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¶ … Roman Holiday Pizza's treatment of fair market valuation and other accounting issues, and assesses their business risk and accounting controls. Roman Holiday Pizza is a restaurant franchise that has undertaken a strategy of growth through reacquiring franchise rights. Accounting for those reacquisitions raises serious issues during the audit process.
SAS 109 states that the auditor must gain a sufficient understanding of the entity and its environment, including its internal control, so that the auditor can determine the risk of material misstatement of financial statements, either because of error or fraud. There are red flags in Roman Holiday's environment.
According to the audit team, Roman Holiday has been growing faster than other firms within the industry, but analysts expect that growth rate to slow. Annual sales growth for firms in the restaurant industry was 4.3% for the preceding year, 2006. During recent years, most of Roman Holiday's growth came from acquisitions of franchise rights and existing restaurants, rather than real growth in the franchise. Consequently management is under some pressure to meet growth targets and earnings forecasts.
Also, the preparation of Roman Holiday's financial statements indicate they did not follow GAAP with respect to the valuation of franchise rights, nor is it clear that impairment testing is adequate. These questionable accounting practices raise the possibility that Roman Holiday's assets and income are materially misstated.
Business Risk Assessment
The process of risk assessment is used to identify and analyze risks to the achievement of an entity's objectives, in order to determine how those risks should be managed. Roman Holiday's treatment of reacquisition rights, their valuation approach and impairment testing pose significant risks to them achieving their business objectives. Roman Holiday accounted for the value of reacquired franchise rights by treating them like goodwill; they determined the excess of the net amount assigned to identifiable assets and liabilities. This valuation method is incorrect and according to PCAOB 2007a, paragraph 28, the auditor has a duty to identify any financial...
Roman Holiday did not follow the methodologies that SFAS 142 establishes for fair value measurement of an indefinite-lived intangible asset, which standard applies to the reacquired franchise rights. SFAS 142 requires that, in estimating the fair value of a reporting unit, a valuation technique based on multiples of earnings or revenue or a similar performance measure may be used if that technique is consistent with the objective of measuring fair value. Roman Holiday's preliminary balance sheet shows $127 million in reacquired franchise rights; this amount represents more than 25% of the company's total assets, a potentially significant misstatement.
With respect to impairment analysis, Roman Holiday possesses audit risk for both the frequency and accuracy of testing to make certain that no material misstatements occur.
Audit risk associated with the reporting of Roman Holiday's reacquired franchise rights includes three components: inherent risk, control risk and detection risk. There is inherent risk associated with Roman Holiday's valuation approach. Control risk exists with the book value of the reacquired franchise rights of $127 million. Detection risk is associated with an instance of fraud or error that could occur with respect to the impairment tests for the reacquired franchise rights.
Internal control issues exist due to the complexity of the transaction, which criteria apply to Roman Holiday's reacquisition transactions. Accounting standards prescribe additional criteria to determine risk, including significant transactions with related parties, which is the case with Roman Holiday's reverse franchising; understanding the degree of subjectivity in the measurement of financial information related to the risk, especially those measurements involving a wide range of measurement uncertainty; and whether the risk involves significant transactions that are outside the normal course of business for the entity, or that otherwise appear to be unusual. Roman Holiday's…
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