Chapter 6 Topic 5 Assessing inherent risk and other specific business risks NEW - Part A and B updated PDF

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Auditing and Assurance Services in Australia 7 edition by Gay & Simnett @ McGraw-Hill Education (Australia)2018...

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Chapter 6 Assessing inherent risk and other specific business risks Learning objectives 6.1 Explain the factors that influence the assessment of inherent risk. 6.2 Explain the auditor’s consideration of the risk of fraud. 6.3 Explain the auditor’s consideration of related parties. 6.4 Explain the auditor’s consideration of the appropriateness of the going concern basis. Major chapter sections Inherent risk Fraud Related parties Appropriateness of the going concern basis

Lecture plan In the last lecture students were exposed to a process by which auditors gain knowledge of the business and industry of their client and evaluate business risk. The knowledge gained at this stage will provide the auditor with the information to assess inherent risk at an overall level, with the assessment continuing at the assertion level and at the account balance, class of transactions and related disclosure levels. The chapter also covers the special risk areas of fraud, related parties and the appropriateness of the going concern basis.

Instructor Resource Manual t/a Auditing and Assurance Services in Australia 7e by Gay & Simnett © McGraw-Hill Education (Australia) 2018 Chapter 6

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You should outline the learning objectives for this chapter, and also walk them through how this chapter fits into the flowchart of the planning and risk assessment stage of a financial report audit. [Use slides 6-1 to 6-3] LO 6.1: Inherent risk A lot of this knowledge comes through gaining an understanding of the business and industry and assessing business risk. It is important to talk about assessing the risk of material misstatement and then introduce the concept of inherent risk and its relationship to business risk. It is necessary to explain the different levels at which inherent risk is assessed. An example is included of how an identified inherent risk can flow through to an account balance assertion, and the type of audit procedures the auditor would later undertake. [Use slides 6-4 to 6-11] LO 6.2: Fraud This section covers the issues of assessing the risk of fraud. It covers the auditor’s requirements regarding fraud at the planning stage of the audit. Students should be exposed to the different types of frauds— fraudulent financial reporting and misappropriation of assets. Fraud should be distinguished from errors. It includes a discussion of red flags which indicate fraud, and the different types of earnings management that the auditor should be aware of. Students are introduced to the fraud triangle that needs to exist for fraud to occur. We discuss the auditor’s responsibilities in fraud detection, which can be referred back to our earlier discussion of the expectation gap. We also discuss the auditor’s responsibilities for reporting fraud and discuss the concept of whistleblowing. [Use slides 6-12 to 6-29] LO 6.3: Related parties ASA 550/ISA 550 requires auditors to specifically assess the risk that related parties and related-party transactions will not be identified or appropriately disclosed and/or measured. The reasons that the auditor must identify all related parties when planning the audit include the existence of related parties or relatedparty transactions that can affect the financial information, the reliability of audit evidence as a function of the source of that evidence and that the initiation of a related-party transaction might be motivated by fraud rather than ordinary business conditions. Examples of related party frauds and procedures for identifying related parties are considered. [Use slides 6-30 to 6-34]

Instructor Resource Manual t/a Auditing and Assurance Services in Australia 7e by Gay & Simnett © McGraw-Hill Education (Australia) 2018 Chapter 6

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LO 6.4: Appropriateness of the going concern basis ASA 570/ISA 570 requires auditors to assess going concern at planning stage, as imminent business failure might have an effect on the appropriateness of presentation of financial report or might motivate management misrepresentations. Examples of going concern indicators and mitigating factors are considered. [Use slides 6-35 to 6-40] Summary We provide a summary slide of the main learning takeaways in this chapter. [Use slide 6-41]

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SOLUTIONS REVIEW QUESTIONS

Inherent risk 6.1 Define inherent risk and explain why it is important to evaluate inherent risk as part of audit planning. LO 6.1 6.1

Inherent risk is the susceptibility of an account balance, class of transactions or disclosure to material misstatement given inherent and environmental characteristics, but without regard to internal control. Inherent risk at the financial report level is an important consideration in general planning because it specifically affects other decisions made at this time, such as staffing requirements, and other aspects of the audit plan. For example, some of the possible responses to high inherent risk are to assign more experienced audit personnel, to increase the extent of supervision and to conduct the audit with a heightened degree of professional scepticism. Consideration of the inherent risk of material misstatement at the assertion level for classes of transactions, account balances and disclosures is important, as it directly assists the auditor in determining the nature, timing and extent of specific further audit procedures at the account and assertion level necessary to obtain sufficient appropriate audit evidence.

