Discuss about the Strategic Business Inherent Risk Assessment and Preliminary.
In the context of auditing, the inherent risk implies a risk of misstatement in the financial statement without taking into account the controls. The entity lay down the controls on various business processes to reduce the risk of misstatement in the financial statements, which are not considered by the auditor at the time preliminary assessment of the audit risk (Johnstone, Gramling, and Rittenberg, 2015). This preliminary assessment of the audit risk is known as inherent risk. The assessment of the inherent risk is made at the financial report level and at the particular account balance level. The assessment of inherent risk at the financial report level takes into account the broad view as to what could go wrong at the higher management level in finalising the financial statements (Johnstone, Gramling, and Rittenberg, 2015). There are various factors that affect the assessment of the inherent risk at the financial report level as discussed below:
The management’s integrity is crucial matter for the organisation’s reputation. If the management of an organisation is dishonest, the auditor is likely to assess the inherent risk high (Delaney and Whittington, 2012). On the other hand, if the management is integrate; the auditor would assess the inherent risk low considering less possibility of manipulation in the financial statements. Thus, the lack integrity of the management would increase the risk of misstatements in the financial statements.
The experience and knowledge possessed by the board of directors of a company is another factor that contributes to the assessment of the inherent risk at the financial statement level (Delaney and Whittington, 2012). The auditor need to give due consideration to the experience and knowledge level of the board of directors of the company, the supreme management authority, while assessing the inherent risk at the financial report level. This is because the inexperienced people or novices in the board can easily be caught up by the swindlers. Thus, if the people in the board of directors are inexperienced or lacks in knowledge, it is more likely that the auditor assesses the inherent risk high than usual (Delaney and Whittington, 2012).
This is perhaps the most crucial factor that the auditor is required to take into account while assessing the inherent risk. A substantial and sudden change in the composition of the board of directors is an indication of something wrong in the entity. Thus, if the auditor, prior to conduct the audit, comes across of any substantial change in the board in the recent years, the inherent risk should be assessed high (Johnstone, Gramling, and Rittenberg, 2015).
The nature of business could also affect the assessment of the inherent risk. For example, a new venture with different business processes like internet companies are more prone to the inherent risk. Further, the industry conditions such as increase in the competition in the market could create usual pressure on the management. The management may tempt to manipulate the financial statements and window dressing to impress the investors in such situations (Young, 2003).
The political and regulatory together affect the assessment of the inherent risk. For example, the changes in the regulatory regime in the telecom sector in Australia affected the entire industry. Thus, the changes in the regulations, which are likely to have adverse impact on the business of the company, also enhance the degree of inherent risk (Young, 2003).
The strategic business risk assessment is the process of identifying the circumstances that could lead to potential hazard to the business and providing for the safeguard against those circumstances. In the present scenario, the organisations are adopting very comprehensively risk assessment mechanism that takes into account the internal as well as external risk factors (Fraser and Simkins, 2009). The internal risk factors cover the circumstances related to the internal processes and business environment of the company. Further, the external factors relate to the environment outside the company, for example, the political conditions, regulations, and geographical conditions. Among the above discussed risk factors, the factors pertaining to the management and nature of business are could be identified during internal risk assessment. Further, the risk factors pertaining to the political and regulatory environment are likely to be identified during the external risk assessment (Curtis and Cary, 2012).
The auditor is required to maintain highest level of quality in auditing and assurance services. In order to maintain the highest level of quality, the auditor should assess the risk material of misstatements, which includes the inherent risk, at the accounts balance level (Puncel, 2007). The risk of material misstatement at the account balance level is about confirming that the account balances shown in the financial statements are true and correct. Thus, the auditor is required to verify various assertions in respect of the account balances and classes of transactions. Such assertions are existence, occurrence, completeness, and classifications of the transactions and account balances. In verifying these assertions, the auditor should pay due regard to various risk factors as discussed below:
Complexity of Transactions
The auditor may observe the financial transactions a little bit complex in the special nature business entities as compared to the normal business entities. In the fast developing business environment, it is possible that an entity may have the special financial arrangements making it really difficult for the auditor to evaluate their impact on the financial statements. Thus, the auditor should have due regard to the level of complexity of the transactions (AU Section 312, 2006). The higher the level of complexity adjudged by the auditor higher will be the assessment of inherent risk.
Accounting System
The accounting system employed by the entity is also a major factor in assessing the inherent risk at the account balance level. In this regard, the auditor should verify that whether the entity has accounting system in place that commensurate with its size and the nature of business. If the accounting system does not commensurate with the size of the entity and nature of its business; the auditor should assess the inherent risk high (AU Section 312, 2006).
The accounting transactions and balances that involve management’s judgment are more prone to misstatement. The accounting transactions such as determination of the useful life of the depreciable assets and selecting the method of depreciation depend upon the management’s judgment. The more there is scope for management judgment, the more will be the inherent risk assessed by the auditor (AU Section 312, 2006).
Susceptibility of Misappropriation
The auditor should cover here the factors such as skills of the staff, instances of circumvention of the authorities in the past, and the overall structure of the concern. Considering these all factors if the susceptibility of misappropriation is higher, the inherent risk should be assessed as high (Johnstone, Gramling, and Rittenberg, 2015).
Cut off Transactions
The cut off transactions refers to the transactions occurring at the end of the accounting period. The auditor should pay attention to the past records and also refer to the previous audit reports to identify the volume and the nature of transaction that occurred at the end of the accounting period (Johnstone, Gramling, and Rittenberg, 2015).
