Executive Summary
We have been given the task of conducting an audit on ABC Learning Centres Ltd. The objective of this memo is to give the audit manager information on the areas of concern in relation to how auditing should be approached. The memo will focus on audit scope and approach, materiality risk assessment and areas of audit focus, audit engagement and reporting and the team. We will conduct financial statements auditing in accordance with international Standards of Auditing and ASA 240 standards. There are different factors that determine the benchmarks for materiality. The factors include the type of the entity, the nature of industry of operation and the complexity and size of the organization. Our audit team will be analysing the financial information of ABC Learning Centres Ltd from 2000-2007 applying analytical review approaches like Beneish M-Score models, DuPont Analysis, Trend Analysis and Common Size. The audit will be conducted to establish any possible earnings manipulation in some accounts during a particular year. Our team of auditors will provide audit engagement and reporting required to gather enough and reliable evidence about account procedures and balances. Focusing on the design of controls is important to eradicate the level of testing that is required. Reliable controls can alleviate the amount of intensity and procedures of substantive procedures.
Description of the Client and Business
ABC Learning Centres Ltd was established in 1988 by Eddy Groves and his wife. The company started from a humble background but developed rapidly to become one of the global renowned businesses offering educational and developmental care for children internationally. The business mainly provided long day care services, vacation services, before school care services and after school services (McRobert 2009). The vision of the company was to ensure that all children were nurtured, loved and given education for them to have a bright future. To achieve this vision, the organization developed four building blocks which are:
• Facilities and environment
• Centres staff training and development
• A learning curriculum
• Physical and nutrition development
The organization grew very first in Australia and beyond borders into the UK, New Zealand and even the USA (Auditing Standard ASA 240). Given that it was listed in the stock exchange, it expended fast through mergers and acquisitions. It acquired La Petite which was the largest childcare organization in the US. ABC Learning Centres Ltd also acquired other companies such as Busy Bess Group Ltd of the UK.
Recent Business Developments
After commanding a big share in the childcare industry for close to 20 years, ABC learning Centres eventually collapsed. The company collapsed because of many internal errors. One of the reasons why the organization collapsed is the manipulated accounts and lack of transparency. There were various discrepancies in the figures, profits and revenues stated in the accounting books. Additionally, ABC Learning Centres closed down because of related party transactions. After an investigation by Ernest and Young auditors, it was revealed that a company associated with the former CEO’s in law was appointed for maintenance works at the centres (ERNST & YOUNG 2016). More than $74 million was irregularly paid for work that was not completed. Poor management of the board is also associated with the closure of ABC Learning Centres. Poor strategies in expansion resulted in poor performance because there was no clear risk analysis while venturing in international markets (McRobert 2009). The financial statements showed that the company had engaged in intentional embezzlement of funds. More significantly, the amount of cash flow to service the debt from operations was materially overstated. Only 30% of the current liability emanated from the net operating cash flow. More importantly, table 2 gives some previous warnings of imminent risk. It is clear that the capacity of ABC Learning Centres to cater to the clients was not impressive and indicated that it was on the verge of collapse after seven years of listing.
Results from Overall Analytical Review
Table 1 ABC Learning Centres Limited, key financial ratios 30 June
Table 2 ABC Learning Centres Limited, debt service capacity
Table 1 has the key ratios from the analysis. Including the operating leases in the balance sheet shows the level which the company was strongly geared. In 2007, the disclosed gearing and restated gearing was 1.14:1 and 2.03:1 respectively. More importantly, the amount of cash flow to service the debt from operations was materially overstated. Only 30% of the current liability emanated from the net operating cash flow. More importantly, table 2 gives some previous warnings of an imminent risk (McRobert 2009). It is palpable that the capacity of the organization to cater to the clients was not impressive and indicated that ABC was deteriorating after seven years of listing. It is more surprising that the banks were able to support ABC yet it was evident that it was performing poorly.
