E-Business is the modern day equivalent of the industrial revolution -
and it is drastically changing almost every industry. If your client is
not already engaged in e‑business, it will be affected by the emerging
potential competitors!
Impact
of e-business on clients and the importance
of understanding clients’ businesses:
More than ever, for all e-businesses, it is critical that we truly
understand the client’s business and how the business is organized to
deliver the desired / planned results. a thorough, detailed
understanding of the client’s business objectives and strategy, the
associated business risks and how the client is responding to those
risks is of paramount importance . This, together with an understanding
of the accounting and auditing issues arising as a result of the changes
in client’s businesses, resulting from the impact of pervasive new
technologies and innovative business models, forms the basis to develop
an appropriate audit response.
Understanding
client’s business is not new as a concept; our audit approach has always
been built around an understanding of our clients’ businesses. In an
e‑business environment this understanding becomes essential in order to
be able to make a proper risk assessment and develop our audit
response. The stakes are raised because traditional approaches based
around understanding financial components may no longer be effective as
business models become more complex and physical assets and working
capital can become less significant.
The following
guidance seeks to provide some insight as to what we mean by
understanding the client’s business in this context and the sort of
questions we should be asking to obtain this understanding.
What is meant by understanding our client’s business?
If this is not a new
concept, but at the same time is critical to developing an appropriate
audit response, it is helpful to consider just what we mean by
“understanding the client’s business” and what questions we might be
asking to help achieve that.
In simple terms what
we are trying to obtain is an understanding of:
·
What
the business is trying to achieve and the economics of the business
model;
·
How the
business is structured – from technological, contractual and operational
perspectives – to achieve these aims;
·
How are
management measuring, monitoring and controlling the actual results
achieved and ensuring the accuracy of the information they use.
The
need for industry and specialist expertise
It is important to
have the necessary skills within the team to be able to understand and
determine the impact of new electronic delivery channels, new means of
interaction with suppliers and other impacts of moving to an e-business
environment. Whether caused by changing business models or the
technology itself, the appropriate industry and technical knowledge must
be brought to bear.
However, the need for
relevant industry expertise is also of primary importance –
understanding how that industry operates and familiarity with the issues
in that industry. Most e-businesses have derived from more traditional
business models and so knowledge of the business, accounting and
auditing issues of those industries is an important starting point to
understanding the business and issues faced as these businesses transfer
to the e‑business world and new business models evolve.
Apnaloan.com for example:
An internet
based finance lender is still basically a financial services company.
It will be regulated as a finance company; most of the business and
accounting issues it will face will be those of a finance company.
There may well be some unique technology-based, contractual and
security considerations because of the chosen sales channel which are
important to understand, but the primary expertise needed to
understand and audit such a company will be those of a team whose
specialism is in finance companies. This team will either need to
develop or bring in the relevant specialist skills relating to the
proper understanding of the issues, including the technology specific
issues, surrounding the new delivery channel, but the industry
knowledge will be primary.
There are situations
in which determining the most relevant industry expertise is more
difficult. This will likely occur in many e-business models, such as the
Internet portals (e.g. Yahoo.com) or auction sites (e.g. ebay.com)etc. -
often referred to as “dot.com” businesses. These “dot.coms” have
developed internet-based business models which have no direct comparison
in the non-e-business world and may derive their income from many
different sources.
The changing methods
of transacting business and particularly the immediate global reach
enabled by e-business is leading to some very wide reaching issues for
many companies engaged in e-commerce. This is necessarily leading to an
increased focus on the tax, legal and regulatory issues (including
privacy, tax residence, conduct of business etc.) arising from
businesses operating over the internet and which will require new types
of expertise to be available and deployed in audits.
Subtle changes in
business structures and contractual arrangements can have drastic
changes on accounting results. If the business model is not properly
understood upfront, and the accounting implications fully considered,
this could, for example, very easily lead to a restatement of revenue
and cost of sales to a net presentation instead of gross (which could be
a very material difference to each). Since the market valuations of many
internet companies are based on gross revenues rather than profits, this
could have significant implications for the company's market valuation
and is the kind of issue which needs to be addressed early on in our
engagement, not just as a reporting matter as we conclude the audit.
How comprehensive
does our understanding of our client’s business need to be?
