The inherent risks are those risks that can cause a material misstatement in the financial statements irrespective of the internal controls. The inherent risks are present in the e-business and there is no method that can completely remove the existence of it. When it comes to the concept of inherent risk, it is essential that the organization should have a sound risk management approach (Merchant, 2012). In the case of Max Security Limited, the inherent risks are the following:
The top-level employees or the employees that are directly related to the operations may have committed fraud- the main inherent risk that is expected in this case is that fraud. The company deals in manufacturing of high tech armour plated vehicles. Such kinds of vehicles are used for safety and security of top class people such as bureaucrats, army officers and other top-level security officers. Hence, the company has to maintain a very highly secure environment where the designs of the vehicles can be kept safe and confidential. If there is any leakage in the designs of the company vehicles, it might bear a threat to the high-level officials using the same (Neimi & Sundgren, 2012). The inherent risk here is that any top-level management employee of the company may leak the design of the vehicle just in order to earn some good money as they have major control over the internal controls of the entity. This will lead to the leakage of design and create an adverse situation for the company. In addition, they have the ability to manipulate the accounts and stop the auditors from detection of such manipulations in accounts thus leading to misstatements in financial statements.
Risk in successful implementation of the new costing system- another inherent risk that is there while conducting audit is that there has been change in the costing system. A new costing system has been introduced in the company over the old one. The old costing system was unable to capture the complex manufacturing process. In addition, there were problems in reporting of the total costing of the manufacturing process. Hence, a new costing system was put in place. Inherent risk here is that while replacing the systems, there might be some major costs that were not recorded by mistake or that were overlooking in the time gap between discarding old system and implementation of new one as implementation of any new system takes time. These overlooked or non-booked costs can lead to financial misstatements.
Leakage of information- another risk considering the industry as a whole is that the patent information of the security vehicles may be leaked and may cause huge losses to the company. The auditor must go through each aspect to check financial and nonfinancial leakages, which may lead to any kind of misstatement or may affect the company as a whole.
Clerical errors – it might be possible that while compiling the database of the products cost and their inventories each time a transaction is moved such as purchase, sales, returns etc., there might be clerical errors on the part of the employee who is feeding the database (Matthew, 2015). Hence, where such error exists, there are major changes that there may be material misstatement in the financial statements, as the wrong inputs will obviously result in wrong output in the form of reports.
Other risks may include failure of the completely costing system, theft of patent information, theft of data, loss of data by fire, etc.
Hence the costing system should provide more security and a backup plan may be formed by the company so that in case there is a loss of data by theft etc the company should have a backup plan ready in hand.
Factors to consider while determining preliminary materiality for Max Security:
Materiality is the amount that makes a difference in the analysis of financial statements. For example, if a company has booked the total revenues of the company as $ 750000 whereas the actual revenues were $ 700000 only, this is not material. However, if the actual revenues were only $ 250000 this is ‘Material’ for the company accounts.
The factors that need consideration in determining materiality in the given case are:
Whether the costs of the new costing system implemented has been taken into consideration or not.
Whether the benefits and limitations of the new costing system been considered or not before bringing the same into implementation.
iii. Whether or not the costs of the product being manufactured are competitive with other companies in the market.
Other factors that are to be considered while determining materiality include- the level of internal controls in the company, governance controls, fraud risk factors such as incompetent employees, number of accounting adjustments required due to change in costing system, etc (Hoffelder, 2012).
Further, the nature of business should also be considered for determining the materiality.
There are various methods to find out the materiality with regard to financial statements such as percentage method, etc.
In the given case, the given scenario is that the debtors comprise two components. Firstly, debtors arising out of use of medical services and secondly use of nurses, equipment, etc by medical practitioners on hire basis. The medical practitioners are given a credit period of 14 days and 60% of total debtors comprising of five medical practitioners it. This creates a doubt as an auditor because roughly mainly five medical practitioners hold $ 23, 84,741. Therefore, we are discussing the strengths and weaknesses of adopting debtor’s confirmation as audit evidence:
Where the balance shown in the debtor’s confirmation tallies with the account balances maintained with the client, it itself is a sufficient proof of audit evidence. It can easily be relied upon where the debtor confirmation is signed and stamped and properly reflected in the accounts confirmation statement.
Where the credit period is small and the client adopts bill-to-bill payment system, the auditor can rely upon the debtor confirmation statement with the outstanding bills of the client (Lapsley, 2012). Hence, the evidence needs to be taken into consideration before opting for the payment. The auditor should act when he is clearly justified by the relevant details present.
