Auditing of Virgin Australia Holdings Limited Group - Case Study Example

Running Head: AUDITING ASSIGNMENT Auditing Assignment Name of Student Name of Course Course Instructor Date TABLE OF CONTENTS Executive Summary 3 Introduction 3 Business Risk Assessment 4 Preliminary Analytical Procedures 6 Inherent Risk Assessment 9 Control Risk Assessment 11 Audit Strategy 12 Planning Materiality 13 Audit Procedures 14 Using the Work of Other 17 References 18 Auditing Assignment Executive Summary The purpose of this auditing report is to identify the audit risk areas and the key audit risks that are faced by Virgin Australia Holdings Limited Group (Virgin Airlines) in Australia. The report has identified major business risks, internal risks and other sources of audit risk areas for Virgin Australia Holdings Limited Group. For instance, the rising prices of the fuel are a major risk factor that might impact on the business risks at the entity and the industry level.The inherent risk assessment also identifies other areas of audit risk such as there is risk of fraud and also risks associated with the going concern status of the company. The financial analysis for 2015 and 2016 also reveals other risk areas for the audit. The control risk overall low for the company as compared to the inherent risks and the business risks faced by Virgin Australia Holdings Limited Group. In response to these risk areas we have determined the overall audit risk of the company and the audit strategy for the company. In addition the planning materiality level has also been determined for the company. In the end of the report, we have identified suitable audit procedures such as tests of controls and substantive testing to verify the account balance impacted by the audit risks identified in the report. Introduction The Virgin Australia Holdings Limited Group (Virgin Airlines) is the second largest airline company in Australia after the Qantas airline company. Moreover, it is the largest airline by fleet size in Australia which uses the Virgin brand. Richard Branson who was the British businessman had founded the airline back in 2000, and the airline is now based in Bowen Hills, Brisbane[Ste13]. The airline company had been operating as a low-cost carrier for several years and after several years the company had been called as the New World Carrier because it has a low-cost strategy and the low-cost model by which it charges lower ticket prices to its passengers[Ste13]. It is the only airline in Australia which offers their customers the option of purchasing the ticket for a flight with the aspect of no-frills as the approach of the low-cost model for competing effectively with Qantas within the entire business travel market[Sad14]. Business Risk Assessment First, we identify the major audit risk areas and the major audit risks and their potential impact on the financial statements of the company at the entity level, industry level and the economy level. These are stated as follows: Business Risks – Entity-Level There are some the business risks to which the Virgin Airline Company is exposed to, and theses all are briefly defined below: The rise in the prices of the fuel is a major risk for the Virgin Airline Company at an entity level. Although, the company remains competitive against its competitor Qantas through the adoption of low-cost model but still the fluctuating oil prices exposes the firm to business risks. Unlike the other modes of transportation, the 100% costs for the aviation infrastructure are paid by the customers. Another business risk at the entity level is the de-motivation among the employees due to the lack of senior management interest. Prolonged union negotiations, increased competition, and the Ash Cloud events are also other business risks which prevent the management from maintaining its day to day operations of the business[Sad14]. Compliance with the Australian aviation authorities and the sudden changes in laws such as carbon emission levels. Finally, there are also many other risks at entity level such as safety risks, fuel availability, adequate liquidity, IT failures, terrorism, seasonal demand, supply chain risks, etc. Business Risks – Industry Level Intense competition, market volatility, the impact of wild weather and the corrosive effects of skyrocketing jet fuel prices are all industry specific risks. The carbon tax in Australia is higher, and the latest Euro tax with the aim of environmental protection increases the risk of losses for smaller firms[OSu11]. Along with the climatic change regulations, the airlines in Australian aviation industry also face the risks of physical hazards such as flash floods, fierce storms, and typhoons. Business Risks – Economy Level Aviation war risk has become a significant issue. The Ansett collapse had decreased the competition in many parts of the regional airline industry of Australia[OSu11]. The airline industry of Australia is also subject to detailed capacity controls, and these are part of the long-established bilateral air service agreements. These all are enforceable through law, and thus these could become more stringent in future years[Bir08]. Preliminary Analytical Procedures Before performing the inherent risk assessment and identifying other risk areas of the audit, we need to perform the preliminary analytical procedures so that more audit risk areas can be identified[Ell00]. The preliminary analytical procedures and the financial analysis interpretation is performed as follows: Ratios Formula used (in words) Actual formula (in numbers) Results 2016 Results 2015 Profitability Profit margin Net profit/Net Revenue 2015=-93.8/3999= 2016=-224.7/4194.8= -5.36% -2.35% Return on equity Net Income/Total