Question

You are the audit senior responsible for the audit of Oriental Limited. You are currently planning the audit for the year ended 31 December 20X9. During your initial planning meeting held with the financial controller, he told you of the following changes in the company’s operations.

(i) Due to the financial controller’s workload, the company has employed a treasurer. The financial controller is excited about the appointment because in the two months that the treasurer has been with the company he has realised a small profit for the company through foreign-exchange transactions in yen.

(ii) Oriental has planned to close an inefficient factory in country New South Wales before the end of 20X9. It is expected that the redeployment and disposal of the factory’s assets will not be completed until the end of the following year. However, the financial controller is confident that he will be able to determine reasonably accurate closure provisions.

(iii) To help achieve the budgeted sales for the year, Oriental is about to introduce bonuses for its sales staff. The bonuses will be an increasing percentage of the gross sales made, by each salesperson, above certain monthly targets.

(iv) The company is using a new general ledger software package. The financial controller is impressed with the new system, because management accounts are easily produced and allow detailed comparisons with budgets and prior-period figures across product lines and geographical areas. The conversion to the new system occurred with a minimum of fuss. As it is a popular computer package, it required only minor modifications.

(v) As part of the conversion, the position of systems administrator was created. This position is responsible for all systems maintenance, including data backups and modifications. These tasks were the responsibility of the accountant.

(vi) The managing director has returned from the USA, where he signed a contract to import a line of clothing that has become the latest fashion fad in the USA. The company has not previously been engaged in the clothing industry.

Required: For each of the scenarios above, explain how the components of audit risk (inherent, control or detection risk) are affected.

Answer 1

Answer:

(i)

Inherent Risk (IR) - increased because of the exposure of the company to foreign currency exchange

Control Risk (CR) - increased because of a new appointment in the company

Detection Risk (DR - decreased because of the increase in both IR and CR

.

(ii)

IR - increased because of the risks involved in the closure of the factory, and the subsequent redeployment and disposal of its assets

CR - increased since this is most likely not a regular activity, and that certain internal controls must come into play

DR - decreased because of the increase in both IR and CR

.

(iii)

IR - increased since revenue is always a high-risk, and the introduction of the bonuses may increase the risk of overstatement in revenue

CR - increased since additional controls must be designed, implemented, and maintained for the validity of the sales and bonuses

DR - decreased because of the increase in both IR and CR

.

(iv)

IR - most likely unaffected

CR - increased since it is almost always a challenge to develop new internal controls whenever there is a change in accounting software

DR - decreased because of the increase in CR

.

(v)

IR - most likely unaffected

CR - increased as a conservative evaluation since we still have to assess how the new position affects the internal control of the client.

DR - decreased because of the increase in CR

.

Notes:

Note: The effects are analyzed based on the fact that Audit Risk is fixed; and the formula for Audit Risk is as follows:

Audit Risk = Inherent Risk * Control Risk * Detection Risk

Or...

AR = IR * CR *DR

.

Inherent Risk and Control Risk make up the Risk of Material Misstatemet (RoMM). Another version of the formula is:

AR = RoMM * DR

.

It means that the RoMM and DR are inversely related (i.e. an increase in RoMM, whether in IR or CR, decreases DR; and vice versa)