Audit Strategy Memorandum ABC Learning Centre
Table of Contents
Introduction 2
The purposed of the report……………………………………………………………………………………………………..2
Our area of focus 2
Background 3
Aggressive expansion strategy…………………………………………………………………………………………………3
Valuation of Intangible assets and Goodwill…………………………………………………………………………….5
High level of debt…………………………………………………………………………………………………………………….6
Poor corporate governance……………………………………………………………………………………………………..7
Operating cash flow and questionable accounting practices……………………………………………………7
Accounting Dashboard…………………………………………………………………………………………………………….8
Ratio Analysis 9
Nature and type of ratio analysis conducted……………………………………………………………………….9
Auditing implications from the ratio analysis…………………………………………………………………….11
Other implications from the ratio analysis…………………………………………………………………………12
Risk assessment and areas of audit focus…………………………………………………………………………..12
Conclusion 15
1. INTRODUCTION
The purpose of this report is to set out our planned approach in respect of the audit of ABC Learning Centres Limited (ABC) and
ief the Audit Committee of its outcomes.
a) The purpose of the report
An entire scope audit of the financial statements of ABC Learning Centres for the financial years of 2001 to 2007 has been executed in accordance with the International Standards of Auditing.
We have concluded an opinion of the statements provided and we will be discussed if ABC’s reports were co
ect and appropriately prepared in accordance with the International Financial Reporting standards.
) Our areas of focus
The preface assessment of our research indicates that ABC Learning centres had poor corporate governance and therefore our audit approach is to execute a total review on all financial statements and key risk areas before developing an opinion.
Our audit will focus on the below account balances in the financial statements:
Statements of Cash Flows
1. Investing cash flows
Balance Sheet Accounts
1. Non-cu
ent assets with a great focus on Intangible assets and Goodwill
1. Non-cu
ent liabilities including provisions and long-term debts
Profit and Loss Accounts
1. Operating Revenue
1. Intangible assets amortisation
1. Operating expenses including Repairs and maintenance costs, Rental expenses and Impairment charges
2. BACKGROUND
In 1988, ABC Learning Centres Limited was established in Brisbane, Australia, as private childcare centres. In 1997, ABC Learning had 18 centres in Australia. In 2001, with 43 centres, ABC Learning was listed on the Australian Stock Exchange. Its share prices increased dramatically in a short time of 300%.[endnoteRef:1] [1: ]
a) AGRESSIVE EXPANSION STRATEGY
Implementing the childcare rebate policy, ABC Learning centre expanded aggressively and strategically tried to monopolize the childcare industry. And since the government provided non-ending funds, ABC Learning considered it an advantage to expand locally and internationally.
ABC Learning made its biggest acquisition in 2004, buying out Peppercorn Childcare for $340 million dollars adding 450 centres to their portfolio. They applied the same strategy internationally and in 2005, they acquired, in the United States of America, its second and third largest childcare operators (La Petite Academy, Learning Care Group Inc.).
This massive expansion had a huge impact on their asset’s accounts increasing up to $ 4 Billion dollars in 6 years. The below chart shows the year on year changes in their total assets caused by the rapid expansion:
) VALUATION OF INTANGIBLE ASSETS AND GOODWILL
As stated earlier, the ABC Learning assets have increased dramatically during 2001 to 2007 due to the acquisition of centres and licenses. In 2005, the licence value on the balance sheet has augmented from a cost value of $58.5 million dollars to a market value of $700 million dollars as this was the goodwill revenue they would generate from their assets.
The average of Intangible assets contribution to total assets was 70.90%, PP&E ranking number 2 with an average of 10.5% and cash in number 3 with an average of 5.07%.
ABC Learning had inaccurately amortised the Goodwill account instead of assessing it for impairment; the original ca
ying amount was wrongly recognised in the Profit and Loss as Revenue.
c) HIGH LEVEL OF DEBT
ABC Learning has a crisis of liquidity; they struggled to pay employees, dividends, couldn’t raise capital and had insufficient earnings to finance their enormous debts (In 2007, they have paid $112 million dollars in Interest alone).
d) POOR CORPORATE GOVERNANCE
The Board of Directors and the founders were obsessed with growth and expansion but having educated and experienced people managing the business wasn’t enough. Many of their decisions were questionable; In 2006, ABC Learning paid transactions fees of $27 million to a
oking firm which Groves had a sizable share in. The company sponsored the basketball team that Groves owned. Edmund Groves and his wife bought their shares in ABC Learning with investment loans and have not made this information public for their shareholders.
This fact implied poor corporate governance and misled shareholders that had confidence in the management strategy.
e) OPERATING CASH FLOW AND QUESTIONABLE ACCOUNTING PRACTICES
The intangible assets and liabilities impact of acquisitions were removed from the cash flow statement to highlight the ABC Learning cash flow without those impacts. The fixed assets under operating lease the minimum future payments were mistakenly recognised in ABC Learning’s balance sheet.
ABC’s gross revenue figures might have been overstated because it included the developer rebates in gross revenue. There are some evidence that negative Goodwill was inco
ectly recognized as other revenue.
