Briefing notes
To: Stella Cross, Audit engagement partner
From: Audit manager
Subject: Audit of Redback Sports Co and potential provision of an audit or limited assurance review to Emu Gyms Co
Introduction
The first part of these briefing notes has been prepared in relation to the audit of Redback Sports Co. The audit planning will commence shortly, and these notes evaluate the business risks and the risks of material misstatement to be considered in planning the audit. The notes then go on to recommend the principal audit procedures to be used in the audit of a government grant which the company received during the year.
The second part of the briefing notes focuses on Emu Gyms Co, in particular the request from the company’s managing director for our firm to provide an audit or a limited assurance review of the company’s financial statements. The notes finish by discussing a question which has been raised by the company’s managing director, in relation to a suspected fraud at the company.
(a) Evaluation of business risks to be considered in planning the audit of Redback Sports Co
Corporate governance
The company does not have to comply with corporate governance requirements as it is not a listed entity, and it is good to note that the board includes two non-executive directors who seem able to offer independent views on strategy and management. However, the company lacks an audit committee and the internal audit team is small and lacking in independence as they report directly to the finance director. This means that the scope of their work is likely to be quite limited due to insufficient resources, and any recommendations made could potentially be ignored by the finance director. Overall, this could lead to deficiencies in controls and inefficiencies in business operations. In addition, given that the company is looking to achieve a stock market listing in the next few years, it would be good practice to implement stronger governance procedures sooner rather than later. For example, having two non-executive directors may not be enough to meet the corporate governance requirements in the company’s jurisdiction.
Health and safety regulations
The company operates in a highly regulated industry, and the risk of non-compliance with various laws and regulations is high. The sport and leisure industry has strict health and safety regulations which must be complied with, and there are regular health and safety inspections to ensure that regulations are being adhered to. If the company is found not to be in compliance with the relevant regulations, its operating licence could be revoked, which would have reputational consequences, and ultimately could impact on the company’s going concern status. In addition to the risk of non-compliance, it will be costly to reduce this risk to an acceptable level, for example, through regular staff training on health and safety, leading to cash flow and profit implications. This is particularly relevant to the more adventurous sporting activities such as scuba diving, which the company has recently started to offer.
Capital expenditure and maintenance requirements
The company’s success relies on gyms being equipped with modern equipment, and the other facilities such as tennis courts being maintained to a high standard. This requires a high annual expenditure, for example, this year alone $5·5 million has been incurred on maintenance and repairs. Such high annual expenditure is a big drain on cash, and the company could face liquidity problems if cash inflows from customers are not maintained.
Liquidity and overtrading
The company’s cash position is projected to deteriorate significantly, with the level of cash falling from $5·6 million to $1·4 million in the year. At the same time, revenue and profit before tax are both projected to increase, by 17·8% and 50% respectively. While there is some doubt over the integrity of the figures reported by management, which will be discussed in the next section of the briefing notes, the trends could indicate that the company is expanding too quickly and overtrading, focusing on generating revenue rather than on managing cash flows appropriately. This is particularly concerning given the company’s plans for further expansion in the next few years.
Capacity​​​​​​​
There could be problems facing the company in terms of the capacity of its facilities. Membership has increased significantly during the year, by 12·4%, and the number of pay as you go visits has increased by 5·3%. Although two new sport and leisure centres have opened this year, this may not be sufficient expansion, and there may be times when the facilities are overcrowded. This may deter members from renewing their membership, and pay as you go customers might prefer to use other sport and leisure providers if overcrowding becomes problematical. The ‘Healthy Kids’ programme, and the government initiative to provide free access to the unemployed will exacerbate this problem.
​​​​​​​Competition and marketing expenses
The industry is competitive, which itself is a business risk, meaning there is pressure on the company to maintain its market share and customer base. There may be pressure to cut membership or pay as you go prices, which will impact on profit margins and cash flow. The company appears to spend a lot on marketing to support its brand. This year, $8·5 million has been spent on marketing, which equates to 16% of revenue. This is a huge drain on cash and will impact significantly on the company’s liquidity position.
