Internal Audit Function Quality – Understanding Inherent And Control Risks

Introduction:

Discuss about the Internal Audit Function Quality.

Risk is synonymous to business. In addition, inherent risk is the risk that arises due to the very existence of business. These risks cannot be detected even after taking proper audit training and doing efficient audit procedures. These are risks that are more capable of getting missed by the audit procedures and internal control functions too. These can be mitigated to some extent but cannot be done away with fully.

OneTel, a global telecommunication company is being talked about here. It had business all over the globe. Their business based on innovation and technology. It provided a wide range of integrated products and services to the customers and it was a leader in its business in Australia. Initially only OneTel was a market player. Gradually, more companies got into the industry and more than 35 network providers then entered the industry and joined the race of telecommunication service providing business (Monem, 2009). With more and smaller companies getting into the industry, the call rates and other communication services became cheaper. Competitive prices ruled the industry. More market competition led to more competitive prices of international and long distance calls, and telephony services. With all the scale of business, OneTel was capturing a major share of the market. However, gradually as companies began entering the industry, the market share began decreasing (Monem, 2009). The various factors which would have led to inherent risk assessment at financial reporting level are as follows:

The financial statements of the company reflect that the shares of the company had been issued in the open market. From 355.6 million $ in 1999 it reached to 1225.6 million $ in 2000. Inherent risks arise when there is a high level of investment involved or when transactions are highly complex. Although dematerialization of shares has brought about high level of controls, still there are chances of inherent risks since there are millions of transactions involved and the entire system of share issue, money receipt and allotment of shares is complex. The procedure requires an increased inherent risk assessment.

A purchase of license transaction in the year 2000 is depicted by the cash flow statement of the company. License purchasing, registration, capitalization, amortization, and maintenance of these accounts is a humongous task. It requires a lot of financial planning and aftermath. This requires inherent risk assessment of a higher degree. The valuations of intangible assets, their charges, are a few of the computations that need management intervention and fair play. There has to be a fixed amount of care and risk mitigation measure to be taken since these are transactions that are more prone to misstatements and mistakes. These are complex transactions involving management judgment and hence need inherent risk assessment procedures to be fully prevalent. As is evident from the financial statements, the company has taken up multiple loans and advances, from short term to medium term to long term. These transactions are much prone to misstatements and mistakes. There are chances of frauds that can be mitigated and controlled by control risk assessment measures. However, if not for frauds, the natures of risks associated with these transactions involve many inherent risk assessment measures. The company has taken borrowings, issued shares. These attract inherent risk assessment procedures to be in place.

Factors Contributing to Inherent Risk:

There are abnormal items in the financial statement. These abnormal items require that there should be risk assessment procedures in place that risks assessed well before time, their impact to be assessed and mitigate. There are huge accumulated losses for the year both at entity level and at consolidated financial statement level. The computation and maintenance, writing off, etc. of accumulated losses is a complex transaction that requires management intervention and hence inherent risk assessments becomes imperative here. There was an increase in the value of plant and machinery. Evidently, there was purchase of plant and machinery. Purchase of assets is a purely management decision making. Discretion of management works. What to purchase, from where to purchase, how to purchase, how to manage finances, the actual requirements should meet with the asset purchased, etc.

This needs inherent risk assessment procedure to be in place. Strategic risks are those risks that are crucial to the ongoing of a business and require attention and care as a continuous and long-term effort. Loose ends can be left open if strategic risks have to be mitigated (Cook, 2001). Strategic risks are those that exist at the top most level of management related to incorrect decision making. These risks exist because the management might take a wrong decision or might not be able to implement significant decisions and plans. All planning risks as mentioned above, such as the risks arising because of issue of shares, or purchase of rights and licenses identified at strategic risk assessment level itself (Matthew, 2015). Risk assessment has a top down approach. Risks assessed from the management level and going down they are assessed at the individual transaction level in the name of inherent and control risks.