What we are
seeking to achieve is not a minutely detailed, exhaustive description of
the technology and software configurations utilized by the client in
lengthy unpenetrable systems notes but a concise and clear understanding
of the business model and how the business is structured to deliver that
model.
Remember we are
trying to address the following questions:
·
what
the business is trying to achieve and the economics of the business
model
·
how the
business is structured – from technological, contractual and operational
perspectives – to achieve these aims in sufficient detail that we can
assess the specific risks for our audit arising from the business
Aspects
to be considered when seeking an understanding of the client’s business
Increased focus on
understanding the economics of the business model
Increased focus on viability - new types of business model can make it
more difficult to assess:
·
impairment considerations become more complex (e.g. goodwill,
capitalised R&D, fixed assets)
·
unique considerations for e-business start-ups and entities in growth
phase
·
going concern considerations are complex – sustainability of service,
customers can disappear quicker than they were generated,
never-made-a-profit companies betting on future revenue streams
Increased
need to be able to penetrate contracts and understand contract
administration processes
·
variable terms of trade possible
·
what constitutes a contract in an electronic environment?
·
how does management control contractual risk and administer contracts?
·
what constitutes reliable documentation/evidence for legal/tax purposes
and for auditors?
·
what are the accounting and reporting implications of contractual
relationships and terms?
·
how do complex contractual arrangements need to be unbundled for
accounting purposes?
Issues surrounding
outsourcing and alliances
May be increased reliance on outsourcing, other service providers and
alliances
·
business not confined to legal entities – how does this impact our audit
scope
·
difficulties over determining effective control for consolidation
·
dependence on contracts to determine results attributable to company
Importance of cash
flows and new metrics
Increased need to understand how cash flows derive from operations
(balance sheet may be less important)
·
analyzing and understanding the implications of cash flows varying from
expectations is essential
·
working capital models may change dramatically as receiveables relate to
credit card sales or inventory is pushed back to suppliers.
Need to focus on and understand the metrics relevant to the client’s new
business model and understand how these relate to industry trends and
norms.
Increased reliance on
controls
Most e-businesses are based upon automated and/or high volume
transactions. This means that clients will need processes to get things
right first time which in turn will mean an increased reliance on
process design and operation of preventative controls by management
·
new/greater opportunities for auditors to add value (both through
process improvement advice and through assurance on process operation)
·
clients might expect us to rely on controls in audits
·
traditional audit approaches may not be practicable because of changes
in the way processes are controlled and difficulties in obtaining direct
evidence for transactions
Tax and Legal Issues
·
unique tax, regulatory or legal exposures may exist due to unique
business models not yet challenged by the taxing, regulatory and legal
authorities.
·
legal enforceability of electronic documents (e.g. electronic contracts,
signatures, etc.) varies by geography and is evolving
·
privacy issues exist with respect to sharing of customer data (e.g. web
activity, personal profiles, etc.) and are governed by varying data
protection acts in different jurisdictions.
·
consultation with relative taxation, regulatory and legal expertise
becomes critical for entities conducting e-business in multiple
jurisdictions.
Accounting issues
·
major issues have developed due to practices which have become more
prominent because of e‑business. Many of these accounting issues are
fundamental to the way the market values companies
·
many areas are very judgmental or evolving
·
new business models increase difficulties with revenue and cost
recognition;
·
significant issues regarding gross versus net presentation for many
transactions or whole revenue streams and on which line costs are
reported;
·
increasing use of barter, cash floats and free services for customers;
·
distinguishing between commitments and liabilities;
·
distinguishing between principal and agent when value chain is
disaggregated.
Audit
Evidence
When a
company conducts e-business, many of the documents we consider “audit
evidence” such as invoices, purchase orders, shipping documents, etc.
become electronic. Electronic evidence is inherently riskier than
manual evidence because it is more susceptible to manipulation and it is
more difficult to understand and verify its source. In certain
circumstances when evidential matter is in electronic form, it may not
be practical or possible to reduce audit risk to an acceptable level by
only performing substantive tests. In these circumstances, the audit
teams would have no alternative but to perform tests of controls
(although this likely to be the most efficient strategy to adopt in any
event).
Another
consideration of electronic evidence is the client’s document retention
policy. Electronic documents may not be retrievable after a specified
period. Accordingly, the period during which electronic evidential
matter will be in existence or available should be considered in
determining the nature, timing and extent of the auditor's substantive
tests.
