Audit Risk Model - Case Study Example

4-57 Audit Risk Model Audit risk assessments can be quantitative or qualitative in approach. In fact, the combination of both approaches is most effective in substantiating an auditor’s assessment of all factors affecting the audit risk model (inherent, control, and detection risks). First an auditor may perform numerical assessments. A quantitative audit inquiry is especially appropriate for an intricate business environment like in insurance industries. It is when auditor refers to a specific numerical formula to dissect malpractices during operations and which could actually raise risks assessment levels. Alongside a quantitative approach is a non-quantitative procedure. A qualitative approach, on the other hand, requires reasonable and political judgment in analyzing whether the client’s practices adhere to Generally Accepted Accounting Principles (GAAP). 2. Setting inherent risks at maximum to keep audit risks at an acceptably low level is a valid assumption. In fact, this is a conservative defense of the auditor in saying that there is only a small possibility that he or she failed to modify his or her auditing conclusion. When auditors suppose that there is certain interdependency between the inherent and control risks, then such case is a valid principle. With high levels of inherent risks and control risks, mathematically, audit risks will remain at lower levels. However there is the major rub: no auditing firm would take the risks of concluding that 5 percent of its audit report is potentially wrong and goes to assume that most of the client ‘s transactions or if not all are recorded improperly. 3. This assumption can be applied in a case to case basis. When inherent risks are gauged at low levels, detection risks don’t necessarily become relatively high where rigorous substantive tests need not be performed. Control risks are still elemental to the whole equation. When control risks are high while inherent risks are low, this reduces the detection risks. In such cases, chances are fraudulent practices have occurred during transactions. To substantiate this presumption, the auditor needs to perform more substantive tests. Only when control risk and inherent risk are both assumed at low levels that direct tests for account balances need not be performed. So all in all, performance of substantive tests is still a variable procedure when inherent risks are low. 4. Control risks refer to the possibility that the accounting and internal controls of the client were unable to prevent, detect, resolve a misstatement. In effort to reduce levels of control risks, the auditor should gather sufficient evidence by testing the functionality of the design and operation of controls (e.g. policies and procedures, management system, operating style). This is the phase that precedes substantive testing; therefore this stage is crucial to the failure or success of the overall risk assessment process. Weak accounting and internal controls suggest that billing and recording of the financial transactions may not have been done correctly. This increases the levels of control risks. 5. The tendencies of being unable to detect material misstatement in financial balances or transactions during substantive procedures are called detection risks. Detection risk is independent from the inherent and control risks because this aspect is entirely about the scope and effectiveness of the auditor’s procedures. Therefore, setting detection risks at 50% literally means that there is an equally 50 percent chance of not detecting any material misstatement in a financial account. 6. Perhaps during audit engagement, an auditing firm’s top of mind should be evaluating the engagement risks. Engagement risks refer to the risks involved when an audit firm comes to terms with a client. Audit risk has an inverse relationship with engagement risk. High engagement risks mean that involvement with the potential client may lead to damages on the financial stability, or image and reputation of the auditing firm because the client may have had unresolved transactions or balances (e.g. unlawful suits, poor financial health). This indicates that the nature of the business operations and its internal control mechanisms must be in poor condition – suggesting that inherent and control risks must be at higher levels, therefore reducing audit risks to an acceptably low level. Though accepting a client with high engagement risks may benefit the audit firm because it can reasonably set the audit risk at the most reduced level, audit firms don’t tend to accept clients with really high engagement risks. 7. The context of assessment per se is already a political process like in designing parameters or criteria for an evaluation. Giving value to all the components in the audit risk model needs the subjective but professional judgment of the auditor. That is why he or she needs a preponderance of evidence which may not be just a form of mathematical equation (in fact not only at all) from the interpretation of data or situations to resorting to intuitions just to come up with conclusions while knowing that he or she might fail to elaborate his or her interpretations and analyses. Should most of the procedures be accounted with highest precision, one numerical proof should be enough to erase all doubts about material misstatements. However this is not the case in auditing. Auditing is simply not a mathematical process where there is only one universal answer. 