Debtor confirmations can also act as a reconciling statement in case the client has lost the data due to the destruction of digital media, loss by fire, or any unprecedented event that results in complete loss of data. It acts as a sufficient proof and sometimes an account statement may back it.
The major weakness in considering the debtor’s confirmations as main audit evidence is that there may be less authenticity in accounts of the client. It might be possible that after obtaining the debtor’s confirmation, the client may manipulate his accounts according to the balances of the debtor just in order to present a true position of the account balances (Gay & Simnet, 2015).
In the case where the account balance is quite old that is more than 180 days old, debtor confirmations cannot rely on as audit evidence because it is not easy to check every balance which ranges in more than one financial year (Geoffrey et. al, 2016). In this case, it is better to reconcile the debtors with their actual ledger statement.
The company shows the bad debts only against the accounts receivable and does not show it separately anywhere. So just because of debtor balance confirmations, the auditor cannot reconcile the number of bad debts actually arose. If the client would have procured full ledger statements then it might have been easier to reconcile the bad debts (Kaplan, 2011).
No, it is not possible for the auditors to take debtors confirmations as conclusive audit evidence. It is possible that the client in order to create an inflated balance sheet manipulates the debtors and shows a higher amount of debtors in the books of accounts. The client may also arrange a fake debtor confirmation statement or list so that the auditor is misled accepts debtor confirmation as conclusive evidence (Fazal, 2013).
The auditor should personally talk or procure the account statements of debtors for a full financial year and this should mainly be done with the debtors having large or old balances because the client can in order to misguide the auditor, may inflate the sales figures so that the debtor balances are increased. In the above case study also, five persons reflect 60% of the debtors only that is a substantial amount. Therefore, the auditor should procure all the audit evidence because in this case the debtor amounts are concentrated with few debtors only while the remaining 40 % of debtors comprise of small numerous amounts.
Further, only verifying the closing balances of debtors with the balances of debtors at the year-end is not a sufficient audit procedure. The auditor should indulge himself in complete in-depth checking of all the debtor’s accounts so that he can find out if there is any fake entry in the accounts or the amounts have been shown to be received in cash (Elder et. al, 2010). The auditor should use his expertise to find out any discrepancies from the Sales Invoices and the Bank statements also to assess whether the accounting entries passed by the client are authentic or not.
Hence, it is not possible for Chan and Partners to use debtor balance confirmations as the only audit evidence. The auditors should use the full year debtor statements, bank statements, sales invoices, opening balances, and all the documents relevant to the debtor balances. The substantial amount of debtor balances is with five people only and hence they are the major consideration for the auditor firms. The auditor should apply his prudence and due diligence while checking the accounts related to the debtors or amount receivables. In addition, the bad debts that have been mentioned by the client are to be checked as to their authenticity and valuation. The debtors that are traceable so that the auditor can check whether the client has reduced the number of receivables by booking the bad debts should also verify the bad debts.
References
Elder, J. R., Beasley S. M., and Arens A. A. (2010). Auditing and Assurance Services. Person Education, New Jersey: USA
Fazal, H. (2013, May 13). What is Intimidation threat in auditing?.Retrieved from: https://pakaccountants.com/what-is-intimidation-threat-in-auditing/
Gay, G., and Simnet, R. (2015). Auditing and Assurance Services. McGraw Hill
Geoffrey D. B., Joleen K., K. K.S., and David A. W. (2016). Attracting Applicants for In-House and Outsourced Internal Audit Positions: Views from External Auditors. Accounting Horizons, 30(1), 143-156. https://doi.org/10.2308/acch-51309
Hoffelder, K. (2012). New Audit Standard Encourages More Talking. Harvard Press.
Kaplan, R.S. (2011). Accounting scholarship that advances professional knowledge and practice. The Accounting Review, 86(2), 367–383. https://doi.org/10.2308/accr.00000031
Lapsley, I. (2012). Commentary: Financial Accountability & Management. Qualitative Research in Accounting & Management, 9(3), pp. 291-292. https://doi.org/10.1111/1468-0408.00081
Niemi, L., and Sundgren, S. (2012). Are modified audit opinions related to the availability of credit? Evidence from Finnish SMEs. European Accounting Review, 21(4), 767-796. https://doi.org/10.1080/09638180.2012.671465
Matthew, S. E. (2015). Does Internal Audit Function Quality Deter Management Misconduct?. The Accounting Review, 90(2), 495-527. https://doi.org/10.2308/accr-50871
Merchant, K. A. (2012). Making Management Accounting Research More Useful. Pacific Accounting Review, 24(3), 1-34. https://doi.org/10.1108/01140581211283904
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