6.2 Outline the factors that may influence inherent risk at the financial report level. LO 6.1 6.2

Inherent risk at the financial report level refers to risks that are pervasive to the financial report as a whole and therefore may affect many assertions. These risks are not necessarily identifiable with specific assertions at the class of transactions, account balance or disclosure level. Rather, they represent circumstances that may increase the risks of material misstatement at the assertion level through factors that could potentially affect several accounts and several assertions. Factors that may increase inherent risk at the financial report level include the following: 

Integrity of management

If management lacks integrity, it is more likely to be prepared to produce materially misleading financial reports. 

Management experience, knowledge and changes during the period

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Inexperience of management and its lack of knowledge may affect the preparation of the financial report. In addition, if poor business decisions are made, this may introduce pressure to bias the results. 

Unusual pressure on management

This may provide incentives for management to misstate the financial report. For example, if the entity is facing cash flow problems, poor liquidity, poor operating results or insufficient capital to continue operations, there may be an incentive to make the financial position look better than the true situation. If management compensation schemes are tied to earnings or share prices, there is an incentive for management to misstate the result in order to obtain a bonus. 

Nature of the entity’s business

Some types of businesses are inherently risky. For example, companies will be inherently risky if their products are subject to a high inherent risk of obsolescence. Products such as high technology and fashion items may become obsolete due to changes in technology or consumer tastes. 

Factors affecting the industry in which the entity operates

Changes in economic and competitive conditions would be expected to have a major impact on the inherent risk of an entity. For example, the possibility of breaches of restrictive covenants in loan agreements increases during economic downturns.

6.3 Outline the factors that may influence inherent risk at the assertion level. LO 6.1 6.3

Inherent risk is greater for some assertions and related classes of transactions, account balances and disclosures than for others. Inherent risk at the assertion level refers to the likelihood of a material misstatement existing in a particular account balance, class of transactions or disclosures. Factors that may increase inherent risk at the assertion level include the following: 

Accounts likely to require adjustment Accounts that were found to be misstated in previous audits are likely to contain similar misstatements in the current year’s accounts.



Complexity of underlying transactions Transactions characterised by difficult calculations or a complex accounting standard are more prone to error than simple repetitive transactions.



Judgment involved in determining account balances

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The greater the degree of judgment involved in determining account balances, the greater the chance of error. Accounting estimates, such as provision for doubtful debts, obsolescence and warranty, are more likely to be misstated than routine factual data. 

Susceptibility of assets to loss or misappropriation If an entity processes large amounts of cash, such as a supermarket, susceptibility to misappropriation is increased.



Occurrence of unusual and complex transactions, particularly at or near year-end Material and/or unusual transactions occurring near the end of the year have a higher inherent risk, as they may have been undertaken with the objective of manipulating profits or covering up a poor liquidity position.



Transactions not subject to ordinary processing Transactions that are not subject to ordinary processing are more susceptible to errors or misappropriation.

Risk of fraud 6.4 What are the ways in which fraudulent financial reporting may be achieved? LO 6.2 6.4

Fraudulent financial reporting may be achieved by: 

manipulation, falsification or alteration of records or documents



suppression or omission of the effects of transactions from records or documents



recording of transactions without substance



intentional misapplication of accounting policies.

6.5 Describe three types of enquiry that an auditor will make of management with regard to fraud. LO 6.2 6.5

Types of enquiry that the auditor will make of management in regard to fraud include: 

management’s assessment of the risk that the financial report may be materially misstated due to fraud



management’s process for identifying and responding to the risks of fraud in the entity, including any specific risks of fraud that management has identified or account balances, classes of transactions or disclosures for which a risk of fraud is likely to exist

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

management’s communication, if any, to those charged with governance regarding its processes for identifying and responding to the risks of fraud in the entity



management’s communication, if any, to employees regarding its views on business practices and ethical behaviour.

6.6 What impact will advanced data analytics have on fraud detection? LO 6.2 6.6

The auditor needs to have a thorough knowledge of the client’s business to be able to identify opportunities for the perpetration of fraud. Advanced data analytics can assist in this area, as patterns or connections that might not have been discovered with traditional methods are much more easily identified, analysed and visualised with advanced data analytics.

Related parties 6.7 Explain what is meant by the term ‘related parties’. LO 6.3 6.7

Related parties exist where one entity is able to significantly influence or control the operating, financing or investing decisions of another; or if several entities are subject to control from the same entity; or if the party is a joint venture in which the entity is a venturer. Key management personnel (including directors), their close family members and entities controlled by them are also related parties, as are superannuation funds for the benefit of employees or related parties of the entity.

