Describe about the Auditing and Assurance Services for Audit Inherent Risk Model.
Inherent Risk is the risk of a material misstatement in the financial statements arising due to error or omission as a result of factors other than the failure of controls (factors that may cause a misstatement due to absence or lapse of controls are considered separately in the assessment of control risk).
Factors that would have contributed to increased inherent risk assessment at the financial reporting level:
Competence and Integrity of management:
At financial reporting level, many disclosures in financial statements, policies, trade practices etc. Are based on management judgement and their approach towards future economic growth. Say few estimates are to made to disclose true picture of financials i.e provision for employee benefits, provision for expenses etc
Assessing management integrity is no easy task but at financial reporting level, inherent risk of audit increases if competence and integrity of management is found to be low by the auditor.
As mentioned in the question, due to rapid industry growth in the industry, significant managerial experience in the industry was limited. Thus, due to limited experience management may not get proper solutions for complex situations arising in the business or it may not be able to estimate future trends and technologies of which management of competitor entity are aware of.
It may happen that the accounting records are maintained properly in an entity. Say for example, there are many errors and omissions in the accounting records. Due to this factor, financial position as at reporting date may be mislead to an large extent
Discrepancy in accounting records affects can effect any component of financial statement i.e. revenue, expenditure of any other balance sheet or profit and loss item. Thus, if any discrepancies are found in accounting records inherent risk of audit will be assessed as high.
In case of inexperienced accounting personnel, it may happen that accountants are not clear at entry level only. They may get confused in debit and credit entries. Thus, it may cost discrepancies in accounting records. The trail balance of the company may not tally, account balances may not represent actual account balances, etc. which increases inherent risk involved in audit at financial reporting level.
Unusual relationship between auditor and management:
An audit involves reporting on financial statements of an entity whether they are true and fair independently.
If there is any indication of unusual relationship between auditor and management i.e. high volume of transactions between both, old friendship or relationship between auditor and management. Etc may affect the independence of auditor and the auditor may not report the actual picture of financial statements and he may end up reporting in favour of the entity. Thus, this factor increases inherent risk of audit.
The indicators of unusual relationships may be recurring cash transactions between auditor and the company, auditor and company are related parties, etc.
Related parties are parties which are mainly controlled by common controlling authority. It may happen that, for personal benefits directors may transfer profits of one entity to other. Or it may happen that they sell products of one company to other related party at cheaper rates to make other entity profitable. Thus, in case if at the beginning of audit, the auditor finds large volume of transactions with related party or any unusual transaction with related party, he may classify inherent risk of audit as high.
There may be some transactions with external parties identified at the start of audit or during the course of audit which are unusual in nature. For example, a transaction not related to business, high cash value transaction or other transaction which the auditor may find unusual increase the inherent risk of audit. These transactions may also impact financial position of an entity. Thus, occurrence of such unusual transactions increases the inherent risk of audit.
Further, if transactions with related parties are high in volume also affect the inherent risk involved in audit. As the entity has interest in its related party, the transactions may not be arms length price or it may happen that funds are transferred from one entity to other and share holders funds are used for related party of the entity. Such kind of transactions increase the inherent risk involved in a audit at financial statement level.
Financial results that seem too good to be true:
In some cases, financial results of a company seem too good i.e financial position of the company seems too good as compared to industry trends and company’s internal financial structure and capability of the management.
For example, average profit in industry is 10% but the financial of the entity are showing profit of 40 %. This kind of situations leads to more complex judgements by the auditor. Thus, if financial results seem too good to be true, the inherent risk in audit will increase.
The company may display wrong picture in financials to attract shareholders, investors and customers towards services. It may happen that, to attract large investments, profit of the company is disclosed doubled or the liquid ratio is disclosed favourable to the company. Though, the auditor through his professional scepticism may identify that such financials are not in line with current financial position of the company of industry. Thus, he may have to perform additional audit procedures to ensure the financial results disclosed by the company are true and fair.
Competency and Integrity of management: Management can plan and divide work in such a manner that expert in particular work in allotted to the work matching with his expertise.
Discrepancies in accounting records: Management can set up controls for accounting at strategic planning level.
Solution:
Inherent risk factors that would have contributed to increased inherent risk assessment at the account balance level:
Account represents an asset that can be easily stolen:
There may be a case where assets of the entity are kept or maintained in such a way that they can be easily stolen. For example, company keeps few of its machines outside the factory due to storage issues in factory and no security is there to keep watch on that machines which are kept outside the factory. Now there may be a case where this assets are stolen and the auditor even the company is not aware of the case.
