Inherent risks for Wesfamers Limited

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Inherent risks for Wesfamers Limited

Wesfarmers Limited is a group of being a diversified conglomerate engaged in eight core business divisions including retail operations (Coles) such as home improvements and office supplies, target, shopping mart (Kmart), insurance, resources sector (coal mining), chemicals, energy and fertilizers sector, industrial and safety products and investment sectors. Keeping in view the veracity of business risks within industrial perspective of each segment, following are few identified possible inherent risks at the planning phase of audit.

Inherent Risks Implications
1. Wesfarmers’ breach of environmental regulation imposed by the Federal Government of Australia against carbon and greenhouse emissions particularly pertaining to coal mining and chemicals and fertilizer sectors. ·        Legal complications leading to fines and penalties

·        Non-disclosure of contingent liabilities in the financial statements

·         Bad reputation and loss of goodwill among the general public

2. Wesfarmers’ significant risk of uncertainty in insurance business causing high claim costs prone to increasing trends in natural disasters, calamities and catastrophes and death rates across worldwide, credit risks and complexity of calculations in actuarial valuation reports subjecting to significant estimation uncertainty. ·        Insurance liabilities are not stated accurately in the financial statements.

·        Inability to meet insurance liabilities as and when they fall due

 

3. Wesfarmers’ retail business operational risks including disruption in replenishment of stock (supply chain), theft of stock and risk of embezzlement of cash due to millions of transaction each week in retail outlets. In addition, there is a considerable risk of valuation of the stock leading to overstatement of stock if net realizable value is lower than the cost caused by price fluctuations. ·        Revenue from retail business is not giving true and fair view.

·        Frequent stock outs and inefficiency in the operations

·        Loss of physical and financial resources

·        Overstatement of stock of retail segment

 

4. A newly integrated management information system has been implemented in the current year 2012 to effectively monitor the activities of the retail business. However, there is a considerable risk in the effectiveness and efficiency of such system unless examined by our information risk management team. ·        Since it is newly incorporated, it is highly prone to errors and omissions thus challenging the reliability of data.

 

Inherent risks for Virgin Australia Group of Airlines

Virgin Australia Holdings Limited formerly known as ‘Virgin Blue Holdings Limited’ is primarily engaged in the airline industry both domestic and international. The principal office of the company is situated at 56 Edmondstone Road, Bowen Hills, Queenland 4006. After performing risk assessment procedures, the key identified possible inherent risks at the planning stage of the audit are as follows;

Inherent Risks Implications
1. Virgin Australia Holdings Limited is a highly geared company having 153% debt to equity ratio ($m 1,420.1/929.7) which can be regarded as key business concern. This situation can significantly impair future operating capability. ·        Manipulation of financial statements by falsely concealing any significant charges and encumbrances of the loaner because too much gearing inhibits any sort of further investment.

·        Inadequate or misclassifying interest expense to show good returns with intent to reward employees or payment of dividends to shareholders

 

2.  Lack of sufficient working capital to continue operations with a total deficit of $m 559.6 ($m 1,032-1,591.6). ·        Inability to meet current liabilities as and when they fall due

·        Manipulation in the current liabilities by understating

3. The fuel supply is integral to the airline industry and any length of time lag for any reason can have a significant operational impact which can consequently result in total loss of revenue and customers’ goodwill at the same time. Accordingly, the rise in fuel costs over the periods has adversely affected the airline industry. ·        Significant rise in fuel cost is indicative of the increased pressure to manipulate financial statements to show better earnings by understating or misclassifying fuel expense.
4. All the airline companies in Australia are bound to comply with the rules and regulations imposed by Australian Government’s Civil Aviation Safety Authority (CASA) and have severe legal repercussions in case of non-compliance including the safety and security of its customers and employees. The breach of such regulations can be imminent. ·        Legal complications leading to fines and penalties

·        Non-disclosure of contingent liabilities in the financial statements

·         Bad reputation and loss of goodwill among the general public

5. The revenue of Virgin Australia Holdings Limited and airline industry in general in Australia is highly sensitive to fluctuating economic conditions. Any sort of deterioration on the Australian economy would have a material impact on its financial position and financial performance. ·        Creates incentives and pressures towards management to manipulate reported earnings.

·        Falsely concealing or misleading the material information required for the users.

 

(B) What audit procedures and/or tasks would you have planned to carry out in response to the inherent risks identified by you in 1 above?

Audit procedures against identified inherent risks at planning stage of audit of Wesfarmers Limited are as follows;

Inherent risks Audit procedures
1. Breach of environmental regulations ·        Obtain list of all litigations from the Chief Compliance Officer or other responsible personnel and corroborate it with the Wesfamers’ legal adviser/consultant.

·        Meetings with the Wesfarmers’ legal consultant to clarify whether it is compliant with the environmental regulations or if there is a pending litigation obtain an understanding of the outcome of decision and probable penalty to be imposed on the company.

 

2. Significant risk of uncertainty in insurance business ·        Engage an actuarial expert (actuary) independent of the Wesfarmer to cross examine the actuarial reports issued by the Wesfarmers’ actuary including benchmarking data and performing industry analysis to identify unusual trends

·        Read the minutes of the meetings of the Board of Directors to identify whether any unfavorable incidents have occurred which can result in significant claim of the insured entity.

 

3. Retail business operational risks ·        Perform a walkthrough test over the point of sales terminal to evaluate whether the retail process is operating effectively

·        Perform a physical cash and stock count at year end on surprised basis to verify existence and completion

·        Benchmark data along with competitors and compare prices to test for the net realizable value to check the correct valuation of retail inventory items

4. Implementation of newly integrated management information system in retail segment ·        Employ and use the services of an IT expert independent of Wesfamers particularly specialist in information systems audit to evaluate the consistency, effectiveness and reliability of the reports generated by the system and any exception reports are noted.

