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This report is presented as an audit senior of S and Co. about the audit planning of their client Rainbow Paints Co. The report provides an understanding of the assurance concept in audit and explains the meaning of audit risk along with its components. The audit risk components are explained with examples for better understanding of the concept of audit risk in assurance engagement by the professional auditors. It evaluates the internal audit control system and disclosure procedures of the company Rainbow Paints. It also identifies the weaknesses of the system to be addressed during the assurance engagement in accordance with the UK (ISA) standards and IAASB standards. It defines the audit risk at the planning stage of the audit for the company and describes the need and usefulness of risk assessment at the planning stage of the audit. Thus, the report helps learn about the audit engagement risks and weaknesses in the internal control system with guidance to the standards of IAS and IAASB.
1. Audit Risk and three components of audit risk
Audit Risk:
The risks of auditing can be described as the possibility that during the examination of the financial reports of a corporation or an entity, the auditor does not detect any mistakes or deliberate weaknesses (Han et al., 2016). Audit risk is the vulnerability that if the financial results are materially inaccurate the auditor holds an incorrect judgement. The risk is that an auditor would give the financial report an erroneous opinion. The below are instances of deficient audit reports:
Providing a qualified auditor's report when there is no requirement for an audit;
Not underlining an important topic in the audit report;
Reporting on an unqualified audit where a qualification is fairly plausible;
Giving an opinion in the financial report, where an opinion cannot be fairly articulated because the nature of the audit is substantially restricted (Han et al., 2016).
Components of audit risk:
The risk of the audit can be seen as the outcome of the multiple risks faced during the process of the audit. The auditor should evaluate the risks of each aspect of the audit risk in order to maintain the total audit risk of commitments within an acceptable level.
The three audit risk elements are explained as follows:
Inherent risk: The inherent risk is the vulnerability of substantial mistake in the financial report owing to a mistake or misstatement due to non-control variables (Zhang, 2018). This probability is usually shown to be higher if the assessment and estimate of the activities are extremely complicated then this risk may be found higher.
Example: A considerable trading and participation of complicated securities products can be deemed considerably higher by the inherent audit risk of a recently established finance company than an audit for a developed output company operating in a reasonably secure competitive setting (Zhang, 2018).
Control risk: The possibility of a significant mistake in the financial records due to lack of negligence to operate a company's respective measures is the control risk. In order to deter and identify events of theft and mistake, companies should have effective internal control in effect (Zamboni, and Litschig, 2018). In the lack of sufficient internal checks to deter and identify the cases of theft and mistake in the annual report, the control risk of such a company is deemed to be higher.
Example: The control risk evaluation could be larger for a small company with a lack of well-defined responsibilities separation and financial reporting by persons that lack the professional know-how required to prepare account and manage finance (Zamboni, and Litschig, 2018).
Detection risk: Detection risk is the vulnerability that a factual error in financial reporting may not be found by an external auditor. An auditor shall use audit techniques to find substantive errors, either due to theft or omission, in the financial reports. A substance error left unidentified for the auditor may lead in the misinterpretation or failure of important audit assessment (Sardasht, and Rashedi, 2018). Due to the intrinsic constraints of the audit, there is often a detection risk. By raising the size of sampled transfers for thorough testing, auditors can decrease the detection risk.
Example: Risk present in using the sampling methods to provide an audit opinion on the large-sized data in financial statements (Sardasht, and Rashedi, 2018).
2. Identified audit risks at the planning stage of Rainbow Paints Co.
According to International Standard on Auditing (ISA) 315, "Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment" in conjunction with ISA 200, "Overall Objectives of the Independent Auditor and the Conduct of an Audit following International Standards on Auditing"; The auditor's purpose is to recognise and evaluate, by knowing the organisation and its environment, which include internal monitoring of the organization, the possible risks of material mistakes, whether attributable to theft or negligence and therefore to devise and incorporate alternatives to the risk assessment of material mistaking (Broberg et al., 2018).
ISA 330, "The Auditor's Responses to Assessed Risks", convey how to collect adequate evidence of measured risks of material errors by the creation and execution of the required approaches to these risks from auditors. ISA 330 allows an auditor to both conduct substantial material things proceedings, regardless of the risk identified by material errors, and to establish and enforce substantive proceedings in reference of each material type of purchases, account balance and reporting (Velte and Issa, 2019).
Rainbow Paints Co. is a manufacturer of paint and has provided with certain internal control and disclosure information that should be identified for the assessment of audit risks at the stage of planning. These risks are the material items that should be audited with due diligence to provide a true and fair opinion on the financial statements of the entity (Velte and Issa, 2019). Some of these audit items are pointed as follows:
The firm is the exclusive provider of paint for Homewares on a one-year term. By considerably lowering its rates, it obtained the deal and gave a four-month credit term, the usual credit period of the business is one month. The audit should pay specific attention to this contract as it amounts to a huge portion of company's revenue and the terms of credit in this contract is different than the usual practice of the company (Chou, 2015). The credit term will create differences in the cash flow statement and the approval of the terms should be verified by the auditor for providing a true and fair opinion. Therefore, it is an identified matter by the auditor that will be considered by him in the planning stage.
The auditor should assess the risk of credit approvals and pre-payments for the shipments as it could be a window for fraud by the internal management and accountants. Therefore, it should be identified as a risky matter in the planning of audit (Chou, 2015).
