PwC

1. Credit Crunch? – Audit Implications May 2009 PwC

2. Credit Crunch? – Audit implications • Current economic conditions require significant changes or review of approach to financial statements audit Credit Crunch? – Audit Implications

3. Why? • Because economic conditions impact on all entities but the degree depends on factors such as: • Nature of the entity and industry eg discretionary expenditure • An entities financing arrangements eg ability to obtain financing/ability to provide financing • Extent of exposure to financial instruments – eg investments in asset-backed commercial paper/CDO’s etc • Extent of accounting estimates – especially fair value measurements • Extent of exposure to property assets whose value may be impaired • Impact of customers/suppliers on an entities ability to continue as a going concern Credit Crunch? – Audit Implications

4. Long period of economic growth: • Risks arise that now need to be considered in greater detail than the past • Focus on: • Planning • Audit Risks • Accounts Disclosures • Relevant to financial institutions as well as auditors Credit Crunch? – Audit Implications

5. PlanningConsiderations: • Continuance of the relationship • Integrity of those charged with governance eg pressure • Change in risk profile of entity • Communicating with management and those charged with governance – issues to consider • Has the AC considered new risks, change in existing risks • Re-confirm reporting and internal control systems in place and functioning • Any doubt about a going concern – has the AC and management considered – increased liquidity risk, rigour of managements and AC assessment, disclosure Credit Crunch? – Audit Implications

6. PlanningConsiderations: • Judgements around asset values – analysis and supporting documentation, new accounting standards, disclosures, is AC aware? • Fraud risk eg compensation schemes, tone at the top etc • Going concern assumption • Management responsibility • Auditor needs to consider appropriateness of managements view • At least 12 months from date of signing • Past profitability and availability of finance may not be suitable as assumption • Have management documented their assumption • Considerations discussed in more detail later Credit Crunch? – Audit Implications

7. PlanningConsiderations: • Audit strategy • Resources for the audit: • Experience of staff • Extent of partner involvement • Use of experts – eg valuers • Other experts - eg fair value measurements, asset impairments, deferred tax asset carrying amounts, super fund measurements, • Quality review partners Credit Crunch? – Audit Implications

8. PlanningConsiderations: • Materiality • Net profit may be much lower compared to previous materiality assessments • Consider break even situations • Past materiality misstatements in opening balances may need to be considered • Users expectations may differ from prior periods • Other factors – eg turn a profit to loss and vice versa • Potential effect on misstatement on debt covenants, regulatory requirements contractual agreements • Effect on disclosures • Management’s motivation Credit Crunch? – Audit Implications

9. PlanningConsiderations: • Timing of audit procedures • Risk assessment in areas may be upgraded resulting in a change in the nature, timing and extent of substantive procedures Credit Crunch? – Audit Implications

10. Audit Risk • The risk that an inappropriate opinion will be issued • Risk of material misstatement of a financial report • The nature and extent of risk will vary – depends on: • Industry conditions • Regulatory environment • Exposure to volatility in markets • Going concern • Constraints on capital, credit and liquidity • Complexity of accounting measurements eg financial instruments • Uncertainty of accounting measurements eg fair value measurements, accounting estimates • Non-financial asset value declines Credit Crunch? – Audit Implications

11. Audit Risk • Restructurings • Changes in control environment eg fewer people, less experienced people, management focus, process changes • Risk of management bias and override • Fraud considerations eg • pressure on management to achieve outcomes • Reduced staff resources – increased opportunity for fraud • Management override of controls Credit Crunch? – Audit Implications

12. Responding to audit risks • Emphasise need for audit teams to maintain scepticism – notwithstanding past experience • Fair value measurements and accounting estimates represent significant area of increased risk of material misstatement • Eg include • Fair value of financial assets • Impairment calculations for financial instruments, accounts and loans receivable, goodwill, other intangibles, property assets • Audit focus on evaluation of assumptions and data used in fair value measurements and accounting estimates • Consider ASA 545 Auditing Fair Value Measurements and Disclosures • Significant assumptions – relevant and provide a reasonable basis for fair value measurements and disclosures Credit Crunch? – Audit Implications