According to the Auditing Standard ASA 240, the annual financial reporting reveals a relentless increase in assets, centres and revenue. However, they don’t reveal any material strengthening of the company’s financial wellbeing from the growth. It is obvious from the analysis that the organization’s gearing grew its return on sales and equity reduced drastically, the ability to operate cash flow to pay the debts shrunk. The business model was imperfect because it could not be shifted to different business settings. The analysis clearly shows that there were a lot of warning signals from the financial performance which was unsustainable (ERNST & YOUNG 2016).
Audit Scope and Approach
Scope of work
Our audit technique is developed to give an audit which conforms to all professional requirements. We will conduct financial statements auditing in accordance with international Standards of Auditing and ASA 240 standards (Auditing Standard ASA 240). Our work is to put a lot of emphasis on the aspects of ABC Company that we consider to be affected with the potential risk of material misstatement influenced by the firm wiping out its claim of profitability, opaque operations, mismatch of centres, assets and revenue, poor management and board
(McRobert 2009). We use a risk-based audit technique primarily driven by the issues we consider to cause a higher risk of misstatement of the financial statements.
Opinions on the financial statements
We take the responsibility of developing and expressing a judgment on the financial statements. The audit is organized and conducted to provide rational assurance that the financial statements don’t have material errors and provides a true reflection of the financial position and performance of ABC Learning.
Value for money conclusion
We are expected to conclude if the ABC Learning Centres Ltd has appropriate arrangements to secure effectiveness, efficiency, and economy it applies in its resources.
Our response to the risk of fraud
According to the International Standards of Auditing (ISAs), we are required to get sensible assurance that the financial statements have no error or fraud. There are various ways that fraud can emanate in the context of the financial statements and that’s why we believe the risk of fraud should be part of our planning design and work to reduce the chances of risks identified (KPMG ASM 2014). Throughout our work, we uphold a suitable level of professional performance in the audit.
Working with professionals and auditors
Auditor experts and management
Your financial statements have material entries that are provided by management experts. We will seek the services of our own experts to provide the necessary assurances in some of your material entries (ERNST & YOUNG 2016).
Other auditors
In earlier years, we have relied on assurances offered by other auditors. However, we intend to eliminate or reduce the need for such kinds of assurances, through conducting extra procedures in our audit (Simnett 2007).
Internal audit
In several circumstances, we will be required to depend on work conducted by an internal auditor that provides us with the needed assurance. We will engage the internal auditor and deliberate on their work findings, programme and issues while determining the most appropriate testing strategy (McRobert 2009).
IT general controls assessment
Integrated and innovative use of IT drives the effectiveness and efficiency of our audit. Your audit team has IT auditors with vast knowledge concerning the public sector and offers advisory services. Additionally, your IT audit team uses the most current IT solutions. We understand that different organizations have varied risks. Our audit platform is the latest and flexible enough to enable us to achieve a tailored audit approach to fit the situation and ensure conformity with the current auditing standards (Auditing Standard ASA 240). We emphasize on the risks to your organization’s stability and others that affect the financial statement associated in the risk of material mismanagement.
Materiality
The materiality of the memo is divided into sections including clearly trivial nominal amounts, monetary testing entry for a particular account, performance materiality for accounts, and general materiality of the audit and materiality benchmarks.
Materiality Benchmark
According to ASA 240, there are different factors that determine the benchmarks for materiality. The factors include the type of the entity, the nature of industry of operation and the complexity and size of the organization. We also assessed the relevant financial statement and its users while establishing a materiality benchmark. We have decided to choose the materiality benchmark as total revenue since it is the most appropriate to the sales and receivable accounts. We apply the total revenue of the year ending 2004 which is $219.8 million. This figure gives us broader materiality and will not be part of internal management adjustments such as materiality benchmarks of operating income, total assets and pre-tax profit. Notably, this benchmark is based on the 2004 revenue, where no issue was established.
Performance materiality
We have verified a performance materiality misstatement at a figure which reduces the possibility that the amount of undetected and uncorrected misstatement may lead in errors of the statements (Xu et al. 2013). Performance materiality is lower than the materiality of the financial statement. In this case, there were some previous warnings of imminent risk. It is evident that the capacity of the organization to cater to the clients was not impressive and indicated that it was deteriorating after seven years of listing affecting performance materiality.
