ASHER FARMS INC

Understanding of Client’s Business Environment

INTRODUCTION
Asher Farms, Inc. is a fully-integrated poultry processing company engaged in the
production, processing, marketing and distribution of fresh and frozen chicken products.
Asher Farms sells ice pack, chill pack and frozen chicken, in whole, cut-up and boneless form
to retailers, distributors, and casual dining operators principally in the south-eastern and
south-western United States. During its fiscal year ended October 31, 2014 the company
processed 343.6 million chickens, or approximately 2.0 billion dressed pounds. Based on
industry statistics, Asher Farms is one of the largest processors of dressed chickens in the
United States based on estimated average weekly processing. Asher Farms’ common stock is
traded on the NASDAQ national market with an aggregate market value of $677 million on
October 31, 2014. Asher Farms’ chicken operations presently encompass 7 hatcheries, 6 feed
mills and 8 processing plants employing 1,059 salaried and 8,646 hourly employees. The
company has contracts with operators of approximately 530 broiler farms that provide the
company with sufficient housing capacity for its current operations. Asher Farms also has
contracts with 173 breeder farm operators and 44 pullet farm operators.

INFORMATION ABOUT THE AUDIT

Asher Farms is required to have an integrated audit of its consolidated financial statements
and its internal control over financial reporting in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Your firm, Smith and Jones, PA.,
recently accepted Asher Farms as an audit client and as a staff auditor you have been asked to
obtain some preliminary information about the poultry industry to provide a basis for
understanding the client’s business environment. Background information about the poultry
industry from Smith and Jones’ industry database is provided for your review.

REQUIRED
1. A useful approach for understanding a client’s business environment and associated
business risks is to perform a PESTLE analysis. PESTLE is an acronym for Political,
Economic, Social, Technological, Legal and Environmental factors that are used to
asses the client’s business environment. A PESTLE analysis focuses on factors that
may affect an entity’s business model, but are beyond the control or influence of the
client. While beyond management’s direct influence, such factors may significantly
impact an entity’s business risk. Read the background information about the poultry
industry and conduct additional research on the internet to obtain the latest news and
information on the industry. Brainstorm political, economic, social, technological,
legal and environmental factors that could affect Asher Farms’ business risk. Unless
your instructor indicates otherwise, identify at least one business risk factor for each
component of the PESTLE acronym.

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. Professional auditing standards provide guidance on the auditor’s consideration of an

entity’s business environment and associated business risks. (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 misstatement in the financial statements.
ANSWER 1 & 2

The increasing demand for animal products resulting from demographic factors, technical and
scientific developments, diminishing resources, and increasing consumer demands for more
food safety, lower environmental impact, and better animal welfare conditions will determine
the development of the poultry industry during the next decade. Here are the components of
PESTLE contributed to the business risks of Asher Farms, Inc.:

P – Political
Regulation for Broiler Production
 After decades of rapid expansion, growth in both broiler production and productivity
began to slow in the mid-1990s. Slowing growth creates challenges for industry
decision makers, as they consider how to encourage further investments in capacity
and new technology, and attempt to manage existing and aging production networks.
The broiler industry has a unique organization. Firms called integrators own
processing plants, hatcheries, and feed mills, and contract with independent “grow-
out” operations to raise their broilers to market weight. The contractual relationship
between farmers and integrators, however, is coming under growing scrutiny from
Congress and regulatory agencies, and the industry relies heavily on a
particular kind of production contract that has attracted considerable attention.

Corporate Bureaucracies Hindered Improvements in Innovation

 Capital management will be subjected to stringent corporate evaluations and
assessments, such that the time to complete a project and its successful outcome could
be jeopardized by inefficient corporate bureaucracies. Therefore, implementing clear,
concise procedures for managing this process efficiently is critical to long-term
success of the new technology program and the poultry company’s long-term
survival.

