Santos Limited In Australia - Inherent Risk Factors - Case Study Example

SANTOS LIMITED IN AUSTRALIA (CASE STUDY) INHERENT RISK FACTORS Name: Grade Course Tutor’s Name (14, May, 2010) Santos Limited In Australia (Case Study) Inherent Risk Factors Inherent risk is the probability that there are misstatements in an audited section in an organization that arise out of existing circumstances and before the implementation of internal controls. In assessing the inherent risk the audit is expected to apply his professional discretion. Inherent risk – Nature of the industry (ASA315 Appendix 1) Santos Limited operates in gas production which is an industry that is susceptible to market fluctuations and volatility as a result of growth in demand and different product specifications as demanded by the consumers, the different quality in crude oil and the influence of the new investors in the market. The global economic crisis had an effect on the oil prices where there were frequent price changes within the year. This is possible to have an effect on the stock prices as stated in the financial statements. The stock prices affect both the income statement in calculating the cost of sales and the balance sheet while recording the stock balances. Hence the focus will be on the cost of sales and in the calculation of the realizable value. There was a big decrease in the profit that is attributable to the shareholders (BusinessDay, 2010). This has mainly been attributed to the change in prices affected by the global crisis, and partly by demand from other countries and more specifically the Asian population and mostly China. The price and demand changes may also be affected by new oil explorations globally. Therefore is a need to analyze all the figures that affect financial statements. Therefore the sampling of the audit will need to be a wide one so as to cover all areas with the intention to conduct audit that will be very thorough. However the inherent risk in this report will concentrate mostly on other reports that are not in the financial statements and reports of Santo Limited. The reports are available in the newsrooms and in the public media. Santos was also planning to sell it stake to in Evans Shoal to Magellan. The inherent risk in this are and what is questionable is the possibility that the transaction between Santos and Evans Shoal (Santos limited, 2010). The auditor would need to audit on the integrity of the officers who are dealing with the transaction. There is a possibility that if these officers are not of high integrity they may collude and overprice the sale. In planning to conduct the audit in this particular transaction the auditor needs to take into consideration the factors that may lead to an inherent risk. The integrity of the new managing director and possibly the board maybe a possible contributing factor that will lead to the misstatement or rather the overstatement of the sale. ISA 400 gives the integrity of the management as one of the examples of factors may affect inherent risk in an organization. Being a new managing director it would not be easy to predict his business managing skill. In April 2009 it was reported that the company was lying off 140 staff members and another 90 of them contractors were to be terminated in responding to the effects of the global crisis. There is an inherent risk whereby the company may fraudulently or by error fail to make provisions for the final dues to these employees. Paying 140 employees may result to a material figure both in the income statement and the balance sheet. This provision is in accordance with ISA 37 Provisions, Contingent Liabilities and Contingent Assets of International Financial Reporting Standards (IFRS). This risk may be affected by two factors that are given as examples in the ISA 400. One of them is the possible lack of knowledge by the accounting officer that any material figures that may affect the company’s financial position should be provided for. The next factor is the pressure to show positive performance after the profits decline reported in the financial year 2009. The management may be tempted to hide some of the figures so as to show an increase in profit. The integrity of the management will also contribute. Integrity is crucial for the accounting staff. This is because there are called to be representatives of the shareholders, which they should deliver through without favor. These figures should include any pension dues and any leave pays that the employees may not have taken. There is a 40 percent tax increase from 6 percent on profit that is to be paid to the government by the oil companies. According to the news reports the Managing Director, David Knox said that this tax increase proposal could push out the final investment and paralyze investment. There is an inherent risk here first if the tax will be adjusted and provided for in the Financial. The results of this increased tax will a major impact in the figures and any tax additional amount should be provided for in the accounts. The accountants should be well informed as such a failure to make the provision would completely distort the profit that is attributable to the shareholder (BusinessDaily, 2010). A failure make the actually payment, and on good time may attract heavy penalties on Santos Limited. According to ISA 400 conditions within the industry may be a factor that affects inherent risk. This causes turmoil in the industry making it a bigger risk. The knowledge of the accountant will also be a contributing factor to consider if this will actually be a risk. The effect on the tax increment creates another inherent risk. According to the managing director the investors had stopped their investing making it more difficult