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:
1. 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.
2. 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.
3. 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.
4. 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.
5. 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”.
6. 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.
7. 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.
8. 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.
9. 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.
10. 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.
11. 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.
12. 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.
13. 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.
14. 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.
15. 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.
16. 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.
17. 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. So when making assessment
of detection risk following matrix should be considered:
Auditor’s assessment of control risk
High Medium Low
Auditor’s assessment of inherent risk High
Lowest Lower Medium
Medium Lower Medium Higher
Low Medium High Highest
Shaded area in table relates to detection 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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