Question

Case

Assume that the new entity, AMT, was established, that the board accepted Helen Grant’s recommendation of an annual audit for the company, and that after conducting a tender for the audit, AMT selected ABC Auditors (ABCA) to conduct the audit. Unfortunately, Helen Grant found that, for personal reasons, she was unable to continue in the new role as CFO. The case continues…

ABCA was selected to conduct the audit because one of the board members of AMT was aware of its reputation as an auditor in the wine industry where he was involved in a joint venture (a small winery) with one of the partners of AMT.

In the year first year of operation AMT made large investments in state-of-the–art computer aided manufacturing equipment, obtained licenses to use the latest software programs, and significantly increased its research and development capability. It funded this expansion through a number of bank loans and a bank overdraft. In order to minimise risk, the board of AMT accepted a proposal from one of its major customers for a seat on the board in return for signing a 5 year contract to purchase one of AMT’s main products a set price. As well, AMT sought to optimise operating cash flow by reducing executives’ base salaries and increasing the amount of bonuses that they could earn. The key performance indicator on which bonuses are to be calculated is accounting profit.

AMT has 3,600 active customers located across Australia. All sales are on credit, with outstanding accounts due within 30 days. Customers who pay within 7 days are given a 2% discount. Approximately 30% of customers represent 70% of the accounts receivable balance at year end.

In recent months, the Australian Dollar depreciated 35 % against the $US, which has made some of, AMT’s inputs more expensive. Furthermore, rising interest rates in the Australian economy are putting pressure on some of AMT’s major customers. Consequently, the new CFO, who joined AMT after many years in the building industry, is closely monitoring receivables.

The total balance of outstanding amounts owing from customers at balance date is $90m, for which the new CFO made a provision for doubtful debts of $450,000. She based this figure based on her reading of the records that Helen Grant kept while she was the senior accountant at AM.

Question

1. With reference to the facts of the case, identify three inherent risk factors that may because concern when planning the audit of AMT. Ensure these risks are specific to AMT and classify them as either a financial report level risk or an assertion level risk.

2. Explain why the risk factors in (a) above are potential problems for the audit. That is, why could these factors increase the risk of misstatement in the financial statements of AMT?

(c)   For each of the three risks you have identified, state one significant Balance Sheet account that could at risk of material misstatement because of risk. For each account you have identified, provide a brief explanation of why it is a risk and identify the key assertions affected.

Answer 1

A) With reference to the facts of the case,we can identify three inherent risk factors that are specific to AMT. They are as follows:

1. Risk of Obsolescence
2. Risk of subjective estimates.
3. Risk of dollar size of the account

AMT is facing risk of obsolescence because it purchased a computer aided manufacturing equipment which is extremely vulnerable to become obsolete and be no longer competent in the market place. A large investment was made on a computer aided manufacturing equipment though it has increased the research and development capability of AMT, there is a significant risk of obsolescence because the investment is huge and it can be at the risk of being thrown away by new technological softwares, development and licenses.

AMT faces risk of subjective estimates as the new CFO has made a provision for doubtful debts figure based on the reading of the records of the previous senior accountant. She has not taken into consideration the changes that had occurred in the firm and the high trade receivable amount shown by the companys books of accounts. There is a significant chance of many debts becoming bad and therefore the provision estimated need to have been taken into consideration during the course of time.

Since there is a significant fall in the value of Australian dollar there is a significant decrease in the value of receivables as well. This could lead to a loss due to the difference in foreign exchange.

Risk of obsolescence and risk of dollar size of the account can be classified as Financial report level risk because they are pervasive and can arise from any internal or external factors events, conditions, choices made by people in the company as well as decisions taken by AMT. Risk of subjective estimate is an assertion level risk because it is an error and it relates to the financial statements as a whole. This risk can have a possibility of fraud and there can be a higher chance of material misstatement.

B) The risk factors above are potential problems of the audit because it is the risk that the auditor may fail to express an appropriate opinion in an audit assignment. Audit risk is a function of the risks of material misstatement and detection risk. Materiality and audit risk are considered throughout the audit, in particular when: a) Identifying and assessing the risks of material misstatement b) Determining the nature, timing and extent of further audit procedures c) Evaluating the effect of uncorrected misstatement, if any, on the financial statements and in forming the opinion in the auditor's report.

These factors increase the risk of misstatement in the financial statements of AMT because

• Unauthorized changes to data, systems or programs
• Failure to make necessary changes to systems or programs
• Reliance on systems or programs that are inaccurately processing data, processing inaccurate data, or both.
• Manual elements in internal control may be more suitable where judgement and discretion are required.
• The extent and nature of the risks to internal control vary depending on the nature and characteristics of the entity's information system.
• Manual elements in internal control may be less reliable than automated elements because they can be more easily bypassed, ignored, or overridden and they are also more prone to simple errors and mistakes. Consistency of application of a manual control element cannot therefore be assumed.
• Potential loss of data or inability to access data as required.

C) For risk of obsolescence, there can be changes in the depreciation account. There is high chance of giving a wrong value to the depreciation as well as also finding the right amount of depreciation.

For risk of subjective estimates, trade receivables and provision for doubtful debts can be misstated because 70% of the debt unpaid is owned by 30%of the people and this can be misstated to show increase in profits. This can also misstate the stakeholders as well.

For risk of dollar size of the account, foreign exchange reserve account will be misstated as the company wanted to show the profit as the highest motivatioal factors for the stakeholders. Thus, there is always a chance of not estimating the foreign exchange value as per the date mentioned and also since there is higher chance of loss the company can hide it from the public.