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The present report is based on understanding the audit failure of ABC Learning. The company expanded in such an exponential manner over the span of twenty years that it appeared very spectacular (Vovchenko et al. 2017). Nevertheless the main reason for conducting the research is because of the several internal audit failure inside the company ultimately contributed to the massive fall of the massive organization. The report will recognize the key audit themes and the key audit matter recognized in context of the ABC Learning.
The later part of the report would assess the ratio analysis to summarize the key findings gained from the numerical figures reported by the ABC Learning. The ratio analysis will be linked with the key audit themes that will be identified in the literature review. Furthermore, a risk assessment will be conducted as well to focus on the audit areas. Conclusively, the report will summarize the central points and would also restate the major view point gathered from the report.
ABC Learning Centres was one time hailed as the major public listed child-care company in the world. During the financial year of 2004-2005, ABC Learning reported the net income of $52.3 million from the total revenues of $292.7 million. Initially ABC Learning was considered very money-making company (Newton et al. 2015). In the subsequent six months ending 31 December 2005 the business reported the profit reaching to $38 million and revenues of $219.8 million. By the conclusion of 2006, ABC Learning was dealing on the market share of $8.80. Nevertheless, within the span of two years the shares of ABC Learning worth $0.54 and the corporation was given to the administrators.
Manipulation of books of accounts and lack of transparency was one of the factors that added to the downfall of ABC Learning. Without any doubt it can be stated that there were important defects in the accounting bookkeeping of the business and it was not maintained in a right manner. The books of accounts had numerous discrepancies in the sales, incomes and numerical records that were stated in the company accounts books (Chen et al. 2014). Several assets were written off and before tax incomes were not conclusive. At the time of handing over the company to the administrator in the course of its bankruptcy period, the new auditors Earnest & Young educated the investors that the financial records of the ABC Learning were extremely manipulated and the financial statement would be required to be re-established.
During the year 2005 and 2006, ABC Learning divided the profits of its redeemable convertible preference shares and redeemable convertible reset note issued among the debt and constituents of equity. Though, from the perspective of moneylender both the issues have resulted in obligatory debt service requirements. With respect to the analysis, 100% of the profits were considered as debt (Lisic et al. 2016). With regard to the fixed type of the operational lease requirements to the landlords of ABC, the entire amount of outstanding within the operating leases were considered as debt, while the conforming assets were considered as fixed assets.
Lastly, the effects of acquisition relating to assets and liabilities were detached from the cash flow statement, to ascertain the amount of ABC’s own cash flow producing ability without any of those effects. Besides these restatements, the numbers in the financial statement were considered based on the face value (Alzeban and Gwilliam 2014). There are no such evidences gained from yearly statements and financial examination that ABC Learning was engaged in the deliberate manipulation of books of accounts. Commentaries in the financial media have stated that ABC Learning gross revenue might have been exaggerated by including the developer returns in the company revenues.
During the year 2005, the accounting notes have disclosed on sale of assets and investment which were included within the gross proceeds. The notes to financial statement have disclosed that goodwill upon merging is progressively removed by lowering the carrying amount and once the discount goes past zero, any residual balance is considered as revenue.
Apart from the above stated literature, the company also had transactions that were related to the liquidated damages with more than 123 international group of corporations. ABC Learning would have had 123 global buy land, build centres, running them until the occupancy rates were at adequate level and then it would ultimately purchase the centres at the higher price from 123 international group (Knechel and Salterio 2016). The liquidated damages represents the monetary payment that is paid by the clients given they have failed to carry-out the contract or there are contractual breaches based on the stipulation of contract.
In addition to this, the business processes of ABC Learning was not at all clear either as well (Duncan and Whittington 2014). The business operations was not very well devised and it was also not cleared how every centres would function, what would be the amount of cost that will be related with each centres, performance of those centres and the amount of time each centres would take be commercially viable.
The findings from the ratios can be summarized. Taking into the account the operating lease on the balance sheet, the degree up to which ABC was hugely geared. The company disclosed the gearing during the year 2007 stood 1.14:1 and the restated gearing stood 2.03:1. Furthermore, the capability of the cash flow from the operations to service the debt of the company was very much substantially exaggerated. The net operating cash flow to the present liabilities including the present share of the operating lease obligations comprised of only around 30% of the current liabilities.
The return on equity of the company started deteriorating from 5.78% in 2001 to eventually stand at 1.91% in 2007 (Cohen and Simnett 2014). While the return assets represented the identical trend as the ratio reported by ABC learning in 2001 stood 3.04% while in 2007 it deteriorated to 1.12%. The declining return on asset ratio shows a deteriorating profit trend as well.
Moving on towards the gross margin index, ABC Learning gross margin for 2001 stood 53% and declined further in 2007 to stand at 19%. The lower gross margin index of ABC Learning suggest that the company has lower money to pay its operating expenditure. As this ratio measures the profitability from selling its inventory, it is also shows that the company has lower percentage of sales that can be used to fund the other parts of the business.
