Suncorp - Inherent Audit Risks - Case Study Example

Running Head: Inherent Audit Risks Name: University: Course: Tutor: Date of Submission: QUESTION ONE Introduction Suncorp is a third leading Australian general insurance, finance and banking corporation based in Brisbane, Queensland Australia. The general insurance company is unique well diversified financial services group operating in Australia and New Zealand. With a well known portfolio of brands, the Suncorp Group is the largest general insurer of Australians by gross written premium, the largest regional bank, and includes a life insurer positioned for growth. Suncorp is Top 25 ASX-listed company with over $95 billion in assets, being a general insurance company, the company’s business includes personal insurance products such as home contents, personal effects cover, motor and boat, compulsory third party insurance, workers compensation and a range of commercial insurance products tailored to the small to medium business market such as property, marine, rural and liability. In accounting any company is liable to inherent risks hence Suncorp is not an exception given the mere fact that these intrinsic risks to a business activity arising from exposure to, and uncertainty from, possible future events, or changes in business or economic conditions (Gupta,. 2004). Due to the specific nature of business activities that various organizations tend to engage in, inherent risks usually arise leading to materially misstatements in financial statements due to errors or fraud. Discussion Looking at the financial statements of Suncorp, key inherent risk factors that could have an impact on the audit of The Suncorp Group for the year ended 30th June 2011 consists of ; Inherent Risk-Nature of the company and its activities Suncorp is a general insurance company involved in various financial and insurance activities as a result of its business nature. Primarily, the company is involved in various lending activities, issuing of receivable and premiums to various customers, Bank’s loans, advances, investments in financial instruments, reinsurance recoveries, international trade and capital market activities. The nature of these business activities exposes Suncorp to credit risk as a consequence of its lending activities (Graham, 1999). Given the mere fact that the company offers its services to various customers with different financial capability, some of the company’s customer’s may deliberately refuse to make their payments on time as well as others may find themselves incapable of paying as result of bankruptcy and financial problems resulting to defaults (Sing ,2000). The debts’ arising from defaulting customers exposes the company to credit risk which is a risk due to uncertainty in the counterparty’s ability to definitely meet its obligations. Credit risk in most cases is tied to the potential return of an investment hence it’s usually calculated based on the borrower’s overall ability to repay (Turley, 1997). To effectively manage credit risk resulting from the daily activities of the company and account for it in its financial statements, Suncorp maintains provisions which provide for bad and doubtful debts. The calculation in most cases comprises of borrowers' collateral assets, revenue-generating ability and taxing authority. Since credit risk is bound to occur to any financial institution, credit analysts are required to review information about the counterparty in an accurate and concise manner (Arens Best, Shailer, Fiedler, Elder and Beasley, 2011). This might include the balance sheets income statements recent trends in its industry, the current economic environment among other factors. Credit analysts are required to accurately assess the exact nature of the counterparty’s obligation, example could be senior debt which in most cases has a higher credit quality than subordinated debt. Basing upon the analysis and calculations, credit analysts are required to assign the counterparty a specific credit rating which can be used for making credit decisions as well as making cash estimations for the provisions. Once the calculations have been properly done, the company provides some provisions for this kind of risk through bad and doubtful debts (Jackson & Stent, 2010). If the assessments and calculations are not properly done, the provisions for bad and doubtful debts might not be accurate leading to overstatement as well as understatement in cash provisions resulting to material misstatements in the financial statements due to errors. If these provisions are not adequately documented and addressed, there is a possibility that they may have an adverse impact on Suncorp’s financial statements (Houghton and Fogarty, 1991). Inherent Risk-Regulatory and statutory factors Suncorp’s business is subject to substantial regulatory and legal oversight. In particular, Suncorp is subject to prudential supervision by APRA, which requires Suncorp amongst other things to meet minimum capital requirements within its standards and tax laws. These laws have adverse effects on how Suncorp conducts its business as well as on Suncorp’s financial conditions and results (Arens Best, Shailer, Fiedler,Elder