Research Korner: Auditing Essay Examples

Sustainability Audit Report of Bell Fire Equipment

Sustainability Audit:   Bell Fire Equipment                                                                   Executive Summary               Bell Fire Equipment needs to enhance its sustainability policies by adopting changes. The two areas of priority are improving collaboration between the R&D and marketing departments and the other is improving its processes of selecting and building relations with suppliers. The change strategy to develop collaboration is through team-building activities such as challenge simulations and meetings. The measure of change is by integrating financial measures, key performance indicators and benchmarking. The sustainability measure considers costs and benefits. The change strategy for improving supplier relations is taking feedback from the different departments to determine factors for consideration and top managers in charge of negotiating with suppliers developing the standards. The measure of change is key performance indicators and the measure of sustainability is corporate sustainability model.                                                 Table of Contents   Executive Summary. 2 Table of Contents. 3 Introduction. 4 Company Background. 4 Purpose of the Report 4 Scope of the Report 4 Sustainability Audit 5 Overview of Priority Areas. 5 Priority Area 1. 7 Priority Area 2. 9 Recommendations in Improving Sustainability. 10 Conclusion. 11 Reference List 13 Appendices. 14                               Introduction Company Background Bell Fire Equipment is a fire protection company established in Western Australia. As a small business, it employs 30 people handling the sale, installation and maintenance of fire protection equipment and provision of fire protection services. ( 2008) While the company experienced growth, there are issues or risk areas requiring prioritisation for change. Purpose of the Report             The report is a sustainability audit for Bell Fire Equipment that lists down the areas for change in business, the prioritisation of these areas, and the change strategy and measures for the top priorities.   Scope of the Report             The report focused on the priority areas in the company and specific discussion of change strategy and measures in the context of Bell Fire Equipment and supported by relevant theories Sustainability Audit             The process of sustainability audit offers key benefits to business firms seeking improvements in operations and long-term goal achievement. One benefit is the ability of the firm to focus on all evidence entrenched in the organisation to understand its sustainability as a company. Another is the consideration of internal and external perspectives of the organisation to support future oriented planning. Last is assessment of progress in sustainability by the company by using measures such as comparing the objectives with actual incremental outcomes. ( 2005) Overview of Priority Areas             The list of stakeholders of Bell Fire Equipment [See Summary in Table 1 in the Appendix] shows the stakeholders of the company, their influence on the business, sustainability issues, and the prioritisation of the issues.  The stakeholders are all the parties that affect the success or failure of the company in its strategic actions but since various stakeholders represent various interests, issues or problems are abound to arise ( 2007). These issues require consideration to determine the priority areas and identify change strategies and measures. The stakeholders of the company include Bell Fire Equipment as the owner that provides leadership, authority, direction, and oversight of the company. Employees implement decisions or policies and provide feedback to the leaders. Customers determine the needs and objectives of the company. Investors provide capitalisation and share in risks. Customers determine the needs and objectives of the company. Regulatory and safety authorities impose standards for aspects of the firm’s operations. Suppliers provide the resource needs and affect the supply chain of the company. Government agencies offer mutually beneficial large-scale and long-term collaboration with the company. Private companies provide large-scale and long-term collaboration with the company. [j1]  The company face a number of sustainability issues relative to the different stakeholders. These issues include: 1) collaboration between the R&D and marketing teams for efficient resource utilization and customer needs fulfilment; 2) careful selection of investor relations on mutual terms; 3) dissemination of information to the company of new regulations; 4) consistency in the quality of raw materials and components from suppliers; and 5) possible involvement of the company in political affairs by engaging in government agencies as its main client pool through bidding contracts. [j2] The priority issues are collaboration between R&D and marketing and consistency in the quality of raw materials and components from suppliers[j3] . By applying the triple bottom line model ( 2007), the sustainability issues emerging from the operations of Bell Fire Equipment fall under environmental, economic or social concerns considered relative to resource, internal and external impact [See Summary in Table 2.in the Appendix]. Based on the TBL, most of the issues fall under the economic and social components. This means that the concerns faced by the company pertain more to the financial and resources aspects as well as building social relations with various stakeholders. Adhering to economic and social components justifies the prioritisation of collaboration between R&D and marketing. Nevertheless, the company also face an environmental issue in relation to its sourcing of raw materials. Consideration of environmental aspect justifies the prioritisation of consistency in the raw materials and components from suppliers. [j4] According to  (1991), these various issues correspond to the corporate social responsibility of the company. Corporate social responsibility finds representation in a pyramid [See Figure 1 in Appendix] with economic factors at the bottom and philanthropic activities at the top. The progress of the company determines the depth of its corporate social responsibility and sustainability. By focusing on these issues, Bell Fire Equipment considers the three aspects of corporate social responsibility, albeit in varying extents.  