Case Study No.

2 Planning an Audit of Financial Statements

Learning Objectives

After completing and discussing this case you should

be able to
• Describe the implications of an audit client’s
business environment on the audit
engagement strategy
• Identify factors affecting an audit client’s
environment and related business risk
• Link business risk factors to the risk of
material misstatements in financial
statement accounts

E
Introduction1

than Properties Philippines, Inc. was registered with the Philippine SEC in 2008 and is engaged in
developing and operating for sale, lease, or hold for investment real estate of all kinds, including buildings, houses,
apartments, and other structures. From the its inception, the company has completed various developments
including a number of high-rise building, a mid-rise development, residential subdivisions, commercial centers, BPO
Offices, an Events Venue Center, and serviced residences. Currently, the company has three (3) on-going
development of commercial buildings.

The Company markets its projects to residential market segments, office locators and commercial tenants through
internal and external sales and marketing channels. For its leasing business, the Company employs a dedicated team
who coordinates with business entities for leasing opportunities in the company’s various projects. The Company
has a wide network of suppliers, both local and foreign. The Company has also a wide customer base and is not
dependent on one or a limited number of customers. The Company complies with all government agencies in
securing licenses to sell, development permits, Environmental Compliance Certificate (ECC) and all other mandated
requirements of the industry. The Company had 391 and 400 employees at the close of the calendar year December
31, 2019 and 2018, respectively. The Company’s employees do not belong to any labor union or federation. At
present, its employees receive compensation and benefits in accordance with the Labor Code of the Philippines.

The Philippine real estate development industry is highly competitive with respect to township developments in
Metro Manila and high-rise condominiums. Ethan believes that it is a strong competitor in the mid- and high-end
markets due to the quality of its products and materials used in construction and finishing. In addition, the Company
believes that the prime locations of its developments allow it to effectively compete in the market. On the other hand,
the Company has access, through its holdings and holdings of its affiliates, to one of the most extensive land banks in
the Philippines, comprising properties strategically located in the prime areas of Metro Manila and its periphery.

1 Information from LTG Group Inc.’s 17A Annual Report was used in developing this case (see edge.pse.com.ph).

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Currently, majority of the Company’s commercial spaces are leased-out to entities in the BPO industry. Should the
country experience a slowdown in performance and growth of this sector of the economy, the Company is exposed
to the risk of lower occupancy, reduction in rental rates and late or non-payment of rentals. While forecast for the
BPO industry remains bullish, the industry is sensitive to changes in government policies particularly with respect
to the tax holidays it currently enjoys. Political uncertainty and peace and order problems may likewise affect the
growth of this industry as experienced in the past. Despite this, the outlook for the BPO industry continues to be
positive as the country remains to be one of top BPO destinations in the world.

The Company’s residential sales on the other hand is exposed to the cyclical nature of the real estate industry. As
seen in the past, the real estate industry has the tendency to expand and contract depending on the movement of
interest rate and the confidence in the Philippine economy.

The Company operates in a highly regulated environment and it is affected by the development and application of
regulations in the Philippines. The development of condominium projects, subdivision and other residential projects
is subject to a wide range of government regulations, which, while varying from one locality to another, typically
include zoning considerations as well as the requirements to procure a variety of environmental and
constructionrelated permits. The Company closely monitors all government regulatory requirements and institute
measures to strictly comply with them.

The Company is exposed to credit risk from its leasing and residential sales. To manage the credit risk from
residential sales, the Company has ceased to offer in-house financing to its buyers. Instead, buyers are encouraged
to either pay in cash, avail of a deferred cash payment term or secure financing from banks to finance their property
acquisition. Credit risk from leasing, on the other hand, is minimal given the profile of the Company’s tenants. The
terms of the Company’s leases are likewise structured to mitigate credit risks.

Fluctuations in interest rates, changes in Government borrowing patterns and Government regulations could have a
material adverse effect in the Company’s and its customers’ ability to obtain financing. Higher interest rates make it
more expensive for the Company to borrow funds to finance its ongoing projects or to obtain financing for new
projects. In addition, the Company’s access to capital and its cost of financing are also affected by restrictions, such
as single borrower limits, imposed by Bangko Sentral of the Philippines (BSP) on bank lending. These could
materially and adversely affect the Company’s business, financial condition, and results of operations. In order to
reduce its earnings volatility and diversify its revenue streams, the Company has targeted to derive approximately
35-40% of its revenues from recurring sources within the next five years, primarily through rentals from its BPO
properties and retail malls. The Company believes this will complement the Company’s overall growth strategy by
providing recurring cash flows to support its developmental capital expenditure requirements and driving demand
for its master-planned community residential offerings.

The company reported a net income of P479 million during the year. Real estate sales of P1.7 billion were 101.7%
higher y-o-y and comprised 53.3% of revenues. Rental revenue for the year accounted for P1.5 billion or 46.7% of
revenues, representing a 7.7% growth over the same period in prior year, as lease contracts were renewed at higher
rates for the BPO offices as well as the additional retail space completed late last year. Operating expenses were P948
million during the year.

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Background2

Your auditing firm, SDS & Co. CPAs recently accepted Ethan as an audit client and as an audit associate, you were
asked to obtain some preliminary information about the real estate industry to provide a basis for understanding
the client’s business environment. Background information about the real estate industry is provided below for your
review:

State of the Philippine Real Estate

The country’s economic boom shows no signs of slowing down. Considered as one of the fastest-growing economies
in the region, it exhibited an increase in gross domestic product (GDP) by 6.7% in 2017. This robust macroeconomic
condition continues to pave the way for different sectors to further flourish, including that of the real estate.

