Question

(1) Related parties are a major factor in assessing inherent risk. Why? (2) Fair value accounting may be a major factor in assessing both inherent risk and even control risk. Discuss how the extensive use of fair value accounting could affect both inherent risk and control risk.

Answer 1

1. As we know that inherent risk is related to material misstatements before considering effectiveness of internal control.

Related parties like-Parent company, and subsidiary companies, directors and other top level management are a major factor in assessing inherent risk because transactions that no occur between independent parties dealing are more likely to be misstated.

2.Extensive use of fair value accounting could affect both inherent risk and control risk because-

a)- Assessment of inherent risk affects amount of evidence, assignment of staff, review of audit documentation. These are directly related to fair value accounting Specifically, when measuring the current level of inherent risk controls are factored into either the frequency or magnitude side of the model based on their nature avoidance, deterrent, response, etc. which are some essential parts of  fair value accounting.

b)-Control risk is the amount of risk that remains after controls are accounted for.So the assessment of likelihood that misstatements exceeding tolerable amount in a segment won’t be prevented or detected by internal control. Fair value accounting obtains understanding of internal control, evaluate expected effectiveness based on understanding, test internal control for effectiveness etc. to reduce control risk in the organization.

Thanks & all the best................