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:

1.Assuming that the Audit Risk is set to 10%, determine the rating for Detection Risk using the Audit Risk Model                                                                                                                                                       

2. If Detection Risk based on preliminary audit procedures is estimated as 15%; what should be done to achieve the desired level of audit risk. How will this impact on the concern expressed for a curtailment in audit costs?

3.Complete the table above for changes in the items noted

Make an appropriate comment against the change computed, indicating how the change will impact the audit risk assessment and the audit work to be done on that area

4. Compute the following ratios:

Net Margin

Return on Investments

Make an appropriate comment against the change computed indicating how the change will impact the risk assessment and audit work to be done on that area   

Answer 1

1) Audit Risk= Inherent

Assume Inherent risk & Control risk

60%*60%*Detection risk= 28% 2) On basis of Detection risk as 15% and other 2 risk as 60% the audit risk will be 5.5% 3) Particulars 2016 2015 %Change Comments Income/(expense) Premiums 5,771,000 5,858,000 1.5% Immaterial Operating Expenses -2,323,000 -2,397,000 3.1% Immaterial Claims Expenses -3,710,000 -3,843,000 3.5% Immaterial Payroll Costs -880,000 -680,000 -29.4% Check for Audit rirk on basis of sample Investment Income 856,000 851,000 -0.6% Immaterial Net Income 2,088,000 940,000 -122.1% Check for Audit rirk on basis of sample ASSETS/ (LIABILITIES) Fixed Asset 941,000 1,064,000 11.6% Check for Audit rirk on basis of sample Investments 11,383.00 10,577,000 99.9% Check for Audit rirk on basis of sample Outstanding Claim Settlement -8,483,000 -8,795,000 3.5% Immaterial Shareholders’ Equity -6,088,000 -4,993,000 -21.9% Check for Audit rirk on basis of sample    4) Ratio NetMargin 36% 16% -125.5% Check for Audit rirk on basis of sample Return on investment 34% 19% -82.2% Check for Audit rirk on basis of sample

There is significant jump in net margin and ROI. The auditor should check the revenue are not overstated or expense are not understated in current year which is leading to significant jump in the margin and rutun on investment.