Shareholders’ Equity 2015=-93.8/1020.8= 2016=-224.7/898.8= -25% -919% Liquidity Current ratio Current Assets/Current Liabilities 2015=1586/2299.8= 2016=1713.7/2779.8= 0.616 x 0.690 x Cash flow ratio Net cash flows from operating activities / current liabilities 2015=218.1/2299.8= 2016=198.5/2779.8= 0.071 x 0.095 x Solvency Debt to equity ratio Total Debt/Total Shareholder Equity 2015=4758.8/1020.8= 2016=5142/898.8= 5.721 4.662 Trend Analysis Total revenues=2016 – 2015 – 2014 2016 2015 2014 2013 Average Revenues 4194.8 3999 4286.8 3987.8   4.90% -6.71% 7.50% - 1.89% Net profit/(loss) after tax=2016 – 2015 – 2014   2016 2015 2014 2013 Average Net profit/(loss) after tax -224.7 -93.8 -355.6 -98.1   139.55% -73.62% 262.49% - 109.47% Net cash flow from operating activities=2016 – 2015 – 2014   2016 2015 2014 2013 Average NCF from operating activities 198.5 218.1 -7.7 246.9   Trend -8.99% -2932.47% -103.12% - -1014.86% Interpretation of Financial Analysis First of all, if we analyze the profitability position of Virgin Airlines Company, we can see that the net margin ratios for the company have worsened and the company has a negative net margin for the years 2015and 2016. The profits for the company have become more negative in the year 2016[Vir16]. If we analyze the liquidity position of the company through the use of current ratio, then this ratio has declined in 2016 as compared to 2015. Also, the current ratio for both the years is less than one which is not a positive sign for the company. The company might face liquidity issues in the future years, and it might not have enough short-term assets to pay the short-term obligations if they become due. If we analyze the liquidity position for Virgin Airlines Company through the cash flow ratio, then this ratio has declined from 0.095 to 0.071 times in 2016. This means that the company does not have enough cash to repay the short-term obligations if they fall due. The debt to equity ratio has been computed to assess the financial leverage for the airline company. The debt to equity ratio has increased for the company which means that the company has taken additional debt to finance the equity of the shareholders. This makes the company highly levered and thus increases the risk of bankruptcy. Finally, if we analyze the trend analysis for the airline company, then we can see that the revenues for the company are declining and also the same growth rate is not static. For example, the revenue declined in 2015 for the Virgin airline company. The average growth rate over the four-year period is 1.89%. The trend analysis for the net income for the company shows that the company is consistently generating losses in all the years. However, the net income for the company has also been fluctuating up and down, but it is still negative. Finally, the trend analysis for the net cash flow from the operating activities shows that the operating cash flow has not been growing at a good rate in the past . However, it is improving now. The net cash flow for the company is, however, positive for the year 2015 and 2016. Inherent Risk Assessment Next, we perform the inherent risk assessment of the Virgin Airlines Australia which is stated as follows: Fraud Risk There is a huge risk of overstatement of the short term assets of the company since the short-term obligations are much higher for the company. There is a huge risk for the overstatement of the revenue for the company since the profits of the company have weakened due to the closing of the merger by Alaska[Aus16]. There is a huge risk of fraud for understating the amoung of the debt, perhaps through off-balance sheet items. All the airlines are fighting to reduce their indebtedness including the Qantas airline however, the lower net operating income for Virgin airline makes this risk of fraud more severe. Going Concern Risk There are some the indicators which show that there is severe going concern risk at Virgin Airlines Company. First of all, the liquidity position of the company is weak. The current ratio is too low along with the cash flow ratio which shows that the operating cash and the current assets of the company are too low as compared to the short-term obligations. The company might run out of cash to finance its day to day operations and thus invalidate the going concern assumption. The loss of revenues and the huge generation of the losses along with the declining net cash position as shown by the annual reports of 2014, 2015 and 2016 is another indicator of the going concern risk. The company might also face a legal action or a class action against its drip pricing. According to the reports, the company has misled its consumers regarding its prices[Cla15]. The drip pricing tactic and legal action against it is a significant going concern risk. Inherent Risk Assessment Inherent Risk Accounts and Assertions Affected Reason Lower profitability Income Statement would be affected as a key account, and the valuation assertions would be affected. The airline industry has always seen a lower profitability. The major worldwide airlines of the world have made cumulative losses over the past 120 years[Sad14]. Rise in Jet Fuel Prices Income Statement would be affected as a key account, and the management assertions would be affected. There are significant fluctuations in the fuel prices of the companies, and these are highly certain. There might cause misstatements or omissions. Global slowdown or recession All the financial statements would be affected as the key accounts along with the management assertions. The company is highly affected by the global recession of the economies such as the financial crisis of 2008. This would involve subjectivity in the prediction of