6.8 Provide four examples of transactions outside an entity’s normal course of business that may indicate the existence of unidentified related parties. LO 6.3 6.8

Examples of transactions that may indicate the existence of unidentified related parties include transactions that: 

are overly complex (for example, transactions involving multiple parties within a consolidated group)



have abnormal terms of trade, such as unusual prices, interest rates, repayment terms or guarantees



lack an apparent logical business reason to justify their occurrence



have been processed in an unusual matter.

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6.9 List three indicators of dominant influence being exerted by a related party. LO 6.3 6.9

As per ASA 550.A29 (ISA 550.A29), indicators of dominant influence being exerted by a related party include the following. 

The related party has vetoed significant business decisions that have been taken by management or those charged with governance.



Significant transactions are referred to the related party for final approval.



There is little or no debate among management and those charged with governance concerning business proposals initiated by the related party.

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Transactions involving the related party (or a close family member of the related party) are only rarely independently reviewed and approved.

Appropriateness of going concern basis 6.10 Explain why the auditor’s assessment of the appropriateness of the going concern assumption is so important. LO 6.4 6.10

The going concern assumption means that the entity is viewed as continuing in business for the foreseeable future without any intention or necessity to liquidate or otherwise cease its operations. When the going concern assumption is appropriate, assets and liabilities are recorded on the basis that the assets will be realised and the liabilities discharged in the normal course of business. This means either cost or fair value is used. However, an imminent business failure will have an effect on the appropriateness of the presentation of the financial report. If the company is not a going concern, the financial report should be prepared on a liquidation basis, which is likely to be vastly different to the going concern basis. Further, going concern problems may motivate management misrepresentation. Therefore, the appropriateness of the going concern assumption is very important in determining the audit procedures and the degree of professional scepticism to be applied and whether the fina1ncial report gives a true and fair view. As a result, ASA 570.10 (ISA 570.10) requires that when planning and performing audit procedures and evaluating the results, the auditor must consider the appropriateness of the going concern assumption that underlies the financial report.

6.11 Identify three factors that are relevant to management’s assessment of an entity’s ability to continue as a going concern. LO 6.4

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6.11

As per ASA 570.5 (ISA 570.5), factors that affect management’s assessment of the appropriateness of the going concern basis include the following. 

The uncertainty associated with the outcome of an event or condition increases significantly the further into the future the event or condition or its outcome occurs.



The size and complexity of the entity, the nature and condition of its business and the degree to which it is affected by external factors all affect the judgment regarding the outcome of events or conditions.



Any judgment about the future is based on information available at the time at which the judgment is made. Subsequent events may result in outcomes that are inconsistent with judgments that were reasonable at the time they were made.

6.12 Provide three additional audit procedures that the auditor should perform when events or conditions are identified that call into question the ability of an entity to continue as a going concern. LO 6.4 6.12

As per ASA 570.16 (ISA 570.16), additional audit procedures that the auditor shall perform when events or conditions are identified that call into question the ability of an entity to continue as a going concern include the following: 

Where management has not yet performed an assessment of the entity’s ability to continue as a going concern, request that management make such an assessment.

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Evaluate management’s plans for future actions in relation to its going concern assessment, whether the outcome of these plans is likely to improve the situation and whether management’s plans are feasible under the circumstances.

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Where the entity has prepared a cash flow forecast, and analysis of the forecast is a significant factor in considering the future outcome of events or conditions in the evaluation of management’s plans for future action:



o

evaluate the reliability of the underlying data generated to prepare the forecast

o

determine whether there is adequate support for the assumptions underlying the forecast.

Consider whether any additional facts or information have become available since the date on which management made its assessment.

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Request written representations from management and, where appropriate, those charged with governance, regarding their plans for future action and the feasibility of these plans.

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DISCUSSION PROBLEMS AND CASE STUDIES Inherent risk 6.13 EASY Megan Martin has been assigned to the audit of the inventory section of two unrelated companies. The first client, Ready Made Pty Ltd, sells quality made-to-order cabinetry. Inventory comprises raw materials used to manufacture its existing product range, partially completed cabinets and cabinets which have just been finished and are awaiting delivery to customers. The second client, Exclusive Boutique Pty Ltd, is a retailer of exclusive and everyday wines. Its inventory is made up of bottles of wine, including current vintages and aged bottles that are ready for drinking now. REQUIRED Explain which of the two clients you would expect Megan to assess as having the higher inherent risk. LO 6.1 6.13

(Easy) The following factors should be considered by Megan Martin when making her assessment. 

Accuracy, valuation and allocation: The exclusive wines may be subject to obsolescence if not sold relatively...