Risk-based Approach of Auditing

Auditing refers to the process of examination of the books of accounts and financial statements of an entity by an independent individual or body of individuals called auditor. The auditor owes duty to the company which is under audit as well as public at large to carry out the examination independently and professionally (Gramling, Johnstone, Rittenberg, 2012). For this purpose, the auditor needs to adopt systematic approach to evaluate the audit risk and design suitable responses to reduce that risk. In this context, a report has been prepared here that deals with various crucial aspects related to audit risk evaluation referring to the audit of Sport Direct International Plc.     

The risk based approach of auditing requires the auditor to focus on the inherent and control risk areas and find out the factors that indicate risk of financial statements being manipulated. The standards of auditing require that the auditor should assess the risk of material misstatement at the planning level and then revise it from time to time as the audit approaches (Johnstone, Gramling, and Rittenberg, 2015).     

In assessing the degree of business risk, the auditor is required to take an understanding of the entity and the environment in which it operates. Based on this understanding, the auditor can get the knowledge of industry regulations, nature of operations, ownership structure, and internal controls (ISA 315, 2009). In order to get this knowledge, the auditor can review previous audit reports, annual report, and other documents such as memorandum and articles of the company. Further, the auditor can also visit the company and have a pre-audit discussion with the management for this purpose. The auditor can identity certain factors that indicate high business risk, for example, lack of adequate controls, complex business processes, unskilled staffing etc (ISA 315, 2009).        

Based on the knowledge of entity and its environment, the auditor should assess the likelihood of manipulations in the financial statements. The financial statements could be misstated for two reasons such as fraud or error. The auditor should maintain professional skepticism to identify the factors that provide indication of fraud or error in the financial statements (ISA 240, 2009). Following are few examples of such factors:

• Management is under pressure to meet the targets
• Authority in a single hand
• Sudden changes in top management
• Financial indicators such as sudden hike in revenues or profits
• Weak internal controls (ISA 240, 2009)

In respect of audit of Sport Direct International Plc for the year 2016, the risk of material misstatement could be assessed to be high because the retail industry in UK is facing slow growth and the management is under pressure to increase the sales and meet the targets (Sports Direct, 2015).      

Assessing Business Risk

The auditor should list the factors that affect the control environment of the company before going for assessment of adequacy of the internal controls. The primary factors that affect the company’s control environment are integrity of the management and staff, promotion of ethical values, management philosophy, and the organizational structure (ACCA, 2017).   

The management prepares the financial statements taking assumption that the entity will continue for the foreseeable future. In this regards, it is the primary responsibility of the auditor to ensure that the management has rightly used the going concern assumption in preparing the financial statements. The auditor is required to take evidences that there does not exist any significant doubt that the entity will collapse and liquidate in the near future (ISA 570, 2009). The ISA 570 provides that it is the management who is responsible to assess that the use of going concern assumption is appropriate in the circumstances. The auditor is required to test the veracity of the management’s assessment (ISA 570, 2009).

In assessing the adequacy of going concern assumption, the auditor has to pay due regard to various financial and non- financial factors. These financial and non financial factors may not provide concrete evidence, but the auditor will have an initial indication of the appropriateness of use of going concern assumption (ISA 570, 2009). The most crucial non- financial indictors may be non-compliance with laws by the company, pending legal cases of huge amount, sudden change in government policies related to business, any catastrophic event. Further, the financial indicators may involve negative net worth, continuously incurring losses, adverse solvency and liquidity ratios, and inability to pay creditors and lenders on time. Thus, while assessing the adequacy of use of going concern assumption, the auditor needs to pay attention to these indicative factors (ISA 570, 2009).

In respect of Sport Direct International Plc, it has been observed that the group was operating profitably as depicted from the financial results of 2015. In the year 2015, the revenues of the company increased from £2,705.96 million in 2014 to £2,832.56 million (Sports Direct, 2015). Further, the net profit of the company also increased from £179.61 million to £241.36 million. However, looking at the interim results of 2016, it has been observed that the company is incurring operating losses.

Figure 1: Sports Direct International Plc (Sports Direct, 2016)

It could be observed that the key profitability ratios of the company are showing adverse trend. The gross margin is down from 44.9% in first half of 2015-16 to 40.4% in the first half of 2016-17. The EBITDA is down by 33.5% and the earnings per share are down by 61.1%. Further, the current ratio has been found to be declining from 2.29 times to 1.69 and the debt ratio has been observed to be rising from 0.37 times to 0.46 times (Sports Direct, 2016). The decrease in current ratio implies that the company is facing liquidity problems and increase in debt ratio implies that the company may face solvency problems.

Assessing the Risk of Material Misstatement

Further, apart from the financial factors, there has been observed a significant change in the top management which also casts doubt on the use of going concern assumption by the company. The chief executive officer of the company, Dave Forsey, and the chief financial officer, Matt Pearson, have resigned from the services (Sports Direct, 2016). The resignation of the chief executive officer and the chief financial officer is a big event from the view point of assessment of going concern assumption.        