E – Economic

Sensitivity of Production Prices

 Broiler production is gradually shifting to larger operations, a trend common to
most agricultural commodities. As a result, operators of larger enterprises may be
more sensitive to the income risks arising from energy price fluctuations and contract
settlements. Contract features may need to be redesigned to adjust for differing risk
exposures faced by growers.
 Overall production growth slowed sharply after 2000. While per capita
consumption continued to grow at 1.9 percent per year, the contribution of population
growth fell in comparison to earlier years and export growth fell sharply. But changes
in exchange rates can affect the competitiveness of U.S. exports, and growth in
foreign incomes can be an important force. In the near future, a declining dollar,
combined with income growth in Asia, may boost export growth again.
 It is expected that prices for raw materials will remain low due to new market
developments and introductions, improved technology offerings, especially herbicide
resistant crops, and genetically engineered crops with improved economic traits. All
of these changes translate into lower costs per unit of available nutrient, and as such,
will provide most companies with inexpensive raw materials costs with which to
produce their products.
Rigorous Competition
 The poultry industry from its inception has been largely a cost driven industry. As
such, feed prices and the ingredients that comprise a finished poultry feed have
typically represented65-70% of the cost of live production and therefore a focal point
for most managers trying to save money. Recently, and with the evolution toward
further processing and value added production, producers can now effectively lower
their total feed costs as a percentage of total costs of production by investing capital
into further processing equipment and the production of value added products.
However, it is clear that opportunities exist for companies that can continue to move
toward further processed, value added products that meet consumer demand for
convenience, wholesomeness, safety, and palatability at a reasonable price. Investing
in capital to achieve these higher margin product offerings is the wave of the future
and will be the new arena of competition in the industry.
 Competition is fierce and is today still largely driven by the cost of manufacturing and
the quality of the output or product sold to the customers. As demand for poultry
products slows around the world, the next wave of consolidation in the
industry will occur. Larger companies will continue to get larger and poultry
plants will be designed larger still to capture all possible scale economies.
Getting larger for these companies means that transportation issues on
effectively manage supply will become ever more critical to address and resolve for
long term company sustainability.
 It is believed that feed prices, like grain and soybean prices will remain soft, given
noun foreseen dramatic reductions in yield due to droughts or other factors that might
impact a healthy harvest, globally. Moreover, the continued oversupply of these
grains, compounded by US price supports, and new improved technologies, including
herbicide resistant grain sand other improved varieties that achieve higher yields, will
continue to keep prices at or below the 9 year average for the foreseeable future.

Price Advantages Are Limited

 The industry’s rapid productivity growth has been driven, in large part, by improved
poultry genetics, but also by steady improvements in structures, equipment, and
production practices. These improvements, taken together, have led to greater feed
efficiency, lower mortality, and more intensive use of capital and labor services—
essentially, raising the output of broiler meat that can be achieved for given inputs of
feed, fuel, capital, and labor inputs. Slowing investment in new housing could reduce
the industry’s productivity growth and, in turn, limit any price advantages over other
meats.

S – Social
Convenience and Quality Contributed to Growth of Consumption
 The demographics of the consumer as already mentioned has changed and will
continue to change over the foreseeable future but with a continuing trend
toward embracing convenience and quality. The poultry products consumer of
tomorrow will be a cross between the retiring baby boomer of today and the
sophisticated Gen-Xer that will continue to balance career, family and household
management with food protein solutions that are cost effective, convenient and
wholesome. That includes the selection of protein food sources that are part and
parcel of a total nutrition program that delivers quality, safety and convenience at a
reasonable price. This translates to pressures on the poultry industry to significantly
reduce or eliminate any risk of food borne pathogens, reducing or eliminating the use
 of antibiotics and/or other controlled additive usage in the feed, and providing
products that are tasty, tender, and convenient to prepare at a reasonable price.

Healthier Diet Consciousness

 Fanatical pressures on the meat industry in general and the poultry industry,
specifically will continue to create doubt in the consumer’s minds about the
wholesomeness of meat products in general and poultry products specifically; both
from a health standpoint and from an animal welfare perspective. However, a
more powerful, opposite influence, based on ongoing, empirical, scientific
evidence, is the endorsement of credible nutritionists and dietitians that the
consumption of poultry products is paramount to achieving a well
balanced, high protein, lean, healthful diet to prevent obesity, heart disease and
diabetes.These forces are also in play in the global arena and will likely spur
additional growth in third world countries as these nations improve their overall
nutritional programs and the quality of food choices available to their citizens.

T – Technology
Genetic Engineering
 Feed stuffs should no longer be considered as commodities. Qualitative and
nutritional criteria should be used for their purchase and segregation in feed
mills. Technologies allowing the immediate analysis of feedstuffs, such as NIRS, will
be required. Genetic engineering will become an important tool to improve feedstuff
nutritional quality and, perhaps bird performance.
 Growth modelling and data-analysis using computer systems will allow more robust
decision-making, which will be the key for the sustainability and success of the
poultry industry. Moreover, new technologies on the live production side must be
implemented to both ensure source of supply and improve the overall efficacy of
production so that profitability from the further processed end products will be
maximized. Technological approaches that accelerate improvement in the supply
situation include genetics programs that create ever more efficient, fast
growing, high yielding birds.
 In addition, hedging futures commodities to lock in future costs will continue to be
critical in managing the overall cost structure, future risk and uncertainty of the
supply side of. This area of raw material management will require a more accurate
and precise global perspective of the dynamically volatile international markets to
ascertain the impact of these global changes on domestic grain prices. To that end,
decision-enhancing models that assess the impact of these changes will become more
valuable to companies who wish to manage this process with precision and accuracy.
o Financial Statement Accounts/Disclosures that could be affected: Revenues,
inventory
If the company does not keep pace with technological advances it could find itself at a
competitive disadvantage negatively impacting its ability to sell chicken at a profit.

