You are the senior auditor in charge of the audit of Potholders Ltd, a retailler

Question

You are the senior auditor in charge of the audit of Potholders Ltd, a retailler of garden pots. Your audit firm has been the auditor for the last four years. Historically, the firm has had a competent and qualified internal audit team upon whose work you have placed significant reliance. Management is well respected and is viewed to have high integrity, although there was some friction last year when the auditor discovered sales cut-off errors, which reduced profit and which had an adverse impact on management bonuses under the new bonus scheme. While the company has been very profitable, the drought and water restrictions have placed pressure on management to maintain profitability. In planning the audit you become aware of the following facts: i0 There is a cash shortage caused by recent expansions and falls in cash inflow i) The accounts payable balance has increased by 30 per cent last year. ii) Debtors' collection period has increased from 45 days to 63 days v)Due to the difficulty of maintaining sales levels, credit checks are not always carried out. v) Internal audit department staff levels have been reduced. vi) After a recent series of thefts, control over inventory has been tightened. When goods are received, they are counted and inspected and, after a pre-numbered goods received advice is prepared, the goods are moved to an enclosed storage area with adequate security including closed circuit TV. Goods are released from the store only upon receipt of a properly authorized requisition form. vil) In the past, all purchases were made centrally at head office. However, store managers are now asked/allowed to purchase direct from local suppliers in order to obtain inventory at lower prices and avoid transport costs. Some store managers are importing from Indonesia. Required: a) Discuss facts that increase inherent risks at the financial statement level. b) Discuss inherent risks at the account level for inventory and accounts receivable.(12 marks) c) Discuss facts that increase or decrease control risk (12 marks) (12 marks)

Explanation / Answer

Answer :

Whats is inherent risk?

Inherent risk is the risk posed by an error or omission in a financial statement due to a factor other than a failure of control. In a financial audit, inherent risk is most likely to occur when transactions are complex, or in situations that require a high degree of judgment in regards to financial estimates.

In another words,

Inherent risk is the susceptibility of an account balance or class of transaction to a material misstatement , assuming that there were no iternal control.

Each entity should decide on the inherent risk factors most appropriate to its own operations and circumstances and the weightings to be applied to each factor. Examples of factors that can impact inherent risk are materiality, the level of judgment involved, disparity of data sources and results of previous audits by internal audit and the ANAO.

a) Some of the below mentioned facts increase the inherent risk at financial statement level:

# Integrity of management.

# Management's experience, knowledge and changes in management during the period.

# Unusual pressures on the management.

# The nature of entity's business.

# Factors affecting the industry in which the entity operates.

b) Inherent risks at account level for inventory are:

# Theft/inventory loss

# Inventory waste

# Damage

# Shelf life

# Life cycle

Inherent risks at accounts receivable are:

c)  Control risk has been defined under International Standards of Auditing (ISAs) as following:

The risk that a misstatement that could occur in an assertion about a class of transaction, account balance or disclosure and that could be material, either individually or when aggregated with other misstatements, will not be prevented, or detected and corrected, on a timely basis by the entity’s internal control.

In simple words control risk is the probability that a material misstatement exists in an assertion because that misstatement was not either prevented from entering entity’s financial information or it was not detected and corrected by the internal control system of the entity.

It is the responsibility of the management and those charged with governance to implement internal control system and maintain it appropriately which includes managing control risk.

Control risk is one of the components of Risk of material misstatement while the other component is inherent risk. It is the responsibility of the management to minimize inherent risk which is done by implementing internal control system. But if internal control system is not preventing, detecting and correcting misstatements on timely basis then inherent problems will creep in the entity’s system and thus risk of material misstatement will increase.

Auditor is not responsible for managing internal control system and also under ISAs he is not under the duty to assess and report i.e. give his opinion on internal control system of the entity unless he is required under other applicable rules and regulations. But as said above if control risk is high which in other words mean internal control system is not working effectively then risk of material misstatement will increase which ultimately increases the chances that auditor may end giving inappropriate opinion which is termed as audit risk. In response to increased audit risk he is required detect material misstatements through by designing appropriate audit procedures.

One important point to note about control risk is that this also is assessed in relation to assertions i.e. at assertion level and not just at financial statement level.

There can be many reasons for control risk to arise and why it cannot be eliminated absolutely. But some of them are as follows:

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