As per ISA 570, when the auditor identifies factors that indicate possibility of abuse of going concern assumption by the entity, the auditor should collect concrete evidences to affirm that the use of going concern assumption is not valid (ISA 570, 2009). For this purpose, the auditor can discuss with the management of their plans to overcome the risk factors and meet out the challenges. In regards to Sport Direct International Plc, there have been observed certain events that indicate that the use of going concern assumption might be inappropriate (ISA 570, 2009). However, the review of management plans and strategies shows that it might be able to continue the operations in future. The management is planning to acquire companies outside the UK. The acquisition outside the UK will increase the market share of company and it will also reduce the risk of loss on account of devaluation of euro. Further, the management is also planning to hedge the foreign currency risk which has been the primary reason for reduced profitability of the company in the recent years (Sports Direct, 2015).           

The auditor needs to collect concrete evidences in relation to assertions made in the financial statements before forming the audit opinion. The auditor needs to be sure that the financial statements are free from any type of material misstatement (ISA 700, 2009). In case the material misstatements are found out by the auditor, these should be adjusted in the financial statement and if the management neglects to do so, the auditor should qualify the report by giving adverse or disclaimer of opinion. The auditor’s opinion could be in three forms such as unqualified opinion, qualified opinion, and disclaimer of opinion. Apart from this, the auditor may also include “Other Matter” paragraph and “Emphasis of Matter” paragraph within the audit report. The auditor considers giving “Emphasis of Matter” paragraph when something needs to be highlighted for investor’s attention but the report can not be qualified based on that matter (ISA 705, 2009).    

In regards to the audit of Sport Direct International Plc for 2016 there are various factors which will affect the auditor opinion. The first among them is the material uncertainty in relation to the use of going concern assumption. However, the auditor might not qualify the report for this material uncertainty, but this is certainly the matter which requires attention. Therefore, the auditor may consider including Emphasis on Matter paragraph to highlight the material uncertainty. Further, the high business risk and the risk of misstatement is also a factor that would affect the auditor’s opinion on financial statements of the company for the year 2016. The observations from the previous auditor’s report and the opinion given in the previous audit report, is also needed to be considered while forming the opinion.             

Conclusion

The report given here provides discussion on the essential auditing concepts pertaining to the risk assessment and forming opinion on the financial statements. Further, the report also covers the discussion on the use of going concern assumption by the management and assessing its appropriateness by the auditor. The Sport Direct International Plc has been taken as reference case for discussion on these auditing aspects.    

References

ACCA. 2017. The control environment of a company. [Online]. Available at: https://www.accaglobal.com/vn/en/student/exam-support-resources/fundamentals-exams-study-resources/f8/technical-articles/the-control-environment-of-a-company.html [Accessed on: 31 March 2017].

Gramling, A.A., Johnstone, K.M., Rittenberg, L.E. 2012. Auditing. Cengage Learning.

ISA 240. 2009. The auditor’s responsibilities relating to fraud in an audit of financial statements. [Online]. Available at:

https://www.ifac.org/system/files/downloads/a012-2010-iaasb-handbook-isa-240.pdf [Accessed on: 31 March 2017].

ISA 315. 2009. Identifying and assessing the risks of material misstatement through understanding the entity and its environment. [Online]. Available at: https://www.ifac.org/system/files/downloads/a017-2010-iaasb-handbook-isa-315.pdf [Accessed on: 31 March 2017].

ISA 570. 2009. Going Concern. [Online]. Available at: https://www.ifac.org/system/files/downloads/a031-2010-iaasb-handbook-isa-570.pdf [Accessed on: 31 March 2017].

ISA 700. 2009. Forming an opinion and reporting on financial statements. [Online]. Available at:

https://www.ifac.org/system/files/downloads/a036-2010-iaasb-handbook-isa-700.pdf [Accessed on: 31 March 2017].

ISA 705. 2009. Modifications to the opinion in the independent auditor’s report. [Online]. Available at:

https://www.ifac.org/system/files/downloads/a037-2010-iaasb-handbook-isa-705.pdf [Accessed on: 31 March 2017].

Johnstone, K., Gramling, A., and Rittenberg, L.E. 2015. Auditing: A Risk Based-Approach to Conducting a Quality Audit. Cengage Learning.

Sports Direct. 2015. Annual report of Sports Direct International Plc. [Online]. Available at:

https://www.sportsdirectplc.com/~/media/Files/S/Sports-Direct/annual-report/Annual%20Report%202015%20-%20FINAL.pdf [Accessed on: 31 March 2017].

Sports Direct. 2016. Interim report Sports Direct International Plc. [Online]. Available at:

https://www.sportsdirectplc.com/~/media/Files/S/Sports-Direct/interim-results/interim-results-report-08-12-2016.pdf [Accessed on: 31 March 2017].