Government initiative​​​​​​​
While the company’s involvement with the government initiative to promote a healthy lifestyle to unemployed people is commendable, it may not prove popular with the existing sport and leisure centre members and pay as you go customers. The initiative will put pressure on the capacity of the gyms, and could lead to the facilities becoming crowded, especially at peak time. This could lead to memberships not being renewed, and pay as you go customers moving to other providers. There is also an opportunity cost issue for the company, as the $2 million grant receipt does not appear to be particularly profitable in terms of the number of hours of free access to the gyms which have to be provided for the next three years.
There is an associated risk in that the company’s systems need to be capable of accurately recording the number of free hours which are provided under this initiative, as this has to be reported on a monthly basis. The risk is that the systems do not capture the necessary information accurately, which could lead to reporting false information to the government. There is evidence that this system of recording could be overstating the hours of free access, as according to the finance director, 33,900 free hours have already been provided, which in the three-month period since the start of the initiative in September 20X8 equates to 11,300 hours per month, which seems high as this implies that approximately 3,800 people have responded to the initiative.
Expansion plans​​​​​​​
The expansion plans could take management’s attention away from running the business, especially if identification of potential target companies becomes a time consuming process over the next year. Management controls over existing operations could deteriorate while attention is focused on the planned expansion and possible future flotation. If there is pressure from existing shareholders for the expansion to be successful and flotation to take place, management could be pressured into making unwise decisions to increase the pace of development of the company’s activities.
New data management system​​​​​​​
Introducing a new data management system can create a business risk in that insufficient training may have been provided and/or appropriate internal controls may not have been designed or implemented in relation to the new system, increasing the risk of inaccurate recording, processing and reporting of information. This would have a negative impact on management’s ability to monitor the company’s performance. Given that the new system is linked to the company’s accounting software, there is a related audit risk, which will be discussed in the next section of these briefing notes.
(b) Risk of material misstatement evaluation
Management bias​​​​​​​
The company has ambitious expansion plans, and is aiming to achieve a stock market listing within five years. This can create significant pressure on management to report strong financial performance, and the risk of earnings management is high. This can lead to a range of inappropriate accounting treatments including early recognition of revenue and other income and deferral of expenses. There is some indication that earnings management may have taken place this year, for example, revenue is projected to increase by 17·8%, whereas the number of members, who provide the majority of the company’s revenue, has increased by only 12·4%. Profit before tax is projected to increase by 50%. These trends indicate that income could be overstated and expenses understated, the specific reasons for which are evaluated below.
Corporate governance and internal controls​​​​​​​
As discussed in the previous section, the company lacks an audit committee and only has a small internal audit team which is not operating independently. This has implications for controls over financial reporting, which could be deficient, and increases control risk. There is a high scope for errors in financial reporting processes and for deliberate manipulation of balances and transactions, as the internal audit team does not have sufficient resources for thorough monitoring and reporting.
Revenue recognition​​​​​​​
With 85% of revenue being from members’ subscriptions, there is a risk that revenue is recognised incorrectly. There is a risk that the timing of revenue recognition is not appropriate, for example, if an annual membership is recognised in full when it is received by the company, rather than being recognised over the period of membership, thereby overstating revenue.
There are multiple revenue streams which complicates the financial reporting process and increases the risk. As well as members paying an annual subscription, customers can pay for access under the pay as you go scheme. In addition, the free access to the unemployed should not result in revenue recognition, but must be properly recorded as it has to be reported to the government on a monthly basis. As discussed above, it is possible that the system is not recording the free access provided to the unemployed accurately, and that figures may be overstated.
Capital expenditure and maintenance costs​​​​​​​
The company has high levels of both capital expenditure and maintenance costs. There is a risk of material misstatement that capital expenditure and operating expenditure have not been appropriately separated for accounting purposes. For example, maintenance costs could be incorrectly capitalised into non-current assets, overstating assets and understating operating expenses. This could be indicated by maintenance costs representing 10·4% of revenue this year, compared to 11·7% in the previous year. Capital expenditure is recorded at $32 million this year compared to $20 million in the previous year; this significant increase can be at least partly explained by two new centres being opened in the year, but audit work will need to focus on the possible overstatement of the capital expenditure.
