Question

Identify a factor that makes for high inherent risk in audits and discuss why it would make inherent risk higher.

Answer 1

Audit Risk

Audit risk is the risk than an auditor may issue an unqualified opinion on materially misstated financial statements. Audit risk is the risk that the auditor gives an inappropriate audit opinion. For example, the auditor fails to detect material misstatement(s) after completing the audit and expresses an unqualified opinion despite the fact that the financial statements are materially misstated.

The Audit Risk Model

Audit risk has two elements: Risk of material misstatement and detection risk. Risk of material misstatement is the combination of inherent risk and control risk.

Inherent Risk

The susceptibility of an assertion about a transaction, account balance or disclosure to a misstatement, individually or in total with other misstatements, that can be material, assuming no related internal controls.

This means that the auditor assesses the likelihood of material misstatement before considering the effectiveness and impact of the client entity’s internal control.

Factors affecting a client entity’s inherent risk. Common factors include:

1) Nature of the Client’s Business:- An entity in the fast-changing high-technology industry faces a risk of inventory obsolescence. Rapid innovations can cause the entity’s products to become obsolete very quickly and the inventory may not be appropriately valued. This risk is inherent in the business of the entity.

2) Results of Previous Audits:- If material misstatements were discovered in the previous audit, it is possible that same kind of material misstatements may have occurred in the current year.

For example, when material misstatements, individually or in total, in pricing inventory had been discovered in the previous audit, the auditor tends to use a high inherent risk in the current year’s audit and performs more extensive tests in order to assess whether the deficiency in the client’s system has been followed up and amended.

3) Initial vs. Repeat Engagement:- After auditing the same client for a number of years, the auditor gains substantial experience and relevant knowledge about the engagement. It makes sense for the auditor to feel more confident in auditing the same client instead of a new one.

Usually, the auditor is likely to set a high inherent risk in the first year of an audit and gradually lowers this risk level as they obtain more experience and knowledge about the client.

4) Related Parties:- Transactions between parent and subsidiary entities, and transactions between management or the owner and the entity, are considered relatedparty transactions.

Since related-party transactions do not take place between two independent parties at arm’s length or on an equal footing, there is a lack of transparency. Without enough confidence, the auditor probably sets a high inherent risk in the audit.

5) Non-routine Transactions:- Non-routine or unusual transactions include, but are not limited to, losses due to fires, major property acquisitions, asset write-offs, and new product implementation.

When recording transactions that occur infrequently, the client may not have sufficient and adequate experience to record them correctly. The client is more likely to make mistake(s) due to a lack of relevant experience. It is logical for the auditor to estimate a high inherent risk in this situation.

6) Judgment Required :- There are situations when the management of the client entity needs to exercise a great deal of judgment in estimating and recording transactions.

Examples: certain investments recorded at fair value, allowances for uncollectible trade receivables, write-off of obsolete inventory, product warranty payable, and reserves for bank loan loss.

The greater the exercise of judgment required, the greater the likelihood of misstatements. Thus, the auditor is more likely to assess a high inherent risk.