Question

You are an Audit Senior on the AUDIO Health Limited (AUDIO) audit engagement for the financial year ending 30 June 2019. AUDIO specialises in the design and manufacture of implantable hearing aids and invests more than twice the industry average in research and development. While undertaking audit planning procedures you become aware of the following:

AUDIO has been developing its latest hearing implant, the X5, for a number of years. AUDIO has invested heavily in research and development of the X5 and has capitalised a significant amount in relation to the development phase of the product. Market studies and prototypes of the X5 have proved successful for bringing it to the market. In July 2018, AUDIO acquired two technologically advanced machines specifically designed for manufacturing the X5, at a cost of $15 million each. Production and sales of the X5 hearing implant commenced in October 2018, and demand for the product has been extremely high since its launch. AUDIO has sold large volumes of the product and further manufactured a large stockpile of the X5 in anticipation of on-going high demand, and a substantial number have already been implanted in patients.

There has recently been a sharp increase in incidences of the implant shutting down post-surgery, resulting in a number of patients commencing legal action against AUDIO for damages and prompting the company to initiate a recall. Initial investigations reveal that the defect is attributable to a design flaw. It is likely that the product in its current form cannot be sold. Management of AUDIO is confident that it will be possible to re-engineer the two machines acquired for the manufacturing of the X5 to enable production of its four other product lines and potentially for other products currently under development.

You have raised concerns with AUDIO’s audit committee on improving the competence and objectivity of the internal audit department. Currently, the internal audit department is made up of three recent graduates with no prior experience who periodically report the Audio’s Chief Executive Officer Dr. Dave Bautista.

Required:

Prepare a memorandum to the audit manager, outlining your risk assessment relating to AUDIO Limited. When making your risk assessment:

(a) Identify how the audit plan will be affected and recommend specific audit procedures to address the risks associated with each account identified.

Answer 1

The auditor should perform risk assessment procedures that are sufficient to provide a reasonable basis for identifying and assessing the risks of material misstatement, whether due to error or fraud, and designing further audit procedures.

. Risks of material misstatement can arise from a variety of sources, including external factors, such as conditions in the company's industry and environment, and company-specific factors, such as the nature of the company, its activities, and internal control over financial reporting.. Also, risks of material misstatement may relate to, e.g., personnel who lack the necessary financial reporting competencies, information systems that fail to accurately capture business transactions, or financial reporting processes that are not adequately aligned with the requirements in the applicable financial reporting framework. Thus, the audit procedures that are necessary to identify and appropriately assess the risks of material misstatement include consideration of both external factors and company-specific factors. This standard discusses the following risk assessment procedures:

1. Obtaining an understanding of the company and its environment
2. Obtaining an understanding of internal control over financial reporting
3. Considering information from the client acceptance and retention evaluation, audit planning activities, past audits, and other engagements performed for the company
4. Performing analytical procedures
5. Conducting a discussion among engagement team members regarding the risks of material misstatement

6. Inquiring of the audit committee, management, and others within the company about the risks of material misstatement

In an integrated audit, the risks of material misstatement of the financial statements are the same for both the audit of internal control over financial reporting and the audit of financial statements. The auditor's risk assessment procedures should apply to both the audit of internal control over financial reporting and the audit of financial statements.

Obtaining an Understanding of the Company and Its Environment

The auditor should obtain an understanding of the company and its environment ("understanding of the company") to understand the events, conditions, and company activities that might reasonably be expected to have a significant effect on the risks of material misstatement. Obtaining an understanding of the company includes understanding:

1. Relevant industry, regulatory, and other external factors;
2. The nature of the company;
3. The company's selection and application of accounting principles, including related disclosures;
4. The company's objectives and strategies and those related business risks that might reasonably be expected to result in risks of material misstatement; and
5. The company's measurement and analysis of its financial performance.     In obtaining an understanding of the company, the auditor should evaluate whether significant changes in the company from prior periods, including changes in its internal control over financial reporting, affect the risks of material misstatement.