- 20 Marks
Question
Home Care is a charity that provides accommodation for unemployed young people.
The constitution of the charity explains how the charity’s income could be spent and also contains a requirement that administrative expenditure cannot exceed 10% of income in any year.
The charity’s income is mainly derived from voluntary cash donations collected by volunteers from members of the public. Recently, the charity’s income has been impacted by the current global economic and financial meltdown.
Required:
a. Describe the term ‘audit risk’ and explain the THREE elements of risk that contribute to total audit risk. (8 Marks)
b. Using the information provided in the question, identify FOUR areas of inherent risk to be taken into account in planning the audit of Home Care and explain the effect of each of these risks on the audit approach. (12 Marks)
Answer
(a) Audit Risk and its Components (8 Marks)
Audit Risk:
Audit risk is the risk that the auditor may express an inappropriate audit opinion on financial statements that are materially misstated. It arises due to the possibility of errors, fraud, or omission of material items that may not be detected during the audit process.
Components of Audit Risk:
- Inherent Risk:
- The susceptibility of an assertion about a class of transaction, account balance, or disclosure to a material misstatement before considering related controls.
- Higher where transactions are complex or involve significant judgment or estimation.
- Control Risk:
- The risk that a material misstatement will not be prevented, detected, or corrected in a timely manner by the entity’s internal control system.
- Indicates weaknesses in the design, implementation, or operation of controls.
- Detection Risk:
- The risk that the auditor’s procedures will not detect a material misstatement that exists in the financial statements.
- Depends on the effectiveness of audit procedures and auditor performance.
Total Audit Risk = Inherent Risk × Control Risk × Detection Risk
(b) Inherent Risks and Their Impact on Audit Approach (12 Marks)
- Reliance on Cash Donations (Risk of Misappropriation):
- Risk: Cash donations are highly susceptible to theft or misappropriation due to lack of traceability.
- Effect on Audit Approach: Increase substantive testing of cash donations, including reconciliations, cash count procedures, and confirmation from donation records.
- Economic Downturn (Risk of Reduced Income):
- Risk: The global financial meltdown may lead to a significant decline in donations, impacting the charity’s ability to meet its objectives and leading to potential going concern issues.
- Effect on Audit Approach: Perform going concern analysis, review forecasts, and ensure adequate disclosures regarding the financial position of the charity.
- Administrative Expense Cap (Compliance Risk):
- Risk: Administrative expenses exceeding 10% of income could violate the charity’s constitution and lead to reputational and legal risks.
- Effect on Audit Approach: Conduct detailed testing of administrative expenses and verify compliance with the 10% cap. Ensure accurate classification of expenses to prevent manipulation.
- Volunteer-Managed Collections (Risk of Incomplete Recording):
- Risk: Donations collected by volunteers may not be fully recorded due to error or fraud.
- Effect on Audit Approach: Test controls over collection processes, inspect volunteer records, and compare collections to historical trends for anomalies.
- Tags: Audit Planning, Audit Risk, Charities, Inherent Risk, Risk Assessment
- Level: Level 3
- Topic: Risk Management in Audits
- Uploader: Kofi