Question

Consider the following independent situations, all of which apply to audits of entities for the year ended 31 December 2019:

(i) In July 2019, Alpha Ltd started using a new general ledger software package. The Financial Controller is impressed with the new system, because management accounts are easily produced and allow detailed comparisons with budgets and prior-period figures across product lines and geographical areas. The conversion to the new system went smoothly. As it is a popular computer package, it required only minor modifications.

(ii) As part of a computer systems conversion in Beta Ltd, the position of Systems Administrator was created. This position is responsible for all systems maintenance, including data backups and modifications. These tasks were previously the responsibility of the Accountant.

(iii) Gamma Ltd is a large supermarket chain with outlets in all major cities in the country. In August 2019 Gamma Ltd contracted out its payroll data processing in each city to an independent computer service provider.

(iv) Delta Ltd is a long established firm which has been operating a hotel for over 10 years. During this time, it has adopted a conservative business strategy that has seen it produce adequate, though slightly unimpressive, results. A new CEO was appointed to run the firm from September 2019. He has already released his plans for renovating the hotel, despite not officially serving as CEO yet. You have also heard him discuss the implementation of a new marketing strategy to improve occupancy rates.

Required:

For each situation (i) to (iv) above.

(a) State whether Inherent Risk, Control Risk or Detection Risk have increased or decreased.

(b) Provide an explanation for your answer in (a)

Answer 1

1. In this case the detection risk will increase as detection risk is the risk in which auditors fails to detect material mistatement in financial statements. In this case it is easy to get detailed budget reports etc but there is still scope of improvement which is there. Minor modifications are required to get the accurate results, therefore, if auditor rely's on the current position of the software then detection risk will increase.  To get lower detection risk, increasing the sample size for audit testing is helpful.

2. In this case the control risk will decrease as the control risk is the chance that financial statements are materially misstated due to failures in a company’s system of internal controls.Therefore if a System administrator is assigned to be responsible for all systems maintenance, including data backups and modifications then the chances of error will be minimum.

3. In this case the inherent risk will be decreased . Inherent risk is the risk which states the process of a company records complex transactions and activities. A company collecting data from several subsidiaries with the intention of combining that information later is considered to be engaging in complex work, which could comprise material misstatements and thus resulting in more of inherent risk, but in this case the company has contracted out its payroll data processing in each city to an independent computer service provider which will result in proper management of this process by experts thus resulting in low inherent risk

4. In this case the control risk will be decreased as an organization’s leadership is responsible for designing, implementing, and maintaining a system of internal controls that can adequately prevent the loss of revenue in future. However, it’s not easy for a company to maintain a solid system of internal controls. To maintain a solid system of internal controls, management has to alter the system periodically to fit ongoing changes in the business.

Control risks happen because of the limitations of a company’s internal control system. If the internal control systems aren’t reviewed periodically, it will likely lose its effectiveness over time. But in this case the management is reviewing their system properly, as soon as they know that the strategy is slightly unimpressive they have appointed the new CEO, who is controlling the matters properly.