Question

Question 1

Inherent risks can be classified according to their nature, such as “unusual pressure on management” or “account likely to require adjustments”; and also their level as either a “financial report level inherent risk” or an “assertion level inherent risk”.

Required: Below are listed six situations that can give rise to inherent risks. Classify each situation by its nature and level.

Note: In answering this question please write the letter that denotes the situation followed by its nature and level. For example, if you believe that the situation A is an example of “Nature of the Entity”, write: A: Nature of the entity; FR level

SITUATIONS
A. Senior management of your client, Black Pty Ltd, can earn substantial bonuses if they meet certain revenue targets.

B. This the fourth year that you are auditing Brown Pty Ltd. In the past two years you have had to ask Brown to adjust its provision for warranty.

C. You are auditing Blue Pty Ltd (Blue). During the year, Blue’s CFO entered into a number of hedging contracts in an attempt to smooth fluctuations in the costs of imported inventory.

D. Your client, Red Pty Ltd, a leading home builder, hired a new Credit Controller during the year. While this person is highly credentialed, she has not worked in the building industry before.

E. Your client, Green Pty Ltd (Green) sells mobile telephones. Recently, Green’s CFO undertook a comprehensive review of inventory.

Answer 1

SOLUTION:

Inherent risk as a component of Audit risk, refers to the risk which is a part of every audit assignment and is inherent within such an assignment. These represent limitation which are inseparable from an entity’s system of internal controls. Inherent risk is subdivided and assessed at two levels namely; accounts balance I,e assertion level and financial statement level i.e financial report level.

Table showing classification of given situations as per their nature and level

S NO.	SITUATION	NATURE OF INHERENT RISK	LEVEL OF INHERENT RISK
A.	Senior management earning substantial bonuses upon meeting certain revenue targets.	Unusual pressure on management.	Financial Report (FR) level.
B.	Asking client to adjust provision for warranty.	Account likely to require adjustment.	Assertion Level.
C.	Client entering hedging contracts affecting the cost and valuation of imported inventory.	Account likely to require adjustment.	Assertion Level.
D.	Hiring of an inexperienced manager at a key position.	Unusual pressure on management	Financial Report level.
E.	CFO of client undertaking a comprehensive review of inventory.	Account likely to require adjustment.	Assertion Level.