to raise funds and thus delaying the project. This statement may raise a few questions that may affect the inherent risk. The first risk is in the delay of the implementation of Gladstone liquefied natural gas, GLNG (Cosserat, 1999). There are funds that have already been raised for this project. The money is in the bank accounts. Cash is very tempting while it is in liquid cash as there is always the possibility of it being misappropriated. This may be affected by the integrity of the management. The third risk that may lead to an inherent risk and that can increase the inherent risk and that is questionable is if the delay is really as a result of the tax increase or it could be an indirect way of the managements plan to have more time to collect more funds (Khanna, 2010). There are reports that the project maybe under budgeted. As such the management may be playing delay tactics in order to collect more funds to finance the project. According to John Macbee, an analyst with the a Royal Bank of Scotland, there is the possibility that the budget would exceed the $7.7billion and suggestions to make it a joint venture with Shell BP. This plus the fact that there will be delay in finalizing the project GLNG may show that there is a risk of funds being not enough. Santo limited has sold its assets in the year 2008 and again in 2009 and it has also been reported that it is selling its stake in Evans Shoal. This shows a risk of misstatement of the budget. This maybe affected by several factors that are in ISA 400 among them the management experience, unusual pressure and the nature of the business. According to Pritchard, (2008) the oil and gas industry is affected by frequent oil prices. It is therefore not very possible to give accurate budget figures. The recorded reduced profits of the financial year 2009 profit may have led to investors inserting pressure on the management. This may lead to wrong figures being presented to the investors in order to please them and help them retain their jobs. In so doing the management may have under-budgeted the GLNG project. There was a change in management in the year 2009 and whereby it was reported that there was some displeasure from the former Chief Executive Officer who in order to please him he had to given the position of the CEO. Investigations should be directed towards finding out if there was a possibility of figures being distorted by the employees who were loyal to him. In this case the investigations should be started with senior accounting staff to establish their loyalty. Deeper investigations should be directed towards those areas where the staffs were loyal and their figures verified. To give an example, if the Invoicing Manager was loyal to the form CEO, the invoices should be audited more thoroughly with a narrowed down sampling. The financial statements may report some discrepancies that need to be affect the inherent risk. The assets recording needs to be investigated. The change in depreciation charge in the income statement is not proportionate to the change in assets. Considering that there is a recorded additional cost of asset of $523m and if we put into consideration the disposal of assets as evidenced by the sales proceeds of $260m then the change in the depreciation change recorded should be more. There is a possible misstatement of the assets that could be aimed at impressing the investors who need to be encouraged to raise new finance to fund the new GNLG. This could be affected by the integrity of the management, the unusual pressure put on the management to perform and the unusual constraints that are experienced in the oil industry. The writing off of $202m in 2009 of capital expenditure was written off as unsuccessful exploration. This should be investigated because it could have had an effect on the 2008 financial reports which may lead to adjustments of the 2008 published accounts. It is an unusual transaction whose amount is material and the audit plan should investigate how that figure may have been calculated in the year 2009. The global prices were very low in the year 2009 as compared to 2008. There is a possibility that the amount would have been used as a ‘hidden provision’ in 2008 so as the profits published would be attractive to the investors. A risk that is caused by lack of integrity by the management. An Adelaide based company had analysed the Santos 2009 financial statements and had indicated that much of the profits reported in 2008 was as a result of Santos selling its stake in Queensland liquefied natural gas. Such reports will also show a weakness and an inherent risk by misrepresenting figures and especially if this had not been a disclosure in the reporting. Other factors apart from lack of integrity in the management that would contribute is the complexity of the transactions. This is more so if the management have not had such a transaction in their records in the previous financial statements. Again the management maybe under pressure to perform hence misrepresentation of figures. Another news report by businessday had indicated that the reports that the investors were anxious over the failure or reluctance of the management to provide them with Capital Expenditure requirements of Gladstone liquefied natural gas (GLNG). This should be a source of a possible inherent risk whereby the figures are misstated so as to retain their confidence. This could result to misstatements in all areas of the financial statements, that is, the assets, and equity shares, understatement of the liability, expenses being understated and cash misappropriated. In this case the situation will have been affected by all the ISA 400 examples, the integrity of directors and management, the experience of the