Inherent Risks of the Business
Inherent risks refer to the risk which occurs due to the certain errors and omissions which takes place in the financial statements and the same is not due to failure of internal control of the business. Generally, it is seen, inherent risks take place when in transactions which are complex in nature and which requires a general level of accurate judgements both by management and the auditor (Knechel and Salterio 2016). The case study which is provided in the assessment describes a manufacturing company which is engaged in producing high quality wrist watches which are embedded with precious stones and gems. The name of the company as shown in the case study is Wicked Wrist Watch ltd (WWW). The inherent risks which can be identified for the business are discussed below in details:
- The company has two skilled watchmakers who are approaching the age of retirement and therefore this is matter of serious consideration on the part of the management as retirement of such skill workers will definitely affect the quality of the wrist watches and the younger generation might not be interest to develop the same level of skills. This shows that the numbers of skill labourer in the industry is less which is a serious risk to the business as it signifies fall in the level of operations of the business.
- The management of the business are engaged in the production of wrist watches which are mostly embedded with precious diamonds which are mostly obtained from overseas. Now most of diamonds are obtained from African countries. Due to environmental conditions, the government in African nations have decided to close down the diamond mines which can pose a serious threat to the business of WWW as most of the diamonds are supplied from there only and it can hamper the production and operations of the business.
- As per the case study, the sales of the business are not the same as it used to be due to the changes in the trend and taste and preference pattern of the consumers which affects the revenue generating capabilities of the business and moreover the costs of business are increasing as the cost of materials are constantly rising which affects the revenues of the business and it poses a threat to the continuity of operations of the business.
Control risks are those risks which arises due to the ineffectiveness of the internal control system which is established in the business. Such types of risks arise when the internal control of the business is unable to detect risks which might be material in nature. Considering the case study which is provided on WWW, the control risks which can be identified are listed below:
- The products which is offered by the company is classic and embedded with gems and precious jewels which are naturally costly and therefore employees and staff working in the business might get tempted to steal the product or abscond with the same. Therefore, there is a significant risk which is related to internal theft and the same will be easy as well as employee can easily access the store with the help of spare keys.
- The case study also shows that the management of WWW also make cash sales which are kept in the cash register and the same is banked once in a week which is generally on Monday as per the policy of the business (Hribar, Kravet and Wilson 2014). The liquid cash represents the earnings of the business for the week which are under the risk of being stolen by the staff members or external parties as well which creates a control risk.
- The case study also states that the management has the policy of conducting stock takes in order to verify the stocks of the business and the same is generally conducted by the manager of the business. The manager of the business is on a sick leave for a long period of time and therefore stock takes are not being conducted which creates a control risk related to misappropriation of stocks, under or over statement of stocks.
As per the analysis of the case study of WWW, the strengths in the internal control framework which can be identified are shown below:
- The management of WWW for the purpose of preventing thefts and for protection of the inventory and staff has appointed two security guards out of which one remains while the management is looking for replacement for the other. This promotes the security measures of the business and shows the strengths of internal control system.
- The management has an effective inventory management system which looks after the stocks of precious jewels and gems and also the stock of the work-in-progress and the finished wrist watches of the business. The business follows perpetual system for inventory management and has an efficient point of sales. In addition to this, to verify the stocks of the business, the management has incorporated a program for stock takes which is conducted by the manager. The business also has an effective cash collection system which is indicated in the case study.
- The management of WWW has incorporated policies for the security of the store and the inventories of the business from thefts and burglary. The wrist watches which are not on display at any time is safely locked up in a safe. The safe is highly secure as the same is linked with the nearest police station. In case of any tampering with the safe occurs, an alarm will go off notifying the nearest policy station.
As per the requirement of the audit program, the auditor needs to identify the risks which are associated with the business of the client and classify the same on the basis of inherent, control and detection risks. The classification and segregation of the risks of the business are shown below:
- Inherent Risks: These types of risks generally is related to certain misstatements or omission which affects the financial statements of the company are not related to the failure of internal control of the business. The risks which are faced by the faced by the business are related to theft which affects the business drastically. Another risks which can be identified is relate to the inventory of the business being obsolete due to the changing trend of the market (Johnstone, Gramling and Rittenberg 2013). The management needs to consider such risks and come up with a plan to combat such risks. The risk which is related to inherent risks of the business are quite high as the major risk which the business of WWW can be related to is not because of failure of internal control and therefore are inherent in nature.
