Elders Limited Inherent Risk - Case Study Example

Elders Limited Inherent Risk Name of the student: Course Tittle: Name of the professor: Date Table of Contents Table of Contents 2 1.0 Introduction 3 2.0 Inherent risk 4 2.1 Inherent risk factors relating to management characteristics 4 2.2 Inherent risk factors relating to the industry condition 5 2.3 Inherent risk factors relating to operating characteristics and the company financial stability 7 2.4 Inherent risk of Nonroutine Transactions 8 2.5 Nature of the Elders business 8 3.0 Risk models in controlling company risks 9 3.1 Audit risk 9 3.2 Inherent Risk 9 3.3 Control Risk 10 3.4 Detection risk 10 Reference 11 Elders Limited Inherent Risk 1.0 Introduction Audit risk is the risk that a qualified auditor expresses an inappropriate or qualified opinion on the financial statements (SBP, 2003). Auditors risk is calculated as; Audit Risk   =   Inherent Risk   x   Control Risk   x   Detection Risk Hence, audit risk has three major components as discussed below; a) Inherent risk can be defined as the risk that results due to material misstatement in the financial statements due to error or omission because of factors that are not related to control system in an organization (SBP, 2003). Inherent risk is normally considered very high in situations with high degree of judgment and estimations is involved and in situations where transactions of the entity are highly complex. b) Control Risk- This is the risk that a rises because of material misstatement in the financial statements because of absence of control system or failure of control system within an organization (SBP, 2003). Organizations must have appropriate and adequate control systems in place to prevent and detect instances of error and fraud within an organization. Control risk is usually considered high in situations where audit entity does not have proper internal control system to help in preventing and detecting instances of fraud and error in the financial statements. c) Detection risk- this is the risk which the auditors fails to detect a material misstatement in the financial statements during the auditing (SBP, 2003). An auditor has the responsibility of detecting any material misstatement in the financial statements whether it is an error or a fraud. This paper intends to discuss one of the components of audit risk and that is Inherent risk in the Elders Limited Company on the annual report of 2013and audit models which can be used to prevent risk. 2.0 Inherent risk The inherent risk is a general risk that consists in the possibility of the appearance of significant errors given in a particular entity, activities, environment and the nature of accounts. Some of the inherent risk factors that can be considered in the Elders Company include; 2.1 Inherent risk factors relating to management characteristics The management might fail to display and communicate appropriated attitudes concerning the internal control and the financial reporting process. Failure by management to properly communicate these internal control procedures can lead to misstatement of financial statements hence inherent risk. Sometimes a larger portion of managements compensation represented by bonuses, incentives, stock option, the amount of which is contingent upon the Company realizing unduly aggressive targets for operating results in its operation hence inherent risk. The finance officer may put an excessive interest in maintaining the company stock price through unusual means of accounting practices that may result into material misstatement in the financial statements. Another inherent risk due to management characteristics is nonfinancial managements in excessive participation in the selection of accounting principles or in the determination of the significant estimates. The management may unduly commit to creditors, analyst, or any other third parties unrealistic forecast of the company resulting to material misstatement. High turnover of senior management is also an indication of inherent risk and the red flag should be red. A stained working relationship between the management and the current predecessor auditor is a warning of inherent risk brought by the management characteristics and may affect the financial reports of the Company. This is because the misstatement found in the previous year audit has high chances and likelihood of occurring again. Most of the misstatements are systematic in nature and organizations are normally very slow in making changes concerning them hence their chances of recurring are very high. From the Elders annual return as at 30th September 2013, there are a big variation in management bonuses and salary showing poor internal control concerning the executive director remuneration. For example, M G Jackman Base salary in 2013 is $1,146,536 while that of M G De Wit in 2013 is $ 610,964 Difference = ($1,146,536 -$ 610,964) = $535,572 The difference shows lack of consistence and harmonization on the human resource departments resulting to inherent risk. 2.2 Inherent risk factors relating to the industry condition The Company needs to consider new accounting, regulatory and any other statutory requirements that could result into impairments of the financial stability and profitability of the Company. The accounting policies might result to inconsistency on the figures being reported resulting to lack of prudency one of the major key GAAP principles. Inherent risk can also be indicated by high degree of market competition and market saturation that result into declining profit margins. It also result into general industry decline and increase in business failure. Rapid changes in industry are also an inherent risk that an auditor needs to take into consideration like technological changes and high rate in product obsolescence. From the share prices history from 2008 to 2013, there has been continuous decline of the company share prices indicating inherent risk within the industry as the general performance of the Company share prices continue to decline. The management should consider restructuring the company to improve its performance in the stock exchange. Sales revenue of the company also continue to decline though poor management practices has poised risk to the company performance has the managers and executive continue to reward themselves bonuses while the company is reporting losses. In 2013 sales revenue = 1,657.1 In 2012 sales revenue = 2157.9 Percentage decrease = (1,657.1-215.9)/2157.9 = - 23.20% From the result, the company continues posting losses in 2013 loss was ($ 505.3) while in 2012($ 60.6) cash flow also decreases through 2010 to 2013. This is an indication of inherent risk in the industry and general business performance. 