the future cash flows or budgeting[Vau13]. Theft of cash The cash flow statement account would be affected, and the completeness assumption would be affected. This is because the cash balance for the company is still positive and as compared to inventory it has huge cash balances which might create significant risks for survival. Meeting loan covenants The income statement and balance sheets accounts would be affected by these inherent risks and the valuation, completeness and rights and obligations assertions would be affected. The valuation of the financial securities is another complex area, and there are many other complex transactions involved. Therefore, this might create issues within the valuation of the complex business transactions[Aus16]. Rapid technological developments The balance sheet accounts would be affected, and the valuation and completeness assertion would be affected. This is because due to the rapid technological developments might create a higher risk for the inventory becoming obsolete in the airline industry as compared to the other industries. Inherent Risk Conclusion If we summarize all the above inherent risks, then we would conclude that the inherent risk level for Virgin Airlines is high. This is because almost all of the assertions and accounts of the company would be affected if these risks materialize either individually or in aggregation. Lower profitability, theft of cash and meeting loan covenants are some of the assertions which have a higher inherent risk involved. Control Risk Assessment After this we perform the risks inherent in the control procedures or the internal controls of the organization. Control Risk Assessment Entity Level Internal Controls The company has established and Audit and Risk Management Committee which oversights the responsibilities of the management related to the internal controls, policies and procedures for the company. The directors of the company are responsible for the preparation of the financial reports of the company by the Corporations Act 2001 and the Australian Accounting Standards. The directors and the management are responsible for the Assured Sustainability Parameters according to the GRI guidelines. The management and the directors have the combined responsibility for the preparation of these parameters which are included within the sustainability section of the annual reports of Virgin Airlines. Finally, the management of the company is also strong on documentation of the invoices, customer invoices, and other key documents. The management maintains adequate records and documents. Control Risk Conclusion If we analyze the overall control risk level for Virgin airlines, then the control risk is low for the company. This is because the company has strong internal controls in place which would mitigate the inherent risks faced by the company. Moreover, the company has also established an independent internal audit committee. Audit Strategy The summation of the risks identified above and the risk profile for VHA is described below and then we have specified the audit strategy for the company too. Risk Profile As we have concluded that the level of the inherent risk is high, and the level of the control risk is low, therefore, the detection risk would be moderate to high. The inherent limitations of the audit would also have an impact on the detection risk of the audit. The company is operating in a highly regulated industry . Therefore, the magnitude for the inherent risks for Virgin Airlines would be high. The company has a complex network of the related entities and some related party transactions such as the related party loans which could be misrepresented by the management in the absence of the relevant financial controls in place[Mor15]. If the inherent risk is set at 60% and the control risk is set at 20% then the detection risk needs to be set at to prevent the overall audit risk from exceeding 10%. The working is shown as follows: Audit Risk   =   Inherent Risk   x   Control Risk   x   Detection Risk 0.10   =   0.60   x   0.20   x   Detection Risk 0.10   =   Detection Risk   =   0.0833   =   8.33%  0.36 Therefore, the amount of the evidence required to be gathered should be equal to this percentage of the total evidence. Although, the 10% limit on the audit evidence is just an assumption, the audit risk might increase above this level and as the inherent risk is high for Virgin Airlines, therefore, the amount of evidence which should be obtained by the auditor also needs to be increased. Audit Strategy A detailed audit strategy needs to be devised to address the risk profile of the Virgin Airlines and then plan the audit in detail. The audio needs to set the timing and scope of the complete audit. Since, Virgin Airlines, is a moderate to high-risk level client, therefore, no or very limited tests of controls would need to be performed, and increased reliance should be placed on the substantive tests of the account balances and the transactions [Mor15]. The auditor would gain a low necessary knowledge about the internal control systems of the client. Detailed substantive testing would be performed for the year-end account balances and transactions conducted by the business throughout the year[Fla15]. An auditor can never rely on the internal controls of the clients, and the audit strategy would have to conduct some tests of controls on these internal controls. For each of the identified risks, the first step of the auditor would be to assess whether an internal control would have reduced the likelihood of a material misstatement or omission which might occur as a result of that risk. If the client has effective controls in place, then the auditor should first test