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Abstract
This paper identifies the inherent risk factors that can
have an impact on the audit of Woolworth’s limited. For each of these
risk factors, an analysis has been carried out so that potential
discrepancies can be pointed out in the financial statements. Related
evidence is also provided within.
Part 1
To carry out an audit of Woolworths, an auditor needs to
understand the internal control system and the accounting procedures
followed by the company. This is required so that the auditor can
effectively plan and develop an audit procedure for the company. One of
the most important aspects for this understanding is to identify the
audit risks involved. Audit risks can undermine the professional
judgment of the auditor as well as the position of the company if
discovered by the authority. It is the risk of damaging the reputation
of the auditor which may result in monetary loss as well as profession.
Since the auditor is to analyze financial statements and internal
controls independently and to provide an unbiased view of the financial
performance of any company for third parties or client, it is
imperative that the auditor ensures that his/her judgments do not
damage any party's interests. For example the reputation of the
auditor, the company or the monetary loss for shareholders and venture
capitalists etc. For this purpose, an auditor needs to assess the risks
and attempt to reduce it to an acceptable level so that there are less
chances of misstatement of financial statements. In this regard, there
are three components to audit risks namely inherent risks, control
risks and detection risks. These are defined as follows:
Inherent risks: "This refers to the susceptibility of an account
balance or class of transaction to misstatement that could be material,
individually or when aggregated with misstatements in other balances or
classes, assuming that there were no related internal controls. Control
Risk: "Is the risk that a misstatement, that could occur in an account
balance or class of transaction and that could be material individually
or when aggregated with misstatements in other balances or classes,
will not be prevented, detected or corrected on a timely basis by the
accounting and internal control system. Detection Risk: “Is the risk
that an auditor’s substantive procedures will not detect a misstatement
that exists in an account balance or class of transaction that could be
material individually or when aggregated with misstatement in other
balances or classes." (Chapter 5 - Audit Planning 2004)
For the purpose of this report the auditor will focus on the
inherent risk of assessing and auditing Woolworths Limited. The auditor
must note that such risks arise from: - "not gathering appropriate
audit evidence - being deliberately misled by the those providing the
evidence who conceal evidence that would have led to a different
opinion or who falsify evidence - misinterpreting and drawing
inappropriate conclusions from the evidence gathered." (Liandu 2004).
To resolve the above problems the auditor needs to consider
preliminary assessment of risks to detect the risks involved in
auditing the financial statements of the company, and to reveal any
assertion of misstatement. In considering the overall audit plan for
Woolworth, the auditor should consider the inherent risks involved,
assuming that it is high for the assertion so that detection of
material account balance and class of transaction misstatements could
be detected. There are two classes or level of assessment of inherent
risks.
At the financial level, the auditor must ensure the integrity of the
management so that disclosures of the company's intention would be
considered honest and transparent. Similarly, the role of management in
making decisions pertaining to the company is important for its
performance. Any change of company's executives and department heads
should be disclosed to the auditor so that its impact on the company's
performance can be forecasted accordingly. During the financial period
it is imperative that clients and third parties be assured of the
integrity of management. Inclusion of new executives or company head
would not only undermine their trusts but also of its performance. As a
result there would be undue pressure on the management who is already
constraint by market environment and industry forces (Liandu 2004). In
the case of Woolworths, the dynamic and competitive nature of the
industry not only point to this fact but also direct the attention of
the auditor to the risk in forecasting long term performance when there
is a change in the management and execution process within the company.
At the account balance and class of transaction level, auditors must be
aware of the accounts that are likely to be misstated. Some of the fast
moving accounts such as accounts receivables, payables, cash purchases,
inventory etc. all are susceptible to misstatement due to the fact that
the accounting of these heads are dependent on the departments as well
as the executives who plan for the department. The complexity of the
transactions and the events that impact the transactions as well as the
degree of judgment of the people involved in the reportage of the
account balances all can greatly impact its final assertions. Losses
such as assets and misappropriations can result in misstatements. Not
only this but the auditor is also aware of the fact that such
misappropriations can also affect the company in the long term as in
the case of carried forward balances which would also affect the
company's future year's financial statements (Internal Auditing
Standards Board 2004)
Identification of Inherent Risks: Given the above aspects of
inherent risks, the auditor find that there are some inherent risks
that could be detected in the assessment of Woolworth's financial
statements. These would greatly impact the assessment of financial
statements by third parties and clients should they be bias or
misstated. These are discussed as follows:
- Cash Handling As it has been mentioned that free cash flows
increased by 70.2% therefore there is a risk in handling such a heavy
amount of cash. Also it shows that company has decreased investments
and surplus cash is available. Since cash is the most sensitive item in
the account balances its auditing procedure involve the tracing out of
all cash related transactions and activities. A difference in the
reportage of cash in the balance sheet would result in decreased or
increased assets level.
