Understanding the entity and its environment

Accounting Ahead | Original study resource | accountingahead.com.au

Understanding the entity and its

environment

MODULE 2 | 2.4 | STUDENT COMPANION

Before assessing risk, the auditor must understand the entity well enough to see where misstatements

are likely and how serious they could be: its organisation, ownership, governance and business model; its

industry, regulation and economy; its performance measures; its reporting framework and accounting

policies; and its system of internal control. Business risks usually have financial consequences that land

on specific assertions.

What the understanding covers

The point

To see where the numbers are most

likely to be wrong, and how serious it

could be

Organisation, ownership and

governance

And the business model, including its use of

IT. Voltana: an ASX-listed company whose

founder-CEO owns a large stakeIndustry, regulation and other

external factors

Voltana: rivals cutting prices, rebate rules,

interest rates and the US dollar

Measures of financial performance

Used inside and outside the entity. Voltana:

a 30% revenue growth target drives

bonuses

Reporting framework and

accounting policies

Voltana: Australian Accounting Standards;

revenue on installation; the warranty

provision

The system of internal control

Covered in the next two lessons. Voltana: a

new accounting system from February

The revised risk assessment standard requires this understanding before risks are assessed

Starting outside the entity

Auditors learn about these from industry reports, government statistics, trade publications, analysts' reports and

their own experience with similar clients.

Area What the auditor looks at At Voltana (imagined)

Industry conditions The market and competition, cyclical or seasonal

patterns, changes in technology, the reliability of

supply

Battery technology changing fast; rivals

cutting prices

Regulatory

environment

Industry accounting practices, licensing, safety and

environmental laws, tax, tariffs, government

programs such as subsidies or rebates

Household rebate rules can change at

short notice

Other external factors The general economy, interest rates, inflation,

exchange rates, access to finance

Interest rates affect whether customers

borrow to buy; the US dollar drives the

cost of every imported cell

ADVANCED AUDIT AND ASSURANCE | M2 | 2.4 | STUDENT COMPANION

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Accounting Ahead | Original study resource | accountingahead.com.au

Inside the entity

Area What the auditor learns

Operations Where revenue comes from, the products and customers, suppliers, locations and people

Investments Acquisitions, and spending on plant and equipment

Financing The structure of the debt, the conditions in loan agreements, and any arrangements with related

parties

Accounting policies Whether they suit the business and the framework, how unusual or significant transactions are

accounted for, and the reasons for any changes. A change of policy in a year when profit is under

pressure deserves a particularly careful look.

How a business risk reaches the statements

1. Event or condition

Something happens, or is

done or left undone

2. Business risk

It could stop the entity

achieving its objectives

3. Financial

consequence

Sooner or later it shows up

in the numbers

4. Assertion at risk

A particular claim in the

statements may now be

wrong

A business risk

Any significant situation, event, action or inaction that could stop the entity achieving its objectives, or the risk of setting the wrong objectives and

strategies in the first place

Business risks are a wider set than the risks of material misstatement, but most of them land on a specific assertion in the end

Performance measures matter twice. The targets the board watches, the measures analysts follow and the

measures that decide bonuses show what management cares about, and they can create pressure to make the

numbers look better than they are.

Case note: Dick Smith

Dick Smith was an Australian electronics retailer that Woolworths sold to a private equity firm in 2012. The new

owners floated it on the stock exchange in December 2013. Like many retailers, it earned rebates from suppliers,

and a large part of those rebates depended on how much stock it bought. Through 2015 its inventory grew

heavily, and much of it sold slowly. In October 2015 it cut its profit forecast, and on 30 November it announced a

$60 million write-down of inventory and said it could no longer stand by that forecast. In January 2016 the

company went into administration and its lenders appointed receivers; within a few months, every store had

closed. The administrators later reported that buying decisions had been driven by supplier rebates rather than

customer demand, building up stock that customers didn't want. The lesson: if rebates for buying stock are

counted as profit before that stock is sold, buying more makes profit look better even as the shelves fill with

products nobody wants. An auditor who understands that business model looks at how rebates are recognised,

whether inventory is carried above what it will sell for, and whether reported profit is turning into cash.

Source: Dick Smith Holdings ASX announcements (30 November 2015; 5 January 2016); administrators' report (July 2016).

