INHERENT RISK & AUDIT RISK MODEL
Factors affecting inherent risks
Nature of client’s business:
- value of obsolescent inventory in highly technology industry (computer retailers, electronics manufacturer)
- music industry (depends on customer references and violate)
Result of previous audits:
- misstatement found in previous year’s audit is more likely to occur again
- misstatement are systematic in nature
- organisations are slow in making changes
Initial versus repeat engagement:
- lack of experience and understanding of clients and its operations
- risk of not initially identifying problems that existed in the past to considered in design of the audit program
- Enquiries should be made as to the reasons for the change of auditor
- Enquiries should be made about the nature of problems evident in the previous year’s audit
Related parties:
- transactions that no occur between independent parties dealing at arm’s length are more likely to be misstated
- parent and subsidiary companies
- director ands and corporate
Non-routine transactions:
- might be incorrectly recorded due to lack of recording experience
- fire losses, major property acquisitions, lease agreement
- install new computer system: error due to lack of knowledge of new system, error due to lack of skill by
employees, fail to implement controls during implementation, misstatements during conversion process
Judgment required to correctly record account balances and transactions:
- likelihood of misstatement increases when considerable judgment is required
- doubtful debt, obsolescent inventory, liability for warranty payments, repair vs replacement of assets
- litigation liability from law sue
Makeup of population:
- individual items making up total population affects expectation of material misstatement
- outstanding account receivables for several months
- cash payment made payable to cash
Going concern issue (ASA
- Sale of stores to offer short term cash issues,
- Negotiation with bank to change loan terms, extent repayments
Complexity of transactions
- Open new brand in overseas: transactions using foreign currency
- Lease agreement
- Leave entitlements related to employee issues
Factors related to fraudulent financial reporting:
- intentional misstatement or omission of amounts or disclosures with intent to deceive users
- example: capitalised fixed assets that should be expenses, overstate profit by omitting accounts payable and
other liabilities
- Earnings management: deliberate actions taken by management to meet earnings objectives
