Inherent Risk and Their Impact on Business Essay

Objectives

1. Analysis of non-quantitative aspects of inherent risk in the audit
2. Analysis of quantitative aspects of inherent risk in the audit
3. Highlighting of specific areas of risk important to the Audit Plan

This note discusses only areas of risk that require special attention during audit and it does not discuss the audit procedures in detail.

Non-Quantitative Aspects of Inherent Risk

Audit risk is concerned with the risk that the auditor may fail to express an appropriate opinion pertaining to any transaction or balance reported in the financial statements of the company audited. In the case of a financial audit report, the audit risk is that the auditor might give an unqualified opinion on financial statements where there are material misstatements (Kamal Gupta, 2005). Audit risk comprises inherent risk, control risk and detection risk. “Inherent risk is the auditor’s assessment of the susceptibility of an account balance or a class of transactions to misstatements that could be material (Kamal Gupta, 2005). There are various non-quantitative aspects, which need the consideration of the auditor in identifying and assessing the inherent risk in respect of the audit of the accounts of any client. While gathering an understanding of the industry, the auditor may have to consider the regulatory and other external factors, which have a bearing on the functioning of the firms in the industry. In addition, the auditor has to take into account the applicable financial reporting framework, nature of the firm, objectives and strategies and related business risks and measurement and review of the financial performance of the firm (Appendix1, 2006)

Industry Environment

Overall, retail industry is the largest in Australia employing about 15% of the total workforce. The easy availability of credit over the last decade has resulted in a boom for the retail industry in general, of which discount retail-like TRS is a segment. However, with the global economic slowdown, the Australian economy is also affected showing its impact on retail sales, which was very sluggish during the later part of 2008. During an economic recession when the consumers are trying to spend less, the discount stores are likely to do well since the consumers “trade down’ (Vault, 2008). Therefore, from the audit point of view, there may not be any significant reduction in the sale figure of TRS for the financial year ending 29 June 2008 due to economic recession.

Nature of the Entity

The Reject Shop Limited (TRS) is a budget variety general merchandise discount retailer. The company is a fast-growing one with 150 retail outlets spread over various parts of Australia. The company locates its stores in shopping centres, standalone sites, major regional centres and small country towns. Focusing on catering to the everyday needs of the customers, who are price conscious the company deals in household cleaning products, cosmetics, basic furniture and kitchenware. Customers are public. Competitors include other similar operators and major retail chain stores (Investsmart, 2008). TRS was founded in the year 1981 and the company is progressing in an orderly manner. This is an important positive non-quantitative aspect in favour of the company for assessing the inherent audit risk.

Business Operations

The vision of the company is to become the most successful retailer in Australia in terms of growth, profitability and customer satisfaction. To achieve this, the company follows a business model of offering “value-added” general everyday merchandise at competitive prices to price-conscious customers. The company achieves its sales growth through the opening of new stores in locations, which are not being served already by the company. 2700 employees were working for the company as of June 2008. The company has a 100% owned subsidiary TRS Trading Pty Limited incorporated in Australia (Google Finance, 2008). The company has made significant investments in various information technology and e-commerce aids to conduct its operations more efficiently. This gives rise to the scope for a possible risk in the systems side of the company. Executive compensation is closely linked to the performance measured by earnings per share. This is another area, which needs a closer look from the audit risk point of view.

Investments and Financing

The company seems to have a comfortable and sufficient cash flow situation and therefore the company should be having a good debt to equity ratio. However, there is the need to look into the long-term borrowings of the company whether there have been any significant changes as compared to the previous audit period. This becomes important from an inherent risk assessment perspective, as there is the likelihood the long-term funds are being used to meet the short-term obligations including payment of dividends.

Ownership and Governance Arrangements

Since the company is listed on the Australian Stock Exchange, the company should have closely followed the disclosure requirements of the regulators. The company is complying with the best corporate governance practices wherever possible, as recommended by the Australian Stock Exchange. There is an established audit committee and remuneration committee as reported by the company in its Annual report for the financial year ended June 24, 2007. The company has sufficient number of directors on the board with one non-executive Chairman. The company follows prescribed accounting policies in terms of financial reporting as exhibited by the annual report 2007 (Annaul Report, 2007). From the audit point of view, there is the need to check the periodicity of meetings of the board including that of the committees and the attendance of the members.

Business Objectives and Strategies

The strategy of the company is to promote growth through organic growth reflected in comparable stores sales and through a consistent program of new store openings. The company is keen on opening new stores in markets, in which the company is not currently operating. Competitive pricing is the key success factor for the company and pricing the products properly adds to the competitive strength of the company (The Reject Shop, 2007). The company has strategic planning of opening at least 20 stores in a year and presently the company has 156 stores (as of June 2008) across Australia. The pricing of the products is one of the areas that may need specific attention from the audit risk point of view.

Quantitative Aspects of Inherent Risk

The purpose of collecting quantitative information is to make an analytic review. The review is meant to identify the potential problem areas to properly define the scope of the financial report audit, ensure the availability of adequate staff resources and arrive at the appropriate audit techniques. The analytic review will draw information mainly from the financial statements and ledgers of the firms, formal and non-formal management information system reports, transaction journals and/or subsidiary ledgers (Comptroller’s HandBook, 1990).

Sales and Earnings

There has been a consistent growth in the sales of the company from $ 180.6 million in 2004 to $ 353.0 million in 2008. There has been an increase in the number of stores from 103 in 2004 to 151 in 2008. This implies that the number of sales and purchase transactions has been increasing since the year 2004. As compared to the year, 2007 the sales have increased by 25.8% and the net profit has grown by 35% (Annual Report, 2008). The number of stores has increased by 21. All this quantitative information implies that the number of sales transactions has gone up during the year under review.

