To: John Starling, audit engagement partner
From: Audit manager
Subject: Sunshine Hotel Group – audit planning
Introduction
These briefing notes relate to the initial audit planning for the Sunshine Hotel Group (the Group), for the year ending 31 December 2017. As requested, the notes contain an evaluation of the business risks facing our client, and the significant risks of material misstatement to be considered in our audit planning. Finally, the notes contain a discussion of the impact which an email received from the Group finance director relating to a claim for damages will have on our audit planning, as well as the recommended actions to be taken by Dove & Co and principal procedures which should be carried out in relation to this claim.
(a)    Evaluation of business risks
Luxury product
The Group offers a luxury product aimed at an exclusive market. This in itself creates a business risk, as the Group’s activities are not diversified, and any decline in demand will immediately impact on profitability and cash flows. The demand for luxury holidays will be sensitive to economic problems such as recession and travel to international destinations will be affected by events in the transportation industry, for example, if oil prices increase, there will be a knock-on effect on air fares, meaning less demand for the Group’s hotels.
Business expansion – inappropriate strategy
It is questionable whether the Group has a sound policy on expansion, given the problems encountered with recent acquisitions which have involved expanding into locations with political instability and local regulations which seem incompatible with the Group’s operations and strategic goals. The Group would appear to have invested $98 million, accounting for 28% of the Group’s total assets, in these unsuitable locations, and it is doubtful whether an appropriate return on these investments will be possible. There is a risk that further unsuitable investments will be made as a result of poor strategic decisions on where to locate new hotels. The Group appears to have a strategy of fairly rapid expansion, acquiring new sites and a hotel complex without properly investigating their appropriateness and fit with the Group’s business model.
Business expansion – finance
The Group is planning further expansion with capital expenditure of $45 million planned for new sites in 2018. This equates to 12·9% of the Group’s total assets, which is a significant amount and will be financed by a bank loan. While the Group’s gearing is currently low at 25%, the additional finance being taken out from the Group’s lending facility will increase gearing and incur additional interest charges of $1·6 million per annum, which is 16% of the projected profit before tax for the year. The increased debt and finance charges could impact on existing loan covenants and the additional interest payments will have cash flow as well as profit implications.
In addition, $5 million has been spent on the Moulin Blanche agreement. A further $25 million is needed for renovating the hotels which were damaged following a hurricane. Despite the fact that the repair work following the hurricane will ultimately be covered by insurance, the Group’s capital expenditure at this time appears very high, and needs to be underpinned by sound financial planning in order to maintain solvency, especially given that only half of the insurance claim in relation to repair work will be paid in advance and it may take some time to recover the full amount given the significant sums involved.
Profit margins and cash management
The nature of the business means that overheads will be high and profit margins likely to be low. Based on the projected profit before tax, the projected margin for 2017 is 8%, and for 2016 was 8·2%. Annual expenses on marketing and advertising are high, and given the focus on luxury, a lot will need to be spent on maintenance of the hotels, purchasing quality food and drink, and training staff to provide high levels of customer service. Offering all-inclusive holidays will also have implications for profit margins and for managing working capital as services, as well as food and drink, will have to be available whether guests use or consume them or not. The Group will need to maintain a high rate of room occupancy in order to maintain cash flows and profit margins. Cash management might be particularly problematic given that the majority of cash is received on departure, rather than when the guests book their stay. Refunds to customers following the recent hurricane will also impact on cash flows, as will the repairs needed to the damaged hotels.
International operations
The Group’s international operations expose it to a number of risks. One which has already been mentioned relates to local regulations; with any international operation there is risk of non-compliance with local laws and regulations which could affect business operations. Additionally, political and economic instability introduces possible unpredictability into operations, making it difficult to plan and budget for the Group’s activities, as seen with the recent investment in a politically unstable area which is not yet generating a return for the Group. There are also foreign exchange issues, which unless properly managed, for example, by using currency derivatives, can introduce volatility to profit and cash flows.
Hurricanes
The hurricane guarantee scheme exposes the Group to unforeseeable costs in the event of a hurricane disrupting operations. The costs of moving guests to another hotel could be high, as could be the costs of refunding customer deposits if they choose to cancel their booking rather than transfer to a different hotel. The cost of renovation in the case of hotels being damaged by hurricane is also high and while this is covered by insurance, the Group will still need to fund the repair work before the full amount claimed on insurance is received which as discussed above will put significant pressure on the Group’s cash flow. In addition, having two hotels which have been damaged by hurricanes closed for several months while repair work is carried out will result in lost revenue and cash inflows.
Claim relating to environmental damage
This is potentially a very serious matter, should it become public knowledge. The reputational damage could be significant, especially given that the Group markets itself as a luxury brand. Consumers are likely to react unfavourably to the allegations that the Group’s activities are harming the environment; this could result in cancellation of existing bookings and lower demand in the future, impacting on revenue and cash flows. The email relating to the claim from Ocean Protection refers to international legislation and therefore this issue could impact in all of the countries in which the Group operates. The Group is hoping to negotiate with Ocean Protection to reduce the amount which is potentially payable and minimise media attention, but this may not be successful, Ocean Protection may not be willing to keep the issue out of the public eye or to settle for a smaller monetary amount.
