Identifying And Assessing Inherent Risks In Cloud 9

Management character as a critical factor

Management character is a critical factor in both in initial audit engagements. The style of management can create risks that could impact the audit. The auditor examines the books of account which are obviously based on assertions of the entity’s management. This can range from the existence of some elements in the entities books of accounts to some declarations regarding the same elements. No professional auditor would rely on assertions of a management whose character is questionable. Questionable character is an indication of the level of integrity.

Management integrity always presents hidden risks. Core management staff who are mainly the chief officers, audit, finance, and accounting officers and core operations. The board of directors have a critical role in influencing staff integrity at all levels of the entity. The board of directors plays an oversight role and are ultimately responsible (Elder, Beasley & Arens, 2010). One of the most obvious risks is if one of the core member of management has been charged in a court of law or is undergoing a conviction for criminal offenses. Suspension made by regulatory body against a potential client’s management either individually, group or the whole entity is of an area of concern (Dauber, 2009). This also includes sanction and penalties for breach of code of conduct.

In this case of Cloud 9, I would check if past corrective actions arising from past audits have been implemented. I would also check for instances of the same issues being flagged in subsequent audits. A check on if there have been material misstatements on financial statements would also give an indication of the integrity of the management (ASA 450).

According to ASA 200, I would rely on my judgement and scepticism on how much I can rely on management reports and assertions. This will be guided on my interactions with management (ASA 260) and a background check on the company and the former auditor. My main agenda is to be objective and in conformance with standards.

This will give me the confidence that management takes responsibility of the audit.

1. Risk of association

An auditor should not onboard a client who can damage the auditor’s reputation. Some client acceptance decisions are hard to make in some circumstances. Conflicts of interest exists in the decision making. This can happen when subjecting a new prospect for a rejection or acceptance decision. This also happens when obtaining new clients who are profitable (English, Guthrie, Broadbent & Laughlin, 2010). The current competition for new clients in the industry among the auditors amplifies this conflict.

Conflicts of interest in potential client acceptance decisions

Some industries and professions are not desirable anymore to the audit profession due to the ripple effect of precedent cases. This is the case with industries that have ethical concerns, companies with dubious associations and environmental concerns (Cappelleto, 2010).

A potential client who is involved in many court cases may not be a suitable fit. This is especially the case if the audit work that is to be performed may be used in the same legal action or in some forms of a claims (Geoffrey et. al, 2016). Worse still would be a legal action between the potential clients and existing clients of the auditor.

In the case of Cloud 9, I would check to see if the related parties (ASA 550) and management have outstanding litigations. Such litigations can result in reputation damage especially if it relates to elements of what is being audited.

I would also check the going concern assumption for the company (ASA 570).

I would check if there is conflict of interest with my existing clients. The conflict of interest could be existing litigation between the clients.

1. Technical capabilities

It cannot be stressed enough that the audit assignment must be done by persons with adequate, relevant, technical prowess, experience and proficiency. The complexities of the modern world are constantly changing and add different dimensions to these requirements. This goes far beyond the expected technical aspects of accounting and auditing. The auditors must have the necessary training, exposure, technical competence and experience to perform the assigned work. The risk is potential professional liability and damage to their reputation. Auditors are also expected to continuously update themselves with the changing business operating and auditing environment. This has seen some clients to demand professional indemnity before contracting with a new auditor.

Specialised expertise in the industry is one of the key factors in many of the audit engagements. Different industries will present unique aspects in terms of internalising, understanding and interpreting their processes and business of how the goods or services are produced. Risks are usually unique to any given industry and all these risks will require special technical procedures and experience for each of the risk (Goodstein, 2011).

Many potential clients are subjected to regulations which require experts to interpret (ASA 620). There are also regulations of several regulators. These regulations require in-depth knowledge of the technical aspects if such regulations and rules are to be complied with (Ghandhar & Tsahuridu, 2013).

Specialised expertise required for auditing Cloud 9

Auditors should ensure that they have the relevant skillset and experience to deliver the services required by potential clients. This will ensure they complete the engagement to the satisfaction. Failure to give thought to some unique industry, entity or regulatory matters that may have material effects on financial statements can be detrimental to any auditor (Arens et. al, 2013).

