Audit and Internal Control
Question 1 - Relationship between the Concepts of ‘Business Risk’ and ‘Financial Statement Risk’
The business risk and financial statement risk tend to have a direct relationship with one another because occurrence of business risks, if not addressed by the internal management of ABCDE Company in a timely and wise manner, will potentially result in material misstatements of the figures in financial statements of ABCDE Company. For instance, due to increase in competition, the demand for cleaning equipment sold by ABCDE Company to commercial cleaning contractors decreases which itself is identified as a business risk for ABCDE Company. Due to this uncertainty, there is a potential vulnerability in financial statements that these records may contain over-valuation of outdated levels of ending inventories in ABCDE Company’s warehouse.
Sometimes, financial statement risk is directly translated by uncertainties in business. For example, weaker business processes, ineffective internal controls and lack of transparency are most prominent forms of business risks. Inadequacy in internal controls and inappropriate accounting as well as other departmental systems could result in material misstatements or errors in the financial statements.
If ABCDE Company is unable to repay its liabilities to creditors and lenders or is at the verge of becoming bankrupt, it compromises the ability of ABCDE Company to continue as a going concern which itself is a business risk. Because of this, it is more likely that the internal management of ABCDE Company may falsely represent the figures in the financial figures. This record temperament to mislead the market investors about the ability of ABCDE Company to continue as a going concern would result in a financial statement risk of material misstatement due to wrongdoing or fraudulent activity. This is how the business and financial statement risk are in close relationship with each other.
Question 2 - Implications of Five Principal Business Risks Facing ABCDE Company
Decline in Product Demand and Sales Revenue
After carefully analysing the whole case, it is found that ABCDE Company is exposed to certain business risks that have potential to result into financial statement risk. The very first business risk which ABCDE Company is facing is the decline in the sales revenue generation capacity in the face of intense competition from existing rivalry and decline in demand for traditional cleaning equipment.
The primary reason for which this business risk has been highlighted is because ABCDE Company has only one scientist working, as a freelancer, on the traditional cleaning equipment design. While its competitors are coming up with innovative cleaning solutions and consumers’ preferences are consistently changing, offering traditional cleaning equipment to address ever changing needs of the target market is not good for business performance of ABCDE Company.
The implication of this business risk is that due to decline in sales revenue, ABCDE Company would be unable to cover its business costs of generating sales, operating expenses and create value for all stakeholders. ABCDE Company would witness decrease in cash balance for financing operational activities and liquidity management practices would become weaker than before. In all, ABCDE Company would lose its customers if it kept depending on obsolete as well as traditional cleaning equipment while losing its current market share to competitors.
Applying for more Variable Interest Bearing Loan
The second business risk to which ABCDE Company is exposed concerns the employment of variable interest rate bearing debt into the capital structure while reducing dependence on common equity for raising capital.
This business risk is cited because variable interest rate keeps fluctuating up and down in the face of monetary policy announcement at a specific interval throughout the year. If the variable interest rate increases, it would raise the cost of debt for ABCDE Company that will also raise the Weighted Average Cost of Capital (WACC) for ABCDE Company. The reason that this risk is also highlighted because variable interest bearing debt may raise the financial obligations of ABCDE Company by increasing the fixed interest payments ABCDE Company has to cover for every given payment interval.
There is an implication of this business risk that interest rate may increase due to which debt servicing capacity of ABCDE Company would be damaged dramatically. The drastic increase in interest expense would result in bankruptcy risk for ABCDE Company which is another implication of business risk related to increased debt usage. In all, the financial flexibility of ABCDE Company would decline with implication that it would be unable to raise further capital from the debt market. Lenders will only extend financial support with strict credit terms and higher interest rate as an extra compensation of increased riskiness.