ADVANCED AUDIT AND ASSURANCE | M2 | 2.4 | STUDENT COMPANION

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Accounting Ahead | Original study resource | accountingahead.com.au

From business risk to assertion at Voltana

Event or condition Business risk Financial consequence Assertion at risk

A rival launches a cheaper,

longer-lasting battery

Falling demand for Voltana's

current model

Stock may sell only at a discount Valuation of inventory

The US dollar strengthens Costs rise and margins fall Pressure on management and on

costing

Accuracy of inventory costing

The rules of a rebate program

change

Demand may drop Rebate amounts Voltana expects to

receive may not be collectable

Valuation of the rebate

receivable

The 30% growth target drives

bonuses

Pressure to record sales before

installation

Revenue recorded too early Occurrence and cut-off of

revenue

The bank facility falls due in about

13 months

Refinancing may be uncertain Going concern questions Classification of the debt; going

concern disclosures

Practice questions

MODULE 2 | 2.4 | TRY THESE BEFORE THE WORKED ANSWERS

Question 1 - Identify the business risks

Gumnut Grove Early Learning Ltd (imagined) is a listed company running 46 childcare centres in Victoria and

New South Wales. Identify the business risks each fact creates.

Fact Business risk(s)

(a) Average occupancy has fallen from 86% to 78% since

two rival operators opened large new centres nearby.

(b) About 70% of fees come through a government

childcare subsidy, which can be clawed back if

attendance records are wrong. Centre managers earn

bonuses based on occupancy.

(c) Centres must keep minimum educator-to-child ratios,

and several have turned families away because they

couldn't recruit enough staff.

(d) Educators' wages are rising sharply, and a

government grant that pays for part of the increase ends

in two years.

(e) Ten new centres are planned, funded by a bank loan

that requires profit to cover interest at least three times.

(f) Most centres are leased for 10 to 15 years with fixed

rent increases, including some in suburbs where

occupancy is falling.

ADVANCED AUDIT AND ASSURANCE | M2 | 2.4 | STUDENT COMPANION

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Question 2 - Trace three risks to the assertions

Choose three of Gumnut Grove's business risks and trace each one through to its financial consequence and

the assertions at risk.

Business risk Financial consequence Assertion(s) at risk

Question 3 - Sources of industry knowledge

List five sources of information an auditor could use to understand the childcare industry, and what each would

tell you.

Source of information What it would tell you about the childcare industry

ADVANCED AUDIT AND ASSURANCE | M2 | 2.4 | STUDENT COMPANION

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Accounting Ahead | Original study resource | accountingahead.com.au

Worked answers

MODULE 2 | 2.4 | WORKED ANSWERS - ATTEMPT THE QUESTIONS FIRST

Question 1 - Gumnut Grove's business risks (suggested)

Business risk(s)

(a) Competition is taking customers, so revenue falls while costs stay fixed; some centres may stop being viable.

(b) Heavy dependence on one government program whose rules can change; subsidy may have to be repaid if

attendance records are wrong; occupancy bonuses give managers a reason to overstate attendance.

(c) Staff shortages cap revenue; breaching the required ratios could bring fines or threaten a centre's approval to

operate.

(d) Wage costs squeeze margins, especially when the grant ends; fees may not be raised enough to cover them.

(e) New centres may fill slowly; lower profits could breach the loan's interest cover condition.

(f) Long, fixed leases lock in rising rent at centres that are losing children.

Question 2 - Three risks traced (suggested)

Business risk Financial consequence Assertion(s) at risk

Falling occupancy at leased

centres (a, f)

Lower revenue and cash flows at some

centres, so their fit-outs and leased

premises may be worth less than their

carrying amount

Accuracy, valuation and allocation of

property, plant and equipment and

right-of-use assets; impairment

disclosures

Subsidy depends on accurate

attendance, and bonuses reward

occupancy (b)

Revenue may include subsidy for children

who didn't attend, and amounts may have

to be repaid

Occurrence of revenue; completeness of

the liability for repayments; disclosure of

possible claims

Expansion funded by a loan with

an interest cover condition (e)

A breach could let the bank demand early

repayment

Classification of the loan as current or

non-current; going concern disclosures

Question 3 - Five sources (suggested)

Source What it would tell you

Industry reports and industry association

publications

Occupancy and fee trends, competition, new centres opening, typical margins

Government statistics and regulator

publications

Subsidy rules and changes, numbers of approved services, quality ratings,

staffing requirements

Trade publications and news Wage developments, staff shortages, policy debates, new entrants

Analysts' reports on listed childcare

operators

What the market expects and the measures it watches, such as occupancy

and earnings per centre

The audit firm's own experience with

similar clients

Common risks and errors, such as subsidy reconciliations and lease

accounting

ADVANCED AUDIT AND ASSURANCE | M2 | 2.4 | WORKED ANSWERS

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