AA – L2 – Q21 – Risk Assessment and Internal Control

Explain the meaning of audit risk and its importance to the auditor. Identify risks in auditing Aurum LLC and explain why they need consideration.

Question

21 Golden LLC

Golden LLC designs, manufactures and retails traditional Ghanaian jewellery. Inventory is held at the design warehouse and at three shops. Inventory is also sometimes sent to customers for approval prior to a sale being made. Your firm has been re-appointed as auditors for the year ended 31st December 20X8.

Golden LLC has had a difficult year. A recession has caused a fall in revenue and the future is uncertain. A fourth shop was closed during the year and the premises are still up for sale. The financial director was dismissed half way through the year and is pursuing a claim for unfair dismissal. A replacement has not yet been found.

The managing director is due to retire next year and is likely to require loans he has made to the business to be repaid. Negotiations with the bank in respect of loans to cover these repayments have started.

Required

(a) State what you understand by audit risk and why it is important to the auditor.

(b) Identify the risks arising from the above that will need to be considered when planning the audit of Golden LLC. Explain why these risks need to be considered.

Answer

(a) ‘Audit risk’ is the risk that an auditor forms an inappropriate audit opinion on the financial statements. It has three components: inherent risk, control risk and detection risk. The following equation represents the relationship:

Audit risk = Inherent risk × Control risk × Detection risk

If inherent risk is high, there is greater potential for material misstatement in the financial statements. This risk of misstatement is reduced if control risk is low, i.e. the system of internal control of the enterprise is effective in detecting and correcting errors arising.

Detection risk is under the control of the auditor and is dependent on the assessment of inherent and control risk. In the audit risk model detection risk is the balancing figure to satisfy the ultimate risk accepted.

If detection risk needs to be kept low (e.g. because inherent and control risk are high), this would mean increased audit testing to ensure that the financial statements are not materially misstated.

The level of risk also affects the nature and timing of audit work. For example, when risk is increased, more reliable evidence should be sought, e.g. more independent/third party evidence.

(b)

Risk	Why to be taken into account
Inventory is moved about between the design warehouse and the shops and occasionally is sent out to customers for approval.	Because of the portable and valuable nature of the inventory, strong controls will be needed to ensure it is not stolen – both in general and to control these movements. Where customers hold goods on approval it may be difficult to determine when revenue should be recognised.
Some items of inventory will be individually material.	Counting and valuation procedures will need to be carefully assessed.
The entity operates from multiple locations.	Cut-off will need to be carefully controlled.
The entity is likely to keep permanent inventory records.	This may reduce the amount of work the auditor needs to carry out at the year-end physical inventory count.
Significant inventory may be held by customers.	Confirmation from customers as to inventory held at the year-end will be needed. In the case of individually material items, a visit to the customer by the auditor may be considered appropriate.
Inventory is of a specialised nature.	Evidence from an independent expert may be required (e.g. to certify that any gemstones or precious metals are real and not fake).
Because of the decline in revenue, the closure of one shop and the imminent retirement of the managing director, the ability of the entity to continue in business must be in doubt.	The going concern basis of accounting may not be appropriate. The auditor will need to consider any future orders/projected sales, the progress of the negotiations with the bank and plans to replace key staff.
The premises from the closed shop are still held for sale.	The accounting treatment and disclosure of these premises in the year-end financial statements will need to be checked.
The financial director has been dismissed and not replaced.	The accounting systems and internal controls may not be operating reliably due to the loss of a key member of staff.
The financial director is suing for unfair dismissal.	A provision may be needed in the financial statements if the claim is likely to succeed.

Tags: Audit Risk, Financial Reporting, Going Concern, Internal controls, Inventory Management
Level: Level 2

Topic: Risk Assessment and Internal Control

Uploader: Samuel Duah