Question

LLL Avionics Ltd. has contacted your certified general accounting firm to inquire about the cost of an external audit. The company's president explained that he feels that "the previous auditor charged too much and only issued a qualified opinion." Your firm was recommended to LLL by your bank manager. LLL has a large loan request at the bank, and the interest rate of the new loan will depend on the audit opinion. As the partner in charge of this file, you interviewed the president and controller of the company as part of your decision to accept or reject LLL as a client. You have found that the company has a new design for an aircraft and plans to borrow funds from the bank and to issue common shares to finance a prototype plane to test the design. The new funds will also greatly improve the company's balance sheet by providing the funds to bring the company's existing bank loan up-to-date. If the design is successful, more common shares will be issued for more capital.
The controller was very helpful in your discussions, and you note his high level of enthusiasm for the project as this is his first job at this level. However, the president was to not so helpful and seemed annoyed with your questions.

Required
Indicate five factors in the above situation that point to high inherent risk. Explain your answer.

Answer 1

Some of the factors that indicate high inherent risk include:

•   Management integrity is in question as the president is unwilling to provide information.

 

•   The client’s motivation is to secure an audit opinion that will assist it in getting a bank loan to pay for existing debt in arrears. This suggests high inherent risk as the client has financial problems, which could motivate management to make misstatements to make the financial statements look better.

 

•   There is high inherent risk due to the fact that the previous audit appears to have resulted in a qualified opinion.

 

•   This would be an initial engagement for your firm; therefore inherent risk would be higher than usual.

 

•   The audited financial statements would be used by the bank and potential shareholders, therefore there is a wide group of users who could potentially sue the auditor for negligence.

 

•   The company is planning on borrowing funds to build a prototype of an experimental plane, which would likely involve unusual and complex calculations and accounting policy issues.

•   The company is planning on borrowing funds to build a prototype of an experimental plane, which would likely involve unusual and complex calculations and accounting policy issues.