Audit Risk Report: Examining Oroton Group’s Viability

Methodology

Introduction

Oroton Group is used in this audit risk report as the case study to help investigate the viability of the Company in dealing with business risk, inherent risk and control risk. Oroton Group has had a lot of problems that have contributed to various business risk, control risk and inherent risk facing it. This forced the business to file for bankruptcy after attempts to find a rescue plan failed to get a secure trading future in Australia. Subsequently, the business was put into Voluntary Administration (VA) in November 2017 with 100 percent of its shares being transferred to Manderrah for nil consideration. Moreover, the problems facing the Group also led to its delisting from ASX in early 2018. This has since made the business to be operated as a private company. Following its fall into VA in April 2018, the Oroton Group has since been granted a new life. This followed the approval by NSW Supreme Court to transfer all ORL shares to Manderrah. This has since allowed the retailers to continue operating over fifty stores across Australia and globally.  It is against this backdrop that this paper is intended to use the risk-based auditing approach, auditing concepts, auditing standards and other information learned in the unit to present a conclusion and recommendations about Oroton Australia viability. The main areas of this research include business risk, inherent risk, control risks and other risks.    

The analysis assumes the risk-based auditing approach based on auditing concepts, Australian auditing standards to unearth the viability of Oroton Group in terms of its ability to survive the many risk affecting the business. To do this, the Group’s annual reports for the period between 2016 and 2018 were reviewed and analyzed based on such key areas as business risk, inherent risk and control risk.  The compliance with the laws, legislation and Australian auditing standards were also established.

Findings

Business Risk:

From the audit, various factors, particular to the Company have been noted to be threatening both the Group’s future financial and operating performance and the result of the investment in this firm. The Group faces various business risks including ineffective advertising to millennials who could never afford to buy their products thereby affecting their sales. A reduction in sales is a business risk and negatively affects revenue. They also kept non-profitable stores open but continue to pay high rent which brought a lot financial problems to the Group. This implies that the Group’s cost of operation increased without any material return thus accounting for the challenges the business has undergone.  The particular material business risks facing the Company, and how they are managed by the Group, are as discussed:

The Group is operated in a retail industry and depends consumer discretionary spending   and consumer sentiment. Negative changes to retail and economic environment greatly impact the firm’s financial outcome (Baatwah, Salleh & Ahmad, 2015). This risk is mitigated in the Group by being well-informed of the global economic data, consumer data, and trend in the industry inventory and expenses management aligned to alterations in the environment (Sisk, Remington & Jiang, 2018). The flexible business model of the Group as a multi-channel retailer, remains adaptive based on the market changes (Flanagin et al., 2014).

Findings

Competition and Margin Risk:

The Group is operated in an extremely competitive retail market combined with the new entrants in the market. This leads to an increase in the manufacturing costs and raw material price. These factors affect financial outcome of this Company. Oroton Australia mitigates such a risk by careful management of the intake margins, working with major long-term suppliers, as well as the managing intellectual property and brand development. The Company also monitors both price and quality closely against various retailers and brand owners to make sure it maintains its competitive position in the retail industry.

Foreign exchange Exposure:

The Company depends substantially on imported products that are primarily paid for using USD and, therefore, attracts transactional exposure. Thus, a stronger USD will have a significant impact on earnings reported. The Company will apply forward exchange contracts for the mitigation of some foreign exchange exposures. This is also aimed at decreasing certain costs for the purposes of planning based on the expected cash-flows timing. The Company has a transactional exposure since its international earning are translated into the AUD for the purposes of reporting (Griffiths, 2016). This is never a material component of business since international sales only represent approximately three percent of the sales of the Group.

The Company is operated under “Modern Retail Award” for the stores within Australia and use lease arrangements. These have inbuilt annual cost increments. Oroton is focused on the improvement of efficiencies in its operations. These include vigorous negotiations of rents on the lease expiry and active store rostering to offset part of the cost surges (Bromiley, McShane, Nair & Rustambekov, 2015). The Company manages its portfolio against the operational and financial criteria to ensure stores’ compliance. There is no guarantee that stores will be renewed at acceptable terms to the Company.  The potential effect of closing one store is mitigated by number of the stores currently operated by the firm and a strong Oroton brand presence in online platforms (Gemson & Rajan, 2017).    

