Auditing is considered as the process to inspect and examine the financial statements of the companies with the aim to makes sure that they are free from material misstatements (Persellin, Schmidt & Wilkins, 2014). At the time to search for the material misstatements in the financial statements, the need for the auditors is to carefully examine as well as inspect the inherent business risks of the companies due to the fact that they can lead to material misstatements in the financial statements. For this reason, the auditors are needed to ensure the examination of the balances of the doubtful accounts along with the underlying assumptions associated with them with the aim to identify the material impact of them on the company’s financial results (Tritschler, 2013). This report undertakes the analysis of the areas of business of A2 Milk Ltd with inherent risks that can lead to the material misstatements in the company’s financial statements. After that, this report involves in the identification of the major areas with the risk of material misstatements in the financial statements.
A2 Milk Ltd is considered as a major Australian companies and the name of the company can be found in ASX. The company was established in the year of 2000 and it is headquartered at Sydney, Australia (thea2milkcompany.com, 2019). The main business operation of A2 Milk Ltd can be seen in commercializing the intellectual property associated with A2 Milk and other products in the same category. It needs to be mentioned that the products of A2 Milk Ltd are available in the six large supermarkets of Australia. A2 Milk Ltd has a market share of 10 per cent in terms of the grocer value products (thea2milkcompany.com, 2019). In the year 2013, a2 Platinum was launched by A2 Milk Ltd and this particular product of the company has become the chief infant formula brand in Australia in the presence of the market share of 32 per cent (thea2milkcompany.com, 2019). After that, in the year 2018, A2 Milk Ltd has ensured huge amount for the development of all of their products; at the same time, the company has also increased their investment for the purpose of advertising of their products in both of the categories of infant formula as well as fresh milk in the Australian market. In addition, A2 Milk Ltd has been able in registering strong growth for their new product called a2 Platinum Premium stage 4 milk drink for the juniors and others (thea2milkcompany.com, 2019).
A2 Milk Ltd has their business operations in the food processing industry of Australia. This particular Australian industry has been a standout performer in Australia when the manufacturing industry of Australia has registered low growth in the same period. $25 billion is the contribution of this industry to the Australian economy (deloitte.com, 2019). The average growth rate of the food processing industry of Australia over the last ten years is 8.5 per cent and the forecast states that this growth will be continued in this industry in the presence of increased demand for the health products, natural food, and safety of foods along with the major growth in the middle class families in Asia. The major growth of the business of A2 Milk Ltd is one major contributor towards the growth of this industry (deloitte.com, 2019).
The following discussion shows the four areas of business risk of A2 Milk Ltd that the company is exposed to:
Risk of Fair Value Measurement: The risk related to the fair value measurement of A2 Milk Ltd is a major inherent risk that the company is exposed to (Cannon & Bedard, 2016). The development of this specific inherent risk can be seen due to the presence of any kind of mistake or error in the process to estimate the fair value of the assets along with the other financial instruments. The management of A2 Milk Ltd uses three specific steps to measure the fair value (thea2milkcompany.com, 2019).
Liquidity Risk: Another major inherent risk of A2 Milk Ltd is the liquidity risk as the development of this risk can be seen in the presence of the inability of the company to meet their business obligations (thea2milkcompany.com, 2019). The management of A2 Milk Ltd handles this risk by ensuring the presence of a target minimum level of liquidity along with appropriately manage the present business commitments by considering the predicted cash inflows. The presence of a cash reserve can be seen in the company to fulfill the present business commitments (García Blandón & Argilés Bosch, 2013).
Market Risk: Another crucial inherent risk of the business operation of A2 Milk Ltd is the market risk and the presence of this risk affects the income as well as value of financial instruments of A2 Milk Ltd with the change in market price (thea2milkcompany.com, 2019). A2 Milk Ltd faces this risk because of the nature of their business activities as there is change in the foreign currency exchange rate. After that, certain investments of the company also faces this risk (Griffiths, 2016). Thus, the management of A2 Milk Ltd ensures the ongoing basis management of this particular risk.