- Consumable Items Two risks are involved in case of consumable items
a. Expiry Such goods may expire in short duration of time. Such
perishable items may involve high risk of being destroyed. b.
Misappropriate Consumable items are more susceptible of being
misappropriated by company’s staff and management. Consumable items
thus can be a risk for auditing as it may become expired by the time
the auditing process is complete. Forward appropriations may result in
lowered cash spent on consumable items and not being able to account
for the cash debit. While delayed appropriations would result in low
inventory for the future and yet it would tie up a huge cash balance
that would most probably be free by the beginning of the next year.
- Decision-Making with Few People: As it has been mentioned that
Roger Corbett is the person involved in almost all the decisions
therefore there is a risk that he might get biased in certain
circumstances and this might result in a loss for company. Company must
ensure integrity of management, and its working philosophy. The company
should make sure that there is no biasness in the company’s decision
making. To ensure that this does not happen, members of the board as
well as appointed head of the financial department should participate
in the analysis of the company's financial statements and its reportage
before it is publicly announced.
- Reliance on Supplier for Quality Supplies: Reliance on one specific
supplier for quality goods may cause problems in case of urgency or
quick supplies; storage of perishable items in bulk is not possible and
involves risk. This reliance on one supplier always results in a higher
risk for the company in turbulent times. Not only would this but it
mean that the company is tying up its capital to a few suppliers. To
ensure that the risk level is reduced, the company needs to strengthen
its supply chain system so that suppliers' relationship is maintained
effectively and efficiently.
- Stock Management: As company heavily depends on stocks for its
operations, stock management is necessary. The company must ensure that
following levels of stock are maintained. Continuous monitoring of
stock should be ensured. As the dependency of company’s operations is
all stock based therefore the company’s management should internalize
systems where accountability is high.
a. Minimum stock: It is stock level which company has to maintain in
any case, such levels f stocks should always be present in stores.
Inventory systems should be designed in a way so that this problem can
be effectively catered to.
b. Maximum stock: In order to avoid over stacking of stock maximum
stock level should be defined. It will ensure that stock is control of
management. Here too, the point is again same where the inventory
system should be effectively designed.
c. Lead stock: It is stock, which company must maintain during
lead-time i.e. time taken by supplier to supply goods. Cycle time or
lead-time for any company has been identified as the basic productivity
indicator. The goal is to be productive and profitable so that purpose
is met.
d. Reordering levels: Reorder level is most important level of
stock. It is level where order for the supply of goods must be placed
with supplier. Similarly, it can be safely assumed that no inventory
system would be effective without pre-defined reorder levels. Thus in
order to minimize inherent risk involved in stock, company must install
“Stock Management System”.
- Seasonal Variances Because Of Demand: Demand has significant effect
on company’s turnover. Seasonal fluctuations may increase or decrease
turn over. Forecasting and planning becomes an important variable of
where the turnover can be handled.
- Market Price Wars: Monopolies and power in the industry involve
great risk. As a result introduction of new competitor may have
significant affect on company’s turnover.
- Warehousing and Related Control: The stock in a manufacturing
industry is a material item so checks and balances have to be placed
beforehand so that there is no discrepancy. Compliance and
documentation is important for all audit procedures as the screening
has to be accessible and transparent.
- Cash in Transit: At account balance level ‘cash’ is most
susceptible item and involves great deal of risk. Decision pertaining
to the nature of cash must be established before hand so that auditing
of the same is easier. For example should the company decide to
consider cash in transit as cash, this would increase its account
balance but it does not ensure that the company has enough liquid cash
to cover its expenditure and utilization.
- Reliance on Timely Transportation of Goods (Outlets & Stores):
Inventory is the most important aspect of Woolworth's operations.
Logistics and distribution of goods and material is critical. For this
reason, to manage the inventory in a timely manner so that supplies of
the goods may not be hindered is important as this would impact on the
financial performance of the company.
- Public preferences: Turn over of FMCG’S (Fast Moving Consumer
Goods) largely depend on likes and dislikes of people, which is quiet
risky. In the case of Woolworths business this is a high risk that the
company takes on its hand. However, careful evaluation of just-in-time
procedures along with inventory management can greatly benefit the
company as it would reduce the risk of over stocking of out-of-trend
goods.
- Government policy and any restrictions on sales: Government
policies and legislative changes have significant effect on company’s
operations e.g. the Australian government recently adopted the Trade
Practices Act of 2002 and the Competition Policy to rejuvenate the
industry can greatly affect the company's position among industrial
leaders. This poses a risk in competition as well as how the company
internally controls its finance to curb industry environment
turbulence.