Lack of Commitment of Senior Management to Excellence
ABCDE Company is also exposed to a third but intensely serious risk that its senior management is not committed to excellence and implementation of continuous improvement systems as highlighted by one of the senior members of the audit team, Ms. Janie Lambert. ABCDE Company faces an enormous business risk that its management is not implementing effective internal controls and transparent business process throughout the organisation. The implication of such a business risk is that some senior managers with immediate authority may try to commit fraudulent activities or indulge in wrongdoings. Due to the lack of transparency in records, there is a financial statement risk that the material errors or financial frauds may go undetected. Due to this, financial statements may be leading to investors and regulatory authorities, where not only the ABCDE Company but its external auditor would lose market reputation as well.
Overseas Manufacturing Facility
ABCDE Company also faces a fourth business risk that its manufacturing facility is installed in another country from which goods are imported through aeroplanes. The reason for highlighting this business risk for ABCDE Company is that the organization’s exposure to foreign currency risk may increase dramatically which will surely raise its import cost if the fuel prices increase.
There is an implication to this business risk that importing cleaning equipment from the other country may expose ABCDE Company to trade restrictions in host country. This will jeopardise its existence in host country as a going concern. ABCDE Company, in such a case, will be unable to meet local demand in host country. Also, translating net profit from host country to the economy of origin has a business risk implication that ABCDE Company will be exposed to double taxation.
Increase Workload for External Auditors but No Increase in their Audit Fee
As the workload for external auditors is unnecessarily very high and the audit fee is low, there is a business risk that current external auditor would leave ABCDE Company in no time, as communicated by Ms. Janie Lambert at end of the case.
This business risk has been highlighted because if the workload kept increasing for the current external auditor while the audit fee remains the same, it would be difficult for the external auditor to cover its own operating expenses and business costs. Due to this, the external auditor (KPMG) would find it difficult to hire the necessary and retain key performing employees. Therefore, if KPMG kept working for ABCDE Company for the same audit fee and increased workload, it would be unable to address the concerns of other clients and it working efficiency would reduce as well.
The implication of this business risk is that ABCDE Company would lose its credibility to all accounting firms and shall be unable to publish its financial statements on time without opinion or judgment passed by external auditor in specific audit report. The financial statements of ABCDE Company would be unreliable to market investors and ABCDE Company can no longer raise debt from lending institutions.
Question 3 – Memorandum Addressed to the Audit Partner about Appointment
Based on the discussion in our comprehensive business meeting held in previous month, we are regretfully informing you that KPMG shall no longer act as external auditor to ABCDE Company from the next financial accounting period. The reason for discontinuing such a three-year relationship is based on the identification of four core issues for which the reputation of KPMG would be at risk for acting as an auditor to ABCDE Company. These four issues are highlighted as follows:
Since the workload has been increasing but the audit fee remains the same, it is cited that such an activity is very exhausting and time-consuming. Much of the time is wasted in addressing non-productive activities and issues.
Because the senior is non-serious about implementing strict internal controls and transparent business processes despite our continuous recommendations for improvement, it is felt that this form of business risk has implications to material misstatements and errors in the financial statements. It is more likely that KPMG’s corporate image would be compromised if the audit firm kept addressing non-productive issues. In such a case, KPMG shall no longer be able to pass “unqualified” opinion on the reliability and accuracy ABCDE Company’s financial statements.
As ABCDE Company tends to employ more debt than normal, it is more likely that the company is at the verge of going bankrupt. In such a case of decline in financial flexibility, ABCDE Company would be unable to repay its obligations including the ones owed to its external auditor in the form of audit and non-audit fee.
As stated earlier, lack of transparent business process and strict internal control would cause the internal management of ABCDE Company to resort to any fraudulent activity. Due to this, there is a greater degree that the auditor’s independence may be compromised. The audit committee might become a victim of neglecting regulatory obligations and compliance issues.
Based on these four issues, KPMG has decided that it will no longer provide audit services to ABCDE Company, however, in continuity of three-year professional relationship, KPMG is extending offer to provide ABCDE Company with its non-audit services. Should you have any further queries in this regard, you may contact us to arrange further meetings at convenience of both the parties.
Thank you for understanding. We are looking forward to your response in this regard
References
Hayes, R., Wallage, P., & Gortemaker, H. (2014). Principles of Auditing: An Introduction to International Standards on Auditing (3 ed.). Pearson Education Limited.