and Beasley , 2011). Suncorp’s business and earning are also affected by the fiscal or other policies that are adopted by various regulatory authorities of the Australian government. The nature and impact of the future changes in such policies are not predictable and beyond Suncorp’s control. The general insurance, banking or wealth management industries could be subjected to changes or additions to existing governmental regulations that may impair Suncorp’s financial performance. If Suncorp does not me regulatory requirements, it may be subject to penalties, including fines or the suspension or cancellation of authority to conduct business. A change in laws or regulations made by the government or a regulatory body can increase the costs of operating a business, reduce the attractiveness of investment and/or change the competitive landscape. Changes in laws and regulations can materially impact on the organizational investments, earnings, cash flows, capital and market leading to potential financial loss if not carefully analyzed and managed(Arens Best, Shailer, Fiedler,Elder and Beasley , 2011). Since regulatory factors have adverse effect on the company’s financial statements, when such changes occur it is always important that the financial losses and costs be properly accounted for. If the losses and costs resulting from the changes in regulatory laws standard, fiscal laws, policies and tax laws are nor properly accounted for, some of the costs and losses may be omitted out during categorization process resulting to effect of significant accounting estimates and fair value measurements on overall profitability and net asset position eventually leading to material misstatements in the financial statements of Suncorp company(Arens Best, Shailer, Fiedler,Elder and Beasley , 2011). Inherent-Uncertain environmental conditions Though Suncorp is a general insurance company, Suncorp is subject to claims arising from catastrophes caused by various events, including cyclones, earthquakes, tsunami, wind, hail, fires , floods, volcanic activity and bushfires in addition to manmade disasters. These events are inherently unpredictable in terms of their incidence and severity. The extent of insured losses from catastrophes is usually determined by the total amount of insured exposure in the area affected by the event and the severity of the event. While Suncorp manages its exposure to catastrophes through the purchase of catastrophe reinsurance, Suncorp cannot be assured that such coverage will be adequate or will continue to be available at acceptable levels or at all. Suncorp’s provisions for its insurance liabilities may prove to be inadequate to cover its ultimate liability under policies written by its insurance subsidiaries due to poor risk analysis (Janet & Colbert, 2009). Within its general insurance subsidiaries Suncorp maintains provisions to cover the estimated ultimate liability for claims and within its life insurance subsidiary provisions for future policy benefits. Although, Suncorp seeks to maintain outstanding claims provisions in its general insurance subsidiaries at a probability of adequacy of approximately 90%, actual future events and conditions may result in the current estimates of claims costs being inadequate due to lack of adequate analysis. Insufficient provisions for insurance liabilities resulting from poor risk analysis eventually could result to understatement in cash provisions. Understatement in cash provisions can lead to material misstatements in the financial statements as a result of errors eventually affecting the company’s cash flows Inherent Risk-Uncertain Financial and economic conditions Occasionally an industry may be subject to various volatile market conditions due economic changes. As Suncorp conducts all of its business in Australia and New Zealand, its performance is influenced by the level and cyclical nature of business activity in Australia and Zealand, in particular Queensland where its business is concentrated (Arens Best, Shailer, Fiedler,Elder and Beasley , 2011).Suncorp’s business activity is also influenced by both the Australian and New Zealand economies and the Queensland economy in particular. This will have a material effect on Suncorp’s financial condition and results of operations. Banks and other financial institutions including Suncorp are subject to highly volatile credit market conditions (Arens Best, Shailer, Fiedler,Elder and Beasley , 2011). . This volatility may result in many things such an increase in the cost of funding, more onerous lending conditions, an increase in potential counterparty default among other factors (Puncel, 2008). As a result of volatile market conditions the shares of Suncorp Company may fluctuate due to various factors including investor perceptions, domestic and international markets and economic conditions and other factors that affecting Suncorp’s overall financial performance and position. Continued volatility additionally may result to changes in interest rates on interest bearing asset such as a loan or a bond (Rittenberg, Johnstone, Gramling & Schweiger, 2009). Adverse movements in interest rates, both in Australia and abroad may impact Suncorp’s