Government grant​​​​​​​
The company has received a $2 million grant this year, which has been recognised as other operating income. The amount is material, representing 29% of projected profit before tax. The risk of material misstatement relates to whether this should all have been recognised as income in the current accounting period. IAS® 20 Accounting for Government Grants and Disclosure of Government Assistance requires that government grants are recognised in profit or loss on a systematic basis over the periods in which the entity recognises expenses for the related costs for which the grants are intended to compensate. Redback Sports Co has recognised all the income this year, however, the scheme is intended to run for three years. Therefore there is a risk that the company has recognised the income too early, and a proportion of it should remain as deferred income; this leads to overstated profit and understated liabilities.
There could be a further issue in that the terms of the grant may require complete or partial repayment if the required number of hours of free access to sport facilities is not met. If any such terms exist, the company should evaluate whether the terms are likely to be met, and if not, should consider whether it would be appropriate to recognise a provision or disclose a contingent liability in the notes to the financial statements. The risk is therefore that this has not been considered by management, leading possibly to understated liabilities or inadequate disclosure as required by IAS 37 Provisions, Contingent Liabilities and Contingent Assets.
Data management system​​​​​​​
The introduction of new systems, especially those which interface with the accounting system, creates a risk of material misstatement. Errors could have been made in the transfer of data from the old to the new system, and as this system deals with membership information, it is likely to impact on how revenue is recorded and processed. Not all staff may yet have been trained in operating the system, leading to a higher risk of error, and controls may not yet have been fully implemented. This all means that transactions and balances relating to members are at risk of misstatement.
Fee paid to celebrity athlete​​​​​​​
The $1 million paid to the celebrity athlete is material, representing 14·4% of projected net profit for the year. Given that the athlete is providing a service to the company for two years, the cost should be recognised over that two-year period, with an element of the cost deferred until the 20Y0 financial statements. If all of the expense has been recognised this year, profit is understated and assets are understated.
Operating expenses​​​​​​​
Operating expenses includes staff costs, which are projected to increase by 7%, marketing costs, which are projected to stay at the same amount compared to 20X8, and maintenance and repair costs which have increased by 3·8%. Given the increase in revenue of 17·8%, and the scale of operations increasing by the opening of two new centres, these categories of expenses would be expected to increase by a larger amount this year. It could be that expenses have been omitted in error, or have been deliberately excluded, thereby understating expenses and overstating profit. These trends should be discussed with management, especially the staff costs, as this alone is highly material, representing 28·9% of projected revenue.
Bank loan​​​​​​​
During the year, the company took out a significant loan of $30 million; this is material as it represents 23·1% of total assets. The loan has been issued at a deep discount and there is a risk of material misstatement in that the finance costs associated with this loan may not be accounted for in accordance with IFRS® 9 Financial Instruments. IFRS 9 requires that the finance cost associated with a deep discount – in this case the $4 million difference between the amount received by Redback Sports Co of $30 million, and the amount repayable on maturity of the debt of $34 million – should be amortised over the term of the loan. The risk is that finance costs and non-current liabilities will be understated if the appropriate finance cost is not accrued in this financial year.
Related party transaction
​​​​​​The managing director of Redback Sports Co, Bob Glider, has made a loan to the company of $1 million. While this is not material in monetary terms, representing only 0·8% of total assets, it is material by nature and is a related party transaction according to IAS 24 Related Party Disclosures given that the loan to the company is from a member of key management personnel. The relevant disclosures as required by IAS 24 must be made in the notes to the financial statements, and there is a risk that the disclosures are incomplete. The necessary disclosures include information on the nature of the related party transaction, its amount, and the relevant terms and conditions of the loan.
There is also a risk that interest will not be accrued on the loan. The loan was made on 1 July 20X8, so by the year end interest of $20,000 ($1m x 3% x 8/12) should be accrued. This is not material in monetary terms to the financial statements as it represents less than 1% of projected profit before tax, however, audit judgement may conclude that it is material given the related party nature of the transaction.
(c) Principal audit procedures to be used on the government grant​​​​​​​
– Obtain the documentation relating to the grant, to confirm the amount, the date the cash was transferred to the company, the period covered by the grant, and terms on which the grant was awarded.
– Review the terms to confirm whether they contain any conditions relating to potential repayment of part or all of the grant if a required number of hours of free access is not met in the period covered by the grant.
– Agree the amount of cash received to the bank statement and cash book.
