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This article was first published in the October 2009 edition of Accounting and Business magazine.
Auditors are required by ISA 315, Understanding the Entity and its Environment and Assessing the Risks of Material Misstatement, or its local equivalents to assess and develop responses to risks.
This process requires that auditors:
- Gain an understanding of the company's business and the environment in which it operates.
- Use that understanding to identify the business risks facing their clients.
- Assess the risks of material misstatement arising from the business risks.
- Design suitable responses to the risks of material misstatement, ie decide what audit work to do.
Business risks are risks that could affect an entity's ability to achieve its objectives and execute its strategies.
Since the objective of the vast majority of businesses is to maximize profits, business risks are essentially risks which if, if left unmanaged, could reduce the company's profits and eventually could mean that the company is not a going concern.
In the current economic circumstances it seems clear that, for many companies, there are more business risks and therefore increased risks of going concern problems which must be addressed by auditors.
Business risks can increase the risk of material misstatement as follows:
- There may be specific numbers in the financial statements which may be misstated as a result of a business risk. For example, poor economic conditions in an industry could increase the risk that customers will not be able to pay their debts. This means that for the supplier there is a risk that receivables are overstated.
- There may be many numbers that could be affected. For example, the management of a listed company facing scrutiny of its profits may be tempted to manage its earnings by the use of creative accounting techniques.
- If the company is facing going concern problems that require disclosure or adjustments in the financial statements but the company fails to do so, this will result in misstatements.
A thorough risk analysis is obviously a crucial part of the audit process in the current economic circumstances, focusing particularly on risks relating to going concern.
A UK Auditing Practices Board Bulletin issued in January 2008 called Audit Issues when Financial Market Conditions are Difficult and Credit Facilities May be Restricted, gives examples of risk factors which may have increased relevance at the current time. Some of these are discussed below.
Going concern factors
- Entity has had past difficulties in obtaining external finance and/or complying with the related terms and covenants. Companies need cash for working capital and salaries. As sales fall and customers take longer to pay, having adequate cash resources becomes even more critical. Companies which have a poor credit history or insufficient assets to secure borrowings will face problems.
- Finance facilities are due for renewal but have not yet been agreed, and management has no planned alternatives should current facilities not be extended. A company which may run out of cash within the foreseeable future may not be able to keep trading and will not be a going concern.
- The terms of debt covenants have been changed, making it more difficult for the entity to comply, or the company may already have breached such conditions. Debt covenants generally grant to lenders remedies such as the right to put the company into receivership. If many or all of the company's assets are sold, the company will not be able to continue trading.
- Finance facility is secured on assets, eg properties, which have decreased in value. Banks generally apply a maximum loan-to-value (LTV) ratio for different classes of assets. If the value of assets falls then the company will find it difficult to secure new financing and may have to repay some of its existing borrowings to reduce the LTV ratio.
- Management has plans to sell assets to overcome financing difficulties, but the values included in the plans may not be realised at present. If the assets will not sell or will only sell at a lower value, the sale will generate less cash than the company needs, and so the company may not overcome its financing difficulties. It should also be considered whether the company can operate without the assets which are being sold, assuming this is not a sale and leaseback.
- Entity provides significant loans or guarantees. If borrowers are unable to pay the amounts owing, this will obviously have an adverse effect on the lending company's cashflows, especially if it is unaware of the problem in advance and therefore has no time to plan for its own cash shortfall. If a company has guaranteed the borrowings of another, for example another group company, and the borrower fails to repay the loan, the lender may require the guarantor to contribute. Again, the lack of advance notice of this and ability to plan the guarantor's own cash needs can exacerbate the situation.
- Entity dependent on guarantees provided by another party and guarantor no longer able/willing to provide the guarantee. Guarantors may be facing cash constraints of their own and so will be unwilling to risk continuing to guarantee the borrowings of others. As banks become more risk averse, some entities will find it very difficult to borrow money without the use of a guarantor.