The real estate industry’s steady growth in the past decades is attributed to the increase in demand for residential
and commercial properties driven by various factors. These demand drivers, according to a report by Leechiu
Property Consultants, include rising urban population growth; housing needs of BPO (business process outsourcing)
employees, since a growing number of these workers need to live near their workplace; and remittances from
overseas Filipino workers (OFWs), more than half of which are real estate-related.

Oxford Business Group (OBG) stated in a 2017 report, “Years of investment and strong economic development in the
Philippines have fostered a robust real estate sector that now extends outside of the greater Metro Manila region
and into secondary markets around the country. Economic development and a growing middle class continue to fuel
demand for new, high-grade residential units, while commercial investment drives an ever-increasing amount of
retail and office space.”

The bullish performance of the country’s real estate sector is projected to further thrive in the years to come. The
OBG report continued, “Buoyed by a strong macroeconomic environment, cash-laden investors and a full pipeline of
projects scheduled to be built over the next decade, the real estate sector will continue to exhibit strong growth in
the coming years. A steady stream of new residential and mixed-use projects is under way at locations across the
Metro Manila area, as well as other fast-growing secondary cities around the country.”

Real estate consulting services firm Colliers International also shared the same outlook in a December 2017 report,
which stated that opportunities abound for the property sector this year.

“Colliers encourages developers to take advantage of opportunities that could arise from the implementation of
government policies such as the Comprehensive Tax Reform Package; relaxation of foreign ownership restrictions
on retail and construction; and amendments to the existing procurement law and business registration systems
which should entice more developers to take part in the government’s ambitious infrastructure development
program,” the firm said in the report.

Colliers sees that the improvement of road networks and expansion of airports in major urban areas in the country
will further unlock land values, making it more feasible for residential projects.

2 SDS & Co. CPAs is a fictitious firm. Any similarity to existing companies or persons is purely coincidental.

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Moreover, Colliers said that the demand for residential units in these locations would continuously grow, as OFWs
will continue to set aside part of their remittances for housing requirements.

“Colliers expects developers to continue venturing into residential projects in second-tier and third-tier cities all over
the country, where demand primarily comes from end-user buyers. The markets may be smaller compared to Manila
but more stable in terms of end user housing demand,” the report continued.

On the other hand, the firm predicted that there will be less of office launches following the decline in BPO companies’
office space demand. However, there will be a greater demand for flexible office spaces over the near to medium
term given that there are 1.3 million freelancers in the Philippines, and as mobility, connectivity, and flexibility is
becoming the norm.

Opportunities are also seen in the popularity of e-commerce, which is expected to drive warehousing and logistics
demand. According to Colliers, this particular demand will particularly propel the economy of Northern and Central
Luzon especially because of Clark Airport’s planned expansion and the construction of the Subic-Clark cargo railway.

Northern and Central Luzon is also set to be an industrial hub as major developers are developing industrial parks,
which is foreseen to increase industrial lease rates especially in areas such as Cavite, Laguna, and Batangas.

Not only industrial parks are going outside Metro Manila. Colliers said that townships are also projected to rise in
areas such as Cavite, Laguna, Bulacan, Pampanga, Cebu, and Davao over the near to medium term as land values are
being unlocked by an aggressive expansion of road networks anchored on the government’s initiative to generate
economic opportunities outside Metro Manila.

The increasing tourist arrivals in the country also open more possibilities for the real estate sector. In terms of hotels,
it is seen that three-star and four-star hotels in resort destinations will be more visible in the next two to three years
with Cebu, Bacolod, Iloilo, Palawan, Davao, and Bohol as among the most attractive locations for these developments.

Cebu, in particular, experiences a continued surge of tourists resulting to an increase in occupancy rate as well. Seeing
the rising attractiveness as a tourist spot and growing competitiveness as an investment destination, Colliers
encourages industrial locators in Visayas to consider this province.

Moreover, to cater to the growing domestic market driven by millennial travelers, Colliers encourages investors to
build more budget hotels.

Meanwhile, for the retail segment, Colliers said that malls will still be an important part of the Filipino lifestyle and
will continue to attract consumer traffic, thus, are encouraged to provide more lifestyle amenities that generate a
sense of destination.

Source: https://www.bworldonline.com/state-of-the-philippine-real-estate/ (March 26, 2018)

Requirements:

1. Read the background information about the real estate industry and conduct additional research on the
internet to obtain the latest news and information on the industry, specially the effects of the Covid-19

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 pandemic. Brainstorm relevant industry, regulatory, and other external factors including the applicable
financial reporting framework. Relevant industry factors include industry conditions such as the competitive
environment, supplier and customer relationships, and technological developments. Examples of matters the
auditor may consider include

a. The market and competition, including demand, capacity, and price competition. b. Cyclical or
seasonal activity.
c. Product technology relating to the entity’s products.
d. Energy supply and cost.
e. Regulatory factors.

Identify at least one business risk factor for each area mentioned above.

2. For each of the business risk factors identified in question 1 above, indicate how each risk factor might impact
the risk of material misstatements in specific financial statement accounts or disclosures.

3. PSA 315 (Redrafted), Identifying and Assessing the Risks of Material Misstatement Through Understanding
the Entity and Its Environment provides guidance on the auditor’s consideration of an entity’s business
environment and associated risks. Answer the following questions:

a. What is the auditor’s objective for understanding an entity’s business environment?

b. Why does an auditor not have responsibility to identify or assess all business risks?
c. Provide some examples of business risks associated with an entity that an auditor should consider
when performing an audit.
d. Provide some additional examples of business risks that might not lead to a risk of material
misstatements in the financial statements.

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