those controls and then perform substantive testing. Planning Materiality Base Selected The profit before tax is typically selected as the base for the planning materiality, however since the Virgin Airlines has been generating losses for the past several years and the profitability of the company is not consistent therefore, this could not be used as the planning materiality base [Mor15]. However, since this business is also revenue oriented, therefore, total revenue less the discounts would be used as the planning materiality base. Percentage Applied to Base All the combined misstatements or omissions of less than 0.5% of the total revenue would not be considered as material. Therefore, the combined misstatements or omissions of greater than 1% would be considered to be materiality. Relationship to Risk Assessment Since the inherent risk is high and detailed tests of controls and substantive tests would be performed for the business, therefore, the audit risk would also be high. Moreover, the nature of the business of Virgin Airlines and its business model of a low-cost carrier justify the 1% of revenue as the most reasonable planning materiality level for the audit of Virgin Airlines. Audit Procedures In this section of the report, we determine the audit procedures for verifying the account balances which are impacted by the above identified risks. Audit Procedures – Test of Controls WCGW/Risk Accounts/Assertions Affected Control Testing Procedure There is a risk in approving credit. For instance, the management might approve the credit for the customers or their close relatives or friends which are unable to pay The revenue accounts would be affected, and the Accuracy assumption would be affected. The credit committee reviews and approves all the credit transactions which exceed a credit limit of $1000. Determine that whether there is adequate segregation of duties in the credit department and also the existence of the credit committee. The credit limits of some of the customers are exceeded. The revenue accounts would be affected, and the Accuracy assumption would be affected. The application control should review the approval for exceeding the credit limits such as exception report should be generated and reviewed. Determine that whether there is adequate segregation of duties in the credit department and also the existence of the credit committee. Identify the unusual and uncertain sales terms[Joh14]. The discounts such as the volume rebates are incorrectly applied. The revenue accounts would be affected, and the occurrence, accuracy, and the completeness assertions would be affected. All the discounts which exceed the amount of $1000 must be approved by the sales manager. The sales discount procedures and records should be reviewed. Observe the procedure and reperform the procedures for a sample period[Joh14]. Sales are recorded in the wrong period. The revenue accounts would be affected, and the cut-off assertions would be affected. The date recorded should be set by the date of the transaction in the software. The senior sales manager should also review the sales exceeding $1000 for the last three to five days of each month. Observe and reperform. Inspect the customer exception file and disposition. Finally, perform the independent check fro selected dates[Joh14]. Audit Procedures – Substantive Testing Account Assertion Substantive Procedure Sampling Method Accounts Receivable Existence, Valuation Comparing the receivables amounts with the passengers owning the money and evaluate the history of the airline company to evaluate the accuracy of the allowance for doubtful accounts. Examination of the related documentations. Revenue Existence, Valuation Verify the accuracy of the sales invoices and compare the quantities billed with the total amount of the ticket purchased. Computerized Audit process Sold discounted and pledged receivables Existence, Valuation Management Inquiry, scan the cash journals for large cash inflows from unusual sources and review the board of director minutes which contain the approval for these items[Are08]. Probabilistic sampling method Related party receivables Existence, accuracy, completeness., valuation. Review the SEC filings, review the trial balance and the receivables subsidiary ledger, management inquiry and communicate the names of the related parties so that all the audit team members should be aware of the related parties[Are08]. Direct sample selection Using the Work of Other The external audit might use the work of the internal auditors when he would be performing the tests of controls on the internal controls of the internal auditors. A strengthened relationship will have to be created for an effective dialogue with the internal and the external auditors[Phi01]. Finally, when the external auditor would be performing the substantive analytical procedures such as to determine the cut-off for the sales, he would again need to make use of the previous external auditor. The current auditor will need to ensure that whether the previous auditor ascertains that all the revenues and expenses are complete and correct, the application of the group accounting policies are correct, and there is adequate disclosure of the financial information published by the airline company[PCA16]. References Ste13: , (Stephen, 2013), Sad14: , (Sadler, 2014), OSu11: , (O'Sullivan, 2011), Bir08: , (Bird, 2008), Ell00: , (Stoddart, 2000), Vir16: , (Australia, 2016), Aus16: , (Aviation, 2016), Cla15: , (Yeates, 2015), Vau13: , (Vaustralia, 2013), Mor15: , (Campbell, 2015), Mor15: , (Campbell, 2015), Fla15: , (Flanagan, 2015), Joh14: , (Johnstone, 2014), Are08: , (Arens, 2008), Phi01: , (Brown, 2001), PCA16: , (PCAOB, 2016), Read More