L – Legal
Immigration Labor

 Immigration reform continues to attract significant attention. New immigration

legislation at the federal or state level could make it more difficult or costly for the
company to hire United States citizens and/or legal immigrant workers. Also,
 increased enforcement efforts with respect to existing immigration laws by
governmental authorities could disrupt a portion of the workforce in the industry and
thus adversely impact production of chicken products.
o Financial Statement Accounts/Disclosures that could be affected: Cost of
sales, revenue

The company may have to pay higher labor costs or may not be able to produce and sell as
much poultry.

Unique Manners in Managing Contracts

 Other industries use production contracts, but the broiler industry is distinguished by
the dominance of such contracts and the methods by which growers are paid. Almost
all broiler growers’ contracts base the compensation on how each grower’s
performance compares with that of others. Beyond that feature, however, contracts
are far from uniform. Variations in contract design likely follow from differences in
grower location, size, and type of broiler housing, but the wide variation in terms and
payments makes it difficult for growers to evaluate contracts. Long durations tend to
be offered to newer and larger operations. Among recent entrants, those with long-
term contracts averaged half again as much production as those with shorter contracts.

Contracts and Competing Integrators

 Because production is so localized, most producers have few integrators to choose
from. Those findings may overstate the number of integrators farmers can choose
among if some integrators are not actively seeking new growers. Integrators must
recruit growers away from other activities, such as producing other commodities on
the farm or working off the farm. Those outside options for growers set limits on the
degree to which integrators can impose low fees on growers. There is little empirical
evidence, however, of the effects of integrator concentration on grower returns. Once
a contract has expired, growers may have to retrofit their houses with new capital
equipment in order to gain a contract extension. These expenditures can be
substantial.

Food Safety
 Chicken producers are subject to international, federal, and state laws and regulations
concerning food safety standards and processing, packaging, storage, distribution,
advertising and labeling of chicken products. Non-compliance could adversely affect
the cost of producing or ability to sell chicken products.

o Financial Statement Accounts/Disclosures that could be affected: Cost of

sales, revenues, inventory

The company may have to pay higher production costs or may not be able to produce and/ or
sell as much poultry.

 Regulatory changes concerning the discharge of chicken manure by government

agencies could adversely affect the cost of producing or ability to sell chicken
products.
 o Financial Statement Accounts/Disclosures that could be affected: Cost of
sales, revenues, inventory

The company may have to pay higher production costs or may not be able to produce and/ or
sell as much poultry.

 Agricultural policies of the United States and foreign governments all affect the
supply of feed and could adversely impact the cost of feed.
o Financial Statement Accounts/Disclosures that could be affected: Cost of
sales, revenues

The company may have to pay higher production costs or may not be able to produce and sell
as much poultry.

 Imposition of tariffs, quotas, trade barriers and other trade protection measures
imposed by foreign countries like Russia, China, Mexico, etc. could impact demand
for chicken products causing domestic chicken prices to decline.
o Financial Statement Accounts/Disclosures that could be affected: Revenues,
inventory

The company may not be able to sell as much poultry

E – Environment
Litter Disposal Contamination
 Larger operations may realize scale economies in production, but they also
concentrate poultry litter in localized areas. Litter disposal remains a major
issue confronting the industry.

Global Warming
 Global warming could affect weather patterns that could adversely impact the
production of feed and chicken products. The changing weather patterns could have a
negative impact on the cost of chicken products.
o Financial Statement Accounts/Disclosures that could be affected: Cost of
sales, revenues
The company may have to pay higher production costs or may not be able to produce
and sell as much poultry.
 ANSWER 3
a. The auditor must obtain an understanding of the entity and its environment to assess
the risk of material misstatement and to design the nature, timing, and extent of
further audit procedures to perform.

b. Not all business risks give rise to risks of material misstatement. The auditor needs to
consider those business risks that could result in a material misstatement at either the
financial statement level or assertion level to classes of transactions, account balances,
and disclosures.

c. Appendix C of AU Section 314 provides examples of business risks that could give
rise to material misstatements. Some examples provided are:

 Operations in regions that are economically unstable, for example, countries

with significant currency devaluation or highly inflationary economies.
 High degree of complex regulation.
 Marginally achieving explicitly stated strategic objectives.
 Constraints on the availability of capital and credit.
 Changes in the industry in which the entity operates.
 Changes in the supply chain.
 Developing or offering new products or services, or moving into new lines of
business
 Expanding into new locations.

d. Most business risks will eventually have financial consequences. However not all
business risks will give rise to material misstatements. A few examples of business
risks that might not lead to a risk of material misstatement in the financial statements
may include:

 Employee stealing petty cash funds.

 Employee use of company office supplies for personal benefit not company
benefit.
 Employee running a personal side business from company facilities.