Inherent Risks and Control Risk

Audit risk consideration is a financial statement audit which is discussed as a component of integrated audit. The inherent risk falls under the “risk of material misstatement which helps identify and assess risk of material misstatement and assessed by auditor at two levels: at financial statement and at assertion. The inherent and control risk thus fall under the assertion level. Inherent risk refers to the assertion susceptibility to a misstatement resulting from fraud or error which might be material, individually/in combination with the other misstatement, prior to consideration of any associated controls (ASA320 (2)). On the other hand, control risk refers to the risk that a misstatement, as a result of fraud or error that might occur in assertion and could be material, individually/in combination with other misstatement, will not be prevented or detected on a timely manner by the internal control of the company. Control risk is thus a function of the effectiveness of design as well as operations of internal control.  

Business Risk

The Group is in compliance with ASA315 when identifying and assessing risks of material misstatement because its auditors always try to understand the entity and its environment. Moreover, the Group complied with ASA315 (3) when it contracted PWC to identify and assess risk of material misstatement due to error or fraud at the assertion level. This has helped minimize the inherent risks. ASA315 has also been complied with under ASA315 (19 (a) and (b) and 20). This is because the external auditors obtained an understanding of control activities specific to audit and hence has enabled the company to ensure that inherent and control risks are mitigated. The auditing standard ASA320 has also been complied with by having auditors considering materiality in planning and performance of audit. As provided for under ASA320 (1), the auditors have correctly applied the concept of materiality to plan and perform audit.  The ASA240 is also applicable in understanding control and inherent risk as it provides for the responsibility of an auditor regarding fraud in auditing financial report.  The external auditor (PWC) complied with ASA240 (4) by conducting the audit and giving audit opinion as required to the department charged with governance of entity and management on how to prevent and detect fraud.   

According the annual report, it can be categorically stated that the company has effective control to minimize any material misstatement. This is in compliance with ASA265 which requires that deficiencies in internal control are communicated to those mandated with governance and management. As indicated by the external auditor under principle 5-make timely and balanced disclosure, the Group has an effective policy in place which state that all shareholders and investors have equal access to the information of the Group. The Company also has effective procedures to guarantee that all price sensitive information is revealed to the ASX according to disclosure requirement as provided for in Corporations Act 2001 (Cth) alongside ASX Listing Rules. Moreover, the Group is committed to provide timely, full as well as accurate disclosure of material information and avail this information publicly on its websites at www.orotongroup.com. This means that the Company is able to detect the material misstatement immediately and, hence less inherent and control risks.

According to the Certification Process undertaken by Managing Director alongside CFO and report made to the Board, it is clear that the Group’s financial statement offer a true and fair view, in all materials aspects of the Group’s financial condition alongside operating outcome as required by ASX Corporate Governance’s best practice recommendation 4.20. Also, the inherent risk and control risk have been significantly cut by having a sound system of risk management as well as internal compliance and control (Choi, Chan & Yue, 2017). The Group’s operations are in compliance with relevant laws and regulation. The risk management plan, internal compliance and control systems of Oroton Group are efficient (Dao & Pham, 2014).

The audit has also revealed that there is no effective internal audit function. As indicated by the board’s view in the annual report, a formal internal audit function is missing. The board feels it is not necessary because internal procedures and processes can be depended on to guarantee ongoing compliance obligations. However, this is not a problem as it has been mitigated by the effective focus on maintaining a firm control environment in the Consolidated Entity. Moreover, there is an organizational structure with clearly drawn accountability lines and authority delegation to mitigate the problem. Also, internal control reviews are periodically undertaken. Subsequent reporting of the outcomes to the Audit Committee remains effective (Glover & Benbasat, 2010).

Inherent Risks and Control Risk

Implication of Findings

Oroton Group Limited remains a small-cap stock with a market capitalization of A$18.26M AUD. Whereas investors mainly focus on the potential of growth and competitive landscape of small-cap firms, they end up negating a vital aspect, which might be the biggest threat to the Group’s existence: the Group’s financial health. This is important since firms operating in specialty retail industry face headwinds from existing disruption. Therefore, understanding the financial health of Oroton Group becomes vital (Bottia, Bragattob, Duraccioc, Gnoni, & Morad, 2016).