Customer Credit Risk: Customer credit risk is one of the major inherent risk faced by A2 Milk Ltd and the development of this risk largely depends on the customer characteristics of the company (thea2milkcompany.com, 2019). Top retailers of Australia accounts for the majority of the sales of the company where the company examines the retailer’s credit worthiness and level of default; and the rest of the sales is made on cash basis. For this reason, A2 Milk Ltd ensures the examination and evaluation of the credit worthiness of the new clients with the help of examining past credit record, past trading experience, financial position and others (Groomer & Murthy, 2018).
It needs to be mentioned that the areas of inherent risks can lead to material misstatements in the financial statements of A2 Milk Ltd and they are discussed below:
First Risk: This particular risk occurs in the presence of any dispute in the fair value measurement process of A2 Milk Ltd. 2018 Annual Report of A2 Milk Ltd indicates towards the presence of listed investments worth $186,862 that have been measured based on fair value (thea2milkcompany.com, 2019). There can be the development of major amount of the risk of material misstatements in case the responsible personnel makes any mistake or error while using the methods and applying the assumptions for measuring the fair value of these investments (Lobo & Zhao, 2013). For this risk, the assertion of valuation is at risk as this assertion puts the obligation on the companies to ensure the correct valuation of assets, liabilities and equity in the financial statements.
Second Risk: The ability of A2 Milk Ltd to repay the obligation leads to the liquidity risk. 2018 Annual Report of the company indicates that $166,749 is the total current liabilities of A2 Milk Ltd in 2018 (thea2milkcompany.com, 2019). In case the company fails in the payment of these current liabilities or the majority potion of this current inabilities, there can be creation of the risk of material misstatements in the company’s financial statements. In this scenario, the assertion of existence is at the risk as this assertion denotes that the values of assets, liabilities and equity have their existence in the company’s financial statements (Ettredge, Fuerherm & Li, 2014).
Third Risk: A2 Milk Ltd is exposed to the market risk when the income of the company is affected with the change in the price in the market. 2018 Annual Report of A2 Milk Ltd indicates towards the fact that the total comprehensive income of the company in 2018 is $304,351 (thea2milkcompany.com, 2019). In this position, in case the value of the currency decreases in the market, it will lead to the decrease in the total comprehensive income of the company; hence, there will be the creation in material misstatements in the income statements of A2 Milk Ltd due to the presence of these aspects. In this case, the relevant assertion of completeness is at the risk which denotes that the company has recognized the recorded transactions in the relevant financial statements (Knechel & Salterio, 2016).
Fourth Risk: The occurrence of customer credit risk largely depends on the characteristics of the customers. As per the 2018 Annual Report of A2 Milk Ltd, three specific customers were accountable for the 36 per cent sales of the company that is $332,047 (36% × $922,354 Sales of 2018) (thea2milkcompany.com, 2019). As the majority portion of the sales of the company is made on credit basis, the company is yet to receive this amount from these three customers. In this situation, there can be the development of material misstatements in the income statement in case these customers fails in their due payment in time. Thus, the assertion of occurrence is at risk which denotes the occurrence of the transactions recorded in the financial statements (Lennox & Li, 2014).
The presence of certain more areas can be seen that can lead to material misstatements in the financial statements of A2 Milk Ltd and they are discussed below:
First Risk: Valuation of inventory in A2 Milk Ltd can create material misstatements in the company’s balance sheet. 2018 Annual Report of the company indicates that $64,101 is the amount of inventory in 2018 (thea2milkcompany.com, 2019). After that, the management of A2 Milk Ltd has used certain key estimates and accounting judgments for inventory valuation; and the predictable future inventory turnover and for sale along with the predicted future selling price is included in this valuation. Thus, the presence of material misstatements can be there due to the use of these complex judgments as well as estimates. Thus, the assertions of valuation and existence can be considered at risk as they denote the correct valuation and existence of the assets and liabilities in the financial statements (Johnstone, Gramling & Rittenberg, 2013).
Second Risk: After that, the presence of rebate and customer discount from the sale of A2 Milk Ltd can lead to material misstatements. In A2 Milk Ltd, at the time of the transfer of the reward and risk to the buyers, revenue is recognized at net of trade discount and rebates to the customers. $922,354 is the sales from the customers of A2 Milk Ltd in 2018 (thea2milkcompany.com, 2019). Thus, the presence of this difficult arrangement around trade discount and rebates can lead to the material misstatements in the income statement. The assertions of occurrence and completes are at risk (DeFond, Lim & Zang, 2015).