- Control Risks: These risks are associated with the failure of the internal control of the business. In the case of WWW, the major control risk which can be identified is related to the internal thefts which can affect the business. The business deals with classic watches and precious jewels which are quite costly and therefore staff members might get tempted to steal the same (Ruhnke and Schmidt 2014). Then there is the risk of understating the sales revenue which is generated by the business due to manipulation by the staff members of the business. The internal control of the business needs to improve in order to avoid such risks. The control risks which are identified for the business can mostly be rectified with minor changes and therefore such risks are medium in nature.
- Detection Risks: These types of risks refer to the risks which arise when the auditor misses out a material detail which can affect the financial statement of the business. The level of detection risks depends on the sample size which is considered by the auditor for the purpose of conducting the audit process. In the case of WWW, the auditor needs to extensively apply audit procedure in order to ensure that there is no material misstatement in the financial statements of the business. The detection risks of the audit depends on the sample size which is considered by the auditor. If the sample size of the audit is high than the audit risks of the business will also be high and similarly if the sample size is small than audit risks will also be low in this respect.
Audit Strategy refers to the plan which is followed by the management of WWW for conducting the audit of the business. A proper and systematic plan helps the auditor to apply the audit procedures effectively and apply judgements wherever required. The auditor will be applying vouching and verification procedures in order to assess the reliability of the expenses, revenues and assets of the business are showing correct view. The auditor will also ask for management representation regarding matters which are related to the workings of internal control of the business. This will help to reduce the control risks of the business as the auditor will then have a clear understanding of the controls risks of the business and how to reduce the same. Inherent risks of the business are generally high when there is a lot of judgements and assumptions are made by the management (Legoria, Melendrez and Reynolds 2013). The auditor needs to ensure that application of estimates and judgements are to be kept at a minimum in order to control the inherent risks of the business.
Control Risks of the Business
The control risks of the business can be reduced by identifying the weaknesses in internal control and suggesting improvements for the same to the management of the company. In the case of WWW, the cash sales system needs to be improved and the cash received should be banked twice a week to reduce the risks of thefts.
The detection risks of the business which occurs due to the mistakes of the auditor can be reduced significantly if the sample size which is considered by the auditor is reduced, which needs to be done by the auditor with the help of an efficient audit program.
The concept of planning materiality may be defined as the amount of misstatements which is anticipated by the audited during the audit planning process for a business. An auditor generally takes a base for computing the planning materiality which is generally the item which has the highest value in the financial statements and then an estimated percentage is used for computing the planning materiality of the business (Eilifsen and Messier Jr 2014). In the case of WWW, the total assets figure which is shown to be $ 4,400,000 is considered and the percentage which is considered for computing the planning materiality is considered to be 2%. The computation of planning materiality is shown below:
The planning materiality amount is computed to be $ 88,000 which is based on the estimate of percentage which is taken to be 2% and the figure of total asset is considered which is shown to be $ 4,400,000.
The questioning attitude and the attitude of questioning the reliability of the information which is presented by the business in the financial statements of the company is known as professional skepticism (Quadackers, Groot and Wright 2014). It is a quality which every auditor should have while conducting any audit for a business as the same helps the auditor to maintain a professional behaviour and carry out the duties of the business in an efficient manner. Professional Skepticism may be defined as a professional attitude which requires a questioning mind and also being alert to the surrounding areas. Such awareness can bring about improvements and indicate to the auditor about the possible misstatements which may be caused due to errors, frauds and omissions. Professional Skepticism of an auditor alerts the auditor for any presence of fraud which might be taking place in a business (Carpenter and Reimers 2013). Professional Skepticism in an audit helps to conduct a thorough investigations of the books of accounts of the client in order to identify presence of any frauds or errors. It brings about a questioning attitude of the auditor which allows the auditor to investigate every item thoroughly. In other words, this improves the overall quality of the audit. In order to apply professional judgements and skills in audit process, the auditor must have professional skepticism quality. The role of professional skepticism is significant as the same frames the policies and practices which the auditor enforces during the course of audit and plays a vital role in the overall scope of audit. Therefore, this attitude improves the overall audit process of the business.