In respect to the Group’s operating cash flow stacking up against its debt, as has been seen it its report, the Group’s debt  increased by about A$7M. This is primarily composed of short-term debt. With such a ramp up in the debt, the present cash and short-term investment levels stands at A$2M, ready to be deployed into its business. The Group’s small cash flows, from the operations, make cash-to-debt ratio less valuable to us but suggest the need to improve operational efficiency (Bédard, Gonthier-Besacier & Schatt, 2014).

In respect of the Group’s liquid assets covering its short-term commitments, the company has been able to meet such commitment at the present liabilities level of A$39M liabilities with a current asset level of A$40M.  This has led to a suitable current account ratio of 1.04x (Nitsch et al., 2017).

In terms of whether the Group is facing the risk of succumbing to its debt-load, the analysis reveals that it has a debt-to-equity ratio of 37.46%. This is a prudent ratio because the range is regarded safe because the Group is never taking on too much debt obligation. This hence means that its obligation does not constrain its future growth. The risk of the investor linked to debt is, therefore, extremely low with the Group. Oroton has a potential of raise its debt in the future (Blankley, Hurtt & MacGregor, 2014).

However, as a shareholder, even if the Group’s debt level remains relatively low, the cash-flow still cannot cover its borrowings. This could suggest room for improvement based on the Group’s operating efficiency. Nevertheless, the Group exhibits the ability to meet its short-term obligations in case a negative event takes place provided the Group’s financial scenario could change (Bédard, Gonthier-Besacier & Schatt, 2014).

For a potential investor, the Group’s low-debt position provides a headroom for the future growth funding. Moreover, the Group’s high liquidity guarantees that the firm shall continue to smoothly operate should unfavorable scenario emerge (Christensen, Glover & Wolfe, 2014). Group’s track record helps gain more confidence in its stock. Thus, an investor needs to scrutinize the Group’s past performance analysis to establish for himself, whether its debt stance stays justified.

The investors must further look at and understand the meaning of the Group’s beta (statistical measure of stock volatility against overal market) before investing in Oroton Group. Analyzing its beta will make stockholders and potential investors understand how beta affects the risk of their portfolio (Bollerslev, Li & Todorov, 2016). From the analysis, two types of risk afffect the market value of the Group. The first one is the company-specific. This can be diversified away by the investment in other firms to lower the investor’s exposure to a single stock. The second type of risk that can never be diversified away, is the market risk. Each stock in market is exposed to market risk that emerges from the microeconomic factors like economic growth as well as geo-political tussles (Giannakis & Papadopoulos, 2016).

It must be noted that stocks are exposed to different market risk level. A broadly-used metric in measuring the market risk of a stock is beta while the brand index denotes a beta value of one (Sultana, Singh & Van der Zahn, 2015). Thus, a stock with a beta value more than one is anticipated to exhibit a higher volatility arising from the market-wide shocks as opposed to one with a less than one beta.

The five-year beta of Oroton group is 0.31. This means that the Group seems to be less volatile compared to the competitors in the market (Chan & Liu, 2018). This implies that the alteration in the Group’s beta, whether positive or negative, shall be of a trivial degree than that in value of the whole stock in the market index. Depending on this beta, the Group thus seems to be a stock, which a high-beta portfolio investor, would consider to lessen risk exposure to the market.

The Group’s assets affects its beta. An asset-heavy firm tends to assume a higher beta since the risks linked with running fixed assets in the course of a downturn remains extremely expensive (Sutherland, 2017). The examination of the Group’s ratio of fixed assets to total assets gives a 30% ratio. This means that the Group seems to invest a huge chunk of its capital on the assets which can never be scaled down unless there is a long notice (Flanagin, Metzger, Pure, Markov & Hartsell, 2014). Therefore, it is expected that the Group will be more volatile in presence of market movements, relative to its rivals of identical size, but with a lower fixed assets proportions in their books. This revelation is a contradiction of the Group’s present beta value that shows a below-average volatility (Akingunola, Soyemi & Okunuga, 2018).

Conclusion

The above revelation implies that one can benefit from lower risk in the face of economic plunge by holding onto the ORL. Consider one’s portfolio sensitivity to the market prior to investing in a stock, and current economic cycle, ORL might stay a valuable stock to hold onto to cushion the downturn’s impact. The Group remains viable and effective in terms of how it mitigate its business risk, inherent risk and control risk. It is established that Oroton Group has effective internal control measures to deal with the risk associated with its operations.

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