Risk assessment support and manage change by facilitating prioritisation ( 2007). The application of risk assessment, which assesses sustainability issues according to the degree of risk, posed for Bell Fire Company shows that two sustainability issues receiving high prioritisation [See Summary in Table 3 in the Appendix]. One is organisational decay from failure of the R&D and marketing departments to collaborate and the other is failure to maintain quality of products and services because of inconsistencies or decline in the quality of raw materials and components. The priority areas pose immediate risk with wider and longer impact deserve attention and the change management plan organised. [j5] Business firms have limited resources and response to issues requires timely action so prioritisation according to risk is a necessity. Priority Area 1             The first area of priority for Bell Fire Equipment is preventing organisational decay by building collaboration between the R&D and marketing departments. The solution to this is building better working relations between the two departments by changing processes, systems and structures.             Change Strategy             The driver for change is management dilemma [j6] or the means of improving management to support collaborative practice. The type of change required is continuous transformation [j7] ( 2006) because relations develop over time and requires nurturing to continue. The organisational development [j8] strategy is normative re-educative [j9] ( 2000) because the activities for change create symbolic environments in starting collaborative relationships. Team building activities such as simulation challenges and formal meetings support collaboration. As such, the management approach would necessarily be collaborative[j10]  ( 1999) also with the heads of the departments facilitating the communication exchanges or information sharing between the two departments. The leadership style is coaching[j11]  ( 1994) because the managers lead collaboration by example and point out flaws and best practices in collaborative practice in the course of task completion. This also supports change through the voluntary action of individuals with managers stimulating action.             There are also changes in the organisational structure to a more organic [j12] one to create cross-functional teams ( 2006) that support open communications and easy information sharing between the R&D and marketing departments as horizontal units. This also lowers the wall of formality between the two groups to build a friendly atmosphere. This involves the change process of horizontal communication             There would be resistance during the change process [j13] because change is transitional so that individuals affected by the change go through the stages of security, anxiety, discovery and integration ( 1996). Resistance of Bell Fire Equipment to the change process largely occurs during the anxiety phase since it is in this phase that the employees in the two departments experience stress in re-establishing their place relative to the change. Easing resistance is through information sharing, coaching and collaborative management.             Measures             To determine the extent of success, the integrated measures of change include the combination of financial measures, key performance indicators, and benchmarking[j14] . The integrative approach is necessary since different measures focus on various areas and combining measures ensures that more coverage. Financial measures by looking at changes in market share, profitability, cash blow and budget targets. Key performance indicators are factors for success that have been pre-identified prior to the change and serve as comparison of outcomes. Benchmarking is the measurement of change outcomes based on best practices developed by the company and/or based on industry best practices. This considers what ought to be done relative to what was done. ( 2006) Since the change addresses sustainability issues, measures of sustainability also require consideration. The cost and benefit analysis [j15] that considers economic, social, legal and environmental costs work best by focusing on impacts in multidimensional areas ( 2008). Priority Area 2             The second area of priority for the company is ensuring consistency in the quality of raw materials and resources by selecting and enhancing relations with supply partners. The solution to this is identifying and selecting from firms that align with the quality standard of the company. Change Strategy The change driver for this priority area is consumerism[j16] , particularly the growing concern of the market for fire protection on quality that encompasses not only the functional quality but also environmental quality. Since the change process involves the shift in external boundaries or the manner of building supplier relations, the change strategy is empirical-rational strategy [j17] ( 2000), which operates based on the assumption that change occurs through information that point out areas for change. In particular, Bell Fire Equipment needs to gather information on various suppliers of raw materials and components, compare performance, identify which companies align with its quality values, and establish the link. It may also be necessary for the company to cut relations with low quality suppliers and establish new ones. The style of change management for the second priority area is consultative[j18]  ( 1999) since the development of the process of selection and relationship building would form from consultations with the different departments particularly the R&D departments that directly handle raw materials and components. The leadership style that best fit this change is captain profile[j19]  ( 1994). Although the change management style is consultative, there is need for a central authority directing the consultative tasks. In addition, the objective is to ensure consistency in the outcome and a directive leader becomes necessary. The type of change is punctuated equilibrium [j20] ( 2007) because the establishment of a new supplier selection system comes after a long period of stability. However, after determining and establishing a new system, this would apply for a longer period of equilibrium. This fits the change since the intention is to build long-term relations corresponding with the long period of equilibrium. The nature of change is also mechanistic ( 2006) because even if there the process involves collaboration, the leadership style fits the captain profile and the decision rests on top management in charge of negotiating with suppliers. This requires high specialisation, authority, and formal processes.             