Question

 

You, a recent auditor with a local auditing firm, are responsible for the audit of a new client, PresentShop, a retailer of electronic home and office equipment in Western Canada.

PresentShop has 14 locations across Western Canada. It specializes in providing customers with the latest technology in home entertainment electronics such as televisions and DVD players as well as top of the line office technology such as computers.

The business was started 15 years ago in Alberta by two brothers who are still the only owners of the company. The brothers paid themselves a management bonus in 2017 of $60,000. The business has grown as a result of excellent advertising, good locations, and reasonable prices based on the ability of the company to buy in volume. Each store has a high degree of security such as electronic bars and video surveillance.

The accounting for the stores is all electronically performed. The sales tills are downloaded every day to the main office in Calgary which performs the accounting for all of the stores. The main office also has the warehouse from which all inventory is shipped to the stores.

Business has been relatively stable but the company does have pressure from American competitors moving into Canada as well as another Western Canadian competitor, B&C Sound. As well, the business tends to fluctuate with the economic cycles so recent government cutbacks in B.C. have resulted in lower sales. As a result of a decrease in profits, the company requires a significant loan from a bank and the bank has requested audited financial statements. It is the first year that the financial statements have been audited. The bank intends to use the inventory as collateral for the loan.

PresentShop has provided you with the following financial information for the years ending December 31, 2017:

	December 31, 2017 (‘000s)
Total assets	$48,900
Total revenues	$124,900
Total net income before tax	$23,500
Total net income after tax	$15,400

Required:

Assess inherent risk at the overall financial statement level. Conclude on inherent risk. Is it low, medium or high?

Assess control risk at the overall financial statement level. Conclude on control risk. Is it low, medium or high?

Conclude on detection risk and the level of substantive testing required.

Assess overall (planning) materiality

Question 3

Explain the approach adopted by auditors of identifying accounts and related assertions at risk of material misstatement. How does this approach help auditors to reduce audit risk to an acceptably low level?

Question 4

What is the relationship between materiality and audit risk?

Answer 1

Ans 1

There is always a certain amount of risk involved in audit as auditor is giving an opinion. There are basically three types of risk involved in audit namely inherent risk, control risk and detection risk.

Inherent risk is the risk posed by an error or omission in a financial statement due to a factor other than a failure of control. In a financial audit, inherent risk is most likely to occur when transactions are complex, or in situations that require a high degree of judgment in regard to financial estimates. This type of risk represents a worst-case scenario because all controls in place have nonetheless failed

Inherent risk in the audit of Presentshop financial statements is high because the entity is operating in a business which is depending on technology which is dynamic in nature, although the data processing is done electronically there is always a chance of some glitches in the system, since the items like cash or inventory are more susceptible to theft or fraud, inherent risk is higher. In the present case inventory is shipped from warehouse, there are higher chances of froud or theft hence inherent risk is higher. When there is earning based bonus plans like the one present in this case as brothers paid themselves a management bonus in 2017 of $60,000, hence there could be a management bias which increases it inherent risk. The first audit assignment is also inherently risky as the firm has relatively less understanding of the entity and its environment at this stage. The inherent risk for the audit may therefore be considered as high.

Control Risk is the risk of a material misstatement in the financial statements arising due to absence or failure in the operation of relevant controls of the entity.

Organizations must have adequate internal controls in place to prevent and detect instances of fraud and error. Control risk is considered to be high where the audit entity does not have adequate internal controls to prevent and detect instances of fraud and error in the financial statements.

Control risk involved in the audit also appears to be high since the company does not have proper oversight by a competent audit committee of financial aspects of the organization. As one can gauge from the information provided that the company also lacks an internal audit department which is a key control especially in a highly regulated environment. The control risk for the audit may therefore be considered as high. Although the accounting data is electronically processed there should be in place proper checks and balances to validate the data, which seems missing in the present case and hence, control risk is also high.

The risk of failure to detect the occurrence of material misstatements in the financial statements is called Detection Risk. The auditor must use proper audit procedures to alert to misstatements whether due to error or fraud. If proper procedures are not followed or not applied correctly a misstatement could be undetected. There is always a certain amount of detection risk due to the inherent limits of an audit, for example, using sampling in selecting transactions. This risk can be lessened by sampling more transactions.

If inherent risk and control risk is higher, then the requirement of checks and testing will be more which would lower the chances of detection risk. In the present case inherent risk and control risk is high requiring additional checks and testing and hence detection risk will be low.

Planning materiality is basically refer to the misstatement amount that set by auditors at the planning stage of an audit based on the materiality to financial statements. This is normally done by using the combination of both quantitative method and qualitative method. Total Assets could be a great base for this type of organisation for calcualting planing materiality as it is stable and predictable.

Ans 3

Audit risk is the risk that the auditor gives an inappropriate opinion on the financial report.

The auditor tries to keep this risk to an acceptably low level by planning the audit according

to the key risks faced by the client and allocating more audit time where the risk of material

misstatement is highest. This means that the auditor tailors the audit work to the client’s

characteristics. If the client has characteristics which suggest that the greater risk of material

misstatement is in a particular account or transaction cycle, the auditor will plan to do more

audit work on that account or transaction cycle than would be done for another client with

different characteristics and lower risk in that area.

The auditor identifies the specific accounts that are most at risk, and how those accounts are

likely to be misstated. For example, one client may have a greater risk that fictitious credit

sales are included in the balance of accounts receivable, while another client may have a

greater risk that accounts receivable balance includes balances that are not likely to be

collected. The first client has ineffective controls over processing credit sales and the second

client has ineffective controls over granting credit to customers. The auditor would spend

more time gathering evidence over the validity of credit sales transactions for the first client,

and more time gathering evidence about the collectability of accounts receivable for the

second client.

Ans 4

There is an inverse relationship between materiality and the level of audit risk, that is,the higher the materiality level, the lower the audit risk and vice versa. The auditortakes the inverse relationship between materiality and audit risk into account when determining the nature, timing and extent of audit procedures. for example, if, after planning for specific audit procedures, the auditor determines that the acceptable materiality level is lower, audit risk is increased. The auditor would compensate for this by either reducing the assessed risk of material misstatement, where this is possible,and supporting the reduced level by carrying out extended or additional tests of control or by reducing detection risk by modifying the nature, timing and extent of planned substantive procedures.

Materiality and Audit Risk in Evaluating Audit Evidence

The auditor's assessment of materiality and audit risk may be different at the time of initially planning the engagement from at the time of evaluating the results of audit procedures. This could be because of a change in circumstances or because of a change in the auditor's knowledge as a result of performing audit procedures. For example, if audit procedures are performed prior to period end, the auditor will anticipate the results of operations and the financial position. If actual results of operations and financial position are substantially different, the assessment of materiality and audit risk may also change. Additionally, the auditor may, in planning the audit work, intentionally set the acceptable materiality level at a lower level than is intended to be used to evaluate the results of the audit. This may be done to reduce the likelihood of undiscovered misstatements and to provide the auditor with a margin of safety when evaluating the effect of misstatements discovered during the audit.