earning in each of the Banking. The price of Suncorp shares and Suncorp ability to access debt at a reasonable cost may be affected by a down grade to its credit ratings affecting its general financial performance. In this event of these occurrences the management may decide make decide to make bias judgments increasing the risk of material misstatements. For example the management may decide to develop new accounting estimates including fair values which in the end can impact on the final values in the financial statements. Without fraudulent intent in the event of volatile market conditions affecting the ASX share price of Suncorp Company, there may be a natural temptation for management to bias their underlying judgments on assets estimates and disclosures towards the most favorable end (Arens Best, Shailer, Fiedler,Elder and Beasley , 2011).On other hand management may bias judgments towards the least favorable end of the spectrum, taking the opportunity of the economic uncertainty to overestimate, for example, the write- down of assets. Such bias judgments may increase the risk of material misstatements in the financial statements if the decisions are not carefully analyzed and the events. Inherent risk- High volume of cash and bank transactions Suncorp is a general insurance company as well as a banking financial institution. Given the mere fact that it is a banking financial institution it deals with high volumes of cash on daily basis resulting from the bank transactions. Going through the financial statements of Suncorp, at the end of financial year June 30th Cash and cash equivalents at the end of the financial year was 1,466M. The high volumes of cash the company deals with involves complex calculations, if the calculations are not done appropriately and accurately it may result to errors when recording figures in the financial statements resulting to material misstatement risk (Morse, 2009). Additionally, the high volume of cash and bank transactions contributes to a significant level of inherent risk as a result of cash balance assertions, classes of transactions and account balance closures (Messier, 2000). This is because high volumes of cash involve complex financial transactions which could easily led to errors if the transactions are not accurately recorded(Messier, 2000). In addition, the nature of cash balances makes them susceptible to theft and other numerous kinds of fraudulent schemes involving cash which could easily led to material misstatement risk Inherent Risk- Management judgments and accounting estimates In preparing consolidated financial statements Suncorp Company requires management to make judgments, estimates and assumptions that affect the application of accounting policies and the amounts reported in the financial statements. The estimates and associated assumptions are based on historical experience and various other factors that are believed to be reasonable under the circumstances. Estimates and underlying assumptions are reviewed on an ongoing basis. Where revisions are made to accounting estimates, any financial impact is recognized in the period in which the estimate is revised. Use of judgments and estimates has a greater impact on the financial statements of the company since such accounting methods can easily result to the risk of material misstatement (Robert, Ashton, & Ashton, 2005). In accounting the risk of material misstatements of the financial statements is generally greater when account balances and classes of transactions are subject to estimation rather than precise measurement because of the inherent subjectivity in estimating future events as in the case of Suncorp Company. According to the financial statements of Suncorp as at 30 June 2011, the Schemes’ investments were carried at fair value on the statements of financial position. Usually the fair value of the financial instruments is reliably determined within a reasonable range of estimates. As at 30 June 2011, the fair values of all investments were derived by reference to published price quotations. The value of exchange traded futures contracts were calculated using the last traded settlement price. The settlement price was assumed to approximate fair value, as the spread between bid/ask and settlement. Such estimates are subject not only to the unpredictability of future events, but also to misstatements that may arise from using inadequate or inappropriate data or misapplying appropriate data(Robert, Ashton, & Ashton, 2005). Given the mere fact that no accounting estimate can be considered accurate with certainty, the auditor therefore is required to determine that a difference between an estimated amount best supported by the audit evidence and the estimated amount included in the financial statements of Suncorp Company is not significant, and such difference should be considered to be a likely misstatement. Inherent Risk- Organizational operational and technological factors General insurance and financial services business rely to a significant degree on information technology systems, with day to day operations of each aspect of business being computer based, as are the systems used to calculate and monitor