Measures             The measures for the change process include key performance indicators [j21] ( 2006), especially on quality. However, as a sustainability issue, the quality indicators should include social, economic, legal and environmental components. Indicators for success should be identified prior to the change process based on expectations of successful supplier partnerships and then the outcomes would be compared with the expectations. The extent of different and the justifications would determine the success of the change process. Applicable sustainability measure for the second priority is the corporate sustainability model [j22] of considering the relationship of input to process to output and then outcome ( 2006). This coincides with the supply chain process. Recommendations in Improving Sustainability             Bell Fire Equipment can improve its sustainability by furthering the adoption of more encompassing sustainability policies. So far, the company has considered its economic and social sustainability. However, these only focused on internal impact. The company has not really made any strong connections with the community it serves through corporate social responsibility practices ( 2003) of sponsoring fire protection programs in the community as a philanthropic activity instead of just offering these services to its paying customers. Conclusion             Sustainability is building the value of the company to various stakeholders to ensure viability in the long-term. The sustainability audit allowed the determination of the areas for change for Bell Fire Equipment to support sustainability.                                       Appendices   Table 1: Summary of Stakeholders, Issues & Prioritization     Influence on Business Sustainability Issues Priority Level (High/Low) Owner (Bell Fire Equipment) Bell Fire Equipment provides leadership, authority, direction, and oversight of the company. Inefficient management, weak leadership               Low      Employees Employees implement decisions or policies and provide feedback to the leaders. Poor collaboration between key departments (R&D and marketing) High      Customers Customers determine the needs and objectives of the company. dissatisfaction and loose loyalty Low     R&D Investors Investors provide capitalisation and share in risks. Poor or non-mutual investor relations Low Quality and Safety Regulatory Authorities Regulatory and safety authorities impose standards for aspects of the firm’s operations.   Untimely dissemination of new regulations Low Raw Materials and Prefabricated Materials Suppliers Suppliers provide the resource needs and affect the supply chain of the company. Consistency in quality of raw materials and components High Government Agencies in Western Australia Government agencies offer mutually beneficial large-scale and long-term collaboration with the company. Breakdown of collaborative relations Low      Private      Companies Private companies provide large-scale and long-term collaboration with the company. Breakdown of collaborative relations Low   Table 2: Summary of Triple Bottom Line Analysis   Sustainability Issues Triple Bottom Line Component Resources & Respect Internal Impact External Impact collaboration between the R&D and marketing teams Economic       Social Efficiency in human resource functions     Respect for employees, customers, and community Improve performance and productivity   Effective human resource management Meet needs of customers     Improved customer and community relations careful selection of investor relations Economic         Social Efficient management of capital investments     Respect for investors and the community Maximised investment returns     Accountability Economic benefits to the community     Continuity of employment and income generation for the community dissemination of new regulations  to the company Social Respect for people’s right to information Adherence to new regulations Benefits of compliance to the community consistency in the quality of raw materials and components from suppliers Economic         Environmental Efficient sourcing         Respect for the environment by incorporating earth friendly features of raw materials and components as part of quality Adhere, maintain or enhance quality standards   Assumption of environmental responsibility Provision of quality products and services     Helping to alleviate pollution and release of greenhouse gases     Table 3: Summary of Risk Assessment   Risk Impact (High/Low) Parties Affected Controls Further Action Organisational decay High Employees, Customers and Community Performance measures, HRM policies Information sharing Negative investor relations Low Investors and community Mutuality-based assessment of investors, building long-term relations Improved selection methods and expansion of investor relations to support R&D Non-compliance with new regulations because of lack of information Low Customers and community     Failure to sustain product and service quality Inconsistent or Low Quality of Raw Materials High Customers and Community         Figure 1: Corporate Social Responsibility Pyramid    [j1]List of stakeholders and description  [j2]List of sustainability issues  [j3]Priority issues  [j4]Justification for the priority areas using TBL  [j5]Justification for priority areas using risk assessment  [j6]Lecture 5  [j7]Lecture 5  [j8]Lecture 6  [j9]Lecture 5  [j10]Lecture 5  [j11]Lecture 6  [j12]Lecture 6  [j13]Lecture 7  [j14]Lecture 12  [j15]Lecture 12  [j16]Lecture 5  [j17]Lecture 5  [j18]Lecture 5  [j19]Lecture 6  [j20]Lecture 5  [j21]Lecture 12  [j22]Lecture 12

Sustainability Audit Report of Bell Fire Equipment

Sustainability Audit: Bell Fire Equipment ...

