinancialReporting
Accountingprinciplesandindustryspecific
practices,includingindustryspecificsignificant
categories(forexample,loansandinvestments
forbanks,orresearchanddevelopmentfor
pharmaceuticals).
Revenuerecognitionpractices.
Accountingforfairvalues.
Foreigncurrencyassets,liabilitiesand
transactions.
Accountingforunusualorcomplextransactions
includingthoseincontroversialoremergingareas

AnalyticalProcedures
Analyticalproceduresarequantitative
proceduresthatauditorsusefor
Riskassessmentandplanning
tobecoveredthislecture

Evidencegathering(substantiveanalyticalprocedures)
tobecoveredinlecture8

Reviewoffinancialstatementsatendofaudit.

TherelevantstandardisASA520Analytical
Procedures

Definition(ASA520.4)
ForpurposesoftheAustralianAuditing
Standards,thetermanalyticalprocedures
meansevaluationsoffinancialinformation
throughanalysisofplausiblerelationshipsamong
bothfinancialandnonfinancialdata.Analytical
proceduresalsoencompasssuchinvestigationas
isnecessaryofidentifiedfluctuationsor
relationshipsthatareinconsistentwithother
relevantinformationorthatdifferfromexpected
valuesbyasignificantamount.

Definition(ASA520.A1)
Analyticalproceduresincludetheconsideration
ofcomparisonsoftheentitysfinancial
informationwith,forexample:
Comparableinformationforpriorperiods.
Anticipatedresultsoftheentity,suchasbudgetsor
forecasts,orexpectationsoftheauditor,suchasan
estimationofdepreciation.
Similarindustryinformation,suchasacomparisonof
theentitysratioofsalestoaccountsreceivablewith
industryaveragesorwithotherentitiesofcomparable
sizeinthesameindustry.

Definition(ASA520.A2)
Analyticalproceduresalsoinclude
considerationofrelationships,forexample:
Amongelementsoffinancialinformationthat
wouldbeexpectedtoconformtoapredictable
patternbasedontheentitysexperience,suchas
grossmarginpercentages.
Betweenfinancialinformationandrelevantnon
financialinformation,suchaspayrollcoststo
numberofemployees.

TheBasicIdea
Theauditorformsapredictionaboutthe
valueanitem(suchasrevenue)shouldhave.
Theauditorcomparesthepredictedvalueto
theactualvalue.
Ifthevaluedifferbyasignificantamount,this
isevidenceofanerror.

PredictionMethods
Ratioanalysis
Trendanalysis
Commonsizefinancialstatements
Comparisonswithotherfirmsinindustry
Comparisonswithbudgetedfigures
Mathematicalrelationshipwithotherfinancial
statementfigures.
Mathematicalrelationshipwithnonfinancial
information.

PredictionsExample1
XYZssalesfigures
2011 $25million
2012 $26million
2013 $28million
2014 $40million

Asimpletrendanalysissuggeststhatsales
maybeoverstatedin2014.
Arethereoverstatedsales?
25

PredictionsExample1
No!
InvestigationofXYZsbusinessindicatesthatit
wasinvolvedinamergerwithalarge
competitorin2014.
Thisaccountsforthelargejumpinsales
Inthiscase,asimpletrendanalysissuggested
aproblemthatneededtobefurther
investigated.
26

PredictionsExample2
XYZswagesexpense
2011 $10million
2012 $11million
2013 $10million
2014 $10.5million
Asimpletrendanalysissuggeststhatthereareno
problemswiththewagesexpenseaccount.
Isthiscorrect?
27

PredictionsExample2
No!
XYZsmergershouldhaveincreasedwages
expense(moreemployees).
Themessage
Sometimesdeviationsfromtrends(andexpected
ratios)shouldbeexpected.
Aconsistenttrendcanindicateerrors.

Todistinguish,understandthebusiness
28

AnalyticalProcedures Example

YouaretheauditorofCharlesCoy,alargehardwareretaileroperatingwithstoresthroughoutthecountry.Aspart
oftheplanningstageoftheaudityouhaveperformedanalyticalprocedureswiththefollowingresults:

ACTUAL
RESULTS

BUDGETED
RESULTS

PREVIOUS
YEAR

INDUSTRY
AVERAGE

Inventory
Turnover Ratio

4.35

5.00

4.70

4.66

Current
Ratio

1.80

1.70

1.51

1.66

Quick Asset
Ratio

1.10

1.10

1.10

1.20

Debt to
Equity Ratio

0.60

0.55

0.62

0.58

8.50

7.20

6.80

5.00

Number of
Times interest
earned ratio

29

AnalyticalProcedures Example

DecreaseinInventoryturnover presenceofobsoletestock.
Increaseinthecurrentratio duetoincreaseininventory.
Quickassetratiounchanged indicatingincreaseincurrentratiocouldbe
duetoincreaseininventorylevels.
Liquiditypositionimportantinensuringthatthegoingconcernbasisof
accountingisappropriate.Noproblemshere,quickassetratioisabove
normalbenchmarkof1:1.
Debttoequity gearinghighbutconsistentwithindustry
Interest riseindicatesreducedauditriskremeetingcommitments
possiblyduetodecreasinginterestrates,goodprofitabilityor
understatementofinterestexpense.Furtherinvestigationneededhere.

