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                                                

Using your judgement, assign an appropriate risk rating for

Inherent Risk

Control Risk

Provide a brief justification for your risk rating. Use the table below as a guide to assign ratings      

Risk Level	Risk Rating
High	80 – 100%
Medium	50% - 79%
Low	0% - 49%

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

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?                                                                                                

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

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

Answer: The five significant risk factors involved in the scenario are:

1. The director and chairman's compensation includes a share of margin from the total profits, based on company's performance. This may influence the director and chairman to manipulate the profits of the company, so that they can earn extra money from the inflated profitability of the firm.
2. Material Mis-statement shown in the previous year's audit report is still being shown in the current year financial statements.
3. The internal control in connection to the review of the balances doesnt seem to be accurate.
4. The review procedures for claims is inconsistant.
5. The provision for claims, could lead to frauds in collection of receivables.

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

The type of risks noted in the above answer:

1. Inherent Risk: The director and chairman's compensation includes a share of margin from the total profits, based on company's performance. This may influence the director and chairman to manipulate the profits of the company, so that they can earn extra money from the inflated profitability of the firm...........
2. Control Risk: Material Mis-statement shown in the previous year's audit report is still being shown in the current year financial statements.
3. Detection Risk: The internal control in connection to the review of the balances doesnt seem to be accurate.
4. Control Risk: The review procedures for claims is inconsistant.
5. Detection Risk: The provision for claims, could lead to frauds in collection of receivables.  

3. Using your judgement, assign an appropriate risk rating for

Inherent Risk: "Very High Inherent Risk"......Because the chairman and director are actively involved in the operations of the business, they have control over the business, they have access and control to all the information in the business. It would be very easy to manipulate the financial statements for their selfish interest.

Control Risk: "Medium" : The control risk is medium, it can be avoided oro controlled by proper control and detection procedures.

4. Provide a brief justification for your risk rating. Use the table below as a guide to assign ratings

From the above excel sheet info. All of the fields exceeding 10% is risky and needs immediate attention of the management. The auditor needs to devote more time to find out more time towards the risky areas.