The financial statements of an entity are prepared based on the fundamental accounting assumption of going concern (IAS 570, 2016). The assumption of going concern implies that the financial position of the company appears adequate and the entity is not going to liquidate its assets in the near future. The management of the company has to explicitly state that the financial statements have been prepared on the basis of going concern assumption and the role of the auditor is to verify the appropriateness of this statement of the management. In verifying the appropriateness of the management’s statement the auditor should take in to account the significant events and transactions that impair the ability of the organization to continue as a going concern (IAS 570, 2016).
Based on the analysis of the significant events and transactions, the auditor should assess the risk of going concern as high, low, or medium. The assessment of the risk pertaining to the going concern is crucial in drawing audit opinion, thus, the auditor should maintain professional skepticism while verifying the appropriateness of the going concern assumption (Dagwell, Wines, and Lambert, 2011). The auditor should consider the following events or transactions while verifying the appropriateness of the going concern assumption:
Financial Events
The auditor should be alert while verifying some of the important items of the financial statements such as net worth, debt liability, and operating cash flows. Further, the key financial ratios such as debt equity ratio and current ratio also need to be considered by the auditor. The events such as negative net worth, negative operating cash flows, adverse debt equity ratio and current ratio increases the risk of going concern (Flood, 2014).
Non Financial
Further, the non financial conditions such as management’s intention to liquidate the business operations in the near future, key changes in the management, and loss of major market share also contributes the risk of going concern. Further, the other events such as major non compliances with the laws and regulations, major change in the laws, and emergence of the highly successful competitors in the market also increases the risk of going concern. Therefore, the auditor should be updated with the legal and regulatory environment in which the company operates (Kan, 2013).
The going concern risk in respect of OneTel has been assessed as high based on the identification and analysis of the following events:
OneTel’s major operations are in Australia as depicted from the fact that 64% of the worldwide revenues come from Australia (OneTel Case, 2001). Therefore, it is essential to analyze the prevailing conditions in the Australian telecommunication industry. In this regard, it has been observed that competition is increasing rapidly and the revenues of the existing telecom companies like OneTel are decreasing. Further, there have been changes in the industry regulations in respect of licensing arrangement, which are also affecting the existing companies adversely. These adverse changes in the market regulations and sudden increase in the competition can be perceived to be increasing the going concern risk of OneTel.
OneTel incurred huge operating losses amounting to $262.40 million in the financial year 2000 (OneTel Case, 2001). The financial performance of the company went down drastically in the year 2000, which casts significant doubt on the going concern. Further, due to losses being incurred by the company, the dividend paid out to the shareholders also went down to $0.10 million from $3 million (OneTel Case, 2001). This reduction in the dividend also contributes to the risk of going concern.
The payment to suppliers was $328.10 million in the year 1999, which increased sharply to $684.80 million in the year 2000 (OneTel Case, 2001). The sharp increase in the payment to suppliers shows that the suppliers have discontinued giving material on credit to the company. The shift from the suppliers from credit to cash based delivery of material shows the reduction in their confidence in the company. The lost confidence of the suppliers enhances the risk of going concern.
The operating cash flows of the company have gone negative. The company is facing negative operating cash flows since last two years. Further, in order to maintain liquidity, the company has borrowed a significant amount in the current year. Further, the total debt of the company has reached to $490.70 million in the year 2000 from $163 million in the year 1999 (OneTel Case, 2001). The significant increase in the debt and negative cash flows from operations indicates high risk of going concern.
References
AU Section 312. 2006. Audit risk and materiality in conducting an audit. [Online]. Available at: https://www.aicpa.org/Research/Standards/AuditAttest/DownloadableDocuments/AU-00312.pdf [Accessed on: 06 September 2016].
Curtis, P. and Cary, M. 2012. Risk Assessment in Practice. [Online]. Available at: https://www2.deloitte.com/content/dam/Deloitte/global/Documents/Governance-Risk-Compliance/dttl-grc-riskassessmentinpractice.pdf [Accessed on: 06 September 2016].
Dagwell, R., Wines, W., and Lambert, C. 2011. Corporate Accounting in Australia. Pearson Higher Education AU.
Delaney, P.R. and Whittington, O.R. 2012. Wiley CPA examination review, outlines and study guides. John Wiley & Sons.
Flood, J.M. 2014. Wiley GAAP 2015: interpretation and application of generally accepted accounting principles 2015. John Wiley & Sons.
Fraser, J. and Simkins, B. 2009. Enterprise risk management: today’s leading research and best practices for tomorrow’s executives. John Wiley & Sons.
IAS 570. 2016. International standard on auditing 570 (revised) going concern. [Online]. Available at: https://www.nba.nl/Documents/Wet-%20en%20Regelgeving/Adviescollege%20voor%20Beroepsreglementering/naar%20een%20uitgebreide%20controleverklaring/ISA%20570%20(Revised).pdf [Accessed on: 06 September 2016].
Johnstone, K., Gramling, A., and Rittenberg, L.E. 2015. Auditing: a risk based-approach to conducting a quality audit. Cengage Learning.
Johnstone, K., Gramling, A., and Rittenberg, L.E. 2015. Auditing: a risk based-approach to conducting a quality audit. Cengage Learning.
Kan, E. 2013. Audit and assurance – principles and practices in Singapore (3rd edition). CCH Asia Pte Ltd.
OneTel Case. 2001. Strategic Business Risk Assessment, Inherent Risk Assessment and Preliminary Going Concern Assessment.
Puncel, L. 2007. Audit Procedures 2008. CCH.
Young, M.R. 2003. Financial reporting handbook. Aspen Publishers Online.
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