2. Contents
Part 1 ............................................................................................................................................................. 3
1.
Industry, regulatory and external factors including applicable financial reporting framework ....... 3
2.
The Nature of the entity ................................................................................................................... 4
3.
The entity’s selection and application of accounting policies .......................................................... 5
4.
The entity’s objectives, strategies and business risks....................................................................... 5
5.
The measurement and review of entity’s financial performance .................................................... 6
Part 2 ............................................................................................................................................................. 7
Reference .................................................................................................................................................... 10
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3. Part 1
As per the provisions of International standards on auditing 315, “Identifying and assessing risks of
material misstatement through understanding the entity and its environment”, the auditor is
required to understand five aspects in order to obtain an understanding of the audit client and its
operational environment and assess the business risk of the entity. Accordingly following aspects
needs to be considered by the audit team.
1. Industry, regulatory and external factors including applicable financial
reporting framework
When obtain understanding about the industry in which the entity is operates the audit team
should pay attention to following factors,
It is important to understand the market competition that the audit client faces which gives
an insight in to the demand prevails for the products of the company and the capacity of the
market and the pricing wars prevailed in the market.
Seasonal factors affecting to the products such as festival seasons or climate factors
o Eg. Increased demand for winter clothes in the winter season
Technological factors such as current technology of the product relating to the company
and the availability of new technology as opposed to the current technology of the product.
o Eg. Decrease of the demand for floppy discs with the invention of Compact discs
It should be noted that the industry and regulatory factors affecting the audit client may rise to
significant risks which may lead to a material misstatement in the financial statements. For example
existence of complex financial instruments such as complex derivatives may rise to a risk of material
misstatements in the financial statements.
Another aspect that the audit team should consider is the regulatory factors affecting to the entity.
In particular, following needs to be considered,
Accounting principles and practices adopted by the entity and the industry specific practices
that are used by other entities in the same industry.
o Eg. Specific methods used by the entities in the banking industry when determining
impairment provision for loans and receivable financial assets.
Applicable regulatory framework for the entity.
o Eg. BASEL rules on risk weighted capital for banks
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4. Laws and regulations that affect to the operational activities of the entity.
o Eg. Laws and regulations laid by the central banks to commercial banks
Applicable tax laws and regulations
Fiscal, Monetary and other policies adopted by the relevant governments which affect to
the entity.
Laws and regulations relating to environmental requirements.
The audit team needs to consider other external factors that affects to the audit client such as,
Current Economic condition and environment
o Eg. Hyperinflation situation in the economy may affect to the audit client and to the
audit strategy.
Market rates of interest such as interest rates and rates offered for government securities.
Availability of financing facilities
2. The Nature of the entity
The audit team should obtain a in-depth knowledge about the entity. This can be identified as one
of the most important activity in the entire auditing process of the audit client. Accordingly in order
to obtain an understanding of the entity the audit team should consider following aspects,
The audit team should obtain an understanding about the operational activities of the entity.
Accordingly following needs to be considered,
The sources of revenue that the company has, the products and services it offers
and involvement of e commerce in the activities of the company.
Business alliances such as joint venture arrangements and outsourcing
arrangements that the entity involved in.
Geographical dispersion of the entity including industry segmentation.
Transactions carried out with the related parties of the entity.
o Eg. Purchase and sale of goods and services
o Loans granted or obtained
o Investments made
Expenses incurred on the research and development activities
Further the team should obtain an understanding about the investment activities of the entity. In
this regard followings needs to be considered,
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5. Acquisitions and divestments made by the company or planned in the future
Investments and disposals of any kind of investments and loan stocks
Capital investment activities carried out by the entity.
Investments in joint ventures and special purpose entities
The team also should consider financing and financing activities such as,
Subsidiaries and associates of the audit client, both consolidated and non consolidated
Equity and debt structure of the entity and off balance sheet financing arrangements.
A financial reporting activity is another area that the audit team must understand. Accordingly
following factors needs to be considered
Accounting principles adopted by the entity and industry specific accounting treatments
Accounting policy for revenue recognition
Transactions involving foreign currencies
Accounting for complex or unusual transactions
3. The entity’s selection and application of accounting policies
The auditor should obtain an understanding about the selection and application of accounting policies of
the entity. In this regard audit team should consider whether management has applied those accounting
policies consistently or any changes made. To obtain an understanding in this regard auditor shall
consider following aspects,
The ways and means that the company uses to record unusual and significant transactions
arising from its operations.
o Eg. Complex derivatives, Acquisitions and divestments
Effects of company’s accounting policies in the areas which are emerging or which has
controversial ideas for which there are lack of authoritative guidance.
Changes made to the accounting policies of the company
Application of new financial reporting standards and laws and regulations and the effect of
those to the entity.
4. The entity’s objectives, strategies and business risks
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6. To plan and perform the audit of the financial statements of the entity effectively and efficiently, the
audit team should understand the entity’s business objectives and strategies. Inability of the company
to achieve stated objectives and strategies may lead to a business risk and this may result in a material
misstatement. In order to obtain an understanding on the objectives and strategies audit team should
consider following aspects,
New developments in the industry in which the entity operates
New developments in the industry may result inability of the company to achieve its objectives causing a
business risk.
New products or services offered by the entity which may rise a risk of returns and after sale
services
Expansions made to the operational activities of the entity
This may pose a risk that the company may not assess the demand for the product and ultimately failure
of the investment.