In the case of Cloud 9, I would check competency on systems audit. The SWIFT system is a critical resource for the company and should be subjected to a comprehensive audit. Competency on audit of related parties is also a key aspect to review for this company. Competency on group audit is also required (ASA 600). These are over and above the competency for auditing the industry Cloud 9 is operating in.

1. Audit fees

If the auditor feels that the prospective client may not pay the fee for the work, no commitment should be made with such a client. This also applies to potential client who owes fees to the previous auditor or even other professionals. Such a client with such a record of not paying in the past will likely not change. Audit fees should be priced according to the risks borne by the auditor when providing the services as requested (Messier & Emby, 2005). The audit fees should cover the all the costs of all the services provided and a margin. The fees must be reflective of the terms of agreement (ASA 210). A client should be approached with caution if they propose that it will require the auditor to adjust the audit fee charged should business conditions change. For example, payment of fees should not be based on the fortunes of future economic or business circumstances of the potential client.

Adequate fees that are charged by an auditor must be adequate to attract, retrain, maintain and retain proficient personnel. Profits cannot be used to compromise on integrity, it must be taken into consideration if the auditor is find success at their work (Livne, 2015).   Consideration must also be taken when competing with fellow auditors (Mock et. al, 2013). Ethical issues must be considered (ASA 102).

The factors to consider when planning for audit are (ASA 300);

1. System of internal controls and accounting

The auditor must take time to internalise the accounting policies. The auditor should also take into note any recent changes to the policies. The auditor’s knowledge of such accounting systems and internal control will inform the importance that is expected to be placed on the tests of controls (ASA 500), samples and auditing procedures.

1. Prior years’ audit

Audit fees, pricing, and ethical considerations

Matters raised in the prior year’s audit and which may be relevant in the current year must be reviewed. This is done by reviewing prior year’s working papers. The auditor will note areas noted as having weak controls or requiring attention. Attention should be paid to those areas in the audit plan.

1. Legislation

This is to assess if any changes in legislation and accounting standards have any impact. The changes may affect the financial statements of the company. The audit plan should include whether those changes have any impact and if the client has complied with such changes (Moroney & Trotman, 2016).

1. Business environment

The auditor will usually engage with peers, management and staff of the entity about current operating environment and outlook for the industry. This should include any changes in the strategy, business model, and on changes in management of the entity. E.g. changes in management might have an impact on the internal control system.

1. Changes in accounting procedures

The auditor should consider if there have been changes to the accounting procedures. The accounting procedures should be in line with the appropriate accounting standards (Nicolaescu, 2013).

1. Related parties.

The auditor should review if the entity has related parties and how such interests are reported in the financial statements

The audit can also review the work of internal audit and decide if reliance can be placed on such reports. Such evidence should be subject to validation steps before it can be accepted as suitable evidence for which reliance can be placed on (Rezaee & Kediaa, 2012).

1. Scoping the resources necessary to perform the work

The auditor should scope the work for resources needed given the time required, manpower available, resources and complexities. The terms of engagement must be clear to the auditor and management (Arens et. al, 2013).

• Factors to consider when performing preliminary risk assessment

1. Recognising the nature of the company and the environment it is operating.

Some companies operate in highly regulated jurisdictions, while others will operate many branches in different jurisdictions. Some companies will own subsidiaries or be part of a group of companies. The company could have a sizable market share in the market it is operating in.

In this context, I would take into consideration that this entity has subsidiaries, has an online presence and a brand that has loyal following.

1. Quality of management;Inept management that’s not taking appropriate action about adherence and enforcing the entity’s policies and procedures will encourage that concurrence throughout the entity. I would assess management culture through observation, interaction and quality of responses to queries. Another indicator is high employee turnover, some indicator is employees are seeking other opportunities because core management has failed to address their concerns (Shah, 2013).

If key personnel such as the core management have been with the entity for several years, that’s usually an indication of stable management. A positive sign is if previous audits have required minor accounting adjustments and that there have been no material financial statement restatements (Wagenhofer, 2014).

I would perform the risk assessment procedures like analytics, observation, inspection and enquiries from management (ASA 315).