Clearly Trivial (CT)
Clearly, trivial nominal amounts relate to issues which are of a smaller range as compared to material currently revealed. The normal figure for CT falls between 3% and 5%, but in this case, we have established the CT amount at 6%. The figure is obtained from different issues such as the most current fraud, the risks of accounts balanced and receivable. Increasing the level of CT to 6% makes our audit team evaluate account transactions and balances that usually were disregarded. The organization’s gearing grew its return on sales and equity reduced drastically, the ability to operate cash flow to pay the debts shrunk.
Risk Assessment and areas of audit focus
This section of the memo addresses the financial statements just before its final collapse showing massive losses from the end of 2007 which could easily diminish the profits.
The firm wiped out its claim of profitability
During the treatment of earnings and revenues, the company was satisfied with the previous interpretation of the performance. The developers made payments to subsidise centres that were making profits and concealed the reality that more than a half of them were losing huge amount of money quickly. The key areas of audit included a failure of accounting and regulatory processes. The rapid expansion of market share presented a lot of risks which was not reflected in the company’s financial statements.
Poor management and board
The area of concern is the management of the company that is too focused on the rapid expansion of the entire operations to global markets despite of various risks. A good number of the board members are politicians who have little knowledge of childcare issues.
Opaque operations
Another important key area of concern is the opaque operations. The operations of ABC Learning were not clearly transparent and the impacts of massive expansion were concealed. It is unclear and well-devised how each centre operates and the expenses associated with the centres and the duration the centres would become profitable. It is clear that the stakeholders are not aware of the impending risks.
Mismatch of centres, assets and revenue
ABC Learning Centres Ltd recorded revenue prematurely; channel stuffed and intentionally misreported revenue figures. Additionally, it did not reveal any material strengthening of the company’s financial wellbeing from the growth. Increase in assets, centres and revenue does not correspond with the accounting reporting. The statements don’t disclose any material strengthening of the company’s financial wellbeing from the growth. It is obvious from the analysis that the organization’s gearing grew its return on sales and equity reduced drastically, the ability to operate cash flow to pay the debts shrunk. The business model was imperfect because it could not be shifted to different business settings. The analysis clearly shows that there were a lot of warning signals from the financial performance which was unsustainable
Audit Engagement and Reporting
The section of the memo address audit engagement and reporting required to gather enough and reliable evidence about account procedures and balances. Looking at the design of controls is important to eliminate the level of testing that is required (Simnett, R., 2007). Consistent controls may mitigate the amount of intensity and procedures of substantive procedures.
Communication approach
The ASA 240 on auditing necessitate that we communicate various issues with the company at different stages of the audit cycle. As well as being part of our responsibility, the auditing standards prefer two-way communication with ABC Learning staff and the audit team (Xu et al. 2013). The staffs are important because they provide very vital information since they understand the organization’s challenges and risks they face and the plans the company has to solve the problems.
Audit timetable
Stage 1 (November 2006 to February 2009)
This is the planning stage where we will be updating our understanding of ABC Learning Centres Ltd opinion and risk assessment. The stage will involve the development of the audit testing approach and agree on one audit time table.
Stage 2 (January/April 2007)
The interim stage is the second activity where we will test and document systems and controls. The audit team will perform IT audit testing by employing out IT experts. At this stage, we will report the main communication output and draft an audit progress report.
Stage 3(June/July 2009)
The fieldwork stage involves the completion of work done and finishing the bulk of our audit testing. At this stage, the main communication and reporting outputs will be done. It will be followed closely by constant update meetings in the finance department.
Stage 4 (July 2007)
Stage four will involve completion of the audit process. We will engage in the final review of the financial statements. The reviewing of the post balance sheet will be performed. We shall engage the partners in the process of reviewing the audit files (Xu et al. 2013). This being the last stage, the output will be the final audit completion report and auditor’s report.
The Team
Appendix A: Results of Analytical Review
Appendix B: DuPont Analysis
Appendix C: Beneish M-Score models
Appendix D: Common size
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