Generally speaking,
the risks resulting from companies conducting e-business are not
conceptually different than traditional business risks – they just
surface in different ways. The audit risk factors identified in the
below table can be generally categorized into the following groups:
¨
Clients’ new business models and the processes and controls surrounding
them
¨
The
implication of changing processes and business models on accounting
policies and procedures
¨
Increased importance of contractual arrangements
¨
Changing nature of evidential matter
¨
Heightened security risk (e.g. that products can be stolen or data can
be manipulated)
¨
Increased reliance on outsourcing and other alliances
|
Business Attribute |
Possible Audit Risk - Points of Focus |
Revenue and Accounts Receivable |
|
·
The
organization accepts orders for goods or services electronically.
|
·
The
interface (manual or electronic) between the website (or other form of
electronic data capture) and the fulfilment / back-office systems may
not transfer data between systems accurately.
·
There
will likely be new processes and surrounding controls applicable to
the new electronic channel that may have an implication on the audit
strategy.
·
It is
critical to understand the contractual relationships between the
parties.
·
Transaction records may become largely electronic and hence direct
audit evidence may be less verifiable.
·
There
will likely be new controls which govern how contractual arrangements
are adhered to (e.g. what type of evidence is required for a valid
order to be placed – email, fax, etc.)
·
There
will likely be conditions impacting the timing of revenue recognition
(i.e. cut-off).
·
There
are unique and complex accounting issues surrounding whether revenue
and certain expenses should be recognised on a gross or net basis
(principal vs. agent issue). See relevant national accounting guidance
for details.
·
The
risk of pervasive pricing errors is increased (e.g. Rs.3.33 vs.
Rs.333.00).
·
If the
online determination of product availability does not function
accurately, this could result in increased charge-backs, returns, etc.
(e.g. if a customer orders – and is charged for – 5 units, but the
company only has available and delivers 3 units, this could result in
concessions or order cancellation).
·
If the
company does not have a process to identify the geographical location
of the customer, there could be errors in the sales tax charged.
·
There
may be new fulfilment processes in place at the company – specific to
the online activity.
|
Revenue and Accounts Receivable (continued) |
2.
|
·
Customer accounts are settled online at the time of the transaction
(e.g. with credit cards or otherwise). |
·
If the
credit-card authorisation/validation is not performed prior to
shipment of goods (or construction of custom goods), there will be an
increased risk of fraud loss (i.e. if goods are shipped or produced
and subsequently the credit card is not authorised). The controls
surrounding this process are key.
·
The
reserve for credit-card charge-backs (e.g. customer disputes) and
fraudulent charges will likely become more significant than for the
company’s sales through traditional channels.
·
There
may be new payment mechanisms in place (e.g. financial intermediaries
which take payment from the customer and remit to the selling party,
online escrow services, etc.)
|
3.
|
·
The
company accepts returns of goods purchased electronically. |
·
The
company may experience a different pattern of customer returns than
experienced in traditional channels (e.g. if customers can’t touch and
feel the product prior to purchasing).
·
The
client’s return policy will greatly impact the expected level of
returns (e.g. whether they charge a restocking fee, who pays the
return freight, etc.).
·
If the
client is unable to make a reasonable estimate of returns at the time
of the sale, it may be inappropriate to recognise revenue until return
rights elapse. |
4.
|
·
The
prices of on-line products are unable to automatically follow
promotions of the same products through traditional channels, for
example because of lack of integration between systems. |
·
If
prices do not follow other promotions, it may cause an increased rate
of sales returns based on price protection, concessions, etc. |
5.
|
·
The
company enters into sales arrangements that have continuing
obligations. |
·
There
are unique and complex accounting issues surrounding sales
arrangements that contain continuing obligations. E.g. software
revenue recognition.
|
6.
|
·
The
organization undertakes barter transactions (e.g. exchanging inventory
for advertising). |
·
Unique
and complex accounting issues exist in determining the amount and
timing of recognition of barter transactions. See relevant national
accounting guidance for details.
|
Revenue and Accounts Receivable (continued) |
7.
|
·
The
organisation uses its on-line channels to generate additional revenue
through advertising, or advertises on other web sites that are
targeted to its consumer market. |
·
Revenue generated through advertising is largely governed by
contractual relationships. These relationships will be different from
customer to customer and will require sophisticated management and
monitoring. Slight differences in contractual terms can have a
drastic impact on revenue recognition timing.