Analytical procedures and going concern at the planning stage

Applicable Auditing Standards (based on HK Standard on Auditing 570)             Going concern is a fundamental principle in preparing financial reports and a vital assumption applied by the reporting entity. When going concern is claimed, the business necessarily means to continue operations for the foreseeable future with no indication to cease trade, liquidate, or seek protection from creditors to pay obligations.  It also indicates the strength of financial statements and components that are being reported such as realizing assets and discharging liabilities.  Going concern assumption undergoes auditing procedures to test if the assumption is appropriate and subsequently protect the decision-making implications of investors, creditor, suppliers, regulators and other users of financial statements.                       When the business has shown historically profitable activities and business stakes as well as provides evidence for easy access of financial resources, detailed analysis on going concert test need not be imposed.  Otherwise, the business will be applied with sequential audit trail set forth by pertinent auditing standards.  Going concern assumption is significantly injected with judgment of future outcomes for certain events/ conditions.  The soundness of these judgments is inclined on three notions.  As they are pushed further into the future, outcomes become more uncertain.  They are based on the contemporary facts relevant to the business.  Lastly, judgments are affected by size and complexity of the business, nature and condition of operations and degree of impact of external factors.             Some events/ conditions that may cause business risks and contribution to doubt on going concern assumption are the following: financial (net current liability position, excessive reliance on short-term loans, signs of withdrawal of support from creditors, negative operating cash flows, substantial degradation of valued assets, inability to pay on due dates, inability to comply with loan agreements, inability to obtain financing for new product, adverse financial ratios, etc.), operating (loss of key management yet to be replaced, loose of major market and business partners, shortages on factors of production, etc.) and other factors outside company’s control.  However, the business can mitigate the doubt by disclosing plans and strategies to solve the adversaries.                Two main tasks of auditors are assessing the validity of going concern assumption claimed by the business in preparing financial statements and evidence supporting such assessment.  Procedures of evaluation include identification of events/ conditions leading doubt to going concern, evidence and risks of misstatements.  In most cases, the management of the business executed preliminary evaluation that is required to be at least a going concern assumption for 12-month period.  However, the review of auditor can involve consideration of periods exceeding this required period if the effort significantly affect going concern assumption for the original time frame.  As judgment further in the future is more uncertain, evaluations exceeding the original period must have determined impact to going concern assumption.               The mitigation that management offers in the case the doubts to going concern validity is also audited to evidence feasibility and effectiveness.  One useful tool and basis is cash flow analysis where consideration is applied to reliability of inputs that generate the information, adequacy of supporting variables in reaching the forecasts, historical accounts and current performance.  When material uncertainty is proven, the financial statements of the business can gain an assessment that its contents have significant potential to mislead users.  However, if material uncertainty is proven but going concern is assumed, financial statements must show events/ conditions that can increase significant doubt to going concern validity or simply directly state doubt to such validity.  Regarding material uncertainty conclusions, the auditor can apply unqualified position where financial statements reflect them and sketch the important parts of the report that signal going concern issues.  If they are not reflected, qualified or adverse position can explicitly explain material uncertainty.        Financial Position of the Business (i.e. IOL)             Average collection period is increasing since 2006.  As a general rule, lower average collection period is optimal because the business need not wait long to receive cash payments from their credit sales.  The performance of the business for this ratio indicates that it has difficult time in converting account receivables into more liquid assets (i.e. cash).  It can also mean that the business is more exposed in acquiring bad debts and defaults.  Cash conversion cycle is adversely affected because of the pressure imposed by longer collection periods.  The time of outlaying cash and cash recovery is widened which signifies more time capital is tied-up to business processes (i.e. conversion of inputs to outputs).  Due to this, the business is required to source out additional capital to maintain daily operations because most of its current capital is tied-up.  This additional requirement is necessary to pay production expenditures, wages and overheads.  Failure to address these costs can lead to interruption and stoppage of work or even disposal of value-creating assets that suggest bigger problems.  High average collection period is aggravated/ mitigated by low/ high inventory turnover and high/ low average payment period.               Current ratio is decreasing since 2006.  From stronger liquidity in 2005, the business dropped to a ratio less than 1 suggesting that it cannot pay its obligations as they fall due.  These obligations are accounted to short-term liabilities such as debt and other payables while short-term assets that are used to pay them include cash, inventory and receivables.  With reduced current ratio, the business has more obligations than potential payments and signals the need to source financing to various channels.  The risk, however, is that the strain of overdue obligation which can force the business to enter credit agreements and other contracts that are obviously detrimental compared to options available if the strain is not too urgent or if it only has assets to pay them.  Lower current ratio is related to higher average collection period which implicated likelihood of bad debts.  With a more conservative analysis (i.e. getting the quick ratio), the exclusion of inventories, pre-paid expenses, and as proved, account receivables, can only aggravate the liquidity of the business.               Debt-equity ratio is rising since 2006.  This indicates that the business is becoming more dependent on interest-bearing debt financing than less risky internal or equity financing.  As a result, its earnings are also more volatile due to reductions by payment of the interest.  It can also put the business into greater agreement risks mentioned in current ratio such as collateral of value-creating assets and disposal when debts are long overdue.  In the case of dissolution, shareholders are in greater risks to recover investments because outside creditors are preferred in distribution of assets and may even demand the former to contribute to the losses.  In 2007, the business is sourcing debt that is two-times larger than proceeds from equity which can trigger the preceding consequences.  However, there is a need to investigate where the debt proceeds are invested.  This is important because debt-financed projects with significantly high returns compared to debt interest (i.e. debt coverage) can alternatively increase earnings.                Gross profit ratio is decreasing since 2006.  This can either mean that the business is generating fewer revenues or experiencing price increases on cost of goods sold than previous periods.  As a result, it decreases its opportunity to create savings for engagements in the future and payment of unexpected expenses.  Problems are likely rooted in ineffective production and marketing of products, inefficient relationship with suppliers and expensive logistics design.  On the other hand, the negative figures pertaining to profit after tax ratio show that the business has no earnings (i.e. at loss) from 2005 to 2007.  