Audit For Financial Statements: Inherent Risk, Increased Inherent Risk And Going Concern Assumption

Inherent Risk

Discuss about the Audit for Financial Statements.

An inherent risk is the risk that there would be material misstatements in the financial statements that would be the result of the error or the omission that would be the cause of the failure of the various controls. These are the factors that would cause the misstatement that would be due to the absence or the lapse of the various different controls. The implementation of these controls is the sole responsibility of the management (ISA handbook, 2016).

An inherent risk is considered to be high when there is a high degree of judgment involved and the estimation has been involved in the various transactions that are considered to be complex in nature (Techtarget, 2016).

The following are the factors that affects or increases the inherent risk of the business of the client:

• The business in which the client deals: when the client is involved in a very high technology industry, then it faces the risk of inventory going obsolete. New inventions and innovations are taking place each and every day. And in such a case, the inventory of the entity may go waste and this increases the inherent risk of the entity. When an audit is assumed to have a higher risk, then an auditor will have to conduct an increased amounts of tests and review inventory on regular basis (Florea et al, 2016).
• Earlier audits: the issues or the errors or the fraud that was found earlier would definitely appear in the financial statements of the current year as well. For example, in case, an error or shortage was observed in the inventory during the audit of the previous audit, then that should be checked during the current year as well. When an audit is assumed to have a higher risk, then an auditor will have to conduct an increased amounts of tests and review inventory on regular basis.
• Initial or recurring audits: in case, the same client is being audited by the auditor for an increased number of years, then the auditor gains some experience with regard to the relevant knowledge about the engagement. This makes the sense for the auditor and they feel more confident in the auditing using the same client instead of the new one. An auditor would always consider the inherent risk to be higher during the initial years whereas the same is considered to be lower during the later years of the audit.
• Related party transactions: there are of the transactions that takes place between the company and its subsidiaries, between the entity and the employees etc. all these transactions have to be reported at the price at which these would have been reported if entered into with the non-related party. There is not much of transparency when these transactions take place. When the auditor is convinced, then he would assign high inherent risk to these transactions.
• Non-routine activities: there are many of the transactions that includes the transactions like losses, fires, major property acquisitions, write off of the assets and the implementation of the new product. When it comes to recording these transactions, the client may not have some sufficient transactions that takes place more frequently, then the client may lack enough experience to deal and to report such of the transactions. The client is more likely to make mistakes due to the lack of the experience. It is quite logical for the auditor to estimate a high degree of inherent risk and extend his audit procedures accordingly (Emerald insight, 2016).
• Judgment and experience: there are many of the cases wherein the management of the client needs to exercise a great amount of judgement while recording and estimating the various transactions. The examples would include the investments must be reported at their fair values, allowances for the trade receivables that go uncollected etc. There is a greater likelihood of the misstatements when the inherent risk is quite high. Hence, the auditors is more inclined in assessing a higher amount of inherent risk.
• Population: from the point of view of an auditor, the nature of the items that make up the entire population affects the likelihood of the material misstatements. When there is a higher likelihood of the material misstatements, then that would lead to an increased investigation and testing. As the result of this, the auditor would assess a higher degree of the inherent risk that is questionable to the various items such as the transactions that have been entered into with the related parties etc. (HKIAAT, 2016).

An auditor needs to consider these risks and then plan his audit accordingly since an increased inherent risk would require more detailed audit procedures.

An inherent risk is the risk that there would be material misstatements in the financial statements that would be the result of the error or the omission that would be the cause of the failure of the various controls. These are the factors that would cause the misstatement that would be due to the absence or the lapse of the various different controls. The implementation of these controls is the sole responsibility of the management.

An inherent risk is considered to be high when there is a high degree of judgment involved and the estimation has been involved in the various transactions that are considered to be complex in nature.

The following are the factors that affects or increases the inherent risk of the business of the client:

• The business in which the client deals: when the client is involved in a very high technology industry, then it faces the risk of inventory going obsolete. New inventions and innovations are taking place each and every day. And in such a case, the inventory of the entity may go waste and this increases the inherent risk of the entity. When an audit is assumed to have a higher risk, then an auditor will have to conduct an increased amounts of tests and review inventory on regular basis. The business in which the company is dealing in is much complicated and it has quite tight competition.
• Earlier audits: the issues or the errors or the fraud that was found earlier would definitely appear in the financial statements of the current year as well. For example, in case, an error or shortage was observed in the inventory during the audit of the previous audit, then that should be checked during the current year as well. When an audit is assumed to have a higher risk, then an auditor will have to conduct an increased amounts of tests and review inventory on regular basis. No data available.
• Initial or recurring audits: in case, the same client is being audited by the auditor for an increased number of years, then the auditor gains some experience with regard to the relevant knowledge about the engagement. This makes the sense for the auditor and they feel more confident in the auditing using the same client instead of the new one. An auditor would always consider the inherent risk to be higher during the initial years whereas the same is considered to be lower during the later years of the audit. No data available.
• Related party transactions: there are of the transactions that takes place between the company and its subsidiaries, between the entity and the employees etc. all these transactions have to be reported at the price at which these would have been reported if entered into with the non-related party. There is not much of transparency when these transactions take place. When the auditor is convinced, then he would assign high inherent risk to these transactions. No data available.
• Non-routine activities: there are many of the transactions that includes the transactions like losses, fires, major property acquisitions, write off of the assets and the implementation of the new product. When it comes to recording these transactions, the client may not have some sufficient transactions that takes place more frequently, then the client may lack enough experience to deal and to report such of the transactions. The client is more likely to make mistakes due to the lack of the experience. It is quite logical for the auditor to estimate a high degree of inherent risk and extend his audit procedures accordingly. No such transactions have been observed from the statement of profits or loss.
• Judgment and experience: there are many of the cases wherein the management of the client needs to exercise a great amount of judgement while recording and estimating the various transactions. The examples would include the investments must be reported at their fair values, allowances for the trade receivables that go uncollected etc. There is a greater likelihood of the misstatements when the inherent risk is quite high. Hence, the auditors is more inclined in assessing a higher amount of inherent risk. No data available.
• Population: from the point of view of an auditor, the nature of the items that make up the entire population affects the likelihood of the material misstatements. When there is a higher likelihood of the material misstatements, then that would lead to an increased investigation and testing. As the result of this, the auditor would assess a higher degree of the inherent risk that is questionable to the various items such as the transactions that have been entered into with the related parties etc. No data available.