In such situations, it may happen that auditor reports gross block of assets as 1,00,000$ and only assets worth 97,000$ are available physically. This increases the inherent audit risk at account balance level.
Fixed assets cover a major portion of entity’s financials. If fixed assets are not disclosed properly in the financials, there is high risk of misrepresentation of the company’s financial position. Thus account balances represent assets that can be easily stolen, it is high risk item for an auditor and thus it increases inherent audit risk at financial statement level.
If any account has complex entries and account balance is not clear or the nature of transactions in that account is not clear to auditor the auditor has to perform additional procedures to comment on true and fair view of that account.
For example, an account used for accounting of taxes and proper narration is not given to entries in that account, it may happen that auditor finds that account very complex and perform additional procedures to get comfort on the figures of that account. Further, it is also possible that technical knowledge of accountant is less and entries of expenses are routed through the ledger of tax. Such cases increase the inherent audit risk at account balance level.
Account balance requires a high level of estimation to value:
There are some transactions in which proper estimation by management is required to complete the accounts so that false picture financial position of the entity is not reported. Examples of such kind of estimations are provisions for expenses accrued but not due, provision for gratuity, contingent liability, etc. If the company is incurring high volume of expenditure at the year end of which exact payment to be made for that expenditure in not know by the management, management estimates become more crucial in depicting the financial picture and thus it increases the inherent risk of audit.
Account balance subject to adjustments that are not in the ordinary processing routine: Financials are finalised after making some adjustments in accounts for presentation of financial statements to comply with reporting standards. If the accounts are too complex and many adjustments are required in that for proper disclosure, probability of error increases and inherent risk of audit also increases.
Account balances are composed of high value of non routine transactions:
In such cases it becomes difficult for auditor to easily rely on account balances as it consists of unusual transactions which are not in course of business. Auditor has to perform additional audit procedures to insure that balance in such kind of accounts is true and fair.
Solution
Comment on going concern of business enterprise:
Going concern if affected by the following:
Stability of business: If there is any indication of any future or current event which may impact operations of business substantially going concern concept is affected.. For example, if any new product is launched in market which is better than the company’s product and company is not able to upgrade its product due to limitation of resources, it may happen that customers start buying new product in market and demand of company’s product decreases drastically.
In case of Nokia, the company was not able to upgrade with technology and it continued with old technology and ended up being sold to Microsoft.
There are many other factors which affect the going concern assumption of business entity such as continuous losses to the company, internal work environment of the company shows possibility of lock out, strike of worker etc.
Australia’s telecommunication sector is already well grown and many telecom companies are operating in the market with big investments and well skilled man force. Further, Telstra is holding major customer share in market. Along with Telstra there are many players in the market in this sector. In such kind of markets and such kind of business scales it becomes very difficult for new enterprises like Telstra to operate in market and sustain growth continuously.
Considering the mobile operators in Australia, 42% of the population is already using mobile phones. In such case it becomes difficult to attract new customers as many of the customers are already using the service and One Tel has to launch a very attractive productservice to attract the buyers.
Due to the rapid growth of the industry described in the previous section significant managerial experience in the industry was limited. This is most important factor for an enterprise to continue in a competitive market. It may happen that, management fails to attract customers with its products as management of competitor is more efficient than one tel. Decision making may fail due to lack of experience. In complex situations, management decisions play crucial role, and if management is not competent enough to cope with situation, the company may suffer heavy losses.
One Tel is operating in a competitive business environment where already many businesses are already established one tel will start establishing its business from this point. Considering the market share of competition and experience of the competitors it is tough job for one tel to establish a customer base and sustain in such a competitive market and achieve growth along with earning profits.
References:
Accounting-Simplified.com, S 2014, Audit Risk Model: Inherent Risk, Control Risk & Detection Risk, viewed 19 September 2016, https://accounting-simplified.com/audit/risk-assessment/audit-risk.html
Investopidea, S 2015, Examples of inherent risk, viewed 19 September 2016, https://www.investopedia.com/ask/answers/041615/what-are-some-examples-inherent-risk.asp
The InformationOverload.com, S 2015, Inherent Risk in Audit, viewed 19 September 2016, https://theinformationoverload.com/what-is-inherent-risk/
Wikipedia, S 2016, Audit Risk, viewed 19 September 2016, https://en.wikipedia.org/wiki/Audit_risk
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