It is a difficult time for the business which various aggravations such as low collection period, current ratio and high debt-equity ratio.  This can also indicates that the projects the business is entering and financing are not contributing to profitability.  However, the ratio on profit after tax can be applied with tax holidays or incentives that can transform profit to positive figures.               Net asset per share is declining since 2006.  Assuming that shares outstanding are constant, this indicates that the assets of the business have lower values and new value-creating assets are yet to be included in its operations.  As a result, the interest and wealth of shareholders is not protected leading to their divestment.  The preceding possibility can aggravate the problem of the business on sourcing out safer funds to pay current obligations, prevent stoppage/ litigation and finally to report its financial statements as a going concern.  However, there is a need to investigate whether this ratio includes intangible assets which is eminent to the innovative products that the business is creating and planning to distribute.    Factors Evidencing Going Concern Problems             For the first product that the business launched into the market, it gained success although only temporary as shown by decline and moderate attention of the market for succeeding products.  With the promises of the new program developed over a three-year period, history of profitability is difficult to attach to its operations.  The market for Internet-based computer programs is exposed to numerous companies and similar products whose purchase decisions are unpredictable.  For example, computer programs bought in the internet through online payment is a transaction viewed risky by the market while bogus offers are inevitable.  As Internet business is global, predicting market response and demands is very difficult due to various culture, level of technology and economic status.  With cheap prices tagged on the product, the business is unsure that its investments for research and profit targets will be met.               Further, its access to financial resources is very limited especially with its adverse financial ratio.  It cannot rely on its debtors/ accounts receivables as it accumulated decreasing collection period, on its short-term creditors due to decreasing current ratio, on its long-term creditors due to increasing debt-equity ratio, on its retained earnings due to decreasing profit ratios and on its shareholders due to its decreasing assets per share.  The raising of funds to finalize and launch the new product has been possible because of sourcing from personal savings or borrowing with relatives as the company started with financing on this method.  Although this can evidence that the business has access to financial sources, additional working is required to validate the extent and depth of this kind of informal financing.  The absence of sufficient evidence of profitable history and access to financial resources is a sign that probable going concern problem is demanding for proof.               The launching of the new product is regarded as the breakthrough of the business in reversing previous trading problems with other lines of products.  However, this claim is inappropriate in judging events/ conditions to arrive at going concern assumption.  It is not based on facts at the time of judgment because past trading problems are undermined.  The success of the new product is related to the success of previous launchings.  Further, forecasting that the new product will be completed and launched in six months time triggered uncertain outcome as it is judged further in the future.  Three years that the product is under development and there is no evidence that its development is supported by a time-line.  The fast-paced and ever-changing level of Internet technology likely deemed innovativeness of the new product designed three years ago obsolete.  Its main features and forecasted reaction of the market are highly questionable with the level of technology today.               Forecasting the future performance of the new product is also exposed to several risks.  Although there is evidence that the business is issuing shares, the declining performance of post-first product launched and cheap price supports the idea that it is under the category of small and medium enterprises.  The environment is very competitive where big program developers can easily be pirated employees, sued due to infringement of trademark, and bought in case of financial difficulties.  It is also operating on a research extensive industry where earnings are not certain until a new product is not only successful in production but more importantly appealing to market preference.  There is also crucial emphasis on protection of proprietary and speed to market where the new product forecasted to be launched after six months can leak into the Internet or produced by other companies.  The nature and condition of the business and the industry are very unpredictable and bounded by changes in regulation (e.g. applying for patents).                   Solution to the Going Concern Problems             The business can present supporting details that can mitigate the implication of unhealthy financial statements.  For example, lower collection period can be trade-off by higher inventory turnover or lower payment period.  Lower current ratio can indicate high inventory turnover and shortage in cash assets is triggered by increase in bad debts due to lower collection period.  In effect, favorable data about inventory and payment terms of the business can mitigate going concern problem.  Further, high debt-equity ratio can reduce its inherent risk if loan documents can prove that most of the debts of the business are not interest-bearing.  This can relax the requirement for interest coverage and minimize the vitality of the success of the new product in its launching.  The negative profit after tax ratio can be relieved by government correspondence reflecting tax holidays that the business can use in the future.  Data about the current level of shares outstanding can verify the cause why net asset per share is reduced.  If it is caused by increases in issues, then the claim of the business that its assets are undervalued can gain ground.               Product features of the new product and its impact to purchasing decisions of users can be used.  It can also compare how the new product is similar to the first product to claim the former turnaround impact to sales.  Without this evidence, the forecasts that the new product is a breakthrough can only be assessed as having material uncertainty.  Information about target market, previous sales data, contribution of each specific segment, and other marketing reports is necessary.  The new product must also prove to assure that its features are compatible with the current needs of the market and the current level of technology.  Certifications that the product already has patent to prevent piracy and value-decreasing actions from competitors.  In simple terms, the business must provide information that the new product is supported by valuable, inimitable and non-substitutable features.               The business can also suggest plans on how to assure that the 6-month completion and launching of the new product is realistic.  It can present project plans, milestones, funding allocation and actions in case of project failure.  If the new product is proved to be valuable and has potential like the first product, the launching date is crucial to realize the cash flows and provide insight on how the business can protect its adverse financial ratios to becoming indication of bankruptcy.  Delay in project completion can reduced its value creation as the general rule states that the money hold today is more valuable than the money that will be hold tomorrow (i.e. time value of money).  Alternatively, the business can offer other plans to improve the current features of the product, increase investments in marketing, boosting relationships with business partners and the like.  This engagement must be supported by annual budgets, monthly performance reports, correspondence with suppliers and distributors and even performance appraisal of employees.          Bibliography Books   Electronic Sources

Analytical procedures and going concern at the planning stage

Applicable Auditing Standards (based on HK Standard on Auditing 570) Going concern is a fundamental principle in preparing ...