- Regulatory Body’s Regulations: Regulations of regulatory bodies
governing the operations of companies may have affect on the operations
of company. Regulatory bodies influence the workings and the policies
of the companies. One such body within the company is the board and its
executive who have been responsible for new projects and regulations
such as Project Refresh and Woolworths' Double Loop program.
- Reliance on it and its Function with the Company: Technology
provides competitive advantage on competitors. Drastic change in
technology has significant effect on company’s operations and
production. Investment in IT such as supply chain systems as well as
communication systems at all distribution channels not only prove to be
costly but can tie capital for the medium and short term that could be
utilized elsewhere. The risk in not reporting of the investment in such
none-returnable items on the balance sheet and the profit and loss
statements.
- Continuous Fluctuations in Net Profit: Net profit fluctuation is
inherent risk as it shows great fluctuation in operating expenses.
There should be a consistency in gross profit and net profit which is
the main aim.
- Inconsistent Investment in Assets: Net assets employed shows an
inconsistent rate ranging from $1713.1 to 2215.9 millions as given in
the financial analysis of the Woolworth’s company; it affects return on
fixed assets. Adverse return on assets employed is due to lack of
investment in assets. The ROA of the company is around 33% as given in
the financial analysis of the Woolworth’s Company, which is equal to
the ROE, which is not a good sign as the ROE of the company should be
more than the ROA.
- Unreliable Profits: Industry is highly competitive which require
extensive reliance on competency and efficiency for high profit
margins. Although company has show reasonable increase in its profits
yet its profits are not reliable due to non-reliability of company’s
operating expenses. The company should at least try to maintain its
operating expenses due to which the Net profits are also affected. The
management should try managing its operating expenses well, which will,
then result in profits. Inherent risk is always measured in combination
with control risk. There is an inverse relationship between detection
risk and combined level of inherent risk and control risk.
Part 2
The assessment of Woolworth’s business structure and
available information (assignment 1: Company’s financial analysis)
suggests that the inherent risks identified, cause a serious threat to
the overall audit procedure. A major contribution to the development of
audit procedure depends on the internal control system of the company
that would either support the audit procedure or pose great threat to
it. As the level of inherent risk increases the auditor need to plan
accordingly with assertions of high risks in mind. With the increased
level of inherent risk, the auditor would need to plan detailed
procedures and base the sufficiency of the audit evidence upon the
substantive procedure rather than relying upon analytical procedures.
The substantive procedure carried out would be based on sample
selection (increased size of the sample) keeping the materiality level
low to ensure that the audit risk increased as a result of high
inherent risk is substantially reduced and the comforts the auditor as
to the fact that no material misstatement is reflected in the financial
statements. However, before the start of the auditing procedure the
auditor need to ensure that the plan and the audit steps are designed
to cover all risks with resolutions. Items such as time, scope, extent
of the auditor's responsibilities to perform the audit should be
detailed so that the plan is carried out in a timely manner. Such a
plan usually depend on the size of the company, the complexity of the
auditing procedure, the level of professional experience the auditor
has and the auditor's knowledge of the business and industry.
Part 3
In adopting the audit procedure, the auditor has to keep in
mind the impact of the missing information in the financial disclosures
and how it pose risks to the auditor. The degree of importance of the
information depends on its financial impact. This known as materiality.
Thus materiality can be defined as (Bagshaw 1999): “Information is said
to be material if its omission or misstatement could influence the
economic decisions of the users taken on basis of the financial
statements. Materiality depends on size of the item or judged in the
particular circumstances of its omission or misstatement. Thus,
materiality provides a threshold or cut off point rather than being a
primary qualitative characteristic which information must have if it is
to be useful.”
From this definition one understands that materiality allows one to
effectively measure the degree of risks and how the materiality can
impact the judgment of the auditor. Quantifying the degree of audit
risks also enable the auditor to plan procedures and standards of
acceptability for materiality. This is because there has to be certain
level of materiality in business processes especially in an FMCG where
the degree of liquid risks and inventory is high, materiality tends to
be high too. The auditor thus needs to keep in mind that the audit plan
should reflect the nature of the business and to detect of the same.
The amount and the nature of the misstatements therefore becomes
cumulative and its impact on the financial statements.
In the case of Woolworth Limited the initial materiality level is set to 5% of the EBIT i.e. (945.7 X 5%) = $ 47m
Since the relationship of materiality and level of audit risks is
reverse, it is expected that the higher the materiality the lower the
audit risk. In the case of Woolworth, audit risks are high as the
materiality level has been set at 5% of EBIT. When translated to dollar
amount this has a significant impact on the financial performance which
require the auditor's specific action for reducing risks through
reduction in control risks as well as to reduce detection risks.
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