·
Certain revenue transactions (e.g. advertising) are measured by
reference to reports produced by purchased software or third parties.
If the reports can be proven inaccurate, revenue may need to be
restated.
·
Auditing the advertising measurement process, whether internally or
externally performed, will need to include procedures to understand
and test the controls
·
There
can be a potential for contingent liabilities if electronic agreements
are not properly fulfilled (e.g. if advertising impressions are not
delivered in accordance with agreements – and this is subsequently
discovered by an “advertising audit”).
|
8.
|
·
The
organization generates advertising revenues which are dependent upon
certain “electronic occurrences”. For example, the client may earn
Rs.0.01 if a web user “clicks” on an advertiser’s banner, Rs.0.10 if
the user becomes a registered member at the destination website and
Rs.1.00 if the user makes a purchase at the destination website. |
·
This
type of revenue stream is generally dependent upon reports from third
parties (e.g. a firm hired to count “electronic clicks”) or from the
vendor (i.e. the website being advertised and receiving vendors).
·
The
client may not have visibility or control surrounding the process
generating these reports (e.g. the client will not have direct access
to its customer’s sales order system, but will receive a report
indicating how many sales were generated from “click-throughs” from
the client’s website. Understanding the client’s right to audit these
reports and how the reports are generated, will be important in
determining the audit strategy.
·
Contractual arrangements will determine how revenue will be recognised
and how revenue will be audited.
·
Auditing these other sources of revenue will need to include
procedures to understand and test the controls surrounding how the
“electronic occurrences” are measured in relationship to the
underlying contract. |
9.
|
·
The
company bundles its sales transactions (i.e. sells more than one
product in one transaction). |
·
Timing
of revenue recognition may be different for each separate element of
the bundle. This will depend on many factors, including whether there
is a discount implicit in the contract. An accounting issue may arise
relating to how to apply the implicit discount to each of the elements
for which revenue is being recognised. |
Revenue and Accounts Receivable (continued) |
10.
|
·
The
organisation uses its electronic channels to provide customer support
through online technical documentation, handling of routine inquiries,
and integration with call centres. |
·
There
may be an opportunity to leverage the information gathered through
this process to make warranty reserves. |
Purchasing and Purchase Obligations |
1 |
·
The
company enters into multiple-element arrangements to purchase goods or
services which entitle them to certain other contractual rights. |
·
Unique
and complex accounting issues surround the amount and timing of
expense recognition for such purchases. See relevant accounting
guidance for details.
|
2 |
·
The
organization purchases goods via electronic transactions (e.g. EDI,
web-based applications, etc.) |
·
There
will likely be new processes and surrounding controls.
·
Heightened risk in the purchasing authorisation function may exist
(e.g. if orders are placed via email or another low controlled
process).
·
If
electronic purchasing controls are effectively implemented, they may
be more effective than traditional purchasing controls; however if
controls are not effectively implemented, there may be increased risk
of having liabilities related to purchase orders/commitments placed
over the web which the company is not aware of. (i.e. don’t get
recorded). |
3 |
·
The
organisation’s supply chain implementation supports communication with
partners with dissimilar systems and data formats by using third party
services. |
·
If
adequate controls surrounding the communication with dissimilar system
and data formats via third parties do not exist, data errors may
occur.
·
Reconciliation of data between the client and its vendors is a key
control for ensuring accurate data transfer. |
4 |
·
Potential suppliers can view the organisation’s purchasing
requirements (product specs, design requirements) and bid for the
organisations business on-line. |
·
If a
vendor is able to view the client’s purchasing requirements, an
implied purchase obligation may be created. This will depend upon the
contractual relationship between the client and the vendor.
·
Contractual relationships related to on-line bidding may differ from
traditional vendor relationships.
|
Purchasing and Purchase Obligations (continued) |
5 |
·
The
company uses its electronic integration with its suppliers to
aggressively manage (minimise) its inventory levels. |
·
When
client actively manages its supply chain, it is important to
understand the contractual relationships with the client and its
suppliers and fulfilment centres to understand whether the inventory
is owned by the client or its suppliers/fulfilment centres.
·
When a
customer return is received, the client may not contractually be able
to cancel the vendor production, which may result in inventory losses.