Risk-Based Approach to Financial Statement Audit

Risk-Based Approach to Financial Statement Audit             In the late 1990s, Enterprise Risk Management (ERM) began to evolve as an approach for companies to manage risks on a holistic, company-wide basis. Audit departments employing a risk-based audit approach are probably already focusing on the same key risks that management focuses on as part of the ERM process. However, there are other characteristics of the ERM that a risk-based audit approach does not comprehensively address. Therefore, a fourth generation of auditing, risk management-based auditing, is necessary to optimize in an ERM environment. Risk management-based auditing embodies many of the characteristics of risk-based auditing with an expanded focus on key business objectives, management’s tolerance to risk, key risk measurements or performance indicators, and risk management capabilities. Additionally, risk-based auditing primarily focuses on mitigating risks to an acceptable level. Risk-based audits have the following characteristics: 1. Objective – Determine the primary business objectives, risks, measurements, and tolerances, and evaluate how effectively the risk management activities are supporting the objectives by managing the risks to an acceptable level 2. Approach – Focus on the following <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Understanding management’s strategic, operational and 	value objectives</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Identifying and evaluating the key business risks that 	are barriers to achieving those objectives</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Understanding management’s tolerance relative to risk 	occurrence</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Understanding how management monitors and measures  and 	how successfully they are managing those risks</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Determining the risk management activities deployed to 	manage the risks to an acceptable level</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Assessing how effectively the risk management activities 	manage those risks to an acceptable level</li> </ul> 3. Focus – Identify gaps between the current and desired level of risk management effectiveness. 4. Testing Approach – Typically, a combination of substantive and compliance testing is utilized, depending on how effectively the risk management activities are designed. 5. Recommendations – Relate gaps in risk management effectiveness to the underlying risks and key business objectives (Sobel 2005).             Risk-based auditing centers on the efficient review of the key elements of the financial statements. Essentially, this involved the concentration of audit resources on the material areas of the financial statements. This approach entails: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	A systematic approach to planning where the auditors 	related audit task to audit risk by reducing the time spent on low-risk 	situations and concentrated on the coverage of high-risk situations</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	The evaluation of the internal control systems of the 	auditee</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	The use of analytical procedures to form an opinion that 	is within the desired level of assurance (Wanna and Ng 2001)</li> </ul>             At the planning stage, the main consideration for determining a level for audit risk is the extent to which external users rely on the financial statements. Accordingly, questions such as who the potential users are, their purpose for using information and the total effect of using materially misstated information for their purpose are considered by the auditor. Apart from the audit risk, auditors also assess a risk that is related to the organization itself – inherent risk. The higher the inherent risk, the more audit effort required. This approach is currently evolving in practice and is referred to as the ‘business risk’ approach. Central to this audit methodology is an understanding of the auditee's business, how it is organized, and how transactions are controlled and recorded. The methodology focuses the financial statement audit on those activities that could give rise to a risk of a material misstatement in the financial statements. A SWOT (strengths, weaknesses, environmental opportunities and threats) analysis is carried out for the assessment of business, operational, financial, management, computerized information systems and control risks. Consideration of a client's business risks requires the auditor to know and understand the client's business strategy and how it plans to respond to changes in its environment. An emphasis on the client's business risks will lead to a more strategic and systematic approach to auditing. The auditor can use this knowledge of the client's business and industry to develop a more efficient and effective audit. The auditor will then place less emphasis on routine transactions that are likely to be tightly controlled through the client's internal control structure and concentrate on identifying non-routine transactions, accounting estimates and valuation issues that are much more likely to lead to misstatements in the financial statements.   Forensic Accounting Investigation vs. Statutory Audit             Forensic accounting investigation involves litigation. In such circumstances, accountants may be called on to provide expert investigations and evidence. Forensic accounting according to Crumbley et al (2005) is the use of accounting for legal purposes. It is the use of intelligence-gathering techniques and accounting/business skills to develop information and opinion for use by attorneys involved in civil litigation and give trial testimony if called upon. Forensic accounting in the action of identifying, recording, setting, extracting, sorting, reporting, and verifying past financial data or other accounting activities for settling current or prospective legal disputes or using such past financial data for projecting future financial data to settle legal disputes.             Statutory audit is an audit of a company as required by the Companies Act (1985), subject to small company exemptions. The auditors are required to report to the company’s member on all accounts of the company, copies of which are laid before the company in general meeting.               