underwriting risks, reserve modeling and reinsurance arrangements. Failure of such systems could result in business interruption, the loss of customers, damage reputation and weakening of competitive position and this could adversely affect business and profitability (Elliott,1994). Since Suncorp is one of the fastest growing insurance companies, technologically advancements are a requirement. Some technologically developments implemented within the company might have made certain products Obsolete, thereby making such products more susceptible to overstatement resulting to the risk of material misstatement. QUESTION TWO Risk assessment is a process which entails evaluating and combining professional judgments about risk factors and adverse organizational conditions. Risk assessment is usually assessed on the scale of high, medium and low depending on the risk factors identified. Assessing the inherent risks factors discussed in question one above, the factors can cause a significant risk of material misstatement. To begin with, inherent risk factors such as Nature of the company and its activities, Organizational operational and technological factors, uncertain environmental conditions have a lower inherent risk since they are external factors (Arens, Best, Shailer, Fiedler, Elder and Beasley, 2011).Though an uncertain financial and economic condition is an external environmental factor, it poses a higher level inherent risk. Difficult as well as uncertain economic conditions will have a significant effect on the risks of material misstatement as far as the entity’s financial reports are concerned. Suncorp general insurance company operates in a competitive environment which is likely to be affected by interest rates and price fluctuations (Austen, 2000). Additionally, it’s likely to be affected by tough economic conditions making it more susceptible to the risk of material misstatement operations of the entity are exposed to volatile markets. Assessing the factor in relation to the financial reports of the company, the risk can described as one of a high scale. Another inherent risk factor identified in question one is high volume of cash and ban transactions. Suncorp though being a general insurance company is also a banking company which deals with large sums of cash. Large sums of cash can cause the risk of material misstatement as a result of complex calculations, looking through the financial statements of the company, this factor poses a lower inherent risk. This is because valuations of cash and cash equivalents have a lower inherent risk as the amount involves no estimation and is thus less susceptible to manipulation (Eilifsen and Messier, 2000). Though, the company is exposed to risk factors such as valuation of accounts receivables and insurance provisions which are subjective to accounting estimates hence would have a high scale inherent, the company’s overall inherent risk can be described as low scale because all the inherent factors which would led to a risk of material misstatement have been taken into consideration by the company hence occurrence of this risk is at a minimal scale. As identified the overall inherent risk of Suncorp company can be described as low scale. Taking into account all the inherent risks factors the risk assessment process will be required to outline the nature timing and the extent of audit procedures which will be required to be performed. The low level of audit risk at the financial statement level will be apportioned to the individual balances and classes of transactions so that when the results of tests at the individual level are combined, the planned low level of audit risk at the financial statement level is achieved (Caster, Massey, and Wright, 2000). Using the Risk model shown below and the identified inherent risk factors the external auditor will be required to set audit risk at the individual level by considering the previously established audit risk at the financial statement level. The auditor‘s planning and assessment of inherent risk will be done by studying the nature of the account or class of transactions and factors suggested by SAS 47 that may impact inherent risk. AR = IR x CR x DR, where AR is audit risk at the individual level; IR is inherent risk; CR is control risk; DR is detection risk. References Austen.L. 2000. Inherent and control risk assessments: Evidence on the effects of pervasive and specific risk factors. Auditing: A Journal of Practice & Theory. . Publisher: General Books,pp34 Arens A A; Best, P J; Shailer, G E P; Fiedler B A, Elder R. and Beasley M., (2011). Auditing, Assurance Services & Ethics in Australia – An Integrated Approach. Clarity Update edition, Sydney: Pearson Australia Caster, P., D. W. Massey, and A. M. Wright. 2000. Research on the nature, characteristics, and causes of accounting errors: The need for a multi-method approach. Journal of Accounting Literature vol 18.New York: Irwin McGraw-Hill Eilifsen, A., and W.F. Messier, Jr. 2000. Auditor detection of misstatements: A review and integration of empirical research. Journal of Accounting Literature. Elliott, R. K. 1994. The Future of Audits. 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