 

Audit procedures against identified inherent risks at planning stage of audit of Virgin Australia Holdings Limited are as follows;

Inherent risks Audit procedures
1. Highly geared 153% debt to equity ratio susceptible to undisclosed charges and encumbrances ·        Obtain the list of all financing facilities from the management and seek for external confirmation from the bank in respect of terms and conditions of the facilities, limit of any fixed and floating charge against all classes of assets including letters of credit and bank guarantees and other related covenants.

·        Perform compliance whether the facility is used for the stipulated purpose as mentioned on the agreement.

·        Recalculate the amount of interest and check whether the company is not defaulting towards payments of principal and interest

2. Lack of sufficient working capital to continue operations ·        Enhance the nature, timing and extent of substantive testing over current assets and current liabilities
3. Significant increase in fuel costs susceptible to misstatement in fuel expense ·        Review the agreement of the company between its fuel supplier to establish whether there are any unusual terms and conditions.

·        Design procedures to verify assertions such as occurrence, completeness, accuracy, classification and cut-off by detailing testing of fuel transactions (vouching) along with test of controls put in place by the company

·        Check for accruals of any unpaid bills at year end and seek for external confirmation with the supplier(s).

4. Possibility of non-compliance with rules and regulations of Civil Aviation Safety Authority (CASA) ·        Obtain list of all litigations from the Chief Compliance Officer or other responsible personnel and corroborate it with the company’s legal adviser/consultant.

·        Meetings with the company’s legal consultant to clarify whether it is compliant with the CASA regulations or if there is a pending litigation obtain an understanding of the outcome of decision and probable penalty to be imposed on the company

5. Deterioration in the Australian economy creating pressure for the management to manipulate reported earnings ·        Benchmarking and compare the industry wide trends for effects of economy on the business of competitors through ratios analysis

(C) If you had carried out an analytical review on the financial statements of these companies in the planning phase, what areas of concern (high risk or problem areas) or comfort would you have identified? Justify your answer and identify at least three (3) points for each company. (Hint: To answer this part you will need to carry out an analytical review.)

Answer:

A diagnostic examination have been performed on the financial statements of Wesfarmers Limited for the year ended June 30, 2012 ranging from simple comparison with prior periods to detailed ratios analysis including checking consistency with other relevant financial information with the results as follows;

Results

  • Although the above financial ratios indicate more of kind of satisfactory results with exception of high inventory turnover days. This might indicate that the company takes a long time in replenishing of existing finished goods stock. Possible reasons can be low demand of product which can result in deterioration of stock resulting in overstatement of stock if it had not reduced against its respective net realizable value as inventory is always stated at lower of cost or net realizable value (NRV). Quite possibly that is why sales have only increased by 6% over the year of which might be contributed by inflation factor. So, the key areas of concern are
  • Revenue from sale of goods because it comprises of 96% of the total revenue along with the detailed testing on inventory items 
  • Another key area of concern is 850% increase in impairment of goodwill. That happened following the announcement by BlueScope Steel Limited (BlueScope), on 22 August 2011, that it intended to significantly restructure its Port Kembla operations, including a shutdown of its No.6 Blast Furnace at Port Kembla, the Industrial and Safety division’s Coregas business agreed to amend its contract with BlueScope for the supply of industrial gases to its steel operations as a result of the amendments, Coregas has become the primary supplier of industrial gases to BlueScope at the Port Kembla operations, with reduced volumes reflecting the reduced demand from BlueScope under its new operating structure. Given the amendments to this agreement, and having regard to an associated review of the Coregas business, Coregas has recognized an impairment charge against goodwill and plant and equipment of $172 million and $9 million respectively in the year ended 30 June 2012.
  • The total goodwill comprises of 38% of the total assets which is a significant area of concern with regard to its reported amount in the balance sheet. The high amount of impairment as mentioned above is indicative of possible issues that might also exist in the valuation of goodwill. A key focus should be devoted to this area of the financial statements including the reliability, reasonableness and consistency of methods used therein.

Comfort level

  • The only comfort level at the planning phase is its financial stability in terms of its leverage and low debt to equity ratio that comprises of 15% and good interest coverage ratio. Moreover, the interest bearing liabilities have been reduced by 16% which is also a good sign as the company is placing more reliance on equity injection rather than debt borrowing.

A diagnostic examination have been performed on the financial statements of Virgin Holdings Australia Limited for the year ended June 30, 2012 from simple comparisons with prior periods to detailed ratios analysis including checking consistency with other relevant financial information resulted as follows;

Key areas of concern identified

  1. Highly geared debt to equity ratio and low interest coverage ratio calculated above based on the financial statements of 2012. This casts significant doubt about going concern issues in the subsequent years. Interest coverage ratio of 0.9 times indicate that the company would not be able to pay off interest costs with ease. It also shows the company’s potential reliance on borrowings. Hence, at planning phase I as an auditor should devote key attention towards loan financing and all its related covenants.
  2. Poor liquidity position because of inadequate working capital. It is evident from the fact that since average collection period of 9 days is a good sign for cash flow, however, in contrast the company is taking too long to settle its liabilities towards its creditors resulting in negative cash conversion cycle. This might also be indicative of disputes among the creditors for delayed payments and also necessitates the need to check for completeness of provisions booked in the current liabilities.
  3. There has been decrease in value of property, plant and equipment during the financial year 2012 for changes in the airline’s use of certain assets resulted in devaluation and write-down of aircrafts and aeronautical assets totaling $ 18.5 million (2011: nil). A thoroughly analysis and scrutiny is needed to be done to check the basis and reasonableness of such treatment.

(D) What audit procedures and/or tasks would y.............


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