Strengths of Internal Control
As per the situation which is shown in the case study, Nick settled his own transactions bypassing the internal control system of the banks. This relates to threat which is associated with self-review which is discussed in the case study which can impose a serious threat on the principle of independence. This threat arises when a member of the audit team provides non-audit services which are reflected in the financial statements of the company.
The first and foremost step which the bank can undertake is to establish an appropriate internal control system which can avoid such a situation and in addition to this, the management needs to incorporate proper supervision for the activities of the employees of the business in order to avoid such fraudulent activities (Vîls?noiu and Buzenche 2014). The management of the banks should introduce regulations which are related to trade and supervise whether the regulations which are brought in by the management are implemented ads per the requirements of the business. In the case study Nick looked after his personal interest by eluding the internal control system of the bank and therefore it can be identified that there lies a weakness in the internal control framework of the business and therefore improvements need to be made in the same in order to avoid such a practice in future.
An unqualified report which is given by an auditor suggest that the financial statements which is prepared by the business are showing true and fair view and all relevant accounting standards and provisions are followed while preparation and presentation of financial statements of the business (Czerney, Schmidt and Thompson 2014). In the case which is provided of the bank, the auditor issued an unqualified report without giving much consideration to the going concern principle. The bank went into bankruptcy during the year and for such a purpose the responsibility will fall on the auditor of the business who had issued an unqualified report without including an emphasis of matter paragraph in the auditor report. There is clearly a gap between the expectation of the auditor and the actual results which is clearly due to the inadequate audit procedures which is applied by the auditor.
In a business, the going concern principle is considered to be an important principle on the basis of which financial statements are prepared and presented to the general public. This principle also affects the decision-making process of the investors as the investors are often planning to make long term investments. Therefore, such an importance is given to this principle as it can affect the decision of the investors and also comment on the future of the business.
The auditor needs to consider the going concern principle as negative factors affecting the principle must be evident in the financial statements of the business. In the case of Barings Bank, the auditor did not consider the going concern principle and therefore the same can be held as a negligence on the scope of audit.
Reference
Carpenter, T.D. and Reimers, J.L., 2013. Professional skepticism: The effects of a partner’s influence and the level of fraud indicators on auditors’ fraud judgments and actions. Behavioral Research in Accounting, 25(2), pp.45-69.
Czerney, K., Schmidt, J.J. and Thompson, A.M., 2014. Does auditor explanatory language in unqualified audit reports indicate increased financial misstatement risk?. The Accounting Review, 89(6), pp.2115-2149.
Eilifsen, A. and Messier Jr, W.F., 2014. Materiality guidance of the major public accounting firms. Auditing: A Journal of Practice & Theory, 34(2), pp.3-26.
Hribar, P., Kravet, T. and Wilson, R., 2014. A new measure of accounting quality. Review of Accounting Studies, 19(1), pp.506-538.
Johnstone, K., Gramling, A. and Rittenberg, L.E., 2013. Auditing: a risk-based approach to conducting a quality audit. Cengage learning.
Knechel, W.R. and Salterio, S.E., 2016. Auditing: Assurance and risk. Routledge.
Legoria, J., Melendrez, K.D. and Reynolds, J.K., 2013. Qualitative audit materiality and earnings management. Review of Accounting Studies, 18(2), pp.414-442.
Quadackers, L., Groot, T. and Wright, A., 2014. Auditors’ professional skepticism: Neutrality versus presumptive doubt. Contemporary accounting research, 31(3), pp.639-657.
Ruhnke, K. and Schmidt, M., 2014. Misstatements in financial statements: The relationship between inherent and control risk factors and audit adjustments. Auditing: A Journal of Practice & Theory, 33(4), pp.247-269.
Vîls?noiu, D. and Buzenche, S., 2014. Determining Audit Materiality in the Banking Industry–A Knowledge Based Approach. Procedia Economics and Finance, 15, pp.935-942.
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