A forensic audit is different from statutory audit (typical financial audit) a financial audit is generally a sampling activity that does not look at every transaction. Thus, the system can be exploited by someone, such as an executive who knows the ins and outs of the company’s finances. A forensic audit looks at every detail of a specific aspect of the records, trying to determine why everything does not or should not add up. Thus a forensic audit is much more time consuming and can be significantly more expensive than a statutory audit (Crumbley et al 2005). Forensic accounting is a science dealing with the application of accounting facts gathered through auditing methods and procedures to resolve legal problems. Forensic accounting is much different from traditional auditing. The main purpose of a traditional audit id to examine the financial statements of an organization and express an opinion on the fairness of the financial statements. In other words, auditors give an opinion whether the financial statements have been prepared in accordance with generally accepted accounting principles. Auditors employ limited procedures and use extensive testing and sampling techniques. Audits are performed by independent accountants and are not conducted with a view to present the evidence in a judicial forum. An audit is not an investigation; its main objective is not to uncover fraud. Forensic accounting, on the other hand, is for investigation of an allegation with the assumption that the forensic accountant will have to present the evidence in a judicial forum. A forensic accountant often employs specialists in other areas as part of a team to gather evidence. In order to present the evidence in court, there must be absolute assurance; thus, testing and sampling methods are usually not employed as part of the evidence-gathering procedures. The scope of the investigation is limited because it is determined by the client (Siegel and Shim 2006).   Auditor’s Roles and Responsibilities             While both management and the auditor address some of the same issues, their roles are vastly different. There has been some confusion on this point, especially within the general public, which tends to attribute to the auditor certain responsibilities that actually rest with management. The professional standards of the American Institute of Certified Public Accountants (AICPA) have long made clear that the financial statements and the decisions shaping the financials are the responsibility of management. The financial statements are management’s responsibility. The auditor’s responsibility is to express an opinion on the financial statements (Golden et al 2006).               There are three most common audit deficiencies that auditors commit. One is the auditor’s failure to gather sufficient evidence. In some instances, this failure was pervasive throughout the engagement; in other instances, the allegations were more specific. For example, many cases involved inadequate evidence in the areas of: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Asset Valuation – the auditor did not obtain evidence to 	support key assumptions.</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Asset Ownership – the auditor did not obtain evidence to 	indicate the company owed certain assets.</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Management Representations – the auditor did not 	corroborate management responses to inquiries.</li> </ul> Some cases involved the auditor's failure to examine relevant supporting documents (for example, examining a draft, instead of a final, sales contract) or failure to perform steps listed in the audit program. Overall, this failure contributed to management's success in overstating assets, the most common fraud technique.             Another common problem relates to audit program design. Planning the audit engagement is crucial to its success. Deficiencies in audit planning are very common. Specifically the auditor fails to: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Properly assess inherent risk and adjust the audit 	program accordingly</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Recognize the heightened risk associated with non-routine 	transactions</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Prepare an audit program</li> </ul>             Still one of the most common deficiencies in auditing is failure in confirming accounts receivable. These deficiencies include: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Failure to confirm enough receivables</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Failure to perform alternative procedures when 	confirmations were not returned or were returned with material exceptions 	</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Problems with sending and receiving confirmation requests</li> </ul>             Another common problem is the auditor's failure to recognize or disclose transactions with related parties. The auditor is either unaware of the related party or appears to cooperate in the client's decision to conceal a transaction with this party. Such transactions often resulted in inflated asset values (Beasly et al 2001).               Fraud symptoms--the specific, observable signs that fraud might be present--may be of the actual fraud or of the cover-up attempt. The easiest symptoms to spot involve cash and inventory shortages. But even there, clever thieves find ways to obscure the symptoms. For example, it's hard to tell immediately whether missing original documentation may be due to filing errors or because someone destroyed the documents to cover up a theft. Here is a short list of some fraud symptoms: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Multiple endorsements on commercial checks. </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	The use of common or repetitive names for refunds--such 	as Smith or Jones or a commercial name that is very similar to one in your 	industry but is spelled slightly differently. </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Line items in standard reconciliations that do not go 	away. </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Customer complaints about having paid invoices for which 	they are being dunned. </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Adjustments to either inventory records and customer 	accounts. </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	The addresses of vendors that are the same as employee 	addresses. </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	No proceeds from the disposition of used assets (Hall 	1996). </li> </ul>               When one of these symptoms appears, use caution. Often there are reasonable explanations and they usually do not lead to a thief--just an error or an ill-designed process.               Risk factors pertaining to management’s characteristics and influence over the control environment are aimed at identifying pressure or an incentive to engage in financial statement fraud and perceived opportunity to commit such fraud. The risk factors involving management’s motivations to engage in financial statement fraud are the following: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	A considerable portion of management’s compensation, 	represented by bonuses, stock options, or other incentives that pressure 	management to achieve unduly aggressive targets for operating results, 	financial position or cash flow.