13. Responding to audit risks • Not to form an opinion on assumption themselves but a reasonable basis • Identify assumptions that require management judgement – eg incorrect application or bias • Evaluate data on which fair value calculation based for completeness, accuracy, validity • Consider ASA 540 Auditing Accounting Estimates • Need to understand procedures, methods and controls in developing estimates • Review and test the procedures and methods and controls • Review subsequent events as a basis for the reasonableness of the estimate Credit Crunch? – Audit Implications

14. Responding to audit risks • Impairment of assets • Is ASIC’s number one issue – testing for impairment and models used are based on up to date assumptions • Need to consider impairment indicators – standard gives examples • When using models: • Consider discount rate – don’t just use a lower discount rate because of lower cash rates – offset by increased risk of the asset • Consider growth rates built into cash flow estimates – need to reflect current conditions • Models can’t include expenditure to enhance assets • Cross-check data with external data where available Credit Crunch? – Audit Implications

15. Responding to audit risks • Receivables • Increased risk of doubtful collection • Consider indicators such as ageing deterioration, overdues, subsequent receipts • Loan Impairment • Objective evidence required • Beware of past history • Decline in financial position of borrower • Not meeting requirements • Debt covenants, employment Credit Crunch? – Audit Implications

16. Responding to audit risks • Goodwill and intangibles (indefinite useful life) • Impairment test required between annual impairment tests if indication that recoverable amount of CGU has declined below carrying value • Lower estimated cash flows – growth rates etc • Management difficulty/bias etc • Deferred tax assets • Consider whether (for first time?) DTA’s recoverable • Need to estimate whether sufficient operating profits generated for future taxable income • Recovery not based on “all or nothing” decisions and not an arbitrary time frame Credit Crunch? – Audit Implications

17. Responding to audit risks • Restructuring provisions • Costs can be included when directly attributable to redundancies, terminating leases, onerous contracts • Can’t include relocation and retraining costs and future losses • Going concern • Examples of conditions that could cost significant doubt over going concern assumption • Fixed loan borrowings, approaching maturing with no realistic prospects for renewal • Excessive reliance on short term borrowings to fund LT assets • Withdrawal of support by financiers • Adverse key ratios • Inability to comply with loan agreements/covenants Credit Crunch? – Audit Implications

18. Responding to audit risks • Review management future plans based on going concern assumption • Cash flow analysis • Check assumption in budgets etc • Valid/realistic in current environment • Subsequent events • Be aware – changes in commitments, borrowings, guarantees etc • Events impacting recorded asset values • Change in capital, debt arrangements Credit Crunch? – Audit Implications

19. Disclosures • Need to give increased focus to disclosures in current environment • Disclosures to consider: • AASB 101 paragraph 116 – key sources of estimation uncertainty; • AASB 101 paragraph 113 – significant accounting judgements; • AASB 7 paragraph 10 – the amount of any change in the fair value of a financial liability attributable to movements in the credit risk of that liability; • AASB 7 paragraph 27 – methods and assumptions used to determine fair value; effect of reasonably possible changes in assumptions where valuation techniques are used not supported by observable market data; • AASB 7 paragraph 33 – qualitative disclosures in risk of exposure to risk (including credit and liquidity risk), policies for managing risks and methods used to measure risk; Credit Crunch? – Audit Implications

20. Disclosures • AASB 7 paragraph 34 – summary quantitative disclosures about exposure to risk (including credit and liquidity risk), including concentrations of risks; • AASB 7 paragraph 36 to 38 – credit risk disclosures, including the maximum credit risk exposure from loan commitments and guarantees [AASB 7 paragraph 36(a)] • AASB 7 paragraph 39 – liquidity risk disclosures, including how management manages the liquidity risk arising from the repayment of liabilities and any changes to their liquidity policy; and • AASB 7 paragraph 40 to 42 – market risk disclosures, including what is regarded as a reasonably possible change in a risk variable under paragraph 40(a) of AASB 7 given current market events. • AASB 136 paragraph 134 and 135 – extensive disclosures on possible impairment of non-financial assets • Subsequent events Credit Crunch? – Audit Implications

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