– Perform tests of control on the system used to record the number of free hours of access which have been used by the unemployed, focusing on how the access is recorded, to ensure that the recording is complete and accurate and that revenue is not recorded.
– Review forecasts and budgets to evaluate the pattern of anticipated use of the initiative by the unemployed, and to confirm that repayment of the grant is not likely.
– Discuss with management the accounting policy used for the receipt of cash, to confirm understanding that it has all been recognised in full this year, and to understand management’s rationale for this accounting treatment.
– Recalculate the amount which should have been recognised on the basis of recognising the grant over the three-year period of the government’s initiative.
(d) Evaluation of the matters to be considered in deciding whether to accept an engagement to provide Emu Gyms Co with an audit or limited assurance review​​​​​​​
Requirements and guidance relevant to accepting and continuing client relationships is contained in ISQC 1 Quality Control for Firms that Perform Audits and Reviews of Financial Statements and Other Assurance and Related Services Engagements. The fundamental requirements are that a firm must consider:
​​​​​​​– Whether it is competent to perform the engagement and has the capabilities, including time and resources to do so;
– Whether the relevant ethical requirements can be complied with; and
– The integrity of the client, and whether there is information which would lead it to conclude that the client lacks integrity.
Competence and resources​​​​​​​
In terms of competence, our firm should be competent to perform the audit of a small company or to conduct a limited assurance review of the company’s financial statements. As a firm of chartered certified accountants, and performing the audit of Redback Sports Co – a much larger company in the same industry – means that the firm has the relevant knowledge and experience to perform a high quality audit or limited assurance review.
The deadline by which the work needs to be completed should be confirmed with Mick Emu. The bank manager has suggested that the loan could be made available within the next two months, meaning that the audit or limited assurance review on the financial statements needs to be carried out as soon as possible. Our firm may not have enough staff available at short notice to perform the work required.
The other matter relevant is the scope of work which is required, this can have a significant impact on the resources needed. An audit will require more work and is therefore more resource-intensive, so it may be more difficult for our firm to carry out an audit at short notice compared to a limited assurance review. In addition, we should clarify whether the bank manager expects any work to be performed, and conclusions drawn, on the cash flow and profit forecasts, in which case more resources will need to be available to complete the engagement.
Ethics​​​​​​​
Huntsman & Co provides the payroll service to Emu Gyms Co. This would give rise to a self-review threat because our firm has determined the payroll figures which form part of the financial statements which would then be subject to audit or limited assurance review and may result in over reliance on the payroll figures included in the financial statements. Huntsman & Co should consider whether the payroll figure is material to the financial statements, and whether safeguards can be used to reduce any ethical threats to an acceptable level, for example, through the use of separate teams to provide the audit or limited assurance review and the payroll services and by having an independent second partner to review the work performed. If safeguards do not reduce the threats to an acceptable level, then the payroll service should not be carried out in addition to the audit or limited assurance review.
Providing the payroll service could also be seen as acting on behalf of management, further impairing the objectivity of the audit or limited assurance review provided on the financial statements. However, if the payroll service is purely routine transaction processing in its nature, this is less of a threat.
According to the Code, in order to avoid the risk of assuming a management responsibility, prior to accepting the non-audit service the firm should satisfy itself that company management:
– has designated an individual who possesses suitable skill, knowledge and experience to be responsible for client decisions and oversee the services;
– will provide oversight of the services and evaluate the adequacy of the results of the services performed; and
​​​​​​​– accept responsibility for the actions, if any, to be taken arising from the results of the services.
There would also be ethical threats arising if our firm were to perform work on the prospective financial information and also attend the meeting at the bank – this could be perceived as management involvement and creates an advocacy threat whereby the audit firm is promoting the interests of the client. There could also be a perception by the bank that by attending the meeting, our firm is not only supporting our client’s loan application, but also confirming the ability of the client to repay the loan, which is not the case. A liability issue could arise for our firm, in the event of the client defaulting on the loan, unless our firm’s position is made very clear to the bank. If a member of our firm does attend the meeting with the bank manager, it should be a representative of the firm who has not been involved with the audit or limited assurance review, and Mick should acknowledge his responsibility with regard to the preparation of the financial statements.