9-60 A. Inherent risks in the Revenue Cycle 1. Bill-and-hold Transactions Recognition of sales before completion of transaction, that is, recording revenue before shipment 2. Related-party transactions Acquisition of another corporation for the benefit of the business 3. Manipulated sales accounts Possibility of improper sales adjustments 9-60 B. Audit Concerns and Procedures 1. Bill-and-hold Transactions Audit Concern The auditor should be concerned about the occurrence and classification tests check for bill-and-hold transactions. Drea Tech recorded the revenue from the goods that though significantly valued already were still yet to be shipped. The company then had recognized sales before the actual completion of the transaction. This is a kind of accounting practice subject to contention. In bill-and-hold practices, a company finds the avenue to exaggerate revenues. The certainty that there will truly be economic impacts is the auditor’s perfect basis for assessment regardless of whether it befell on the buyer or seller. Therefore in principle, this entry is potentially misstated. Audit Procedures. The auditor must first understand Drea Tech’s terms on revenue-recognition and inspect whether these terms and conditions conform to the generally accepted accounting principles (GAAP). Sales transactions usually bear higher levels of inherent risks. Essentially, the auditor should select a sample of evidences (e.g. invoices, cash receipts) in sales transactions that may significantly represent all other vouchers. To validate that the revenue-producing activities had indeed been executed, the auditor can refer to the recorded sales transactions and scrutinize terms of shipment with the customers or previous shipping methods. In order to uncover concealed fraudulent practices during bill and hold transactions, the auditor may compare the monthly sales of the current year with the former year. Additionally, it is important for the auditor to identify and assess the distinct notations present on invoices. The auditor should track a sample of sales transactions or other shipping documents and qualify their integrity and completeness. 2. Related-party Transactions Audit Concern. With Dreason’s acquisition of Materials Movement Ltd, it is reasonable to conclude that during the first few steps of the revenue cycle specifically when he decided to outsource a major proportion of component production from the privately-held company, management biases could have transpired. Fraudulent practices can be easily managed during related-party transactions. Since Dreason has the affinity to connive with his personal interests during transactions between Materials Movement Ltd and Drea Tech, it is very probable that he understated debts or overstated receivables or misreported such other accounting numbers which can be easily manipulated with ample bases. The accuracy of the valuations arising from such transactions should be examined carefully by the auditor. Audit Procedures. First the auditor should determine Dreason’s scope of control over Materials Movement Ltd. Then, the auditor should determine whether all related-party transactions were adequately recorded then disclosed to the auditing party. Unusual sales terms that may be fraudulent or insubstantial in nature usually arise from related-party transactions therefore, the auditor should examine the veracity of sales transactions between both companies especially during the near end of the reporting period. By the performance of this procedure, the auditor should now be able to completely comprehend Drea Tech’s financial statements. This can be possible by performing the following: Reviewing their terms regarding conflict-of-interest of both companies; Reviewing major business activities between both companies and then sift through the cash provisions; and Reviewing non-routine or unusual transactions especially towards the end of the reporting period; More importantly though, the auditor should research about the company’s other major corporate connections. In case if fraudulent practices had indeed occurred between Materials Movement Ltd and Drea Tech or among any other companies the latter indirectly or directly connected with, the auditor should determine the effects of these unethical transactions to the audit process. 3. Overestimated Amount of Revenue Audit Concern. The transaction objectives under this section are to perform valuations & estimate checks and completeness control procedures. Sales must reconcile with the inventory the same way that billing documents must agree with the shipping records. Though cost-cutting efforts may increase profit margins, setting it off with an obsolete inventory cannot generate as much sales returns as what Drea Tech reported in its income statement. Added to the outmoded machinery which should not be able to keep up with fast paced production with respect to a proclaimed consistent profitability, there was a remarkable bulk of inventory stocked and ready for disposal. Low inventory turnover only contributes to poor sales. With a case like Drea Tech’s, there can be no doubt that there was an unethical reportage. Audit Procedures. The auditor first has to make sure that billing and recording controls were appropriately complied during the reporting period; for instance recording sales transactions should be done without the bookkeeper’s personal biases for any for-profit organization does not tend to understate sales revenues or overstate payables. The auditor should also take into account the identifiable impacts of cutting the expenses for personnel and for the R&D upon the net income by comparing it to the income report when the cost-cutting have not yet been implemented. In determining whether customers were properly invoiced, the auditor may study the shipping documents to pre-numbered sales invoices. To ensure that no transactions were duplicated, there should be a thorough review of customer purchase orders, cash receipts and other pertinent agreement documents between the clients and its customers. The auditor should not forget to compare current bad debts, accounts receivables, estimates and other amounts with those during the previous reporting periods. The auditor should particularly observe the periodic inventory practices (quality or counting methods); inquire when was the time the company had last performed renovations and upgrading of machinery in the plant. Read More