E-Business and Auditors’ role
S. Gopalakrishnan , FCA

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

1.      

·        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.