Third Risk: Lastly, the impairment testing and charging mechanism of A2 Milk Ltd can contribute towards the development of material misstatements. 2018 Annual Report of A2 Milk Ltd indicates that $10,209 is the cost-generating unit of goodwill for impairment (thea2milkcompany.com, 2019). The management of A2 Milk Ltd has used certain accounting judgments as well as key accounting assumptions for the purpose of impairment calculation such as rate of growth, discount rate and others. There can be material misstatements in the financial statements of A2 Milk Ltd as the management has used these complex assumptions and estimates (Mostafa Mohamed & Hussien Habib, 2013). Thus, the assertion of valuation can be considered at the risk in this case.
Conclusion
One significant aspect that can be observed from the above discussion is that it is necessary for the auditors of the companies to mandatorily analyze and evaluate the business risk areas in the presence of the fact that these inherent business risks can create material misstatements in the financial reports of the firms. As per the above discussion, the major inherent business risks of A2 Milk Ltd are risk associated with fair value measurement, market risk, liquidity risk and customer credit risk. It can also be seen from the above discussion that these inherent risks can be developed in material misstatements in financial statements in the presence of complex business arrangements, use of difficult accounting estimates, judgments and others. For this reason, it is needed for the auditors to consider these risks in their audit programs.
References
Cannon, N. H., & Bedard, J. C. (2016). Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), 81-114.
DeFond, M. L., Lim, C. Y., & Zang, Y. (2015). Client conservatism and auditor-client contracting. The Accounting Review, 91(1), 69-98.
Ettredge, M., Fuerherm, E. E., & Li, C. (2014). Fee pressure and audit quality. Accounting, Organizations and Society, 39(4), 247-263.
García Blandón, J., & Argilés Bosch, J. M. (2013). Audit tenure and audit Qualifications in a low litigation risk setting: An analysis of the Spanish market. Estudios de Economía, 40(2), 133-156.
Griffiths, P. (2016). Risk-based auditing. Routledge.
Groomer, S. M., & Murthy, U. S. (2018). Continuous auditing of database applications: An embedded audit module approach. In Continuous Auditing: Theory and Application (pp. 105-124). Emerald Publishing Limited.
Johnstone, K., Gramling, A., & Rittenberg, L. E. (2013). Auditing: a risk-based approach to conducting a quality audit. Cengage learning.
Knechel, W. R., & Salterio, S. E. (2016). Auditing: Assurance and risk. Routledge.
Lennox, C., & Li, B. (2014). Accounting misstatements following lawsuits against auditors. Journal of Accounting and Economics, 57(1), 58-75.
Lobo, G. J., & Zhao, Y. (2013). Relation between audit effort and financial report misstatements: Evidence from quarterly and annual restatements. The Accounting Review, 88(4), 1385-1412.
Mostafa Mohamed, D., & Hussien Habib, M. (2013). Auditor independence, audit quality and the mandatory auditor rotation in Egypt. Education, Business and Society: Contemporary Middle Eastern Issues, 6(2), 116-144.
Our businesses – The a2 Milk Company. (2019). The a2 Milk Company. Retrieved 22 January 2019, from https://thea2milkcompany.com/about-us/our-businesses/
Persellin, J., Schmidt, J., & Wilkins, M. S. (2014). Auditor perceptions of audit workloads, audit quality, and the auditing profession.
The two-speed food processing industry in Australia | Deloitte Australia | Consumer & Industrial Products, Agribusiness. (2019). Deloitte Australia. Retrieved 22 January 2019, from https://www2.deloitte.com/au/en/pages/consumer-industrial-products/articles/two-speed-food-processing-industry.html
Thea2milkcompany.com. (2019). 2018 Annual Report. Retrieved 22 January 2019, from https://thea2milkcompany.com/wp-content/uploads/A2M-Annual-Report-FY18.pdf
Tritschler, J. (2013). Audit quality: Association between published reporting errors and audit firm characteristics. Springer Science & Business Media.
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