The ratio contributes to the understanding that there is a large increase days sales in receivables index which suggest an accelerated recognition of revenue by ABC Learning to simply inflate the profits (Chambers and Odar 2015). Furthermore the deteriorating gross margin of ABC Learning sends the negative signal regarding the company’s prospect and has created an incentive to inflate the profits.
Going further these mere figures, the ratio provides an early cautions of looming disaster. The analysis clearly says that ABC’s capability to serve its present obligation was never inspiring and represented the signs of weakening for the seven years that it was listed (William, Glover and Prawitt 2016). One might wonder whether the banks would have supported ABC so enthusiastically, the company has computed this degree of cash and operating lease rental cover.
The depreciation index also represented in 2001 a negative figure of -0.17 which declined further to -0.07 in 2007. The declining extent of depreciation comparative to its fixed assets brings forward the likelihood that ABC Learning has revised upwards the projected useful life of assets or have implemented the new method which increases the income. In addition to this, a rise in leverage of ABC Learning have paved the way to inflate the profits (Pitt 2014). The ABC Learning beneish M-Score have concluded that the score of 8.29 was very much likely that company had very likely manipulated the profits.
The capability of ABC to provide its shareholders with the positive funds was completely reliant on the company’s intangibles. The ratio analysis further explores the effect created on the shareholders fund and gearing of higher conservative valuations (Lombardi, Bloch and Vasarhelyi 2014). Obviously, depending upon how hostile view one may take on the values of intangibles, ABC may have been thought to be significantly highly geared and suggestively closer to practical insolvency in 2001.
As the part of the risk assessment procedure for ABC Learning, a detailed areas of audit has been analysed to understand the key changes in the business and the audit approach has been adopted accordingly (Knechel 2016). The key areas of focus has been summarized below and an accompanied explanation has been provided as well. The key areas of focus widely remain consistent with the previous year;
1. Infrastructure assets
2. Integrity of invoicing and collections
3. Facilities of debt
3. Core controls over the operative expenses, procurement and tendering
As noted the audit approach of ABC Learning widely remains the same as the previous year. The risk assessment seeks to test the internal controls in the key financial reports processes and hence anticipates to take controls on the basis of the approach.
Areas of audit Focus (Account / Area) |
Your Perspective (Why) |
Audit Work to be performed (Approach) |
Infrastructure Assets |
ABC Learning’s valuation of infrastructure is viewed as highly judgemental and there are certain key assumptions which the valuer should make. Judgements regarding the assets have the potential of materially effecting the valuation (Wong and Millington 2014). The assumption of useful life in valuation reports is not very reflective. |
a. For the class of assets that is revalued during the year must be reviewed for appropriateness. b. It is also necessary to assess the assets information given to the valuer is very much thoughtful of the assets data maintained. |
Integrity of invoicing and collection |
The accuracy associated to the invoicing is very much dependent on the rate of integrity database and the reliability of the billing system must assure that the rates are billed correctly. Certain types of paying customers might constitute a significant amount of collection risk. |
a. The audit would review the process of claim and control system to make sure that the funds are received and recorded appropriately in the financial statements. |
Debt facilities and derivatives |
ABC Learning access debt through funding and bank facilities. ABC Learning maintains the interest rate swaps so that it can manage the company’s exposure to the interest rate fluctuations. These swaps are carried on the basis of fair value. |
a. Reviewing the disclosure that is related with the debt and swap position held. b. Assuring that the debt position is in accordance with the company’s long term plan. |
Controls over the operating expenses, procurement and tendering |
The company’s capital work programme comprises of the significant amount of cash flow. The areas of expenses such as the training, accommodation etc. can result in opportunities for private benefits. |
a. It is necessary to undertake control testing of the payroll procedure and controls that is used by the management.] b. Reviewing the correctness of the procurement policies. |
On a conclusive note, the yearly accounts stated regarding the persistent growth in the number of centres, revenues and assets. What the company has not disclosed is regarding the material consolidation of the ABC financial position from this growth. The detailed financial analysis has evidently made it evident that the ABC Learning gearing had grew significantly, its return on sales along with the equity have declined progressively. The ratio further stated that the return to stockholders declined and the ability of the operational cash flow to serve the company’s debt deteriorated, with the unavoidable and predicable conclusion.
Undoubtedly, it is argued that the business model of ABC Learning was a flaw or it was not at all changeable into different business surroundings which the group have failed to apply reporting as well as controls to commensurate with its size. The analysis clearly says that there were a number of cautionary signals from fiscal analysis which stated that the ABC Learning financial position and financial performance were not sustainable. ABC Learning became the victim of the founders, unyielding ambition and obsession towards growth.
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