management and Directors, unusual pressures on management to perform exceptionally well and conditions within the industry. There are reports that indicate that Shell BP should get into a joint venture with Santos. John McBee continues to suggest that a tie up that is expected between Santos and Petronas and Petronas and Shell Petro-China should not be ignored but should be taken positively by the market. As Macbee continues and suggested that Petronas and Santos “should stop to invest in hardly valued-enhancing single train development. These statements contain an inherent risk in that there is a possibility that the investment with GLNG has not been properly analysed. This can lead to increase the already anxious investors to stop investing. This can be supported by the delay in the final plan of the implementation of the project. This inherent risk is affected by lack pf proper skills in this new venture and again the unusual pressure. With the investors making their demands to have their returns from investing in the venture. Another factor affecting the inherent risk is the conditions within the industry. The oil industry business has its complexities. There is always a risk involved caused by unpredictability of the prices and other factors. Evidence The evidence that will be required in the investigation of the Santo’s inherent risk will need to prove a few facts that are laid down in the ISA500 as assertive measures in audit evidence. These are existence of the transaction subject, the rights of obligation by the organization, occurrence that the transaction really happened, completeness of the transaction, valuation that the amount is valid and accurate, measurement of valuing the transaction and the presentations and disclosures of the transactions in the financial statements or in the notes (Santos limited, 2010). These will be analysed in each of the above transactions. The reliability of the evidence will depend on the source. Third party sources are more reliable than internal information. Original documents are more reliable than photocopies. Electronically produced data is more reliable than manual data. These too will be applied in investigating the evidence. The audit evidence that will be needed will be the confirmation of the transactions between Santos Limited and Magellan to ensure that the transactions were conducted in a transparent manner. If there is transparency in this deal, then the evidence should be sought to prove that there were tenders that guided in selecting Magellan as the firm to sell to. ISA500, on reliability of audit evidence states that audit evidence is more reliable if it comes from a third party than internally originated evidence. This means that the confirmations by the management of Magellan will be more reliable. This should be done by sending a letter to the management of Magellan whereby they are expected to confirm or dispute the transaction and the amount To make it more reliable the auditor should insist on original documents. There should also be the minutes that would prove that it was a decision by the board but not a personal decision made by one person. In getting the audit evidence for the provision of the employee’s dues in the financial statements, the first step is to confirm that such an amount has already been provided for. Then the auditor will need to get the evidence to prove that an obligation to pay actually exists. To do this the auditor will need to counter check the information with the Human Resources Department to check on the amounts to be paid and on what they are based on. This is meant to confirm the accuracy and checking on the credibility of the amounts calculated. If there are employees who have already been paid this can be verified with the use of copies of their pay slips and signoff forms. This will also be evidence that the transaction really happened that is occurrence. The audit evidence in the tax adjustment provision will be tracing the provision from the published financial statements. The quarterly interim tax payment should also have been paid by the time the accounts are published. Thus this evidence of the payment can be traced in the bank statements. A confirmation with the country’s revenue authority should make the evidence more reliable. The need for the audit evidence is to show completeness, the measurement, presentation and disclosure of the tax increment effect. Audit evidence on cash will need to verify the existence, occurrence and the completeness of the transactions through the bank statements. This will be done by cash counts for any monies that may be held in the office cash box and the bank statements will verify what is in the bank accounts (Smith, 2010). Verification of the bank balance will include the bank statement and a request letter to the bank management. The bank management is supposed to confirm or dispute the amounts in the bank balance. This is more reliable evidence. In the valuation and budgeting for the GNLG, the evidence that maybe available may not be very reliable because it is based on estimations but not actual. However it is possible to get the evidence in terms of the calculation details explain in details how that figure was worked out. This is to show the completeness of the figures, valuation and measurement. The right of obligation is not however proved. In this case the source of evidence will depend on the section or department. But in most cases it will be internal manipulation of figures, as such the original documents to customers, or suppliers as the case maybe will be used as evidence (Rittenberg, Et al. 2009). This will verify the accuracy, completeness, valuation, measurement and occurrence. The evidence on asset will include the verification