The inventory system of Rainbow Paints Co. is very complicated and the counting of the items is done once in a year as the warehouse is divided into 12 areas. The team of counting inventory includes the warehouse members and internal audit team members. It has been discussed that the discrepancies are just noted and adjusted in the finance department (Patriarca et al., 2017). There is no procedure to allocate the reason for such discrepancies in the physical and perpetual stock. Inventory is an important element in the audit process and it covers a significant portion of an organization's asset. It requires special attention of the auditor to detect any chances of fraud and error. The internal system of Rainbow Paints is weak in accounting and management of its inventory and therefore it implies the audit risk in the planning stage. The auditor should identify the risk of internal control and respond according to the ISA theories, practical approaches and due diligence for providing a correct opinion on the financial statements of the entity (Velte and Issa, 2019).
The finance director of Rainbow Paints has left the office due to some disputes and has filed a case against the company for unfair dismissal. The company has not provided for any disclosure or provision in this regard considering the claim has no merit. This is not the correct practice of accounting as per the GAAP and the conventions of accounting. This is therefore identified as an audit risk in the initial step of audit that is audit planning (Chou, 2015). The auditor should check the disclosure in the financial statements and provide for the corrective actions to be taken to meet the requirements of the standards and then provide its opinion on the same.
The identification of the audit risks provides an insight that there is high control risk in Rainbow Paints Co. due to a weak inventory management system and internal disputes leading to the vacancy of office by the finance director. The auditor should follow the ISA practices to carry out the audit procedure for providing reasonable assurance (Patriarca et al., 2017).
3. Importance of assessing risks at the planning stage of an audit
ISA 315 (the UK and Ireland): "Identifying and Assessing the Risks of Material Misstatement through Understanding the Entity and Its Environment", allows the auditors at a financial reporting and claim stage to define and measure the likelihood of material errors, whether triggered by fraud or accident (Council, 2015).
Risk management assessments are carried out to develop an overview of the business and the environment, like internal monitoring, and recognise and evaluate the hazards of the financial results, either owing to fraud or omission, as a consequence of material errors. These activities are typically carried out until the financial year is finished and entail numerous methods like management investigations and other chosen staff, review procedures, organisational control assessments, and record examination to established controls (Council, 2015).
There are numerous reasons which explain the significance of assessing the risk of audit at the initial stage of audit procedure, that is the planning stage. Some of these are pointed out as follows:
For auditors it is beneficial to know risk at the planning level, so that emphasis is early concentrated on the fields where there is a strong likelihood of material wrongdoing. The auditor frequently tries to consider the organization in depth by a detailed risk evaluation.
Risk management often helps the auditor to decide whether the company is a problem (Cannon and Bedard, 2017).
Any suspicious transfers or balances are often reported early, to comply with them promptly. Further, as most auditors follow a risk-based audit plan, the audit methods and comprehensive plans of work must be reviewed at an initial level (Cannon and Bedard, 2017).
Risk identification can therefore contribute to an appropriate audit at an early point. In comparison to balance or transfers which may be immaterial or impossible to have mistaken, the team reflects instead on their time and effort (Patriarca et al., 2017). In fact, the early risk evaluation can imply that more competent workers for greater risk audits and moderate risk balancing are chosen for the most suitable team.
In the end, the possibility of an unsuitable audit opinion can be minimised by a diligent risk assessment. The audit concentrated on the core problem areas and should thus have found both material mistakes and issued the right opinion (Patriarca et al., 2017). The auditor should be able to grasp the risks of bribery, financial manipulation etc.
Conclusion
The report has described the audit risk and the three elements of audit risk with suitable examples for the clear understanding of the audit risk concept. It has assessed the inherent and control risk of Rainbow Paints Company. It has identified the various audit risks present in the entity at the time of audit planning. The study has also explained the relevant standards of auditing that helps the auditor in the risk assessment procedure. The study has also highlighted the significance of risk assessment at the initial stage of audit planning and provided the advantages of the risk assessment in the planning stage. Therefore, the report has provided an understanding of the audit risks, their identification and assessment importance in the audit process at the planning stage for providing reasonable assurance to the entities.
Reference
Broberg, P., Umans, T., Skog, P. and Theodorsson, E., 2018. Auditors' professional and organizational identities and commercialization in audit firms. Accounting, Auditing & Accountability Journal.
Cannon, N.H. and Bedard, J.C., 2017. Auditing challenging fair value measurements: Evidence from the field. The Accounting Review, 92(4), pp.81-114.
Council, F.R., 2015. Enhancing confidence in audit: Proposed revisions to the ethical standard, auditing standards, UK corporate governance code and guidance on audit committees.
Han, S., Rezaee, Z., Xue, L. and Zhang, J.H., 2016. The association between information technology investments and audit risk. Journal of Information Systems, 30(1), pp.93-116.
Patriarca, R., Di Gravio, G., Costantino, F. and Tronci, M., 2017. The Functional Resonance Analysis Method for a systemic risk based environmental auditing in a sinter plant: A semi-quantitative approach. Environmental Impact Assessment Review, 63, pp.72-86.
Sardasht, M.S. and Rashedi, E., 2018. Identifying Influencing Factors of Audit Risk Model: A Combined Fuzzy ANP-DEMATEL Approach. The International Journal of Digital Accounting Research, 18(24), pp.69-117.
Velte, P. and Issa, J., 2019. The impact of key audit matter (KAM) disclosure in audit reports on stakeholders' reactions: a literature review. Problems and Perspectives in Management, 17(3), pp.323-341.
Zamboni, Y. and Litschig, S., 2018. Audit risk and rent extraction: Evidence from a randomized evaluation in Brazil. Journal of Development Economics, 134, pp.133-149.