(b)    Significant risks of material misstatement
Revenue recognition
The Group’s revenue could be over or understated due to timing issues relating to the recognition of revenue. Customers pay 40% of the cost of their holiday in advance, and the Group has to refund any bookings which are cancelled a week or more before a guest is due to stay at a hotel. There is a risk that revenue is recognised when deposits are received, which would be against the requirements of IFRS 15 Revenue from Contracts with Customers, which states that revenue should be recognised when, or as, an entity satisfies a performance obligation. Therefore, the deposits should be recognised within current liabilities as deferred revenue until a week prior to a guest’s stay, when they become non-refundable. There is the risk that revenue is overstated and deferred revenue and therefore current liabilities are understated if revenue is recognised in advance of the date the amount becomes non-refundable.
Tutorial note: Credit will be awarded for discussion of further risk of misstatement relating to revenue recognition, for example, when the Group satisfies its performance obligations and whether the goods and services provided to hotel guests are separate revenue streams.
Foreign exchange
The Group holds $20 million in cash at the year end, most of which is held in foreign currencies. This represents 5·7% of Group assets, thus cash is material to the financial statements. According to IAS 21 The Effects of Changes in Foreign Exchange Rates, at the reporting date foreign currency monetary amounts should be reported using the closing exchange rate, and the exchange difference should be reported as part of profit or loss. There is a risk that the cash holdings are not retranslated using an appropriate year end exchange rate, causing assets and profit to be over or understated.
Licence agreement
The cost of the agreement with Moulin Blanche is 1·4% of Group assets, and 50% of profit for the year. It is highly material to profit and is borderline in terms of materiality to the statement of financial position. The agreement appears to be a licensing arrangement, and as such it should be recognised in accordance with IAS 38 Intangible Assets, which requires initial recognition at cost and subsequent amortisation over the life of the asset, if the life is finite. The current accounting treatment appears to be incorrect, because the cost has been treated as a marketing expense, leading to understatement of non-current assets and understatement of profit for the year by a significant amount. If the financial statements are not adjusted, they will contain a material misstatement, with implications for the auditor’s report. As the restaurants were opened on 1 July 2017, six months after the licence was agreed, it would seem appropriate to amortise the asset over the remaining term of the agreement of 9·5 years as this is the timeframe over which the licence will generate economic benefit. The annual amortisation expense would be $526,316, so if six months is recognised in this financial year, $263,158 should be charged to operating expenses, resulting in profit being closer to $14·74 million for the year.
Impairment of non-current assets due to political instability and regulatory issues
The sites acquired at a cost of $75 million represent 21·4% of total assets, and the hotel complex acquired at a cost of $23 million represents 6·6% of total assets; these assets are material to the Group financial statements. There are risks associated with the measurement of the assets, which are recognised as property, plant and equipment, as the assets could be impaired. None of these assets is currently being used by the Group in line with their principal activities, and there are indications that their recoverable value may be less than their cost. Due to the political instability and the regulatory issues, it seems that the assets may never generate the value in use which was anticipated, and their fair value may also have fallen below cost. Therefore, in accordance with IAS 36 Impairment of Assets, management should conduct an impairment review, to determine the recoverable amount of the assets and whether any impairment loss should be recognised. The risk is that assets are overstated, and profit overstated, if any necessary impairment of assets is not recognised at the reporting date.
Effect of the hurricane
Two of the Group’s hotels are closed due to extensive damage caused by a recent hurricane. It is anticipated that the Group’s insurance policy will cover the damage of $25 million and the terms of the policy are that half will be paid in advance and the remainder on completion of the repairs, although this will need confirming during our audit testing. The accounting for theseevents will need to be carefully considered as there is a risk that assets and profit are overstated if the damage and subsequent claim have not been accounted for correctly.
The damage caused to the hotels and resultant loss of revenue are likely to represent an indicator of impairment which should be recorded in line with IAS 36. IAS 16 Property, Plant and Equipment requires the impairment and derecognition of PPE and any subsequent compensation claims to be treated as separate economic events and accounted for separately in the period they occur. The standard specifically states that it is not appropriate to net the events off and not record an impairment loss because there is an insurance claim in relation to the same assets. As such, this may mean that the Group has to account for the impairment loss in the current year but cannot recognise the compensation claim until the next financial period as this can only be recognised when the compensation becomes receivable. If it is indeed the case that the insurance company will pay half of the claim in advance, then it is likely that $12·5m could be included in profit or loss in the current year.
Provision/contingent liability
The letter received from Ocean Protection indicates that it may be necessary to recognise a provision or disclose a contingent liability, in respect of the $10 million damages which have been claimed. The amount is material at 2·9% of total assets, and 67·9% of profit before tax (adjusted for the incorrect accounting treatment of the licence agreement).