Cost of Sales and Store Expenses

The cost of sales for the years 2007 and 2008 both show a 52.37 percentage of sales. This seems to be somewhat abnormal (Annual Report, 2008). This area needs to have scrutiny while conducting the audit. The store expenses also appear to be more or less at the same percentage for both the years. There is a slight decrease in the administrative costs in the year 2008 as compared to 2007. Audit should focus on the total area of expenses.

Current Assets

The inventories to sales were at 9.58 percent for the year 2007 and for the year 2008 it is reported at 10.0 percent. The quantitative information and valuation of inventories is another area that needs scrutiny, as there is very close resemblance of the numbers. The average expenses to income ratio per store will throw light on the individual profitability of the stores. The obsolescence of stocks is also to be looked at (Annual Report, 2008).

Liabilities

There is no significant change in the current liabilities as at the end of 2007 and as at the end of the year 2008. However, there is a considerable jump in the borrowings in dollar terms from the year 2007. The borrowings have increased 125 percent in 2008 over the previous year’s figures. The necessity and purpose of borrowing is another risk factor that has been exhibited by the quantitative information.

Derivative and Forward Contracts

There is ample scope for the company to make impressive returns due to favourable exchange factors on imports. The company by proper forward contracts should have been able to realize maximum profits out of exchange fluctuations. A look into the derivative transactions should be a part of the audit scope.

Cash Flows

The cash flow from financing activities needs scrutiny, as there is the outflow of dividends to the extent of $ 11,055 million during 2008 along with an inflow of borrowed funds of $ 6500 million. Out of the operating cash inflow of $ 19,024 million, the company has made a cash outflow of $ 15,163 to the investing activities. The company it appears has borrowed and used the borrowed funds to keep the record of accomplishment of dividend payments. A close look at this point is necessary, as the company has also changed its executive compensation policy to be based on the earnings per share.

Operating Lease Commitments

There is a sharp increase in the operating lease commitment during the year 2008. A review of the operating leases with their salient conditions may be necessary while conducting the audit.

Internal Memorandum

Based on the review of quantitative and non-quantitative aspects of The Reject Shop Limited the following report on the inherent audit risk of the company is submitted for your review:

The existence of the company since the year 1981 and the continued progressive operations of the company mitigate any serious inherent audit risks. However, certain areas need to focus to substantiate the presence of a true and fair financial statement of the company for the year ended 29 June 2008 without any material misstatements. They are:

1. The company has made significant investments in installing an ERP system. Therefore, the present system of bookkeeping is to be thoroughly checked and balances arrived so that the transition to the new system of operations would not be hindered. Moreover, it is necessary to ascertain that the company presently is not following a dual system so that there are no chances of omission of any material accounting entries.
2. With the mandatory consolidation of the balances of the 100% subsidiary of the company, the accounts of the subsidiary company should be put to thorough scrutiny.
3. The company shows a year-end cash balance of $ 4,885 million as at the end of the year and 2 months bills payable of $ 6,500 million borrowed at fixed interest rate of 7.8%. Reasons for carrying the liability need to be ascertained.
4. From corporate governance point of view, regular check on the reported number of board and committee meetings and an examination of the relevant minutes is to be planned.
5. Cost of purchases, margins and pricing policies need to be scrutinized as the company shows a consistent cost of sales percentage for the consecutive years. Since the company is keen on offering competitive prices to the customers the pricing of products that sell in a major proportion may be test checked to check the appropriateness of pricing.
6. There has been a 25.8 percent increase in sales as compared to the previous year. This implies that the number of sales transactions would have also been increased proportionately. There need to be clear planning of the resources in terms of personnel to check the sales and purchase transactions at random.
7. Inventory is an area that needs scrutiny. Though we rely on the certification of the management on the quantity and value of the closing inventory test checks need to be conducted to ascertain the movements of certain stocks, which are in higher proportions to the total inventory.
8. Expense to sales ratio per store needs to be checked, to identify the profitability or otherwise of the individual stores. Since the company follows an aggressive store opening strategy for its growth this check is necessary to ascertain whether the company is progressing in the proper direction.
9. The liability because of operating leases has increased substantially as at the end of the year 2008 as compared to the year 2007. The reasons and necessity of such increase need to be looked into.
10. Cash flows are another area that needs scrutiny as the company has increased its short-term borrowings heavily despite having enough cash balances.
11. The company has been following the performance incentive plan for the executives based on the increase in earnings per share. A detailed study of the different aspects of working of the system and calculations of performance incentives are worth studying to avoid any misstatements.
12. The forward and derivative transactions of the company should be checked completely to ensure that there are no material misstatements or omissions in that area.

Besides the regular audit points, the above are some of the areas identified by this report that needs special attention to avoid an inherent audit risk in the audit of the financial reports of the client ‘The Reject Shop Limited’. A detailed audit plan encompassing the scrutiny of the above areas/points may be drawn up for pursuing the audit of the company.

Bibliography

Annual Report. Annual Report for the year 2007. Web.

Annual Report. Annual Report 2008. Web.

Appendix1, 2006. Auditing Standard ASA 315: Understanding the Entity and Its Environment and Assessing the Risks of Material Misstatement. Guidance Note. Auditing and Assurance Standard Board Australian Government Comptroller’s HandBook, 1990. Web.

Google Finance, 2008. The Reject Shop Limited. Web.

Invest smart, 2008. The Reject Shop Limited (TRS). [Online]. Web.

Kamal Gupta, 2005. Contemporary Auditing vi Edition. New Delhi: Tata-McGraw Hills Private Limited.

The Reject Shop, 2007. Home Page: The Reject Shop Limited. [Online]. Web.

Vault, 2008. Retail Industry Overview. [Online]. Web.