</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Commitments to analysts or creditors of unduly aggressive 	unrealistic forecasts</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Undue pressure on management and/or interest by 	management in maintaining or increasing the company’s stock price or 	earnings trend through the use of unusually aggressive accounting practices</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	The use of inappropriate means to minimize earnings for 	tax-motivated purposes</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Domination of management by a single person or small 	group without effective monitoring oversight by the board of directors 	and/or the audit committee</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Ineffective communication and support of entity values 	and ethics</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Management failure to correct known reportable conditions</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Management disregard for regulatory authorities</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Management setting unduly aggressive financial targets 	and expectations for operating personnel</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	High turnover of senior management, counsel, or board 	members</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Management continuing to employ ineffective and 	incompetent accounting, information technology, or internal audit staff</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Unreasonable demands for auditor completion of the audit 	report issuance </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Formal or informal restrictions on auditor access to 	people or information</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Domineering management behavior or attempts to influence 	audit scope</li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Known history of securities law violations or fraud or 	allegations of financial statement fraud (Rezaee 2002)</li> </ul>     Benefits and Limitations of Risk-Based Approach             Risk-Based Auditing is an auditing technique that responds to the risk factors in an audit by assessing the levels of risk attached to different areas of an organization’s system and using the results to devise audit tests. The purpose is to focus the audit in the areas of highest risk in order to improve the chances of detecting errors (Hussey 1999).             In recent years, many auditors have expanded their focus to explicitly include the client's strategy and business processes. A number of recent studies examine whether a business process focus affects auditors' effectiveness in identifying risks. Bell et al. (1997) describe how this approach moves auditors from a balance sheet orientation to a broader focus on the overall organization, its environment, and its key processes. Lemon et al. (2000) describe the extent to which firms are adopting this focus in their audit methodology, and Eilifsen et al. (2001) describe how this approach is applied to an individual audit. The approach involves: <ul style="margin-top: 0in; margin-bottom: 0in" type="circle"> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Understanding and developing a mental model of the 	client's strategic environment, </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Understanding the key processes for executing that 	strategy, including the related risks and controls, and </li> 	<li class="MsoNormal" style="text-align: justify; line-height: 200%"> 	Relating these factors to financial statement assertions. 	</li> </ul>   Understanding the client's business processes aids in understanding key performance indicators and in developing expectations for financial statement accounts. Several studies examine the advantages of the business process approach. Organizing information about controls around business processes produces stronger category knowledge during auditor training and improves internal control evaluation performance compared to organizing information around traditional control objectives (Kopp and O'Donnell 2005). Using such an approach also increases the extent to which auditors integrate assessments of strategic business risks (O'Donnell et al. 2005). Auditors using strategic business risk analysis document more client business risks, and they assess the strength of the control environment and inherent risk differently (i.e., they perceive a stronger link between the strength of the control environment and the risk of material misstatement, and between inherent risk and the risk of material misstatement) (Kotchetova 2005). Additionally, auditors' assessments of client business risk and the analysis and documentation of business processes influence their business process-level risk assessments (Kotchetova et al. 2005). When auditors analyze and document business processes, their process-level risk assessments are related to their previous assessments of entity-level business risk, indicating that documenting the process analysis creates linkages between risks at different levels. Finally, using software adapted to a business risk approach allows auditors to identify more risks (O'Donnell and Schultz 2003). Two recent studies, however, document potential disadvantages of the business risk approach. First, Ballou et al. (2004) find that when the strategic analysis of a client indicates that it is typical of its industry, auditors may underweight small problems within business processes. Second, O'Donnell and Schultz (2005) find evidence of a "halo effect" when auditors use strategic risk assessment. Specifically, auditors performing such strategic assessments with favorable results are less likely to adjust their risk assessments at the account level when they uncover unusual fluctuations. Thus, both studies suggest that auditors getting positive news from the strategic-level risk assessment may be less attuned to specific risks noted subsequently. Most firms have developed decision aids to help identify client business risks, particularly on first-time audits (e.g., see Bell et al. 2002). Moreover, many have developed software that facilitates the use of the business risk approach discussed above (O'Donnell and Schultz 2003). However, practitioners should be aware that the orientation of a decision aid (i.e., a negative focus emphasizing risks and their consequences versus a positive focus) can affect auditors' judgments (Bedard and Graham 2002). Investigating auditors' responses relative to their actual (as opposed to hypothetical) clients, Bedard and Graham (2002) find that auditors who use a negatively focused decision aid identify more risk factors than auditors using a positively focused decision aid, and auditors who use a negatively focused decision aid link substantive tests to the risk factors. Auditors also can use analytical procedures that use a business risk approach and are adapted to clients' key processes (Ballou and Heitger 2004).

Risk-Based Approach to Financial Statement Audit

Risk-Based Approach to Financial Statement Audit In the late 1990s, Enterprise Risk Management (ERM) began to evolve as an a...