- Future cashflows are uncertain or volatile. Most industries have experienced falling sales as a result of the credit crisis, although different industries have been affected to differing extents. The unpredictable nature of the current environment makes it hard for companies to forecast the extent of their cash shortfall and to ensure they have adequate facilities available.
- Customers taking longer or unable to pay. The slow receipt of cash will have an adverse effect on the company's own cashflow, which will need to be managed. If customers ultimately don't pay at all, then the value of receivables at the year end will be overstated.
- Entity dependent on key suppliers. If suppliers are facing their own difficulties and are not able to supply an entity with essential raw materials, the company will have to spend time sourcing another suitable supplier. In the meantime, its own operations and sales could be adversely affected.
Fair value factors
The fair values of many asset types could be affected by current market conditions, particularly financial instruments.
- Active market no longer exists, requiring use of a model for valuation purposes. Due to reduced or suspended trading in particular asset classes, assets may have become illiquid. Models may be required to estimate values, for example the use of the Black-Scholes option pricing model, but such models are based on assumptions which may be unrealistic in the real world, resulting in inaccurate valuations.
- Impairment of non-current assets. Many properties, for example, will have fallen in value. If the properties are unusual it may be difficult to determine their value. Other non-current assets will be impaired if poor trading conditions have caused their recoverable value (based on net present values and realisable values) to fall below carrying value. Entity does not have necessary expertise to undertake valuations. Valuations of some assets can be very subjective, and if staff do not have the necessary expertise there is obviously a high risk of material misstatement.
Other risk factors
- Impairment of assets other than those held at fair value. Since customers are likely to be experiencing some degree of financial difficulty, higher levels of receivables than normal will be irrecoverable. It will be very difficult for companies to estimate the provision required since the extent and duration of the crisis remains so uncertain.
- Impairment of the carrying value of purchased goodwill. If companies have acquired subsidiaries which are performing poorly, the value in use of the subsidiaries may have fallen below carrying value. (Note that this is only a risk of material misstatement for purchased goodwill. Since non-purchased goodwill is not capitalised, any impairment in its value does not affect the financial statements.)
- Net pension obligation (defined benefit scheme) has increased as the value of assets in the pension fund has decreased. The pension obligation shown in the financial statements is essentially the pension liability to employees less the value of assets in the fund to finance it. A fall in the value of assets due to falls in the stock market, for example, will increase the net obligation. Although this position may be reversed when the stock market recovers, in the meantime the company's net asset position will appear worse.
As well as considering risks that obviously impact on the financial statements, such as those above, auditors would be well advised to consider any obvious strategic risks facing their clients, which could lead to going concern problems.
For example, one of the most well-known corporate collapses of the crisis has been UK retailer Woolworths. Even a cursory consideration of its strategy would highlight that it had no obvious market niche (it sold limited ranges of lots of different product types); it faced severe price competition for its goods (most notably from supermarkets) such as CDs and household equipment; it had expensive high-street locations; and its customer base was mainly lower socio-economic groups.
It would seem clear that the high rents would increase operating costs, buying smaller quantities of many different products would increase buying costs, price competition would create downward pressure on prices, and the customer base would have limited spending power, especially in the crisis.
Woolworths will be remembered fondly by many for its 'pick and mix' sweets, but they were not enough to ensure the company's viability.
Systems and controls
As part of his or her risk assessment, the auditor should consider the design and operational effectiveness of any controls the company has undertaken to address the identified risks.
The auditor should also ensure that the controls stated within the company's systems documentation are actually being performed. Since companies will be trying to cut costs, there may be fewer staff employed within the accounting department and so some controls may not be performed due to time pressures.
Also, since many employees may be facing personal financial difficulties in the current circumstances, there may be more temptation to commit fraud. Auditors should pay particular attention to this possibility.
Next time: The final article of this series will focus on the audit work that is necessary to address these risks, as well as stage and reporting issues.
Connie Richardson, auditing and accounting lecturer, Kaplan Financial in Singapore