·
Issues
may arise over ownership of inventory in transit.
|
6 |
·
The
organization has integrated its supply chain processes with its
customer-facing processes, for example so that procurement and
logistical management of core materials are driven automatically by
the end-customer. |
·
There
will likely be new procedures and controls surrounding this process.
·
When
client actively manages its supply chain, it is important to
understand the contractual relationships with the client and its
suppliers and fulfilment centres to understand whether the inventory
is owned by the client or its suppliers/fulfilment centres.
·
Management may inquire about what level of comfort over their
processes is ascertained through the financial statement audit
process. Clear communication with the audit committee will be
required. |
Inventories, Fixed Assets and Deferred Charges |
1 |
·
The
organisation has dis-aggregated its product to meet actual consumer
requirements (e.g. delivering a music track rather than an album, or
news articles rather than a newspaper). |
·
There
may be unique product rights and/or royalty implications.
·
As dis-aggregated
product becomes accepted by the market, inventory which is not dis-aggregated
(e.g. album vs. track) may become obsolete or have impaired value.
·
There
may be impairment of long-term assets within business unit creating
original product (e.g. the album factory).
·
How do
we treat pre-paid costs for “virtual inventory”? |
2 |
·
The
organisation allows the consumers to tailor or configure the product
to their own specification. |
·
The
company’s policy for changes to orders and returns will impact
inventory values.
·
If the
company allows customers to return customised product, the value of
returned product may be impaired.
·
If the
company allows customers to change orders
·
After
they are begun, this may result in impairment to the value of
work-in-process inventory. |
3 |
·
The
organisation has dematerialised its products where possible. For
example, divorced the information content from a paper-based delivery
mechanism such as manuals, newspapers, and tickets. |
·
The
original version (i.e. before dematerialization) of inventory may be
impaired.
·
Carrying value of physical capital may be impaired. |
Treasury Cycle |
1 |
·
The
company performs its banking electronically. |
·
There
may be a lack of physical evidence supporting cash transactions. It
will be important to consider the validity of the resulting electronic
evidence. Certain evidence may not be reliable. |
2 |
·
The
company manages currency hedging tools electronically. |
·
The
form of audit evidence will be electronic and may require independent
verification.
|
Commitments and Contingencies |
1 |
·
The
organization uses on-line channels to target consumers outside of its
traditional markets (geographically or demographically). |
·
Unique
tax, regulatory or legal exposures may exist due to unique business
models not yet challenged by the taxing, regulatory and legal
authorities.
·
New
currency translation issues may exist.
·
There
may be new implications on segment reporting.
·
The
credit risk of customers outside traditional markets could be
different than those of traditional markets. |
2 |
·
The
organisation uses on-line technology to track and predict the
customer’s needs and then proactively sells, and targets the marketing
information and product to small customer segments, even to a market
of one. |
·
There
are privacy and data protection laws which govern how online
information can be used. If the client does not understand these laws,
or have adequate site disclosure, a liability may arise.
·
If the
client does not have controls to ensure compliance with privacy laws,
the risk of violation may increase. |
Outsourcing and Strategic Partnerships |
1 |
·
Certain business processes are outsourced. |
·
There
should be monitoring controls over the service provided by the
outsourcer and contractual protection against process failures. third
party processor.
·
When
the order fulfilment function is outsourced, shipments may be delayed
from the time that credit card authorisation is received. Also, it
may be difficult to obtain reliable shipping documentation if it
resides at a third party.
·
There
may be unique and complex accounting issues surrounding the
classification of order fulfilment costs. See relevant national
accounting guidance for details.
|
2 |
·
The
company has many strategic partners. |
·
Strategic partner selection is a developed skill. There will likely be
a control process surrounding the selection of strategic partners.
|
All
Audit Areas |
1 |
·
The
organisation generates electronic business data such as shipping
documents or invoices electronically directly to its customers rather
than printing and mailing documentation. |
·
There
may be a lack of physical evidence. It will be important to consider
the validity of the resulting electronic evidence. Certain evidence
may not be reliable.
·
As
evidence becomes more electronic, there may be increased opportunity
for creation of bogus sales transactions. |
2 |
·
The
organisation makes use of workflow management techniques such as
scanning etc. |
·
There
may be new procedures and controls surrounding this process. |