New accounting regulations that the company needs to adhere
This may result a risk of non compliance or improper implementation of the requirements.
Regulatory requirements affecting to the entity
This may result a risk of non compliance and legal exposure.
Use of Information technology in the operational activities of the entity
5. The measurement and review of entity’s financial performance
The audit team should understand the ways that the entity measures and review its financial
performance. This may help the audit team to understand the specific risk that may rise due to the
pressure on the management to achieve financial and non financial goals. For example the audit team
can identify any pressure on management after reviewing the financial and non financial targets set for
each individual or business unit.
Eg .
Identifying profit targets established by the company
Key performance indicators established to evaluate the performance
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7. Part 2
Business risk refers to the risks face by the organisation which arises due to significant conditions,
events, circumstances, actions or inactions that could adversely affect an entity’s ability to achieve its
objectives and execute its strategies, or from the setting of inappropriate objectives and strategies.
Certain business risks face by the company may not have any implication on its financial statements as
the risk arises mainly in the operational aspect of the company.
When evaluating the GB Foods Ltd following business risk factors can be identified
Decrease in the profit margins with the increase in the minimum wage by 14%
With the effect of new wage regulations effect April 2011 the salary cost of the company may increase
which adversely affect to the profitability of the company. Accordingly, the company may face to a
business risk which may raise a risk of material misstatement in the financial statements due to the
fraudulent financial reporting that might take place in the financial statements of the company in order
to achieve the established performance goals of the company.
Eg. With the decrease in the profitability the management may tend to manipulate the revenue or
expenses with the intention of increase the profitability to meet targets and performance requirements.
Non compliance with rules and regulations relating to health and hygiene factors.
Due to the increasing health and safety inspections and new laws and regulations the company may face
to non compliance with such requirements which may result in closure or suspension of restaurants and
outlets. Further this may result in penalties and surcharges to the company which affect to the financial
statements.
Impairment of investments due to new entrants to the market with new and innovative
concepts
As the concepts of food market is rapidly changing, new entrants to the market with innovative ideas
may affect to the new investments made by the entity. Accordingly the investment of £ 202 mn made in
the “Star Gazers” cafe chain may be impaired due to the new entrants to the market or due to
innovative concepts.
For example if another new company or existing rivalry comes up with a new or innovative concept, the
company will not be able to achieve its objectives which it expects from Star Gazers restaurant chain as
the restaurant failing after the competition against new entrant. This will prompt certain indications of
the impairment of the investment made in such restaurants and company may have to impair such
investment.
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8. High dependence on a single product
50% of the revenue of the “Jamie the cook” is earned from a single product. This raises a business risk to
the company as in an event where the failure of such product may harm to the operational results of the
company. For example if due to any reason the demand for “rocking horse” is decreased the
operations of the “ Jamie the cook “ may affect significantly.
Steep decrease in cash balances which may pose threats to day to day operations
It can be noted that the cash at bank balance of the company is forecasted to be decreased drastically
which may raise a risk of carrying out day to day operational activities of the entity. This raise a business
risk to the company due to the fact that company is involved in food industry which is vulnerable to the
liquidity of the company. If the company does not have appropriate levels of liquidity it may not be able
to manage its supply chain and may fail to carry out its operations.
Inappropriate spending on advertising activities
It can be noted that the company has spent £146 Mn advertising expenses on improving the brand
“Jamie the cook” in the current financial year. However, after spending such amount in such brand the
company forecast a decrease in its revenue from 406 Mn to 371 Mn. This highlight the fact that the
advertising activities are carried out inappropriately as the company does not expect an increase in its
revenue from this restaurant after spending of such amount.
This poses a business risk that the management of the company failing to identify and promote the
relevant brand of food chain in order to approach to the correct customer segment. Due to this fact the
company may not be able to achieve its established goals and objectives.
Continuous increase in the global food cost which may result in narrow margins
From the researches carried out, it was revealed that over the past few years the cost of the foods have
increased continuously due to the extreme environmental factors such as drought, hurricanes and
increase in the sea water levels etc. Due to this reason the margins of the companies in the food
industry may decrease and such decrease will affect to the company also.
Decrease in demand due to public awareness on fast foods
It is noted that the public awareness about the cons of consumption of fast food is increasing which may
decrease the demand to such food. Accordingly, the revenue of “Jamie the cook’ may decrease, and this
may adversely affect in achieving the goals and objectives of the entity. This can be identified as a
business risk faces by the company.
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9. Competition from global fast food giants
Strong competition from global fast food giants such as McDonalds may have a significant influence over
the operations of the company. Such companies already operate in the country effectively with strong
brand value and supply chain. Accordingly, due to this competition the company may not be able to
achieve its goals and objectives.
Unavailability of resources for expansion activities
It can be noted that the company is planning to double its number of “Star Gazes” cafe restaurants
during the next two financial years. Further, it can be noted that for the construction of 25 restaurants
the company has incurred £ 202 Mn. Accordingly in order to double the number of restaurants the
company may have to incur a cost of £ 202 Mn in the next two financial years. However it is noted that
cash balance that the company has is only £ 122 Mn which will not by sufficient to finance the
expansion activities.
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10. Reference
1. IFAC,2010, International Standard on Auditing,315, Identifying and assessing the risk of
material misstatement through the understanding the entity and its environment, IFAC
2. Porter & Brenda,2003,Principles of external auditing, John wiley,NJ USA
3. Arens,Elder and Beasley,2011,Auditing and Assurance services, prentice Hall,NJ USA
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