Question

What are some of the risk factors that indicates that financial statements may be misstated and the potential risks factors that this might and how to address the risks of material misstatements

Answer 1

Factors that indicates that Financial Statement may be misstated:-

1. Overstating Revenues

Because net income equals revenue minus expenses, any time revenues are overstated, net income also will be overstated.

Revenue can be overstated by doing the following:

• Recording fictitious revenue
• Recognizing revenue prematurely
• Understating sales returns

2. Understating Expenses

Understating expenses is a fraudulent technique that has the same effect on net income as overstating revenues. Because net income equals revenue minus expenses, any time expenses are understated, net income will be overstated.

Expenses can be understated by:

• Postponing expense recognition
• Capitalizing expenses (i.e., recording an expense as an asset)

3. Understating Liabilities

The fewer liabilities—or the less debt—a company has, the healthier and less risky it appears. Because the balance sheet must remain in balance, it will appear that more of the company is owned than owed.

This effect occurs because if a liability is understated, there is usually an expense that is not recorded (giving rise to the debt). As was explained in the previous section, if expenses are understated, net income is overstated, which in turn overstates equity. Note that these fraudulent financial reporting schemes are not necessarily mutually exclusive.

Liabilities can be understated by:

• Completely omitting some of them from the financial statements; or
• Recording them at an amount lower than what is proper    4 . Overstating Assets

• Overstating assets will achieve the same objectives as understating liabilities. The more assets a company has, the healthier it appears. Because the balance sheet must remain in balance, it will appear that more of the company is owned than owed.

  This effect occurs because if an asset is overstated, the company is not going to record a corresponding nonexistent or overstated debt for the nonexistent or overstated asset. Rather, there is usually a revenue that also was recorded. As was explained earlier in this chapter, if revenues are overstated, net income is overstated, which in turn overstates equity. Again notice how these fraudulent financial reporting schemes are not necessarily mutually exclusive.

  Any asset can be overstated, but commonly the following assets are targeted:

• Inventory
• Accounts receivable
• Fixed assets (property, plant, and equipment)

Address teh risks of material misstatments:

1. The auditor should determine overall responses to address risks of material misstatement at the financial statement level. “The phrase over all responses” mean that the auditor should:

– maintain professional skepticism in gathering and evaluating audit evidence
– delegate the work to more experienced and skilled staff
– consult with experts
– modify nature, timing and extent of audit procedures as overall response.

2. Understanding of control environment assists the auditor in assessment of risks of material misstatements at the financial statement level. For example, if control environment is weak, the auditor may use a substantive approach; else combined approach (tests of controls as well as substantive procedures) may be used.

The overall response is affected by control environment and inherent risk at financial statement level. Such response includes consideration when to use restrictive substantive procedure or expanded substantive procedures.

Specific response to material misstatement involves designing and performing appropriate tests of controls and substantive procedures.

3. Nature of audit procedures refers to two aspects:

– Whether to perform test of control or substantive procedures
– Selection of type of procedures i.e., inspection, observation inquiry, confirmation, recalculation, performance or analytical procedures.

4.

FINANCIAL STATEMENT ASSERTIONS

The objective of audit is expression of opinion whether the financial statements give true and fair view. To attain this objective, the auditor identifies specific objectives for each account reported in the financial statements. These specific objectives are derived from the assertions made by management that are contained in the financial statements.

The financial statements’ assertions are categorized in three classifications.

a). Assertions about class of transactions and events for the period under audit.

b). Assertion about account balances at year end

c). Assertions about presentation and disclosures