A further potential ethical issue arises in that our firm audits Redback Sports Co, which could be a competitor of Emu Gyms Co despite their difference in size. This situation can create a conflict of interest. According to the IESBA Code of Ethics for Professional Accountants, before accepting a new client relationship or engagement, the audit firm should identify circumstances which could give rise to a conflict of interest and evaluate the significance of any ethical threats raised. In this case, Huntsman & Co should disclose to both Emu Gyms Co and Redback Sports Co that the firm acts for both companies and obtain consent from both companies. The firm should also use separate teams to carry out work for the two companies and establish appropriate review procedures by an independent member of the firm.
Huntsman & Co should also remain alert for changes in circumstances which may make the conflict of interest more of an issue, for example, if Redback Sports Co identified that Emu Gyms Co could be a potential target company to acquire as part of its planned growth strategy.
​​​​​​​Integrity
Emu Gyms Co is already a client of our firm, as we provide the company with a payroll service, therefore all of the necessary client due diligence will have taken place. There is nothing in the note provided by Stella Cross to indicate that client integrity could be a problem.
(e) Suspected fraud​​​​​​​
An audit and a limited assurance review differ in their scope and in the nature of procedures which are performed. It is not the purpose of either an audit or a limited assurance review to detect or prevent fraud, this is the responsibility of management, but arguably the indicators of fraud may have been noticed earlier if either had been performed.
In an audit, there is a wide scope in the work performed. Audit procedures are comprehensive, including tests of detail and tests of control, and will cover all material aspects of the financial statements. Given that historically the revenue from shop and café sales represented 5% and 8% of the company’s revenue, these would represent a material source of revenue, and there would have been audit testing of the revenue transactions, including tests of detail performed on a sample basis. Additionally, the change in gross margin from 32% to 26% would have alerted the auditor to an unusual trend, leading to additional audit procedures being performed.
Part of the audit process is documenting and evaluating internal controls, and this would have involved an assessment of the controls over sales in the shops and cafés and over inventory. It is likely that deficiencies in internal controls, which may be allowing fraud to be carried out unnoticed, would be detected by the audit process and then communicated to management.
However, it is possible that even with an audit being conducted, the fraud might not have been detected. This is because frauds are usually concealed, and particularly if the employees involved have been colluding to carry out the fraud, it would be difficult to detect, especially if there has been deliberate falsification of accounting records.
In addition, the amounts involved are not highly material, the amount of inventory held by the company is small, meaning that this may not have been classified as an area with a high risk of material misstatement if an audit had been conducted. The inventory held at the shops is not likely to be material, and the inventory count might not have been attended by the audit team. Also, the detailed testing of sales transactions may not have uncovered the fraud given that the fraud appears to be based on theft of inventory. It is possible that the fraud would only have been uncovered through detailed testing of the controls over movement of inventory.
If a limited assurance review had been carried out, again it may have uncovered the fraud, but it is less likely compared to an audit. This is because a limited assurance review has a narrower scope than an audit, and investigation procedures are usually limited to only enquiry and analytical review. Tests of controls and detailed tests of detail are not carried out and therefore control deficiencies would not be picked up or reported to management, and it is not likely that inventory in the shop and café would have been a priority for review.
In conclusion, Mick is correct in thinking that if the company’s financial statements had been subject to audit or limited assurance review before now, the suspected fraud is likely to have been uncovered by the audit, and may have been uncovered by a limited assurance review. However, if the fraud was well concealed, it is possible that even an audit would not have uncovered the activities of the fraudsters.
Conclusion​​​​​​​
The evaluation in relation to Redback Sports Co indicates that the company faces a range of business risks, for instance, possible overtrading and problems with liquidity. There are also a number of significant audit risks which will impact on our audit planning, for example, the accounting treatment which has been applied to a government grant, and possible understatement of expenses. There is a significant risk of management bias given the company’s plans for expansion. In relation to Emu Gyms Co, our firm should be able to provide a limited assurance review or audit of the company, provided that safeguards are put in place to reduce ethical threats, in particular self-review in relation to payroll costs, to an acceptable level. Finally, a discussion has been provided which considers whether an audit or limited assurance review would have uncovered the fraud which Mick suspects is taking place.​​​​​​​