An auditor needs to consider these risks and then plan his audit accordingly since an increased inherent risk would require more detailed audit procedures.

Hence, in the light of the above factors, it can be stated that the audit risk is not high but is low.

An enterprise is always assumed to have been following the assumption of going concern which means that the operations of the entity shall continue for the foreseeable future. It is also assumed that the enterprise nether has an intention nor the necessity of liquidation or of curtailing materiality the level of the operations being carried on by the entity (MCA, 2016).

Factors that Affect or Increase Inherent Risk

It is the duty of the management to prepare the financial statements as per the given accounting standards and as per the accounting standards that are being followed in the preparation of the various financial statements. The auditor just has to report whether the financial statements represent a true and a fair position of the company. An auditor has to undertake an evaluation of the ability of the company of the financial statements as been following the going concern for the period of not more than a year. The auditor usually takes into account the ability of the company to act on the assumption of going concern.

The following are some of the things that have to be considered:

• Whether the financial statements shows any trend in the operating results such as losses. The company under review has losses and the same have been piling year after year as can be seen from the income statement.
• When the company has defaulted in the loan. The company does have loan which could be seen from its balance sheet but no payment of either instalment or interest is seen from the statement of cash flows which is not possible since the non-payment could not be there for 2 consecutive years.
• Denial of the trade credit given to the company by the suppliers. No such information is there in the financial statements.
• Uneconomical commitments to which the company is subjected to in the longer term. No such information is there in the financial statements.
• Legal proceedings as against the company. No such information is there in the financial statements (Accounting tools, 2016). 

In the above case, if any of the above holds true, then the auditor will have to qualify his report.

In the given case, he will have to obtain much more information since the information given in the case study is less. He is required to further investigate into the liquidity ratios since they would help him in ascertaining the ability of the company to pay its debts that are due within the period of 1 year or one operating cycle. The examples of liquidity ratios include current ratio, inventory turnover ratio, quick ratio etc.

These ratios are important to be calculated since in case, they are negative, then that would mean that the business entity will not be able to continue its business operations due to shortage of cash. And it will have to shut down its business or discontinue its operations. Further they are quite important to calculate since the going concern assumption of accounting is just an assumption, in case the auditor feels that it may not be true, then he would exercise more of his audit procedures. Also, the going concern assumption does not always mean that the company will be forced to shut down its operations any time soon (Accounting for management, 2016).

References: 

Accountingformanagement.org. (2016). Going concern concept – definition, explanation examples and importance | Accounting For Management. [online] Available at: https://www.accountingformanagement.org/going-concern-concept/ [Accessed 23 Sep. 2016].

Accountingtools.com. (2016). Going Concern Principle – AccountingTools. [online] Available at: https://www.accountingtools.com/going-concern-principle [Accessed 23 Sep. 2016].

Florea, R. (2016). The Implications of Inherent Risks’ Assessment in Audit Risk Limitation. [online] www.ugb.ro. Available at: https://www.ugb.ro/etc/etc2012no1/06fa.pdf [Accessed 23 Sep. 2016].

Inherent risk and indicative factors: senior auditors’ perceptions: Managerial Auditing Journal: Vol 13, No 8. (2016). Managerial Auditing Journal. [online] Available at: https://www.emeraldinsight.com/doi/abs/10.1108/02686909810370551 [Accessed 23 Sep. 2016].

Ishandbook.bsewall.com. (2016). Inherent & Residual Risk. [online] Available at: https://ishandbook.bsewall.com/risk/Assess/Risk/inherent_risk.html [Accessed 23 Sep. 2016].

SearchCompliance. (2016). What is inherent risk? – Definition from WhatIs.com. [online] Available at: https://searchcompliance.techtarget.com/definition/inherent-risk [Accessed 23 Sep. 2016].

www.hkiaat.org. (2016). Risk in Auditing – Inherent Risk (Relevant to PBE Paper III – Auditing and Information Systems and AAT Examination Paper 8 – Principles of Auditing and Management Information Systems). [online] Available at: https://www.hkiaat.org/images/uploads/articles/PBEPIII_inherent_risk.pdf [Accessed 23 Sep. 2016].

www.mca.gov.in. (2016). Accounting Standard (AS) 1. [online] Available at: https://www.mca.gov.in/Ministry/notification/pdf/AS_1.pdf [Accessed 23 Sep. 2016].