Question

Identifying and Assessing Audit Risk

Blue &Green Chartered Accountants has just been appointed the external auditor for Orange Ltd.

Tom Brown is the Audit Senior for the new client and is in the process of planning the audit for the year ended December 31, 2016. He is currently performing risk assessment procedures to identify and assess the risk of material misstatement for further development of the audit procedures to ensure that the requisite audit evidence is obtained.

Background Data

Orange Ltd is a public limited company which was incorporated on June 1, 2000 as a motor insurance business. Its primary activity is the provision of motor insurance in return for a premium and its main expenses are Operating Expenses, Claims Expenses and Payroll Costs. The company’s major assets are Fixed Assets and Investments and its major liability is Outstanding Claim Settlement.

The Managing Director is connected to the Chairman of the Board of Directors by marriage and is paid a 40% share of profits in addition to a fixed salary. The criteria for profit pay is that the company must achieve a 25% Return on Investment; the other companies in the industry make an average ROI of 10%.

The following issues were extracted from the respective sources noted:

Review of previous year financial statements and discussion with previous auditors

There is a concern that the fair value of a commercial building owned by the company is materially overstated as the building which is currently unoccupied is in an area which has become rundown

The Provision for Outstanding Claims is deemed to be understated as based on the tests done the level of provision on a case to case basis is understated

Review of the Management Letters from the previous auditors

The procedure to review balances due from a customer on a periodic basis to assess collectivity has not been effective as it was discovered that the supervisor was not doing the review as required

The procedure to review Claims and make a provision based on an assessment of liability was not applied consistently, especially in the case of bodily injury which were the higher cost claims. The Managing Director had given directives to ensure that provisions were kept as low as possible.

The Managing Director authorized the write off of a material amount from Deferred Tax Liability which was unsupported.

Analytical review of current financials against prior year

	2016	2015	% Change
	$’000	$’000
INCOME / (EXPENSES)
Premiums	5,771,000	5,858,000	?
Operating Expenses	(2,323,000)	(2,397,000)	?
Claims Expenses	(3,710,000)	(3,843,000)	?
Payroll Costs	(880,000)	(680,000)	?
Investment Income	856,000	851,000	?
Net Income	2,088,000	940,000	?
ASSETS/ (LIABILITIES)
Fixed Assets	941,000	1,064,000	?
Investments	11,383.000	10,577,000	?
Outstanding Claim Settlement	(8,483,000)	(8,795,000)	?
Shareholders’ Equity	(6,088,000)	(4,993,000)	?
RATIOS
Net Margin	?	?	?
Return on Investment	?	?	?

On the social scene it was the talk that the Managing Director had deposited funds on a property in a high-scale community and that he was awaiting profit-share to pay off the outstanding amount.

Tom is a bit concerned that the level of audit work required will far exceed the cost for the audit. He has to be thinking of ways and means by which he can cut down the work. He hoped that the test of controls will allow him to reduce the level of testing.

Required:

Identify at least five (5) significant risk factors in the scenario above                                               

State the type of risk for each risk noted in (1) above                                                              (5marks)

Answer 1

Analytical review of current financials against prior year

	2016	2015	% Change
	$’000	$’000
INCOME / (EXPENSES)
Premiums	5,771,000	5,858,000	Decreases by 1.485 %
Operating Expenses	(2,323,000)	(2,397,000)	Decreases by 3.087%
Claims Expenses	(3,710,000)	(3,843,000)	Decreases by 3.460%
Payroll Costs	(880,000)	(680,000)	Increases by 29.41%
Investment Income	856,000	851,000	Increases by 0.5875%
Net Income	2,088,000	940,000	Increases by 122.12 %
ASSETS/ (LIABILITIES)
Fixed Assets	941,000	1,064,000	Decreases by 11.56%
Investments	11,383.000	10,577,000	Increases by 7.62 %
Outstanding Claim Settlement	(8,483,000)	(8,795,000)	Increases by 3.547 %
Shareholders’ Equity	(6,088,000)	(4,993,000)	Increases by 21.93 %
RATIOS
Net Margin	36.180 %	16.046 %	Increaes by 125.47 %
Return on Investment	99.25%	91.95%

Net margin = Net profit / Sales i.e premium

Significant Risk factors are –

1. As the managing director is directly connected by chairman of board of directors by marriage so They will try to maximize the return of investment over and above 25 % , so as to get 40 % of profit .

Consequently , Investment costs may be overstated in the balance sheet and understatement of claims outstanding . This is for to show more investment so as to get investment income and profit both.

It is internal risk related to management of Company .Auditors has to focus on these point majorly..

1. Provisions of outstanding claims is understated so Mr.Tom Brown has to give attention towards outstanding claims.

Check whether the provisions is done on the basis of related policy and there is no understatement of liability.

It is type of liability risk company that ultimately result into profit.

1. As early audit reports the Commercial building owned by the company is overstated .

Auditors has to find out to reflect true and fair financial position so to better reflection of claims.

It is financial risk.

1. As the company fails to access periodic balance of dues to be recovered from customers ,this is become main risk as Claim is not receiving in regularly way .This will result in undertstament of income and debtors and may affect net margin in net .

And Tax liability will also get hit .

It is Startegic risk

1. MD is making sure to keep provisions as low as possible ultimately balance sheet is not reflecting true position .Auditors has to apply the auit procedures according to ternms and conditions of policy .

Operational risk and related to management.