Inherent Risks and the Audit Plan - Case Study Example

Inherent Risks and the Audit Plan Analytical Review of quantitative aspect of inherent risk The selected listed company is Analytica Limited for its inherent risk review and audit planning. As per International Standard of Auditing (ISA 400)i inherent risk “is the risk of susceptibility of an account balance or class of transactions to misstatement that could be material, individually or when aggregating with misstatements in other balances or classes, assuming that there were no related internal controls.” For example complex calculations are more likely to be misstated than simple calculations; or cash is more susceptible to theft than an inventory of goods. It must be remembered that “determination of significant risks, which arise on most of audits, is a matter for professional judgment.” (ASA 315, Para 128)ii.A quantitative analytical study of Analytica limited’s financial statements and other information reveals the following areas that might carry the inherent risk of misstatement of assertions in the financial statements : A1 The company has used it major resources for promoting its product AutoStart ® Burette. But the increase in revenue is the result of increase in R & D concessions, as the company is making huge revenue expenditure in R & D activities. Under such circumstances there is inherent risk of earning revenue losses in the initial years of R & D expenditure. The revenue of the company has increased from $164894 in 2008 to $247617 in 2009 resulting into a whopping 50.16% increase over revenue in 2009. On the other hand operating loss in 2009 has increased to an aggregate value of $1901, 780 from $829,457 in 2008. Losses have increased in 2009 despite almost 50% increase in revenue. The reason is that expenditure on R & D in 2009 has not resulted into revenue because of inherent risk involved in the initial years of expenditure. Whatever increase in revenue is because of increase in tax concessions, which increased from $78550 in 2008 to $159394 in 2009. So the inherent risk on R & D expenditure played its part and the company suffered losses. A2 There is huge increase in administrative expenses in 2009. These expenses have added greatly to the rising losses for 2009. These expenses in 2008 were merely $462,531 and that rose to an amount of $ 1,181,044 providing an increase to the tune of 127.72% over 2008 expenditure. One of the reasons appears to be increase in managerial remunerations during 2009, as the directors’ report in the annual report 2009iii of the company states that “during the 2008 year, there were no bonuses, non monetary benefits, or cash settled share- based payments to key management personnel.” Annual report also states that losses were higher because of expenses on issue of options. Most of managerial remunerations were non cash expenses as those were settled by exercise of share options during 2009. This increase of managerial remuneration is not the result of any managerial activity in 2009 but compensation that accrued in 2009 but provided for efforts of management in earlier periods. Inherent risk is that such expenditure might result into a misstatement for non- increase in revenue for 2009. Analytical Review of non- quantitative aspect of inherent risk Certain activities of the company during 2009 were of financial investment nature, but those investments have not been fully disclosed as per the applicable accounting standards. The Company has acquired $100,000 convertible notes in certain unlisted entity CBio Limited. These investments for sale carry the inherent risk of suffering impairment losses. The company is required to disclose these investments at fair value on balance sheet date. The balance sheet and notes thereto reveal that the company has not revalued the investment on the date of balance sheet as per the provisions of AASB 130, even though the implied value of option to convert the debt into equity has been taken into account. This investment is meant for ‘for sale’ and therefore inherently exposed to market risks. This is a clear cut situation of inherent audit risk where impairment losses, if any can be misstated in financial statements, mainly because the standards require that investment meant for sale should be revalued at fair value on reporting date and impairment losses, if any, should be charged to profit and loss. The company avoided such disclosure might be because of non availability of information of an unlisted company. Another reason for non- revaluation of the investment in unlisted entity CBio Limited perhaps is not to burden the profit and loss with impairment losses keeping in view the increased operative losses being suffered by the company. The disclosure made by the company of the investment in convertible notes of an unlisted company is not justified as it defies the requirements of disclosure of fair value and adjustment of impairment losses, if any. Substantive auditing procedures for quantitative issues of inherent risk The suggestive substantive procedures in respect of matters arisen herein above on account analytical appraisal are as under: A1 Losses have been caused by the inherent effects of R & D expenditure. Careful review also reveals that some losses have been reduced because of concessions claimed under R & D scheme. The requirement is to study the R& D scheme in detail in order to examine the revenue raised by the company from R & D concessions. This becomes more important when we study the nature of recovery of receivables on account of R & D concessions. Trade receivable under the current assets has shown a decline in 2009 as compared to 2008, and in particular the R & D tax concession receivable has been completely recovered. Not only R & D tax concessions receivable for 2008 have been recovered but also there are no receivables on this account for the year 2009. So the main issue is whether the R & D expenditures have been inflated just to claim the concessions under the scheme of R & D Concessions. Also are there any changes in the scheme that have made the recovery instantly on raising of claims: and this might have persuaded the company to increase the R & D expenditure unnecessarily? Secondly, R & D expenditure is also required to be examined from the point of view of its propriety keeping in view the increasing trend of expenditure for 2009 when compared to expenditure in 2008. A2 Non- cash managerial remuneration is also inherently responsible for losses in 2009, as management was remunerated for their earlier activities though expenses accrued in current year 2009. That is why Chairman’s letter in annual report 2009iv categorically puts the reason for loss in 2009 on non- cash expenses of $669,972 relating to issue of share option during the year. The audit test should involve the investigation of these expenses on issue of share expenses. What was basis of allotment of options? Whether the options issued during 2009 also expired during the year causing further increase in the option expenses. Why all these expenses were charged to revenue, if all options were not utilized during 2009? In particular the computation of equity settled managerial expenses of $669,972 need to be examined in depth keeping in view the provisions of the Corporation Act. Further marketing expenses incurred during 2009 has inherently contributed to losses. The reason for increase in marketing expenses is caused by the promotion of company’s new product called AutoStart ® Burette. The important issue here is to examine as to why such market expenses have been charged to revenue when increase in revenue during 2009 was not caused by increase in sales of AutoStart ® Burette. The revenue, if at all, is increased because of R & D concessions claimed during the year by the company. Substantive auditing procedures for non- quantitative issue of financial investment in CBio Limited Financial investment of convertible bonds in the unlisted entity CBio Limited carried the inherent risk of impairment loses on revaluation at reporting date. The company didn’t made disclosures at fair value and thus kept the effects of operation of such inherent risk at bay. The company completely disregarded the accounting standards to revaluation of financial assets at reporting date. The audit planning should include the examinations of interests of Analytica Limited in the management of CBio Limited in order to find out direct and indirect links of its directors. There is a possibility that such interests might have persuaded Analytica Limited to make investment in CBio Limited. Directors might have controlling interests in the management of CBio Limited making the required disclosure of investments t be made by Analytica Limited in its balance sheet an altogether a different proposal. The auditors should examine the minute books of directors meeting to examine the interests revealed by the directors of Analytica Limited in CBio Limited. Notes to financial statement do not carry any comment on revaluation of investment in CBio Limited. Keeping this fact in view the auditors should seek an audited balance sheet of the CBio Limited and take the help of specialist in valuing the investment of Analytica Limited in CBio Limited. This will reveal the extent of damage caused non- disclosure of financial investment at fair value on reporting date, and if material, the auditor can consider the matter for reporting purposes as well. Word Count: 1621 References Read More