This paper examines the accounting and audit issues surrounding Roman Holiday Pizza, a restaurant franchise that pursued aggressive growth through reacquiring franchise rights. The analysis covers business risk assessment under SAS 109, the improper valuation of reacquired franchise rights relative to SFAS 142 requirements, and the three components of audit risk: inherent, control, and detection. The paper further applies the fraud triangle framework to identify pressures, opportunities, and rationalizations present in the engagement, and evaluates internal controls through the COSO framework. Together, these analyses highlight the potential for material misstatement in Roman Holiday's financial statements, particularly regarding the $127 million in reacquired franchise rights on its balance sheet.
This analysis examines Roman Holiday Pizza's treatment of fair market valuation and other accounting issues, and assesses the company's 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 the financial statements, whether due to 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 organic growth in the franchise. Consequently, management is under some pressure to meet growth targets and earnings forecasts.
The preparation of Roman Holiday's financial statements also indicates that the company 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.
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, its valuation approach, and its impairment testing pose significant risks to achieving its business objectives. Roman Holiday accounted for the value of reacquired franchise rights by treating them like goodwill, determining the excess of the net amount assigned to identifiable assets and liabilities. This valuation method is incorrect. According to PCAOB 2007a, paragraph 28, the auditor has a duty to identify any financial statement assertion that would cause the financial statements to be materially misstated.
SFAS 142 addresses the accounting of goodwill and other intangible assets subsequent to their acquisition. Roman Holiday did not follow the methodologies that SFAS 142 establishes for fair value measurement of an indefinite-lived intangible asset — the standard that applies to 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, provided 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 and constitutes a potentially significant misstatement.
With respect to impairment analysis, Roman Holiday carries audit risk regarding both the frequency and accuracy of testing, making it uncertain that no material misstatements have occurred.
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 respect to the book value of the reacquired franchise rights of $127 million. Detection risk is associated with the possibility of fraud or error occurring within the impairment tests for those reacquired franchise rights.
Internal control issues exist because of the complexity of determining 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 — as well as the degree of subjectivity in the measurement of financial information, especially those measurements involving a wide range of measurement uncertainty. Standards also flag 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 franchise reacquisitions possess all of these risk characteristics.
"Opportunity, pressure, and rationalization in management fraud"
"Applying COSO components to franchise rights controls"
When the auditor selects controls to test during the Roman Holiday audit, the primary objectives include understanding the flow of transactions pertaining to management assertions regarding the indefinite life of the reacquired franchise rights. Impairment testing and valuation measurement must be reviewed, and the auditor must identify the points within Roman Holiday's processes at which a misstatement, including one due to fraud, could arise.
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