of assets and confirmation of the assets through documentation of the assets that were used in purchasing or sale of the assets. The physical verification will be physically counting the assets as the auditor confirms existence both in documentation and physically. The transaction of purchase can also be traced to the Bank account all with a confirmation from the supplier. The disposal of the asset should also be traced to the bank account as well as checking on the accuracy of the recording of the transactions. Question 2 The Inherent Risk Opinion The management of Santos limited has put into place controls to minimize possible inherent risk in its business. The probability that each of the transactions will have an impact on the profitability of the company is minimal. This has been made possible through proper controls being put into place by the management. In announcing the financial reports the management said that they had worked on improving the corporate governance in the organization. The internal department has its say in the decision making and in the control process. There however are a few high risk areas, an example being the effects of the anxieties caused by lack of required information to the investors. The CEO should address this issue and bring down the anxiety it has caused which may have a negative impact on the shareholders willingness to invest with Santos ltd. The anxieties are triggered by the reports of a possible joint venture with other oil companies. According to Arens, Et al. (2009) another high inherent risk area is in misrepresentation of figures. The accounting standards require that profits from sale of assets be disclosed separately. The 2008 profits had been overstated. There is also overestimate in the calculation of depreciation. This is an area of serious inherent weakness. Another area of concern is the managements reluctance to review the budget and give consideration to a joint venture which maybe more profitable and of higher benefit to the investor. There should be stronger controls on how information is relayed to the investors. The oil industry business is complex and full of unpredictability. Therefore though Santos may introduce some controls, there will always be those areas that no one will know the turn of the event. Variations in Evidence Mix Test of controls Procedures to obtain an understanding Test pf procedures and processes in decision making Test details of documents Audit 1 E E E E Audit 2 E E M M Audit 3 M N M M Audit 4 M N E E E= Extensive amount of testing; M= Medium amount of testing; S=Small amount of testing; N=No testing done The audit risk model has historically been modified for the auditor to use the model in making an opinion in internal controls and in making an opinion of the inherent risk. It is designed to assist the auditor in determining the effectiveness of controls. Akresh (not dated) gives the formula for Internal controls as: AR (Internal control risk) = Risk of undetected material weakness where the risk components are broken and the formula becomes: AR (Internal control risk) = f(CDIR/given IR; COER/if CDIR effective) Where IR= Inherent risk CDIR = the assessment by the auditor that Internal Controls are not adequate such that an aggregate material misstatements cannot be detected or prevented in light of inherent risk. COER= auditors assessment of the risk that the already designed but are not followed in-order to prevent or detect an aggregate material misstatement. In the Santos case the controls that are there are not being followed. In applying the CDIR in this case the control that isn’t being followed is the accessibility of information to the public by the Managing Director. In applying (COER) in this case there are some controls that need to be implemented, like in decision making to sell the forms assets. It isn’t clear how transparently this is done. This will lead to the auditor giving an opinion that there is low inherent risk after all the testing because there is undetected material weakness. This may lead to a qualified report. References Arens, A., Elder, R & Beasley, M. (2009). Auditing and Assurance Services: An Integrated Approach. Upper-Saddle-River: Prentice Hall. BusinessDaily. (2010). Time For Suntos To Put A Price On Hold LNG Dreams. Retrieved on May 14, 2010 from http://www.businessday.com.au/business/time-for-santos-to-put-a-price-on-lng-dreams-20100218-oj1m.html BusinessDay, (2010). Suntos Eyes Further Asset Sales To Fund LNG Plans. Retrieved on May 14, 2010 from http://www.businessday.com.au/business/santos-eyes-further-asset-sales-to-fund-lng-plans-20100218-og98.html Cosserat, G. (1999). Inherent risk and the Control Environment. Retrieved on May 14, 2010 from http://www.accaglobal.com/archive/sa_oldarticles/50047 Khanna, R. (2010). Santos Plans To Sell Stake In Evans Shoal To Magellan. Retrieved on May 14, 2010 from http://www.topnews.in/companies/santos-ltd Pritchard, E. (2008). Oils Perfect Storm May Blow Over. Retrieved on May 14, 2010 from http://www.telegraph.co.uk/finance/newsbysector/energy/2790363/Oils-perfect-storm-may-blow-over.html Rittenberg, L., Johnstone, K & Gramling, A. (2009). Auditing: A Business Risk Approach. Boston: South-Western College Publisher Santos limited, (2010). Corporate Governance. Retrieved on May 14, 2010 from http://www.santos.com/annual-report-2009/corporate-governance.aspx Santos limited, (2010). Appendix 4E Preliminary Final Report Under ASX Listing Rule 4.3A: For the period 31 December 2009. Retrieved on May 14, 2010 from http://www.santos.com/library/2009%20Appendix%204E%20Preliminary%20Final%20Report.pdf Smith, A. (2010). Santos Cuts Spending, Exploration to Focus on LNG. 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