Inherent risk is all about judgment. The judgment of individuals is associated with the measure of risk. Detection risk and control risks can be overcome but what remains is the inherent risk that requires judgment and far sightedness of the management. Inherent risk is present in the system irrespective of the risk management strategy. However, the impact of inherent is entirely based on various factors.The various factors are as under:

Given the nature of business, the first and obvious factor that contributes to increased inherent risk is the existence of a large network of companies. The existence of a large number of companies as subsidiaries, holdings, associates, joint ventures, partnerships, all contribute to an increase in the inherent risk. More wide the network, more the number of companies in the network, higher are the chances of risks. There can be many more entities the company has to manage off balance sheet as well. As complexity of management grows, the capabilities of the management to void inherent risks reduce.

Abnormal Activities and Events

Abnormal events, transactions or any non-routine activity add to inherent risks increased. Abnormal activities require speculations and adjustments that invite inherent risks. Any transaction that involves management estimates and ideas are prone to inherent risks, this is because of the subjectivity of the situation. The transactions or events, their management and measurement, all require estimates and idea of the management that may and may not always hold good for the business (Kaplan, 2011). There is always a risk. Determination of fair value, computation of estimates, etc. pose a risk, the inherent risk.

Related party transactions are another factor that increases the inherent risks. This is because of the obvious emotional bias of the management towards the transaction. Thus, a related arty transaction is another fair factor that can increase the inherent risks of an organization. Potential debt covenant violations are another factor which ad to inherent risks. In the given case itself, we see that OneTel has taken huge loans, and all loans come with covenants. Moreover, violations of corporate debt covenants can lead to serious consequences (Kruger, 2009). The company has made losses. Repayment of loans and its interest, or abiding by other covenants is not a cakewalk. A risk of management override is always there. If the management tries to over play, the risk might never be mitigated or even detected. The stronger the audit team the weaker are the risks (Vause, 2009). As we talk about the company and its transactions, we tend to miss the fact that the inherent risks caused by the incompetence of audit personnel as well. An incompetent audit team act as another contributor to inherent risks. Hence training, expertise and knowledge of audit personnel is another prerequisite to mitigate and detect risks.

A businesses is started with an obvious thought in mind that it shall run for lifetime. It shall generate profits and run forever. Any activity of business, which can disrupt this thought, needs immediate action against it. The most fundamental accounting assumption is that the business is going to run forever, in the fairest possible way any transaction, decision or event that threatens the possibility of this needs to be highlighted immediately (Manoharan, 2011). All stakeholders and investors expect the business to continue and keep generating profits.

Any small activity that tends to threatens these needs to be taken care of (Geoffrey et. al, 2016). This is because it is not just management but expectation of other stakeholders as well (Brown et. al, 2006). Thus, it is very much agreeable that all activities going against the principle of going concern measured, as well as reported as high, medium, or low. It is important for directors and auditors to discuss at the earliest possible opportunity in the audit process any issues that could or do impact the company is going concern assessment. Uncertain or sudden economic crisis is beyond control but all controlled decisions taken to avoid such a scenario. The various factors which cause a set back to the going concern assumption may be various. Such as a major debt repayment failure, non-fulfilment of creditor’s covenants, indications of withdrawal of credit support, or withdrawal or loss of keep management personnel without replacement, company’s inability to face competition, or continuous losses, or the company’s continuous erosion of assets and consecutive losses. All the above-mentioned factors can lead to considerable losses of finance, and reputation and hence hit the going concern assumption of the company (Douglas et. al, 2015). However, to avert such situation, the management needs to lay a special interest so that there is less room for error. Some factors are under the control of the company and management while some are beyond control. Sudden change of trend, newer products introduced in the market and the company not being fast enough to cope, sudden disrupt or fail in market, a natural calamity etc. are scenarios which affect the going concern of an entity but the entity has no control over these (Wood, 2011). Therefore, there needs to be a parameter that can reflect to the management the gravity of the situation and how immediately it needs to be address. Thus an indicator of high medium and low, to judge how bad or easily manageable the situation is and how fast an action is to be taken is a safe play idea which can be adopted by many. This will help in understanding the overall scenario of the organization and lead to a better action.

References

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