1. Understanding system of internal controls;This is the overall policies and procedures adopted by the entity to achieve its objectives. This is beyond the normal accounting polices (ASA 315). Adherence, application and review of such procedures give an indication of how the internal control structure is working (Subramanyam & Wild, 2014).

Factors to consider when planning for an audit engagement

The auditor’s assessment of inherent risk is a key factor is assessment of preliminary risk. This is done through walkthrough of the systems of internal control and accounting policies in use by the entity (Wood, 2011).

• Preliminary materiality calculation

The materiality guidelines are subject to the auditor’s experience and judgement.

However, I would have the following consideration which act as guidelines (ASA 320);

1. a) Quantitative Considerations.

Preliminary judgement – The general rule of thumb is either 10% of normalized net income or 1% of total assets.

I would set performance materiality on a line item like income, expense or asset.

Other factors to consider are the timing and frequency of identified misstatements

1. b) Qualitative Considerations.

-Disclosure on related parties. This will be guided on if management has disclosed interest of the entity in related parties (Wood, 2011).

-Misstatements and disclosures. The extent of misstatements and non-disclosure will have an impact on the materiality calculations that auditor will have on the management assertions.

2.Four inherent risks that are involved in Cloud 9 and its industry, the account and audit assertions that are likely to be misstated.

Inherent risk description	Accounts affected	Assertions affected	Risk assessment (likelihood and materiality)
1.Error of      misstatement.	All financial statements	Assertions related to transactions, account balances and disclosures	The likelihood of misstatement is high given the different division in this company. We have an online store, a warehouse and a wholesale shop. We also have many inventory items on transit at any one time. We also have reliance on a system which the management asserts that they are not properly conversant with (Wright & Charles, 2012). All these factors have made me classify this assertion as high risk due to the many touch points as far as inventory handling is concerned.
2.Risk of fraud    and theft	Inventory accounts	Assertions related to transactions	The likelihood of theft and fraud is high due to the following (ASA 240); Likelihood of inventory being lost or misplaced during transit to the clients. The control of undelivered goods may give opportunity for theft. Weak controls on replacement of faulty goods may give opportunity for fraud. All these factors have made me classify this assertion as high risk.
3.Risk of business    failure	All financial statements	Assertions related to transactions, account balances and disclosures	The revenue generated in year 2015 by the Cloud 9 show marginal increase from year 2014 despite pumping of $ 2 M in 2014 for boosting the capacity to service demand. All these factors have made me classify this assertion as medium risk (Zhang et. al, 2007).
4.Risk of system    failure	All financial statements	Assertions related to transactions, account balances and disclosures	The system reports need to be tested for integrity (ASA 520). We can do a stock inventory and confirm that it tallies with the system reports. All these factors have made me classify this assertion as high risk.

After a review of the transcript of meeting with Carla Johnson, the Financial Controller of Cloud 9 (Appendix, Moroney 3e, pp.444-445), here are the THREE internal controls that Cloud 9 has in place to stop errors occurring as well as the accounts and assertions covered by those controls and an explanation of how i will test these controls.

Internal control description	Accounts affected	Assertions affected	Proposed tests of controls
1.Generating a sales order after a credit check.	Inventory accounts	Assertions related to transactions.	a) I will first check how the credit scoring criteria is set up and how often it is updated (ASA 530). b) Select a sample of sales orders and check whether the clients will pass the credit check.
2. Generating an invoice on acknowledged delivery notes	Inventory accounts	Assertions related to transactions.	a) Select a sample of delivery notes to see if they were acknowledged by the clients. b) Select a sample of matched invoices with delivery notes to confirm they belong to the same entity. c) Select a sample of matched invoices with delivery notes to confirm delivery notes are acknowledged and details match the respective invoice details (ASA 501).
3.Daily reconciliation and review of the cash receipts reconciliation.	Cash accounts	Assertions related to transactions and account balances.	a) Select a sample of cash reconciliations filings for consecutive days to confirm the reconciliation is being done daily. b) Select a sample of cash reconciliations filings and confirm the reconciliations are being reviewed. This should be through annotations by whoever is reviewing.

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