Assessing Inherent Risk and Performing Analytical Procedure
While carrying out the audit procedure, the auditor must determine the inherent risk associated with various accounts. In assessing the level of inherent risk, the level of internal control must be analysed and the susceptibility of the financial statement to material misstatement are also analysed. The factors that can be analysed to assess the level of inherent risk are –
In the given situation the Posh Limited hired the new CEO during 2013 and the company experienced the growth rate in profit ranged to 6% during 2013 and 2015. As the board of directors were satisfied with the performance of the CEO, they offered him with cash bonus in every year if the growth exceeds 5%. The CEO was dedicated to increase the performance and planned to open 15 new stores. In the given case of Posh Limited, as the CEO was to get annual cash bonus if the profit exceed 5%, there is a likelihood that the CEO will try to manipulate the profit, so that he can get the cash bonus. This risk shall be analytically checked to remove the likelihood of risk as it is clear from the given financial results that the profit growth for 2016 is over 5%. (Barndt, Fuller & Flynn, 2016).
On the other hand, the analytical procedures are performed at the planning period to determine the timing, nature and extent of work that are required to be performed under the audit process. The analytical procedure includes the following:
- The interest coverage ratio of the company must be compared with the industrial average
- The debt to asset ratio of the company must be compared with the industrial average
- Comparing the growth percentage of profit of the client with the industry data
- Comparing the inventory turnover ratio of Posh Limited or the the similar data of prior period (Walsh, 2014).
Control risk and relevant internal control for audit objectives
Control risk is the risk of likelihood that the misstatement above the tolerance level will not be detected or prevented by the internet control system of the client. Generally, there are 4 phases for understanding the internal control and evaluating the control risk. In 1st phase the auditor gets an idea of internal controls. At next phase the auditor make a preliminary analysis of control risk and carry out control tests in every audit as part of the 3rd phase. The auditor utilises the results from the controls test for both the internal control and audit report over financial reporting and to analyze the control risk that is in phase 4 (Jiang & Son 2015).
The management generally has 3 bigger objectives while designing for an effective system of internal control. They are:
- Financial reporting reliability: the report of Posh limited must be prepared with the the regulations under the GAAP. The financial statement of the company do not include the write-down expense of inventory, therefore, they are not following the standards of GAAP.
- Effectiveness and efficiency of operations: as per the view of the chief accountant, the unrealised inventory is not required to recognize the loses from inventory. This will hamper the effectiveness and efficiency of the financial statements as well as the operations of the company.
- Compliance with regulations and laws: the chief accountant is the close friends of the CEO and he keeps him updated regarding the financial progress of the company and also discuss the crucial accounting issues with the CEO. This violates the regulations and compliance of the auditing standard (Zhao et al., 2016).
In the given circumstances, if the loan raised for the expansion of Posh Limited, it can be seen from the given ratios that immediately after obtaining the loan during February 2016, the debt asset ratio of the company goes up to 62% that is higher than the prescribed limit of 60% and the interest coverage ratio fell to 9.6% that is lower than the prescribed requirement of 10%. However, when the full year is considered, it is identified that the both the ratios are as per the requirement. Therefore, it can be said that the company’s internal control and risk control approach are in place.
The inherent risks are associated with the structure or model of the organization like financial institutions and banks that have the inherent risk of cash robbery, misstatement that are handled at big volumes. These risks cannot be controlled owing to the fundamental structure of the organization. On the other hand, control risks are the risks that take place due to the implementation of internal control for minimizing the material misstatements. Managements of any business design their internal control to minimize the level of control risk and prevent the occurrence of material misstatement (Jans, Alles and Vasarhelyi, 2014). Inherent risk is the original risk level (probability x impact) before application of any treatment for mitigating risk.
In the given case study of Posh limited, the record keeping system is in order except for the process of sales transaction. The transaction for sales are made at the end of each day and by that time the delivery are already made. Therefore, the sales transactions are susceptible to inherent risk as the sales transaction shall be processed at the time of delivery only. Further, as the inventory turnover ratios of the company are in continuously decreasing, there must be some control procedure for inventory to mitigate the inherent risk. The most crucial thing associated with the inventory is the proper documentation. The receipt of order must be signed at the time when it is received by the company. The personnel who is in charge of receiving the stock must check it fully and assure that every single item that is been ordered is delivered at accurate amount and exact condition. The incomplete order shall never be signed. Receiving is the 1st gateway for inventory and shall be properly controlled to assure proper internal control (Glover, Prawitt & Drake, 2014).
Substantive test procedures for the transactions to assess the monetary misstatements for determining whether the audit objectives related to accounting transaction have been satisfied for all the transactions or not.
Substantive tests are carried out by Posh Limited to verify the accurateness of the clients accounting system. This is fulfilled by assessing the accounting system of the client. This is performed by going through the each individual transaction to analyze that whether they are recorded and summarized correctly in the journals, general ledgers or master files. The substantive tests procedures are also concerned with the transaction classes like cash receipts, acquisitions and payroll. Tracking the amounts from the voucher file for acquisition of journal is an instance for the substantive test procedure of the transactions (DeFond & Lennox, 2016).
One test that can be carried out to control the mentioned accounts of Posh Limited is dual-purpose test. As the substantive test as well as the control test both includes the inspection of the documents for each transaction, they are usually performed simultaneously. Though various tests are performed, it is crucial to be specific for the aim of the specific procedure. The Dual-purpose test specifically define regarding which tests are to be included as they are planned specifically to deliver direct evidence of substantive as well as control matters (PricewaterhouseCoopers & Everson, 2013).
Barndt, R. J., Fuller, L. R., & Flynn, K. E. (2016). Teaching Inherent Risk and Tolerable Misstatement in Auditing: A Modified Delphi Method as a Teaching Tool. In Advances in Accounting Education: Teaching and Curriculum Innovations (pp. 125-140). Emerald Group Publishing Limited. (Lecture 4)
DeFond, M. L., & Lennox, C. S. (2016). Do PCAOB Inspections Improve the Quality of Internal Control Audits?. Journal of Accounting Research. (Lecture 7)
Glover, S. M., Prawitt, D. F., & Drake, M. S. (2014). Between a Rock and a Hard Place: A Path Forward for Using Substantive Analytical Procedures in Auditing Large P&L Accounts: Commentary and Analysis. Auditing: A Journal of Practice & Theory, 34(3), 161-179. (Lecture 6)
Jans, M., Alles, M.G. and Vasarhelyi, M.A., 2014. A field study on the use of process mining of event logs as an analytical procedure in auditing. The Accounting Review, 89(5), pp.1751-1773. (Lecture 6)
Jiang, W., & Son, M. (2015). Do Audit Fees Reflect Risk Premiums for Control Risk?. Journal of Accounting, Auditing & Finance, 30(3), 318-340. (Lecture 5)
PricewaterhouseCoopers (Firme), & Everson, M. E. (2013). Internal control: Integrated framework. Committee of Sponsoring Organizations of the Treadway Commission. (Lecture 7)
Walsh, A. (2014). Normative causation and inherent risk in the medical negligence context:'Paul v Cooke' NSWCA 311. Precedent (Sydney, NSW), (121), 51. (Lecture 4)
Zhao, M., Cooney, M. T., Klipstein-Grobusch, K., Vaartjes, I., De Bacquer, D., De Sutter, J., ... & AlFaleh, H. (2016). Simplifying the audit of risk factor recording and control: A report from an international study in 11 countries. European journal of preventive cardiology, 23(11), 1202-1210. (Lecture 5)