According to IAS 37 Provisions, Contingent Liabilities and Contingent Assets, a provision should be recognised if there is a present obligation as a result of a past event, and that there is a probable outflow of future economic benefits for which a reliable estimate can be made. It remains to be seen as to whether the Group can be held liable for the damage to the coral reefs. However, the finance director seems to be implying that the Group would like to reach a settlement, in which case a provision should be recognised.
A provision could therefore be necessary, but this depends on the negotiations between the Group and Ocean Protection, the outcome of which can only be confirmed following further investigation by the audit team during the final audit.
A contingent liability arises where there is either a possible obligation depending on whether some uncertain future event occurs, or a present obligation but payment is not probable or the amount cannot be measured reliably. There is a risk that adequate disclosure is not provided in the notes to the financial statements, especially given the finance director’s reluctance to draw attention to the matter.
Tutorial note: Credit would also be awarded for discussion of other relevant risks of material misstatements
(c)    (i) Implications for audit planning
The finance director’s requests which restrict the audit team’s ability to obtain audit evidence in relation to the environmental damage claim are inappropriate. In particular, the finance director should not dictate to the audit engagement partner that the audit team may not speak to Group employees. According to ISA 210 Agreeing the Terms of Audit Engagements, the management of a client should acknowledge their responsibility to provide the auditor with access to all information which is relevant to the preparation of the financial statements which includes unrestricted access to persons within the entity from whom the auditor determines it necessary to obtain audit evidence.
This would appear to be an imposed limitation on scope, and the audit engagement partner should raise this issue with the Group’s audit committee. The audit committee should be involved at the planning stage to obtain comfort that a quality audit will be performed, in accordance with corporate governance best practice, and therefore the audit committee should be able to intervene with the finance director’s demands and allow the audit team full access to the relevant information, including the ability to contact Ocean Protection and the Group’s lawyers.
The finance director would appear to lack integrity as he is trying to keep the issue a secret, possibly from others within the Group as well as the public. The audit engagement partner should consider whether other representations made by the finance director should be treated with an added emphasis on professional scepticism, and the risk of management bias leading to a risk of material misstatement could be high. This should be discussed during the audit team briefing meeting.
There is also an issue arising in relation to ISA 250 Consideration of Laws and Regulations in an Audit of Financial Statements, which requires that if the auditor becomes aware of information concerning an instance of non-compliance or suspected non-compliance with laws and regulations, the auditor shall obtain an understanding of the act and the circumstances in which it has occurred, and further information to evaluate the possible effect on the financial statements. Therefore, the audit plan should contain planned audit procedures which are sufficient for the audit team to conclude on the accounting treatment and on whether the auditor has any reporting responsibilities outside the Group, for example, to communicate a breach of international environmental protection legislation to the appropriate authorities.
(ii) Planned audit procedures
– Obtain the letter received from Ocean Protection and review to understand the basis of the claim, for example, to confirm if it refers to a specific incident when damage was caused to the coral reefs.
– Discuss the issue with the Group’s legal adviser, to understand whether in their opinion, the Group could be liable for the damages, for example, to ascertain if there is any evidence that the damage to the coral reef was caused by activities of the Group or its customers.
– Discuss with the Group’s legal adviser the remit and scope of the legislation in relation to environmental protection to ensure an appropriate level of understanding in relation to the regulatory framework within which the Group operates.
– Discuss with management and those charged with governance the procedures which the Group utilises to ensure that it is identifying and ensuring compliance with relevant legislation.
– Obtain an understanding, through enquiry with relevant employees, such as those responsible for scuba diving and other water sports, as to the nature of activities which take place, the locations and frequency of scuba diving trips, and the level of supervision which the Group provides to its guests involved in these activities.
– Obtain and read all correspondence between the Group and Ocean Protection, to track the progress of the legal claim up to the date that the auditor’s report is issued, and to form an opinion on its treatment in the financial statements.
– Obtain a written representation from management, as required by ISA 250, that all known instances of non-compliance, whether suspected or otherwise, have been made known to the auditor.
– Discuss the issue with those charged with governance, including discussion of whether the Group has taken any necessary steps to inform the relevant external authorities, if the Group has not complied with the international environmental protection legislation.
– Review the disclosures, if any, provided in the notes to the financial statements, to conclude as to whether the disclosure is sufficient for compliance with IAS 37.
– Read the other information published with the financial statements, including chairman’s statement and directors’ report, to assess whether any disclosure relating to the issue has been made, and if so, whether it is consistent with the financial statements.
Conclusion
These briefing notes highlight that the Group faces significant and varied business risk, in particular in relation to its expansion strategy which is possibly unsound. There are a number of significant risks of material misstatement which will need to be carefully considered during the planning of the Group audit, to ensure that an appropriate audit strategy is devised. Several issues are raised by the claim from Ocean Protection, and our audit programme should contain detailed and specific procedures to enable the audit team to form a conclusion on an appropriate accounting treatment.