Question

During your review of the audit field work completed by a new junior employee of the audit firm, John Smith, you have noted many areas which require additional review notes. John, who has just completed the interim audit of Taxon Ltd for the year ended 30 June 2019, has just performed testing of controls. When testing controls over payments made to related parties, there should be evidence of approval and sign-off by the chief financial officer (CFO). John selected a sample of payments made to related parties and vouched them back to the electronic funds transfer (EFT) forms to sight the CFO’s signature of approval. Based on a sample of ten payments, six had been approved by the CFO in writing. However, the remaining four EFT forms (for immaterial amounts) did not have the CFO’s signature, but John noted that the CFO had given verbal approval. John concluded that because all internal controls were working, the audit team could use analytical procedures alone to audit payments made to related parties. Required: Based on the results of the testing of controls outlined above, determine whether John has arrived at the appropriate conclusion? (1 mark) Justify your answer by addressing the following areas: the risks associated with related party transactions, and the reliability of controls at Taxon Ltd.

Answer 1

John, in above case, selected sample basis of testing and in these 10 samples also, only six has been approved by CFO in signature, other four did not have CFO signature. However, these transactions are immaterial even though we can't conclude that internal controls are opertaing effectively because only sample testing has been done and there can also be certain material transactions which does not met the standard controls levied by the company.

However such risks reduced if transactions are entered into arm's length prices.

Risks associated with Related Party Transactions:-

Since related party transactions are such transactions where risks can be highly associated. In view of the nature of related party relationships & transactions, they may carry a higher risk of material misstatement in respect of:-

1. Risks from inappropriate accounting.
2. Risks from non-identification or non-disclosure.
3. Risks of Fraud
4. Risks about the ability of company to continue in business as a going concern - if the entity's interests is constantly subordinated to that of related parties.

Additionally, in respect of related parties, the detection risk faced by the auditor is generally greater than for other assertions in the financial statements. The inherent limitations of an audit, whereby some material misstatements may not be identified even if the audit is properly planned and performed as magnified by peculiar cases.

Risks associated with Internal Controls:-

Every organizations develop internal controls to achieve the objectives. These controls should be re-evaluated on a routine basis to ensure that they are operating properly and still meets its objectives. The common controls risks in business include lack of sound internal control environment, poorly designed business processes, IT security risks, integrity risks, human errors and fraud risks, among others. When designing internal control policies, there are some common risks that every organisation should consider,including:-

1. Management Override of Controls
2. Limited Segregationof Duties
3. Overreliance on Detective controls v.s. Preventative Controls
4. Informal V.s. formal Controls.
5. Overly Trusting