30

PuttingitTogether
Quantitativefactors(analyticalProcedures)
tellyouthatsomethinghashappened.
Qualitativefactorstellyouwhyithas
happened.
Whenyouhavebothqualitativeand
quantitativefactorsyouhaveastrongbasisfor
havingidentifiedarisk ofmisstatement.
Onlysubstantivetestingwilltellyouifthereisan
actualerror.

BusinessRiskExample1
ABCLtdmanufacturesandsellsbeachtowels
Itsinventorybalanceis$5,000,000.
ItisfacingincreasingcompetitionfromChinese
imports.
Inventoryturnoverhasdecreasedfrom5.6to4.4
timesperyear.
Thecurrentratiohasincreasedfrom1.2to1.8
whilethequickratiohasremainedat0.9.

Whatistherisktotheauditor?

BusinessRiskExample1
Theratiosshowthattheinventoryisselling
moreslowlyandthestockisbuildingup.
Thequalitativefactor(Chinesecompetition)
explainwhytheinventoryisnotselling.
Conclusion
Inventorymightbeovervaluedandmightneedto
bewrittendown.
ThisistheassertionofValuationandAllocation.

BusinessRiskExample2
XYZLtdemploysagroupofsalespeopletosell
machinerytosmallconstructionfirms.
XYZhasrecentlyintroducedacommission
structureforitssalesstaff.
Saleshaveincreasedby15%duringtheyear,
comparedto5%foreachofthepreviousthree
years.
Accountsreceivablehaveincreasedby25%and
debtorsturnoverhasfallenfrom11.5to8.4.

BusinessRiskExample2
Salespeoplehaveanincentivetooverstate
salestomakemorecommissions
Bigjumpinsalessupportsthis.

Theremaybefakesales
ThisistheassertionofOccurrence.

BusinessRiskExample2
Evenifthesalesarereal,someofthemmight
bemadetocustomerswhocantpayfortheir
equipment.
Salespeoplehaveanincentivetorelaxcredit
termstomakemoresales.
Largeincreaseinaccountsreceivableandfallin
debtorsturnoversupportsthis.
XYZmighthaveaproblemwithbaddebts.
ThisisValuationandAllocation ofA/CRec

BusinessRiskExample3
FGHLtdisanASXlistedretailerofwhitegoods
Saleshavefallenfrom$150millionin2013to
$120min2014.
Earningshasfallenfrom$6millionin2013to
$500,000in2014.
ThecompensationoftheCEOandsenior
managementislinkedtomeetingearningstargets.
Ifalossismade,noexecutivebonuseswillbepaid.

TheCEO,MrBrianShiftyresignedfromhis
previouscompanywithoutexplanation.

BusinessRiskExample3
FGHLtdhasaclearincentivetomisstate
profit.
Executivepaylinkedtoearnings
Massivefallinsales.
Onlyjustmakingaprofit
Orarethey?
Isprofitdeclinebelievablegivenfallinsales.

Managementteammaylackintegrity.

BusinessRiskExample3
Profitcannotbemanipulateddirectly.
VeryfewentriesintheactualProfitaccount.
Needtomanipulaterevenuesupand/orexpenses
down.

Howisthisdone?

BusinessRiskExample3
Increasingrevenuesthroughmanipulation
Fakesales(occurrence)
Bringforwardsalesfromnextperiod(cutoff)
Recordsalesathigherpricesorfailtorecognise
discounts(accuracy)
Failtorecognisesalesreturns(completeness)
Channelstuffing(classification)

BusinessRiskExample3
Decreasingcoststhroughmanipulation
Omitcosts(completeness)
Delaycoststillnextperiod(cutoff)
Recordcostsatloweramountsorrecognise
unearneddiscounts(accuracy)
Capitalisecoststhatshouldbeexpensed
(existence/valuationandallocation)
Failtowritedowninventory(valuationand
allocation)

BusinessRiskExample3
Decreasingcoststhroughmanipulation
Failtoimpairassets(valuationandallocation)
Underprovisione.g.baddebts(valuationand
allocation/completeness)
Lengthenusefullivesofdepreciableassets
(accuracy)
Incorrectamortisation(accuracy)

Allofthesewillneedtobetestedfor.
Overallriskoffinancialstatementsishigh.

BusinessRiskSummary
Businessriskscausefinancialstatement
errors.
Businessriskscanbeinternalorexternal.
Toefficientlyfinderrors,businessriskmustbe
analysedandlinkedtopossibleerrorsat
Thefinancialstatementlevel.
Theassertionlevel

Bothqualitativeandquantitativetechniques
(analyticalprocedures)shouldbeused.