The maintenance costs were very high and has badly impacted the profitability of the company. Repairs and maintenance cost were understated in the Profit and Loss statements and it might have been e
oneously recognized as fixed assets.
f) ACCOUNTING DASHBOARD
3. RATIO ANALYSIS
a) NATURE AND TYPE OF RATIO ANALYSIS CONDUCTED
Five types of ratio analysis have been conducted in the given data which are as follows:
· DuPoint Analysis – This analysis mainly helps the investors to understand Return on Equity’s (ROE) different drivers (Bauman XXXXXXXXXXThe main focus is on the financial metrics to understand the strengths and weaknesses of the company.
In the given ratio analysis, under Dupoint analysis, return on equity, return on assets, financial leverage and return on sales have been calculated.
· Asset Turnover Ratios Analysis – This analysis reveals the revenue generated by the company with reference to the asset owned. This analysis reveals the capacity of the company to utilize its assets at the optimum level (Gibson 2012).
In the given ratio analysis, under asset turnover analysis, asset turnover, accounts receivable turnover, accounts payable turnover, inventory turnover and fixed assets turnover have been calculated.
· Earnings Management Analysis – This analysis present an overall view of the financial position of the company along with its business activities. Often the management of a company bases their decisions on this analysis (Lin and Hwang 2010).
In the given ratio analysis, under earnings management analysis, year over year revenue growth and year over year growth in accounts receivables have been calculated.
· Fraud Prediction Analysis – Under this analysis, both fraud data as well as predictive data is analysed together to discover any fraudulent or suspicious activities going on in the business (Schrand and Zechman XXXXXXXXXXIn fact, such analysis also helps to determine the future behaviour for fraudulent activities in the company.
In the given ratio analysis, under fraud prediction analysis, days sales receivable index, gross margin index, asset quality index, sales growth index, depreciation index, SG&A index have been calculated.
· M Score Analysis – This analysis reveals if the company has manipulated the earnings shown in the financial statement (Herawati XXXXXXXXXXIt is a type of mathematical model which uses eight ratios XXXXXXXXXXis the limit M score and score greater than that reveals manipulation.
Key Findings from the ratio analysis:
Return on equity ratio had a sharp rise in the year 2002 compared to 2001 but after that there was a constant fall in the ratio from 2003 to 2006. It again rose in 2007 slightly. Return on asset ratio had a rise in the year 2002 compared to 2001 but after that there was a constant fall in the ratio from 2003 to 2007. Financial leverage ratio had a significant rise in the year 2002 compared to 2001 but after that there was a continuous fall in the ratio from 2003 to 2006. It again rose in 2007. Return on sales ratio had a rise in the year 2002 compared to 2001, then it fell in 2003 but again had a slight rise in 2004. But after that throughout 2005 to 2007 there was high fall in the ratio.
Asset turnover ratio highly fluctuated with rise and fall but the changes were very slight. Accounts receivable turnover ratio increased from 2001 to 2005 but then there were significant fall in 2006 and 2007 in the ratio. The inventory turnover ratio was negative throughout. Accounts payable ratio was also negative throughout with slight changes. Fixed asset turnover ratio decreased till 2004, then rose in 2005, again fell in 2006 and then rose in 2007.
The revenue showed a growth from 2001 to 2003, but then fell in 2004 and showed constant fluctuations after that. The growth of accounts receivable were very similar to that of revenue growth.
Days sales receivable index showed constant fluctuations with simultaneous increase and decrease. Gross margin index showed increase till 2003 but then there was fluctuation with simultaneous increase and decrease. Asset margin index, depreciation index as well as sales growth index showed constant fluctuations with simultaneous increase and decrease. Gross SG&A index showed increase till 2003 but then there was fluctuation with simultaneous increase and decrease.
The M score of the company showed constant fluctuation and twice it went below the threshold point of -2.22 in the year 2001 with the score -3.08 and in 2003 with the score XXXXXXXXXXBut in the recent years the score was within the threshold limit.
) AUDITING IMPLICATIONS FROM THE RATIO ANALYSIS
The M score of the company is at alarming stage. For two years the rate was higher than the threshold limit indicating manipulation in the financial statement. Even in the last two years, the score is close to the limit that is -1.95 in 2006 and -1.91 in 2007. Audit should be done carefully to identify if there is any scope of fraud in the financial statement. Vouching and verification of the records, slips and documents can be done to check if the figures stated in the financial statement are right. External confirmation can be taken from debtors, creditors and other vendors to tally the figures.
There are also high fluctuations among all of the fraud prediction ratios. The reason for such fluctuation needs to be checked and it is to be seen if there is any fraud present in the company. The access of each of the employees to the financial statement of the company is to be checked to identify if any alternations can be made. Internal control system of the company needs to be checked to find out the possibility of the existence of fraud.
c) OTHER IMPLICATIONS FROM THE RATIO ANALYSIS
The inventory turnover ratio is negative in every year. Negative inventory turnover shows that the company is selling more goods than in inventory and this might pose a problem for the company in the long term. So, the company should try to make this ratio positive.
The