2.3 Inherent risk factors relating to operating characteristics and the company financial stability The company may be under pressure to obtain more capital in order to continue staying competitive in the market considering the financial position of the company. It includes need for major funds to finance major research and development or capital expenditure of the company. The company may post liabilities, assets, revenue and expenses based on the significant estimates that normally involve unusual subjective judgments or uncertainties in the financial statements, such as ultimate collectability of receivable, timing of revenue recognition, reliability of financial instruments based on the highly subjective valuation of collateral (Rolland, 2008). The company may have significant, unusual and highly complex transaction close to year that pose difficulty and poises the question on substance over form. Difficulty in determine the organization or the individual company that controls the other. The company may be exposed to high vulnerability to changes interest rates posing inherent risk. Unrealistic aggressive sales or profitability incentives program even if the company is posting losses as in in the hefty bonuses given to management. Inability of the company to generate cash flow from operating activities, while at the same time the company is reporting earnings and continuous growth(Rolland, 2008). The company changes in the composition of the combination bring ambiguous scenario and challenge relating to the preparation of the financial statements hence inherent risk that might result into financial misstatement. It is not also easy to detect the controlling parent from the financial statements and reporting format. The company is not in position to generate enough cash flow from the operation as can be seen in the cash flow statement of the company hence a red flag that the company needs to consider (ASANZ, 2004). 2.4 Inherent risk of Nonroutine Transactions These are transactions which are unusual to the company and they are likely to be incorrectly recorded as opposed t the normal transactions which the company is used to record. The new method of business combination to the Elders Limited is an inherent risk. How to record the new business transaction and issuance of new shares is a big challenge and the possibility that the transactions will be incorrectly recorded is high. Some other areas present the annual report of the Elders limited are acquisition of new assets and the company major property. Lease transactions are incorrectly recorded. 2.5 Nature of the Elders business Inherent risk is most likely to vary from one business to another depending on the type of the business an auditor is auditing. Accounts such as inventory, loans receivable, property, plants and equipment’s are inherent risk that are present in different magnitude depending with the nature of the business. Elders Ltd with subsidiaries in different countries and parts of the federal, post many challenges recording for accounting for inventories and as a result, the error might occur in the reporting of the company closing and opening inventory. There is little effect on cash, notes payables and mortgages in terms of the inherent risk presented in the company financial statements. The misstatement found in the previous year audit has high likelihood of happening again and before any audit is carried and the company should consider changing auditing procedures and plans to help in minimizing the inherent risk (ASANZ, 2004).. 3.0 Risk models in controlling company risks 3.1 Audit risk Audit risk is the risk that auditor will give opinion with an unqualified opinion when unknown to the auditor that the financial statements are materially misstated resulting to ultimate risk. Inherent risk on the other hand is the risk resulting from financial misstatement and control risk is the lack or risk occurring because of poor control systems within an organization and lastly, detection risk are risk that occur as failure of auditor’s procedure to detect the risk (SBP, 2003). Audit risk model is given by; Audit risk = inherent risk * control risk * detection risk To solve and minimized these risk, then the set should be i. Detection risk = audit risk/(Inherent risk*control risk) ii. Detection risk low... the more the evidence one has collected iii. Detection risk high the lesser the evidence one has collected. 3.2 Inherent Risk On the management inherent risk, the auditor should ensure that i. Their existence or occurrence of an event ii. The management should be complete iii. They should have right obligations iv. Right valuation methods v. Good presentation and disclosure of financial statement The auditor’s judgments are based on assertion concerning risk and the assertions translate to accounts balances, and then an auditor creates audit objectives and procedures. The inherent factors, which should be used in the model to reduce risk include Simplifying the nature of business to help reduce complexity of an organization, the management should follow regulatory framework when reporting the financial statements. They should ensure that there is high degree of estimates during reporting and competency in the reporting where the finance officers are highly qualified as per the AASB and SAS (SBP, 2003). An auditor should consider the preliminaries analysis in testing as required by SAS in audit planning and this will the auditors in identifying areas where misstatements have occurred. 3.3 Control Risk According to SAS 78, auditors are required to document all the control risk assessment used in an organization and this will help in assessing working control risk in an organization. That is an auditor must document and test the document before giving the opinion (SBP, 2003). 3.4 Detection risk The auditor must carry an analytical procedure and test regarding ratio used in reporting to help in determine the confidence level. The detection risk cannot be lower that the audit risk and if that happens then there is a problem. Reference Rolland, H. (2008), “Using IT to drive effective risk management”, The Risk and Insurance Management Society, Inc. (RIMS SBP (2003), “Risk Management Guidelines for Commercial Banks & DFIs”, State Bank of Pakistan, from http://www.sbp.org.pk/about/riskmgm.pdf Standards Australia and Standards New Zealand (2004), Australia/ New Zealand Standard Risk Management AS/NZS 4360:2004, Standards Australia, Sydney/Standards New Zealand, Auckland. Read More